After years of stagnation, the German economy will receive a boost from increased government spending on defense and infrastructure, but a failure to implement flanking structural reform will fail to substantially increase medium-term economic growth. Following the breakdown of the dysfunctional three-party coalition, consisting of SPD, Greens and FDP, the February legislative elections led to the formation of a grand coalition of CDU and SPD. Following the reform of the constitutionally mandated limits on government deficits, the new coalition government has committed to significant increases in defense expenditure and infrastructure, especially transportation infrastructure investment. The new government has also agreed to implement reform aimed at reducing growth-impeding bureaucratic rules governing product markets and infrastructure investment. Intra-coalition disagreements have translated into a very limited reform agenda, and significant reform of welfare spending is opposed by the SPD, while the CDU only half-heartedly supports politically costly reform.
> The CDU-SPD coalition controls 328 out of 630 seats in the lower house. The next lower house elections will need to be held by March 2029.
> Real GDP growth has averaged less than 1% over the past decade. Economic output decreased in three out of the past five years due to exogenous shocks (COVID-19, Ukraine war) and limited policy flexibility (debt brake).
> Constitutional reform now allows for greater fiscal flexibility by exempting defense and security, encompassing intelligence agencies and assistance to Ukraine, exceeding 1% of GDP from the calculation of the 0.35% of GDP deficit limit. As part of the reform, the German government has established a EUR 500 fund, of which EUR 100 billion will be allocated to climate change, to allocate funding to infrastructure over the next 12 years.
The significant increase in government spending in the next few years will lift short-term economic growth, provide a significant boost to its defense sector and pull the economy out of stagnation. However, if the government fails to streamline bureaucratic rules, increase incentives for increased labor market participation and implement wider growth-supporting structural reform, the medium-term effect will be limited. In this scenario, real GDP growth is not likely to exceed 1.5% over the next five years. This is because the boost to spending will be temporary and somewhat gradual. Significant labor market rigidities and costly bureaucratic rules will dampen the effect and limit the fiscal multiplier effect. Moreover, infrastructure investment may help improve the quality of the transport infrastructure as much as it will prevent a further deterioration in quality. To the extent that increased defense outlays increase demand for domestically produced goods, this will help lift output, but the spill-over effects of defense spending will also be more limited, at least compared to spending on high-tech sectors. Finally, the government coalition will also be forced to limit non-defense spending over the next few years to remain compliant with the debt brake, as the reform reform only exempts defense-related spending. Longer-term non-defense spending need will need to be brought under control and this will moderately offset spending increases over the medium term. The IMF projects real GDP growth to average 1% of GDP in 2026-2030. The German Ifo Institute forecasts real GDP growth of 1.3% for next year.
· In September, the government passed its first budget under the new debt rules. The government plans to borrow EUR 174 billion, more than triple the amount compared to 2024. The budget includes EUR 83 billion for defense spending, or EUR 117 billion if spending from the special funds is included. Total defense spending will amount to nearly 3% of GDP next year.
· In its coalition agreement, the new government has agreed to pass several administrative reform to reduce administrative regulations and reporting requirements. The government will also take on more responsibility for digitalization enforcement. The corporate income tax rate is to be reduced by one percentage point in each of five steps, starting on 1 January 2028, which will help support investment.
Financially, the German government is well-positioned to run larger fiscal deficits for an extended period of time, without it leading to a significant weakening of its financial position. Amounting to 64% of GDP, German government remains low by international standards. The IMF projects the government debt-to-GDP ratio to increase two percentage points a year with debt reaching 75% of GDP by the end of the decade. Average debt in the G7 and G20 stood at around 120% of GDP in 2024. Government debt in France, Italy, the UK and the US all exceed 100% of GDP. Moreover, government debt in the other G7 economies will continue to increase, or, in a best-case scenario, will remain unchanged. Although Germany, like all other NATO members has committed to increasing defense expenditure to 5% of GDP by 2035, it is highly unlikely that Germany or any other government will spend 5% of GDP on defense by then. Russia will not be able to sustain defense spending at current levels, and its economy is stagnating. This will allow for a significant reduction in defense spending and significant fiscal savings following the sharp increases of the next few years. Similarly, infrastructure spending, once the investment fund has been exhausted, will be self-liquidating from a budgetary point of view. Meanwhile, the German government will be forced to keep limit the non-defense deficit to 0.35% of GDP. This will effectively limit the size of fiscal deficit over the next few years.
> The IMF projects government pension and healthcare expenditure to increase by 0.4% and 0.4% of GDP respectively between now and 2030. It estimates the net present value of pension and healthcare expenditure at 13% and 35% of GDP, meaning Germany, like most other advanced economies, is faced with significant increases in social welfare spending over the next few decades.
> In the coalition agreement, the CDU and SPD agreed to welfare spending reform, but the agreement primarily focuses on increasing but has failed to provide a substantial roadmap toward reining in the projected increases in welfare spending. The government has established a commission due to provide proposals by 2027, suggesting that the government is not serious about reform, as the SPD largely opposes spending-related reform while the CDU is less than keen on it.
Significant increases of defense spending over the next few years will lead the German government and German industry to take the initiative and play a leading role on defense-industrial cooperation in Europe. Germany plans to increase defense expenditure by 70% by 2039 to exceed EUR 160 billion meaning increased defense spending will prove sustainable, politically and financially, creating greater incentives for the private sector to participate in various projects. German defense companies will benefit greatly from increased spending, which will lead to significant innovation given Germany’s large industrial-technological base. Increased increased defense spending will also benefit Europea’s defense-industrial base in terms of demand, planning horizons and investments. As for the German government, the UK and Italy, and especially will face significant greater budgetary constraints in terms of defense spending increases, despite their official commitment to increase expenditure to 5% of GDP by the middle of the next decade. Germany’s financial flexibility will put it in a position to strongly shape future EU- and European policies. However, it will continue to oppose the issuance of common debt to finance EU defense expenditure, beyond the financial agreements already reached (see below). With Germany taking the lead, however, European initiatives will be more open to cooperation, including production, development and procurement, with non-EU countries.
> Germany will remain by far the largest European provider of military aid to Ukraine. The 2026 budget foresees EUR 9 billion in aid.
> Germany has threatened to drop France as its major partner in the development of sixth-generation fighter aircraft in the context of Future Combat Air System (FCAS), launched in 2017, and may to go ahead with its remaining partner, Spain, or explore cooperation with Sweden and the UK, while joining Global Combat Air Programme led by the UK, Italy and Japan is not probable at this point.
> The EU helps finance European defense spending through a variety of financial and non-financial instruments. The European Defence Fund provides funding for defense research and development as well as capability development projects, promoting cooperation among EU defense companies. The Security Action for Europe provides EUR 150 billion worth "loans fr arms" to provide financial assistance to Member States for defense investments. Finally, the EU now also provides greater flexibility under the Stability and Growth Pact by allowing members to activate the National Escape Clause for higher defense spending, while defense-related projects.
