Europe's largest economy under pressure, German officials warn that the Iran crisis could halve economic growth by 2026

Ask AI · How the Iran Conflict Could Impact Germany’s Economic Recovery Through Energy Prices?

The German economy is facing a serious threat from the escalating situation in the Middle East.

On March 26, Bloomberg cited informed sources stating that German officials believe, if the Iran conflict persists, the growth rate of the German economy in 2026 could be only half of the official target. This scenario not only complicates the German government’s financial consolidation efforts but also forces a reevaluation of the overall growth prospects for the Eurozone.

According to insiders, the German government’s internal estimates suggest that in the worst-case scenario, where the Middle Eastern crisis continues to spread, the GDP growth rate in Germany in 2026 could drop to 0.5%, far below the previous forecast of 1%. If energy prices remain at current high levels for a few weeks, the growth rate is expected to fall within the range of 0.6% to 0.7%. In the worst-case scenario, the growth rate for 2027 will also be 0.1 percentage points lower than expected, dropping to 1.2%.

The associated risks have prompted the European Central Bank and the Italian government to lower their growth expectations. According to Bloomberg, the Italian government plans to cut its growth forecast for 2026 to 0.5%. The German Bundesbank also lowered its economic outlook on Thursday and listed the Iran conflict as a significant factor that could lead to stagnation in the German economy in the first quarter.

Shadows Over Recovery Prospects

For Chancellor Friedrich Merz’s governing coalition, the escalation of the Middle East conflict represents a clear setback. Previously, after two years of contraction and near stagnation, the German economy had shown signs of recovery driven by public investment, and the government was hopeful for a sustained recovery.

Currently, the energy supply disruptions caused by the Middle East conflict are posing an increasingly severe impact on Europe’s largest economy. The official economic forecast for Germany will be jointly released by several major economic research institutions on April 1, and the internal scenario estimates may not be directly reflected in it.

Increased Fiscal Pressure, Tax Increase Discussions Emerge

The slowdown in economic growth poses a particularly severe challenge to Germany’s public finances—weak growth means corresponding reductions in tax revenue.

Currently, the Christian Democratic Union/Christian Social Union (CDU/CSU), led by Chancellor Merz, is negotiating large-scale reforms with the center-left Social Democratic Party, aiming to restore economic competitiveness and fill a fiscal gap of up to €140 billion (approximately $162 billion) by the end of the current legislative term in 2029.

Although the government has launched an infrastructure investment plan of around €500 billion and exempted defense spending from the “debt brake” restrictions, next year’s core budget still needs to be cut by €20 billion, with cuts reaching as high as €60 billion in 2028.

According to Bloomberg citing informed sources, given that relying solely on spending cuts is insufficient to close the gap, officials have begun discussing the possibility of raising the value-added tax rate from 19% to at least 21%. This move would be another policy touching the bottom line of conservative voters, following the easing of the infrastructure spending “debt brake” rules—Merz had previously explicitly promised not to raise taxes, and this was not part of the coalition agreement.

Energy Subsidies and Internal Party Divisions

Meanwhile, the coalition government is weighing whether to introduce further support measures to alleviate the pressure on consumers from rising fuel prices. Finance Minister Lars Klingbeil proposed imposing a windfall tax on energy companies to prevent further strain on the budget, but this proposal has been opposed by CDU member and Economics Minister Katherina Reiche.

On the political front, far-right forces are continuing to expand by capitalizing on public dissatisfaction with the economic downturn. The support rate for the nationalist party Alternative for Germany (AfD) is now on par with Merz’s conservative bloc. State elections taking place later this year in eastern Germany may see the party gain control in a federal state for the first time.