Germany's Fiscal Spending Sparks Growth Optimism Amid Reform Delays

Germany's Economic Outlook

By Maria Martinez

Impact of Fiscal Measures

BERLIN, Jan 26 (Reuters) - German Chancellor Friedrich Merz took office last year promising an unprecedented fiscal splurge that would revive growth in Europe's largest economy after two years of contraction, but economists and business groups say many promised reforms also required for sustainable growth are still not in place.

Challenges in Decision-Making

Faster German growth is central to the euro zone's recovery prospects, as it accounts for around a quarter of the bloc's economic output - far more than any other member nation.

Structural Issues and Reforms

But a sluggish federal decision-making process and a coalition partner wary of some of Merz's more ambitious plans could put the brakes on his reform drive, while idle industrial capacity that will take time to bring back online may also slow the recovery down.

After growth of just 0.2% in 2025, a much healthier expansion is expected this year as Merz' spending push gathers pace.

The International Monetary Fund forecasts 2026 growth of 1.1%, and the government officially expects a 1.3% expansion, although it is likely to trim that to 1.0%, a source familiar with the projections told Reuters.

"A moderate upswing is a good sign, but the recovery remains fragile," said Ulrich Reuter, president of Germany's savings banks association DSGV, forecasting 1.0% growth. 

Investor morale rose in January to its highest reading since August 2021, the ZEW economic research institute said last week. 

"It is reasonable to look ahead to 2026 with cautious optimism: If the fiscal measures that have already been decided take full effect, a noticeable pickup is possible," said Geraldine Dany-Knedlik, economist at the German Institute for Economic Research DIW Berlin.

SLOW DECISION-MAKING HAMPERS INVESTMENT

But while the national parliament last March approved a landmark 500 billion euro ($593 billion) special fund for infrastructure, by the end of the year only 24 billion euros had been invested, reflecting the slow pace of decision-making in Germany’s federal system.

By mid-2025, Germans were starting to get impatient. Now the concern is rising further, given that Merz has been in power for more than eight months.

Even if a lift-off is under way, Germany's problems are deep-rooted - often structural and self-inflicted - and cannot be quickly fixed, said Carsten Brzeski, global head of macro at ING.

"This time around, the economy almost needs a complete makeover," Brzeski said, from cutting red tape and rolling out e-government to reducing the fiscal burden of demographics. 

However, while Merz has long championed a pro-business agenda, his centre-left Social Democrat (SPD) coalition partners are more wary of reforms they fear could erode workers' rights, with disputes over pension changes and tax policy hindering progress. 

The most politically difficult structural fixes — on pensions, health insurance financing and reform of Germany's fiscal rules — are being pushed into commissions due to report by the end of 2026, meaning many of the biggest decisions are still pending.

Fiscal stimulus, meanwhile, will provide some support to the industrial sector, which has shown tentative signs of stabilising. Industrial production rose 0.8% in November, its third consecutive monthly increase.   

Industrial orders climbed 5.6% month-on-month in November and private sector business activity grew at its fastest pace in three months in January, the flash composite PMI showed.

"This makes us more confident that, after six years of stagnation, Germany will grow again in 2026. However, we would not get carried away," said Franziska Palmas, senior Europe economist at Capital Economics. 

Despite some encouraging data, however, industry is likely to expand more slowly than the overall economy this year, the BDI industry association said. 

BDI Managing Director Tanja Goenner pointed to the longest period of underutilised capacity, with utilisation at 78% in October, well below the long-term average of 83.3%. 

"This means machines are standing still, production potential remains unused, investments are being postponed and employment is being reduced," she said.

The initial optimism after the government's fiscal U-turn has also faded as it became clear that parts of the infrastructure fund were being used to shore up day-to-day spending rather than growth-boosting infrastructure.

Household demand, meanwhile, remains fragile. Consumer sentiment fell in January as the propensity to save hit its highest level since the 2008 financial crisis. Spending is expected to remain muted this year as unemployment rises, reflecting the labour-market lag from the previous years' economic stagnation.

Corporate distress is also mounting, with high numbers of bankruptcies and insolvency-related business closures at their highest in 11 years.

To turn the tide, the structural problems companies face must be tackled urgently, said DIHK chief analyst Volker Treier.

"It is up to Chancellor Friedrich Merz and his government to implement these reforms this year and turn a long-awaited rebound into a sustainable recovery," he said.

($1 = 0.8434 euros)

(Reporting by Maria Martinez, Editing by Friederike Heine and Hugh Lawson)