The German economic miracle is coming unstuck. And while a German recession this year would merely be a technical recession, it would highlight the underlying flaw in German economic policy, both domestically and for the Eurozone as a whole. The German paradigm is predicated on fiscal probity, wage restraint and growth via trade. As such it is at once predicated on weakness in both public sector and private sector domestic consumption and on export competitiveness due in part to lower cost. This policy worked for Germany in isolation in the previous decade. But it means a perpetual domestic consumer weakness and a dependence on foreign demand. For the Eurozone as a whole, the German model will be catastrophic.
The economic history
In understanding how we got here, let’s start with German reunification. As I outlined in my post on Germany’s post-reunification soft Depression, German reunification was botched from an economic perspective. The east Germans were brought into the union at too high an exchange rate, putting a drag on eastern labor productivity just as eastern Germany lost its export markets in the eastern bloc. Unemployment skyrocketed and the fiscal drag was severe. The result was an economic malaise that lasted into the formation of the euro and the Eurozone.
Early in the 2000s, when the Internet bubble popped, Germany and France both entered recession. German Chancellor Gerhard Schröder and French President Jacques Chirac successfully lobbied to relax the Maastricht Treaty deficit hurdle in order to allow their economies to recover more quickly. Having suffered multiple downturns since reunification, Germany went further and instituted a program of reforms called the Hartz Reforms in order to give the famously expensive and rigid German labour market more flexibility and to lower the cost of labour.
Comparing Germany and Italy in the subsequent period reveals how successful this effort was.
First, let’s note that German labour costs continued to outpace costs elsewhere. The comparison to Italy shows Italian labour costs as always much lower than German ones throughout the euro period.
Source: VoxEU.org
But labour costs grew more slowly in Germany than in Italy. And just as importantly, labour productivity in Germany advanced prodigiously, while it stalled in Italy.
Source: VoxEU.org
With Germany locked into a fixed exchange rate with its major trading partners in Europe, relative unit labour costs for Germany plummeted, allowing the Germans to export to the rest of the Eurozone, not just based on the quality of their wares but also based on price.
Source: VoxEU.org
The economics behind the German model
In 2011, I wrote three posts highlighting the German model and the secret to Germany’s success. In the first post, I noted that “in the private sector, German households have the second lowest debt levels in the G7. And in the public realm, German fiscal deficits are the lowest in the G7 and are now poised to drop under the Maastricht 3% hurdle.” Today, the private debt remains low and the fiscal deficits are even lower. Though Germany has technically been in violation of the Maastricht Treaty for most of the euro’s existence, debt is not a big problem either in the public or private sector. This is the primary goal of the German model, to minimize debt as a potential catalyst for crisis. But this economic model suffers from multiple shortcomings.
First, as originally implemented, the German growth model was effectively a vendor financing scheme. The Germans exported goods and services to Eurozone trading partners, using increasingly favourable relative unit labor cost developments to increase their trade surplus. In return, German banks effectively financed the current account deficits of the periphery. When the periphery went into recession in 2008, the German economy collapsed, recording the worst decline in GDP in the history of the Bundesrepublik. While Germany has successfully reoriented itself away from over-reliance on the Eurozone periphery, this episode highlights the dependence on foreign demand inherent in Germany’s economic model. Moreover, recent German economic weakness is also due to weakness abroad, highlighting again that the German model is susceptible to slowdowns abroad.
Second, Germany is demographically challenged, meaning it is aging quickly, in part due to increasing lifespans and low fertility rates in Germany. This is a drag on consumption growth and strains the allocation of resources used to fund the German social safety net. In this context, a model based on suppressing unit labor costs is inherently deflationary, meaning it lowers domestic consumption growth enough to engender retail price cuts just to spur demand. A country like Germany, with poor demographics needs a growth model not to succumb to deflation as Japan, with even worse demographics has done. Having Italy take on the German model, then, is a recipe for disaster given Italy’s bloated public debt load and poor demographics. Italy needs domestic growth much more than it needs export-led growth.
Third, the German model is inherently a beggar thy neighbour policy. The German paradigm takes point one about dependence on foreign demand and point two on domestic weakness as given and relies on productivity growth and real effective exchange rates to drive growth. If we think of a closed economy as balancing government and private spending, in an open economy, this balance can be changed even though current account and trade flows net to zero because one country runs a persistent and large current account surplus. Germany’s current account surplus is so large that it risks EU fines as a result. But it is exactly this surplus which allows Germany to run a government budget surplus and maintain a private sector surplus at the same time.
