Debt brake may be one German export too many

As Berlin presses its eurozone partners to introduce tough German-style deficit rules, first cracks are emerging in the country’s own commitment to the “debt brake” law it holds up as a model for others.

Chancellor Angela Merkel is pushing other European countries to enshrine binding rules based on the German legislation in their constitutions as part of a new anti-crisis package meant to overcome the currency bloc’s debt crisis.

The German law forces the federal and state governments to virtually eliminate their structural budget deficits over the next five to 10 years. Already eurozone members such as France and Spain have expressed interest in pursuing similar steps.

The appeal is simple: national deficit limits that reinforced the EU’s discredited Stability and Growth Pact would show markets that leaders are serious about getting their finances in order and reduce the risk of future crises.

But economists who have studied the effectiveness of fiscal rules in shaping policy are sceptical about whether Germany’s debt-brake law can be successfully exported to other members of the currency bloc with no tradition of fiscal discipline.

Some worry that such a drive could even increase the risk of member states pursuing the kind of creative accounting that helped get the bloc into its current mess.

“I am far from sure that these rules would work,” said Alberto Alesina, an economist at Harvard University. “A government can put rules in place but experience shows that if they want to find a way around them and pursue a different policy, they will.”

Debt denial drama
Exhibit A is Germany itself.

Late last year, the Bundesbank and the government’s “wise men” panel of economic advisers, criticised Merkel’s coalition for violating the spirit of its own debt-brake law after Berlin refused to adjust its consolidation plans to take into account better-than-expected 2010 tax revenues.

Had it done so, its scope for new borrowing in the coming years would have been sharply reduced because 2010 is used as the base year for its goal of cutting the structural deficit to 0.35 percent of GDP by 2016.

Signs of backsliding are also evident in Germany’s most populous state, North Rhine-Westphalia, where a regional court is threatening to block plans by the minority government of Social Democrats (SPD) and Greens to sharply increase borrowing – in part to cover losses at regional Landesbank WestLB.

Under the state government’s plan, net new borrowing would surge to €7.8bn this year, compared to €4.1bn in 2009. That would cast doubt on NRW’s ability to meet its commmitments under the debt-brake law, which gives Germany’s regions until 2020 to slash their deficits to near zero.

“If the state government sticks to its stance I don’t think NRW will be able to achieve the limits set out in the law,” said Juergen von Hagen, an economics professor at Bonn University. “Then other German states will say, if the big guys don’t have to play by the rules why should we?”

Von Hagen believes a similar debt denial drama could play out in Europe if other countries follow Germany’s lead and introduce tough new fiscal rules in their national legislation.

He points to the example of the US, where many states have rules in place to limit public debt but have found ways around them by inventing new financial instruments that are not defined as debt.

“One of the dangers of rules like this is they create a lot of opacity in public finances. You run the risk of creating Enrons all over the place,” he said, referring to the Texas-based energy services group that collapsed in 2001 when its off-balance sheet accounting tricks came to light.

French resistance
Not all economists share this scepticism about extending Germany’s debt-brake law across Europe.

Charles Wyplosz, an expert on international economics at the Graduate Institute of International Studies in Geneva, has argued for years that EU-wide budget rules cannot work because they conflict with the sovereignty of the bloc’s member states.

He sees Germany’s 2009 law as a potential “game changer” precisely because it was self-inflicted rather than imposed by Brussels. But even Wyplosz admits that the political hurdles to extending it are formidable.

As a member of a special commission set up last year by President Sarkozy to study the introduction of a debt rule in France, he says it quickly became clear that opposition from lawmakers on the right and left would doom the plans.

In the end, the commission led by former IMF head Michel Camdessus came out with vague recommendations that Wyplosz refused to endorse.

“When the lawmakers in Sarkozy’s own party argued against it, then it was clear there was no majority and it wouldn’t go through,” he said.

That suggests France’s pledge to follow Germany’s lead and write new budget-balancing rules into its constitution should be taken with a grain of salt.

Hungary is another EU country whose commitment to fiscal discipline has fallen victim to shifts in the political tide.

In 2008, Budapest was hailed as a fiscal policy model for setting up an independent council to oversee budget planning and act as a counterweight to spend-thrift governments. Now that council has been stripped of its funding and staff by the new government of Prime Minister Viktor Orban.

Zsolt Darvas, a fellow at the Brussels-based Bruegel think tank, says the case of Hungary shows the risk of imposing fiscal rules in countries where there is no broad public consensus for economic rigour – the rules can vanish as quickly as they come.

He says the real lesson from the eurozone crisis is that markets have taken over as the guardians of fiscal rectitude in Europe by pushing up the borrowing costs of countries who fail to put their finances in order.

“Rules can be good, but markets have become a much more important disciplining factor,” he said.