A System Dynamics Approach to Macroeconomic
Policy Evaluation -
The Case of the German Debt Brake
Klaus Dieter John
Chemnitz University of Technology
Thueringer Weg 7, D-09107 Chemnitz, Germany
Fon +49 371 531 34198 / Fax +49 371 531 33969
john@wirtschaft.tu-chemnitz.de
Abstract
In the aftermath of the expansive fiscal policy stimuli dealing with the
consequences of the world financial crisis of 2007/2008 the public indebtedness
around the world has increased dramatically. As a consequence the world-wide
interest in policy measures to limit and reduce public debt has increased
drastically. In Germany the parliament has altered the constitution which
encompasses now a new article regarding a seemingly tight debt rule. In many
member states of the EU and around a political discussion has started whether
the German debt rule could serve as a guideline. This article explains the
German rule and analyses its effects by employing system dynamics methods.
The mainly qualitative analysis demonstrates that the German debt rule has
important shortcomings and that there are severe “side effects” which have to be
addressed by public policy.
Keywords: Debt rule, system dynamics, policy evaluation.
JEL classification: E6, H6, H7
1. Introduction
As a reaction to the global and financial crisis of the years 2008 and 2009,
governments around the world switched to massive expansionary fiscal policies.
These expansionary fiscal policies encompassed tax decreases, tax rebates, and
increases of government expenditures.! As a result of these policy measures and
the sharp decrease in tax revenues (due to the global depression) the often
already high government debt in most industrialized countries increased
dramatically. The increase of government debt triggered the so-called Euro-crisis
of 2010. The Euro-crisis raised doubt regarding the sustainability of the
European Economic and Monetary Union. It was the turmoil of this discussion
about the future of the Economic and Monetary Union that focused the attention
of the media and the public on the problem of high and fast increasing
government debt.2
In Germany, the governing parties argued in favor of a sharp consolidation
policy. In addition to the requirements of the Stability and Growth Pact they
pointed to the debt rule enacted in 2009 that enforces an even tighter debt policy.
The key aspect of the German debt rule is that it aims to take away discretionary
leeway from the political decision process and to enforce a steady decline of
national debt in the long run.
As most industrialized countries around the world see high and increasing public
indebtedness, the German debt brake is regarded as a possible example in other
countries of the European Union. Therefore, it is of interest to analyze the
operation, the effects and the “side effects” of the German debt rule in order to
learn whether it may, in fact, serve as a desirable model.
Despite of its novelty, there is a growing body of literature discussing the new
rule. Most of this literature consists of juristic and economic contributions. To the
best of my knowledge, there exists no paper dealing with the German debt rule
from a system dynamics point of view. As feedbacks play an important role in the
dynamics of national debt and as the German debt rule itself rests on feedback
mechanisms, additional insights in the operation, the effects, and the side effects
can be gained by employing system dynamics methods.
Obviously, the problem of public debt and its effects is not a central theme of the
system dynamics literature. Only few studies pick up the problem. Most closely
1 The expansionary fiscal policies were accompanied by expansionary monetary policies of the
central banks.
2In 2010 most of the member states of the Eurozone did not fulfill the requirements of the
Stability and Growth Pact, which states that the annual budget deficit must not be higher than
three percent of Gross Domestic Product (GDP) and that the public debt must not exceed sixty
percent of GDP.
3 The German debt rule has an antetype: the Swiss debt brake.
related to the spirit of our analysis are the papers of Ansah (2010a, 2010b, 2006),
Burns and Janamanchi (2007), Radianti (2004) and Arenas (2003). But none of
the papers deals with a debt rule. Ansah (2010a) models the vicious cycle of
poverty, economic performance, and debt. Ansah (2010b) examines in a case
study of Ghana the mechanisms that generate government debt. Ansah (2006)
focuses on the side effects of structural adjustment programs. The paper of Burns
and Janamanchi (2007) concentrates on the demographic aspects of the debt
problem. Radianti (2004) deals with the effects of external debt financing on the
sustainability of Indonesian fiscal policy. Finally, Arenas (2003) analyzes the
sustainability of public debt referring to Colombia.
