The banking union alone cannot bring recovery

The banking union alone cannot bring recovery

The banking union alone cannot bring recovery

Written by Christian Odendahl, 29 July 2014

The eurozone's real interest rate problem

The eurozone’s real interest rate problem

The eurozone's real interest rate problem

Written by Christian Odendahl, 08 July 2014

When the UK was considering euro membership, former chancellor Gordon Brown suggested five criteria that needed to be met. The first, and arguably most important, concerned interest rates. Specifically, he said economies of the eurozone needed to be sufficiently compatible to live with common eurozone interest rates on a permanent basis. The recent crisis suggests they were not. The main underlying reason is that real interest rates, that is, the interest rates after adjusting for inflation, can diverge quite drastically in a monetary union – and unfortunately in the wrong direction, thereby amplifying boom and bust cycles. This is especially true in a diverse and decentralised monetary union like the eurozone. Fiscal and regulatory policies need to work aggressively against this phenomenon, to ensure countries grow steadily without protracted booms or slumps. Before the crisis, the eurozone clearly failed on this account. Today it continues to do too little to avoid such harmful divergence, which points to a period of low and uneven growth in the eurozone.

In the eurozone, market forces and the benchmark rates set by the European Central Bank (ECB) collaborate to make nominal interest rates converge in normal times. If there were differences, markets would make use of it and ‘arbitrage’ the difference away. As a result, nominal interest rates for government bonds or corporate loans across the eurozone are usually similar. However, it is real interest rates which ultimately matter for investment and consumption decisions because they represent the real cost of borrowing. If nominal interest rates are 2 per cent but inflation is also 2 per cent, the cost of borrowing is zero because everything will have become more expensive over the year. Since inflation rates differ across countries that are at different points of the business cycle, real interest rates can and usually are very different across countries in a monetary union.

Unfortunately, this divergence tends to amplify the cycle. When an economy is booming, inflation is usually high; whereas when an economy is stagnating or in recession, inflation tends to be low. Real interest rates will thus be low in booming countries with high inflation. This gives the boom a further push, as lower real interest rates encourage consumption and investment. In stagnating economies, where inflation is low, real interest rates will be high, further weakening the recovery.

Chart one: The difference between real interest rates for German and Spanish governments

Source: Haver Analytics, CER calculation; the calculation is simplified: 10 year government bonds minus current CPI (instead of inflation expectations).

Spain in the early 2000s is a case in point: the more the economy boomed and the more inflation rose, the lower real interest rates became (see charts). This stimulated the economy further, as low interest rates made investment (for instance in real estate) more worthwhile. Since there was no national Spanish interest rate but a eurozone one, such self-reinforcing dynamics played out almost uncontested – until the crash. In Germany, with low inflation and growth in the first half of the 2000s, the opposite was the case: low inflation led to high real interest rates. Thus, the economy was further weakened at a time when it needed stimulus, prolonging the period of subpar growth. Now the pattern is reversed, Spain has experienced a depression and struggles to recover while Germany is growing. Real interest rates show the same upside-down pattern: Spain’s real interest rates are significantly above Germany’s, crippling a recovery in Spain while low real rates in Germany potentially stimulate its already robust economy further.

Chart two: Real interest rates for firms in Europe

Source: Haver Analytics, CER calculation; the calculation is simplified: 1-5 year interest rates on firm loans minus current CPI (instead of inflation expectations) for the past, and IMF inflation expectations for 2014-2019.

Divergent real interest rates are a natural phenomenon in a monetary union. The policy response to them is not: fiscal and regulatory policies need to be used aggressively in order to counteract the negative effects of this upside-down divergence – especially in a decentralised monetary union like the eurozone where there are no automated fiscal transfers. In a boom, fiscal policy needs to be very restrictive – Spain’s surpluses before the crisis were not large enough. Financial regulation should make lending more expensive in booming countries, thus effectively increasing interest rates for businesses and consumers there. At the same time, eurozone member-states that are in recession or only growing slowly need to be able to use fiscal stimulus to counteract the negative effects of higher real interest rates. Financial regulation should facilitate lending in these countries.

