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Germany embarks on a dramatic shift in fiscal policy
With further US tariffs coming on-line during the week, this time the 25% tariffs on steel and aluminium imports, it is easy to get swept away by the rapid shake-up of the global trading system emanating from Washington. However, it is important not to conflate the US economy with the global economy.
Yes, the US remains the world’s largest economy (based on 2024 market exchange rates), accounting for around 27% of global GDP. But together, the European Union (18% of global US$ GDP) and China (17% of global US$ GDP) comprise a larger share. While headwinds from the US continue to build, last week we saw Chinese and European policymakers announce more supportive fiscal policy settings.
The news from China’s National People’s Congress was largely as expected. China’s 2025 real GDP growth target was unveiled at ‘around 5%’ the same as seen in 2024, and the official budget deficit target was increased from 3% of GDP in 2024 to 4% of GDP in 2025. Total government bond net issuance (including special government bonds) will be stepped up from a target of RMB 9 trillion in 2024 to RMB 11.9 trillion of GDP in 2025, an increase worth around 1.8% of GDP. Although we remain sceptical that authorities will hit their 2025 growth target given both the property market and tariff headwinds facing China, the stimulus measures will help underpin activity and we retain our forecast for real GDP growth to average around a 4½% pace in 2025.
More importantly for the global economy have been signs of a fundamental change in fiscal policy in the EU and Germany. The EU is clearly responding to the shifting geopolitical environment caused by the new US administration and the freezing of US military aid to the Ukraine. The European Commission has unveiled an €800 billion plan to boost defence spending over the next four years and activate an ‘escape clause’ so that it doesn’t fall foul of EU budget rules. Boosting EU defence spending will not only allow the region to be less reliant on US security support, but will also help stimulate the economy, with the plan worth around 1.1% of annual EU GDP.
An even more seismic shift is occurring in Germany following the recent national elections. New Chancellor-elect Friedrich Merz has unveiled a plan to reform the constitutional debt brake – a rule that has ensured prudent fiscal policy settings in Germany by limiting the structural budget deficit to 0.35% of GDP, but that has constrained the ability of the government to stimulate the economy and respond to the shifting geopolitical environment.
Under the German fiscal plan, defence spending in excess of 1% of GDP will be exempt from the debt break rule. With defence spending in 2024 around 2% of GDP, this reform will provide immediate fiscal space worth 1% of GDP that can be used to fund increased spending or tax cuts elsewhere in the economy. The fiscal boost is likely to build over time, with Germany expected to gradually increase defence spending towards 3% of GDP. The Chancellor-elect has also outlined a new €500 billion infrastructure fund to be spent over the next decade (1.2% of GDP p.a.) and proposed to increase state government borrowing caps from 0% to 0.35% of GDP.
These more stimulatory fiscal settings from Germany will drive a much-needed turnaround after the economy contracted modestly in 2023 and 2024. The proposals are being rushed through the outgoing German parliament, with the composition of the new parliament, including the far-right AfD and The Left, likely to block the two-thirds majority required to pass the debt brake and infrastructure fund legislation.
While the disruption caused by President Trump is causing a rapid shift in international trading relationships, it is also galvanising other countries to increase defence spending and pursue more stimulatory domestic fiscal policies. Although these shifts will not offset the headwinds from the US, they should help provide an important partial counterbalance for global economic growth over 2025 and 2026.