China - Bar For Large Consumption-Focused Fiscal Stimulus Remains High (2024)

Chinese policymakers have thus far largely relied on targeted, limited and incremental policies to support economic rebalancing away from real estate sector focussed growth, and it would require a significant worsening of the growth outlook, greater deflation and an increasing risk of a debt-deflation spiral for the authorities to opt for a large, largely consumption-focused fiscal stimulus. In an attempt to tackle macroeconomic imbalances (overinvestment in the real estate sector) and reduce related financial vulnerabilities (over-indebted real estate developers and impact on banks’ balance sheets), the Chinese authorities in 2022 introduced measures to rebalance the economic away from real estate sector investment with the goal of redirecting investment toward other, higher-productivity economic sectors. The rebalancing process, which is not yet complete, led to weakening real estate prices and led to, or at least coincided, with softening domestic consumption and declining economic confidence. Economic growth has decelerated from 6-7% during the years leading up to the COVID-19 pandemic in 2020 to around 5% in 2023-24. The deceleration in economic growth can also in part be attributed to a structural decline in productivity growth, less favorable demographics, increasing government intervention in the economy and increasing regulatory uncertainty and, more recently, geopolitical tensions and declining foreign direct investment inflows. Nonetheless, China did exceed its five-percent growth target in 2023 and is set to meet its 2024 target of “around 5%”, even if the final full-year print comes in slightly below 5%. Concerns about the growth outlook in the context of seeming deflationary pressure have increased over the course of 2024. In response, the authorities have taken a gradual, incremental and largely targeted approach to support rebalancing through selective measures targeting the housing market and limited macroeconomic stimulus. Policymakers have also remained committed to promoting so-called “new productive forces” aimed at supporting productivity growth, largely through manufacturing-focused industrial policies and government-supported investment, rather than through a large-scale macroeconomic, including consumption-focused fiscal measures.

> China’s economy grew 5.2% in 2023 and 5% during the first half of 2024. Chinese policymakers seem to view the measures they have taken thus far as sufficient to meet the 2024 growth target. They have also stated to be willing to take a more “proactive” fiscal stance in 2025 depending on economic developments.
Fiscal support for the real estate sector has been targeted to affordable housing and completing pre-sold, yet uncompleted housing projects. The government also issued a special bond worth RMB 1 trillion to finance projects and help support investment as well as help local governments finance real estate purchases to clear the market. 

> Despite some very limited measures encouraging consumption, additional spending has been focused on investment rather than consumption. Most recently, the government announced its intention to bring forward the issuance of RMB 200 bn worth of bond issuance from 2025 (or less than $ 30 billion), which amounts to less than 0.2% of GDP and may not even constitute additional spending if it ends up being subtracted from next year’s spending. Fiscal measures directly targeting consumption rather than investment, housing-related objectives or support for financially distressed local governments have been quite limited. In general, fiscal and quasi-fiscal policy remains strongly focused on technology investment and manufacturing development in the context of the Made in China 2025 strategy. Policymakers view public investment rather than private consumption as the key driver of economic growth.

 
> The PBoC has provided some macroeconomic support, most recently on September 24 in the guise of simultaneous and larger than usual reserve requirement and policy rate cuts, but the central bank has been careful not to ease up too much for fear of weakening the RMB in the context of the large China-US interest rate differential and possible out of concern for banking sector profitability in the context of increased real-estate-sector-related credit risk. The PBoc also lowered the mortgage rate to support the housing market and it has introduced policy tools to support the equity market. None of these measures are game-changers and fail to address more directly the immediate problem of limited domestic demand, especially household consumption. The relative efficacy of an easier monetary policy and supportive credit policy will be much more limited than fiscal measures targeting public or household consumption. 

> The PBoC has repeatedly intervened in the foreign-exchange market, not just through its daily fixing but also in offshore markets to prevent RMB weakness. The limited monetary stimulus is reflected in the fact that real interest rates remain high and financial conditions are tight. The PBoC has also provided support through so-called structural credit policy measures targeting the housing market. Overall, macroeconomic support through monetary policy has been modest.

