MNI INTERVIEW: German Defence Drive Brings Eurobonds Closer

Recently-announced defence and infrastructure spending plans are likely to raise German inflation rather than growth and make joint European debt issuance more likely if they threaten to breach EU fiscal rules, the finance ministry’s former chief economist told MNI.

Plans by new Chancellor Friedrich Merz’s CDU-led government to spend up to 3% of GDP on defence will cost close to EUR1 trillion, said Wolf Reuter, also former state secretary for finance and director general for econominc and fiscal policy under then-minister and Free Democratic Party leader Christian Linder until November last year.

“Then there is the infrastructure investment fund of EUR500 billion for 12 years. And there is an increase in the limit for structural deficits for federal states, to allow them more fiscal space. Altogether, it’s going to look more like EUR1.5 trillion or more for the whole package over the next 12 years. “ (See MNI INTERVIEW: German Defence Employment To 'At Least' Double)

The government’s plans may come into conflict with the EU’s fiscal rules, with any violation of these by Germany likely to prompt other member states such as France and Italy expected to follow suit, he said.

JOINT BORROWING RISK

“It's clear that if they want to comply with the fiscal rules as they are today, they can spend almost nothing of that infrastructure fund in the next years. There’s very little headroom,” Reuter said, adding that this means the probability is rising that the EU might issue joint bonds.

“We need binding constraints at the European level if we don't want to go towards a political union with euro bonds or the ECB buying up all the government bonds. I think the risk of that - others might call it potential - is currently very high,” he said. 

“If Germany doesn't change its spending in other areas so that they do actually comply with the fiscal rules - and instead want to have some kind of exception or workaround at the European level - then there is a big risk that other countries, especially the ones with high debt ratios, will probably push for common financing, probably of defence spending.” (See MNI: Additional EU Defence-Financing Prospects Bleak)

In the absence of a European defence procurement system, the higher prices caused by the spending drive will for the most part remain concentrated in Germany, however should it cause a broader inflationary impulse then there is a risk of second- and third-round impacts which could cross borders within the eurozone, Reuter said.

“The main problem right now in Germany is that you have very low potential growth - 0.3% to 0.5% depending on whose estimates it is - and if you don't increase that potential growth rate, then spending all that money means you don’t get much more growth, but you do risk inflation and replacing private investment activity,” he said, noting that Germany’s inflation rate was already above 2% despite flatlining output, and that labour markets remain tight.

RUSH TO SPEND

Politicians may also rush to spend money quickly rather than efficiently, said Reuter, amid fear of public criticism and concern that the hard-right Alternative for Germany will make further gains ahead of 2029’s national poll. 

“After four years the electorate will ask, ‘How much of that money did the government actually spend?’ The chancellor, already in his first speech in the parliament, said he wants to spend EUR150 billion of that investment fund in these four years. So there will always be a clock ticking, and there’s a huge risk that that becomes the main focus.”

Another clear “bad sign" is Germany’s failure to submit to the European Commission details of its longer-term funding plans, which were due last year, Reuter said.

“I think now there is no other way than to submit a seven-year plan. Spending larger parts of the infrastructure fund will not be possible in the four-year period, and it will also not be easily possible in the seven-year period.