Economics and politics - comment and analysis
20. February 2024 I Heiner Flassbeck I Economic Policy, Economic Theory, Europe

It is high time for Germany to understand the market economy

Germany is proud of its market economy. Some call the German economic system a “social market economy”, believing that the market economy is inherently social because it helps to improve living conditions for everyone. The hero of the market economy, social or not, is the entrepreneur. As all good liberals and market economists know, it is the entrepreneur who drives the system forward, invests, introduces innovations and thus creates new income opportunities for everyone.

The funny thing is that it is precisely those who hold up the market economy like a monstrance who least understand what role their hero plays in a complex economy. Sure, everyone knows a successful entrepreneur and knows the individual heroic deeds they have accomplished. However, when it comes to the question of whether and how the state can help the entrepreneurs who are currently in collective difficulties in Germany, it is clear that the greatest preachers of market economy doctrine know the least about the market economy.

The German Economics and Finance Ministers agree that the burden on German companies must now be eased in order to stimulate investment activity and improve competitiveness. Robert Habeck and Christian Lindner have just announced this independently of each other. Each believes that with sufficient political will, the state can simply reduce corporate taxes, ease depreciation or distribute even more subsidies so that everything would be fine again. The only question at the moment seems to be where the state will get the money it needs to “do something for the economy” in this way, provided it complies with the debt brake.

If such a source could be found, i.e. a place where the state could reduce its current spending without too much political resistance or raise taxes elsewhere to relieve the corporate sector, nobody would have any doubt that it would then be possible to help companies and stimulate the German economy. But that is wrong. You can’t do that.

Companies receive the residual income

Companies have a very special position in the market economy and it is precisely this that prevents us from achieving anything with simple milquetoast calculations à la Habeck or Lindner. Companies receive as income what is left over after all contractual obligations to employees, suppliers and the state have been fulfilled. This is called residual income. This is both a blessing and a curse. If the company’s income is not sufficient to fulfil all contractual obligations, the company is left holding the bag and may have to file for insolvency. If much more revenue comes in than corresponds to the contractual obligations, the companies may be swimming in profits.

This complicates matters for the state who wants to relieve the burden on companies. If it takes around 10 billion less tax from companies and finances the loss of revenue, for example by reducing the so-called Citizen’s Income (there minimum social support), the recipients of the Citizen’s Income will reduce their demand for the companies’ products by exactly the 10 billion that the state wanted to give to the companies. It is unlikely that the situation of companies will improve on balance. Under no circumstances will they invest more because their current business is performing worse than expected. Regardless of where the state cuts its spending or which taxes it increases elsewhere in order to finance the corporate tax cut, the financing always has a direct or indirect negative impact on companies.

It follows quite clearly from this that the state can only improve the income situation of companies if it refrains from counter-financing its measures, which means that it raises the funds for this on the capital market. Only by increasing debt can money be made available that does not reduce residual income elsewhere. For a real improvement in investment conditions, it is also important that interest rates do not rise at the same time, as this could also cancel out the positive effect of debt-financed relief for companies.

Lower interest rates are the safest form of relief

If, for example, an (independent) central bank were to raise interest rates because it is concerned about the solidity of public finances in the event of debt financing, this attempt to relieve the burden on companies is in vain from the outset. In this case, there is only monetary policy that can provide relief for companies by lowering interest rates. However, as economic development is not one of the central bank’s objectives, at least in Europe, it is no exaggeration to say that there is no systematic way for the state to stimulate the economy because it is always dependent on the co-operation of the central bank, which it cannot demand.

If, on the other hand, the central bank sees that it is necessary to relieve the economy, it can do so at any time by lowering interest rates without incurring further costs. However, if, as is currently the case in Europe, the central bank is focussed on achieving price stability at all costs and keeps interest rates high despite a significant reduction in the risk of inflation, the state can dispense with almost any consideration of stimulating the economy. As the USA did after coronavirus, the state would have to step into the breach with huge sums of borrowed money to bring about a turnaround. However, this would only be possible with a central bank that, like the US central bank, is explicitly committed to the goal of full employment.

Europe has driven itself into a dead end

What Europe and Germany need is not the kind of discussion currently being conducted by Lindner and Habeck. What is absolutely necessary is for politicians and most economists to broaden their field of vision to include the macroeconomic dimension. But this is precisely what the liberals and libertarians do not want, because looking beyond the horizon of the Swabian housewife is ideologically forbidden because it is associated with Keynesianism. This is why the Federal Minister of Finance, who by his own admission is keen to “enter into dialogue” with those who think differently, engages in lengthy discussions with ultra-libertarians, where they only confirm each other instead of engaging in a serious debate with those who really think differently.

Such a debate would show that it was the ideas of the northern countries, including Germany, that led Europe and the European Monetary Union into this predicament (as shown here). But instead of talking openly about this with the other Europeans in the current situation, they are digging themselves even deeper into their own trenches so that they can no longer see the horizon.

As a politician who has to stand for election, you might argue that it is practically impossible to win even a flower pot with an economic policy U-turn given the current attitude of the German population towards such issues. That is probably true. However, if the turnaround is not attempted, if everything possible is not done to speak openly with the population and raise the discussion to a new level, then soon there will be no need for politicians to stand for election.

Then there will no longer be any discussion, but instead it will be decided from above without discussion who has to think how. That’s called fascism. Democracy thrives on open debate. But if it is incapable of doing so and therefore completely fails economically, then those who dislike any kind of discussion and blame the discussion itself for the failure of the state will come to power.