Sunday, 15 December 2013

Germany and interest rates

This comment from Mysjkin on my previous post about Germany has made me think about the effect of free movement of capital and harmonised interest rates in a currency union:
"Imagine a German company going to a German bank, asking for a loan. The German bank answers: no we are not going to lend money to you because we can lend it for a higher interest rate to a company in Spain, but we will lend the money to you if you will also pay this higher rate. If the investment, at that interest rate, is still profitable for the company, it will borrow the money at the higher rate, problem solved. If the company (read: German corporations) does not want to borrow at this higher interest rate, it seems to me that monetary policy is not too loose, but too tight for German domestic conditions."
The argument is that ECB interest rate policy prior to the Eurozone crisis resulted in interest rates that were too high for Germany and too low for the periphery. And indeed, a look at Germany's economic performance during that time suggests that this is indeed the case. Germany was "bumping along the bottom" from 2000-2005. Even its pre-crisis boom barely reached 5% and was very short-lived:

FRED Graph

This is certainly not a shining economic performance. And it suggests that ECB interest rate policy has been persistently too tight for Germany.

What would be the effects of policy that is persistently too tight, remembering that Germany is part of a currency union? As Mysjkin points out, bank credit would be too expensive. Banks might of course reduce margins in order to maintain lending volumes as funding costs rose. And there is some evidence that they did exactly that:

Graph of Bank's Net Interest Margin for Germany

But in a currency union with free movement of capital, banks can simply lend to households, firms and governments in other countries where the returns are better. Indeed they were encouraged to do so. And the result was a horrible collapse in domestic bank lending to the private sector - a collapse which it seems is still continuing:

FRED Graph

Of course, this chart is in relation to GDP. But a quick look at the GDP growth chart above doesn't suggest that the reason is a massive rise in the denominator. No, it genuinely seems to be a fall in domestic bank credit.

So interest rates prior to the crisis were too high for Germany. Banks were not able to earn enough by lending to the domestic private sector, so they looked elsewhere. And in a currency union, they didn't have far to look. Commercial property lending in Ireland, Spain and Portugal. Greek and Italian sovereign debt. Not that they stayed within the currency union, though - they also invested heavily in US subprime mortgage assets. The result was a series of frightful crashes, as one after another these more lucrative lending markets collapsed and cross-border deposits fled back to Germany. But that doesn't mean that banks are lending any more domestically. The charts above show that they are not.

So if German banks still aren't lending domestically, and investment is continuing to fall, what on earth is the justification for arguing, as this paper does, that ECB interest rates are now too low for Germany? How exactly would raising interest rates encourage cash-rich NFCs to borrow? Raising interest rates to borrowers discourages demand for loans, and raising funding costs for banks discourages their supply. Even if Germany were not in a currency union, raising interest rates at present would be idiotic. Fortunately it is in the Euro area, and the ECB is not going to raise rates simply because German savers would like it to.

Solving Germany's investment problem requires both low interest rates and increased government investment. The ECB is at least attempting to address the first of these. But when is the German government going to accept its responsibility for the second?


Related reading
Germany's investment problem
Cross-border banking transactions in the Euro area - BIS (pdf)
Cross-border banking and financial stability - vox (pdf)
Financial crises and cross-border banking - Cass business school (pdf)
Banking across borders - NY Fed (pdf)
Why Germany's exports are so strong - World Review
Germany's recovery is faltering - Michael Burke

10 comments:

  1. Breaking news: Asmussen (SPD) to leave ECB and to become top civil servant in Nahles (SPD) lead ministry of labour.

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  2. http://www.spiegel.de/politik/deutschland/ezb-mann-asmussen-wird-staatssekretaer-bei-nahles-a-939202.html

    With compliments.

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  3. He says this enables him to spend more time with his family.

