Why export-mad Germany and the euro can't coexist indefinitely

by Michael Collins, Investment Commentator at Fidelity International

August 2016

The eurozone, after eight years, has just achieved an economic feat that took the world economy just one year to complete.[1] Advanced economies as a group managed the exploit in only two years; Germany and the US in just three. Even Japan managed the accomplishment in six years, while countries such as Australia and China were too successful to face the challenge. The currency bloc’s triumph was that its output in the first quarter of 2016 finally surpassed its pre-crisis (2008) level.[2]

The eurozone’s economic recovery is yet to be achieved on an annual basis, which is a better hurdle. GDP per capita still has to catch up. Unemployment is still about 3.5 percentage points higher than it was eight years ago.[3] Nonetheless, the news sparked talk that Europe is emerging from its economic downturn.

If the eurozone is escaping recession then the imbalances that triggered the eurozone’s financial crisis should be history too because recessions are capitalism’s way of fixing flaws – think of how a slump curbs inflation. The eurozone financial crisis was triggered in 2009 when Greece admitted to lying about its public finances. But excessive government debt didn’t trigger the crisis, even though it became a symptom. The calamity was sparked by external imbalances between the members of a fixed-exchange-rate system. These disparities are captured in current accounts, the widest measure of a country’s trade with the rest of the world.

The culprit was largely Germany’s hyper export success. Germany’s current-account surplus exceeded 5% of GDP from 2004 to 2008. Other large surplus countries were the Austria (4.5% of GDP in 2008) and the Netherlands (5.8%). Germany’s matters more, though, because, as Europe’s largest economy, it comprises about 30% of the eurozone economy; it’s more than four times larger than, say, the Netherlands. On the current-account deficit side, to no surprise, were the countries that needed to be rescued: Cyprus, (a current-account balance at minus 7.7% of GDP in 2008), Greece (minus 12.4%), Ireland (minus 3.3%), Portugal (minus 10.4%) and Spain (minus 4.3%).

Eight years of hardship later and Germany’s role in triggering the crisis is unaddressed. In fact, the situation has worsened. Germany’s current-account surplus soared to a record 8.5% of output in 2015, a gap the country is expected to maintain in coming years. This imbalance has financial consequences that led to, and in turn are exacerbated by, the imposition of negative interest rates across the eurozone. Perhaps even more worrying these days, the imbalance has political repercussions. These extend to a brawl between Berlin and the European Central Bank and the rise of the right-wing anti-euro Alternative for Germany party. Its success is pushing Angela Merkel’s coalition to the right within Germany and is forcing her to take harsher stances against deficit neighbours.

To be sure, some imbalances on current accounts will always exist. Austria and the Netherlands are still running surpluses (3.6% and 11%, respectively, in 2015). So Germany is not the only source of instability within the euro straightjacket. Germans could go on a spending spree and rectify the problem. Many deficit countries have narrowed their imbalances on the current account in recent years. Italy, Ireland, Spain and Portugal have even turned deficits into surpluses by crunching imports and Greece has almost achieved the feat (a deficit of just minus 0.004% of GDP in 2015). So one side of the imbalance has deflated. There could well be bigger threats to the eurozone anyway. Populists gaining control of a major country via elections, for example, can’t be ruled out. The eurozone could always create the political, fiscal and banking ties that a currency union needs, breakthroughs that would diffuse the threat from external imbalances. (These ties ensure that imbalances between the states don’t pose a threat to Australia’s currency union, although trade flows do determine standards of living.) But there’s little chance of closer integration in Europe. What hope is there then for the eurozone if the cause of its original crisis is as menacing as ever?

Success leading to failure

Germany is such an industrial powerhouse its exports amount to about 50% of its GDP, which is a large number for such a big economy (and sometimes a weakness, for it makes the country hostage to global growth). By way of comparison, US exports total about 15% of US output.

But Germany’s export success hasn’t always come easily. Absorbing the inefficient former East Germany in 1990 dragged on the reunified country’s economic growth and reduced its competitiveness. A strong Deutsche mark at the time hastened the decline in competitiveness. Around the turn of the century, Germany’s sluggishness earned it the nickname the “sick man of Europe”. To help the country regain its export edge, German businesses negotiated with unions to ensure that wages lagged productivity gains. To aid exporters, Berlin implemented welfare changes that pushed people into work (the Hartz IV reforms), gave companies more flexibility to adjust staff numbers to match economic conditions and made tax and other concessions to encourage foreign sales. From 1999, exporters enjoyed a boost from the more favourably priced euro. Add on the emerging world’s appetite for German capital goods and the German economy flourished so much in the mid-2000s that the era became known as the second Wirtschaftswunder or miracle (the post-war recovery being the first).

Obviously a key sign of Germany’s economic rebound was a healthy balance of payments, which consists of the current and capital accounts. To make the balance of payments balance, the capital and current account must offset each other. So too must countries’ balance of payments add up to zero. One country in current-account surplus means others must be in current-account deficit, while the opposite happens with capital accounts. The eurozone crisis was essentially triggered because capital flows from creditor (or current-account-surplus) countries flowed to debtor (or current-account-deficit) countries, a process enabled by the adoption of the euro because it did away with currency risk. In a sense, capital overflowed into debtor countries generally in the form of bank loans or investments. The money encouraged excessive consumption and wage spirals and created asset bubbles. Deficit countries became uncompetitive to the point of crisis when private creditors lost faith and rescue packages were needed to stabilise the weaker countries (and repay lenders in creditor countries).

