Thursday, June 24, 2010

In Defense of German Austerity

The following is a letter from the German Finance Minister published in the Financial Times.

Consider the raft of stimulating measures the German government adopted in late 2008 and early 2009 to stabilise the economy and mitigate the impact of the financial crisis on other sectors; not to mention our automatic stabilisers, which acted to the full, cushioning the labour market and domestic demand from the steep downturn. Some of those who are pointing fingers at Germany on Thursday hail from countries where such built-in mechanisms to tackle economic slowdowns are much weaker.

As we acted, we saw our budget turn from a nearly balanced position to a deficit of 5 per cent of gross domestic product. Just as it would be dangerous to remove such support abruptly, governments should not become addicted to borrowing as a quick fix to stimulate demand. Deficit spending cannot become a permanent state of affairs. We need carefully considered exit strategies.

Germany has such a strategy. We will launch it next year (unlike most of its European peers, Germany still has an expansionary budget in 2010) with saving measures representing less than 0.5 per cent of GDP.

These steps are not only moderate in scale, but they are also economically sensible because they will increase incentives for the jobless to find work, reduce subsidies and trim the civil service. This controlled and measured approach to reducing our deficit is hardly what one would call “slamming on the brakes”. Indeed, one of its objectives is to strengthen our growth potential. Our course could be described as one of “expansionary fiscal consolidation”.

Behind the calls for us to pursue a more expansionary fiscal course lie two different approaches to economic policymaking on each side of the Atlantic. While US policymakers like to focus on short-term corrective measures, we take the longer view and are, therefore, more preoccupied with the implications of excessive deficits and the dangers of high inflation.

So are German consumers. This aversion to deficits and inflationary fears, which have their roots in German history in the past century, may appear peculiar to our American friends, whose economic culture is, in part, shaped by deflationary episodes. Yet these fears are among the most potent factors of consumption and saving rates in our country. Seeking to engineer more domestic demand by raising government borrowing even further would, here at least, be counterproductive. On the contrary, restoring confidence in our ability to cut the deficit is a prerequisite for balanced and sustainable growth.

Demography is another reason why we must work harder at reducing deficits in the medium term than many others. Not only are Germans getting older, but our population is also shrinking year after year. This will make it harder for future generations to service our debts and, in time, will reduce our growth potential to about 1.5 per cent a year. Whereas the US, with its more vital demographic trends, can hope to “grow” its way out of its public debt, this is not an avenue that is open to us.

Although we have no alternative to consolidating, we can do it in an intelligent way that will foster growth in the long term. One way to do this is by focusing our efforts on the expenditure side rather than increasing taxes. Meanwhile, we plan to maintain or even increase public investments in education and research.

The German government knows it has a responsibility to promote growth in Europe and the world. We will rise to it not by piling up public debt but by fulfilling our traditional role as an anchor of stability. The “debt brake” – a sophisticated set of fiscal rules now enshrined in our constitution – will provide the framework for our exit from the emergency fiscal measures adopted to combat the economic fallout of the financial crisis.

Far from being a straitjacket, the “brake” provides flexible rules that give governments fiscal leeway in cyclically hard times and encourage consolidation in good times. While it will force us to reduce our structural federal deficit to 0.35 per cent of GDP by 2016, it will not prevent the deployment of automatic stabilisers in case of a renewed economic slowdown.

We will abide by the rules of the “debt brake” and by its European equivalent, the stability and growth pact, not for prestige reasons, not just because we are legally bound to, nor, as has been comically suggested, out of masochism, but because it is the best way to inspire confidence in our citizens and investors that the state can cope with the current situation.

Without this confidence there can be no durable growth. This is the lesson of the recent crisis. This is what financial markets, in their unambiguous reaction to excessive budget deficits, are telling us and our partners in Europe and elsewhere.

I disagree, but I thought his point was incredibly well articulated.