Saturday, March 30, 2013

30/3/2013: Euro area sovereign risk rises in March 2013


Here's an interesting bit of data (pertaining to analysts' survey): per Euromoney Country Risk survey:

"As of late March 2013, the survey indicates that 13 of the 17 single currency nations have succumbed to increased transfer risk [risk of government non-payment or non-repatriation of funds] since... two-and-a-half years ago." And the worst offenders are?.. Take a look at two charts (lower scores, higher risk):




Per definition of the transfer risk: "The risk of government non-payment/non-repatriation – a measure of the risk government policies and actions pose to financial transfers – is one of 15 indicators economists and other country risk experts are asked to evaluate each quarter. It is used to compile the country’s overall sovereign risk score, in combination with data concerning access to capital, credit ratings and debt indicators."

Friday, March 29, 2013

29/3/2013: Eurocoin signals 18th consecutive month of recession

Eurocoin leading indicator for euro area growth was out today. Key highlights:

  • Eurocoin rose to -0.12 in March 2013 from -0.2 in February 2013. 
  • Eurocoin remains below -0.03 reading attained in March 2012 and +0.57 reading for March 2011.
  • 3mo MA is now at -0.183 which gives Q1 2013 growth forecast (q/q) or 0.18% for euro area GDP.
  • This means that Eurocoin is now below zero in every month since September 2011, marking a massive 18 months in a row.
  • In previous recession of 2008-2009 Eurocoin duration below zero was 13 months, which means that the current bout of economic contraction is longer in duration than the so-called Great Recession.
  • In March 2013 Eurocoin gained some upside support solely from buoyant stock markets. 
Here are some charts:


And as usual, monetary policy charts for which analysis remains as postulated in my February post (here):



Thursday, March 28, 2013

28/3/2013: Cyprus: too-small-to-fail, too-small-to-bail



This is an unedited version of my article for Sunday Times, March 24.


This week, euro area leaders have added yet another term to the already rich vocabulary engendered by the financial crisis. If only a few days ago the world was divided into too-big-to-fail (e.g. Irish pillar banks and Spain) and too-big-to-bail (e.g. Italy) institutions and economies, today we also have too-small-to-fail and too-small-to-bail economy, Cyprus.

Worth just 0.2% of the euro area GDP, with the insolvent banking sector and the liquidity strained sovereign, Cyprus is a tiny minnow in terms of both the required external assistance and its direct impact on the euro area economy. The country overall GDP amounts to about ½ of the cost of bailing out Anglo Irish Bank, and its banking and fiscal troubles need just EUR15.8 billion of funding to plug the gap left by the EU mishandling of the Greek bailout back in 2011-2012. With the reputational costs to the euro area of letting this nation go into an unassisted default, Cyprus is simply too-small-to-fail.

Despite this, the end game now being played in Nicosia, Moscow, Frankfurt and Berlin shows that Cyprus, perhaps, is also too-small-to-bail. The problem is that granting sufficient funding to Cyprus via Troika loans risks pushing the Cypriot Government debt/GDP ratio to 170% even with the haircut on depositors. Were the EU adhere to the conditions of the bailout that also envision Cypriot banking and financial services sectors shrinking to euro area average in size, the government debt to GDP ratio can reach above 210 percent. Yet, altering the terms of the bailout to provide funds that are not debt-based, such as directly funding the banks writedowns of Greek Government bonds, risks triggering calls for similar actions across the rest of the euro area periphery. Pretty quickly, Cypriot EUR10 billion bill can swell to EUR200-250 billion call on the ECB.

These dilemmas, yet to be fully articulated by the policymakers publicly, are nonetheless informing the mess behind the recent events. In the view of euro area leadership, dealing with Cyprus either requires bankrupting its economy and its people, or risking destroying the monetary system infrastructure that rests on the ECB’s pursuit of singular, deeply flawed, yet legally unalterable mandate. A familiar conundrum that has been played out in Ireland, Greece, Portugal and Spain by the incompetent crisis management from Brussels, Frankfurt and Berlin.

