A new fiscal strategy for Germany

By Lars P. Feld and Christian Lindner
Lars P. Feld, Professor of Economics at the University of Freiburg, is Director of the Walter Eucken Institute. Christian Lindner is Finance Minister of Germany.

The extraordinary shock of the ongoing COVID-19 pandemic and the impact of Russia’s war of aggression against Ukraine are reverberating throughout the German economy. Sharp increases in the prices of energy and raw materials, as well as continued and new disruptions to global supply chains, are postponing economic recovery. Consumer and producer prices are rising at their fastest rate in a half-century, while forecasts for GDP growth are being revised downward.

In addition to these shocks, Germany is facing major medium- and long-term challenges that could further dampen growth and contribute to higher inflation. For starters, productivity growth has fallen sharply since reunification in 1990 and has remained low since the 2008 global financial crisis. Higher productivity is key to longer-term economic growth, competitiveness, and price stability.

Moreover, demographic change in Germany will accelerate sharply, with the ratio of retirees to the working-age population set to rise markedly in the second half of this decade. This will put increasing pressures on social security systems and labor markets, where limited access to skilled workers, already a problem, will constrain the economy’s medium-term growth prospects.

Fragile supply chains

Future economic growth could also be markedly weaker if the necessary investments in decarbonization fail to materialize or Germany’s transition toward climate neutrality turns out to be excessively disruptive. Higher fossil-fuel costs due to carbon pricing are essential incentives for developing renewable energy sources, but these intentional relative price changes risk driving up the overall price level.

Finally, Germany’s export-oriented economy is particularly dependent on the functioning and resilience of international supply chains, which since 2020 have proven to be fragile and vulnerable to persistent disruptions. Economic growth could be slower and inflation higher if a partial reversal or reorganization of global trade means that Germany cannot rely on the benefits of the international division of labor as it did in the past

Against this backdrop, Germany requires an efficient, forward-looking, and proactive fiscal policy that boosts sustainable growth through supply-side measures without further stoking inflation, and thus counteracts current stagflation risks. At the same time, fiscal policy must take account of today’s global geostrategic challenges and strengthen the private-sector forces required for economic modernization, digitization, and carbon-neutral transformation.

These principles are reflected in the new fiscal strategy we recently presented at the Federal Ministry of Finance. The strategy rests on three pillars, and seeks to achieve a carefully calibrated balance between tackling the current crisis and preventing the build-up of further inflationary pressures.

Emergency measures for specific target groups

The first pillar is a powerful and resolute response to exceptional events like the ongoing war in Ukraine. To this end, the government has already implemented two relief packages for households and firms that are suffering from the sharp increase in energy prices, including swift one-off payments to vulnerable households. It is also protecting hard-hit companies. To avoid creating additional inflationary pressures, these shock-absorbing measures are designed to be limited, temporary, and targeted. For example, the support for companies is front-loaded to ensure that hard-hit but otherwise profitable businesses will survive the crisis

The government is able to respond in this way thanks to the fiscal buffers built up before the pandemic. Prudence in good times meant that we had sufficient financial reserves to boost the economy’s resilience in response to COVID-19 and now the war in Ukraine.

The second pillar of our fiscal strategy aims to initiate self-sustaining economic growth by unleashing the allocative and productive forces of the market. Supply-side policies are therefore an integral part of our efforts to mitigate stagflation risks

The strategy envisages the fiscal mobilization of private-sector investment without squeezing the economy further into inflationary bottlenecks. This entails providing attractive incentives for companies and high-skilled individuals as well as improving financing opportunities for promising risk-taking enterprises.

Role model energy transition

More generally, we must strengthen Germany’s position as a good place to do business. That will require a more innovation-friendly environment, with a competitive tax system, modernized public administration, and fast-tracked procedures. The speed with which Germany is now building liquefied natural gas terminals and accelerating the energy-sector transition shows what can be done. We urgently need to undertake similar initiatives in other sectors.

The third pillar of our strategy emphasizes fiscal resilience and thus debt sustainability. It is reflected in the government’s commitment to return as early as next year to Germany’s constitutional “debt brake” (a balanced-budget rule that limits the state’s ability to borrow). Exiting fiscal expansion and returning to a neutral stance will also contribute to the fight against inflation.

Returning to structurally balanced budgets will safeguard the sustainability of public finances, preserve investor confidence, and maintain public trust in the government. The coalition government will need all three to secure funding for its modernization projects.

At a time of heightened inflation expectations, fiscal resilience and higher productivity growth are complementary goals. Both will help to moderate inflation and boost the German economy.

In cooperation with Project Syndicate.

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