While economic growth has held up so far, deflation has persisted and the outlook for economic growth may be weakening, which has led the government to announce a fiscal stimulus” flanked by other supporting measures in late September. Since then, the government has failed to offer a detailed plan as to the kind and size of fiscal stimulus. There is likely a lively debate taking place in the Chinese government over the size and type of fiscal stimulus that is required. But the September 24 announcement strongly suggests that policymakers’ worries about the outlook for economic growth and continued deflation is increasing. A sufficiently strong fiscal stimulus would help reduce the risk of deflation, stimulate the economy and revive consumer confidence, and thus help put a floor under economic growth while economic rebalancing is proceeding and while deflation continues to points to continued spare capacity, itself partly a consequence of strong manufacturing investment, but also of weaker commodity prices and relatively subdued domestic consumption. A permanent drift into deflation raises the risk of an adverse feedback loop between falling prices, including asset and property prices, and an emerging debt overhang, raising fears of a Japan-style economic deflation and depression. But policymakers likely remain fairly strongly wedded to investment-focused industrial policies and remain somewhat reluctant to increase government spending to support “unproductive”, non-productivity-enhancing consumption, consumption not being investment. A large fiscal stimulus is likely seen as costly in the context of high general (augmented) government debt, which limits the appetite for a large-scale, consumption-oriented fiscal stimulus among parts of the government. The bar for a large, consumption-oriented stimulus remains high, but not(?) insurmountably so.

> The IMF has highlighted the risk of significant property market downturn, deflation and negative feedback loop of high debt level and deflation, making debt less sustainable. A combination of falling prices, declining consumer confidence and lower economic growth risk denting the economic outlook. However, price decline in major urban centers has been relatively limited, so it is far from clear that marginally weaker home prices are the major factor explaining less rapidly growing consumption. Deflation has also been affected by lower good and commodity prices. In line with the authorities commitment to “new productive forces”, public sector investment has increased, while private investment has been relatively stagnant, although it has increased in manufacturing while declining in the real estate sector. 

> Total non-financial debt exceeds 300% of GDP, which is very high even though it is underpinned by a very high national savings ratio. Corporate debt exceeds 130% of GDP. While general government debt amounts to a seemingly manageable 60% of GDP, augmented debt (incl. LGFVs) is approaching 130% of GDP. Meanwhile, the augmented fiscal deficit remains very high in the context of sharply lower nominal GDP growth, which leads to a continuous increase in government debt, absent major fiscal reform. This is likely one reason why parts of the government are reluctant to support large fiscal stimulus, particularly if it does not look necessarily urgent given that China has been able to meet its growth targets.

China will remain wedded to an incremental approach to supporting growth rather than opt for a major fiscal stimulus, unless the economic growth were at risk of slowing down significantly and deflation risks accelerating further. For a start, an incremental approach is more likely because the economic outlook, unlike in 2008-09, will deteriorate gradually rather than suddenly. However, if full-year growth projections were to fall below 4% in the near term and deflation to reach 1% on a year-on-year basis for more than a quarter, the cost-benefit calculus would change in favor of a larger fiscal stimulus, including one with a significant consumption-oriented component.This is our best guidance in an increasingly opaque policy environment. We define a large fiscal stimulus as additional full-year fiscal spending measures, at least half of which needs to target household consumption, exceeding 5% of GDP. Such a scenario would not prevent policymakers from continuing to introduce targeted measures aimed at stabilizing real estate prices, as well as provide further monetary stimulus, particularly in the context of declining U.S. interest rates, thus creating more supportive domestic financial conditions. 

> The IMF projects real GDP growth of 5%, 4.5% and 4.1% in 2024-26. Officialunemployment remains low at just over 5%. The IMF also projects real GDP growth to slow from currently 5% to 3.3% by 2029 due to slowing productivity growth and adverse demographics as well as increasing international economic fragmentation. 

