Germany’s Debt Brake and Europe’s Fiscal Stance after COVID-19

The online version of the text contains no footnotes or citations. To view the footnotes and citations, please download the PDF version here. 

After suspending the debt brake (Schuldenbremse) to respond to the pandemic, Germany’s federal government is currently planning to go back to its fiscal rule book next year. Following through with this plan would imply a large reduction in the structural deficit of around 2 percent of GDP in 2022. The risk to European recovery of prematurely adopting such a consolidation course is clear – both directly, because Germany accounts for almost 30 percent of the euro area economy, and indirectly, because Germany’s fiscal choices will set the tone for the euro area as a whole.

Given that the United States is currently in the process of implementing a very ambitious short-term fiscal plan, an unnecessarily tight fiscal stance by Europe would create a sharp divergence with US fiscal policy that would weigh on global recovery and likely stifle efforts to rebuild transatlantic ties. While the new administration of US President Joe Biden is expected to depart from excessive reliance on tariff threats, it will count on Europe to not freeride on US demand but rather implement its own supportive fiscal policy to help sustain global recovery. Because tight German and European fiscal policy helped drive external imbalances and slow recovery after the Great Financial Crisis (Figure 1), international macroeconomic cooperation will focus on Europe’s contribution to global fiscal policy or the lack thereof.

The German fiscal rulebook is, in fact, more flexible than commonly believed. Reintroducing the federal and state debt rules in their original forms as early as 2022 is a political choice that is starting to be challenged and alternative fiscal paths can and should emerge. The question is when these alternative policy options will first be discussed – in March when the federal government prepares its annual budget (Finanzplan), in April when Germany submits its stability program, before the general elections in September, or before the submission of the draft budgetary plan in October 2021? In any case, a whole menu of policy options is available.

Beyond the option of applying the escape clause of the debt brake for as long as necessary, a transition period for the permissible level of net new borrowing could be considered to address the specific fiscal challenges posed by the coronavirus pandemic. While these changes may require constitutional amendments, other changes would only require a change in ordinary law or a change in the regulations agreed upon by Germany’s Federal Ministry of Finance (BMF) and Federal Ministry for Economic Affairs and Energy (BMWi). In particular, the formula used to calculate the cyclical component of the debt brake – flexibility margin authorized on the basis of economic activity – could be revised to provide for a more fiscal space in the current period. The repayment plans that have been agreed to reimburse the borrowing in excess of the debt brake limit in 2020 and 2021 could start later than is currently provided for, could be made countercyclical, and stretched from 20 years to 50 years by a simple law as has been done, for example, in some of Germany’s federal states (Länder). More generous transfers, for example in the form of concessional loans to the Länder and municipalities could also relieve important bottlenecks at lower levels of government. Finally, recent history highlights that constitutional amendments affecting the letter and spirit of the debt brake are, in fact, possible.

Consequences of the Debt Brake for the COVID-19 Crisis Response

Here, we review the repercussions of the debt brake on the three levels of German government: federal (Bund), state (Länder), and municipal (Kommunen).

Bund

The debt brake sets a maximum permissible net borrowing. This maximum has several components:

• A structural component that corresponds to the maximum permissible deficit, which is 0.35 percent of GDP;
• A cyclical component, which increases or decreases the leeway for additional borrowing over and above the structural component depending on the current economic situation; and
• A balance of financial transactions component, which excludes transactions that do not alter the federal government’s net assets – as in the case of debt-financed loans granted by the government. This financial transaction component has often been used to finance off-balance-sheet expenditure outside of the debt brake.

Between 2020 and 2024, the structural component will amount to roughly €12 billion. With output planned to remain below potential until 2024, the cyclical component will stay positive during that period; it will, however, decrease quickly from €45 billion in 2020 to less than €13 billion in 2021. Finally, while the balance of financial transactions was €15 billion in 2020, reflecting the expansive use of this accounting technique by the BMF, it is planned to be small in the following years.

As a result of these elements, the planned borrowing by Germany’s federal government for 2020 and 2021 is €199 billion and €114 billion, respectively, as seen in Figure 3. Both are above the maximum permissible amount under the debt brake, which is why applying its escape clause was necessary. A return to the debt brake in 2022 would require that net federal borrowing be reduced from its 2021 level of €198 billion to the maximum permissible amount for 2022 of €24 billion – a reduction of almost €175 billion (around 4.5 percent of GDP). Thus, this planned return will have a considerable impact on Germany’s fiscal stance.

Länder

The structure of the debt brake for the Länder is similar to that of the federal government. It also has structural, cyclical, and balance of financial transactions components. Its application became effective in 2020 after a long transition period. But at the Länder level, the structural component is stricter than for the federal government as it requires a structurally balanced budget (rather than a maximum structural deficit of 0.35 percent of GDP for the Bund).

