Insight
How the ECB should respond to a German fiscal boost by Christian Odendahl 26 September 2017
A German stimulus has the potential to help the eurozone economy. But how the ECB reacts is key. There will be difficult coalition talks ahead for Angela Merkel and her party, after Sunday’s election. A ‘Jamaica’ coalition of the conservative CDU/CSU, the Greens, and the pro-business Free Democrats (FDP), named after the parties’ colours, emerged quickly as the most likely. And that government will be under pressure to invest more. A large majority of German voters, even right-leaning voters, favour higher public investment over tax cuts and debt repayments (see Chart 1). Also outside Germany, many would like Germany to spend and invest more to boost Europe’s economy. But to what extent would a German fiscal expansion help the rest of the eurozone, now that it is recovering? Start with how big a German fiscal expansion will be. Berlin’s fiscal policy is constrained by a constitutional ‘debt brake’, which restricts the federal public deficit to less than 0.35 per cent of GDP and those of the Länder (the German states) to zero. Both thresholds are applied after accounting for the ups and downs of the business cycle. As a result, the debt brake is supposed to mandate neutral fiscal policy throughout the cycle: deficits in recessions, surpluses when growth is strong. But even with the debt brake mechanism in place, German fiscal policy is gradually becoming more expansionary. Start with how big a German fiscal expansion will be. Berlin’s fiscal policy is constrained by a constitutional ‘debt brake’, which restricts the federal public deficit to less than 0.35 per cent. First, in order to apply the debt brake, policymakers need to know at what stage the economy is in the business cycle, and how that affects government revenue and spending. This calculation is prone to error and later revisions. The International Monetary Fund (IMF) thought the German economy was running at close to full capacity as far back as 2014 (see Chart 2). But the German economy continued to grow (red line), unemployment fell further (green line), while inflation fell to close to zero (purple line). In short, Germany’s economic potential was larger than economists thought at the time, which gave the treasury additional leeway to spend in subsequent years. CER INSIGHT: How the ECB should respond to a German fiscal boost 26 SEPTEMBER 2017
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