> China’s producer price index has been in negative territory for almost two years, pointing to both weak demand and continued significant (over) investment. The last time China’s consumer price inflation was negative on a year-on-year basis was in January. More recently, it has been helped by higher food prices. The last time core consumer price inflation was negative was in January 2021 at the beginning of COVID-19, but in August core inflation fell to 0.3%, or less than half than a year earlier. 

> The 2008-09 fiscal and quasi-fiscal (credit policy driven) stimulus in response to the global financial crisis was predominantly focused on investment, such as public infrastructure investment, rural development and industrial upgrading and reconstruction (in the wake of the Sichuan earthquake) and a relatively small share going towards social spending. It exceeded 10% of China’s 2009 GDP. It raised concerns about mal-investment, financial write-downs and unbalanced economic growth, which continues to shape policymakers’ attitudes towards another large-scale stimulus in a context where such a measure does not necessarily appear necessary. 

>Private-sector economists put the total stimulus required to reflate the economy at Rmb5-10tn (Macquarie, HSBC). Morgan Stanley estimates puts the number at Rmb10tn over 24 months to reflate and return to stable growth. This is roughly equivalent to 7-8% of GDP annually and would lead to a massive widening of the fiscal deficit.

If a large consumption-oriented fiscal were stimulus were implemented, it would help reduce the risk of a debt-deflation spiral and might help put China on a path toward more sustainable economic growth. However, longer-lasting sustainability would require structural fiscal reform (e.g. health, pension and social expenditure) to support domestic consumption rather than a one-off, potentially time-limited fiscal stimulus. A successful stimulus would not necessarily raise China’s medium-term economic growth substantially. This would require wide-ranging structural economic reform, including reducing the role of the government in the economy, reducing regulatory uncertainty and providing for a more market-directed allocation of savings and investment. China’s focus on national security and increased government involvement and the more prominent role played by SOEs compared to more efficient private companies, the economy will continue to weigh on the medium- to long-term growth outlook. Stronger consumption-driven economic growth would help reduce China’s trade surpluses and provide a demand stimulus to the global economy and especially countries relying on exports to China. But a smaller Chinese trade surplus would only marginally reduce trade tensions with the US, the EU and RoW. As long as China continues to rely on industrial policy, including public investment in strategic industries, the outlook for international trade tension would improve and will be limited. If China manages to move toward a more consumption-oriented economic model, the risk of a broader systemic crisis or broader economic stagnation would diminish. But this world requires broader structural economic and fiscal reform that provides sufficient incentives to households to reduce their savings rate.

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How a “Defense Tax” Can Finance Europe’s Higher Defense Expenditure (2024)

See also: https://ip-quarterly.com/en/how-defense-tax-can-finance-europes-higher-defense-expenditure

Highly indebted European NATO countries should levy a “defense tax” to make their long-term commitment to higher defense spending politically credible and financially sustainable.

This year, 23 out of 32 NATO members are expected to meet the 2 percent of gross domestic product (GDP) defense spending target that the allies agreed to in 2014. While this is an improvement, the failure of nearly one third of NATO members to meet the relatively modest two-percent spending target speaks for itself. To strengthen its political-strategic and deterrence effect, defense spending needs to be made politically credible and financially sustainable. A long-term commitment to higher defense spending would also incentivize Europe’s private sector to make the investments necessary to rebuild Europe’s indigenous defense-industrial base.

European NATO countries have a sufficiently large economic resource base to balance Russia militarily. In terms of economic size, measured in purchasing power parity (PPP) terms to adjust for differences in prices, NATO GDP exceeds Russian GDP by a factor of 12, European NATO GDP exceeds Russia’s by a factor of six, and the combined GDP of Germany, the United Kingdom, and France exceed Russia’s by a factor of two and half. (Measured at market exchange rates, European NATO member GDP is more than 20 times larger than Russia’s.) 

