Speech delivered at the Centre for Independent Studies (Sydney), 13 October 2009
When the Reserve Bank raised interest rates last week, it was widely interpreted to mean that – at least for Australia – the worst of the global financial crisis was over. The gradual tightening in monetary policy signalled that things are slowly going back to normal in the Australian economy. And indeed, some economic optimism may well be justified if we look at recent news from the job market, the recovery in the share market, and higher activity in the housing market.
In its statement last Tuesday, the Reserve Bank also said that the global economy is resuming growth. Indeed, we can see signs of economic stabilisation in other parts of the world as well. Notably in Europe, it now looks as if the worst of the financial crisis is over.
Having said that, I believe there are good reasons to remain cautious about Europe’s economic future. While it is true that things have somewhat stabilised after the tumultuous events of the last 12 months, we should not forget that there are some difficult challenges ahead. For Europe, the financial crisis may be over, but a new crisis is just about to begin. I am talking about the fiscal crisis that many European economies will have to tackle over the coming years.
We have called tonight’s event ‘trans-Atlantic fiscal follies’. Robert Carling has dealt with the Western side of the Atlantic, which leaves me to describe what is happening on the Eastern side of the Big Pond. The European Union consists of 27 member states, and going through them one by one would probably take more than the 15 minutes I have. So instead, tonight I will focus on just two countries, the United Kingdom and Germany.
Why the United Kingdom and Germany, you may ask. From an Australian perspective, the United Kingdom may be the country in Europe whose development we follow most closely. Australia, of course, has some traditional links with Britain that are reflected in the bilateral economic relations between the two countries.
However, if we are talking about Europe more generally we must talk about Germany – for a very simple reason. It is not only Europe’s largest economy by far, but also Europe’s most connected economy. Germany is famous as a big exporter. In fact, it was only recently overtaken by China as the world’s biggest export nation, but it continues to export more than countries like Japan or the United States. The flipside of this is that it imports a lot, too. Imports of goods and services are equivalent to 41% of German GDP. This makes Germany the single-biggest market for almost all other European countries. So whatever happens in Germany affects other European countries.
So for these reasons, I want to concentrate on Germany and Britain tonight. Having said that, the problems I am going to talk about are not unique to either of them. High levels of public debt and large fiscal deficits can be found in many other European economies as well. The state of public finances in countries such as France or Italy, let alone Greece, can hardly be called rosy.
In any case, let us begin with the situation in Europe’s largest economy, Germany. As you are probably aware, Germany recently elected a new centre-right government to replace the so-called Grand Coalition of conservatives and social democrats. The new government, led by the previous Chancellor Angela Merkel, will be confronted with a difficult task from the first day in office: to restore Germany’s public finances and to get its soaring budget deficit under control.
German politicians are quick to blame the global financial crisis for the country’s fiscal problems. If they were honest, they should only blame themselves. On the one hand, Germany’s fiscal problems predate the crisis in the world’s financial markets. On the other, German governments – both at state and federal level – have made costly mistakes in dealing with the financial crisis.
Germany’s fiscal problems clearly became a lot worse when the crisis first hit in 2007. However, running substantial budget deficits is a long and unfortunate tradition in German politics.
In the immediate years after the founding of the Federal Republic in 1949, moderate state surpluses were recorded. This came to an end in the mid-1950s, and ever since finance ministers of all political parties have continued to use deficits to fund all sorts of political programs of the day. In theory, they should have been restrained by Article 115 of the Basic Law, the country’s constitution, which limits budget deficits to the total sum of investments. In practice, this constitutional rule turned out to be easy to circumvent. Not only were politicians creative in their definition of what constitutes an ‘investment,’ but under the constitution, they could also run higher deficits in order to restore the ‘economic equilibrium’ – whatever that may be.
The result of these decades of profligacy was a fast increasing public debt burden. In 1955, the total public debt was just about €20 billion. By 1975, it had climbed to roughly €130 billion. On the eve of the global financial crisis in December 2006, the total debt level stood at €1.53 trillion.
These are staggering figures indeed. They are even more alarming if you consider that the debt to GDP ratio had also gone up substantially: It had risen from under 20% in the 1950s to about 40% in the mid-1980s to eventually reach 67.6% by the end of 2006.
Considering that the EU Growth and Stability Pact allows Eurozone countries a debt to GDP ratio of up to 60%, Germany was already in violation of the Monetary Union’s rules before the global financial crisis struck. Germany had also run annual deficits of more than 3% of GDP between 2003 and 2006 – again breaching the Growth and Stability Pact, which (ironically) had originally been introduced at the request of the German government.
So despite the fiscal rules in Germany’s own Constitution, and despite the rules laid out in the European Union’s Growth and Stability Pact, public debt had risen to unsustainable levels before the global financial crisis. Germany was a country desperately in need of fiscal consolidation, and to the credit of the outgoing Grand Coalition they had originally tried to get things under control.
