Angela Merkel has often called on the wisdom of the prudent Swabian housewife from southern Germany during her 16 years in power.
The outgoing Chancellor has used the image of a thrifty matriarch who keeps a short leash on her household’s finances to argue that debt crisis-hit Europe was living beyond its means. But as “Mutti” finally leaves the stage following Sunday’s election, there is a growing consensus that her era of ultra-prudence is over – both in Berlin and Brussels.
The winner of Germany’s election – likely to be the centre-left SPD and its Chancellor candidate Olaf Scholz – will be tasked with bridging a huge divide in Brussels as EU tensions threaten to explode once again. EU members are gearing up for a big battle over the bloc’s debt rules that will pit the north and south against each other.
“There is a lack of credibility about these rules,” says Maria Demertzis, deputy director of Bruegel, a Brussels economic think tank. “We’ve had two once-in-a-lifetime shocks in the last 10 years and who says we’re not going to have similar shocks in the future. There is going to be a need for active fiscal policy in the future.”
The EU debt rules outlined under the Stability and Growth Pact were agreed in the 1990s and have been suspended until 2023 due to the pandemic, giving members breathing space to thrash out an overhaul.
The rules, which aim to limit total public debt to 60pc of GDP and deficits to 3pc, are considered by many as irrelevant in a world of eye-watering debt levels, low interest rates and big investment needs from the climate transition. But striking a deal that transforms how countries borrow and spend in Europe will be fiendishly difficult.
The north and south are already on a collision course. A coalition of northern frugal nations, including Austria, the Netherlands and Denmark, have already set out their stall, warning in a recent paper they will take a tough approach to cutting debt piles post-pandemic.
Meanwhile many in the more spendthrift south have said going back to the old debt rules blamed for stifling growth is unimaginable in post-pandemic Europe.
While the future of Brussels has not been a key election talking point for German voters, the new government will be highly influential in reshaping Europe as its own politics moves away from Merkel’s fiscal doctrine.
Europe’s biggest economy has even tougher fiscal rules than the EU: its debt brake limits its structural deficit to just 0.35pc of GDP. But prospective German chancellors are promising more spending to boost low levels of public investment, including frontrunner Scholz.
Felix Huefner, economist at UBS, says: “There’s much more recognition that fiscal policy needs to play a bigger role for cyclical reasons.”
Not only did public debt levels soar across the region during the pandemic but the European Central Bank has blitzed through its monetary ammunition, having already taken interest rates into negative territory before Covid. With little left in firepower at the ECB, the burden has fallen on fiscal policy to prevent an even deeper recession during the Covid crisis.
“That debate has certainly changed in Germany as well, not least during the Covid crisis,” Huefner adds. “Every party in Germany wants to spend more in their party manifestos and that’s also related to reaching the climate targets.”
With Merkel’s CDU braced for historically bad results on Sunday, the SPD and Greens are set to play a major part of the next coalition government.
Scholz has had to pay lip service to fiscal discipline to woo German voters but both the SPD and Greens want to relax the European debt pact to allow for more space on investment.
However, the complicated coalition mathematics means a three-way alliance will be needed, potentially forcing the more relaxed parties into bed with the FDP, the fiscally hawkish liberals, or Merkel’s frugal CDU. Investors could be waiting months for a clear picture to emerge as coalition talks are likely to drag on.
Philippe Gudin, economist at Barclays, says: “An inflexion point is possible in the event both the SPD and the Greens are involved in a coalition, potentially leading to a slower return to fiscal balance and a slightly more open position on European integration.”
A complete ripping-up of the EU’s rulebook will face fierce opposition from the frugal north, but there are paths to meaningful tweaks and loopholes that could maintain the Stability and Growth Pact’s sacrosanct targets.
With the climate transition requiring huge spending that economists believe will eventually pay for itself, Europe could agree to exclude public investment from the rule. That would allow countries to spend big on the likes of clean energy and the economy’s digital transformation, encouraging capital spending that is likely to pay off in the long run.
The SPD has proposed changing the EU debt rulebook into a “sustainability pact” that will allow for more green investment.
Brussels could also reach for extending the time it gives countries to bring debt levels back to low levels.
Many countries have little hope of bringing their debt piles down to levels outlined in the growth pact. Italy and Greece have debt mountains of 160pc and 210pc of GDP respectively, but both still benefit from low borrowing costs.
“You need to get down to 60pc over 20 years so every year you cut 1/20th and that’s enormous,” says Huefne.“What you could do is take this from 20 years to 50 years, so it gives countries enormously more time to get there. That’s probably easier to agree on.”
However the chips fall in the election, Germany will be crucial in closing the gap between the north and south. Berlin was important in helping the EU’s pandemic-fighting €750bn Recovery Fund get over the line despite opposition from northern countries to jointly issued debt.
“The European Commission is really pushing for this so I don’t think we’re just going to sleepwalk into no change,” says Demertzis. The stance of the new German government is also likely to affectt how France tackles the upcoming debate, she adds.
Revamping Europe’s debt rulebook will be fiercely contested by the north and south, but Merkel’s successor will hold the key to bridging the divide.
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