First the U.S. Treasury, then the International Monetary Fund and finally the EU Commission all criticized Germany last year for burdening other economies by running a continuous and increasing trade surplus. So what is so bad about producing and exporting the goods that are apparently in demand by the rest of the world?
When the U.S. Treasury’s semiannual report on international economic and exchange rate policies blasted Germany’s massive trade surplus in November 2013, it raised a few eyebrows on both sides of the Atlantic.
The report pointed out that Germany maintained a large current account surplus throughout the euro area financial crisis, and that in 2012, Germany’s nominal current account surplus was larger than that of China. The trade balance – goods and services exports less imports – is by far the largest component of the current account.
Although the criticism is not new – Germany has been running an annual trade surplus since 1952 – the place and intensity of the criticism was surprising.
Normally the Treasury report is reserved to lambasting countries that, in the view of the United States, manipulate their exchange rates to boost exports. But as Holger Schmieding, chief economist at Berenberg Bank in London, noted, Germany’s currency is modestly overvalued, so the country can hardly be blamed for depressing its currency to generate a large surplus.
“With the euro trading well above its long-term fair value of 1.25 to the U.S. dollar, the Eurozone would have a reason to complain about U.S. policies that artificially depress the currency, not vice versa,” Schmieding said.
Beggar thy neighbor
So what is the issue? For some economists, international trade will produce winners and losers rather than benefit everyone. The belief is that longer-term trade surpluses in one country will lead to economic problems in the countries that run deficits.
Of course in the real world, trade balances are not the result of an active process steered by governments. Trade surpluses and deficits arise naturally from the economic interaction between various players in different countries. They may even be a correct reflection of consumption and savings over time. It could therefore be argued that the structure of Germany’s economy with a focus on the production of high-end goods for export at competitive prices should result in a surplus.
This is precisely the response to the criticism by the German government, which stated that current account surpluses are a sign of the competitiveness of the German economy and global demand for quality products. “The innovative German economy contributes significantly to global growth through exports and the import of components for finished products,” a finance ministry spokesman told the Financial Times.
The counter-argument made by the U.S. Treasury is that the trade surplus has nothing to do with innovative, competitive exports but is a mere reflection of structural developments in Germany’s economy and policy decisions that result in a lack of imports. And this allegedly has hurt other countries.
“Germany’s anemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro-area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment. The net result has been a deflationary bias for the euro area, as well as for the world economy,” the Treasury wrote.
In other words, the U.S. Treasury suggests Germany’s trade surplus not only contributed to the euro crisis, but it now prevents the euro area and the global economy from recovering.
The euro crisis
It is correct that a deficit in one country requires a surplus in another country to finance it. It is also true that prior to the financial crisis, the increasingly high deficits in the Eurozone periphery countries were matched by high surpluses in core European countries, especially Germany.
The question is, what caused the trade surplus in Germany and what caused the deficit in the periphery countries?
Typically, changes in currency exchange rates will influence the trade balance by making goods and services either cheaper or more expensive. Following the introduction of the euro, however, there were no diverging currency exchange rates to influence the competitiveness within the Eurozone. What remained were simply diverging labor costs and productivity.
Labor costs, productivity
Between 2000 and 2006, the German government undertook major labor market reforms, and wage growth remained restricted. Just when Germany’s labor costs decreased, Southern European countries saw significant wage hikes, often not supported by corresponding increases in productivity, making German goods and services relatively cheaper.
Increasing competition from emerging markets also affected internal imbalances in the Eurozone. Germany withstood this competition better than other advanced and periphery countries, according to International Monetary Fund economists Fabian Bornhorst and Anna Ivanova.
“Through its advantage in a large number of specialized products, in particular capital goods and consumer durables, Germany, unlike many other advanced countries, was able to maintain its world market shares in the past decade. German exports have remained largely insulated from Asian and lower-wage European competition,” Borhnhorst and Ivanova wrote in a 2011 paper on current account imbalances.
Thus, whereas Germany has stood its ground in the face of global competition, other European economies have not been so successful. While this phenomenon manifests as increased intra-European imbalances, the outcome is not the consequence of direct trade relationships between the surplus and deficit countries, they noted.
Interest and savings rates
A European Commission report in 2012 highlighted that the buildup of current account imbalances in the Eurozone before the crisis was not only caused by diverging labor costs and productivity. Instead, the convergence of interest rates in the Eurozone contributed to a widening of the current account imbalances.
Lower interest rates in the periphery countries meant access to cheap capital stimulated domestic demand which exceeded domestic production and led to current account deficits.
Most of the debt was financed by the excess savings deposited with banks by households and companies in core economies, such as Germany and France, and transferred to the periphery through the bond and interbank markets. Via these channels, core European markets also facilitated the transfer of capital from non-EU countries to European periphery countries like Ireland, Spain, Portugal and Greece.
“All this resulted in credit-driven booms, reductions in savings, excessive investment in non-productive activities in the periphery, and excessive risk concentration in the financial systems of the core countries,” noted Alexandr Hobza and Stefan Zeugner in their 2013 paper “Current account surpluses in the Eurozone: Should they be reduced?”
