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Utilizing the margins of the debt brake in Germany’s federal states

A decrepit building in the eastern city of Magdeburg. CC BY-NC 2.0, Foto: Sebastian Vandrey

Net government investment in Germany (gross investment minus estimated write-downs from local authorities and social insurance) after separating national accounts has been largely negative since 2003. Consequently, the state is living off its capital. The enforced austerity policy in the Eurozone has also led other countries to reduce their net investment to the German level. Germany’s solution became a universal one as a result. Even if it is difficult to determine the optimum amount of public investment and the resulting capital stock, these figures still point to a massive investment backlog.

This trend concerns local investment in particular, which had already been reduced in the early 2000s in the course of the tax cut programmes enacted by the first Schröder government. In the period between 2015 and 2017 alone, negative net investment at municipal level amounted to just under 20 billion euro. The “Kommunalpanel 2018”, the current municipal commission of Germany’s government-owned development bank (Kreditanstalt für Wiederaufbau or KfW) and the German Institute of Urban Affairs (“Difu”) estimates the spending gap at a total of 159 billion euro. 48 billion euro are no longer being provided to schools and educational infrastructure. Regarding the investment backlog in the federal states and federal government, only broadband expansion are mentioned; hospitals and transport infrastructure have not yet been taken into account at all.

Even if many local authorities are generating budget surpluses for the first time in years due to the positive economic development, there is little room for complacency. Firstly, the regionally very unevenly distributed investment backlog cannot easily be recovered using current surpluses; secondly, many local authorities, especially in North Rhine-Westphalia and Hesse, face enormous consolidation challenges.

The negative impacts of the austerity policy prescribed in Southern Europe after the financial crisis also resulted in a reassessment of the use of public investment. Various new types of modelling show that the fiscal costs of higher public investment would be relatively low due to self-financing impacts (multiplier effects). According to a study by the Bertelsmann Foundation, targeted public investment in high-quality day-care centres and all-day schools, in affordable housing for middle and lower income populations, and in a modern digital infrastructure—particularly when compared to immediate debt repayment—would not only strengthen growth and employment, but also reduce income inequality in Germany.

Moreover, weak public investment corresponds with below-average corporate investment. It is clear that without the momentum of public investment which can result in more domestic sales opportunities and improved supply-side conditions, private sector investment remains inadequate. This aggregate under-investment was extensively analysed and discussed in recent years. Nevertheless, no change of course has taken place in federal policy as yet. Schäuble’s dogma, the “the black and the red zeros” (i.e. no new loans) continues to set the tone in Germany.

Municipal authorities as part of the federal states are subject to the respective budget monitoring systems. Income can only be increased to a limited extent within the rate of assessment law for local taxes (business taxes and property taxes). The states will in turn be subject to the regime of the constitutional debt brake beginning in 2020, which prohibits any new borrowing beyond the economic cycle. The only potential to increase revenue independently here is from real estate transfer tax.

Without substantial increases in government revenue (wealth tax, inheritance tax, progressive taxation of capital gains, raising the top tax rate, etc.), the states and their local authorities have a choice of either refraining from necessary investment or similarly cutting back necessary consumer spending elsewhere. In this context, the following article gives a preliminary outline of the debt brake’s counter-productive effect and analyses the advantages and disadvantages of credit financing beyond the core budget as part of Public-Public Partnerships (PuP) using the example of school construction in Berlin. In considering all the arguments, we insist on the importance of an aggressive utilization of the margins still available despite the debt brake, in particular via PuP, although we know that many political stakeholders denounce this as a call to create shadow budgets and an irresponsible breach of the debt brake. At the same time, specific requirements of PuP models such as transparency and parliamentary supervision are being discussed for Berlin.

Berlin makes for a fitting case study, as in no other federal state was public expenditure so sharply reduced over the past decades as in the German capital – particularly for qualified personnel and investment. If the public investment of the city-state amounted on average to 3.4 percent of Berlin’s gross domestic product (GDP) specifically from 1991 to 2000, it fell in the period from 2001 to 2015 to on average 1.5 per cent of GDP. Also, in the case of state participation, investment in the past was reduced in favour of profits and distributions. If the public write-downs in the state budget were identified the long-standing contraction of Berlin’s fixed assets would be obvious. However, even without this information, Berliners have been feeling the consequences of the noughties’ austerity policy in their everyday lives for a long time. The quality of public goods, services and infrastructure has been failing requirements for years. This also results in a problem of legitimacy for the redistributive tax system as a whole. It is clear that Berlin’s huge spending needs, reinforced by the demands of the growing city in education, integration, traffic, personnel and housing cannot conceivably be covered by the core budget.

