New constitutional ‘‘debt brakes’’ for Euroland? A ... · December 2011—but just as an...

ORI GIN AL PA PER

New constitutional ‘‘debt brakes’’ for Euroland?A question of institutional complementarity

Karsten Mause • Friedrich Groeteke

Published online: 15 June 2012

� Springer Science + Business Media, LLC 2012

Abstract Despite the EU Stability & Growth Pact and existing constitutional

limits on public deficit/debt at the (sub)national level in many EU member coun-

tries, in the wake of the 2010 Greek bailout, many politicians and policy advisors

have proposed new constitutional ‘‘debt brakes’’ to prevent future fiscal crises and

bailouts. This paper puts a question mark behind this popular policy recommen-

dation. Public choice scholars and other critical observers have repeatedly

emphasised that constitutional deficit/debt limits are not per se credible commit-

ments to run a sound fiscal policy in the future. To demonstrate this, design defects

of such fiscal constraints are usually pointed out (no politically independent control,

no sanctions, etc.). Going beyond this standard approach of credibility assessment,

this paper argues for taking the issue of institutional complementarity seriously. To

assess its credibility, one has to not only examine the design of a deficit/debt limit

but also the institutional environment (tax/expenditure policy, capital market, etc.)

in which such a constitutional commitment is embedded.

Keywords Public debt � Constitutional borrowing limits �Credible commitment � Institutional complementarity

JEL Classification E62 � H61 � H62 � H63

K. Mause (&)

Research Center ‘‘Transformations of the State’’ (SFB 597), University of Bremen, Linzer Str. 9a,

28359 Bremen, Germany

e-mail: [email protected]

F. Groeteke

Department of Economics, University of Marburg, Am Plan 2, 35032 Marburg, Germany

123

Const Polit Econ (2012) 23:279–301

DOI 10.1007/s10602-012-9125-4

1 Introduction

In the wake of the 2010 Greek bailout, German chancellor Merkel and French prime

minister Sarkozy, the European Commission, the Deutsche Bank (Heinen 2010),

and other policy makers and advisors have proposed that each member state of the

European Union (EU) should install a constitutional ‘‘debt brake’’ a la Germany to

prevent future fiscal crises and bailouts. The German one, which was established in

2009, applies to the central government and state level, and limits the amount of net

new borrowings governments are permitted to take on in a fiscal year (Feld and

Baskaran 2010; more details below). Similar annual budget deficit caps exist in, for

example, the USA at the state level (Inman 1997) and Switzerland at the central

government and state level (Feld and Kirchgassner 2008). In order to limit the

leeway of governments to run further into debt, it is certainly also possible to cap the

total public debt level that a jurisdiction must not exceed. Since the analytical

framework presented below applies to both types of caps, in what follows, the term

‘‘debt brake’’ will be used without inverted commas as a label for any kind of formal

deficit/debt limit.

If each jurisdiction had a debt brake—a simple argument these days—then no

jurisdiction in the world would find itself in danger of going bankrupt, and no one

would have to bail out a jurisdiction. In this spirit, in March 2012 under the heading

‘‘Fiscal Compact’’ 25 of 27 EU member countries (the Czech Republic and UK

opted out) agreed to integrate ‘‘preferably constitutional’’ German-style debt brakes

into their national fiscal frameworks. As the intergovernmental ‘‘Treaty on Stability,

Coordination & Governance in the Economic and Monetary Union’’, which includes

this commitment, is currently in the process of ratification, it remains to be seen

whether/when and how exactly the signatory countries will fulfil their debt-brake

promise. For example, Austria implemented a German-style debt brake in

December 2011—but just as an ‘ordinary’ law. However, economic theory and

history tell us that a (constitutional) debt brake is not per se a credible commitment

to slow down/stop running further into public debt, preventing a fiscal ‘tragedy’ like

the Greek one. Such limitations might be just cheap talk in the sense that public

policy makers may use this to signal responsiveness (‘‘Look, we have a debt brake’’)

but—for whatever reason—would not abide by the constitutional rule later on.

An example of such time-inconsistent government behaviour (Alesina and

Tabellini 1988) is that Germany, France and other member states have breached the

rules of the EU’s debt brake, that is, the deficit criteria of the Stability & Growth

Pact (more examples below). And it should be taken into account that many EU

member states and their sub-national jurisdictions—in addition to the supranational

Stability & Growth Pact rules—already have different types of deficit, debt and/or

expenditure limits (see Heinen 2010, for an overview). While it is beyond the scope

of this paper to evaluate each single rule’s effectiveness, a brief look into Eurostat’s

Government Finance Statistics Database reveals that national budget rules at least

have not prevented 24 of the current EU-27 countries from accumulating more

public debt over the pre-crisis period 1999–2007: only in Denmark (-32.1 billion

EUR), Sweden (-27.4), and Bulgaria (-4.4) the absolute amount of general

government debt did not increase (for comparison: France ?407.1, Germany

280 K. Mause, F. Groeteke

123

?357.2, Italy ?320.6, UK ?199.3, Greece ?116.9, Portugal ?56.9, Spain ?19.6,

Ireland ?3.3). So, before claiming new constitutional ‘‘Debt Brakes for Euroland’’

(Heinen 2010, and many others) or for any other parts of the world, in our view it

makes sense to pause for a moment and think about the fundamental issue: under

what conditions is a debt brake a credible commitment to limit public borrowing.

While unsurprisingly not discussed by politicians proposing new debt brakes,

public choice scholars and other critical observers have more or less explicitly

addressed the credibility issue sketched above. There are conceptual analyses asking

questions like ‘Are there escape clauses?’, ‘Is there a politically-independent control

of rule compliance?’, or ‘Are there sanctions for rule breakers?’ in order to evaluate

the credibility/effectiveness of different types of debt brakes (see e.g. Kopits 2001;

Schuknecht 2004; Debrun and Kumar 2007). Moreover there are numerous

empirical analyses statistically examining the effect of different types of fiscal rules

on fiscal outcomes (for an overview, see Fatas and Mihov 2006; Debrun et al. 2008;

Hallerberg et al. 2009). Going beyond the standard approach of focussing on the

inherent design of debt brakes, this paper argues that one has to take a broader

perspective and examine the institutional environment in which such a fiscal

constraint is embedded in order to assess whether the announcement of a new debt

brake can be considered as a credible commitment.

