Weekly global economic update
What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Europe pivots toward more defense spending
Ian Stewart, chief economist of Deloitte UK, and Tom Avis, economist at Deloitte UK, offer a perspective on the changing outlook for defense spending in Europe:
- For the last 80 years, Europe’s security has been underpinned by the United States. American spending on defense far exceeds Europe’s. The United States spent about 3.2% of GDP on defense in 2023 compared with an average of 1.8% in European NATO members, below NATO’s 2% target. Almost all European NATO states have raised defense spending in the last decade in response to Russian’s invasion of Ukraine and rising levels of geopolitical risk. Countries closest to Russia—Poland, the Nordics, and the Baltic states—have stepped up spending the most and have the highest military spending as a share of GDP.
Perceptions of the threat tend to diminish the further west and south one goes. Eight out of NATO’s 29 European members, including Italy, Spain, Belgium, and Portugal, spend below the 2% NATO target. Germany, Europe’s largest economy, only reached the 2% threshold last year after years of low spending. The failure of many countries to live up to their NATO commitments has been a source of frustration for successive US presidents. Donald Trump is the first to suggest that America could walk away from a military commitment to Europe.
In terms of dollar spending, the United States dwarfs its allies and its rivals. In 2023, the United States spent more than US$900 billion on defense, 65% of all NATO spending, and equivalent to the total of the next nine highest spending nations combined. In dollar terms, the United States spends more than twice as much as China and Russia combined.
A more accurate way of looking at defense spending is to measure what money will buy in terms of manpower and materiel (US$1 million, for instance, goes further in terms of pay, rations, and equipment in China than in the United States). The United States dominates on this measure too, though its lead narrows. A recent report from the International Institute for Strategic Studies found that on a purchasing power parity (PPP) basis, American defense spending was at roughly the same level as China and Russia combined.
Although the United States accounts for the majority of NATO defense spending, much of that spending relates to commitments outside Europe, mainly in the Pacific and the United States. One 2019 study found that US direct military spending on Europe was equivalent to less than 15% of military spending by European NATO members. This estimate, however, comes with the hefty caveat that it excludes US nuclear weapons and America’s capacity to reinforce its position in Europe in the event of a conflict.
What is clear is that a potential US withdrawal would leave a large gap in Europe’s defenses. It is not just US leadership and the 90,000 personnel stationed in Europe, but communications and electronic warfare support, tanker and heavy transport aircraft, and ammunition resupply as well.
So how does Europe, without America, measure up against Russia in terms of scale? Estimates vary, but most point to a significant mismatch. As per the Economist, in the long term, European defense expenditure needs to more than double to deal with Russia. Figures cited recently by Fenella McGerty, senior fellow for defense economics at the International Institute for Strategic Studies, suggest that on a PPP basis, Europe would need to almost triple its spending to match Russia.
Yet Europe does not necessarily need to match Russian capacity 1:1 to deter aggression. A widely cited rule of thumb is that an attacking force needs three times the number of troops as the defending force to ensure success. This can be seen in Ukraine, a country with just 7% of Europe’s population and a fraction of its GDP, which has held back Russian forces for more than three years. The Economist’s defense editor, Shashank Joshi, cites the example of Israel, which, although a small country with fewer than 10 million people, has sustained investment in defense and built up its resources and capabilities to world-class standards.
NATO’s European members make up one of the most economically developed and wealthiest areas of the world, with a population and combined GDP (measured in PPP) approximately five times that of Russia. In terms of economic heft and population, Europe far outstrips Russia.
Conflicts, however, are not always won by the richer or most populous power. Political will and public support matter enormously. The next test of Europe’s resolve will be whether it can raise the money to rearm. Countries with low levels of public debt including Germany, the Netherlands, and Sweden could finance increased defense spending through borrowing. Many European nations, including France, Italy, Spain, and the United Kingdom, are more indebted and might need to raise taxes or cut other spending programmes. Without more borrowing, higher taxes or reducing spending elsewhere, Europe cannot increase defense spending. Germany has led the way, with the Bundestag recently approving plans to ease constitutional limits on public borrowing. Many others have yet to lay out a path to higher defense spending, let alone how it will be financed.
