Europe often gets left behind in discussions about the global economy, with many analysts preferring to focus on more “exciting topics” such as the U.S., China, or, sometimes, the grab-bag “emerging markets” category.
But Europe is the third-largest economy in the world (second-largest until relatively recently) and has long played a major role in shaping global outcomes that affect everyone. That was why Michael and I spent so much time in Trade Wars Are Class Wars discussing Europe and how changes within Europe fit into our overall understanding of the past several decades.
In this episode, we review what happened, and then continue the story to see what has changed since the pandemic and Russia’s war on Ukraine. The edited transcript is below the fold. Remember, subscribers cover our cost of production. Paying listeners get to listen to the full recording and read the full transcript.
Europe's Imbalances in Pandemic and War — The Overshoot
EXPORTWELTMEISTER: GERMANY’S FOREIGN INVESTMENT RETURNS IN INTERNATIONAL COMPARISON — Franziska Hünnekes, Maximilian Konradt, Moritz Schularick, Christoph Trebesch and Julian Wingenbach
Global Imbalances Tracker — Council on Foreign Relations
Matt Klein: Hello! And welcome back to UN/BALANCED, a listener-supported podcast about the global economy and financial system. I’m Matt Klein.
Michael Pettis: And I’m Michael Pettis. Today we’re going to look at Europe’s internal and external imbalances, how they’ve evolved in response to the pandemic and Russia’s war on Ukraine, and more importantly, what those changes might mean given the patterns we identified in our book Trade Wars Are Class Wars.
Matt Klein: The thing that we pointed out is that the common narrative is that the euro is formed, the European Union adds a lot of new members, and then there’s this problem of “competitiveness”. The idea is that Germany is this paragon of efficiency and high-quality industry, and then these other countries come in and supposedly they’re not as good: their workers are “lazier”, or whatever. And this is the common narrative. And you still hear people saying this even now, and that this explains the problems and those countries just need to have more “structural reforms” to make their labor markets more competitive.
One of the big points of making our book is that’s just completely a backwards way of understanding what happened. The significant change was actually in Germany itself. What happened there was partly a consequence of reunification, and more importantly, was a consequence of how policy elites and business elites understood the experience of reunification—and what they chose to do in response to that in the early 2000s.
Business investment in Germany fell very dramatically, the wage share fell very dramatically, and public investment fell very dramatically.
So even though the growth in sales of these businesses, many of which were globally oriented, continued to chug along at a normal rate, there was no commensurate increase in domestic consumption and domestic investment. That is what led to Germany’s trade surplus. That’s something I think that a lot of people don’t understand. We spent a lot of time in our book trying to explain this.
It’s really striking: if you look at the change in Germany’s current account balance—which is essentially the difference in all the income earned in Germany and all the money spent by German residents—that change in the current account surplus from 2000-2007, when it went from being more or less in balance to being very, very large, that almost perfectly matches the increase in the total profits generated by German nonfinancial companies. The idea that it had to do with “prudence” or anything like that, it’s just not right. It came at the cost of lower living standards and a big shift in the distribution of income. So that’s what happened there.
Germany, of course, is only part of a much larger global system. That couldn’t have happened in isolation. Thinking about how the Euro crisis played out, what the origins were, the question is what would be the ramifications of the changes in Germany? What was the counterpart to this big shift in the distribution of income within Germany and the big decline in domestic German spending relative to domestic German production? That happened in the rest of Europe. You have a lot of connections to Spain, Michael, maybe you want to lay out how that played out?
Michael Pettis: Sure. What happened in Germany is that before a set of labor reforms in the early 2000s, wage growth kept pace with growth in productivity and growth in GDP. After the so-called Hartz reforms, wage growth fell behind, and as a result, the household income share of GDP declined exactly in line with an increase in the business profit share of GDP.
And as we point out in our book, business profits are all saved. Household income, particularly among workers, is mostly consumed.
Shifting income from workers to businesses automatically raised the German savings rate. It had nothing to do with thriftiness.
Ordinary Germans were no more or less thrifty than they had been in the past, but total savings went up. And if total savings go up, ideally that should fund an increase in investment, so that investment goes up as consumption goes down and there’s no change in demand.
