Simon Nixon / Mar 2025
Image: Shutterstock
Trump’s threats against allies have already delivered one extraordinary result. Three years after Olaf Scholz declared a Zeitenwende, or epochal change, in Germany’s approach to security and defence, the country has finally got one. Last week’s announcement by Scholz, the current chancellor, and Friedrich Merz, his likely successor, of an unprecedented increase in public borrowing to fund spending on defence and infrastructure. The package will:
- exempt defence spending above 1% of GDP from the debt brake limit
- establish a €500bn (11.6% of GDP in 2024) off-budget infrastructure fund that is planned to be disbursed over the next 10 years
- allow states to increase their borrowing from 0.0% of GDP to 0.35%.
The aim is to drive this through the outgoing Bundestag, where Merz’s Christian Democratic Union and Scholz’s Social Democratic Party, along with the Greens should be able to achieve the two thirds constitutional supermajority needed to reform the debt brake. Depending on how fast the package is implemented, Goldman Sachs reckons German military spending could rise to 2.5% this year and 3.5% in 2027. It has raised its growth forecast for Germany from 0.0% to 0.2% this year rising to 2% in 2027, lifting the economy out of its recent slump.
Just as importantly, Germany’s dramatic shift has opened the door to similarly big developments at the European level. The European Commission last week proposed to change the EU’s fiscal rules to exempt defence spending, as Germany has done, which could unlock up to €650 billion of extra defence spending. At the same time, it proposes to establish a new fund that will allow member states to borrow up to €150 billion to spend on defence investment.
These astonishingly bold moves have taken the markets by surprise, driving European stocks, German and eurozone bond yields and the euro higher on expectations of stronger European growth. German 10yr sovereign bond yields saw their biggest one-day jump since Feb 1990. European stock markets have significantly outperformed US stocks this year, while European defence stocks are now up a remarkable 50% so far this year, even as US defence stocks flounder, as can be seen in this chart from Gavekal.
Meanwhile the big question is whether there is more to come. That seems almost certain. So far at the European level, there is little new money for defence, with most of the extra spending falling on over-extended national balance sheets. That suggests that some form of common borrowing is highly likely.
The precedent would be Covid, when the initial response took the form of the small-scale SURE programme (Support to mitigate Unemployment Risks in an Emergency). But that was soon over-taken by the game-changing €800 billionNext Generation EU support package for member states funded by common borrowing. Despite insistence by traditional frugal states such as Germany that this was a one-off, something similar seems sure to emerge this time as it becomes clear that there is no alternative.
Such a “Hamiltonian moment” would have geopolitical consequences. As Katie Martin noted in the Financial Times, investors globally are looking at how the Trump administration is trashing the global order and all the institutional underpinnings of US exceptionalism and questioning to what extent they want to remain exposed to the US markets:
This cuts across asset classes. In stocks, the preference for Europe is clear — markets are streaking ahead of the US in a highly unusual pattern. But flighty stock markets are just the surface. The bit that really matters is the international use of the dollar, and dollar bond markets, as the supposedly risk-free bedrock of global finance. This is already starting to show. On Tuesday, for instance, despite the shock of new US trade tariffs on Canada and Mexico, the dollar is not climbing in its usual fashion. Deutsche Bank says this in part reflects “the potential loss of the dollar’s safe-haven status”.
Dedollarisation has been a consistent theme on Wealth of Nations over the past year. But what has held the process back has long been the lack of any alternative to the dollar. European government bond markets are too small and fragmented to meet the requirements of reserve managers. The result is that the dollar makes up 57 percent of global reserves, far in excess of America’s share of the global economy, while the euro is a distant second on 20 percent.
But as was clear from the success of NextGenEU, there is huge investor appetite for common European bonds. A big increase in common European debt would not just fulfil a market need, it would help the rest of the world pivot away from the dollar. As Katie says:
US dominance of global debt markets does not have to end with a bang. Large, slow-moving investors would simply have to accumulate other assets rather than necessarily dumping their Treasuries. But over time, the result would be the same. Regime shifts of this kind do not happen often. But they do happen. Sterling was the global reserve currency once too.
Simon Nixon writes the Wealth of Nations newsletter on Substack
