Germany: A Change In Direction For Fiscal Policy

Germany's fiscal policy

Posted By: The Corner 17th April 2018

Germany has managed to form a coalition government between conservatives and social
democrats, known as the GroKo III as it is the country’s third Große Koalition, six months
after September’s general elections. Agreeing on a coalition has been a complicated process
and both parties have had to give up part of their programme. One of the strategic points in
the agreement is fiscal policy. After three years in «austerity mode» it now seems to be
changing direction. CaixaBank’s economists analyse this in more detail.

They flag that the agreement reached establishes a number of measures to increase social
spending and also investment in education and infrastructures. These measures would come to
around EUR 79.6 billion (2.4% of GDP) in the period 2018-2021. This is a “significant” fiscal
stimulus and, if all the measures are implemented, “it could erode the government surplus
enjoyed by the German economy”

A brief look at the main measures announced for each area to better gauge their impact on
economic growth lead CaixaBank’s analysts to the following arguments.

Regarding the boost for social spending, the main aim is to increase aid for childcare and the
generosity of the pension system. In the case of pensions, the idea is to guarantee a 48%
replacement rate up to 2025 (the system’s current level), as well as broaden the pension rights
of women with children. According to the experts these measures will particularly benefit a
group of people:

The retired or those who will soon retire who largely vote for the two coalition parties but, in
the long run, it will put more pressure on the sustainability of the pension system.

These are not the only measures based more on political than economic reasoning which the
coalition government has agreed. In the area of employment, the coalition has decided to
implement measures that restrict the use of temporary contracts.

This could particularly please those who have switched their vote from the government’s
coalition parties to the AfD, people whose employment conditions tend to be more precarious.
They might therefore believe this measure helps them although the medium-term impact will
probably be the opposite.

Returning to fiscal policy, the increased investment is mostly to be allocated to education,

with federal government aid to the länder to improve their education systems, especially
nurseries and full-time and professional training centres.

Regarding the larger investment in infrastructures, most should be aimed at improving the
existing transport network which is felt to be quite obsolete. The coalition also wants to carry
out actions that support the digitalisation of Germany’s production system and society in
general. In opinion of Caixabank:

The boost intended by GroKo III for investment in education and infrastructures will help to
offset a deficit in public investment in these two areas which, for instance, has been detected
by the European Commission. Such measures could therefore have significant impact on
Germany’s long-term economic growth.

The overall impact of the measures agreed in the short and medium term is not negligible
either, given the focus on social spending and investment. The impact on GDP growth could
be around 0.5 pp over the next few years. But there is a lot of uncertainty surrounding this
figure.

Firstly, because no specific schedule has been provided for implementing the different
measures agreed. But especially because a reluctance to erode Germany’s prized government
surplus to any great extent may end up limiting the fiscal drive.

In any case, the evidence suggests that Germany’s fiscal policy will change direction over the
coming years.
Commentary
Internal Assessment 2
Macroeconomics
The article concerns a change in German government policies by the GroKo III. The
government wants to turn towards fiscal policy (manipulation of the level of government
spending (G) and taxation (T) to affect aggregate demand (AD)), increase expenditures in
pensions, healthcare and education, and change employment policies. The word “increase”
implies that the government will use expansionary fiscal policy (increasing G and reducing
T). Aggregate demand is the total planned spending on domestic goods and services at various
average price levels per period of time. (Consumption+Investments+Government
expenditures+Net export). Unemployment also needs to be defined; it exists when individuals
who are actively searching for a job cannot find one.
“<…> the coalition has decided to implement measures that restrict the use of
temporary contracts.” Unemployed are often afraid to accept contracts because they don’t
want to lose their unemployment benefits. If many people accept temporary contracts, the
unemployment rate will fluctuate between a very high and a very low level, while the
macroeconomic objective would mean an
unemployment rate of ~5%.
Considering the use of fiscal policy to
decrease unemployment, we can consider
this diagram. Cyclical unemployment
(unemployment due to insufficient AD)
exists originally, but fiscal policy is used to
Real output
increase AD to move the economy towards
full employment. Originally, the equilibrium
Effects of increasing Aggregate Demand
is at A. By increasing AD(AD1AD2),
output increases, labour demand increases, and cyclical unemployment levels fall. Prices
increase (P1P2), and at higher prices producers want to sell more goods. New equilibrium
exists at B. How does expansionary fiscal policy increase AD? Firstly, G is part of AD, so
increasing G will also increase AD. Reduced taxes lead to increased disposable income and
thus consumption, and to increased investments as firms will have more retained profits to
invest.
Fiscal policy has several advantages; investments by the government (=G) are “mostly
to be allocated to education” and are “aimed at improving the existing transport network”.
Improving education boosts human capital substantially, which first leads to economic growth
due to higher productivity, then a circle of investments and growth in the long-run, and an
increase in LRAS.
Considering unemployment (natural (unemployment that exists even at full
employment level) and cyclical), the conclusion is simple; if the government uses demand-
side policies, they will only be effective against cyclical unemployment, as demand-side
policies close deflationary gaps (present if equilibrium real output is smaller than the full-
employment level output due to insufficient AD). However, it will be ineffective against
natural unemployment since it exists even at full employment levels, and because natural
unemployment is caused by supply-side factors.
Secondly, advantages exist considering actual growth (increase in real GDP
throughout time). If, due to fiscal policy, AD increases, equilibrium level of economy shifts to
the right, increasing real output/GDP, which, through higher disposable income, could lead to
better standards of living or even higher life expectancy. Potential growth is irrelevant,
because supply-side policies would be necessary for that.
Furthermore, multiplier effect is an advantage of fiscal policy. Increased government
spending is received as re-spendable income for households, leading to multiple rounds of
receiving income and re-spending. Thus increase in AD is greater than increase in G.
However, crowding-out works against multiplier, for example if budget deficit due to
increased G has to be financed through borrowing. Higher borrowing increases interest rates,
thus decreases consumption and AD. Size of these effects are difficult to estimate.
If we want to analyse consequences the long- and short-run, the following diagram
might help to understand them:
Originally, there is a deflationary gap Y1Y2.
The government can close this gap by increasing
AD(AD1AD2), and it can also reduce
unemployment in the short-run. However, the
neoclassical view says that economy returns to
full employment in the long-run by itself, so
demand-side policies may not be necessary. If
the government chose to decrease AD, in the
short-run it would increase unemployment, but
then as SRAS would shift to the right due to
lower wages (meaning firm costs
decreasesupply increases) caused by deflation,
and economy would return to full employment again. Firms (stakeholders) are better-off in
the short-run.
Considering macroeconomic objectives, trade-offs include that if the government uses
fiscal policy to reduce unemployment, it leads to higher rate of growth, since output increases.
This leads to inflation, and if the government tries to reduce inflation, there will be lower
output, so finding balance is difficult. In Europe, unemployment is a severe problem, and low
inflation is one reason. Only time will tell whether imposing fiscal policy is the good long-run
choice for Germany.

Word count: 750

Bibliography:
URL for the article: http://thecorner.eu/news-europe/germany-a-change-in-direction-for-
fiscal-policy/72466/ , accessed on 30.01.2019