Germany’s bubble economy is on borrowed time

Published in Business Spectator (Melbourne), 26 March 2015

If the latest signals coming from the Federal Reserve are anything to go by, it is only a matter of time until the US central bank increases its funds rate. Most likely it is going to happen some time over the northern hemisphere summer.

On the other side of the Atlantic, meanwhile, there have been movements in a different direction. The European Central Bank has only just begun its quantitative easing program, making any upward interest rate moves highly unlikely for at least the next couple of years.

Though the fragile state of the eurozone may not leave the ECB much room for manoeuvre, questions need to be asked about whether this continuing deviation from monetary policy normalcy has side effects that could be more severe than the problems it is supposed to cure.

The countries most at risk from ultra-low interest rates are the ones that are, relatively speaking, the healthiest in the eurozone. For eurozone members in crisis or recession like Italy or Greece, low interest rates are easily justifiable; for the stronger eurozone economies, such interest rates are definitely too low. This has the potential to create serious distortions.

One of the most obvious distortions caused by the low interest rate environment is the yield on German government bonds. For the past half-year, Berlin has been able to auction off 12-month bills at negative interest rates. The current yield is -0.244 percent or, as the macro commentary newsletter The Daily Shot put it succinctly, “borrowing money has become the government’s new profit centre”.

For finance minister Wolfgang Schäuble, such interest rates are like manna from heaven. Even borrowing money now contributes to consolidating his budget. Little wonder that the German federal government is able to present its first surplus in four decades. However, it also means that Schäuble does not have much reason to be proud of this achievement.

When there were still ‘more normal’ interest rates back in 2008, the German federal government needed to pay just over €40 billion in interest on its debt, equivalent to about 14 per cent of total expenditure. Despite an increasing absolute debt burden as a result of the Great Recession, the German federal government’s interest payments for this year are likely to be around €27bn. This is way below the 2008 figure.

It is even further below the level of interest payments there would be today given the increased absolute debt load. A back-of-envelope calculation suggests that the German government saves at least €20bn a year in interest payments thanks to the extraordinary monetary environment it finds itself in. Germany is a major beneficiary of the euro crisis in the short run — that is, as long as the guarantees it has given are not triggered.

One should therefore look at Germany’s wafer-thin budget surplus for this year differently. Instead of celebrating it as a success and a sign of fiscal prudence, we should ask whether, given the extraordinary windfall of super-low interest rates (and increasing tax revenue, one might add), Germany should not have recorded a much higher surplus.

In other words, Germany’s real fiscal situation is not nearly as rosy at it may look at first sight. Any return to monetary normality would put the federal budget out of balance.

The other obvious distortion caused by zero interest rates is the stockmarket. The long-term average for the price-earnings ratio of DAX-listed companies is under 15. The majority of companies in the DAX 30 are now much more expensive than that. Adidas, for example, shows a current P/E ratio of 21, Deutsche Telekom of 24, and Beiersdorf of 27.

One way to interpret such P/E ratios and the rally that led the DAX to recent all-time highs above the 12,000 mark is to understand them as side effects of the ECB’s monetary policy. These stock prices are driven by capital in search of a yield better than zero. In turn, this means that once the ECB changes course and moves towards positive interest rates one faraway day, this will deflate the German stockmarket.

In the meantime, of course, the negative interest rate environment hurts anyone who is not a finance minister or a shareholder. Savers now see their capital shrink in real terms year-on-year, while pension funds and life insurances struggle to provide any investment gains to their clients.

Finally, the low interest rate environment has also triggered a boom in Germany’s property market. Transactions in German real estate this year will reach a volume of €190bn which is up from just €130bn in 2008/09. Thanks only to a flexible housing supply-side, house price increases have been relatively moderate. Last year, building permits were issued for more than 284,000 new homes which was 20 year high – and another effect of zero interest rates.

It is astonishing to see that the ECB’s response to the eurozone periphery’s crisis has now put Germany in a position where it cannot afford a return to more normal monetary conditions without it posing a major threat to its economy.

Imagine what might happen if the ECB returned its key interest rate to around the 4 per cent mark, where it was in 2007/08. At one stroke this would ruin the federal budget, send the stockmarket into a tailspin and bring the housing and construction boom to an abrupt halt.

The Germans are usually the most vocal nation when it comes to complaining about the ECB’s unorthodox policies — and they certainly have good arguments on their side. Ironically, Germany is also the country that has, in the short run, benefitted the most from the ECB’s expansionary policies. The ECB has fixed Germany’s budget, provided a bonanza to German shareholders, made it cheaper for German companies to borrow and allowed more Germans to buy their own home.

The real problems for Germany will begin once the ECB follows the Fed’s example and tapers its monetary stimulus. But thanks to the eurozone periphery, it may take years until the ECB feels ready to take this step.

In the meantime, Germany may enjoy its bubble economy while it lasts.

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