Evaluating Germany’s €130 Billion COVID-19 Aid Package
March 9, 2022
In response to the economic recession caused by the COVID-19 pandemic, the German administration spearheaded a €130 billion aid package that focused on VAT reduction, transfer payments to aid parents, and the allocation of funds to struggling businesses. The package, largely funded by borrowing, is seemingly uncharacteristic of a government “fiercely committed to a balanced budget” (Posaner). Therefore, the central question regarding the efficacy of this fiscal package is whether its stimulus outweighs the drawbacks of large-scale borrowing and upsetting the budget balance.
Direct Effect On The Economy
Though COVID-19 induced recession has halted many supply chains in the nation, aggregate demand has already reached regular levels (Deutsche Welle). Thus, all expansionary policies must aim to solve the supply chain issues and increase aggregate supply.
Reduction of VAT
Within the package, Value Added Tax (VAT) was reduced from 19% to 16% for the general population and from 7% to 5% for those eligible for a reduced VAT rate in order to “boost spending power” (Bundesministerium Der Finanzen). In consequence, this will result in a boost in aggregate demand. Modeled with the decrease in aggregate supply, there will be a significant amount of inflation and no determinable change in real output. Since this particular component of the package does not directly tackle the supply chain issue, it is not effective in dealing with the recession.
The effects of transfer payments to families with children are similar to the reduction in VAT. By easing financial burdens, the spending power of the population will increase, causing a rightwards shift in the aggregate demand curve (modeled with the same graph as above). Though this will not mitigate the effects of the stagflation, it will ease financial hardships caused by children, as the little rascals are very expensive.
Since the fall in aggregate supply was partially caused by businesses struggling with negative supply shocks (Weber), it would therefore make sense to relieve financial burdens suffered by the businesses in order to mitigate stagflation. In the package, businesses that have experienced year-on-year losses of at least 60% between April and May will have 80% of fixed costs covered (Bundesministerium Der Finanzen). Providing support to businesses will incentivize business investment spending, increasing aggregate demand. Moreover this will allow more businesses to handle the negative supply shock and therefore produce more. The increase in aggregate supply separates the business relief portion of the package from the previous two components. Modeled in an aggregate supply and demand graph, it results in an increase in both output and price level, which mitigates the effect of stagflation.
Effects on Unemployment
The shifts in aggregate demand and supply affect both the inflation (price level) and unemployment levels, which can be modeled by a Phillips curve. The initial decrease in aggregate supply causes the Philip’s curve to shift rightwards, indicating a higher amount of unemployment for any level of inflation. Consequently, after the stimulus package, the increase in aggregate demand will cause a movement along the curve to the left and the increase in aggregate supply will shift the whole curve leftwards.
The Effects of Large Scale Borrowing
Though the immediate effects of such fiscal policy will result in a positive change in aggregate demand, it should be noted that there may be secondary effects due to changes in the interest rate. Former finance minister Olaf Scholtz stated that they will allocate “60 billion euros of the 156 billion euros in new debt approved in March” and they will cover the rest with national reserves (Nienaber, Michael, and Hansen). However, according to modern economic theory, large-scale borrowing conducted by the government significantly raises the demand for loanable funds in the loanable funds market. The real interest rate, in consequence, will be drastically raised, preventing private businesses from acquiring loans and conducting investment spending due to the higher cost of borrowing. The large-scale borrowing detailed by Scholtz is no exception. The likely scenario caused by the government borrowing is modeled below on a loanable funds market graph and its effect on the aggregate supply and demand graph.
Since the real interest rate is increasing (as corroborated by the graphic from Trading Economics), it follows that many of the businesses that the package aimed to help will actually suffer the unintended consequence of reduced access to loans, which will partially negate the effects of the bill. In order to make this bill more effective, then, the government could either refinance this bill by tapping into government savings and avoiding tapping into the loanable funds market or by restricting the loanable fund market.
Tapping into Government savings
Historically, the German government has been averse to large-scale spending, keeping a balanced budget since 2014 (Nienaber, Michael, and Hansen). However, since the government is not running a surplus in the budget, they will not be able to reach funds lying around, which makes this solution unviable.
Restricting the Loanable Funds Market. In contrast, the Government can take a different approach by imposing regulations upon the loanable funds market. This could be done by creating a binding real interest rate ceiling, which would ensure that the loanable funds taken by the government won’t raise the interest rate excessively. However, this would have the drawback of deadweight loss, as the restriction would have fewer loanable funds supplied vs loanable funds demanded. The graph below shows the creation of deadweight loss given the real interest rate ceiling.
Though this solution results in clear inefficiency, it ultimately accomplishes the goal of allowing the government to acquire loanable funds without causing the crowding-out effect, which makes it a viable solution.
In response to the COVID-19 recession, the German government has come up with a stimulus package that is, while well-intentioned, riddled with potential unwanted side effects. It relies on large-scale borrowing that is likely to result in a decrease in aggregate demand as an effect of crowding out. In order to reduce this issue, the government should implement a binding real interest rate ceiling to ensure that real interest rates do not run rampant.
“Emerging from the Crisis with Full Strength.” Bundesministerium Der Finanzen, Federal Ministry of Finance , 8 June 2020, https://www.bundesfinanzministerium.de/Content/EN/Standardartikel/Topics/Public-Finances/Articles/2020-06-04-fiscal-package.html.
“Germany - Gross Savings (% of GDP)2022 Data 2023 Forecast 1971-2020 Historical.” Trading Economics, 3 Nov. 2021, https://cdn.tradingeconomics.com/germany/gross-savings-percent-of-gdp-wb-data.html.
“Germany: Supply Chain Crisis Slows Economic Growth: DW: 29.10.2021.” DW.COM, Deutsche Welle, 29 Oct. 2021, https://www.dw.com/en/germany-supply-chain-crisis-slows-economic-growth/a-59661859.
Nienaber, Michael, and Holger Hansen. “German Coalition Parties Agree 130 Billion Euro Stimulus Package.” Reuters, Thomson Reuters, 3 June 2020, https://www.reuters.com/article/us-health-coronavirus-germany-stimulus-idINKBN23A26W.
Posaner, Joshua. “German Coalition Agrees €130b Economic Rescue Package.” POLITICO, 4 June 2020, https://www.politico.eu/article/german-coalition-agrees-e130b-economic-rescue-package/
Weber, Alexander. “German Economy Contracts Amid Virus Curbs, Supply Snags.” Bloomberg.com, Bloomberg, 28 Jan. 2022, https://www.bloomberg.com/news/articles/2022-01-28/german-economy-contracted-amid-tighter-virus-curbs-supply-snags.