Moving from Germany to Europe as a whole
Despite the flaws in this economic model, Europe is in the process of trying to transform the whole of Europe into one super-sized Germany, with private savings balanced, not by public deficits, but by low public deficits or public surpluses and current account surpluses across the Eurozone. In essence, the Eurozone is moving from a net neutral position to a permanent current account surplus position, relying on external demand to maintain economic growth, while domestic demand is curtailed by wages and government austerity.
If we go back to the Schröder period, we can see the genesis of this thinking. As much as the Germans praise Schröder’s Hartz reforms, they have always regretted the changes to Maastricht France and Germany allowed to occur in 2003. Just as in the lead-up to Maastricht, Germany was directly responsible for watering down the debt criteria for political reasons to allow Italy into the Euro, Germany was equally responsible for the changes to the deficit criteria. And many parts of the German policymaking crowd regret this. For example, earlier in the week, Former ECB Chief Economist Jürgen Stark and IFO head Hans-Werner Sinn talked about 2003’s “destruction of important planks” of the Maastricht Treaty (link in German).
The Germans, therefore, see the genesis of the sovereign debt crisis as being a lack of adherence to the tenets of Maastricht. In accordance with this thinking, the ECB has floated the idea of a Super stability and growth pact for Europe that includes penalties, oversight and now potentially expulsion for serial violators. We are seeing the first test of this thinking in the treatment of France and Italy’s 2015 budget review process. Pressure is on Luxembourg-born EC Head Jean-Claude Juncker to reject these budgets as not sufficiently austere in order to move toward a more stringent fiscal paradigm now that the sovereign debt crisis is deemed over.
The problems in the periphery are seen as an “opportunity” to push through reform that may not otherwise be available.
“Crisis necessary for structural reforms”
These politicians were not even satisfied with the state of structural reforms in their own country, arguing that Germany still had much work to do. But based on their experience of the difficulty of implementing these reforms, they believe firmly that this represents a once-in-a-lifetime opportunity to pursue similar initiatives in southern Europe.
When Germany implemented its reforms around 2005, there was no time to waste because German businesses were moving one factory after another to the low-wage countries of eastern Europe. Even so, they said there was tremendous political opposition. What they learned from this experience was that such reforms were possible only under crisis-like conditions. That experience contributed to their view that the current economic crisis represented an excellent opportunity for fundamental reforms in southern Europe.
Perfect opportunity?
In other words, Germany’s own trying experiences around 2005 had convinced them that the unfolding crisis in southern Europe represented a once-in-a-lifetime opportunity. Chancellor Angela Merkel’s tendency to talk about the need for structural reforms whenever she has a chance is based on her own experience of the difficulty of implementing those reforms in Germany. One member of parliament close to Ms. Merkel said the Chancellor is not opposed to fiscal stimulus itself but cannot accept fiscal stimulus without structural reform.
The way to accomplish this is through beggar-thy-neighbor Eurozone-wide current account surpluses. The Germans would prefer to see this happen via productivity growth and lower relative unit labour costs in the periphery rather than through currency effects.
Some ECB governing council members like Austrian central bank head Nowotny have suggested ECB policy is geared toward driving down the euro. But this will have limited impact on trade balances in the periphery since much of their trade is intra-EU. Moreover, we can see the problem with relying on the currency to do the heavy lifting as this approach has not worked in Japan.
But the Germans have said previously that they are willing to risk a higher inflation rate and permit wage increases as long as reforms in the periphery allow unit labour costs there to decline.
Conclusions
I don’t see this working. The policy is deflationary and completely unworkable on a European-wide level when we are barely out of the acute phase of the sovereign debt crisis. The reason the Eurozone is mired in an economic malaise is because of this approach.
Moreover, given the fiscal and wage restraint, the central bank and the EIB are the only vehicles left to add stimulus when needed. This accounts for the primacy of monetary policy in Europe.
But monetary policy alone won’t get Europe where it needs to go. The latest statements from Bundesbank head Jens Weidmann demonstrate how restricted the ECB’s role truly is. In an interview with the Wall Street Journal, Weidmann made his displeasure for the activist policy of the ECB known. And while he did not rule out government bond purchases, he did say they were a last resort. And Weidmann did say no to the ECB’s ABS program. Thus, it leaves TLTRO as the only vehicle that Weidmann seems to support which will add liquidity. At the same time, IFO President Sinn has suggested lawsuits are coming due to the ABS program, which he deems ‘illegal fiscal meddling’.
Perhaps the EIB will eventually be pressed into action. But we are a long way from there. In the meantime, the weaknesses of the German model will undermine domestic consumption growth in Europe and bring deflation closer and closer to a reality. Eurozone core government bonds will continue to rally under this scenario, while periphery bonds may at some point decouple due to renewed doubts about the ECB’s backstop.