Very much like the federal government, all of the Länder have decided on additional credit authorizations under the debt brake’s escape clause. In total, they have collectively authorized nearly €130 billion of exceptional borrowing in excess of the debt brake (Table 2), and they had to vote on a repayment schedule at the same time.

Kommunen

While the debt brake does not apply to municipalities (Kommunen), the control over their resources and expenditures happens largely at the Länder level. Municipalities themselves control only a fraction of their resources, which in most cases do not cover municipal expenditures. The Länder and the Bund receive most tax revenues and are responsible for ensuring that Kommunen receive adequate and sufficient funding.

However, the debt brake puts additional pressure on the relationship of the Länder and the Kommunen. As the Länder’s hands are institutionally tied, their ability to support municipalities decline. This can lead to a situation where the debt brake on the Bund and Länder levels lead to a negative knock-on-effect at the level of the Kommunen by intensifying their investment backlog and/or making their indebtedness less sustainable.

In principle, this design was supposed to tighten fiscal responsibility at every level of government. In practice, however, it has led to multiple problems that each required a new exceptional solution. To prevent large procyclical expenditure cuts at the municipal level, large transfers have just been approved from the COVID-19 packages of the Länder and Bund for a total of €13 billion in 2020 and another €4.3 billion per year thereafter.

Interestingly, two of the measures to support Kommunen and Länder included in the COVID-19 response of the federal government required changing the constitution. This highlights that – contrary to public perception – when there is a will, there is an easy majority to change both the debt brake and the constitution. The two amendments passed by the Bundestag (Germany’s parliament) and Bundesrat (put simply, the higher chamber that represents the interests of the Länder vis-à-vis the federal government) on September 18, 2020, achieved the following:

• With the addition of paragraph 3 in Article 104a of Germany’s constitution, the Bund increases its support of the Kommunen and the Länder in organizing housing for job-seekers who become permanently relieved of bearing the financial costs for housing and heating as part of the “basic security for job-seekers” (Grundsicherung für Arbeitssuchende). The Bund increased its maximum contribution to these housing costs from 49 to 74 percent.
• With Article 143h, the Bund compensated 50 percent of the lost revenues from the business tax (Gewerbesteuer); the Länder compensated the remaining lost revenues. This change was temporary, however, and expired at the end of 2020.

Many municipalities already entered the crisis highly indebted. For this reason, in 2019, the Federal Minister of Finance proposed a scheme to relieve highly indebted municipalities by covering some of their Altschulden (debts that have been accumulating over time and that pose an insurmountable challenge to some municipalities). With only 4 out of 16 Länder benefiting from this plan – North Rhein-Westphalia, Rheinland-Palatinate, Saarland, and Hesse – the plan would be virtually impossible to pass the Bundesrat. With slightly more fiscal space, however, each of the Länder could now address the issue of a growing number of municipalities in financial distress despite the recent transfers and constitutional amendments. There might be a growing consensus to agree to a broader municipal debt relief plan along the lines of what the government of Hesse undertook in 2019 when it took over €4.9 billion Altschulden of 179 municipalities and supported investments of €700 million in 257 municipalities.

Returning To and/or Reforming the Debt Brake

A return to the debt brake in 2022 as planned would imply a large reduction in borrowing from 2021 and generate a large fiscal drag (Table 1). Germany’s federal government will have to decide whether to carry on with this plan when it outlines its budgetary plans in March, when it issues its stability program in the spring of 2021, or when it starts formalizing its draft budget for 2022. This is an entirely political decision of the ruling coalition, but it is likely to be heavily tainted by the political programs and strategies of the parties that make up that coalition in the run-up to Germany’s general election in September 2021.

Several options to loosen fiscal policy in the short term are possible within Germany’s fiscal framework and would not require constitutional amendments. Although we present these options first, we will then argue that bolder reforms that would require constitutional amendments are desirable and, eventually, necessary.

1. Extending a State Contingent Suspension

In view of the exceptional nature of the current health and economic situation, the debt brake’s escape clauses could be applied at the federal and state levels for as long as necessary – the constitution only asks that such applications be temporary. Doing this would help convince economic agents that demand support will be provided for as long as required. Adopting this form of forward guidance for fiscal policy at the federal level may require a new vote every year, but a political commitment to extend the escape clause every year until the economy has returned to its potential could enable it and would likely support the adoption of similar suspensions at the Länder level.

