In his 12th and last Letter from Germany, Michael Burda comments on Germany’s forthcoming fiscal expansion and the accelerating readjustment of internal Eurozone imbalances.
Who would have thunk it? In the final days of the “traffic-light” coalition (Social Democrats, Liberals and Greens), Germany’s parliament passed a constitutional amendment that released the “debt brake” for funding of up to 1 trillion Euros of government spending over the next decade. This represents a doubling of the country’s annual public borrowing requirement from 2.8% in 2024 to at least 5.5% of GDP. The new conservative-led grand coalition government led by Friedrich Merz (CDU) now owns this, throwing previous fiscal rectitude to the wind and beginning to spend – even before the summer recess began. This dramatic release of the hallowed “debt brake” represents a rupture with decades of fiscal austerity that had been Germany’s calling card. What happened?
Germany’s infrastructure is in a woeful state. Trains run late, bridges and tunnels are showing their age, school buildings are in visible need of repair. In Berlin, an entire decrepit highway overpass was recently declared unsafe and summarily demolished. The reason for this sad state of affairs is clear: To honour the “Schwarze Null” (the balanced budget requirement or “debt brake”), Merz’s predecessors took the easy path, cutting infrastructure spending to the bone while sparing government consumption (civil service salaries, social programmes). OECD indicators show that these cuts reduced investment well below replacement levels and led to a significant deterioration of the quality of German roads, bridges, public buildings and communication systems. Germany was able to achieve pre-monetary union debt levels, but at a considerable cost to current and future generations.
At the same time, the Russian invasion of Ukraine more than three years ago and subsequent vagaries of President Trump’s foreign policy focused attention on its own chronic freeloading off the US and other Western allies. As little as five years ago, military spending was far below NATO’s soft goal of 2% of GDP. Observing Ukraine’s fate has convinced most mainstream politicians that the gravy train is over. To the discomfort of many, Germany must assume military leadership on the continent, ideally in close cooperation with France, Poland and the UK. Friedrich Merz has pursued this strategy aggressively in the first 75 days of his chancellorship. Yet a remarkably large fraction of the German population remains ambivalent about the Russian invasion of Ukraine and the “asymmetric warfare” being waged on the West in general. Increasingly brazen local acts of sabotage seem to be part of a general game plan, with fake news and the extreme political parties on the right (AfD) and extreme left (BSW) propagated by Russian media or operatives. Defence of democracy and freedom will be costly.
As Figure 1 shows, Germany had been the poster child of fiscal prudence, if not downright austerity, for the past fifteen years. Debt/GDP ratios rose everywhere in the wake of the great financial crisis, but in the southern periphery after 2010 they rose again sharply, despite falling nominal and real interest rates. Germany went against this trend, but may have overdone it, with negative consequences for trend growth and underlying potential aggregate supply. Much austerity fell on universities and schools, the incubators of human capital formation and innovation, leading to a degradation of the education system in a country already stretched by an influx of immigration.
There is remarkable consensus that this is the proper time for more debt, especially when the spending will benefit future generations. There are significant clashes on emphasis: The CDU wants to boost military spending, while the SPD is more interested in civilian infrastructure. Defence minister Pistorius (SPD) has deftly argued that military-related infrastructure could support both objectives. The quality and quantity of personnel in the armed forces is a key issue. Naturally, money is fungible and it is inevitable that funds currently budgeted for defence and infrastructure will be shifted to government consumption on non-defence and non-infrastructural projects such as climate, aid to the federal states, and subsidization of maternity pension credits as well as military pay. Finance minister Klingbeil (SPD) suffered much criticism for cancelling an electricity tax reduction for households and small businesses that had been promised in the election campaign.
Will the Great German Gambit pay off? Financial markets appear sanguine enough. Global financial markets continue to offer excellent terms for Germany – the bellwether ten-year Bund yield is around 2.6%, about where it was in January of 2024, after rising to 2.84% in March of this year. This optimistic market assessment seems to incorporate long-run growth effects of infrastructure and military spending, and new German debt will add to the supply of high-quality debt in high demand. The fiscal expansion will create bottlenecks, however, especially in the labour market. Unemployment is remarkably low and firms are unwilling to fire workers, even when demand is stagnant. A recent newspaper article in the Frankfurter Allgemeine Zeitung raised fears that increased spending may wind up in the pockets of contractors rather than in expanded capacity. The share price of Rheinmetall, Germany’s primary manufacturer of battle tanks, has risen by 2000% since 2022. One would expect that this rise in Tobin’s q would lead to more investment – or at least to a repurposing of some of Germany’s flagging combustion engine automobile segment. It may simply reflect the extraordinarily high costs of adjustment in a country that still uses fax machines.
One of my lasting obsessions with continental European macroeconomics has been the ability of the Eurozone to rebalance internally – to correct a persistent and lopsided balance of payments situation that emerged between the centre and the periphery in the first decade of the Euro. In a monetary union, this is only possible via relative price flexibility – an internal devaluation. As Churchill’s return to gold parity in the late 1920s reminds us and a half-century or more of Keynesian macroeconomic research confirms, this can be a painful process. In principle, adjustment to regionally asymmetric shocks gives rise to intra-Eurozone payment flows which ultimately correct the imbalance, but this can become an issue for nationalists who still care about national boundaries, ownership and identity. The “Target-2” debate and surrounding discussion could have been avoided, had monetary union abolished national central banks or redrawn administrative districts, as the Federal Reserve System was designed in 1913. It took the sovereign debt crisis to convince sceptics that internal adjustment really works. As Figure 2 shows, Greece saw a 22% real appreciation from 1999, prior to the sovereign debt crisis and vis-à-vis Germany, up to 2011. After a wrenching decade of shrinking public and private demand afterwards, Greece has returned to a sustainable growth path and – like Portugal, Spain and Italy – become a new destination for international (and especially German) capital.
Europe – and Germany in particular – need to focus on the more important fish and not micro-regulate everything. The difficulty of starting a company in Germany is more evident than ever, most of all due to boundless bureaucracy. Upon applying for retirement, I was asked to scan all my degrees and other documents and send them via email to the university administration, only for them to print them out and deliver them in paper form to the Berlin government pension office! Germany’s federalism has been not only a barrier but an excuse for intellectual laziness in dealing with “digitalization challenges.”
On a positive note, Poland and Estonia are the new poster children of European integration, doubling their respective GDPs since accession in 2004. On an international purchasing power basis, per capita income is within spitting distance of Japanese levels. This is a considerable achievement. When I first started looking at Eastern Europe in the 1990s, OECD-ILO unemployment in Poland was over 20%; it is now below 3%. (EU unemployment averages 5.8% and is even higher in the Euro area.) Poland also meets the Maastricht Criteria for joining the monetary union. How ironic that they politely demur, although joining the Euro is supposed to be the endgame. They correctly see, in my view, more real appreciation on the cards as their economy matures and grows richer. All the while, expat Poles in the UK continue to return home, an estimated net remigration of 300,000 since 2017.
This longer Letter from Germany will be my last. Many thanks go to Peter Howells, who got me involved with this project back in 2013 when Ray Rees stepped down, and to Jon Temple, who managed to maintain my enthusiasm afterwards. Above all, I am grateful to the RES for the opportunity to express my thoughts on economic policy here in Germany, the perils of Brexit, and the process of European disintegration in general. Even though she herself was a Eurosceptic, my Liverpudlian mother would have been proud.
Michael Burda
Berlin, 21 July 2025