Unfortunately though, they had tried it through tax increases. For example, in 2006 Value Added Tax, the equivalent of Australia’s GST, was raised from 16% to 19%. In the same year, insurance tax went up 3% and the top rate of income tax was also increased from 42% to 45%. And these were only the most visible tax increases. Far better hidden were the changes in Germany’s complex tax law that broadened the definition of taxable income without compensating for these changes by lowering tax rates. Open and covert tax hikes boosted tax revenue substantially.
When the Grand Coalition took office in 2005, total tax revenue in Germany stood at €452.1 billion. By 2008, this had gone up to €561.2 billion– that’s a nominal increase of 24% over just three years. Given these strong increases in tax revenues, it is unsurprising that Germany came close to balancing its budget for the first time in over four decades. But this was not thanks to any prudent fiscal management but mainly the result of an unprecedented tax increase. Politicians are never good at saving, and Germany’s politicians were clearly no exception.
When politicians like Peer Steinbrück, the Federal Treasurer of the outgoing Grand Coalition, claim that they had done their homework before the crisis, you are advised to take this with more than just a pinch of salt. They had not done anything to consolidate the budget on the expenditure side.
When the financial crisis hit Germany in 2007, things got worse. The main reasons are the declines in tax revenue, the drop in employment and the costs of unemployment, the costs of bailing out financial institutions, plus a number of measures that were meant to stimulate the economy. Taken together, all of this had the effect of substantially deteriorating public finances.
Saving financial institutions from collapse clearly was expensive. Germany’s Finanzmarktstabilisierungsfonds(Financial Market Stabilization Fund, SoFFin) was authorised to give guarantees of up to €400 billion and provide capital of up to €80 billion. In total, after less than a week’s consultation, the German Parliament had authorised the government to intervene to a total of almost half a trillion Euros in financial markets. The money was then used to recapitalise and nationalise the HypoRealEstate Bank in Munich, which alone cost about €100 billion. Commerzbank received guarantees of €15 billion plus €18.2 billion of fresh capital when its attempt to take over Dresdner Bank became ailing.
The Dresdner Bank case is interesting. Clearly, there was no threat to the stability of the financial system when Commerzbank could no longer find the capital for the takeover of its competitor. Instead, it was a political decision because the federal government clearly believed it was desirable to establish a second big bank in Germany to check the dominance of market leader Deutsche Bank. Sadly though, German taxpayers have to pay more than €30 billion for this political adventure.
If the engagement of the taxpayer in saving private banks is bad enough, the insistence by Germany’s federal states to run their own banks is even worse. Of all German banks, these were the institutes worst hit by the financial crisis. In various forms HSH Nordbank, Landesbank Baden-Württemberg, NordLB, WestLB and BayernLB received guarantees of €45 billion and subsidies of more than €80 billion.
Saving the banks was expensive, but that was not the only result of the financial crisis. Two stimulus packages of more than €80 billion were put in place. They contained, for example, a cash-for-clunkers scheme that financed the destruction of two million cars in order to stimulate new car sales. On top of that, there were measures to renovate train stations, improve broadband connection, and paint town halls.
To an Australian audience, this must sound somewhat familiar. But Germany went further than Australia in helping struggling companies: A so-called Germany Fund was set up to provide up to €115 billion to struggling companies in the so-called real economy. It was surprising to see which companies suddenly felt that they were struggling as soon as the money was made available. According to the Economics Ministry, about 10.000 companies have received money from the fund. Among them are well-known companies like car manufacturer Opel, shipping company Hapag-Lloyd, and car parts supplier ZF Friedrichshafen.
As unemployment is forecast to rise to up to 4.5 million next year, tax revenue will fall substantially. Unemployment benefits in Germany are much more generous than in Australia, so you can expect that worsening unemployment will have an even bigger impact on the budget. The German Finance Ministry expects a massive drop for the next four years. Only by 2013 would the tax revenues have recovered to their 2008 levels. In the meantime, however, there is a gap of more than €300 billion in public budgets. And even this may be too optimistic.
The winning parties of the general elections have all promised lower taxes. What they haven’t said, though, is where they are going to find the money for their plans. While in theory there are many subsidies in place that could and should be cut, in practice no government has ever had the courage to do so. As a result, about one-third of next year’s federal budget will be deficit financed.
This means that in all likelihood, Germany’s public debt will keep rising for years to come. Whether this can go on for much longer is a matter for debate. According to the German Taxpayers’ Federation, interest paid on public debt will be €71.3 billion this year – at a time of historically low interest rates. It doesn’t take much fantasy to imagine that rising interest rates and rising debt levels will let this go up even further. Soon Germany will need to borrow as much as it pays in interest on the public debt.
The Germans, of course, know all this. Earlier this year, they passed a constitutional amendment that should make future deficit spending more difficult. If the experiences with previous fiscal rules are anything to go by, we should not hold our breath, though. It is far more likely that Germany’s fiscal situation will deteriorate further. And don’t forget that that all the figures I have given so far are only official debt figures. Not included were the hidden liabilities that result from Germany’s rapidly ageing population.