2. Allowing a Gradual Reintroduction of the Rules

As the German Council of Economic Experts proposed in 2020, a transition phase for reintroducing the statutory limit could also help make the return to the debt brake more gradual. While this option may require amending the constitution, it would not be different than the transition period that was granted in 2009 when the debt brake was introduced – it allowed for a gradual adjustment of the federal budget (until 2016) toward the statutory limit of 0.35 percent of GDP. If the escape clause is not used for 2022, the maximum permissible structural borrowing component would have to be high enough to avoid an unnecessarily abrupt fiscal consolidation. In this respect, the German Council of Economic Experts’ 2020 proposal of a maximum permissible structural borrowing component of 1 percent of GDP in 2022 is, in our view, too small. It should rather be in the range of 1.752 to 2.25 percent of GDP in 2022 and aim to return to the statutory limit of 0.35 percent of GDP by 2026 rather than 2024.

3. Frontloading the Use of Reserves

In the past, the federal government has used fiscal overperformance to accumulate some €54.9 billion in reserves in various special vehicle funds (SPV): the asylum and refugee reserve (€48.2 billion), the energy and climate fund (€6.2 billion), and the reserves for the Bundeswehr, Germany’s armed forces and their civil administration and procurement authorities (€0.6 billion). This was an intelligent way of appropriating fiscal overperformance to allow its future use, which the simple “control account” (Kontrollkonto) does not allow. At the time of this writing, frontloading the disbursement of these funds does not yet appear to be a policy pushed by the federal government. But it could choose to do so in order to limit the contractionary fiscal impulse that a return to the debt brake would imply. Fully drawing down the reserves of the special funds in 2022 would provide a buffer of up to 1.5 percent of GDP.

4. Modifying the Cyclicality of the Rule

The requirement that a cyclical component be included in the debt brake to adjust the amount of permissible borrowing depending on the economic situation is part of Article 115 of Germany’s constitution, the Grundgesetz. But paragraph 5 of the implementation law for this article only requires that this cyclical component be calculated as the product of an “output gap” and a “budget sensitivity” parameter; the output gap is calculated according to a “cyclical adjustment procedure” (Konjunkturbereinigungsverfahren). Neither the methodology used to calculate the output gap, nor the methodology used to obtain a budget sensitivity parameter is, however, defined in ordinary implementation law. Consequently, both can be modified without changing the constitution.

• Changing the “budget sensitivity” parameter: The federal government currently uses a budget semi-elasticity that is typically around 0.2. For any 1 percent deviation of output from potential, net borrowing can thus be changed by 0.2 percent of GDP. That parameter could be increased to require more consolidation in good times and more stimulus in bad times and/or could be modified to only increase the amount of stimulus possible in bad times.
• Changing the “output gap” reference: The constitution requires that the federal government apply a specific procedure to calculate the output gap based on the EU’s methodology (aggregiertes Quotierungsverfahren (AQV)). Experts have, however, criticized this EU methodology for being particularly procyclical, generating unreasonably lower levels of potential output and, thus, artificially low output gaps during bad times. Germany could use its influence as a member of the Output Gap Working Group of the Economic Policy Committee to push for methodological changes that would make estimates of potential output less cyclical.

5. Extending the Repayment Plans

The redemption schedule approved by the Bundestag for excess borrowing both at the Bund and Länder level will reduce the scope for countercyclical policy in future years. Indeed, the debt brake does not only require that a debt repayment plan be decided when the debt break’s escape clause is used, but also reduces future maximum levels of permissible borrowing under the debt brake. The repayment plans at the Bund level approved by the Bundestag for 2020 and 2021 provide for a linear proportional repayment each year regardless of economic growth. For the federal borrowing that occurred in 2020, the repayment will amount to €2 billion per year between 2023 and 2042. With €165 billion of borrowing in excess of the debt brake limit forecasted for 2021, the repayment would further reduce the maximum amount of permissible borrowing under the debt brake by another €9.1 billion per year between 2026 and 2042 (Figure 4).

According to the rules, all Länder had to vote on similar repayment plans agreed upon by the various Landtage (the parliaments of the Länder) to finance the debt issued to finance expenditures in excess of the Länder debt brake. The repayment periods are, however, more heterogeneous. Depending on the political coalition ruling each of the Länder, they range from 4 to 50 years with their starts staggered between 2020 and 2026. Altogether, we estimate that the repayments will amount to around €15 billion per year between 2026 and 2042. This may seem relatively small, but the cyclical component buffer allowed under the debt brake is also very small. Under the debt brake, a negative output gap of 1 percent of potential GDP would only allow for a cyclical buffer of 0.2 percent of potential GDP. Throughout the period from 2026 to 2042, this ranges from €7.5 billion to €11 billion. During normal business cycle fluctuations, the current repayment structure could introduce a systematic procyclical bias that would effectively cancel the small countercyclicality provided by the debt brake.

Given that there are no specific requirements that the federal debt be repaid by 2042, the repayment plan could be extended to avoid these effects. As the German Council of Economic Experts suggested, it could be cyclically adjusted as in the case of some Länder. Under this approach, the size of the repayment would be linked to the strength of the economic cycle. This would imply a degree of uncertainty about when the repayment will be completed, but this cost is arguably much lower than the cost of procyclical fiscal consolidations.

