German Financialization and the Eurozone Crisis

By Nina Eichacker, a lecturer in economics at Bentley University. This blog post summarizes her recent Political Economy Research Institute (PERI) working paper “German Financialization, the Global Financial Crisis, and the Eurozone Crisis.” Her previous blog post, on financial liberalization and Iceland’s financial crisis, is available here. Originally published at Triple Crisis

Many studies of the Eurozone crisis focus on peripheral European states’ current account deficits, or German neo-mercantilist policies that promoted export surpluses. However, German financialization and input on the eurozone’s financial architecture promoted deficits, increased systemic risk, and facilitated the onset of Europe’s subsequent crises.

Increasing German financial sector competition encouraged German banks’ increasing securitization and participation in global capital markets. Regional liberalization created new marketplaces for German finance and increased crisis risk as current accounts diverged between Europe’s core and periphery. After the global financial crisis of 2008, German losses on international securitized assets prompted retrenchment of lending, paving the way for the eurozone’s sovereign debt crisis. Rethinking how financial liberalization facilitated German and European financial crises may prevent the eurozone from repeating these performances in the future.

After the 1970s, German banks’ trading activity came to surpass lending as the largest share of assets, while German firms increasingly borrowed in international capital markets rather than from domestic banks. Private banks alleged that political subsidies and higher credit ratings for Landesbanks, public banks that insured household, small enterprise, and local banks’ access to capital, were unfair, and, in response, German lawmakers eliminated state guarantees for public banks. Landesbanks, despite their historic role as stable, non-profit, providers of credit, consequently had to compete with Germany’s largest private banks for business. Changes in competition restructured the German financial system. Mergers and takeovers occurred, especially in commercial banks and Landesbanks. German financial intermediation ratios—total financial assets of financial corporations divided by the total financial assets of the economy—increased. Greater securitization and shadow banking relative to long-term lending increased German propensity for financial crisis, as securities, shares, and securitized debt constituted increasing percentages of German banks’ assets and liabilities.

Throughout this period, Germany lacked a centralized financial regulatory apparatus. Only in 2002 did the country’s central bank, the Bundesbank, establish the Bundenstalt für Finanzdienstleistungsaufsicht (Federal Financial Supervisory Authority, known as BaFin), which consolidated the responsibilities of three agencies to oversee the whole financial sector. However, neither institution could keep pace with new sources of financial and economic instability. German banking changes continued apace and destabilizing trends in banking grew.

German desire for financial liberalization at the European level, meanwhile, helped increase potential systemic risk of European finance. Despite some European opposition to removing barriers to capital and trade flows, Germany prevailed in setting these preconditions for membership in the European economic union. Germany’s negotiating power stemmed from its strong currency, as well as French, Italian, and smaller European economies’ desire for currency stability. Germany demanded an independent central bank for the union, removal of capital controls, and an expansion of the tasks banks could perform within the Economic and Monetary Union (EMU). The Second Banking Coordination Directive (SBCD) mandated that banks perform commercial and investment intermediation to be certified within the EMU; the Single Market Passport (SMP) required free trade and capital flows throughout the EMU. The SMP and SBCD increased the scope of activity that financial institutions throughout the union were expected to provide, and opened banks up to markets, instruments, and activities they could neither monitor nor regulate, and hence to destabilizing shocks.

Intra-EMU lending and borrowing subsequently increased, and total lending and borrowing grew relative to European countries’ GDP from the early 1990s onward. Asymmetries emerged in capital flows between Europe’s core, particularly the UK, Germany, and the Netherlands, to Europe’s newly liberalized periphery. German banks lent increasing volumes to EMU member states, especially peripheral states. Though this lending on a country-by-country basis was a small percentage of Germany’s GDP, it constituted larger percentages of borrowers’ GDPs. In 2007, Germany lent 1.23% of its GDP to Portugal; this represented 17.68% of Portugal’s GDP; in 2008, Germany lent 6% of its GDP to Ireland; this was 84% of Irish GDP. Germany, the largest European economy, lent larger percentages of its GDP to peripheral EMU nations relative to its lending to richer European economies. These flows, more potentially disruptive for borrowers than for the lender, reflected lack of oversight in asset management. German lending helped destabilize European financial systems more vulnerable to rapid capital inflows, and created conditions for large-scale capital flight in a crisis.