The Debt Brake Is Fraught with Problems

The constitutionally enshrined objective of a structural net new debt ceiling of 0.35 per cent of GDP for the federal government and the ban on structural net new debt for the states are, economically speaking, arbitrary. Implicitly, these stipulations will, with an average annual growth of nominal GDP of 3 percent, amount to a general government debt ratio of 11.7 per cent in the long term. The question of whether there is an upper limit for the debt ratio above which effects harmful for growth occur is highly controversial in economic literature. But in any case the empirically calculated critical values, as problematic as this approach at defining maximum indebtedness is, are clearly above the current debt ratio in Germany and therefore do not offer any growth policy justification for the reduction to an implicit limit far below 20 percent.

Conversely, there is a fear that with the introduction of the debt brake at the falling volumes sought by the German federal government and state bonds, the capital markets as the safest form of investment to date will lose their status as an important anchor of stability and a key reference point. It is conceptually entirely unclear into which form of investment and into which states the traditionally high surplus savings by the private sector in Germany and thereby, among other things, expenses for private pension provision should flow. The surpluses of the private and public sector in Germany are de facto synonymous with a persistent and unsustainable current account surplus. The stability of the financial markets should not increase this.

Furthermore, the fiscal policy with the debt brake ironically abandons the one widely accepted economic benchmark for the level of government deficit, known as the Golden Rule. The Golden Rule or the “pay-as-you-go principle” is justified both as a growth policy and from the point of view of generational fairness: it calls for a structural new debt beyond the cycle amounting to public (net) investment. The underlying idea is to enlist several generations in the financing of public capital stock, as future generations will benefit from the prolific public investment made today insofar as their prosperity will grow. The old indebtedness regulation in the German constitution (permitted net new debt up to the level of public investment, even higher during recessions) certainly had the weakness of not making the distinction between gross and net investment and, in addition, of not covering all the relevant investment from an economic point of view. But instead of looking for an appropriate definition or estimate for write-downs, the necessary discussion was waived and also the recommendation of the council of experts – not exactly known for advocating unlimited public debt – ignored. Also, in light of the inadequate net investment of the last 15 years, it would have been obvious to enshrine a regulation to promote public investment in the constitution. The most recent experiences in the euro area also show that public investment – if not protected by appropriate regulation – is particularly affected by budget cuts in periods of consolidation.

The Debt Brake Is Pro-Cyclical

Last but not least, the debt brake has a pro-cyclical tendency due to the mechanism of the cyclical adjustment methods normally used: These methods fundamentally underestimate the extent of cyclical fluctuations and entail a pro-cyclical stance if they are made the benchmark of fiscal policy. This relates to the fact that the methods ultimately always diagnose the average development or trend of GDP as a normal position and thereby elevate it to the status of benchmark. If, however, the actual economic development unexpectedly falls or rises this inevitably pushes the trend upwards or downwards, especially if the change continues for several years. In downturn or upswing periods, production potential will therefore be quickly and sharply revised downwards or upwards. The cyclical part of the government balance is underestimated as a result. This is why considerable parts of the deficit or surplus are quickly recorded as structural in cyclical weak and strong periods, although they are possibly only cyclically contingent. Consequently, during a downturn excess consolidation tends to be requested; in contrast, during an upswing, too little, which needlessly destabilises economic development.

In fact, clearly a substantial part of the “structural consolidation” of the German government is ultimately cyclical, while at the same time the “failings” of the European countries in crisis are ultimately cyclical during structural consolidation. The European Commission, on whose methods the implementation of Germany’s debt brake is also based, had to admit long ago that the consolidation efforts they had estimated on the basis of the change to the structural deficit significantly underestimate the real efforts. The commission has therefore already been consulting additional indicators in the meantime.

