Something that has been going under the radar in forex markets is the potential for Germany to “reform” its debt brake. It’s understandable, given that the issue is kind of technical, and there is a lot going on in the markets. But a change in Germany’s debt structure could have significant impacts on the Euro, potentially similar to the UK’s “mini budget” of a few years ago. So, it’s good to have at least a general understanding of what’s going on and how it could move the markets.
The debt brake refers to an amendment introduced into Germany’s constitution back in 2009 which prevents the government from deficit spending above 0.35% of the structural GDP. Effectively, this puts a “brake” on how much borrowing the government can do in any given year. It’s not a hard “ceiling”, like in the US, that has to be moved every so often. In Germany’s case, the deficit can grow as long as the economy is growing.
The Effects on the Market
As a result of the debt brake, Germany has a relatively low debt (around 60% of GDP, compared to over 1120% in France, for example). Germany is well known for its fiscal strength and prudent management of government finances. Consequently, markets are supremely confident in Germany’s ability to pay its debt, which allows its interest rates to be particularly low. Germany’s position as the preeminent economy in Europe means the interest rate on its debt is considered the benchmark.
Critics of the debt brake have argued that it means Germany hasn’t been able to increase government spending on infrastructure and other projects that would help grow its economy. With the phenomenon of Germany being the “sick man of Europe” in terms of economy (racking up two consecutive years of negative growth), this has led to calls for German fiscal policy to better match that of other countries in the Euro Area. Ie that Germany needs to do more deficit spending to boost the economy.
There Have Been Consequences
The debate over debt spending was one of the major issues that fractured the governing coalition in Germany, leading to the upcoming general elections on February 23. The debt brake is inevitably a major part of the discussion, as voters seek improvements in economic performance. Left-leaning candidates generally favor getting rid of the brake, while centrist and right-leading candidates argue for fiscal prudence and boosting the economy in other ways.
Notably, former German Chancellor Angela Merkel, whose tenure was almost entirely under the brake’s restrictions, has broken with her party’s usual stance. She argues that it is time to revise the break. It’s also worth pointing out that Germany managed to be substantially fiscally responsible without the brake for decades before its introduction.
How the Change Can Move the Markets
A “reform” in the debt brake would imply that Germany would increase its debt, something that could leave investors less confident that it would be able to manage its payments. Germany’s benchmark interest rates could rise to match those of other Euro Area countries that have higher debts.
Exactly how much of an impact this will have on the economy is not entirely certain. Particularly considering that the interest rates that would be most affected would be the long term ones. Unlike short-term rates that generally support the price of a currency, higher long term rates would likely weigh on the Euro. And make it more difficult for the ECB to do its job of easing borrowing costs. The increased uncertainty could be another factor weighing on the Euro, depending on how the general elections in Germany go.
