The intra-Eurozone current account deficits have frequently been mentioned as one of the causes of the current malaise in the euro area. Krugman (2012(1)) has stated that the current crisis is “a balance of payments problem, in which capital flooded south after the creation of the euro, leading to overvaluation in southern Europe”. Dadush and Wyne have argued that at the root of the current crisis lies severe misalignment of real effective exchange rates in the Eurozone. In the public discourse one can also frequently come across a simplified explanation of the roots of the current crisis, which tells you that the current account surplus of Germany has largely been achieved at the expense of southern Europe*, where countries have lost competitiveness due to inability to devalue their currencies.
Some authors have also been quick to prescribe medicine to the Eurozone based on the above diagnosis. Krugman (2012(1)) has suggested that “non-GIPSI European leaders should realize that what the GIPSIs really need is a general European reflation” and a way to correct the imbalances would be for Germany to accept inflation above 2% (say 4%) for several years while southern Europe would have zero inflation. According to him, “we need a real devaluation in Spain mainly via German inflation rather than Spanish deflation. 4 percent German inflation plus zero in Spain might work; 2 and minus 2 can’t” (Krugman, 2012(2)). Darvas has also suggested that unit labor cost increases in the “core” countries would be one way to achieve internal adjustment. Dadush and Wyne mention that higher Eurozone inflation would ease adjustment in the periphery. The logic goes that this would help southern European countries regain competitiveness and bring their current accounts back to balance while the übercompetitiveness of Germany would be reduced and along with it its trade surplus.
Indeed, while Germany has been running a large current account surplus, such countries as Spain, Portugal and Greece and to a lesser extent Italy have been living with current account deficits for many years, the flip side of the coin being that the deficits have been financed by borrowing from abroad. Thus the southern European countries have been accumulating more and more foreign debt, both public and private or, in other words, their net international investment positions have deteriorated. However, this does not tell the whole story. Let us look at how the competitiveness of Germany and southern European countries evolved during last decade by examining the development of their market shares in global merchandise exports since 2000.
The market share of Germany in global exports in 2011 was about 8.2%, only slightly down from 8.6% in 2000. At the same time Italy’s market share has gone from 3.8% in 2000 to 4.0% in 2003 to 2.9% in 2011. However, Germany has also been losing market share since 2003-2004 when it peaked at about 10% and a similar trend over last decade has been experienced by most other developed countries. The name of the biggest gainer is, of course, China, as can be seen in the chart below.
As the economies of China and such countries as Turkey and Russia have been growing faster than the economically advanced nations, it is only logical to expect the weight of the former in global trade to increase at the expense of the latter. Thus, if Germany is the only nation that has been able to keep its market share almost unchanged while those of other countries have gone down significantly, that might indeed give support for the argument that Germany is benefiting from an undervalued exchange rate. However, looking at a broader set of countries, a somewhat different picture emerges.
Both Switzerland and the Republic of Korea have shown even stronger merchandise export development than Germany while allowing their currencies to float. At the same time Sweden with a freely floating currency and Denmark with a band vis-à-vis the euro, both frequently celebrated as export champions, have seen their global market shares fall during last decade by about as much as Italy. It is true that this comparison over time ignores the fact that the ratio of exports to GDP in Sweden and Demark was much higher than in Italy back in 2000, however, since then Italy has done as well (or as badly) as Sweden and Denmark while the other southern European countries have done better in relative terms.
Finally, it could be possible that Germany has been able to keep its share of global exports almost constant by increasing its exports to southern Europe, in particular, its larger economies such as Italy and Spain. However, a look at the development of the market share of German merchandise exports into Italy, Spain, Portugal and Greece does not confirm this view either. As can be seen in the chart below, Germany has been losing market share in southern Europe during last decade.
Germany is not trading only with southern Europe. In fact, more than half of its foreign trade turnover is with countries outside the Eurozone. Three of its Top 5 and five of its Top 10 trading partners are not members of the euro zone and the large weight of the Netherlands in its trade turnover is partly explained by the port of Rotterdam being a significant transportation hub for German imports and exports.