To develop this argument more fully, in the remainder of this paper a ‘credibility

test’ for debt brakes is presented which takes the issue of ‘‘institutional

complementarity’’, addressed in research on varieties of capitalism (e.g. Hall and

Gingerich 2009) and legal transplants (Berkowitz et al. 2003), seriously. Method-

ologically, this credibility test constitutes a public choice analysis of debt brakes.

Assuming that political decision makers will try to circumvent such limit, it is

analysed which institutional environment (tax/expenditure policy, capital market,

etc.) gives such ‘rule-breaker’ type politicians incentives to comply with the debt-

brake commitment. This test can be used as a tool for positive analyses (i.e. help

explain why a real-world debt brake does not work) and as a normative guide for

how the institutional environment of a debt brake should be designed to make the

latter workable.

2 A credibility test for debt brakes

Starting with the standard approach of analysing whether a certain debt brake has

inherent ‘design flaws’ making it a non-credible commitment (Sect. 2.1), in a next

step of our credibility test it is analysed whether a jurisdiction with a borrowing

constraint possesses sufficient taxation/expenditure autonomy: if it is unable to react

to budgetary problems by adjusting its public revenues and spending, then one

should not be surprised when it reneges on its debt-brake promise and/or must be

bailed out by other jurisdictions or the central bank (Sect. 2.2). If the capital marketdoes not have the expected disciplining effect on a jurisdiction’s borrowing

activities, then this makes high demands on the ‘braking effect’ of a jurisdiction’s

debt brake—if the latter does not work, the likelihood of fiscal crises rises (Sect.

2.3). Moreover, the likelihood of a bailout of the jurisdiction under investigation by

New constitutional ‘‘debt brakes’’ for Euroland? 281

123

potential rescuers (e.g. other jurisdictions, the central bank) has to be taken into

account: because a jurisdiction with a high bailout expectation has weak incentives

to comply with a constitutional debt brake, casting the latter’s credibility into doubt

(Sect. 2.4). Finally, if the jurisdiction does operate in the shadow of an insolvencylaw, then this may have a constraining effect on a jurisdiction’s borrowing

opportunities, supporting or even superseding a debt brake (Sect. 2.5).

The five-step checklist employed does not claim to be exhaustive. It is based on

arguments dispersed across the large politico-economic literature on fiscal policy,

which were systematised and adjusted to the specific field under investigation. The

usefulness of the presented credibility test is illustrated below by analysing the

constraints German governments at the national and state level face under the 2009

German debt brake, the previously existing golden-rule type borrowing limits, and

the supranational Stability & Growth Pact (see Table 1). However, this test can also

be applied to other jurisdictions that are about to implement a deficit/debt limit or

still have one. Interestingly, it turns out that the 2009 German debt brake, which is

currently regarded as a role model for re-designing other European countries’ fiscal

constitutions, is not a credible commitment—given the institutional environment in

which it is currently embedded. So, other jurisdictions should carefully check

whether a legal ‘transplant’ from Germany would be at all helpful in light of theirspecific institutional environments.

2.1 How credible is the debt brake itself?

If it is easy for a government to soften/ignore a borrowing constraint, then this fiscal

rule obviously cannot be considered a credible commitment. In the case of the 2009

German debt brake, the budgets of the national government and the state

governments ‘‘in principle must be balanced without revenue from credits’’ (Art.

109 § 3 German Constitution; here and below our translation). This rule must be met

by the national government from the fiscal year 2016 onwards and by state

governments from 2020 onwards. It has to be acknowledged that the German debt

brake is a constitutional rule and, therefore, a stronger commitment than basing a

borrowing rule on a legal act or just making a political commitment (e.g. in a

coalition agreement or speech) to run a sound fiscal policy (Buchanan 1997, p. 131;

Inman 1997; Debrun et al. 2008). Changing this constitutional rule requires a two-

third majority in both houses of the German parliament (i.e. Bundestag and

Bundesrat). However, a number of exceptions to the aforementioned basic rule,

which are a potential danger to the credibility of this debt brake, are codified.

2.1.1 Escape routes?

In the economic literature on the effectiveness of fiscal rules, exceptions are usually

discussed under the keyword ‘‘escape clauses’’ (see e.g. Sutherland et al. 2005;

Debrun et al. 2008). In the German case, the national government is allowed to take

out new loans amounting to a maximum value of 0.35 % of the nominal GDP per

year (Art. 109 § 3 German Constitution). To illustrate, in 2010 new borrowings to

the amount of EUR 8.7 billion would have been possible; this is important to note


123

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123

since the politicians introducing the debt brake have often suggested in public

debates that this new policy tool would stop the march into debt. In addition, for

both the national and the state level, it is possible to make exceptions to the basic

rule to take into account the ‘‘effects of a cyclical development that deviates from

normal conditions’’ (Art. 109 § 3 German Constitution). In a Keynesian spirit,

public budgets are still able to cyclically ‘breathe’—while cyclical debt caused by

deficit spending is registered on an ‘‘adjustment account’’ and has to be reduced

during phases of economic upswing.

Furthermore, exceptions to the debt brake are allowed at the national and state

level in the case of ‘‘natural disasters or extraordinary emergency situations that are

beyond governmental control and substantially impair government finances’’ (Art.

109 § 3 German Constitution). If this exception is applied, the respective

government has to present a loan redemption plan. At the national level, such an

emergency exception comes into effect after an absolute majority of the German

national parliament has consented to it (Art. 115 § 2 German Constitution).1 The

emergency-escape procedure (including a redemption plan) at the state level must

be defined by each state itself; the same holds for the procedure for defining the

deviation of economic development from the ‘‘normal cyclical condition’’ (see

German Council of Economic Experts 2011, pp. 185–190, for more details).

