The week ahead: Seismic shift in Europe to boost economic growth

It is hard to overstate the importance of the fiscal transition currently taking place in Europe. Germany’s new Chancellor in waiting, Friedrich Merz, has announced a frankly enormous fiscal plan totalling some €800bn. This is on par with the increase in spending during German unification. Combined with higher spending in other European countries, this represents an increase in spending in.

Europe in the trillions of euros over the next decade, most of which will go to defence and infrastructure needs. The impact of this enormous spending program will be far reaching and inevitably there will be some unanticipated consequences, but here are the top five things we think will come from this. 

Boost to economic growth

First, spending on this scale is a good old-fashioned Keynesian stimulus – meaning it will boost growth. Assuming it is spent evenly over the next decade it would boost German GDP by 1% in 2026 alone. Given Germany is about a quarter of the eurozone economy, the spill over effects could boost the eurozone economy as a whole by almost 0.5% next year. Stronger growth in Europe should feed through into stronger growth in the UK. What’s more, assuming the UK gradually increases defence spending to 3% of GDP over the next few years, that could boost UK growth by a further 0.1% a year. 

Impact on manufacturing sector 

Second, much of the impact will be on Europe’s flagging manufacturing sector. If Europe is to increase its defence capabilities, that also means improving its industrial capacity. Manufacturing sectors across Europe will need to scale up to meet the demand. For example, the UK going from spending 2.3% of GDP to 3% by 2030 would represent spending an extra £30bn a year on defence, if all that was spent in the UK it could boost the UK manufacturing sector by over 10%. The case is even starker in Germany where manufacturing makes up almost 20% compared to 10% in the UK. 

Higher inflation

Third, all this extra spending will result in higher inflation. Bloomberg estimates that the extra German spending will boost eurozone inflation by 0.3 percentage points in 2026. That may not sound that much given the scale of the additional spending, that’s because Europe’s manufacturing sector is running well below capacity. UK manufacturing output is still 5% below its pre-pandemic level and a whopping 15% below its most recent peak – clearly there is a significant amount of spare capacity that can be brought into use.

Surge in debt issuance

Fourth, all this extra spending will, initially at least, be paid for by a surge in debt issuance. This has pushed the yield on 10-year German government debt up from 2.5% to almost 3%, the biggest increase since reunification. Given that German debt is the benchmark for borrowing in Europe that will push up borrowing costs across the continent regardless of what the European Central Bank does this year. With debt to GDP of a little over 60% Germany (compared to the UK at 100%) can afford some extra borrowing. 

Increase in defence spending

Fifth, there is a bigger question for how the UK will pay for increased defence spending. The initial 0.2% of GDP increase is being paid for by cutting aid spending. That “hard choice” will be easy compared to the choices for how to pay for the boost to 3% or even higher. Given the Chancellor has probably already lost her meagre £10bn headroom that she had in October and will have to cut back on non-ring fenced spending, extra borrowing seems difficult. Admittedly, there are some measures she could take. Germany has effectively removed defence spending from its fiscal rules for example, or by signing up to a new European defence Bank it could shift some borrowing off its balance sheet. But the UK, and most other countries, are more limited in their ability to use debt compared to Germany. That means higher taxes down the line, or a reduction in spending elsewhere, but the only departments with budgets large enough to offset a £30bn-ish increase in defence spending are welfare or health – neither will be popular options. A combination of higher taxes and less generous welfare spending seems the most likely option. 

There are a lot of details to work out, but the fiscal winds are blowing strongly towards more spending. That represents a risk to government balance sheets, but also a golden opportunity to boost growth and revive Europe’s flagging manufacturing sector. For UK middle market firms the challenge will be making sure they are benefitting from this bonanza. Currently only 4% of defence spending goes to SMEs. The government has acknowledged this issue and promised to spend more with UK SMEs. If done properly, the coming increase in spending could be transformational for European and UK middle market manufacturers.