What the U.S. Could Learn from Germany

Steep budget cuts are linked to recession and higher unemployment in Europe, argue several commentators (see here for example). Are they right? Certainly, some countries have struggled economically when reducing deficits before their economies have made a recovery. But Germany’s case bears examination as a successful example of combining fiscal sustainability with economic growth.

Since late 2010, Germany has pursued gradual deficit reduction in solid, reassuring plans for medium-term debt reduction. Germany entered the recession with a balanced budget and declining yet high unemployment of 7.6 percent. In late 2008 and 2009, the German government passed stimulus measures which, when combined with increased mandatory spending, lifted total spending from about 44 percent of GDP in 2008 to 48.1 percent in 2009 (including state and local spending). This brought the 2010 deficit to 4.3 percent, while holding unemployment steady for a year before seeing a modest drop to 7.1 percent in 2010. Then in 2010, the government announced a significant deficit-reduction package, which has combined with a wind-down of stimulus spending to result in spending at 45.6 percent of GDP in 2011 and projected at 44.7 percent in 2013, alongside slightly declining tax revenues as a share of GDP.

German Deficit Reduction (Percent of GDP)
  2010 2011 2012 2013 2014 2015 2016 2017
Spending Cuts 0% 0.4% 0.6% 0.9% 1.2% *** *** ***
Gross Debt 83.2% 81.5% 78.9% 77.4% 75.8% 74.4% 72.7% 71.1%

Sources: IMF, La Gazette De Berlin
***Numbers not available for these years

As a result of Germany’s fiscal reforms, gross debt is predicted to decline from 82 percent of GDP in 2011 to 71 percent in 2017. While German GDP growth will be lower this year than last, so will German unemployment (it also helps that their unemployment is relatively low to begin with). Despite recent state election victories for the opposition Social Democrats, an early May opinion poll shows that Germans support ongoing budget discipline, by 55 percent to 33 percent.

A main reason for Italy’s current decline in deficits is an intentional defensive reaction against the recent sharp increase in interest rates on Italian debt, which exceeds 100 percent of GDP. This dynamic offers a second lesson next to Germany’s model of gradual deficit reduction. Namely, Italy’s pre-recession debt of nearly 90 percent of GDP left it with fewer options today, because Italy now pays a high interest rate premium in order to sell government bonds. And in order to hold interest rates from rising even higher, Italy has little room for counter-cyclical fiscal policy.

German and Italian Unemployment and Deficits
  2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Unemployment Rate
Germany 10.5% 11.2% 10.2% 8.8% 7.6% 7.7% 7.1% 6.0% 5.6% 5.5%
Italy 8.0% 7.7% 6.8% 6.1% 6.8% 7.8% 8.4% 8.4% 9.5% 9.7%
Deficits (Percent of GDP)
Germany 3.8% 3.4% 1.6% -0.2% 0.1% 3.2% 4.3% 1.0% 0.8% 0.6%
Italy 3.5% 4.4% 3.3% 1.5% 2.7% 5.4% 4.5% 3.9% 2.4% 1.5%

Source: IMF

All governments are ultimately limited in their ability to borrow. The sooner they implement specific plans for debt stabilization, the better their options for the short and long term, including the flexibility to reduce deficits gradually. Germany has demonstrated this the past two years, and it offers the United States a useful model for getting our own fiscal house in order. We should pass a plan now while we have the ability to bring our deficits down gradually rather than immediately.