Saturday, 30 June 2012

Sweden - a cherry on top

The final chapter of the cross-country coverage of successful (and not so successful) recoveries ends this month with Sweden, the star of the recovery. 

Sweden is often hailed by Keynesists and many alike as a "poster child" of a welfare state that succeeds in creating an equal society while maintaining macroeconomic stability. It is very often promoted as the model upon which the US and the UK should organize their economies.  

But Sweden today is far from it. It has moved from a focus on equality to a focus on dynamic growth. It is persistently ranked among the most free nations in the world (along with other Scandinavian countries). Particularly in the last 20 years, Sweden became the perfect example of a state with high levels of individual and economic freedom. It has an institutional system which clearly defines rules in a society but which doesn't discourage innovation or incentives to work and create value. 

Its history of strong unions, high taxes, high government spending and high inflation has put too much pressure on the country which culminated in its 1991 crisis, following a housing bubble burst and a credit crunch. The systemic instabilities accumulated over the years became obvious and reforms needed to be done. 

Andres Borg lecture

The best person to speak of this is the Swedish finance minister, Andres Borg, several years in a row voted as the best finance minister in Europe by the Financial Times. He did a lecture in April this year in Washington at the Peterson Institute (find the transcript here). I strongly encourage you to read the entire text or at least see his presentation

Figure 1: Sweden and the crisis. Source: Andres Borg, Lessons
from Sweden on the Global Financial Crisis
. April 24, 2012.   
He pointed out that Sweden “weathered the current crisis relatively well” compared to the rest of Europe. The reason for this were the lessons they learned in the 1990s and the structural reforms they made back then which made them much more resilient to future demand shocks. 

It is hardly a surprise that Germany and Sweden were the two economies that came strongest out of the crisis. The Swedish structural reform, as told by Mr. Borg was very similar to what Germany did in its Agenda 2010. The structural reforms which I will touch upon in the text are the reasons why both Germany and Sweden maintained the competitiveness of their labour force. 

Figure 2: Competitiveness crisis. Source: Andres Borg,
Lessons from Sweden on the Global Financial Crisis.
April 24, 2012
It wasn’t the euro’s fault that Germany benefited (after all Sweden doesn’t have the euro); it was the fault of the PIGS which failed to reform their labour markets. Their governments lacked the courage to fight the unions and other blocking interest groups and failed to reform their entitlements and transfer systems. Just look at the difference between unit labour costs between Sweden and Greece (or Italy, or Spain) in 2007. It amounts to almost 70 basis points. Borg also points out how Italy for example had a negative total factor productivity since 1995 (-0.5), meaning that nothing justified these rising labour costs, apart from union pressures. 

What Sweden did in the 90-ies 

The starting point was as hard as it is in peripheral Eurozone now. Lagging growth, low productivity, highly regulated markets, huge barriers to entry for entrepreneurs, high marginal tax rates, political battles between unions and businesses (Borg points to the proposals of unions to take over controlling stocks from companies and for themselves to become owners – does this ring a bell?), inflation-driven wages set by the public sector (which was a big deal with a 10% average inflation), entrepreneurs leaving the country, and finally large deficits and rising debt levels. This sounds like a description of a typical peripheral Eurozone country today. But Sweden was determined to reform: 
“Since then, there has been a period of two decades of consistent...and broad-based reforms. While keeping a very well-functioning welfare state, we have been able to transform the labor market, so it is much more flexible. We have increased production [and] productivity in the industry substantially...We have cut taxes. We have restored our public finances...Last year we repaid the last of our current account debt that we built up over the last two decades.” 
All this wouldn’t have been possible without a broad-based political support. They made a consolidation close to 15% of GDP, using both taxes and expenditures, and for that a social cohesion and a broad coalition are a necessity. 
“My experience from Sweden, from Latvia, from Ireland and from other countries that I’ve been involved in..., I would argue that the combination of broad-based [political support] and social cohesion is very, very important. Equally important and even more so in the current situation are the structural reforms to be pro-growth. To be able to grow out the crisis, you have to deal with the fiscal side but you must also deal with the structural side, if this is going to be long-term sustained, because....growth [means] creating the resources.” 
His point from this is that there is no quick fix with structural reforms, that a broad-based support in the electorate is needed to undergo through this, and most importantly that there is no one-size-fits-all solution: 
“Ours was balanced between revenues and expenditure cuts. You must remember that we are coming from a very, very high tax rate to begin with. So you cannot say that there is a one size fits all [approach]. One has to go through the details of the specific country and try to balance the reform program. But in general terms, a European situation where public expenditures are in the neighbourhood of 45-50% of GDP, it is quite clear that most of the consolidation should be taken on the expenditure side, and if you’re in a situation where the tax rates are substantially lower, the balance could be in a different manner. For example, it was more natural for Latvia to do tax increases than it was for Sweden, given that they had very low taxes to start with.”
The reforms
"We’ve done a major tax reform...We have cut back the taxes on income, particularly earned income...The overall tax level in Sweden is still very close to slightly below 50% and so we still have a very high tax level, but that is based primarily on the ATs and social fees, rather than income taxes. The role for income taxes have been quite dramatically changed in the composition of taxes...The actual tax for a blue-collar job working half time...would not be higher than 10-15%." 
"There was a very, very broad based deregulation. Today, if you go to the OECD “Going for growth” report, they are looking at 8 different sectors; 6 out of those we have a regulatory burden less than the US. So we have gone from being one of the heaviest regulated economies of Europe to one of the least regulated when it comes to product markets." 
"There were other structural reforms. The pension reform [increasing the retirement age, lowering the indexation for the pension system]...European Union membership has lowered the tariffs and opened our economy even further. We are today well above 50% in exports. We have changed the central bank system to independent central bank, the wage setting system has been reformed, and all of these reforms have strengthened each other. There is a new sense among the Swedish unions that we are now setting wages so that the competitive sector starts first. That becomes a norm for the rest of the wage negotiation."
The health reform was also a major success, where Sweden is spending half of what the US is spending and is offering equal or in some cases even better health care (based on diagnoses and the frequency of certain illnesses). They have imposed a balanced budget requirement in health care, changed incentives in patient care, changed the prescription system and introduced competition particularly in the primary care sector. 

A model to follow 

Finally, going through all these structural reforms, it’s time to say something about why Sweden was able to close the output gap in the 90s so fast. If anyone want’s proof that austerity works (real austerity that is, – one based on real reforms and adjustments, and on decreasing expenditures, while not increasing the overall tax burden), look no further than Sweden: 

Figure 3: Austerity worked?. Source: Andres Borg, Lessons
from Sweden on the Global Financial Crisis
. April 24, 2012
This is now about how big the optimal government should be (again, every country is different in that perspective), but it’s clear why Swedish consolidation worked. 

