At its crux, German policy and social preferences led the Member-State’s policy makers and firms to ignore the repeated urge for more investment, not least by the European Commission.
Feldstein and Horioka, who uncovered the correlation between savings and investment levels, reinterpreted their findings to describe how capital markets fail to effectively channel savings to where it is most profitable. According to a new paper by Horioka and Ford, as good and financial markets net bilaterally capital is reallocated only if countries exchange and consume goods.
Horioka’s theory is not observable in the German economy. At its core, the theory describes how lower real interest rates lead to currency depreciation – the correlation between both in the German economy is negative, though, implying the exchange rate strengthened when the real interest rate was in a downward trend.
It may be that Germany’s role at the center of an incomplete Capital Markets Union has skewed risks to the upside and reinforced the role of the Teutonic economy as safe haven. The Union must thus – as is – work towards a more coherent reallocation of investment within the Union, including excess capital within the EU.
Accordingly, a strengthening exchange rate has done little to counteract current account surpluses (correlation .77), perhaps because Germany has until recently reaped unexpectedly high returns to capital (see ahead).
High returns to capital and persistent capital inflows produce the puzzle that Feldstein and Horioka observed in 1980 – savings that correlate positively (.94) with investment rates.
Persistent capital inflows are likely responsible for the positive correlation between current account and productive capital through to 2016 (between .38 and .67 with a peak of .81, before lowering to -.18).
Crucially, decades of persistent capital accumulation have turned the correlation between capital accumulation and capital returns from positive (as high as .26 between 2008 and 2010) to negative (-.47 between 2016 and 2018), complacent with the long term decline of the real interest rate.
Reforms in Germany should focus on both ensuring an adequately depreciating exchange rate (somehow vindicating the claim that the Euro is too strong for Germany) that could depend on risk reduction across the Capital Markets Union and specifically to German investors; and capital replacement through accelerated amortization as announced by Minister Altmaier in January 2019 and suggested on this blog last year.
In order to discourage both ageing, unproductive capital and nominal exchange rate appreciation, Germany could also increase its capital gains tax (that currently stands at 0% except on speculative investment) or its corporate income tax.
The latter, now at 30% average, is becoming increasingly less competitive compared with other jurisdictions – and it may actually help Germany.