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Germany braced for Europe’s next debt crunch

Scholz
Scholz

Dressed in military fatigues on Monday, Germany’s defence minister voiced his irritation over cuts to the country’s military budget.

Boris Pistorius said he was “annoyed” that his department had suffered a real-terms cut in 2025 to ensure Germany’s tax and spending plans added up.

It follows months of crisis talks to fill a black hole triggered by a debt ruling by the country’s constitutional court. A deal clinched on Friday by Germany’s three-party coalition keeps German defence spending above the Nato target of 2pc of the economy.

But Pistorius failed to secure the €58bn (£49bn) in annual funding he requested. The €53bn he secured does not keep pace with inflation.

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Defence spending will be top of the agenda at this week’s Nato summit in Washington DC.

Germany's Defense Minister Boris Pistorius
German defence minister Boris Pistorius failed to secure a real increase in military spending - REUTERS/Johanna Geron

France has garnered all the attention when it comes to Europe’s latest debt woes. A hung parliament left the door open to higher spending presided over by the Left, which won the most seats in the National Assembly.

France’s debts have surged and are set to keep on rising, pushing up the premium between French and German borrowing costs as investors seek to punish profligacy.

Yet the decision to move cash away from heavy borrowers to safer countries, including Germany, belies financial problems even in the most parsimonious nations.

Germany is usually viewed as the most responsible major economy in the eurozone when it comes to finances.

This is embodied in its “schwarze null”, or black zero – a political commitment to a balanced budget – and the all-powerful debt brake, a limit on borrowing which is enshrined in the country’s Basic Law and is enforced rigorously by the constitutional court.

The result is shown in a comparison of French and German finances.

Before the financial crisis, both had the same debts, at around two-thirds of GDP. Yet in the subsequent decade the two diverged. By the eve of the pandemic, France’s ratio had risen close to 100pc while Germany’s was below 60pc.

Even after Covid and the energy crisis, Germany has debts amounting to below 64pc of GDP, while France’s are at 110pc and rising.

It means the German government is simultaneously in a very strong financial position but dangerously constrained on what it can do with its money, says Holger Schmieding, chief economist at Berenberg bank.

“Germany has much more fiscal headroom than almost any other country – it just doesn’t allow itself to use it. Our debt is low, our deficit is reasonable. Our debt is, if anything, declining as a share of GDP,” he says.

“Yet we are stuck with a debt brake that seemed to make sense 10 or 15 years ago, but does not make sense now.”

While Germany has prided itself on prudence, the coalition government headed by Chancellor Olaf Scholz also took a beating in the European elections, much like Emmanuel Macron’s party.

Scholz’s Social Democrats (SPD) came third, with just under 14pc of the vote, the Greens were fourth on 11.9pc. The more free market Free Democratic Party (FDP), which rounds off the coalition, secured just above 5pc. The Christian Democrats (CDU) – the party of the previous chancellor, Angela Merkel – led the way on 30pc, followed by the far Right Alternative for Germany (AfD), which won almost 16pc of the vote.

That made the frictions of coalition politics even more painful than usual ahead of last week’s budget agreement.

The parties ultimately clinched a budget deal that sticks to tight borrowing rules while trying to enhance economic growth by getting more people to work beyond the retirement age and to help migrants enter the job market.

Economists say that one of the reasons why it no longer makes sense for Germany to stick to its fiscal straitjacket is the new threats facing Europe’s largest economy following Russia’s invasion of Ukraine.

But there are other financial strains too.

Germany’s population is ageing, putting pressure on its public finances as pensions and healthcare spending rise. At the same time, the number of workers is plunging, not only as a share of the population but in absolute terms too.

The UN predicts that between 2020 and the mid-2030s, the number of people aged between 20 and 69 in the country will drop by around five million, or close to one-tenth.

This will put ever-growing pressure on Berlin’s artificially constrained finances, says Franziska Palmas at Capital Economics.

“Sticking to the debt brake will become ever more difficult in the coming years,” she says. “Expenditures on pensions are likely to rise significantly owing to the ageing of the population, eating up most of the room for deficit spending allowed by the debt brake.”

The squeeze is so intense that most other areas of spending will suffer a real-terms fall between now and 2027. Infrastructure is already in particularly dire shape, with Germany’s once-admired train network now something of a national humiliation.

Keeping spending low holds back GDP growth in the short-term, says Felix Hufner at UBS, and the longer infrastructure is allowed to deteriorate, the worse Germany’s longer-term prospects will be.

The situation is becoming more critical as the population ages and the country’s workforce shrinks.

“If you have fewer people available, investing is one way to support your long-run growth,” says Hufner.

“One way to make them more productive is to have a better infrastructure, digitalisation and so on. It is something that would help potential growth. It just needs to happen quickly.”

Economists are not universally convinced the debt rules must be changed.

Clemens Fuest, president of the influential IFO Institute, for instance, wrote a report last week arguing that the government must prioritise investment instead of pension spending to boost growth while sticking to the borrowing rules.

Politicians are even more split.

The FDP, in charge of the finance ministry, does not want to scrap the debt brake. The SPD is divided. The Greens are more keen.

There are ways around the rule, for instance by declaring an emergency, as in the pandemic.

But an attempt to divert unspent Covid funds into a pot to cover green spending was shot down by the constitutional court last year, in a case brought by the opposition CDU party.

It indicates there may only be a change to the rules after the next election in late 2025, and even then only if a new government has both the two-thirds majority needed to change the constitution, and the will to press ahead.

Schmieding says the debt brake was supposed to make politicians think carefully about their spending, but ultimately pushed them to slash investment and favour pensions. Loosening the rules could let the nation overhaul its creaking infrastructure, offering a boost to the economy in the years to come.

“Germany works by consensus. In the run up to the election, the opposition is just happy to have the government in trouble, and will not lend a hand,” he says.

“I am quite confident that after the election, sense will prevail and the debt brake will be changed to create more room for investment and defence.”

Unless that happens, Berlin’s low-debt problems will slow the German economy just as surely as Paris’s heavy borrowing is harming France.