Auf Wiedersehen, U.S. Exceptionalism

Europe in general, and Germany in particular, plan significant increases in defense spending at a time when U.S. growth has been softening. That combination is putting U.S. exceptionalism at risk, as we explore in a new Citi Research note from Adam Pickett and his Global Macro Strategy team.

We explore this shift by considering multiple key points.

For Europe, joint defense spending and further softening of fiscal rules is a big moment. EU Commission President Ursula von der Leyen has announced a EUR800 billion package with three parts. The first is the EUR150 billion ReArm Europe Fund providing joint borrowing for defense spending. The second is the activation of the escape clause in the Stability & Growth Pact, which creates fiscal space of 1.5% of GDP that EU member states can use for defense spending. The third is allowing cohesion program funds — ordinarily earmarked for reducing economic disparities between member states and promoting sustainable growth — to be diverted to defense-related investments.

German defense spending is ramping up more aggressively than we’d expected. Going into the German election, our expectation was for a EUR100 billion defense fund to be drawn on over three years, and for a loosening of the debt brake from 0.35% to 1% in 2028. This now looks much too conservative. German policymakers are discussing EUR500 billion for defense (partly accounted for in the European number above) and a vote is expected relatively quickly.

Germany’s infrastructure spending plans are also aggressive. Coalition negotiations between the Christian Democratic Union (CDU) and the Social Democratic Party (SPD) include an infrastructure fund valued at EUR400 billion to EUR500 billion. Together, the two German funds are around 20% of German GDP. This fiscal U-turn is even more surprising as there was no clear external shock to have changed the mindset of the CDU’s fiscally conservative policymakers. The infrastructure fund will be voted on by Germany’s new parliament; it’s not clear whether the country’s debt brake will be changed as well, and in theory the two special funds may mean that it doesn’t have to be.

Despite the above, the overall stimulus is exaggerated as spending is likely to be slow. We note that European policymakers have a clear incentive to demonstrate to both Presidents Trump and Putin that they’re serious about defense. This suggests actual spending may fall short of the lofty numbers discussed above, and it’s unclear over how many years the proposed spending would be spread. It seems unlikely to be spread out for more than 10 years, suggesting that Germany’s spending might grow an extra 2% of GDP. Isolating public investment, Germany’s single-largest ramp-up was around 1% of GDP following the 1990 reunification, with the 2020 jump in COVID spending more like 0.5%. It’s likely difficult to ramp up infrastructure and defense spending much more quickly than that.

The majority of European defense spending is going to U.S. contractors, though less so over time. Our defense analysts estimate that prior to the Russia–Ukraine conflict, around 60% of European defense budgets ended up in the coffers of U.S. companies, a percentage that grew to 80% during the Ukraine conflict as European firms struggled to scale up quickly enough. European policymakers will now try to source more defense spending locally, but even getting back to 60% will take quite some time. This means in the near term, a meaningful part of the additional defense spending will benefit the U.S. more than Europe.

What’s the effect on U.S. exceptionalism from Trump administration policies? U.S. exceptionalism has been challenged by weaker U.S. growth, with U.S. policy seeming to have encouraged upside fiscal surprises in the EU and China while being underwhelming on the domestic front. At the same time, U.S. growth has been challenged by a combination of tariff uncertainty, DOGE job cuts and sticky inflation. Moreover, weaker U.S. growth has longer to last given the normal seasonality of our U.S. economic surprise index and the fact that DOGE job cuts aren’t yet reflected in the numbers. 

Tariffs are coming for Europe, but the U.S. is vulnerable too. Given that Mexico and Canada weren’t spared U.S. tariffs, it seems reasonable to assume some tariffs on Europe are still likely. But our economists’ simulations suggest the negative growth impact will be worse for the U.S. than for the rest of the world, reinforcing stagflationary trends in the U.S.