A tale of two economic futures

Germany’s new government, a reluctant coalition between the Christian Democratic Union of Germany (CDU)/Christian Social Union in Bavaria (CSU) and the Social Democratic Party of Germany (SPD), represents the fourth time they have teamed up in coalition since the 1990s.

12 June 2025

This time, the threats they face are existential, with the Alternative for Germany (AfD) and far left parties taking ever more share of the vote. Alongside the inauguration of the new government, a wordy 146-page agreement was published. For the economy, the message was simple. The coalition needs to get Germany’s economy back on track, and quickly. This time they have Germany’s new unleashed fiscal headroom on their side. If they can deliver, this could mark a significant turning point for European equities more broadly, powered by a rebirth in domestically generated European GDP growth.

Germany has significant fiscal headroom to reverse economic stagnation and underinvestment

Long constrained by the constitutional "debt brake" (Schuldenbremse), which caps structural deficits at 0.35% of GDP, the country is now embracing a more pragmatic approach to public investment. With a debt-to-GDP ratio below 65% – far more conservative than many peers – Germany has significant fiscal headroom. For the first time in decades, it appears ready to use it.

Germany has significantly more fiscal headroom than many of its peers. With debt at just 63% of GDP and a modest 2.1% fiscal deficit, it stands well below the US, Japan and most major European economies. Illustratively, Germany could borrow over USD 1.7 trillion before hitting 100% debt-to-GDP and still spend an additional USD 130 billion annually while staying within a 5% deficit threshold. While constitutional fiscal rules remain in place, recent exemptions show their growing scope for flexibility when needed.

Chart 1: Comparative fiscal health: Germany vs major economies

 

 

 

 

Germany’s shift is driven by necessity as much as vision. After years of underinvestment, the cracks in Germany’s infrastructure have become impossible to ignore. The long-term incumbent parties and new CDU/CSU and SDP coalition have only won a narrow mandate to govern, due to a surge in support for the AfD. Infrastructure investment averaged just 2.3% of GDP since the early 2000s – well below the euro area average of 3.3% and France’s 4.3%¹. The result has been a growing backlog of neglected assets: over 4,000 bridges in disrepair, declining rail performance with Deutsche Bahn posting a EUR 1.77 billion loss in 2024, and a long-delayed energy grid modernisation that has stymied the country’s clean energy transition. Social infrastructure has fared no better. Schools and hospitals suffer from outdated facilities and limited capacity, while Germany’s once-proud digital infrastructure now trails its European neighbours.

Chart 2: Gross public investment as % of GDP (2018-2022)

A EUR 500 billion infrastructure fund and a proactive approach to competitiveness

Recognising these weaknesses, Berlin has approved a EUR 500 billion infrastructure fund to be deployed over the next 12 years. This package – averaging roughly 1% of GDP per year – will target transport, energy, digital networks, defence and education. It is a decisive break from the post-2008 austerity model and a strategic bet on long-term productivity and resilience. This, we think, could create a halo effect for European growth.

The 2025 coalition agreement also introduces a broad range of economic reforms aimed at enhancing industrial competitiveness and accelerating the energy transition. Key measures include targeted energy subsidies, such as reducing electricity taxes and capping grid fees, and potentially introducing a heavily discounted power price for energy-intensive industries. Strategic sectors will benefit from expanded gas-fired power capacity and legal frameworks for carbon capture and storage. Tax reforms feature phased corporate tax cuts of five annual 1% cuts starting in 2028, accelerated depreciation for equipment investment, and incentives for workforce participation, including tax-free overtime and income exemptions for working pensioners.

On Wednesday 4 June, German Finance minister Lars Klingbeil confirmed plans for a EUR 46 billion corporate tax break which would enable companies to deduct 30% of the cost of new machinery and other equipment from their tax bill annually between 2025 and 2027. From 2028, the federal corporate tax rate of 15% would then decrease by a point every year to 10%. With the changes, the overall rate would fall to 24%, bringing Germany in line with the OECD average.

Germany is now leading the initiative on European rearmament

Defence has been another area of chronic underinvestment. For decades, Germany's military spending lagged NATO benchmarks, averaging around 1.5% of GDP. This underfunding left the Bundeswehr with outdated equipment and limited operational readiness. In response to growing security challenges, including Russia's aggression in Ukraine, Germany has initiated a significant shift in defence policy. In 2022, a EUR 100 billion special fund was established to modernise the armed forces.

Further reforms came in 2025, when German lawmakers amended the constitution to exempt defence and security spending beyond 1% of GDP from the debt brake. This change enables additional investments in defence infrastructure and capabilities. Chancellor Friedrich Merz has pledged to build Europe's most formidable conventional army, with plans to allocate 3.5% of GDP to military procurement and an additional 1.5% to dual-use infrastructure projects, such as roads and bridges that serve both civilian and military purposes.

Chart 3: Defence expenditure as % of GDP (2024 estimates)

These developments come ahead of the NATO summit scheduled for 24-26 June, 2025, in The Hague. At the summit, NATO members are expected to discuss a proposed increase in defence spending targets to 5% of GDP, with 3.5% dedicated to core military capabilities and 1.5% to broader security-related investments. Germany's proactive steps in defence spending position it as a leader in meeting these ambitious goals. Although it seems unlikely all European NATO members will get there, given the differing fiscal deficits, the direction of travel is clear.

Assuming Europe’s NATO members got to 5% of GDP spend on defence by 2030, it could unlock more than USD 500 billion of incremental spending versus 2023.

By contrast, the US fiscal path is increasingly uncertain

Germany should be able to achieve these significant changes without adding significantly to its national debt. This in stark contrast to the fiscal trajectory of the US. With its debt-to-GDP ratio exceeding 120% and annual deficits expected to remain above USD 1.5 trillion for the foreseeable future, the US is navigating uncharted territory. These levels of borrowing are historically exceptional outside wartime and are becoming increasingly unsustainable in a high-interest-rate environment. Debt servicing costs are now one of the largest components of federal expenditure, threatening to crowd out discretionary spending and limit economic manoeuvrability.

The Republican Party, once known for fiscal conservatism, has increasingly supported large, unfunded expenditures. Trump's ‘Big, Beautiful Bill’ and proposals for sweeping infrastructure packages and tax cuts, with little regard for budgetary offsets, highlight the growing bipartisan disinterest in fiscal discipline. Markets are beginning to price in the risk of further debt expansion, which could stoke inflationary pressures or even spark a bond market correction.

Germany’s fiscal pivot could signal a generational opportunity for Europe

We believe Germany's fiscal pivot can change the investment landscape for Europe. This shift, combined with a more assertive and growth minded EU could signal a significant change to Europe’s investment proposition. Within Europe, we see particularly attractive exposure associated with Germany's renaissance, including sectors tied to electrification, banks, industrials, and construction – areas poised to benefit most directly from the country's structural investment wave.

Tom O’Hara, Jamie Ross and David Barker manage European Equities strategies at GAM Investments. You can find out more information on the team and the strategies they are responsible for here.