Unfortunately, the eurozone is not drawing the right conclusions. Most countries are consolidating their budgets during a period of low growth and inflation, instead of counteracting the drag from high real interest rates. For the future of eurozone growth, that means too high real interest rates will continue to weigh on countries like Spain, Italy and even France. The verdict on German fiscal policy is still out, given that Germany has yet to boom.

Likewise, regulatory policies are not being used to lower interest rates in countries in recession or stagnation, and to tighten standards in the booming parts. The reason is not a policy failure by regulators – they stand ready to counteract booms, certainly more so than in the past. The failure lies with the ECB and the overall fiscal policy in the eurozone. Both have prevented the eurozone from growing at a sufficient level by being too cautious (ECB) or outright restrictive (fiscal policy). Ideally, the overall fiscal and monetary policy stance should raise average growth and inflation to an appropriate level. Regulatory policies could then curtail a lending spree in the booming parts that enjoy too low real interest rates while facilitating lower real interest rates in sluggish economies.

Finally, the financial sector is adding to the divergence in real interest rates: banks and, more importantly, firms have to pay a premium on borrowed money for the simple fact of being in, say, Italy. This is because financial risk after the crisis is still attached to the government of the state where the bank or firm is located. The European banking union was supposed to bring an end to this ‘country risk’ but it has so far only partially succeeded: in the event of a major crisis, German banks will still be perceived as safer, reducing their borrowing costs now, and vice versa for Italian or Spanish banks. Thus, some country risk will remain for the coming years. As the cruel logic of a crisis mandates, this country risk adds to the real interest rates in the worst-affected countries, worsening the macroeconomic dynamic outlined above.

For the growth prospects of the eurozone, in particular those countries currently growing slowly, this has important implications. While diverging real interest rates are a common feature of a decentralised monetary union, fiscal, regulatory and monetary policy play an important part in counteracting their upside-down dynamic. But as long as eurozone fiscal and monetary policy does not change to support growth, and inflation remains very low as a result, real interest rates in the South will remain high – too high for a meaningful recovery. The recent news on a stalling recovery should come as no surprise.

Christian Odendahl is chief economist at the Centre for European Reform.

Europe’s dowry is not weighed in pounds and pence

Europe’s dowry is not weighed in pounds and pence

Europe’s dowry is not weighed in pounds and pence

06 July 2014
From Financial Times

The eurozone is no place for poor countries

The eurozone is no place for poor countries

The eurozone is no place for poor countries

Written by Simon Tilford, 27 June 2014

The economic rationale for poorer countries joining the eurozone was that it would hasten economic convergence between themselves and the richer members of the currency union. They would benefit from a stable macroeconomic environment and more trade and inward investment. And Portugal aside, there was some convergence in the early years of the single currency. But this went into reverse in 2008 and by 2013 the poorer members of the currency union were no better off relative to the EU-15 average than they had been in 1999. Worse still, they have been overtaken by a number of the 2004’s EU intake, who in 1999 had been much poorer. Has the euro become a mechanism for divergence? If so, what are the implications for growth across the eurozone as a whole and for the case for joining?

In 1999, Greek and Portuguese per capita GDP were around 70 per cent of the EU-15 average, and Spanish a little over 80 per cent. By 2013, Greek and Portuguese GDP was under 70 per cent of the average. Spain has not done quite as badly, but has been diverging since 2008 (see chart 1). Indeed, far from converging with the richer members of the EU, they have converged with the Central and Eastern European countries which joined the EU in 2004. In 1999, the GDP levels in Poland and Slovakia (a euro member since 2009) were 42 per cent and 43 per cent of the EU-15 average respectively. The Czech Republic’s was just over 60 per cent of the average. By 2013, these figures were 65 per cent, 72 per cent and 75 per cent.

