Too Fast and Too Furious? Germany as Europe’s New Drift King

Why is Germany in Europe’s catbird seat? Yes, it’s Europe’s largest economy, but not so long ago it was the “sick man of Europe,” earning only disdain or indifference from its European neighbors. What really matters is what didn’t happen: the German economy did not blow up in the global financial crisis like its erstwhile Anglo detractors – the UK and the US. Thanks to the Chinese stimulus plan, German exports quickly boomed again and without a huge domestic debt or banking crisis holding it back, Germany was the only one in a position to bail out the rest of Europe (to a point) and thus call the political shots. So, why did Germany come through the financial crisis of 2007-09 in relatively good shape? The answer lies in understanding why the German financial system (and economy generally) didn’t come to depend on a derivatives pyramid and debt-driven growth.

Let me start by summarizing the institutional cornerstones of the postwar German financial system. First, through equity ownership by banks in many large firms, widespread bank representation on company boards, as well bank voting of proxy shares on behalf of other investors, large banks played a central role in the corporate governance of many large German firms. Banks supported long-term corporate strategies of competing through innovation and productivity growth rather than cost cutting, labor shedding or outsourcing, and a focus on revenue growth as much as profitability. Second, banks played a central and supporting role in firm-level co-determination or stakeholder corporate governance by accepting labor as a partner (even if junior) in corporate management. Third, postwar Germany developed/preserved a large system of public banks that served both commercial markets and broader social purposes. In a narrow sense, many of these banks provided funds (often government subsidized) for a variety of investment purposes, notably for smaller firms, infrastructure development, R\&D, and housing construction. More than half the banking sector is comprised of “boring” savings and cooperative banks which never did much other than conventional commercial and retail banking. Finally, the provision of long-term funds to firms was enabled by the savings behavior of households because they channeled most of their savings into banks (and insurance companies) that, in turn, channeled these to firms.

Some elements of this financial system as just described have changed dramatically over the last twenty years while others remain largely intact. Perhaps the most important change is that large banks — both commercial and public – turned increasingly to investment banking and international banking as their traditional business with large firms declined. The strategic redirection coincided with a substantial withdrawal of large banks from providing long-term patient capital to firms and participating in stakeholder corporate governance. With the exception of Deutsche Bank, however, this strategic shift has not been very successful. Though bank revenue as a share of GDP in Germany has grown since the early 1990s, profitability remains quite low by international comparison and has not grown (figure 1). This is partly because Germany is “overbanked” and thus a highly competitive market. Meanwhile, conservative regulation limited the involvement of German banks in the dark but outrageously profitable corners of the Anglo financial world, such as securitization, derivatives trading, prime brokering, etc.

_Return on Equity of German Banks (1994-2007) Source: `Die Ertragslage der Kreditinstitute’, April 2009, Bundesbank (own calculations)_

To overstate the case and confirm the popular view, the financial derivatives (aka `risk management’) revolution that transformed finance in the US and UK largely bypassed Germany’s domestic financial system. Though many large German banks — notably several of the Landesbanks and some public sector banks — did participate in this revolution by buying lots of bad assets in London and New York (they were generally the suckers on the wrong end of the bets). Landesbanks were driven in this direction by long-running problems, including the loss of much of their public utility functions during the 1990s, the loss of state guarantees of their assets in 2005 as a result of EU decisions, and their inability to transform into pure commercial banks (but this is a long story for another day). Among the public Landesbanks, quite a few suffered very large losses from their foreign asset exposures, in several cases requiring bailouts from the state government and savings banks. The worst of the public banks was the IKB, one of the two banks burned in Goldman Sachs’ infamous Abacus deal. Among private banks, the worst was Hypo Real Estate, which got burned in American muni bond insurance and was taken over by the state at cost of more than euro 100 billion. The Dresdner Bank was merged with the Commerzbank, greased with a very heavy infusion of public money.

