Germany’s Historic Shift: Loosening the Debt Brake and Embracing a New Era of Spending

Introduction: A New Economic Chapter for Germany

In a landmark decision that signals a significant departure from its historically cautious approach to debt, Germany is set to loosen its constitutional restrictions on borrowing. This move, agreed upon by the two leading political parties, the conservative Union bloc and the center-left Social Democrats, paves the way for an unprecedented 1 trillion euros ($1.08 trillion) in spending on defense and infrastructure. This shift marks a bold step away from the country’s debt-averse culture, which has long defined its economic policies. The decision reflects the pressing need to address both internal and external challenges, from strengthening national defense to supporting Ukraine in its conflict with Russia.

The debt brake, a constitutional measure introduced in 2009 following the global financial crisis, has traditionally limited Germany’s new borrowing to 0.35% of its gross domestic product (GDP). This restriction was a response to the heightened government borrowing during the crisis and was rooted in a deep-seated skepticism toward debt in German politics. However, the combination of the COVID-19 pandemic, slowing economic growth, and the geopolitical tensions following Russia’s invasion of Ukraine has placed immense strain on this policy. The government has repeatedly invoked emergency clauses to exceed the debt limit, but the Federal Constitutional Court’s ruling in late 2023 that these measures were unconstitutional forced a rethink of the nation’s fiscal strategy.

The Debt Brake: A Look Back

The debt brake was implemented in 2009 as a means to control government borrowing and ensure fiscal discipline. It was a time when the global financial crisis had led to a surge in government debt across the world, including Germany. The policy reflected a broader cultural and political aversion to debt, which had long influenced German politics and economic decision-making. The limit of 0.35% of GDP for new borrowing was significantly lower than the 3% ceiling set by European Union budget rules and far below the 2024 U.S. federal deficit of 6.4%.

Initially, the debt brake seemed to work effectively, with German governments often operating within the limits and even running small surpluses during the prosperous years of the 2010s. However, the onset of the pandemic in 2020, followed by the economic slowdown and the fallout from Russia’s invasion of Ukraine, tested the policy’s flexibility. The government resorted to invoking emergency clauses in 2020, 2021, and 2022 to meet the heightened spending demands for pandemic relief, defense, and utility support. Despite these temporary measures, the Federal Constitutional Court ruled in late 2023 that the government had overstepped its constitutional authority by consistently circumventing the debt limit, prompting a hurried revision of the 2024 budget.

The collapse of Chancellor Olaf Scholz’s government in November 2024, due to disagreements with the pro-business Free Democrats over spending and the debt brake, further highlighted the need for a more sustainable solution. The political stalemate and the urgent need for increased defense and infrastructure spending created aripe environment for rethinking the debt brake.

Defense and Support for Ukraine: A New Era of Responsibility

The proposed reforms to the debt brake hold significant implications for Germany’s defense capabilities and its role in supporting Ukraine. Under the new rules, defense spending exceeding 1% of GDP will be exempt from the debt limit, providing Germany with the fiscal space to strengthen its military and enhance its ability to support Ukraine. This move is particularly timely, as Germany has already emerged as a leading backer of Ukraine, providing substantial military aid, including 60 Leopard tanks, 175 Marder infantry fighting vehicles, and 27 air defense systems, including three U.S.-made Patriot missile batteries.

According to Holger Schmieding, chief economist at Berenberg bank, the increased defense spending sends a clear message to both adversaries like Russian President Vladimir Putin and allies like the United States that Germany is committed to defending itself and supporting Ukraine. "Germany is finally taking on the leadership role which, given its size and its fiscal space, it should have assumed years ago," Schmieding commented. This shift in policy not only strengthens Germany’s military posture but also reinforces its commitment to European security at a time when the transatlantic alliance is undergoing significant changes.

A Political Shift: The Decision to Amend the Debt Brake

The decision to relax the debt brake was reached during coalition talks between the conservative Union bloc and the center-left Social Democrats, which are expected to form the next German government. The agreement includes provisions to exempt military spending above 1% of GDP from the debt limit, as well as the creation of a 500 billion euro infrastructure fund. This fund will target critical areas such as civil and disaster protection, transport infrastructure, hospitals, energy infrastructure, education, scientific research, and digitization. Economists estimate that these measures could unlock up to 1 trillion euros in new borrowing and spending over the next decade.

The move represents a significant reversal for Friedrich Merz, the leader of the Union bloc and the likely next chancellor following his party’s strong performance in the February 2024 national elections. Merz’s party platform had initially opposed changes to the debt brake, though he had hinted at a willingness to negotiate on the issue. The decision to amend the debt brake aligns with the pragmatic political principle that "if the facts change, I change my mind," as noted by Carsten Brzeski, global chief macroeconomist at ING bank.

The agreement also reflects broader shifts in the global security landscape, particularly the impact of former U.S. President Donald Trump’s administration on transatlantic relations. Trump’s demands for Europe to take greater responsibility for its own security, coupled with his public criticism of Ukrainian President Volodymyr Zelenskyy and the suspension of military aid to Ukraine, have served as a wake-up call for European governments. The perceived waning commitment of the U.S. to European security under Trump has created an urgent need for increased defense spending across the continent.

Why Now? The Timing of the Debt Brake Reform

The decision to amend the debt brake is being fast-tracked through the outgoing parliament, as mainstream parties currently hold the two-thirds majority needed to pass constitutional changes. However, this majority is set to be lost in the new parliament due to the electoral gains of the far-right Alternative for Germany and the far-left The Left party, both of which oppose the reforms. The passage of the measure will thus depend on securing the support of the environmentalist Greens, who were not part of the coalition talks.

The urgency of the situation is driven by the need to address both immediate and long-term challenges. Germany’s defense spending has only recently met the NATO target of 2% of GDP, achieved through a special fund exempted from the debt brake in 2022. However, this fund is set to expire in 2027, creating a pressing need for a more sustainable solution. Additionally, the ongoing conflict in Ukraine and the broader geopolitical shifts underscore the importance of swift action to bolster Germany’s defense capabilities and its ability to support allies.

The Economic Implications: A Catalyst for Growth

The loosening of the debt brake is expected to have far-reaching implications for the German economy, which has experienced stagnation over the past five years. Economists argue that increased spending on infrastructure, education, and renewable energy could stimulate long-term economic growth and address critical domestic shortcomings. Years of underinvestment in infrastructure have taken a toll on the country’s transport networks, healthcare systems, and education sector, as well as its transition to renewable energy and digital technologies.

The announcement of the reforms has already led to a revision of economic forecasts, with Morgan Stanley predicting a potential increase in GDP growth of 0.2% this year and 0.7% next year. This would be a welcome development for an economy that has contracted over the past two years. Jim Reid, research strategist at Deutsche Bank, described the move as "game-changing if it goes through," emphasizing that it challenges previous assumptions about Germany’s economic trajectory. Economist Holger Schmieding added that the infrastructure fund signals a commitment to addressing key domestic deficiencies, paving the way for a more robust and modern economy.

In summary, Germany’s decision to relax its debt brake marks a bold departure from its traditional fiscal conservatism. The move is driven by the need to address pressing challenges, from bolstering defense and supporting Ukraine to revitalizing the domestic economy. As the country embarks on this new path, it remains to be seen how these reforms will shape Germany’s future and its role on the global stage.