Financial competition increased in Europe over this period. Financial merger activity first accelerated within national borders, and later grew at supra-national levels. These movements increased eurozone access to capital, but increased pressure for banks to widen the scope of the services and lending that they provided. Rising European securitization in this period increased systemic risk for the EMU financial system. European holdings of U.S.-originated asset-backed securities increased by billions of dollars from the early 2000s until shortly before 2008. German banks were among the EMU’s top issuers and acquirers of such assets. As banks’ holdings of these assets increased, European systemic risk increased as well.

European total debt as a percentage of GDP rose in this period. Financial debt relative to GDP grew particularly sharply in core economies; Ireland was the only peripheral EMU economy with comparable levels of financial debt. Though government debt relative to GDP fell or held constant for most EMU nations, cross-border acquisition of sovereign debt increased until 2007. German banks acquired substantially larger portfolios of sovereign debt issued by other European states, which would not decrease until 2010. Only in 2009 did government debt relative to GDP increase throughout the eurozone, as governments guaranteed their financial systems to minimize the costs of the ensuing financial crisis.

The newly liberalized financial architecture of the eurozone increased both the market for German financial services and overall systemic risk of the European financial system; these dynamics helped destabilize the German financial system and economy at large. Rising German exports of goods, services, and capital to the rest of Europe grew the German economy, but divergence of current account balances within the EMU exposed it to sovereign debt risk in peripheral states. Potential systemic risk changed into systemic risk after the subprime mortgage crisis began. EMU economies would not have subsequently experienced such pressure to backstop national financial systems or to repay sovereign loans had German banks not lent so much or purchased so many sovereign bonds within the union. Narratives that fail to acknowledge Germany’s role in promoting the circumstances that underlay the eurozone crisis ignore the destabilizing power of financial liberalization, even for a global financial center like Germany.

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  1. susan the other

    This is very interesting. It describes just how the EU mess unfolded beginning in 1970 with deregulation of the financial industry in the core. Big fish eat little fish. It is as if for 4 decades the banks in Germany compensated their losses to the bigger international lenders by taking on the riskier borrowers and were able to do so because of German mercantilism and financial deregulation. Like the German domestic banks loaned the periphery money with abandon, and effectively borrowed their own profits by speculating on bad customers. As German corporations did business with big international banksters, who lent at lower rates, other German banks resorted to buying the sovereign bonds of the periphery and selling CDOs, etc. The German banks were as over-extended looking for profit as consumers living on their credit cards. Deregulation enriched only the biggest international banks. We could call this behavior a form of digging your own grave. In 2009 the periphery saw their borrowing costs threatened and guaranteed their own financial institutions creating the “sovereign debt” that the core then refused to touch. Hypocrisy ruled. Generosity was in short supply. The whole thing fell apart. Deregulation was just another form of looting.

  2. washunate

    German losses on international securitized assets prompted retrenchment of lending, paving the way for the eurozone’s sovereign debt crisis.

    I agree with the general conclusion at the end that German financialization is part of the overall narrative of EMU, but I don’t follow this specific link in the chain of events as described. The eurozone has a sovereign debt crisis because those sovereign governments privatized the profits and socialized the losses of a global system of fraud. And if we’re assigning national blame, it’s a system run out of DC, NY, and London a lot more than Berlin, Frankfurt, and Brussels.

    Current and capital account imbalances cancel each other out in the overall balance of payments. As bank lending decreases (capital account surplus shrinks) then the current account deficit shrinks as well (the ‘trade deficit’). The problem is when governments step in and haphazardly backstop some of the losses – at least, when they do so without imposing taxes on the wealthy to a sufficient degree to pay for these bailouts.