Europe’s pivot means fiscal stimulus
- The European economy may be at a pivot point. After a long period of subpar growth, there is an increasing expectation that Europe’s economy could experience significantly faster growth in the coming years. This expectation is already reflected in the strong performance of equity prices, especially compared to the US equity market. The expectation of stronger growth partly reflects confidence that there will be a substantial change in fiscal policy.
In recent years, the poor performance of the European economy has often been attributed to a number of factors such as inadequate investment; poor financial intermediation that fails to provide funding for entrepreneurs and innovators; excessive regulation; sclerotic labor markets due to restrictive rules governing hiring and dismissals; and a failure to fully integrate the European Union and, thereby, take advantage of scale.
Yet it is also likely that slow growth was due to restrictive fiscal policies. Consider that, since 2018, European sovereign debt as a share of GDP has fallen while, in the United States, it increased sharply. Thus, the US government provided fiscal stimulus that boosted growth while European governments restricted the growth of debt, thereby removing stimulus from the economy. However, this is about to change. If European governments and the EU follow through on their plans to boost defense and infrastructure spending, financed by debt, then growth will likely accelerate.
On the other hand, Europe faces a new challenge from potentially restrictive trade policies on the part of the United States. European Central Bank (ECB) President Lagarde has warned that, if the United States imposes a 25% tariff on imports from the EU, it would cut GDP growth by 0.3 percentage points in the first year. If the EU retaliates, growth will be cut by 0.5 percentage points. This might not seem like much. Yet, consider that the ECB’s baseline forecast for GDP growth in 2025 is 0.9%. Cutting it by 0.5 percentage points would indeed be significant.
Still, Lagarde noted that the inflationary impact of tariffs would likely be temporary. Imposition of a tariff is a one-off event that would boost inflation for a while but not permanently. Lagarde also said that “the effect would ease in the medium term due to lower economic activity dampening inflationary pressures.” Consequently, she indicated that monetary policy needn’t respond to tariff policy.
Meanwhile, Italian Prime Minister Giorgia Meloni warned against retaliating against US tariffs, saying that this will harm Europe’s economy. She was specifically responding to the European Commission’s decision to impose retaliatory tariffs on some US products due to US tariffs on European steel and aluminum. Moreover, US President Trump threatened to retaliate against the European tariffs by imposing a 200% tariff on EU alcoholic products. Meloni said that, if the EU keeps retaliating, “the result would be inflation and monetary tightening that dampens economic growth. Italy’s energies must be spent in the search for common sense solutions between the US and Europe.” She urged negotiations with the United States.
Germany all in on fiscal stimulus
- Both houses of the German Parliament approved a constitutional amendment to remove the so-called debt brake that limits government borrowing. The amendment was approved with more than the required two-thirds majority. This sets the stage for a massive fiscal stimulus that the likely next Chancellor, Friedrich Merz, has proposed.
Merz intends to borrow enough to fund about 500 billion euros in infrastructure investment over the next 12 years and 400 billion euros in additional defense spending. In addition, the 16 federal states of Germany will be permitted to increase their borrowing as well.
Merz said that “it must be an absolute priority to strengthen Europe as quickly as possible so that, step by step, we actually achieve independence from the US.” He added that “this decision we are making today on our country’s defense readiness is no less than the first major step towards a new European defense community.” This is consistent with the intention of the European Commission to boost EU-wide borrowing to fund the development of a pan-European defense capability.
If the proposed program is implemented, it could have a positive impact on growth, especially in Germany but also in other European countries. The degree of impact will depend on how quickly spending can be implemented—not a trivial issue. A boost to German growth would have a positive spillover effect on other countries in the region. The expectation of this is already reflected in the recent changes in asset prices. European equities have performed very well, bond yields have risen, and the value of the euro has risen. For the European Central Bank (ECB), fiscal stimulus in Europe would relieve the ECB of having to worry about growth and recession. As such, it will likely be more focused on inflation and therefore take a more gradual approach to easing of monetary policy.
Chinese indicators are positive as government initiates reforms
- China’s government released economic indicators for the January–February period and the results were favorable. After a long period of subpar performance, the numbers for the first two months of the year were a marked improvement. This suggests that recent measures undertaken by the Chinese government to boost growth might be bearing fruit. Let’s look at the data.
