European Commission gives Germany a slap on the wrist for its current account surplus, but shirks stronger action

The European Commission has today published its in-depth review of EU member states' macroeconomic imbalances. The European Commission's full memo is here.

This is the follow-up to the report which caused quite a stir back in November, as pressure from the Commission and the US mounted on Germany over its significant current account surplus.

This report had been billed as the arena for the Commission to finally rip into Germany for feeding the imbalances in the eurozone and hampering the periphery’s chances of recovery (although, as we noted back then, to us this is not quite the case in reality).

So, what has the Commission done? Well, it seems to have backed away from this somewhat and given Germany more of a slap on the wrist.

The Commission does say that German imbalances require “policy action” but notes:

“The current account has persistently recorded a surplus at a very high level, which reflects strong competitiveness but is also a sign that domestic growth has remained subdued and economic resources may not have been allocated efficiently.”

Not exactly the strong wording some might have been hoping for. Crucially, it also appeases Germany by suggesting:

“The current account surplus does not raise risks similar to large deficits”

Plenty, including some peripheral eurozone countries and the US, might disagree with this assessment, but it’s clear the Commission has been very careful in how it phrases its criticism.

It does go on to outline the need for “sustained policy action” to boost domestic demand and rebalance away from export led growth. But then it also accepts that this is already happening and that the current account surplus Germany has with the rest of the eurozone has been “receding” since the onset of the crisis. There are few specific policy recommendations in there and the general tone is balanced but with a bit of edge to warn Germany of the need to focus on boosting the domestic economy.

As such this assessment may disappoint those who were looking for a strong position, but to us it is in keeping with the current data and evidence. All that said, there might be a double whammy in there for France and Italy as they come in for some surprisingly strong criticism.

France has dodged being moved to the group of countries with excessive macroeconomic imbalances this time around, but the European Commission’s assessment is far from optimistic. France is losing competitiveness for a number of well-known reasons: high labour costs (primarily driven by high payroll taxes), an “unfavourable business environment”, a “low level of competition” in the services sector and “rigidities in the wage-setting system” resulting in “difficulties for firms to adjust wages to productivity”. Compared to the vague comments on the German economy this is a pretty specific series of sectors which need specific policy action.

France’s public finances are another source of concern, since public debt is on the rise and the European Commission expects Paris to miss its deficit targets “over the entire forecast period” – that is, at least until 2015. This seems to confirm that France is obliged to deliver on economic reform this year. Otherwise, being ‘downgraded’ to the club of countries with excessive macroeconomic imbalances will be hard to avoid.

Italy also gets a pretty damning assessment, and joins the club of countries experiencing excessive macroeconomic imbalances – and potentially most exposed to the risk of fines. According to the Commission,

“Reaching and sustaining very high primary surpluses – above historical averages – and robust GDP growth for an extended period, both necessary to put the debt-to-GDP ratio on a firmly declining path, will be a major challenge."

This assessment, along with the Commission’s repeated hints at Italy’s “chronically weak growth”, paints a pretty clear picture of the size of the challenge facing Matteo Renzi and his government – essentially reversing Italy’s recent economic history and trying to ensure surpluses for decades to come.   

We would also like to pick up on the comments on Finland – a new running theme on this blog, you might have noticed. The report highlights similar issues to ones we did, in terms of some big challenges facing Finland, notably, “industrial restructuring”, “deterioration in competitiveness” and a “declining working age population”.

But it is not bad news for everyone. The Commission, for instance, gives Spain a pat on the back by removing it from the group of countries with excessive macroeconomic imbalances. This because, according to Olli Rehn and his team, “The adjustment of the imbalances identified last year as excessive has clearly advanced, and the return to positive growth has reduced risks.” In practice, this means Spain does remain under surveillance from Brussels – but is no longer at immediate risk of sanctions.

The fallout over the next day or two will be interesting, especially with the German media today reporting that internal German government documents admit some problems with the current account surplus (see our press summary and we’ll have more in a blog post soon).

Reviewing Germany's surplus

As expected, the European Commission today announced a review into Germany’s current account surplus under its Macroeconomic Imbalance Procedure (MIP).

This has been a topic of hot debate recently and has the potential to become a very important debate in the future of the euro and Germany's role in it. We laid out our thoughts on the issue in a detailed post last week. We recommend re-reading it, but the thrust is that, while rebalancing is needed, boosting imports in Germany or cutting exports would do little to help the peripheral economies because they simply do not produce goods and services which Germany want and do not produce the same exports to replace Germany’s if it lost competitiveness.

That said, by the letter of the law the Commission was right to launch the procedure given that Germany has broken its threshold on the current account surplus (over 6% of GDP since 2007, see graph below). The key point is for the Commission to judge it on its merits not as a political process – to be fair the Commission itself stressed this point but there have been hints that it takes a bit of a dim view of the large surplus.

What happens now? It’s early days yet. The Commission will begin its review and complete it by spring next year. The recommendations will then be included in next year’s European Semester and country specific economic recommendations. The key will be how hard the Commission goes on the arguments and how Germany responds. If it fails to implement the reforms the Commission does have the option of imposing a fine or even sanctions on Germany.

Signs on this front so far show the potential for conflict. German reactions have already been quite hostile with CSU General Secretary Alexander Dobrindt warning that, “You don't strengthen Europe by weakening Germany” and CDU General Secretary Hermann Gröhe adding, “Our export strength is the corner stone of our prosperity”. Bundesbank President Jens Weidmann added that expanding Germany fiscal policy is also not the answer, saying, “The positive knock-on effects would be limited”.

