Germany’s debt brake and EU fiscal rules will make it well neigh impossible for EU countries to fund the investments needed to decarbonize their economies.
Two separate events in the final weeks of 2023 have reignited the bitter debate over European fiscal rules. The first was the decision, in November, by the German Constitutional Court to deny the constitutional legality of the substantial off-budget spending by the ruling German government. The second event happened in December in Brussels, where the European Union (EU) finance ministers, on December 8, initially failed to reach an agreement on new fiscal rules, set to replace the older rules of the Stability and Growth Pact (SGP) and the EU Fiscal Compact—but then, on December 20, bowed to German pressure for tough debt-reduction rules and clinched a deal. Both events suddenly breathed new life into older arguments over debt brakes and fiscal consolidation that had looked rather dead-in-the-water in recent years. Why so close to Christmas did the ghost of Ebenezer Scrooge decide to reappear in Europe?
The unexpected revival of Germany’s debt brake
On November 15, a bombshell ruling by the German Constitutional Court triggered a month-long political crisis in Berlin that threatened to throw Germany’s ruling coalition government, led by SPD-Bundeskanzler Olaf Scholz, off the rails. According to the German Constitutional Court, the €60 billion extra-budgetary spending earmarked for a climate fund by the Scholz government is illegal—because it violates the so-called Schuldenbremse, i.e., the brake on new government debt that was enshrined in the German constitution in 2009. According to this Constitutional article, Germany’s structural fiscal deficit must be limited to only 0.35% of GDP, thereby capping the debt that either the federal government or the Bundesländer (federal states) can issue in any given year.
Germany’s debt brake had been officially and effectively put on hold in 2020, in response to the national emergency triggered by the COVID-19 crisis, by Mr. Scholz himself, who at that time was Germany’s finance minister in a Merkel-led coalition government, and who invoked the emergency exception clause that allows for a larger deficit. To mitigate the effects of COVID-19 lockdowns, a large stimulus bill was passed in 2020 and a large shadow (“off-budget”) fund was set up for spending on pandemic relief that would not count against the debt limit. In 2021, following the Zeitenwende speech by (now) Prime Minister Scholz, the ruling coalition government authorized an additional shadow budget for military spending (worth €100 billion) and repurposed €60 billion of unspent money from the pandemic emergency support facility to establish a new Climate and Transformation Fund (CTF).
Throwing fiscal caution to the wind and deliberately working around the fiscal straightjacket imposed by the Constitution, the ruling German government proceeded to enlarge the space for fiscal policy by creating a total of 29 off-budget financing vehicles—all supposedly permitted under the constitutional emergency exception clause. The biggest and most important one is the already-mentioned climate fund CTF, because this fund is fundamental to both the 2021 agreement underpinning the coalition politics of the three-party “traffic-light” coalition government and the financing of Germany’s ambitious climate and energy transition during the coming decade.
In short, the German government has been bypassing its debt brake and quite likely also the SGP. To a non-German observer, the duplicity is plain: while the current German government has no qualms about running large unchecked (off-budget) deficits outside its regular budget, it has continued to insist that other countries in the European Union follow the fiscal rules of the SGP to the letter.
This hypocrisy has now been exposed by the opposition party CDU, which, seizing the political opportunity, challenged the constitutional legality of rechanneling emergency funds originally intended for COVID for use against climate change. Reminding everyone of Wolfgang Schäuble’s reputation as the Swabian guardian angel of fiscal responsibility, the CDU argued that the emergency exception clause (which made the suspension of the debt brake possible in the first place) no longer applied and, hence, Germany’s fiscal policy stance should return to the constitutionally prescribed ‘black zero’.
Germany’s Constitutional Court agreed with this argument—and thus blew a big hole in Germany’s public finances. For the 2024 budget, the Scholtz-led government has had to find an additional €17 billion to fill the hole, and drastic spending cuts, including on social policies, have become unavoidable. This is no accident: it is precisely what a Constitutional debt brake is designed to do: prevent fiscal deficits from swelling for contingent political reasons and instead forcing them to shrink. In attempting to shield public finances from political influences, this mechanism denies the inherently political character of any fiscal policy and depicts austerity as a neutral, good bookkeeping practice. Unable or unwilling to modify the rule, the German government is left with no other choice than to implement a completely unnecessary round of fiscal austerity in an already stagnating German economy.