Alas, what is still missing in the Cypriot Dilemma debates is the consideration of the longer-term impact of this latest iteration in the euro area crisis on broader European economy.

In this context, Cyprus is neither too-small-to-bail, nor too-small-to-fail. Instead, it is a systemically important focal point of the euro area financial crisis.

The Cypriot crisis orderly resolution requires funding from some non-debt sources to plug the gap between EUR17 billion in funds needed and EUR10 billion that can be committed in the form of loans. The EU has opted to bridge this gap with a levy on the deposits, thus triggering a wholesale expropriation of private property without any legal basis for doing so.  This expropriation, termed in the language resembling Orwell’s “1984” “an upfront one-off stability levy”, also cuts through the allegedly inviolable State Guarantee on all deposits under EUR100,000.

As the result, since last weekend all European and foreign depositors in the EU banks are no longer treated either pari passu or senior to risk investors, such as bondholders, but subordinated to them. Safety of deposits is no longer assured by the banking system or by the Sovereign guarantees. One of the cornerstones of the yet-to-be-established European Banking Union - the joint system of deposits insurance protection – is no more a credible mechanism of protection of ordinary savers.

In the short run, as highlighted in the media during the week, this means potential for bank runs in Greece (where depositors are already facing substantial potential losses through their savings in Cypriot banks and the state finances are in a much worse state than they are in Cyprus), Spain (with the Government desperate to fund its fiscal adjustments amidst rising tide of discontent with austerity measures) or even Italy (where savings in form of bank deposits are the main pillar of pensions provision for the aging population). In Cyprus itself, the debacle of the European leadership crisis management approach is now leading to the growing risk of the country being forced to exit the euro area.

In my view, these are low probability, but high impact risks that must be considered simply for the devastating effect they would have on the rest of the euro system.

Even if the above short-term nightmare scenarios do not play out, the Cypriot Dilemma is not going away.

Throughout the crisis, the EU has adopted a ‘muddle-through’ approach to dealing with the problems. This has meant that instead of using aggressive monetary policy, as the US and the UK, in addressing the crisis, the EU used debt tools to plug the financing gaps in the banking and fiscal sectors. The result of this was a dramatic uplift in overall debt burdens.  While euro area General Government deficit is expected to reach a relatively benign 2.56% in 2013 with a primary balance (excluding debt financing costs) forecast to post a surplus of 0.25%, close to the pre-crisis 2008 levels, euro area government debt is expected to rise from 70% of GDP in 2008 to 95% this year. Deficits are down, debt is up, public and private investment and deleveraging running at negative or zero rates. These dynamics clearly show the true cost of the EU leadership crisis.

In the long run, Cyprus blunder is going to yield dramatic economic and social costs.

Firstly, any resolution of the Cypriot crisis will involve unsustainable debt for the Government and the wholesale destruction of the Cypriot economy. With EU-demanded scaling back of the banking sector on the island to the ‘euro area average’, Nicosia is facing an outright contraction in the nation GDP of some 15-17% on pre-crisis levels. Second-order effects of this measure and the increase in the island corporation tax rate also demanded by Brussels will take economic losses closer to a quarter of the national income. There are no potential sources for plugging this economic hole. Even the promises of the off-shore gas reserves will not deliver economic recovery to the society with effectively no oil and gas expertise, skills or firms present in the economy.

The EU is de facto sealing the fate of one of its members as the second-class state within the Union just as it did with the rest of the ‘periphery’.

Long-term impact of debt accumulation as the sole mechanism for dealing with the crisis will also hit the entire euro area.  Per IMF relatively benign projections, euro area combined debt to GDP ratio will now exceed or equal 90% bound for at least six years in a row. This means that the euro area is facing a debt overhang crisis of the size where Government debt levels impose a long-term drag on overall economic growth. Any adverse headwinds to economic growth and fiscal performance in years to come will have to be faced without a cushion allowing for fiscal policy accommodation.