The biggest success in all of this is that Sweden has switched from an equal and non-dynamic society, to a society that is both equal and dynamic – in my opinion the best possible scenario. But it had the courage to reform no matter how painful it initially was. The United States, not only Europe, should learn from this. 

Wednesday, 27 June 2012

What Germany wants?

Europe is once again on the edge of the cliff. They’ve been in this situation so many times since August last year that the entire story is becoming ridiculous. Spain is out of money to finance itself and its banks; Greece, even though the pro-bailout coalition was formed, remains Europe’s weakest point; Italy is in direct threat of a Spanish default (the situation was reversed 6 months ago, when Italy was the one who threatened to pull Spain along with it), and yet the blame again falls on Germany. Some economists even claim that Germany is being the biggest threat to the survival of the euro and that its forced austerity and unwillingness to step up and offer more bailouts and more support for the Union, are the main reasons behind Europe’s slow (and virtually non-existent) recovery. 

Even among the Germans themselves, notable economists argue over whether or not Germany should offer more bailouts and consequentially bear more risk (I recommend an interesting debate on this issue, started after Prof. Hans-Werner Sinn, President of the Ifo Institute, University of Munich, wrote an op-ed in the NYT on “Why Germany is Balking on a Bailout”, to which Prof. Albrecht Ritschl of LSE replied on the Economist’s Free Exchange blog. The debate continued further - here and here. I encourage you to read it). 

But Merkel stands strong against her critics, domestic and (particularly) foreign. In her latest speech she rejected any possibility of a Eurobond, and pointed out how there is no easy solution to the debt crisis (see here, here, and here). 

From her, or in general, the German perspective all this hardly looks immoral or threatening to the survival of the Union and its currency. More than a decade ago Germany had very similar problems of an inefficient and protected labour market, falling productivity, and a congested business sector. But they overcame them more than successfully and have turned into Europe’s genuine economic powerhouse. The conventional wisdom of today says that the euro gave Germany an unfair advantage over the rest of Europe. Apparently, the capital that flew across borders to help finance Greek and Italian government and personal consumption, Spanish and Irish housing bubbles, and increased Europe’s systemic risk, benefited Germany in some way. Furthermore, the common currency made it easier for Germany to export goods to the rest of Europe, thus increasing the gap between Germany and the rest of the Eurozone. Germany benefited on everyone else’s loss, or something like that. 

While it is true that German exports grew rapidly sustaining its CA surplus during the past decade, the huge difference between Germany and the rest of Europe can hardly be explained by exports and benefits from the exchange rate. The difference was much more systemic. And it is these systemic and institutional differences that Germany is now trying to fix and close. 

German structural reform 

Even after the adjustment and convergence of East Germany, the most important long-run structural reform was rather recent. It started in 2003 under the name “Agenda 2010, and its plan was to reform the business environment in Germany. Its main goal was to reforming the social security system in order to incentivise more people to work, not live off the welfare state (this included cutting the unemployment benefits, cutting income taxes, and cutting medical treatment benefits). It was also aimed at restoring businesses growth and reducing their regulatory burden. Surprisingly or not, it was initiated by a social democrat government, under the Chancellor Gerhard Schroeder. 

Donald Luskin and Lorcan Roche Kelly in the WSJ recognize the importance of this reform: 
“The centerpiece were labor-market reforms...The power of unions and craft guilds was curtailed, making it easier for unskilled youth to enter the job market and easier for employers to hire and fire at will. Germany's lavish unemployment benefits were sharply cut back. An unemployed person in social-democratic Germany today can draw benefits for only about half as long as his counterpart in capitalist America. 

The immediate reaction was a brief rise in unemployment, as German business was allowed for the first time to optimize its labor force. And there was a backlash by powerful union and guild interests, costing Mr. Schroeder his bid for re-election. But Germany was transformed.” 
The full effects of the reform weren’t visible until 2005 when unemployment started falling and businesses started growing. This is best shown in Germany’s business freedom index which went up by almost 20 points as a result of the reform: 

Source: Heritage Index of Economic Freedom, Germany.
Note: the black line represents the World average scores.
Naturally the measures were unpopular at first. They actually caused  Schroeder to lose the elections (in 2005 it was a grand coalition of the two biggest parties – SPD and CDU, with Merkel becoming the Chancellor. That already signalled the political end of Schroeder, with elections in 2009 only strengthening Merkel’s position, even though she still needed a coalition – this time, with the liberal FDP). 

The ultimate cost of unpopular measures is very often an election loss to the governing party. But the situation in Europe now made voters prepared for a tough time and painful reforms. The interest groups who will be hit mostly by the reforms are resilient in their fight against them. And this is creating even more political pressure. But so far, all the governments in the periphery won the elections (or were appointed – Monti) in order to do the reforms. The democratic majority accepted that reforms are a must. 

So what does Germany really want for Europe? It wants it to go through its own supply side revolution. Just like they did in the 90s and the 2000s, which created a basis upon which they built their export-led growth in the later part of the 2000s (see first graph here). They had to have something to export in order to exploit the favourable currency, didn’t they? 

The bottom line is that Germany wants Europe to create its own supply-side revolution. That's why the current measures are necessary and that's why I strongly support Angela Merkel and her government. No one ever said it was going to be easy, but the periphery has postponed it long enough.

Monday, 25 June 2012

Graphs (images) of the week: Separated by a border

Usually comparing countries or regions requires looking at GDP growth data, GDP per capita, living standards, relative income or even the happiness index. But even a simple areal glimpse at the borders separating two systems can be more than enough to conclude which country is richer, healthier, more educated and on average more prosperous. It tells us that the causes of between-country differences have to be more than just climate, geography, culture or mentality. Particularly when the same nation is separated by nothing more than a border depicting the striking differences in political systems of the two countries (a classical example here are East and West Germany, but an equally good example can be North or South Korea). 

As a result I found that the following set of images paint a better picture on between-country differences than any existing data on global inequality. 

