German external investment model a failure

I read an interesting research report recently – Exportweltmeister: The Low Returns on Germany’s Capital Exports – published by the London-based Centre of Economic Policy Research (CEPR) in July 2019. It tells us a lot about the dysfunctional nature of the Economic and Monetary Union (EMU) and Germany’s role within it, in particular. Germany has been running persistent and very large external surpluses for some years now in violation of EU rules. It also suppresses domestic demand by its punitive labour market policies and persistent fiscal surpluses. At the same time as these strategies have resulted in the massive degradation of essential infrastructure (roads, buildings, bridges etc), Germany has been exporting its massive savings in the form of international investments (FDI, equity, etc). The evidence is now in that the returns on those investments have been poor, which amounts to a comprehensive rejection of many of the shibboleths that German politicians and their industrialists hold and use as frames to bully other nations

The CEPR article starts by introducing us to the term “Stupid German Money”, which comes from the way the German government helped fund the US movie industry when it was really aiming to stimulate its own movie production sector.

On February 5, 2004, the German media academic Matthias Kurp published an article – Mediafonds als “Stupid German Money” – which told us that in the previous five years, German investors had pumped €10 billion into so-called media funds as equity participation.

The inducement was the tax write-offs that were held out by the German government on these investments.

The reality was that around 80 per cent of the investment funds went to the US (Hollywood) and very small amounts went into the German film industry despite the tax advantages being provided to bost the German film industry.

The tax advantages mean that the investor writes off the ‘loss’ immediately and, then, if the film is profitable can enjoy the profits, often, according to Kurp, long into the future often as a retired (low-tax bracket) person.

The “Hollywood bosses” termed these investments “stupid German money” because the US film industry gets funded, the German investors get tax advantages and the German Ministry of Finance picks up the tab.

The CEPR paper notes that in the Hollywood movie “The Big Short”, the concept of ‘stupid German money’ is generalised and we see:

… a senior executive at Deutsche Bank, Greg Lippmann, tours Wall Street in 2007 to short-sell securities containing US subprime mortgages. When asked who was still buying these toxic, high-risk papers, “he always just said: Du ̈sseldorf”

The concept of “stupid German money” motivates the research presented in the paper. The authors ask the question “Are German investment returns particularly low, and if so, why?”

As background, we need to take a step back to understand the CEPR conclusions (which I present later).

Germany determined well before other Eurozone nations that they would adapt to the fixed exchange rate they faced once they entered the Eurozone by suppressing domestic demand – public and private consumption and capital formation investment – through its attacks on wages growth and fiscal austerity.

Previously, the Bundesbank was able to manipulate the exchange rate to ensure its manufacturing sector remained internationally competitive.

Once it entered the Eurozone it had to manipulate domestic costs – so they were the first to engage in deliberate ‘internal devaluation’ (Hartz, etc).

Coupled with an increasingly austere fiscal outlook, Germany was able to stifle imports, run persistent current account surpluses well above the allowable European Union thresholds, and build up massive financial claims against the rest of the world.

I wrote about these matters in detail in these blog posts (among others):

1. Germany – a most dangerous and ridiculous nation (December 27, 2017).

2. Massive Eurozone infrastructure deficit requires urgent redress ( November 27, 2017).

3. Wolfgang Schäuble is gone but his disastrous legacy will continue (October 16, 2017).

4. The chickens are coming home to roost for Europe’s so-called powerhouse (August 10, 2017).

5. More Germans are at risk of severe poverty than ever before (July 6, 2017).

6. German trade surpluses demonstrate the failure of the Eurozone (April 24, 2017).

7. Germany should look at itself in the mirror (June 17, 2015).

8. Germany is not a model for Europe – it fails abroad and at home (March 2, 2015).

9. The stupidity of the German ideology will come back to haunt them (September 2, 2013).

10. The German model is not workable for the Eurozone (February 3, 2012).

As you can see – it is a long list (of an even longer list) – going back well into the crisis.

The facts are that I started writing about these matters in social media in early 2005 (Source), well before crisis began and published academic papers earlier than the crisis on the way the Germans were manipulating the Eurozone to its advantage and imposing costs on its Member State partners.

And since that time, nothing much has changed despite the GFC exposing the folly of the German position.

The inference that the German approach has been static, is, in fact, not quite right.

As Wolfgang Münchau wrote in his recent Financial Times article (August 5, 2019) – Germany is replaying Britain’s Brexit debate – the reality is that:

It is impossible to predict how Germany will confront the dual threat of a fundamental technology shift and a monetary union plagued by imbalances. The best solution would be to fix the problem by doing whatever it takes to make the monetary union sustainable; ending the obsession with fiscal surpluses; and increasing investment in science, technology, and military infrastructure. But that would be a triumph of hope over experience. Germany is moving in exactly the opposite direction.

So Germany is shifting – but only by intensifying the ridiculous position that is destroying the chance that the EMU can deliver prosperity.

And those shifts are now coming back in the form of the renewed likelihood of recession, which I analysed in this blog post last week – Germany is now suffering from the illogical nature of its own behaviour (August 13, 2019).

What happens when Germany runs such large external surpluses? The net outflow of real goods and services is accompanied by accumulating financial claims against the rest of the world.

The high level of German savings may have gone into the domestic economy if there were profitable opportunities to invest. But in Germany’s case, its whole strategy was based on suppressing domestic demand (Hartz reforms, wage suppression, mini-jobs etc), and so profitable investment opportunities were limited in the German economy.

As a result and capital sought profits elsewhere.

The persistently large external surpluses which began long before the crisis (and 6 per cent is large) were the reason that so much debt was incurred in Spain and elsewhere. German investors pushed capital externally.

