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A new fiscal policy for a new era: proposed reforms for German fiscal policy

The current debt rules are from a different era, with different challenges. Today's world looks different: We are in the midst of a profound transformation - economically, demographically and politically. This world needs a new definition of sustainable financial policy.

 

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The future was the central concept of the 2021 federal election campaign. All parties came forward with the aspiration to shape the future. And the challenges remain enormous: Germany, Europe and the world are faced with the task of decarbonising their economies, even fundamentally transforming entire economic structures that have emerged over centuries. In addition, there is the need to cope with demographic change, which means that more and more pension recipients are faced with fewer and fewer contributors. In Europe, we also face structural trade imbalances that call for economic convergence and monetary union stability.

It takes an active state to meet these challenges. Some authors have already emphasized this point and called for a readjustment of the relationship between the market and the state. For example, Claus Leggewie and Gustav Horn see a renaissance of the modern state approaching, which actively shapes the transformation and creates economic stabilization. The ability of the state to act inevitably requires the future viability of state finances. Once again it is about the concept of the future. But what do we mean by sustainable financial policy?

The status quo primarily determines the sustainability of the federal budget in terms of the debt ratio, i.e. the ratio of public debt to gross domestic product (GDP). The “magic” number is 60 percent. Falling below these guarantees the ability to act and protect future generations from contaminated sites. But as Jan Priewe shows, the 60 percent mark has no theoretical justification. It simply reflects the average in the European Community at the beginning of the 1990s when the Maastricht treaties were concluded.

The key indicator of fiscal policy is therefore not without a certain arbitrariness – which, however, would not be reprehensible as long as the general economic conditions remained the same. But the framework conditions have changed, both on the expenditure and on the revenue side of the state budget. The yield on 10-year Bunds reached 9 percent in 1990, GDP growth was 5 percent, and both inflation and the share of interest payments in the budget increased. Today, yields are -0.2 percent, growth and inflation have more than halved, and the cost of interest as a proportion of the budget has been steadily declining since 1999.

The challenges have changed

The problems of the federal budget today are not in the interest burden, but elsewhere: Almost a third of government spending is subsidies to the pension fund. And the number of those dependent on state transfers is high. There are currently around 36 pensioners for every 100 employees, and this number will rise to 52 by 2040. If you take all state transfers together, 100 employees are already financing 62 transfer dependents today. Among these are also those who work in the low-wage sector (which accounts for a good fifth of all employees) and need to increase their income. But these are by no means all construction sites. The digital and ecological transformation of the economy requires every available workforce: in trade, construction, energy production and industry.

»Government financial policy is sustainable if it contributes to the full utilization of the labor market and the economy.«

A new era with new challenges requires a new level of sustainability. Our reform proposal, which we present in our study A New German Fiscal Policysubmit, defines this measure: The state financial policy is sustainable if it contributes to the full utilization of the labor market and the economy. This goal will be achieved when everyone who is able and willing can finance their life and pension to the desired extent through their own work. A busy labor market is key to overcoming the challenges outlined above. It limits the necessary subsidies for pension insurance and social benefits from the federal budget. It also mobilizes the workforce that is needed for the transformation and creates sustainable growth in economic output and tax revenue. This means that the state's expenditure and income are future-proof.

Today's fiscal rules are obsolete

Critics would argue that the goal of full capacity utilization is already built into German fiscal policy. After all, the debt brake does not prescribe a rigid deficit limit, but rather allows a fiscal policy that stabilizes the economy via an emergency clause and the economic component. The economic component allows for additional debt if current economic output remains below the past average. However, on closer inspection, economic stabilization and full capacity utilization are two different objectives: while the former tries to guide the economy onto the trend path of the past, the latter aims to exhaust the potential of the economy. Only in exceptional cases, if the economy is already historically on the best possible growth path, 

However, there are numerous reasons why this case is exceptional: Past downturns can push economies onto lower growth paths, for example due to hysteresis, ie permanent labor market and lack of investment effects. Subdued expectations for the future and a chronic weakness in demand mean that investments are not made even in times when there is no crisis. Due to these and other mechanisms, there is no automatism that brings economies to the utilization of their supply-side capacities. On the contrary: As one could see from the development in the US in recent years, a high demand for labor has led to an expansion of the labor supply. This does not mean that the potential of an economy is determined by demand alone. Supply-side aspects also count. For example: without daycare places that enable mothers to meet the demand for their labor, additional demand has no effect either. 

