Adieu to the “Schwarze Null”
Strange things are happening in Europe. Alarmed by the U-turn of the Trump presidency on European defence, the new incoming government coalition in Germany decided to do ‘whatever it takes’ by going for major public spending on defence and, to a lesser extent, for extra investment in infrastructure and the greening of the economy. Almost overnight the country that has systematically pushed over the past decades for strict rules on fiscal policy across Europe completely switched positions, thereby significantly loosening the famous debt brake that is embedded in the German constitution and requires the deficit to be capped at just 0.35% of GDP.
A non-significant part of this extra spending, in particular when it comes to infrastructure and greening, will provide fiscal stimulus to the German economy. This is surely welcome for an economy that has been in recession for the past two years and facing an extremely weak recovery because of the turmoil in global trade and the economic insecurity unleashed by the Trump administration’s trade war.
Breaching the European fiscal rulebook
At the same time, the reform of the German debt brake does not respect European fiscal rules. The European Commission (probably at Berlin’s request) did change the rules temporarily by excluding a maximum of 1.5% of GDP of defence spending for the next four years from excessive deficit proceedings. However, the new German fiscal rules go much further. In contrast to the recent European fiscal policy approach, they do not set any limit in terms of the amount or the duration of the exclusion of defence expenditure from regular budget discipline. Moreover, Germany is now extending the exceptional treatment of defence spending also to infrastructure investment, and this by an amount of 500 billion euro over the next ten years. Taking all of this special public spending in account implies that total deficit numbers in Germany will easily swell up to reach 2.85% of GDP or more (the formal deficit cap of 0.35% of GDP plus 1% of GDP annual infrastructure investment plus 1.5% of GDP or more extra defence spending).
Even more striking is that fact that the turnaround in German fiscal policy will also result in public debt significantly going up to exceed the famous Maastricht threshold of 60% of GDP. Bruegel for example estimates that German debt would increase from the current 64% of GDP to 85% of GDP in 2035 before stabilising afterwards around 90% of GDP.
A fundamental reform, not a quick fix
The reform of the German debt brake vividly illustrates that statistical numbers such as the 3 and 60% deficit and debt should not be allowed to stand in the way of existential policy priorities.
But what does this imply for the current European fiscal policy framework? Europe is indeed facing several existential challenges with each of those challenges requiring a massive and urgent public investment effort: The green and digital transitions, ensuring the existence of Europe as a sovereign economic entity by fostering the industries of the future, as well as the need to switch back to domestically-led growth instead of relying on insecure and volatile export markets, all of these together with a defence spending easily imply 3 to 4% of GDP extra public investment spending. Such an amount of investment will not be reached if fiscal policy across Europe continues to be based on a pure accounting approach of the 3 and 60% deficit and debt numbers.
In this respect, raising the Maastricht Treaty’s public debt number from 60 to 90% of GDP, as some are proposing, is not enough. It would boil down to replacing one randomly chosen number by picking another one. What Europe instead needs are new and better fiscal policy rules.
A new approach to fiscal policy should, first of all, start from a wider perspective than just the strictly fiscal side of things by turning the concept of debt sustainability into a broader one of “policy sustainability”. What benefit is there in trying to deliver lower debt burdens to future generations if the failure to invest in decarbonisation and innovation substantially degrades living conditions and reduces Europe to a playing ball in the hands of autocratic regimes from the rest of the world? What if the social turmoil unleashed by austerity 2.0 undermines democracy and turns the massive spending on defence into a new “Maginot line” with Putin friendly politicians gaining even more political power across Europe? Meanwhile, as suggested by IMF-analysis, the coming wave of austerity will most likely fail to get public debt rates down as it will pull economic activity down.
To be clear, avoiding public debt from spinning out of control, with all the economic damage the latter would inflict, remains a key challenge. But there are many degrees of freedom between this extreme scenario of skyrocketing debt rates and the Maastricht definition of fiscal sustainability, defined as “debt declining in any case towards 60% of GDP”. Olivier Blanchard, former chief economist of the IMF in particular, argues that “a reduction (of public debt) may be highly desirable but it is not as existential as sustainability”. Instead, Blanchard proposes to aim for a debt rate that stabilizes over the medium term as the key objective that absolutely matters for sustainability. A key advantage of this approach is that it allows to increase debt to finance higher public investment as long as there is a high probability of debt stabilising at this higher level in the longer run. In exchange for this level shift in public debt, the economy benefits from an investment shock that equips future generations with the capital stock necessary to face the different existential challenges. This is what the new German government is actually doing: Allowing a temporary increase in public debt in order to provide the necessary room for a major catch-up in key public (investment) spending.
A second pillar of this new approach is European policy action to back up member states in their implementation of this strategy to stabilise debt over time. Here, avoiding interest rates to exceed the rate of economic growth is crucial as this will avoid the infamous “snowball” effect of debt and interest rate spending feeding upon themselves.
As the current US administration seems intent on weakening the position of the US dollar as a reserve currency, and with international investors keen to switch to non-dollar investments, the time is ripe for Europe to offer its own alternative “safe asset”. By massively issuing common debt to fund a coordinated public investment shock, Europe could catch some of the ‘extraordinary benefit’ of the dollar, that is to say more international capital flowing into European investment and this at a lower financial cost.
At the same time, interest rates are in the end not determined by the amount of “loanable funds” available on global financial markets but are steered by monetary policy, in particular by central banks pushing down long term interest rates by purchasing sovereign bonds. For example, a study from the Bank for International Settlements concluded that without the ECB’s 1.8 trillion Pandemic Emergency Purchasing Programme (PEPP) and its substantial impact on lower interest rates on euro area government bonds, the pandemic would have made public debt become unsustainable. In other words, mobilising monetary policy in times of extraordinary challenges has been done before and can be done again.
In fact, when it comes to defence expenditure, things already seem to be moving at the ECB. For example, the ECB Governing Council, gathering on 16-17 April, was provided with an in-depth analysis of the fiscal and economic consequences of boosting military spending in Europe to counter the threat of Russian aggression. More recently, Christine Lagarde, in a 26th of May speech on how to strengthen the international role of the euro, was very clear on the fact that one precondition for the euro to be more widely used is rebuilding hard European security power in the form of robust military partnerships. However, if this type of unconventional monetary policy is to be mobilised to support the financing of European defence, what about the other existential threats Europe is facing?
Conclusion
Existential challenges, in combination with the shocking U-turn in US security and global trade policy, are a strong reminder of the fact that the Maastricht fiscal policy framework is not fit for duty. At the same time, the fiscal policy turnaround in Germany offers the opportunity to fundamentally review the European framework and widen the concept of sustainability itself. Targeting public debt rates that are stable over the medium term would free policy from the Maastricht fiscal straightjacket and deliver the fiscal headroom for a public investment shock that Europe urgently needs.