The sudden collapse of Germany’s ruling coalition has sent ripples through the euro zone, sparking hopes of increased government spending that could support the region’s ailing economy and boost both the euro and stock markets. Although the path forward remains uncertain, markets have already reacted positively. A key bond market gauge for debt issuance has surged to a record high as investors anticipate potential fiscal easing and increased borrowing to stimulate growth.
One major contention in the coalition’s dissolution was the debate over Germany’s debt brake, a policy adopted in 2009 that limits government borrowing. The fresh elections set for February could potentially offer clarity on Germany’s fiscal future, providing a more stable economic outlook for the country that narrowly avoided recession.
Positive Market Movement Amid Political Change
German stocks outperformed European counterparts following news of the government’s collapse. This optimistic turn came shortly after Donald Trump’s U.S. election win, which raised concerns over new tariffs that could impact Germany’s economy. Guy Miller, chief markets strategist at Zurich Insurance Group, noted, “The German growth dynamic has been anaemic and a large part of that has been self-inflicted as Germany has stuck with the debt brake at a time when the economy needs support. The collapse of the coalition is constructive and we hope there could be more fiscal leeway in the 2025 budget.”
Potential Economic Benefits of Looser Fiscal Policies
Economists have often blamed the debt brake for stifling growth in Germany, which is expected to see economic contraction this year. ING’s head of global macro, Carsten Brzeski, estimates that a 1% to 2% increase in government spending annually over a decade could potentially lift Germany’s growth rate to 1% from the current 0.5%. “Germany is not in any public finance problem,” Brzeski pointed out, emphasizing that its debt stands at just 63% of GDP, giving it more room for fiscal maneuver compared to France and Italy. “If you can combine reforms with looser fiscal policies, please do it,” he added.
The International Monetary Fund (IMF) has also advocated for Germany to consider easing its debt brake. Any indication of higher spending could potentially bolster European shares, which have lagged behind U.S. markets. The STOXX 600 is up only 6% this year compared to the S&P 500’s 26% gain, underscoring the need for pro-growth policies in Europe.
The Role of Political Parties and Policy Expectations
While some view the coalition’s collapse as an opportunity for fiscal reform, it’s not guaranteed. The conservative Christian Democrats, currently leading in the polls, favor a cautious approach. Party leader Friedrich Merz has expressed a commitment to maintaining the debt brake and has called for controlled welfare spending. He also opposes additional EU debt-sharing initiatives. Thierry Wizman, a strategist at Macquarie, remains skeptical of major reforms and advises betting against the euro, citing the uncertainties of a reformist government.
Nonetheless, Citi predicts that tax cuts proposed by the Christian Democrats could support equities. Kit Juckes, Societe Generale’s chief FX strategist, notes that Germany’s status as the world’s largest holder of foreign assets positions it well for potential domestic investment. “Such money could be used to buy high-yielding German government bonds to get the economy moving,” Juckes said, suggesting this could significantly impact the euro if a material policy shift occurs.
The Long-Term Impact and European Integration
Analysts like Gilles Guibout of AXA Investment Managers believe that changes in Germany’s fiscal policy could open the door to greater European integration. “A change in tone at the top in Germany is essential to move toward greater European integration,” Guibout said, adding that the sacking of finance minister Christian Lindner, known for his fiscally conservative views, is “great news” for Europe. However, he cautioned that it remains to be seen whether this will be enough to bring about substantial change.
Goldman Sachs expects any changes to the debt brake under conservative leadership to be modest, potentially allowing only an additional 0.5% of output in new spending. This could mean that fiscal policy might continue to act as a drag on growth, rather than a driver.
Future Challenges and Debates
As snap elections approach, debates around Germany’s growth model and EU security risks are likely to take center stage. Davide Oneglia of TS Lombard suggests that the elections could prompt a reevaluation of economic priorities. “The main risk to our view is that they fail to grasp the need of a paradigm shift and fall back on old, now unviable, economic recipes,” Oneglia warned. “A still harsher reckoning would then come for the German and EU economy.”
The collapse of Germany’s government has created an environment ripe for economic speculation and potential change. While markets have responded with cautious optimism, the direction of fiscal policy will depend heavily on the outcome of the February elections and the political will to reform the debt brake. With the euro and European stocks in need of a boost, any shift towards increased spending and pro-growth policies could have significant implications for the region’s economic stability and growth.