  3. craazyman

    wow I cant believe this postt only got three comments. That’s pretty lame. The peanut gallery did not shine for this one. It is not the gallerys finest hour when a serius post gets onnly 3 comment. Nobody I guess wants to engage in thoughtful academic discourse about such a perplexing situation, but I will. You don’t want professors who post here to think nobody cares what they have to say

    Hit it boys!. . .

    And now it’s
    Springtime for finance and Germany
    Dieutschland is happy and gay!
    They’re lending at a faster pace
    the debt loads grow to outer space
    why worry if nobody can pay?

    because it’s
    Springtime for finance and Germany
    Rhineland’s a fine land once more!
    Their exports shipping everywhere
    But who willl pay they just don’t care!
    cause they can always lend out more and more

    Yes it’s
    springtime for finance and Germany
    it’s winter for the PIIGGies and France
    it may be quite repetitive
    to say they’re not competitive
    but someone has to kick them in the pants

    Cause it’s
    springtime for finance and Germany
    tthat jackboot on the rear is just for you!
    cause Hans and Franz are ready
    to get you pumped and sweaty
    caause for every euro they lent you owe them two!

    1. craazyman

      oh man this post needs some musical accompaniment.

      why hold back? The road of excess leads to the palace of wisdom. Indulge yourself and your aesthetic senses! Surround yourself in the sights and sounds of . . . Springtime for Finance and Germany

      I know this is gonna trip the mod wire but this is so worth it.

      Not everybody is able to think in the manner of an academic economist. some people intuit things through metaphor and spectacle. For them, this is worth at least a 20 page paper with lots of equilbrium mathematics . . . hopefully using inscrutable linear algebra techniques and lots of differential equations

      1. Barry Fay

        Oh man! I forgot just how funny and how well done that song was in the movie. Of course it may be that living here in Berlin for the last 20 years has added a certain amount of Schadenfreude to my emotional make-up but still…The columns turning into howitzers was a stroke of genius! Thanks for the memories and the yard stick for my emotions!

    2. Steven

      Out of sight great!!! As for the dearth of comments, I suspect many in the peanut gallery are beginning to feel like the world’s last few honest economists, e.g. Michael Hudson, Steve Keen (and of course I can’t leave out the now departed Hyman Minsky and Frederick Soddy), to wit:

      It doesn’t matter how clearly you lay it out. People just don’t give a damn. Like Pavlov’s dogs, they still salivate at the sight of money, no matter how impossible it has become to exchange for real wealth should the need ever arise – a highly unlikely event for the dwindling number of big fish in the 0.01%

      But there I go again… Eat, drink and be merry because tomorrow the world dies.

  4. Ulysses

    Hyper-financialization will always be tempting to capitalists. They start out thinking that their looting won’t do real long-term damage, but eventually they cook and eat all the geese that lay the golden eggs.

    The morally troubling aspect of this is that most of the big capitalists can ride out the ensuing depression, and score cheap assets after economic collapse. The smaller capitalists, and especially the workers, are the ones who suffer from the greed and reckless speculation of the kleptocrats.

    1. digi_owl

      Meh, to say they even contemplate potential damage is too kind.

      They have dollar signs in their eyes, and therefore willfully blind to anything but profits.

  5. ckimball

    Admittedly there is so much I don’t understand as well as most here however what came to me in this reading is how with tending, lending
    can serve as a far greater asset than the capital loaned when enforcement supports the liquidation of the depreciated real assets of whole countries. I’m still thinking, I should say emotional, about Greece.

  6. Michael

    There are a lot of interesting things to be said about the German banking system, but they are not in this text. For example that probably 70% of the banking sector is non-profit (state owned or mutual) and that in the crisis these banks have been much more supportive of industry than the private sector banks. As a consequence most private sector banks about which the text seems to be, have today disappeared, been aquired or partially nationalized.

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