• The blockbuster German fiscal reform package has now been approved. Focus now turns back to the government formation process, with the hope being that it will be completed in around a month. The 2025 budget could in turn be presented by July, which would set out in detail how the expanded scope for debt-financed spending will actually be used.
• It’s still unclear whether the urgency required for the approval of the package will translate into its actual implementation, but we think that the new government will reluctant to let things drift given the economy’s weak starting point and range of external risks.
• As well as the upcoming direct boost from higher spending, there are already signs that the sea change in domestic fiscal policy is feeding through to business confidence. As an indicative forecast, we are now pencilling in growth of 1.7% in 2026, up from 1.1% in our January outlook.
• We stress that near-term growth risks are tilted to the downside. The US administration’s announcement on ‘reciprocal’ tariffs on 2 April continues to loom large over the European economy. However, it is reasonable to assume that new spending would be fast-tracked and/or re-directed in the event of a large negative shock such as an escalating US-EU trade war.

Confirmed: The next German government will have substantial fiscal firepower

Germany’s blockbuster fiscal package has now been passed by lawmakers. The large expansion of debt-financed spending was first announced early this month and we set out our initial take here: The brakes are off in Germany.

To recap, there are three pillars to the package:

• The creation of a 500bn EUR infrastructure fund outside of the ordinary budget to be used for additional investment. 100bn of this will immediately be funnelled into the existing Climate Transition Fund (KTF). Of the remainder, 300bn is allocated to the federal government and 100bn for the state governments.
• Defence spending above 1% of GDP will be exempted from the constitutional debt brake which limits the structural deficit to 0.35% of GDP. In other words, it will be possible to fund defence through borrowing and so there will be no legal upper limit to the defence-to-GDP ratio, which stands at around 2% currently.
• Reform of the regional debt rule so federal states will be allowed to run deficits of up to 0.35% of cyclically-adjusted GDP (i.e. matching the federal government’s current borrowing limit).

Things have moved quickly since the election on 23 February to get to this point. The two-thirds majority required to change the constitutional debt brake would be difficult to achieve in the new parliament which meant that the package was rushed through the outgoing assembly.

While the expanded fiscal envelope is now fixed, the details will be determined in the next parliament and the immediate focus will now turn back to the CDU/CSU and SPD government formation talks. There are various sticking points (especially around immigration policy, welfare and tax reform) but the parties have indicated that the aim is to reach an agreement by Easter (i.e. mid-April).

The hope will then be that the 2025 budget can then be agreed by early July before the Bundestag summer recess. While a two-thirds majority was required to amend the constitutional debt brake, a simple majority will suffice for specific spending decisions.

At this stage, the CDU/CSU and SPD have only indicated a broad desire to invest in transport, energy and medical infrastructure, as well as R&D and digitalisation. We don’t have any details on allocations or timing.

Unlocked funds, unclear timetable

The short-term growth outlook largely hinges on the whether the urgency involved in the approval of the package will be carried over into its actual implementation.

The draft law noted that a “slow, incremental increase in [military] funding” is “not sufficient”. We think that equally applies to broader capex given German industry’s extended period of stagnation. We are encouraged by chancellor-in-waiting Merz’s proactivity and think that the new government will be mindful of the policy inertia under the previous administration.

On the carve out of defence spending, we don’t know what the ultimate target will be in terms of GDP share or the timeframe to get there. It’s also still unclear whether the focus is to 1) increase military capacity as quickly as possible (which would mean high share of imports), or 2) to build domestic capacity (which would be a gradual process).

Reports that the EU may exclude the US, UK and Turkey from its rearmament fund suggests that it could be the latter. Either way, we don’t expect a significant boost to near term activity from higher defence spending, but longer-term there could be some positive spillover effects to wider industry from R&D if domestic production is increased meaningfully.

An immediate confidence boost

Details aside, there is likely to be a significant and immediate confidence boost. This is a sea change in German fiscal policy which constitutes a huge positive demand shock. We also expect businesses will react favourably to next government’s stated intentions for structural reforms to reduce bureaucracy, as well as the broader increase in stability that seems likely after the unwieldy three-party previous administration. There are already signs of a boost to sentiment – the ZEW expectations indicator surged to a three-year high in March.

On growth, the focus on infrastructure rather than current spending is positive both in terms of the near-term effect on growth (funds must be spent domestically and cannot be saved) and longer-term potential output.

Still, we are dialling back our initial ballpark estimate of a 0.8pp boost to 2026 growth slightly after some changes to the initial announcement. The 500bn EUR infrastructure fund will be spread over 12 years, not 10 as originally suggested. The draft law also indicated that the time frame is for approval of investments which means that funds can be disbursed after the 12-year term. Together this points to a more gradual spread of new spending.

As an indicative forecast, we are now pencilling in growth of 1.7% in 2026. That’s up from 1.1% in our January forecasts (here).

Tariff risks loom large

Risks are that estimate remain firmly tilted to the downside. The US administration’s upcoming announcement on “reciprocal” tariffs (2 April) is looming large over the European economy. The threat is that tariffs will match a range of measures (perhaps including VAT, which the US administration apparently sees as similar to a tariff) imposed by other countries, on an individual basis. The EU seems very likely to be in the crosshairs for these measures given its large goods trade surplus with the US.

As noted last autumn (here), we worry about the risk of second-round effects from tariffs on the labour market. With difficulties in recruiting appropriately skilled workers, it seems that German manufacturing firms have ‘hoarded’ labour and avoided redundancies in the hope that demand conditions will eventually turn around. Trump tariffs could be the trigger for firms to push ahead with lay-offs that could tip the economy into a more serious slowdown.

There are also increasing concerns around the health of the US economy itself, which could have implications for European export demand regardless of trade policy. US consumption growth looks weaker at the start of the year even before any uptick in inflation related to tariffs. At the same time, volatility around trade, immigration and fiscal policy is likely to remain a headwind for fixed investment and employment growth.

So, there are numerous external headwinds. But the expansion of Germany’s fiscal leeway means that risks around the outlook are clearly more balanced. It is reasonable to assume that new spending would be fast-tracked and/or re-directed in the event of any negative shock such as an escalating US-EU trade war.