The Debt Brake Creates Incentives for Public-Private Partnerships

Beginning in 2020 – or while there are no majorities for alternative distribution and fiscal policies – the federal states are faced with the decision: should investment be increased at the expense of other necessary and appropriate expenses, e.g. social issues or integration? Or should, despite the debt brake, existing margins continue to be used as aggressively as possible?

As the debt brake only relates to core budgets and legally dependent units, what are known as Public-Private Partnerships (PPP) present themselves as an alternative. The ardent advocates of the debt brake were also aware of this. In this respect, the debt brake is and was, from the outset, a PPP incentive and enabling act. Fortunately, the reputation of PPP projects has suffered considerably, thanks, in part, to extensive comparative studies by Germany’s Federal Audit Office in recent years. As a rule, PPP projects result in higher costs for public authorities. There are several key reasons for this. Firstly, the borrowing costs of private investors are always significantly higher than those of local authorities and, secondly, the equity should have an “appropriate” interest rate. Thirdly, the compulsory involvement of advisors and lawyers adds to the costs. Fourthly, other factors are the risks of legal disputes, often originating in view of highly complex contractual arrangements, at the expense of the public authorities. In the case of long terms over the life cycle of an investment measure, such disputes are the rule rather than the exception. In Berlin, PPP projects were therefore rejected in 2016 in the coalition agreement between the SPD, Die Linke, and the Green Party.

Public-Public Partnerships: A Viable Option

Instead of PPPs, PuP models should be tried out in the renovation and new construction of Berlin’s schools, as already put to the test in Hamburg, amounting to 1.5 billion euro of the 5.5 billion euro estimated in total for this purpose over the next ten years. The crucial difference to PPPs lies in the fact that private investors remain excluded. Consequently, no profit reaches their pockets. For this purpose, an urban housing association, HoWoGe, is to renovate the schools and lease them to districts in Berlin for 25 years. The properties or schools to be renovated will be transferred to HoWoGe from the state by purpose-restricted leasehold beforehand. After the end of the agreement, the property rights in the buildings will revert to the districts. Use other than for school purposes will be rejected. The legal device is identical to so-called PPP hire-purchase models. Private companies, however, are only involved as external investors to HoWoGe. HoWoGe’s borrowing replaces the issuing of state bonds in the case of a conventional construction project.

Interest is Decisive

The main drawback of this model is the interest cost differential between lower interest rates of state bonds and the higher borrowing costs as part of a PuP rental model. This drawback cannot be completely avoided, but can be significantly minimised due to two provisions: a waiver of objections and the use of public development banks. The drawback from the point of view of the banks is that the servicing of loans ultimately depends on the willingness of the state to pay rent to HoWoGe on time. Therefore, in order to squeeze the borrowing costs, the model of «forfeiting with waiver of objections» is used. The state commits itself to paying the rent to the lending banks (waiver of objections of non- and inadequate performance). In implementing the forfeiting model, HoWoGe can use the lease agreement as loan collateral and, where applicable, resell it to the banks, who would then receive the rental payments directly from the state of Berlin. In this way, the bank receives a risk-free, so-called certain claim on the state and can therefore grant loans at terms similar to a public authority loan. The «waiver of objections» does not, however, mean that HoWoGe is released from any liability. As lessor of the schools, it remains contractually bound to the district. Recourse may also be enforced.

In contrast to PPP models, there is also no risk of the project company, i.e. HoWoGe, becoming insolvent. That is why a waiver of objections with forfeiting is a sensible instrument for a PuP model in order to reduce borrowing costs. Critics of this model confuse the option of forfeiting, i.e. the resale of a claim, with the privatisation of public property. But even bonds issued by Berlin are traded on the market resulting in the reselling of claims.

The use of loans from public development banks such as Investitionsbank Berlin (IBB), the Kreditanstalt für Wiederaufbau or the European Investment Bank is the second method to reduce borrowing costs. In the case of loans from the state-owned IBB, the credit margin also increases the equity of the bank and thereby improves future funding opportunities. Nevertheless, there is an interest rate differential in the end which, in view of the conceived credit volume of well over a billion euro over the long term, is not insignificant and which must be classified as debt brake-associated costs. It is also conceivable that there will be conflicts and even legal disputes between the districts as long-standing tenants and HoWoGe as the lessor. However, as the state reimburses the districts with the rental payments (these primarily equate to interest, repayment and other expenses of HoWoGe), there is no disadvantage for the districts. This should be avoided by clever equity investment management on the part of the state, as the owner of HoWoGe. But even with increased rental payments for the districts, there is no loss to them, as the state reimburses the districts with the rental expenses. HoWoGe would be the winner, as it could build municipal housing with the additional capital.