In most cases these losses are tied to non-domestic financial activities by these banks. In other words, the sources of Germany’s financial crisis are not domestic in origin. This is largely a result of the fact that Germany did not experience a debt-fuelled consumption binge nor a liquidity-driven asset (real estate) bubble, unlike the UK, Ireland and Spain. There are undoubtedly several factors that explain this: First, with very low inflation, real interest rates were relatively high in Germany during the 2000s, thus limiting borrowing. Second, while there was a significant shift from savings via bank deposits to savings via mutual funds, pensions and life insurance since the early 1990s (see figure 2), German household saving and investing behavior remained relatively conservative compared to other countries. Thus the expansion of the institutional investors who drove financialization process elsewhere (including demand for structured financial products at the root of the crisis in the UK and US) was more limited than elsewhere and German institutional investors, for a number of reasons (mostly regulatory) remain more conservative in their investment strategies. Third, Germany already had a long established covered bond market — a form of mortgage securitization that proved immune to the excesses and manipulation that occurred elsewhere (and probably precluded the rise of a big RMBS market in Germany). Finally, the mortgage financing market in Germany is accounted for to a great degree by savings and public banks, which are subjected to tight prudential regulation and conservative lending practices. Thus while the bailouts were costly to the German taxpayers, the fact that households and firms were not saddled with excessive debts meant the German economy could quickly revive.

_Composition of German Household Financial Assets, 1991-2007._

Altogether, then, the financial crisis in Germany was not ‘made in Germany’ (at least in the sense of the bad assets or bad bets not originating in Germany) but in the Anglo-American financial world. Although German banks are certainly not without culpability, the largely external character of Germany’s financial problems enabled Merkel and other leaders to portray Germany and its banks as victims of Anglo-American finance. This is central to understanding how the government has subsequently altered domestic financial regulation and what kinds of international financial regulation it has pursued.

Of course, the banking/financial crisis of 2007-09 has turned into a eurozone crisis this past year. The sovereign debt problem at the root of the eurozone crisis is a result of both fiscal profligacy in a number of states but also, in several instances, a result of massive bank bailouts by governments. From the German perspective, fixing this problem must thus address two sources: excessive leverage, risk-taking and non-transparency in the financial system which created the bank failures that led to government bailouts, on one hand, and the lack of spending discipline in several states on the other. While perhaps more due to dumb luck than pluck, the fact that Germany didn’t take part in the debt-binge and derivatives frenzy of the US and UK affirmed in the minds of many German elites that their conservative approach to financial regulation should be reproduced at the European and international levels. It is Germany that has strongly pushed for more regulation of hedge funds, moving all derivatives trading onto exchanges, and taxing banks to fund future bailouts and limit the exposure of taxpayers to bank and, now, sovereign debt in Europe.

So what is Germany’s plan to get Europe through this? This is where drifting comes in. To quote from Wikipedia, “drift racing challenges drivers to navigate a course in a sustained sideslip by exploiting coupled nonlinearities in the tire force response.” Got it? Ok, in drifting drivers let their rear wheels spin and slide when entering a curve in order to exit the curve at a high speed. It works, if you know what you’re doing. If not, your car spins out of control and you end up with lots of twisted metal. As the largest and soundest economy in Europe, Germany is drift driving Europe right now: Germany is leading the bailout plan for Europe (steering the front wheels), but flirts with the euro’s demise by hesitating to bail out Greece, then by talking about haircuts for sovereign debt holders and imposing Germanic fiscal austerity and financial regulation on the rest of Europe (spinning the rear wheels) — all of which it sees as necessary to get Europe quickly back on course (exiting the turn). The risk is that Germany is pushing too fast, forcing levels of fiscal austerity and proposing fiscal coordination across the euro-zone that may not be politically tolerable in much of Europe. The irony is that crashing the euro-car would hurt Germany more than anyone else because Germany needs exports to thrive. German export competitiveness hinges on both high productivity and moderate unit wage costs. If the euro goes, everyone else in Europe devalues vis-à-vis Germany and German competitiveness goes out the window. The good news is that Porsche 911s are good for drifting (rear wheel drive), the bad news is that angry Germans are at the wheel — Europe had better hope they took good driving lessons.