The challenge European governments face is how to mobilize the necessary resources in the face of domestic distributional conflict. To the extent that greater resources are allocated to defense, fewer resources will be available for private consumption or non-defense investment (or both), unless they are borrowed from abroad. If the increase in defense spending comes primarily at the expense of private consumption, the population will be economically worse off. If it comes primarily at the expense of non-defense investment, longer-term growth will suffer. Allocating greater resources to defense implies economic tradeoffs and gives rise to domestic distributional conflict.

High Government Debt Constrains Larger European NATO Members

The five economically largest Western European NATO members (Germany, the United Kingdom, France, Italy, and Spain) account for 60 percent of European NATO GDP. Their ability to mobilize resources will have an outsized impact on European defense capabilities. But with the exception of Germany, government debt in these countries exceeds 100 percent of GDP and the International Monetary Fund (IMF) projects debt ratios to continue to exceed this level by the end of the decade. Financing substantial increases in defense spending through larger fiscal deficits therefore would seem at best financially imprudent. (All the other 25 European NATO members have more manageable debt levels of 80 percent of GDP or less, except for Belgium, Greece, and Portugal.)

Admittedly, France and the United Kingdom already spend 2 percent of GDP or more on defense, compared to 1.5 percent of GDP in Italy and Spain as well as Germany (if one discounts the contribution from its €100 billion special defense fund). However, should it become necessary to raise defense spending to 3 percent of GDP, as recently suggested by Poland, they would be faced with financial challenges. All of them are already faced with significant spending pressures as a result of higher spending related to demographic change, climate change, and defense. The European Central Bank (ECB) estimates that eurozone governments would need to raise an additional 3 percent of GDP – and substantially more than that in France, Italy and Spain – to cope with these increasing spending pressures and stabilize their debt-to-GDP ratios at current levels. But this would, according to the ECB’s projection, only prevent debt levels from increasing from today’s already high levels. It would require an additional 2 percent of GDP to bring government debt levels to the eurozone target of 60 percent of GDP. 

How to Finance Increased Defense Expenditure

So how should they go about financing higher defense expenditure? First, governments can increase defense expenditure by simply running larger deficits and accumulating additional debt. Germany has some fiscal space to do so in the short- to medium term. The other large European NATO members, as suggested, do not have that option. At the very least, it would be financially imprudent to do so, as it might undermine financial sustainability and therefore also political credibility. In terms of distributional politics, however, it would be the least challenging option, as it largely sidesteps distributional conflict by pushing the costs into the future and leaving it uncertain who will end up having to pay for higher spending.

Second, governments can cut non-defense spending (or, if no major immediate increase is necessary, reduce its increase relative to economic growth over time), thus freeing up resources to be spent on defense. According to the OECD, public social spending, by far the largest single expenditure category in the five countries, exceeds 30 percent of GDP in France and Italy. It is also high in Germany and Spain. 

Economically, reducing non-defense spending would be the preferred option, as the concomitant reduction in transfers to households for consumption purposes would help finance higher defense expenditure without reducing national savings. But politically it would be the most challenging option, as reducing social welfare spending or “acquired rights” typically mobilizes significant opposition, not least because who will incur economic losses, even if the materialize in the future, will be far less uncertain than in the case of issuing additional debt. Governments can also reduce public investment or other types of expenditure, like subsidies. But the former is costly in terms of foregone future economic growth, and the latter can just easily lead to significant political opposition if it affects well-organized or highly mobilized interests, such as farmers.

Third, governments can increase revenues, primarily income taxes, social security contributions, and taxes on goods and services. Higher taxes are hardly politically popular, and they, too, can trigger distributional conflict, particularly if they are perceived to exempt or favor one group over another. And increasing social security contributions to finance defense expenditure would be a difficult sell, even if higher contributions simply helped plug existing social security deficits and thereby allow the government to redirect resources to defense. But unlike spending cuts, higher taxes, if properly designed, can help spread the costs more evenly and more widely, thus limiting domestic political opposition.