Under a flexible-exchange-rate system, currency movements help rebalance external deficits while policymakers can curb demand through monetary and fiscal policy for the same end (by lowering demand for imports). Under the fixed-exchange-rate euro system, members lack a currency and a monetary policy. Only through fiscal policy can policymakers take steps to calibrate competitiveness and demand to correct imbalances. Thus creditor nations pushed austerity, a form of internal devaluation, as the chief remedy (along with micro-economic reforms). One of the many problems with austerity is that creditor countries imposed it on themselves at the same time, thus negating any competitive advantage it gave the debtor nations. A more drastic option to correct imbalances, if it were ever needed, would be debt forgiveness by creditor countries. But that solution would pose a systemic threat to the banking systems of creditor nations and would punish their taxpayers. This option thus rules itself out.

The only other remedies the EU has to fix external imbalances are rules that carry penalties if breached. Under the Macroeconomic Imbalance Procedure, the EC (via a lengthy process) is supposed to fine countries if their current-account surpluses exceed 6% of GDP for three consecutive years. Yet nobody is pursuing Germany (or Luxembourg or the Netherlands) for busting this limit for five straight years.[4] The EU’s hypocrisy in seeking to enforce laws on fiscal deficits (and refugee quotas) is helping to fan right wing parties across the continent.

Obvious solution

A current-account surplus generally shows two things. The most obvious is that exports (broadly defined) exceed imports, an outcome that boosts GDP growth. The other is that it’s a sign of excess savings (or too little consumption) in an economy. Consider then, that with all its recent export success, Germany’s economy has only averaged 1% growth per annum over the past four years. This means that Germany’s economy has grown only by sucking demand from other economies, mostly its neighbours. Germany’s distorted economic model and the austerity Berlin has enforced on itself and deficit countries hold much blame for the poor performance of the deflation-prone eurozone economy. The menace of deflation, in turn, prompted the European Central Bank to introduce negative deposit interest rates in 2014 and commence quantitative easing in 2015, steps that have led to negative yields on much European sovereign debt. As of August 31, German bonds out to 10-years offered negative yields. The 10-year bond was yielding -0.12%.

Germany’s economic and political problem is that its savings glut leaves the country more vulnerable than most to the unheralded experiment of negative interest rates. Germans place most of their savings with banks so these deposits form a hefty share of bank liabilities. German banks, under pressure to offer positive nominal interest rates, are among the most exposed to the damage that negative rates are inflicting on traditional banking models.[5] Even more precariously situated are German life insurance companies because their business models are based around offering guaranteed rates of return. BaFin, Germany’s financial regulator, warns that low interest rates are a “seeping poison” within Germany’s financial system.[6]

Such is the angst about negative interest rates in Germany that Finance Minister (Treasurer) Wolfgang Schäuble blames the ascent of the populist Alternative for Germany party in part on the ECB’s policies. “Ultra low interest rate policies are 50% responsible for the rise of the Alternative for Germany party”, was how Schäuble put it.[7] Amid media coverage that painted the ECB as a threat to Germany’s prosperity and tarred low rates as subsidies for lazy deficit countries, the Alternative for Germany party in regional (state) elections in March won 15% of the vote in Baden-Württemberg, 12.5% in Rhineland-Palatinate and more than 24% in Saxony-Anhalt. These results forced Berlin to toughen its stance in the latest debt showdown over Greece, to name just another confrontation that tears at European cohesion. The same shift to right-wing populism is taking place in the Netherlands too.

The best solution to Europe’s external balances would be for German policymakers to take steps to spur domestic demand in Germany. Measures to encourage consumer spending or decisions to boost public investment, especially to fix Germany’s crumbling infrastructure, would bolster German living standards, narrow external imbalances in the eurozone, prod the eurozone economy and could even engender some inflation that would lift bond yields. At the same time, it would ease tensions between Berlin and the ECB and possibly undercut the drift to populist parties. Alas, Germany’s mercantilist mentality, its inflation phobia, its rigidity on public finances and the political backlash inside Germany against the damage wrought by the eurozone’s eight-years struggle to regain its pre-crisis peak block these cures.

Eurozone current account and growth numbers come from the IMF’s World Economic Outlook database. April 2016. http://www.imf.org/external/pubs/ft/weo/2016/01/weodata/index.aspx. Other financial information comes from Bloomberg unless stated otherwise.


[1] The data allows for the enlargement of the eurozone since 2008. http://ec.europa.eu/eurostat/data/database

[2] IMF World Economic Outlook database. April 2016. Measured in US dollars. Greece, Japan and the US set their pre-crisis peaks in GDP in 2007 while Germany’s was set in 2007.

[3] Eurostat database. http://ec.europa.eu/eurostat/data/database

[4] Europa website. Macroeconomic Imbalance Procedure.  http://ec.europa.eu/economy_finance/economic_governance/macroeconomic_imbalance_procedure/index_en.htm

[5] IMF. “Global financial stability report: Potent policies for a successful normalisation.” “Box 1.3. Impact of low and negative rates on banks.” April 2016. http://www.imf.org/external/pubs/ft/gfsr/2016/01/pdf/c1_v3.pdf

[6] German financial watchdog warns on low rates “poison”. 10 May 2016. http://www.ft.com/intl/cms/s/0/2304a2f6-16a5-11e6-b197-a4af20d5575e.html#axzz488LuorWe

[7] Telegraph. “Europe doesn’t work for Germany either, as Schäuble faux pas demonstrates.” 26 April 2016. http://www.telegraph.co.uk/business/2016/04/26/europe-doesnt-work-for-germany-either-as-schubles-faux-pas-demon/