Reforms of the Debt Brake Are Necessary

The adjustments mentioned up to now are entirely possible within the existing rules and would go a long way to reduce the planned tightening and its effect on the overall policy of the euro area. Together, they would play a considerable role in avoiding a fiscal cliff that would put unnecessary pressure on Germany, Europe, and the global recovery. However, the current crisis – as well as the first decade the debt brake’s application – has exposed critical limitations that should allow for a serious political debate on how to reform the German and, eventually, the European fiscal framework. Revising the debt brake, which governs the operation of the rule and German fiscal federalism, would require amending Germany’s constitution and would entail securing a two-thirds majority in the Bundestag.

Several aspects stand out and could justify a more ambitious reform:

• The debt brake has probably played a role in strengthening Germany’s fiscal position even though fiscal consolidation preceded its introduction. But a framework resting on unobservable data such as the structural balance and output gap is prone to procyclicality, revisions, and mismanagement. The consistent overperformance of fiscal rules from Germany’s federal government is not a sign of success, but rather a sign of consistent bias in the operation of the rules.
• The mandate to simultaneously have balanced Länder budgets and a small Bund deficit does not provide enough flexibility to respond to shocks. This is the reason why budgetary transfers are regularly contradicting the original intent of the rules.
• The limited ability of Länder and Kommunen to raise autonomous revenues should impose more solidarity between the federal level and lower levels of government. In practice, these issues are being addressed through surgical but profound amendments to the letter and the spirit of Germany’s fiscal rules. These include the constitutional amendment of 2017 that prolonged (potentially permanently) transfers to Saarland, Bremen, and Berlin that were supposed to come to an end and the constitutional amendment of September 2020 that extended transfers to municipalities.
• The use of reserve and off-balance-sheet funds to offer some flexibility within the rules that govern the accumulation of fiscal overperformance and use of financial investment has made the budgetary process less transparent, less efficient, and less democratic.
• Last but not least, the debt brake has also profoundly undermined Germany’s public investment. It has considerably weakened its ability to act in the face of crisis, modernize its economy, and allow for an effective climate and energy transition.

These drawbacks not only have profound and lasting consequences for the German economy, but also, more broadly, for the European economy as a whole. But since they have taken root against the backdrop of a fairly buoyant German economy, the urgency to redress them has been limited. With the previous administraton of US President Donald Trump and a stronger global economy, Europe and Germany could afford to ignore the importance of a coordinated global macroeconomic policy. If the EU is serious about being a cooperative international player and rebuilding transatlantic ties, however, it cannot ignore the role that its fiscal policy plays and the effect it has on external imbalances. Indeed, with the intense reflationary efforts currently taking place in the United States and the improved situation in Asia, the EU stands to be a freerider on global recovery.

Conclusion

Making fiscal policy is generally complex, but it is particularly so under the current circumstances in which usual instruments and measures are questioned. Indeed, since automatic stabilizers have proven to be insufficient, extraordinary measures are required. The typical output gap used to understand the deviation between economic activity at a given point in time and economic potential loses relevance in an environment in which output is deliberately suppressed to contain a pandemic. This makes policy planning and implementation extraordinarily difficult and requires more flexible thinking and ad hoc instruments.

Germany’s fiscal policy in response to the COVID-19 crisis has allowed for a very substantial expansion – in large part because the fiscal rules were suspended. An early return to the strictures of the debt brake could have serious consequences for German and European recovery. With Germany accounting for almost one third of the total euro area, a contractionary impulse of 2 percent of GDP in Germany would in itself imply a contractionary impulse of almost 0.7 percent of GDP for the euro zone as a whole. Such a large fiscal contraction would be unlikely to be compensated by expansionary fiscal actions in other economies. If anything, this attempt at returning to the pre-crisis debt brake in Germany would put pressure on other European economies to also return to the pre-crisis European fiscal rules.

German fiscal policy has global consequences and must be understood as such. While the fiscal rules have enough flexibility built into them to avoid the worst short-term risks, they have proven their limits and need for reform. Therefore, beyond transitory adjustments, a more serious political discussion about the pros and cons of the current fiscal framework is in order. This is necessary both to allow fiscal rather than monetary policy to play a greater role in the recovery and to limit the looming explosion in EU-US external imbalances that would have significant economic and political consequences. Indeed, the new administration of US President Joe Biden will rightly demand a greater degree of economic policy coordination at the global level than was the case during the previous administration of Donald Trump or even that of Barack Obama.

The authors would like to thank Lucas Guttenberg, Philipp Heimberger, Daniela Schwarzer, Philippa Sigl-Glockner, Sander Tordoir, and Achim Truger for feedback and discussions. All remaining errors are ours.