Economic Effects of Higher Defense Spending Will Vary 

The macroeconomic effects of increased defense spending will depend on how they are financed, but also on how the additional funds are spent. If financed by additional debt in the absence of binding financial constraints, higher defense spending would provide a demand stimulus, at least in the short term. In debt-constrained economies, however, higher debt would increase the level of interest to be repaid, thus offsetting some or even all of the fiscal stimulus. In a worst-case scenario, it might undermine economic confidence altogether and force the government into a strategically disastrous fiscal retrenchment.

If financed by higher taxes or lower non-defense expenditure, the impact on short-term economic growth would likely be limited. Much would depend on where higher defense expenditure is directed. Increased spending on personnel, maintenance, and infrastructure would support domestic demand, while spending on overseas operations and equipment, much of which is currently being bought from abroad, would lead to what economists call fiscal leakage. But with spending on equipment typically accounting for about one third of defense spending, the broader macroeconomic drag—all other things being equal—would be limited. Over time, the build-up of intra-EU defense production capacity would also lead equipment spending to be redirected to the EU economy and support domestic and growth in the future. 

However, without a complete offset from a reduction of domestic consumption, allocating greater resources to defense would weigh on longer-term economic growth, at least in savings-constrained economies. Here again, Germany’s very large current account surpluses, which reflect “excess savings,” would provide it with much greater leeway to increase defense spending without jeopardizing non-defense investment than France, Italy, Spain, and the United Kingdom, whose current account positions are far less favorable.

European Governments Should Consider a “Defense Tax” 

In view of the need to raise defense spending in a financially sustainable and politically credible manner, fiscally constrained EU governments should consider introducing a “defense tax” at the national level. The related recurrent revenues should be earmarked for defense spending and finance the gap between current defense spending levels and current (and future) expenditure goals. If properly designed, such a tax would spread the financial burden broadly across society. 

This should help make it politically more palatable, compared to the alternative of financing increased defense expenditure through cuts to welfare spending. After all, the defense of the realm is a public good. So, everybody should contribute to it. Naturally, such a tax would not help governments avoid tackling broader, politically painful budgetary reform to address current and future spending pressures related to demographic change and the green transition. But by earmarking the revenue raised with the new tax for defense, it would go quite some way toward credibly and sustainably committing European governments to higher long-term defense spending, thus bolstering its strategic and deterrence effect.

Why Germany Can and Should Increase Defense Spending (2024)

See also: https://ip-quarterly.com/en/why-germany-can-and-should-increase-defense-spending

Economically and financially, Germany is well-positioned to increase defense expenditure and provide support to Ukraine. Over the short- to medium-term, a declining debt-to-GDP ratio allows Germany to increase expenditure without jeopardizing debt sustainability and without having to increase taxes or cut non-defense expenditure. The government should consider reforming, but not abandoning the constitutionally mandated debt brake to allow for structurally higher medium-term defense spending. Given its economic size and financial strength, Germany is pivotal in terms of strengthening European defense and deterrence.

Increasing Defense Expenditure Is Strategically Necessary

Maintaining the conventional military balance in Europe and denying Russia victory in Ukraine are both critical to European security. Strategically, a credible NATO, European and German commitment to match Russian defense expenditure offers the best prospect of maintaining the military balance of power in Europe as well as ending hostilities in Ukraine. Russia’s best policy is to weaken the West’s economic-financial resolve and thereby undermine its support for Ukraine. If NATO or European NATO members managed to credibly commit to matching any Russian defense spending increases and providing support to Ukraine to make a Russian victory impossible, Moscow’s political and military objectives in Ukraine would be thwarted and its incentive to continue the war would diminish, if not under the current leadership, then under the next one. 

Economically Possible

In terms of potential economic resources, if not necessarily resource mobilizability, Russia is at a significant disadvantage vis-à-vis NATO and European NATO members. Economically, Russia is far smaller than NATO and smaller even than the big-4 European NATO members, France, Germany, Italy and the UK. 

Economic size is of course only a rough proxy for the ability to “buy” security and prevail in long-term strategic competition. Available economic resources need to be mobilized politically and they need to be converted efficiently and efficaciously into security. [1] A sufficiently large economic resource base does not guarantee strategic success. It also requires an effective security strategy. But any credible and effective security strategy needs to be supported by adequate resources. 

