Of hawks and doves: Reflections on German’s new expansive fiscal policy

Bob Hancké

25 March 2025

Winston Churchill is supposed to have remarked that the Americans will always do the right thing – after exhausting all the alternatives. Not sure that is still true today, but the sentiment underlying the expression should travel to the other side of the Atlantic. Not to London, of course, where Chancellor of the Exchequer (Finance Minister in the rest of the world) Rachel Reeves seems to have forgotten the Keynesian economics she learned at the LSE (for the uninitiated: debt/GDP is a fraction, not an absolute number; it has two variables not one). No, to Berlin. Germany is now an expansive fiscal power in the vanguard: after more than fifteen years of clutching its purse strings, the incoming German government (a work in progress at the time of writing) has thrown off the self-imposed and self-defeating ‘debt brake’ and will spend lavishly on defence including work towards peace, on infrastructure and on the green transition to the tune of almost €1bn. This is no small beer.

A few thoughts that, I hope, highllight points that other commentators have overlooked. One, the unstable politics at the basis of this policy shift are worrying. The fiscal package followed elections where, arguably as a result of the weak economy that was partly a consequence of overly restrictive government economic policies, the combined vote share of the centre-Right CDU-CSU and the centre-Left SPD was only just above 40%, its lowest level since the Second World War. In its place: the far-Right AfD, now the second-largest party in Parliament and the official opposition, and almost 15% of the vote to the left of the SPD. This new constellation is beginning to look a bit like the last two elections during the Weimar Republic. Ignore, if that is possible, the racist and otherwise inhumane ideology and the expansionist war that followed the collapse of the Weimar Republic, and concentrate on domestic economic policy in the 1930s, when large public works put the economy back on track. The shoe is on the other foot – history never quitre repeats itself – but do not ignore the parallels.

Secondly, it is impossible to overstate the positive economic effect of this sudden volte-face in German economic policy. Not only will this domestic spending package, about half of which is public consumption in defence and the other half public investment, produce a short-term boost and increase the long-term German growth rate, but it will also produce benefits for the rest of Europe. If Germany does well, France, its main trading partner does well, since German consumers like French products. When France and Germany, combined almost half of eurozone GDP and about 40% of aggregate EU GDP, do well, the rest of Europe does well, since they sell their products and services to these two. When the rest of Europe is growing, Germany and France grow as well, since they sell a lot there. You get the idea: because of the economic interdependencies, the E(M)U’s macroeconomy should start to pick up again and grow. Why didn’t we think of that earlier…?

This is the moment where my conservative friends, not unreasonably, warn about inflation. With all that sudden money sloshing around the economy, which faces short-term output constraints, prices will rise and we end up in the worst of all worlds: higher debt, accelerating inflation, a real collapse waiting in the wings, and political discontent as a result. Perhaps that will happen, but it is unlikely. Public debt will rise, yes, but incurring debt for investment should be considered ‘credit’ not ‘debt’, with an appropriate expected return. While there may be questions about the size of the benefits of the investment plans, there is no doubt that the return will be positive: that’s what better roads and houses, faster broadband and higher skills do.

In addition, even the defence expenditures, almost all pure one-off public consumption budget lines (all else equal, you produce bombs but hope you do not have to use them), involves a complex supply chain. Demand at the top of that supply chain will imply investment further down, in Germany and abroad. It’s no coincidence that shares in European defence contractors went up as a result of the German fiscal shift and Trump’s anti-European policy stance. This all matters because it suggests that the long-term effects on inflation are likely very modest: investment has very different on inflation than consumption.

It’s not even certain if the short-term effects on prices will be significant: German industry and society have developed a series of institutions to keep domestic inflation under control, the ECB seems aware of the balancing act required, and most other European economies in this value chain have effectively copied German anti-inflationary institutions or developed an equivalent since the start of EMU. The institutional containment of the short-term inflationary effect, coupled with the outward shift of the non-inflationary long-term growth rate because of productivity-enhancing investment, will therefore most likely only have modest short-term and long-term price effects.

That all said, there is more to Germany’s problems than fiscal masochism, of course: its energy, while moving green, is still pretty brown, and its industry has been slower in engaging in the green transition than is warranted. But this is where public investment will help. For example, if the German car industry has been reluctant to develop and build electric cars, the massive public investment in new charging infrastructure, revised zoning regulations for supporting industries, and reconversion plans for regions that are disproportionately affected by the green transition will certainly reduce the remaining uncertainty and help automobile producers and their unions focus on the future.

Finally, a thought for fiscal hawks everywhere. The previous SPD-Green-FDP government hit a road block in 2024 when the FDP refused to find €8-9bn for the green transition. That sum not only almost looks like a rounding error now, but this doctrinaire position also led to the decimation of the FDP, who was forced out of the Bundestag.

Now, if the FDP had been more sensible, we could perhaps have saved ourselves the psychodrama of late 2024 and have orderly elections after the summer as planned. But a little voice in my head shouts ‘no, then they would not have done what they did!!’. Trump’s pivot away from Europe was the catalyst for the fiscal shift, no doubt, but without the elections and their outcome, Germany would probably still be looking at more alternatives before finally doing the right thing.