A more pragmatic approach to debt could turn things around in Germany

It is the time of year when economists inevitably publish their year ahead outlook - and The Times survey of the U.K. profession will be in these pages later this week. Such crystal ball gazing - something I personally dislike - tends to fall into one of two styles. The first style is taken up by those economists that try hard to capture all the economic factors at play, and boil these down into a credible forecast. The second style is by those who use the turn of the Gregorian calendar to come out with a series of outlandish predictions in the hope that if one or more of them emerges they look prophetic. Black swan events like Brexit, Trump and COVID have made this second approach an ever more attractive option.

When it comes to Germany, however, no forecast I have recently seen has anything other than expectations for another 12 months of economic struggle. There is an election on February 23. But, with that, will come an aftermath of fraught coalition-making - all against a backdrop that includes the extended fallout from energy market and auto production mistakes of the past, plus the looming threat of export tariffs into the United States.

The German central bank, The Bundesbank, has recently forecast economic growth of just 0.2% next year making the International Monetary Fund (IMF) appear atypically optimistic in their forecast for German growth of 0.8% in 2025. The risks of a further escalation in protectionist trade measures between the US and trade surplus countries such as Germany dominate the Bundesbank pessimistic reasoning. The risk that tit-for-tat tariffs also chokes off any economic recovery in China - Germany’s largest trade partner - looms as a parallel big threat.

However a near-universal bearish consensus should always attract scepticism. So let’s take a moment to consider an alternative path. One where the German economy outperforms these brow-beaten expectations. There are three under-explored areas where I think that the German consensus may prove too pessimistic.

First and most prescient the German debt brake, or Schuldenbremse, may be approaching the end of its political life. Introduced in 2009 this fiscal rule limits Federal Deficits to just 0.35% of GDP outside of economic and societal emergencies. For its advocates, Schuldenbremse, is central to Germany staying sober in a world of fiscal drunkards. At just 60% of the size of its economy, the German national debt is just half the G7 average and comfortably the lowest amongst major developed economies. With an ageing population, the recent spike in global interest rates, and a fragmented world order this may yet prove to have been smart prudence. But for now it has left the German economy in the dust as the US, China, and India have raced ahead with electrification of energy systems, and building out their digital infrastructure. All pump primed by large state balance sheets. The February election in Germany provides the opportunity to loosen this financial straight jacket. The front runner to lead a new German government - Friedrich Merz - has been a consistent supporter of Shuldenbremse but the challenge of coalition building and the current economic backdrop presents the opportunity for pragmatism to overtake ideological purity. This would be well received by financial markets that have concluded that Germany’s financial discipline will ultimately prove self-defeating.

The second upside surprise could stem from a faster pace of interest rate cuts in Germany and across the Eurozone than in other major economies. Financial markets are expecting just a handful of rate cuts from a US Federal Reserve concerned about inflation in a strong US economy, whilst the Bank of England and Bank of Japan have idiosyncratic challenges that will limit their room for monetary easing - indeed in Japan they may raise its interest rates again in 2025. This leaves the Eurozone with the latitude to ease borrowing costs for households and businesses and soften the Euro exchange rate to offset any tariff headwinds. A pick up in the credit cycle from looser money is one of the potential upside risks for the German economy.

Finally, the shadow cast by the horrors of the Ukraine war is not all bad news - at least economically. With President-elect Trump having rhetorically committed to securing a swift resolution to the conflict the knock to European sentiment from a hot war on its doorstep may begin to unwind. But the legacy of the conflict on the German energy strategy and security resilience will play out long after the guns have fallen silent. A more pragmatic approach to energy source pluralism, and to military capacity seems likely under a right-leaning coalition than the recent administrations led by Angela Merkel and Olaf Scholz. Selling any such pivot to a sceptical Washington will be a key strategic priority for the new German leadership team.

UK-based companies I have been speaking to in recent weeks with German operations report rather more robust trading conditions than the headline commentary suggests. There is a sense that corporate Germany is anticipating a turning point. Whilst the auto industry remains in a deep freeze with little hope of an immediate reversal, alternative sources of demand for space in fast-growing manufacturing sectors such as optics and pharmacology are mopping up excess supply of industrial capacity and German workers.

The key to a German inflection point when it comes will be a political coalition that avoids puncturing the emergent enthusiasm with a cross-party blame game for past mistakes. We have seen in the U.K. how blaming political predecessors can quickly sour the economic mood, and prove self-defeating. German politicians would be wise to avoid the same mistake. Animal spirits - or a lack of them - have led to a high European household saving ratio since the end of the COVID-19 pandemic. A new German government that can unlock some of that latent economic firepower will be a real pushback to the doomsayers. Binding coalition partners into a commitment to revisit the German debt brake must be a top priority.

Make no mistake this remains the most challenging economic backdrop for Germany since reunification. But students of European political economy are well accustomed to economic progress being forged during moments of acute stress. 2025 may well be the year this pattern of behaviour comes to Germany.