Friday, 10 May 2013

Sprechen Sie Deutsch? Martin Wolf does not

Germany is truly Europe's great unknown. 

Everyone has an opinion about the country. Often a very strong one. Regarding Germany's EU crisis resolution strategy this is no different. And the dominant opinion goes like this: when it comes to economics, Germany is first class in practice. And third class in theory - Germans don't get it.


However, very few actually know what Germany is all about. With all sympathy, FT's Martin Wolf is not among them. His article in Wednesday's FT shows it once again

Contrary to what Martin Wolf writes, and many analysts claim, Germany never said that Eurozone's peripheral crisis was a fiscal crisis at inception (with the exception of Greece). Germany knows all too well that it was a private debt crisis. Just like everyone else does.

However, Germans also know - don't we all? - that the peripheral countries are plagued by structural problems that are at the origin of their lack of competitiveness , which led to the current crisis. The external imbalances are simply the expression of it.

What to do? Expansionary fiscal policies in Germany today and Eurobonds asap? 
Let's do the  numbers for the impact of a German expansionary policy in Spain:

- German imports from Spain were Eur 22bn in 2012, 2% of Spain's GDP. 

- Let's be optimistic and say that a fiscal expansion in Germany would lead to a 5% increase in its imports from Spain. This amounts to 0.1% of Spanish GDP. 

- Let's say that Spain's foreign trade multiplier is 2.5. This would lead to an increase of 0.25% in Spanish GDP. 

- Let's be optimistic and further assume that the fiscal expansion in Germany by having an impact in its imports from other countries, leading to an increase in their GDP, which in turn would lead to an increase in their Spanish imports set the Spanish foreign trade multiplier at 5. 

- The result would be an increase in Spanish GDP growth of 0.5% as a result of a German  fiscal expansionary policy. 

- A similar exercise could be run for Portugal (0.75% GDP growth) and Greece (0.25% GDP growth). 

All nice to have, but it wouldn't solve the EU periphery's underlying problems. If anything, it would only perpetuate them by delaying necessary reform implementation.

So, what's the alternative? What is Germany's implicit strategy? Keep the pressure high on the periphery, thus forcing / incentivising structural reforms that otherwise would never take place - well knowing that not all necessary reforms will be carried out to their full extent - and in this way create a very attractive environment for foreign direct investment (FDI). 

FDI is the most effective way to create the strong industrial basis the EU periphery is lacking over a relatively short period of time (5 to 10 years). And it will allow to reverse its chronic external debt / current account problem: it will have an immediate direct impact on the capital account. Once the FDI projects start to become operational they will generate a rise in exports, and allow for a sustainable and balanced current account at a higher level of imports (increase in imports driven by the rebound in internal demand once the economy starts to recover).

By how much will FDI have to increase in, e.g., Spain and Portugal to make this a successful and sustainable external re-balancing strategy? Make it 5% of GDP annually and we start talking business 
(note: acquisition of domestic assets by foreign investors, e.g. privatisations, don't count as FDI for the 5% target. A narrow FDI definition is being used: just the building of new production capacity by foreign investors qualifies as FDI)

If we assume, conservatively, that FDI projects on average

a) have a 1.5x sales / capital employed ratio

b)  that all the capital employed comes from abroad

c) that 50% of the input factors have to be imported

d) that 90% of the production will be exported

we'll have a direct first-round increase in net exports accounting for 4.25% of GDP once the projects become operational. Implement an aggressive FDI strategy over a 10-year period and the peripheral countries' industrial landscape will look very different at the end of it.

In fact, current data shows the way: tourism, food, textiles / footwear account for only 40% of Spanish and Portuguese total exports. Not the 80%-90% that people tend intuitively to think. Where do the other 60% come from? Surprise, surprise: transportation equipment, electronics, high precision machinery, optical devices, chemicals/pharma. Do you know many Portuguese, Spanish companies from these sectors? No one does. The explanation is that multinational companies present in the countries are the main responsibles for these exports.

Conclusion: attract more of them. Make FDI bigger. Much bigger. And for this to happen do structural reforms conducive to an attractive 
FDI environment.

Will this be enough to eliminate the peripheral countries' legacy net external debt? No. Once the economic reforms are concluded or the social support for them has completely eroded (in 2-3 years time, the latest) a debt restructuring will have to take place. 
And top German officials are aware of this as well. But the debt restructuring should only take place then. Not now - as at least two very important reforms have barely started to be implemented: that of the overblown political-public administration apparatus (including subsidies to a diverse range of economic activities) and pensions (whose level is too high as they are based on salaries that were way above what the underlying level of productivity at the time justified).

Once you look at the numbers and think it through, the German strategy seems actually quite sensible. Only the illusion of short-term fixes for long-lasting structural problems can make anyone think otherwise. But short-term pain is, at times, the unavoidable price to pay for substantial long-term gain. For the EU peripheral countries, today is one of those times. They should seize the moment and don't let the crisis go waste. 


  1. What would motivate foreign investors to set up operations in Spain or Portugal? With the numbers you are giving (90% export of end products) it is not internal markets. Is it cheaper labor? Any other factor they are better on than placing said production facilities closer to their final demand or in Asian/Eastern Europe cheaper locations?

  2. Top quality infrastructure and low cost qualified (young) labor combined with measures mentioned in last post about FDI