The first one is from a blog post I encountered on the Why Nations Fail blog, comparing the cities of Gisenyi, Rwanda and Goma, DR Congo. One would be surprised to learn that the right hand, decent looking side of the city is in Rwanda, while the left hand, chaotic side is in DR Congo. After all, Rwanda experienced a horrifying genocide in 1994. But both were hurt during the Great War of Africa, 1998 - 2003, fought mostly on Congo's territory. 
"The Rwandan side is very orderly. The streets are clean even if not all tarmacked. The drivers of motor cycle taxis...wear a helmet and carry spare ones for their passengers. Drivers drive beneath the speed limit and policemen do not ask for bribes. There is electricity and running water...But Goma is like a different planet. As the next picture shows...the chaos on the DRC side of the border is readily evident. To get into Goma you have to pay “du sucree” the Congolese phrase for a bribe and you have to pay more to get out. The town has a faded grandeur, but electricity, water and basic services are erratic to non-existent."

Neither of the two countries can serve as an example of a good institutional system, obviously. However, one seems to be doing better than the other. In their blog post Acemoglu and Robinson explain how this is primarily due to centralization:
"...political centralization is key not only for the development of inclusive institutions but for even the most basic form of growth under extractive institutions, and the orderliness and the economic revival in Rwanda since 1994 are both due to this type of growth under extractive institutions. But Rwanda also illustrates that political centralization can also have perverse consequences, particularly when the state turns genocidal."
In Africa, centralization in order to achieve and maintain political stability is the starting point of moving forward. Those African countries that lack basic centralization can turn out to be even poorer and more disorganized than countries like Rwanda (whose GDP p/c PPP is a mere $1,300). 

This encouraged me to think further and I immediately remembered an excellent picture from National Geographic on the deforestation in Haiti as compared to Dominican Republic. Property rights tend to be much better defined in the Dominican Republic, obviously. Dominican Republic is hardly a paradise in private property ownership, but their GDP p/c is 9 times of its neighbour sharing the same island. And it shows

Then came the most famous (and most obvious) example – Koreas in the dark. After 10 o'clock, it’s bed time for North Koreans. The difference? One is a highly extractive communist dictatorship with no personal freedom whatsoever, while the other is a democracy ranking high in both economic and individual freedom for over 6 decades. Again, the results are obvious. 

And finally, Nogales, the city depicted in the beginning of the book “Why Nations Fail”. Take a look at the differences in the US part and the Mexian part now and 110 years ago. 

The Mexican part has hardly changed – we see more or less the same buildings still holding on, with only a bit more houses built in the landscape and one skyscraper. I assume it’s a residential skyscraper. 

On the other hand, the US part has changed significantly. Not a single building is the same as before, a highway was built coming in from the north, and the whole town seems much higher. 

Again, one can hardly call Nogales, AZ the prime example of US success. The city is nothing special. But even then one cannot shake the fact that people living on this side of the border are much better off than the people on the other side. On average, of course. 

Also, one other important thing has changed – just look at the size of the border. There wasn't even a fence before. Now it’s a 10-foot wall. That too can say a lot about the development paths of one country as opposed to the other.

Friday, 22 June 2012

The Baltic lessons

The monthly cross-country overview continues with examples from the Baltic and their lessons for Europe and its endless recovery. 

Source: Trading Economics
In his latest article, Olivier Blanchard, chief economist of the IMF, pinpoints the success story of Latvia, a country that experienced a typical boom-bust cycle. After a strong, Chinese-style growth in the decade preceding the crisis followed by a sharp increase of its current account deficit (>20% of GDP - see figure), in 2008 due to mostly outside contagion came a slump and a 10% decrease of GDP (in 2009), huge fiscal deficit, capital flight and surging unemployment (from 5.4% at its 2008 bottom to 20.7% at its peak in 2010). It’s striking how similar all these European cases are – from Iceland to Spain and Ireland, which all sustained a typical asset price boom, to Greece, Italy or Portugal whose governments based their electoral winning welfare state policies on cheep borrowing conditions – they all have one similar condition: large current account deficits based on an unsustainable public finance model (whether due to an asset price boom, or just plain corruption and vote-buying).

But they all underwent different recovery paths, some more successful (the Baltic countries), some less (Iceland), and some outright terrible (PIIGS). And while Iceland’s recovery was based on depreciation of its currency, letting the banks default and export-led growth supported by a stronger institutional environment than in the rest of Europe, the recovery of Latvia appears to be a much more sustainable path (even though it didn't seem like it 2 years ago), especially applicable to countries with similar conditions (like Greece, Hungary, Croatia or any number of Eastern European countries). 

It didn't start well at all for Latvia. If you see the graph above, after their adjustment started, GDP plummeted in 2010. It was painful. Unemployment surged, people emigrated massively and capital flew from the country. However, the peg remained fixed, and Latvia avoided the Argentine scenario (hint: Corralito). 

And here’s why it needed to stay fixed (with even Blanchard being rather sceptical at this strategy at first): 
"The treatment seemed straightforward: a sharp nominal depreciation, together with a steady fiscal consolidation. The Latvian government however, wanted to keep its currency peg, partly because of a commitment to eventually enter the euro, partly because of the fear of immediate balance sheet effects of devaluation on domestic loans, 90% of them denominated in euros. And it believed that credibility required strong frontloading of the fiscal adjustment." Blanchard, "Lessons from Latvia", June 11th 2012
So, depreciation was not an option due to serious problems it might have caused to all those with loans outstanding in foreign currency. As I've emphasized before, the same effect would have caught Greece if it suddenly returns to the Drachma. Croatia has the same euro-denominated monetary system. With countries like Latvia or Croatia, maintaining a fixed peg is a must, or else financial stability is seriously threatened. 

Blanchard further stresses why this strategy has succeeded, amid the initial difficulties:
"1. The adjustment was preceded by an unusually strong boom, so there was wide acceptance on the part of people that part of the downward adjustment was a return to normal....

2. There was support for fiscal consolidation, and the acceptance of pain. Parties which argue for stronger fiscal austerity often did better than the others at the polls....historical reasons, including the painful transition from central planning in the 1990s, surely played an important role. The Latvians could take the pain.
(I think we already established that the Greeks and other peripheral nations can take the pain - they've put up with it for 5 years now, and due to the incompetence of their leaders to deliver the necessary reforms, it looks like they will have to put up with it even longer - unfortunately)
3. Wages were flexible, at least relative to the generic European labor market. The initial adjustment came with a dramatic reduction in public sector wages, and thus a direct improvement in the fiscal position. Together with unemployment, lower public sector wages put pressure on private sector wages to adjust...however...private sector wages, which are the wages which matter for competitiveness, have adjusted much less than public sector wages. Indeed, I worry that nominal wages have started to increase, while more adjustment still has to come to maintain current account balance as output recovers. 
4. There was...substantial room for productivity increases. Latvia has income per capita of half the European Union average. Being far behind the technology frontier, it has a lot of room for catch up.
(Again, both applicable to PIIGS)
5. Latvia is a small, open economy—although less so than its Baltic neighbors. With exports around 50% of GDP, improvements in competitiveness can have large effects on both imports and exports, and in turn on GDP.

