Germany’s new government has taken a significant risk by amending the debt brake and allowing for increased infrastructure and defense spending, marking a departure from its traditionally conservative approach to government spending.
Germany’s Likely New Government Makes a Risky Gambit
A Historic Change to Fiscal Policy
Germany’s main political parties have agreed on increasing fiscal flexibility, amending the existing debt brake, and allowing for increased infrastructure and defense spending. This historic change to fiscal policy is significant, as it marks a departure from Germany’s traditionally conservative approach to government spending.
In response to the European Union's (EU) growing debt crisis, Germany has implemented a new fiscal policy aimed at promoting economic sustainability.
The policy focuses on reducing public debt, increasing tax revenues, and investing in infrastructure projects.
According to the German Federal Ministry of Finance, the country's debt-to-GDP ratio is expected to decrease from 69% in 2020 to 60% by 2025.
Additionally, Germany plans to increase its investment in renewable energy sources, aiming to reduce greenhouse gas emissions by 55% by 2030.
The Proposal: Three Main Changes
The proposal includes three main changes:
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Reform of the Constitutional Debt Brake: ‘The rule traditionally allowed a maximum deficit of 0.35% of gross domestic product (GDP)‘. Going forward, however, it will exclude defense spending above 1% of GDP, freeing up money for other expenditures.
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Creation of a €500 Billion Infrastructure Fund: This fund will be spent over the next 10 years and is equivalent to ‘11.6% of 2024 GDP’.
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Reform of the Regional Debt Rule: The proposal would lift the structural deficit allowance for states to bring it in line with the national limit.
Implications for European Fixed Income Markets
The new fiscal paradigm has significant implications for European fixed income markets. With increased spending on infrastructure and defense, Germany is likely to issue more debt, which could lead to structurally higher yields on European bonds over the medium term.
European countries have increased their defense spending in recent years, driven by security concerns and a desire to reduce reliance on the United States.
According to NATO's guidelines, member states aim to spend at least 2% of their GDP on defense.
In 2020, only six out of 30 European countries met this target.
The UK, France, and Germany have consistently been among the top spenders, while Eastern European nations like Poland and Estonia have increased their spending significantly.
The European bond market is a significant component of the global financial system, facilitating investment and borrowing between governments, corporations, and investors.
It encompasses various types of bonds, including government securities, corporate bonds, and supranational bonds.
The European bond market is characterized by high liquidity, with trading volumes exceeding $1 trillion annually.
Key players include the European Central Bank, national central banks, and major financial institutions.
The market is also influenced by economic indicators such as GDP growth, inflation rates, and interest rates.
Risks and Uncertainties
All investments involve risks, including possible loss of principal. Fixed income securities are subject to interest rate, credit, inflation, and reinvestment risks, as well as the possibility of default. The timing of new bond issuance and the implementation of actual projects remains uncertain, which adds to the overall uncertainty.
European Defense Spending: A New Reality
Europe has underspent on defense for decades, with defense expenditure declining from more than 3% of real GDP in the 1980s to around 1.5% in the 2010s. However, Russia‘s invasion of Ukraine led to an uptick in spending to around 2% of GDP in 2024. With the new fiscal paradigm, Europe is likely to increase defense spending, which could lead to a higher yield on European bonds.
The Road Ahead
The road ahead for Germany and Europe is uncertain, with many risks and uncertainties still present. However, one thing is clear: the new fiscal paradigm marks a significant shift in Germany’s approach to government spending, and its implications will be felt across European fixed income markets.
- dw.com | Germanys likely new government makes a risky gambit
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