By Wei Hongxu
Amidst the concerns over the possibility that the U.S. economy may fall into recession, European stock markets have performed better than U.S. stocks this year, despite the ongoing economic downturn. Market institutions believe that Europe has been shielded from the impact of U.S. President Donald Trump’s tariffs, which has led investors to turn to European stocks as a way to hedge risks and diversify.
Recently, the new German government introduced a large-scale fiscal stimulus plan aimed at increasing defense spending and infrastructure development, which has sparked hope in the market about the future of the European economy. To stimulate the economy, newly elected German Chancellor Friedrich Merz has departed from traditional fiscal conservatism, vowing to do “whatever it takes” and seeking to relax the restrictions of Germany’s constitutional “debt brake”, increasing defense spending, and boosting infrastructure investment. This has led to market optimism regarding large-scale fiscal stimulus in European countries, with European defense industry stocks seeing significant rises.
However, the European stock markets have not been able to maintain their previous momentum. European benchmark indices have been on a continuous decline, with the STOXX 600 index down 4.4% from its record high on March 3, although this decline is about half of the S&P 500’s drop since its February peak. Despite the differences compared to the U.S. stock market, the ongoing decline in European stocks reflects the impact of the U.S. economy’s drag and the potential for higher U.S. tariffs, which seem to be outweighing the positive effects of Germany’s fiscal stimulus. According to researchers at ANBOUND, these changes in European stocks largely reflect the market’s expectations for Europe’s economic outlook. While Germany’s unprecedented large-scale fiscal stimulus may provide short-term relief for the European economy, in the medium to long term, the debt “gray rhino” facing Europe’s economy and capital markets still looms large. Considering the potential for a U.S.-EU trade war, Europe’s economic outlook remains bleak in the face of both internal and external challenges.
In fact, the European Central Bank’s (ECB) continued interest rate cuts and Germany’s large-scale fiscal stimulus are both a response to the persistent economic downturn in Europe. In February, the eurozone’s year-on-year CPI growth slowed to 2.4%, marking the first decline in five months. While inflation in the services sector remains relatively sticky, the overall decline in inflation indicates that demand is cooling. The ECB’s latest economic forecast for the eurozone has lowered its 2025 growth outlook from 1.1% to 0.95%, also revising down its growth projections for 2026 and 2027. ECB President Christine Lagarde has emphasized that, due to trade tensions, growth risks remain tilted to the downside. Particularly, Germany and France, as the two economic powerhouses of the eurozone, have seen poor economic performance in recent years, with Germany experiencing negative growth for two consecutive years. In this context, Germany has shifted its long-standing policy of fiscal conservatism and opted for large-scale fiscal stimulus. This decision, aside from security considerations, is largely driven by the aim to reverse economic stagnation. Some analyses suggest that fiscal expansion could boost Germany’s GDP by 0.7-1 percentage points in 2025. This would lift Germany’s GDP growth for 2025 from 0.3%, according to the Bloomberg consensus forecast, to above 1%. In 2024, Germany accounted for 28% of the eurozone’s GDP, meaning that the country’s fiscal expansion could contribute 0.2-0.3 percentage points to the eurozone’s GDP growth in 2025.
At the same time, this actually pushes up Germany’s inflation by about 0.2 percentage points. As a result, the effectiveness of the policy is somewhat diminished. Crucially, half of the additional fiscal easing in Germany is allocated to defense-related spending, and Europe still relies on purchasing defense equipment from abroad. For instance, according to the Draghi report on EU competitiveness, 78% of the EU’s defense procurement comes from outside the EU, with 63% sourced from the U.S. While this helps reduce Germany’s trade surplus with the U.S., it contributes little to Germany’s manufacturing sector. Similarly, the current political fragmentation in Germany, along with the rising geopolitical risks from the Russia-Ukraine conflict, has led to rising costs for businesses, labor shortages, and a decline in public services and government efficiency. These factors are contributing to the outsourcing of Germany’s manufacturing industry. However, addressing these supply-side issues cannot be quickly achieved simply by “spending money”. An article in the Financial Times on March 7 asked, “Can Germany spend its way out of industrial decline?”. The article described how Germany, a country that has long adhered to conservatism, is now pushing for the most dramatic policy shift. It also mentioned that many are strongly skeptical of the reforms, believing that long-standing issues such as administrative inefficiency are deeply entrenched. Expanding expenditures while simultaneously pushing for structural reforms is likened to performing open heart surgery “while it is pumping”, which would put enormous pressure on German society.
