Months ago, Germany’s government plunged into crisis. Chancellor Olaf Scholz’s coalition collapsed amid internal disputes over fiscal policy and defense spending, crippling the government.
The political turmoil in Germany is further exacerbated by the shifting geopolitical landscape following the U.S. election. President Trump’s confrontational stance toward European allies and strained relations with Ukraine have heightened concerns about the future of transatlantic alliances. This uncertainty has put additional pressure on future Chancellor Friedrich Merz, leader of the Christian Democrats (CDU), to expedite the formation of a new government, and simultaneously end Germany’s current economic stagnation via increased military spending.
And it looks like the CDU/CSU and SPD coalition is rising to the challenge. The parties agreed to set up a €500 billion infrastructure program and to spend big on defense. However, there is still a considerable chance that opposition parties will block the spending surge that the new government is planning for.
The economic boost from rearmament is uncertain
How will defense spending impact economic growth? A lot will depend on the size of the economic stimulus set aside and how exactly the money is spent.
As we have reported previously, Germany has been in a mild recession for about two years now. Though the labor market was just recently historically tight, labor demand has been easing quickly in the past year, as the economy continues to weaken.
While economic models suggest that increases in government spending, like the suggested increase in defense spending, are more effective during economic downturns, there is a high degree of uncertainty around these estimates. For example, some researchers have found that additional public spending worth 1% of GDP could boost GDP by more than 1% during recessions whereas other studies suggest significantly smaller effects.
The employment effects are even more benign: 1% of additional public spending only boosts employment by about 0.1 to 0.15% (some 40 to 60 thousand jobs in the case of Germany).
And caveats apply to military spending, in particular. One study looked at the increase in defense spending in Eastern Europe. Higher spending on military equipment led to negligible effects on economic growth whereas higher spending on soldiers did have some effect.
What explains the difference? Smaller countries often procure military equipment from countries with a big defense industry, meaning that the money leaks abroad. Expanding the military workforce, on the other hand, increases employment, which in turn provides a boost to domestic consumption and therefore GDP.
Another mechanism via which military spending can boost economic growth is through increased research and development. Studies have found important spillover effects across some industries that benefit from higher defense spending thanks to innovations and new technologies being developed.
Can Germany’s economy escape stagnation with higher defense spending?
Coalition talks between the CDU/CSU and SPD suggest a consensus on ramping up defense spending. Markets have taken note, with German and European defense stocks surging.
One figure being floated is an increase in the special defense fund from €100 billion to €200 billion—or even €300 billion—pushing military spending far above the current 2% of GDP for years to come. Additionally, the government appears willing to exempt military expenses from the debt brake. Meanwhile, Germany is also considering a €500 billion infrastructure investment package.
These moves suggest a broader policy shift toward expansive fiscal policy, with defense and infrastructure emerging as top priorities.
In keeping military spending within the national economy, Germany has an advantage over other countries. The domestic defense industry is relatively large with some €30 billion in annual revenues, producing anything from sophisticated tanks, drones, navy ships, and more. As the government would primarily order from German and European producers, leakage to abroad might be minimal.
Therefore, it is plausible that additional spending worth 0.5% to 1% of GDP can boost economic output by almost that much. One of the main reasons is that higher defense spending will also have some beneficial employment effects.
A lift in manufacturing
German manufacturing, and car producers specifically, are currently in crisis due to declining sales. Competition with China and the excessive cost of domestic production are heavily weighing on them. Employment in car manufacturing has already declined by some 70,000 since 2018 and additional layoffs for the coming years have been announced.
With the help of the German government, arms producers could absorb some of the employment losses that are currently happening in the car industry.
For example, Rheinmetall recently announced that it will repurpose two production plants that were previously producing car supplies to produce weapons instead. While weapons manufacturing employs less than 14,000 workers, the entire defense sector employs more than 100,000.
Jobs in the car sector are well-paid and regionally concentrated. Large layoffs in that industry have the potential to spillover and lead to further job losses within supply chains and even the service sector due to the loss of local purchasing power.
Therefore, German politicians are advocating to shift employment from cars to weapons producers, hopefully preventing further job losses . The employment multiplier for additional defense spending might thus be somewhat higher than previous studies have found. Ernst and Young suggests that increased defense spending could boost employment by more than half a million in Europe and by 100,000 in Germany. The context obviously matters a lot. Unemployment rates in many European countries are already relatively low and adverse demographic developments will be a constraint on job growth.
One of the biggest limitations that arms producers face, of course, is the pipeline of new orders, which can only come from governments. However, with the massive geopolitical uncertainty that Europe is now facing, being forced into a proxy war with Russia while the U.S. is threatening to dismantle NATO, the outlook for European defense spending has changed significantly within just a few weeks. German manufacturing of weapons and ammunition is surging accordingly.
Conclusion
The current geopolitical landscape has changed dramatically. The incoming German government is addressing two massive crises – an economic recession and a rundown military during a fraught geopolitical moment. A major policy shift was just introduced, backed by a government that is willing to do “whatever it takes” and spend big on defense and infrastructure. However, the program might still be blocked.
As domestic car producers are struggling and planning further layoffs, the defense industry can help absorb a share of these job losses. Higher defense spending would therefore provide a welcome boost to domestic employment and consumption, but the size of these effects is somewhat uncertain. Increased military spending is not going to be the miracle salve for a hurting German economy; it is very unlikely for it to create more than 100,000 jobs in the long run. The indirect effects, though, may have a larger impact. The rearmament of Germany represents a large shift in the European military environment that was unimaginable just a few years ago. We are witnessing a rapid reshaping of the global geopolitical landscape with Germany perhaps taking center stage.