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    1. This may be risking writing way too much on Asmussen here, for which I apologose, but on balance, I think it may be worth pointing out that the post he'll get in the labour ministry is a very high ranking one indeed, but he will not really be a deputy minister. There is the minister. (In Merkels world preferably a woman.) Then there is one so-called "parliamentary state secretary", who is a member of parliament and can be called the "deputy minister" (paralmentarischer Staatssekretär), as he assists the minister in the political sphere. In practice it is, however, not a very important postion. And then there is a so-called "civil service state secretary" (verbeamteter Staatssekretär), who is responsible for running the ministry's civil service. He is the ministry's top civil servant. That's what Asmussen will get.

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  4. You've argued before - very persuasively - that banks won't lend to business unless the risk/reward ratio works for them, regardless of what amount of extra lending the government would like them to undertake. In that case wouldn't German banks be indifferent between domestic and foreign companies at a given rate of interest only if those companies presented comparable risks of default. Is that plausible, taking the German and e.g. the Spanish commercial sectors as a whole, and given the finger-burning that has taken place?

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    1. Hi Elliot,

      No, it's not remotely plausible. At present, since it is blindingly obvious that the risk of German and Spanish counterparties is very different, I would expect a loan to a German company to command a much lower rate than a loan to a Spanish company. And indeed that is the case. This of course undermines the principles of the single currency, but I think we have to recognise that the legacy of the Eurozone crisis is that the single currency is single in name only. Until we have far greater integration, including some mechanism for pooling risks across the member states, there can be no effective harmonisation of interest rates.

      Prior to the crisis, banks were led to believe (by both the ECB and the Commission) that risks were the same across the entire Eurozone, and interest rate differences were simply a matter of supply and demand. So, understandably, they lent where the apparent "demand" raised interest rates. We now know that those higher interest rates represented risk, not demand.... but they didn't know that then. I'm not defending banks, mind - they should have assessed the risks for themselves, not assumed that risks were pooled when there was no Treaty directive supporting this. I would say that pre-crisis was wishful thinking and post-crisis is humdrum reality.

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  5. The paper is full of the official propaganda.

    What happened? I heard in a interview with Mr. Flassbeck. When Mr. Schroeder came into power all economic experts Mr. Flassbeck included left and in the end Mr. Schröder's cabinet was underminded by the neo-liberal avidisors sent by the global corporates. That happened. That's the reason why the salaries dropped.

    Indeed Germany was a net importer before 2k and successfully turned into a net exporter. The weakening economy is a result of something different. That goes to far. It has something to do with the reunion but goes back to the time of selling the 'Deutschland AG', the nationalized industry.

    Exports. You have at least 2 different exports everyone talks about
    a) Those to the European Union while the Southern Europe economies started to weaken because of the increased price levels and salareis due to either the real estate bubble and investment bubble in general in the case of Spain, not talking about Greece and ... - low interest because of the EURO
    b) Machinery Construction and Cars

    a) Started to happen at the time of 2008 and started to become a problem in 2012. First the German goods started to compete with local goods usually subject to export in the import country (Milk products, ...) - Europe
    b) A substantial improvement, low price and to low EURO exchange rate in general. The World.
    c) Cheaper

    The German subsidize their industries in many creative ways. Now the Germand government does have 150 billion higher tax income, on the other hand still 6-7 mio people unemployed or jobs subsidized. 37 Mio in the workforce. In order to get a realistic picture it is wise to ignore Berlin. Berlin dependent on the data source does have 25 to 48% unemployment rate because the subsidized full time jobs and subsidized jobs qualifying for social insurance are there.

    The unemployment rate (ALGI - just normal unemployment benefit) is low 2,5%. Including those who are in training, 1 EURO jobs, subsidized jobs, long term unemployed (reduced unemployment benefit about 382 ER (flat and heat payed by the state - no extra pay for children) ... is about 12%. If you include those who receive social assitance add another 4,6%. So you have 14,5% unemployed and not sustain jobs ... and another 4,6% inevitably lost at the moment. The trick is that the 12% are not made up of unemployed people only. Many of those jobs are more or less subsidized jobs but not sustain.

    Saving in favor of exports very likely never paid. That happens.

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    1. Sorry. Not the paper is full of official propaganda - it's the article mentioned.

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    2. Now the German government does have 150 billion tax income surplus.

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