Today’s commentary
Summary: The U.S. Treasury’s semi-annual currency report had surprisingly strong criticism for Germany. The U.S. claims that Germany’s macroeconomic policies are inherently deflationary, creating risk for further crisis. I agree with this criticism and I will explain why it is valid here.
Here is the part of the report on Europe that everyone is talking about (pdf here). I have added underlining on the key bits for emphasis:
Euro area deficit countries have sharply reduced their current account deficits, but euro area surplus countries have not reduced their current account surpluses. The euro area’s overall current account swung into surplus in 2012, and the surplus has increased further in the first half of 2013 to almost 2. 3 percent of GDP. The Netherlands and Germany have continued to run substantial current account surpluses since 2011, while the current accounts deficits of Italy and Spain and the smaller economies in the periphery have contracted significantly, primarily as a result of a collapse of domestic demand and falling wages. Ireland, Italy and Spain have run surpluses in recent quarters, and Portugal moved into surplus in the second quarter of 2013. Germany’s current account surplus, meanwhile, rose above 7 percent of GDP in the first half of 2013, with net exports still accounting for a significant portion (one – third) of total growth in the second quarter, suggesting that rebalancing is not yet occurring domestically. To ease the adjustment process within the euro area, countries with large and persistent surplus need to take action to boost domestic demand growth and shrink their surpluses. Germany has maintained a large current account surplus throughout the euro area financial crisis, and in 2012, Germany’s nominal current account surplus was larger than that of China. 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. Stronger domestic demand growth in surplus European economies, particularly in Germany, would help to facilitate a durable rebalancing of imbalances in the euro area. The EU’s annual Macroeconomic Imbalances Procedure, developed as part of the EU’s increased focus on surveillance, should help signal building external and internal imbalances; however, the procedure remains somewhat asymmetric and does not give sufficient attention to countries with large and sustained external surpluses like Germany.
Explosive commentary!
From a political perspective the release of this report is unfortunate for a number of reasons. Right now, the U.S. is in the hot seat for its massive spying operations and Germans are particularly incensed over the decade long spying on German Chancellor Angela Merkel as well as the U.S.’s indiscriminate collection of German e-mails and internet activities. So, the criticism will most probably be disregarded for this reason alone.
Moreover, the recent U.S. shutdown and threat of sovereign default has made U.S. economic policy look disastrously reckless. And so it strikes anyone watching events as the height of hypocrisy that the U.S. could criticize any nation for its macro policies.
But the criticism is right. Here’s why.
Exports lower a nation’s living standards. Every economist knows that the central tenet of trade theory holds that exports are a cost and imports are a benefit. Free trade is predicated on this framing. Here’s how economics professor Andrea Terzi put it early this year:
The simple fact that exports represent the use of domestic resources for the production of output that will benefit foreigners has become (oddly) contentious. Perhaps, it is because of a mistaken belief that accepting that exports are a cost to the nation (and thus lower a nation’s standard of living) means that national policies should turn against exports to prevent a nation from losing any output that it worked so hard to obtain, and should aim at a trade deficit instead.
In fact, the implication of fully acknowledging that exports are a cost (and imports a benefit) is that a net export position (i.e., exports exceeding imports) is a costly one, and one that policy-makers can only justify against well-defined benefits.
How policy should consider exports (as opposed to net exports) is a question that depends on the broader context, such as the one that prevailed when Keynes was advising the Treasury during World War II. Although he was fully aware that exports reduce the nation’s living standards, Keynes claimed that “export industries must have the first claim on our attention” and that “until we have rebuilt our export trade to its former dimensions, we must be prepared to any reasonable sacrifice in the interests of exports.” Britain was then running a significant trade deficit, as exports had shrunk due to enemy action and diversion of production capacity to war production. Britain’s demand for imports, however, was high, and it could be met through a desire of foreigners to net save in pounds, or an increase in Britain’s exports. Alternatively, Britain would have to accept a weaker pound.
The point here is that exporting for export’s sake or for GDP’s sake is a simplistic understanding of the cost-benefit analysis of trade policy. This can lead to big problems.
