German parliament approves Merz's spending surge as allies cheer

By Sarah Marsh and Matthias Williams

BERLIN (Reuters) -Germany's parliament approved plans for a massive spending surge on Tuesday, throwing off decades of fiscal conservatism in hopes of reviving economic growth and scaling up military spending for a new era of European collective defence.

The approval in the Bundestag hands conservative leader Friedrich Merz a huge boost, giving the chancellor-in-waiting a windfall of hundreds of billions of euros to ramp up investment after two years of contraction in Europe's largest economy.

Germany and other European nations have been under pressure to shore up their defences in the face of hostile Russia and shifts in U.S. policy under President Donald Trump, which European leaders fear could leave the continent exposed.

Merz's conservatives and Social Democrats (SPD), who are in talks to form a centrist coalition after last month's election, want to create a 500 billion euro ($546 billion) fund for infrastructure and to ease constitutionally enshrined borrowing rules to allow higher spending on defence.

"We have for at least a decade felt a false sense of security," Merz told lawmakers ahead of the vote.

"The decision we are taking today on defence readiness ... can be nothing less than the first major step towards a new European defence community," he said.

The legislation still has to go on Friday to the Bundesrat upper house but the main hurdle to passage there appeared to fall on Monday when the Bavarian Free Voters agreed to back the plans.

The conservatives and SPD wanted to pass the legislation through the outgoing parliament for fear it could be blocked by an enlarged contingent of far-right and far-left lawmakers in the next Bundestag starting March 25. Merz has justified the tight timetable with the rapidly changing geopolitical situation.

"In our view, this is a historic fiscal regime shift, arguably the largest since German reunification," said Robin Winkler, Chief German Economist at Deutsche Bank Research.

"Yet, as with reunification, a fiscal expansion does not guarantee success: the next government will need to deliver structural reforms to turn this fiscal package into sustainable growth."

The plans have already lifted euro zone yields, the euro currency and European shares over the past week.

Germany's blue-chip DAX index, which hovered around a record high ahead of the vote, pared some gains, while Germany's 10-year bond yields edged down. The euro, which has strengthened in recent weeks as word of the deal emerged, eased slightly after the widely anticipated approval of the spending plan.

Merz had declared "Germany is back" and allies were quick to welcome the breakthrough.

"It's excellent news because it sends a very clear message, very clear message also to Europe that Germany is determined to invest massively in defence," said EU Commission President Ursula von der Leyen. Speaking alongside her in Copenhagen, Danish Prime Minister Mette Frederiksen said: "as a neighbouring country it's fantastic news because we need a strong Europe".

EASING THE DEBT BRAKE

The reforms mark a major rollback of the so-called debt brake imposed after the 2008 global financial crisis but since criticised by many as outdated and putting Germany into a fiscal straitjacket.

The prospects of a borrowing bonanza lifted German investor morale by more than expected in March, the ZEW economic research institute said on Tuesday.

The construction sector can look forward to a boost from the fund to overhaul Germany's creaking infrastructure while the defence industry also stands to gain.

"The prospect of a fiscal bazooka is causing expectations to skyrocket," said Alexander Krueger, chief economist at the private bank, Hauck Aufhaeuser Lampe.

Merz comfortably secured the two-thirds majority required for a change to the constitution with 513 lawmakers backing the reform and 207 voting against it. There were no abstentions.

But critics, including within his own party, accuse Merz of "voter fraud" for promising spending restraint during the campaign only to announce the shift in fiscal policy just days after winning.

Economists caution further reforms are needed, for example to cut bureaucracy, to ensure sustainable growth.

Fitch Ratings agency also warned on Tuesday Germany's coveted AAA rating could come under pressure in the longer run if its vast spending effort is not offset by consolidation measures, or fails to produce a lasting improvement in economic growth.

(Reporting by Sarah Marsh, Andreas Rinke, Holger Hansen, Madeline Chambers, Matthias Williams, Alexander Ratz, Louise Breusch Rasmussen; Writing by Sarah Marsh and Matthias Williams; Editing by Rod Nickel and Tomasz Janowski)