The parties hoping to form Germany's next government agreed to create a 500 billion euro infrastructure fund and overhaul borrowing rules, a tectonic spending shift that jolted markets on Wednesday on hopes of reviving Europe's largest economy.
Friedrich Merz's conservatives and the Social Democrats (SPD), who are in negotiations to form a coalition after a national election last month, will put their proposals to the German parliament next week.
Merz, Germany's likely next chancellor, has seized the moment after the return of Donald Trump to the White House threw the transatlantic alliance into turmoil, and has underlined the urgency for Europe to strengthen its own defences.
Trump froze military aid to Ukraine after a bitter clash last week with its president, Volodymyr Zelenskiy, reinforcing fears that the U.S. could strike a deal with Russia to end the war in Ukraine while disengaging from Europe.
Economists and investors have long urged Germany to reform its constitutionally enshrined state borrowing limits - known as the "debt brake" - in order to free up investment and support an economy that has contracted for the past two years.
The reform would mark a rollback of borrowing rules imposed after the 2008 global financial crisis that many now say are outdated and keep Germany in a fiscal straitjacket.
"A really big bazooka," wrote Berenberg economist Holger Schmieding, commenting on the German measures. "These proposals for an immediate loosening of Germany’s fiscal rules will likely be enacted. They are a fiscal sea change for Germany."
The euro hit its highest level in nearly four months on Wednesday after the news. Euro zone bond yields jumped, with 30-year German yields on course for their biggest one-day rise since the late 1990s.
Germany's blue-chip index .GDAXI jumped 3.4% as of 0930 GMT to near a record high, while the midcap index .MDAXI soared 10.3%, on track for its biggest daily gain in three years.
Construction firms were among the top gainers, with Heidelberg Materials, the world's second-largest cement maker, up 13% at the top of Frankfurt's blue-chip index.
European defence company shares have also soared as momentum to ramp up spending gathers pace. German defence companies Rheinmetall, Hensoldt, Thyssenkrupp and Renk had notched up gains so far this week of between 16% and 35% as of Wednesday morning.
AMENDING CONSTITUTION
Merz said the CDU/CSU and SPD would submit a motion to the Bundestag lower house of parliament next week to amend the constitution so defence expenditure above 1% of economic output is exempt from the debt brake.
A commission of experts will separately develop a proposal for modernizing the debt brake to boost investments on a permanent basis.
According to a poll by INSA, 49% of Germans support loosening the debt brake while only 28% are against. But changing the debt rules and creating a special fund require a two-thirds majority in parliament.
The conservatives and SPD are rushing to get the moves passed in the outgoing parliament, given far-right and far-left parties will have a blocking minority in the new parliament after scoring strongly in last month's election.
The radical Left party has threatened a legal challenge if Germany takes on new debt to fund defence expenditure.
The Greens party, whose support is needed to get the debt brake reform across the line, said it would examine the proposals but made no firm commitment.
And while markets were jubilant, sceptical voices also emerged. Kyrill-Alexander Schwarz, a constitutional lawyer at the University of Wuerzburg, said it was "extremely problematic" for an outgoing parliament to take such big binding decisions.
German newspapers said Merz was breaking a campaign promise of fiscal rectitude just 10 days after the election.
"Mr Merz, that is voter deception!" warned top-selling paper Bild. "Merz carried out a 180 U-turn in record time" wrote Handelsblatt.
Left-leaning papers were more indulgent. "Good that Merz breaks his campaign promise," wrote the Sueddeutsche Zeitung.
Friedrich Heinemann from the ZEW economic research institute said Germany's debt to GDP ratio could exceed 100% by 2034. It is now around 64%, far below other major industrialized countries such as the U.S., France or Japan.
The U.S. has repeatedly pressured Germany to increase its defence spending to overhaul a military that has felt neglected since the end of the Cold War and has diverted weapons to support Ukraine in the war against Russia.
"Pending more clarity on this issue, and being mindful of some execution risk, we believe this is one of the most historic paradigm shifts in German postwar history," said Robin Winkler, chief economist at Deutsche Bank Research.
($1 = 0.9351 euros)
