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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