VOX, www.voxeu.org, 2. August 2011.
With the fire in the Eurozone still burning, this column asks how it started. It highlights three phases in capital flows since the introduction of the euro. First, capital flowed out of Germany to the booming periphery countries. Second, as the crisis hit, TARGET2 caused a forced capital export from the Bundesbank . Third, public capital flows, which again rely on money from Germany, have only just begun.
Europe is stuck in a balance-of-payments crisis. Private capital shuns the countries in the periphery, the heads of government agree to ever larger rescue packages, and the parliaments of the more solid euro countries acquiesce with growing reluctance. Germans are increasingly vexed by the whole thing. Some warn of mounting liabilities, while others assert that Germany is the main winner of the euro and should show some gratitude. What do the facts say?
In order to understand what has happened, it is useful to cast a glance at international capital flows, TARGET2 balances in particular, which have grown excessively under the euro [For the colourful and varied discussions on the topic see for example Buiter et al. (2011a,b), European Economic Advisory Group (2011), Sinn et al. (2011), Sinn(2010a,b,c), and Wolf (2011).] Three phases can be seen.
- In the first phase, private capital flowed copiously from Germany to the periphery and helped the economies there to bloom.
- In the second phase, which started when the financial crisis hit, private capital dried up and the ECB helped out by running the money-printing press, which, as will be explained below, amounted to a forced capital export from the Bundesbank.
- In the third phase, which has just begun, public capital flows by way of the rescue packages are being activated.
This column explains these three phases.
Private capital flows essentially as credit over the bank and insurance systems by means of foreign asset purchases and also as direct investment, i.e. through the acquisition of foreign real assets. Public capital can flow as intergovernmental loans, but it has flowed in fact mainly through the shifting of the stock of refinancing credit within the Eurosystem, the Eurozone’s central bank system.
As a whole, a country’s capital exports are fed by the country’s savings. Saving is that part of income that is not consumed by either private or public agents. It can be used for real domestic investment or for capital exports. Normally, domestic investment consumes the lion’s share of savings. But in Germany it was different. Since the introduction of the euro, the largest part of savings flowed abroad. This is illustrated by Figure 1.
The sum of savings of private households, companies, and the German government (which unfortunately was negative in the calculation) amounted to €1,626 billion since the introduction of the euro. That was the amount of money available for net investment in Germany. Factories, schools, bridges, roads, apartment buildings, office blocks, and much more could have been built with it. But barely one third of it, €554 billion, was invested at home. Two thirds of the savings, or €1,071 billion, flowed abroad instead. That would have been enough for 357 maglev lines from Munich’s airport into the city.
Out of the total capital exports, only €227 billion went to net direct investment. The investments of Audi in Hungary’s Györ were as much part of it as, with the opposite sign, those of private equity funds in the German Mittelstand.
Almost half of the capital, €470 billion, flowed abroad as net financial capital. [Of this, minus €122 billion is shown as a “residual item”, which is not broken down further in the statistics.]
The Germans brought their savings to their banks or insurance companies and these institutions invested them in financial instruments of other countries. Among these were many sensible investments, but also securities that, with hindsight, were less profitable than appeared initially, such as Greek government bonds, Lehman Brothers certificates, or Spanish savings banks’ debt instruments. In a smaller measure, export credits, development aid and also Germany’s first rescue loans to Greece are also included in this total. [The credit given directly by Germany as help amounted to merely €6 billion by the end of 2010. The lion’s share of loans is provided by the newly-created Luxembourg special vehicle, guaranteed by Germany in proportion to its capital share in the ECB. The guarantees are not treated as a capital export. This point will be addressed later on in this article.]
It is noteworthy that €356 billion, enough for 119 maglev lines, flowed through the Bundesbank as so-called TARGET loans to other countries in the Eurozone, primarily Greece, Ireland, Portugal, and Spain. The borrowing of these countries through the Eurosystem amounted to around €350 billion from 2002 to 2010.
These are the facts. The question is how these capital flows came to be.
First phase: The euro and interest-rate convergence
The onset of the first phase is characterised by the convergence of interest rates that occurred in the Eurozone from 1995 to 1997. This is shown in Figure 2 using 10-year government bonds as an example. At that time, the euro had already been announced and it was clear that the exchange rates would be irrevocably fixed on 3 May 1998. The depreciation risk of the southern countries lessened with every passing day towards this deadline, making the risk premiums decrease accordingly. Greece joined later on. After doctoring its budget figures in 1999, it managed to enter the Eurozone in 2001. Figure 2 also shows that the approach of this date brought about a rate convergence in this case as well.
