A Grave Mistake (?)
Whatever it takes, says Friedrich Merz. But What If Something Breaks?
If the credit expansion is not stopped in time, the boom turns to crack-up boom. – Ludwig von Mises
Sometimes, things change rapidly. On Monday, I already had a rough idea of the topics I’d cover today. Having written about Europe and its challenges in my monthly opinion piece (published this week), I intended to shift my focus back to the US.
But the news over the weekend and the bond price action on Monday and Tuesday completely upended my outlook for the coming months—perhaps even years. The announcements from the EU and Germany regarding defense spending are so monumental that they could leave a lasting mark.
I’ll be fair here, presenting both the best- and worst-case scenarios and letting readers decide which side they prefer.
Let’s start with a quick recap of the events!
On Friday, German conservatives signaled they’re open to bypassing the debt brake, sparking talks with the Social Democrats. Following last week’s Zelensky debacle at the White House, Europe began debating the issue, concluding it’s time to go big.
On Monday, price movements in German Bunds already hinted at traders’ jitters over a potential major announcement. Then came Tuesday’s bombshell from Ursula von der Leyen: the EU proposed a plan to "urgently increase defense spending by mobilizing around $840 billion." That was the opening shot.
European stock markets rallied, anticipating further government declarations. Rumors swirled that Friedrich Merz’s conservatives—who campaigned against higher deficit spending—were planning a massive boost to German government expenditure.
On Tuesday, I wrote that if these plans materialize, they’d likely create significant "short-term" headwinds for Bunds. After some reflection, I think I was wrong. These won’t be short-term headwinds.
The real hammer dropped after markets closed on Tuesday when Merz announced that the CDU and Social Democrats had struck a deal. As Bloomberg reported:
Friedrich Merz...announced late Tuesday that Europe’s biggest economy would amend the constitution to exempt defense and security outlays from limits on fiscal spending to do “whatever it takes” to defend the country. This will allow Berlin to allot essentially unlimited amounts of money to bolster its military.
In total, the government aims to establish funds totaling €900 billion—€500 billion for infrastructure and €400 billion for defense. It’s a staggering sum. Bloomberg opinion writer John Authers, who visited Frankfurt last week, observed:
...nobody I spoke to pretended to have had any idea of the scale of what is underway. Only a week ago, the talk was of €200 billion, which seemed extraordinary...Everybody in the Frankfurt financial center seems elated. You would think that Germany had just won the World Cup.
The German stock market cheered the news, surging sharply. Small-cap stocks, in particular, reveled in the prospect of a government spending spree in the years ahead.
Meanwhile, that was all German Bund traders needed to hear. Prices for German government bonds plummeted and haven’t recovered since. On Wednesday, Bunds recorded their steepest drop since German reunification.
Reactions so far have mainly been positive, at least in the Anglo-American sphere. Paraphrased sentiments range from "Europe finally got some grip" to "Germany steps up to do whatever it takes." One Financial Times article even argued that "Europe must trim its welfare state to build a warfare state."
German-speaking responses, however, have been more restrained and sober. Economist Veronika Grimm, a member of the German Council of Economic Experts, called the plans "Harakiri." While acknowledging the rationale for increased defense spending, she slammed the €500 billion infrastructure package. Speaking to ZDF, she said:
I wonder why we still have to do this in the old Bundestag now? The global situation hasn’t 'dramatically and suddenly' changed....With the 500-billion special fund, the big problem is that we’re coming into conflict with European fiscal rules.
So, what do we make of these changes? So far, the market reaction has been overwhelmingly positive for the economy. However, it’s made government refinancing costlier, as markets now price in a significant push for growth—and potential inflation—down the line.
This market response makes sense. More government spending does boost GDP. Take the US in recent years: running a 7% annual deficit during a strong economy helped drive GDP higher.
Increased infrastructure spending will benefit businesses. Meanwhile, ramped-up defense spending will bolster the defense industry, expanding a sector that creates high-paying R&D jobs. Economist Rüdiger Bachmann from the University of Notre Dame (Indiana, US) recently suggested on German TV that the auto industry could repurpose its facilities to produce military equipment like tanks.
But here’s the flip side: Are Europeans willing to cut spending elsewhere to offset the burden of new debt? Even if they slash welfare, debt issuance will still rise. History shows voters hate welfare cuts—and when politicians try, they often fail.
