Harr’s View: Why Germany should ease fiscal policy

Good evening all

Today, I argue why Germany should immediately ease fiscal policy. In recent weeks, speculation has intensified that the German government is mulling fiscal stimulus. In my view, it might take some time before policymakers act, but it would make so much sense. First, I believe the timing is right. Data this week showed that the German economy contracted in Q2 and it has worsened in Q3. I expect Germany to weaken further in coming months due to the contraction in global manufacturing, trade and non-residential investments. In my view, Germany is likely to face a technical recession in Q3, defined as two quarters of negative growth. Meanwhile, manufacturers report they are cutting employment. The German labour market is tight, but employment growth in Q2 was the weakest since Q1-13. I exp ect Germany 's labour market to weaken further in coming months. Fiscal easing could mitigate the downturn. It is crucial the German government acts now given the usual legislative and implementation lag of fiscal policy.

Second, the secular decline in interest rates provides the policy space for a permanently looser fiscal policy. Since 2010, the average yield on German government debt has been below nominal GDP growth rates. Currently, the average maturity of German debt is 6.9 years with an indicative yield of -0.89%. Meanwhile, nominal Q2 GDP growth was 1.03% y/y. I expect German interest rates on average to be below growth rates for a long time. Most estimates suggest that the real neutral interest rate in the Eurozone is around 0% to -1%. We expect the ECB to maintain negative policy rates for the next 4-5 years, anchoring the short-end of the German yield curve. In my view, the scarcity of safe assets due to the limited supply of AAA-rated government bonds, risk aversion and financial regulation will continue to put downward pressure on German yields in coming years. Low interest rates relative to growth rates will tend to lower Germany 's debt-to-GDP ratio. The IMF estimates that its gross debt-to-GDP ratio will drop to 44.7% in 2024 from 60.9% currently, while the primary surplus will average 1.73% during this period. I believe this is too optimistic as the economy slows. However, the risk that investors suddenly view German debt as unsustainable is extremely low even with a permanent fiscal loosening. Germany faces a substantial demographic challenge over coming decades, which should raise ageing related spending and dampen growth. However, in my view the solution is not to prefund future spending with larger government surpluses today, but instead to provide workers the incentives and skills to extend working lives.

Third, German fiscal stimulus could lift the neutral rate in the Eurozone, which is of the essence. The current low neutral rate necessitates a very low policy rate in the Eurozone. This constrains the space for monetary policy to react to the next downturn due to the lower bound, and cripples the banking system. We expect the ECB to announce a comprehensive package of easing measures next month, including measures to mitigate the cost for Eurozone banks. (See the piece by our ECB strategist Piet Christiansen here, which explains how a tiering system could be constructed). However, I believe that the costs to Eurozone banks of negative rates will still increase over time due to rising excess liquidity, flat yield curves and limited transmission to depositors. (A recent ECB study finds that only 5% of total deposits in the Eurozone face negative rates). Instead, I believe that German policymakers should have a greater tolerance of a looser fiscal stance, as well as focusing on measures which promote private investments. Empirical studies suggest that a permanent 2% worsening of the fiscal deficit in Germany could perhaps raise the neutral rate in the Eurozone by 25-50bp. This implies that interest rates in Germany would still be below growth rates, which will tend to lower the debt-to-GDP ratio.

Fourth, a looser fiscal stance will support short- and long-term growth prospects. Public investment in Germany has been very sluggish over the last 20 years, while corporate tax rates are relatively high. The German government could focus on measures such as raising public infrastructure and digital services and reducing the corporate tax rates, which would boost the economy over the short- to medium-term. Germany should also focus on public investments and expenditures such as education and green transition, which are crucial to securing long-term sustainable growth. A loosening of Germany 's fiscal stance will be esp ecially p owerful now when monetary policy is likely to be very accommodative for a long time. Moreover, a permanent loosing of the fiscal stance, which is not financed by an increase in taxes at a later stage, will make it more powerful in lifting domestic demand.

Over the last week, euro swap yields continued to collapse with a modest spike on Friday triggered by a news story that the German government will raise debt in case of a recession. This suggests that the market remains focused on the worsening slowdown and recession risk, forcing capitulation among investors. I expect the market would like to see more concrete evidence of a shift in the German stance before it might have a lasting impact. We might receive more concrete evidence in coming months.

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