Saturday, March 23, 2013

23/3/2013: And the Strong Are Yet to Become Strong: German Debt Sustainability


A very interesting paper by Burret, Heiko T, Feld, Lars P. and Koehler, Ekkehard A., titled "Sustainability of German Fiscal Policy and Public Debt: Historical and Time Series Evidence for the Period 1850-2010" (February 28, 2013). CESifo Working Paper Series No. 4135. Available at SSRN: http://ssrn.com/abstract=2228623

Here's from the abstract:

"In the last decades, the majority of OECD countries has experienced a continuous increase in public debt. The European debt crisis has prompted a fundamental re‐evaluation of public debt sustainability and the looming threat of sovereign debt default. Due to a multitude of large scale events in its past, Germany is far from being an exception: In fact, Germany’s peacetime debt‐to‐GDP (Gross Domestic Product) ratio has never been higher."

And a chart:
[Click on the chart to enlarge]

On methodology: "In this paper, we analyse the sustainability of Germany’s public finances against the standard theoretical back‐ground using a unique database, retrieved from multiple sources covering the period from 1850 to 2010. Multiple currency crises and external events offer anecdotal evidence, contradicting the historical perception of Germany as the poster child of European public finance. Given these corresponding breaks in time series, the empirical analysis is conducted for the sub‐periods 1872‐1913 and 1950‐2010. In addition to an anecdotal historical analysis, we conduct formal tests on fiscal sustainability, including tests on stationarity and cointegration and the estimation of Vector Autoregression (VAR) and Vector Error Correction Models (VECM)."

And the punchline: "While we cannot reject the hypothesis that fiscal policy was sustainable in the period before the First World War, the tests allow for a rejection of the hypothesis of fiscal sustainability for the period from 1950 to 2010. This evidence leads to the conclusion that Germany’s public debt is in dire need of consolidation. Albeit a much needed reform, the incompleteness of the German debt brake will have to be addressed in the coming years, in order to ensure that fiscal consolidation actually takes place"

[Skip below to see the more extensive summary of conclusions]

And the recent experience? Here are the economic fundamentals pertaining to the cost of capital and growth:





A descriptive table of stats summarising the overall performance:


And public expenditure levels (alongside revenue and balances)


So the results after skipping through loads of rigorous tests are:

"After the experience of the two World Wars, the German population is quickly alarmed when debt levels appear to be rising to unsustainable levels. This holds particularly for recent years, as Germany’s debt‐to‐GDP ratio has never been higher in peacetime than today...

In this paper, we analyse sustainability of German public finances from 1872 to 2010. Given the breaks in the data series, in particular those induced by the two World Wars, the main analysis is conducted for the sub‐periods 1872‐1913 and 1950‐2010. …While we cannot reject the hypothesis that fiscal policy was sustainable in the period before the First World War, this only holds if we do not allow for trends in the cointegration relation. The hypothesis of fiscal sustainability for the years 1950 to 2010, on the other hand, must be rejected. After the Second World War, German public finances have become unsustainable.

This evidence leads to the conclusion that public finances in Germany are in dire need of consolidation. In fact, the introduction of the debt brake in the year 2009 is a much needed reaction to this development. Although such fiscal rules always have their loopholes and are necessarily incomplete, they usually have some success in restricting public deficits and debt (Feld and Kirchgässner 2008, Feld and Baskaran 2010). The incompleteness of the German debt brake will have to be addressed in the coming years in order to ensure that fiscal consolidation actually takes place. One shortcoming of the new debt rule requires wider ranging reform, however: The Länder (including their local jurisdic‐tions) not only have huge consolidation requirements, they also do not have the tax autonomy to balance the spending demands on their budgets. The next major reform of the German fiscal constitution should thus allow for more tax autonomy at the sub‐federal level."
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