Germany’s new fiscal rule: A responsible approach to fiscal sustainability

Ashoka Mody, Sven Jari Stehn 11 August 2009

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On 12 June 2009 the German parliament amended the constitution to include a new fiscal rule for both federal and state governments. The rule, conceived in 2006 as a mechanism to impose fiscal discipline, requires the federal government’s structural deficit – the deficit adjusted for the influence of the economic cycle and one-off operations – not to exceed 0.35% of GDP. The rule becomes binding for the federal government in 2016 and requires a gradual move to structural balance from 2011. The states are required to run structurally balanced budgets from 2020. The rule is embedded in the constitution (Germany’s “basic law”), as was its “golden rule” predecessor, which restricted borrowing not to exceed budgeted gross investment expenditure.

The fiscal rule provides a timely "exit strategy" from the current accumulation of public debt. The rule constitutes a credible commitment to fiscal sustainability, which is welcome in the current context of the large fiscal costs associated with the financial crisis and steadily rising debt levels in the states (see Figure 1). The timing of the required consolidation is consistent with our economic outlook – the phasing in of the rule should not conflict with the need for continued stimulus in 2010 and a projected economic recovery in 2011.

Figure 1. German growth and fiscal outlooks

 

The structural deficit ceiling is complemented by mechanisms to allow flexibility in its implementation. A credible fiscal rule necessarily constrains the room for discretionary fiscal actions (Eichengreen and Wyplosz 1998; Kopits and Symansky 1998). Concerns with regard to the limits the new German rule may place on counter-cyclical policy, however, appear greatly overstated. First, Germany has large automatic stabilisers (see Figure 2), which will have full play under the new rule. Second, since there is no limit on the surplus that could be run, the authorities could choose to maintain a positive structural balance during “good” times, allowing some discretionary scope when needed. Finally, the provisions allow for an escape clause that can be invoked by parliamentary majority in the event of natural catastrophes and other emergencies outside the control of the government.

Figure 2. Automatic stabilisers

The rule is consistent with the European fiscal framework and could work to strengthen that framework. The rule formalises the preventive arm of the European Stability and Growth Pact (SGP), which requires countries to maintain a fiscal position close to structural balance. Moreover, its numerical ceiling is consistent with the latest medium-term objective under the SGP. This preventive aspect of the SGP has been non-binding for member states and has, therefore, been disregarded. Our ongoing research shows that because German fiscal decisions have often been a focal point for fiscal changes in Europe, Germany’s lead could well induce others to formalise their exit strategies while strengthening multilateral discipline (Mody and Stehn 2009).

The real risk – as often with fiscal rules – is that compromises in implementation could undermine the intent. First, given the problems with determining cyclical positions, the government’s proposed reliance on the European Commission’s methodology will ensure transparency. An equally transparent approach for the states will be important. But more seriously, the recent crisis has revealed the limits of measuring potential output – and hence structural deficits. How transparency is balanced with continued advances in measuring potential output remains a serious challenge.

Second, while the escape clause is only valid with parliamentary approval and in conjunction with a corresponding consolidation plan, it could be abused.1 Under the previous “golden rule,” it was relatively easy to invoke the escape clause behind the “veil of macroeconomic equilibrium” (Baumann et al. 2008). To this end, a newly-created Stability Council is a step in the right direction and could help lift the veil. It will conduct surveillance of the finances of the federal and state governments, issue early warnings, and coordinate corrective measures. However, it will not have binding authority. For these reasons, however well-designed the rules, there is eventually no substitute for a government’s commitment to fiscal sustainability.

Footnotes

1 To ensure consistency of the federal budget with the rule both ex ante and ex post, execution errors are cumulated in a notional account which has to be corrected once errors accumulate above 1 percent of GDP.

References

Baumann, Elke, Elmar Doennebrink and Christian Kastrop (2008): “A Concept for a New Budget Rule for Germany”, CESifo Forum 2/2008.

Eichengreen, Barry and Charles Wyplosz (1998): “The Stability Pact: More than a Minor Nuisance?”, Economic Policy, 26.

Kopits, George and Steven Symansky (1998): “Fiscal Policy Rules”, IMF Occasional Paper 162.

Mody, Ashoka and Sven Jari Stehn (2009): “Fiscal Policy in Euroland: Does Germany play a Leadership Role?”, mimeo, International Monetary Fund.

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Topics:  Europe's nations and regions

Tags:  Germany, fiscal rules

Visiting Professor in International Economic Policy at the Woodrow Wilson School, Princeton University

Economist at the International Monetary Fund

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