More on Germany’s deflationary bias

Martin Wolf has written a column in the FT with which I largely agree, claiming that Germany is a weight on the world. The essence of his argument is that Germany’s export-led growth model is a ‘beggar-thy-neighbor’ policy in a world short of demand. In my view, it is unlikely that the periphery can match Germany’s export-led internal devaluation success under those circumstances, one reason for caution on Europe.

What Wolf says is this:

Export surpluses do not reflect merely competitiveness but also an excess of output over spending. Surplus countries import the demand they do not generate internally. When global demand is buoyant, this need not be a problem provided the money borrowed by deficit countries is invested in activities that can subsequently service the debts they are incurring. Alas, this does not happen often, partly because the deficit countries are pushed by the supply of cheap imports from surplus countries towards investing in non-tradeable activities, which do not support the servicing of international debts. But in current conditions, when short-term official interest rates are close to zero and demand is chronically deficient across the globe, the import of demand by the surplus country is a “beggar-my-neighbour” policy: it exacerbates this global economic weakness. 

I give Wolf full marks for this paragraph. It distills succinctly why Germany’s export-led growth paradigm is ill-considered in this economic environment.

However, here is a question: Do surplus countries export to satisfy external demand or to make up for a lack of internal demand?

It would seem obvious that Germany, with its aging demographics and weak internal demand, is exporting to make up for a lack of internal demand. But, there are two sides to any coin. And clearly, the demand for German wares externally is sufficient to allow German manufacturers to export them.

I would put the narrative this way: After reunification, Germany experienced a speculative bubble in the east, which, when combined with the heavy infrastructure spending the Germans did to support reunification, created a large public and private debt overhang for the Germans given their lack of fiscal space as part of the European currency union. The Germans understood this and took advantage of the booming economy in the eurozone periphery and in the United States to institute a policy of export-led growth predicated on wage restraint and improving export competitiveness.

When the euro was introduced, it led to high growth rates in many areas in the periphery. As convergence played out, external capital flowed to the periphery and bond yields dropped accordingly. This led to a boom time economy which contrasted drastically with anemic growth in Germany, despite Germany’s export-led growth model. It is key to realize that it is the lack of internally-generated growth in Germany that made the export-led growth internal devaluation model possible. Economies in boom times do not cut wages and prices to generate export-led growth because they have plenty of internally-generated growth that puts upward pressure on wages and prices.

When the world collapsed into crisis after the U.S.-led global financial crisis, Germany suffered disproportionately, with GDP collapsing 5% in 2009 alone, a figure five times worse than the 1975 recession, previously the worst recession in Bundesrepublik history. But German manufacturers were resilient. And even while the European sovereign debt crisis took form, German manufacturers shifted their export-led growth model to the emerging markets, maintaining Germany’s large external surplus. In 2012, Germany had a trade surplus of 188.1 billion euros, of which less than a third came from France, Italy, Spain, Greece, Portugal, Ireland – my expanded list of periphery countries.

But note that German growth is still weak because of weak internal demand growth. Germany’s private sector economic forecasters have been cutting German growth estimates. Collectively they now say Germany will only grow 0.4% in 2013 and 1.8% in 2014. That’s down from predictions of 0.8% and 1.9% respectively in April. “The German economy is on the verge of an upturn driven by domestic demand,” they say; hence the higher growth estimates for 2014. The European Commission expects Germany to grow 0.5% in 2013 and 1.7% in 2014.

My view has always been that Europe needed rebalancing and that the operating policy response in Europe would lead to that rebalancing happening via the demand loss of a double dip. That’s a deflationary scenario. And since the ECB is running up against the zero lower bound, it puts upward pressure on real interest rates and exchange rates, making the internal devaluation strategy harder to achieve.

The policy mix in Europe is toxic. Yes, we are probably in a nascent recovery in Europe right now, one that I saw forming five months ago. But the policy mix is not going to be enough to promote a strong recovery. Export-led internal devaluation strategies will be hard pressed to achieve success in the present economic environment. And that means downside risk remains elevated in Europe.