“Whatever it takes must now also apply to our defense”
In our note from April of 2020, which now feels like half a lifetime ago rather than less than 5 years (it’s not the years but the miles?), we wrote about how COVID and the related crises had “made it clear that in many ways, reality is more like Calvinball” than an orderly system: one where “the rules of the game around the world appear to be in flux”. This week has provided yet more evidence, if any more was needed, for this view. We all knew that “All is fair in love and war” but the Bund market can testify to how jarring it is when we are confronted with a stark case of “needs must when the devil drives, and the consequences be damned”.
Around the same time that we were noting the weird flexibility of spending rules when it came to Covid spending, we wrote about how the Germans were perhaps the exception to that rule: people who were willing to stick to their principles. Principles like the “black zero”, which largely ruled out engaging in the hodgepodge of stimulus measures that other countries were ready to adopt on the fly.
How things change! It’s one thing to have the Trump administration do another quick whipsaw on tariffs – that’s so commonplace as to be barely noticeable. But it’s quite another when it’s the Germans offering the proofs that what you might have thought of as rules were actually more like suggestions (Pirates of the Caribbean version, or classic Ghostbusters (PG-13)). In response to the US’s winding down of its support for the war in Ukraine, European leaders found their martial spirit. Germany’s next chancellor took a page out of Mario Draghi’s playbook and said that “the rule for our defense now has to be ‘whatever it takes’”. It’s hard to exaggerate the scale of this sea change, if they actually meant it. “The new defense proposal recommends that ‘necessary defense spending’ above 1% of GDP should be exempt from debt brake restrictions, with no upper limit” (Emphasis our own). For casual observers who might wonder why this was a big deal, the BBC was happy to explain, “The debt brake has been written into Germany’s constitution, or Basic Law, and any change requires a two-thirds majority in parliament”. This isn’t just a spending proposal, but a constitutional amendment. But as we said above, needs must when the Devil drives through Kiev.
Whether this spending actually materializes is certainly not guaranteed, and there is a further wrinkle courtesy of the latest election results, “this [plan] would likely work at present – but would be very difficult to achieve once the newly elected parliament representatives come together for the first time later this month.” So, far from a foregone conclusion… but perhaps unsurprisingly, that hasn’t deterred markets. As this article notes, the “market reaction has widely been positive, with economists and analysts describing the moves as ‘historic’ and a ‘game changer’”. “Positive” is, of course, dependent on which side of the trade you are on, and holders of German government debt might feel differently. Bunds “suffered their worst day since the months following the fall of the Berlin Wall on an historic spending plan that will unlock hundreds of billions of euros for defense and infrastructure investments.” The irony certainly didn’t escape us. But, having made the mental shift that defense spending shouldn’t be hostage to debt brakes and whatnot, this article noted that “Germany called for the European Union to reform its fiscal rules to allow countries to make bigger defense expenditures without running afoul of the bloc’s budget rules”. Oh, and “European Commission President Ursula von der Leyen had already proposed the bloc extend €150 billion in loans to boost defense spending and loosen fiscal rules constraining national spending.” Some might wonder where the money will come from. This article suggests there might be some shifting of money away from welfare services, but… that seems like an unpopular opinion.
Clearly Bund investors had their own ideas of who was likely to end up footing the bill, and they weren’t afraid to express it. But, when the Russians are coming, who cares what Bund buyers think? If Merz and Co do follow through, Bund investors (normally a conservative bunch) might wonder whether they would be better off joining the military.
P.S. Amid all the headlines about European tomfoolery, layoff announcements hit the highest level since July 2020 and were “the highest total for the month of February since 2009 during the global financial crisis”, and Secretary Bessent said earlier today that “access to cheap goods is not the essence of the American dream”. What a week!
