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Public Finances
16 June 2016
Public finances at a crossroads
Ludger Schuknecht notes that most Western governments have stopped pursuing policies of budget consolidation for the
time being. He rejects calls made by many for debt-fueled growth and sets out the reasons why sound public finances
are crucial.
Ludger Schuknecht, chief economist at the German Finance Ministry
Most Western governments have stopped pursuing policies of budget consolidation for the time being. This is confirmed
by the European Commission’s most recent forecast, and many leading Keynesian economists think it’s a good thing.
Most international organisations – if they aren’t calling for new spending programmes – are satisfied with this
development as well. Critics appear to be zeroing in on Germany in particular, urging the government to convert the last
smidgen of “fiscal space” into more short-term demand and long-term debt. Even though Germany has adopted an
expansionary fiscal policy to deal with refugee-related costs, raised investment levels, and increased social benefits, this
still isn’t enough according to experts like Joseph Stiglitz, some international organisations, and a good number of
prominent policy-makers in other parts of the world.
Critics too easily overlook the fact that there are important reasons for continuing to carry out policies that improve the
health of public finances. After all, demand requires confidence. Confidence isn’t likely to grow if moving to sound
public finances is put off until tomorrow – or if tomorrow is too soon, until kingdom come.
First of all, with some exceptions, most Western economies are in pretty decent shape and unemployment levels are low.
Europe’s economy is growing at an above-average rate, and the U.S. economy has been expanding for seven years in a
row. There is no convincing evidence of a global shortage in demand, or of a crisis that would call for global stimulus.
In Germany, indicators show that the economy is running at full or even excess capacity, so adopting new stimulus
programmes here makes no sense at all.
Second, the “fiscal space” – that is, the leeway for additional government spending – that so many people invoke simply
does not exist, neither in Germany nor in other countries. Rather, most advanced economies are facing the problem of
record debt levels that have surged since the global financial crisis. On average, eurozone countries have seen their debt
levels rise by almost half to over 90% of G D P. This figure is even higher in the G7 countries, where average general
government debt-to-GDP ratios stand at 120%. The debt ratio in the United States exceeds 100%, and is about 250% in
Japan. At the moment, debt ratios in most countries are no longer rising, but they are not going down much either,
because very little progress is being made in cutting budget deficits further.
Third, societies around the world – in Germany, in the United States, in Asia – are ageing at a rapid pace. So far, not
enough has been done to prepare for this development, either by reforming social benefit programmes, building up
financial reserves, or reducing debt. Germany too has a significant sustainability gap and must take care not to fall into
complacency. The measures our government adopted in recent years have caused social spending to rise again – the
curse of good deeds done during good economic times.
Fourth, how debt reduction affects a country’s economic performance depends very much on the quality of the fiscal
measures that are taken. For example, reducing government consumption fosters growth and confidence better than tax
hikes do. Here it is important to underscore the fact that government spending as a share of GDP is already extremely
high in most Western countries. In Europe, government spending accounts for just under 50% of GDP on average, with
markedly higher rates in France and Scandinavia. Germany’s government expenditure ratio stands at just under 45%.
East Asia presents a different picture: here, government expenditure makes up just 20-25% of GDP. Measures to lower
spending in the right improve efficiency and cut red tape, thereby boosting the incentives for employment and
investment while simultaneously reducing budget deficits.
There are other important arguments for pursuing policies of growth-friendly consolidation and debt reduction. Only
these types of policies can ensure that, during the next economic downturn or financial crisis, all countries have enough
fiscal leeway to avoid losing the confidence of markets and sliding into another sovereign debt crisis. Sound public
finances protect states from having to take emergency measures on an ad hoc basis, which often cut spending in the
wrong place, such as investment. They make it possible to carry out long-term strategies that leave enough room to
finance programmes and policies to master new challenges, such as the costs of the refugee crisis or the need for extra
spending on internal and external security. Strategies like this generate confidence that leads to higher rates of
consumption and investment. Economists refer to these developments as “non-Keynesian” effects that counteract the
negative impact that consolidation can have on demand.
And this brings us to the issue of the credibility of our politics and institutions. When economists claim that higher
spending can deliver a big boost to growth – which then allegedly makes it safe to put off budget consolidation because
such measures can pay for themselves – they are being naïve. Politics is never as perfect and manageable as economists
may think. Furthermore, such claims cause the general public to develop expectations that cannot be fulfilled:
expectations of predictable and equitable economic outcomes, higher incomes and security. In this way, we economists
lead policy-makers into a trap of wishful thinking rather than providing recommendations that show them how to make
the best of the world as it really is.
Naïveté and disregard also characterise the way in which some economists and policy-makers treat the Stability and
Growth Pact, even though this pact constitutes one of the most important institutional pillars of the Economic and
Monetary Union. The pact is intended to show governments where the limits to indebtedness lie. But repeated
exceptions and special circumstances give the impression that the rules can be applied with almost any outcome. It is
deeply regrettable that the European Commission has just decided to delay its decision regarding two countries that
have breached deficit limits. This would suggest that it might be better for an independent authority to implement the
Stability Pact in order to restore confidence and reinforce expectations for sound public finances.
Sound public finances are also crucial for not preventing the European Central Bank to exit from the unconventional
monetary policy it has adopted. Excess government debt means that if the ECB were to curtail its purchases of
government bonds or raise interest rates, this could trigger market turbulence and thereby hinder the bank in fulfilling
its mandate. Economists refer to this scenario as “fiscal dominance”, and it would cause great harm to Europe, both
economically and institutionally. Therefore, a lot is at stake. Public finances are truly at a crossroads.
This article first appeared on the Frankfurter Allgemeine Zeitung website
blogs.faz.net on 16 June 2016.
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