Preliminary talks between the Christian Democratic Union (CDU) and Social Democratic Party (SPD) – the two parties hoping to form Germany’s next government – have yielded early results. In what amounts to a potentially seismic shift, the two parties agreed to lead constitutional changes to overhaul borrowing rules, reforming and loosening Germany’s ‘debt brake’.

The next step is for Germany’s Chancellor-in-waiting, the CDU’s Friedrich Merz, along with the SPD, to bring that proposal to Germany’s parliament. Although spokespeople from the Green and Liberal parties – which will not be part of the next government – have signalled hesitation, we suspect that there will ultimately be enough support to get the proposal over the line.

The agreement would exempt defence spending above 1% of GDP from the debt brake limit (effectively enabling the government to increase military spending as required) and open the door to a €500 billion (US$535 billion) financial infrastructure package aimed at overhauling the economy, with release of the funds over a 10-year period. If approved, we would expect the government to take some time to identify and prioritise projects, so would expect to start seeing the impact of that spending filtering through to the economy in 2026.

Germany’s debt position is currently relatively healthy, with federal debt to GDP around 61%, so these packages would add perhaps 20 percentage points to that debt level (currently a crude estimate). Markets responded positively to the news and, given the very low relative valuation starting point for European equities, we think it is possible that further news could help to sustain a positive shift in investment sentiment towards the region.

We are hopeful that a new German government under Chancellor Merz will prove much more dynamic than its predecessors. Germany needs to take on a leadership role again to drive reform in European institutions and in the European project itself, a process that we believe is underway. Over the past few months, we have seen the European Commission working on reduce supply chain law, sustainability reporting, CO2 border tax and taxonomy. We have seen consultation on the securitisation market, a softening of the auto industry emissions target, and a ‘coalition of the willing’ to support Ukraine. Our hope is that the vast external pressures from friends and foes onto Europe will serve to catalyse change and improvement that might have been otherwise unthinkable.

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Glossary:

GDP: Gross domestic product – the value of all finished goods and services produced by a country, within a specific time period (usually quarterly or annually). When GDP is increasing, people are spending more, and businesses may be expanding, and vice versa. GDP is a broad measure of the size and health of a country’s economy and can be used to compare different economies.

Debt to GDP: A measure of how much debt a country has relative to its GDP, usually expressed as a percentage.

Germany’s debt brake: Legally binding for Germany’s federal government since 2016, and the country’s 16 states since 2020, the debt brake puts strict limits on borrowing. While there is an outright ban on debt for the states, the debt brake left some leeway for the federal government to spend during exceptional times and take on a small amount of borrowing in normal times.