Flash Insights: Germany’s fiscal shift—an opening gambit

The CDU/CSU (the Christian Democratic Union and Christian Social Union) and the SPD (the Social Democratic Party), the likely new coalition partners after Germany’s February elections. They agreed to make a historic change to the country’s conservative fiscal approach. The aim is to boost a struggling economy and increase defense spending. The proposal includes three main changes:

• A reform of the constitutional debt brake. This rule traditionally allowed a maximum deficit of 0.35% of gross domestic product (GDP). Going forward, however, it will exclude defense spending above 1% of GDP. Since Germany currently allocates around 2% of GDP on its military and wants to increase this target, the move will free up money for other expenditures.
• The creation of a €500 billion infrastructure fund, to be spent over the next 10 years. This total amount is equivalent to 11.6% of 2024 GDP.
• A reform of the regional debt rule. Currently, federal states cannot spend more than they collect in revenues. The proposal would lift the structural deficit allowance for states to bring it in line with the national limit.

Germany has traditionally been one of the most fiscally conservative countries in the European Union (EU), so this move is significant. It will likely open the door for increased spending across other member states, too, which is necessary if the EU wishes to raise its defense capabilities.

Another point of significance is the political angle. The current Bundestag will likely approve the proposal, which was unforeseen. The newly elected parliament—yet to take office—will present a "blocking minority," made up of the far-left and far-right parties, which will prevent centrist parties reaching the two-thirds majority necessary to amend the constitution or approve ex-budget items (such as the infrastructure fund). Therefore, the idea is to vote on the defense package in the outgoing parliament, where the CDU and SPD hold enough votes to approve it—with help from the Greens. While there’s a risk that some legal aspects of this fiscal overhaul might be challenged in the German Constitutional Court , the new fiscal paradigm is here to stay.

What does this mean for the German and European economies?

The timing of new bond issuance and of the implementation of actual projects, as well as the subsequent macroeconomic impact, all remain uncertain. Both infrastructure and military projects take time. We expect first moves in late 2025, with the majority of projects concentrated in 2026 and 2027 and onwards. However, this is a perceived structural change for Germany from the status quo of no growth. Starting from 2026, we now see upside risks to the growth outlook.

It is important to note, though, that military spending has a low multiplier effect and there is still a large import component associated with it. The EU will want to focus on spending in Europe, but European arms manufacturers are still relatively small and have limited capacity. That is why expenditure will likely need to ramp up alongside domestic production capabilities.

What does this mean for European defense spending?

Europe has underspent on defense for decades, with defense expenditure declining from more than 3% of real GDP in the 1980s to around 1.5% in the 2010s, as the EU enjoyed the so-called peace dividend.¹ However, Russia’s invasion of Ukraine led to an uptick in spending to around 2% of GDP in 2024.² In our new geopolitical reality, military spending between 3%–4% does not seem too high, in our view. Moreover, this higher level would need to be maintained for many years or even decades in order to sustainably improve Europe’s military stature.

The EU now needs to figure out how to finance its increased security need. The European Commission is proposing a ReArm Europe plan, which would comprise:

1. An escape clause from the current fiscal rules. However, this is transitory in nature—while attempting to address a structural issue—and possibly lacks the proper incentives for bold actions, as there is no commonly defined defense spending goal.
2. A €150 billion instrument similar to the pandemic Support to Mitigate Unemployment Risks in an Emergency (SURE) program. Its size is small, however, and it’s unclear if it is attractive enough for Germany to participate.
3. Repurposing existing unspent or unallocated EU program money (€93 billion of NextGenerationEU plus Cohesion funds up to €60 billion per year) could be agreed, but these involve trade-offs with other spending already allocated.

Thus, some additional bond issuance at the country level, intended to increase national defense spending targets, will likely come through, but how much it will be remains unclear. A renewed common funding instrument would be a game-changer and would have the added benefit of bringing the EU closer together. So far, there are no indications that this is happening, as the political incentives remain limited only to certain countries. Additionally, several countries—such as France and Italy—are already struggling with high budget deficits and debt levels, and they have less room for spending increases. Nevertheless, the situation remains very fluid, and we cannot exclude rapid, radical changes towards a closer EU over the coming weeks and months. In the end, as French Diplomat Jean Monnet said: “Europe will be forged in crises and will be the sum of the solutions adopted for those crises.”

Why is this important for bond markets?

For the European Central Bank (ECB), significant fiscal easing calls for prudence. Germany’s debt reform is material information for the hawks on the ECB’s Governing Council, as it softens the structural weakness argument that could pull inflation down over the medium term. The March 6 ECB monetary policy meeting confirmed this, as ECB President Christine Lagarde stressed that uncertainty is “phenomenal,” driven by both internal and external sources. We believe this means that the ECB will be even more data dependent going forward. Some additional policy rate cuts are still possible this year since short-term growth prospects remain grim, but the ECB’s optionality has widened.

In bond markets, increased German and European spending means issuing more debt seems likely. This indicates, in our view, the likelihood of structurally higher yields on European bonds over the medium term. Since the start of March, the yield on the 10-year Bund has risen from 2.41% to 2.87%. However, the extent of EU or intergovernmental support for increased defense spending remains uncertain. That is why it is difficult to provide any solid outlook on what’s to come. Over the medium term, we could envisage 10-year Bund yields between 3%–3.5% but we will keep a close eye on market developments.