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Germany’s Latest Fiscal Adjustment: A Success


For those of you who, like me, think of Germany as an example of what we don’t want the United States to become (think large welfare state, for one), here is a challenge. As my colleague Matt Mitchell reported a few weeks ago:

Germany’s unemployment rate is only 6.2 percent today. This is pretty remarkable given the severity of the recent recession, the slow growth of Germany’s trade partners (including the U.S.) and the unfolding fiscal crisis in the Eurozone.

The other challenge is that — while it’s a little hard for me to say it, being French and all — when it comes to fiscal adjustments, the Germans have been really impressive. In fact, they may be among the best in that area, along with Canada.

For instance, as Mitchell explains, their changes to labor-market laws ten years ago, and in particular to unemployment policies, could be at the core of the economic success mentioned above. One of the goals of that reform was to enable Germans to get “mini-jobs” without a large penalty and to make unemployment relatively uncomfortable so that people would look for jobs. These changes are both real and impressive — especially compared with equivalent European countries like France.

But there is much more to the German story. In fact, the labor-law reforms were only one part of a broader and ambitious fiscal adjustment. I mentioned last week an interesting new book by the IMF called Chipping Away at Our Debt, edited by Paulo Mauro. One chapter, written by economists Christina Breuer, Jan Gottschalk, and Anna Ivanova, is devoted to Germany and the four major fiscal adjustments the country adopted in the last 40 years. Let’s focus on the last one (2004–2007), which is particularly interesting since it was challenging, ambitious, successful, and probably responsible for Germany’s ability to sustain the financial crisis better than most countries. (The previous three — 1976–1979, 1982–1985, and 1992–1995 — are also worth looking at, if you have time and an interest in the topic.)

As is always the case, there were several challenges to the fiscal adjustment, including poor economic performance at the time and a continued struggle to absorb the costs of German reunification (for which the Germans didn’t ask any help from other EU countries, by the way). The reunification challenge was a really tough one that put massive costs on the table and was a real tax on an already rigid labor market (especially because of generous long-term unemployment benefits). As the authors explain:

The key obstacle was that absorbing relatively low skilled labor or labor with skills that are not easily transferred to non-manufacturing sectors meant that their relative wage had to decline, but this was hindered by generous unemployment benefits. However, lowering these benefits ran counter to a social consensus that preferred income equality; it also posed a question of fairness, because many unemployed had paid taxes and made contributions to unemployment insurance for decades.

In that context, the German reforms are even more impressive. Here were the main features:

  • A stimulus by reduction of income-tax rates. This reduction was part of a series of supply-side-oriented reforms implemented between 1999 to 2005 — including a wide-ranging overhaul of the income-tax system meant to boost potential growth that didn’t have much effect until 2004.
  • Significant structural reforms to tackle the rigidity in the labor market as well as demographic pressure on the pension system. These two were connected and perceived as a response to an aging population. These reforms included “an increase in the statutory retirement age, the elimination of early retirement clauses, and tighter rules for calculating imputed pension contributions.” The reform avoided an increase in social-security contribution rates.
  • Large expenditure cuts in the fringe benefits in public administration (no more Christmas-related extra payments!) and also serious reductions in subsidies for specific industries (residential construction, coal mining, and agriculture).

Another thing that the German consolidation did effectively, according to the authors, is that it responded quickly to unanticipated challenges arising from the reforms. For instance, the government responded to the higher-than-expected cost of labor-market reforms by raising the VAT rate, with part of the VAT collection going toward financing a reduction in the overall tax burden through a cut in unemployment contribution rates. (I personally don’t think it is a good idea to cut contribution rates, because it tends to lower the perceived cost of government.) The authors also explain that the fact that consolidation efforts took place in the wake of fundamental reforms of both the personal and the corporate income tax — involving rate reductions and a broadening of the tax base — probably worked to the reformers’ advantage.

In the “lessons learned” section, the authors attribute the success of this fiscal adjustment (unlike the previous one) in large part to the structural reforms. However, they also explain the important of political feasibility, which can take many forms. They conclude:

The experience of part consolidations illustrates that risks are substantial: economic conditions may weaken and conflicting objectives may appear. This suggests that, in designing adjustment plans, important elements to consider include a reasonable buffer in the event such risks materialize and an explanation of the extent to which economic downturns would be temporary accommodated; moreover, the plans’ successful implementation importantly depends on political commitment to persevere with and to reinforce economic reforms and consolidation into the medium-term.

In that context, it is interesting to know that in 2009 Germany adopted an amendment to its constitution to introduce a balanced-budget provision at both the federal and the Länder (state) levels. From 2016, it will be illegal for the federal government to run a deficit of more than 0.35 percent of GDP. From 2020, the federal states will not be allowed to run any deficit at all. The law, of course, allows for some exceptions in case of emergencies. It will be interesting to see if this rule sticks or is subjected to same level of disdain as the European rules have been in the last 15 years. However, since it’s Germany we are talking about, and the Germans are generally rule followers, it may well stick.

Now, does this mean that I think the United States should adopt the German model? No. (For one thing I think Germany’s government is much too big and still growing too fast). But I do think that lawmakers in the U.S. could learn from the reforms put in place in Germany, especially when it comes to structural changes to the labor market and the retirement system. Of course, it could be that the U.S. never went as far in growing that side of government as the Germans did, and didn’t have to go through a painful reunification, so it never had to implement such large reforms. Nonetheless, it is worth thinking about.


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