With the outbreak of the recent Eurozone Debt Crisis, constitutional debt brakes seem to be the cure-all solution for government’s debt problems. In September 2011, Spain introduced such a debt limit into its constitution.1 Since then, the 10-Year Spanish Government Bond dropped from 6.2% in late July 2011 to 5.2% in October 2011.2 Given its potential to stabilize and pacify markets, there are already proposals saying that debt brakes should now be obligatory for all EU member states. In Germany, however, the debt brake had already been introduced under the Grand Coalition in June 2009. So, there was a search for a pioneer’s debt brake, this is –besides the Swiss one, which was introduced in 2001– which was found in the German Constitution. But, is the German debt brake designed well enough to pursue a sustainable fiscal policy? Can the German debt brake provide a role model for fiscal policy makers in other European countries?

Constructing effective fiscal rules is easier said than done. According to Anderson and Minarik, an effective fiscal rule requires a balance of two major objectives.3 First, it has to guarantee fiscal responsibility in the sense that the accumulation of debt is controlled and reduced in the long-term. Second, this debt reduction has to occur at the lowest possible costs. This means that short-term macroeconomic stabilization, at some points, implies the acceptance of temporal deficits in order to prevent unemployment and economic slack. It is precisely the matching of these somewhat contradictory characteristics of credible fiscal rules that guarantee both long-term sustainability and short-term stabilization.

This ideal-type functioning of fiscal rules, however, was widely violated when Germany introduced the new constitutional budget rule in 2009. In reality, the principal of borrowing up to the amount of investments rapidly increased public debt. This close connection meant that both the amount of investments and deficits increased heavily: in good economic times because of pro-cyclical policies, in bad economic times because of anti-cyclical policies. No doubt, this practice reduced the Anderson/Minarik fiscal goal of short-term stabilization and long-term responsibility to absurdity.

The German constitutional budget rule, however, precisely counteracts this pitfall. On the one hand, there is now a structural component of debt reduction stating that “debt must grow at a substantially lower pace than GDP.”4 Therefore, German policy makers imposed, as Anderson/Minarik put it, a “numerical limit on the amount of the annual deficit”5 – which is, in practice, a deficit rule. As a result, the German debt brake restricts the annual deficit to a maximum of 0.35% of GDP. With an actual deficit of €8.5 billion this is, incidentally, a huge step forward seeing that the old rule would allow about €25 billion of additional debt. Nevertheless, the effectiveness of the debt brake is complemented by a cyclical component as well. The new budget rule is responsive to the economy in the sense that it “allows for changes in revenue and spending brought about by the business cycle”6.

At this point, however, Anderson and Minarik would contradict this. In their view, deficit rules disclose substantial weaknesses as they “allow manipulation through the choice of an economic and budget forecast that drives a politically desirable outcome.”7 Just like with deficit rules, the allowed deficit depends directly on the amount of predicted GDP. So policy makers can easily inflate their deficits if potential GDP is predicted to be greater than actual GDP. Similarly, deficit rules tend to be pro-cyclical both in an expansion and a recession of the economy. Anderson and Minarik would argue that if actual GDP increases in a strengthening economy, the value of the debt brake’s allowed 0.35% deficit limit increases as well. In a weak economy with a shrinking percentage reference level the same logic would apply: here deficit rules actively “constrain counter-cyclical fiscal policy, including notably the workings of automatic stabilizers.”8

For the German debt brake, however, these doubts are not justified. First, the established deficit of 0.35% of GDP sets a very narrow and tight limit to policy makers especially as privatization revenues cannot be used anymore to sugarcoat revenues and thereby meet the borrowing limit.9 Compared to the broadly tuned Maastricht rule, which allows a deficit of 3% of GDP from the EU-level, this is– by all means –a major step forward. Second, the cyclical component of the German debt brake truly allows for automatic stabilizers to work properly. In fact, the new budget rule may even “require surpluses to be run”10 if cyclical changes offer the chance to do so. Third, the new budget rule makes manipulation of economic forecasts by policy makers practically useless as it “introduces a control account, which acts as a ‘memory and buffer’ if non-compliance with the rule is established ex post.”11 This means that so-called debits and credits count non-cyclical deviations from the budget forecast and require negative balances (>1.5 of GDP) to be reduced. In sum, all these characteristics not only guarantee the debt brake’s structural and cyclical effectiveness, but also its ability to eliminate incentives of policy makers to use temporal deviations within the budget process to their advantage.

Still, despite these obvious advantages of the German budget rule, Anderson and Minarik would still consider such deficit rules to be the second-best solution. Instead, they give preference to expenditure rules that “aim to limit policy-induced increases in spending and reductions in taxes, rather than to focus directly on the deficit.”12 Spending rules, they argue, rely on prescribed annual caps on spending and therefore allow no extra deficits in case of a positive economic development. In weak economic times, the same caps would then work as automatic stabilizers and tolerate higher budget deficits – though, not beyond the binding limit on expenditures. However, at least in the case of Germany, lavish fiscal policy in times of recession turned out to be a de-stabilizer in the long run. In reality, it worked like a boomerang on the economy requiring cumulative interest payments on public debt and thus restricting necessary investments in infrastructure or education. For that reason, the debt brake’s strict deficit limit of 0.35% on GDP is well suited especially for those countries that do already suffer from huge debt mountains.