6. Public debt was very low to start, less than 10% of GDP. Even today, public debt remains around 40% of GDP. This more or less eliminated foreign investors’ worries about default on sovereign debt, and allowed for a quicker return of Latvia to international financial markets.
(Ok, so this is the only advantage Latvia had over the PIIGS. But I doubt it's a crucial difference, as reforms and willingness to adjust make investors more optimistic on the final outcome - besides, every one of the PIIGS had a much better starting point in the eyes of foreign investors than Latvia ever did, despite its low debts). 
7. The Latvian financial system was largely composed of relatively friendly foreign banks...or friendly but weak domestic banks... the Swedish banks recapitalized their banks and maintained their credit lines to the Latvian subsidiaries, reducing the intensity of the sudden stop and of the credit squeeze." Blanchard, "Lessons from Latvia", June 11th 2012
(I find this argument rather confusing, mainly due to the interpretation of the word "friendly" - Swedish banks weren't "friendly" to Latvia - they were "friendly" to themselves in order to prevent massive losses - something German or French banks failed to do so effectively).

Turning to Estonia

Source: Trading Economics
Another similar success story that gained even more attention in Western media was Estonia. It was equally struck by the crisis as Latvia, with and equally impressive pre-crisis growth funded on a large CA deficit. Once the crisis hit, things went down pretty bad - rapid fall in output, massive rise in unemployment (almost similar to Latvia - from 4% to 20.1%), stock market slump, capital flights, etc. And the response - austerity - all the way! They started with the labour market; slashing public sector wages, raising the retirement age, reducing job protection - all painful reforms which led to more job losses initially, but in the end all necessary to address the competitiveness issue. The second step was on businesses. Reducing and simplifying taxes, removing regulatory burdens, creating a favorable business environment - these are the sort of things that will attract foreign investors, not ECB cash. Innovation, start-ups and technology were at the center of their recovery. In the end, Estonia even joined the euro on 1st Jan 2011 - so, again, no external devaluation, no easy short-term solution, but rather internal devaluation, painful in the short run, but much better in the long run. And for those saying that in the long run we're all dead - well, Estonia has already reached it's long run, and is quite enjoying it. 

Critics say that this was too drastic. But isn't the 5 year torture of peripheral Eurozone drastic as well? Which is more moral in these cases? To suffer for two years like Latvia, Estonia or Iceland or to suffer for 5 years without any positive sign on the horizon for the upcoming 5 years either? 

Finally, in comparing the cases of both Latvia and Estonia with Iceland or Argentina, one can once again see that currency depreciation isn't always the solution. And from the looks of it, Estonia and Latvia picked a much better path to recovery - no one ever said it would be easy, but it sure doesn't have to last long. Europe, take note. 

Monday, 18 June 2012

What’s behind Iceland’s rapid recovery?

Source: Trading Economics
Iceland’s crisis and recession went down much harder than in most European countries (well, except Greece). Cheep credit and (unobserved) accumulation of systemic risk in the early 2000s led to a substantial distortion of signals sent to the real economy. They had a huge exposure to the US financial system with assets tied to many US subprime mortgage-based securities. The post-Lehman collapse followed by the subsequent bankruptcy of Iceland’s overleveraged banks was hardly a surprise. The state interfered by protecting domestic depositors, not allowing the taxpayers to take the burden of a bailout. But this didn't stop Iceland from leading a first case of a trial against a PM for mishandling of the crisis (accused for "negligence"). Mr Haarde was later found innocent by the countries’ courts, but it was nonetheless a strong message sent from Iceland on the seriousness of what happened back in those years. The GDP fell during his prime-ministership for 10% in 2009 with a sevenfold increase in unemployment (see figure). Three biggest banks declared default on more than $85bn of debt which led to a decline of the currency and the economy. 

He’s not the only one on trial though – the trial on bankers seems much more important to the nation. This is perceived to be the quickest way for the people to forget all the misery that happened back then. And as long as there is someone to blame, the voters will always be satisfied. In fact, there are even claims that the trials and the determination of the new government to criminally prosecute all those deemed “responsible” for the crisis could have contributed to the rise in consumer confidence across the country.

What happened?

The banks were expanding their asset size built on huge leverage. They were borrowing from foreign lenders and used this money to finance their asset purchases (mostly US MBSs). The increase of prices in the property market (another bubble very similar to Ireland or Spain) induced households to borrow even more. Bank debt and household debt plummeted, reaching levels of up to 6 times of Iceland’s GDP. Households acquired debts of more than 200% of their disposable income. Iceland therefore wasn't a story of a government running high debts and being fiscally irresponsible, but of the private sector running high debts and banks getting over-leveraged and overexposed to risk (again, similar to Spain or Ireland). The problem with the government was corruption and aligning of the in-office party with the banks that eventually went under (that's why the trials were necessary - see more here). 

Even when the interest rates started rising, the growing bubble couldn’t be sustained as foreign investors seized the opportunity of an attractive investment in Iceland’s government bonds, supported by a strong currency (which had to be sustained since the domestic households were borrowing in foreign denominated currencies with low initial interest rates – a strong krona ensured that these loan repayments stayed cheep). 

As a consequence Iceland experienced high current account deficits throughout the decade (see figure above). This implied, just as in the peripheral eurozone scenario, that a lot of foreign capital was entering the country. When assessing the CA sustainability, it is important to see where the inflows ended up. In the Icelandic case, as shown above, it mainly fueled the property and asset bubbles. 

Once outside contagion took place (Lehman bankruptcy), it resulted in a rapid decrease of asset prices meaning that both banks and households found themselves on the brink of bankruptcy. So essentially, it was the same story as with peripheral eurozone

Recovery and deleveraging 

But Iceland reacted differently. Instead of bank bailouts (like in the US, UK, Ireland, etc.), it opted for defaults of the banks. It only protected the domestic bank account holders. This enraged all foreign depositors (particularly the British) even though the new government pledged to return its debts gradually.

The next two steps Iceland undertook is the focus of many in the economic profession as the reason of why Iceland succeeded - currency devaluation and capital controls. The krona devalued 50% against the dollar making Iceland's exports (fish) and tourism cheaper and more attractive. It was these two industries that flourished and mostly helped form the increasing growth Iceland is experiencing for 6 quarters now

Ever since the crash Iceland has worked hard in restoring macroeconomic stability and rebuilding its financial sector. They received help from the IMF ($10bn) and have pledged to a 3-year restructuring programme. After three years we can surly say that the programme was a success leading to a 2.5% GDP growth following last years’ 2.5% growth. The NGDP is still below its trend line, but it is on a good path to recovering. 