Chart 1: GDP per capita


Source: European Commission

For crude supply-siders, the lack of convergence between members of the eurozone reflects the failure of the poorer member-states to push through reforms of their economies rather than anything to do with the structure of the currency union. This has cost them competitiveness, leading to economic stagnation.

Others maintain that divergence since 2008 is cyclical and will be quickly reversed. According to this view, the South is simply going through what Germany went through in the early 2000s. Interest rates are too high for the periphery in much the same way as they were for Germany between 1999 and 2006; conversely, they are now too low for Germany. Germany will grow more rapidly than the south for the next few years, but that will then reverse as Germany loses competitiveness and finds itself in similar position to that of the periphery now – with an overvalued real exchange rate and excessively tight monetary policy. At that point there will be renewed convergence between rich and poor. The worst that can be said is that the eurozone has amplified business cycles, but not that it has become an obstacle to convergence between rich and poor.

There are problems with both these arguments. First, it is hard to ascertain a correlation between the kinds of structural reforms the Commission is demanding of the South (principally labour market deregulation) and economic growth. Some of the best performing European economies over the last 20 years – notably Sweden and Austria – have relatively highly regulated labour markets. Germany – the benchmark for much of the Commission’s thinking – also has a tightly regulated labour market (notwithstanding 2004’s Hartz IV reforms), at least in regards to permanent workers (see chart 2). There is certainly a case for labour market reforms to address insider/outsider problems and to help young people and those with poor skills into work. But it is important not to exaggerate the economic effects of such reforms.

Chart 2: OECD indicators of employment protection legislation, 2013
(0 = least restrictions, 6 = most restrictions)

Source: OCED

Nor can differences in product market regulation explain the lack of convergence in living standards within the eurozone. First, according to the Organisation for Economic Co-operation and Development (OECD), there has been steady convergence of such regulation among EU member-states. Second, there is no discernible correlation between levels of product market liberalisation and economic growth. For example, Sweden has among the more tightly regulated product markets in the EU, while Germany and Italy score about the same as each other. Greece does rank badly, but only as badly as Sweden did five year earlier (see chart 3).

Chart 3: OECD indicators of product market regulation
(0 = least restrictions, 6 = most restrictions)

Source: OECD

This is not to say that – all other things being equal – competitive product markets will not boost economic performance, only that they can be more than offset by other things such as the wrong macroeconomic policies or misalignments of real exchange rates. The latter can have a big impact on levels of capital stock per employee and labour skills, which are more important in determining economic performance than levels of labour and product regulation. Cuts in education spending, large-scale emigration of young skilled workers and huge falls in business investment have damaged the productive capacity of the eurozone’s poorer economies.

The cyclical argument for the lack of convergence is also weak. There are several differences between Germany’s position in the early years of the euro and the south now. Germany’s period of retrenchment within the euro was essentially over by 2006. Germany’s real effective exchange rate was not seriously overvalued to start with. Germany was aided in its drive to reduce its real exchange rate by inflation being relatively high elsewhere in the eurozone. And, finally, the country was not highly indebted.

By contrast, the retrenchment in the poorer members of the eurozone has already lasted longer than in Germany in the early 2000s, and there is no end in sight for a number of reasons. First, their loss of trade competitiveness relative to the core is far bigger. Second, they are trying to regain competitiveness by holding inflation rates below the eurozone average at a time when inflation is chronically low elsewhere in the eurozone (German inflation is around 1 per cent and forecast to remain low). And third, they have very high levels of debt. Their drive to improve competitiveness is pushing them into deflation, increasing the real value of their debts and making it harder to deleverage.

As a result, overall levels of indebtedness in Greece, Portugal and Spain are still close to their all-time highs. Their levels of private sector debt have fallen, but there has been an offsetting increase in public debt. According to Standard and Poor’s, the so-called leverage ratio (public and private debt as a share of GDP) in Greece, Spain, and Portugal is currently around twice what it was at the beginning of 1999; Italy’s is 35 per cent higher.