State pensions and public sector pensions will make the fiscal situation much worse still. Germany’s leading demographer Herwig Birg predicts that by the middle of the century, there will be just about one pensioner for every person of working age. As Germany finances its state pensions out of current contributions, it is clear to see that the system has no chance of surviving this demographic shock.
Given these dark clouds on the horizon, it is only reasonable to expect Germany’s fiscal situation to be a burden to its economic development for decades to come. Furthermore, it will negatively affect Germany’s neighbours and trade partners as well. Last but not least, it could cause problems for the Euro.
If you think public finances can hardly be in a worse shape than in Germany, you should look at Britain.
Britain was in a much better fiscal shape than Germany a few years back. From 1992, the British economy had been growing strongly – thanks to the tough economic reforms initiated by Margaret Thatcher. Under the Major government, this extra revenue was used to consolidate public finances. When Tony Blair became Prime Minister, he had promised to honour his predecessor’s spending plans. This way, the extra tax revenue was not spent but instead the budget recorded a substantial surplus between 1999 and 2002.
However, the British Labour Party’s transformation into an economically conservative party was as shallow as it was short-lived. While fiscal discipline indeed lasted for the first few years in government, the party soon reverted to more traditional Labour policies. In particular, public spending on health and education dramatically increased. Unfortunately for Britain, the surge in funding mainly helped feed large and growing bureaucracies. During a decade of New Labour an extra £1.2 trillion was spent, financed partly by covert tax hikes but also by running large budget deficits, even when the economy was still growing.
On the eve of the global financial crisis, Britain was running budget deficits of around 3% of GDP – far too high for an economy that was growing at just over 3%. Worse still, Britain’s economy was built on foundations that simultaneously crumbled under the financial crisis. The UK economy was heavily reliant on rising house prices and the practice of mortgage equity withdrawal. It was built around a strong financial sector in London. And finally, it was an economy that was propelled by strong consumption and virtually no household savings.
The global financial crisis revealed how unsustainable the British model had been. As a result of falling house prices, the decline of tax revenue from the City, rising unemployment and subdued consumer spending, public finances have deteriorated rapidly. Treasury officials now admit that the deficit for this year will exceed £200 billion this year. And Capital Economics, one of the country’s leading economic consultancies, believes that deficits of similar proportions are likely to stay for at least the next four years.
The International Monetary Fund has just presented the perhaps gloomiest forecast for Britain’s public finances so far. It predicts that by next year, Britain’s debt will stand at 81.7% of GDP, going up to 98.3% by 2014.
Clearly, such projections require tough policy actions. As the British state already accounts for about half of economic output, there is little scope to start the consolidation of public finances on the revenue side. Besides, the top rate of income tax already stands at 50%. What would be required instead are spending cuts. It is doubtful, though, that either of the two major parties will be able to deliver them.
The British Labour Party is not only responsible for the spending increases that have got Britain into the current situation but it was Prime Minister Gordon Brown who had initiated them as Chancellor of the Exchequer. For these reasons, we cannot expect any radical policy reversal from the current Labour government.
In any case, Labour is unlikely to win the next election, which has to be called by June of next year. Current polls suggest a new Conservative government under David Cameron as Prime Minister. So the real question is whether Cameron and Chancellor George Osborne will have the courage to turn things around and fix Britain’s broken public finances.
Having worked at Policy Exchange, a think tank close to the Conservative party leadership, for some years, I have doubts whether the next Tory government will be up to the monumental task of fixing Britain. When I was in London, Tory economic policy was not only cautious but quite cowardly. For fear of not alienating voters, the Tories were unwilling to tackle Britain’s fiscal problems. For some time, they had even promised to honour Labour’s spending plans – until even a blind person could see that Labour’s plans weren’t worth the paper they were printed on.
Before the financial crisis, the Tories tried to keep everyone happy by hiding behind the empty formula of ‘sharing the proceeds of growth’ between tax cuts and spending increases. Now that there is hardly any growth left and nothing to share, it is plain that such hollow rhetoric will not do.
To be fair to the Tories, at their last party conference in Manchester George Osborne has finally spelt out that a future Conservative government will be cutting public spending. But even the £23 billion over the next five years that Osborne announced amounts to little more than a rounding error in Britain’s public finances. Even in the face of the greatest economic crisis that Britain has experienced in decades, Tory policy remains timid, unimaginative and dishonest. If the Tories can’t offer anything better than managing Britain’s decline, then what’s the point of a change in government?
As the global financial crisis is about to come to an end, the really big challenges still lie ahead of many European economies. It was all too easy for politicians to throw around money they did not have and pretend that they could fix all economic problems. The real legacy of this reckless spending is a mountain of debt that will substantially weaken Europe’s economies for years if not decades to come. Maybe in a few years’ time, we will look back and say that it wasn’t the global financial crisis that wrecked Europe but the political responses to the crisis.