Saturday, 14 December 2013

Germany's investment problem

We all know that Euro membership has been of doubtful benefit to periphery countries such as Greece and Portugal. But Germany has been a net beneficiary of the Euro, hasn't it?

Not according to these charts from Albert Edwards (h/t Edward Harrison).



(larger image here)

Note the point on both charts where the trend changed sharply. Yes, it's 2000 - when the Euro was introduced. Admittedly, Germany's gross fixed investment was already declining, but after 2000 it fell off a cliff. And the current account decomposition chart shows us why. Note the collapse in borrowing by non-financial corporations from 2000 onwards. That is disappearing domestic private sector investment. In fact in 2009-10 NFCs were net saving. This is distinctly unhelpful in an economy which has seen gross fixed investment falling for the last twenty years.

To start with, it appears that government borrowing replaced private sector net borrowing. But even that declined from 2004 onwards, replaced by income from a growing current account surplus. Good news for German households, apparently. They increased their saving. But contrary to popular belief, their hard-earned savings have not been productively invested in the local economy. They have unproductively blown up sovereign and private debt bubbles in other countries. The German banking system - including the marvellous Sparkassen, whose equivalent some people would like to see in Britain - has not been doing its job.

Admittedly these charts only go as far as 2010. But they do not tell a story of a booming Germany benefiting from the single currency. They tell a story of a country from which productive investment is being drained by a banking system that sees greater returns elsewhere.

If the German banking system were genuinely a private, free-enterprise system, this would be understandable. But it is not. The majority of it is either state-owned or state-controlled, and even the parts of it that are not state-owned benefit from implicit sovereign guarantee. No way is Germany going to allow its bigger banks to fail: to do so would put at risk the prized Sparkassen, Volksbanken and Raffeisenbanken. It would surely be reasonable to expect that a state-backed banking system would principally invest domestically. But clearly, it doesn't. German domestic businesses can rightly feel that they have been let down by their banks.

But this is not entirely a story of banking. After all, savers expect banks to generate good returns on their savings, and if that can best be done by investing that money outside the country, then can we really blame banks for doing so? This is a story of the ECB's one-size-fits-all monetary policy and its insane insistence, prior to 2009, that all sovereign debt was of equal quality.

And it is also a story of too-tight fiscal policy. Instead of increasing its own borrowing to compensate for the fall in NFC borrowing, the German government gradually reduced its fiscal deficit - indeed in 2007 and 2008, it was net saving (running a surplus). On the face of it, this looks sensible: after all, we are led to believe that governments should net save during booms. But not, emphatically not, when there is a growing current account surplus. A persistent current account surplus is contractionary over the medium-term, because it by definition means that productive investment is leaving the country. Note how the domestic deficit (private and public sector) exactly parallels the current account surplus: as I've noted before, the larger the current account surplus, the greater the capital deficit, and that translates into reduced domestic investment. If Germany were not in a currency union, then the correct course of action would be to raise interest rates to encourage domestic investment. But Germany does not have that option. Its government should therefore have been borrowing to invest even during the boom, which would have had the effect of raising real interest rates. I know it seems counter-intuitive to suggest looser fiscal policy as a counter to too-loose monetary policy, but remember that the problem is lack of investment: if the private sector won't invest domestically (because real returns are higher elsewhere), then government must. When countries have no control of monetary policy, fiscal policy cannot be counter-cyclical.

So it seems that Germany has suffered from poor investment since the start of the Euro as a direct consequence not only of the ECB's interest rate policy but also of its own government's tight fiscal stance. And this story continues. The German government is intent on fiscal consolidation, even as the current account surplus grows ever larger in relation to GDP:

Graph of Total Current Account Balance for Germany


Increasing government investment in Germany would not necessarily mean the current account surplus fell, at least at first. It could be done on a balanced-budget basis, in which case it would mean reduced domestic consumption spending instead (government spending cuts and/or higher taxes, forcing the private sector to cut spending). Given that German GDP is stagnating at present, this is perhaps not the best course of action. Borrowing to finance increased government investment strikes me as a much better approach. This might mean that the German government would face higher borrowing costs - although savvy investors should regard an increase in German government debt for investment as a good thing. But it would stop the bleeding of capital investment from the domestic economy without squashing domestic demand.

The ghosts of Weimar need to be laid to rest. An increase in government borrowing to fund medium-term investment is not going to result in out-of-control inflation. But failure of capital investment due to an out-of-control capital account deficit will in the end impoverish Germany.

UPDATE. Via @wonkmonk_ on twitter, this special report by Natixis into the German current account surplus reaches the same conclusion as me. The fundamental problem is failure of private sector investment in Germany throughout the period of the euro - and it is very bad for Germany.

30 comments:

  1. "But clearly, it doesn't. German domestic businesses can rightly feel that they have been let down by their banks."

    So you think that German businesses would like to borrow more, but can't because German banks prefer to invest in other countries? Do you really think German business have not enough access to credit from German banks? That seems very implausible. Is the problem in Germany not rather that there is not enough demand for credit?

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  2. I'm really not sure whether the problem is banks not lending or companies not borrowing. But banks do chase higher rates, and the fact is that throughout the 00s higher rates were to be found outside Germany.