What can we conclude from the above analysis of merchandise export market shares? While the role of capital inflows in sustaining the current account deficits in southern Europe is obvious and Spain, Portugal, Greece and even Italy had relatively low ratios of exports to GDP at the advent of the euro, it is wrong to say both that the export sectors of southern European countries have experienced a huge loss of competitiveness during last decade and that this has happened as a result of their inability to devalue. In fact, the loss of global export market shares by southern European countries since 2000 has been comparable with that experienced by large developed trading nations while changes in market shares over a longer period of time are not correlated with the currency regime chosen by a country (Aghion and Durlauf).
The above also means that the cure suggested for the Eurozone in the form of higher inflation in the “core” countries might actually rather turn out to be poison. For example, what would be the result of German ULC going up significantly? That would inevitably result in loss of competitiveness and market share in global exports. However, the German market share in global exports is 8.2% while the combined market share of Italy and Spain is about 4.6%. Given the relatively lower weight of southern Europe in the global exports, the gains in competitiveness by Italy and Spain as a result of zero inflation there are unlikely to be big enough to offset the losses by Germany. Thus, not only Germany, but the Eurozone as a whole would be worse off as a result.
A fundamental problem for the Eurozone is that its institutions lack credibility, and higher inflation will further reduce credibility without contributing to long-run growth. The original rules of the Eurozone stated that member countries were not responsible for the debts of other members. Explicit limits were imposed on the size of budget deficits and debt ratios. The European Central Bank was assigned an inflation goal that would dominate all other goals. The nature of Eurozone membership has changed dramatically as nearly all these rules have been broken. Members are increasingly responsible for the debts of others. Most members violate the budget deficit and debt limits with impunity. Now if higher inflation is imposed on the European Central Bank, all the original rules will have been violated. The rule of law would be replaced by an awkward and unpredictable policy of „making up the rules as one goes along”. Any future promises or commitments by Eurozone institutions would have little credibility with the public as a result. Furthermore, once inflation gets anticipated, it is difficult to lower inflation expectations without a severe reduction in real output and employment.
The export sectors in Italy, Spain, Portugal and Greece might indeed be relatively small for them alone to bring the countries back onto growth path. We agree that a part of the solution could be tax changes in the southern European countries that incentivize exports and discourage consumption and imports, and more far-reaching labor and product market reforms as proposed by Dadush and Wyne. Similar ideas have been proposed by Gopinath et al. as well as Keen and de Mooij. A combination of privatization of state assets and debt restructuring is also an option for southern Europe to bring the public debt to GDP ratios down to a level that does not hamper growth (see Caner et al.). Reducing the competitiveness of Germany and resorting to inflation should not be a part of the solution.
*For the purpose of this analysis southern Europe refers to Greece, Italy, Portugal and Spain
Aghion, Philippe and Stephen Durlauf, eds., “Handbook of Economic Growth”, Elsevier, 2005.
Caner, Mehmet, Thomas Grennes and Fritzi Koehler-Geib, “Finding the Tipping Point – When Sovereign Debt Turns Bad”, The World Bank, July 2010.
Dadush, Uri and Zaahira Wyne, “Is the euro rescue succeeding? An update”, VoxEU.org, April 20, 2012
Darvas, Zsolt, “Internal adjustment of the real exchange rate: Does it work?”, VoxEU.org, July 6, 2012
Gopinath, Gita, Emmanuel Farhi and Oleg Itskhoki, “A Devaluation Option for Southern Europe”, Project Syndicate, March 1, 2012
Keen, Michael and Ruud de Mooij, “Fiscal devaluation as a cure for Eurozone ills – Could it work?”, VoxEU.org, April 6, 2012
Krugman, Paul (2012), “European Crisis Realities”, New York Times, February 25, 2012
Krugman, Paul (2012), “The Breakeven Point (Wonkish But Terrifying)”, New York Times, June 1,2012
19 Responses to “Is Germany Übercompetitive and Should it Accept Higher Inflation?”
This analysis is a non-sequiter. The issue is relative trade balances- positive for Germany, negative for the periphery. The absolute flows and global flows are red herrings. The relative balances lead to relative financial flows, i.e. endless borrowing in the periphery, as noted, which at some point, as all unsustainable things, reaches an end if forced to occur on market terms.
It is true that inflation is a poor and blunt solution. Better to have full monetary, fiscal and banking union, where the banks operate on a fully europe-wide basis, with deposit insurance, the ECB acts as lender of last resort for all members, and fiscal support goes by automatic mechanisms from richer to poorer regions. And the member governments do not have significant independent borrowing capacity.
