The Economic Consequences of the Grand Coalition in Germany

Last week, the Grand Coalition made sure that their legacy in Germany’s economic policy stance will be far beyond the next election on September 27, 2008. After the Bundestag had already voted to amend the constitution and to include a sweeping ban on public borrowing a couple weeks ago, the Bundesrat (the part of parliament which represents the Länder) now also voted for including a more strict ban on public borrowing into the constitution.

Prior to this change, the German constitution had a simple rule: Outside times of “economic disequilibrium”, the government was not allowed to borrow more than it was spending on investment.

From now on, the rules are much strikter. According to the new rule in the constitution, the German federal level will only be allowed to have a structural deficit of 0.35 percent of GDP from 2016 onwards. The German Länder will not be allowed any structural deficit from 2020 onwards. Only in cases of “desasters outside the control of the government”, a deviation from this rule is allowed. (See for a previous critique http://www.euro-area.org/blog/?p=190)

This means that the German constitution now forces a very harsh austerity stance one Germany for the coming years. Most recent forecasts include a structural budget deficit for 2010 of 4 to 5 percent of GDP. If the government wants to bring this down into the range of constitutionality before the end of the transition period, it would have to start rebalancing its budget very soon. As most of this structural deficit is now at the federal level and has thus to be all but eliminated by 2016, one can expect an extremely tight fiscal policy over the coming years. In order to reach this target, a consolidation effort of almost 0.8 percent of GDP is needed each year from 2011 onwards. Should there be more need for stimulus in 2009 and 2010 than forecast so far, the necessary consolidation effort will grow accordingly.

While the constitutional rule might well prove to cause a lot of problems at the technical level of operating it (as it uses a HP-filter like procedure to estimate structural deficits which tend to be revised very strongly several years into the past), it is very likely that German politicians will try to stick to it before they change it again.

Moreover, changing this rule again will prove very hard: Even the grand coalition only got about 10 more votes in the Bundestag than it needed to change the constitution (such a change needs a two-third-majority both in the Bundestag and Bundesrat). In times of normal-sized coalitions, it will prove much harder to mobilize such a majority. Moreover, if the grand coalition continues after September 27 and the Social Democrats will lose as much as the polls predict, even the grand coalition will not be able to change the rules back again.

For the rest of EMU this means that after the crisis, Germany will consolidate its budget much earlier and much quicker than the rest of Europe. Consequently, domestic demand will remain weak in Germany. Thus, in the (hopefully) coming recovery, not much of a growth impulse can be expected from EMU’s largest economy.

This post has been co-posted at Eurozone Watch.