However, the most important thing proved out to be that Iceland allowed its banking sector to collapse, not socializing its losses. The government did protect the domestic assets, but foreign creditors were the ones who took the majority of the loss. The government is now looking to pay them back, but at a slow pace. The UK and the Netherlands were most struck by this decision, since these governments stepped in to repay the losses to their own people who lost out in Icelandic bank accounts. The Icelandic government still needs to repay around $4bn to them and all its foreign creditors. 

Iceland isn't out of the gutter quite yet, as its private sector and households are still holding a lot of debt. This is preventing the private sector from investments and is preventing households from increasing consumption. It seems as if the entire country is busy deleveraging, but without affecting growth that much. The next step to an even higher growth rate would be to easily remove the capital controls set up during the restructuring to prevent money flowing abroad. This is affecting the attractiveness of foreign investments to Iceland. The recovery based on tourism and fishing will soon come to an end if other sectors don’t follow. And to do that they need fresh money and a stable financial system ready to lend again. From the way they started the recovery it seems they will be able to achieve that.

No, it still isn't applicable to Greece

The whole story made Iceland often recognized as yet another example of the success of currency depreciation (and capital controls) that should be allowed in Greece (once it exits the euro of course). However, Iceland is a much different economy than Greece. First of all, it's an export oriented, small, open economy with a bit over 300,000 people living there. While its exports account close to 60% of GDP, Greek exports are just over 20%. Another crucial difference is that in Iceland, people pay taxes. The rule of law is strong, implying that political stability will be strong as well. The best proof are the trials against the former PM (this is a strong signal to foreign investors, despite the capital controls which should slowly be removed). Furthermore, it doesn't suffer from a constraining labour market, nor does it suffer from regulations and bureaucracy that stifle market opportunities. It isn't without problems, but these are certainly more easily to deal with than in the case of any peripheral eurozone economy and their pre-existing institutional failures

The story of Iceland is actually a perfect story of what certain economists have been calling for from the start. Let the risk-takers go under without imposing a cost to the society as a whole. This is why Iceland bounced back quite quickly, not because of the depreciation. We can claim that the depreciation eased the transition but it certainly didn’t cause the recovery, unlike many economists tend to think.

It is precisely because of the defaults made that Iceland was able to bounce back. The alternative was the peripheral Eurozone scenario. Now compare Iceland with the PIIGS; Iceland’s misery lasted for 2 and a half years, while Greece’s is already running for 5 years now, likely to go on even further. 

Friday, 15 June 2012

European North-South divide and the role of corruption

Is the European North-South divide a consequence of a different mentality, where one implies fiscal profligacy, an intuitively lazier workforce and an incentive to cheat, while the other implies the opposite? Is the peripheral eurozone a ‘victim’ of its culture or geographical position (amid Ireland) that makes the Southerners work less and live ‘easier’? 

No. Culture, mentality and even the Mediterranean climate have nothing to do with the deep problems and divides Europe is facing at the moment. Other factors like the establishment of the euro exploiting the CA deficits, the paradoxical banking regulations leading to an equal risk and low interest rates for all countries making borrowing easier, and finally outside contagion that ceased the intra-regional transfers from the ‘rich’ North to the ‘poor’ periphery are much more liable for eurozone’s sovereign debt crisis

As for the structural imbalances like the competitiveness of the labour force or the stifling bureaucracy - now these can be explained through other factors. Primarily through institutional differences. These can be traced historically all the way to the Middle Ages, but a more modern approach has been applied by the recent report of Transparency International measuring the relative levels of corruption among EU members.

Source: "Money, Politics, Power: Corruption Risks in Europe"
Transparency International, pg. 16.
The FT had this to say as a comment (it summarizes the findings pretty well):
"It comes as little surprise to learn from Transparency International that corruption is least extensive in Denmark, Norway (non-EU but mighty rich) and Sweden. The EU’s worst problems are to be found in Greece, Italy, Portugal and Spain (in the eurozone), and Bulgaria and Romania (outside it). 
More disturbing is the report’s contention that the Czech Republic, Hungary and Slovakia are displaying signs of a rollback of anti-corruption efforts since they joined the EU in 2004. In Slovenia, meanwhile, a remarkably high 93 per cent of respondents in a recent opinion poll thought that corruption in their country had either increased or stayed at the same level over the past three years. 
The report makes a good point when it says that, even in rich countries, there is often a close connection between unpunished corruption and disorderly public finances. Greece is Europe’s supreme exampleBut can one construct the same case for the UK’s parliamentary expenses scandal and its extremely high budget deficit? Transparency International doesn’t try to make this argument, but maybe some of this blog’s readers would beg to differ."
One should be careful in assessing the causal effect in corruption being the cause of structural imbalances within Europe. However, the correlation between high corruption and peripheral troubles somewhat induced by fiscal profligacy is astonishing (search the report for individual institutional failures like the public sector, political parties or the media). Even though causality is left to be proven, one cannot shake the idea that differing types of institutions determine the different levels of corruption and consequently lead to worse-off outcomes. 

All of the PIIGS are near the bottom of the corruption list. And the problem with corruption isn’t new, it started a long time ago. Can we conclude it is embedded in the mentality of some peripheral nations? 

Perhaps corruption can be used as a proxy to measure differences between institutions in Europe. A similar methodology was applied by Acemoglu, Johnson and Robinson (2007) in their paper “Colonial Origins of Comparative Development”. They use settler mortality as a proxy to measure institutional differences in colonies. The idea is that more settlers died in countries with poor institutions as they weren't able to adapt to the new area. In colonies in which settler mortality was low, they ended up being rich and prosperous, meaning that a proper set of institutions ensured this transition. The paper is an excellent example of instrumental variable regression. I recommend it in that perspective.

So can the same methodology be applied to corruption to prove institutional failure? Perhaps. In order to do so, we must operate under similar assumptions on what affects institutional change and how existing institutions affect other outcomes and determine future changes in behaviour. 