Undermining of the sovereign guarantees and depositors’ protection principles in the Cypriot case, even if reversed in the final agreement, will also have a long-term effect on euro area growth potential. With savings no longer secured from expropriation, euro area is facing long-term realignment of the household investment portfolios. This realignment will reduce bank deposits, especially the more stable termed deposits, and lower euro area assets held by the households. The end result will be higher cost of bank credit and equity in Europe, smaller supply of loanable and investable funds and, thus, lower long-term investment activity.

Violation of the property rights and trampling upon the principles of the common market in structuring of the original Cyprus ‘rescue’ plan means that overall risk-return valuations by investors will be re-adjusted to reflect the state of policymaking in Europe that puts bondholders over all other financial system participants, including, now, the depositors.

Currently, euro area economic activity and investment are funded primarily via bank credit, reliant on deposits and bank capital. Shares and equity account for around 14.3% of the total household portoflios in Europe as contrasted by 32.9% in the US. In order to rebalance the euro area investment markets away from reliance on more expensive and risk-prone bank lending, the EU must incentivize equity holdings over debt and shift more of the banks funding activity toward more stable deposits, reducing the amount of leverage allowed within the system.  Cypriot precedent makes structural change away from debt financing much harder to achieve.

Lastly, the Cypriot crisis has contributed to the continued process of deligitimisation of the EU authorities in the eyes of European people who witnessed an entirely new and ever more egregious level of the first-tier Europe (the so-called ‘core’) diktat over the social and economic policies in the peripheral state.

Prior to last week, Cyprus might have been too-small-to-fail or too-small-to-bail from Frankfurt’s or Berlin’s perspective, however the way the EU has dealt with this crisis exposes systemic flaws in the political economy of the euro area that cannot be easily repaired and will end up costing dearly to the entire EU economy.




Box-out: 
The revenue commissioners annual statistics data for 2011 throws some interesting comparisons. Back in 2010, prior to the more recent increases in income-related levies and charges, gross taxable personal income in Ireland amounted to EUR77.7 billion against the taxable corporate income of EUR70.8 billion. The amounts of income and corporate taxes paid on these were, respectively EUR9.82 billion and EUR4.25 billion, yielding effective economy-wide rates of tax of 12.6% for personal income and 6.0% for corporate tax. Thus, excluding USC, PRSI, most of Vat, and a host of other taxes and charges applicable uniquely to households, Irish Government policy is explicitly to tax personal income at an effective rate of more than twice the rate of corporate income. Of course, this disparity in taxation is inversely correlated with the disparity in representation: when was the last time you heard our leaders talk about not increasing tax burden on people as a sacrosanct principle of the state in the same way they talk about protecting our corporation tax regime?

Monday, March 25, 2013

25/3/2013: Cyprus is unique in its problem... oh, wait...

So you'd think Cyprus is the 'bad boy' in grossly-overweight-financial-services club? Oh... right:


Source

Now, wait, I am sure the Department of Spin is going to come after me pointing that 'Ireland's figures include IFSC'... my reply... so what? Cypriot figures include Sberbank & VTB... and, unlike the-best-in-the-class Ireland, Cyprus is just starting to deleverage its financial services sector.