In Europe, the genesis of this thinking has roots from twenty years ago. After reunification, Germany had a speculative bubble and crash which put the economy into what I have called a soft depression. The Germans saw three fixes for this. First was exports. The Germans have an industrial base which is far larger than the U.S. or Britain which are more heavily dependent on services and finance. The Germans understood that a large manufacturing base made it easier for GDP to benefit from exports. Second was the euro which would eliminate currency volatility within Europe and open up export markets within Europe more fully to German wares. And third was wage restraint and labour market reform, which Chancellor Schröder was able to enact.
However, when the financial crisis hit, Germany suffered disproportionately, with GDP falling 5% in 2009 alone. The Germans had one of the more severe collapses in GDP in the eurozone in 2009 because of the German economy’s lack of domestic demand and the dependence on exports for GDP growth.
Now, large export of goods means a large export of capital as the current account surplus implies an equivalently large capital account deficit. Because of Germany’s export-led growth model, the euro zone is one giant vendor financing scheme. The Germans are effectively loaning the Spanish and the Greeks money to buy their goods. The way this goods export shows up in national accounting is not via the borrowing by the specific purchasers of the goods but via the recycling of funds through the banking system that results in a net export of capital from one country to another. For example, German banks ended up with large financial holdings in Spain, far in excess of what Spanish banks have in Germany. But vendor finance only works if the borrower has the funds to repay the loans. In the case of the eurozone, the scale of this vendor financing was so large that repayment has become problematic.
All of this, remember, is because of an imbalance within the eurozone between surplus and deficit nations. The right thing to do here then would be to rebalance such that the deficit nations have lower deficits and the surplus nations have lower surpluses. But that is not what the Europeans are doing. Instead, the Germans are attempting to maintain their surpluses and to force internal devaluation policies on deficit countries in order for them to also have a surplus as well. This is the stated policy goal. In essence, the European policy is to turn Europe into one big vendor financier with an aggregate current account surplus.
This is disastrous and has led to the deflationary bias that the U.S. Treasury complains of. I predicted in 2010 that Spain’s debt woes and German intransigence lead to double dip.And they have done. Yet, the policy is still the same – largely one-sided adjustment. Michael Pettis predicts that “Germany will stubbornly refuse to bear its share of the burden of the European adjustment, and the subsequent retaliation by the deficit countries will cause German growth to drop to zero or negative for many years.” I hope that prediction turns out to be false but this is the risk.
In the Germans’ defence, it must be noted that they have put a number of reflationary policies into place to boost domestic wage growth and demand and that this has been ongoing since at least the beginning of this year. Moreover, the move to backloading austerity and the support of the ECB’s OMT program have been key concessions by Germany. So, it’s not that Germany isn’t making adjustments. The question is whether those adjustments are enough to offset the deflationary bias of the policy governing the periphery. Many believe the adjustments have not been enough. I agree. For example, I learned just today that inflation the euro area is the lowest in four years (link in Dutch). That tells you that deflation – even debt-deflation – is still a threat to the eurozone.
Europe is in a tepid upswing right now. We should rejoice over this. Let’s hope it can be sustained. However, my conclusion about the macro situation is that this is a false dawn. The Germans will have to move more forcefully to improve their own domestic demand or they will have to relax the deflationary policies governing the periphery – or both. If the Germans do not change course, the high levels of both private and public debt within the euro zone will impede demand, eventually leading to defaults, credit writedowns, bankruptcies and renewed crisis.
The US criticism of Germany’s economic policy is correct
Today’s commentary
Summary: The U.S. Treasury’s semi-annual currency report had surprisingly strong criticism for Germany. The U.S. claims that Germany’s macroeconomic policies are inherently deflationary, creating risk for further crisis. I agree with this criticism and I will explain why it is valid here.
Here is the part of the report on Europe that everyone is talking about (pdf here). I have added underlining on the key bits for emphasis:
Explosive commentary!
From a political perspective the release of this report is unfortunate for a number of reasons. Right now, the U.S. is in the hot seat for its massive spying operations and Germans are particularly incensed over the decade long spying on German Chancellor Angela Merkel as well as the U.S.’s indiscriminate collection of German e-mails and internet activities. So, the criticism will most probably be disregarded for this reason alone.
