German parties agree on historic debt overhaul to revamp military and economy

Berlin: The parties hoping to form Germany's next government on Tuesday agreed to create a 500 billion euro infrastructure fund and overhaul borrowing rules in a tectonic spending shift to revamp the military and revive growth in Europe's largest economy.

Friedrich Merz's conservatives and the Social Democrats (SPD), who are in negotiations to form a coalition after a national election last month, will put their proposals to the German parliament next week.

Germany's likely next chancellor, Merz, has seized the moment after the return of Donald Trump to the White House put the transatlantic alliance in turmoil and underlined the urgency for Europe to strengthen its own defences.

Trump froze military aid to Ukraine after a bitter clash last week with its President Volodymyr Zelenskiy, reinforcing fears he could strike a deal with Russia to end the war in Ukraine while disengaging from Europe.

Economists and investors have urged Germany to reform its constitutionally enshrined state borrowing limits known as the "debt brake" in order to free up investment and support an economy that has contracted for the past two years.

The reform would mark a rollback of borrowing rules imposed after the 2008 global financial crisis that many have since criticised as outdated and putting Germany into a fiscal straitjacket.

"In view of the threats to our freedom and peace on our continent, whatever it takes must now also apply to our defence," said Merz, leader of the CDU/CSU conservatives.

"We are counting on the United States of America to continue to stand by our mutual alliance obligations in the future. But we also know that the resources for our national and alliance defence must now be significantly expanded."

The euro rallied to a three-month high on the news, German government bond futures fell sharply, while stock futures rose. European defence company shares have soared in recent days as momentum to ramp up spending across the region gathers pace.

"Pending more clarity on this issue, and being mindful of some execution risk, we believe this is one of the most historic paradigm shifts in German postwar history," said Robin Winkler, chief economist at Deutsche Bank Research.

"It is clear at the time of writing that there is now meaningful upside risk to our 1.0 per cent growth forecast for 2026."

Merz said the CDU/CSU and SPD parliamentary group would submit a motion to the Bundestag lower house of parliament next week to amend the constitution so defence expenditure above 1 per cent of economic output is exempt from the debt brake.

A commission of experts will separately develop a proposal for modernizing the debt brake to boost investments on a permanent basis.

Changing the so-called debt brake and creating a special fund require a two-thirds majority.

The conservatives and SPD are rushing to get the moves passed in the outgoing parliament, given far-right and far-left parties will have a blocking minority in the new parliament after scoring strongly in last month's election.

The Greens party, whose support is needed to get the debt brake reform across the line, said it would look at the proposals but made no firm commitment.

"The outcome of the exploratory talks on the special infrastructure fund and the reform of the debt brake is a real game-changer," said Sebastian Dullien of the IMK institute.

"If this succeeds, then the stagnation of the German economy is likely to be overcome quickly. Not only because urgently needed investments will now be made, but also because the overall mood is likely to shift significantly. Germany is once again economically and militarily capable of taking action."

Frankfurt-listed shares in German defence firms Rheinmetall , Hensoldt and Renk all rose on the news in late trading, gaining between 1.5 per cent and 5.2 per cent at 1909 GMT.

Merz said he would meet outgoing SPD Chancellor Olaf Scholz on Wednesday to discuss additional aid for Ukraine, with more than 3 billion euros on the table.

"Our country is running on wear and tear, and that is why it was important for us to invest, to invest massively, so that our country functions better again. A future government must stop the deterioration of our country," SPD leader Lars Klingbeil said.

The United States has repeatedly pressured Germany to increase its defence spending to overhaul a military that has felt neglected since the end of the Cold War and diverted weapons to support Ukraine in the war against Russia.

"All in all, Europe is in the midst of historical changes," said Carsten Brzeski, global head of macro at ING.

"The developments of the last few days have pushed the likely next German government to make a historical move by announcing a fiscal package that could finally mark the start of better years for the economy."