In the first two months of the year, retail sales were up 4% from a year earlier. This was the best performance since October and the second-best performance since February of 2024. Moreover, considering that there is almost no inflation in China, this represented a sizable real (inflation-adjusted) increase in spending. Although sales of automobiles were down 4.4% from a year earlier, several other categories saw strong growth. For example, spending on sports and entertainment was up 25%, spending on appliances was up 10.9%, and spending on office supplies was up 21.8%. The government had recently implemented a program of subsidies to encourage consumers to trade in old products. It is possible that this contributed to the rebound in spending.
In addition, industrial production was up 5.9% in the first two months. This was the second strongest growth since April 2024. The manufacturing component of industrial production was up a strong 6.9%. This included growth of 12% for automobiles and 10.6% for computers and communications equipment.
Also, fixed asset investment was up 4.1% in the first two months, the strongest growth since April 2024. As previously, there was strong growth of investment in manufacturing, partly offset by a decline in investment in property. Specifically, manufacturing investment was up 9% while investment in property was down 9.8% from a year earlier. In fact, when property is excluded, fixed asset investment was up 8.4% from a year earlier.
Although these indicators improved, the steep tariffs imposed by the United States on imports from China will likely have a negative impact on export growth in the months to come. That, in turn, could affect industrial production.
- While the US administration bemoans the US trade deficit, leaders in China likely bemoan China’s trade surplus. That surplus exists because China saves more than it invests, generating excess savings that is invested overseas. That outflow of capital can only happen if there is a trade surplus. The problem with excess savings is that it suppresses domestic demand, especially consumer demand. This is a challenge for economic growth at a time when China’s ability to grow through exports and export-oriented investment is being impacted by trade restrictions.
There is now a widespread view that, for China to experience a rebound in growth, there must be an expansion of domestic demand. That, in turn, requires that households save less and spend more. There is also a consensus that the first step toward this goal is a bond-financed fiscal stimulus that boosts the spending power of households. That is, the government should borrow the money that households save and give it to households to spend. Yet fiscal stimulus alone is likely not sufficient. Structural factors in the Chinese economy encourage saving. Thus, the assumption is that, if households are provided more financial resources, they will simply save more rather than spend more.
Consequently, the government has recently announced a reform program partly aimed at discouraging saving. Specifically, the government and the Communist Party jointly announced a 30-point program. Among other things, it includes a plan to boost wages, in part by raising the minimum wage; a program of subsidies for childcare; a program of subsidies for elderly care; encouraging the development of more automotive services such as car leasing and the sale of camping equipment; promoting animation, online gaming, and esports; promoting the development of new consumer products that utilize new technologies such as AI; and allowing and encouraging more foreign investment in consumer-related services. In addition, there will be a program aimed at stabilizing the property market.
The hope is that a boost to consumer demand will help to absorb the excess production of goods that cannot easily be exported. If this happens, it will reduce the deflationary pressure created by excess capacity. A senior government official said that the program is meant to “make people more confident to spend and more stable in their expectations.”
Increasing talk about recession risk in the United States
- The US Administration is reacting to market concerns that tariffs and tariff uncertainty could have negative consequences for the US economy. In a meeting with reporters, President Trump said that he will not rule out recession or higher inflation. He suggested that the current policy adjustment will have costs, but that they will produce positive results over time. Specifically, he said that “there is a period of transition, because what we’re doing is very big. We’re bringing wealth back to America. That’s a big thing, and there are always periods, it takes a little time.” He also dismissed concerns that his policies are creating uncertainty for business.
Meanwhile, although Trump acknowledged the possibility of recession, market indicators still do not necessarily point in that direction. There have been some indicators pointing to a slowdown in growth, but not an outright contraction in activity. However, it is worth recalling that, when downturns have come in the past, they were often a surprise. Forward-looking indicators are often not good at predicting turning points. In any event, Trump’s comments on the possibility of recession were quickly followed by a very sharp decline in US equity prices, with the S&P 500 hitting the lowest level since September. The tech-heavy NASDAQ was down 4%. For both indices, it was the worst day since 2022.
Separately, US Commerce Secretary Howard Lutnick acknowledged that tariffs could lead to inflationary pressure. Specifically, he said “so, will there be distortions? Of course, foreign goods may get a little more expensive, but American goods are going to get cheaper.” Regarding American goods, it is important to note that a majority of US imports are intermediate goods used by US companies to produce goods and services. As such, there is a strong likelihood that tariffs will boost domestic production costs, thereby leading to higher prices for American goods.