But Politically Difficult

Although NATO and European NATO members produce collectively far more economic output than Russia, high debt levels in countries like France, Italy and the UK, and even the United States, constrain the degree to which these countries are politically willing to increase defense expenditure and provide support to Ukraine. But this constraint is political, not economic or financial in the sense that Western countries are weary of raising taxes or cutting non-defense expenditure to free up financial resources. They sit on a far larger economic resource base than Russia. Meanwhile, Russia is being forced to divert more and more resources to defense spending, resources that will not be available to finance investment to support future economic growth, and will sooner or later force difficult economic and financial choices on the Russian government. 

European countries do face fiscal and debt sustainability challenges. The European Central Bank[2] estimates that for euro area economies to cope with higher spending related to demographic change, climate change and defense by 2070 (!), governments would need to raise an additional 3% of GDP (or reduce spending by the same amount) starting 2024. But this would, according to the projection, only prevent debt levels from increasing from today’s high levels. It would require an additional 2% of GDP to bring euro are government debt levels to the 60% of GDP target. 

Distributional conflict and difficult choices over defense expenditure and Ukraine aid are real. But it does not mean that the economic resources are not in principle available to support tangibly higher defense spending or Ukraine. For some countries, the near-term constraints and ensuing trade-offs are more immediate due to high debt levels and limited fiscal space (France, Italy, UK), than for others, the challenges are more long-term (German), meaning that politically difficult choices can be pushed further into the future. Countries that face greater near-term choices would need to reduce non-defense expenditure or raise additional revenue to support substantially higher defense expenditure. Nevertheless, raising the level of defense expenditure from currently low levels is first and foremost a political issue. However, Russia’s economic resources are not unlimited, either, even if in the short run its low level of government debt and continued export revenues give it more short-term financial flexibility than its Western opponents, while a lesser need for political responsiveness give it more political room for maneuver, at least in the short- to medium-term. The fact remains that Russia’s economic resource is insufficient to compete with NATO or even European NATO member, provided the latter are politically willing to mobilize the necessary resources. 

Why Germany Can and Should Raise Defense Expenditure

Germany, the second-largest economy in NATO. It is also the most populous country in Europe (other than Russia). It has the largest economy and the largest and most advanced technological-industrial base. It benefits from far greater fiscal space and fewer economic-financial constraints than its European allies. Germany has therefore has a crucial role to play in terms of European defense.

Fact #1: NATO and European NATO member economies are far larger than Russia’s economy

The combined, purchasing-power-parity-adjusted gross domestic product (GDP) of NATO is about ten times larger than Russia’s. The combined GDP of France, Germany, Italy and the UK (or E-4) is three times larger. Germany’s economy alone is slightly larger than Russia’s. In addition, the per capita income of the E-4 is higher than in Russia, which, economically, if not necessarily politically speaking, translates into larger resources mobilizable for national security. E-4 per capita income ranges from $57,000 to $67,000, compared to only $38,000 in Russia.

This economic balance in favor of European NATO countries will not change meaningfully if at all in the next few years. The IMF projects Russian economic growth to average 1.7% annually in 2024-29, compared to 0.9% in Germany. However, unless Russia makes a much more intensive use of its existing capital and labor, it is not likely to grow twice as fast as Germany or the other larger European economies, not least given the medium-term effects of sanctions, the increasing share of national resources Russia is dedicating to “unproductive” defense economy and the war’s negative effect on labor supply. But even if Russia’s were to grow at twice the rate of Germany over the next five years, it would have a very negligible effect on the two countries’ relative economic size over the medium-term and would not change the E-4/ Russia economic balance meaningfully.

