Germany's recent decision to relax its historic "debt brake" (Schuldenbremse), marks a radical shift in its fiscal policy and - possibly - in the European economy as a whole. This reform allows for a significant increase in defense and infrastructure spending, which could redefine Germany's position on the global stage.

Since the 2008 financial crisis, the debt brake, enshrined in the German constitution, has been a central pillar of the country's fiscal policy. This mechanism limited the government's structural deficit to 0.35% of GDP and severely restricted borrowing capacity, except in exceptional situations, such as economic crises or natural disasters.

While this policy has promoted sound fiscal discipline, with relatively low debt compared to other G7 countries, it has also generated costs. Germany now faces the need to make productive investments to strengthen its economy, especially in a context where its export model has been hit by rising energy prices and increasing global competition. Even so, the debt brake allowed Germany to take advantage of years of prosperity to strengthen its public finances, ensuring a margin of maneuver to face more challenging times.

Low public investment has been a persistent problem, especially in key areas to improve its competitiveness, such as the digitalization of public services, infrastructure, education and energy. Net public investment (gross public investment minus depreciation) has declined drastically, from 1% of GDP in the early 1990s to close to 0% in recent years.

In addition, Donald Trump's order to suspend military aid to Ukraine, shifting this burden to European allies, together with the threat of tariffs that could affect exports, has generated pressure to reform the fiscal system. In this context, the need to implement an expansionary fiscal policy is becoming increasingly urgent. Even the Bundesbankthe German central bank, has pointed out the importance of reforming the debt brake to strengthen public finances and allow for increased investment.

The German economy faces a number of significant challenges. After two years of stagnation, the outlook for 2025 remains bleak. However, the passage of this tax reform could provide the necessary impetus to revive the economy and even foster long-term sustainable growth.

The bill proposes the creation of a €500 billion fund to invest in priority areas such as transportation, energy networks and housing over the next 12 years. In addition, it provides for an exemption from the debt brake for defense spending exceeding 1% of GDP. This change represents Germany's biggest tax reform since reunification.

Friedrich Merz, the next German Chancellor, has stated that "Germany will do whatever it takes" to ensure the country's defense. The initiative was approved in the Bundestag (Lower House) on Tuesday and now awaits a vote in the Bundesrat. Bundesrat (Upper House) which will take place on Friday. (*). If it obtains two-thirds support, it will be signed by the President of Germany.

The immediate impact of this decision is already being reflected in the markets. The German bond rate has risen sharply, with the bunds 10-year bunds reaching 2.9%, levels not seen since 2011, up from 2.5% previously. The euro has also appreciated sharply, driven by expectations of economic growth and higher debt issuance.

Germany's shift to a more expansionary fiscal policy marks a turning point with implications far beyond its borders. While it is still uncertain whether the strategy will boost growth or jeopardize long-term fiscal stability, what is clear is that the principle of austerity is no longer immovable. Beyond economics, Germany has shown a strong determination to address urgent challenges, such as countering the threat from Russia and tackling structural problems in its economy.

Vincent Dourthé, CFA

Portfolio Manager Private Debt Fynsa AGF

(*) This note was written before the vote in the Upper House.