Reducing these leverage ratios will be hard. Firms and households will continue to pay down debt for a long time to come, depressing consumption and investment. For their part, poorer eurozone governments risk contributing to the weakness of demand by continuing their drive to consolidate public finances. The result threatens to be weak economic growth and inflation and hence slow deleveraging. This is less a cyclical issue than a semi-permanent state of affairs. Growth in the poorer states will at some point in the future exceed that of the wealthier North, but any convergence is likely to be slow because of the permanent damage done to their growth potential.

A combination of debt write-offs, co-ordinated eurozone fiscal stimulus and a concerted drive by the European Central Bank (ECB) to drive up eurozone inflation could head off this unfavourable outcome. Anything is possible, of course, but all of these things look unlikely. Low borrowing costs have reduced pressure for institutional reforms of the eurozone, even if low bond yields should be ringing alarm bells (reflecting as they do mounting deflationary pressures). The eurozone might agree an investment programme, but a big fiscal stimulus is impossible without rewriting the rules. And there is little chance the ECB is going to morph into a European version of the US Federal Reserve and launch a full-blooded battle against deflation.

The fate of poorer EU-15 members of the eurozone should give prospective eastern and south-eastern EU member-states pause for thought before joining. They should also closely monitor the experience of Slovenia and Slovakia, which joined the single currency in 2007 and 2009 respectively. Slovenia is considerably poorer relative to the EU-15 average than when it joined. Slovakia has performed respectably within the single currency, but its real effective exchange rate has risen steeply relative to its peers (Czech Republic and Poland) and it has slipped into deflation.

For some – Lithuania, for example – joining the euro is about guarding its independence against a revanchist Russia. But the others face a trade-off: join the euro and get a seat at the top table (more and more of the real decisions on economic issues are taken by eurozone countries rather than the EU) in return for a loss of policy autonomy and much increased economic risk. Or reiterate their commitment to join but postpone doing so in the hope that the eurozone is reformed in such a way that it becomes a mechanism for convergence rather than divergence. This is the strategy being successfully pursued by Poland and the Czech Republic. Others would be wise to follow suit.

Simon Tilford is deputy director at the Centre for European Reform.


Added on 17 Jul 2014 at 10:20 by Simon Tilford

Would spreads have compressed to that extent if the euro had not existed? Would these countries have had more mechanisms for adjustment outside the euro? The answer to the first question is no and to the second yes.

Added on 16 Jul 2014 at 16:57 by Quentin Davies

”Simon Tilford has failed to understand my essential point. Of course debt is a (negative) function of real interest rates. And in monetary union the base or “risk free” interest rate is common across the system. But individual borrowing rates certainly should not be. They are made up of the “risk free” rate plus a spread or margin determined by lenders or bond holders to reflect the risk. My point was that pre-Lehmann these spreads were quite irresponsibly compressed – and quite inadequate to the risks of, for example, Greece, or Spanish real estate developers. That was the fault of “lenders, fund managers and (bond) underwriters” – not the euro.

Added on 15 Jul 2014 at 15:37 by Simon Tilford

The problem is that the level of “debt” is more determined by real interest rates than by “short-term bankers' bonuses, conflict of interest, other dishonesty or sheer incompetence”. All countries had this problem. The reason why the eurozone with its one-size-fits-all interest rate amplifies the credit cycle is well known: see CER’s latest piece on this here: This point has been central to the debate about the eurozone from the beginning: unless economies converge to the extent that a single interest rate does not lead to credit imbalances the eurozone will continue to be an unstable place. There is now divergence because a number of poor countries are caught in debt traps.