Social Majorities Decide on Privatization

Civil society stakeholders such as Attac or Gemeingut in BürgerInnenhand as well as members of the trade union GEW fear “privatisation through the back door”: at first, formal privatisation takes place; then later tangible privatisation if HoWoGe sells or private investors become involved in the schools.

It is true that historically, formal privatisation often preceded tangible privatisation. But it is also true that Berlin’s financial regulation regarding its budget has already set tight limits concerning asset sales from state companies. All relevant sales of subsidiary companies, assets or property are subject to a parliamentary reservation. Ultimately, however, political and social majority and power relations are pivotal as to whether public property – regardless of whether in the legal form of a public agency or GmbH – is sold or not. Majorities may always change, irrespective of the specific PuP model. Let us not forget the sale of Berlin’s housing association GSW in 2004, at that time actually governed by the Party of Democratic Socialism (PDS). Just imagine what housing policy a senate to the right of the centre held by the Alternative for Germany (AfD) would implement. Even the Federal Constitutional Court in its budget emergency ruling in 2006 – at the height of the neoliberal hegemony, shortly after the Agenda Policy and before the global financial crisis – aggressively decreed that Berlin was only entitled to federal assistance, since all housing had been privatised.

In another majority configuration, school buildings owned by Berlin’s districts (and even university buildings) could therefore be sold to private investors and then be leased back. Schools owned by the state directly are consequently no less “capable of privatisation” in the case of relevant political majority relations. A curb on privatisation in the state constitution as was brought into play by Die Linke would constitute a very considerable obstacle to privatisation. Such a constitutional arrangement would in principle also be revocable – but only with a two-thirds majority.

Dare to Be Transparent

Another objection by the critics of the school building campaign concerns the loss of parliamentary control and transparency. This argument is also serious. Management of state-owned shareholdings, whether set up under private or public law, is carried out by the company committees provided under company law (supervisory board, shareholders’ meeting). Parliament only receives confidential company information (company and trade secrets) for inspection in the data room. Notes may be taken, but these remain on site and are only circulated for the respective session of parliament’s competent participation committee, which then holds a meeting hidden from the public gaze. Management of the companies is, furthermore, not automatically bound by instruction and may refuse or delay the release of information, as, at first, it is merely obliged to meet specifications under company law.

In a PuP model, however, confidentiality takes a different form when compared, for example, to the Flughafengesellschaft Berlin Brandenburg, which competes with other companies. The leases between the housing association and the districts, including all incidental clauses, could of course be disclosed. The same applies to the internal accounting entity (balance sheet, profit and loss accounts) for the school buildings with HoWoGe and the loan terms with the banks. It is also possible to grant parliamentarians a comprehensive right to information regarding any matters of school construction. In order to do so, a change to the State Budget Regulation and HoWoGe’s articles of association may be necessary. Such transparency clauses would be helpful confidence-building measures, making clear the objective of the policy, i.e. the opening of scope for action and not privatisation of school infrastructure.

The disclosure of the agreements for the partial privatisation of the water utility company Berliner Wasserbetriebe, which took place due to the massive pressure of a successful referendum, has already shown an example that greater transparency can and should be attempted. Without the debt brake, would the state of Berlin be organizing school construction in a different manner and not via HoWoGe? You cannot assume that, as the districts and also the building construction management of the state no longer have the personnel capacities required for this, after years of austerity and staff cuts. Neither can you assume that the staff required can be recruited swiftly on the open market. Berlin’s senate also makes a convincing argument in that centralization of school construction and also the involvement of general contractors are necessary to enable economies of scale, due to a modular system design and standardization, and to speed up the construction process. As already planned for the transfer, the state of Berlin would commission HoWoGe with the construction and provide it with the funds from the core budget. The lease model and transfer of the properties could, however, be waived, as HoWoGe would not have to take on its own borrowed funds and consequently would not have to enter the schools in its fixed assets either. It is also important to mention that the structural maintenance and facility management should remain with the districts.