Moreover, Germany’s large-scale fiscal stimulus will influence inflation, which in turn affects the monetary policy. If inflation eases as the market expects, the ECB is likely to slow down its interest rate cuts. Additionally, the risk of stagflation narrows the policy space for the ECB, meaning it will adopt a more cautious approach going forward. At the same time, there are significant external factors, such as Trump’s tariff policies, adding to considerable uncertainty. If the structural imbalances in the economy are not effectively addressed, increased fiscal stimulus that drives up demand could lead Germany and the broader European economy toward a “stagflationary” divide. These factors suggest that the policy effects of Germany’s fiscal shift may not be as optimistic as the market anticipates. A senior researcher at ANBOUND noted that Germany’s productivity factors have not yet returned, and during the era of globalization, many businesses and industries have already shifted abroad. Relying solely on fiscal expansion now may have a limited impact. This fiscal monetization will eventually translate into debt, and its contribution to long-term growth is limited, as it lacks an industrial foundation. Unless these industrial foundations can be restored, which will undoubtedly take more than a few years, the long-term benefits will be minimal.
A more serious issue is that Germany’s increased fiscal stimulus and expanded deficits will largely rely on issuing sovereign debt to raise funds. The larger the stimulus plan, the more sovereign debt needs to be issued, which will inevitably lead to higher German sovereign bond yields. This not only increases future government interest expenses but also puts pressure on the European sovereign debt market, further complicating the already precarious financial situation of some EU member states that are burdened with high debt levels. On March 12, the yield on Germany’s 10-year government bonds rose to 2.93%, the highest level since October 2023. Since the beginning of this month, the yield on Germany’s 10-year bonds has increased by a cumulative 53 basis points, and analysts have raised their forecast for German bond yields to 3%. Over the past week, the yields on Spain and Italy’s 10-year bonds have rapidly risen by around 40 basis points. Financial institutions like Goldman Sachs believe that the rapid rise in European bond yields and fiscal expansion led by Germany may soon face a severe test.
Indeed, the risk of European sovereign debt has become a long-term “gray rhino”. Germany’s fiscal stimulus plan means that eurozone countries will ease fiscal constraints, leading to a continued widening of fiscal deficits and further loss of control over sovereign debt. The ECB previously issued a Financial Stability Review report warning that the sovereign debt risk in the eurozone is rising, threatening financial stability. The report highlighted that, due to some member states’ weak fiscal fundamentals, rising debt levels, and persistent budget deficits, along with low long-term growth prospects and increasing policy uncertainty, the market is becoming more concerned about the sustainability of eurozone sovereign debt. The report also pointed out that macroeconomic shocks could significantly increase government financing costs. It warned, “interest costs are set to rise further and weigh on government finances for many years to come”. Data from the end of the second quarter of 2024 indicated that the EU’s public debt-to-GDP ratio was 81.5%. At the same time, the most heavily indebted EU countries were Greece (163.6% of GDP), followed by Italy (137%) and France (112.1%). According to EU estimates, by 2034, France’s interest payments will more than double, surpassing 4% of GDP, while Italy’s interest payments are expected to rise by nearly one-third, reaching 6% of GDP. Furthermore, rising geopolitical uncertainty could mean additional burdens for sovereign nations, making it more difficult for governments to meet rising defense needs and the investment required to address climate change. This is particularly challenging for countries with high levels of public debt, as these nations have less fiscal space to support the economy in the face of adverse shocks.
Meanwhile, the U.S. government recently announced a 25% tariff on imported steel products, and the EU has since proposed retaliatory measures. The worsening of external trade conflicts can only make things worse for the European economy. On March 4, online media Project Syndicate published an article by economist Desmond Lachman titled “Will Trump Trigger a Eurozone Debt Crisis?”, which warns that in Italy and France, the ratio of public debt to GDP is currently higher than it was during the eurozone sovereign debt crisis from 2010 to 2012, making a sustainable path forward difficult. The U.S. government may realize that its tariff policy—part of the “America First” agenda—could trigger an economic recession in Europe and a eurozone debt crisis. A senior researcher at ANBOUND had previously noted that a Greek-style debt crisis may be looming. European countries’ debt repayment is subject to clear legal constraints, but now, due to political reasons and the need to fend off right-wing criticism, many governments are rolling out plans to increase fiscal spending, including boosting defense spending and infrastructure projects. These actions suggest that a debt crisis in Europe is likely to emerge in the future. In this context, Germany’s fiscal policy, with its massive stimulus approach, may come at the cost of increasing sovereign debt risks for the entire region.
Final analysis conclusion:
Germany’s shift towards large-scale fiscal stimulus, while boosting short-term demand, will bring some negative consequences. Particularly for European countries that have long been plagued by sovereign debt issues, this could lead to the erosion of fiscal constraints across EU nations and drive up sovereign bond yields. Combined with the impact of Trump’s tariff policy, this will further exacerbate the risk of sovereign debt in Europe, being one of the costs associated with Germany’s fiscal push.