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RESEARCH PRODUCT

Growing Like Germany: Local Public Debt, Local Banks, Low Private Investment

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The paper uses a panel of more than 1m German firms over 2010-2016, to provide the first firm-bank level evidence of local crowding out for a developed economy characterized by low interest rates and fiscal austerity. Our mechanism relies on two structural features of Germany's banking landscape: the local segmentation of credit markets for small and medium-sized firms (SME) and the role of local public banks in local public finance. Local public banks dominate lending to small and medium firms in Germany and also have an explicit mandate to lend to the local public sector. With spreads on local government debt at all-time lows, local public banks tried to break even, using their market power in geographically segmented lending markets to charge higher rates on their SME customers. This crowded out firm investment. Perversely, fiscal consolidation at the state and federal levels substantially worsened this effect by putting pressure on the budgets of municipal governments which increasingly borrowed from local public banks. We estimate that our mechanism lowered aggregate private investment by around 30-40 bio euros per year (or 1 percent of GDP). Our findings identify a novel channel through which low interest rates can adversely affect bank lending and firm performance. They also illustrate how negative multiplier effects from fiscal austerity can be exacerbated if credit markets are locally segmented.