Fiscal reaction to interest rate changes

Normally, I write about monetary policy only when the Fed has a meeting, but today I wanted to break the tradition because I found a study that gives us an idea how German politicians adjust fiscal policy in reaction to surprise rate decisions by the ECB. And I emphasise that this is about German politicians because you won’t believe their actions and what that could mean for the EU.

A group of economists from ETH Zurich surveyed senior government officials in Germany on how they adjust their inflation and growth expectations in response to the surprise rate hikes in 2022 after Russia invaded Ukraine. They also surveyed them on how they adjust fiscal policy to cover the increase in interest expenses triggered by the higher interest rates.

Even for a country with low debt, the rate hikes by the ECB in 2022 and 2023, from 0% to a peak of 4.25%, added billions to the country's annual interest expense.

In response to a hypothetical increase in annual interest expenses of €10bn (c. 0.3% of German GDP), these senior government officials were asked how they would raise the expected shortfall in the government budget. They had four options:

• Reduce a planned increase in government transfers that have not yet been announced in public.

• Reduce other government spending.

• Increase in taxes.

• Issue new debt.

My intuition said that German politicians would likely cut unpublished spending programmes to balance the books. I expected them to be reluctant to cut other spending programmes (that’s always unpopular) and reluctant to hike taxes (even Germans don’t like to pay more taxes to balance the books). But I certainly wouldn’t think that German politicians would increase debt to pay for debt.

Yet, here is the typical mix of how German politicians would change fiscal policy in reaction to a surprise rate increase.

Average funding for a surprise increase in debt spending

Source: Dibiasi et al. (2025)

About half of the increase in debt spending is financed by reducing government spending, but only about half of that is achieved through cuts to existing government spending programmes. The other half is hidden by cutting back the planned new government spending programme. Honestly, I am surprised by this mix. I would have expected government officials to hide more of the spending cuts by cutting back unannounced spending.

What I am not surprised by is that increasing taxes is the least popular funding source.

But I am very surprised to see the high propensity by German government officials to pay for higher debt costs by issuing new debt. In the US and the UK, that is common practice, but in Germany?

At the very least, it indicates that German fiscal policy is much more open to increasing debt-financed spending than many investors think (if I may extrapolate from my intuition to all investors, for a moment).

This may sound like an academic question for Germany at the moment since the ECB is cutting rates, but I think it has an application in the current environment.

There is increasing talk about ‘blue bonds’ in the EU, i.e. the issuance of true Eurobonds that help finance EU fiscal spending and boost productivity growth in the EU (a perennial weakness that urgently needs to be overcome with improvements in infrastructure, regulation, etc.). Such blue bonds could also serve as an alternative to US Treasuries for investors seeking a safe asset, especially in times when the stability of the dollar and the Treasury market may be uncertain.

But in the past, Germany’s debt aversion has been the main hurdle to the introduction of these blue bonds. I think the experience of the pandemic, when Germany agreed to true Eurobonds to finance the Next Generation EU programme, and the results from this survey indicate that the resistance in Germany may be less than, and the birth of a true Eurobond market may be closer than many think.