Germany’s new government last week announced a large fiscal expansion, which on some forecasts lifts debt from its current 60% of GDP level to 90% over the next decade. This stimulus is heavily geared toward military and infrastructure spending, in the hope that it will help reenergize Europe’s largest economy and provide a deterrent to Russia.
In this post, we discuss three questions that have arisen in the wake of this news. First, does Germany have sufficient fiscal space for this kind of stimulus? The answer to this question is an unequivocal yes. German government bond yields rose only modestly after the announcement and remain low by international standards. Second, will this stimulus lift Germany out of its growth malaise? This is less clear, because much of that malaise stems from Russia’s invasion of Ukraine. It is not obvious that a 10-year rearmament program will be much of a deterrent to Russian President Vladimir Putin, especially once you allow for the possibility that parties with pro-Russia leanings (such as Alternative for Germany, Linke, and Sahra Wagenknecht Alliance) may gain further in coming elections. Third, is this the best way to counter Russia in an era where U.S. military protection can no longer be counted on? Likely no. As we have written in a series of blog posts, shutting down Russia’s shadow fleet in the Baltic would be far more effective since it would weaken Russia’s economy in short order and can be done at very little cost. Europe is still not taking away the right lessons from Russia’s invasion of Ukraine.
Market reaction to Germany’s fiscal stimulus
Germany’s 10-year government bond yield rose sharply last week (Figure 1) but remains very low by international standards (Figure 2). Therefore, there can be little doubt that Germany has ample fiscal space for this kind of stimulus, even with the full scope of this debt expansion still subject to negotiations.
Figure 1. 10-year nominal sovereign bond yields, in %
10-year nominal sovereign bond yields, in %
Source: Bloomberg
Figure 2. Government debt vs. 10-year bond yields in the G10 and eurozone
Government debt vs. 10-year bond yields in the G10 and eurozone
Source: Bloomberg
However, it is less obvious if this stimulus will lift Germany out of its growth malaise in the medium term. On the surface, the rise in EUR/$ looks like markets see this stimulus as a growth positive, something that proponents of the stimulus have seized on as validation. Unfortunately, how markets trade the euro is more complicated than that, leaving aside the fact that exchange rates are volatile and subject to all kinds of drivers. In the past, whenever debt mutualization has taken a step forward—like in July 2012 with Draghi’s “whatever it takes” or in March 2020 when the European Central Bank (ECB) dropped the capital key as a constraint on quantitative-easing sovereign bond buying—EUR/$ has risen substantially (Figure 3). Many of Europe’s high-debt countries have been pushing for more joint EU debt issuance. This stimulus makes it hard for Germany to oppose that, so this is arguably another one of those pro-mutualization moments.
Figure 3. EUR/$ rises whenever eurozone debt mutualization takes a step forward
EUR/$ rises whenever eurozone debt mutualization takes a step forward
Source: Bloomberg
Figure 4. 10-year nominal government bond yields for Italy and Germany
10-year nominal government bond yields for Italy and Germany
Source: Bloomberg
In the past, market participants with a negative view on the eurozone would short Italian government bonds so that progress on mutualization would inevitably cause the spread to tighten (Figure 4). This is no longer true now because periodic ECB intervention to cap Italy’s bond yield makes such short positions unviable. As a result, negative views on the eurozone now get expressed in EUR/$, perhaps causing the euro to rally disproportionately when debt mutualization takes a step forward. Whether or not markets have a positive growth view on this fiscal expansion—beyond the very short term—is therefore an open question. The rally in the euro could be mostly about debt mutualization.
Is this the best way to counter Russia and help Ukraine?
German politics are unsettled to put it mildly. Parties with pro-Russia leanings garnered close to 35% of the vote in the February election, up sharply from the previous vote in 2021. Given this trend, a 10-year rearmament program may not be much of a deterrent to Russia and does little to help Ukraine in the short term. A better approach—certainly a complementary one—would be to shut down Russia’s shadow fleet of oil tankers in the Baltic, the single biggest exit point for seaborne oil out of Russia. This could hurt materially Russia’s tax revenues from oil exports (Figure 5) by weighing on the price of Urals versus Brent, as was the case in December 2022 when the start of the G7 price cap impaired Russia’s access to global oil markets (Figure 6). Shutting down the shadow fleet could be done in short order and at very little cost. At the very least, this should be done in conjunction with Germany’s fiscal expansion, which is oriented more toward the medium term. This would be the best way to deter Russia and help Ukraine.
Figure 5. Russia’s oil tax revenues, in $ bn
Russia’s oil tax revenues, in $ bn
Source: Haver Analytics
Figure 6. Brent and Urals oil price, in $ per barrel
10-year nominal government bond yields for Italy and Germany
Source: Haver Analytics
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