Ifo Viewpoint No. 115: Reallocation of Savings in Europe*
Munich, 22 June 2010
I had said that Germany need not be too gloomy about the euro crisis, because one of its effects would be to prompt some capital to remain in Germany, thus rectifying the excessive capital export that the euro had fostered. Thanks to the euro, the countries in Europe’s south-western rim gained access to a functioning capital market that accepted low interest rates and offered long-term fixed-interest contracts. The resulting capital influx fed a construction boom in those countries that pulled their entire economy with it, but which also reduced their competitiveness, leading to higher foreign trade deficits. The capital came mostly from Germany, where it naturally was then unavailable for domestic private or public investments. That was why Germany’s economy flagged as a mirror-image of the booming economies of the south-western periphery of Europe. Germany was bottom of the heap in domestic investment on a worldwide basis and next-to-last in terms of growth in Europe. Construction and the domestic economy slumped, while prices and wages rose only modestly. The only bright spot, which helped to avert the worst, was that the resulting better competitiveness boosted exports.
My thesis was that the euro crisis would put an end to this problematic development, since Germany’s savings would find no attractive investment opportunities abroad, in particular given that the USA had lost its safe-haven aura. This lack of options would perforce direct these funds towards German real estate and feed a domestic boom, scaling back the foreign trade surplus, not unlike the earlier economic flourishing on Europe’s periphery.
But then comes the rescue plan for the euro-zone countries into play and changes the situation dramatically. The EU is providing a credit facility amounting to 60 billion euros. A further 440 billion euros are pledged as guarantees. In addition, the International Monetary Fund (IMF) commits a further 250 billion euros. The European Central Bank has purchased sovereign bonds of the troubled countries, so far to the tune of 35 billion euros. This all complements the lifeline provided by the EU and the IMF to Greece, which entails loans amounting to 110 billion euros. The overall volume of the rescue measures comes to 895 billion euros so far, to which Germany, with over 200 billion, is the largest contributor.
On either side of the Atlantic, the largest capital exporter by far is also Germany. With the assistance programmes that the German Bundestag recently nodded through, it provides its competitors with the necessary creditworthiness in the capital markets, making it possible for them to snatch loans from the nose of German homebuilders and companies in its Mittelstand. The rescue package thus continues to dampen growth in Germany.
What this translates to in the capital markets is shown by interest spreads. In 1995, the average interest rate for ten-year bonds issued by the countries now protected by the guarantee package hovered 2.60 percentage points above the German benchmark. For some countries, such as Italy and Spain, the premium was even 4 to 5 points. By joining the euro, these countries hoped to shake off such spreads, and it indeed turned out to be so. The median spread in 2008 was only 0.40 percentage points.
And then the debt crisis struck. The interest rates started to diverge again. Just before the EU’s emergency meeting on May 8 and 9, the average spread had crept up to 1.08 percentage points. That was by no means as large as before the introduction of the euro and definitely no justification for dealing a blow to the Maastricht Treaty. It did suffice, however, to set leading EU countries on edge and make them feel compelled to give Germany an ultimatum. The rescue programmes indeed show a noticeable effect: by May 28 the spread had shrunk to 0.89 percentage points. This way, Germany had made it once again easier for capital to flee its domestic economy.
However, the spreads are still over twice as high as before the crisis, because investors continue to be sceptical. Germany can therefore still look to higher domestic economic growth in the medium term. The economic boost will be more modest than if the rescue package had been less generous, but it is still there. Much will depend on subsequent political decisions once the three years set for this rescue package expire. The larger the spreads, the better the growth prospects for Germany. For this reason, Germany should see to it that prior to each disbursement of rescue money, creditors receive a haircut for the old debts, since only a haircut will instil more caution amongst investors and prompt them to demand a suitable risk premium from each country. The interest spreads slapped on heavily indebted countries are necessary to avoid distorting European capital flows and the overheating of the countries on Europe’s south-western periphery. They are a better fiscal stimulus for Germany than any state programme to foster investment could ever be.
Professor for Economics and Public Finance
President of the Ifo Institute
*Published as “Nachweisbare Wirkung”, Wirtschaftswoche, no. 23, 07 June 2010, p. 39.