When you think about culture or mentality as the reasons for change, think about the impact different institutional settings have on the formation of culture, mentality or identity. For example, generations of Americans were born in one institutional environment which influenced their culture and their mentality. On the contrary the Chinese for example were born and brought up in another institutional environment affecting their cultural development in a different way. One can say that these two factors interlink – those born in a certain environment tend to (and in good environments have an incentive to) preserve it. This is what generates a positive feedback loop that ensures that the society built on a proper institutional setting will evolve and generate more freedom and more prosperity (Acemoglu and Robinson, 2012 call it the virtuous cycle – examples include the Civil Rights Movement in the American South in the 1960s, busting up the trusts in the 1910s and even Roosevelt’s failed attempts to control the Supreme Court). A similar institutional dynamic was set forward in Great Britain and most other currently successful nations. 

The problem with empirically proving causality in this case is how to accurately measure corruption? Using an index may lead to possible bias. Settler mortality was easier since the data is clear. Measurements of corruption are subject to differing definitions of what corruption is and how it manifests itself. Even if a credible institution like Transparency International provides the data, this still might not be the best way to start conducting an econometric research (perhaps a weighted index of corruption from different sources can go beyond the measurement error).

Nevertheless, it’s still a very interesting topic to think about.

Wednesday, 13 June 2012

Graph(s) of the week: Italian and Spanish bond yields

As expected, the Spanish bank bailout effect was so short term that it didn’t provide any momentum at all. I expected it to end right after the Greek elections this weekend, but it went down even quicker than that – one week, that’s how long the markets were optimistic about the bailout. But is this all that surprising? Not really. It’s just another good proof of the (in)effectiveness of ECBs policies (*even though the bailout was officially made by the ESM, I explain in the comments why I consider them the same thing). When banks hoard cash and deposit it overnight at the ECB or use it to buy government bonds with record low yields to hedge against any possible risk, then it’s obvious that the hands of the monetary authority are tied. 

Spanish 10-year government bond yield
Source: Bloomberg, 13/06/2012
Italian 10-year government bond yield
Source: Bloomberg, 13/06/2012
Perhaps the investors are realizing this, which could be why the Italian bond yields surged today as well. So obviously, the contagion wasn't stopped. It is very likely that it was, in fact, encouraged as investors realized the ineffectiveness of the bailout to turn things around. They have witnessed moves like these too many times in the past year and not once did they prove good enough to stop further contagion. Markets demand stability. The ECB can only provide it for a couple of months (or days). But political incentives can either maintain it for quite some time, or destroy it in a matter of minutes. Europe has experienced both these scenarios. 

One other point from the graphs is the difference in yields between Italy and Spain since December and January. While back then it was the risk of Italian default that was driving up the yields in Spain and threatening a euro break-up, now it's the other way around. What happened? 

To remind ourselves, in November Italian bond yields went up to over 7% signalling a possible Italian default and a potential bailout triggering mass turmoil in Europe. But what happened since clearly stressed out the different paths undertaken by Italy and Spain. While both governments pledged to reform, and both are still considered credible on that promise, Spanish yields went up significantly and returned to their pre-December levels (as seen in the first graph above). On the other hand Italy has experienced a slow decrease of yields only responsive to outside shocks like the Greek elections and the Spanish bank bailout. 

So what are the main causes of diverging paths in Spain and Italy since December, even though both countries started with reforms and both received help via the LTRO? Why are foreign debt holders massively running away from Spain, completely reversing the previous trend as shown in the figure? The obvious answer is that one is more successful than the other in undergoing reforms, and that Spain's serious banking problems sent investors panicking (again). 

According to the Germans at least, Italy has been very successful: 
"German Finance Minister Wolfgang Schaeuble said Italy “has made remarkable progress in the last six months” under Prime Minister Mario Monti.
Italy will have the highest primary surplus in the euro region next year if budget policies are implemented, Schaeuble said in Berlin today. At the same time, there is scope for more growth-friendly measures, he said."
Even though much, much more could be done in Italy as many have accused the Monti government of being too political for a technocratic government. But this is understandable since they are forced to make concessions in order to get support for policies in Parliament. Then again, whose fault is that, the vote-buying self-preserving Italian politicians or the reformist technocratic government?

So the only option left is to forgo short-term solutions and deficit financing and stick with the reforms which will restore competitiveness. Italy is far from being safe but that's precisely why it needs to continue reforming. Spain should take note. The ECB at this point can do more harm than good.  

Monday, 11 June 2012

Spanish bank bailout – another half-baked solution

Even thought today’s €100bn Spanish bank bailout was hailed by Europe’s policymakers and markets as it once again temporary saved Spain and consequentially Europe from much bigger turmoil, the crucial emphasis is on the word temporary. In this case, as in any, temporary easing cannot be a good thing. Similar to the Long Term Refinancing Operation (LTRO) done by the ECB in December that was supposed to provide European governments with much more time to engage into and finally start with necessary institutional and restructuring reforms, the bailout effect is bound to only last for a few months, or maybe not even that much. Even more importantly (i) it won’t do any good for Spanish consumers or businesses, (ii) it will provide only limited time for the government to carry on with reforms, thereby not helping them much, as sooner or later the situation is likely to be the same, and finally (iii) it won’t even encourage Spanish banks to lend more. 

I’ve already covered the ECBs policies with respect to the temporary effects of the LTRO, and the conclusion was that the effect was surprisingly temporary – it wasn’t long term at all. It offered relief only for a few months, and mostly to the governments who didn’t do anything to seize this moment. It didn’t do much to increase consumer and business confidence, but this is expected since its final effects weren’t aimed at helping businesses or consumers at all. It was supposed to help banks. So, we ask ourselves, how is it possible that the Spanish banks need even more funds to keep them from defaulting? Could it be that the ECB’s first LTRO only made things worse by offering false hope to the Spanish banks and governments, thereby only strengthening the argument Germany is constantly holding against Europe – that massive bailouts will only cause more moral hazard, more profligacy and an lesser commitment to reforms? 

Then why did this bank bailout even go through? 

Well, Spain needed something to restore credibility in its banking system. It needed desperately to avoid a banking collapse. The banks really did need more money. If it weren’t for the ESM funds, this would imply that the government itself would have to bailout the banks, which would be an impossible task endangering its solvency and pushing the entire country into default. This would be a much more expensive thing to finance at the moment. Some even say impossible. 

So is Spain now out of danger? Not at all. With expectations of negative growth and rising unemployment the deficit will be even larger than projected, meaning that more borrowing could be on the way. Let’s not forget, Spain still needs €36bn this year to cover the deficit and keep the country going. 

And who would buy the Spanish debt? Only the Spanish banks, as investors are fleeing from Spanish bonds. The big banks are also staying away from government bonds, afraid of being pulled in the turmoil. So the only banks buying government debt are the same ones that are being bailed out (!). That makes the current bank bailout in fact a government bailout – or a “credit line” to the government, to be more precise. (Technically the story is more complicated than that - even more so as the government will have to repay the European loans made to the banks, but the idea is essentially the same).