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    1. Isn' the the distinction crucial? Normally you would expect interest rates to rise if there's a higher demand for credit (that also the reason why interest rates in the PIGS were higher). So if there would be a shortage of credit for German businesses why are interest rates so low then?
      If German businesses do not want to borrow (invest) enough to keep the economy going, it seems logical that the government should invest/spend more instead, but if German businesses do want to borrow, why would more government borrowing help them?

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    2. You are ignoring the fact that benchmark interest rates are set by the ECB, not the Bundesbank. Admittedly banks do not have to charge these rates or anything like them, but we did not have a bifurcated credit market prior to 2009. German interest rates were therefore lower than they should have been, not because of lack of demand but because of monetary policy.

      Having said that, it is entirely possible that the reason businesses don't borrow is because they don't want to invest. The question is why - and I don't have an answer for that.

      If German businesses want to borrow, but can't - because banks don't want to lend to them - then it may be that changes are needed to encourage banks to lend. But if they aren't borrowing because they don't want to, then government investment is needed to plug the gap.

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    3. Germany is a pretty mature and well maintained country, what do you want them to invest in? There's always some stuff you could improve, but at some point if you invest for the sake of investing, you get to marginally or negatively productive investment. It's not too surprising that they find better opportunities abroad in less mature environments and it is generally good for the receiving country.

      Besides German industry has been pretty insular until relatively recently, so net investing abroad doesn't look like a bad idea: it's difficult to keep a business world class if you're too introverted. This is a rebalancing process that should mature in due course (with little new net investment or incoming profits coming back).

      I also don't see that the euro has much to do with this, a stronger DM would have made it easier for German companies to invest abroad (cheaper factories and workers!) probably offsetting any interest rate effect. Beyond the short term the fundamental forces are likely to dominate the monetary ones, it's just accounting after all.

      And we have another generic (see UK and US having low/declining investment too) measurement issue that in mature/technological developed economies investment in things or activities that constitute common sense investment but show up as consumption in statistics which like to count how many gasometers you build.

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  3. 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.

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    1. Actually I think you are on to something there. Natixis (see the Update) say "we don't know why German private sector forms stopped investing", but the borrowing figures do suggest that the reason was a problem with either the availability or the price of credit. It's not normal for an entire NFC sector to eschew borrowing so completely. If German banks were trying to charge the sort of rates they were getting in Greece, no wonder German firms didn't want to borrow. The German economy was pretty depressed at that time: domestically, the returns to justify the expenditure wouldn't have been there.

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    2. that should be "firms", of course.

      I don't think it is widely known that the German economy was "bumping along the bottom" from 2000-2005 in much the same way as the UK's has been recently, and in my view for much the same reason - failure of both private and public sector investment.

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    3. There was the whole subprime bubble as well at that time (German bankers buying US subprime en masse), which I'm tempted to see as self-contained: it's not because people didn't want to invest or bankers didn't want to lend, as such, but merely that the mirage of subprime risk-adjusted returns outcompeted reality (as mirages do...).

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  4. Very interesting, thanks. Finally, a post on the German economy that takes a sober look at the problems, rather than the usual "Germans want to conquer the periphery" rubbish.

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  5. Information that may (or may not) be of interest: in 2013, fewer youths than ever since reunification managed to get a trainee contract that enables dual (vocational and school) education in industry. http://www.faz.net/aktuell/beruf-chance/arbeitsmarkt-so-wenige-lehrvertraege-wie-noch-nie-12709345.html

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    1. Interesting. In addition to the reasons mentioned in the article, I suspect there's an effect that as you get closer to full employment, it's easier for applicants to demand a real job, so skip or get out of apprenticeship earlier than otherwise. Some of the apprenticeship system is obviously very good, but it's also a way for employers to pay workers below grown-up tariffs (which are oft regulated, so they can't just pay everybody a crap wage), and some not particularly skilled jobs don't really need a long apprenticeship. If so it's good news (better wages for the low paid, and helps close remaining eurozone imbalances faster).

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    2. Yes, there are presumably several reasons for this decline. Still, even accounting for the fact that more are today seeking academic rather than vocational training, etc., it is still true that fewer apprenticeships were offered than demanded.

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  6. Frances, Your claim that German savings have been drawn away from fixed investment in Germany and towards sovereign debt in other countries tends to support the claim made by several advocates of Modern Monetary Theory, namely that governments should not borrow at all.

    E.g. see second last paragraph of Warren Mosler’s article here:

    http://www.huffingtonpost.com/warren-mosler/proposals-for-the-banking_b_432105.html

    Plus here is a phrase from a recent article by Stephanie Kelton and Scott Fullwiler: “there is no reason for the government to sell bonds at all. We can stop today.” See:

    http://neweconomicperspectives.org/2013/12/krugman-helicopters-consolidation.html#more-7092

    Plus I argued in 2010 against government borrowing here:

    http://mpra.ub.uni-muenchen.de/23785/

    The latter works all apply to countries that issue their own currencies and obviously EZ countries don’t do that. But my hunch is that the same arguments apply in both scenarios.