Germany is clearly supplying large flows of capital to the rest of the world.

German citizens generally have been led to believe that these external surpluses are ‘good’ – the outcome of the relentless pursuit of external competitiveness and the superiority of German industrial know-how and efficiency.

Regular contributions in the literature have downplayed the suppression of domestic spending as the source of the exported savings.

For example, there was an article in The International Economy magazine (Fall 2014) – The Empire Strikes Back – by the Director General of the German Ministry of Finance, Ludger Schuknecht – which carried the sub-title “Why Germany’s exports and current account surpluses benefit other countries”.

Schuknecht sought to counter criticism of the huge German current account surpluses and dispel the notion that they were thre result of depressed domestic spending (in part).

He wrote:

Germany’s exports not only benefit Germans, they very significantly benefit other countries as well … the German current account surplus reflects a lot of foreign direct investment. Is this bad?

And the surpluses reflected (in part):

I mentioned the policy reforms that strengthened Germany’s competitiveness over the past ten to fifteen years. at the same time, some of our trading partners allowed import booms related to construction, expansionary fiscal policies, and excessive wage growth.

Mainstream economists have long argued that a nation can shift the risk of demographic change (ageing) by pumping capital into economies with younger demographic profiles.

For example, Alan Taylor and Jeffrey Williamson published an NBER Working Paper in 1991 – Capital Flows to the New World as an Intergenerational Transfer (subsequently published in 1994 by the Journal of Political Economy, 102(2), pp.348-371) – which argued that in the “New World” immigration and high fertility rates choked off “domestic savings” and created “an external demand for savings”, which capital flows from the “Old World” (Britain before WWI) that provided intergenerational transfers.

These external flows also allow a nation with an ageing population (and strong savings) to enjoy “better investment returns in younger, more dynamic economies abroad” (CEPR article).

The external flows also, allegedly, insulate (insure) a nation against falling domestic demand.

Whether any of these claims have validity is questionable and provides motivation for the CEPR study.

It is clear that with Germany pushing austerity on the Eurozone generally, the opportunities for investment within Europe has declined. Hence Germany’s push into China and the US.

Moreover, the German government’s obsessive pursuit of fiscal surpluses (as noted by Wolfgang Münchau above) has also created a German infrastructure crisis – “the deteriorating condition of actual bridges over the Rhine has become a symbol of crumbling infrastructure and growing domestic investment needs”.

The debate has now moved to questioning the German external investment bias.

And the CEPR Report is now providing an evidence base to allow us to assess the consequences of that bias by presenting “a comprehensive empirical assessment of Germany’s investments abroad over the entire postwar period.”

I won’t discuss the data or statistical methods used – you can read them if you are interested.

The external surpluses are mainly reinvested “in other advanced economies, especially in fellow European countries” ( almost 70%).

The results of the CEPR study are:

1. “the returns on German foreign assets are considerably lower than those earned by other countries investing abroad.”

Their Table 1 (reproduced next “summarizes the main findings … Germany has the worst invest- ment performance among the G7-countries.”

2. “Since 1975, the average of Germany’s yearly foreign returns was about 5 percentage points lower than that of the US and close to 3 percentage points lower than the average returns of other European countries.”

3. “Germany fared particularly bad as an equity investor where investment returns under-performed by 4 percentage points annually.”

4. “Germany earns significantly lower foreign returns within each asset category, after controlling for risk.”

5. “Germany’s weak financial performance abroad is not merely the result of a more conservative investment strategy that focuses on safer assets.”

6. “low German returns compared to other countries also cannot be explained by exchange rate effects (appreciation), nor by the recent build-up of Target2 balances.”

7. “The valuation of Germany’s external asset portfolio has stagnated or decreased, while other countries witnessed considerable capital gains, on average.”

8. “Germany’s frequent investment losses are remarkable given that the world economy has witnessed a spectacular price boom across all major asset markets over the past 30 years.”

9. “German returns on foreign investment were considerably lower than the returns on domestic investment.”

This was an interesting result given my earlier comments. The following graph (CEPR Figure 9) tells the story. “On average, the difference was more than 3 percentage points”

The question then is: why does Germany invest so much abroad and neglect domestic opportunities.

10. “little evidence that foreign returns have positive effects for consumption insurance.”

This is because the “the returns on German foreign assets are more strongly correlated with domestic consumption growth than a bundle of domestic German assets”.

So that when the Germany economy is weak, the returns on German foreign assets are lower.

11. “70% of Germany’s foreign assets are invested in other advanced economies that face similar demographic risks.”

In other words, there is no intergenerational transfers evident.

The evidence is that “the share of German investments to younger and more dynamic developing countries and emerging markets has decreased rather than increased, from 25-30% in the 1980s to less than 10% in 2017.”

The CEPR report finds that “the “home-bias” of German investments in favor of European investments has intensified and the potential for demographic risk hedging has decreased accordingly” and that this tendency is “more pronounced in Germany than in other countries”.

Conclusion

The CEPR results present a comprehensive rejection of many of the shibboleths that German politicians and their industrialists hold and use as frames to bully other nations.

While “Germany is world champion when it comes to exporting savings”, the data shows that “the reputation of German household, firms, and banks of being bad foreign investors is mostly justified.”

In other words, not only is the external surplus bias damaging, in that results in a suppression of domestic spending and decaying public and private infrastructure, but it clearly is accompanied by the fact that the German financial sector misallocates Germany’s massive savings exports.

Which is one reason why Wolfgang Münchau is concerned that Germany is in danger of being left behind with an “uncertain future” as the technological revolution passes them by.

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.