Regardless, in the short term, I believe current market moves simply reflect an adjustment to new realities. European economies could indeed benefit from higher GDP growth and stage an economic recovery. In the best case, Europe ends up with robust defense capabilities, reduced regulation, and trimmed spending elsewhere to propel the economy forward.
The euro was also lifted from the announcement, which was seen as signaling greater investment demand in the euro area—especially as the Trump administration pushes for a weaker dollar. Price action only reinforces my EUR/USD view, and a move to 1.10 wouldn’t be surprising, given the euro’s tailwinds and the dollar’s headwinds.
Bloomberg’s John Authers captures the mood among financiers and politicians: "They’re really excited now." Yet the path chosen by Ursula von der Leyen’s EU and Friedrich Merz’s Germany carries enormous risks.
For one, Merz’s approach raises red flags. He wants to ram this through with the outgoing parliament, not the newly elected one. As Authers aptly notes, "that isn't a great advertisment for democracy."
Second, the plan harbors a downright dire worst-case scenario. Authers warns, "there will be real trouble if it goes wrong." I agree—plenty could derail it.
So, what could go wrong? For starters, it’s doubtful Germany’s government can push through significant welfare cuts—especially with Merz’s coalition partner, the SPD, still scarred by Gerhard Schröder’s "Hartz" reforms. Those reforms revived Germany’s economy but cost Schröder the election, leaving Angela Merkel to reap the rewards. Significant cuts seem unlikely beyond cosmetic tweaks.
Another question is whether the government can allocate these funds efficiently. If it can, it might create new agencies to dither over distribution. One might hope Germany’s bureaucracy is savvier than its southern European counterparts, but I’m skeptical.
Moreover, this spending doesn’t just pile atop thriving private-sector activity—it displaces it. The struggling private market won’t feel the pinch initially, as financial markets happily lend to governments at higher rates.
But even in the best case, these plans will fuel higher growth and inflation. Money will shift from financial markets to the real economy, creating jobs and increasing wages amid rising labor demand. Europe’s aging demographics—baby boomers retiring—will further tighten labor supply, driving wages higher.
Eventually, easy government funds for infrastructure and defense will crowd out the private sector, curbing production there. Consumer prices will rise as demand holds steady or grows.
A stronger euro could soften import costs, giving the economy an initial boost. Eurozone countries would pay less for dollar-denominated imports like energy, which would be a short—to medium-term tailwind. Rising interest rates could also draw foreign investment, increasing euro demand.
That all sounds rosy, which explains the excitement, but the plan includes a potential financial atom bomb.
Recall the last Eurozone debt crisis: Italy, Spain, and Greece overspent, and when the reckoning hit in 2012, investors flocked to German Bunds, the eurozone’s safe haven. As southern government bonds tanked, Bunds soared.
Back then, Germany was the Eurozone’s paragon of prudence. With Merz’s "whatever it takes" pivot, it’s unclear if other Eurozone nations will follow suit. France ran a 6% deficit in 2024, Italy 3%. With frugal Germany unleashing the floodgates, expect France, Italy, and others to join the party. Emmanuel Macron already pledged more military spending without tax hikes—meaning more borrowing.
Sugar highs fade. Eventually, people will scrutinize the results and question these countries’ repayment ability. With German exceptionalism gone, no Eurozone nation is big enough to shoulder the burden.
Interest rates, already up due to growth and inflation, will climb further if growth slows. The ECB, unable to cut rates enough to ease debt pressure, will face a dilemma. Investors may look elsewhere.
German Bunds won’t be a safe parking spot anymore—Germany will have its own debt woes. So what will investors do? Sell euro-denominated assets and move on, as they always do. That tanks the euro and drives yields higher (bonds lower).
The ECB would then be trapped. Cutting rates to ease debt burdens would accelerate the euro’s sell-off, spiraling bond yields upward. With no good options, it faces either bankrupting nations or plunging into a currency crisis and economic meltdown—a "Weimar scenario." Capital controls and financial repression might delay the fallout, but it could be the euro’s final nail in the coffin. A "grave mistake," indeed.
But for now, enjoy the coming crack-up boom in Europe!
You can't save yourself or save your soul
When you meet the man whose life you stole
With withered wings and broken bones
A flight for the fallen, flies the crowIce Nine Kills — A Grave Mistake
Have a great weekend!
Fabian Wintersberger
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All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change over time in response to evolving facts. IT IS STRONGLY RECOMMENDED TO SEEK INDEPENDENT ADVICE AND CONDUCT YOUR OWN RESEARCH BEFORE MAKING INVESTMENT DECISIONS.