Added on 15 Jul 2014 at 14:46 by Quentin Davies

Part 3:

Some people will blame the borrowers, some people will blame the lenders, some perhaps the supervisors and regulators. Tilford prefers simply to blame the euro. But he offers not a shred of evidence either in support of a hypothesis that the euro necessarily increases debt, or of a hypothesis that debt has caused a greater problem for indebted countries who have joined the euro system than they would have faced with the same level of debt outside it (external devaluation would surely lead to inflation, a banking crisis, and the bankruptcy of businesses or households with euro - or dollar - debt. and would of course remove all pressure for structural reform and productivity growth). There is an obvious link between debt and the business cycle - and between excessive debt and serious recession. But there is no necessary or causal connection between the euro and the grave recession we have all been passing through, and to suggest one without evidence is surely to fall into the classic fallacy of confusing timing with causality - post hoc propter hoc.

Added on 15 Jul 2014 at 14:45 by Quentin Davies

Part 2: If Tilford's chart fails to support his conclusions, would his argument be helped by extending his trawl and looking at the record of other euro-participating states? The answer is no. Tilford left two "poor" euro-participating states, who have been euro participants for more than six and three years respectively, out of his chart: Malta and Estonia. Perhaps he thought they were too small, but he does not explain why size should be considered a critical variable in this context (and Greece and Portugal are hardly large). In any event Malta and Estonia go against the Tilford rule - both have done better than the EU15 average since they joined the euro, and have therefore converged.

The clue to the solution is to look at the performance of the EU 15 themselves (only one of which, Germany, is included in Tilford's chart). The worst performers in this group by far were Italy and Ireland. What unites Italy, Ireland, Greece, Spain and Portugal - the worst performers in the two groups ("poor" and "rich")? The answer is debt. These countries had the highest leverage ratios in the EU, among euro participants and non-participants. Their poor performance in a recession is no more surprising than would be a table showing that the earnings (and share prices) of highly leveraged firms under-perform in a recession. If the problem of under-performance in these countries is a problem of debt then debt itself - not the euro - is the "wrong macroeconomic policy" which has produced the evils of "divergence", "amplified business cycles" and (because of the loose spending of the debt proceeds) the"misalignments of real exchange rates" of which Tilford rightly complains,

Tilford recognises that debt is the serious problem we now confront but speaks of it as a consequence and an inheritance we now face not a cause. "Firms and households will continue to pay down debt for a long time ...depressing consumption and investment...governments risk contributing to the weakness of demand by continuing their drive to consolidate public finances. The result threatens to be weak economic growth." He may be over-pessimistic on the timing (British households have begun quite quickly after 6 years of recession and flat-lining to reduce their savings ratio and to generate a consumer-led revival of growth up to or above trend level and we all hope that business investment will flow from that). But clearly the whole of Europe (and the US) suffered from quite egregiously irresponsible levels of borrowing (and lending practices) at the end of the last decade,and in some countries the impact was dramatic. Whether the error was excessive borrowing by governments when spreads were compressed in a mad scramble for yield as interest rates fell (Portugal and Greece), or crazy lending to the real estate sector (Spain, Ireland and sub-primes and CDOs in the US), the cost has been felt by every citizen. Of course Greece was a special case because there the public accounts were actually falsified and the borrower must assume a large part of the blame (and hopefully criminal liability). Elsewhere lenders, fund managers and underwriters, who are supposed to deliver lending discipline, had no such excuse - there was simple massive mis-pricing of risk. Was this caused by short-term bankers' bonuses, conflict of interest, other dishonesty or sheer incompetence? Were supervisors and regulators asleep, or just not up to the job? We have no final answer to these questions.

Added on 15 Jul 2014 at 14:44 by Quentin Davies

Simon Tilford's piece entitled "The Eurozone is no Place for Poor Countries" (27 June) is a full-throttled attack on the decision of poorer EU countries to join the system, and in effect on the whole euro project. In Tilford's view the euro has "become a mechanism for divergence", has "amplified business cycles", induced "wrong macroeconomic policies" and produced "misalignments of real exchange rates". The reader is left wondering whether there are any economic ills for which the euro is not responsible.

