The contours of a policy shift in Germany

Thursday, 6 March 2025

Based on a podcast debate with Christian Odendahl, European Economics Editor at The Economist

The recent German elections have signalled a moment of deep reflection for Europe's largest economy. With a high voter turnout and shifting political dynamics, the election results highlight the urgency of tackling economic stagnation, structural weaknesses, and growing geopolitical uncertainties. The historical fiscal package that has been agreed to boost defence spending encapsulate the scale and significance of these challenges.

In the latest Future is Blue podcast episode, Christian Odendahl, European Economics Editor at The Economist, and Raymond Torres, Director at Funcas Europe, analyzed the election's implications for Germany and its role in Europe. Their insights underscored the complex balancing act that the new government must navigate.

You can listen to the podcast here.

A political shift with economic consequences

One of the biggest takeaways from the election was the electorate’s shift to the right, as Christian Odendahl explained:

"We are seeing a shift to the right, in part because the CDU gained votes, and in part because of the strength of the AfD. That was to be expected after a progressive government had a difficult time. But the biggest surprise was the surge of the hard-left party, which went from near irrelevance to 9% in the final weeks."

The most likely outcome remains a grand coalition between the CDU and the Social Democrats (SPD). However, the extent to which this coalition will drive meaningful economic reforms remains uncertain.

Odendahl sees two possible paths:

Optimistic scenario – The CDU and SPD, as Germany’s two main parties, could work together to tackle long-standing economic and structural issues, using their broad governance presence at federal, state, and local levels.
Pessimistic scenario – Both parties, fearing electoral losses to their respective opposition forces (AfD on the right, Die Linke and Greens on the left), could fall into a defensive posture, resisting bold reforms.

"These two parties do not necessarily scream future optimism and reform," Odendahl noted. "They are the oldest in terms of voter demographics, and their instinct might be to preserve rather than transform."

Underinvestment, industrial decline and geopolitical challenges

The German economy is at a critical juncture. Underinvestment in infrastructure, declining industrial production, and mounting competition from China are eroding its traditional economic model. The challenge for the new government is whether it can break from old patterns and embrace much-needed reforms.

Raymond Torres highlighted Germany’s struggle to respond quickly to structural changes:

"Germany has taken time to react to global shifts—be it China’s rise, escalating protectionism, or Europe’s energy crisis. Failing to act swiftly risks political fragmentation and economic stagnation."

One of the most pressing concerns is Germany’s high energy prices, which are making industrial production less competitive. Germany's electricity costs are 15% higher than the EU average, while countries like Spain enjoy prices 20% lower. This has fuelled calls for an integrated EU energy market, which could help lower costs and boost competitiveness.

The Debt Brake Debate – A Historic Shift

For years, Germany’s debt brake—a constitutional rule limiting government borrowing—was seen as an immovable pillar of fiscal policy. That has now changed dramatically. The CDU and SPD have announced an unprecedented fiscal package amounting to 10-20% of GDP, fundamentally altering Germany’s approach to public spending. The package includes:

A €500 billion, 10-year fund for public investment.
All defence spending above 1% of GDP exempted from the debt brake.
Federal states allowed to borrow 0.35% of GDP per year for investment.

This move marks a dramatic break from two decades of fiscal conservatism, a shift that Christian Odendahl described as the "Conservatives throwing out 20 years of fiscal ideology out the window."

"The CDU leadership recognized that under the old constraints, governing for four years would have been incredibly difficult. The last government collapsed over this. Then, Trump’s return added urgency and political cover for this dramatic turnaround."

Germany now has unprecedented fiscal flexibility, particularly in defence and infrastructure investment. While this is a major economic boost, concerns remain about how the funds will be spent and the impact on financial markets.

Raymond Torres emphasized that while this is a major positive turning point, challenges remain:

"Public investment is set to increase significantly, but the private sector must be ready to absorb this stimulus. Much of Germany’s recent defence spending has gone to purchasing U.S. military equipment. To maximize economic impact, Germany, along with other EU countries, must ensure more of this spending supports European industry."

There is also the question of interest rates. The announcement has already pushed up bond yields, highlighting the risks of increased public debt. While Germany has fiscal space, other European countries may struggle to follow suit.

"We need to be ensure that public funds yield a high economic return," Torres added. "Higher borrowing costs mean efficiency in spending is more important than ever."

Germany’s Role in Europe – A New Leadership Dynamic?

Beyond its internal challenges, Germany must also redefine its role in Europe. The new fiscal direction could reshape EU economic policy, particularly on investment, defence spending, and fiscal rules.

Christian Odendahl pointed out that Germany’s uncertain positioning in Europe has been a challenge, particularly since Brexit:

"For years, Germany wavered on key issues—transatlantic relations, China, industrial policy. It lacked a clear vision. This new government has the opportunity to define Germany’s interests more decisively."

This shift could also reignite Germany’s partnership with France and potentially strengthen cooperation with the UK under Keir Starmer. The Franco-German engine has long been key to European integration, and the new fiscal stance may open doors for deeper defence collaboration at the EU level.

However, Germany’s fiscal flexibility does not necessarily mean a shift in its approach to EU-wide spending. As Odendahl noted:

"Some European countries may think Germany is now open to joint borrowing on a wider scale. But in reality, Germany's shift is still largely confined to defence. The broader hawkish stance on EU fiscal rules remains."

Raymond Torres stressed that fragmentation has been Europe’s biggest weakness, and Germany’s move could help unify the EU on key economic and security issues:

"The message is clear: no single European country can face these challenges alone. This turning point could push Europe toward a more cohesive approach to economic and defence policy."

A defining moment for Germany

The new government must decide whether to preserve an outdated economic model or fully embrace structural reforms that could revitalize Germany and strengthen Europe. This historic fiscal shift is a first step, but the true test lies in implementation and long-term impact.

As Christian Odendahl summed up:

"Germany does best when it tries something new. The question is whether this new government will have the courage to do so."

You can listen to the podcast here.

Carlos Carnicero Urabayen