Germany versus the Commission: A “lose-lose” situation

Germany versus the Commission: A “lose-lose” situation

The Commission and Germany are embroiled in an unpleasant controversy over plans to send Germany an ‘early warning’ that the country is getting too close to the 3 % limit on public sector deficits. This fight can only produce losers: if Germany ‘wins’, the Stability Pact will effectively be dead; and if the Commission wins, the German government will have egg all over its face. Any victory by Germany would anyway be Phyrric, because it would mean that Germany would have a licence to pursue a fiscal policy that is not in the long-term interest of the country.

As with any controversy, it is useful to start with the facts. The starting point must be that the deficit of Germany was 2.6% of GDP last year and is forecast to remain around 2.7% during 2002. This is perilously close to the 3% limit so that an early warning seems entirely appropriate. But in the interpretation of these simple numbers two key aspects tend to be overlooked: I) the German complaint that its problems stem from an external shock is contradicted by the facts. II) While the abrupt slowdown was the major cause of the increase of the German deficit during 2001, the underlying cause of the current difficulties is that, contrary to the precepts of the Stability Pact, Germany let its structural deficit deteriorate to the point where it was in danger of hitting quickly the 3% limit.

I) The German government claims that it cannot be held responsible for the abrupt slowdown during 2001 because it was due to a global negative shock. Unfortunately this argument does not stand up to the facts. Between the years 2000 and 2001 real growth fell from 3.0 to 0.6%. None of this was due to a fall in net exports. The fall in growth was entirely due to domestic factors: a collapse of investment and a negative contribution from stock building. A comparison between Germany and its European partners reveals the same picture: Germany lags its partners, not because it is more exposed to the global economy, but because its enterprises stopped investing during 2001. Could one argue that German investment was more affected by the global slowdown? It is difficult to see why this should be the case. Growth and investment held up much better in other member countries which are even more exposed to globalisation, such as for example Holland or Belgium.

II) Even if the sharp slowdown in Germany was mainly home grown, could one not argue that the deficit increased only due to the working of the automatic stabilisers? When growth stops enterprises and households pay less taxes so that the deficit increases even in the absence of any specific measures. It is true that most of the deterioration of the deficit during 2001 was due to the working of the automatic stabilisers, but this brought Germany so perilously close to the 3% limit because its structural deficit was not brought under control. There are many ways to calculate a structural deficit. The Commission, the OECD and the IMF all produce numbers based on very sophisticated techniques, but there is also a very simple approach, which has the advantage of being transparent. One just uses the rule of thumb that every point less growth leads automatically to an increase in the deficit of a bit less than 0.5% of GDP. If one combines this rule of thumb with the known estimates of potential growth for Germany one can easily calculate the deficit Germany should have if it had obeyed the Stability Pact of aiming at ‘approximate balance’ over the cycle. There is little dispute that the potential growth rate for Germany is between 2.25 and 2.5. Taking 2.4 as a reasonable upper limit one can easily see that in 2000, when growth hit 3 %, Germany should have had a small surplus (equal to 0.3% of GDP; 0.5*(3-2.4)). As the actual deficit (after taking out the UMTS licence special income) was then 1.2% of GDP, German y had already then a structural deficit of around 1.5% of GDP. As the table below shows the structural deficit actually deteriorated during 2001. The underlying cause of the problem is thus that Germany violated the key precept of the Stability Pact, namely to bring its structural deficit under control.

Given this deterioration of its structural and actual deficit there can be no doubt that the Commission is entirely justified to remind Germany publicly of the rules of the Stability Pact. The Commission could also not accept that Germany is the first and only country to present a stability programme which does not foresee within its time horizon a return to the goal of a structurally balanced budget.

Until recently it seemed that the German government would take the EU reminder in a constructive way. It could be used by the Finance Minister Eichel as a shield against the opposition’s demands of moving the tax reform forward. The warning to Germany would then have had no effect in the election campaign, as basically the warning could be interpreted to be addressed to both sides. The intervention by the German Chancellor has upped the ante and has produced a situation in which both sides can only lose.

What needs to be done now in Germany is quite clear: the warning from the EU should not be opposed. On the contrary, it should be taken seriously as a signal that structural reforms are needed also in public finances.

The Maastricht Treaty was signed in February 1992. There is now a concrete danger that one of its central planks is destroyed on its tenth anniversary at the hands of the country which contributed so much to shaping the Treaty in the first place.

By Daniel Gros, Director CEPS.

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