Debt, Defense and Democracy: German Elections 2025

This article is co-authored by Luo Xuhong and Adeline Li. Cover image by authors.

An end to the traffic light coalition

On the same day that Donald Trump’s 2nd term win signalled a new era of geopolitical uncertainty, few paid close attention to developments in Europe’s largest economy 4000 miles from Capitol Hill. Then-chancellor Olaf Scholz abruptly dismissed his finance minister Christian Lindner, bringing his traffic light coalition to an end. Marked by years of fractious disputes between the 3 parties, the coalition was rocked by deeply irreconcilable differences regarding how best to fix the ailing economy that shrank by 0.3% in 2023 and was widely expected to contract again in 2024 (it eventually did). The September 2024 state elections best foreshadowed this result: all 3 parties fared disastrously as voters expressed their dissatisfaction over tepid policy-making at the federal level. More worryingly, both the far right AfD party and far left BSW surged in popularity at the expense of the centrist coalition.

Sick Man of Europe (Once Again)?

Over the past few years, the German economy has been rocked by a confluence of external factors that earned it the moniker “sick man of Europe” as it slipped into a recession in 2023-4. For much of the past decade, the German economic model has relied upon increasing quantities of cheap Russian gas that ground to an immediate halt upon the outbreak of the Russia-Ukraine war. High-value exports of automobiles - a strong national pride - have kept the German economy humming along until the flood of cheap Chinese electric vehicles (EVs) undercut traditional export markets. The effective upending of the German economic model meant that an overhaul of industrial policy was needed to uplift the German economy out of the depths of a recession. Unfortunately, Scholz’s coalition simply could not agree on how to do so, rendering a collapse all but a matter of time.

The proverbial straw that broke the camel’s back was the long-running disagreement over abolishing the debt brake. The highly controversial policy is the reason behind Germany’s remarkably low debt-to-GDP ratio in the low 60s (in comparison, the government debt to GDP ratio in the euro area has hovered at around 88% in 2023-4). Introduced by Angela Merkel in the aftermath of the financial crisis in 2008-9, the debt brake limits federal government borrowing to 0.35% of GDP except when suspended in an “extraordinary emergency situation” as proclaimed by parliament. Examples of past suspensions include in 2020/1 for pandemic relief spending and war supplies for Ukraine. Moreover, federal states are barred from taking on new debt since 2020, effectively prohibiting any fiscal policy that would allow Germany to spend its way out of the malaise from being implemented. Notably, amendments to the debt brake may only pass with a 2/3rds majority vote in the Bundestag. While increased spending is seen as key to reviving the German economy, debt hawk Lindner consistently blocked reforms to remove the debt brake, citing its use as an inflation control tool. With no compromise in sight, Lindner simply had to go.

Notably, Scholz's one major saving grace is the launch of a €100bn special fund in 2022 to strengthen the Bundeswehr (Federal Armed Forces). Its strategic position outside of the debt brake protects it as an off-budget appropriation that will not be ensnared by budget negotiations. Estimates suggest that by mid-2024, just under half (€47.8bn) of the fund has been spent while the remaining sum has been committed for spending by 2027. The unexpected boost in defense spending has propelled Germany to meet NATO’s defense spending target of 2% of its GDP for the first time in 2024. Nevertheless, how the government intends to sustain defense spending after the special fund is depleted remains to be seen.

Trump and German Politics

Another major factor that has shaped Germany’s economic policy is the evolving geopolitical landscape. As Germany grapples with economic instability, Trump's tariffs threats also loom ominously ahead. How has Trump's second win left an indelible mark on the German elections?

Trump’s policies have shown a profound impact on German politics. Initially opposed to Germany’s debt brake reforms, Merz has gradually shifted his position in response to Trump’s repeated hints at his intention to step away from transatlantic defence commitments. As Trump cozies up to Putin and fails to consult NATO on a potential Russia-Ukraine peace deal, German political figures have recognised the importance of greater economic flexibility and reduced dependence on the US for defence capabilities. This reform shows how Germany’s traditional fiscal policy is being re-evaluated in light of political shifts, demonstrating the effect of how external pressures can influence the long-standing economic policy that a country adopts. 

