Friedrich Merz’s “whatever it takes” plan to unleash defence spending and overhaul German infrastructure is set to usher in the largest economic stimulus since the fall of the Berlin Wall.
While details still need to be fleshed out, the historic deal between the chancellor-in-waiting and his likely coalition partners, the centre-left Social Democrats, allows for potentially unlimited borrowing for defence spending and creates a €500bn 10-year fund to drive infrastructure investments.
Economists expect the plan, which must still be approved by a two-thirds supermajority in parliament, can provide up to €1tn of additional borrowing over the next decade — a sum that represents more than a fifth of Germany’s entire economic output — and resurrect Europe’s largest economy after years of stagnation.
“This is very good news for military capacity and also economic growth,” said Jens Südekum, professor of international economics at Heinrich Heine University Düsseldorf.
The plan also breaks with more than two decades of fiscal conservatism, and puts government spending on track to surge at a pace not seen since the fall of the Wall in 1989, with economists at Hamburg Commercial Bank anticipating a rise in the debt-to-GDP level from 63 to 84 per cent.
“Both the speed at which this is happening and the magnitude of the prospective fiscal expansion is reminiscent of German reunification,” said Robin Winkler, economist at Deutsche Bank.
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In the five years after reunification in October 1990, German debt levels shot up from 41 to 60 per cent of GDP as the country increased public investment into the former German Democratic Republic’s rundown infrastructure.
Since then, successive governments have adopted a model of fiscal restraint that resulted in years of under-investment in public infrastructure — characterised by the increasing inability of Deutsche Bahn trains to arrive on time.
“I look forward to the day in the — probably still somewhat distant — future when German trains may run as fast and punctual as those in France, Switzerland or Austria,” said Holger Schmieding, economist at Berenberg Bank.
At the core of the problem has been a “debt brake”, written into Germany’s constitution in 2009 at the peak of the global financial crisis, that limited the government’s capacity to take on new debt to 0.35 per cent of GDP — one of the most stringent anti-borrowing laws in history. Much of the fiscal space that did exist was spent on the welfare state and social benefits.
Merz’s plans bypass the debt brake by enabling the exclusion of everything over 1 per cent of GDP spent on defence. Goldman Sachs anticipates that the plan will drive German defence spending to as much as 3.5 per cent of GDP by 2027 — up from 2.1 per cent in 2024 and a mere 1.5 per cent in earlier years, according to Nato numbers.
Merz’s decision to eschew fiscal restraint comes amid a rapid unravelling of security ties between the US and Europe. With President Donald Trump threatening to end US security guarantees and at least temporarily cutting off support for Ukraine, Merz said Germany had to do away with guardrails to defend Europe against “threats to freedom and peace”.
While German borrowing costs surged by the most in 17 years on Wednesday, economists were unfazed about the potential fallout on debt sustainability.
Even with a debt-to-GDP ratio of about 84 per cent, German public leverage would be “still pretty favourable” compared with most peers, said Cyrus de la Rubia, chief economist at Hamburg Commercial Bank, pointing to ratios of 115 per cent in France and 124 per cent in the US.
And the higher borrowing is widely expected to boost output.
“[It will remove] many of the obstacles that have recently hindered Germany’s economic growth,” said Sebastian Dullien, research director at the Düsseldorf-based Macroeconomic Policy Institute. He said he believed that a 2 per cent growth rate — roughly in line with Germany’s average of 1.8 per cent over the 15 years to the pandemic — was now possible.
Niklas Garnadt, economist at Goldman Sachs, said a growth rate of 2 per cent was now on the cards as soon as 2026 — a figure that is double the investment bank’s previous forecast of 1 per cent, made before Merz unveiled his plan.
Some infrastructure projects, such as a €53bn investment plan for Germany’s creaking railway infrastructure between 2025 and 2027 that was fleshed out late last year, are largely “shovel-ready”, providing the potential to more or less immediately lift growth.
Boosting defence expenditure may have a smaller impact on growth than other forms of public spending, given Europe’s continued reliance on American defence products.
At least €21bn of the €100bn special fund that Berlin earmarked for overhauling the armed forces in 2022 was used to buy US-engineered F-35 fighter jets, Chinook helicopters and Patriot air defence systems.
“It will take a few years to level up the domestic defence industry,” said Deutsche Bank’s Winkler, though he added that he was optimistic that higher military spending could increase the country’s potential growth rate by triggering more innovation.
A German defence ministry spokesperson said on Wednesday that the government would aim to direct money not only into the biggest companies but also smaller firms and start-ups “to create spillover effects on the entire economy”.
Shares of German defence companies, including Rheinmetall, Hensoldt and Thyssenkrupp, continued their sharp rally on Wednesday following Merz’s announcement the previous night, building on several weeks of gains.
After years of concern over looming deindustrialisation amid high energy costs and tough competition from China, the push to increase domestic manufacturing gave a new lease of life to struggling giants such as Volkswagen, whose shares were up close to 5 per cent on Wednesday.
Some economists have argued that idle production capacity in the struggling car industry could be repurposed for the defence industry.
The announcement of the infrastructure package also boosted cement maker Heidelberg Materials and construction group Hochtief, which were among the best performing German blue-chips on Wednesday with gains of up to 14 per cent.
The €500bn fund will fill much of the €600bn spending gap Germany needs to fill to improve its infrastructure. The €600bn estimate, made by think-tanks IW and IMK last year, said a third of the figure would need to be spent on decarbonisation and another €177bn on local infrastructure.
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Sceptics, however, warned that the plan would be far from a cure-all.
Germany’s economy still faces “massive structural challenges” such as tougher global competition in manufacturing, an ageing workforce and costly energy, said Matthew Morgan, head of fixed income at Jupiter Asset Management.
With the potential for a trade war with the US, DIW president Marcel Fratzscher said geopolitical risks could still “outweigh the positive effects from domestic politics for at least the next one or two years”. German GDP was still likely to “contract in 2025 for the third year in a row”.
Isabelle Mateos y Lago, chief economist at BNP Paribas, said she did not share that gloomy view. While the investment push will take time to increase growth, “a positive confidence shock” can have immediate effects, she said.
She added: “[This] would be particularly welcome at this time of historically high geopolitical uncertainty.”
Additional reporting by Ian Smith in London; data visualisation by William Crofton and Clara Murray
