Can fiscal stimulus really fix Germany’s economy?

Capital Economics reports that Germany's shift to looser fiscal policy, including increased public spending in defense and infrastructure, is expected to provide a short-term boost to GDP, forecasting 1.0% growth in both 2026 and 2027. However, this growth is unsustainable due to structural issues, including declining productivity, demographic challenges, and a weakening industrial base, leading to projected growth of only 0.5% annually beyond 2027. The report suggests these economic challenges could fuel political instability and limit Germany's influence within the EU, despite its continued role as the bloc's largest economy.

Analysis

Germany's recent shift towards a more accommodative fiscal stance, involving increased public expenditure on defense and infrastructure, is projected by Capital Economics to deliver a modest, short-term boost to economic activity. GDP growth is forecast at 1.0% for both 2026 and 2027, with public spending contributing approximately 0.7 percentage points annually during this period. However, this fiscal impetus is deemed insufficient to counteract deep-seated structural impediments, with growth anticipated to decelerate sharply to just 0.5% per year beyond 2027, markedly below the pre-pandemic average approaching 2%. Critically, the nature of the increased spending—primarily allocated to defense materiel and infrastructure maintenance rather than productivity-enhancing research, development, or new projects—limits its long-term economic benefits. Germany also faces significant demographic pressures, including a declining working-age population that planned immigration of around 270,000 annually is unlikely to fully offset, leading to an expected contraction in the labor force. Productivity growth is also forecast to remain subdued, with digitalization and green transition initiatives reportedly lagging and taking a secondary role to traditional sectors. The country's industrial base has been contracting since 2017, impacted by weaker demand from Europe and China, U.S. tariffs, and elevated domestic energy and labor costs, with the automotive sector potentially facing an output reduction of up to 20% over the next decade. These persistent economic challenges could exacerbate political fragmentation, potentially bolstering support for parties like the AfD, and while Germany is expected to retain its position as the EU's largest economy, its sluggish growth may diminish the bloc's collective global influence.

Key Decisions for Investors

• Investors should exercise caution regarding long-term exposures to the German domestic economy, particularly within its traditional industrial and automotive sectors, given the projected structural decline and significant headwinds beyond the short-term fiscal stimulus.
• Closely monitor the German government's policy effectiveness in addressing deep-seated issues such as labor shortages through immigration and participation, productivity stagnation, and the pace of its green and digital transitions, as current measures appear insufficient to alter the pessimistic long-term outlook.
• While the fiscal stimulus may offer tactical opportunities in specific areas like defense or subsidized sectors in the near term, its limited scope suggests that a sustained economic recovery is unlikely without more profound structural reforms, warranting a selective approach to German assets.
• Factor in potential political risks associated with economic stagnation and rising populism, especially concerning policy stability and coalition-building complexities after the 2029 federal election, which could further impact market sentiment.