By Desmond Lachman

About the author: American Enterprise Institute senior fellow Desmond Lachman was a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

Troubles have come to the German economy not as single spies, but in battalions. First, it was the Covid-19 pandemic. Then it was a major energy shock induced by natural gas and oil supply disruptions from the Russia-Ukraine war, followed by an abrupt slowdown in the Chinese economy, which is a major export market for German capital goods. Now Germany faces the threat of U.S. import tariffs to curb its large trade surplus.

Unlike the U.S., which responded to its Covid-induced, two-month blip of a recession with the largest peacetime budget stimulus on record, Germany has -- until now -- been constrained in responding to its series of shocks by its so-called debt brake. The brake is a rule established in 2009 that limits German public debt to 60% of gross domestic product, one of the conditions known as the Maastricht criteria after one of the European Union's founding treaties. The brake has limited Germany's budget deficit to no more than 0.35% of GDP, with exceptions in times of economic emergencies.

This spending restriction has prevented Germany from taking a forceful budget response to the supply-side shocks of recent years. The net result is that Germany went from being the European economy's locomotive to being the sick man of Europe. While the U.S. economy grew by around 12% since the Covid-19 pandemic, the German economy is barely above its pre-Covid level. Germany has idled in recession over the past two years, while the recovery in the U.S. and elsewhere has driven the global economy to 3.3% growth in 2023 and 3.2% in 2024, according to the International Monetary Fund.

No longer. The Bundestag's decision last month to fundamentally reform the debt brake should allow Germany to provide a much-needed fiscal stimulus to both the German and European economies. It should also allow Germany to address its infrastructure and investment deficit, as well as to reduce its large current account surplus which has been a great cause of trade friction with the United States.

Incoming Chancellor Friedrich Merz, leader of the center-right Christian Democratic Union party, engineered the reform to the debt brake. It now provides Germany with the ability to jump start its economy with a large budget stimulus. The reform exempts from the debt brake all defense spending above 1% of GDP and by establishing a 500 billion euro fund for infrastructure improvement over the next twelve years.

Merz had little alternative. President Donald Trump's recently imposed 20% import tariff on China may further slow the already-stagnant Chinese economy -- bad news for Germany, which exports nearly $100 billion worth of goods to China annually. Additional so-called reciprocal tariffs expected from the administration this week may add to the economic concerns.

Fortunately, with a public debt ratio of around 63% of GDP, Germany has ample fiscal room to run a meaningful budget deficit for some time without having to be concerned about debt sustainability issues.

Germany may once again serve as the locomotive for the rest of the European economy. In turn, that should provide some relief to the French and Italian economies, which presently have higher public debt to GDP ratios than they did at the time of the 2010 euro zone debt crisis and seem to lack the political will to address their public sector imbalances.

The lifting of Germany's debt brake also offers a glimmer of hope that it can reduce trade tensions with the U.S. By stimulating investment and reducing national savings through an expansionary fiscal policy, Germany can plausibly make the case that it is doing its part to reduce its large current account surplus. It could also argue that it is doing its part to help weaken the dollar by reducing pressure on the European Central Bank to reduce interest rates to support the European economic recovery.

Germany's debt-brake turnaround alone cannot get the world out of the present economic mess in which it now finds itself. For that to happen, the Trump administration would need to dial back its present policy of aggressive import tariff hikes and massive tax cuts -- and show some international economic leadership.

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April 01, 2025 17:34 ET (21:34 GMT)

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