Inflation through monetary measures is undesirable, but wage hikes in germany at 6% and at 1% in the periphery woud also be à solution. And that is exactly what is happening.
Neither Spain, Greece or Portugal compete with the high-end goods Germany produces. They compete with Asia. Whatever Germany does, the problem is that there is hardly a product you could not source cheaper, faster and in better quality than from Southern Europe. The Euro crisis is a competitiveness crises of bloated and sclerotic Southern Europeans, failing to adjust to challengers from Asia – and to a certain extend – Eastern Europe (Poland, Czech Republic, etc)
Great comment Dan!!
Let me add that in my opinion leave GIIPS compete vs. Asia without a free x-rate floating regime for China represent a structural problem that should be urgently solved by IMF and/or WTO: that incoherence undermines world trade "decent flows".
Burkbraun is right that it's the flows within the EZ that matter. Also, it was the credit bubble that caused the periphery current account deficits, not the other way around.
I don't see how engineering more inflation in Germany would solve the periphery's recession and capital flight crisis. The only way it could be done would be with very large fiscal stimulus, driving Germany's debt-to-GDP well above 100% while making the German economy very much less efficient. This is where the authors' points really come in. For every euro of German fiscal stimulus, only some pennies would reach the periphery. Most would go into imports from China and the rest of the emerging world.
Try this analogy. You've got a neighbor who overspent and overindebted himself. Do you solve the problem by leaving him to live with the austerity that lenders will impose on him, or by having the neighborhood all agree to spend 10% more each year? The latter might help if you live in the kind of village where everybody buys almost everything from fellow villagers. Europe is not that kind of village.
burkbraun: Yes, a country's total foreign borrowing is identically equal to the negative of
its balance on current account. But if the issue is the ability of a government to repay its
sovereign debt, this is more closely related to a government's budget deficit, interest payments on outstanding debt, and the rate of economic growth (current and future).
Private borrowing may be positively correlated with government borrowing, but they are not Identical.
I agree that once individual EZ members accept liability for the debts of other members,
the system cannot work without much tighter fiscal and banking union. However, this requires greater political integration that some current and prospective EZ members are reluctant to accept. ThomasGrennes
Dan: Yes, wages and incomes per capita are substantially lower in Spain, Greece, and Portugal than in Germany, and there are de facto barriers to labor mobility. Robert Mundell pointed out in his seminal 1961 article on optimum currency areas that countries with wage differences and labor immobility would face problems in monetary unions.
I find it very interesting to put the export trends in a global context, and I agree with the prescription that structural reforms are needed in Southern Europe. Beyond that, there are some points in this post I am not so sure I agree with.
1. "For example, what would be the result of German ULC going up significantly? That would inevitably result in loss of competitiveness and market share in global exports." If the ULC increase is the result of inflation induced by monetary policy, why wouldn't the nominal exchange rate of the euro weaken enough to leave the real exchange rate unchanged? Maybe it's not that simple, but somehow the argument needs to encompass the effects of different policy options on the real and nominal value of the euro relative to trading partners.
2. "Now if higher inflation is imposed on the European Central Bank, all the original rules will have been violated. The rule of law would be replaced by an awkward and unpredictable policy of „making up the rules as one goes along”." The trouble is, the EZ rules never should have had any credibility in the first place. The fiscal policy rules were crudely formulated; the ECB's hard-line commitment to inflation targeting came into being just at a time when other economies were realizing the limits of IT and shifting to flexible IT; and it should have been foreseen that solvent euro members would blink the first time any EZ members reached the brink of default. There was never any alternative to making up the rules as one went along. No credibility is at risk because there never was any. If the EZ is to continue to exist, it must have a new set of rules. Internal structural consistency is a necessary (although I agree, not sufficient) condition for any set of rules to be credible.
3. "Furthermore, once inflation gets anticipated, it is difficult to lower inflation expectations without a severe reduction in real output and employment." This is definitely something worth worrying about. The solution could be some set of rules that allows more inflation now without creating open-ended inflation expectations. In principle, something like NGDP targeting should do that. Monetary policy aiming at 4 to 5 percent NGDP growth now would create inflation in the short run but the expected rate of inflation would automatically slow as real growth returned. Of course, the commitment to the NGDP target would itself have to be credible to make that work.