Though forecasting is difficult, it can be expected that each time a government is

about to make use of one of the possible exceptions, a heated debate among

politicians, legal scientists/practitioners, and economists on the governmental

interpretation of the legal rules will be triggered off: Do we really have an

‘‘extraordinary emergency situation’’?2 Is this situation really ‘‘beyond governmen-

tal control’’? Should an exception to the debt brake be allowed in an ‘‘emergency

situation’’ that is actually the result of governmental activities like an unsound fiscal

policy in the past? Do we really have an ‘‘extraordinary emergency situation that

substantially impairs government finances’’? What does ‘‘substantially’’ mean in

this situation? Are we really suffering from the ‘‘effects of a cyclical development

that deviates from normal conditions’’? In the constitution there is no definition of

what an ‘abnormal’ economic development means. In Article 5 of a special

implementation law to Article 115 of the constitution, however, the procedure used

to calculate the amount of new borrowings the national government is allowed to

take out to respond to the business cycle (the so-called ‘‘cyclical component’’) is

specified:

(2) A deviation of economic development from the normal cyclical condition

is given when an under- or over-utilisation of macroeconomic production

capacities is expected (output gap). This is the case if the production potential,

1 In light of Germany’s post-World War II history, this seems to be no great obstacle: up to now, except

for three short-term episodes with minority governments (1966, 1972, 1982) all national governments

have possessed such a majority in parliament.2 Clearly, it is impossible to integrate an all-encompassing list of ‘‘extraordinary emergency situations’’

in a constitution since unforeseeable events might happen in the future (Inman 1997, p. 313; Feld 2008).

In any event, a government’s rationale for declaring a certain situation as an ‘‘extraordinary emergency

situation’’ may be more or less convincing.


123

which is estimated on the basis of a cyclical adjustment process, deviates from

the expected gross domestic product for the fiscal year […].

(3) The cyclical component is the product of the output gap and the budget

sensitivity which indicates how the national revenues and expenditures change

when macroeconomic activity changes.

(4) The Federal Ministry of Finance, in agreement with the Federal Ministry of

Economics & Technology, specifies the details of the procedure for

determining the cyclical component […] (our translation).

It should now be clear that the constitutional rules offer an array of opportunities

for governments to run further into debt—and this will hold for all jurisdictions in

Europe that copy the German debt brake. In addition, there might be ‘creative’ ways

of ‘hidden borrowing’ not explicitly mentioned in the legal documents including,

for example, Public–Private Partnership or Sale-&-Lease-Back arrangements. While

shifting debts to new off-budget ‘‘Federal Special Funds’’ (a gladly used

circumvention strategy in the past) is no longer permitted at the central government

level, ‘‘existing off-budget funds are not covered by the debt brake and continue to

exist’’ (Feld and Baskaran 2010, p. 386). Also note that borrowing by public

enterprises and public banks is not covered by the new budgetary regime. The same

holds for implicit borrowing (e.g. the government’s promise of future pension and

health expenditures). From the viewpoint of public choice theory, it can be expected

that governmental actors would try to apply such circumvention strategies (or find

other ones). This is a basic danger to the credibility of fiscal rules (see e.g. Buchanan

1997, p. 130; Sutherland et al. 2005, pp. 41–43; Debrun et al. 2008, p. 302) as, for

example, EU member states’ activities under the Stability & Growth Pact regime

illustrate: several countries applied ‘budget tricks’ to lower their deficit/debt and

meet the rules (Koen and van den Noord 2006). Greece even ‘‘deliberately

misreported’’ (European Commission 2010) debt figures presented to the EU

institutions (see also Eurostat 2004).

Since the 2009 German debt brake will start at the national and state level in

2016 and 2020 respectively, it remains to be seen whether (and how) the legally

codified exceptions and sketched circumvention strategies will be used in political

practice. What is known, however, is that the escape clauses of the old golden-rule

type borrowing limits (i.e. annual net new borrowing must not exceed investment

expenditures), which existed since the late 1960s at the national and state level,

were oftentimes used. Between 1991 and 2005, these limits were exceeded by the

national government seven times and by state governments in 68 cases (see Feld

2008). To extend their annual borrowing leeway under the golden-rule regime,

governments often simply declared as many as possible public expenditures to

‘‘investment expenditures’’ and/or used the available escape clauses ‘‘exceptions are

permissible only to avert a disturbance of macroeconomic equilibrium’’ (included in

federal constitution and 13 of 16 state constitutions) or borrowing is justified for

‘‘extraordinary need’’ (three state constitutions). The indefiniteness of the terms

‘‘investment’’ and ‘‘macroeconomic equilibrium’’ mentioned in the legal documents

left much leeway for interpretation, justification constructs, and escape. And even if

a year’s budget was assessed as unconstitutional by the national or state-level


123

constitutional court later on (e.g. sometimes opposition parties went to court), there

were no sanctions.3 Under the new debt brake regime, the golden-rule escape route

‘investment expenditures’ no longer exists, and ‘extraordinary’ debts shall be

reduced in better times according to a redemption plan.

2.1.2 Independent watchdogs?

Given the potential escape routes, another important design issue is the issue of who

controls rule compliance. European countries copying the German debt brake

should know that its designers assumed that governments are able to control

themselves: the newly established ‘‘Stability Council’’, consisting of the national

minister of finance, the finance ministers of the 16 states, and the national minister

of economics, will monitor the budget policies at the national and state level, and

will publicly report rule violations in the future. Viewed through the ‘unromantic’

lens of public choice theory (Buchanan 2003), the assumption that this kind of

debtor self-control will work, however, appears to be naıve. To make a debt brake

(more) credible, a jurisdiction could—in an additional act of self-commitment—

delegate the decision of whether and to what extent an exception to the budget rule

is allowed to a politically independent watchdog body (Inman 1997, 2001;

Sutherland et al. 2005, pp. 22–23; Debrun et al. 2008, pp. 301, 304).

In Germany, the courts of auditors at the central and state level, the German

Central Bank, or the German Council of Economic Experts could play the role of a

politically independent umpire in the debt game. To be certain, there are the Federal

Constitutional Court (Bundesverfassungsgericht) and corresponding constitutional

courts at the state level which can be appealed to to check whether a government’s

budget plan in a certain fiscal year violates the constitutional rules of the debt brake.

This option already existed and was sometimes used in the golden-rule years

(without consequences for ‘debt sinners’). One basic problem of this corrective is

that such a court procedure (1) is only possible after the budget plan is enacted and

(2) usually takes (a lot of) time (Jochimsen 2008, p. 547). It is not unlikely that a

constitutional court would decide that the new borrowings were unconstitutional—

but these new borrowings cannot simply be revoked; especially when the borrowed

money has already been spent by the government.