Moreover, the recent U.S. shutdown and threat of sovereign default has made U.S. economic policy look disastrously reckless. And so it strikes anyone watching events as the height of hypocrisy that the U.S. could criticize any nation for its macro policies.
But the criticism is right. Here’s why.
Exports lower a nation’s living standards. Every economist knows that the central tenet of trade theory holds that exports are a cost and imports are a benefit. Free trade is predicated on this framing. Here’s how economics professor Andrea Terzi put it early this year:
The point here is that exporting for export’s sake or for GDP’s sake is a simplistic understanding of the cost-benefit analysis of trade policy. This can lead to big problems.
In Europe, the genesis of this thinking has roots from twenty years ago. After reunification, Germany had a speculative bubble and crash which put the economy into what I have called a soft depression. The Germans saw three fixes for this. First was exports. The Germans have an industrial base which is far larger than the U.S. or Britain which are more heavily dependent on services and finance. The Germans understood that a large manufacturing base made it easier for GDP to benefit from exports. Second was the euro which would eliminate currency volatility within Europe and open up export markets within Europe more fully to German wares. And third was wage restraint and labour market reform, which Chancellor Schröder was able to enact.
However, when the financial crisis hit, Germany suffered disproportionately, with GDP falling 5% in 2009 alone. The Germans had one of the more severe collapses in GDP in the eurozone in 2009 because of the German economy’s lack of domestic demand and the dependence on exports for GDP growth.
Now, large export of goods means a large export of capital as the current account surplus implies an equivalently large capital account deficit. Because of Germany’s export-led growth model, the euro zone is one giant vendor financing scheme. The Germans are effectively loaning the Spanish and the Greeks money to buy their goods. The way this goods export shows up in national accounting is not via the borrowing by the specific purchasers of the goods but via the recycling of funds through the banking system that results in a net export of capital from one country to another. For example, German banks ended up with large financial holdings in Spain, far in excess of what Spanish banks have in Germany. But vendor finance only works if the borrower has the funds to repay the loans. In the case of the eurozone, the scale of this vendor financing was so large that repayment has become problematic.
All of this, remember, is because of an imbalance within the eurozone between surplus and deficit nations. The right thing to do here then would be to rebalance such that the deficit nations have lower deficits and the surplus nations have lower surpluses. But that is not what the Europeans are doing. Instead, the Germans are attempting to maintain their surpluses and to force internal devaluation policies on deficit countries in order for them to also have a surplus as well. This is the stated policy goal. In essence, the European policy is to turn Europe into one big vendor financier with an aggregate current account surplus.
This is disastrous and has led to the deflationary bias that the U.S. Treasury complains of. I predicted in 2010 that Spain’s debt woes and German intransigence lead to double dip.And they have done. Yet, the policy is still the same – largely one-sided adjustment. Michael Pettis predicts that “Germany will stubbornly refuse to bear its share of the burden of the European adjustment, and the subsequent retaliation by the deficit countries will cause German growth to drop to zero or negative for many years.” I hope that prediction turns out to be false but this is the risk.
In the Germans’ defence, it must be noted that they have put a number of reflationary policies into place to boost domestic wage growth and demand and that this has been ongoing since at least the beginning of this year. Moreover, the move to backloading austerity and the support of the ECB’s OMT program have been key concessions by Germany. So, it’s not that Germany isn’t making adjustments. The question is whether those adjustments are enough to offset the deflationary bias of the policy governing the periphery. Many believe the adjustments have not been enough. I agree. For example, I learned just today that inflation the euro area is the lowest in four years (link in Dutch). That tells you that deflation – even debt-deflation – is still a threat to the eurozone.
Europe is in a tepid upswing right now. We should rejoice over this. Let’s hope it can be sustained. However, my conclusion about the macro situation is that this is a false dawn. The Germans will have to move more forcefully to improve their own domestic demand or they will have to relax the deflationary policies governing the periphery – or both. If the Germans do not change course, the high levels of both private and public debt within the euro zone will impede demand, eventually leading to defaults, credit writedowns, bankruptcies and renewed crisis.