German military spending has been in the news a lot in recent days, which isn't always a good thing. The political parties that are expected to form Germany's next government agreed this week to overhaul borrowing rules, creating a €500 billion infrastructure fund, exempt defence spending above 1% of GDP from Germany's strict constitutional borrowing limit and loosened debt rules for states. This is a massive shift in spending to revamp the German military and revive growth in
Europe's largest economy. America's turn away from its traditional allies towards Russia and its move away from free trade may be the biggest shift in global trade relations since the collapse of the Bretton Woods agreement, according to Reuters, and may have sparked the most dramatic shift in German fiscal policy since its reunification.
Friedrich Mertz, whose conservatives won Germany's election last month, is planning to push these spending changes through parliament before new lawmakers take their seats in a few weeks. This is a bit unusual as Mertz won't become chancellor until then, But the German debt break is a constitutional provision or part of the Basic Law, and amending it requires a 2/3 majority vote.
The far right Alternative for Germany, which was promoted by both Elon Musk and JD Vance in the lead up to the election, and the radical left wing populist party both have close ties with Russia and oppose any additional military spending. These fringe parties won sufficient seats in the recent election that when combined they have enough votes to block any constitutional changes in the next legislative period. For that reason Mertz has to move quickly.
Afd opposes any change in the rules and the radical left party opposes any additional defence spending, meaning that if this spending is to be approved, it must be approved right away. The yield on the 10 year German Bund made headlines when it rose to 2.8% on Wednesday in its biggest one day move since the fall of the Berlin Wall and the DAX. The German stock index rose 3.4% as markets priced in more economic growth, boosting risky assets like stocks at the
expense of government debt. The euro strengthened against the dollar and European defense stocks rose, while US defense stocks and the overall U.S. market fell. We saw strength in European infrastructure stocks and European financial stocks too. So far this year, the euro stocks index is up over 11%, while the S&P 500 is down almost 2%. This was not what many expected
when Trump won the election. Germany has been in recession for the last two years with no economic growth over the last five years, marking one of the longest periods of economic stagnation in its post war history. Many economists were warning of a potential third year of recession in 2025. the FT described this planned increase in spending as a double bazooka for defence and infrastructure.
The announcement is being compared to Mario Draghi's Whatever It Takes speech, which marked the turn around of the euro crisis in 2012. And Deutsche Bank. Economists described Mertz's deal with the rival Social Democrats as one of the most historic paradigm shifts in German post war history, saying that both the speed at which it's happening and the magnitude of the prospective fiscal expansion is reminiscent of German reunification.
So this is quite a big deal. The German debt break was first introduced under Angela Merkel in 2009 in the wake of the global financial crisis, when a bank bailout led to a sharp increase in government borrowing, which had already been rising for years. The rule limited new borrowing to .35% of GDP, which was a tight limit compared to EU budget rules requiring less than 3%.
There was a lot of debate around the introduction of the debt break, with critics arguing that the state was restricting its own ability to act. Proponents, on the other hand, said that if debt was allowed to grow, the state would have to spend more and more on interest payments, burdening future generations. Public investment in infrastructure in Germany has long been a problem.
It first declined in the 1990s and then was kept so low that it hasn't even covered the depreciation in the existing infrastructure. Having high quality public infrastructure means that you have to be spending enough money to maintain it, which Germany has not been doing. Germany has been near the bottom of advanced economies in public investment for decades, and even when money was budgeted for investment, it was frequently still underspend.
Many of Germany's roads and bridges are crumbling today. As many as 5000 of the bridges along the nation's world famous autobahns are in such poor condition that they've been flagged as being in urgent need of repair. In September, the Corolla Bridge in Dresden, which was scheduled for renovation, collapsed overnight into the Elba River, causing severe disruption to both road and ship traffic.
Most German economists today say that the debt break is too strict, and even Angela Merkel, who introduced it in 2009, has come out to say that it should be lifted, but only to allow investment. Disagreement over the debt break and the need for additional military spending is what led to the collapse of the German coalition government and the snap election that occurred last month.