2.1.3 Sanctions for rule breakers?

Another credibility-building measure would be to commit to automatic and rule-

based sanctions in the case where a jurisdiction has not complied with the deficit/

debt rules (Inman 1997; Debrun et al. 2008, pp. 301–302; Sutherland et al. 2005,

pp. 24–26). In the German case, the only ‘sanction’ for rule breaking will be naming

by the aforementioned ‘‘Stability Council’’ and (possibly) shaming afterwards. A

harder sanction for rule violation proposed by economists in the public debate is a

3 See German Council of Economic Experts (2007, chap. 4), for a more detailed critique. Jochimsen

(2008, p. 542) concludes: ‘‘Existing rules to prevent over-indebtedness of the Bund or the Lander have

proved to be nothing but a paper tiger.’’


123

compulsion to increase taxes (Feld 2008; Jochimsen 2008, p. 548). Moreover it is

debatable whether rule-violating state governments should be punished by a

temporary reduction/denial of transfer payments within the fiscal equalisation

scheme (Finanzausgleich); in this system, financially weaker states receive fiscal

transfers from the richer ones and from the national government (see BMF 2009).

Another debatable sanction for ‘debt sinners’ is a temporary withdrawal of voting

rights or a temporary reduction of the number of votes in the upper house of the

German parliament (the Bundesrat; consisting of state government representatives).

A warning in this context is that both (1) the absence of a politically independent

body enforcing the rules and (2) a no-sanctions policy in the case of rule violations

were major reasons for the ineffectiveness of the golden-rule type borrowing limits

in Germany and the EU Stability & Growth Pact.

As Column (12) in Table 2 illustrates, over the period 1999–2010 the Pact’s

deficit criterion (i.e. annual budget deficit must not exceed 3 % of GDP) was

violated in 40 % (= 82) of 204 possible cases (i.e. 17 Eurozone countries

x 12 years). Though the European Commission used its powers several times to

open a formal ‘‘excessive deficit procedure’’ against a member state, so far no rule

breaker has been sanctioned through the fines defined in the Stability & Growth Pact

rules. Apart from the issue of whether fines are an appropriate instrument (they

would further worsen a country’s financial situation), a basic problem of the EU’s

debt brake is that the member states themselves decide on sanctions: the

Commission is able to open the ‘‘excessive deficit procedure’’ and propose

sanctions—however, a qualified majority in the Council of Ministers must approve

both steps. In other words, potential rule breakers judge actual rule breakers—and,

as Table 2 (Column 12) shows, there are only two ‘no-sin’ countries (Finland,

Luxembourg) that never exceeded the 3 % deficit limit over the 1999–2010 period.

While there will still be no politically independent enforcer of the Stability &

Growth Pact, in winter 2011/2012 the rules were ‘‘reinforced’’ in the sense that in

the future a qualified majority of the Council of Ministers is necessary to avoidsanctions proposed by the Commission (see EU Stability Treaty 2012). Moreover

countries exceeding the Maastricht public debt criterion (i.e. annual debt level must

not exceed 60 % of GDP), which was the case in 47 % (= 96) of 204 possible cases

in the Eurozone between 1999 and 2010 (see Table 2, Column 12), have to reduce

their debt level in certain steps. These changes, however, only apply to Eurozone

countries. And the (potential) sanctioning by fines remains unchanged—though

some interesting reform proposals in this respect were made in the political and

scholarly debate to enhance rule compliance. For example, what about a temporary

reduction/denial of EU subsidy payments (e.g. EU Structural Funds) to ‘debt

sinners’, or a temporary reduction/withdrawal of a member state’s voting rights in

the European Council of Ministers?

Overall, the analysis of a number of crucial design issues suggests that the 2009

German debt brake is actually not a credible commitment to slow down or stop the

‘drive’ further into public debt. There are many escape routes that allow further

borrowing. There is no politically independent body monitoring rule compliance.

There are no sanctions in the event of rule violations. These issues will appear in all

European countries which copy the German debt brake as agreed in the 2012 EU


123

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123

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cannot

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ayed

’’


123

http://www.usdebtclock.org

‘‘Fiscal Compact’’. And from experience with German national and state

governments’ (non-)compliance with the old golden-rule type borrowing limits,

we come to a rather pessimistic assessment of whether German politicians will be

able to control rule compliance themselves. Moreover in seven out of 12 years

during the period 1999–2010, Germany exceeded the 3 % deficit-to-GDP ratio laid

down in the EU Stability & Growth Pact; in 11 years general government debt

exceeded the 60 % debt-to-GDP ratio. Since 1970, there has been only one fiscal

year (2000 due to one-off revenues from auctioning mobile licenses) where the

national government’s budget was not in deficit. In light of the preceding analysis, it

is somewhat surprising that Germany is currently both praised and hated by many

observers throughout Europe due to its perceived ‘fiscal conservatism’.

2.2 Sufficient taxation/expenditure autonomy?

Even when a constitutional debt brake is designed in a way that makes it difficult for

a jurisdiction’s government to circumvent this borrowing constraint, it could be the

case that this constraint is too restrictive: if this jurisdiction is unable to react on itsown to a looming public deficit by means of increasing taxes and/or reducing public

expenditures (i.e. insufficient taxation/expenditure autonomy), then it can be

expected that this jurisdiction reneges on its debt-brake commitment and/or asks

other jurisdictions or the central bank for financial rescue. While central

governments throughout the EU have complete taxation and expenditure autonomy,

research on sub-national public finance (e.g. Wildasin 2004; Sutherland et al. 2005,

pp. 28–36; Vigneault 2005, pp. 4–5, 24–25) indicates that insufficient taxation/

expenditure autonomy might be a problem wherever a sub-central government

operates under a debt brake. This is illustrated below by the case of the 16 German

states—though, for example, the Austrian states or the Belgian, Italian and Spanish

regions may be confronted with similar problems as they likewise are not fully

autonomous in their taxation and spending policies.

In the German case, it turns out that the national government and state

governments have the possibility to reduce public expenditures to consolidate their

public finances. This includes searching for ways to make the public sector work

more efficiently. A state government’s budgetary leeway is influenced by national

laws. But this interference is relatively low: approximately 20 % of a state’s

expenditures (25 % in the case of the city-states Berlin, Bremen, Hamburg) are

determined by national laws (Seitz 2008). Moreover, both jurisdictional levels have

publicly-owned assets (public enterprises, buildings, etc.) which could be sold off to

generate public revenue. One-off revenues due to privatisation proceeds are

excluded from the calculation of the borrowing ceiling under the 2009 German debt

brake regime. Yet thinking about the proper scope of publicly-owned assets and

privatising (parts of) them could be part of a consolidation program.

