In storms and swells, sailing with full rigging risks breaking masts and sheets. In the face of strong headwinds, governments, too, will need to furl their fair-weather sails to manage the polycrisis. Steering a steady course through overlapping, interconnected, and self-reinforcing crises (encompassing financial, economic, environmental, social, political, technological, and geopolitical dimensions) requires a political admission that public finances have already been weakened by Keynesian policies during the rapid succession of global and regional crises. Finance ministers face the dilemma of having to consolidate budgets and spend more to address the existential risks posed by climate change, geopolitical uncertainty, public investment backlogs, and/or contingent liabilities (such as pay-as-you-go pensions systems).
Whether governments tolerate an expansionary fiscal stance ‘for too long’ or rely ‘mechanically’ on a rigid corset of fiscal rules, political polarisation and systemic credibility crises reflect the difficulty in delivering growth, prosperity, sustainability, security, and inclusion. The current turmoil and uncertainties are a stark reminder that successful economic and fiscal policies are more an art than a science. This is one of the key findings of the Growth Report (2008): ‘Bad policies are often good policies applied for too long’.
The main problem with extrapolating current economic policies is the inherent vulnerability of either provoking debt-induced economic crises or accepting the negative consequences of continued underinvestment in human capital, public infrastructure and governance. In either scenario, economies would be unable to cope with the challenges of impending climate catastrophe or growing security risks, either because of a lack of financial resources or of modern infrastructure. This could exacerbate the risks of further polarisation.
Higher debt service, lower investments
The end of the quantitative easing experiment and rising interest rates since early/mid-2022 have signalled a new (interim) phase of fiscal consolidation. As a result, finance ministers will have to increase significantly budget lines for interest payments. The resulting fiscal commitments will put a particular strain on the budgets of highly indebted countries. For instance, the US Congressional Budget Office (2024) projects general government net debt to reach 98 per cent of gross domestic product (GDP) in 2024, with interest payments increasing from 2.4 per cent of GDP (US$659 billion) in the previous year to 3.1 per cent of GDP (US$870 billion) in 2024. This amount accounts for approximately 17.7 (13.4) percent of expected government revenue (total expenditure) and is 0.2 percentage points of GDP higher than the defence budget.
Even under optimistic assumptions, fiscal projections raise significant concerns about the ability to make sufficient room for discretionary spending. To date, the economic outlook has largely depended on the country’s strong productivity and growth performance as the most dynamic of the G7 economies. This suggests that US administrations have tended to borrow for the ‘right’ investments, i.e., those with high internal rates of return that promote investment, innovation and knowledge. A central component of the current administration’s (post-)pandemic response and economic policies are credit-financed programmes to support domestic research and manufacturing. Given the heightened risks of a macro-fiscal and socio-political crisis, the US has no real alternative but to base its economic policy on ‘endogenous growth’ driven by productivity gains and innovation, notwithstanding the considerable need for fiscal consolidation. This strategy—ultimately a gamble without a hedge—aims at outgrowing its rapidly escalating debt, broadening the tax base, and reducing the share of debt service payments in the overall budget.
Lower investments, lower growth potential
Not all countries share the same basic confidence in their innovative potentials. The other three highly indebted G7 economies (France, Italy, and Japan) have been less successful in converting high deficits and debt into engines of innovation and dynamic growth. Even countries with relatively stable public finances are realising that the pillars of their future prosperity, sustainability, and stability have become fragile. Germany is a case in point: weakened by internal divisions over the role of the State, the ruling three-party coalition is seeking a way out of its self-inflicted fiscal dilemma.
The political predicament centres on reconciling the Schuldenbremse (debt brake), the constitutional limit for structural deficits (0.35 per cent of GDP), with ministerial budget allocation requests that exceed the 2025 financial framework. Unresolved contradictions over overarching political objectives have led Social Democrats, Greens, and Liberals to block potential adjustments in, respectively, social spending, green transition investments, and key macroeconomic instruments such as taxes and budget deficits. The challenges are compounded by the need to find a consensus in an economy characterised by sluggish growth and waning support. The spectre of early elections looms over the budget preparation process.
In this scenario, the IMF (2024) has advocated for the comprehensive utilisation of all available policy tools, emphasising that a sustainable budget framework would have to comprise measures to reduce spending, increase revenue, and identify additional sources of financing. It warned that the medium-term decline in the working-age population of around 0.7 percentage points, more than in any other G7 country, was ‘expected to slow economic growth and adversely affect public finances.’ Contrary to the very public stance of the German finance minister, the IMF recommended that additional spending requests be accommodated by ‘moderately easing the debt brake’:
‘A well-designed fiscal rule helps to ensure that debt remains at sustainable levels. However, Germany’s debt brake is set at a relatively tight level, such that the annual limit on net borrowing could be eased by about 1 percentage point of GDP while still keeping the debt-to-GDP ratio on a downward path. Such an easing would allow more room for much-needed public investment and other key priorities.’
Last year, the IMF (2023) had already cautioned the government that its fiscal rules were too strict and inflexible, encouraging the reliance on budgetary practices that obscured fiscal transparency and reduced policy credibility. This was in reference to the establishment of several extrabudgetary funds, amounting to 9 per cent of GDP. Even with relatively optimistic growth forecasts and assumptions of a less stringent fiscal approach, the IMF had agreed with about half of Germany’s economics professors that structural borrowing limits were an impediment to investment. There was ‘no scope for boosting productivity via higher public investment.’
‘Right’ investments and economic growth
For reasons that are diametrically opposed to those in the US, Germany’s socio-economic future as well depends on an overarching political narrative and a corresponding programme of priority reforms and investments with which to incentivise investment, innovation, and knowledge, as well as a robust regulatory framework to support the private sector dimension of the green transition agenda. Such an approach could help to identify potential sources of financing, such as the phasing out of environmentally harmful subsidies (net of the cost of associated social compensation).
