Germany is Europe’s engine, and when it splutters the entire region gets the shakes. That is precisely what is happening at the moment – German industry is struggling and the German economy saw negative growth in the second quarter, which is putting a damper on the whole of Europe.
The European Central Bank (ECB) has long lent a supporting hand to European economies via an extremely accommodative monetary policy, but fiscal policy, in contrast – in other words taxes and government spending – has not really been in focus in recent years. That could be about to change, and investors should take note.
An obvious route in theory, a difficult path in practice
German budget negotiations for 2020 kicked off this week, and speculation is rife that Germany could potentially stoke the financial embers with a substantial fiscal policy stimulation package.
On paper such a move looks deceptively straightforward. With limited government debt, also in comparison to the US and Japan, for example, Germany has the financial leeway to ease and also reason to do so, yet many doubt the country has the will. In addition, Germany’s options are limited by a number of fiscal rules and guidelines.
The EU has rules for how large a budget deficit EU countries may have, and thus for how much fiscal stimulation they can apply. If Germany was to be constrained by the EU rules alone, it would in fact have ample scope to ease fiscal policy. Moreover, financing costs – in other words, interest rates – are historically low, even negative.
Germany’s fiscal straitjacket
However, the Germans have imposed upon themselves a fiscal straitjacket that is tighter than the EU rules:
- First, Germans have the so-called black zero principle: All increases in government spending should be financed by equivalent increases in revenues. This is not inscribed in law, but is rather a very firm principle.
- Then there is the debt brake: The structural balance (the government balance corrected for economic cycle and one-off factors) may at must amount to a deficit of 0.35% of GDP. This rule was enshrined in the German constitution in 2011.
One could be tempted to think that the politicians could deviate from the rules, but here we should remember that German citizens in general support the black zero, while dropping the debt brake requires an amendment to the constitution.
German politicians get creative
That being said, there are signs that German politicians are trying to find ways in which they can step lightly on the accelerator without breaking their own rules. Budget negotiations revealed that the government is planning to establish three new independent entities which, among other things, will promote a number of climate projects. The budgets of the three entities will not be included in the budget and so their debt will not form part of the debt brake calculation.
Hence, while major fiscal policy easing is difficult to implement in Germany, and although the debt brake limits the scale of the easing, there are nevertheless signs that the German politicians are willing to do something – which in itself is a very strong signal to the financial markets. Moreover, any nascent economic optimism in Germany could quickly ripple through the rest of Europe.
Significance for investors
At Danske Bank, we currently have a neutral weight on European equities in our portfolios and see a greater return potential on US equities. However, as we noted in late August in our latest quarterly report, Quarterly House View, looser German fiscal policy is one of the events that could help pull the European economy out of its current doldrums and lift European equities.
Hence, while we do not want to cheer too soon, we will be following events in Germany with great interest. We also note that a German fiscal policy with particular focus on green investments could bolster companies associated with the green transformation, where we already see an attractive return potential.
Danske Bank has prepared this material for information purposes only, and it does not constitute investment advice. Always speak to an advisor if you are considering making an investment based on this material to establish whether a particular investment suits your investment profile, including your risk appetite, investment horizon and ability to absorb a loss