Also, US Treasury Secretary Scott Bessent, in acknowledging the possibility of higher prices due to tariffs, said that “access to cheap goods is not the essence of the American dream.” Rather, he defended tariff policy on other grounds. He talked about “what tariffs are designed to address: leveling the playing field such that the international trading system begins to reward ingenuity, security, rule of law, and stability. Not wage suppression, currency manipulation, intellectual property theft, non-tariff barrier, and draconian regulations.” Although these issues are important, he did not make it clear how tariffs would resolve them.
- With increasing discussion in the media and in politics about recession risk, the question arises as to whether there is indeed a serious risk of recession. It is hard to know. In the past, recessions often, but not always, were not strongly signaled by the data. Moreover, sometimes when the data screamed recession, a recession did not actually happen. Still, there are some cautionary signs about the US economy, suggesting a potential slowdown in the near term if not recession. What are those signs?
First, an index of consumer confidence published by the University of Michigan fell sharply in February. It declined from 71.1 in January to 64.7 in February, the lowest level since November 2023. The decline was led by a 19% drop in the sub-index for buying conditions for durable goods. Evidently, consumers became more averse to such purchases due to fears of tariff-fueled price increases. Moreover, they likely responded to weakening financial conditions. Indeed, the sub-index for expected financial conditions fell 10%. On the other hand, inflation expectations soared. The increase in the sub-index for inflation expectations was the biggest gain since May 2021.
Consumers were not alone in having weakened confidence. An index of small business confidence published by the National Federation of Independent Business (NFIB) fell in February for the second consecutive month. NFIB commented that “economic policies are raising concerns among firms that depend on imports or export, as tariffs are being broadly applied and retaliated against, changing the prices of imports and exports. The federal government is shedding workers and trimming expenditures. Many small firms are supported by assisting firms with government contracts. How these developments are resolved will shape the economy’s future.” It concluded that “confidence that the economy will continue to grow is fading.” Meanwhile, the survey found that NFIB members are increasingly worried about inflation.
Another warning sign came from the latest employment report for February released recently by the US government. The overall report was quite favorable, with a healthy increase in the number of employed. Yet within the report were troubling signals regarding under-employment. Specifically, the household survey found that, although the headline unemployment rate increased modestly from 4% in January to 4.1% in February, a broader measure of unemployment that encompasses discouraged and part-time workers (known as U-6) increased sharply from 7.5% in January to 8% in February. This was the highest rate since October 2021 and the biggest monthly jump since during the pandemic. This rise in U-6 suggests that the labor market is softening after a long period of tightness.
Finally, financial markets are signaling concern. Often, but not always, sharp movements in asset prices portend changes in the real economy. In recent weeks we have seen softening of equity prices, a decline in bond yields, and a drop in the value of the US dollar. Loss of wealth in financial markets can influence spending decisions. Volatility can stifle risk taking. Thus, the financial situation, if not soon reversed, could have consequences.
US inflation decelerates, but risk remains
- Inflation in the United States was lower than anticipated in February. This fact applied to both headline inflation and core inflation, to both year-over-year and month-to-month inflation. Along with signs of a possible slowing of economic activity in the United States, this inflation news bolsters the likelihood that the Federal Reserve will engage in multiple interest rate reductions this year. In fact, the futures markets are pricing in a 60% probability of three or more rate cuts this year. That is up from a 7.4% probability one month ago—a dramatic change reflecting big changes in investor views on the current and expected state of the US economy. Let’s look at the inflation data.
In February, the consumer price index (CPI) was up 2.8% from a year earlier, down from 3% in January and the lowest rate of annual headline inflation since October. Energy prices were down while food prices rose more slowly than headline inflation. Thus, when food and energy are excluded, core prices were up 3.1% in February from a year earlier. This was the lowest figure since April 2021. This is notable as core inflation has been relatively steady for the past half year. Now, underlying inflation appears to be decelerating.
Among the notable price changes revealed in the government’s inflation report were a 58.8% increase in the price of eggs. This was largely due to avian flu and has become a huge source of consumer frustration as well as some very funny videos on social media. In addition, the price of smartphones fell 13.7%, tomatoes were down 9.7%, and cigarettes were up 7.8%.
