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How Germany’s ‘debt brake’ broke the budget

When Germany enshrined a “debt brake” in its constitution in 2009, it was celebrated as a victory for fiscal rectitude and a definitive break with the profligacy of the past.

Fourteen years later, with Olaf Scholz’s government in the throes of a burgeoning budget crisis, the strict curb on public deficits does not seem such a great idea after all.

“It was the biggest mistake in German economic policy in the last 20, 30 years,” said Jens Südekum, professor of international economics at Heinrich Heine University in Düsseldorf. “The stupid thing is now in the constitution and you can’t get rid of it.”

Doubts about the debt brake — which Germany has sought to impose on other eurozone countries, too — have proliferated since last week’s bombshell ruling by its constitutional court that threw spending plans into disarray and plunged Scholz’s fragile coalition into the worst crisis of its two-year reign.

Talks on next year’s budget have been postponed indefinitely and future funding for Ukraine and other major spending lines frozen.

On Thursday, finance minister Christian Lindner said he would declare 2023 a year of emergency, allowing him to suspend the debt rule for the fourth year running and so put spending on a “firm constitutional footing”.

The trigger for the crisis was the constitutional court’s decision to block a government move to transfer €60bn of unused borrowing capacity from its pandemic budget to a “climate and transformation fund” (KTF) that finances projects to modernise German industry and fight climate change.

A balloon bearing the likeness of Christian Lindner, finance minister, flies in front of parliament, during a demonstration in June calling on the government coalition to stick to its agreement to reach the UN’s sustainable development goals
A balloon bearing the likeness of Christian Lindner, finance minister, at a demonstration in June calling on the government to stick to its sustainable development goals © John Macdouglal/AFP/Getty Images

The judges, much of whose reasoning was based on the principle — and implications — of the debt brake, said the shifting of funds “does not meet the constitutional requirements for emergency borrowing”. Ministers are now frantically trying to figure out how to plug the €60bn hole in Germany’s finances.

The crisis has highlighted how the unintended consequences of the debt rule, conceived as a way of strengthening confidence in Germany’s public finances, risk destabilising the country’s entire budgetary system, with huge potential knock-on effects for the eurozone.

The increasingly elaborate tricks ministers have resorted to get around the rule have now been called out by Germany’s top court, in a move that could drastically weaken voters’ faith in the competence of their politicians.

“This budget and coalition crisis threatens to turn into a crisis of confidence in the effectiveness of our state,” the Christian Democrat MP Thorsten Frei wrote in a letter to the chancellery.

Many on the left are placing blame for the debacle fairly and squarely on the debt rule and are demanding it be overhauled — or even scrapped. A paper drawn up this week by Scholz’s Social Democrats said it was “inappropriate for the challenges of the future” and required urgent reform.

The debt brake was a “brake on the future”, the SPD said.

First introduced in 2009, the rule limits the federal government’s structural deficit to 0.35 per cent of gross domestic product, adjusted for the economic cycle, and effectively prohibits Germany’s 16 federal states from running any deficits at all.

The intellectual seeds for the reform were sown in the early 2000s, when Germany was seen as the sick man of Europe. With the cost of reunification weighing heavily on the public purse, unemployment high and debt spiralling, policymakers thought strict rules were needed to force governments to behave more responsibly.

“Governments have an infinite desire to spend . . . and you need to place limits on that,” said Lars Feld, professor of economics at the University of Freiburg, who advises the fiscally hawkish finance minister. “And that’s precisely what the debt brake does.”

It was also part of the neoliberal Zeitgeist that pushed privatisation of state-owned enterprises as well as reform of the welfare system and the labour market.

“There was this idea that unless you place shackles on the state, it has this natural tendency to keep expanding,” said Südekum of Heinrich Heine University.

But it was the havoc wrought on state coffers by the global financial crisis which ensured its passage into law. Two fiscal stimulus packages and a €500bn bank bailout had left the eurozone’s largest economy with an €86bn deficit and a debt-to-GDP ratio of 81 per cent, much higher than the 60 per cent limit set out in the EU treaty.

In the years that followed, it seemed to prove its worth, providing an element of stability at a time when the sovereign debt crisis was throwing the very existence of the European single currency into doubt.

“It reassured the markets about the sustainability of Germany’s public finances and the country’s status as the eurozone’s de facto fiscal backstop,” said Marco Buti, an economist at the European University Institute in Florence and former long-serving EU official.

The debt brake certainly helped to place Germany on a more sustainable footing. Under Angela Merkel, the veteran Christian Democrat chancellor, the country consistently ran balanced budgets — known as the schwarze Null, or “black zero” — and by 2019 its debt-to-GDP ratio had dropped to 60 per cent. It experienced 10 straight years of economic growth, the highest levels of employment since reunification and surging tax receipts.

Angela Merkel, centre, the former chancellor or Germany, with other world leaders in 2017
Angela Merkel, centre, the former chancellor or Germany, with other world leaders in 2017. Her government consistently had balanced budgets © AP

But there was frustration in Europe when Germany began to preach the thinking behind the debt brake idea to its eurozone partners. This peaked with the fiscal pact of 2012, which dictated strict budget discipline for all eurozone members, and which Berlin saw as a first step towards a “fiscal union”.

Other EU countries have been reluctant to copy Germany’s experiment. “The excessively rigid way it was conceived was suboptimal,” Buti said. “You can see that in the way the government has created this multiplicity of special vehicles to help bypass the rules. And now the constitutional court has exposed this contradiction.”

Feld, who continues to champion the rule, said the debt brake is much more flexible than its detractors make out. “The way it’s designed, it can be eased when we’re in recession, and when we’re in a really serious crisis, we can activate the escape clause, which is precisely what happened in the pandemic,” he said. “Look how much debt we took on after that.”

He added that this emergency exemption, which was also deployed last year, after Russia invaded Ukraine and energy prices went through the roof, was an “intrinsic part” of the debt brake’s design.

Others are less sure. Peer Steinbrück, the Social Democrat former finance minister who was one of its authors, is now in favour of reforming it. “There must be a debt brake but the current one is clearly no longer in step with the times,” he told Die Zeit this week.

Rules were needed to ensure robust public finances, he said. Governments tend to take refuge in debt, to lower taxes and hand out goodies, “because it’s naturally popular [to do so]”.

But there were also are good reasons to “take on debt to finance investments in the future”, he added. “The debt brake should take that into consideration.”

Hopes for reform, however, might prove illusory. Any change to the constitution requires a two-thirds majority in the Bundestag. Yet it is unclear whether the opposition Christian Democrats would play ball.

For Südekum, the original sin was to enshrine it in basic law in the first place. “The result is that in the end, judges and lawyers enact fiscal policy, rather than economists,” he said.

To Buti, that’s unsurprising. “It’s the German way.”

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