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Europe Plunges Into Chaos After Germany Freezes Public Spending Following Shock Top Court Decision

Germany’s economy, Europe’s largest, is contracting as surging energy prices and trade tensions cast doubt on its export-oriented business model

Europe Plunges Into Chaos After Germany Freezes Public Spending Following Shock Top Court Decision Image Credit: Uli Deck/picture alliance via Getty Images
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Europe, already sliding into a stagflationary recession, is about to unleash the same crushing austerity that brought the continent to the verge of collapse over a decade ago.

One day after the German constitutional court ruled a decision to move €60BN from unused pandemic funds in 2021 into the Energy and Climate Fund, later renamed the Climate and Transformation Fund (KTF), was unconstitutional and void, the German government froze public spending for the rest of the year, dealing a blow to Europe’s recovery and efforts to beef up Zelensky’s offshore bank accounts Ukraine’s military and reduce carbon emissions.

The court decision, details of which are laid out below courtesy of SocGen, will widen the economic speed gap between Europe, whose economy has stagnated for over a year, and the US, which grew at an annualized 5% in the three months through September, turbocharged by massive fiscal stimulus which led to a crisis era-like $2 trillion budget deficit in 2023.

Germany’s economy, Europe’s largest, is contracting as surging energy prices and trade tensions cast doubt on its export-oriented business model. Chancellor Olaf Scholz’s government had been counting on that old virtue signaling switcheroo – a flood of spending on “green-energy projects and technology”, from chips to batteries, to revive the old model. That way, if anyone asks why Germany is deficit-spending its way to mercantilist utopia, Berlin could always lie and say it was doing the right thing for the world and wasn’t interested in a debt-funded stimulus. Alas, now the “Cardinals of Karlsruhe” have made this impossible.

And without a new spending stimulus, Germany may be doomed: as the WSJ notes, energy prices are expected to remain permanently above pre-Ukraine war levels (much to the benefit of US LNG exporters and the Biden regime which directly benefits from monopolizing the trade route that previously was dominated by Moscow) which will squeeze out energy-intensive manufacturing, while an aging population and a labor force that is projected to shrink will likely constrain potential growth.

Berlin’s decision to freeze all federal spending for the rest of the year came after the court defunded the government’s €60 billion —the equivalent of more than $65 billion—green-transition project. The court said Berlin couldn’t repurpose unspent credits originally earmarked to tackle the Covid-19 pandemic to fund environmental and energy projects. It said Berlin was bound by the country’s constitutionally enshrined fiscal rules that limit budget deficits to 0.35% of gross domestic product in normal times.

Berlin now faces a choice of finding equivalent budget cuts or raising taxes—or both—if it wants to go ahead with the plan, which includes, among other items, multibillion-euro subsidies to build chip-making plants.

The judgment also raises questions about the use of off-budget special funds to finance public investments, including a €100 billion plan to revamp Germany’s underfunded military that was announced after Russia’s invasion of Ukraine.

In short, not only Germany’s economy is about to get crushed, Zelensky’s visions of a comfortable retirement in some Polynesian island followed suit.

While some German economists welcomed the ruling, which they said would impose much-needed fiscal discipline at a time of high interest rates, others think it could prevent Scholz and his successors from retooling an economy that has been losing competitiveness.

More importantly, in the short term, the government must decide which policy areas—from boosting Europe’s collective defenses to supporting Ukraine or cushioning the impact of surging energy prices and inflation on businesses and households—it should give priority to. Berlin must also review all debt-financed expenditures in the last eight years to ensure it was compliant with the new ruling (spoiler alert: it wasn’t).

German officials in Brussels told European Union counterparts Friday that they would continue supporting a €50 billion four-year EU budget package for Ukraine, which is supposed to take effect next year, according to two people briefed on discussions. However, Berlin made it clear it wouldn’t back an additional €50 billion spending request from the European Commission on migration and other Brussels priorities. Germany pays for around a quarter of EU spending.

And with that, following the recent decision by the House majority to effectively stop the Zelensky money train, Ukraine’s money has dried out.

Meanwhile, things for Germany’s establishment are going from bad to worse: the emergency belt-tightening comes amid growing political fragmentation and accumulated crises that have eroded the ratings of Germany’s three-party coalition. The antiestablishment opposition party Alternative for Germany, or AfD, is now polling at 22%, making it the first far-right group to obtain such support since the 1930s. The party opposes German military spending in Ukraine and generous outlays on refugees.

