The impending approval of a historic reform to Germany's debt rules will allow for increased investment and higher defense spending, which will help raise medium-term economic growth in both Germany and the euro area. On March 18, the lower house of Germany's parliament, the Bundestag, approved a constitutional amendment to reform the country's so-called ''debt brake,'' a constitutional rule introduced in 2009 that restricts government borrowing, limits the structural deficit to 0.35% of GDP and requires states to run a balanced budget. The reform exempts defense expenditures exceeding 1% of GDP from the debt brake, thereby removing legal limits to German military spending. It also allows the next parliament to establish a EUR 500 billion special purpose fund to finance spending for civil protection, intelligence services and military aid for Ukraine, as well as infrastructure and climate-related investments. Additionally, the reform allows German states to run a deficit of 0.35% of GDP (up from the current zero deficit cap), but many states would need to reform their own legislation to take advantage of the loosened borrowing limits. The constitutional amendment will now go to a vote in the Bundesrat (the upper house of parliament) on March 21, where it is widely expected to pass.
> The debt brake reform passed in the Bundestag with 512 votes to 206, thanks to the backing of incoming Chancellor Fredrich Merz's conservative Christian Democratic Union (CDU) and its prospective coalition partner, the center-left Social Democratic Party, along with the environmentalist Greens. In the Bundesrat, these parties only control 41 of the chamber's 69 seats, leaving them six votes shy of the two-thirds majority needed to pass constitutional amendments. However, the CDU's Bavarian sister party, the Christian Social Union (CSU), which controls six votes in the Bundesrat, has signaled its firm intent to support the debt brake reform when it goes to a vote in the upper house, despite the fact that the CSU's coalition partner in Bavaria, the Free Voters, remain skeptical about the reform.
> The debt brake has significantly constrained German government borrowing over the past 16 years, which has, in turn, prevented necessary infrastructure investment and a more proactive fiscal policy to support Germany's economic growth. Through its proposed reform, Merz's incoming government is also seeking to increase defense spending in response to U.S. President Donald Trump's March 4 decision to suspend all military aid to Ukraine and the broader uncertainty regarding future U.S. support for German (and European) security.
A sharp increase in government spending will help boost Germany's medium-term economic growth, upgrade its defense-industrial base, lift asset prices and support the rotation out of the U.S. into European stocks in the context of an increasingly uncertain U.S. economic outlook and unpredictable U.S. policymaking. Germany's economic performance has been very disappointing following the energy price shock in the wake of the 2022 Russian-Ukrainian war and in the context of chronic underinvestment. A large-scale, investment-focused fiscal stimulus could boost economic growth over the medium term, though the precise growth effect will hinge on how well the money is spent and on what. That said, even if the money is spent poorly, it will help boost economic growth and revive economic confidence. Higher German economic growth will also help support eurozone growth, particularly in countries that supply the German market (like France and Poland) or are deeply integrated into German supply chains (like the Czech Republic, Hungary and Slovakia). Additionally, a stronger German economy will make Europe a more attractive investment location, continued regulatory impediments notwithstanding.
> The International Monetary Fund has repeatedly highlighted the need for Germany to raise public and infrastructure investment. German real GDP growth is estimated to have averaged a mere 0.2% annually in 2020-24. High energy prices and increasing competition have hit Germany's chemicals and auto sectors particularly hard.
> Since the beginning of the year, European and German asset prices have increased as markets became convinced the debt brake reform will happen. Over the medium term, European asset prices and especially German and European defense sector stocks will continue to benefit from a successful reform of the debt brake. Banking stocks will also benefit from higher growth and higher interest rates. This will support a rotation of investors from the United States into European equities, not least due to U.S. political and economic uncertainty under the Trump administration.
Due to significantly higher German borrowing, euro-area interest rates will increase over the medium term, which will increase nominal debt servicing costs for all euro-area sovereigns, even as other economies stand to benefit from higher German economic growth. German debt is set to increase significantly from around 62% to 90% of GDP over the next ten years, according to some private-sector estimates, though any projections depend on how rapidly defense expenditure can and will be ramped up following the debt brake reform. This will not represent a financial problem for Germany due to its history of fiscal discipline, which has characterized policymaking since the establishment of the Federal Republic in 1949. However, higher European interest rates, combined with a larger fiscal deficit in other eurozone countries, will still further increase German debt levels. These developments could also renew concerns about fiscal sustainability in some of the more highly indebted euro area countries in the coming years, particularly those planning to increase defense spending in the context of more accommodating euro area fiscal rules.