28 March 2012

Achim Truger: The German debt brake – A shining example for Europe?

Under closer examination, the shining example loses much of its lustre. A considerable part of the successful consolidation up to now is based solely on the completely unexpected rapid economic recovery over the last two years. In 2010 and 2011, real GDP increased by 3.7  per cent and 3  per cent respectively and unemployment fell dramatically. Such conditions mean that budget consolidation is feasible and indeed easy because tax income increases and social transfers are reduced due to lower unemployment. This situation also helps to reduce the “structural”, i.e. cyclically adjusted, deficit which should in principle be independent from the temporary ups and downs of the economy. As is the case with almost all cyclically-adjusted procedures according to the German procedure the structural deficit also depends to a considerable extent on the actual cyclical performance of the economy. This means that the German debt brake has up to now benefited primarily from an unexpectedly favourable economic upturn. However, it still awaits the first serious test in an economic downturn.

But has the German debt brake not at least reinforced the credibility of Germany’s fiscal policy in financial markets? That is extremely unlikely. Firstly, from an empirical viewpoint, there is no strong connection between strict institutional debt brakes and interest rate risk premiums in financial markets. In addition, if one assumes comparatively rational behaviour in the financial markets, the German debt brake should not be able to increase the government’s credibility: The procedure practised by the federal government largely lacks transparency and is subject to cosmetic changes. The procedure for cyclical adjustments, which follows that of the European Commission, contains so many adjustable screws and possibilities for manipulation that the structural deficits can be calculated virtually at will. Thus on the basis of the general method employed by the federal government, Germany’s structural deficit for 2010 could be anywhere between €10 billion and €40 billion.

Worse still, the federal government, which has got into the habit of tearing strips off other European governments for their allegedly dubious fiscal policies, has in its own practical implementation of the debt brake ensured a lack of transparency and has manipulated the situation.

Thus on closer analysis the shining example loses all its lustre. Germany and its debt brake are currently in the middle of a major fiscal policy experiment and the outcome is far from certain. The successes noted for the time being are mainly due to an economic recovery and the technically successful manipulation of figures by the federal government, but the real test lies ahead. It was obviously a serious mistake to accept a debt brake so similar to the German model so quickly at the European level. Given these basic errors, which are hard to reverse, and faced with the difficulties and problems of the German example in specifically reshaping the German debt brake, European fiscal policy should instead go its own way and investigate thoroughly all the ways in which it can be reshaped.

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