Reliable Fiscal Rules Becoming Increasingly Important

European and national debt rules are coming under fire in the current discourse. In view of the challenges posed by climate change, demographics and defence, it seems astounding that politicians are imposing restrictions on themselves. Why do we not just free ourselves from the chains of the debt brake and the European Stability and Growth Pact (SGP) and use debt to finance our future? As plausible as this anti-fiscal rule mindset may seem, it is ultimately not very convincing. This is because it is fundamentally based on the fallacy that a debt rule creates an artificial limit where there would otherwise be none. This is not true, however, because no country has an unlimited debt capacity. One of the crucial functions of a country’s debt rule is to ensure that it does not move too close to the maximum level of debt that can be financed, as this would lead to a loss of any room for manoeuvre or be the catalyst for an extremely costly debt crisis.

The maximum debt limit is primarily determined by the ratio between the real economic growth rate attainable in the future g and the long-term real interest rate r. The variable g gives an indication of how the ability to levy taxes develops over time. The variable r is instrumental in determining the interest burden on government debt. A line can be drawn between two systems here. If the interest rate is lower than the growth rate (r < g), then a country can let time run its course to grow its way out of any debt rate, no matter how high.  In this configuration, the increase in economic output and revenue would relieve the burden on the state at a higher rate than the interest rate for the old debt would burden the state. In this case, it would even be possible to experience a permanently high deficit without the debt level rising uncontrollably relative to the economic situation. A completely different situation emerges when the interest rate is higher than the growth rate (r > g). Then, there is no permanent leeway for the deficit if you don’t want the debt to get out of control. This is because the level of outstanding debt with its accompanying interest would grow continuously in relation to economic output, unless budgetary policy were to generate permanent surpluses in the current budget.

This differentiation is highly relevant for the present debate around the debt brake and the EU SGP. For Germany and most EU countries, the last few pre-COVID years were a time when interest rates were well below the growth rate. These fiscally prosperous times are now over, and it is highly likely that they will not resurface in the coming decades. European government bond yields r have increased both in nominal and real terms, when realistic inflation expectations are used as a reference point. At the same time, the prospects for potential growth g are falling. Demographics, but also the decline of Europe’s competitiveness, are further reducing growth potential in Germany and in other European countries. It’s no wonder, then, that MIT macroeconomist Olivier Blanchard recently backtracked on some of his statements. In an influential speech in 2019, Blanchard pointed out the yet-untouched margin of government debt, using the argument that r was smaller than g. Now, he is cautioning against exploding debt levels across the United States and Europe. The tides have turned, he claims, and in the meantime, r has grown to be equal to or greater than g. According to Blanchard, this means the maximum margin for debt, as perceived by the markets, is progressively waning. Without external guarantees from the EU or the ECB, Europe’s deeply indebted countries are unlikely to have any significant fiscal space remaining. This was already evident during the pandemic, when major crisis recovery programmes in Italy and Spain could not be financed entirely on a national level. This necessitated the creation of large-scale EU financial operations to guarantee a united economic recovery from the effects of the pandemic.