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Germany’s game

Ever since the euro crisis erupted the blame game for its origins has been heavily one-sided against the southern peripheral states, which for long lived beyond their means on borrowed money. A few voices have tried to assign the blame also on Germany due to its efforts to suppress Germans’ wages, but the truth is that German can hardly be blamed for the crisis. What is not heard however in the same talks is who could or should have taken action to avert the crisis (ECB) or who has a strong interest in seeing the crisis indefinitely prolonged and in fact has consistently took action towards that goal. This is where Germany truly enters the picture.

Analysts of the euro crisis seldom point out the apparent negative correlation in growth rates between Germany and eurozone’s periphery. From the inception of the euro till the financial crisis of 2007-8, Germany experienced subpar growth rates and lagged noticeably behind a booming periphery (the “sick man of Europe”). One of the main reasons for this divergence has been a steady export of capital from Germany to the periphery, which provided better growth prospects and investment opportunities than the highly developed domestic market. This flow of capital boosted demand abroad while constraining demand at home, further contributing to the outflow of capital and keeping wages suppressed. The upside of this process for Germany has been a buildup of the country’s competitive advantage against its European peers.

The financial crisis triggered a reversal of the capital flows within the eurozone and put Germany into a position unique in the whole world: a position of being a net exporter of both capital and goods, or conversely a net importer of money. A handful of other countries in the eurozone enjoyed the same benefits, namely Netherlands, Finland and Luxembourg. They have all been best friends ever since, under the leadership of mighty Germany, to protect the exorbitant privileges the euro has granted them.

The significance of this privilege for Germany cannot be overemphasized. Over the last four years, Germany has been flooded with more than 500 bn euros (peaking at 750 bn euros). This amount of money has been a massive stimulus to the national economy which easily surpasses QE in the United States as a percentage of GDP – and it should be noted that the German version has taken the form of actual bank money, held by the public, not central bank reserves.

The benefits of this bonanza have been numerous and obvious: low borrowing costs, record low unemployment, inflow of skilled labor, rising home prices (against the worldwide trend) and a rapid recovery form the financial crisis to name a few. The stimulus has proved invaluable in sheltering the German economy from the repercussions of a financial crisis that decimated other economies.

During this whole period the Bundesbank has been unashamedly trying to relay an image of a monetary hawk while in reality being among the most dovish central banks in the world and has welcomed the increase in the money supply and the inflationary boost despite its vocal apprehension of expansionary policies. Even more astonishing has been the near oblivion of the German press to these effects for the German economy. While all seem so worried about the recent meaningless 25bp reduction of interest rates by the ECB, the real thing does not get any coverage at all.

The ability to import money should however have an unintended consequence. In general, a net exporting nation faces a simple accounting constraint in its foreign trade and investment activities: that it is forced to assume also the risk on the foreign assets it accumulates. In the case of the eurozone, the persistent balance-of-payment surpluses of Germany necessarily need to be reinvested in foreign assets and since the rest of the world seems unwilling to acquire the assets of the net importers of the eurozone, Germany should normally be forced to fund them instead. Now of course, from the side of Germany such an arrangement would be unwelcome, since the value of these assets is a decreasing function of Germany’s current account surplus (as I have explained here).

Luckily for Germany this risk is largely mitigated thanks to TARGET2, which allows German banks to shelter the German savings in ultra-safe reserves at the Bundesbank instead of having to fund Greek, Spanish, Irish or Cypriot banks. TARGET2 might have been widely criticized in Germany by all circles, the reality is however, that it has been pivotal in securing the value of German savings, at least over the short-run.

This feature of the euro explains the reluctance of Germany to agree on a banking union across the eurozone that would create common resolution mechanisms and shared liability, since such an arrangement would expose the banks of the net exporting countries to the risks created by this export-based strategy. A situation in which the euro benefits are internalized in Germany while the risks are externalized is much more preferable.

And the benefits of the current crisis to Germany have not been just economic. Since the crisis broke out, Germany has out of the blue assumed a dominant position within the EU. So many decisions concerning European affairs have so far been taken against the will of individual countries, yet none has been taken against the will of Germany. This near-veto power has been backed by an unfounded notion that Germany is disproportionately burdened with the bailout of the other failing economies of the eurozone. However, Germany’s contribution to the bailouts has been comparable to that of any other country of the eurozone, after taking into account of course the country’s population and per capita income. Countries like France or Italy have also been major contributors to the bailouts at a moment when their national economies have been very weak, they do not seem though to have gained any political leverage out of it.

With the above in mind, one could hardly find a reason why Germany might want to see the crisis resolved quickly and the peripheral countries returning to growth. If history is any guide, growth in the periphery has coincided with stagnation in Germany. If the countries in the periphery could somehow quickly convince the capital markets that they can offer better returns on capital (which can only happen for as long as they don’t run sizeable current account deficits), the 500bn stimulus could quickly be lifted. The southern governments would be able to make a stand on their own feet and would not be strong-armed anymore to implement any changes that serve foreign interests. German banks could potentially face massive losses from a burst of a domestic housing and equity bubble. The ruling CDU party would be held responsible of sacrificing German interests to the altar of the EU and would be decimated in the next elections. Clearly the German Government would do anything to avert this scenario.

This strategy does not come without risks, but for the moment these risks are well contained. The downside would materialize either if the eurozone were to adopt policies that structurally ensure that the balances of payments of the individual countries are balanced (which would mean the elimination of the abovementioned exorbitant privileges) or if the euro were to collapse. Unfortunately, none of these two scenarios seem likely in the near future, because the southern governments are politically numb in the European arena and their people have been so massively brainwashed that they still believe that the euro has been good for their economies despite the abundant evidence for the opposite.

