Germany is fueling cautious optimism in the European economy

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The closely followed German Ifo business confidence index fell to its lowest level since the spring at the end of 2025. “The year ends without any sense of optimism,” the Ifo Institute said noted short and concise.

But for some economists, this sense of gloom in the eurozone’s largest economy is misplaced – at least partly. Not only did the single currency area prove to be more economically resilient than expected in 2025, but additional growth engines will kick in over the next twelve months, with the potential to improve the outlook.

The most important is the impact of German fiscal policy. The country will stimulate the economy even as the benefits of the European Central Bank’s interest rate cuts continue. Falling inflation and continued real growth in household incomes should support the outlook, analysts added.

“We expect growth to accelerate in the course of this year,” says economist Bert Colijn of ING bank.

The global environment will remain challenging due to competition from China, US trade tensions and a strong euro, he says, but there are optimistic economic arguments based on domestic factors.

Cautious optimism about the eurozone lifted some of the region’s major stock indexes in 2025, including Germany’s Dax index of 40 blue chip companies, which rose 23 percent versus the S&P 500’s 18 percent.

ECB forecasts published just before the year-end holiday period pointed to solid growth performance over the next two years. Eurozone GDP growth is forecast to reach 1.2 percent in 2026 and 1.4 percent in 2027 and 2028 – similar to last year’s growth.

Business investment will rise in 2026-2028, the ECB predicts, and will be further supported by increasing profit growth and relatively low interest rates.

The biggest shift comes down to fiscal policy, which is expected to be broadly stimulative due to the decision by Chancellor Friedrich Merz’s government to ease self-imposed budgetary restrictions and invest in defense and infrastructure.

According to forecasts by the European Commission, the German budget deficit will increase from 3.1 percent of GDP in 2025 to 4 percent in 2026.

More government spending in the region’s largest economy will have knock-on effects for businesses and consumers elsewhere in the currency zone. The peak of the impact on the single currency will be felt in 2026, the ECB projections suggest, with an overall fiscal easing in the eurozone of 0.3 percentage points. This comes as some eurozone countries are scrambling to rein in sovereign debt, including France and Italy.

Household sentiment remains subdued, with the European Commission’s optimism index falling in December and still hovering below pre-pandemic levels. The savings rate of households remains high: more than 15 percent of disposable income.

But unemployment is still near record lows, real wages are rising and credit growth has increased, says Claus Vistesen of Pantheon Macroeconomics. “We think eurozone household spending will continue to grow modestly in the coming quarters.”

At the same time, growth threats remain numerous. These include the risk of new political tensions with the US and the war between Russia and Ukraine.

A renewed Chinese drive for export growth poses particularly acute challenges for German GDP, Goldman Sachs analysts warn, with slightly less pronounced consequences for Italy, France and Spain.

As a recent global FT survey shows, economists expect the US to increase its productivity lead over Europe thanks to AI investments. Meanwhile, progress in deepening the EU’s internal market and strengthening economic dynamism in the region has been patchy.

And while Germany may have room for debt-financed spending of €1 trillion on infrastructure and defense, the economy’s overall performance remains tepid. The Bundesbank in December cut its forecast for German growth for 2026 by 0.1 percentage point to 0.6 percent, while raising its forecast for 2027 by the same amount to 1.3 percent.

Nevertheless, lower energy costs should help the region’s industrial powerhouses, and inflation now appears to have been firmly suppressed, leading to ECB predictions that policy is in a “good place.” It predicts annual inflation of 1.9 percent in 2026.

Then comes the shift in fiscal policy in the largest economy.

“The biggest factor making 2026 better is that we are likely to see a private sector response to the German fiscal stimulus – consumers and businesses feeling better and spending more money,” said Holger Schmieding of Berenberg Bank.

Low interest rates will have even more far-reaching consequences across the eurozone, boosting investment and housing construction, he adds. “It’s not just a German budget story.”