There is a broad consensus across society and among political parties, at least in principle, on the need to (i) eliminate unnecessary, growth-inhibiting red tape; (ii) modernise and streamline tax policy and administration; and (iii) prioritise the overdue digitalisation agenda. This would allow Germany to renew its commitment to Standortwettbewerb—i.e., the global competition for international capital, expertise, skills, and technology that could be attracted through the provision of an attractive legal framework, effective public services, modern infrastructure, and a well-trained workforce. Ultimately, this is a much more sustainable policy than offering negotiated subsidies to individual investors. The ‘ right’ investments would trigger higher rates of economic activity and secure social well-being well into the future.
In principle, fiscal rules are an effective tool for ensuring the long-term soundness of public finances. However, Germany is subject to two sets of such rules, with the EU framework for fiscal policies—underpinning the single currency—being the more important of the two. The discrepancy in the respective reference values and the parallelism of the budgetary constraints have the effect of obfuscating the function of the deficit limits as an anchor of fiscal prudence. There is no clear justification for this. Deficit ceilings are not ‘objectives’ of economic policymaking per se but rather serve to focus the day-to-day policy attention on the longer-term implications of the policy choices contained in the budget. These affect both the expected impact on an economy’s growth potential and the soundness of its public finances (and thus the fiscal space crowded out by corresponding debt service obligations). Ultimately, a successful budgeting process starts with identifying the policy objectives to be achieved before assessing the potential means to finance the policy priorities. An ‘accounting’ process that starts with tax estimates and only then considers their distribution will fail to deliver on the initial promises made. Without taking into account both the inherent growth impulses and the resulting debt dynamics, a successful fiscal policy will not be possible. Neither a stagnating economy that is fiscally sound but foregoes growth-enhancing investment, nor one that triggers a political business cycle with a short-lived boom fuelled by increasing risks of bust, will be able to secure prosperity in the longer term.
‘Good’ rules for efficient fiscal policy
The combination of Germany’s disappointing growth performance, the overlap with existing EU fiscal rules, and the need to respond to a number of extraordinary—and increasingly urgent—challenges (climate, security, contingent liabilities, and the public investment backlog) has sparked a new debate on the need for, or the form of, the domestic Schuldenbremse, the national component of the dual deficit ceilings. The rift runs right through the government, including ministerial threats to break up the coalition. The mutual veto on the use of the main economic policy instruments (deficits, taxes, and spending) and the expected electoral setbacks for all three coalition partners in the European elections on 9 June 2024 have blocked the interplay between fiscal and economic policies. This is detrimental to the political-economic outlook, not least because the necessary next steps seem relatively obvious: (i) the reform of the debt brake and its harmonisation with European fiscal rules; (ii) the prioritisation of spending and subsidies in line with the overarching objectives; and (iii) the strengthening of the regulatory, institutional and infrastructure base with a modern tax policy to support private sector-led green growth.
On the first point, experience shows that fiscal rules are not a panacea. In the absence of political ownership, they are vulnerable to circumvention. To be effective as a policy anchor, the translation of deficit limits into policy must be consistent with a country’s overall development objectives and take into account the long-term aspects of fiscal solvency. It is common practice to assess the ultimate effectiveness of such a policy anchor against five credibility criteria, viz., its ability to be
With the exception of the fourth bullet, Germany’s complicated framework of overlapping national and EU fiscal rules deviates from best practice. Assuming the necessary two-thirds majority could be mustered, Article 115 of the Basic Law (limits to borrowing) should be reformed with a view to (i) reinforcing the obligations under the EU framework; (ii) outlining processes for economic projections that underpin a budget preparation process; (iii) defining escape clauses for ‘emergency periods’ and fiscal measures for post-crisis consolidation; and (iv) strengthening reporting requirements for public investment financed by current or past deficits.
Sustainability through transparency and credibility
A single set of fiscal rules would enhance transparency and credibility, not least because external EU institutions would monitor and report on implementation. By requiring the finance ministry to use growth projections at a pre-specified rate of, say, one per cent from year t – 1 (with known outcomes) to t + 1 (thereby automatically allowing for countercyclical fiscal policy), the need to calculate structural balances would be avoided. To be able to increase capital expenditure for overarching reasons above a given deficit ceiling, governments should be required to justify the additional capital expenditure in a specific annex to the budget, showing that the respective benefits outweigh the budgetary costs. This should be done both as a projection in the current financial plan and as a realised estimate in future budgets. They should be prepared to demonstrate urgency (by co-financing a minimum share through expenditure cuts) and broad political support (by co-financing another share through higher taxes).
Current estimates of future budgetary outlays for climate change (both domestically and for ‘loss and damage’ payments elsewhere), security, and contingent liabilities are both non-trivial and long-term. However, the future costs of not responding fiscally to the various dimensions of the polycrisis would be incomparably higher. The downside risks associated with the various climate scenarios, the geopolitical realignment (and its impact on the rules-based liberal order), and the general security situation that results from the current wars are existential. Looking beyond next year’s budget, it is crucial that finance ministers, whether in Berlin, Washington or elsewhere, find a way out of the dilemma of having to consolidate budgets, increase procedural flexibility, and ensure outcomes that allow governments to resist growing credibility crises and associated political polarisation. There is no choice but to set spending priorities through an overarching narrative, develop credible medium-term fiscal frameworks (accompanied by a corresponding programme of growth-enhancing investments and reforms), and create sufficient fiscal space to withstand future economic shocks. As the breakers grow in size and power, consideration needs to be given to economic seaworthiness in the forecast of further approaching storms.
Jan-Peter Olters
powered by Borlabs Cookie
2 comments