No. While there is no danger of the fiscal floodgates opening in Europe, the ‘traffic-light’ coalition of the Social Democratic Party (SPD), the Greens, and the Free Democratic Party (FDP) looks set to oversee some loosening of the fiscal purse strings in Germany. We expect a similar influence on EU policy, which should be supportive of growth over the next couple of years and a tailwind for European risk assets.
Olaf Scholz was sworn in last Wednesday as the new German chancellor, heading up the first three-party government in Germany at the national level since the 1950s. Some of the partners’ campaign promises make them seem like unlikely bedfellows, particularly the Greens and the FDP. The Greens campaigned on wanting to raise income and inheritance taxes, as well as introducing a wealth tax, while the FDP want to cut taxes and abolish the ‘soli’, or reunification surcharge, for the top earners who still face it. However, the partners found common ground on the need for Germany to increase public and private investment, particularly regarding climate change, in addition to a platform of social liberalism. Some of the most economically impactful policies of the resulting coalition agreement include:
- Phase out coal usage by 2030 and commit to 80% renewable energy. Also phase out gas usage for power generation by 2040,
- Increase rail freight by 25% and have 15 million electric cars on the road by 2030,
- Initiate an International Climate Club with a minimum CO2 price and common carbon border adjustment, and
- Increase the minimum wage to €12 from €9.60.
In recent years, Germany’s fiscal landscape has been shaped by two policy directives, the ‘schuldenbremse’, or debt brake, and the ‘schwarze null’, or black zero. The debt brake is a constitutionally enshrined limit on government borrowing that mandates the cyclically adjusted budget deficit can be no greater than 0.35% of GDP, except in the case of an economic emergency. By contrast, the black zero has been a political commitment to run a balanced budget. Abolition of the debt brake is highly unlikely to occur during this administration both because it requires a two-thirds majority in the two houses of Parliament and the FDP remains opposed to the idea. However, sentiment had been gradually shifting in favour of more fiscal flexibility even prior to COVID-19 as growth decelerated sharply in 2018 and 2019.
The debt brake clearly negates the possibility of a sustained, major fiscal expansion. However, the coalition has avenues open to it that allow for some circumvention of these rules, and it will likely take advantage of several of them. Firstly, the hiatus in application of the debt brake is to last until 2023, after the rule was suspended with the onset of the pandemic. The government is likely to borrow more heavily next year as a result, placing unused proceeds into a fund that can be drawn down in subsequent years. Secondly, KfW Development Bank (the state-owned investment and development bank) may be recapitalised and its balance sheet leveraged to finance investments in green energy and digitisation. Finally, the estimate of the output gap used to calculate the cyclically adjusted budget balance is considered quite conservative, with a proposed methodology change potentially freeing up to an extra €10 billion a year.
The EU also suspended its Stability and Growth Pact (SGP) budgetary rules with the onset of COVID-19. Under the SGP, members’ budget deficits may not exceed 3% of GDP, while national debt cannot exceed 60% of GDP. Though these rules were frequently breached, the attempts to adhere to them by countries that would have benefitted from continued fiscal support hampered the region’s post–Global Financial Crisis recovery. Certain EU members want a return to the strict adherence of these rules, while others are pushing for flexibility in their interpretation. The position of Germany will likely be the deciding factor. Though a permanent adjustment to the SGP would require a change of the Maastricht treaty, there remains scope for flexible implementation of the rules even outside of a treaty change. One option is stripping out fixed investment, particularly “green” investment, from the rule calculations. This seems a real possibility based on the first comments from FDP leader Christian Lindner, who was installed as German finance minister. Combined with back-loaded disbursements from the more than €800 billion NextGenerationEU recovery plan, this should see a stronger fiscal impulse in the EU than among most of its peers.
Risks remain to the outlook in the euro area. COVID-19 cases are rising, and governments are increasingly reimposing restrictions that will impact activity to varying extents in the near term. Energy prices also represent a headwind to consumption for as long as they remain elevated. Nonetheless, fiscal policy looks likely to be supportive over the next couple of years, and the prospects of an early, damaging tightening of policy are waning. In addition, the European Central Bank should stay accommodative longer than its peers, as labour market dynamics are indicative of lower underlying price pressures in the euro area than in the United States or United Kingdom. These factors look set to provide a positive backdrop for European risk assets.
Thomas O’Mahony, Investment Director, Capital Markets Research