More broadly, prices of durable goods were down 1.2%, non-durables excluding food and beverages were down 0.2%, and prices of services were up 4.1%. Although this remains too high, it is the lowest rate of services inflation since December 2021. This fact is likely important to the Federal Reserve. For a long time, services inflation has been driving overall inflation. Moreover, services tend to be labor intensive while a tight labor market has driven up wages. Yet lately, the Fed has indicated labor market conditions are no longer fueling inflation. Plus, data suggests that the tightness of the job market has eased. Also, gains in labor productivity have offset the inflationary impact of rising wages. Thus, there are plenty of reasons for the Fed to be more comfortable about potentially easing monetary policy.
Moreover, the Fed has a dual mandate from the US Congress. It is charged with minimizing inflation and maximizing employment. With signs that the economy could be slowing and that the job market is weakening, and with signs that underlying inflation is easing as well, it is not surprising that investors now expect the Fed to engage in multiple interest rate reductions this year. If that happens, it will likely lead to lower bond yields, lower mortgage interest rates, a boost to housing activity, and a boost to private equity deals and overall M&A activity. Lower interest rates could help minimize the risk of recession.
On the other hand, if the US administration imposes sizable tariffs on major trading partners (which is by no means certain), this could change the trajectory of inflation and Fed policy. High tariffs would be inflationary, at least temporarily, thereby reducing the likelihood of interest rate cuts. Also, tariffs would reduce consumer purchasing power and hurt the competitiveness of US producers, thereby slowing the economy. That, in turn, could lead the Fed to maintain an aggressive policy stance. Thus, a high degree of uncertainty remains. Uncertainty, of course, can have a stifling impact on business investment.
Meanwhile, the only significant tariffs that had been imposed by February were the additional 20% tariffs on imports from China. As of February, this did not yet have an impact on import prices. Yet an impact will likely come, thereby potentially affecting US inflation. Plus, tariffs on steel and aluminum went into effect today. Tariffs on imports from Canada, Mexico, the European Union, Japan, and South Korea remain on the table.
Europe’s pivot to increased defense spending could boost growth
- There is a growing consensus in Europe that defense spending ought to be increased substantially. A recent survey found that only 16% of Europeans see the United States as a reliable ally. Aside from the geopolitical impact, increased European defense spending could be the tool by which European growth is revived through fiscal stimulus, especially as it will likely be financed through increased borrowing. Faster growth would mean that European assets become more attractive to global investors, thereby boosting the value of the euro. Faster growth likely means higher borrowing costs and slower easing of monetary policy by the European Central Bank (ECB).
In the process of developing a joint defense capability outside the NATO umbrella, Europe could set the stage for boosting the global role of the euro. Joint issuance of debt by the European Union (EU) would move Europe in the direction of creating a large and liquid secondary market for European debt that might one day challenge the dominance of US Treasury securities. It is the vast US market for debt that, in part, enables the dollar to be the world’s dominant currency. Yet it is likely that European governments and investors would like to reduce dependency on dollars.
One key to Europe’s fiscal revival is Germany, Europe’s largest economy, where the incoming government is likely to engage in a degree of debt issuance that would have been considered nearly unthinkable just a short time ago. This change in thinking has been facilitated by the change in US policy toward Europe. A survey of economists by the Financial Times found that Germany could boost debt by nearly two trillion euros with impunity, especially given that the country’s current debt/GDP ratio is relatively low. German government debt is the benchmark against which all other European government bonds are measured. If there is a dramatic increase in the volume of German government debt, this could enable the euro to become a partial alternative to the US dollar as a reserve and trading currency.
Financial markets react to the latest US trade policy decisions
- Following the US election in November, US equity prices soared on expectations that a combination of tax cuts and deregulation would boost US economic growth, thereby increasing corporate profits. Yet, since that time, most of the economic news has focused on tariffs rather than taxes. Tariff increases are expected to be inflationary and potentially lead to tighter monetary policy. In addition, tariff increases are expected to subdue aggregate demand by reducing consumer purchasing power. Finally, tariffs are expected to hurt the competitiveness of US manufacturers by boosting the cost of imported inputs. Thus, it is not surprising that US equity price indices have fallen back toward the pre-election level. Plus, it is not surprising that equity prices in other markets have fallen on fears of the potential impact of tariffs. There have been especially sharp declines in equity prices for automotive companies in anticipation of massive supply chain disruption due to trade restrictions.