There is a wide and diverse body of economic literature dealing with fiscal rules
in general. Examples are Corsetti, and Roubini (1996), Poterba and Rueben
(1999a), and Poterba and Rueben (1999). Corsetti and Roubini (1996) compare
the European and American perspectives on balanced-budget rules. Poterba and
Rueben (1999 and 2001) look at fiscal rules and public borrowing at the state. In
addition, there is an increasing number of papers, mostly published in German,
that analyze the German debt brake. But neither the economic literature nor the
system dynamics literature deals with the debt brake from a system dynamics
perspective.
This paper aims at supporting economic policy by pointing to side effects of the
debt rule neglected in the discussion so far. It concentrates on two aspects: First,
on demonstrating that the German debt rule is less transparent than claimed.
Second, and even more problematic, there are effects to some of the German
states (“Bundeslander”) which are economically devastating — unless the debt
rule is altered or abolished.
The remaining part of this paper is structured as follows. The following section
gives a brief overview over the debt situation in several industrialized countries
in order to recall the international relevance of the problem. According to its goal
the paper places a special emphasis on some member countries of the Eurozone.
In this section also the view of the economic profession on causes and
consequences of public indebtedness is briefly touched as this paper addresses
itself not only to professional economists. The next section explains the modus
operandi of the German debt rule (also called: German debt brake). Qualitative
system dynamics analysis is used to map the complexity of the rule and to
identify neglected but important side effects. Thereafter, the paper turns to an
especially important side effect which regards the German states. Besides
employing qualitative system dynamics analysis a quantitative simulation model
is developed for the “Saarland”. The model demonstrates that the Saarland will
run under the debt brake into insolvency unless the law is changed or the
Saarland is offered new financial assistance. The main reason for this finding is
3
the fact that the debt rule and the accompanying measures neglect the deeper
structural causes for the public deficit of the Saarland.‘ Finally, the paper draws
some conclusion.
2. Economic Background
The following Figures show the development of national debt and the
development of the ratio of national debt do Gross Domestic Product (GDP) for
selected countries.> The data are from the OECD and from the IMF, respectively.
Note that the time series differ in length due to the availability of data provide by
both institutions. The longest time series available is for the United States.
Figure 1 shows the development of public debt for the United States, the United
Kingdom, and Japan.®
General government gross financial liabilities, as a percentage of GDP
240 4
200 4
160 4
1204
Debt as a percentage (%) of GDP
T T T T T T T T T
1970 1975 1980 1985 1990 1995 2000 2005 2010
[——GGFLO_JPN ----GGFLQ_UK ——-GGFLQ_USA ]
Source: OECD (2011)
Figure 1: Debt-GDP ratio of Japan, the UK, and the US
4 Even for people with a quite limited training in system dynamics it is hard to believe that the
underlying structures of a dynamic system are completely ignored. But this is what obviously has
happened in the political process.
>It is common to evaluate and compare the national debt by looking at ratios. Due to the
differences in the size of the economies a cross-country comparison of the nominal or real value of
debt is not meaningful.
6 The Economic Outlook (OECD 2011) provides data for the time period 1970 — 2012. The data for
2011 and 2012 are estimates.
4
Japan sticks out: In 1970 the Debt-to-GDP ratio was as small as 11 percent. In
the mid-1970* this ratio started to increase more or less steadily. Leaving the
development following the global economic crisis aside there is no clear tendency
of a permanent increase of the debt ratio in the US or the UK. From 1960 to the
1981 the ratio decreased in the US from 62 percent to 42 percent. From 1982 to
1993 it increased to a value of 72 percent. Largely attributable to the economic
growth during the rest of the 1990t the ratio declined again, reaching its
minimum in 2000/2001 with a value of 55 percent. Following the recession of
2001 the debt ratio increased in the following two years to a value of slightly
above 60 percent, where it stood until the financial market crisis hit the United
States and the global economy. Until the global depression the development in
the UK stands in stark contrast to the development in Japan. Starting with a
high value of nearly 90 percent the debt-GDP ratio declined until 1990 to slightly
above 30 percent. In the aftermath of the 1990/1991 recession the ratio started to
increase quite sharply to about 50 percent. At the end of the 1990 the ratio
declined within three years to approximately 40 percent. Following the 2001/2002
recession the ratio increased to 47 percent in 2007. Then the British economy was
hit by the global crisis. In 2008 the debt ratio climbed to 57 percent, in 2009 to 71
percent, and in 2010 to 83 percent. For the year 2011 the OECD estimates a 94
percent. The increases of the debt-GDP ratio observed after the global economic
crisis are unprecedented in the time after World War II.
