Germany’s strict debt brake not only helped to bring down its last government, but will also haunt its next one.
Lacklustre growth, looming spending increases and the need to boost defence and infrastructure investment will test Berlin’s commitment to abide by the constitutional requirement to keep the structural deficit at 0.35 per cent of GDP, economists predict.
“Finding the fiscal space for all the required policies exclusively in austerity looks like a mission impossible,” said Carsten Brzeski, global head of macro at ING. Any new government “will have to agree on looser fiscal policies”, he added.
Friedrich Merz, head of the fiscally conservative Christian Democratic Union and clear frontrunner to become chancellor after federal elections next month, has promised to “uphold” the debt brake. “Today’s debts are tomorrow’s tax increases,” the CDU manifesto claims.
The rule, enacted in 2009 when public borrowing ballooned after the state bailed out the financial services industry, has since been decried by analysts and politicians as too rigid.
Merz has also hinted several times that he may be open to tweaking the rule that Holger Schmieding, chief economist of Berenberg, called an “outdated fiscal straitjacket” for Europe’s largest economy.
Public support for reform has also sharply increased: 55 per cent of Germans now support an overhaul of the strict borrowing limits, according to a January poll by Forsa on behalf of the German Council on Foreign Relations, compared with just 32 per cent last July.
Not everyone is convinced that a Merz-led government would fundamentally change tack.
“I share the markets’ hope that Germany’s fiscal policy will change, but I still struggle to make this my economic base case,” Bank of America’s Europe economist Evelyn Herrmann told the Financial Times.
Most observers expect only a limited relaxing rather than a complete axing of the borrowing cap. Fiscally conservative institutions such as the Bundesbank and the Council of Economic Experts have long called for nuanced changes that would open the door to a limited increase in public borrowing.
The council last year suggested allowing a structural deficit of up to 1 per cent if the government’s debt-to-GDP ratio falls below 60 per cent, and 0.5 per cent as long as it is below 90 per cent. With the ratio hovering just above 60 per cent, that would only create room for 0.15 per cent of GDP of additional government debt per year — a change that would not provide much more fiscal space.
A more powerful option would be the creation of further off-balance sheet funds for areas earmarked for additional spending such as infrastructure and the armed forces. Nato members face increasing pressure from US President Donald Trump to spend more on defence.
“Politically, such [changes in the structural deficit level and off-balance sheet funds] could be put to voters as upholding and reforming the debt brake rather than abolishing it”, said Michael Hüther, president of German Economic Institute (IW), a Cologne-based think-tank.
The blueprint for such off-balance sheet operations is the €100bn in additional borrowing to buy tanks, fighter jets and other weapons and munition that Chancellor Olaf Scholz pushed through parliament shortly after Russia’s full-scale invasion of Ukraine in early 2022.
Hüther is calling for a special purpose fund that borrows to spend €60bn each year on public infrastructure over a decade. Since 2019, the investment needs have surged from €460bn to €600bn, according to a joint study by IW and IMK, another economic think-tank.
Another special purpose fund to cover increases in military spending is seen as an additional option by Hüther and many other economists.
But even if a Merz-led coalition agreed on such steps, it may still struggle to win enough support in parliament for such moves. All reform options require a two-thirds supermajority among MPs, and there is little legal leeway to fudge things. The constitutional court in 2023 shot down the Scholz government’s attempt to use pandemic-era emergency funds for the green transition instead. This ruling eventually led to the demise of the three-way coalition last autumn.
Quirks in the German electoral system mean that the far-right Alternative for Germany (AfD) and the “leftwing-conservative” Sahra Wagenknecht Alliance (BSW) might control one-third of the seats in the next Bundestag even if they only receive a lower share of the popular vote.
Such a scenario would make winning support for the necessary constitutional changes even tougher. The AfD campaigns for a balanced budget and mainstream parties are adamant not to co-operate with the far-right party under any circumstances. Moreover, Wagenknecht herself said that her party would veto any constitutional change to buy “more and more weapons”.
Even if Germany’s next chancellor can overcome all political obstacles, a series of spending decisions taken by Scholz’s ill-fated three-way coalition will further limit the room to increase debt.
Germany’s structural deficit is already on track to rise to 2 per cent in 2027 even without any additional defence and infrastructure investment, according to December’s Bundesbank forecast.
“The idea that the next government has the option to significantly increase public borrowing is hard to reconcile even with a highly generous reading of European fiscal rules,” said one person familiar with those calculations, referring to the EU’s 3 per cent deficit target.
“They are likely to limit the room for additional deficits significantly,” this person added.
Calculations by the Jacques Delors Centre suggest that Germany could borrow an additional €48bn a year, or about 1.2 per cent of GDP, without getting in conflict with the EU rules.
With no party forecast to win a straightforward majority in February’s election, coalition talks are likely to drag on for months. Then the new government’s first priority will be to agree budgets for this year and 2026.
BofA’s Hermann warns that markets may instantly price in any move to increase public borrowing through higher yields on bonds. As private sector borrowing costs would rise as a consequence, this could dampen corporate investment and damage an already weakened economy.
“If we get a market reaction long before real fiscal change, this would tighten finance conditions and potentially damage real GDP growth,” she said.