The low interest rates unleashed a credit-financed boom in the countries in Europe’s periphery, which initially was a godsend for these countries (see Sinn and Kroll 2000). Private individuals used the cheap credit to build property. Construction workers got well-paid jobs. In Spain and Ireland, this even attracted a sizable wave of immigration. The governments used the cheap credit to raise the salaries of public-sector employees and generally to spend more. Everywhere the economy grew at a rapid pace. This growth was by all means real, but it was tainted by a strong inflationary component. Wages and prices rose so much that the competitiveness of the peripheral countries suffered as a result. This dampened exports while the nominal rise in incomes fuelled imports. Increasingly large amounts of capital flowed into these countries to finance the current-account deficit [Excess of imports over exports (goods and services including capital services) minus transfers (such as gifts from other countries and guest-worker remittances) from abroad which, by definition, equals the country’s net capital import], which all too often resulted not from real investment but from new consumption to raise the living standard. In 2010, despite much-trumpeted austerity programmes, Greece still had a current-account deficit of 10.5% of GDP, and its aggregate consumption was 17% higher than its net national income (see Corsetti et al. 2011 and Sinn 2011e on this site).
The capital came primarily from Germany, which had a growing current-account surplus since 2002 and became, after China, the world’s second-largest capital exporter. The German surplus resulted from the slump caused by the fleeing capital. Everywhere else gold appeared to shine more brightly than in Germany, whether it be the USA, Eastern Europe, or the countries in the Eurozone’s periphery. Even small interest rate differences prompted investors to invest abroad the new capital provided by German savers, and not only in the European periphery. The AAA ratings granted with casual deference to the American investment banks stimulated capital exports just as the fact that banking regulation, based on the Basel system, rated the southern countries’ government bonds as safe and therefore did not demand that banks hold equity capital against them. Banks and insurance companies heaped on government bonds of the peripheral countries. The fall of the Iron Curtain, which offered low-wage labour to German companies, also contributed to capital exports. This all occurred at the expense of German economic growth. Over this period, Germany exhibited the lowest aggregate net investment rate of all the OECD countries and was the economic laggard of Europe (see Sinn 2003). It had either the lowest or the second-lowest growth rate in Europe. It suffered from what at the time was called a “location crisis”, a term indicating Germany’s fading relative attractiveness as a business location (see Hankel 2000 and Sinn 2007).
Mass unemployment forced Germany to undergo the painful reforms of the Schroeder government, which dismantled the wage competition posed by unemployment benefits and reduced the implicit minimum wage set by the German social security system. Germany literally swallowed a kill-or-cure remedy. Since wages barely rose during the slump, Germany managed to gradually regain competitiveness. From 1995 to 2010, Germany became 21% cheaper, trade-weighted, with respect to its trading partners.
Price restraint breathed new life into exports, and meagre growth held imports down. The outflow of capital, coupled with the domestic slump, resulted in a trade surplus. That Europe’s and Germany’s political class interprets this surplus as a sign of Germany’s particular gains from the euro is an absurd misinterpretation of the facts.
Second phase: Crisis and rescue by the ECB
The situation for the peripheral countries and for Germany changed dramatically when the American financial crisis spilled over to Europe. Huge write-downs of toxic American securities burdened the European banks and forced them to roll back their engagement in risky investments. This gave rise to a credit crunch in Europe, which hit the peripheral countries particularly hard. Suddenly, private capital was no longer willing to flow to these countries and finance their continuing trade deficits.
Whereas the acute economic crisis of 2008 and 2009 affected all countries equally, it soon exposed the fundamental differences between them. Those countries that had hitherto underpinned their boom on capital imports remained to a greater or lesser extent stuck in a crisis of which they have yet to emerge. Globally, these include the USA and the UK, and in the Eurozone primarily the peripheral countries and, to a lesser extent, also France and Italy. Germany, in contrast, bloomed in the aftermath of the crisis. In 2010, its 3.6% growth was the strongest among the larger Eurozone economies.