The figure points to several important facts:
e There are remarkable differences between the developments in the
considered countries.
e There are time periods with a slow increase (or even a decline) of the ratio
(even though there are only rarely time periods with a decline in the debt
level). In general, these are periods of significant above average economic
prosperity.
e The data reveal a pattern of increases in public debt following
extraordinary events (like the first and second Iraq war or severe
recessions) that are not followed by a symmetric decline of the ratio
thereafter.
e In all countries the debt problems are regarded as important issues not
only in the sphere of economic theory and economic policy but also in the
public and the media. Public debt has become a major political and societal
issue.
e The sharp increase of the debt ratios in the years following the financial
crisis will keep public consciousness at a high level — especially because
there seems to be no way to decrease the ratios within the next years.
on
We will now briefly look at two groups of EU countries. The first group is the
group of the major economies in the EU (excluding the UK). It consists of
Germany, France, and Italy. The second group is the group which came
especially under fire in the aftermath of the financial crisis. This group consists
of Ireland Spain, and Greece. In addition, to allow for comparison, the
development of the 15 countries of the Euro zone is shown.
General government gross financial liabilities, as a percentage of GDP
140 J
AG 120-
oO
5
= 100
ov
a
£80
oO
g
«o 60-
8
20 -
T T T T T T T T T
1970 1975 1980 1985 1990 1995 2000 2005 2010
—— GGFLQ_GER ---- GGFLQ_FRA ——-GGFLQ_ITA —--GGFLQ_EURO15
Figure 2: Debt-GDP ratio of Germany, France, Italy and Euro zone (15 countries)?
The data of Fig. 2 reveal a “twin” development of the debt to GDP ratio in France
and Germany. Only the future development forecasted by the OECD shows a
significant difference between both countries in that the increase of the ratio
triggered by the global crisis is significantly more pronounced in France.® The
increase in the German debt ratio until 1996 can be traced back to the financing
of the German unification. As the economic performance during most of the 1990s
was weak in Germany (and in France as well) the ratio remained at about 60
percent during this decade. Around the turn of the millennium the economic
growth became stronger — and the debt ratios declined somewhat. The recovery
7 The Economic Outlook (OECD 2011) provides data for the following time periods. France, Italy,
and Euro zone (15) 1970 — 2012; Germany 1991 — 2012. The data for 2011 and 2012 are estimates.
8 One explanation for this divergence is the fact that Germany has gained competitive advantages
within the Euro zone as unit labor costs in Germany have declined relatively to most other
members. This decreased the relative price of German export goods. The improved
competitiveness allowed the German economy to recover much faster. The stronger economic
growth is reflected by a flatter time path of the debt ratio.
6
was interrupted by the recession of 2001/2002. Until 2005 the ratios increased to
about 65 percent. Due to the economic upswing the debt to GDP ratios of
Germany and France declined thereafter — until the world was hit by the
financial crisis and its long lasting effects. Italy is another case. Until the middle
of the 1990s the debt ratio grew to about 120 percent. Thereafter it declined quite
steadily to somewhat over 100 percent 2007. The economic crisis brought the debt
ratio back to the level of 120 percent.
General government gross financial liabilities, as a percentage of GDP
160 J
a 1404
0
S 1204
g
i 100 4
8 -
5 80 4 J
© a
» 6047
oO ¥
3
a 404
20 4
TUE EEEETTELaE aS PEERS EEE
1970 1975 1980 1985 1990 1995 2000 2005 2010
—— GGFLQ_GRE ---- GGFLQ_IRE ——-GGFLQ_ITA
—-— GGFLQ_POR —-- GGFLQ_SPA
Figure 3: Debt-GDP ratio of Euro zone countries hit by the debt crisis®
Fig. 3 shows the developments in the “crisis countries” of the Euro zone. The debt
ratio of Greece started in 1980 with a small value of somewhat more than 20
percent (not shown in the figure). Until the middle of the 1990s this number
climbed steadily to a value of about 120 percent where it remained until 2007.
Spain and Ireland managed to bring their deficit ratios down from quite high to
quite low values. When these countries were hit by the global crisis their ratios
were 36 percent (Spain) and 25 percent (Ireland), respectively. Mainly
attributable to the fact that in both economies (as in the United States) housing
price bubbles burst, both countries experienced a dramatic increase in the debt
ratio.
