Economic focus: Wirtschaftsblunder

Date: 21/02/04

Why has the German economy performed so much worse than the rest of Europe?

Over the past ten years, Germany's GDP has grown by an annual average of only 1.4%, barely half as fast as growth in the rest of the European Union, and roughly the same pace as Japan, which has been a byword for slow growth over the past few years. The most popular explanations for Germany's dismal performance are the costs of reunifying East and West Germany, and the arthritic state of the united country's labour markets. However, a new study* by Goldman Sachs, an investment bank, makes an intriguing claim: that it is an artificially low cost of capital, which has encouraged excessive investment, that has been most to blame. A rising cost of capital in recent years can explain much of Germany's weaker growth - and could continue to depress it for several more years.

The study starts with Germany's extraordinarily low return on capital. Goldman Sachs estimates that German firms have earned an average pre-tax rate of return on their capital of only 5% since 1991. In contrast, the average return in the rest of the EU has been 12% which, as the chart shows, is even higher than the 10% earned by American companies. Reunification has been partly to blame: the inclusion of firms in former East Germany and the massive boom in capital investment after unification both depressed average returns. But eastern Germany is only 11% of total GDP - too small to explain the unusually low overall average rate of return. In any case, firms in West Germany already had a low return on capital before reunification.

Some argue that Germany's powerful trade unions have raised wages and so reduced the return on capital. But unions are as strong and labour markets as rigid in other EU countries where returns are higher. Moreover, if trade unions had increased workers' total income, the consequent lower return on capital should have reduced investment. Yet quite the opposite has been true: since 1991 business investment has averaged 21% of GDP in Germany, 18% in the rest of the EU and 15% in America.

The combination of high investment and low returns, says the bank, suggests that the cost of capital has been much lower in Germany than elsewhere. Firms invest up to the point at which the extra return covers the cost of capital plus a profit margin. If capital costs are held down, the result is high investment and low returns. It is Germany's capital market, not its labour market, that sets it apart from other European economies. But in important (and worrying) respects this makes the country similar to Japan, where investment as a proportion of GDP is also very high, and returns on capital are correspondingly low.

Germany's financial system is distinctive in two important ways. First, firms rely much more on banks than financial markets. Bank debt accounts for half of the liabilities of non-financial firms, twice the share in the rest of Europe. Second, state-owned financial institutions (Landesbanks and savings banks) account for a big chunk of corporate borrowing. Debt issued by state-owned banks is guaranteed by the government, reducing their financing costs and hence their lending rates. Moreover, they were set up explicitly to assist the expansion of local business, so their objective has been to support investment not maximise returns. Small wonder that German banks' average return on equity is half that of banks in the rest of the EU.

Capital crunch

With borrowing cheap - their cost of capital was at least two percentage points lower than in the rest of Europe in the late 1990s - German firms invested more. But private-sector banks are now under pressure from shareholders to boost profits and in 2001 the European Commission ruled that public guarantees for state-owned banks were anti-competitive and must be phased out. The result is that firms' risk-adjusted cost of capital will rise to more normal levels. Indeed, the interest rates paid by many German firms have already risen in recent years, even as official rates have fallen.

According to Goldman Sachs, it is this rising capital cost that is largely to blame for Germany's weak investment and slow growth in GDP in recent years. Investment as a share of GDP has fallen from 24% in 1991 to 16% in 2003. It may well fall further, because corporate borrowing costs are still lower than in the rest of Europe, and it will take a long while for firms to adapt to paying more for their money. In Japan, where a low cost of capital similarly caused over-investment in the past, investment and growth have been depressed for more than a decade.

Making various assumptions, Goldman Sachs estimates that, if the average cost of capital in Germany rises to the European average, this could eventually reduce Germany's GDP by 5%. In other words, it could knock half a percentage point off its annual growth rate over ten years. And the country, reckons the bank, is only half way through that process.

In the long run, capital-market reform will lead to a more efficient use of capital, and hence higher rates of return. Indeed, total national income (including foreign income), in contrast to GDP, should increase. As the capital subsidy is eliminated, more money will be invested abroad as firms seek higher returns, making Germans as a whole better off. But for the economy to benefit, the labour market will need to adjust quickly because the shift of capital overseas will otherwise result in job losses.

So even if capital costs are the main source of Germany's sluggish growth, labour-market reform is still important because it would reduce the short-run loss of output as firms adjust to higher borrowing costs. Indeed, if labour costs can be squeezed by reforms, firms can adjust without having to cut investment as much. The snag is that, even if Germany pushes ahead with labour reform, rising capital costs will continue to constrain investment and growth. And with no immediate benefits, public resistance to reform in general is likely to grow.

* “No gain without pain - Germany's adjustment to a higher cost of capital”, by Ben Broadbent, Dirk Schumacher and Sabine Schels. Global Economics Paper No. 103

Why has the German economy performed so much worse than the rest of Europe?

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