“The verdict will have profound effects on the practice of statecraft,” Finance Minister Christian Lindner said.

Following the Ukraine war, Germany embarked on a spending spree to support Kyiv, fortify its own defenses and cut its dependence on Russian natural gas and oil. It also pledged to fund a shift to a zero-emissions economy by supporting consumers and businesses at home and in the EU, and it expanded Germany’s already generous welfare state to keep voters on board.

All these projects are now frozen.

According to the WSJ, lawyers and government officials said Germany’s Constitutional Court ruling last week offered the strictest legal interpretation to date of the country’s fiscal rules—themselves among the toughest in Europe. They said it could severely constrain any future government’s fiscal margin of maneuver unless it can raise more taxes—an unlikely prospect given that Germany already has the second-highest taxes on labor among Organization for Economic Cooperation and Development countries.

Senior government officials said one option under consideration would be to retroactively declare a state of budgetary emergency for 2023, invoking a clause in the fiscal rules that allows for a suspension of the spending limits in exceptional circumstances. Previous governments invoked the exception during the pandemic.

Unfortunately, for Germany’s stimmy-starved politicians, the plan is fraught with legal difficulties, in part because the constitutional court prepared for just this eventuality when it raised the bar for declaring such emergencies, according to Lars Feld, an economist who advises the government.

Strengthening resilience and transforming the economy amid geopolitical crises and climate change was seen as a necessity that required taking on debt, but the court ruling has challenged those assumptions, Feld wrote in the Frankfurter Allgemeine newspaper.

Hilariously, the court said that unlike war and natural disasters, climate change was a foreseeable crisis that had been long in the making and could no longer justify emergency spending. Which, however, means that all Germany will have to do is politely request that the CIA start a new war… or that Fauci mail orders a new virus from Wuhan.

Germany’s fiscal rules were enshrined in the constitution under former Chancellor Angela Merkel. They affect both the federal and state governments and are more constraining than the EU’s own fiscal rules. The cap was one reason Germany didn’t raise borrowing, kept taxes high and faced a shortfall in public investment in transport, education, defense and other critical areas during the years of low interest rates.

It’s not just Germany. European finance ministers are expected to agree next month on new rules to tighten their purse strings after years of heavy spending during the pandemic. At that point Europe’s descent into another austerity-driven sovereign debt crisis will be complete, and central banks – their infllation fighting days long forgotten – will be pumping out new digital currencies by the quadrillions. 

Appendix – details on the German Constitutional Court decision below, courtesy of SocGen:

Background:

On 15 November, the German constitutional court ruled a decision to move €60bn from unused pandemic funds in 2021 into the Energy and Climate Fund, later renamed the Climate and Transformation Fund (KTF), unconstitutional and void. Germany has a long habit of squirreling money into off-budget reserve funds (there are some 30 of them totalling around €870bn). While this has earmarked money for specific purposes, e.g. €100bn for defence spending following the start of the Ukraine war, it has also made the fiscal stance less transparent with question marks over how consistent the practice is with the constitutionally protected debt-brake and EU fiscal rules. The debt brake rule, limiting the structural budget deficit to 0.35% of GDP, was suspended from 2020 to 2023 due to the pandemic, with the intention of returning to it next year. This allowed the government to issue much more debt, incidentally also at a time of exceptionally low interest rates. In 2021, as it became clear that the additional €60bn would not be needed, it was transferred to the KTF, boosting it from €42.6bn to €102.6bn and making it possible to use the funds in subsequent years. However, the transfers were made retroactively in 2022 for the 2021 budget, while allowing it to be used for other objectives than the pandemic. There have been further top-ups of the fund, most recently in August this year by €30bn to about €212bn.

Court ruling:

In its judgement, the Constitutional court ruled that the supplementary 2021 budget, which retroactively amended the 2021 budget, is incompatible with the Basic Law and is void. The court’s decision was based on the following: 1) the government failed to sufficiently demonstrate the necessary connection between the emergency (the pandemic) and the measures taken in response. 2) decoupling the declaration of an emergency from the actual use of the borrowing is incompatible with the constitutional principles of budgeting. The use of emergency borrowing authorisations in subsequent fiscal years without counting them towards the ‘debt brake’ rule for those years (and instead counting them as ‘debt’ for the 2021 fiscal year) is therefore not allowed. Third, the adoption of the supplementary Budget Act 2021 after the end of the 2021 fiscal year violates the principle that the budget must be determined in advance. The court’s decision thus directly means that the volume of the KTF is reduced by €60 billion.