But that’s not what happened. In fact, the investment share of GDP for a few years actually declined. So those of you who remember your accounting identities will remember that if savings go up and investment doesn’t—or worse, if investment declines—then by definition, you have to run a current account surplus. Also, by definition, you have to export those excess savings, and that’s really key because those excess savings [unconsumed production] could have remained in Germany, or they could have gone to other countries.
And it’s very interesting to see what happened. When the euro was created, not all countries in Europe had the same inflation rate. The countries in what we started to call “peripheral Europe” had higher inflation and the countries like Germany and northern Europe had lower inflation. With the creation of the euro, we saw a convergence in European interest rates, but not a convergence in European inflation.
And that’s very important because what it meant was that real interest rates in countries like Spain—and because I was born and grew up in Spain, I’ll use Spain as an example for all of peripheral Europe—real interest rates were very, very low, and even negative. Whereas in countries like Germany, real interest rates were positive. So it’s not surprising that the money flowed heavily into areas where the, uh, where, where interest rates were negative. You had German savings flowing into Spain, Portugal, Italy, etc. into the banking system.
I remember as late as the 1990s, having a credit card in Spain was still a bit of a status symbol. It wasn’t that easy to get, but by the 2000s, everybody had a credit card. I mean, it was one of those things where, sometimes your dog would get a credit card application in the mail.
The reason was not that suddenly Spaniards became better credits. The reason is that the Spanish banking system was flooded with inflows, particularly from Germany, directly and indirectly, and they had to lend it out. And the way you increase loans is you reduce your lending standards.
In addition, with this flood of money coming into Spain, asset prices soared. I remember the stock market did really well, but what did superbly well was real estate. Real estate just exploded.
I’ll give you a little anecdote here. I think it was in 2004 or 2005, I had gone home for the holidays. And my mother decided to have a very big New Year’s Eve party and it was pretty big. It was something like 70 people came before midnight. The tradition in southern Spain is that you go somewhere before midnight, you have the dinner, you have the drinks, you cheer for New Year’s, and then you travel from house to house meeting other friends. So quite a lot of people came to our house that night. I remember I’d had several drinks. I was probably feeling particularly philosophical at the time.
But I remember that at one point it occurred to me that my mom and I were the only two people in the house who didn’t earn a living from real estate; everybody else was a contractor, an architect, an interior decorator, a real estate agent.
Everybody was making tons of money off of real estate. I remember thinking this can’t be a good sign, when no one does any real work. Everyone is simply building apartments.
Matt Klein: If you look at the cumulative investment in housing in Spain and in Germany in the 2000s, even though Spain is a country with less than half the population, or about half the population, there was more cumulative investment net of depreciation in Spain, substantially more, by the eve of the euro crisis than in Germany, and, larger than in France and so forth.
Michael Pettis: You can still go to parts of Spain where there are buildings that are 10 or 12 years old, but they’ve never been lived in. There’s just apartment building after apartment building that nobody lives in. Because at the time, real estate prices were going up so quickly that it was a guaranteed way of getting rich: buy an apartment even if you haven’t seen it and sell it in three or four years and buy a Mercedes. I think Mercedes were selling like hotcakes in Spain at the time.
Now, why does all that matter? It sounds like a good thing. We had a great party. It matters because you had banks that were lowering their lending standards in order to increase their consumer loans. You had surging real estate prices and surging stock markets, which made Spaniards feel much richer than they otherwise were. It turned out to be fake wealth, but at the time they felt very wealthy. And as a result, they increased their spending, they reduced their savings. When you go through all of these different aspects, what ends up happening is that the Spanish savings rate collapsed at exactly the same time that the German savings rate surged.
Matt Klein: Before we go further, because some of these terms might be confusing to some listeners who aren’t as familiar with the official macroeconomic accounting definitions the way we talk about them: when we hear the word “savings”, what it means is it’s literally everything that’s produced, or all the income that is earned, minus whatever is consumed immediately. That’s why normally you say savings and investment have to balance, because by definition, globally, everything that’s produced is either consumed or is an input to investment. So that's where that comes from.
The idea being that if you’re saving more by consuming less, assuming your production hasn’t gone down, then someone somewhere else either is consuming more, or investing more, or you’re investing more. That has to be how those things balance out.
That’s on the real side. And then on the financial side, when we say that savings “flow” from Germany to Spain, for example, that has two implications.