25/3/2013: Cyprus 'deal' - notes from the impact crater


What are the true 'innovations' of the Cypriot 'bailout' deal?
  1. At this junction one must face the realisation that European 'leadership' vacuum has reached alarming proportions. Cyprus was pushed to the brink, literally hours away from ELA cut-off, with a deliberate and mechanical precision. This is hardly consistent with any spirit of subsidiarity and/or cooperation that the EU was allegedly built on. In a further affirmation of the mess that is EU policy-making, the markets must now be aware that the EU has no defined approach to dealing with debtors and creditors, nor with issues of assets or liabilities. In other words, five years into the crisis and numerous 'white papers' later, with acronym soup of various 'solutions' and new 'institutions' thicker than pasta fagioli - there is still no clarity, no legal or institutional commitment, no formula, no predictability, but rather politically-motivated swinging from one extreme (no bail-ins in Ireland) to the other (all bailed-in in Cyprus).
  2. We now have bailed in uninsured bank deposits within the so-called 'open' economy with 'common currency' and 'common market' based on rules and laws. In other words, unlike in Ireland, Portugal and Greece, the EU has crossed another line.
  3. We now have bailed in senior bank bondholders (and the sky did not fall)
  4. We now have capital controls within 'common currency' area and within the 'common market' - kind of equivalent to Louisiana declaring its dollars purely domestic to Louisiana. 
  5. Bail-ins under the Cypriot deal are non-transparent and not defined, showing that the entire package was put together is a half-brained fashion at the last minute. Surely this, if not the first but very much the most exemplary indicator of the complete mess in policymaking. It further reinforces the view of PSI measures - both in Greece and in Cyprus - as being politically motivated, rather than systemically and legally structured.
  6. The fact that the Cypriot banking system will now be completely shut out of the funding markets reinforces my view that unwinding the 'emergency' measures deployed by the ECB during the crisis will be: a) risky, b) costly and c) protracted. As the result, the monetary policy risks missing the window for optimal interest rates reaction and either over-reaching on the inflationary side or over-tightening to the detriment to future growth. either way, peripheral countries will be the likely victims.


Overall, from the EU-wide point of view, Cypriot 'deal':
  • Does not reduce the risk of contagion or re-amplification of the crisis in other peripheral states;
  • Does not create or even enable a break between sovereign and bank crises; 
  • Adds to the overall quantum of policy uncertainty; 
  • Raises even more doubts as to the functionality of the cornerstone crisis-related institutions (ESM and OMT); and
  • Acts to strengthen the hand of eurosceptic, nationalist and populist political movements and parties in the Euro area 'periphery'.


25/3/2013: Debt, Demand & Deposits: Cyprus 2013

Der Spiegel has a handy graphic detailing the extent and the depth of the Financial Services sector in Cyprus...

[link]

The above lumps together couple of things that should, really, be addressed:

  1. Cyprus' financing needs only cover banks recapitalisations to the deposits base as provided by the end-of-January 2013 figures. Since then at least EUR3-5 billion and more likely even more fled the country. And selection bias suggests that larger depositors (potentially with more political connections) were more likely to avail of 'systemic' exemptions to withdrawals in recent days.
  2. As termed deposits mature, more will leave, unless the Government imposes involuntary lock-in for depositors with termed contracts.
  3. Cyprus' financing needs above do not include non-CB and non-deposit funding for the banks that is going to mature in months to come and has to be replaced by some other source of funds (presumably we can assume that ECB / ELA will step in, but I don't see how that arrangement in the medium term can be pleasing to the ECB).
  4. The deposits above do not break out MFI deposits, corporate deposits and personal deposits. It is one thing to bail-in personal accounts and yet altogether another matter to bail-in corporations and other banks (the former are subject to more strict capital controls than the latter two).
These are material risks to the sustainability of the Cypriot 'bailout' programme.

25/3/2013: The False Vacuum of the EU: a must-read essay


On rare occasions does one come across an essay so brilliantly argued and provocative in its depth. A must-read: Nucleating the False Vacuum of the European Union

25/3/2013: Bankrupted Cyprus, aka 'The Rescue'


While European 'leaders' celebrate the breakthrough 'bailout' agreement with Cyprus, let's get back to Planet Reality, folks. The 'deal' is based on a EUR10bn loan to the Cypriot Government for which the taxpayers will be on the hook.

EUR10bn = 56.2% of the country 2013 forecast GDP.