Implications:

The Constitutional court’s decision is a major blow to the German government, at a time when tension within the coalition over the direction of fiscal policy is already increasing. Germany has been one of the few countries with fiscal room to address the pandemic and the war in Ukraine with fiscal policy, raising public debt by some 10% of GDP to 69% in 2021, while arguably still having policy room for further action. However, the debt-brake rule limits the rise in debt by limiting the annual deficits. With a shortfall of €60bn in the KTF, the decision is thus to either cut spending, raise taxes or prolong the suspension of the debt brake rule. The government could also draw on other reserve funds but with unclear legal consequences. Suspending the debt brake for another years seems implausible as it has been ruled out by the opposition CDU party (which brought the court case in the first place). That leaves spending cuts and possibly tax increases, with the latter ruled out by the Free Democrats (FDP).

1)     2024 budget

While there is still much uncertainty as regards the full implications of the ruling and possible solutions, especially to what extent it impacts on other reserve funds (raised during the pandemic or before), the 2024 budget will need to be amended. Around €40bn of funding had originally been planned from the KTF but according to some media reports, the shortfall for 2024 could be lower, around €24bn if other available funds are taken into account. This is still a significant amount (0.6% of GDP) and will require some drastic, pro-cyclical, measures in key spending areas like climate, welfare and housing, and industry support. Recently, there has been much debate on supporting ailing industries, suffering from higher energy prices. Measures have included a corporate tax relief (around €7bn over four years) and an electricity tax relief amounting to €12bn in 2024. Such measures have also drawn the ire of the European Commission, for providing state support to businesses that could distort the Single Market. Plugging the funding needs might thus affect these measures and thus go to the core of the differences between the coalition parties (Greens, Social and Free democrats). Most likely, compromises will need to be made by all parties, possibly even including tax increases, and ultimately the question will be if there is the will, especially for the FDP, to remain in the coalition or break out, also in view of elections awaiting in September 2025. While lawyers will need some time to go through the ruling and the impact on budgets beyond 2024, in an optimistic scenario, the government has only lost €60bn of funding (which should improve the debt ratio by about 1.4% of GDP) while becoming more contained to the annual budgets for its spending plans. However, our reading of the ruling suggests that more funds will be affected.  

2)     What to do about the debt brake rule and the green transition?

There has already been much debate about the wisdom of having a deficit-limiting fiscal rule at a time when German industry is facing significant structural change (see Germany: cyclically okay, but facing massive structural headwinds). Introduced in 2009 as a way of securing that debt trended back to 60% in normal times, it requires a 2/3 majority in parliament to be changed (the creation of a €100bn fund for defence spending following the Russian invasion of Ukraine should not be affected by the court’s decision as it was done by an amendment of the law with 2/3 majority). The ruling by the Constitutional court clearly highlights the limitations of any progressive government to fundamentally change and adjust the economy to new realities, be it regarding energy sources, climate transition, supporting traditional industries or social reform. Supply side reform and tax increases may thus again come into focus until there is sufficient agreement, if at all, in parliament and a 2/3 majority to amend or abolish the debt brake rule. We expect this to be a key topic in the 2025 election campaign and see many reasons why there should be more flexibility to face multi-year but transitory challenges. Options include harmonising the German fiscal target (0.35% of GDP) with the EU one which is slightly less ambitious (of 0.5% of GDP) and introducing an investment (golden) rule. 

3)     Fiscal policy in Germany and EU

Given the relative strength of German public finances and the challenges ahead, we still expect Germany to pursue ambitious fiscal reforms in the coming years, albeit with a more limited ability to use dedicated reserve funds. With much less flexibility due to its domestic fiscal target, it is also possible the Germany will be less inclined to accept additional flexibility in the EU fiscal rules framework. This is currently under discussions, but given Germany’s domestic position, it is hard to see Germany willingly accepting much less ambitious fiscal policy in other EU countries. Next year will thus be very interesting in terms of countries formulating 2025 budgets against a background of much lower inflation and likely a still weak growth outlook.


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