While the degree of expenditure competencies offers sufficient flexibility at the

national and state level, in the area of tax policy this flexibility is only given for the

central government. By contrast, the tax-setting competencies of the German states

are very limited. The largest part of the states’ total tax revenues (roughly 75 %) are


123

currently based on joint taxes (Gemeinschaftsteuern).4 Modifications of these taxes

have to find majorities in both houses of the German parliament (Bundestag and

Bundesrat). So the states participate in the tax-legislation process, but the individual

state has no power to autonomously set the tax rates for joint taxes. The same

applies to the rates of state taxes (Landersteuern) whose revenues are only entitled

to the state budgets (e.g. inheritance tax, beer tax, casino gambling tax). The only

tax whose rate is directly and autonomously set by each single state is the real estate

transfer tax (Grunderwerbsteuer), while the national government fixes the

assessment base of this tax. Against this background, many policy advisors before

and after the introduction of the 2009 debt brake argued that it would be necessary

to enhance states’ taxation autonomy so that they are better able to comply with the

borrowing limit by their own fiscal efforts (e.g. Vigneault 2005, pp. 8–9; BMF 2005,

p. 23; BMWi 2005, p. 27; Jochimsen 2008; Feld and Baskaran 2010). Introducing

fees for using certain public services and/or the increase of existing fees is another

possible option to generate more revenues.

Abstracting from the German case, from the viewpoint of public choice theory it

is clear that re-election-oriented governments have weak incentives to implement

expenditure cuts or tax/fee increases since both measures can be expected to be

unpopular in the electorate. Hence, that a government is able to react on its own to a

looming public deficit does not automatically imply that it is making use of the

fiscal policy tools at its disposal. If a debt brake lacks inherent credibility (see Sect.

2.1), putting no pressure on jurisdictions with poor fiscal performance, then it seems

rather unlikely that such jurisdictions would voluntarily reduce borrowing/

expenditures and increase taxes/fees. Yet there may be institutions (analysed

below) which under certain conditions discipline a government’s borrowing and

expenditure activities in the case of failing or non-existing constitutional debt

brakes.

2.3 Market-based constraints: Bondholders & creditors as debt brakes?

One mechanism which may help to prevent a jurisdiction from running further into

debt and under certain conditions works as another type of ‘debt brake’ is the capital

market (see e.g. Rodden et al. 2003, pp. 18–20; Sutherland et al. 2005, pp. 36–37;

Oates 2005, pp. 362–364; Vigneault 2005, pp. 25–26). From a theoretical

perspective it can be expected that a highly indebted jurisdiction will be ‘punished’

by the capital market in the form of a relatively bad credit rating (compared to

jurisdictions with an excellent creditworthiness) and, therefore, by higher interest

rates on borrowings to be paid by this jurisdiction (due to the risk premium

demanded by creditors).

In the German case, however, the theoretically expected punishment of an

unsound fiscal policy by the capital market is currently rather weak at the state level.The rating agency Fitch gives all German states (and the central government) the

top credit rating ‘Triple-A’—irrespective of a state’s debt position (see Table 2).

4 See BMF (2009). The revenues from joint taxes (mainly income tax, value added tax, and corporate

income tax) are distributed across the national, state, and municipal level.


123

This is justified by the existence of a constitutionally safeguarded fiscal equalisation

scheme and a bailout expectation: ‘‘Under the German constitution, [German]

member states are jointly responsible for supporting a Land [a state] in financial

distress. […] The federal government (the Bund) and all other federal members

have to support a Land if it experiences extreme budgetary hardship. […] Cash

would only not be forthcoming for a Land if there was a complete federation-wide

breakdown, in which neither the other Lander nor the Bund itself could provide

cash’’ (Fitch Ratings 2012, p. 1). The ratings provided by the two other major credit

rating agencies, Standard & Poor’s and Moody’s, take into account differences in

the budgetary performance of the states. In line with the economic reasoning

presented above, only the three least-indebted states of Bavaria, Baden-Wurttem-

berg, and Saxony (not rated by Moody’s) get a ‘Triple-A’. Yet the estimated default

risks of the other, more-indebted states are not much worse: they are located in the

high-grade segment. This is justified by Standard & Poor’s and Moody’s with the

arguments also used by Fitch (i.e. fiscal equalisation system, bailout expectation).

Against this background, it is hardly surprising that there are only minor

differences across German states regarding the risk premia they have to pay for

bonds issued by them: in March 2012, their bond spreads versus German Bunds (i.e.

German federal government bonds) ranged between 0.5 and 0.8 % points (see

Hulverscheidt 2012). Analysing the pre-crisis period 1997–2007, Schulz and Wolff

(2009, p. 61) find that ‘‘spreads of Lander yields to the Bund are driven to a great

extent by general risk aversion. Public debt only has an economically marginal

impact’’. In sum, under the current regime of German fiscal federalism the capital

market was/is not able to effectively constrain German states’ debt policies.

Consequently this theoretically possible market-based mechanism in practice does

not raise the 2009 debt brake’s credibility: if its braking effect fails to appear, state

governments running an unsound fiscal policy are not sanctioned by the capital

market.

However, capital-market constraints currently exist, at least to some extent, at the

national level in the EU. Highly indebted member states exhibit a relatively bad

credit rating (see Table 2).5 In addition to this ‘punishment by downgrading’,

Greece, Ireland, Portugal, Spain and other countries with a relatively low

creditworthiness are punished through higher interest rates to be paid on their

government bonds compared to Germany (i.e. German Bunds) as the deemed ‘safest

capital haven’ and ‘reference debtor’ in the Eurozone; the pairwise correlation

between the bond spreads and Standard & Poor’s numerical rating scale is 0.934

(p \ 0.01). It remains to be seen whether the EU’s recent bailout operations

(considered in Sect. 2.4) and/or domestic consolidation efforts (possibly including

the implementation of a debt brake) will reduce these countries’ sovereign bond

spreads and borrowing costs; whether the frequent proposal to issue ‘‘Eurobonds’’

(i.e. joint bonds of several EU countries) will be realised to lower capital-market

5 There is a statistically significant positive correlation between the debt-to-GDP ratio and Standard &

Poor’s numerical rating scale (high values indicate a bad credit rating): Pearson’s r = 0.661 (p \ 0.01;

two-tailed; N = 17 Eurozone countries).


