German Public Finances: Accounting Tricks in Conflict with the SGP

According to recent news reports, the new German coaliton government has found a nice trick which would allow them to cut taxes in the years from 2011 onwards without having to cut spending nor having to borrow more at that time.

Sounds too good to be true? Right. It is not that Merkel and Westerwelle have found a new way to make debts simply go away, but they are rather resorting to an accounting trick. The idea behind all this is to install a special purpose entity which now borrows something like €40bn from the capital market and uses the money in future years to pay for deficits in the social security system. Thus, the recorded deficit for this year would skyrocket, but it would be lower in the years to come, making it possible to meet German constitutional requirements for deficit reduction even if taxes are cut.

In fact, it is well possible that such an accounting vehicle might well put he future budgets at least within the words of the German constitution. The German laws for public finances often only look at the legal nature of a transaction, not at the economic relevance behind it.

Unfortunately for the new coalition, however, it is very unlikely that this Enron-like accounting trick will actually get Germany off the hook when it comes to the Stability and Growth Pact. This pact prescribes that the combined deficit of the public sector must not be bigger than 3 percent of GDP. In addition, the rules of Eurostat differ from national rules. The basic principle of the Eurostat rules is to look beyond legal form and at the economics behind a government transaction. Thus, proceeds from privatization do not lower the government debt as a privatization is just a change of assets. Moreover, if the government is repayed a loan it had given to the private sector before, this transaction does not lower the public deficit according to the Eurostat measurement even if it lowers current borrowing by the government in question.

Following these rules, the accounting approach envisioned by the new German coalition government would not help to keep the German deficit within the SGP limit for the years after 2010 and it would not increase the deficit this year. While the details are not yet known and Eurostat has not issued a decision, borrowing for a special purpose entity in 2009  would most likely only count as a financial transaction not to be included in deficit calculations. The government has borrowed, but it keeps the cash at hand. As for a normal company, the net worth has not changed. So the deficit remains unchanged.

Only when the social security systems (which – remember – are part of the government sector according to the Eurostat rules) spend the money and actually run the deficits in 2011 or 2012, this will be recorded as a deficit for the German public sector according to the Eurostat rules no matter when the money was borrowed. If now the new government adds tax cuts to these deficits, it is very likely to breach the SGP’s 3-percent limit and will hence come into conflict with the SGP.

Why this needs to be the case in order to make the SGP workable shows this little thought experiment: If the plan of the great coalition really would be accepted, what would keep i.e. Mr. Sarkozy from borrowing €300bn this year, putting it in a special purpose entity, having this entity investing the money in short-term French government bonds and spending the money in the years to come? Clearly, this year, overall borrowings would be enormous, but if the entity at the same time buys government bonds with a shorter maturity, France might be able to borrow that much. And Mr. Sarkozy could continue to run deficits of the magnitude of 5 percent of GDP or so for years to come without coming into conflict with the SGP.

While the drafters of the SGP can be criticised for a lot, they took some care in drafting the technical part of these rules. Germany has always frowned at other countries which used Enron-like accounting for the public balances to conform with the SGP. Now Germany is starting to lead the pact when it comes to accounting alchemy.