® The Economic Outlook (OECD 2011) provides data for the following time periods. Greece 1995 —
2012; Ireland 1998 — 2012; Italy 1970 — 2012; Portugal 1995 — 2012; Spain 1980 — 2012. The data
for 2011 and 2012 are estimates.
7
We turn now briefly to some basic aspects of the accumulation of national debt.
The most fundamental aspect of “debt mechanics” is captured in the causal loop
diagram shown in Fig. 4.
+ debt
te)
borrowing B1
+ ¥ +
interest
repayment +
interest rate
Figure 4: Fundamental debt mechanics
There are one balancing and two reinforcing loops. The balancing loop, labeled B,
comprises the fact that mature debt has to be repaid. An increase in debt leads,
ceteris paribus, to a higher repayment which in turn decreases the debt below the
value it would otherwise have had. On the other hand, repaid government debt is
often financed by new borrowing. Therefore the polarity of the arrow from
repayment to borrowing is positive. And a higher borrowing increases the
national debt. This closes the reinforcing loop R1. For the purposes at hand, let
us assume that the interest rate is exogenous. Then an increase in debt leads to a
higher interest obligation. The higher interest increases ceteris paribus the
deficit which in turn decreases borrowing and debt. The polarity signs of the loop
labeled R2 are all positive which means that it is a reinforcing loop. If we assume
that all repayment is financed by borrowing the effects of loop B1 and loop R1
cancel each other out. Hence, the important determinant of the dynamics of
national debt in the CLD of Fig. 4 is the reinforcing loop R2.
From an economic viewpoint, it is important to add two other factors in order to
get a more complete picture of the debt dynamics. First, we should include the so-
called primary deficit, and, second, as the debt crisis of Greek has emphasized,
we should take into account that the interest rate a country has to pay for its
debt is not just the world interest rate. Fig. 5 shows a CLD that encompasses
these factors. 1°
10 A similar exposition is given in Ansah (2010).
are rating of financial
markets \
+ debt
iD) R3 risk premium
+ % :
interest
=
re interest rate
+
F sa z
pamapy igi world interest
wv rate
revenues
expenditures
Figure 5: Debt dynamics, risk premium, and primary deficit
In addition to the loops B1, R1 and R2 there is a third reinforcing loop R3. The
dynamics described by this loop are the following: An increase in national debt
decreases the rating at the financial markets due to an increased risk of default;
a lower rating means that potential creditors demand a higher risk premium to
compensate for the perceived risk increase; a higher risk premium increases the
interest rate, which pushes the interest payments up. The case of Greece has
demonstrated that the risk perception and the rating of the financial markets can
change quite suddenly due to external factors. Because it is not the purpose of
this paper to build a comprehensive model of the financial markets we just point
to this issue but do not try to model it.
The second enlargement to be found in Fig. 5 is the inclusion of the primary debts
and its two big components: revenues and taxes. If taxes increase the primary
deficit decreases ceteris paribus. Similarly, an increase in expenditures pushes
the primary deficit up. The (total) deficit will only be zero if there is a surplus of
revenues over expenditures which just compensates for the interest.
But in practice, this is often not the case. We have seen that the empirical picture
is mixed. There are countries like Japan and Italy that show a long run increase
in the debt deficit ratio which is not easily explainable by special events. On the
other hand there are countries like the US, the UK or Germany, in which periods
of steep increase in deficit and debt in most cases can be attributed to
extraordinary situations (like the financing of the Iraq wars or the financing of
the German unification, or deep recessions).
°
4k rating of financial
ot markets
Tay wo 4
borrowing t) (48) risk premium
+
interest |
+
repayment = | NC interest rate
+
tw)
deficit
F deficit
aaa al
pena
revenues of the seis of the sire Sits expenditures of the
running account capital account **PC" me ob tne: running account
world interest
rate
ae
im capital account
+ + ; + +
Eee incoming sales of public compensation of ah outgoing
transfers public investment employees expenses transfers
assets
Figure 6: CLD with detailed components of the budget
It would be a questionable undertaking to incorporate such extraordinary events
into a SD model because it does not make sense to try to identify feedbacks that
lead to singular events like the German unification or the global crisis. But to set
the stage for the following discussion of the German debt rule two details should
be included in the CLD. First, it will prove helpful for the understanding of the
next section to show the components of revenues and expenditures explicitly.
Second, we have to note that there is no convincing economic reason for a
government to repay its debt completely in the sense of bringing gross debt to
zero. In the contrary, an ever growing debt may be judged as sustainable
provided the debt to GDP ratio approaches a steady (and not “too high”) value.
