Germany’s Das Kapital Or The Lack Thereof


BoAML Research | The German government has not been overly active in investment expenditure over the last couple of decades. The average share of gross government investment spending in GDP stood at 2.1% in 2015 – private investment was worth roughly 18% of total GDP.

Unlike elsewhere in the euro area, net capex expenditure (taking into account capital stock depreciation) has consistently hovered around 0%. Consequently, the public capital stock in the economy has been roughly unchanged since the early 2000s. Although we have seen a timid pickup in German public sector investment in the past couple of years, the accumulated investment gap remains large. The 2014 KfW Kommunalpanel (a survey conducted among municipalities and cities) found that the cumulative shortfall of public investment amounted to as much as €112bn in 2014 (that is the shortfall of investment required in order to keep the public capital stock intact). This is equivalent to roughly 4% of total GDP or more than two years of public investment spending (although we cannot rule out that states overstate investment needs to increase pressure on the federal government to help with financing where possible). Savings from the declining interest burden could have been an opportunity.

The lack of government capex cannot be justified by the need for budget consolidation. The general government ran a 0.6% of GDP surplus in 2015 (0.3% in 2014). These surpluses are very close to Germany’s expenditure savings from falling debt- servicing costs. Prior to 2009, debt servicing was equivalent to 4.5% of outstanding debt on average, but has since fallen to just above 2%. This is equivalent to annual savings of €20-26bn, equivalent to 0.8% of GDP per year, lowering the aggregate debt- to-GDP level by cumulative 2.3pp between 2010 and 2015.

These hidden gains may be used for refugee-related expenditures (we have written about this in earlier research). However, as the ECB argued in its January Meeting Accounts, fiscal space freed up through lower yields from policy stimulus could have been used very effectively for public investment projects (rather than for consolidation purposes). A debt-financed stimulus can turn out self-financing Germans have a strong preference for structural orthodoxy and have shifted the focus to lowering the debt burden, not least due to looming demographic challenges. The current macro environment is conducive to achieving this aim: at current interest rate levels and absent major shocks, the German debt-to-GDP level looks likely to decline. A balanced or surplus budget could accelerate this trend, but even a deficit of around 0.6% of GDP would still leave the debt burden (in % of GDP) unchanged. The government is often criticised domestically for not reducing debt even faster and so it may not be surprising that the appetite for a fiscal investment push is very limited. However, shrugging off the idea of debt-financed stimulus on partially ideological grounds may mean that Germany is missing an economic opportunity, in our view, as debt-financed stimulus could ultimately be self-funding, and possibly even lower the debt burden in the longer term.

We assume real potential growth at 1.5% and inflation at 1.6%, in line with the Federal Finance Ministry’s own assumptions. We assume the average implied interest rate on existing debt remains stuck at 2% (roughly current levels), although given the renewed decline sovereign bond yields, this may be a very conservative assumption (by increasing the average maturity of any future debt issuance, Germany could lock in low debt servicing costs for even longer). In our baseline scenario, assuming completely neutral fiscal policy, the debt-to-GDP ratio would fall by 3.5ppt between 2016 and 2021.

In alternative scenarios, we assume a 1.3% fiscal impulse in 2017 and 0.7% in 2018. We allow for the fiscal multiplier (the effect of the stimulus on growth) to vary between 0 and 1.5, with front-loaded effect, and higher growth to lead to higher fiscal revenues (the aggregate tax burden is 39.6%). We equally allow for potential growth to respond to higher public investment – we let the elasticity vary between zero and 0.15, which we note is biased towards the conservative side of academic findings. Beneficial effects to potential growth, especially when combined with the potential of crowding in private investment, could be more important.

The framework is straightforward but comes with caveats. As such, we do not allow for any interest rate response to budget deficits or growth; an assumption that we can justify given current ECB policy. We also do not assume changes in inflation due to higher growth – an assumption that ties in with inflation behaviour in the past. This framework equally abstracts from potential Ricardian behaviour, ie, households adjusting current expenditure downwardly in anticipation of future tax hikes.

Despite these caveats and our rather conservative underlying assumptions, the results are clear: the closer the fiscal multiplier is to unity, the more self-financing the stimulus becomes. If potential growth gains are achieved through the stimulus, the positive effect on the debt burden (by that we mean a decline) becomes even more pronounced. The reported existence of a large investment gap should, if anything, increase the likelihood of favourable growth effects.

Public and private investment are complementary and correlated Public investment equally has the potential to crowd-in private investment, thereby amplifying the positive effects on cyclical and potential growth. If the past is any guide, higher public investment typically coincides with higher private investment (Chart 15). It is worth keeping in mind that so far, public-private-partnerships (PPPs) have been used to rather limited extent, only (some 200 PPP projects have been launched since 2002, but annual volumes peaked at €1.5bn on average in 2007/08, dropping to €990mn and €28mn in 2014/15, respectively). Private investment could, however, ultimately function as supplier of public investment.

Easily said, less easily done in a federal setup

Economically, an investment boost makes sense. Practically, it may be difficult to implement, and that not only due to national and European fiscal deficit and debt rules.

First, the German electorate seems to prioritise a balanced budget over an investment programme. A self-financing investment stimulus may be too alien a concept in that respect, and the government’s appetite for experiments ahead of the 2017 general election very limited.

Second, Germany’s federal system makes a top-down investment stimulus quite an administrative and legal undertaking. The system consists of three main administrative layers (federal, states and municipalities) with specific budget autonomy and responsibility. A lot of public investment is the responsibility of states and municipalities, rather than the federal government. Only one-third of public investment is typically conducted at federal level. Tighter financial conditions for states and municipalities (amplified by the fiscal rule requiring balanced budgets from 2020 onwards and less pronounced declines in financing costs than at federal level) mean that in the interest of budget consolidation, investment projects in particular were cut.

This setup makes a federal investment boost tricky. Administrative and legal hurdles are significant, and implementation delays and efficiency losses could be sizeable. Some states/municipalities may need federal help, while others do not, which makes a vertical transfer of fiscal means tricky. While a challenge, this is not an excuse. The federal tax/spending system is long overdue an overhaul, but as with so many structural reform needs, progress has been more than modest recently.

The draft budget reflects tentative but minimalistic moves in the right direction

We had some hope that the social democrats (SPD) – junior grand coalition partner at the moment – would push through higher investment spending. However, the latest federal draft budget plans for 2017-20 fall short of a meaningful impetus. Among the main innovations compared with previous planning is the increase in refugee support by €10bn in 2017. Social housing projects will benefit from additional €800mn in 2017, labour market and integration measures will increase by €1.1bn and defence budgets will be boosted by €1.7bn in 2017 (and by a total of €2.5bn by 2020). Investment spending will rise gradually from €29.4bn in 2015 to €35bn by 2019.

“New” 2017 expenditure amounts to roughly 0.5% of GDP and the balanced budget is a key feature of the plan (although the planned “broad expenditure cut” worth €6.7bn in the 2018 plan is probably an early signal for risks to the budget). The planned expansion of investment spending by almost €6bn may represent a 20% increase compared with previous spending, but will not close the existing investment gap at any meaningful pace. Even the opportunity for a self-financing investment boost may not be appealing to the government – political appetite clearly looks thin ahead of the 2017 general election. A sharp economic downturn could change that, but is neither our main, nor a much desirable scenario.

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The Corner
The Corner has a team of on-the-ground reporters in capital cities ranging from New York to Beijing. Their stories are edited by the teams at the Spanish magazine Consejeros (for members of companies’ boards of directors) and at the stock market news site Consenso Del Mercado (market consensus). They have worked in economics and communication for over 25 years.