19 December 2023

The Economic Distortions of the Federal Constitutional Court’s Debt Brake Decision

Germany is not facing a debt crisis, but rather a serious budget crisis triggered by the ‘debt brake’ ruling of the Federal Constitutional Court (FCC). This crisis is deeper than the 60 billion in unused “Corona debts” being shifted to a climate fund, as reported in the media. More fundamentally, the court has mandated that the federal budget strictly adhere to the “principle of annuality” (Jährlichkeit). This is the most significant impact of the court’s ruling, and from an economic perspective, it is quite perplexing.

Let us illustrate this with a hypothetical scenario. Imagine a natural disaster, such as a flood, occurring in early December 2024. The emergency clause of the debt brake (Art. 115 GG) could apply, as the event is exogenous, unexpected, and beyond government control. Assume the flood causes overall damage (to buildings, infrastructure, local businesses) worth 50 billion euros. This event is “significant” and cannot be covered by petty cash.

So, let us pull the debt brake emergency clause, designed for such situations. Economically, the ideal response would be to set up a special emergency fund after estimating the total damage (50 billion euros in this case). A plan for the outflow of funds would be drawn up, as the outflow of funds will obviously take some time. Some of these funds might go to cash handouts to local business owners and those most affected. If all goes well, these “helicopter drops” could be delivered immediately before the end of 2024. However, this is where the problem begins. Repairs to homes, infrastructure, etc., will undoubtedly take much longer. More generally, targeted investment requires planning and implementation, meaning money will necessarily flow in the years t+1, t+2, t+3, e.g., after the disaster event.

Under the old rules before the court ruling, this was not a problem. The government would ask parliament for credit authorizations worth 50 billion €, get approval, and park them into the special fund. Notice that no debt is actually issued at that point, but the government had filled up a reserve fund for future outflows. In normal times, this would not be possible, as the credit authorization of 50 billion euros would be outside the range allowed by the debt brake. But since the emergency was invoked in 2024, there are no such limits, hence the manoeuvre goes through. Under the old rules, the outflows in 2025, 2026, and so on, are not counted for debt brake limits. Economically, this makes sense, as 2024 was the emergency year, though the shock and the spending to resolve it naturally propagate to later years.

However, the FCC ruling changes everything, essentially stating that this can no longer be done! An emergency fund cannot be filled up with “debt brake neutral” outflows in the future. Instead, in 2024, the Bundestag can only decide on the budget for the fiscal year 2024, but nothing more.

What does this mean for our flooding example? When the emergency is invoked in December 2024, assume you spend 10 billion euros right away on money handouts, while the remaining 40 billion euros should ideally go to repairs/investment in equal portions of 10 billion euros over the next four years. Under the new rules after the court’s decision, the emergency must be reconsidered and reinstated in every consecutive year. In 2025, you would have to remind yourself of the flood, the initial damage estimate, and then release the 10 billion euros needed to address it. The same applies in 2026, 2027, 2028.

Now, imagine the discussions we will have each year from 2025-28: “Hold on, the emergency was in 2024! There is no emergency anymore” (this point is perhaps not made directly in 2025, but certainly by 2028). “Anyway, it’s just 10 billion! It’s not significant in an overall federal budget of 450 billion. We have to cover it by cutting something else” (subtext: preferably social spending).

Declaring a retrospective emergency is a daunting task in a world of inconsistent, short-sighted individuals when memory of the initial emergency fades away. You can see where my argument is heading. The new rules set by the court will lead to:

  1. Frontloading/Consumptive bias: in future emergencies, the government will resort to distributing cash handouts as quickly as possible, avoiding long-term investments and all the associated problems.
  2. Built-in austerity: The later parts of the overall damage caused by the disaster, the 50 billion euros, are forgotten or refinanced by cuts.

And now imagine a world with multiple crises occurring in a short time period, with several emergency funds of varying sizes and maturities, and numerous decisions of “budget extensions” (debt issuance not counted under the debt brake) to be made each year. The tragedy is, none of this would be necessary, because the old set of rules was economically appropriate.

Of course, you could argue that it could lead to reckless government behavior. Why just park 50 billion euros? Why not 100 billion euros just in case? But that argument does not hold water. For every emergency, the government would have to provide a compelling calculation for the size of the emergency fund, and the opposition could always challenge that in court. Besides, the old rules were also superior from a commitment perspective. The emergency fund had a supplementary expenditure plan, which informed investors how much would be spent on what and in which year. Of course, none of that was set in stone. Future governments could change it, but at least there was some level of commitment.

Under the new rules, there is a lot of uncertainty. Will the Bundestag approve the “Ahrtal emergency” in 2024? Will it do so in 2025? Will it invoke a budget extension to finance it, or will they try to cut other types of expenditure? What if the political climate changes? There is much weaker credibility, just uncertainty everywhere, and it’s all self-inflicted with no economic rationale behind it.

I am not angry at the court. Judges are not obliged to think like economists. Their mandate is to interpret the Constitution, and they have done their job (perhaps without fully understanding the implications). The bigger picture is: we cannot continue to execute fiscal policy like this. The political response to the court ruling was severe budget cuts, mainly on investment in the Climate and Transformation Fund (KTF). Economically, there is no justification for this. Germany has ample fiscal space, no debt sustainability issues whatsoever, but a massive under-investment problem which will only worsen now.

Economically, we need very different fiscal policies from those that are currently being implemented, but the debt brake and the new rules imposed by the FCC (which kill flexibility and commitment) make this essentially impossible. The only solution is to reform the debt brake, to allow more investment and to find ways where politicians decide on economic policy, not lawyers. Various concrete proposals are on the table, but I won’t delve into them here. However, all of them require changing the constitution.

Will that happen? Will the CDU/CSU join for a 2/3 majority? If they do, will the FDP play along, or will they leave the government because defending the debt brake is essentially all they have got? Regardless of whether and which of these scenarios occurs: The arguments for a reform of the debt brake are stronger than ever after the decision of Germany’s Federal Constitutional Court.

SUGGESTED CITATION  Südekum, Jens: The Economic Distortions of the Federal Constitutional Court’s Debt Brake Decision, VerfBlog, 2023/12/19, https://verfassungsblog.de/the-economic-distortions-of-the-federal-constitutional-courts-debt-brake-decision/, DOI: 10.59704/e6c66c41faa8da89.

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