The Debt Brake - Germany’s dumbest idea?

Germany's government recently collapsed over a radical economic rule, the debt brake, which states that essentially Germany's government should on average, never spend more than it earns. This is extremely unusual. No other major government in the world has limited itself in such a way.

In fact, most economists around the world think limiting yourself in such a way is a ridiculously bad idea. So then why do most German economists still support the debt brake? Are they right to think that it protects the country from a disastrous debt crisis?

Or did it actually lead to years of under-investment in crucial infrastructure for ruining the German economy for future generations? To answer these questions, I've immersed myself in the German public debate, both from when the debt brake was introduced and from right now when even Chancellor Angela Merkel, who introduced it, has no criticized it for being too strict. Essentially, I found that the main disagreements are about two things.

The first is about whether or not Germany's debt brake is too strict, where it remarkably now most German economists have come to believe that it is too strict, even if that is just by a small margin. The second disagreement is about whether or not you even need a rule, like the debt brake that limits how much the government can borrow, or whether the democratic process can help control debt on its own. But to truly understand these two disagreements, we first need to briefly get into why Germany introduced the debt brake in the first place.

Officially, the debt brake story begins in 2009, in the aftermath of the global financial crisis. To save the economy, Germany's broke banks and needed a bailout. This caused German government debt to skyrocket after it had already risen for years.

The public was afraid of this ever increasing debt. Therefore, Chancellor Angela Merkel felt that to assure the German public government that would be brought back under control, Germany needed a new rule: the debt brake. After codifying this rule into the constitution, Germany's federal government can on average only borrow 0.

35% of its GDP each year. But given that this is an average, the rule is actually less rigid than it seems for two reasons. First, the rule stipulates that if the German economy is in a downturn, the government can borrow more to stimulate the economy.

However, if it does occur, the debt brake requires that the increased debt will need to be repaid later. The second reason that the debt brake is less strict than you might think is that it contains an escape clause for emergencies. This clause, which allows the German parliament to suspend the debt, brake if there is a natural disaster or other extraordinary emergency that requires extra spending.

This can explain why Germany spent quite a lot more than it earned in 2020, up to 2023. Not surprisingly, in these years, the debt shot up after all the pandemic in 2020 was clearly an extraordinary emergency. And after that, the Russian gas crisis was again clearly an extraordinary emergency.

However, underinvestment in the energy transition and in keeping industry competitive with China, was that an extraordinary emergency? No. At least not according to the German Federal Court, which blocked moving pandemic era funds to a so-called climate and transformation fund.

And while it initially seemed that the German government found creative ways to make the next government budget work, despite the court ruling the need to invest in times of sky high energy prices, and when all of Germany's geopolitical rivals are investing heavily in their industries. Ultimately it was not compatible with a debt brake rule, causing the German coalition to collapse. This is where we are now.

It's not very controversial to say that Germany's infrastructure is terrible. Almost everyone agrees that the German economic model needs to be reformed, and almost everyone agrees that reforming all of that is not cheap. So then why is reforming Germany's debt brake so controversial?

Well, as I see it, there are two fundamental disagreements about Germany's debt brake. One disagreement is about whether or not Germany's debt brake is actually too strict. But before getting to that, we first need to talk about the most fundamental disagreement, which is about the question.

Do countries need a rule that limits how much politicians can borrow? Of course they do. Say ultra conservative economists like Romina Boccia from the libertarian think tank the Cato Institute in a recent op ed.

She even said that the United States illustrates the peril of allowing short term political priorities to undermine long term fiscal sustainability without a debt brake or similar fiscal rule. US politicians have repeatedly deferred hard choices about tax and spending policy. To me, the essence of this argument is that if left to their own devices, politicians will always get into more and more debt.

After all, many politicians only care about the next election in four years. However, on average, government debt only comes due in ten years. So of course, politicians will borrow to give goodies and benefits to their voters that the country cannot afford.

I can actually see the logic in this argument. I can also see that in countries where voters are extremely divided. Such a dynamic can take hold, for example in Lebanon and Sri Lanka.

Economists have been warning that the debt built up was unsustainable for a long time. But in highly divided, imperfect democracies, economic research has shown that rather than providing good governance, politicians are often more successful, just bribing voters. In the case of Lebanon and Sri Lanka with borrowed money.

