Rahul Jacob: Global alliances have changed and so have German policies

German chancellor-to-be Friedrich Merz, long a fiscal hawk as the leader of Germany’s centre-right Christian Democratic Union (CDU), recently made an about-turn on the virtues of higher deficit spending after being briefed on the country’s dwindling growth prospects and witnessing geopolitical gyrations in the US, which seems keen to patch up with Russia, potentially leaving its European allies in the lurch.

The irony is that Merz campaigned as a fiscal conservative ahead of last month’s German elections, which delivered a victory for the CDU and its allies. Merz is also a former executive of BlackRock, the world’s largest asset manager. This month, it spent $23 billion buying ports from CK Hutchison, including two in Panama. Although Hutchison is Hong Kong-based, Trump had warned against “Chinese” ownership and said he wanted US ownership of the Panama Canal. 

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Merz had long been committed to stronger ties between the US and Europe, but with security alliances like Nato and Aukus now looking akin to a Scrabble board overturned by an unruly child, all is change.

Early this month, Merz announced that his government would break the debt ceiling imposed on all German administrations since the global financial crisis to raise defence and infrastructure budgets. This includes an infra fund of €500 billion that its alliance partner, the Social Democratic Party, had campaigned for. 

Cumulatively, this would dramatically widen Germany’s fiscal deficit, but with GDP growth flat for two years and major industries (such as automobiles) in crisis, this is a good time for a Keynesian stimulus. Germany’s fiscal deficit was 2.8% of GDP last year and its total government debt is well below that of other large European countries. 

In a rousing speech, Merz vowed a “whatever it takes” approach to defence in the face of “threats to freedom and peace” in Europe. It was a clear reaction to the new world disorder. The CDU and its allies are now expected to rush through a debt-ceiling tweak before the term of this parliament ends because they need a two-thirds majority to do so.

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Significantly, asset markets cheered. “The steepening German yield curve, rising stock prices, euro appreciation, and stable credit default swap prices collectively indicate that markets interpret Germany’s fiscal expansion as growth-enhancing rather than a reckless fiscal bet,” according to a paper by the Kiel Institute for the World Economy. 

The contrast with the market’s punishment of former UK prime minister Liz Truss’s fiscal adventurism in September 2022 could not have been more vivid. Farzad Saidi, author of the Kiel paper, wittily titled it ‘In Merz we Truss.’

Higher defence and infra spending is expected to revive German manufacturing, which has been in the doldrums. Retooling is already underway. The Financial Times outlined some aspects of it: a car parts factory being used to produce military equipment and a state-owned maker of sensors and radars looking to hire “teams of software engineers from Continental and Bosch, two of Germany’s largest automotive suppliers, which together have announced over 10,000 job cuts in the past year.”

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Fiscal policy aside, Germany’s leap of faith from cars to tanks is a 180° pivot from policies pursued since the middle of the last century. Germany has indicated it is open to discussions on a nuclear shield with France. 

Think-tanks estimate that Europe might need “300,000 more troops and an annual defence spending hike of at least €250 billion in the short term to deter Russian aggression.” Across Europe, from Poland to Denmark, governments are raising defence budgets.

As a response to the anarchy of announcements and tweets from the White House, this is simply sensible policy, given Washington’s apparent reversion to the Westphalian state system that arose from treaties at the end of the Thirty Years War in the 17th century. 

According to Oxford Reference, this means “a system of states… possessing the monopoly of force within their mutually recognized territories.” If there is anything consistent in White House outbursts against Canada and Ukraine, it is this. European states, unsurprisingly, are forging closer ties in response.

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New Delhi needs to be similarly agile. For too long, India has been US-centric, apparent in the Indian rupee’s de facto peg to the US dollar on one hand and the slow track of negotiations with the EU for a free trade agreement (FTA) on the other.

Talks on India’s EU FTA began in 2007, then stalled for several years, and are now on again. For our own sake, we must take the US challenge of lowering our unusually high average tariffs and make a genuine attempt to be part of global supply chains. Net foreign direct investment in India plunged to $1.2 billion in the first nine months of this fiscal year, from an already weak $7.8 billion over those three quarters last year.

High levels of MNC disinvestment suggest a global mood change on India. The belief that India would be an automatic beneficiary of Western companies diversifying away from China needs to be reconsidered. As an economist remarked when I ran India’s startling FDI numbers past him, “So much for China plus one.” As Merz has demonstrated, as the world order changes, governments need to respond at top speed.

The author is a Mint columnist and a former Financial Times foreign correspondent.