Germany's decision to give up on fiscal restraint is driven by the rapid unwinding of security ties between the United States and Europe, with the US president threatening to end US security guarantees and cutting off support for Ukraine. Mertz said that Germany had to do away with guardrails to defend Europe against threats to freedom and peace. While German interest rates rose the most in 17 years on Wednesday, analysts were not concerned with any deterioration
in German credit quality. S&P Global said that the ramp up in defence and infrastructure spending would in fact be a positive for Germany's prized AAA sovereign credit rating. They said that their biggest concern had been the stagnating economy and that anything that would boost the domestic economy was a credit positive. Germany's low debt levels mean that it's under leveraged when compared to big economies around the world, and it has plenty of room for additional spending.
According to UBS, if this package passes, government spending could increase by a cumulative 20% of GDP over the coming decade, which would be the biggest fiscal shift in 80 years, surpassing the spending that occurred during the reunification of Germany in the 1990s.
They go on to say that even if Germany were to increase spending to that level over the next 10 years, assuming a moderate growth multiplier, their simulations indicate that Germany's debt to GDP ratio would still land in the mid 60% area by 20-30, which compares favourably to ratios of 115% in France and 124% in the United States. Importantly, the planned infrastructure spending is badly needed and can be expected to grow the German economy.
When a country needs investment and gets it, it's positive for growth and very different to when a country doesn't need new infrastructure but builds it anyhow, which is malinvestment. And with malinvestment, the cost of debt is greater than the return on investment of the underlying project. For many years, Germany has been a critic of any effort to make it easier for European governments to spend money over fears that it could saddle the eurozone with debt and risk the
stability of the euro. The German approach up until this week was to completely ignore growth and try to lead by example with extreme spending restrained.
The US President's repeated threats of tariffs on EU imports, along with the US Vice President's scolding of European leaders last month at the Munich Security Conference, followed by the disastrous meeting with Ukrainian President Zelensky which ended in a public shouting match, spurred on this massive U-turn in German and overall European politics.
Analysts who had been projecting flat economic growth for Germany are now projecting growth of 1.8 to 2%, which is roughly in line with German growth before the pandemic.
The European realization that the United States can no longer be counted on as an ally is likely to cause big changes throughout Europe. Yesterday, the former French President Francois Hollande wrote in The Economist that while the American people may still be our friends, the Trump administration is no longer our ally, he writes.
This is grave. It marks a fundamental break with the historic relationship between Europe and America and the link established published after the Second World War with the creation of the Atlantic Alliance. He voices concern that diplomacy and reason may fall upon deaf ears and concludes that European nations must step up military spending and more importantly, cooperation.
He points out that France, Britain and Germany, when combined, already spend more on defence than Russia does, but the greater cooperation is needed between European countries that oppose Russian aggression. The talks to increase spending in Germany came as the European Commission outlined on Tuesday a joint debt instrument that would enable member states to fund the purchase of military equipment.
The debt instrument would involve the European Commission borrowing against the EU budget, then lending to member states at low interest rates. This would require unanimous backing from EU countries, which may be difficult to achieve.
The €150 billion in loans could buy air and missile defence, artillery systems, missiles, armed drones and anti drone systems, but also be used to address other means from cyber to military mobility, according to the president of the Commission, Ursula von der Leyden. She added that lifting EU fiscal rules for defence investments would enable countries to spend €650 billion on defence over four years, or about one and a half percent of GDP on average.
While US defense stocks have declined since Trump took office, European defense stocks are up more than 30% on average as investors have concluded that Europe will be spending a lot more on defense, but that they'll likely be spending it
internally if possible. While traditionally a lot of European defense spending would have been on American weaponry, investors now expect to see them spending more domestically, as when foreign governments buy weapons from the United States, the United States does get a say in how these weapons are used. With the US aligned more closely with Russia, European buyers are now considering the risk of being unable to use American weapons in a conflict with Russia.