The whole conundrum makes the entire thing look even more absurd and even more of a futile attempt to postpone the inevitable - another collapse of Europe's banking system.

As for the ECBs role in the entire picture, let’s look at how it’s LTRO resulted in the end? Below is the graph depicting yields on 10-year government bonds from Spain, Italy, Portugal and Greece. 

Source: Bloomberg
Not very effective was it? Remember, it was done in December 2011. The graph for Spain alone offers an even better insight (bear in mind that Spanish banks received almost half of all LTRO funds):

Source: Bloomberg
All it did was provide a temporary relief for governments and banks that didn’t even last as long as investors and particularly policymakers were hoping. This isn’t surprising as none of these actions helped the real sector of the economy. Banks received funds which they used to buy government bonds (again an example of an indirect “credit line” to governments). They didn’t increase their loans to businesses or to the public. 

Extra money created and spurred into the system at this point would provide the same result – no boost for the real sector, only a temporary effect on investor optimism and a one-off exchange of money between banks and governments for newly issued government debt. The rest of the money would be used by the banks either to satisfy the capital standards (hold more reserves) or would be deposited at the central bank at a close to zero nominal interest rate. 

The solution therefore doesn’t come from aggressive monetary policy, not at this drastic stage of severe lack of investor confidence and sentiment among the bankers. The answer isn’t fiscal policy either but a pledge to reform; the labour market, the public sector, to release money in the system by cutting regulation and removing barriers for businesses to export and expand, and most importantly to maintain political stability in order to attract foreign investments and keep the country going (even though attracting foreign investments into Europe would require a Gargantuan effort at the moment).

Monetary policy is useless not so much because of the zero lower bound, but due to the confidence among banks and what they plan to do with the money they receive. One doesn't increase bank lending by giving them more money on one hand and asking them to hold more capital on the other. The signals sent to them are heavily distorted and are completely disregarding the real sector of the economy. Both bank confidence and real sector confidence are best restored with a proper institutional reform

Friday, 8 June 2012

Russia’s path to a twin deficit

Vladimir Putin, still hailed by many in Russia for their successful transition from socialism to ‘state capitalism’, is facing much more economic instability than he did in his first two terms (from 2000 to 2008). 

To remind the readers, the Russian transition from socialism in the 90-ies was characterized by a booming number of oligarchs who controlled most of Russia’s oil and gas resources and which were to a large extent responsible for increasing criminalization and impoverishment of the country. In such a desperate situation which has seen Russia slipping from the world super-power to a bankrupt economy dependent on Western aid, the people longed for a leader who can set the country straight again. After all, one has to bear in mind that the Russians got used to having dominant leaders in the past, even much before the Bolshevik revolution in 1917. Never has Russia experienced true political freedom and democracy (especially not in the oligarch-controlled 90-ies), so the sudden transition followed by the formation of a new extractive elite inflicted a lot of pain onto the country. Then Putin came along. He was quick to do everything the people expected and, in general, wanted him to do. He imprisoned the oligarchs or forced them to (cooperate) sell the natural resources back to the state. Once in full control of Russia’s oil and gas, he enjoyed a rapid growth of the economy and state revenues based on a boom in oil and gas prices on world markets. Having control over energy not only helped Putin sustain his power, it made Russia once again a political giant, substantially increasing its bargaining power. Putin held a strong grip on Europe as well, being its main gas supplier. The decisions to export gas to Europe were no longer profit oriented – they became political. Any tensions between Russia and Ukraine would be followed by pipe closures leaving Europe freezing over the winter. It was the zenith of Putin’s and Russia’s newly acquired international power. 

Domestically, Putin was a perfect benevolent dictator – gaining a lot of money, wealth and influence back to Russia, thus healing the Russians’ hurt pride, but also distributing this new wealth to the people as well as investing into the country. Between 2000 and 2011, having seen a quadruple increase in oil prices, Russia’s total budget expenditures grew 9 times, its surpluses accumulated to $785bn and even real wages trebled (FT has the story). Naturally most of the voters were satisfied (albeit some protesters demanding more media freedom and political rights, but during the boom, these people were highly marginalized).

Crisis redux 

Then came the crisis and his second rise to presidency in 2012, following a charade he made with Medvedev, who served as a PM under Putin, while Putin served as a PM under Medvedev. Now Russia is facing an uncertain future and is unable to rely on oil and gas exports to keep it going, at least not to the extent they used to. 

Easy money and social spending, like in much of Europe, have come to a close. Even though it’s hard to call Russia a classical welfare state, Putin’s vote-buying of various interest groups is precisely what characterises an extractive, rent-seeking welfare state. Resource exports made this model possible and somewhat sustainable – at least in the short run. But this has come to an abrupt end following the current crisis and contagion. 

The IMF predicts that the current account surplus will turn into a deficit by 2015 (imports will overtake the exports), pushing Russia into an era of the 'twin deficit' (both budget and CA deficit – a standard occurrence in the West today). This was unimaginable during Putin’s first presidency which saw a persistent 10-year CA and budget surpluses.

Source: "IMF Country Report: Russian Federation",
September 2011, pg. 16
This may not come as a disaster though since it could signal that Russia is becoming more attractive to foreign investments, but as in the case of twin deficits in peripheral eurozone, this is highly unlikely.

Having a twin deficit and no more big exports to make the welfare state model sustainable, the government will have to turn to politically unpopular moves to cut public sector wages, cut entitlements and cut defence programs. Or they could borrow which wouldn’t be a problem to a country with only 15% of debt to GDP. But this is not particularly sustainable in the long run as we have seen in Europe. Also, policy-making in that case would be subject to a bigger scrutiny from foreign investors which will become more reluctant to invest under any sight of political uncertainty.


Some claim this is good news and that it may encourage Russia to cease its dependency on oil and gas exports and switch to institutional reforms – starting from government bureaucracy, the legal system, cutting red tape etc. This would encourage foreign investments since Russia does indeed have potential for high-profit investment projects. But it doesn't have the structure to support them. 

In order to do this, as I have stressed out many times before, political and individual freedom are a necessity. No one will be prepared to invest in a country if he or she is worried about their wealth being expropriated and their business shut down due to local inefficiencies. These can be fixed, but in order to do so, the most important thing is to undergo a political reform guaranteeing fair elections, free media and more political freedom. However, all these seem highly unlikely under Putin who will regard this as a threat to his political power. 

