Investment, Debt, and Balanced Budgets

The recent spate of bad economic news is akin to a freezing autumn rain ruining the end of a sunny late summer’s day. Bold optimism characterised the first half of 2014. The German economy seemed to be brimming with vitality, untouched by problems elsewhere in Europe, and the “grand coalition” was able to pursue two goals that are seldom compatible. First, the government generously introduced numerous relief and benefit measures, including improved pensions for parents, the ability to retire at 63 without penalties, and tax relief for municipalities. Second, flourishing tax revenues placed a balanced federal budget in 2015 in near reach. That the budget is nearly balanced in spite of new benefits is partially attributable to the fact that the costs of recent pension reforms are hidden in the social insurance system's implicit debts, and do not have immediate impact on the budget. Clearly, experts who warned that expenditures should be decreased in good economic times in order to allow increased spending when times are hard went unheeded. Now the economy has begun to falter. Poleaxed by this turn of events, policy-makers have begun squabbling over the best course of action. Some are demanding immediate cutbacks to keep the hope of a balanced budget alive, despite the economic downturn's inevitable reduction in tax revenues. Others propose abandoning the goal of balancing the books, and instead recommend increased expenditures, with more money directed to public works and infrastructure.

There are two fiscal policy guidelines that should always be kept in mind. First, policy-makers should never lose sight of the long-term sustainability of spending. In light of the demographic ageing of the population, which will put a huge strain on public finances over the next two decades, Germany needs to reduce its public debt. With this goal in mind, a debt brake was added to the constitution in 2009. Yet making provisions for the future also means investing in and maintaining public infrastructure. More should be spent in areas where investment is overdue. However, this does not mean the additional investment should be financed taking on new debt. The ‘golden rule’ of sustainable public finances implies that the investment required to replace ageing infrastructure should be financed through current revenues, not debt. Debt should only be used if the investment increases the capital stock. Violating this rule implies eating away at the nation’s wealth.

The second guideline is to recognise the cyclical nature of the economy. It is not advisable to micro-manage financial policy and react to every minor economic fluctuation by fiddling with taxation or expenditure. Launching economic policies in response to huge market crashes, such as in 2009, makes perfect sense. However, increasing expenditures during an economic upswing, as the grand coalition has done since coming into office, is not sound cyclical policy. In normal circumstances, fiscal policy should focus on the mid-term and allow for automatic fluctuations in revenues and expenditures caused by the business cycle, counterbalancing limited borrowing during downturns with surplus revenues during upswings. The result is an automatic stabilising effect that requires no tinkering with tax law or public expenditures.

So what is to be done? The market is signalling a cooling-off in the economy, but not a huge downturn, at least for now. Now is the time to allow the budget to stabilise automatically. Upholding the debt brake is far more important than balancing the budget in 2015. This does allow room for limited borrowing if necessary for automatic stabilisation. However, it would be a mistake to abandon the path toward debt consolidation and launch new, debt-funded spending programmes. Investment is important and should not be carried out solely according to economic circumstances, but the bulk of it should be financed through lowered consumption expenditure, not debt.