Germany needs fiscal reform, says the chair of its council of economic experts

WITH ITS ruling on the country’s “debt brake” last month, the German Constitutional Court has—surprisingly clearly for some—set very tight limits on government borrowing. Now the government is in trouble. According to its own estimates, it is short of €17bn for the 2024 budget; the gap is likely to be much larger in 2025 and thereafter. As a result, it will need to find new ways to fund its projects for climate transformation, digitising the economy, military spending and infrastructure expansion. Germany is not wrong to aim for sustainable debt and prudent fiscal policies. But its fiscal rules need to ensure that politicians are pushed to invest in the future. For that, the rules will need reforming.

Today’s deficit limits were enshrined in Germany’s constitution in 2009, and gradually came into force by 2016 (2020 for its 16 states). The debt brake sets tight limits on debt financing, allowing net borrowing of just 0.35% of GDP, with cyclical adjustments. Yet it does not specify the type of spending for which debt may be incurred.

Before the introduction of the brake, net borrowing could only be used to finance investment or to respond to a macroeconomic disruption. Politicians, however, regularly questioned whether spending designated as investment was actually investment. In any case, the federal government’s debt continued to rise over the years, while investment in infrastructure maintenance and new building remained blatantly insufficient.

The debt brake was intended to prevent debt from rising to a level that could hobble future generations. Its architects had the political economy in mind. A government that wants to be re-elected cares more about current voters than those of the future. It will therefore be inclined to transfer the costs of current projects to the next generation via loan financing. The debt brake blunts this misguided incentive, argue its proponents, by forcing the government to make do with the available tax revenues and to make hard choices on spending.

Governments also have an incentive to focus on spending or tax cuts that directly benefit the current electorate rather than investments that will help future generations. The debt brake does nothing to eliminate this incentive.

Germany’s fiscal rules therefore limit borrowing but don’t end the incentive to favour current spending over public investment. And this is apparent in what happened. Germany had plenty of tax revenues to play with during the first decade of the debt brake. It reduced debt—even paying some back, which governments rarely do—but spent most of the new revenues on giveaways to current voters such as pensioners.

Investment, meanwhile, was neglected. Germany’s roads, bridges and railways are in a pitiful state after years of maintenance being deferred, the digitisation of the state lags far behind that of other European countries and much-needed climate investments have not materialised. At the same time, Germany’s debt-to-GDP ratio is currently the lowest of all G7 countries.

Even if a new government were to take office and recognise these problems, they are not easy to fix. Prioritising spending on some sectors of the economy over others without raising taxes means cutting spending in some areas, if not across the board. This is difficult both legally, because there are existing entitlements enshrined in law, and politically, because the groups that lose out will fight back and might lose trust in the state.

The crucial question, therefore, is how to prevent insufficient investment as effectively as excessive borrowing. One possible answer would be a reform that has just been proposed by the Scientific Advisory Council of the federal economics ministry: the introduction of a “Golden Rule Plus”. This would allow unlimited net borrowing as long as it was used to finance net investment. Unlike with financing gross investment, the state would have to invest more than the depreciation of the existing capital stock to be allowed to borrow. In other words, debt would only be allowed if the capital stock of the state grew. Since a road or bridge depreciates less quickly if it is well-maintained, the government has an incentive to invest sufficiently to keep the existing infrastructure in good shape.

In addition, it would make sense to ensure that investments are given a legally binding status similar to that of statutory consumption spending. To this end, the economics ministry’s advisers have proposed establishing investment-promotion agencies. These agencies would be contractually obliged to make large long-term investments, for instance in the maintenance and expansion of the road network.

It is crucial to find a legal structure that takes into account the interests of future generations in investments to at least the same extent as the interests of the current electorate in consumption spending. Even if such a structure can be agreed and made to work, the state still needs to be able to spend the money. This requires that planning and approval procedures for building are sped up. Public investment spending also needs to be reliable and set up for the long haul. Only then will the private sector build and maintain the necessary production capacity to invest in civil-engineering projects, the expansion of the rail network or whatever else is needed.

The lesson from Germany’s fiscal impasse is clear. It has to find a way to finance necessary investments, by reforming its debt brake such that net investments can be debt-financed. Equally important, it must ensure that investments are given at least as much priority as current consumption—and that, when the financing is available, these investments are actually made. ■

Monika Schnitzer is chair of the German Council of Economic Experts and a professor at Ludwig Maximilian University of Munich.