The court ruling exposed deep rifts between the three coalition parties: the social-democratic SPD, the fiscally very conservative liberal FDP, and the Green Party. The government was forced to adopt an emergency budget for 2023 and struggled to reach a deal concerning the fiscal budget in 2024. Finally, on December 13, the governing coalition parties agreed to stick to the debt brake and cut the federal budget deficit by slashing expenditures by €17 billion in 2024. (The FDP resisted proposals to hike taxes to fill the spending gap, but minor taxation measures made it into the deal.)
The strategically important Climate and Transformation Fund will be cut by €45 billion between 2024 and 2027. Billions of euros in state subsidies agreed with US chipmaker Intel for planned semiconductor production plants in Magdeburg in the state of Saxony-Anhalt—which are considered critical to the transition of Germany’s car manufacturers to electric vehicles—are now up in the air. Likewise, Infineon is building a €5 billion plant in Dresden, Bosch is investing €250 million to expand its Dresden cleanroom and US chipmaker GlobalFoundries is in the fourth year of an expansion of its wafer manufacturing capacity in the same city. All three are banking on generous state support and now fear their promised subsidies are at risk. In addition, financial incentives to buy electric cars will be ended sooner than originally planned; subsidies for the expansion of solar power will be cut, while other funding programs, covering everything from energy-efficient homes to the installation of heat pumps and collective citizen energy initiatives for onshore wind are put on hold; while less public money goes to the urgently needed renovation of the country’s crumbling railway network. Taken together, the austerity drive could well jeopardize Germany’s climate and energy transition.
The Scholtz government promised continued support for Ukraine, allocating €8 billion to the war-ravaged country in 2024. Germany’s bigger problem is that it has committed to structurally ramping up its annual military spending to the NATO guideline of 2% of its GDP—some €80 billion per year. As it turns out, the expenditure on war and armaments will not be affected by the budget cuts. The compromise government budget for 2024 includes the highest military spending in the history of the Federal Republic of Germany: €85.5 billion, which is 26 percent more than in 2023. As Scholz said in his government statement, the military spending serves German great power interests. The costs of Germany’s military grandeur are shifted to working and middle-class households, as social spending is cut, the removal of subsidies on electricity grid charges will raise electricity prices and the CO2 levy on fossil fuels will be increased. Next year economic growth in Germany is predicted to be lower—and because the chronic underinvestment in public infrastructure, education, and the green transition continues, Germany’s longer-term growth prospects are also in doubt.
The revival of the debt brake has reignited the political and economic debate in Germany, and abroad, on the usefulness of fiscal rules. While some conservative political leaders in Germany have now openly expressed support for an intelligent reform of the constitutional debt brake, majority opinion in Germany still continues to consider any such reform politically taboo. The result is a paradox: precisely at the moment when more public funding is needed for strategically addressing pressing collective challenges (including adapting to the consequences of global warming, catching up with the global digital economy, and solving a public housing crisis), Germany’s policy-makers are swept up in a renewed frenzy for belt-tightening austerity.
Unfortunately, the key message of the austerity myth—that what is economically rational for an individual household will also be rational for an entire country and for its government—is plain wrong, macroeconomically and also for the climate, as the United Nations economic analysis repeatedly suggested. As argued by Peter Böfinger (2023), the only effective remedy against Germany’s economic disease is that “public debt [is] deployed as an engine of growth—not by reducing taxes and accompanying transfers but by increasing public investment to stimulate domestic demand and the emergence and deployment of new technologies.” To make this possible, the Germans have to get rid of their debt brake fetish.
Reforming the fiscal rules of the Eurozone
The second recent event that rekindled the debate on fiscal rules was the summit of European Union finance ministers on December 7-8, 2023, on new fiscal rules, set to replace the older rules of the SGP—which include a maximum budget deficit of 3 percent and a maximum ratio of public debt to GDP of 60 percent. In 2020, the European Union suspended its fiscal rules to accommodate the sharply increased public expenditure occasioned by the COVID-19 pandemic – the same moment when Germany suspended its constitutional debt brake.