Tilford's Chart 1, demonstrates quite clearly that all the "poor" EU countries in the chart, euro members and non-euro members, were converging on the "EU 15 average" until the recession, with the best performances being registered by two euro participants (Greece and Spain) and two - at that time - non-participants (Poland and Slovakia). In other words there is no obvious correlation between performance and euro membership in the pre-recessionary period. Thereafter three "poor" countries, Greece, Spain and (to a much slighter extent) Portugal have diverged negatively, but only Greece is in a worse position relative to the "EU 15" at the end of Tilford's chosen 15 year period than at its outset. Most "poor" EU countries in the chart retained a more or less stable relative position during the recession years. Three of the countries included in Tilford's chart were in a markedly better relative position despite the recession at the end of that period (2013): Germany, Slovakia and Poland. In other words the countries whose growth rates were significantly different from the EU15 average over the 2009-2013 period and who appear in the chart, were one very problematic "poor" euro participant (Greece), which of course diverged negatively,and, in the positive category, one successful "poor " non-euro participant (Poland), one successful "poor" euro participant (Slovakia, which joined the euro in 2009), and one successful "rich" euro participant (Germany) all of which improved their relative positions.

That is hardly a sufficient basis from which to draw any general conclusions relating to euro membership, let alone the conclusion that euro membership inhibits good economic performance, whether for "poor" countries or for all countries, whether in normal conditions or in periods of recession . It becomes especially difficult to draw the negative conclusions about the euro which Tilford appears to have drawn if one looks at his own data for Slovakia and the Czech Republic (the latter not a euro participant). It is clear from his chart that Slovakia has been able to complete the process during the recession years, and after she joined the euro in 2009, of converging from a level of qualitatively greater poverty to virtual equality with the Czech Republic - an achievement that had eluded Slovakia under every previous regime since, and including, the Austro-Hungarian Empire. Given these two countries' common history until this point, their combined experience probably gets as close to a controlled experiment as it is possible to get in empirical macroeconomics.

London launch of CER report 'How to finish the euro house' by Philippe Legrain

London launch of CER report 'How to finish the euro house' by Philippe Legrain w

London launch of CER report 'How to finish the euro house' by Philippe Legrain

04 July 2014

With Philippe Legrain, economist and author, and Paul de Grauwe, John Paulson Chair in European Political Economy, London School of Economics and Political Science.

Location info


More investment, for Germany’s sake

More investment, for Germany’s sake

More investment, for Germany’s sake

Written by Christian Odendahl, 13 June 2014

Germany, the biggest economy in Europe and, more importantly, in the eurozone, is being urged to invest more at home. Those that support greater investment argue that it would help to spur a faster recovery in the eurozone and reduce the German current account surplus – lines of argument  that meet resistance from the German public and the country’s policy circles. After all, many Germans feel (rightly or wrongly) that they have done enough for Europe. Luckily, the case for German investment can be based entirely on narrow self-interest: for the sake of its future prosperity, Germany needs to invest more, regardless of whether that helps the rest of the eurozone. Why is Germany not investing more, then? The answer is, as so often, political. But there could be a way to convince the German government to do what is best for Germany – and ultimately for Europe, too.
German investment has been falling steadily over the past two decades, from around 21 per cent of its GDP in the late 1990s to just above 17 per cent now (see chart one). The biggest drop came after 2000, when the German economy slid into a period of low growth and high public deficits. This led both private and public investment to fall: private investment for lack of profitable opportunities, and public investment because of eurozone budgetary constraints.

Chart one: Gross investment as a share of GDP
Source: European Commission / Haver Analytics

By international comparison, this is a low number: The EU15 (roughly the eurozone plus the UK) invested around 20 per cent of GDP in the run-up to crisis. Because of the severe recession in many EU15 countries, this has recently fallen to German levels (but notably not below). Investment in the US and Switzerland has been even higher. But such overall investment figures can only provide a rough guide: they contain construction and equipment, both private and public, each of which needs to be analysed. In addition, intangible investment such as software, R&D and organisational know-how is not included.