And now, let's begin counting the proverbial chickens:

  1. IMF forecast for GDP - used above - is based on nominal GDP growth over the fiscal year 2013 of 0.33%. Even by IMF 'rosy' standards this is way off the mark, as other (EU Commission and Cypriot own) forecasts envisioned GDP contracting between 0.5% and 1.3% in 2013.
  2. IMF forecast is based on pre-bailout assumptions with the banking sector returns to the economy being at the levels consistent with full functioning of the Cypriot financial services sector.
  3. Even outside the above points, IMF forecast through 2017 saw Government debt/GDP ratio in Cyprus rising to 106.11%, prior to the current 'deal' on foot of forecast GDP growth of 2.87% per annum on average between 2013 and 2017.
Now, with the deal:
  1. Shrinkage of the financial services sector will be immediate and deep;
  2. Deficit financing of any capital investment by the Cypriot Government will cease;
  3. New debt is going to be loaded onto the country;
  4. Reduced savings and exits by larger depositors will mean reduced revenues for the economy, etc
Much of this was outlined in my previous post on debt sustainability in Cyprus (http://trueeconomics.blogspot.ie/2013/03/2432013-are-cypriot-debt-dynamics-worse.html)

Now, let's do simple exercise. Add EUR10bn to Cypriot debt pile and get scenario of Cyprus (post-crisis with no growth effects).

Then, adjust GDP growth from 2013 through 2017 to yield average rate of economic growth of -0.18% annually (note, this is much more benign than Greek forecasts for the first 5 years of the crisis which are equal to -2.94% annually on average). This yields scenario of Cyprus (post-crisis with growth effects).

The above two scenarios are compared in the chart below against Greek forecasts by the IMF and the pre-'bailout' forecast by the IMF for Cyprus:


This is what the EU leadership is currently celebrating - a wholesale, outright bankrupting of the entire country. Well done, lads!

Sunday, March 24, 2013

24/3/2013: Few Cypriot Myths & Few Billions in Losses


Ever wondered why would the IMF (and reportedly the EU Commission) reject the proposed (Plan B) Cypriot Government raid on state pensions funds? Oh... ok... IMF review from November 2011:
Naughty, naughty little Cyprus...

And the very same IMF note also sheds some light on those 'oligarchs' deposits that are so vast, the entire EU is apparently chocking on chicken breasts at Herman von Frompuy's dinners:

"First, non-resident deposits (NRD) in Cypriot banks (excluding deposits raised  abroad by foreign affiliates) are €23 billion (125 percent of GDP), most of which are  short-term at low interest rates [note: ECB official data does not exclude foreign affiliates deposits, which are normally out of touch in levy imposition. Also note: much of bulls**t about Russian oligarchs deposits was about high interest rates allegedly collected by them on Cyprus deposits. Guess that wasn't really the case as chart below confirms: deposit rates decline sharply by nationality grouping for both corporates and individuals... so who was exactly earning 'high returns' on Cypriot deposits? oh, well... Cypriots...].


"These could prove unstable in the event of  further confidence shocks. [In other words, Cyprus requires very stringent capital controls if it is to avoid instantaneous bankruptcy even with ELA continuing]

"This risk is partly mitigated by the 70 percent liquid asset requirement against the €12 billion in NRD in foreign currency), and the 20 percent requirement for the €11 billion in euro-denominated NRD). [Wow, so apparently 'oligarchs' deposits carry massive safety cushions, whilst 'ordinary' depositors are not...]

"Second, €17 billion in deposits collected in the Greek branches of the three largest Cypriot-owned banks could be subject to outflows in response to difficult conditions in Greece. Outflows in the first half of 2011 were close to €3 billion (nearly 15 percent of the total), although a portion of these returned to the Cypriot parents as NRD. [Now, there was more of Greek money than 'oligarchs'?]