There is agreement that a return to an unchanged SGP is undesirable because it would be economically painful for the large number of member states that currently breach the existing fiscal rules. Specifically, average government debt in the Euro Area was 91% at the end of 2023Q2 and six member states (Belgium, France, Greece, Italy, Portugal, and Spain) carry public debt above 100% of their GDP. At the same time, in 2022, the average government deficit was 3.6% for the Eurozone countries, and eight member states (including France, Italy, and Spain) have fiscal deficits well above 3 percent. A return to an unchanged SGP would mean that 14 member states would have to cut spending or raise taxes to the tune of €45 billion in 2024 alone. The outcome can only be higher unemployment, lower wages, and further underfunding of public services. What a gift another—unnecessary—round of austerity would be to the smoke-and-mirrors xenophobic arguments, with the next European elections due in June 2024 (Lynch 2023): When resources appear to be scarce, those arguments suggest they should be reserved for the “deserving” native population (however defined) and taken away from the “undeserving” (the migrants). Far from curbing immigration, the ensuing policies merely intensify the race to the bottom in working conditions, by leaving migrant workers less protected, and further reducing internal demand.
It is said that an intelligent donkey does not trip twice on the same stone—so even the European Commission now recognizes that a return to the unreformed SGP would imply a return to stiff austerity which would risk repeating the traumatic recessionary experiences of the Eurozone crisis (2010-2014). A second reason why a return to the SGP rules is undesirable is that all EU member governments understand that the need for public funding is growing because of the climate, digital, and energy transitions in the next decades.
Accordingly, a number of proposals for reforming the SGP have been put on the table—the European Commission itself proposed tweaking the rules by introducing a four-to-seven-year adjustment period in which countries exceeding the deficit (3% of GDP) or debt (60% of GDP) norms of the SGP would commit to ‘sustainable’ policy reforms meant to force down the deficits and public debts. The Commission’s reform proposals met firm opposition from both the pro-austerity camp led by Germany, the Netherlands, and Austria, and the countries (including France and Italy) arguing for more fiscal clemency. Their disagreements concern the minimum pace of deficit and public debt reductions and the inclusion or exclusion of strategic public expenditures including green and digital investments (Italy) and/or defense-related public spending (France) when calculating an “excessive” fiscal deficit.
On December 20, after marathon negotiations, the 27 EU finance ministers reached an agreement on a reform of fiscal rules that will set out a somewhat laxer pace of debt and deficit reduction than had previously been the case, but—crucially—still within tight spending limits demanded by the pro-austerity camp. Under the agreement, member countries with ‘excess public debts’ will get more time—between 4 and 7 years—than before to put their debts on a declining path and more independence in the design of plans outlining their fiscal targets, while the earlier requirement to cut excess debt by 5 percent per year was ditched.
However, the two key fiscal requirements—a 60 percent debt-to-GDP ratio and a 3 percent annual deficits limit—have remained in place, and, at the behest of the pro-austerity camp, the agreement contains extra safeguards and sanctions to enforce debt reduction. Specifically, to make sure that member states stick to the fiscal rules, the European Commission will draw up national spending plans in which countries with debt ratios above 90 percent of GDP will be required to cut excess debt by one percentage point per year over the duration of their national spending plan. That target is halved for countries with debt ratios above 60 percent but below 90 percent of GDP. Additional budget targets will be placed on countries with deficits above 3 percent and debt-to-GDP ratios above 60 percent. Sanctions are strengthened under the agreement, which stipulates that countries that miss spending plan targets are put into a so-called excessive deficit procedure, which would require them to reduce spending by 0.5 percent of GDP per year. The European Commission is expected to slap eight or nine countries (including France and Italy) with its sanctions mechanism in Spring 2024.
A last-minute concession won by France and Italy ensures that countries subject to such a procedure will be able to discount debt interest costs in the period 2025-2027, effectively reducing the required spending cuts. However, in a key win for Berlin, the recent agreement also requires EU governments to keep their annual (structural) deficits at around 1.5 percent of GDP, arguably to give countries some room to increase spending to cope with an unforeseen crisis without breaching the 3 percent public deficit norm.
It is evident that the reformed SGP does not turn the page on austerity. Rather the opposite is true: the notion of ‘fiscal rules’ has lost none of its appeal to policymakers in Brussels and the new rules have an even stronger austerity bias (as the new rules require member states subject to the debt-reduction procedure to aim to cut their deficits to 1.5% of GDP with annual curbs to spending)—which we think is regrettable.