»If you take the goal of full capacity seriously, it means a departure from the goal of not running into permanent deficits.«

However, if one takes the goal of full capacity seriously, it means a departure from the goal of not running into permanent deficits. Because under the debt brake, economic policy and the avoidance of permanent deficits can only be combined by assuming that the past trend represents the potential of the economy. However, the current methodology used to estimate this production potential implies abstruse labor market structures. According to the current methodology, the potential has already been reached when only 75 percent of women participate in the labor market, but a full 84 percent of men. In addition, the current potential estimation method accepts that almost six million people in Germany work part-time, although they want to work full-time or could be, if there were corresponding jobs or the infrastructure for childcare or nursing were expanded. Finally, the current estimate of potential implies that around one million people remain in long-term unemployment in order not to increase wage pressure in the labor market. The current practice of stabilizing the economy is therefore far from fully utilizing the labor market.

And not only that, it also has implausible fiscal consequences. If politicians were very successful today, for example, in expanding the range of childcare options and thus increasing the number of women in the workforce, the fiscal policy acknowledgment would come immediately. The economy would exceed its potential – calculated on the basis of past trends – and savings would have to be made to stave off a rise in inflation. However, this danger does not exist because the investments have simultaneously increased the labor supply, which reduces wage pressure and thus inflationary pressure.

reform proposals

The figures, curiosities and problems mentioned result from the methodology of the European Stability and Growth Pact, according to which the economic component of the debt brake is calculated today. Although the latter has found its way into the Basic Law and can therefore only be reformed with a two-thirds majority in the Bundestag and Bundesrat, the determination of the economic component is regulated by simple law. It is therefore possible to adjust the economic component without changing the Basic Law . In order to move from trend stabilization to full capacity, it would be sufficient, for example, to simply further develop the inputs of the calculation. In this way, the estimate approximates potential output in the literal sense without merely extrapolating the past.

We propose three concrete modifications on the quantitative and qualitative level: The potential of the labor market is considered to be reached when (1) there is only short-term, frictional or seasonal unemployment, (2) the difference in the participation rates of women and men in the labor market to the Scandinavian level of about three percentage points, and (3) the unnecessary or involuntary part-time work in Germany is halved.

These adjustments result in an economic component of 20 to 24 billion euros for 2023. It thus offers substantially more fiscal leeway than the component of 4.5 billion euros currently forecast by the federal government. Increasing the economic component is not an end in itself, but the first step towards a sustainable fiscal policy that reflects the research results of recent years and addresses today's challenges, not those of the 1990s. The additional financial resources can be invested in expanding infrastructure and the education system, qualifying skilled workers, creating future-proof jobs and higher wages.

It should be emphasized that moving away from the goal of avoiding permanent deficits in no way means moving away from the actual goal of the debt brake. Its intention is to limit government debt and thus ensure the long-term sustainability of government finances. A reorientation of German fiscal policy towards the goal of full capacity utilization has precisely this effect: By working to full capacity on the labor market, household income and expenditure stabilize and GDP growth is stimulated.

"By filling the labor market, household income and expenditure stabilize and GDP growth is stimulated."

At the same time, we argue against the debt ratio as a key fiscal indicator. Because fiscal policy should always keep an eye on the risks of debt, in particular the risk of rising interest rates. In an emergency, they can worsen the state's financing conditions and thus limit the active state's ability to act. However, the debt ratio only captures such interest rate risks with a long delay, because it focuses on the accumulated debts of the past. In view of the long average term of German government bonds of seven years, changes in interest rates only have an impact far too late.

A more sensitive, faster-acting indicator is the share of interest payments in the budget, the so-called interest-to-budget ratio. We propose that the federal government must present its assessment of fiscal policy risks to the Bundestag as soon as this ratio increases by more than one percentage point. However, the indicator is not to be understood as a rigid limit from which tough austerity measures automatically take effect, but as an early warning indicator that triggers a strategy review, which can then result in a change of course if necessary. In the past, the indicator would have struck in 1992, 1994, 1997 and most recently in 1999, i.e. it would have warned timely and repeatedly of rising interest costs in the household. 

The time for change is now

The current debt rules are from a different era, with different challenges. Today's world looks different: We are in the midst of a profound transformation - economically, demographically and politically. This world needs a new definition of sustainable financial policy. We propose two reforms: (1) an adjustment of the economic component as part of the debt brake, and (2) moving away from obsolete financial indicators. By enabling public finances to achieve full capacity utilization of the labor market, we simultaneously ensure their future viability and master the challenges of our time. Because a new era needs new answers.

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