There is a way out. If the country does undergo a change the government and starts reforming the system it may curtail public anger by offering more concessions to the public in terms of more political rights and more media freedom. As in the case of a gradual post-industrial revolution shift to more political freedom in 18th and 19th century England, Russia can benefit from having to do the reforms (like privatization or the delicate pension reform) and at the same time gradually increase political freedom in the country. One would offset the other. This would end the resource dependency of the country and the dependency on the government to control the economy and at the same time it would create incentives for the people to innovate and generate more wealth by and for themselves. If this is done carefully during the course of the next 10 years, it would make Putin more popular than ever. If he resists change and chooses the borrowing path to sustain his vote-buying extractive welfare state model (a more likely scenario), the anger among the people will grow and political uncertainty and instability will increase, further discouraging any chance of foreign investments and creative destruction to drive the country forward.


It is crucial to address the business dependency as well. In Russia’s opening to the WTO, domestic production could initially suffer as they are heavily protected by a series of tariffs and subsidies and tend to be highly inefficient. Only in a global market can Russia’s businesses become more competitive, having to do without the hand of the state helping them every step of the way. But they need to be prepared for this change which is likely to initially cause a series of job losses and a lot of voter dissatisfaction, increasing political instability and the pressure for more freedom. That’s why a gradual reform approach would be a better solution. 

Even if initial jobs are lost, this is only a signal that they have been allocated in wrong sectors to begin with. With a more diversified and innovative society, new patterns of specialization will occur. This will, accompanied with more individual and political freedom, lead to more innovation and new jobs being created. This is the path to a sustainable growth model that can be applicable to any country today. 

Finally, the World Economic Forum makes a suggestion how to start:
“Strengthen the rule of law and the protection of property rights, improving the functioning of the judiciary, and raising security levels across the country would greatly benefit the economy”.

Tuesday, 5 June 2012

Why Germany will overtake the UK as Europe’s leading education provider?

So far, most of my blog posts have been (geographically) focused around internal issues in the UK, US and selected Eurozone economies. Now I’ll move a bit “cross-country” which is why this month’s texts will be (mostly) concerning cross-country comparisons. The first post of the month on China has been in that direction.

The success of the US

Education has always been the creator of progress in a society. Technological advancements and innovation (based on secured property rights and the functioning rule of law which prevented new inventions from exploitation) have been the drivers of growth of the United States ever since it was founded. But the rapid accumulation of knowledge and technological innovation didn’t start in the US until after WWII. One proof of this is the disproportional size of Nobel prize winners situated in the US prior and post WWII. With Germany, UK and France leading the way in sciences prior to the War, in the last 60 years the US has outpaced them significantly. It currently holds more Nobel laureates than the first three countries following it on the top list combined. The vast majority of America’s laureates comes from after the War (see here or click on image to enlarge it).

They had a bit of luck at the time to attract all these people, as they mainly came to the States escaping from the Nazi threat in Europe. But the Americans quickly seized this advantage and realized the potential of having all these people in the country. For one thing, the expertise of the world’s leading physicists at the time led to the creation of the atomic bomb, winning the War for the US on the Far East front. It wasn’t hard to realize the importance of having these people stay, in both military terms and economic terms. So the great progress of the United States in technological, military and consequentially political terms began when they started focusing on attracting the best and the brightest. This is a lesson some seem to be forgetting.

While the UK closes its borders...

Even though the UK is currently by far Europe’s most influential education provider, having the reputation of its top educational institutions attract many foreign students in search for a high quality education, the immigration policies aimed to reduce a number of immigrants each year to less than 100,000 by 2015 are hurting the influence of these institutions. This ‘cap on quality’ will make it much harder for Britain to attract top class students wanting to study in the UK, not to mention its negative impact on British businesses. 

Migration caps are generally one of the most ridiculous policies aimed to preserve jobs for domestic workers. If migrants are happy to work for less, so be it. It will cut the costs to business owners making them more open to invest and expand their business later on. The labour market signalization is just another type of specialization patterns that tend (in the long run) to allocate labour to where it is most productive and most efficient. 

The most ridiculous argument against immigration is that it causes congestion in public transportation. Don’t immigrants pay for these services? They don’t ride for free, even if they’re students. Monopolies such as Transport for London can only benefit from the economies of scale and from having more customers paying for their overpriced services offering almost no value for money. 

Besides, anti-immigration policies are highly discriminatory. Why is someone worth less if he’s not of an EU, UK or US origin? Talk about equality. 

But I digress. Attracting talent has become even more important in the current era of globalization where the focus is on creating value. And unique talent which the UK is lucky to attract due to its historically strong educational institutions is the most important parameter in creating value. By throwing this away the UK is seriously undermining its long and medium run competitiveness. 

By putting a cap on quality, the current government is again shooting itself in the foot. The attractiveness of the UK as a place to study and a place to live and generate wealth in, is highly undermined. The graph illustrates this. Signals sent to students that they aren’t welcomed in the UK anymore will only encourage them to seek education and employment elsewhere. Most likely in Germany.

...Germany opens them  

While the UK is closing its doors, another European giant is opening them widely. Germany, already overtaking the UK in economic and political power, will soon do so in the field of education as well. 

The Germans are done with bringing in the low-skilled cheap labour from Turkey and Eastern Europe and they now want to attract the best and the brightest from these areas as well – building primarily on the positive social context in which Germany is presented in these countries (bear in mind that a lot of remittances were flowing out of Germany at the time, having a substantial effect on domestic incomes of the people from emigrant countries). 

But they aren’t stopping there – they seek to attract all those who got rejected by the UK. They are offering an amazing range of scholarships that encourage students from the Far East, Middle East, Eastern Europe and anywhere where there is a concentration of quality which cannot excel in the country of origin, to come and study in Germany. They offer to pay the tuition fees, send the students to study German and encourage them to stay in the country after graduating. Germany is essentially adopting the same strategy the US adopted in post-war reconstruction. 

As a comparison, in the post-war reconstruction both of these nations attracted a lot of migrants – Germany to rebuild the country’s destroyed infrastructure, and the US continuing on the war and pre-war patterns of attracting the brightest of minds. The results were exceptional for both of these countries but Germany has now reached a point where it can focus on the long-run educational strategy to preserve its dominance in Europe. Just like the US did 60 years ago. 

I’m always careful in making bold predictions (because I don’t trust them), but in this case I dare to say that in 20-30 years from now German universities will be better ranked than UK’s and will have a better perception among the non-EU population. That is, if all things stay equal of course, meaning that if the UK continues discouraging high education and if Germany continues to encourage it.