The German debt brake needs a reform

Michael Hüther, Jens Südekum 06 May 2019

INSM / FRANK SENFTLEBEN

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Borne by a broad political majority, the debt brake was introduced into the German constitution in 2009. At that time Germany was under the acute shock of the financial crisis. The massive stimulus packages needed to support the economy had pushed the debt ratio up from 63% to 81% of GDP in just a few years. The purpose of the debt brake was to reverse this trend. 

The rule stipulated that, by 2020, public budgets of the Länder must be balanced in normal times. At the Federal level, structural deficits were restricted to a tight maximum of 0.35% of GDP, currently around €12 billion per year. And actual fiscal policies have not even used that space but overachieved the legal requirements. Most Länder ran balanced budgets or even surpluses well before the end of the transition period. The Federal government implemented the widely known ‘black zero’ policy, which was factually even a ‘black plus’ with budget surpluses in seven consecutive years since 2012. 

Those policies do not seem to have missed their objective. Germany's debt ratio is back at the 60% mark, and on a further downward trend. It is expected to reach 50% in 2023, and with growth unchanged, public debt would be just 11% of GDP in the long run. In short, public finances in Germany seem very healthy at first sight. 

But serious deficiencies in public goods have opened up in the meantime: crumbling schools, roads and bridges; a dramatically underfunded education sector; slow and unreliable internet connections across the country; an army in a deplorable state. The list goes on. 

Those deficits have become the major brake on private investment in Germany. If companies do not have access to good infrastructure and well-educated professionals, they prefer to invest abroad. This fuels the record-high current account surplus. But it does not create capacities, new innovations and jobs in Germany.

It would certainly be unfair to attribute all those problems to the debt brake alone. Investments fell before 2009, especially at the municipal level. And in fact, the constraint has not been formally binding since its introduction, for the German state is currently floating in money. Tax revenues are rising and interest payments are declining sharply. Last year alone, the general government balance showed a surplus of € 54 billion, equivalent to 1.5% of GDP. So it would have been possible to spend more on investment – despite the debt brake. Many of their friends therefore say that, in reality, there is no lack of money but only of political will to invest. 

This view is, however, incomplete. The state needs reliable financing for a major modernisation and investment offensive. Governments do not jump-start big projects simply because there is a temporary windfall of tax revenue. Responsible planning has to take future financial obligations and follow-up costs into account, and budget planners will only be willing to accept those costs if they retain security and flexibility. But those were curtailed by the ban on government borrowing. Thus, the debt brake has already cast its shadow – despite budget surpluses. And private investors are hardly changing their capacities, as in the construction industry, because there is no reliable long-term perspective for government investment and hence demand for construction services. 

Looking ahead is even more important. Record tax revenues will not go on forever. It is therefore imperative that the government creates the conditions for future growth today. To have competitive jobs, the state is required for at least a decade to remedy the deficiencies in infrastructure, education and digital transformation.

Besides, the question arises as to whether the debt brake is even up-to-date with regard to the historically low level of interest rates. If the German government borrows one euro today, it will have to pay back less than 90 cents in real terms in ten years. Nevertheless, demand for bunds remains strong as major institutional investors and insurers are desperately looking for safe havens, of which there are few in the world.

The German state should exploit this potential, borrow at negative interest rates and invest steadily in education and infrastructure. The debt brake, however, prevents government from doing so and thus aggravates sound economic policy. It's as if the state leaves money on the sidewalk instead of picking it up. The burden of this flawed approach is put on future generations.

Figure 1 Government bond yield and nominal growth of GDP, Germany, 1970-2017

Interest rates for government bonds have been below the nominal GDP growth rate for ten years now (see Figure 1). In this constellation, Germany can constantly engage in debt rollover without even getting close to a dangerous debt spiral. 

Of course, interest rates could rise again, for example if the ECB ends its loose monetary policy. But according to current simulations of the IW Cologne, even this would have only a temporary and weak effect on real interest rates, which are projected to decline and stay close to zero until 2050. This is because the deeper root causes are elsewhere: high savings of an ageing society combined with low capital demand of a rapidly digitising economy. Those structural factors are not going to change anytime soon.

Germany should therefore not simply stick to its current fiscal rules. Although the hurdles for another change in the constitution are, admittedly, quite high, the tenth anniversary should be taken as an opportunity for a deep reform of the debt brake. Not a complete abolition, because it is still advisable to exclude debt financing of purely redistributive transfers or social expenditures. But matters are different for public investment and education spending. Those items should be settled in a separate budget where debt financing is generally permitted, consistent with the ‘golden rule’ of public finance.

In theory, this could create the incentive for politicians to label everything an investment in the future, just to be able to debt-finance it. But how real is that threat? And wouldn’t voters punish such label fraud? History suggests that German politicians did not engage in such excessive practices when it was still possible, so why would they do it now? A little confidence in the functioning of democratic institutions seems like a good idea. Because in reality, Germany is facing much bigger economic and political challenges that an alleged deficit bias.

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Topics:  Europe's nations and regions

Tags:  German debt brake, Germany, Lander, structural deficits

Director and Member of the Presidium, German Economic Institute

Professor of International Economics at the Düsseldorf Institute for Competition Economics, Heinrich-Heine University Düsseldorf; Research Fellow, CEPR

CEPR Policy Research