Germany starts afresh

As the CDU/CSU coalition declared victory on the evening of February 23, opposition leader and incoming chancellor Friedrich Merz has outlined his priorities even before the new parliament is convened. Coalition talks are expected to be held between the CDU/CSU victors and Scholz's SPD (now relegated to third place in terms of seats). All have ruled out working with the far-right AfD party. As Merz ushers in a new era for the German economy, the first to go is the debt brake. Seizing the momentum of change, Merz rushes through his €1trn spending package through the outgoing parliament, knowing that combined opposition from the far-right and far-left members in the incoming parliament (that have jointly secured 1/3rd of total seats) could well derail his ambitious spending plans. 53 out of 69 votes in favour were recorded on March 21, in effect handing a clean victory to Merz.

The €1trn spending package will be split evenly into separate special funds for infrastructure and defense spending of €500bn each. Notably, all defense spending above 1% of Germany’s GDP has been granted an exemption from the debt brake. With defense being broadly defined to include spending on domestic intelligence, aid to allies in addition to conventional weapon purchases, the measure effectively hands a blank check to Merz’s new government.

“Defence is now by far the most dynamic sector of German industry” ~Armin Papperger, chief executive of Rheinmetall

Already, the defense sector has reacted strongly to the spending bazooka. Germany’s leading defense industry group has proposed redeploying manufacturing capacity from the ailing auto sector to defense in early March. Even before the proposal, major defense firms have already acquired and repurposed existing auto factories. In a memorandum of understanding signed back in June 2024, Rheinmetall has gone one step further and committed to offering retraining for auto workers affected by inevitable layoffs. Change is on the horizon, as the days of Europe relying on Washington for arms are irrefutably over. 

Beyond defence, Trump’s tariff threats has also prompted the EU to develop a strategy to support crucial export industries. A recent analysis by Aslak Berg at the Centre for European Reform estimates that a 20% tariff on all EU exports could shrink trade flows to the US by $200 billion annually, likely moving the Europe economy into a recession. In response, the EU has prepared a toolkit of retaliatory instruments, including counter-tariffs on US goods, just like how the EU responded to steel tariffs imposed in Trump’s first term. However, such measures are actually hoping to bring Trump to the negotiating table, actually enforcing them will inevitably damage the economy and deepen economic instability.  

Germany’s automotive industry, which accounts for 17% of the country’s exports in 2023, is facing a looming crisis ahead. Just as promised, Trump’s new 25% tariff on imported vehicles materialised yesterday (2 April). Coupled with an extra 25% tax on car parts starting in May, these tax will deal a further blow to German automotive exports. With the U.S. representing 13% of Germany’s total car exports, and Germany being Europe’s largest exporter of passenger cars to the U.S. in 2023, these tariffs pose a severe threat to German automakers. 

At the same time, China—Germany’s biggest car market—is becoming harder to rely on because of cheaper and more advanced Chinese electric vehicles (EVs). With falling sales in China and rising cost of export in the U.S., Germany’s car industry is under massive pressure. Factory closures and job losses could increase, making things even tougher for the economy. Already, major car manufacturers that include behemoths Volkswagen and Mercedes-Benz have warned of lower-than-expected profits for the year ahead.

"The only solution for the European Union will be to raise tariffs on American products in response" ~French Finance Minister Eric Lombard

Furthermore, Merz and his Social Democrats are also considering a reintroduction of EV subsidies. Outgoing Chancellor Scholz has indicated his support for an EU-wide plan to boost EV use in company car fleets. According to an analysis done by Brussels-based NGO Transport and Environment (T&E), these proposals “would guarantee a market demand for European carmakers of more than 2.1 million EVs in 2030”, with particularly large potential in the two major markets of Germany and France. 

Germany is at a crossroads, facing both internal political turmoil and economic pressure from abroad. Scholz’s coalition splintered over the debt brake, paving the way for Friedrich Merz to push through an unprecedented €1 trillion spending plan. Merz's priorities, defence and infrastructure, mark a pardigm shift from Germany’s usual cautious spending. At the same time, Trump’s return has added an unwelcome layer of complexity. U.S. tariffs are expected to hit Germany’s automotive industry hard while the flood of cheap Chinese EVs show no sign of stopping either. In response, Germany and the EU are considering counter-tariffs and bringing back subsidies to support struggling industries. While the implications of the new policies remain to be seen, Germany can certainly no longer afford to rely on its traditional economic model in times of geopolitical and economic upheaval. 

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