How to Improve German Fiscal Policy Without Removing the Schuldenbremse

Matt Klein offers up evidence that German fiscal policy needs a sea change as the German economy is likely under its potential, "...Germany’s massive trade surpluses—which reflect insufficient consumer spending and business investment relative to domestic production—and its poor track record of creating full-time jobs since the end of reunification both suggest that the German economy is operating far below its potential....Replace the “non-accelerating wage rate of unemployment”, which was 3.4% in Germany in 2019, with the actual 2019 unemployment rate after subtracting the number of long-term jobless (1.2%)...Assume that the employment gap between German women and German men (about 9 percentage points in 2019) should be comparable to the gaps in Scandinavian countries (about 3 percentage points)...Assume that many part-time workers would be willing and able to work an extra 1-2 hours each day…”

How to Improve German Fiscal Policy Without Removing the Schuldenbremse

Much of Europe has been locked into decades of stagnation thanks to misguided ideas about how much governments should be allowed to spend and borrow. Instead of investing in growth and supporting household consumption, the public sector has systematically taxed too much and spent too little.1

Those harmful ideas have supporters everywhere, but the most influential proponents of needless austerity have been Germany’s business, academic, and policy elites. They were the ones who:

Led the push for public borrowing limits and prohibitions on “excessive deficits” in the Maastricht Treaty that created the European Union in 1992

Demanded that those limits be permanently enforced through regular monitoring and a system of penalties with the 1997 Stability and Growth Pact (SGP)

Inserted the Schuldenbremse, or “debt brake,” into Germany’s Basic Law in 2009

Exported that law to Germany’s neighbors by convincing them to agree to the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (the Fiscal Compact)

Kept German fiscal policy even tighter than required since 20142

While there were always Germans who opposed this consensus, they have long been in the minority. Ironically, German leaders were among the first to realize that the macroeconomic stance imposed by the European Central Bank and the SGP in the early 2000s would mire the country in stagnation, with Chancellor Gerhard Schröder calling for lower interest rates and exemptions to the strict limits on budget deficits.

But Schröder failed, and his successors—some of whom had helped designed those institutions in the first place—convinced themselves and the general public that “fiscal discipline” was helpful rather than harmful. Thus it was the center-left Social Democrat Peer Steinbrück who developed the Schuldenbremse when he was finance minister in 2005-2009.

Ahead of September’s federal elections, only the Greens have committed explicitly in their platform to altering the debt brake. They want to carve out an exemption for investments “in modern infrastructure and mobility, in energy conservation and energy-efficient construction, in education, research and innovation.”

So it’s worth paying attention to an intriguing new paper from Philippa Sigl-Glöckner, Max Krahé, Pola Schneemelcher, Florian Schuster, Viola Hilbert, and Henrika Meyer published by the Dezernat Zukunft’s Institute for Macrofinance. The whole thing is worth reading in full for its treatment of everything that’s wrong with the establishment consensus, as well as where Germany ought to end up.

Unsurprisingly, their preferred solution involves rewriting Germany’s constitution and the European treaties. That’s not an impossible hurdle—and is clearly the optimal solution—but it’s a big challenge. Fortunately, the authors show that it’s possible to shift to a less austere fiscal posture without altering Germany’s federal constitution or the treaties. A lot can be accomplished with a few technical tweaks to “the inputs to the calculation of potential output.”

The Potential of “Potential”

Article 109 of Germany’s Basic Law states that “the Federation and Länder may introduce rules intended to take into account, symmetrically in times of upswing and downswing, the effects of market developments that deviate from normal conditions,” while Article 115 gives the government discretion over “the procedure for the calculation of the yearly limit on net borrowing, taking into account the economic cycle.”

The big question is how to determine what’s “normal.” It’s more art (or pseudoscience) than science. But the ambiguity also provides an opportunity to reshape German—and perhaps even European—fiscal policy.

German law gives the task of estimating the Konjunkturkomponente (the cyclical component) to the finance ministry, which in turn uses a methodology developed in consultation with the European Commission. If the German economy is running below the official estimate of “potential,” Germany’s federal deficit can be bigger than the constitutional maximum of 0.35% of national income, while the states can also borrow more than their target deficit of zero.