On the assumption that all countries have access to comparable military technology and that PPP conversion rates roughly reflect the price differential of military goods and services, the E-4 have a substantial edge over Russia as far as the mobilizable economic resources are concerned. The resource advantage is particularly salient in case of long-term security competition, like the Cold War, and wars of attrition, like World War I and II, where the side with the greater resources prevails over the long term, provided it is politically able to mobilize the necessary resources for defense purposes in time. [3] In short, the large European countries’ economic resource base is sufficiently large to compete with Russia and prevail. The obstacle to higher spending is domestic distributional conflict, not economics

Fact #2: Russia is currently outspending the E-4 , but only because it allocates a far greater share of GDP to defense

The Stockholm International Peace Research Institute (SIPRI) estimates that Russia spent $100 billion on defense in 2023, measured in current dollar terms at market exchange rates, compared to a combined $200 billion in France, Germany and the UK. Adjusted for PPP, however, Russia spent $250-300 billion, or roughly as much as Germany, France, Italy, the UK, and Poland combined. To be able to do so, however, Russia needed to mobilize nearly 6% of GDP, compared to a GDP-weighted average of less than 2% of GDP in the E-4. If the major European NATO countries doubled their defense spending, Russia would be forced to raise defense spending to 12% of GDP to match it. This would represent a massive increase and force Russia to curtail private consumption or investment, or both. Over the medium term, the former risks causing political discontent, while the latter will lead to economic problems, including declining productivity and growth.

Fact #3: German defense expenditure Is low by historical standards and on a comparative basis

German defense spending peaked in the early 1960s at just over 4% of GDP. In 2023, it stood at 1.5% of GDP, up from an all-time low of 1.1% of GDP in 2016. German defense spending has not exceeded 2% of GDP since 1991. In terms of defense spending as a share of GDP, Germany currently ranks 21st out of 30 NATO countries. Germany also spends tangibly less than France, Italy and the UK where defense expenditure was 2.1%, 1.6% and 2.3% of GDP, respectively. By comparison, Poland spent almost 4% of GDP and the United States spent 3.5% of GDP last year. The NATO defense spending target is 2% of GDP, which was supposed to be reached this year.[4]

Fact #4: Germany can afford to increase defense expenditure in the medium-term without having to cut social expenditure or raise taxes

German government debt is comparatively low and the debt-to-GDP ratio is set to fall by more than one percentage point a year until the end of the decade. A more sophisticated financial is unnecessary to understand that Germany has ample financial room to increase defense expenditure. A one-percentage point increase in spending would help keep the debt-to-GDP ratio roughly unchanged. In the short run, a larger fiscal deficit would boost domestic demand and economic growth. Germany is therefore well-positioned to raise defense expenditure “on the cheap” without having raise additional taxes or cut non-defense, including social expenditure. In other words, a permanently larger fiscal deficit would not undermine the outlook for debt sustainability, certainly not in the near or medium-term. 

Fact #5: Germany has far greater fiscal flexibility than its major European allies

In 2023, German defense expenditure was 1.5% of GDP, making Germany one of the lowest spenders while being one of the countries with the greatest fiscal space. Government debt in the next four largest European NATO countries, France, Italy, Spain and the UK, is much higher, nearly (more than) twice as high in some instances (see chart). Even if projected long-term pension and healthcare spending are added to the debt stock (and suitably discounted) German debt, while high, is far lower than in the other large NATO countries. Finally, German debt is less costly in terms of both nominal and real interest rates. Naturally, larger fiscal deficits and less favorable debt dynamics could help raise interest rates and hence medium-term and long-term debt servicing costs, and thus limit the fiscal space in t future. But thanks to a relatively favorable maturity structure, this would take time. 

Fact #6: Constraints on higher German defense expenditure are legal and political in nature, not economic or financial

If Germany does face short- and medium-term constraints on defense spending, they are legal and political, far less financial or economic. The constitutionally mandated debt brake forces the government to limit the federal budget deficit to 0.35% of GDP. This acts as a check on substantial defense expenditure increases, unless government revenue is increased or spending reductions in other areas are implemented, neither of which would be politically popular. Nonetheless, some poll suggest that the public supports higher defense expenditure. A recent poll has shown that the majority of Germans or 68% supports higher defense spending and 29% oppose it. Support for higher spending was highest among Conservatives (90%) and Liberals (88%) followed by Green voters (75%) and Social Democrats (72% of Social Democrats).[5] It is likely that popular support would be lower if it had to be financed by higher individual income taxes or lower pension and health expenditure, both of which would negatively affect private consumption. This suggests that the constraints in higher German defense spending are legal (debt brake) and political, due to a lack of political leadership, including a willingness or ability to reform the debt brake, less so due to a lack of popular support or outright opposition.

