Critiques of German debt brake are partly misplaced

Debt brake debates are back following the German court ruling. While lot of the criticism is misplaced, it is fair to say that the law works worse than expected.

The German court ruling on the government’s fiscal shenanigans has reignited the debate about the German debt brake. Or maybe more precisely, has bolstered the critics of this constitutional law.  Personally, I am not a huge fan of discussions about fiscal policy (or even worse, austerity…), as I feel they are mostly Rorschach test without much deep thinking. That said, as a supporter of constitutional debt brakes the recent developments did challenge my priors. But at the same time I find most of the criticism of the debt break puzzling or outright wrong. This piece is my attempt to come to terms with these feelings.

It ain’t pretty

My prior was that some form of constitutional debt brake is a reasonable mechanism to deal with the pro-debt bias resulting from democratic political process. This was always the raison d’etre for the debt brake: we know that politicians and voters are somewhat myopic with respect to government debt, leading them favor higher spending and lower taxes now at the cost of higher debt in the future. I don’t think that view is disputed much. And if anything, with ascent of modern monetary theory, which sometimes argues governments fiscal constraints are self-imposed, the pro-debt bias has recently increased – just look at U.S. fiscal situation to see it in action.

Of course, the question is whether constitutional debt brake is a good solution to this problem. And here the German experience has posed some challenge to the supporters, and made me personally more skeptical. There are specifically two aspects that I have in mind. First, the debt brake law led to a lot of “bad” legislating, which was exposed by the court recently. Simply, faced with legal constraint the government was trying to exploit legal loopholes, by for example re-assigning unspent funds from one program to completely different purpose. It also got into habit of creating funds outside of the regular budget. These actions take away clarity about government fiscal behavior and in general lower the quality of legislating: legislators should not be searching for loopholes in laws to exploit.

Second, there is a fair argument to be made that the debt brake is making the government behave in sub-optimal ways. Right now the debt brake is leading Germany to cut spending and increase taxes relative to what the government would want; given the weakness in German economy this does not seem like optimal fiscal policy. (It might be, however: the central bank still sees a reason to have restrictive policy, something that is aided by fiscal restriction; indeed many have called for exactly that over last year). Meanwhile, during the last decade the government was running fiscal surpluses while arguably neglecting to invest in a worthwhile initiatives. This was especially strange given that yields on new debt at that point were negative; in other words, German government was being told by financial markets to invest, so not doing so could hardly have been optimal. This is not the long-term behavior proponents of debt brake were aiming for.

Part of this I think is a question of imperfect design/implementation. For example, the deficit threshold of -0.35% is higher than many would imagine, since in absence of calamities it means that debt will be trending lower over time. Moreover, the cyclical adjustment factor seems to be working less well than I would imagine: After 4 years of overall zero increase in real GDP, it seems strange that the cyclical factor allows for only 0.1% extra deficit relative to the neutral 0.35 benchmark.[1] Another design bug is that finance theory would suggest that the allowed deficits should be related to the current level of interest rates at least in some shape or form. And more broadly, what we really want to evaluate is not the current deficits, but the effect of current plans on long-term debt trajectory, much like CBO does in the U.S.. This would push against the tendency of the government to cut on investment at the expense of future productive capacity.

That said, while one can see a better design for the debt brake, I suspect that imperfect design/implementation will always be a feature of these kind of legalistic rules. In other words, we should not simply say “debt brakes are great, it is just that the German one is badly done”; that would be letting it off too easily. So this leaves me less in favor of debt break than I was before.

It ain’t so bad

But does this mean that debt brakes is as bad as some would have it, and worse than not having one? Here I am not persuaded by the critics.

Take for example the argument about investment. Some go as far as to say that debt brake results in “Germany that doesn’t invest and massively falls behind in economic terms”. This argument seems strange to me. It basically says that the only way the government can find money for investment is by financing it by issuing debt, which of course is not the case. We can also either raise taxes or lower other expenditures. Sure, one could object that there is no political scope for that. But this points to another problem: The argument assumes that higher deficits allowed by abolishment of the debt brake would be used for investment. While in short run that might be the case, I don’t believe it necessarily would be in the long run. Just ask the French who have run deficits every year since the 1970s. To paraphrase one of the Parkinson’s law, current spending has tendency to use out all the available resources. Finally, the argument also assumes that investment financed by debt is better than no investment at all. But this is true only if the investment pays for itself in the long-run. Otherwise, using this argument ad absurdum the government would have to run itself into insolvency: Just consider situation of many firms that did debt-fueled investments which did not provide sufficient returns to pay down the debt. But I rarely see arguments that these investment will fully pay for themselves down the road.

Less radical critics say that the debt brake is good idea in principle “but in practice it’s too inflexible”. This is also combined with argument that the current set of calamities, from war and geopolitical competition to climate transition, make the debt brake just impractical right now. But this simply ignores the fact that legislators have plenty of flexibility. Primarily, the debt brake has been suspended for 4 years in a row, something that does not require a supermajority ruling, showing a great amount of flexibility in face of an imminent crisis. Moreover, for the sake of long-term calamities rather than imminent crises Germany already found a legally-sound solution to such kind of problems when it constitutionally created its 100 billion euro defense spending fund. Sure, that requires a constitutional amendment and hence large degree of consensus, but presumably such long-term calamities should enjoy such consensus.

Maybe it just is not fit for the times?

But maybe this points towards the actual problem: maybe in current society and politics building political consensus has become too hard, even for things which are clearly optimal. This then means that mechanisms that rely too much on creating such consensus are doomed to lead to more problems than their benefit. The US debt ceiling comes to mind: Nobody in their right mind would choose the current brinkmanship and regular government shutdowns as an optimal approach to making fiscal policy. Similarly, I think CDU secretly agrees with some of the governments desires, such as the need to finance the geopolitical struggle or maybe even the climate transition. That said, it will not act on them either because it thinks the crisis might cause current government to collapse, or because it is afraid of its own voters’ reaction.

So maybe this is the main critique of the constitutional debt brake: In the older world it might have been an good tool, but given the general unravelling of political process around the world, it adds too much of a constraint leading to worse outcomes. It simply is not fit for the current times. It might not be. As for me, I am currently in state of “not sure”.

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[1] I am taking the numbers from here. The way I read this table, the estimated output gap is -1% and the elasticity with respect to output gap is 1/10. I would have imagined both numbers to be larger. Output gap of -1% implies that the German economy has lost 3-5% in productive capacity over last 4 years relative to what one would expect (1-1.5% annual growth). Elasticity of 1/10 means that say 5% output gap gives you only 0.5% extra deficit, which seems small.