Lender's Folly (Full Version - Part 1)

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Matthew C. Kline from the Financial Times has written the below piece which is largely based on an article (no longer available via link) by Michael Pettis:

This is literally the best analysis of the euro area’s problems we’ve ever read. You should take the time to closely read the whole thing yourself. We’ll wait.

Now that you’re back, we thought we could add some value by highlighting and expanding on what we believe to be Pettis’s most important insights.

First, the relevant units within the euro area aren’t countries but economic sectors. For all of the suffering that has occurred in places such as Spain, Ireland, and Greece, we shouldn’t forget that German workers have suffered from stagnant wages and decaying infrastructure.

One of the worst costs — for Germany — has been the lack productivity growth. For all the talk of Teutonic competitiveness, German labour productivity has grown at the meagre pace of just 0.6 per cent per year, on average, since 1998. Output per hour worked is actually lower now than it was in 2007. For perspective, this track record is worse than that of practically every other rich country — including Greece and Spain!

(Source: Organisation for Economic Co-operation and Development, author’s calculations)

[UPDATE: a commenter alerts us to another OECD data series on GDP per hour worked, which produces slightly -- but not meaningfully -- different results from the chart above in terms of rank order. (Part of this is probably due to the fact that this other series doesn't include 2014 data.) Germany still lags behind Greece, although it's slightly ahead of Canada and Spain. Here's the chart:

end update]

The right distinction, therefore, isn’t between countries but between classes (emphasis ours):

It was not the German people who lent money to the Spanish people. The policies implemented by Berlin that resulted in the huge swing in Germany’s current account from deficit in the 1990s to surplus in the 2000s were imposed at a cost to German workers, and have been at least partly responsible for Germany’s extremely low productivity growth — most of Germany’s growth before the crisis can be explained by the change in its current account — rather than by rising productivity.

Moreover because German capital flows to Spain ensured that Spanish inflation exceeded German inflation, lending rates that may have been “reasonable” in Germany were extremely low in Spain, perhaps even negative in real terms. With German, Spanish, and other banks offering nearly unlimited amounts of extremely cheap credit to all takers in Spain, the fact that some of these borrowers were terribly irresponsible was not a Spanish “choice.”

I am hesitant to introduce what may seem like class warfare, but if you separate those who benefitted the most from European policies before the crisis from those who befitted the least, and are now expected to pay the bulk of the adjustment costs, rather than posit a conflict between Germans and Spaniards, it might be far more accurate to posit a conflict between the business and financial elite on one side (along with EU officials) and workers and middle class savers on the other. This is a conflict among economic groups, in other words, and not a national conflict, although it is increasingly hard to prevent it from becoming a national conflict.

Ironically, the biggest political beneficiaries of the crisis (so far) haven’t been pan-European socialists, but nationalist movements of both the right and left.

Second, when it comes to big flows of capital across borders, it’s usually better to give than to receive. The basic problem is that huge inflows of money are almost never matched by commensurate increases in the number of profitable investment projects, so a ton of money gets wasted on boondoggles, usually related to real estate. That ends up boosting wages without increasing productivity. That lowers competitiveness and worsens the trade balance, which makes it harder to service foreign debts even as the obligations pile up.

(Borrowing in a currency you can print is helpful but it doesn’t prevent a lot of resources getting misallocated and a lot of people ending up with excessive debt burdens.)

It’s easiest to see how this all adds up in the case of Spain. According to Eurostat, a whopping 20 per cent of all the jobs created in Spain from 1998 through 2007 were construction jobs, even though construction accounted for a little less than 10 per cent of total employment in 1998. The result was zero growth in labour productivity in that period. (The building industry is notorious for its falling productivity, as Cardiff has noted.)

Now look at what happened to Spain’s capital imports, as shown by comparing its current account balance to global GDP:

(Source: International Monetary Fund World Economic Outlook database on GDP and current account balances, author’s calculations)

At the height of the bubble, Spain — a mid-sized economy in Europe that was home to only about 45 million people — was importing more capital than every other country in the world except for the United States. Also note that Greece — a country of just 11 million people — was the fifth-most dependent on foreign creditors:

In addition to reducing productivity, the lending that enabled the Spanish construction boom also led to a lot of overbuilding. The subsequent cutbacks to deal with the inventory overhang have crushed employment and GDP. Had it not been for those cutbacks, Spain’s economy would actually have done pretty well. Via JPMorgan:

Pettis illustrates this brilliantly by looking at what happened to the German economy after it received reparation payments from France following the Franco-Prussian war:

From 1871 to 1873 huge amounts of capital flowed from France to Germany. The inflow of course drove the obverse current account deficits for Germany, and Germany’s manufacturing sector struggled somewhat as an increasing share of rising domestic demand was supplied by French, British and American manufacturers.

But there was a lot more to it than mild unpleasantness for the tradable goods sector. The overall impact in Germany was very negative. In fact economists have long argued that the German economy was badly affected by the indemnity payment both because of its impact on the terms of trade, which undermined German’s manufacturing industry, and its role in setting off the speculative stock market bubble of 1871-73, which among other things unleashed an unproductive investment boom and a surge in debt.

The party ended with the start of the Long Depression in 1873. As boom turned to bust, views on the merits of reparations changed:

Within a few years of the beginning of the crisis attitudes towards the French indemnity had shifted dramatically, with economists and politicians throughout Germany and the world blaming it for the country’s economic collapse. In fact so badly was Germany affected by the indemnity inflows that it was widely believed at the time, especially in France, that Berlin was seriously contemplating their full return. The great beneficiary of French “largesse” turned out not to have benefitted any more than Spain had benefitted from German largesse 135 years later.

The source.

Continued here.