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    1. Ralph,

      Banks and investors bought periphery debt because it was mispriced. It was thought to be risk-free - indeed the ECB had encouraged this belief.

      In a currency union, countries must finance deficits by borrowing, since they do not have their own currencies so cannot print money. They can only "stop borrowing" if they run balanced budgets forever.

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    2. Member states of a currency union can get a regular (e.g. quarterly) allowance of printed money from the federal central bank, so it can be done, it's just that it must be decided at the federal level.

      The decision could be to make it mechanical, e.g. the ECB could decide the allowance according to monetary conditions and distribute it per capita to member states so that there's no new federal policymaking body required beyond enacting the rule (though a federal treasury would be good for other reasons, I'm just pointing out it's not a necessary condition for moving to a bond-free regime in a currency union).

      It would be nice if the central bank had a way to sponge excess money, should the allowance required by monetary conditions be negative. My preference here would be to hand control of say the (base) VAT rate to the central bank which would decide how much of the collected tax it includes in the annual allowance of printed money it credits to member states (or the federal gov for single country currencies). I suspect this would make a better and more responsive policy tool than the interest rate, which should probably be pinned to zero by statute.

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  7. A) An update to 2012 of the first graph, based on Eurostat data: http://www.luxetveritas.nl/blog/?p=3378

    B) Fixed investements consists to quite some extent of houses. it might be interesting to look at non-residential investment

    Merijn Knibbe

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    1. Ooh, thanks. Useful graph. NFCs still net saving, I see!

      Yes, it would be helpful to look at a breakdown of investment by category.

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  8. By the way - I've travelled (bycicle/car) quite some Dutch/German/Swiss/French/Belgian roads, this summer. Guess which roads were clearly the worst.

    Merijn Knibbe

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    1. Quality of roads in Germany differs a lot depending on where you are. In the former east, they are excellent thanks to solidarity tax financed infrastructure projects. In North Rhine Westphalia, they are in a shocking state. As the latter is close to Holland and Belgium, I assume you got a taste of that...

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    2. North Rine is coal and steel. A problem for a long time now. The huge advantage of heavy industries tremendous prosperity but if there is downturn it's better to move away early. The whole region has been kept alive by subsidies.

      The Russians have built tremendous steel works. 20 times the capacity of the one my home-town. If you take steel coils - 2 times cold rolled does offer the highest gross margin. That's the way the steel industry along the Rhine was setup and the remaining steel works are strongly dependent on electricity. Today steel companies are focusing on providing more and more steps in order to ship a finished product to the customer.

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    3. Tell me about structural change in the northern rhineland, it's where I live ;-)

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    4. Ok. Didn't know that. So you know it better. I followed some guys selling real estate there and what I saw ... Those old buildings in the Schimanski films have been way better off.

      Btw ... you can compare the steelworks in my city to Salzgitter about that size. In Russia they simple take land ... and in Europe you cannot even build another plant due to construction regulations. The steelworks in my home-town does produce a wide variety of different kinds of steel, I worked there in IT, but there a few steps in production that make a difference when it comes to steel. Coils logistic is not that simple ... you need special railway routes ... and usually the transportation distance in normal times is limited by transport costs. Maybe they did not do everything right, but they did not listen to McKinsey when it came to strategic decision concerning their business. That's the difference IMHO.

      Swedish steel industry is not better off...

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  9. Flassbeck wrote about this long ago:

    http://www.flassbeck.de/wordpress/japan-why-paul-krugman-doesnt-get-it-right-and-martin-wolf-has-to-move-on/

    ca. 2000 corporate tax was reduced.
    The export companies swim in cash, they dont have to borrow. <- pervert for a economy.

    Private ppl can't get that easy access to credit,
    because in Germany until recently people do NOT know things like 100% funding of real estate.
    If you do not have 25% or so in cash, go away.
    And now also labour market flexibilized.
    Temporary agencies have even more rights as in highway capitalism UK.
    But access to credit still conservative.
    retail trade on a level like ca. 1990.

    But well yes they did lend to other banks.
    And they were still used to soft currency.

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    1. Not Flassbeck only.

      Hans Werner Sinn described the situation as follows. The money printed in South Europe was sent to Germany so that the Deutsche Bundesbank had to destroy all 'German' Euros. There almost no German Euro in Germany. The Deutsche Bundesbank is a net debitor of it's banks. That's why we don't see the inflation. Wonder if this does matter ... but somehow strange.

      In Austria too. You must provide about 25% if you want to build real estate ...

      The German economy currently does benefit from real estate business because of the low interest. There are voices, I don't remember the source, that said - lowering the incomes did not help - the crisis Germany in the 90s was caused by reduced investment into real estate ...

      The current boom is a housing boom and a certain export boom.

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  10. This comment has been removed by the author.

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  11. RE the Internal investment Graph , it shows a reduction in relative size to GDP it doesn't necessarily show that it has shrank in actual size. It could be because GDP is growing and It is inevitable that a graph of internal investment as a percentage of GDP will decline, if the reason that GDP is increasing is because of a trade surplus, as the growing assets associated with a trade surplus are external.

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