Germany’s New Multi-party Government to Raise Investment but Maintain Fiscal Discipline

Without such reform, the government will find it difficult to fill a large public sector investment gap, which we estimate of around EUR 410bn, and maintain the long-run growth potential of Europe’s biggest economy.

Germany’s new government will place a stronger emphasis on increasing public and private sector investment to boost growth and meet environmental targets. Much rides on close collaboration between ministries controlled by the two smaller coalition partners, as well as the federal states, which have significant budgetary responsibilities.

Exploiting the available flexibility in fiscal spending rules is unlikely to be enough

Led by chancellor-in-waiting Olaf Scholz (Social Democratic Party, SPD), the coalition parties have agreed that Christian Lindner (Free Democratic Party, FDP) will be finance minister, with Robert Habeck (Greens) in charge of a new super-ministry responsible for economic affairs, energy and climate change. A new ministry for construction is also planned with a goal of increasing the housing stock 400,000 units per year.

Close collaboration between Lindner’s and Habeck’s ministries will prove crucial given the coalition’s commitment to fiscal discipline. However, to finance priorities outlined in the draft coalition agreement, exploiting the available flexibility in fiscal spending is unlikely to be enough.

Germany’s debt brake, which limits the central government’s structural deficit to 0.35% of GDP a year, allows for some budgetary flexibility. The deficit limit compares with pre-crisis structural surpluses in Germany since 2012, which the IMF estimates to have averaged just over 1% of potential output in the years before the Covid-19 pandemic.

Additional public sector investment could come through changes in how the debt brake is calculated, use of special purpose investment vehicles and/or a bigger role for the federal development bank, KfW. Recent tax estimates also indicate strong government tax revenue, providing more financial room for the new coalition than previously expected.

FDP commitment to fiscal discipline leaves much hinging on private-sector investment

However, with the FDP in charge of the finance ministry, much of the required extra investment will depend on policy changes to create the right incentives for the private sector, notably given SPD and Greens spending priorities: no cuts to pensions, a higher minimum wage of EUR 12/hour, an accelerated phasing out of coal production by 2030 and increased investment in renewables.

Latest economic data point to the urgency of reform. The German economy has grown more slowly than expected in the second half of 2021 due to supply-chain disruptions and a new wave of Covid-19 cases. Scope has lowered its projection for economic growth in 2021 to around 2.4%, while we expect 4.4% growth in 2022 before moderation towards a medium-term growth potential of around 1.1%.

With public sector investment likely remaining constrained, constructive policy reform will be essential to incentivising growth in private sector investments, particularly in digitisation and the environment, the latter if only to meet the government’s ambitious carbon-reduction targets.

Fundamental reform of Stability and Growth Pact less likely with Lindner as Finance Minister

The fiscal orthodoxy that Berlin is set to pursue will also hold ramifications at the European level amid pressure to loosen EU rules on budget deficits and borrowing. A finance ministry led by Mr Lindner will make fundamental reform of the European Union’s Stability and Growth Pact less likely.

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Eiko Sievert is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.