My IMK colleagues Christoph Paetz, Katja Rietzler and Achim Truger have just issued an important analysis of experience with the German Schuldenbremse (debt brake) since 2011. If you read German I heartily recommend you to consult it. We will prepare an English translation, but given the importance of the debt brake for the fiscal policy discussion in Europe (and the fact that quality technical translations take time) let me summarise the main points of interest for European readers here.
The first key mesage is that the apparent successes of the debt brake – the over-fulfilment of fiscal targets, rapid consolidation and emulation by other EU governments under the fiscal compact – are in fact a mirage. The consolidation outcomes, in particular the fact that Germany has posted fiscal surpluses for the past two years, result from the favourable economic and labour market development in Germany, especially the unexpectedly rapid bounce-back from the Great Recession. On top of this came substantial savings in interest payments due to the fall in interest rates, as much of the remaining euro area was mired in recession and the ECB pulled out the monetary stops.
The second, more fundamental point is that the favourable business cycle since the introduction of the debt brake has so far concealed its most insidious danger. On paper the debt brake is expressed in so-called “structural” or “cyclically adjusted” terms. In any one year the government may not borrow more than 0.35% of GDP – the same idea can be expressed in different equivalent ways – on average across the cycle, assuming that the output gap is zero, or after allowing for the current state of the business cycle. This is sensible, in principle, for two reasons. Firstly because governments cannot control the current (i.e. non-adjusted) deficit in the short run, and secondly because focusing on the current balance would make fiscal policy pro-cyclical. It would constrain government to tighten fiscal policy when the economy is weakening (and the cyclical deficit rising) and permit a destabilising loosening of policy when the economy is in a boom.
The problem is that, for technical reasons (for discussions see for instance here and here), the government budget out-turn relevant for the debt brake does in fact contain a substantial cyclical element. This means that when the economy is weak the reported, supposedly structural but actually partly cyclical, deficit is too high, forcing the government into procylical tightening. Growth is depressed further, risking a downward spiral.
To show just how grave this risk is the three researchers conduct a counterfactual simulation using conservative estimations for the key parameters. The simulation is also conservative in focusing only on central government, leaving out federal-state finances. Real growth and inflation are, initially, the same as actually occurred in the years 2012 to 2016. The only change is that the boom in 2010 and 2011, in which the German economy grew by 4.1 and 3.7% respectively, is assumed not to have occurred. Contemporary consensus GDP and inflation forecasts are used instead (GDP: -0.5 and 1.4%). Based on plausible assumptions for the response (elasticity) of the budget to the lower nominal GDP, they then estimate the (supposedly) “structural” budget balance that would have been reported. The calculations indicate that by 2012 the budget out-turn would have contravened the strictures of the debt brake, causing a tightening of German fiscal policy beginning in 2013. Via the multiplier this in turn depresses GDP compared to the actual values. By 2016 federal government spending would be more than 12% below the unconstrained value and more than 7% below the actual budget plan for the current year. And as a result the German economy would not only have missed out on the two-year boom: GDP would have been depressed by a further 1.4pp. thanks to contractionary fiscal policy forced by the application of the Schuldenbremse. Last but not least, this, in turn, would mean that the debt:GDP ratio would have been more than 8pp higher.
Given the conservative paramterisation and the fact that federal state governments, many of whose finances are decidely more shaky and that are more likely to be forced into pro-cyclical tightening, the authors consider these estimates to represent a lower limit for the economic losses. What is certain is that, absent a short boom five years ago, Germany would not now be enjoying the “luxury” of a debate on whether to increase infrstaructure spending or cut taxes.
The conclusion is obvious. The Schuldenbremse is – at best – unproven and on plausible assumptions decidedly procyclical. It was a major policy mistake to impose, via the Fiscal Compact, the newly adopted German fiscal model on other members of the euro area (in nationally somewhat modified forms) before the measure had shown itself to be a useful medium and long-run policy guideline, that is before it had been in operation for a full economic cycle. Germany should urgently consider amending its fiscal rule before the next downturn comes. (This will be hard as the rule, bizarrely, has constitutional status.) And EU policymakers need to revise the Fiscal Compact so as to enable euro area member states to do the same.