One is that the counterpart to German businesses continuing to sell goods and services—mostly goods—in line with global economic growth, even as the German domestic economy is weak, is that the rest of the world must be buying an increasingly larger share of what those German businesses are producing, because they’re not selling to their home market. That’s one way of savings flowing: the German excess production is exported.
The other side is, as you mentioned, to the financial system. You can look at the data on German banks, for example, being very aggressive in foreign lending before 2008 and accumulating claims on banks elsewhere, including, notably in Spain, Ireland, Greece. That’s how those balance out.
And in fact, those have to be simultaneous events. Those Mercedes that you mentioned seeing all the people in Spain buying are the corollary.
Just as they would not have been able to afford those Mercedes without the increase in credit availability in Spain, that increase in credit availability was in large part, not only, but in large part a consequence of the fact that there was this big surplus of funds in German banks that were not lending domestically.
They were accumulating lots of savings from the German companies that were generating those profits from sales abroad. And of course, they couldn’t have generated those profits unless other people were buying. All of these things had to fit together simultaneously. That’s how that worked.
Until, as you mentioned, it stopped. Because as soon as someone somewhere decides, “I don’t want to keep buying debt assets or lending to people who may or may not be able to repay it with those increasingly outlandish investment projects,” then you have a sharp reversal.
Michael Pettis: Now, as you mentioned, Matt, the standard story is, “well, the Germans are very hardworking and thrifty and everyone knows that the Spaniards love to have siestas and go to the beach and things like that.” And of course it’s not true. Spanish workers work more hours every year than German workers.
And there wasn’t really a change in culture. Savings didn’t go up in Germany because Germans suddenly became “Germanically thrifty”. And they didn’t collapse in Spain because the Spanish suddenly became crazy about spending money. It had to do with structural changes in the distribution of income in Germany and the impact of all of these inflows into Spain.
So if German savings went up [and German investment went down], then either investment in the rest of the world had to go up, or savings in the rest of the world had to go down, because at the end of the day, savings and investment must balance.
Investment didn’t go up. There was some investment in a lot of nonproductive empty apartment buildings, but basically, savings had to come down in Spain and in the other peripheral European countries in order to balance the inflow of savings from Germany.
The way they came down is again very structural: you had a wealth effect that caused people to feel richer than they were, which meant they spent more than, than they should have. And then you had banks that were eager to expand consumer loans, and they lowered their lending standards enough.
There are always people who either are foolish, or excessively risky, or whatever, who are always willing to borrow if you’re willing to lend to them. And so that happened.
So notice what happens: as German savings flowed into Spain, Spanish savings had to decline to match that. You can’t have an excess of savings globally.
Matt Klein: I just want to point out briefly, we talked about the quality of the savings, but surprisingly, if you look at the national savings rate in Spain, maybe not the household savings rate, but the national savings rate actually was flat during this period. What happened was that there was a huge increase in investment. So savings net of investment—the current account balance—did deteriorate quite dramatically.
But this is an interesting point. Investment increased so much in Spain—there’s some other countries where the dynamics were slightly different—but at least in the aggregate, I think it’s because the government budget surplus increased, in Spain, that’s how that played out.
Michael Pettis: And some of that investment turned out to be quite good. You know, Spain has some of the best transportation infrastructure in the world: high-speed trains, great highways. Unfortunately, a lot of it turned out to be not just in useless real estate—apartment buildings that remained empty—but… There’s a huge airport built not far—well, it’s actually pretty far from Madrid. And it was going to be this spectacular new airport that was going to become one of the centers of aviation in Europe.
Matt Klein: Don Quixote airport actually, that’s what they called it, I think, because it was in La Mancha.
Michael Pettis: I knew it had something to do with Don Quixote. Or maybe it should be Sancho Panza, I don’t know. But I don’t think an airplane has landed there yet. Certainly no commercial airplane has ever landed there yet. You had a lot of these really crazy projects, and what they required was a surge in debt in order to finance them. Now, had they been productive, the surge in debt would have been sustainable and not a problem. But in 2008-2009, at the beginning of the global crisis, people suddenly started becoming very nervous about debt levels in countries like Spain, Italy, Portugal, et cetera, and the funding dried up.
But things still had to balance, and the way they balanced in Spain was a reduction in savings through a rise in unemployment.