Macro Signposts | 4 March 2025

This week, I asked Nicola Mai to guest author Macro Signposts. He leads sovereign credit research in Europe and formulates key macro views for the region. Here, he shares his views on Europe's fiscal outlook.

Hope and Hype on German and EU Fiscal Reforms

By Nicola Mai

Following the election of U.S. President Donald Trump in November and the February victory of the German center-right CDU/CSU party, led by Friedrich Merz, many market participants are speculating that significant changes in fiscal policy in Europe are imminent.

Specifically, Trump's reluctance for the U.S. to continue as a guarantor of global security has raised expectations for increased European defense spending. At the same time, many believe the German election will prompt the nation to reform its fiscal rules in an effort to revive its ailing growth model.

While we think any fiscal changes are likely to be incremental, the political winds may now be blowing in that direction.

Modest reform in Germany
We believe that Germany's constitutional debt brake - which imposes a largely balanced central government budget - will be reformed over time. However, we also consider that such reform is unlikely to be radical, not least given the CDU's historically hawkish views on fiscal policy.

Based on a proposal by the German Bundesbank, the debt brake could be modified to allow extra fiscal space equal to about 0.7% of GDP. While helpful at the margin, this change would provide a one-off boost to growth of about 0.5 percentage points, after which the economy would likely revert to its prior trend.

However, this small-scale reform is unlikely to overcome significant structural headwinds: weak demographics, low investment and productivity, rising competition with China, and a trailing position in the global tech race.

European defense spending and trade policy
Similarly, higher European defense spending is unlikely to be a growth panacea. Currently, the EU spends around 2% of GDP on defense and could increase it to perhaps 2.5%-3% in the future. Much of this increase would likely stem from national government efforts. In that regard, the European Commission is working on a proposal to relax EU fiscal rules to allow higher spending, while the German government appears to be working on a sizable near-term defense package. Reports suggest that the upcoming German package could be large, but what we've learned in the past is that we need to see details before raising our hopes excessively.

Over time, we expect to see a more coordinated pan-European funding effort for defense. Initial steps could be to repurpose the roughly €90 billion (about 0.5% of EU GDP) of uncommitted funds from Next Generation EU (NGEU) - the fund set up to address the pandemic-related economic crisis - and to introduce a new EU loan facility dedicated to defense for sovereigns. Over time, the EU could create a new facility that includes grants to governments - a sort of NGEU-2 - although this will require ratification by the various national parliaments, which is a lengthy process.

While such evolutions would signal Europe's renewed focus on defense, they are likely to have a contained macroeconomic impact. Europe's defense spending focuses heavily on imports rather than domestically produced goods, so increased spending is unlikely to have a potent growth multiplier. We estimate that if defense spending is raised by 0.5 to 1.0 percentage points over a couple of years, the impact on European growth could be about 0.1 to 0.2 points per year.

All of this comes against a backdrop of a fairly austere fiscal regime in Europe. In effect, the extra spending would merely offset some of the planned tightening rather than unleash a meaningful net fiscal boost.

Note also that Europe's export-oriented growth model will be significantly challenged by the rise in global protectionism. For example, the steep rise in global trade uncertainty is likely to dent corporate investments, as seen during 2018-2019 in Trump's first term. The prospect of a possible resolution of the Russia-Ukraine conflict - which could entail lower gas prices and some boost from reconstruction efforts - could provide a partial offset, but likely only a modest one.

Investment takeaways
Overall, the weak outlook for the German and European economies and ongoing disinflation mean that European duration remains attractive for European investors and can serve as a good diversifier in global portfolios, in our view. We also favor positioning for steeper yield curves, with the European Central Bank (ECB) likely to continue easing policy and with higher sovereign issuance potentially leading to an underperformance of longer-maturity bonds.

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