By Eiko Sievert, Sovereign and Public Sector

A new CDU/CSU-led government would need to agree quickly on how to tackle the economy’s structural weaknesses while navigating increasingly protectionist and adversarial US trade and defence policy.

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Based on preliminary results, the SPD is likely to be the CDU/CSU’s only coalition partner which should accelerate the formation of a government with fewer compromises needed compared with the alternative of a three-party coalition including the Greens.

A broad agreement whereby the SPD agrees to the CDU-demanded supply-side reforms and the CDU in turn agrees to exploit additional fiscal space, mostly on defence and investment, could help improve Germany’s competitiveness and medium-term growth outlook.

Still, reform of Germany’s constitutionally anchored debt brake will remain challenging as the three leading centrist parties hold just under the required two-thirds parliamentary majority needed to amend the constitution. Any changes would therefore require support from the far-right AfD or far-left Linke parties, which are both reluctant to increase defence expenditure.

Germany (AAA/Stable) needs to increase its room for budgetary manoeuvre not only due to the investment required to address structural weaknesses of the economy but also because of the pressure to increase defence spending, which has intensified with the Trump administration’s reluctance to continue to finance Europe’s security (Figure 1).

EU member states in NATO are considering increasing their commitment to defence spending to 3% from 2% of GDP. This would leave many countries with a large budget shortfall, weakening their credit profiles.

Germany’s faces large defence-budget shortfall if NATO commitment increases

Once Germany’s special defence expenditure fund of EUR 100bn is depleted by end-of 2026, its budgetary gap would be the largest among EU member states at around 13.8% of central government revenues. This compares with Italy’s and France’s budgetary impact of around 5%.

The 3% target has not been reached since the Cold War and would require more than one-quarter of Germany’s current budget to be allocated to defence. Sufficiently reducing expenditure elsewhere or raising taxes appears highly unlikely in the near term. The incoming government may therefore have to rely on renewed special funds, approval for which would require a two-thirds parliamentary supermajority.

With the new parliament in place within the next 30 days, the three leading centrist parties still have a short period during which they could theoretically agree on either reforming the debt brake or implementing a special fund for defence.

Any inability to reform the debt brake or approve special funds could help sway the German government to support joint European financing of defence either through supranational institutions, such as the EU, or a newly created funding instrument.

Leaving aside increasing defence spending, the new administration faces a challenging list of reform priorities: establish a clear industrial strategy, modernise Germany’s energy infrastructure, and implement long overdue reforms in taxation, the pension system and the labour market.

Together, these measures could enhance Germany’s economic competitiveness, raise the country’s growth outlook and address growing defence and welfare pressures.