The potential large-scale implications of the German fiscal stimulus

Last week, Germany launched a massive fiscal stimulus package to revive its stagnant economy, including easing the constitutional debt brake and implementing a public investment plan totaling about 1 trillion euros.

Aside from the easy enthusiasms of some observers regarding a possible sudden shift in the fiscal paradigm at the EU level, the sharp turn in fiscal orientation by the Eurozone’s largest economy toward expansionary budgetary policies could indirectly benefit the rest of the euro area. It could take place through a spillover effect that would mitigate macroeconomic imbalances, which, however, will depend on the actual scope of the “defibrillator” stimulus on German economic activity that the fiscal package will eventually manage to secure, whether the measure is cyclical or structural, and the ability of peripheral trading partners, including Italy, to increase their competitiveness, thus export volume. However, this mainly depends on the ability to stimulate productivity through adequate public investment, given the already extremely low level of wages.

Last week, the German government ratified a significant economic stimulus plan that included amending the Constitution, i.e., loosening the constitutional debt brake that required the deficit to be contained to maintain a balanced budget. It also gave the federal states (Länder) the flexibility to make public spending outlays of up to a deficit ceiling of 0.35 percent of GDP annually. This albeit limited flexibility was previously at the sole discretion of the federal government, henceforth also granted at the regional level.

In addition, the plan included investments amounting to 500 billion euros, spread cumulatively over the next twelve years, in infrastructure, ecological transition, and modernization of productive capital. The German fiscal stimulus package is worth about 1 trillion euros in total. It is a turnaround in fiscal policy that starkly contrasts the traditional dogma of budgetary austerity and thrift, which has never been challenged in the country. However, the decisive turn in fiscal orientation in Germany was almost inevitable. Most observers praise it, given the persistent poor performance of the German economy, at least since the outbreak of the pandemic, opposite to the instead excellent performance of countries like Spain, Italy, Greece, and Cyprus, some of which have recorded as shown in the Figure below, the most significant declines in their public debt since the euro was introduced, right from 2020, not coincidentally during the period when the Stability and Growth Pact (SGP) was suspended to allow governments to support economic activity during the pandemic emergency.

In this regard, we could refer to the Covid crisis, with the Stability Pact suspended, as a natural experiment to compare national fiscal policies. All things being equal — without fiscal constraints — the frugal German model of debt restraint proved less effective than the countercyclical stimulus without self-imposed domestic constraints implemented by peripheral countries.

Even if this paradigm shift by the Eurozone’s leading economy does not result in an immediate, large-scale flexibilization of European fiscal rules, the extensive budgetary stimulus package launched by the future chancellor Friedrich Merz could indirectly influence the economies of other member states through mitigation of macroeconomic imbalances, i.e., the discrepancy between the trade surpluses accumulated by Germany and other frugal countries that have geared their growth model toward exports and, on the other hand, the current account and balance of payments deficits recorded by their trading partners in the Eurozone periphery, which apply less fiscal restraint.

However, this beneficial effect will depend on two factors: on the one hand, whether the expansionary fiscal package will deliver the hoped-for “defibrillator” effect on German economic activity, which has been stagnant since 2019, particularly in terms of domestic demand and productivity, considering that the package introduces relatively limited flexibility and spreads over 12 years the public investments, a long period during which unforeseen exogenous shocks could take place, given the continued volatility of the current international scenario. There could be changes in the monetary policy stance that could be relevant for growth, especially in the case of monetary tightening, i.e., in circumstances of possible rate hikes and/or cuts in the money supply to the financial system (quantitative tightening).

In light of this, we must assess whether the change in Germany’s fiscal stance will be cyclical or structural. The other factor that will determine if there is a positive spillover effect on other euro-area economies resulting from Germany’s adoption of expansionary fiscal policies regards the ability of countries such as Italy, Greece, Portugal, and Spain to increase their competitiveness, thus their export volume. It is possible to pursue the latter by cutting unit labor costs, either through wage compression — though it is challenging to go much lower since in Italy, wages have not grown for 30 years and have suffered the most extensive erosion in real terms, i.e., adjusted for inflation, among advanced countries since 2008 — or, more importantly, through productivity gains, which in large part depend on productive public investment.

However, I doubt — though I hope I am wrong — that the Germans will allow, at least in the immediate term, broad exemptions to the SGP fiscal constraints for other investments beyond defense spending.  The simultaneous implementation of budget policies with the same orientation — like in the case of consolidation/restrictive policies during the euro crisis, but it would be interesting to assess the issue in the case of expansionary policies like in this instance — could create problems of the fallacy of composition or coordination in a monetary union. Hence, the effectiveness of policies put in place by one member state diminishes if all other fiscal authorities follow the same strategy in the Union.

So, ultimately, it depends on the eventual introduction of a golden rule for investment within the SGP framework that would stop “tying the hands” of Eurozone governments in implementing investments with returns in terms of productivity, such as research and development, education, and healthcare. Many,  myself included, have invoked this rule since discussions on potential proposals to reform the euro-area governance during the Covid period. It could trigger a positive ripple effect for the entire Eurozone, potentially activated by the shift in Germany’s fiscal stance. Otherwise, this risks becoming yet another European zero-sum game.