123

pressure on highly indebted countries; and whether ongoing sovereign bailouts will

lead to an increase of the borrowing costs of Germany and other rescuer-countries.

It should also be mentioned here that there is another market-based mechanism,

which may work as a ‘debt brake’: the vote market. Voters having a preference for a

sound fiscal policy may sanction an unsound one through the ballot box (Rodden et al.

2003, pp. 20–21). Schneider (2007) for 10 West German states (period 1970–2003),

Brender and Drazen (2008) for 23 OECD countries (period 1960–2003), and

empirical studies using other samples indeed found that governments that ran large

deficits suffered vote losses (see Eslava 2011, pp. 650–652, for a survey of this

literature). Politicians in our German setting seemingly anticipated that ‘‘voters do not

like deficits’’ (as Brender, Drazen and Eslava put it in their papers): Schneider (2007)

finds that West German state governments over the period 1970–2003 reduced budget

deficits before elections. However, the evidence in this context is mixed. Baskaran

(2011) shows that state governments between 1975 and 2005 did not borrow more or

less when an election was imminent or when the government represented a

conservative electorate. Moreover the results of a 2007 public opinion poll published

in Bertelsmann Foundation (2008), displayed in Table 2 (Column 5), suggest that the

share of German citizens who have a preference for fiscal consolidation is rather low:

for example, only 40 % of respondents from the state of Hesse supported the idea to

implement a prohibition to borrow in their state constitution and the German

constitution.

Citizens’ attitudes towards deficit spending certainly may change—especially in

times when over-indebtedness is a hotly debated topic in politics and the media. This

can be illustrated by the result of a sub-national referendum held in March 2011 in the

just mentioned state of Hesse: now 70 % voted for the introduction of state-specific

debt-brake rules (explained in Sect. 2.1) into the Hessian constitution (voter

participation: 48.9 %). Moreover, a November 2011 Eurobarometer poll showed that

92 % supported the notion that ‘‘measures to reduce the public deficit and debt [in

Germany] cannot be delayed’’. According to this poll, in each EU country a large

majority supports this notion (see Table 2, Column 13), implying that the majority of

EU citizens welcomes new debt brakes and shows a preference for a sound fiscal

policy—at least at the moment. The support values for Portugal (77 %), Ireland

(82 %), Italy (85 %), Greece (79 %), and Spain (83 %) indicate, however, that a still

considerable amount of citizens in these financially distressed countries perceive

public deficit/debt reduction as not being a pressing societal problem. We will return

to the link between the degree of fiscal conservatism in a society and the demand for

and effectiveness of formal debt brakes in the conclusion.

2.4 Credible no-bailout signals?

So far, we have examined whether an institutional arrangement including a

constitutional debt brake creates incentives for a jurisdiction to run a sound fiscal

policy, reducing the likelihood of fiscal crises and bailouts. To be consistent, the

potential ‘supply’ of bailouts by actors signalling the rescue of a financially-

distressed jurisdiction also has to be taken into account. If a jurisdiction can expect a

bailout, then this weakens the credibility of a debt brake since this may weaken


123

politicians’ incentives to abide by this fiscal rule. In other words, a government with

bailout expectations ‘‘…may have weak incentives to conduct [its] fiscal policies in

such a way as to minimise the risk of bailouts’’ (Wildasin 2004, p. 252). However, a

more-or-less explicit bailout guarantee may not only affect a jurisdiction’s

behaviour6—but in the eyes of potential creditors is a strong signal that lending

money to this particular jurisdiction is nearly risk free (see previous section). There

are two principal ways of bailing out a jurisdiction whose likelihood has to be

assessed: the bailout by other jurisdictions, and the bailout via the central bank.

2.4.1 Likelihood of bailout by central bank

The central bank can help to reduce a jurisdiction’s debt burden basically in two

ways. First, by setting a lower interest rate in the respective currency area, thereby

expanding the money supply and inflating away (real) debt. Second, via buying the

bonds of an indebted jurisdiction at a lower interest rate than the capital market

would demand; this would also lead to an expansion of money supply and inflation.

These rescue operations are easy to accomplish when a jurisdiction has direct access

to the central bank. So, to make a constitutional debt brake more credible, a

jurisdiction should not have direct access to the central bank or be in the position to

dispose the central bank in any way to conduct a bailout (Qian and Weingast 1997,

p. 87; Wildasin 2004, p. 250). This condition is obviously fulfilled in Germany both

at the central and state government level. With the entry into the EU’s currency area

in 1999, Germany and the other Eurozone countries lost their national monopoly for

steering monetary supply and its currency—both are policy instruments with which

countries have disencumbered themselves in the past. Now the European Central

Bank (ECB) is making the monetary policy in this currency area.

However, as recent history tells us, a bailout by the central bank is by no means

impossible in the Eurozone (The Economist 2011). If a jurisdiction gets into

financial distress in the future, then the ECB could act as they did in the case of

Portugal, Ireland, Italy, Greece and Spain and buyout a certain amount of this

jurisdiction’s government bonds.7 Due to their recent interventions on the market

for government bonds, the ECB has damaged its no-bailout reputation established in

previous years. This loss of reputation has to some degree increased the likelihood

of a bailout by the central bank for the jurisdictions located in the Eurozone.

2.4.2 Likelihood of bailout by another jurisdiction

Another form of bailout is that another jurisdiction rescues an indebted jurisdiction

from going bankrupt (Wildasin 2004, pp. 253–254; Vigneault 2005, pp. 1–2). This

may be accomplished (1) by injecting money in the form of monetary subsidies; (2)

6 Discussed under the keywords ‘moral hazard problem’ (e.g. Persson and Tabellini 1996) and ‘soft

budget constraint problem’ (Rodden et al. 2003; Inman 2003; Vigneault 2005) in the public finance

literature.7 It is, of course, another issue and it is difficult to assess from the outside whether and—if so—to what

extent the ECB’s recent purchase strategy is politically driven. It might just be the act of a politically

independent central bank, which the ECB de jure is.


