Economy & Business Financial Regulation Germany Macroeconomics


December 7, 2023

Germany’s debt brake isn’t working

By Hung Tran

Germany’s coalition government was dealt a fiscal crisis when the country’s Constitutional Court in Karlsruhe ruled on November 15 that repurposing €60 billion of unspent money from the pandemic emergency support facility to the Climate and Transformation Fund (CTF) was unconstitutional.

The pandemic emergency fund was set up in 2021 when the Merkel administration, with support from Parliament, invoked the emergency exception clause, allowing it to borrow well beyond the constitutional debt brake limits (of 0.35 percent of GDP). But the unspent money cannot be reallocated to unrelated government programs in another year, according to the ruling. This has forced the government to remove the €60 billion from the CTF, freezing payments from the fund which had been scheduled to spend €177 billion over the next three years to speed up Germany’s green transition. The ruling has also thrown into doubt commitments already made by the fund and blown a double-digit-billions hole in the 2024 draft budget. As Finance Minister Christian Lindner said in a moment of political understatement, “this judgment has potentially far reaching implications for government practice and the budgetary policy”.

More importantly, the budget crisis has further undermined the credibility of the ruling coalition and in particular the Free Democrats Party (FDP), which embraces the debt brake and sound fiscal policy. This comes at a bad moment for the government, already losing in the polls due mainly to immigration, energy policy, and inflation. Indeed, popular support for the government has fallen to 34 percent—or 18 percentage points less than in the 2021 federal elections—with the SPD scoring 16 percent, the Greens 12 percent and FDP 6 percent. By contrast, the opposition CDU/CSU received the highest support of 30 percent, followed by the far-right AfD at 22 percent. These developments will likely intensify bickering within the coalition government over budget priorities to close the fiscal gap, further weakening its ability to deal with the multi-faceted challenges facing Germany—which is also currently mired in a possible double-dip recession.

Beyond creating immediate problems for the German government, the fiscal crisis has brought to the fore two important issues with international relevance. The fiscal brake does not work and only further erodes trust in economic policymakers. And it subverts much-needed public discussion about fiscal realities in democracies around the world.

Legal constraints on fiscal deficits are not a silver bullet

In 2009, under Chancellor Angela Merkel, the debt brake was enshrined in Germany’s Basic Law (i.e. Constitution) as reflected in Article 109, paragraph three: “The budgets of the Federal and State governments shall, in principle, be balanced without revenue from credits.” However, the federal government is allowed to borrow up to 0.35 percent of GDP (on a net basis) and can be exempt from the debt brake all together if Parliament declares “an extraordinary emergency situation”—which it did for 2020, 2021, and 2022. The debt brake has been promoted as an effective way to restrain politicians from fiscal profligacy, putting unfair burden on future generations.

To opponents, the debt brake idea has been seen as unduly constraining government’s ability to deal with cyclical downturns or unexpected difficult developments. In fact, efforts to close the budget gap caused by the court ruling could make Germany’s fiscal policy pro-cyclical, exacerbating an already bad economic situation. Faced with economic difficulties but constrained by the debt brake, a government may have to let an adverse situation deteriorate (to its political disadvantage) or resort to creative accounting to meet budgetary demands dictated by circumstances. These efforts would further undermine trust in the government’s integrity and competence.

The debt brake is not evidence of fiscal discipline but more a reflection of voters’ lack of trust in elected officials’ ability to conduct responsible fiscal policies. And it does not provide a solution to budgetary challenges facing governments. As such, the debt brake is not a good framework for fiscal policy making. These lessons should be seriously considered when Euro Area members debate the restoration of the Stability and Growth Pact suspended in 2020 (which originally limits members’ budget deficits to 3 percent of GDP, and public debt to 60 percent, over time). And they should be top of mind when countries such as the United States are toying with a balanced budget constitutional amendment.

Budgetary priorities and commitments need to be debated and supported by the electorate

At present, governments around the world find themselves in a very serious fiscal situation. Coming out of the Covid-19 pandemic and with the war in Ukraine still going on, governments everywhere are running large budget deficits of more than 5 percent of GDP, with near record levels of public debt—of 112 percent in advanced economies and 68 percent in emerging market and developing countries (EMDCs). From such a weakened fiscal position, they are faced with urgent demands for government spending in many competing domestic areas—ranging from basic infrastructure, social and healthcare, education and training, investment in high-tech activities, as well as defense and national security due to geopolitical tension. In addition, all have to devote more resources to fund climate mitigation and transition projects.

According to the IMF, for the world to reach the goal of net zero carbon emission by 2050, low-carbon investments need to increase from $900 billion in 2020 to $5 trillion per year by 2030. In particular, emerging market and developing countries (EMDCs) need $2 trillion a year, a five-fold increase from 2020. While private sector investments will need to be mobilized by appropriate policies in both developed countries and EMDCs, governments will have to significantly increase their expenditures for climate mitigation and transition—acting as catalysts for private sector involvement.

Moreover developed countries will have to respond to growing calls by EMDCs for financial transfers to help them make progress toward net zero—as evident in COP28 in Dubai. It is becoming obvious that, given their fiscal constraints, developed countries will not be able to meet climate financing demands from EMDCs. Instead of engaging in wishful thinking—especially about unlocking private sector climate investment—it is much better for the world community to recognize the hash fiscal reality and brings their discussions about climate financing transfers down to realistic and implementable levels.

Generally speaking, to better deal with difficult challenges ahead, governments should present a coherent medium-term fiscal plan with clearly defined priorities and required resources—and engage in serious discussions with voters to get them to support the fiscal plan. That is the only way to mobilize necessary fiscal resources on a sustainable basis to meet all the important challenges facing many countries. A debt brake would make such discussions difficult if not impossible. Without social consensus behind a well-articulated medium-term fiscal plan, the risk is high that politicians will make promises, especially in election campaigns, which they will not be able to implement. This will set the stage for popular disappointment, disillusionment, and deeper distrust of governments—making the situation worse off than it already is.

Hung Tran is a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center, a former executive managing director at the Institute of International Finance and former deputy director at the International Monetary Fund.

At the intersection of economics, finance, and foreign policy, the GeoEconomics Center is a translation hub with the goal of helping shape a better global economic future.

Image: German Chancellor Olaf Scholz is flanked by Economy and Climate Minister Robert Habeck and Finance Minister Christian Lindner to comment on the ruling of Germany's Constitutional court that the government's re-location of 60 billion euros ($65 billion USD) of unused debt from the pandemic era to climate fund was illegal, in Berlin, Germany, November 15, 2023. REUTERS/Annegret Hilse