The German fiscal stimulus package could and should have come earlier. At least since the Spring of 2008, it was clear that expectations and orders were falling. Certainly, after the failure of Lehman Brothers, economic prospects turned sharply, and in November our forecast of shrinkage of the economy by about 1% in 2009 was close to that of other forecasters. But it took until January 12, by when the economic projection for 2009 had moved into a zone not seen in German post-war history – with projection of about a 2.5% contraction—that a sizeable package was finally put together.
The German authorities have been subjected to a chorus of criticism for being slow to respond to the crisis with a needed fiscal stimulus. And despite the announcement on January 12th of a 50 billion euro package, a strand of criticism has continued, with respect to the size and the composition of the package. It is helpful, therefore, to view the package from three perspectives:
- How does its size compare with that of other packages?
- Is it large enough?, and
- Is its composition likely to achieve what it intends to achieve?
The first question is easily answered.
As of today, in terms of stimulus legislated and ready for implementation, the German package is not evidently smaller than that anywhere else and typically significantly larger than that announced by other countries. The reported Chinese stimulus is possibly larger but the details and timing of the proposal make direct comparisons difficult. Proposals for the US fiscal stimulus package, as reported in the press, would make that stimulus larger and more sustained, but that is yet to come. The German stimulus is also above the amount pledged to the European Commission for a coordinated stimulus (1.2% of GDP from national budgets). From an international perspective, then, the German stimulus is a significant contribution.
But is the stimulus large enough for German needs?
Germany faces the prospect of an unprecedented slowdown, with a slow recovery in 2010, and downside risks to this projection remain significant. Recent data releases give a glimpse of things to come. In November, exports dropped by 10% (in real and nominal terms) month-on-month, the largest drop in the last two decades. Led by the fall in exports, real GDP in the fourth quarter contracted by more than 1.5% on a quarter-on-quarter (and seasonally and working day adjusted) basis, implying an annualised contraction in the range of 6-7%. Corporate stress is reflected in increasing bankruptcies and in corporate bond spreads, which shot up after the failure of Lehman Brothers and have remained high despite easing in the credit and money markets. Weakening world trade and corporate stress are feeding on each other worldwide: Germany, with its high dependence on exports, is caught in that spiral. Domestic consumption and investment can be expected to remain weak. In 2009, real GDP is likely to fall by 2½% and be flat in 2010.
The fiscal stimulus (including the packages in October, November, and that announced on January 12) will help prevent a further weakening of domestic demand, absent which the 2009 outcome would have been dire. In combination with earlier fiscal packages, the stimulus amounts to just over 1.25% of GDP in 2009 and another 0.5% of GDP in 2010. In November, IMF staff had recommended a stimulus of between 1.5 to 2% of GDP; but with the significant worsening of the economic outlook, a stimulus of at least 2% of GDP would have been desirable. Such a boost would not only inject demand and impart some growth momentum, but, perhaps more importantly, would be partial insurance against a loss of confidence leading to further deterioration of short-term growth prospects. To the extent it can support confidence, the stimulus could have an effect on growth that significantly exceeds what commonly reported multiplier estimates would suggest.
In hesitating to use fiscal tools, the German authorities have had two legitimate concerns:
- Demands for favoured measures by various interest groups would be difficult to contain,
- The goal of achieving long-term debt sustainability would be set back.
The authorities have been particularly sensitive to these concerns since it has taken several years of consolidation efforts to reach a budget balance in 2008. This, in turn, has required building a policy and political consensus on the need for fiscal discipline. While critics of German hesitation saw in Germany a fiscal space that needed to be used, German authorities saw the likely erosion of a fragile political consensus and the loss of momentum in their goal of debt sustainability.
Good politics makes a bad multiplier
The German concerns have, to an extent, materialised in the composition of the fiscal package that has eventually emerged. The range of measures clearly reflects political compromises, which unfortunately will also limit their effectiveness to prop up a nascent recovery soon. The fiscal multiplier—a gauge of “bang-for-the-buck”—associated with each of them is an indicator of their relative effectiveness.
- Public investment has the highest short-run multiplier. On impact, the one-to-one relationship between public investment and GDP makes its multiplier 1.0. Just under a quarter of the stimulus is directed at public investment. This limit reflects the need for so-called “shovel-ready” projects that can be used for quick injection of demand. The identification of such projects, that also bring longer-term value, could have begun earlier and must now proceed apace.
- Multipliers for raising incomes of consumers are smaller because consumers are likely to save part of any additional income. The aim, therefore, has to be to target any additional income to liquidity-constrained households who are likely to spend. In this regard, the significant reliance on proposed reductions in the personal income tax rate will bring limited benefits. Only the richest half of the population pays personal income taxes. In contrast, reductions in social contributions or an increase in social benefits provide more short-term stimulus. While proponents of personal income tax reduction may argue that it has longer-term incentive effects, so does the reduction of payroll taxes, which is also more strongly stimulative in the short run and which could have received greater weight.
- Finally, incentives for private sector investment are likely to have minimal multipliers in the current environment of low business confidence and corporate stress. Yet, more than one-tenth of the various packages are measures designed to bolster private investment, such as accelerated depreciation rules and greater deductibility of expenditures.
The fiscal stimulus will not provide insurance against further confidence loss unless it is firmly anchored in a credible medium-term consolidation strategy aimed at safeguarding fiscal sustainability. As such, the most important and lasting outcome of the new stimulus package may well be the introduction of a new deficit rule to improve long-term fiscal sustainability.The new rule would require that the proposed structural budget deficit not exceed 0.5% of GDP. While the existing deficit rule has been frequently circumvented, the new one would come with a binding correction mechanism if deficits accumulate. While long discussed, this rule has so far faltered under political opposition. The authorities are to be commended for using the stimulus package as an opportunity for a renewed political push for the introduction of the new deficit rule to improve long-term fiscal sustainability.
The IMF’s staff report of the 2008 Article IV consultation, completed on January 14, is available here. Please note the staff supplement towards the end of the document: events have moved so quickly that the recent developments described in the staff supplement are significant updates to the staff report. The IMF staff survey also contains a recent article on Germany with a link to a video summary.
Work for the IMF’s Article IV consultation suggests that economic and financial volatility induces consumers to increase their savings rate. This is particularly true for the German consumer who, in a very open economy, is exposed to worldwide trade and financial shocks.