Between 2016 and 2021, when it enjoyed nearly negative interest rates, Germany could have been investing to modernise and digitise its economy, addressing its energy challenges and fixing its crumbling infrastructure. Instead, the country chose not only to conform to its constitutional debt brake, which limits new government debt to no more than 0.35 per cent of GDP annually, but actually to outperform it.
In 2021, despite the disastrous economic legacy of the Merkel era, the Social Democrats, the Greens and the Free Democrats avoided a serious discussion about fiscal policy during the election campaign. They frustrated any hope of a much-needed new settlement by agreeing to repurpose pandemic emergency funds into a modest off-balance-sheet climate fund in their coalition agreement.
When Russia’s full-scale invasion of Ukraine began in February 2022, Chancellor Olaf Scholz had another opportunity to push for large investments in defence, energy and infrastructure. But rather than assembling a two-thirds parliamentary supermajority to reform the debt brake, Scholz instead spent political capital in the Bundestag to build that supermajority but only in order to create a new off-balance-sheet €100bn defence fund.
In 2023, the German constitutional court ruled the creation of the climate fund unconstitutional and essentially forced a fiscal and political reckoning that held back climate, energy transition and industrial policy at a critical time and eventually brought down Scholz’s coalition government.
You would think that after two years of recession, fiscal policy would be at the heart of the current election campaign in Germany. But the bad news is that most political parties remain convinced that the German public is not ready for it. However, there is some good news: not only is the consensus among the German economic policy elite gradually shifting, but voters are now also largely favourable to reforming the debt brake and enabling the government to borrow more to fund investment.
Moreover, the economic and political outlook is such that the next chancellor will have no choice but to embark on constitutional reform. Christian Democrat leader Friedrich Merz, for one, has been smart enough to leave that door open.
The participants in any future coalition negotiations will have three options. First, they could simply repeat the Scholz playbook and create yet another off-balance fund via a constitutional amendment. This has the great advantage of containing the scale and duration of the fiscal expansion.
Second, the next chancellor could listen to the advice of the German Council of Economic Experts, or even to that of Bundesbank president Joachim Nagel, and undertake a bold reform of the debt brake itself. This could include changing its cyclical component, which allows the government to take on additional debt during economic downturns, increasing the maximum structural deficit and ensuring that this is used primarily to finance investments. It could also either relax the balanced budget rules of the 16 states (or Länder), or enable the federal government to provide more transfers to the Länder and municipalities in order to remove the most significant obstacles to public sector investment. Although this would rewrite Germany’s economic policy doctrine in fundamental ways, it would nonetheless respect the underlying principles of the country’s fiscal federalism.
Finally, Germany could simply decide to abolish the debt brake altogether, on the grounds that EU fiscal rules provide sufficient commitment to fiscal rectitude. It could complement the European guidelines with a national golden rule according to which for every euro of investment undertaken today, Germany commits to a structural adjustment in the deficit in the future.
It is likely that the European Commission would happily accept such changes. Germany’s current fiscal settlement creates perverse incentives for its European partners. Maintaining national fiscal rules that are tighter and more exacting than the EU ones might convey the appearance of a righteous anchor at the heart of Europe, but in truth it is an invitation to others to engage in freeriding. And in the same way, opposing common borrowing for military spending has in fact forced Germany to contribute far more to Ukraine’s defence than it would otherwise.
What is clear is that the fiscal status quo is unsustainable. It undermines Germany’s growth prospects, makes a defence build-up impossible, damages the social fabric and threatens an already-fragile political stability.
