NEW PARADIGM

New Economy Short Cut Recap: Debt Brake 2.0 - Which reform achieves what?

How exactly should the debt brake be reformed, and wouldn't it need more far-reaching reforms than those recently proposed by the German Council of Economic Experts? We discussed this on 11 December with Achim Truger, Peter Bofinger, Katja Rietzler and Florian Schuster-Johnson.

BY

FORUM NEW ECONOMY

PUBLISHED

6. DECEMBER 2024

The days of the debt brake in its current form appear to be numbered – a reform in the next legislative period is on the horizon. But how exactly should the rules be reformed or amended? And wouldn’t there be a need for more far-reaching reforms than those recently proposed by the German Council of Economic Experts?

 

We talked about this in the New Economy Short Cut ‘Debt brake 2.0 – Which reform does what?’ with Achim Truger, member of the German Council of Economic Experts, Peter Bofinger, Professor of Economics at the University of Würzburg, Katja Rietzler, senior economist in the tax and financial policy department at the IMK and Florian Schuster-Johnson, senior economist at the Berlin think thank Dezernat Zukunft.

Every debt rule is based on a fundamental conflict of objectives between flexibility and commitment. On the one hand, there are political economy processes – e.g. due to election cycles – that cause debt to grow, which argues in favour of a binding rule (e.g. a numerical target enshrined in the constitution). On the other hand, sensible credit-financed government spending can also increase potential output, which argues in favour of a flexible rule.

In January 2024, the German Council of Economic Experts spoke out in favour of a ‘stability-oriented reform’ of the debt brake and took up the proposal again in this year’s annual report. This essentially involves three points:

  1. increase in the structural deficit limit (currently at 0.35%), depending on the debt ratio: 1% for debt below 60% of GDP, 0.5% for debt between 60% and 90% and 0.35% for debt above 90%
  2. transitional phase after application of the exception clause
  3. institutional mechanisms to prioritise certain future-oriented expenditure (investments): e.g. infrastructure fund with tax revenues from the transport sector, minimum spending quotas for education/defence.

Government spending can have a positive (or negative) impact on growth: it is important what the money is spent on.

The German Council of Economic Experts argues that it is not consistent to limit government debt overall for political economy reasons and to disregard the type of expenditure. There would be a danger here that longer-term investments in infrastructure, security or education would be neglected in favour of consumer spending. Katja Rietzler was in favour of strengthening investment-related government spending.

‘If you want to invest, you can do so to a certain extent with credit financing. This prevents debt from being increased for all kinds of purposes without you being restricted in what you can do. However, we have seen that even with sufficient funds, too little was financed.'
Katja Rietzler

Florian Schuster-Johnson (Dezernat Zukunft) criticised the fact that the German Council of Economic Experts continues to adhere to arbitrary numerical limits in the constitution. It would be better to focus on the macroeconomic environment based on debt sustainability indicators such as interest rates and growth potential. The Dezernat Zukunft therefore proposes that the specific organisation with numerical targets should not be regulated in the Basic Law, but in a normal law. As Achim Truger pointed out, one problem with interest expenditure as an indicator is that the interest rate environment can change unpredictably and quickly, which calls for caution.

‘I would like us to use the debate to discuss sustainable public finances in a different way. To move away from numerical and towards dynamic limits on debt.’
Florian Schuster-Johnson

Peter Bofinger agreed that a flexible rule is fundamentally better, but emphasised the importance of a narrative to counter existing scepticism among the German population towards a relaxation of the debt brake. A stable government debt ratio could serve as a narrative, which would allow a deficit of 1,5% with the ECB’s inflation target of 2% and assumed long-term real growth of 0.5%. According to Bofinger, another advantage would be the congruence with European fiscal rules (deficit resilience safeguard at 1.5%). One disadvantage is that the rule could be too rigid if the macroeconomic environment changes. Debt could then continue to rise or fall too far.

‘The story would then be: let's make a debt rule that keeps government debt constant relative to economic output. From an economic point of view, 60% is arbitrary, but it would be a selling point. If you sell it that way, you would create enormous room for manoeuvre.’
Peter Bofinger

To summarise, it can be said that all participants in the discussion would prefer an explicit constitutional amendment to the debt brake rather than circumventing it with new special funds. This solution would be permanent, more flexible and more honest. There was also agreement that productive and investment-related government spending should be prioritised (as opposed to consumptive spending, such as pension insurance subsidies). There was disagreement on whether a numerical target should continue to be part of the constitution. Although everyone agreed that a dynamic and more flexible rule would make more sense from an economic perspective, Achim Truger and Peter Bofinger pointed out the limits of political feasibility.

Re-watch the whole session:

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