Canadian newspapers have similarly raised alarm about buying fighter jets from their newly hostile neighbor. the FT reported yesterday that Europe is rushing to provide Ukraine with alternatives to Starlink, Elon Musk's satellite Internet provider, after the US withdrew military aid and intelligence sharing. This week, four large European satellite operators confirmed that they're in talks with European governments and institutions about providing an
alternative. Provincial leaders in Canada reported that they are cancelling or no longer seeking to deal with Starlink. And Mexican telecom billionaire Carlos Slim cancelled a deal with Starlink, opting to invest in his own telecom infrastructure rather than relying on Musk's satellite technology after being insulted on Twitter by Elon Musk. Musk famously blocked Ukrainian access to Starlink in Russian occupied territories of Ukraine
in 2022 to prevent a Ukrainian military initiative, making Europe nervous about relying on it for military purposes. Sander Tordor of the Center for European Reform points out in a recent Foreign Policy article that Europe outproduces the United States in steel vehicles, ships and civil aircraft, meaning that the EU does have the industrial heft and financial firepower to support Ukraine and rearm their own militaries, with little reliance on the United States if
necessary. But it will need to invest in its defence and protect its manufacturing manufacturing base against China's trade dumping and US tariffs. On average, he says, manufacturing accounts for 16.4% of the EU's gross value added, compared to just 11% in the United States. And the EU's manufacturing sector employs 30 million people versus just 13 million people in the United States. He argues that Germany's existing industrial supply chains double up as defence
supply chains if necessary. Sander points out that the European defence industry is weakened by fragmented bespoke production and years of underspending on defence. He argues that the EU needs to move towards standardized military equipment that can be mass produced and that governments need to give the European defence industry stable long term contracts so that but they can scale up production.
Other weaknesses he highlights are that European manufacturers rely heavily on China for many critical components like batteries and critical minerals. China was able to cut off the supply batteries to AUS drone maker last year, making it difficult to deliver military drones to Ukraine. European arms manufacturers could obviously face similar problems in the future. We're in very early days and it's very difficult to predict how these relationships will
hold in the coming years. In order to reach a point where Europe really pivots, you need the nations to decide that something needs to be done and then you need the politics to align. Europe has a small defence sector at present which will need to be invested in and built up, and this could possibly serve as a growth engine for the
entire continent. While spending on necessary infrastructure is more likely to drive growth, there can be spillovers from defense spending too, where new technologies are developed that have civilian and commercial uses. Military spending in the past led to the airline industry, the Internet and nuclear energy. The fact that Germany has decided to lead the charge is a big deal. As Germany makes up about 1/3 of the European economy. It has engineering expertise and excess capacity.
Analysts are projecting that Germany could potentially target 3 to 3 1/2 percent of GDP for defence spending. This would still be below what Germany spent during the Cold War, when defence spending went as high as 4.9% of GDP. Raising defense spending to 3% would more than double Germany's annual defense budget, and Ernst and Young estimate that this would create over 245,000 direct and indirect jobs in the
country. German revitalization is good for European growth, as in recent years Germany has been the main drag on growth. It's possible that a new focus on defense in Europe could also help the continent catch up in technology, a sector where it's been a laggard when compared to the United States and China. Automakers, which have been Germany's economic powerhouse for decades, are today cutting
jobs and closing factories. Using this excess capacity for military production would help preserve Germany's manufacturing infrastructure while boosting the output of military equipment. ZF Group and auto parts manufacturer, which is going through a restructuring that could lead to factory closures, told Reuters that they've been in touch with defense companies about shifting workers, citing
industrial synergies. Rhine Metal, a German automotive and arms manufacturer, is in talks with Continental about taking on around 100 employees to beef up operations. A lot of the struggles that Europe has had in the past have been around integration and political discord. It's possible that Trump's behaviour in recent weeks has spurred action that could bring an end to internal squabbling and bring about a greater European integration.
A lot will depend on what the US does in the coming years, but with the constant threats of tariffs splintering supply chains and the rest of the world viewing the US as an unreliable signatory on trade deals and alliances, Europe may need to plan for a world where they no longer count on the United States. When the Cold War ended, we were left with a unipolar world where the US was the only remaining
superpower. While China grew in influence over the last 20 to 30 years, Europe never became a truly independent third pole due to its reliance on other nations for its energy and defence needs. It's slow economic growth driven by chronic underinvestment kept Europe in a state of political and economic weakness, which Trump and Vans now seek to capitalize on.
The European recognition that the United States is less of an ally than was previously believed may bring an end to the political gridlock that has held the continent back for years. It's difficult to predict how Trump's plans will affect the United States or its trade partners as they seem to constantly change, but it is possible that the potential crisis facing Europe has forced its leaders to come together as they race to reinvigorate their economies and catch up.
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