This growth was not fuelled primarily by foreign trade, as repeatedly claimed, but mostly by a remarkably strong level of domestic investment. The reason for this is that capital no longer dared leave Germany and satisfied itself with extremely low local interest rates if invested in Germany. Figure 2 shows this very clearly. The widening interest spreads during the crisis did not just burden the highly indebted countries in the periphery, but also granted Germany a great advantage. Construction interest rates in 2010 were lower than ever before and the backlog of architect projects is now higher than at any time in the past 15 years.
The crisis in the periphery was made more moderate by the ECB by forcing a significant portion of the reluctant German capital to continue flowing to those countries. Specifically, it allowed the national central banks of the periphery to finance their current-account deficits with the money-printing press and to replace the dwindling private capital with public loans. In the case of Portugal and Greece, their individual current-account deficits were entirely financed this way. In the case of Ireland, a huge capital flight was financed in addition. And in the case of Spain, around one fourth of the current-account deficit was financed by its central bank. Altogether, the ECB covered 88% of the current-account deficits of these countries with the printing press in the past three years. The money lent this way flowed through the Bundesbank back to Germany, just as the loans that Germany had given to these countries had previously done. In Germany, it crowded out practically one-to-one the money created through refinancing loans (see Sinn 2011c and 2011d on this site).
In exchange for having to create the money without giving a refinancing loan in Germany, the Bundesbank received a claim on the ECB (a so-called TARGET claim). Instead of lending central bank money through refinancing loans to the German economy, the Bundesbank lent it through the Eurosystem, guaranteed by the euro community, to the countries in the periphery. That resulted from the mechanics of the system and not from a conscious decision. In the balance-of-payments statistics, this credit-shifting process is rightly shown as a German public capital export through the Eurosystem. As Figure 1 shows, this amounted to €356 billion, a bit over one fifth of the German savings and one third of the overall German capital exports since introduction of the euro. The lion’s share of this sum, €308 billion, accumulated after the onset of the financial crisis, namely since mid-2007, as the interbank market seized up.
It was similar to the times of the Bretton Woods system, when the USA flooded the world with its money and the Bundesbank was forced to create money by exchanging dollars for D-marks, instead of giving refinancing loans to the German commercial banks. That time the Bundesbank was also forced to export capital. In the Eurozone, the peripheral countries have appointed themselves as quasi reserve currency countries, performing a role similar to that of the USA formerly, forcing a capital import with the money-printing press (see Kohler 2011).
This has not made the credit-fuelled boom in Germany flounder, but it has kept rate spreads in check for a while and delayed the German boom. At the same time, it has relieved the burden of adaptation in the peripheral countries and deferred the crisis, without preventing it more permanently.
This ECB policy has a temporal limit, however, since it will hit a wall when the stock of refinancing credit in Germany is exhausted. In the three crisis years 2008, 2009, and 2010, the stock of refinancing credit in Germany retreated by an average of €38 billion per year, and at the end of 2010 there were €93 billion left. A continuation of this policy would have consumed the entire remaining stock of refinancing credit in Germany by mid-2013, depriving the ECB and the Bundesbank of its main policy instrument for steering the largest economy in the Eurozone. That was the reason that the ECB exerted particular pressure to be relieved of its rescuing duties by the rescue systems of the European community.
Third phase: The public rescue facilities
In the third phase, the official rescue facilities have been deployed. They have started on a provisional basis with a package for Greece, as well as the European Financial Stability Mechanism (EFSM) and the European Financial Stability Facility (EFSF), which financed the rescue operations for Ireland and Portugal. The IMF has also come to the rescue in each case. Until the end of June 2011, €93 billion in rescue funds had been provided, and €236 billion were authorised. A further €109-billion rescue package for Greece was established in July 2011, and it was agreed that the EFSM would in the future be able to buy government bonds in the secondary market to keep interest spreads in check. Since it was foreseeable that much larger funds would soon be needed, during the spring and summer of 2011 a new gigantic rescue package was created under the name European Stability Mechanism (ESM), endowed with €700 billion to give the temporary rescue facilities a permanent character. This facility should start to operate in 2013.
The new rescue operations do not lead as a rule to a public capital export from Germany, since the packages refinance themselves in the international capital market. To date, only €8.4 billion have been lent directly by the German government. Germany, however, guarantees the sums in these community vehicles according to its share in the ECB’s capital; in addition, German banks and insurance companies will once again become prime financiers, since Germany is the largest capital exporter around.