Because, for every given height of national debt the debt ratio decreases as GDP
increases, we should include GDP growth in our considerations. Both points are
taken into account in Fig. 6
Fig. 6 encompasses the most important categories of revenues and expenditures
of the budget. The shown details are important in the discussion of the mechanics
and the effects of the debt rule because some forms of revenues and/or
expenditures can (more or less) easily be adjusted, but others cannot. For
expositional purposes the CLD of Fig. 6 just shows the variable “GDP” in order to
display the “cause” of the debt-GDP ratio, but does not explain it.
10
A quite common way to model the long run development of GDP relies on the
textbook version of the Solow-Swan growth model. The basic idea, framed in a SD
perspective, is given in Fig. 7.
government
expenditures
+
total factor a Sep ea Peconsuimption
productivity—___} production + output
f ie
1D) net exports
Ut +
one i
= nvestment
oe = ss ewig +
3) GDP
ee Se depreciation rate
labor efficiency
= 2
Figure 7: Explaining GDP
From a SD viewpoint the structure of Solow-Swan shown in Fig. 7 is to some
extent a “quick and dirty” approach because of the many exogenous variables.
The two feedbacks identified in the CLD are easily explained: The balancing loop
B1 ensures that the model approaches a global steady state.11 Sustained growth
of GDP depends on the growth of labor which is assumed to be exogenous.
Growth of the population and of the labor force can be observed in many
developing countries. But in most industrialized countries, in fact, population
does not grow. In the absence of growth of labor the GDP approaches in the
Solow-Swan model a steady state with constant per capita income. In order to
explain the fact of a growing per capita income in industrialized countries the
simple neoclassical growth mode uses the “trick” of assuming technological
progress With this approach the steady-state growth in per capita income is
“explained”. Alas, technological progress remains unexplained.!2
This result depends on the provision that the usual assumptions of the neoclassical growth
model hold.
12 The standard way to incorporate technological progress is to measure labor in efficiency units
and to assume technological progress as being labor augmenting. Modern (endogenous) growth
theory seeks to overcome this severe limitation of the traditional growth model. Classic
contributions to this literature include Romer (1986), Lucas (1988), and Aghion and Howitt
(1992). A good introduction to the topic is, e.g., Weil (2009).
i,
3. The German Debt Brake
In 2009 the German parliament enacted an amendment to the German
Constitution. Article 109(3) GG requires, in general, a budget balanced in the
medium term as well on the federal level as on the state level. There are three
exceptions to the general prohibition of financing expenditures by credits.
1. Cyclical component. The federal and the state governments are allowed to
follow an anti-cyclical fiscal policy over the business cycle. That means, that tax
decreases and expenditure increases caused by a downswing of the economy may
be compensated by credits. But, as the budget must be balanced over the cycle,
the borrowing during the downswing must be repaid in the following upswing.
2. Emergency component. In extraordinary emergency situations the federal
government as well as the state governments may borrow at the financial
markets provided there is a schedule which states how the credits will be repaid.
To enact this exception from the general rule, a positive vote of the majority of
the members of the Bundestag is required.
3. Structural component. With respect to the federal level, the requirement of a
medium term balanced budget is substantiated in the way that the federal
government is allowed to finance expenditures by borrowing up to a volume of
0.35 of nominal GDP per year. With respect to the state level, the state
governments are not allowed to raise any “structural” credits.
Almost all economists agree on the welfare increasing effects of cyclical deficits
(and hence, in principle, on the need of a cyclical component in the German debt
rule). The main argument is quite simple: As all taxes have distortionary effects
(i. e. they alter the allocation of goods and factors of production) an increase and
decrease of tax rates that tried to follow the up and down of expenditures would
be costly in terms of welfare losses. Hence, the prevailing view is to let the
automatic stabilizers do their job and to accept deficits in busts that are repaid in
booms.
The emergency component has a similar economic background. If there is an
unforeseeable emergency situation (a natural catastrophe, e.g.) that requires a
big amount of additional public means then it is less distorting (and welfare
decreasing) to finance the needs by raising credits instead of increasing tax rates
or instead of introducing new taxes. As the possibility to raise credits under
exceptional circumstances creates incentives to exploit the debt rule, the barrier
(requirement of a positive vote of the majority of the members of the Bundestag)
is quite high — at least given the German political system which makes it hard to
get such a majority.
