VoxEU Column Europe's nations and regions

The debt hanging over Berlin

Written March 2006: Despite its claim to be ‘sexy but poor’, Berlin’s request for a federal handout was refused by the German Constitutional Court. The tighter conditions on federal assistance should ‘harden’ the Lander budget constraints. If they don’t, Berlin may reappear in the Constitutional Court with fiscal problems so severe that the city is not sexy anymore.

In a recent, widely recognized, decision the German Constitutional court rejected the State of Berlin's request for federal assistance due to its fiscal crisis. Though Berlin is certainly in a difficult situation with a debt burden of more than €60 billion, and with a debt service absorbing more than 20 % of its tax revenue, many economists feared that the court would accept this request and force the federal government to pay.

Berlin is not the first German state which had appealed to the Constitutional court to receive federal fiscal assistance in case of severe fiscal imbalance. About fifteen years ago the Constitutional court already accepted similar requests from the states of Saarland and Bremen, which subsequently received together about €15 billion. In the case of Berlin even bigger figures were discussed: Berlin's own request amounted to €35 billion, an amount almost equal to €1000 per household in the entire country. The court's recent decision is a disappointment not only for Berlin but also for the states of Saarland and Bremen, which despite the significant assistance received in the last decade have recently appealed again to the constitutional court, with the argument that a continuation of the extra grants from the federal level is necessary to avoid fiscal crises.

While the case of Saarland and Bremen is still pending, the decision with regard to the Berlin case was, not surprisingly, received with relief by the federal government. Had the court continued its ruling and confirmed Berlin's request for federal assistance, this would have been a signal to all German states that the financial consequences of sustained fiscal imbalances could be shifted to the federal government. As the example of Bremen and Saarland already suggests, the expectation to receive federal assistance in a situation of a fiscal crisis provides strong disincentives for balancing the budget. In fact, a constitutional guarantee to receive a 'bailout' would weaken the budget constraint of the states and induce them to 'raid the commons' of federal fiscal funds with potentially severe consequences for overall budget balance.

While most countries provide fiscal assistance to subnational governments without incurring major fiscal problems, the German case displays some specific characteristics which contribute to the emergence of significant problems with subnational government debt. A first important aspect is that the German constitution demands 'equal living conditions' in all states. Given strong fiscal disparities before and, in particular, after the unification, this constitutional requirement results in an extensive system of intergovernmental transfers, creating a situation where a large fraction of state spending is financed with grants rather than with its own revenue. A second aspect is the ``taxing cartel'' of the states which have a strong control of federal policies, including taxes, in the Upper House (Bundesrat), and which receive a substantial share of the revenue from federal taxes. The result is that Germany combines a large degree of revenue decentralization without any significant tax autonomy at the level of the states. In this situation, states have few alternatives to budgetary adjustment other than to cut expenditures and to use political power and constitutional status to raise intergovernmental revenue.

The recent constitutional court decision has made this second channel of adjustment more difficult. The Berlin government put much effort into demonstrations of its willingness to consolidate, highlighted by the major's slogan 'Poor, but Sexy' in the recent election. At the court, Berlin claimed that it had tried to consolidate, but that it was not able to do any more. The court came to the opposite view that Berlin has not sufficiently exploited opportunities to restore fiscal balance by its own means. However, the court has not fundamentally changed its view on the need for federal assistance in a situation of severe fiscal imbalance. In fact, the recent decision explicitly notes that if all consolidation possibilities were exploited, federal assistance in a state fiscal crisis would constitute a measure of 'ultima ratio'.

The continuation of the view that federal assistance would still have to be provided in a severe crisis is problematic. The way the potential conflict between creditors and debtors is dealt with overshadows ordinary financial decisions and determines the likelihood of financial crises. In this perspective the recent court decision does not constitute a major change to the institutional conditions for subnational government debt in Germany. This might explain the rating agencies' response to the court decision. None of them saw a need to change the rating of state bonds: even after the court's decision, debt obligations of Berlin as well as of other German states get the same excellent rating as federal government bonds.

It remains to be seen whether rating agencies will stick to this assessment once the court has also ruled in the cases of Saarland and Bremen. Economists are left with the hope that the tighter conditions for receiving federal assistance will result in at least some hardening of state governments' budget constraints. Otherwise, Berlin may reappear in the future at the constitutional court, this time facing such severe fiscal problems that the city is not sexy anymore.

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