Can the German Obsession with Balanced Budgets Be Overcome?

For many years international observers, including U.S. Nobel laureates like Paul Krugman and Robert Solow, have been wondering about certain peculiarities in German economic reasoning and economic policy. These seem to be governed by the strong belief in the need to follow strict principles and rules. This is particularly true for fiscal policy, where German politicians tied their hands by introducing a strict “debt brake” into the constitution in 2009.

After a transition period the debt brake is by now fully binding. Since 2016 the federal budget is only allowed to run a deficit of 0.35 percent of GDP, while the sixteen federal states (Länder) budgets must be balanced over the economic cycle starting in 2020. According to the economy’s position in the business cycle, budgets may need to run deficits or surpluses and there is an exceptional clause for natural disasters or other events that unexpectedly and strongly hit the budget, but this clause has to be activated by a qualified majority in parliament.

Apart from a horribly complex and non-transparent implementation—there are by now seventeen partially different “debt brakes” as each of the sixteen Länder (plus the federal government) has the right to decide about the technical details of implementation by itself—the economic case for such a constitutional debt brake is very weak.

First, the limits set for the budget deficit are economically arbitrary and would, in the long term, lead to extremely low debt levels below 15 percent of GDP, which may be too low to provide financial markets with a sufficient amount of safe assets. Second, the leeway for fiscal policy in economic downturns may be too small, as the debt brake relies on automatic stabilizers only and restricts the use of discretionary measures to exceptional cases. Third, the debt brake has given up the long established “Golden Rule of Public Investment.” This rule is widely accepted in the traditional public finance literature and calls for financing public investment by deficits, thus promoting intergenerational fairness as well as economic growth. Public investment increases the public and/or social capital stock and creates growth to the benefit of future generations. Therefore, future generations are to contribute to financing investment via the debt service. Failure to allow for debt financing will lead to a disproportionate burden for the present generation via higher taxes or expenditure cuts and therefore most probably to under-provision of public investment—in fact, exactly what happened during the Euro crisis in many countries.

In addition to the restrictive debt brake, the federal government has been continuously over-fulfilling the debt brake by running at least a balanced budget or a surplus (“black zero”) since 2014. Within the current grand coalition government, the Social Democratic finance minister Olaf Scholz, who inherited the black zero from his Christian Democratic predecessor Wolfgang Schäuble, has explicitly supported and continued it.

With this debt brake and balanced budget obsession Germany seems ill-equipped for the future challenges the country will be facing and that almost all require increases in public investment.

With this debt brake and balanced budget obsession Germany seems ill-equipped for the future challenges the country will be facing—and that almost all require increases in public investment. As a consequence of underfunding and severe budgetary cuts, primarily in the first decade of the twenty-first century during Germany’s period as the “sick man of Europe,” infrastructure (roads and highways, bridges, public school buildings, railways) has suffered and is in need of repair. At the same time, there is the urgent need for future related investment in research and education, digitalization, and decarbonization to cope with demographic, climate, and structural change. It is difficult to exactly quantify the investment needs; however, thinking through the relevant areas easily leads to investment needs in the range of at least 1 percent of GDP per year.

Over the last few years governments have increased investment spending noticeably despite the debt brake. But this was possible mainly because of the exceptionally long economic upswing since 2010, which only came to an end last year, and the corresponding strong revenue growth. The federal government in particular was able to accumulate some special funds that supported public investment on the municipal level. As neither substantial tax hikes nor cuts in other areas of spending seem politically feasible, however, it is clear that it will not be possible to meet the substantial additional investment needs without additional fiscal deficits. As expressed by the aforementioned Golden Rule of public investment the economic case for such debt financing is strong. It is reinforced by interest rates being at historic lows—actually the government can borrow money at zero or even negative interest rates. According to standard economic cost-benefit logic, benefits (needs) have increased and costs (interest rates) have decreased so that at least a large part of the additional investment needs should be financed by deficits.

Obviously, this is difficult to reconcile with the current fiscal framework of the debt brake, let alone the black zero. So what can be done? Investment-related reform of the debt brake is out of the question politically as it would require a two-thirds majority in both the federal parliament and the Bundesrat. Resistance by the proponents of the debt brake would be fierce as many politicians believe in the debt brake. For many conservatives and liberals, it is the last remaining pillar of a sound, rules-based ordoliberal economic policy that in their view has been undermined by grand coalition social policies in recent years.

However, there is hope as support for the black zero is weakening. More and more German economists have been calling for debt financed investment. In November, the Federation of German Industries (BDI) published a joint declaration with the German Trade Union Federation calling for a large-scale debt-financed public investment initiative. The initiative is all the more remarkable politically as the BDI used to be a firm supporter of balanced budgets, but also because it pointed to a pragmatic solution that would be legally feasible even under the debt brake: an extra budgetary special purpose vehicle that would be able to borrow money or could be equipped with capital by the federal government via financial transactions that are exempt from the debt brake. At the moment some technical details remain unclear and the resistance by the conservatives is still strong; it is completely open whether Germany will be able to tackle the challenge and provide the necessary public investment. However, the chances have not been so high in decades and it seems sure that at least some additional investment will finally be provided.