Future heavy German government borrowing to fund rearmament, infrastructure and climate mitigation raises the likelihood that the European Central Bank will restart public sector bond purchases sooner than expected.
No decisions have been made under various complex internal ECB review processes. But confirmation of much greater German bond issuance in coming years, under a constitutional change decided by the German parliament on 18 March, is likely over time to put pressure on bond markets throughout Europe.
Difficult decisions on the size of the ECB’s future balance sheet, with possible implications for governments seeking relief by the independent central bank from public sector financial strains, will be made in 2026-27. This will coincide with unusual fluctuations in the ECB’s board structure as four key members, led by President Christine Lagarde, step down.
Plans to relax the constraints of the constitutional debt brake, which limits public sector borrowing, have been widely welcomed by Germany’s foreign partners. The new debt framework is being enacted in a series of complicated parliamentary manoeuvrings by Friedrich Merz, Germany’s prospective new chancellor. His right-of-centre Christian Democratic Union/Christian Social Union grouping won the 23 February election.
Crucial condition for reviving stagnant growth
The measures are regarded as a crucial condition for Europe’s largest economy to revive stagnant growth and play a much bigger role in meeting defence challenges from the US and Russia. However, policy officials and market participants believe that the additional German borrowing will have a larger relative effect in pushing up bond market interest rates among Germany’s more indebted European partners than on Germany itself.
The largest differential repercussions are likely to be felt in France. In view of the constitutional limits, Germany maintained its balance of public debt to gross domestic product virtually unchanged over the past two decades, in spite of multiple economic and political disturbances. The ratio was 62.7% in 2024, compared to 63.1% in 2007; France’s rose to 112% in 2024, from 64.7% in 2007.
As part of its balance sheet-trimming exercise after the ebbing of the Covid-19 pandemic, the ECB has been running down its total stock of public and private sector bonds. Stemming from progressive redemptions of the existing holdings, the total has roughly halved from the bloated level of €4.9tn reached at the high point of quantitative easing.
Smaller scale purchases are due to resume in coming years as part of so far ill-defined plans to build a ‘structural bond portfolio’ to assist monetary policy transmission once the public sector band portfolio falls to between €1tn-€2tn.
The ECB has been maintaining maximum policy-making distance between possible purchases to aid its operational monetary framework and satisfy banks’ needs for reserves of central bank money, and those needed to influence the ‘stance’ of monetary policy. Direct government purchases to finance budget deficits are proscribed by the monetary union treaties.
However, heavily indebted governments around Europe are likely to see debt concessions by Merz’s prospective conservative-led government as opening the way for possible indirect assistance if governments get into fiscal trouble, for example over defence spending, in coming years.
Unusual footnote to Lagarde speech
Market participants’ attention has been drawn to an unusual footnote to Lagarde’s speech at the ECB watchers conference in Frankfurt on 12 March. In part of the speech that she did not read out, the footnote states, ‘There needs to be clarity that the central bank will respond appropriately in the event of large market disruptions.’ Underlining the ECB’s ‘backstop instruments’ – outright monetary transactions and the transmission protection instrument – the footnote said these act ‘as a self-stabilising force by limiting incentives to “run for the exit” during stress periods’.
The amounts of government bonds in a future ‘structural’ bond portfolio on the ECB’s consolidated balance sheet will be relatively small compared with the high point of €4.9tn of public and private sector bonds built under the ECB’s exceptional QE programmes of recent years.
Pall over policy-making
Bargaining over changes to the debt brake since the election – well before Merz forms his expected coalition with the defeated Social Democratic Party in around a month – have already cast a pall over future German policy-making.
Fast-track action on the debt brake has been forced by President Donald Trump’s rapprochement with Russia over the war in Ukraine and by the need to use existing rather than future parliamentary majorities to implement amendments to Germany’s Basic Law or constitution.
Merz has faced criticism from conservative supporters who claim he has reneged on election promises to keep debts and deficits under control and to put savings measures and structural reforms ahead of spending proposals. There is unrest about a concession to the Greens party to reaffirm the principle of climate neutrality by 2045 as part of the Basic Law, contrary to the Christian Democrats’ wishes.
Disapproval has focused on the possible duplication of spending on infrastructure and climate under the agreed extra €500bn off-balance sheet borrowing decided as part of compromises with the SPD and Greens. The Greens have successfully pushed through support for spending on programmes outside the strictly defined defence budget – cybersecurity and some transport and health spending.
Public qualms about government policy have been reflected in a fall in opinion ratings for the future coalition partners. According to the Forsa public opinion agency, the score for the CDU/CSU fell 1.6 points in the last week to 27% while the SPD is down 2.6 points at 14%. The far-Right Alternative for Germany (AfD) and far Left Linke have made gains.
David Marsh is Chairman of OMFIF. Andreas Meyer-Schwickerath is a Berlin-based OMFIF adviser.
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