What is surprising, however, is that investor expectations about monetary policy have shifted. Following the election, an expectation of lower taxes, less regulation, higher tariffs, and less immigration led to expectations of higher inflation. This, in turn, led futures markets’ implied probability that the Fed would cut rates several times in 2025 to decline sharply. It became conventional wisdom that the Fed would engage in a wait and see policy for much of 2025, possibly cutting rates only once if at all. Yet lately, expectations have changed, and the futures markets are now predicting as many as three rate cuts in 2025. What happened?
The answer is that the policy of tariffs, combined with uncertainty about tariffs, have led to increased angst on the part of many business leaders. Indeed, the composite purchasing manager’s index (PMI) for the United States fell sharply in February from the previous month, hitting a 17-month low, suggesting an expectation that the US economy will soon start to decelerate if not contract. If the US economy slows down or contracts, that would likely necessitate an easing of monetary policy. Recall that the Fed has a dual mandate from the US Congress: It must minimize inflation while maximizing employment.
Also, it is notable that once the tariffs were implemented the value of the dollar did not rise sharply as normally expected. Here is why the dollar ought to rise: The trade deficit is due to an excess of investment over savings. When a country invests more than it saves, it must experience an inflow of foreign capital to make up the difference. This requires that foreigners accumulate excess dollars. This happens when foreigners sell more to the United States than they purchase (a trade surplus for the foreigners). Thus, if tariffs are introduced, which initially cut demand for imports, there is a drop in demand for foreign currency, thereby boosting the dollar. In addition, something must happen to maintain the trade deficit so long as the gap between investment and savings endures. A rise in the value of the dollar will boost imports and reduce exports, thereby preserving the trade deficit.
The recent experience, however, is troubling. Although the dollar rose sharply against the Mexican peso when the tariffs were introduced, the dollar movement against other major currencies was more muted than expected. Why?
One reason for dollar softness is that investors now see a significant likelihood of a slowdown in the US economy. All other things being equal, a weaker economy means a weaker currency. Plus, the expectation of a weaker economy has led to an expectation of an easier monetary policy. That, too, implies a weaker currency. Thus, the future trajectory of the dollar could be different than previously anticipated.
Another factor driving down the dollar could be the decision by Germany’s two largest parties to engage in massive borrowing to fund defense and infrastructure. This has led to a rise in European bond yields, thereby boosting the value of the euro. Also, investor expectations regarding actions by both the US Federal Reserve and the European Central Bank have shifted substantially in the past few months.
One possibility is that investors are becoming worried that the dominant role of the dollar will decline amid a weakening of the global trading system. Previously, the United States was one of the world’s most open economies, playing a role as the market of last resort for the world’s producers. It also provided a safe haven for investors experiencing risk elsewhere. Yet now, some investors worry that a world in which large trade barriers are erected might become a world in which the dollar is far less attractive.
On the other hand, there is no currency that can easily substitute the role currently played by the US dollar. The United States has a massive, deep, and liquid market for easily substitutable government securities, something the euro lacks. China has capital controls, which makes it nearly impossible for the renminbi to play a major role. No other currency has sufficient scale to challenge the US dollar.
- Investors have been shifting funds toward lower-risk assets as uncertainty, especially regarding tariffs, undermines confidence. Equity prices have been falling, with the Magnificent Seven down 16% from its peak. The tech-heavy NASDAQ index is down 10%. Meanwhile, funds have been pouring into money market funds, which hit a record high volume this week.
The decline in equities reflects not only concern about the potential economic cost of tariffs, but the chilling effect of tariff uncertainty. Consider that, in recent weeks, large tariffs were imposed on Mexico and Canada and then mostly removed, but only for 30 days. There have been several policy reversals on tariffs. Plus, there have been several tariff proposals that have not been implemented. And there have been multiple reasons offered for imposing tariffs. As such, businesses don’t know what to expect and might fear making the wrong long-term decision about allocating capital. This is especially true for companies that must make large, long-term bets such as those in the automotive industry.