Breaking German investment down into its constituent parts reveals that the fall in construction is mostly responsible for the decline in aggregate investment; investment in machinery and equipment has only decreased slightly (see chart two). So does that suggest that German investment is fine? After all, construction investment has not been the wisest use of savings in countries like Spain or Ireland – where much of the money invested was in fact German.

Chart two: German gross investment by type as a share of GDP

Source: European Commission / Haver Analytics

However, by international standards, investment in equipment is also low. While Germany compares well to the US or the EU15 average (see chart three), its real peer group – countries with similarly large manufacturing sectors – invest considerably more: Germany’s manufacturing value added accounts for 22 per cent of GDP, compared to just 10 per cent in France or the UK, and 13 per cent in the US. The relevant comparison group – Japan, Switzerland and Austria with manufacturing sectors contributing similarly to GDP – invest between 1.5 and 4 percentage points of GDP more than Germany in equipment.

Chart three: Gross investment in equipment as a share of GDP

Source: European Commission / Haver Analytics

This investment gap is not compensated for by intangible investment either. On the contrary, such investment in software, R&D and organisational know-how is low compared to countries like the US that have similar levels of investment in equipment. Germany invests more than 5 percentage points of GDP less than the US, and 2.5 percentage points less than the UK or Sweden. Considering both equipment and intangible investment combined, Germany clearly invests too little.

Chart four: Intangible investment as a share of GDP

Source: Carol Corrado, Jonathan Haskel, Cecilia Jona-Lasinio and Massimiliano Iommi (2012) "Intangible Capital and Growth in Advanced Economies: Measurement Methods and Comparative Results" and the associated database; European Commission / Haver Analytics
Public spending on education is not usually considered to be investment. And yet it is clear that, from an economic point of view, education spending is mostly investment in human capital and should be included in investment totals. By international comparison, German public investment in education is very low as a share of GDP. And while the greater number of young people in France, the UK and Sweden explains part of the difference, the difference with Switzerland cannot be explained by demographics; the difference between Germany and Sweden is simply too large to be fully explained by demographic differences, and has been for long.

Chart five: General government expenditure on education as a share of GDP

Source: European Commission / Haver Analytics

Finally, public investment in construction and equipment is also very low – it is actually negative once depreciation is factored in. After all, public capital deteriorates just like private capital: roads get potholes and school equipment breaks. After deducting depreciation of the existing capital, Germany has been investing less than zero in its public infrastructure and equipment for a decade. In essence, Germany has been running down its public capital stock.

Chart six: Net public investment as a share of GDP

Source: European Commission / Haver Analytics

All this leads to the conclusion that Germany has not been investing enough: not in equipment, given its large manufacturing sector, not in R&D and other intangible assets to grow new sectors, not in education or in public infrastructure. This is particularly worrying as the German population is aging quickly, with the median age already close to 47 (up from 40 in 1999) – a high number if compared to Sweden (41.2), the UK (40.4) or the US (37.6). An ageing society needs to invest domestically to make its workers more productive, because these workers will need to support pensioners in the future. Productivity growth is especially important in Germany because its pension system is largely ‘pay-as-you-go’: the young pay for the old. If people had private pensions, in which they built up pension pots for their own use, these could be invested abroad, which would make domestic productivity less of an issue.

What is more, Germany is saving much more than it invests, the result of which is a massive current account surplus of 7 per cent of GDP. Whatever Germany saves beyond what it invests domestically will be invested abroad. But the German banking system, through which most of these savings are intermediated, has not been able to invest this surplus productively. In fact, Germany has lost around €400 billion on its investment abroad since 1999, according to calculations by the German Institute for Economic Research (DIW). In Germany, their research shows, the return on investment – measured by the economic growth per unit of investment – was among the highest in the world over that period of time.