12
The German debt rule does not replace the rules of the Stability and Growth
Pact. These are still as valid for Germany as for any other country of the Euro
zone. All components are compatible with the SGP. This is also true for the
structural component. The SGP requires a maximum deficit of 3 percent of GDP
and a debt of 60 percent at maximum or, if above, a clear tendency to approach
this number) but, what is sometimes overlooked, the SGP aims at a balanced
budget according to the rule “close to balance or in surplus” (CTBOIS) which is
seen as fulfilled if the deficit is not higher than 0.5 percent of GDP.
debt gdp ratio
1
0.75
Boos
0.25
0
1996 2000 2004 2008 2012 2016 2020 2024 2028
Time (Y ear)
debt gdp ratio : high gdp_g
debt gdp ratio : low gdp_g
debt gdp ratio : medium gdp_g
Figure 8: The debt to GDP ratio under different growth scenarios
The effects of the debt brake were simulated. The simulation uses for the period
1996 — 2010 historical data. The Data source is OECD (2010). According to this
source, the public deficit of Germany was 161 Billion EUR. The estimates for
2011 and 2012 are 104 Billion EUR and 88 Billion EUR, respectively.13 The debt
brake requires a deficit down to 0.0035 percent of the GDP in 2017. To calculate
the level of debt allowed in 2017 we estimated the GDP of 2017 assuming a
nominal average growth rate of 3 percent per year. According to this estimate (a
GDP of about 3000 Billion EUR) the structural deficit allowed under the debt
brake is 10 Billion EUR, approximately. We assume further that the government
uses the room the structural component gives. Moreover, in the base scenario
13 For consistency reasons, all numbers have been calculated as differences of government debt
from one year to the year before. It has to be mentioned that the Maastricht deficit is not equal to
the difference of the debt, in general.
13
(medium gdp_g — medium GDP growth), we assume that the growth of nominal
GDP continues as before.
Due to these assumptions the value of nominal public debt increases steadily.
But Fig. 8 reveals that the debt-to-gdp ratio declines after 2013. A lower growth
rate of nominal GDP weakens this process; a higher nominal growth rate of GDP
strengthens it. But the general tendency remains the same.
debt gdp ratio
0.8
0.7
E 0.6
0.5
0.4
1996 2000 2004 2008 2012 2016 2020 2024 2028
Time (Y ear)
debt gdp ratio : shock01
debt gdp ratio : medium gdp_g
Figure 9: Consequences of a negative shock to the economy
Fig. 9 shows the result of a scenario which assumes a shock to the economy. The
shock is modeled as driving up the deficit in two consecutive years (2015, 2016) to
values of 80 Billion EUR in each period. Thereafter a return to the debt brake
path is assumed. As one can see the shock postpones the adjustment path
somewhat but does not alter the general result.
A comparison between the development with and without debt brake is shown in
Fig. 10. All runs assume a nominal GDP growth rate of 3 percent per year. The
run labeled medium gdp_g is the reference scenario which assumes that the debt
rule is completely fulfilled. There are two “business as usual” scenarios: bau01
and bau02; bau01 assumes that the debt brake is not obeyed and that the future
nominal deficits are similar to the deficits of the past before the global crisis. (In
fact, the data of the years before 2007 were just replicated.) Scenario bau02 is
basically the same but the nominal deficit is scaled up by 40 percent to take
account of a slight inflation in future time periods. The simulations show that the
debt ratio is declining, albeit slowly, if the deficits of the future are the “ordinary”
14
deficits of the past. Even when we assume that we get the deficits of the past
including the deficits of the global crisis another time, the debt-gdp ratio remains
stable as “crisis” scenario demonstrates.
debt gdp ratio
0.8
0.7
E 06
fa
0.5
0.4
1996 2000 2004 2008 2012 2016 2020 2024 2028
Time (Y ear)
debt gdp ratio : crisis
debt gdp ratio : bau02
debt gdp ratio : bau01
debt gdp ratio : medium gdp_g
Figure 10: The debt ratio with and without debt brake
debt gdp ratio
1
0.85
E oz
A
0.55
0.4
1996 2000 2004 2008 2012 2016 2020 2024 2028
Time (Y ear)
debt gdp ratio : highgdp_crisis
debt gdp ratio : lowgdp_crisis
debt gdp ratio : crisis
debt gdp ratio : medium gdp_g
Figure 11: Economic growth and debt rule
Much more important than the adherence to the debt rule is economic growth.