Europe shifts gears
- Faced with a dramatic shift in the policy of the United States toward Europe and Ukraine, European governments and the European Union (EU) are engaged in a dramatic shift as well, one that could have significant economic implications. Recent statements by senior US officials about the US role in Europe and its policy toward Ukraine have been a shock to senior European officials. The consequence of this has been a radical shift in European official views about spending on defense.
First, Germany’s two major political parties, the center-right CDU/CSU and the center-left Social Democrats, which will likely form a government together, endorsed a major increase in spending on defense and infrastructure. The former is meant to deal with the Russian threat, the latter to address a shortage of investment that has held back economic growth. The plan calls for creation of two funds worth roughly 900 billion euros. This is a massive shift in policy.
There remain political hurdles to passing the necessary legislation. Specifically, the constitution must be changed to allow a much higher level of government borrowing. This will likely be done by the current Parliament before the newly elected one is seated.
Still, investors evidently expect that the German reforms will take place, given the sharp reaction in financial markets to the plan. Since the announcement recently, the yield on Germany’s 10-year government bond increased by 38 basis points, the biggest short-term rise in nearly 30 years. In addition, the euro surged against the dollar, reflecting a shift in the interest differential between Germany and the United States. Also, it is notable that, since early January, German equity prices have significantly outperformed US equities, evidence that investors had already anticipated some form of German fiscal stimulus. Plus, investors were likely disappointed that the focus of US policy has been tariffs rather than tax cuts and deregulation.
If the German plan is implemented, it is expected to do four important things. First, it will likely be a fiscal stimulus to the German economy that has suffered from sub-par growth. Second, it could kickstart public investment, helping Germany to catch up after a period of inadequate investment. Third, the stimulus to Germany’s economy will likely have a positive spillover impact on the rest of Europe, helping to boost growth while, at the same time, rendering higher borrowing costs (this is already happening). Finally, the surge in spending on defense will potentially play a role in supplying Ukraine at a time when US support is in question.
Second, European Commission President Ursula von der Leyen has urged a large increase in region-wide spending on defense, funded by releasing the cap on borrowing. Specifically, she wants to allow EU members to violate the current rule governing the share of GDP that can be borrowed each year, so long as the increased borrowing is meant for increased defensive capabilities.
In addition, von der Leyen foresees increasing overall European defense spending by 800 billion euros, part of which would be used to buttress Ukrainian defenses. If this happens, it could provide a region-wide fiscal stimulus while, at the same time, boosting the level and cost of government debt.
Notably, European defense company equity prices have lately soared on expectations of increased government spending. Meanwhile, some European leaders have talked about using increased funds to purchase US-made weapons for Ukraine. In doing this, Europe would assure Ukrainian defenses while, at the same time, boosting imports from the United States. The latter would be meant to discourage the United States from imposing tariffs on imports from Europe.
US job growth decelerates
- In the United States, employment continued to grow at a healthy pace in February, although slower than investors had anticipated. Meanwhile, the unemployment rate inched up slightly. The US government releases an employment report that is based on two surveys: One is a survey of establishments; the other is a survey of households. First, we look at the establishment survey results:
In February, the US economy generated 151,000 new non-farm jobs, of which 140,000 were in the private sector. There was strong growth in construction and modest growth in manufacturing. In the realm of services, employment declined for retailing, professional services, leisure and hospitality, and the Federal government. On the other hand, there was strong growth for transportation and warehousing, health care, and local government. In other categories, there was modest growth. Equity prices continued their decline following release of the jobs report. Evidently, investors interpreted the report as signaling slower economic growth than previously believed.
The establishment survey also included data on wages. The report said that average hourly earnings of all non-farm workers were up 4% in February from a year earlier and were up 0.3% from the previous month. These numbers indicate moderate tightness of the labor market, with wages rising modestly faster than inflation. Yet with labor productivity likely rising, the rise in wages is probably not contributing to inflation. Indeed, this is the view of the Federal Reserve.
The separate survey of households found a sharp decline in the number of people participating in the labor force. In part, this could reflect the fact that the number of immigrants entering the United States has dropped sharply since the end of 2024. Indeed, the government reported a 93% decline in the number of daily border encounters since the start of the new administration. The result was a decline in employment (including self-employment) and a modest increase in the unemployment rate from 4% in January to 4.1% in February.
