Germany: A Fiscal Discipline Case Study

Germany is no stranger to economic malaise. Following reunification in 1990, the government poured billions into the eastern half of the country which had stagnated under communist rule. Support for infrastructure, industry and social spending in the East was aimed at bringing wages to parity with the much richer West. This spending, an equivalent deficit of 4.5% of West Germany’s GDP, set the stage for a long-running tension between investment and fiscal discipline.

Scarred by the deficit spending of prior decades and the financial crisis of 2008, the German political class worried about the country’s fiscal credibility. To combat this culture, Angela Merkel’s first cabinet enacted the ‘debt brake’ or Schuldenbremse into law. This fiscal rule was designed to restrict federal structural budget deficits – when day-to-day public spending exceeds tax income – to 0.35% of GDP and German states had to balance the books. This rule provided fiscal discipline at a time when many developed economies did the opposite. Between 2013 and 2019, Germany not only adhered to the rule but consistently achieved budget surpluses. As a result, German government bonds, also known as bunds, are widely regarded as one of the safest, most predictable assets in the Euro area. Markets have rewarded that discipline with lower yields, thereby reducing the country’s borrowing costs should it need to respond to a crisis. This is exemplified with bond spreads, which compares the relative yield (the cost of borrowing) between two bonds of equivalent maturity. A wider spread means investors demand a higher yield to hold one country’s debt over another. For example, the France-Germany spread reflects how much more France must pay compared with Germany, with higher French yields signalling that the market views bunds as the safer option. A major driver of this difference is Germany’s stronger record of fiscal discipline because of its debt brake.

While the debt brake helped lower national debt below 60% of GDP, strict spending limits have constrained infrastructure investment required to maintain German competitiveness. To keep spending within budget, critical infrastructure such as roads, bridges and rail have gone without maintenance. In a 2022 paper, the transport ministry identified 4,000 bridges in need of modernisation, labelled ‘Brösel-Brücken’ or crumble bridges, in the press. The rail network tells the same story: 36% of long-distance trains ran late in 2023, a result that sits badly with Germany’s reputation for reliability. On top of that, uneven digital infrastructure has left parts of the country with poor connectivity. These infrastructure problems have created additional costs for German businesses as they must contend with delays and inefficiencies, increasing production expenses and reducing overall competitiveness.

Germany’s infrastructure woes have been acutely felt recently as the country has tried to diversify away from Russian oil and gas. Until 2022, Russia supplied around 55% of Germany’s natural gas imports, which was used to heat homes, generate electricity and to power the country’s industrial base. The two countries’ energy interconnectivity, exemplified by the Nord Stream mega gas pipelines, came to an abrupt halt following Russia’s invasion of Ukraine. Almost overnight, Germany was forced to diversify its energy mix away from Russia, as it scrambled to secure alternative suppliers. The sudden transition pushed energy costs sharply higher, which particularly affected gas-intensive industries such as chemicals, metals, and manufacturing. Chemicals output has yet to recover from the shock as production fell by 12% and 9% in 2022 and 2023, respectively. Beyond industrial output, rising energy prices tend to dampen consumer demand as households forgo consumption in the face of higher heating and electricity bills.

Germany’s poor infrastructure, high energy costs, and rigid labour market are hitting its car makers the hardest. What was once the heart of the country’s industrial economy is now struggling to keep pace with China. A decade ago, China was considered a growth market for German car makers as they sold millions of high-margin combustion-engine vehicles to an emergent Chinese middle class. Now it is a different story. Warwick Business School notes that German market share in the Chinese market has dropped from 25% to 15% in just five years as domestic brands increasingly crowd them out. But the pressure is also being felt at home. Chinese rivals can build cheaper and faster, from production lines purpose-built for electric vehicles, backed by years of investment in battery technology. The shift is already reshaping Germany’s largest automaker. VW aims to halve its domestic production capacity and cut its workforce by 35,000 by 2030 as it cites “structurally lower sales in Europe and falling market share in China”.

The cumulative impact of these structural issues has pushed Germany to the bottom of the developed-world growth tables. The IMF estimates the economy has grown by just 0.1% since 2019, compared with 12% in the US and 4% across the Euro area. Chancellor Friedrich Merz has proposed a ‘fiscal bazooka’ in response which includes a €500bn infrastructure fund and increased defence spending, exempt from the debt brake, together worth around 11.6% of 2024 GDP. This aims to kickstart the economy and address the country’s maligned infrastructure.

Critics argue that new borrowing will drive up funding costs and eliminate the progress made to the fiscal credibility built under the debt brake, whereas proponents see this as Germany’s ‘whatever it takes’ moment, arguing that the rules were designed to provide headroom for this kind of additional spending. If bund spreads widen, the extra fiscal space created by loosening the rules could be eroded just as quickly as it appears. In many ways, one can strike similarities between the challenges faced after unification and the present-day situation.

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