Fig. 11 supports this point. The scenarios shown here are: (one more time) the
reference scenario medium gdp_g (assuming an economic growth rate of 3
percent per year and adherence to the debt rule); crisis, highgdp_crisis, and
lowgdp_crisis. The latter scenarios assume a replication of the heights of public
debt seen in the global crisis and growth rates of nominal GDP of 3 percent, 4
percent, and 2 percent, respectively. The simulations show that a low nominal
growth of 2 percent per year is not sufficient to keep the debt-gdp ratio stable.
This observation reminds us that it is probably more important to keep the
growth rate of income sufficiently high instead of concentrating on bringing
deficit and debt down. Some observers fear that one of the side effects of fiscal
rules like the debt brake is that they hamper economic growth. Besides this,
there a number of further criticisms that shed doubt on the effectiveness and the
usefulness of the rule. We will now turn to these crticisms.
First, one can argue that there is no need for the debt brake. As we have seen in
section 2 the empirical picture is quite mixed. There are countries with a
permanently high and/or increasing national debt like Italy or Japan. On the
other hand, in countries like the United States or the United Kingdom there have
been prolonged time periods in which the debt-to-GDP ratio was declining. A
typical pattern is that the deficit increases in extraordinary situations and it
declines if the economic growth is robust. The cyclical component and the
emergency component of the debt brake do not exclude this pattern.
The need for a debt rule was, inter alia, based on the argument of gaining better
ratings in the financial markets. The better ratings should lead to lower interest
rates, and a, hence, to less interest expenditures. This argument has only little
substance: the interest rate the German government has to pay is very low
compared to most other nations. And there are no signs that the introduction of
the debt brake has lowered the interest rate any further.
Second, there are fears that the debt rule if obeyed strictly will lead to lower
economic growth and to more unemployment. The argument behind this view is
as follows: The debt rule does not differentiate between public investment and
public consumption. In trying to bring the deficit down to the level required by
the debt brake mainly investment expenditures reduced leading to a
comparatively smaller public capital stock. But a smaller public capital stock (a
less effective infrastructure, e.g.) hampers the productive work of the private
sector.
It is this second viewpoint that is especially relevant for the effects of the German
debt brake for the Bundeslander (states). These effects have been attracted only
very limited attention in the evaluation of the debt rule. In the following section
we will use a qualitative SD approach to foster the discussion.
16
4. Effects of the debt rule on the state level: The case of Saarland
As already stated at the beginning of the last section, the German debt brake is a
rule binding not only the federal government but also the governments of the
federal states, the Bundesldnder. The cyclical component and the emergency
component are effective to the Bundeslander as well. In contrast, the structural
component is not valid on the state level. Thus the Bundeslander have to balance
their budget exactly. The amendment to the constitution requires the balanced
budget starting with the year 2020. Until this point of time, there is a transition
period which should foster a smooth path from a current deficit position to the
balanced budget. As with the regulations to the central government the debt
brake does not aims at reduction of the nominal debt but at a decrease in the
debt-to-GDP ratio. A balanced budget implies approaching a zero debt-to-GDP
ratio in the long run.
Sachsen 4386
Bayern 4531
Baden-Wiirttemberg 8294
Niedersachsen 9186
Rheinland-Pfalz | 9827
Hessen ! 9841
Mecklenburg-VP 9999
Nordrhein-Westfalen | 10020
Brandburg 10166
Thiiringen ! 10188
Schleswig-Holstein 10506
Sachsen-Anhalt | 11846
Saarland ; 16348
0 5000 10000 15000 20000
Debt per inhabitant (EUR/inh)
Figure 12: Public debt of the German states (Euro per inhabitant) (Source: Statistisches
Landesamt Baden-Wiirttemberg 2010)
An important aspect of the evaluation of the debt rule effects on the state level is
the fact that the debt burden differs widely between the Bundeslander. Fig. 12
shows public debt of the Bundeslander per inhabitant for 2009. As the Saarland
L?-
has to bear the highest debt burden, we will use it as an example for our further
considerations.
