This article is part of Macro Hive’s 2025 Grey Swan series, where we let our imaginations loose to try and predict low-probability, high-impact events that almost no one expects. You can read the full list here.
Could Germany Become the Eurozone’s Savior?
Eurozone integration never moves faster than it absolutely must. However, its greatest developments have tended to come in surges of political goodwill to solve overdue crises.
- First came the GFC and the Euro debt crisis, which saw the ECB’s balance sheet balloon into something more fitting for a bloc of its size.
- Then came COVID, which laid the groundwork for large-scale joint issuance (albeit mostly a one off).
Political will has been lacking, particularly from Germany, to back any sustained joint-debt issuance plans. But what if that was about to change…
Nearly three years after Russia invaded Ukraine, Europe is accepting the need to increase defence spending. However, the continent’s manufacturing base is declining (Chart 1).
The election of President-elect Donald Trump ends Europe’s peace dividend; Germany’s attempt to classify retarmacking roads as defence spend was the final straw. The free lunch is over, the waiter has brought the bill, and the meal has been expensive (Chart 2). The US has excused themselves and Germany realizes ‘Going Dutch’ with the rest of Europe is not an option.
Trump could impose greater cost on Europe in several ways. Perhaps he explicitly rules out defending NATO members not paying their way. Perhaps he decides to charge nations for US military bases or demands they buy exorbitant amounts of US goods to stave off tariffs. Perhaps Ukrainian lines buckle and Europe realizes it must act with or without him.
Italy cannot afford more. Even with a primary surplus, its interest costs weigh it down too much. France has its own financial and political travails and cannot balance the books. The risk of an extreme political turn grows day by day. Germany begins to worry a Ruhr Valley defended by a broomstick-wielding Bundeswehr may be too appealing to resist.
But instead of dying a slow death via austerity (or a faster one by its neighbours), German voters rise to the challenge. They back extra spending, and more Europe. Moving with uncharacteristically Prussian speed, fuelled by an unequivocal electoral mandate, Chancellor Friedrich Merz and Deputy Olaf Scholz rewrite the constitution (the Greens help). No more will Karlsruhe stand in the way of spending. Schwarze Null is dead.
The Scrooge-like transformation is almost complete. But not quite. Pragmatism is the word of the day, and Germany sees a looming barrier to its sudden debt splurge. This is a European challenge and must be met as such. Plus, the sudden burst of Bund issuance could well blow out EGB yields and cause even greater issues for its beleaguered Eurozone allies.
Looking across the table to the lonely rhythm of fluttering moths escaped from its neighbours’ wallets, Germany’s heart grows three sizes. It will be spending not just for Germany, but joint issuance for all!
With the explicit backing of the Eurozone, the market reaction is swift. EGBs converge upon a new weighted average yield curve somewhere around Belgium’s plus premium for the extra issuance (Chart 3).
The German budget has deteriorated. Eventually, its average interest rate on debt will rise 0.4ppt, but the Eurozone is in a stronger position given the weaker members are more supported and counter-cyclical fiscal policy can be more effectively used.
The big winners are Italy, Spain and Portugal. These are countries that have sorted out their primary deficits (Chart 4). However, the situation leaves little change to France’s travails.
The unified fiscal policy, alongside modestly more generous Stability and Growth Pact rules (the Dutch are already trampling the last iteration begins a new positive era. Germany takes the burden but ‘Sie schaffen das.’ Infrastructure and investment spend can come; defence spend too.
The ECB remains hawkish (some things never change) but also pragmatic, comforted by SGP rules keeping spend focused on investment and preventing fiscal blowout. With industrial recession and spreads collapsed they can continue to pursue a balance sheet winddown with ZIRP a distant memory.
The situation has changed rapidly for the euro too. In a short period (for Europe), the euro has flipped from being attached to low growth and low inflation rates to a much more attractive reserve currency. It may lack the net-exports it once had, but its political future is more secure, and it has the depth of market and supply of assets to be a more attractive reserve currency.
The feel-good era spreads to consumers, savings rates fall and a more balanced, domestically driven economy begins to emerge.
Unresolved issues include the productivity crisis, innovation scarcity, and overbearing rules. However, surveying an unpredictable geopolitical climate, fiscal unity is an important step towards shoring up the bloc and reduces the risk of EUR-exits.
It only took 25 years, but finally the euro experiment is looking more credible, and all it took was a major war in Europe, a new bout of US isolationism and a little Christmas magic.