The recent collapse of Germany’s governing coalition was drowned out in the international media by Donald Trump’s impressive political comeback. Inevitable as the government breakdown was, a broader discussion of the circumstances under which the Scholz administration failed could inform policy decisions in Germany and other Western European welfare states.
On Tuesday, November 12th, credit rating agency Fitch Ratings assessed the situation:
The collapse of Germany’s governing coalition underscores the political obstacles to reviving growth while adhering to domestic fiscal rules … Chancellor Olaf Scholz’s dismissal … follows prolonged internal conflicts over economic policies, particularly budgetary issues, tax cuts, and fiscal spending.
Going into more detail, Fitch Ratings explains that the coalition between the SPD social democrats, the Greens, and the centrist-liberal FDP fell apart when they could not produce a budget for the federal government under constraints imposed by Germany’s constitutional debt ceiling.
The social democrats and the Greens wanted more government spending despite the debt ceiling—better known as the debt brake—prohibiting it unless more tax revenue was available.
Fitch again:
The SPD and Greens had urged using the emergency provision [in the debt brake] to temporarily ease borrowing constraints to help revive Germany’s economy and fill a funding gap in the proposed 2025 budget.
The liberal FDP opposed any such measures, eventually making the coalition untenable.
Judging from the public debate in Germany in the last few days, there seems to be some hope that a new coalition can be stitched together after the elections that will be held in February 2025. Unfortunately, the outlook for any such coalition is pessimistic at best—and the reason for this is not primarily rooted in Germany’s stale system with four establishment parties dominating the Bundestag.
The reason is instead to be found in Germany’s recent political history, specifically the debt brake itself. It was created and enshrined in the German constitution under former Chancellor Angela Merkel. She is often credited for using the debt brake to bring Germany’s public finances under control; as Figure 1 shows, the debt-to-GDP ratio increased at first, then decreased after the implementation of the debt brake:
Figure 1
The problem with the downward trend in the second half of Figure 1 is that it came at a price: a modest but nevertheless harmful increase in the tax-to-GDP ratio. This, however, never seemed to bother Angela Merkel; for all intents and purposes, she was little more than a fiscal bureaucrat.
Until the German Bundestag can bring itself to comprehensively and structurally reform the government sector in the German economy, every new chancellor will live a political life only one budget negotiation away from Olaf Scholz’s fate. The reason is found in one term in the afore-quoted Fitch article: “funding gap.”
Like all modern European economies, Germany has an elaborate welfare state. With very few exceptions, those welfare states are constructed in such a way that spending automatically increases over time. The programs deliver benefits, the spending on which is determined by the nature of the goods, services, or cash handouts that the benefits program provides.
In health care, for example, the amount of spending needed is determined by the cost of medical equipment, pharmaceutical drugs, and the employment cost of health care workers—from assistants with no education to the most specialized physicians and surgeons. All these costs rise over time—especially over the long term as medical science advances: equipment and pharmaceutical drugs become more complex as they can help cure more complicated health conditions. Likewise, medical staff get better trained as medical science learns to cure and heal better.
All these advances are reflected in higher costs. However, it is not just health care that by its nature costs more every year. Social programs are generally based on a relative understanding of poverty. Our definition of poverty changes over time; if we define poverty as living on 60% of median income, then a 1% increase in median income raises the poverty line by 1%. The monetary value of the 60% poverty line increases, thus incorporating more households.
When the eligibility for social benefits is based on this relative concept of poverty, the cost of those benefits increases automatically over time.
Writ large, the German government under Olaf Scholz was trying to keep up with this systemic upward drift in welfare state expenditures. Their problem was that tax revenue did not rise on par with the costs of the welfare state—and why should it? There is no causal link between the growth rate in welfare state spending and tax revenue; the latter does not grow because the former grows. (Spending on infrastructure expansion and other growth-generating items work differently due to multiplier and accelerator effects, but that is a topic for another day.)
Angela Merkel solved this by driving up the tax pressure on the German economy. From 2005 to 2019, taxes rose from 43.5% of GDP to 46.5%. This is a big increase in the cost of government, big enough to explain the bulk of Germany’s current economic stagnation.
The fall of the Scholz government shows that Germany is politically opposed to further increases in taxes. Therefore, there is no way for the federal government to increase spending and fund it with higher taxes. The question is if the country is politically ready for structural reforms to government spending. Will anyone dare go into the February election with proposals to redesign Germany’s welfare state programs? Is there enough political courage to lead reforms that limit social benefits to a dignified subsistence level—not a way of life?
These reforms, and only these reforms, will permanently solve the problems with Germany’s debt brake.
