Debt brake the central focus for investors ahead of German election
The German elections will take place this weekend amid a dire economic backdrop in Europe’s largest economy.
The German economy has shrunk in each of the past two years, meaning German GDP is now slightly smaller than it was pre-pandemic. In contrast the wider euro area is 4.7 per cent larger than it was before the pandemic.
Consensus expectations for GDP growth in 2025 stand at just 0.3 per cent, down from 1.2 per cent in August. Analysts at Nomura said “Germany has continuously flirted with recession since the pandemic”.
Given this woeful performance, it is no surprise the economy has been a central part of the German election campaign.
Debt brake
For most investors, the crucial question this weekend is whether the election will deliver a majority to reform Germany’s restrictive ‘debt brake’, which puts stringent limits on government spending.
The debt brake has been in place since the financial crisis, and limits the budget deficit to 0.35 per cent of GDP each year.
In effect this makes significant public investment impossible, which is a particular problem given the succession of shocks which have hit the German economy in recent years.
A growing chorus of economists and politicians – including Angela Merkel – think that reforming the debt brake is vital for reinvigorating the German economy.
According to the German Economic Institute, addressing the various challenges facing the German economy – like improving infrastructure, accelerating digitisation and increased defence spending – will cost around €600bn by 2030.
“It is impossible to see any substantial overhaul happening without higher public spending,” Carsten Brzeski, global head of macro at ING said.
“Just to make up for the underinvestment of the last decade, Germany would need to invest around 1.5 per cent of GDP every year for the next 10 years,” he said.
But any constitutional reforms require a two-thirds majority in the Budestag, which is where things start getting complicated.
The centre-right CDU, under the leadership of Friedrich Merz, is projected to emerge as the largest party, and currently polls at around 30 per cent.
Although the CDU promised to maintain the debt brake in its election manifesto, Merz has since sounded more open to reforming the rule.
“I have always said that you can discuss this, but definitely not at first,” Merz said in televised debates last week. Door firmly ajar.
The far-right AfD – which is anti-reform – trails the CDU on 21 per cent, with the ruling SPD on 16 per cent and the Greens on 13 per cent. Both the SPD and the Greens support debt brake reform.
A Grand Coalition between the CDU and the SPD is widely seen as the most likely outcome, since all of the major parties have ruled out going into coalition with the AfD.
But it will likely take months for a coalition to form. In the meantime the best indicator for the likelihood of reform is the performance of Germany’s smaller parties.
Small parties key
Parties need to garner five per cent of the vote to enter the Bundestag, which means very small changes in vote share can have big impacts on wider parliamentary arithmetic.
There are a handful of parties hovering around five per cent, including the left-wing Die Linke (pro-reform), the politically-confused BSW (anti-reform), and the free-market FPD (anti-reform).
The latest seat projections suggested that around 29 per cent of the seats would go to parties opposed to debt brake reform, suggesting there’s hope for fiscal reform.
But this does not include any dissenters from the CDU, and there’s likely to be a few. It will be tight.
“Put simply if one of the fringe parties enters parliament it‘s likely that the centrist parties will still have a two-thirds majority that could allow them to change the debt break if they agree to,” Jim Reid, Deutsche Bank’s head of research said.
“If two enter they are unlikely to have a two-thirds majority and the subsequent horse trading could prevent meaningful reform,” he said.
Either way, it is worth remembering that Merz is not a huge supporter of reform, which will limit the extent to which he’s willing to adjust the rules.
The rest of his platform centres on deregulation, corporate tax cuts and tax cuts for richer households, which does not cohere that neatly with big public investment programmes.
“The scale of any reform is likely to be quite modest,” analysts at Capital Economists said.