Economist Michael Pettis, who two years ago spoke at the Cayman Business Outlook, presents this view from a different angle. In an article in May, he blamed the lender rather than the borrower by stating that German savings caused the credit crisis.
Pettis believes labor market reforms in Germany coupled with wage restraint merely shifted Germany’s unemployment problem elsewhere by driving up the national savings rate “excessively,” which in turn widened the current account surplus.
The savings rate is significant because, according to macroeconomic theory, in an open economy whatever is not consumed or invested in a country is likely to be exported. By exporting the excess savings, that country is essentially providing the funding to foreigners to purchase its excess production.
“Of course the rest of the world had to absorb excess German savings and run the current account deficits that corresponded to Germany’s surpluses,” wrote Pettis. Because these excess savings were so large and had to be absorbed within Europe, the resulting imbalances “almost inevitably” led to the European crisis.
The result was likely to be higher wage growth, higher inflation and soaring asset prices in the deficit countries, Pettis argued.
Chicken or egg
Not everyone agrees with the narrative that excess German savings, invested abroad by buying foreign debt, forced unsuspecting countries to borrow, consume German products and ultimately run deficits. But even if one agrees with the interpretation that current account surpluses and deficits lead to distortions and misallocated investments in other countries, the question remains, what comes first: the deficit or the surplus?
According to Pettis and the U.S. Treasury, surplus countries are causing deficits in other countries. But the reverse could also be true. Deficit countries rely on surpluses elsewhere to import more than they export (trade deficit) and invest more than they are saving (capital account deficit).
Spanish banks would not have borrowed in the interbank lending market if they had not seen the demand for loans domestically. German banks, in turn, bought Spanish bank bonds because they were flush with bank deposits from high savings. As it turns out, European periphery banks should not have borrowed and German banks should not have lent to the extent that they did.
What are the options?
Closely tied to the question whether a deficit or a surplus comes first is who should redress the balance, the surplus or the deficit country?
It would be naïve to demand that Germany should reduce the trade surplus by artificially weakening its competitive position in exports.
But Pettis claims solving the crisis can only be achieved by forcing down the German savings rate to the extent that Germany will have a current account deficit. “Only in this way can countries like Spain stay within the euro while bringing down unemployment.”
So instead of reducing its exports, Germany should stimulate domestic demand and reduce its savings rate to boost imports.
“Stronger domestic demand growth in surplus European economies, particularly in Germany, would help to facilitate a durable rebalancing of imbalances in the euro area,” stated the U.S. Treasury.
The International Monetary Fund urged the German government to reduce its export surplus to an “appropriate rate” to help its euro area partners cut deficits.
Melvyn Krauss, emeritus professor of economics at New York University and a senior fellow at the Hoover Institution at Stanford University, disagrees.
Krauss says the assumption that only domestic German demand could stimulate growth in the periphery is false. As Germany’s export sector grows, so does its demand for goods and services from periphery economies.
Measures to stimulate domestic demand, in turn, could well stimulate deficit economies but there is no guarantee they will have an effect on Europe’s periphery.
“Whether reallocating German savings from the export sector to domestic demand would benefit the likes of Spain, Italy and Greece more than the current situation isn’t at all clear. If Germans are given more money, for example, will they spend it or save it, buy houses or imports? And if they do buy a lot more imports, will these be Greek or Chinese? None of us know,” Krauss says.
Wages have already been rising over the past seven years, but German household consumption has remained relatively weak.
In part this is caused by high taxes and social security contributions that depress the disposable income; in part it is a cultural phenomenon.
Savings rates have traditionally been high in Germany, and credit-based consumption is frowned upon. Higher disposable incomes are therefore not necessarily going to increase domestic demand to the same extent they would in deficit countries.
Increased public investment financed by deficits or tax credits to incentivize investment run contrary to the current German political agenda of reducing public debt.
Krauss says the U.S. Treasury demands amount to nothing but protectionism. If Germany followed the U.S. advice by using public debt to boost domestic demand, it would divert resources from the export sector and increase labor and production costs. This in turn would make German exports more expensive. Good news for the American automobile industry.
But in the long run, “a weak, over-indebted German economy wouldn’t help Greece or the global economy as a whole. It would hurt them,” he says.
Adjustment has already taken place
The U.S. charge that Germany’s export-led growth has “put European periphery countries under severe pressure to curb demand and compress imports in order to promote adjustment” may or may not be correct. However, what the report failed to note is that the adjustment has in fact already taken place, said Berenberg Bank’s Schmieding.
Although Germany is running a current account surplus of close to 7 percent of GDP, that has not been hampering a rebalancing within the Eurozone.
“Within the Eurozone, the German trade surplus has come down rapidly from a pre-Lehman peak of close to 5 percent of German GDP to 2 percent now. That is a significant adjustment. At the same time, Germany has managed to increase its trade surplus with the rest of the world including the United States,” Schmieding noted.
Data by Trading Economics confirms that Portugal, Spain and Greece have returned to a level of trade deficits last seen before the introduction of the euro in the 1990s. Most of the adjustment has indeed come from falling imports, rather than increasing exports. However, neither country has run an annual surplus for decades. Ireland meanwhile has been running a growing trade surplus since the 1980s.