On European rebalancing and Germany’s excess savings

This May 2013 post was for Credit Writedowns Pro members only but in September 2014, it was opened up to the bog site as well.

Michael Pettis had a very good post out yesterday that focused on the sectoral balances within and across eurozone countries which I recommend. His point is that excess German savings driven by wage suppression was behind macro imbalances and not thrift. I want to expand upon this theme. My prediction here is that rebalancing away from excess German savings will not occur on nearly a large of scale to matter.

The core of the argument about macro imbalances comes from the fact that, before the crisis and within the eurozone, you had a number of high external deficit countries and a few high external surplus countries.

The Financial Times had a good chart on this in 2010 that I like to use.

When the housing bubble popped, the imbalances shrank in large part because demand had been vaporized and this turned what were external deficits in 2006 into government deficits by 2009. The question is how did these external imbalances occur – and knowing the answer to this question, should they be corrected.

My answer has been that the source of the imbalance has always been deficient domestic demand in Germany that led to an export-led ‘mercantilist’ economic model. This is an outgrowth of what I labelled Germany’s post-reunification ‘soft depression’. Here’s how I put it in 2010:

“When the Berlin Wall fell, it ushered in monumental changes across central and eastern Europe and no country would feel its impact more than Germany… 

“[Then German Chancellor Helmut] Kohl was adamant about bringing [West and East Germany] back together in a way that quickly brought the east up to the living standards in the west…

“Nevertheless, the economic side of re-unification was a complete disaster. For purely political reasons, Helmut Kohl, then the German Chancellor, rebuffed the advice of his economic advisors and decided to unite East and West Germany at an exchange rate of one for one. This represented a significant over-valuation of the East German currency. Moreover, the privatization of eastern German state enterprises by the Treuhand… led to massive speculation in eastern German real estate… [and] a property bubble and crash and lingering indebtedness in the German corporate sector.

“To make matters worse, Kohl also pushed through the now infamous east-west Lohnangleichung (wage parity) whereby eastern German worker wages quickly rose to the level in the west. The east was a heavily manufacturing-based economy. So wage parity meant a pricing out of eastern German labour, high unemployment there, and an eventual move of German manufacturing to central and Eastern Europe instead of to the former East Germany.

“In short, eastern Germany was uncompetitive. Forget about blühende Landschaften (a flourishing economy ) in the former East Germany. Try depression. I’m talking unemployment to the high teens, a rise in neo-Nazis amongst unemployed young males, huge municipality and state indebtedness to deal with the social costs, and a mass migration from east to west.

“Many people don’t realize this, but Germany has all of the hallmarks of a country in a balance sheet recession that Japan does. It had a property bubble and bust. It has suffered from high business sector indebtedness. The public sector states and municipalities are now highly indebted as well. The result has been low consumption growth and high household sector savings. And the German economy has been in and out of recession 4 times since reunification as a result. While an aging population plays a large roll here, clearly there is more to it than that.

“German politicians are well aware of these problems. The question is what to do about it.

“During the end of the days under Helmut Kohl, Germany was completely unable to undertake any kind of structural labour reform. But the neo-liberal German Chancellor Gerhard Schroeder… instituted widespread reforms in four stages called the Hartz Concept… The result has been stagnating wage growth in Germany which has facilitated an export boom.”

So, that’s how this all began. Germany was in depression. It cut wages, which pushed down domestic demand even more, but this led to export-led growth that resulted in trade and current account surpluses for Germany that were offset by deficits somewhere else in the world. That somewhere else was mostly the eurozone periphery. Germany was the biggest winner from the euro because Germany gained exports via the intra-euro fixed rate and export competitiveness via wage suppression. These current account surpluses were matched by current account deficits in the periphery.

Here’s the thing though, from a national accounts perspective current account or trade imbalances are also reflected by mirror image capital account imbalances. That is to say, any transaction between two economic agents involves an exchange of goods and services for money and that necessarily means that an economic actor that sells fewer goods and services and has a trade or current account deficit must have an equivalent capital account surplus. Think of the euro zone as one big vendor financing scheme in which a demand deficient Germany exports its excess savings to the periphery in exchange for IOUs or debt. And this is why so many German banks – Commerzbank, IKB, WestLB, HSH Nordbank, Hypo Real Estate – all got themselves into trouble during the financial crisis. These banks were essentially investing the funds Germany received from its trade surpluses by extending loans abroad. This is the ‘excess savings’ that Michael talks about.

Now, if you listen to German policy makers no one is talking about gearing down those excess savings. They are instead talking about ramping up the savings of the periphery. Here’s how Jens Weidmann, the head of the Bundesbank, put it in late March (pdf here):

…it is sometimes suggested that rebalancing should be undertaken by “meeting in the middle”, that is by making surplus countries such as Germany less competitive. This suggestion implies that the adjustment as such would be shared between deficit and surplus countries. But the question we have to ask ourselves is: “where would that take us?”

[…]

In my view, we will gain nothing if we try to rebalance by actively shifting weights at both ends of the scale.

[…]

…the deficit countries must take measures that unlock their potential to increase productivity and improve competitiveness. This would considerably reduce the cost of adjustment and the time it takes.

As the deficit countries import less and become more competitive exporters, surplus countries will run lower surpluses. The key issue is whether this happens as a result of market processes or as a result of efforts to fine-tune aggregate demand in the euro area. I would welcome the former, but I object to the latter.

Translation: the periphery must do the heavy lifting of adjustment and their balance with surplus countries will adjust automatically by market forces. The result will either be a larger European-wide surplus or a reduction in intra-European imbalances.

The right question to ask is whether the periphery can pull this off given unemployment over 25% in Spain and Greece and over 11% in Italy, 14% in Ireland, and 18% in Portugal. As I wrote regarding Greece, I don’t believe so. For Greece this will eventually mean eurozone exit. For the other countries it means further political radicalization and economic turmoil that could lead in the same direction.

So, naturally one has ask whether instead of forcing the periphery into debt-deflationary internal devaluation, Germany can be cajoled into assenting to the rebalancing being done on both sides as a swag to deal with the real social costs even if people like Weidmann “object to the latter”. I say yes, but only in part. Germany is already lifting its negotiated wage agreements for public sector employees and it has said that it would be willing to live with higher inflation. So, yes, this can be done. But it won’t be nearly enough.

The scale of European rebalancing needed is on a scale much larger than Germany is willing to accept and also larger than the periphery can tolerate socially. We are at a very good point in this crisis right now, but there is still a long way to go. I don’t believe the present political consensus, slanted toward a status quo of austerity, debt repayment and euro membership can last. One or more of these dams will break. And when it does, it will be time again to re-evaluate your investment portfolios. For the time being, it pays to be bullish.