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Germany should wake up: it's time to ditch the debt ratio limit

German Finance Minister Olaf Scholz talks to Managing Director of EMS (European Stability Mechanism) Klaus Regling, during a meeting of Eurogroup Finance Ministers at the European Council building in Luxembourg, Luxembourg June 17, 2021. Francisco Seco/Po

ESM's Regling calls the 60% limit 'economically nonsensical'

Klaus Regling, managing director of the European Stability Mechanism, called the present formulation of Europe’s Stability and Growth Pact “economically nonsensical”, in an interview with Der Spiegel this week.

This criticism, from a man who helped then German finance minister Theo Waigel to negotiate the terms of the pact in the 90s, could scarcely come from a more damning source. Surely it should be the last nail in the coffin of outdated austerity measures. But no. Germany isn't getting the message.

The Stability and Growth Pact is supposed to keep EU member states’ debt burdens below 60% of GDP and their deficits to below 3% of economic output. Countries with debt burdens of more than 60% of GDP must reduce their annual deficit by a twentieth of the amount by which they exceed the 60% debt limit per year. The reform process was launched this week.

But the man most likely to succeed Angela Merkel as German chancellor, Olaf Scholz, is a fan of the SGP, believing it is already flexible enough for current use. His presumptive finance minister, Christian Lindner, is like-minded.

But there is no flexibility built into the SGP. The Commission can choose not to enforce the corrective clauses or, as it did in response to the Covid-19 pandemic, deactivate it. Neither of those actions is evidence of SGP flexibility, and both operate on the assumption that the only good debt pile is a shrinking one.

Economists all over Europe feel differently. Most want to see investment in reforms promoting growth, rather than the sort of rapid belt-tightening austerity that a return to the original SGP would mean.

Debt to GDP ratios are not an appropriate way to measure a country’s debt sustainability or risk of default. Economists have plenty of other ways to measure it. You can compare interest payments and revenue, or interest payments versus GDP, or interest payments versus the country’s annual budget. The key is that the cost of a debt burden is not the same as the size of the debt pile — a simple concept Regling pointed out in his interview.

The economic community agrees with Mr Regling. The risk of not investing heavily in the years to come far outweighs the risk of overborrowing. Even with the return of inflation causing rates to climb, debt sustainability risks are a distant prospect.

Investors are pricing in a rate rise by the end of 2022. The ECB’s chief economist, Philip Lane, has pushed back on that expectation, saying it is “challenging to reconcile with the ECB’s forward guidance”.

But even if the ECB were to deliver a step up in rates in 2022 and follow up with more in 2023, borrowing costs are so historically low that even if rates were to go up substantially, borrowers would still be able to lower their debt service costs with every trip to the market.

Returning to the punitive formulation of the SGP would damage Europe’s growth prospects as it exits the pandemic. Reducing the supply of government bonds would lower interest rates further. Instead of this benefitting governments by enabling them to borrow more, it would simply disadvantage savers looking for income in safe assets.

The debate should be over. Debt to GDP ratios have no place in determining policy.

Of course, there is such a thing as too much debt, but debt to GDP is the wrong way to measure it, and the next German government will do Germany and Europe a disservice if they insist on clinging to it.