There are essentially two ways for policy-makers in Germany to increase investment. One is to encourage private investment through policies such as predictable energy policies or further liberalisation of services markets, both of which would help. But the biggest impact the government could make is to increase public investment, for a very simple reason: Germany can currently borrow money essentially for free. Interest rates on 10 year government bonds are around 1.4 per cent, which is likely to be below the average inflation rate over the next ten years. This implies that the German government is paid (in real terms) to borrow: the real interest rate is negative. Bonds that mature in 30 years yield 2.3 per cent and hence barely more than the probable inflation over that period of time.

Given that the case for more public investment in Germany is so strong, why is the German government not investing more? There are three reasons. First, the German economy is growing relatively rapidly; the Bundesbank recently upgraded the outlook for 2014 and 2015 to 1.9 and 2 per cent respectively. Germany has little, if any, underutilised capacity and such growth figures are a good deal above Germany’s potential growth, that is, the underlying growth rate around which economies fluctuate. This means that there is currently little need for public investment to stimulate the economy further, from a business cycle perspective. In fact, given that the European Central Bank (ECB) needs to keep rates low to help the rest of the eurozone, there is a danger the German economy might overheat. However, German inflation (a key indicator for a boom) is not projected to rise beyond 2 per cent until 2016, according to Bundesbank estimates. What is more, the risks for the eurozone economy are “to the downside”, as Mario Draghi likes to point out, such that additional public investment would serve as an insurance against a renewed eurozone downturn.

Second, the German constitution contains a fiscal rule known as the ‘debt brake’ that, after a transition period, comes into full effect in 2016. It mandates that the structural balance – the budget balance after the effects of the business cycle have been taken into account – does not exceed 0.35 per cent of GDP. This in effect excludes debt-financed public investment in Germany in the future – a questionable rule to begin with, given the arguments above. However, until 2016 at least, the government has room to go beyond the 0.35 per cent limit and should use this fiscal space. According to KfW, a German state-owned bank, the German government could invest €100 billion more over the next five years (which equals roughly 3.5 per cent of current GDP) without violating the transitional rules of the ‘debt brake’.

Finally, the most important reason why public investment is low is that fiscal consolidation is politically more appealing in Germany than investment: after decades of belt-tightening and fears of ever increasing public debt, a balanced budget is seen as a big accomplishment. This is why the coalition agreement between the two governing parties contains a balanced budget pledge that goes beyond the constitutional debt brake and aims for a faster fiscal consolidation. Unravelling this pledge now, the argument goes, would open a Pandora’s box of government consumption demands and hence not increase investment. Therefore, it is best to keep the lid on it, despite the beneficial effects of more public investment.

The only way to convince the German government to invest more is to emphasize Germany’s gains from such investment rather than Europe’s; to make sure it is politically more profitable than fiscal consolidation; and to ensure that the added fiscal spending really does go into investment rather than public consumption, and preferably sooner rather than later.

One proposal that fulfils all three criteria could lie with German municipalities. First, they are responsible for roughly two thirds of German public investment. Second, they are heavily indebted, some are essentially insolvent, and need help. And third, they are the main stumbling block for dismantling Germany’s local business tax (Gewerbesteuer) – a tax that generates volatile revenues for municipalities; that is uneven both between municipalities and between firms of different types and sizes; and that complicates the German corporate tax system unduly. Wolfgang Schäuble, the German finance minister, has in the past attempted (but failed) to reform municipal finances and to dismantle the Gewerbesteuer. He could offer the municipalities a grand bargain: €133 billion – the total debt of German local governments – in debt relief and investment funding for municipalities in return for a comprehensive reform of municipal finances.

The political benefits of such a deal would be significant and arguably higher than those of fiscal consolidation: removing the municipal business tax is the holy grail of German tax reformers, and municipal spending is an important issue for the public; additional funds would be spend on investment rather than consumption; and the benefits of such investment would accrue visibly to the German public rather than to other European countries. But whatever the details of a deal, convincing the German government to invest more will not be easy.

Christian Odendahl is chief economist at the Centre for European Reform.

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