Winner of the New Statesman SPERI Prize in Political Economy 2016

New! Lecture on 23rd May at Bush House, 44-46 Aldwych on my book 'The Lies We Were Told' with discussion from Rachel Shabi and Aeron Davis. Book here.

Friday, 8 March 2019

Is the German Debt Brake the worst fiscal rule ever?


The answer is probably not: a simple balance budget is worse. The German Schuldenbremse fixes the total cyclically adjusted deficit at 0.35% of GDP, which implies a gradually falling debt to GDP ratio. If actual outturns exceed this figure, there is a control mechanism which reduces the permitted deficit to get the path of debt back on target. So this debt brake improves on a simple balance budget by allowing a very modest deficit and cyclically adjusting. On the other hand it is worse than a simple balanced budget because it error corrects.

The fundamental mistake the rule makes is to make control of debt its central aim. Doing this only makes sense if you ignore macroeconomic common sense. The deficit and debt are macroeconomic shock absorbers. Running a variable deficit allows taxes and spending to be reasonably stable, which is beneficial for obvious and not so obvious reasons. Trying to tightly control the deficit and debt does the opposite. It makes sense to smooth taxes and government spending, but no sense whatsoever to smooth the deficit and debt.

The aim of a good fiscal rule is to eliminate deficit bias, which is the tendency of government debt to rise over time because, for example, politicians always want to spend more and tax less. The timescale for deficit bias is decades rather than years, so there is no need in principle to tightly constrain year to year deficits, or worse still to try and stay on some path for debt, and as I have already noted it is actually harmful from a macroeconomic point of view to do so.

Doesn’t the debt brake make some concession towards the macroeconomic stabilising role of the deficit by cyclical correction? There are two problems here. First, cyclical correction is a very imprecise art, and there is evidence the method used in the German debt brake and elsewhere does not work very well. Second, cyclical shocks are not the only thing that disturbs the government’s deficit. In practice all kinds of things can lead to erratic movements in the deficit, and it makes no sense to have to adjust tax rates or spending to exactly offset this erratic behaviour.

As Jonathan Portes and I explain in our paper on fiscal rules, a better way of keeping the stabilising role of deficits while still ensuring they do not steadily increase over time is to have a rolling target for the future deficit. Five years is the typical length of an economic cycle, so looking ahead five years makes sense, and also avoids the need for imperfect cyclical adjustment.

This kind of rolling future target is open to cheating, because the government can always promise but never intend to deliver on meeting the target. The problem here is that governments can cheat in so many ways when it comes to fiscal planning. No rule, even a draconian one like the debt brake, will stop all forms of cheating. The best way to avoid cheating is to establish a fiscal council with political weight that can distinguish between a government that fails to meet its targets through bad luck and one that fails because of cheating.

Do we need the debt error correction in the debt brake? A consistent result in academic research is that debt correction should be very slow, if it happens at all. That happens automatically with a deficit target, while the debt brake corrects too quickly. So the answer is no.

Another problem with the debt brake, alongside many other fiscal rules, is that it has a target for the overall deficit which includes public investment. Public investment should not be included in any deficit target, because there is no reason the current generation should pay for something that will benefit future generations. As investment is less painful to cut than current spending (or raising taxes), rules for the total deficit often lead to under investment, and we can see this in Germany. That only hurts future generations.

This is not about Anglo-Saxon economists telling Germany what to do. There are plenty of German economists who also see that the German debt brake makes no sense, and anyway economics is universal. The debt brake is a bad fiscal rule. It is doing the German people harm. It needs to change.


6 comments:

  1. Your suggestions are eminently reasonable and provide an excellent basis for managing fiscal policy.

    This dirigisme is unfortunately reflected in no small measure in the EU so by implication you are criticizing its policies. Those policies reflect the German rules you mention but hold sway over the whole of the EU. Does this mean that you would be in favour of changing the Growth and Stability Pact?

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  2. "Public investment should not be included in any deficit target, because there is no reason the current generation should pay for something that will benefit future generations."
    Thanks for this point that had never come to my mind.

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  3. How would this thinking extend to the case of a single jursdiction over diverse economies? E.g. (Ex) West-East Germanies, or diverse economic blocks within theEU and all that. When do the defensive actions of the weaker groups' governing bodies (lower level, e.g. the Laender in Germany, or some of the PIIGS governments within the EU) stop being legitimate attempts for a more targeted shock-absorbing policy and start being cheating? It is the old multi-level government in the case of public goods analysis... Do you have any thoughts to share?

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  4. The following assertion "[...] The aim of a good fiscal rule is to eliminate deficit bias, which is the tendency of government debt to rise over time because, for example, politicians always want to spend more and tax less." assumes that politicians favor spending over taxing presumably because doing so satisfies aligned interests supporting them which in turn manipulate the electoral base and increase the politicians' probabilities of reelection.

    In recent years and especially after the great recession, it has become evident that the politicians do not control spending; they probably never have been in control since central banks became independent and started targeting inflation. If that is the case, then there is no deficit bias per se that needs adjusting, since it's impossible to act on a presumed bias that lacks the possibility of becoming expressed or applied (much like a eunuch cannot act on a supposed biological 'bias' towards reproduction).

    When deficit spending is both ethically and pragmatically off the table (I think it was the former that instigated the later, but that's probably debatable) isn't it the case that fiscal rules are a moot artifact of past institutional arrangements?

    If that is not the case, how is it possible to justify this aversion to public spending in the years after the Great Recession and especially in the light of BREXIT?

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  5. Keep in mind Germany is big, but it's a minority part of the common market. The other countries affect the German economy as well, including their fiscal policies. The issues described are thus smaller than if it was a closed economy (or at least not part of a common market).

    Moreover, the need to keep deficits and public debt in check was identified because of the projected demographic changes that could stall GDP growth in the future.

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  6. I really like and appreciate your post.Thanks Again. Keep writing.

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