The “voodoo economics” of the debt brake and fiscal rules
Let us clarify, right away, that from the point of view of economic theory, nothing justifies the sanctimoniousness of Germany’s constitutional debt brake or the EU’s supranational fiscal rules. Already at the onset of the Maastricht Treaty, economists warned against the inclusion and use of budgetary limits, providing an early critique of the fiscal rules of the SGP and their inherent contractionary bias. Based on a crystal-clear analysis, Luigi Pasinetti (1998, p. 112) warned that the SGP “prevents expansionary policies in periods of recession and mass unemployment [….] and […], on top of that, it also imposes heavy fines. I cannot see how all this could be a symbol for anything. It simply sounds foolish.” Similarly clear and critical was Alain Parguez, who already in the 1990s argued that the true purpose of the EU fiscal rules was to tie the hands of national states through the imposed inability to engage in deficit spending, thereby forcing them to implement a quasi-permanent austerity.
Many mainstream economists agreed. Buiter, Corsetti, Roubini, Repullo, and Frankel (1993), for instance, concluded that “the fiscal convergence criteria designed to eliminate or prevent ‘excessive deficits’ are badly motivated, poorly designed and apt to lead to unnecessary hardship if pursued mechanically. The debt criterion especially would cause avoidable pain. There is no case for restricting the debt-GDP ratio to lie below any specific numerical value; and à fortiori no case for an identical limit for [many] heterogeneous countries” (Buiter et al. 1993, p. 87). The economic price of fiscal deflation and permanently reduced fiscal flexibility, which are part and parcel of the SGP and are paid for by EU member states, may well be unbearable—which was also the argument of Joseph Stiglitz (2016).
The idea that the relative size of public debt is somehow related to economic growth has long been discredited (see the useful meta-analysis based on 47 primary studies by Philip Heimberger 2022). It is clear that this point is well understood even by Germany’s macroeconomic policymakers who, after all, have been caught red-handed, attempting to fuel Germany’s growth and (climate and energy supply) resilience through public investment, financed by shadowy off-budget financing vehicles. Of course, the more indebted EU member states find themselves in a similar predicament and feel the same need to step up public spending in areas that are critical to the future development, competitiveness, and resilience of their economies.
Austerity and stiff fiscal rules unnecessarily restrict the fiscal room for maneuver, which the state could use to help the economy respond to the demands of the coming digital and zero-carbon age. It is a public secret that (unwarranted) austerity crippled the Eurozone economy—especially hurting the countries of Southern Europe—as is shown by recent papers published on the INET website: Storm (2019) on Italy; Stirati (2020) on Italy and elsewhere; Girardi, Paternesi Meloni and Stirati (2017); Toporowski (2023) on Poland; and Roncaglia (2023). Crucially, austerity has also crippled the countries in the pro-austerity camp, as has been argued by Storm (2023) for the Netherlands; and by Bofinger (2023) who uncovers Germany’s true economic disease.
An equally large literature has clarified that a fiscal expansion, focused on public investment geared toward green technological innovation and employment creation, including in sectors connected with health care and education, is needed to overcome the stagnation of the European economy (Bloomfield 2022; Archibugi 2023). This literature points to a growing inconsistency in EU policy-making. On the one hand, the EU countries need to be more ambitious and bolder on climate action, the energy transition, and the digital economy, but on the other hand, these same countries have to work within an unworkable fiscal straightjacket that is fundamentally biased in favor of austerity. In this context, it must be noted that the deflationary macro policy stance of the EU (and imposed on its member states) has also allowed a historic rise in profit shares. Unsurprisingly, while several EU institutional sources have lamented a crisis of competitiveness, none has pointed to critical evidence that a more equal income distribution, to be attained through employment creation and cheap public services provision, is an essential component of a stable growth path with productivity growth (Storm 2017; Taylor and Omer 2018; Capaldo and Omer 2021).
