Ifo Viewpoint No. 114: Cracks in the Business Model

Hans-Werner Sinn
Munich, 09 June 2010

Greece is now receiving a lot of money, but not nearly as much as the capital markets kept providing up to the crisis. The country must pursue a strict austerity programme, as must the other debt sinners as well. Due to the increase in risk premiums that investors are demanding, Portugal, Ireland and Spain will have to reduce their capital imports just as the US will have to do, whose bogus securities no one wants any more. The markets for mortgage-backed securities, which in 2006 still had a volume of 1.9 trillion dollars, collapsed by 97 percent up to last year, and with it a major source of financing the American balance of payments deficit has disappeared. Across the board, the business models of the debtor states have collapsed.

A crack has also formed in the German business model. Selling cars and equipment on credit is no longer a valid business model because the flow of credit will be blocked from now on. Germany must purchase itself the goods that it produces. The increase in domestic demand needed to achieve this will take place via the capital market. Because of the new fears regarding insecure borrowers, in future the banks will no longer convey the savings of the Germans primarily abroad but will increasingly loan it out to German industry. A recent Ifo survey indicates that firms are already having fewer problems obtaining loans than several months ago.

The write-offs of toxic US papers and the resulting capital losses made banks’ lending policies more restrictive. It now appears, however, that this effect has been overcompensated by the reduced foreign investments of German banks. This is a welcome development for Germany. It marks a turnaround in a 15-year trend that caused Germany problems but gave the debtor countries an artificial economic boom.

Greece, the US, Portugal, Ireland and Spain — all these countries experienced a credit-financed economic boom in the years before the crisis. Whether it was the inventiveness of the US financial jugglers or the putative protection of the euro — the debtors always managed to conjure up high yields to lure foreign investors and get them to part with their money, which was used to produce a boom in consumption and to stimulate construction spending. The money for public and private investments came from abroad. The investments stimulated growth, but as always they stimulated demand more than they increased the supply, thus overheating the economy. Wages and prices rose. The countries’ competitiveness weakened, which was reflected by the gigantic trade deficits. These deficits were the necessary counterpart of the capital inflows. By definition, a deficit on current account corresponds to the capital imports of a country.

In Germany it was exactly the reverse. Germans loaned out their money instead of investing it. From 1995 up to the outbreak of the crisis in 2008, Germany had an average net investment rate of only 5.3 percent of net domestic product. That was the lowest rate of all OECD countries. In 2008 Germany had saved 277 billion euros in all sectors (private households, businesses and government); that much money was available for net investments, but in fact only 111 billion euros was invested. The lion’s share of the savings, 166 billion euros, flowed as capital exports abroad, far too frequently via the dubious businesses of the state banks, for which apparently no risk was great enough.

The result of the capital exports, i.e. the transfer of the rights to utilise economic goods, was that from 1995 to 2008 Germany, after Italy, had the lowest growth rate of all EU countries. To the extent that other countries were artificially bloated by the flow of credit, Germany flagged because of the outflows. It is almost tragic that politicians and journalists celebrated Germany’s trade surplus as a sign of strength, overlooking that this was a necessary consequence of the capital flight. If capital leaves a country, its growth slackens as a result, its inflation rate stays low and a trade surplus arises. Germany was such a country. It not only had the lowest investment rate of all OECD countries but precisely for this reason also the lowest inflation rate in the euro zone.

The era of capital exports is now fortunately coming to an end. With the money of its own savers, Germany, once the direct results of the crisis have dissipated, can finance in the medium term an economic boom similar to the one the debtor countries achieved with foreign capital. A sinking surplus is not a problem but a blessing, because it results from the relative improvement in Germany’s attractiveness as a business location. Germany can be grateful to the capital markets for turning off the credit taps to the debt sinners.

Hans-Werner Sinn
Professor for Economics and Public Finance
President of the Ifo Institute

Published as “Knacks im Geschäftsmodell”, Wirtschaftswoche, no. 19, 10 May 2010, p. 38.