As far as the current set of arrangements remains intact the risks for Germany are minimal. TARGET2 loans are in fact a risk mitigant, and not a risk driver. The bailouts bear minimal risk, since the countries do not have the option to unilaterally default on these loans. High interest rates, a weak banking sector and systemic fragility prevent the periphery from quickly gaining competitiveness against Germany over the medium term. Any costs from a decline in intra-eurozone exports have been overcompensated by lower borrowing costs. And support for the CDU has grown stronger. Happy days indeed.

Over the last years those who are covertly undermining the recovery of the eurozone for their own benefit have repeatedly bashed Europe’s South with preachings of sense and morality. This behaviour is as much rational as it is deplorable and remains unnoticed by mainstream media. It may take time before emotions and prejudices wane and the details of the crisis are forgotten, revealing the true story beneath. Germany might be playing and winning on its own game, but there will be little to brag about once the game is over and history is fully written.


5 thoughts on “Germany’s game

  1. I am afraid that there are parts of this piece where I don’t follow. You seem to suggest that the capital flows to Germany are somehow a great benefit for the country in that they acted as a stimulus greater than QE, etc.

    The fact of the matter is that Germany has had net capital OUTFLOWS; it has EXPORTED net capital. True, a lot of money came in but even more money had to go out.

    By definition, current account surplusers must be net exporters of capital. Yes, Germany’s financial liabilities to foreigners increased from 5,4 BEUR to 5,9 BEUR from 2010-12. But their financial assets increased from 6,3 BEUR to 7.0 BEUR, or roughly 700 MEUR. The greater increase in assets than in liabilities is due to the current account surplus. See the link below:

    I actually take the opposite view from you. I think these current account surpluses as well as the gross capital inflows are becomeing a tremendous risk for the German economy. Details are explained in my below blogpost.

    Posted by Klaus Kastner (@kleingut) | December 18, 2013, 12:49
    • Our opinions differ because I don’t treat equally all forms of capital and of capital flows.

      Germany’s primary foreign investment has primarily taken the form of TARGET2 claims, which as you well know has been my point of focus in previous posts. I have argued here why TARGET2 claims cannot be compared to other forms of investment because they do not constitute a provision of liquidity to the borrower, neither do they bear any risk beyond the participation of BuBa in the capital of the ECB (and mind that ECB’s loans to peripheral countries are backed by the best collateral the borrowing banks can offer).

      So even though Germany’s balance sheet has grown on both sides of assets and liabilities, Germany has been a net exporter of risk and a net importer of liquidity, which is not reflected in any way on BuBa’s statistics or on German banks’ financial statements.

      I would agree with you if Germany instead of accumulating TARGET2 claims purchased Greek Government bonds or Spanish equities as an example. In that case, money inflows to the German economy would be diverted into outflows to the periphery. Then there would be no covert stimulus to talk about. But that is not the case.

      Posted by 2mtm | December 18, 2013, 14:32
      • I think you overestimate the target-2 risk-sharing benefit for Germany. Yes, Germany carries only 27%, I believe, of the target-2 claims on the BuBa’s balance sheet. But it also carries 27% of the target-2 claims on the balance sheets of other Central Banks. I do get your point, however. It’s a bit academic, though. Target-2 claims are no risk at all as long as the Eurozone survives in its present form. Should the Eurozone collapse, I would argue that whatever is on the BuBa’s books is 100% German risk, not to be shared with anyone. Why? Because in that scenario, the BuBa’s claims against the EZB, which is what target-2 claims are in the first instance, would be worth zero. And no one else could jump in for his share of the responsibility.

        Still, one thing is risk and another thing is real money. You say more real money came in, triggering a gigantic QE easing in Germany. I say more money flowed out than came in.

        Posted by Klaus Kastner (@kleingut) | December 18, 2013, 22:35
      • I think that the fact that Germany is a TARGET2 creditor suffices to prove that more money has flown into Germany than out of Germany. You could also browse through the monetary data of the EZ countries at to see how M1 or M2 has evolved in Germany and the periphery over the last years. And even without looking into these statistics, we know from circumstantial data that liquidity in Germany has been abundant, pushing interest rates lower, while the periphery has been chocking.

        As for the TARGET2 claims of BuBa, indeed those would be 100% at risk in the event of a eurozone breakdown. However, I find it very unlikely that the TARGET2 debtors will simply default on these debts. Instead they will most probably issue Government bonds and BuBa will keep them as foreign currency reserves. It is even possible that BuBa will make a profit out of this transaction, depending of course on the terms of those bonds.

        Posted by 2mtm | December 20, 2013, 00:06
      • Bear in mind that liquidity has NEVER been a problem in the German economy (at least not in my memory). The major problem of the German economy is that there is far too little investment both on the part of the public and private sector and that German consumers are not at all generous spenders. Add to that that Germany is a country which, only with brief interruptions, has – since WW2 – always produced much more than Germans could consume and you have the situation which we have today.

        Money which flows into some countries is used for investment. Money which flowed into Greece was used for consumption. Money which flows into Germany, it seems, hardly goes into either of these two things. Instead, German banks lend it back offshore. They may earn a good margin on it but they also carry a lot of foreign risk.

        PS: I don’t think low German interest rates have much to do with liquidity. Instead, they reflect that Germany is viewed as a safe haven in the Eurozone these days.

        Posted by Klaus Kastner (@kleingut) | December 20, 2013, 11:35

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