The Debt Brake

As part of the fiscal agreement approved at the EU Summit at the end of January 2012, twenty-five EU nations will seek to pass legislation defining an upper limit on new debt creation. In this connection, the 'debt brakes' already in place in Germany and Switzerland have been serving as a guide for the writing of legislation in various member states. Yet how effective has Germany's deficit reduction legislation been? And does it contain loopholes? To address these questions, it is necessary to draw a distinction between Germany's federal government and states.

According to the provisions of the German debt brake, the balancing of state and federal budgets must be achieved ‘essentially without drawing on credit’ (German Constitution, Art. 109, para. 3, line 1). For the federal government, this provision is regarded as having been fulfilled if, by 2016, total borrowing does not exceed 0.35 per cent of GDP. For the federal government, the proviso ‘essentially’ is of relevance in three ways.

First, the regulations refer to ‘structural’ deficits. Deficits during downturns are allowed as long as they are counterbalanced by debt reduction during periods of growth. The cyclical adjustment procedures for the federal government follow the methodology used by the EU Commission. A second exception relates to situations that involve ‘natural catastrophes or unusual situations of need, which are beyond the control of the government and which significantly constrain the government’s financial position’ (Art. 115, para. 2). The regulations call for a timetable to be developed under such circumstances to ensure that surplus deficits will be paid back ‘within an appropriate period of time’. Unfortunately, the exact meaning of ‘appropriate’ is not further specified. The third exception pertains to failures of projection when drawing up the federal budget. Balances accrued in this context must be entered into a control account, for which there are upper limits, and if these limits are exceeded, this automatically sets in motion an obligation to pay down the excessive deficit.

Seen as a whole, the statutory debt brake that is anchored in the German constitution offers a sufficiently strong foundation for sound fiscal policy. However, the German Council of Economic Experts recently drew attention to a potential loophole. Extension of credit by the federal government to, say, the Federal Employment Agency is classified as a financial transaction, and, initially, it has no impact on the government deficit. Consequently, repayment of the credit is likewise not taken into account. So far so good. But there is no provision for assuring that the absence of repayment should be handled differently than successful repayment. Theoretically, it would be possible to first declare expenditures as a credit – e.g. to define monies for long-term unemployment benefits as a credit to the Federal Employment Agency – and later to release the Agency from having to repay this debt. This loophole in the legislation needs to be closed.

While the federal government has generally been pursuing the right path in implementing the debt brake, the balance sheets of Germany’s states must be regarded with much greater scepticism. The states are called upon ‘within the scope of their constitutional responsibilities’ to put the debt brake into effect, but with the basic stipulation that ‘no income should be allowed from credit’. This means that starting in 2020, the states may not take on any structural debt. As a result, the states have been given a longer time period to implement deficit reduction requirements, but not every state has been making good use of the extra time. In four federal states (Berlin, Brandenburg, North Rhine–Westphalia, and Saarland), the new debt rule has not been legally incorporated into budget regulations, let alone the state constitution. In addition, some states have quite considerable needs for deficit reduction. According to calculations by the German Council of Economic Experts, Bavaria, Baden-Württemberg, Saxony, and Hamburg face little or no need for deficit reduction efforts. By contrast, Berlin, Bremen, Saarland, Saxony-Anhalt, and Thuringia will need to reduce their overall current spending by around one-fifth by 2020 in order to adhere to the new debt rule. Woe unto he who is reminded of Greece at such a moment.