Next German coalition launches fiscal bazooka at new geopolitical realities

New geopolitical realities have forced the likely next German coalition of the CDU and SPD into agreeing to a massive fiscal splurge. Details are scarce and implementation risks loom large, but this could in theory see the fiscal deficit widen to 4% of GDP for the next decade. The measures could help build a viable military deterrent, jumpstart the recovery and transform the economic outlook for the coming decade.

What you will learn:

• The scale and urgency of the proposal suggest that this is in part a political signal to allies and adversaries. However, the required support from other parties isn’t yet secured, and a coalition deal could yet fail to materialize. The proposal also targets a long-term reform of the debt brake, which may envisage less ambitious easing. And the economy may struggle to absorb all funds.
• Nonetheless, even a partial use of the additional fiscal space presents a material upside to our previous baseline, and supports the changes we have made in our latest forecast. We now expect deficit to double over the coming years to 1.5% of GDP to finance a hike in defence spending to 3% of GDP. We think that will lift the level of GDP around 0.6% above baseline by 2029 and raise Bund yields by 20bps to 2.65%.
• In a scenario with a big infrastructure splurge and an even larger and more front-loaded rise in defence spending GDP could be 1.4% above baseline by 2029 But the economy would likely struggle to scale up defence and infrastructure capacity that quickly. So delays to projects, a marked rise in inflation, and a subsequent monetary policy response are likely.