United StatesThe 2025 German federal election could prove a pivotal moment for domestic reform and help reinvigorate broader European economic prospects.
Depending on its outcome, the vote on 23 February could unlock meaningful policy changes that relax Germany’s fiscal conservativism, supporting growth domestically and across the wider region. A shift to fiscal stimulus in Europe’s largest economy – all but prohibited by its constitutional ‘debt brake’ – would be a tailwind for investors in European risk assets, including credit.
Could the fiscal handbrake be released?
One of the most debated pre-election topics has been potential reform to Germany’s constitutional balanced budget rule. Under the ‘Schuldenbremse’, the structural annual budget deficit has been capped at 0.35% of GDP since 2009.1
This fiscal straitjacket has succeeded in achieving the political goal of limiting government debt after the global financial crisis. Germany’s debt-to-GDP ratio remains at around 60%, significantly lower than the EU average of 88% and roughly half that of the US.2
It is increasingly seen as an impediment to economic growth, though. Budget constraints have impeded the government’s capacity to invest in ageing infrastructure or lower taxes.
As the spectre of recession hangs over the German economy and amid growing demands for higher defence spending, the main centre-right opposition, the CDU/CSU, has signalled openness to revisiting these strict borrowing rules.3
Source: IMF, 2024.
Subhead: German and US government debt-to-GDP ratios, 1994 to 2023 (%)
Overview: This line chart illustrates how the levels of German and US government debt, relative to national income, have evolved since 1994.
Overall, this chart shows the divergence of German and US national debts since the global financial crisis, when the German debt brake was introduced. Since 2010, the German government debt-to-GDP ratio has fallen towards 60% while US debt-to-GDP has increased to above 120%.
Implications for the market
By easing restrictions, even if only incrementally or temporarily through mechanisms like special purpose vehicles for defence and growth initiatives, the next government could unlock additional fiscal space. This would enable higher spending on both security and economic stimulus, potentially shifting Germany’s fiscal posture toward a more expansionary stance.
Additionally, the CDU/CSU has proposed tax reforms that include lowering personal income and corporate taxes by €80bn or higher, according to some estimates.4 A reduction in corporate taxes could make German companies more competitive internationally – a structural challenge facing the economy – and tax cuts would, in combination with any increase in government spending, boost near-term growth.
For financial markets, an election outcome that paves the way for a relaxation of public finances and pro-growth tax reform has the potential to drive German equities higher. Expectations of stronger economic activity would also normally be positive for corporate bonds as defaults become less likely. In this environment, we would expect credit spreads over German government bonds (or bunds) to tighten, especially for high yield bonds, leading to relative outperformance.
The debt brake has limited the supply of bunds, contributing to historically low yields. Greater issuance would put upward pressure on bund yields, which effectively serve as a risk-free rate of return in Europe. Bond yields across the region could also therefore face some upward pressure should German fiscal policy be relaxed.
In contrast, an election outcome that maintains the fiscal status quo – more likely under a broad coalition of three parties – would likely support bund prices and disappoint investors in European risk assets.
A fiscal reset for Europe?
Change in Germany, long a model of fiscal prudence, could set off a ripple effect across the region.
Reform to the debt brake could serve as a signal to its European partners that a more flexible approach to fiscal policy is warranted, particularly in the context of rising defence requirements and the need for renewed infrastructure investment. Additionally, a reduction in German corporate taxes could prompt similar measures elsewhere.
Yet there is also a substantial risk that Germany – and, by extension, Europe – ends up following the same path. Political fragmentation and institutional constraints, like EU fiscal rules, could temper any ambitious reforms.
While CDU leader Friedrich Merz’s willingness to discuss fiscal reform is a promising signal, his party’s official commitment to maintaining fiscal discipline remains strong. Similarly, coalition dynamics could lead to compromises that dilute the scope of proposed changes.
A critical moment for fiscal policy
The upcoming elections present both an opportunity and a challenge for Germany. Whether the election leads to bold new political initiatives or merely perpetuates existing policies will depend on the coalition government that ultimately follows, and the political will to overcome both domestic and European fiscal constraints.
The coming months will be critical in determining which path Germany – and Europe – ultimately takes.
1 Pitel, L., 11 November 2024: Will Friedrich Merz get Germany to abandon its fiscal fetish? Financial Times
2 IMF / European Commission, 2024
3 German GDP growth was estimated to be -0.1% in 2024. Source: European Commission, November 2024: Economic forecast for Germany
4 Kinkartz, S., 14 February 2025: German parties consider taking on more debt
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