123

through lending money with favourable credit conditions; (3) by putting a guarantee

of payment of loans; or (4) via purchasing government bonds newly issued by the

financially-distressed jurisdiction at lower levels than the capital market would

demand.8 For example, unlike in the USA and Switzerland, where the federal

governments pursue a credible no-bailout policy vis-a-vis their sub-national states

and Kantone (Inman 2003; Blankart 2011, pp. 78–79), German states in financial

difficulties can expect to be bailed out by its fellow states and the central

government. This bailout expectation has been nurtured by the central government’s

activities in the past, especially the bailouts of the states Bremen and Saarland (for

details, see Rodden 2003). Without regular fiscal transfers and extraordinary bailout

payments, the latter states would be long bankrupt.

Clearly, bailout expectations may change. The Federal Constitutional Court in

2006 rejected the state of Berlin’s action for getting federal grants to attenuate this

state’s fiscal crisis. Yet the court in its decision (BVerfG, 2 BvF 3/03, 19 October

2006) also noted that—abstracting from the specific Berlin judgment—bailouts are

in principle legally allowed and possible in the future if a financially-distressed state

has utilised all possibilities of fiscal self-help but was not successful in rescuing

itself (so-called ‘‘ultima-ratio principle’’). As noted earlier, credit rating agencies

and bond market participants still have bailout expectations. As long as this high

bailout likelihood exists, neither the 2009 debt brake nor the credit-market brake are

likely to have a disciplining effect on states’ debt policies. A similar reasoning

applies to the national level in the EU: the recent bailouts of Greece, Ireland and

Portugal as well as the existence of bailout funds for Eurozone countries (funded by

the still solvent countries and labelled ‘‘EFSM/European Financial Stabilisation

Mechanism’’, ‘‘EFSF/European Financial Stability Facility’’, ‘‘ESM/European

Stability Mechanism’’) make the no-bailout clause of Article 125 of the Treaty

on the Functioning of the EU to a non-credible constitutional commitment and raise

bailout expectations.

The situation may certainly change in the future. The recent developments in

Greece illustrate that creditors must bear in mind that bailout operations can be

combined with a restructuring of an EU country’s debts (see The Economist 2012).

A restructuring could be accompanied by a currency reform: i.e. either the exit of

single countries from the Eurozone or the breakdown of this zone. While this

scenario might appear unlikely today, it will be interesting to see what happens if

Germany and other EU member states, which currently bail out fellow states, have

difficulties with refinancing their own debts.

2.5 Legal environment: Jurisdiction in the shadow of insolvency law?

The budgetary problems facing many countries in the wake of the recent financial

crisis have fuelled the debate on the necessity and adequate design of sovereign

bankruptcy procedures (see Gianviti et al. 2010, for an overview). To date, there

8 In contrast to such rescue operations, ‘normal’ institutionalised fiscal transfers between same

(horizontal) and different (vertical) jurisdictional levels (e.g. German fiscal equalisation scheme) are

usually not denoted as bailouts in the public finance literature.


123

exists no sovereign insolvency law, neither for the member states of Euroland nor

for other nations—but informal institutions exist, like the Paris Club (a group of

creditor countries) and the London Club (consisting of private creditor banks) who

from time to time (try to) negotiate a debt relief for heavily indebted countries.

Moreover, formal insolvency rules exist at the sub-national level. There are, for

example, bankruptcy laws for municipalities in the USA and Switzerland (Duff

2010; Blankart 2011, pp. 80–81). Without going into the details of these insolvency

proceedings, it should be noted that they are designed to offer a highly indebted

municipality a ‘‘fresh start’’ via a ‘‘reorganisation of debts’’ which means not going

into liquidation as is often the case for bankrupt private-sector enterprises.9

Bankruptcy laws for the U.S. states and the Swiss states (Kantone) do not exist so

far (March 2012). The same holds for German states as the sub-national unit in our

case study setting, although the introduction of an insolvency law for jurisdictions

has been recommended again and again by economic policy advisors both before

and after the introduction of the 2009 debt brake (e.g. BMF 2005, pp. 17–21; BMWi

2005, p. 27; Blankart et al. 2006; Jochimsen 2008, pp. 550–551). However, from a

politico-economic perspective, the possibility that a central government or a sub-

national jurisdiction could indeed go bankrupt and the existence of legal rules that

determine what to do in this situation (preventing political activism and discretion)

would be an additional measure to add credibility to a constitutional debt brake:

because such laws make it more difficult for potential rescuers to carry out a bailout

with its negative effects on fiscal discipline stressed above.

The government of jurisdiction X has to explain to the public why the citizen-

taxpayers in X should rescue the highly indebted jurisdiction Y which is subject to an

insolvency law which means (a) that Y is liable for its debts and (b) that there are

legal rules prescribing how Y and its creditors (who made a risky investment

decision) have to act in such emergency situation. A central bank faces a similar

barrier to bailout since it has to explain to the public why—notwithstanding an

existing insolvency procedure—the bank rescues Y and its creditors (which might

lead to inflation). Moreover, potential creditors expecting that a bailout is less likely

due to the bankruptcy law can be expected to run a more careful lending policy

toward jurisdiction Y since their outstanding debits will be (partially) lost if

Y becomes insolvent (Sutherland et al. 2005, p. 36; Blankart and Klaiber 2006,

p. 53). This, in turn, constrains Y’s borrowing activities: the closer Y moves to the

‘bankruptcy abyss’, the more difficult it gets to find someone who is willing to give

(further) credit. Hence, an insolvency law could work in the same direction as the

capital-market mechanism considered above—even if there is no constitutional debt

brake or if an existing one fails.

Clearly, under real-world conditions policy makers and central bankers might

find more or less convincing justifications as to why they perceive a bailout to be

necessary—which prevents a bankruptcy and the insolvency proceedings. And it is

likewise an empirical question, which can only be addressed on a case-by-case

9 See Duff (2010, p. 50), referring to the U.S. case: ‘‘The purpose of chapter 9 is to provide a financially-

distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting

its debts. Reorganisation of the debts of a municipality is typically accomplished either by extending debt

maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new loan.’’


123

basis, whether the vision of an (un)ordered default has a deterrent effect on political

decision makers in a fiscally-distressed jurisdiction. A re-election-oriented and/or

fiscally conservative government can be expected to take precautionary measures

(such as increasing taxes, cutting expenditures, liquidation of assets) in order to

remain liquid and prevent an insolvency with its potential negative effects on

society, the economy, government’s popularity and re-election chances, and

individual government members’ reputation (Blankart et al. 2006, p. 567, 571).