Ed, I think you're fooling yourself about the power of monetary policy to generate inflation in this climate. Germany is already effectively getting massive monetary stimulus as a result of the capital flight from the periphery, which results in periphery NCBs creating reserves through refinancing and those reserves being sent mainly to Germany. How much more reserves on top of that do you think the Bundesbank could inject to generate 4-5% NGDP growth. Monetary stimulus would not do much, you would need major fiscal stimulus to drive NGDP higher, and that would make Germany less efficient.
On point 2, if initial EZ rules lacked any credibility, how could any "new set of rules" establish credibility? For the initial rules, at least certain German central bankers (Axel
Weber and Jurgen Stark) thought the rules were credible, but they resigned in protest
when others pressured them to abandon the initial agreement.
On point 1, changing the real exchange rate between Germany and Spain with a fixed exchange rate is problematic. Krugman advocates 4% inflation for Germany and zero for
Spain to accomplish a 4% change in the real rate. However, how does the ECB accomplish
this differential inflation rate by using its control over assets,liabilities, and interest rates, all
in Euros? In recent years the harmonized inflation rate in the EZ has been around 2% with some variation across countries, but I don't think the ECB can control the inflation difference
with any precision even if they wanted to.
Ed, thanks for your feedback!
On your first point – provided that relative PPP holds based on average inflation in the Eurozone, an inflation rate in Germany higher than the Eurozone average would make Germany less competitive.
burkbraun, our main point was that while the trade balances and financial flows are obvious, they are not caused by Germany having become supercompetitive and southern Europe having suffered a huge loss of competitiveness since the introduction of the euro. The implicit conclusion from that – the current account deficits in southern Europe have mainly been caused by excessive imports supported by cheap financing from abroad.
For EU and Southern European countries question is not whether Germany is ubercompetitive with the likes of China, South Korea, US, UK, Japan, Sweden, Switzerland or Denmark. Those countries do not use one currency. The question is whether Germany is ubercompetitive with Southern European countries because their economy is governed by single monetary policy which is strongly influenced by the inflationary fears within the ubercompetitive countries, like Germany, at the expense of struggling countries, like Spain and Italy.
[...] Is Germany Übercompetitive and Should it Accept Higher Inflation? (EconoMonitor) [...]
Prior to the Euro, Greece, Italy, and Spain all had higher inflation rates than Germany. If one can interpret the observed differences in inflation rates as differences in target inflation based on differences in labor market frictions and other economic and political institutions, then these countries would seem to be poor candidates for a successful monetary union.
Some optimists in the Southern countries may have expected to achieve a lower inflation rate like Germany's without other adverse effects, but experience has been different.
one of the purposes of our article was to answer that question and the answer is largely "no".
Thank you for your replies.. how can one characterize the differing trade flow performance of the two areas, then, other than by differing competitiveness? Where else do "excessive imports" come from? Pre-euro, Greece could devalue and regain its proper balance. Now, it has no way out, forever locked in an embrace with more competitive "partners". No one needs to be "hypercomeptitive", just always a little more competitive.
It reminds me of the post-WWI reparations situation, where Germany was asked to render up trade receipts it didn't have and couldn't get. Germany is doing the same to Greece right now, and it isn't going to work any better. No matter how much current debt is bailed out, the structure will never work until either a complete fiscal union takes place, or Greece's borrowing power is destroyed completely (cordoning it off from the euro zone in some respects) and its people sent back to the dark ages .. or some political convulsion.
Helpful graphic hint – line charts are easier to read when the order of the legend from top to bottom matches the order of the lines.
Export market shares are interesting, but I have never seen them used by themselves as indicators of competitiveness or exchange rate misalignments. Imports matter too, and the CA deficits/surpluses are the strongest sign of who needs to appreciate/depreciate. Look, there is nothing wrong or unusual with this: Germany has fast productivity growth, its "currency" should appreciate vis-a-vis its slower and dysfunctional neighbours, just like Balassa-Samuelson for EMs. That means faster inflation than the PIIGS.
With a 2% ECB inflation target, fiscal austerity in the periphery during a recession means low inflation there, which gives an ugly balance sheet effect as the real value of debt increases. If there were 4% inflation overall, maybe you could get by with 2% inflation in the PIIGS; that would make a huge difference in debt sustainability.