Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate.
As long as the German economy was doing well, as it did during the recovery from the 2008 global financial crisis, there existed a coherent rationale for German fiscal austerity. The national commitment to budget discipline was enshrined in the 2009 “debt brake,” which limits the federal structural deficit to 0.35% of GDP, and by the 2011 “schwarze Null” (that is, “black zero”) policy of fully balancing the budget. Indeed Angela Merkel’s government proudly achieved a balanced budget in 2012 and surpluses in 2014-18.
With unemployment low and growth relatively strong, fear of overheating the domestic economy was a legitimate counter-argument against the other countries that were always urging Germany to undertake fiscal stimulus. They wanted more German spending, which would reduce its current account surplus (a huge 8-9% of GDP in recent years) and spill over into demand that would help other euro members, especially those to the south.
Time for some German stimulus
In any case, overheating concerns are not currently relevant, as German growth has slowed, leading with the trade-sensitive manufacturing sector. The country teeters on the edge of recession: If Germany reports in October that GDP growth in the third quarter was negative as it was in the second, that will qualify as a recession.
Slowing income means slowing tax receipts and a declining budget surplus. Berlin should certainly not take steps to preserve its surplus. To the contrary, it should respond to any slowdown by raising spending and/or cutting taxes. It should particularly raise spending on infrastructure which is in need of maintenance and updating in Germany, even if not as badly as it is in the United States. On the tax side, the government could cut payroll taxes.
The legal constraints of the “debt brake” may limit the size of the stimulus, but they still leave some space – more space than the government budget apparently plans to use. The full “black zero” could be set aside in case of recession. Or it could be re-interpreted to allow deficit spending that goes to investment (especially at the municipal level), while still balancing the government’s current account budget. After all, investment in infrastructure does not constitute borrowing against the future in a true economic sense. That German interest rates are negative (the government can borrow for 10 years at -0.5%) boosts the case for investing in public projects with positive returns, including roads, bridges, and railroads, not to mention 5G networks.
That European interest rates are already so low also means that the European Central Bank cannot do very much more, despite Mario Draghi’s best efforts as he heads out the door. Responding to a slowdown under such conditions is more a job for fiscal policy, as he himself suggested recently.
As Keynes famously said, “The boom, not the slump, is the right time for austerity at the Treasury.”
If Germany allows its philosophical tradition of ordoliberalism to stop it from running a fiscal deficit at a time of recession, its leaders will be placing themselves in a club of foolishly pro-cyclical politicians. They would not lack for company in that group. Historically, many commodity-exporting developing countries have followed pro-cyclical policy — increasing spending and running deficits during a commodity boom, and then forced to retrench when the commodity market falls. Greece did it too, by running big budget deficits during its growth years 2003-08 and then cutting back sharply (under duress from its creditors) in the decade after the euro-crisis hit in 2010. US Republicans have a record of doing it, undertaking fiscal stimulus when the economy is expanding already, as with Trump’s 2017 tax cut, and re-discovering the need to fight deficits when recession hits (1990, 2009).
While some countries like Greece switched from countercyclical spending policy in the late 20th century to a destabilizing pro-cyclical pattern of fiscal policy after the year 2000, others impressively moved in the counter-cyclical direction. To take two examples, Chile and Korea showed pro-cyclical spending on average during the years 1960-1999, but have shown counter-cyclical spending since the turn of the century. Germany could follow the path newly blazed by Korea: after 20 years of surpluses in the overall budget, Korea is now substantially increasing spending to offset slower economic growth. [So could some others with fiscal space, like the Netherlands.]
Yes, long run fiscal responsibility is still warranted
Fiscal policy broadly should be guided by a number of goals in addition to counter-cyclicality. One of them is a long-run path of sustainable debt. One can recognize the mistake of excessive austerity in some countries in the last recession without letting the pendulum swing to the position that countries can run debt without limit, as some observers now give the appearance of believing.
Governments should always check whether their debts are getting too large, even when real interest rates are negative. Many a country has pursued a fiscal path that looked sustainable when the interest rate was below the GDP growth rate, only to find itself trapped by unsustainable debt dynamics when conditions suddenly changed.
One can sympathize with the much-maligned German attitude. Ahead of the 1999 creation of the euro, German citizens had been skeptical of the assurances provided to them in the form of the Maastricht fiscal criteria and the “no-bailout clause.” Their skepticism proved prescient. They make the point that the 2010 Greek/euro crisis would not have happened if Greece after joining the euro had maintained the fiscal discipline called for under the Stability and Growth Pact and had followed the German lead in reforming labor markets (2003-05) and keeping unit labor costs in check.
But to avoid a path of exploding debt/GDP ratio does not require avoiding all deficits at all times. There is a lot of territory in between those two extremes.
Of course it matters how one spends the money
Other critical functions of fiscal policy involve the composition of spending and taxes. Both of those levers can be used to address environmental goals, for example. A renewed German commitment to achieving the goals agreed at Paris for reducing carbon emissions by 2030 is seen as a battering ram against the schwarze Null. Indeed, on September 20 the government announced spending worth some 54 billion euros to cut emissions. In the US, it would be called a Green New Deal.
Spending on such priorities as energy and environmental research can be useful. But in truth, getting serious about carbon and other environmental goals doesn’t have to mean larger budget deficits. Elimination of fossil fuel subsidies and raising taxes on emissions or limiting emission permits and auctioning them can strengthen the budget, as would have been appropriate at the peak of the US and German business cycles. Or the resulting revenues can be redistributed to achieve other goals such as to help the left-behind median household, who may live in the US Midwest or the eastern lander of Germany. The important point for climate change policy is to get the price of carbon up. Doing so is orthogonal to an intelligent choice between fiscal expansion and fiscal austerity.
That choice should be based on the countercyclical criterion and the sustainability of the debt. The US has made some wrong choices, cutting taxes for the rich at the peak of the business cycle. Germany should not make the symmetric wrong choice by preserving its budget surplus as it risks sliding into recession.
This post written by Jeffrey Frankel.