Recommendations

> Explain to voters the economic costs and benefits as well as the strategic rationale of higher defense spending and the provision of aid to Ukraine. Higher defense spending enhances national and alliance security as well as deterrence. Economically, higher government spending on defense helps support the rebuilding of the defense-industrial base, provided military aid comes out of German/ European production rather than imports from the United States (and procurement accounts for a significant share of the spending increases) as well as domestic demand and domestic employment. But increased defense expenditure, unless financed by non-defense expenditure reductions or revenue increases, translates into higher debt levels (relative to the baseline forecast). Importantly, savings-constrained economies also suffer if savings are reduced to support the consumption of defense goods (and services). However, Germany’s large current account surpluses suggest that it is not a savings-constrained economy; if anything, it suffers from excess savings and insufficient domestic demand. This should limit the negative effects of higher defense expenditure on non-defense investment, and if increased defense expenditure is deficit-financed boost short- and medium-term economic growth. 

> Reform the constitutionally mandated debt brake to make room for moderately larger fiscal deficits while remaining committed to long-term debt sustainability. The new rules need to strike a better balance between greater short- and medium-term budgetary flexibility and long-term debt sustainability in order to allow for a reasonable increase in defense expenditure. How this can be done is a highly technically issue. But the rules should allow for a higher defense expenditure and a slightly larger deficit as long as long-term debt sustainability is not jeopardized. This may require a commitment to cut expenditure or, more likely, raise revenue in the future. 

> In conjunction with European NATO allies, make a credible and sustainable commitment to matching future increases of Russian defense expenditure beyond the two-percent NATO expenditure goals. Such a commitment should seek to match any Russian defense expenditure to the extent that the existing NATO commitment to spend 2% of GDP on defense fall short of this goal. [6] Germany and the European NATO members should commit to matching increased Russian military expenditure to the extent that Russian spending increases exceed NATO-related increase, including channeling a share of the increase to Ukraine. Strategically, this should help diminish Russian incentives to continue the war. Economically, it would help incentivize industry to invest in defense production by providing a longer planning and investment horizon, thereby helping to rebuild Germany’s defense-industrial base. (Admittedly, it will be difficult to get all European NATO members to commit to such an automatic increase, but even a non-binding political commitment do doing so would be a signal, if perhaps not a very credibly one, of European resolve. Commitments should be made more credible by other European countries committing to raise additional defense-related taxes or, politically even more challenging, cutting non-defense expenditure).

> Ensure efficiency and efficacy of defense spending, including greater European defense industry integration. The amount of spending share of resources allocated to defense is a proxy and does capture how efficiently it is spent nor how efficaciously economic resources are converted into military power, security and deterrence. Germany should learn from other countries’ best practices as far as procurement is concerned. European defense integration would allow for greater economic efficiency and help military inter-operability.

[1] Markus Jaeger, The Economics of Great Power Competition, DGAP Policy Brief, 2022
[2] European Central Bank, Longer-term challenges for fiscal policy in the euro area, ECB Economic Bulletin 4, 2024
[3] Similarly, Paul Kennedy, The rise and fall of the great powers, New York: Random House, 1987
[4] National defense as well as collective defense are public goods, economically speaking, prone to free riding. Mancur Olson & Richard Zeckhauer, An economic theory of alliances, The Review of Economics and Statistics, 48(3) 1966
[5] Internationale Politik (Forsa), April 2024
[6] NATO, Defence Expenditure of NATO Countries (2014-23), Press Release, July 7, 2023