On top of that, if we compare the debt to victory of Germany to other mature democracies like France and the United States, we can indeed see that after the introduction of the debt brake, Germany's debt started falling while that of other countries continued to climb. However, now have a look at this graph, which compares Germany's government debt to some of its northern neighbors that also have a reputation to be conservative about government debt. As you can see here in these countries that clearly increased and decreased pretty much like in Germany, but without a debt brake.

Similarly, if we take a long historical perspective, we can see that even in countries like the US and France, they have had much higher debts than they have today. And they were also able to bring down these down without a debt break. So I think it's pretty clear that advanced democracies do not need a debt brake to decrease government debt.

That being said, given the government spending really did decrease after German politicians committed to it in 2009. I do think that that brake worked for Germany in reducing the debt. However, this could have come at the cost of gross underinvestment because if you reason that getting into debt to buy votes works because the political cost only comes later, you could also reason that cutting government spending on crucial investments like infrastructure works the same way.

After all, a politician that does this can look really responsible and get votes. But when the time comes that the bridge starts collapsing and trains stop driving, the politician that cut funds to infrastructure ten years ago has already left office. This brings us to the second disagreement, which is about the following question is Germany's debt brake so strict that it is actually bad for the economy?

The two most often heard arguments about why some government debt is good are that number one, government debt plays a crucial role in how our monetary system works. That is, what is debt from the perspective of the government, is an asset from the perspective of its citizens. In fact, government debt is the safest investment there is for institutions that needs stability, such as pension funds, banks and central banks.

Indeed, what is often misunderstood about government debt is that, especially in a democratic nation, the people essentially own the government and therefore, as people say, they are liable for its debt. But they also own almost all of this government debt, either directly or via their bank and or pension fund. So if people say that government debt is a burden on future generations, they forget that if the debt remains high, future generations will indeed inherit the burden of this debt, but also come to hold that debt as an asset as they inherit it from older generations.

The second crucial argument about why some government borrowing is needed is that to grow an economy, governments continuously need to invest in things such as education and infrastructure. If the economy grows, they can collect more taxes. This means that a government can borrow more each year, but if it borrows to invest wisely in a growing economy, its debt load compared to the size of the economy could remain the same or even decrease.

If you look at Germany's debt break through this lens, it looks overly harsh. That is, few people would be willing to invest in a firm that tells its investors that it would never spend more than it earns. Similarly, even relatively conservative economists agree that a government should be allowed to borrow as long as it borrows to grow the economy.

This brings us to the concept of the so-called Golden Rule, which states that the government is only allowed to borrow to finance investments that are needed to grow the economy. But if it wants to redistribute more money, it needs to do so by raising taxes. If the debt brake was turned into a golden rule, Germany's government could borrow to repair its crumbling infrastructure.

It could borrow to fix its broken energy sector, and it could potentially even borrow to modernize its industry to remain competitive with China and the US. However, if its politicians wanted to bribe voters by giving them subsidies and handouts, then they'd still need to raise taxes to do that. The golden rule is unlikely to satisfy ultra conservative economists like Romina Boccia from the Cato Institute, who wrote that infrastructure assets are often better managed by the private sector and state and local governments.

However, there are now clear signs that the political tide in Germany is shifting in favor of reforming the debt brake. Indeed, even Angela Merkel, whose party is expected to win the upcoming elections, has said that while the idea behind the debt brake remains correct, it must be reformed to allow higher debt for future investments. And I absolutely agree with her.

In fact, even as an individual, I do borrow money from time to time, never to buy luxury items or to go out, of course. But I have borrowed in the past to finance my studies and to buy a house. These investments have helped me to grow my income more than my debt burden.

These investments were a no brainer. Similarly, whatever your stance on using debt rules, I think it is really a no brainer that Germany needs to be able to borrow, to invest, to continue to grow its economy. But of course, for a massive country, that is easier said than done, how much should be borrowed and what should be invested in to avoid a debt crunch?

Answering these questions is beyond the scope of this video, but if you want to get into more depth about how countries should avoid a debt crunch, I highly recommend checking out this article about how Trump, Starmer and Macron can avoid a debt crunch from the sponsor of this video. The Economist then I suggest you follow up by this article about how Elon Musk can best cut government expenditures for the US. And then finally, this one about why Germany cannot afford to wait to relax its debt brake.

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