Germany’s debt brake is breaking its economy

BERLIN — Earlier this month, Germany’s constitutional court ruled that the government’s plan to redirect unused COVID-19 aid funds toward combating climate change violated the so-called debt brake. The decision is not just a setback for Chancellor Olaf Scholz; it could also deepen the ideological divisions within the coalition government and undermine the country’s fiscal policy, thereby posing a grave threat to its economic outlook.

Germany introduced the debt brake into its constitution in 2009, imposing limits that were far more rigid than those required by the European Union’s Stability and Growth Pact. The brake largely prohibits the federal and state governments from taking on new debt; exceptions are allowed only in extreme emergencies. The federal government used this emergency exemption in 2020 to allocate more than 200 billion euros in special funds to mitigate the pandemic’s economic impact.

Scholz’s government tried to use the same exemption to channel 60 billion euros ($66 billion), or 1.5 per cent of GDP, from these special funds toward industrial subsidies and climate-related initiatives. The opposition Christian Democratic Union then appealed to the Court, which blocked the government’s plan on the grounds that it did not meet the “constitutional requirements for emergency borrowing”. Ironically, it was the CDU, under the leadership of former Chancellor Angela Merkel, that established this special fund.

While the ruling represents an embarrassment for the federal government, particularly for Finance Minister Christian Lindner, the bigger problem is that the government now faces a €60 billion shortfall for its planned programs and subsidies. Germany’s Climate and Transformation Fund (KTF) has been left nearly depleted, with just 30 billion euros in anticipated revenues, mostly from emissions trading. The ruling also means that the government will not be able to keep some of its commitments, such as 6.5 billion euros in additional funding for Deutsche Bahn, 15 billion euros in subsidies for the planned Intel and Taiwan Semiconductor Manufacturing Company facilities in Magdeburg andDresden, 4 billion euros for green steel production, or the 1.8 billion euros in household heating aid.

Moreover, the ruling introduces a new layer of economic uncertainty, leaving many companies wondering which promises they can still count on. This is set to undermine economic growth at a critical moment. The energy crisis and sluggish global economy have affected Germany more severely than other industrialised countries, and the expected decline in private investment could further impede the economy’s ecological and digital transformation.

Given sufficient political will, this problem could be easily resolved. The Bundestag (parliament) could approve a temporary suspension of the debt brake for 2024, thereby giving the government the necessary financial flexibility. But this is precisely the crux of the problem: When it comes to fiscal policy and debt, the government parties are more divided than ever.

While Scholz’s Social Democratic Party (SPD) has proposed reforming the debt brake and imposing higher taxes on high-income earners and inheritances, Lindner and the Free Democrats pride themselves on acting as the country’s ordoliberal conscience. Believing his political future hinges on adhering to the debt brake and maintaining fiscal prudence without raising taxes, Lindner has already announced plans for even tougher austerity measures. Meanwhile, a substantial portion of the SPD, together with the Greens, the third coalition partner, are eager to implement their ambitious (and costly) agendas. This places Scholz in the unenviable position of having to reconcile two seemingly contradictory fiscal strategies.

This conflict underscores the debt brake’s flaws and the paradoxical nature of German fiscal policy. While governments and finance ministers give lip service to the debt brake, they create shadow budgets to bypass its constraints when it suits their political needs. This has enabled Germany to provide huge financial support to domestic companies during the pandemic and the ongoing energy crisis. At the same time, however, the government maintains a restrictive structural fiscal policy, resulting in inadequate public investment and a significant decline in the quality of infrastructure, education and health care. Simply put, the debt brake has served as a convenient pretext for a fiscal policy that favors corporate subsidies at the expense of public goods.

The real risk stemming from the constitutional court’s ruling is not necessarily a shortage of funds but rather the deepening divisions within the government and the looming political and economic paralysis. Germany’s industrial sector, crucial for creating well-paying jobs and driving innovation, has been slow to embrace the digital and environmental revolutions. To catch up, the government must urgently invest in infrastructure, basic research and education.

By exacerbating the political deadlock, the Constitutional Court’s decision poses a grave threat to Germany’s socioeconomic development. But beyond its domestic consequences, the ruling also has negative implications for Europe, as the German government has used the verdict to decline the EU’s request for a 100 billion euros budget supplement.

Over the past two years, Scholz has repeatedly managed to bridge major differences within his three-party coalition. He now faces the most difficult and potentially defining challenge of his tenure: developing a creative and effective strategy to overcome the political impasse and ensure that Germany remains economically competitive in the twenty-first century.

Marcel Fratzscher, a former senior manager at the European Central Bank, is president of the think tank DIW Berlin and professor of Macroeconomics and Finance at Humboldt University of Berlin. Copyright: Project Syndicate, 2023. 

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