If anything, one may buy Anderson and Minarik’s argument saying that detailed spending rules are by nature more transparent, and thus more credible, than instruments like debt brakes that just consider the overall deficit. After all, violations of spending rules “are apparent as soon as they are taken”.13 This may be true, however, there is nothing earned from transparent debt accumulation that could be actively prohibited by a debt brake like the German one. Rather, one could counter argue Anderson and Minarik at this point by saying that spending rules are useless if the state’s expenditures are systematically assessed higher than its tax revenues. In other words, spending rules are without any obligation regarding the level at which the spending caps are set. With unrealistic spending caps, the counter-cyclical effect of spending rules is likely to be deceptive and, so, produce situations in which deficits in weak economic times outnumber revenues in good economic times. Therefore, the German debt brake that sets a clear focus to limit the deficit itself is the more reliable option.

Besides this one, there is yet another key advantage of spending rules that – at first sight – may serve as a counterargument to strict deficit limits posed by debt brakes. Referring to the history of the spending rule in the US, Anderson and Minarik argue that spending rules make much more specialized and differentiated fiscal priority setting possible. For example, they “could allow more spending for investment purposes and mandate less spending for other appropriation programmes.”14 Here, too, the cleverly designed German debt brake addresses this pitfall of conventional deficit rules. Concretely, it makes sure that “expenditure is allocated in the budget policy areas that […] benefit future generations by strengthening growth and sustainable development on a lasting basis.”15 In the future, this will make public investments in education, research and development and environmental policy more probable to occur. Although focusing primarily on deficit reduction, the link to expenditures that promote sustainable budgeting means that the German debt brake entails favorable features of expenditure rules as well.

However, even though the German debt brake is effective, even the strongest fiscal rule reveals weaknesses. In October 2009, just half a year after the adoption of the debt brake, the newly elected black-yellow coalition tried to hide away expenditures for the Federal Employment Agency and Health insurance. In fact, they considered off-budgeting practices to circumvent the debt brake that was already binding law at that time. Most famous in this context is the statement by Hermann Otto Solms, fiscal policy maker of the FDP: “This is not a shadow budget, this is a sub-budget!”16 If not in 2009, such a shadow budget eventually became reality in 2011. To finance the German energy turnaround, the government introduced a “climate and energy fund”, which excludes expenditures from the normal budget.17 In this, but only in this case, a simple expenditure rule with a cap on overall spending would probably work better to restrict such practices from the beginning.

In sum, this paper provides key arguments to the question why the German debt brake may serve as a role model for European fiscal policy. The analysis showed that Germany’s new budget rule addresses both the structural and cyclical component, which effective fiscal rules should address. This is guaranteed by the tight 0.35%/GDP deficit rule and its internal mechanism that good economic times require budget surpluses to be run. Moreover, its legal prohibition to use privatization revenues to smarten up the budget as well as the debt brake’s control account forbid practices that allowed the breaking of fiscal rules in the past. Finally, it has been shown that the debt brake even allows for priority setting with respect to expenditures. Put another way: even though the German debt brake is, in essence, a deficit rule, it incorporates some favorable features of expenditure rules as well. It is precisely this thorough combination of beneficial characteristics of deficit rules with expenditure rules that account for the strength of the German debt brake. Against this, the newly established “climate and energy fund” proved that Germany’s new budget rule incentivizes shadow budgeting – confirming at least one structural advantage of expenditure rules over deficit rules. In essence, however, this example demonstrates something else: In the end, even the safest rule will be an unsafe commitment if policy makers lack the political will to comply with it.

Bibliography

Anderson, B., Minarik, J. (2006): Design Choices for Fiscal Policy Rules. OECD Journal on Budgeting, Volume 5 – No. 4, pp. 165 – 166.

Kastrop et al. (2009): Reforming the Constitutional Budget Rules in Germany. German Federal Ministry of Finance – Economics Department.

Riedel, D. (2011): Rechnungshof: Schäuble soll härter sparen. In: Handelsblatt, No. 199, October 14/15, 2011, p. 14.

Online Sources:

http://moneycab.com/mcc/?p=64890 (October 6, 2011)

http://www.sueddeutsche.de/politik/schwarz-gelb-seehofer-verteidigt-geplanten-schattenhaushalt-1.49985 (October 6, 2011)

http://www.tradingeconomics.com/spain/government-bond-yield (October 6, 2011)

Notes

1 Cf. http://moneycab.com/mcc/?p=64890 (October 6, 2011)

2 Cf. http://www.tradingeconomics.com/spain/government-bond-yield (October 6, 2011)

3 Cf. Anderson, B., Minarik, J. (2006): Design Choices for Fiscal Policy Rules. OECD Journal on Budgeting, Volume 5 – No. 4, pp. 165 – 166.

4 Cf. Kastrop et al. (2009): Reforming the Constitutional Budget Rules in Germany. German Federal Ministry of Finance – Economics Department, p. 5.

5 Cf. Anderson, B., Minarik, J. (2006): p. 166.

6 Cf. Kastrop et al. (2009): p. 6.

7 Cf. Anderson, B., Minarik, J. (2006): p. 175.

8 Cf. Anderson, B., Minarik, J. (2006): p. 182.

9 Cf. Kastrop et al. (2009): p. 6.

10 Cf. Kastrop et al. (2009): p. 6.

11 Cf. Kastrop et al. (2009): p. 6.

12 Cf. Anderson, B., Minarik, J. (2006): p. 167.

13 Cf. Anderson, B., Minarik, J. (2006): p. 179.

14 Cf. Anderson, B. Minarik, J. (2006): p. 189.

15 Cf. Kastrop et al. (2009): p. 5.

16 Cf. http://www.sueddeutsche.de/politik/schwarz-gelb-seehofer-verteidigt-gepl... (October 6, 2011)

17 Cf. Riedel, D. (2011): Rechnungshof: Schäuble soll härter sparen. In: Handelsblatt, No. 199, October 14/15, 2011, p. 14.