The self-imposed budget limits across the rest of Europe are similarly based on estimates of each country’s “output gap,” with governments in economies with large output gaps having more flexibility than those that are ostensibly close to potential.

This flowchart from the paper explains how Germany’s borrowing rule is applied in practice:

When I started The Overshoot, I pointed out the massive gap between what forecasters had reasonably expected on the eve of the financial crisis and what ended up happening. Rather than treating this as an ongoing catastrophe, most official forecasters have responded by progressively lowering their expectations of the global economy’s “potential.” See, for example, the Congressional Budget Office’s continual downgrades of what the U.S. economy can do.3

Perhaps the most egregious model—which thankfully isn’t used anywhere to calibrate monetary or fiscal policy—is the one developed by Federal Reserve economists Kathryn Holston, Thomas Laubach, and John Williams (currently the President of the New York Fed) to estimate what they call R*, or the “natural rate of interest.”4 The HLW model implies that many rich countries were running “above potential” for years after the financial crisis.

As Sigl-Glöckner and her co-authors put it, “ does not provide a well-founded direction for fiscal policy.” Estimates and models are repeatedly modified to generate “a minimum level of economic and political plausibility,” with the European Commission essentially turning off the computer during the pandemic to “to avoid implausibly large reductions in potential output.”

But it doesn’t have to be that way. Sigl-Glöckner and her co-authors suggest three small tweaks that would immediately help:

Replace the “non-accelerating wage rate of unemployment”, which was 3.4% in Germany in 2019, with the actual 2019 unemployment rate after subtracting the number of long-term jobless (1.2%)

Assume that the employment gap between German women and German men (about 9 percentage points in 2019) should be comparable to the gaps in Scandinavian countries (about 3 percentage points)

Assume that many part-time workers would be willing and able to work an extra 1-2 hours each day

Those modest changes would give the German government a bit of extra fiscal space once the debt brake turns back on in 2023, although not very much. Sigl-Glöckner and her co-authors think that “a full capacity utilisation fiscal policy requires, in the medium term, that the very architecture of rules built around output gaps, however calculated, should be abandoned.”

I’m not as pessimistic as they are about what could be accomplished solely by adopting a more expansive view of economic potential, although getting through my preferred changes might be more contentious than their proposed tweaks. But even their approach could have a substantial effect if adopted more widely across Europe.

More than half of all the unemployed in Italy are long-term unemployed, as are more than 70% of the unemployed in Greece. More than 20% of the “extended labor force” in Greece, Italy, and Spain were counted as unemployed or underemployed at the end of 2019. In France, the number was 17%. Even in Austria, the Netherlands, and Scandinavia, the “slack” in the job market represented more than 10% of the potential workforce. Those numbers are all far higher than in Germany.

There’s no substitute for changing minds

Europe’s harmful fiscal rules were the product of a misguided elite consensus. So while creatively reinterpreting those rules could accomplish a lot, replacing the underlying consensus that drove the continent into years of needless austerity is probably a necessary prerequisite.

There are hints that this could already be happening. Klaas Knot, the head of the Dutch central bank—normally a bastion of European conservatism—recently argued that “the SGP should be sufficiently flexible to allow for sizable and sustained expansionary fiscal policy, beyond normal automatic stabilization, if economic circumstances so dictate” and that governments “should also increase potential economic growth that ultimately generates the debt repayment capacity…by maintaining a sufficient level of public investment.”

Other officials at the European Central Bank have been calling for more expansive fiscal policy, and the ECB as a whole just pledged to underwrite a looser approach by committing to keep interest rates “at their present or lower levels” for years.

The laggards are the political leaders in the major economies, most notably in Germany. Hopefully the new paper from Sigl-Glöckner and her co-authors will help move the needle there.

1 The problem afflicts much of the rich world, not just Europe, but this piece is primarily about Europe and the problem is worst in Europe.

2 If you want to learn a lot more about those policy choices and their impact on Germany and the world, I recommend reading Trade Wars Are Class Wars.

3 In my previous piece, I looked at how some simple assumptions could lift the size of America’s latent labor force by more than 16% from what’s currently assumed by the Congressional Budget Office. That would go a long way to closing the gap between their forecasts of potential GDP from 2007 and more recently.

4 Whether such a thing exists is a topic for another time.