Through the rescue packages, Germany makes its outstanding creditworthiness available to other countries and enables them to tap credit at better terms than would otherwise be the case. This, of course, deteriorates Germany’s creditworthiness, which will force Germany to pay higher interest rates.
In the extreme case--namely if the Luxembourg rescue facility evolves into a Eurobond system that would give all the euro countries the possibility to borrow at the same rate of interest, since what counts is the average creditworthiness--the interest rate that Germany would have to pay, according to calculations by the Ifo Institute, could increase by 1.2 percentage points above the rate it would normally have to pay. This translates, at the current level of sovereign indebtedness, to a yearly additional burden of around €25 billion in interest payments, exactly as much as the German gross transfers to the EU, and around twice as much as its net ones. Furthermore, it could mean that the capital can flow again with no restraints from Germany to the countries in the periphery, where it would once again set an inflationary boom in motion while Germany slips back into a slump.
Editor's note: Additional and missing references have been added to the original post.
Buiter, WH, E Rahbari, and J Michels (2011a), “TARGETing the wrong villain: Target2 and intra-Eurosystem imbalances in credit flows”, Citi Global Economics View, 9 June.
Buiter, WH, E Rahbari, and J Michels (2011b), “TARGETing the wrong villain: a reply”, Citi Global Economics View, 5 July.
Corsetti, Giancarlo, Michael P Devereux, John Hassler, Gilles Saint-Paul, Hans-Werner Sinn, Jan-Egbert Sturm, Xavier Vives (2011), “Can Greece pull it off?”, VoxEU.org, 18 March 2011.
European Economic Advisory Group (2011), "A New Crisis Mechanism for the Euro Area", European Economic Advisory Group, CESifo, Chapter 2, p71-96.
German Bundesbank (2011), Zahlungsbilanzstatistik, June.
German Federal Statistical Office (2011), Fachserie 18, Volkswirtschaftliche Gesamtrechnungen, Reihe 1.4, 2010.
Henkel, H-O (2000), Die Macht der Freiheit, Econ, Munich.
Kohler, W (2011), “Zahlungsbilanzkrisen im Eurosystem: Griechenland in der Rolle des Reservewährungslandes?”, unpublished manuscript, forthcoming in ifo Schnelldienst.
Sinn, H-W (2003), “The Laggard of Europe”, CESifo Forum 4, Special Issue 1, p32.
Sinn, H-W (2007), Can Germany Be Saved?, MIT Press, Cambridge, in particular chapter 2 (Translation of Ist Deutschland noch zu retten?, Econ, Munich, 2003)
Sinn, H-W (2010a), “Knacks im Geschäftsmodell”, Wirtschaftswoche, No. 19, 10 May, p 38 (English translation: Ifo Viewpoint 114, Cracks in the Business Model, 9 June 2010).
Sinn, H-W (2010c), “Rescuing Europe”, CESifo Forum, Special Issue, August.
Sinn, H-W (2010b), “Euro-Krise”, ifo Schnelldienst, Special Issue, May.
Sinn, H-W (2011a), "Deep Chasms", Ifo Viewpoint No. 122, 29 March
Sinn, H-W (2011b), "Die riskante Kreditersatzpolitik der EZB", Frankfurter Allgemeine Zeitung, 4 May.
Sinn, H-W (2011c), “The ECB’s Stealth Bailout”, VoxEU.org, 1 June.
Sinn, H-W (2011d), “On and Off Target”, VoxEU.org, 14 June.
Sinn, H-W (2011e), “Greek Tragedy”, VoxEU.org, 26 July.
Sinn, H-W and R Koll (2000), “The Euro, Interest Rates and European Growth”, CESifo Forum, 1:30-31.
Sinn, H-W and T Wollmershäuser (2011), “Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility”,CESifo Working Paper No. 3500, 24 June, in particular Figure 9.
Sinn, H-W, T Buchen, and T Wollmershäuser (2011), “Trade Imbalances – Causes, Consequences and Policy Measures: Ifo’s Statement for the Camdessus Commission”, CESifo Forum 12 (1):47-58.
Wolf, M (2011), “Intolerable choices for the eurozone”, Financial Times, 31 May.
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