All in all, it is clear that the fiscal rules, which lack a convincing economic rationale, play a primarily political role, because these rules are used to throw a cloak of spurious statistical precision over any mix of cross-pressures and interests (Costantini 2017; Costantini 2018). The real problem concerning fiscal policy, thus, is political. The resistance of the German electorate to the idea that they will have to be held financially responsible for some other country’s overspending is proverbial. The concern is understandable since German voters and policymakers have no real political control over the use of resources outside their borders. But what gives them the right to prevent other countries’ spending, especially if there is no economic logic that should support such limitation? As always, the negotiations in the EU stop short of offering a solution to this impasse.
Ultimately, therefore, the real issue here seems to be one of democratic legitimacy and political representation in the EU, the lack of which impedes a discussion over the economic and social goals to be attained collectively. The democratic deficit drives governments and electorates to embrace economically inefficient and politically unviable positions which have, since the Maastricht Treaty, systematically produced slow growth (except for short-lived spurts of export- or credit-led expansion in some areas), rising inequality, and the deterioration of the health of the people and the environment.
The impact of this reduced political space has dominated the political color of governments regardless of their electoral mandate (Costantini 2015; Storm 2023; Toporowski 2023; Lynch 2023). The seemingly technocratic ‘rules’ have helped to depoliticize policy debates on critical and strategic issues—etching the TINA rule into the DNA of all mainstream political parties. The EU fiscal rules have placed important social and economic issues outside of political contestation, negating the fundamental centrality of politics to achieving our collective goals. The implication is that we, as Europeans, have no effective space to discuss and debate the political, social, and environmental priorities that our public budgets should address with all the unlimited power granted by the strength of our economies. After all, the EU is still one of the largest and richest economies in the world. Instead, European politics has been sadly reduced to petty negotiations and recriminations, with no direct political implications, except that of empowering a complacent and incompetent bureaucracy in Brussels.
Conclusions
Esther Lynch (2023), head of the European Trade Union Confederation (ETUC), is right to warn against the severe social and economic consequences of a failure of a progressive reform of the fiscal rules of the SGP and a return to the traumatizing austerity policies of Christmas Past. The situation is dire and not just for Europeans. Let us not forget that the global consequences of the slowdown in the European Union were estimated earlier this year to be at least twice as large as those of the much-discussed economic slowdown in China, and now they are likely to worsen (UNCTAD 2023).
It will not come as a surprise if the entirely unnecessary round of austerity in an already ‘sick’ German economy (Bofinger 2023) reinforces a ‘doom loop’ of economic stagnation, and heightened mistrust in the political system. Likewise, more austerity in France, which would have to raise around €30 billion annually to meet the fiscal targets of the SGP, will raise political polarization even further.
The debt brake and fiscal rules will make it well neigh impossible for EU countries to fund the investments needed to decarbonize their economies and meet their climate commitments under the Paris Agreement. Worse, it will be impossible to do this in a socially acceptable manner—meaning, in ways that the strongest shoulders carry the largest burden of climate and energy transition, while vulnerable groups are protected from the transition costs. The failure to arrive at a fair and acceptable sharing of these burdens will lower popular support for these environmental policies—while reinforcing narratives that global warming is just a hoax, propagated by the elites, meant to suppress the “vox populi” and to impose an “eco-dictatorship”, another flashpoint in current culture wars.
The only way out of this nightmare scenario is to shift the nature of the economic and political discussion and initiate a process leading to a re-politicization and democratization of fiscal policy in the EU in a permanent way. We are not talking here about the opportunity to slightly change otherwise de-politicized technical rules governing fiscal policy that always are subject to closed-door negotiations and interpretations, and then used to safeguard powerful interests (Costantini 2017; Costantini 2018). What we mean is that it is time to ditch the constitutional debt brake and discard the EU fiscal rules—in order to open up space for meaningful political deliberation and discussion on the short-term and long-term challenges facing all citizens (voters) in the EU. Anything that falls short of this must be considered a failure.
Ebenezer Scrooge, the “squeezing, wrenching, grasping, scraping, clutching, covetous, old sinner”, redeems himself from a life of miserly selfishness by repenting of his past actions after being shown scenes of his younger life, his present life, and his future by the three ghosts that visit him on Christmas Eve. As 2023 turns into 2024, the question is whether Europe can free itself from the grave errors in its economic thinking and policy-making and finally bury the misleading and dangerous ideas concerning fiscal policy and debt brakes.
* The opinions expressed in this article are the authors’ own and do not in any way reflect the views of the organizations at which they are employed.