Now, couple more revealing charts:

Clearly, structuring PSI the EU authorities & IMF knew the above factoid, right? Just as they knew the following (which clearly highlights the fact that any substantial hit on Cypriot banks would have immediately spelled insolvency of the entire economy):


24/3/2013: Irish GDP & GNP Growth 2007-2012


Five charts summarising Irish GDP and GNP dynamics in 2007-2012 period. The first set is of 4 charts plotting various measures of GDP and GNP in constant and current prices in terms of year-on-year changes:




In all of the above, I show two 'trend' figures: the 2% annual real growth trend as a long-term sustainability level of growth and the within-crisis (period of contracting GDP or GNP) and out-of-crisis (period of sustained positive growth) averages. These two sets of lines provide a marker for assessing as to whether or not the economy is currently running at the growth rates above or below trend.

And to summarise the state of play today:


Thus, after almost two years of 'turned corners' and 'recoveries'

  • Ireland's GDP and GNP are still massively below the pre-crisis levels of 2007. 
  • Ireland's GDP growth in constant and current prices is running below trend levels in Q3 and Q4 2012
  • Ireland's GDP growth shorter-term trend (post-crisis) is below the long-term trend levels, which is simply not consistent with normal U-shaped recovery
  • Ireland's GNP growth is running at above trend levels for 3 quarters now in constant prices terms, and close to the trend levels for current prices terms
  • By all measures (across current and constant prices) both GDP and GNP are posting markedly slower rates of growth in Q4 2012 compared to previous quarters.

24/3/2013: Are Cypriot Debt Dynamics Worse than Greek?


A nice chart via Pictet (link) on the size of the banking sector in Cyprus and its dynamics since 2006:


Now, do notice, reducing the above to 300-330% of GDP as required by the Troika in Plan A (and so far not disputed by the Cypriot Government) will imply lowering liabilities by EUR66.6 billion. Overall, banking margins in Cyprus are running at around 1.2% net of funding costs, we can roughly raise that to double to include wages and other costs spillovers, which implies that EUR66.6bn deleveraging of liabilities should take out of the Cypriot GDP somewhere around EUR1.5bn annually or 9% of GDP. Auxilliary services, e.g. legal, accounting and associated expatriate community benefits that arise in relation to international banking services being offered from Cyprus will also have to be scaled back. Assuming that these account for 50% of the margin returns to the economy, overall hit on Cypriot economy from deleveraging can be closer to EUR2.2bn annually or 12.7% of GDP.

Now, consider the loans package of EUR10 billion that Cyprus is set to receive if it manages to close the EUR5.8 billion gap. Absent banking sector deleveraging, this will push Cypriot Government debt/GDP ratio to over 140% of GDP. However, with reduction in GDP, the debt/GDP ratio (assuming to avoid timing considerations assumptions a one-off hit to GDP) will rise to 161%.

Now, recall that IMF and Troika 'sustainability' bound for debt/GDP ratio used to be 120%. We are now clearly beyond that absolutely abstract number even without the banking sector deleveraging. And let's take the path of debt/GDP ratio forecast by the IMF which would have seen - absent the 'rescue' package - debt/GDP ratio in Cyprus rising 106.1% of GDP by 2017. With the 'rescue' package and banking sector deleveraging, this can now be expected to rise to 174% of GDP in 2017 against Greek debt of 153% of GDP.

In short, the EU 'rescue' is going to simply wipe Cyprus off the map in economic terms. All debt 'sustainability' consideration are now out of the window.

Here's the chart:

Of course, the above analysis is crude as it ignores:

  1. Potential positive effects of replacement activity and the fabled 'gas revenues' etc - which presumably were already reflected in GDP growth figures in the IMF forecasts
  2. Potential negative effects of tourism, real estate sales and other services declines due to the reduced activity in the banking sector, which can raise the above adverse impact of the banking sector deleveraging to 15% of GDP. Corporation tax increases can yield further losses.
  3. Timing issues for the deleveraging which is not expected to happen overnight.
Nonetheless, all in, there have to be some severe doubts as to viability of the Cypriot debt path under the Troika Plan A, let alone under the Cypriot Plan B.