PuPs are Constitutional

Borrowing by HoWoGe does not constitute bypassing the debt brake; in fact, it is entirely consistent with the legal specifications of the German constitution. But the negative impacts of the debt brake are neutralised or at least moderated. Due to the prevailing benefits, it makes sense to communicate the leeway offered by the provision in constitutional law in an aggressive manner. The proposed PuP regulations may mean that large-scale future investment can be realized in Berlin despite the debt brake.

The hire-purchase model would not cause an increase in Berlin’s debt in in the long term either, as the HoWoGe loans must be repaid within 25 years – this is consistent with the main objective of the debt brake. As the real useful life lasts far beyond the financial depreciation period, the net state assets also increase. The PuP model does not produce a shadow budget and no additional debt for the state in the long term either, including HoWoGe as a public company. HoWoGe’s borrowing is in fact largely linked to the life cycle of the investment. The performance of the net assets can be precisely understood via HoWoGe’s balance sheet.

The EU Fiscal Pact: A Further Obstacle

In addition to the obligatory constitutional debt brake, the EU Fiscal Pact is increasingly playing a more important role for the federal states (and their municipalities). The Fiscal Pact takes into account all the liabilities assigned to the state sector as part of the European system of national and regional accounts (ESA 2010). Thereby, the Fiscal Pact is in its differentiation of debts sharper and more extensive than Germany’s constitutional debt brake, which, in addition to the core budget, merely records legally dependent units, but no extra budgets such as the Berliner Bäderbetriebe, which, although legally independent, are nevertheless, according to ESA 2010, part of the state sector.

Although the Fiscal Pact applies to the general government only and not directly to the states, it was newly regulated in 2017 as part of the reform of the financial arrangements between Germany’s federation and its federal states under constitutional law that the stability council is to monitor compliance with the debt brake by the states, insofar as it is geared “towards the guidelines and methods of legislative acts based on the Treaty on the functioning of the European Union regarding compliance with budgetary discipline” (Article 109a para. 2 (2) of the German constitution). Federal states which comply with the debt brake but take on debts as stipulated in the Fiscal Pact could be pilloried both politically and morally. Exactly how the intended monitoring by the stability council will look is left open at present. Furthermore, the Fiscal Pact allows the permitted structural deficit to be increased from 0.5 per cent to one per cent of GDP if the debt ratio is significantly below 60 per cent.

As Germany may significantly undercut the 60 percent threshold in the next few years, the federal government having, however, already rejected the utilisation of the 0.5-per cent deficit, the states need to use this margin aggressively for their own future investment. It is a transparent objective of the states to arrange their budgets lawfully in order to comply with the Fiscal Pact. The legal requirements for this are great though and, also in school construction, it is debatable whether HoWoGe’s planned borrowing would be assigned to the market sector or the state sector. What is critical for the assignment is with whom the project and credit risks predominantly lie: with the state or with HoWoGe.

The use of the waiver of objections and the transfer of the structural maintenance to Berlin’s districts make a strong case for entering the loans on the government account. The Statistical Office of the European Union (EUROSTAT) will ultimately decide on this. Berlin is subject to this decision without the possibility of objection. As federal states are not legally bound to avoid debt according to the definition of the Fiscal Pact, this Fiscal Pact regulation for the general government should only be followed by the states if they do not incur additional costs (e.g. relevant tax payments) or other disadvantages as a result of this.

A better alternative than foregoing public investment in accordance with a narrow interpretation of the debt brake and adoption of the Fiscal Pact regulation at state level would be the implementation of the recommendation made by the European Committee of the Regions in 2017. This recommends an increase in investment in favour of local and regional authorities and advocates a defined actual deficit in the case of public investment, «which would not be taken into account for structural deficit in relation to the medium-term budgetary objective». Along the same lines, claims follow a release of net investment from the debt rules (“new golden rule”), which will meanwhile be made by a wide range of civic stakeholders, the European network of cities EUROCITIES and European trade unions.

This position paper was produced by the Rosa-Luxemburg-Stiftung's economic policy discussion group and originally published in July 2018. It has since provoked a response from the citizens' initiative "Unsere Schulen", which views PuPs as an initial step towards privatization and thus rejects them.