There may, however, also be governments who do not care about the possible

social, economic and political costs of a bankruptcy—for instance, because of

including government members who have options to make their living outside the

political business and/or their jurisdiction.10

3 Conclusion

The results of our credibility test (summarised in Table 1 above) suggest the

expectation that the new German debt brake introduced in 2009 is actually not a

credible commitment to slow down/stop the public debt ‘ride’—given the

institutional environment in which it is currently embedded. Taking into account

the (potential) dangers to credibility pointed out in the above analysis and the

experience with older borrowing limits in Germany since the early 1970s, it is rather

likely that we will observe political business as usual in the area of debt policy after

2016/2020 when the new rules start at the national/state level. To make the new

commitment a (more) credible one, ‘‘a fundamental reform of political and fiscal

institutions to alter the whole structure of incentives for budgetary decision-

making’’ (Oates 2005, p. 361) would be necessary. Some considerations in this

direction have been presented in Sects. 2.1–2.5. Moreover, our politico-economic

analysis suggests that it is by no means clear that the popular proposal new ‘‘Debt

Brakes for Euroland’’ (Heinen 2010 and many others) will prevent future fiscal

crises and bailouts. Before transplanting German-style debt brakes into existing

national fiscal frameworks as promised in spring 2012 by 25 EU countries in a

‘‘Fiscal Compact’’, and before issuing another update of the supranational rules of

the EU Stability & Growth Pact, one should scrutinise under which conditions a

particular (constitutional) deficit/debt limit actually can be a credible commitment

to run a sound fiscal policy in the future.

The effectiveness of a debt brake not only depends on its specific design

(politically independent control?, sanctions?, etc.) but also on its institutional

environment. More specifically, if a government can expect a bailout, then one

should not be surprised when this government shows limited or no effort to run a

sound fiscal policy. The same holds if the capital market for whatever reason (e.g.

bailout of this jurisdiction is a likely event) does not punish an unsound fiscal

policy. In such an environment with high bailout expectations and a low degree of

10 To illustrate, recently it became public that several Greek politicians, while the bailout/insolvency

negotiations were under way, transferred considerable amounts of private money abroad (see Capital.gr

2012).


123

punishment through the capital market, a debt brake could indeed be an important

disciplining device and a substitute to other potential mechanisms to achieve fiscal

discipline—but only if this debt brake is a credible constraint (including politically

independent enforcers and sanctions). Otherwise, a fiscal tragedy like the Greek one

is a likely event because governmental borrowing activities in such environment are

neither constrained by the capital market nor by the existing but ineffective debt

brake; moreover, the government under such circumstances can wait for the deus exmachina (e.g. central bank, other governments) which is likely to appear in order to

bail this jurisdiction out.

In other words, taking the issue of ‘‘institutional complementarity’’ (e.g.

Berkowitz et al. 2003; Hall and Gingerich 2009) seriously, it may turn out that

transplanting or implanting a new debt brake into an existing institutional

environment would not change policy makers’ incentives to maintain fiscal

discipline. Moreover, it should now be clear that a formal debt brake may be less

important or even redundant, if a government cannot expect a bailout (e.g. credible

no-bailout rule) and its debt policy is already restrained by the capital market and/or

vote market (i.e. large fraction of fiscally conservative voters; see e.g. Dafflon and

Pujol 2001). Though, in such situation, the implementation of a credible debt brake

could support (i.e. complement) existing market-based mechanisms insofar as this

reform step may be perceived by capital market participants and voters as a signal

that the particular government plans to run a sound fiscal policy from now on.11

Taking such a reform step may be relatively easy in jurisdictions with a high share

of fiscally conservative citizen-voters—in some countries such as Germany the

existence or introduction of (stricter) formal fiscal rules, among other things, could

simply be a manifestation of fiscal conservatism. By contrast, if the population in a

given country is not sufficiently conservative with respect to fiscal policy (which

seems to be the case in Greece, for example), then there may be a low or even no

societal demand for (a) introducing some kind of debt brake and (b) policy makers

complying with an existing one.

However, since it is quite natural that there are exceptions to a formal borrowing

limit which may even be intended to give politicians more flexibility over the

business cycle while simultaneously preventing over-borrowing, the disciplining

power of the policy instrument debt brake should not be overstated—implying that,

from a policy perspective, it seems worthwhile to focus more on the appropriate

(re)design of the broader institutional environment in which debt policy is made

rather than on the introduction of (further) formal borrowing limits. From a politico-

economic viewpoint, a functioning capital market, a functioning interjurisdictional

competition (including jurisdictions with tax and spending autonomy), the existence

of an insolvency law for jurisdictions, and a credible no-bailout rule within a system

of jurisdictions, seem to be more effective instruments to prevent ‘fiscal disasters’.

Under a regime including these instruments, capital market participants send strong

11 See also Blankart (2011, p. 79), referring to the state-level in Switzerland where, since the mid-1990s,

25 of the 26 cantons have voluntarily introduced debt brakes (as of March 2012). In the USA, such

signalling process at the state level started in the 1840s, and ‘‘[t]oday, all U.S. states—except Vermont,

whose fiscal prudence is legendary—have either constitutional or statutory balanced budget rules’’

(Inman 2003, p. 68; this still holds).


123

signals (via credit ratings, risk premia) to a jurisdiction’s government that the

reached public debt level is ‘too high’ from their individual perspective. Moreover

the citizen-principals and their political agents would have to ‘bargain’ as to which

tax/public service package they want to afford—knowing that they are liable for the

jurisdiction’s debts and that bankruptcy is a possible event.

Acknowledgments Earlier versions of this paper were presented at the 2011 German ECSA Conference

‘‘Europe’s Post-Crisis Stability’’ in Berlin, the 2011 General Conference of the European Political

Science Association in Dublin, and the 2011 ECPR Joint Sessions of Workshops St. Gallen. We are

especially indebted to Michael Bechtel, Ansgar Belke, Michael Breen, Bettina Fincke, Clement Fontan,

Mark Kayser, Jennifer Rontganger, Thomas Sattler, Kilian Seng, Amy Verdun, Uwe Wagschal, and an

anonymous reviewer of this journal for useful comments.

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