The German debt rule encompasses financial support for the economically
weakest Bundeslander on their path of transition. The support totals to an
amount of 7.2 Billion EUR over the period from 2011 to 2019. This is equivalent
to a sum of 800 Million EUR per year. Of these 800 Million EUR 260 Million
EUR are allotted to the Saarland. The financial aid is given under the provision
of credible consolidation activities that lead to a balanced budget in 2020. In 2009
the deficit of the Saarland was about 700 million EUR. The debt amounted to
nearly 11.000 million EUR. The revenues of the Saarland were 2.899 million
EUR, of which 2044 million EUR were taxes and 793 million EUR were transfers.
The point is that the state government has nearly no leeway to decide
autonomously on taxes or transfers. The most important positions on the
expenditure side were compensation of employees (2.038 million EUR), operating
expenditures (1.048 million EUR), and interest (529 million EUR). Investment
expenditures were 44 million EUR.
A interest ate
interest *
het) Sehat
PM target deficit
debt rt Be
= desired effective
exceedance of expenditures; expenditures +
desired revenues deficit over target
aoe at J
i exceedance of desired
exeedance of desired expenditures over effective
revenues over effective a
revenues
corivaraanent @}
As) ublic ok
Me
revenues ane
tax 7 ——
OE pi
97 consumption —_
(
public investment
Figure 13: Budget feedbacks and the debt rule
Fig. 13 identifies the important loops which help to evaluate the effects of the
debt brake on a structural weak federal state like the Saarland. There are two
reinforcing loops and seven balancing loops. Loop R1 reflects the debt spiral
already discussed above. Loop R2 may be called the tax erosion loop as it
emphasizes the fact that an increase in tax rates (in order bring effective
18
revenues closer to the desired level) erodes the tax base because the tax increase
is an incentive to avoid the economic activity which is taxed.
The loop B1 describes the balancing effect of an increase in the tax rate, given the
tax base. This loop helps to decrease the discrepancy between desired and
effective revenues. On the expenditure side there are three balancing loops, all
working in a similar way. Therefore, the interpretation is limited to loop B3. If
desired expenditures exceed effective expenditures one way to decrease the
discrepancy is to increase the compensation of public employees (either by
increasing the salaries or by employing more people). This will increase effective
expenditures and narrow the gap. Analogously, the gap can be narrowed by
increasing public consumption or public investment.
The discrepancy between desired and effective levels of revenues and taxes is
caused by the exceedance of the deficit over its target value. An increase in
revenues or a decrease in expenditures helps to lower the discrepancy. The target
deficit is given by the requirement of the debt rule. As the Saarland runs a
substantial deficit in the actual situation the exceedance of desired revenues over
effective revenues is positive but the exceedance of desired over effective
expenditures is negative. Hence, to narrow the gap the compensation of
employees, public consumption, and public investment have to be decreased.
Given a deficit of 700 million EUR, interest expenditures of about 530 million
EUR the primary deficit is approximately 170 million EUR. The transfers of 260
million EUR are only of limited assistance. To get to the path required by the
debt rule the Saarland would have to increase tax revenues and to decrease
expenditures by a large amount. Will this be possible? And what are the
consequences of striving to reach the goal of a balanced budget? As said before,
the German states have nearly no way to influence the revenue side of the
budget. But their possibilities to influence the expenditure side are also limited.
Most of the compensation of employees is fixed by long running contracts. The
same is true for operational expenses. The only category that encompasses
somewhat more flexible expenditures is investment. Hence it is likely that in
order to decrease public spending the government will cut back investment. This
in turn will decrease future prosperity (and future tax revenues).
4. Conclusion
As a consequence of the global economic crisis in most nations the public debt has
increased substantially. This increase has raised concerns of policymakers,
media, and the public. In Europe, the credit crisis of Greece, Ireland, Portugal,
and Spain has drawn special attention to ways to handle the debt problem.
19
Following the Swiss example, Germany has introduced the so-called debt brake
as an amendment to its constitution in 2009.
In order to evaluate some of the effects of this policy measure we employed a
system dynamics approach. In section three of this paper we used a Vensim
model to simulate the effects of the debt rule under ideal conditions. A
subsequent verbal discussion pointed to shortcomings of an analysis limited to
the debt brake “mechanics”.
Section four focused on an aspect of the debt break, widely neglected in the
discussion so far. The debt brake is not only relevant for the central government
but also for the state governments. A qualitative system dynamics approach
revealed important weaknesses of the German debt brake with respect to the
underlying structural problems that cause the deficits of some of the German
states. Further research should elaborate on these structural problems in
extending the qualitative analysis and in developing appropriate simulation
models.
20
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