Germany, once a beacon of frugality, jolts Europe with planned spending splurge

In a hastily convened press conference in Berlin late Tuesday, Friedrich Merz, the man in line to become Germany’s next chancellor, announced a break with a position that had governed the country’s relations with its European partners for decades.

From now on, Germany’s famously strict fiscal rules, Merz said, would no longer apply to military spending, paving the way for a rapid acceleration in the country’s rearmament. The incoming government would also set up a €500 billion infrastructure investment fund to rebuild the country’s long-neglected transport, energy and digital infrastructure, he added.

“Given the threats to our freedom and to peace on our continent, we must do whatever it takes for our continent," Merz said. The country needed to rearm, he added, and to do so it needed to rebuild its economic muscle.

Because of its scale and open-endedness, the splurge is a break with decades of fiscal orthodoxy. Informed by the hyperinflation of the 1920s that led to Adolf Hitler’s rise, the depression of the 1930s or the eurozone debt crisis of the 2010s, generations of German rulers have stressed the importance of sound public finances and economic stability, enshrining thriftiness into the national psyche.

The combined announcements marked the closest Germany has ever come to reinventing its ailing export-dependent economic model by boosting domestic demand to offset flagging international trade and tepid global demand for German goods.

If approved, the fiscal U-turn could give Germany’s neighbors cover to raise their own military spending, as Trump insists they should. It could also jolt the region’s economy. Berlin’s military shopping list in particular could benefit companies across the region.

“Germany and its European partners are aware that this is not a fire drill," said Sudha David-Wilp, vice president of external affairs at the German Marshall Fund of the United States. “Merz’s move…would have been considered radical even six months ago but is now expected and necessary."

By initiating a rapprochement with Russian President Vladimir Putin, the man many European leaders think poses the biggest threat to the continent, Trump persuaded the Europeans they would have to take care of their own security—and invest real money into it.

This posed a particular challenge for Germany. The country has long sought to lead by example in Europe, constraining its own public spending to both inspire and coerce its neighbors into doing the same.

One of the loudest advocates of Germany’s fiscal rules was Merz himself. While he left the door open during his election campaign to some tweaking of the rulebook, which is enshrined in the constitution, economists said what was agreed this week is something different altogether.

“This is much more than a reform," said Dirk Schumacher, head of European economics at French bank Natixis. “If his government is going to be a success, it looks like Merz decided money to spend was going to be a necessary ingredient."

There are still big questions hanging over the announcement. The fiscal rule exemption and the infrastructure fund are constitutional amendments and there is no guarantee they can secure the required two-thirds majority of parliament. Merz and his future coalition partners have also yet to decide by how much they want to raise military spending.

Economically, Germany is likely to be the main beneficiary. After years of frugality, it has one of the lowest public debts in Europe as a percent of gross domestic product. But chronic underinvestment also left it with an unreliable railway system, patchy mobile networks, an aging power grid and a public administration stuck in the paper age.

The market capitalization of Düsseldorf-based defense company Rheinmetall has soared in recent days.

Germany’s blue-chip index rose by more than 3% to a near-record on Wednesday. The market capitalization of Rheinmetall, a Düsseldorf-based defense company with around 30,000 workers, has soared in recent days above €50 billion, equivalent to about $53 billion. That is close to the value of Volkswagen, whose workforce is 20 times as large.

Government bonds had their worst day since the 1990s as investors anticipated a rise in debt issuance. The 10-year bond yield surged about 0.29 percentage point to 2.79%—yields rise as prices fall.

Despite the selloff, most economists think Germany has comfortable leeway to borrow because of its low debt. But higher financing costs could make it harder for Europe’s more indebted countries to increase their military purchases.

Jens Südekum, professor of international economics at Heinrich-Heine University in Düsseldorf, was one of four economists commissioned by Merz and his negotiating partners to deliver a secret blueprint for the future government’s defense and investment spending framework.

One simulation they conducted showed a 1.5 multiplier for infrastructure investment, meaning that the €500 billion fund could turn into €750 billion additional GDP by 2035, with little inflationary pressure, Südekum said.

By then, Germany’s debt-to-GDP ratio could be 10 percentage points higher than it would have otherwise been, he added. “But maybe that’s a price worth paying for a safer and more livable country."

Several private-sector economists raised their growth targets for Germany on Wednesday. Morgan Stanley said the combined defense and investment packages could be worth more than €1 trillion. Germany’s annual growth rate could rise to between 1.5% and 2% starting in 2027, compared with a previous growth trajectory close to zero, according to Bank of America.

Spread over 10 years, the extra infrastructure investment would be worth about €50 billion a year. Calculating conservatively, Schumacher said, this should boost GDP growth by 1 percentage point annually. By raising the economy’s potential growth rate, the infrastructure update could also make it easier for the country to grow without fearing inflation.

Rheinmetall has agreed with Continental to recruit redundant workers from the auto supplier.

Higher government spending generates jobs and household spending, which leads to higher tax revenues. That means the additional spending can sometimes pay for itself, leaving government debt little changed as a share of gross domestic product.

The coming government has yet to agree on a full economic policy program. Taking future military spending and infrastructure investments out of the regular budget could free up space for the corporate and income-tax cuts Merz campaigned on.

There is some disagreement among economists over how military spending affects growth or whether it crowds out private spending. While infrastructure investment can pay for itself, the upside is less obvious in the case of military hardware, which acts more as an insurance policy.

Still, some say the impact could be positive, in part because Germany has spare capacity, such as underemployed workers or idle factories. With its auto industry shedding jobs, Germany has a lot of skilled workers who could transition smoothly into building trains or tanks. Rheinmetall last summer agreed with Continental to recruit redundant workers from the auto supplier.

“If you now boost the industrial sector, I do think some of that capacity could go back to the market," said Guntram Wolff, professor of economics at the Université Libre de Bruxelles.

Economists also think Germany’s defense sector might become a new source of exports. The U.S. accounted for 42% of military exports between 2019 and 2023, compared with only 5.6% for Germany, according to a recent report by Barclays.

Military spending can also boost productivity growth via spillovers to the private sector. Various military innovations have historically transferred to the civilian world, including the internet and GPS positioning. Silicon Valley’s early growth in the 1950s and 1960s was largely supported by defense investment.

A temporary increase in military spending of 1% of GDP could increase long-term productivity by 0.25%, according to a recent report by think tank Kiel Institute for the World Economy.

There are risks too. Germany’s economy has relatively low unemployment and shortages of skilled workers, said Joerg Kraemer, chief economist at Commerzbank in Frankfurt. Companies might struggle to find workers for large projects, which could lead to rising wages and inflation.

“When it comes to infrastructure, craftsmen will be hard to find," said Kraemer.

Most agree, however, that Merz’s bold move has more upsides than downsides, especially if it bolsters economic confidence at a time of heightened geopolitical uncertainty, encouraging investment and consumption.

“There’s an investment case that military spending makes Europe more secure," said Jacob Kirkegaard, senior fellow at the Peterson Institute for International Economics, “freeing us from being at the mercy of increasingly erratic American presidents."

Write to Bertrand Benoit at bertrand.benoit@wsj.com and Tom Fairless at tom.fairless@wsj.com