Saturday, March 23, 2013

23/3/2013: And the Strong Are Yet to Become Strong: German Debt Sustainability


A very interesting paper by Burret, Heiko T, Feld, Lars P. and Koehler, Ekkehard A., titled "Sustainability of German Fiscal Policy and Public Debt: Historical and Time Series Evidence for the Period 1850-2010" (February 28, 2013). CESifo Working Paper Series No. 4135. Available at SSRN: http://ssrn.com/abstract=2228623

Here's from the abstract:

"In the last decades, the majority of OECD countries has experienced a continuous increase in public debt. The European debt crisis has prompted a fundamental re‐evaluation of public debt sustainability and the looming threat of sovereign debt default. Due to a multitude of large scale events in its past, Germany is far from being an exception: In fact, Germany’s peacetime debt‐to‐GDP (Gross Domestic Product) ratio has never been higher."

And a chart:
[Click on the chart to enlarge]

On methodology: "In this paper, we analyse the sustainability of Germany’s public finances against the standard theoretical back‐ground using a unique database, retrieved from multiple sources covering the period from 1850 to 2010. Multiple currency crises and external events offer anecdotal evidence, contradicting the historical perception of Germany as the poster child of European public finance. Given these corresponding breaks in time series, the empirical analysis is conducted for the sub‐periods 1872‐1913 and 1950‐2010. In addition to an anecdotal historical analysis, we conduct formal tests on fiscal sustainability, including tests on stationarity and cointegration and the estimation of Vector Autoregression (VAR) and Vector Error Correction Models (VECM)."

And the punchline: "While we cannot reject the hypothesis that fiscal policy was sustainable in the period before the First World War, the tests allow for a rejection of the hypothesis of fiscal sustainability for the period from 1950 to 2010. This evidence leads to the conclusion that Germany’s public debt is in dire need of consolidation. Albeit a much needed reform, the incompleteness of the German debt brake will have to be addressed in the coming years, in order to ensure that fiscal consolidation actually takes place"

[Skip below to see the more extensive summary of conclusions]

And the recent experience? Here are the economic fundamentals pertaining to the cost of capital and growth:





A descriptive table of stats summarising the overall performance:


And public expenditure levels (alongside revenue and balances)


So the results after skipping through loads of rigorous tests are:

"After the experience of the two World Wars, the German population is quickly alarmed when debt levels appear to be rising to unsustainable levels. This holds particularly for recent years, as Germany’s debt‐to‐GDP ratio has never been higher in peacetime than today...

In this paper, we analyse sustainability of German public finances from 1872 to 2010. Given the breaks in the data series, in particular those induced by the two World Wars, the main analysis is conducted for the sub‐periods 1872‐1913 and 1950‐2010. …While we cannot reject the hypothesis that fiscal policy was sustainable in the period before the First World War, this only holds if we do not allow for trends in the cointegration relation. The hypothesis of fiscal sustainability for the years 1950 to 2010, on the other hand, must be rejected. After the Second World War, German public finances have become unsustainable.

This evidence leads to the conclusion that public finances in Germany are in dire need of consolidation. In fact, the introduction of the debt brake in the year 2009 is a much needed reaction to this development. Although such fiscal rules always have their loopholes and are necessarily incomplete, they usually have some success in restricting public deficits and debt (Feld and Kirchgässner 2008, Feld and Baskaran 2010). The incompleteness of the German debt brake will have to be addressed in the coming years in order to ensure that fiscal consolidation actually takes place. One shortcoming of the new debt rule requires wider ranging reform, however: The Länder (including their local jurisdic‐tions) not only have huge consolidation requirements, they also do not have the tax autonomy to balance the spending demands on their budgets. The next major reform of the German fiscal constitution should thus allow for more tax autonomy at the sub‐federal level."