There are also a few points in the Commission’s report which are worth picking up on:

Emphasis on euro strength: Numerous times the report argues that Germany’s long standing surplus is helping push up the euro exchange rate, making the periphery’s adjustment harder. This seems a strange point to focus on given that it’s not Germany’s job to manage the exchange rate. There are also plenty of other factors which influence the euro, including but not limited to: actions of other central banks (notably the Fed weakening the dollar) and the repatriation of funds to Europe as banks and business refocus on core European operations. The report also says that Germany’s real effective exchange rate (REER) has come down due to a weaker euro, which seems a tad contradictory.

Causality between deficits and surpluses: The Commission highlights that defining a clear link between one country’s deficit and another’s surplus is not as simple as first seems. This is a point we made in our previous blog. While Germany may have previously been the flip side of other countries deficits, these deficits have now closed and Germany has maintained a surplus by trading with non-euro countries. The Commission also notes that countries such as Germany can play a key role in the supply chain – this means its exports create demand of imports of inputs from other countries, it also highlights that Germany is not always the source of the final demand for imports. The German government itself flagged this up, saying that “40%” of its exports rely on intermediate goods imported from EU partners.

Germany did play a role in previous peripheral deficits: As mentioned above Germany did play a role in sustaining the large deficits in the peripheral countries which helped cause the crisis. However, as touched upon in the report, this is more a failure of supervision (both financial and macroeconomic) and a failure on the part of the periphery to invest the money into factors which would promote long term economic growth. After all these investments were helping to drive significant growth at the time and these countries did reap some benefits, but failed to make them lasting. This dynamic was also almost inevitable as a result of pushing such different economies into a single interest and exchange rate policy.

Germany has troubling demographics: Countries such as Germany, with an ageing population, are always going to be inclined to save more. Judging what level of saving is warranted or needed given such constraints is tough, but it’s clear that German businesses and people have already made up their mind to save more.

Germany does need to unblock obstacles to domestic demand: The report is correct to highlight that Germany can do more to promote demand, notably by liberalising its services sector and reducing the level of taxation.

Germany above the threshold for public debt: the Commission will review this imbalance as well, highlighting constraints to any demands for further public spending.

All in all, the Commission does try to cover both sides of the argument but the tone still seems to lean towards asking Germany to do more to boost demand. If this is through liberalising measures it will be welcome (at least by us), however, if it calls further jumps in spending and wages it could find a very hostile reception in Germany.

In any case, the scene is set for what could become a crucial debate over the structure of the euro. The crux of the argument comes down to – what is Germany expected to do to save/aid the euro and what is it willing and able to do (politically, legally and economically)?

US and Germany trade blows over macro policy, but is Germany's export focus really to blame for the woes of the eurozone?

Another dispute arose last week between the US and Germany. This time on macroeconomics. Maybe not quite as glamorous (or controversial) as spying, but interesting nonetheless. The new disagreement was set off by the US Treasury’s semi-annual Report on International Economic and Exchange Rate Policies which said (and reiterated numerous times):

“Germany has maintained a large current account surplus throughout the euro area financial crisis...Germany’s anaemic 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”.

Germany (unsurprisingly) took offence to this and hit back that its surplus was simply a result of competitiveness and global demand for German products.

Numerous commentators have weighed in to add to the criticism of Germany with Paul Krugman, Martin Wolf, the Atlantic and the Economist Free Exchange blog all lambasting Germany, albeit to varying to degrees. (See Bruegel here for a good round up). The WSJ's Richard Barley attempts to provide some much needed balance to the discussion.

The thrust of the argument is: Germany should boost domestic demand to provide a demand boost for the struggling eurozone economies (via imports). It should also allow wages and prices to rise (reflate) to reduce its advantage over these other countries, allowing them to take over some of Germany's market share.

So, who is in the right? We’ll leave that up to you to decide, but we do feel the debate has been rather one sided in its criticism of Germany. With that in mind, below are a few points to ponder.

1) Germany is not as big a source of demand for peripheral economies as assumed: As we have noted before, the assumption that if Germany imported more, the peripheral countries would benefit seems overstated. We have already pointed out that the eurozone and particularly the periphery make up a declining source of Germany’s trade.

Importantly, Germany is also a limited source of demand for these countries. In 2012 exports to Germany from Greece, Italy, Portugal and Spain amounted to 0.9%, 3%, 2.9% and 2.25% of their GDPs respectively. So, if Germany did boost its domestic demand and consumption only a small amount would filter through to imports from these countries and this would amount to a very small boost in GDP. To have any real impact then, Germany would consciously need to direct an increase in imports from these countries - not a realistic proposition. Also, keep in mind as well that it could do little to offset the massive collapse in domestic demand, investment and government spending which in many cases amount to double digit percentages of GDP.

2) ECB’s one-size-fits-all policy: As the Economist Free Exchange blog points out, the issue of reflating probably has as much to do with the ECB as it does with Germany. But as we have pointed out the ECB faces a tough time in tackling low growth and low inflation due to numerous technical, legal and political constraints. Furthermore, if Germany did start reflating quickly, with wages and prices going up, significant problems could be created for the ECB and its middle of the road, one-size-fits-all monetary policy. It would find it even harder to marry its single policy for a fast growing Germany and other countries.

3) Even if Germany became less competitive or exported less the periphery would not necessarily pick up the slack: Again as we noted before, Germany and the periphery have very different areas of expertise and specialisation – if Germany lost competitiveness due to reflating, the periphery may not fill the gap for cheap exports, particularly in manufactured and industrial goods. Chances are that emerging markets would reap the benefits or at least a large share of them. It's also worth noting that increasing wages may not be as simple a prospect as it sounds given that it cannot be done directly by the government and requires an agreement from both unions and businesses.

4) A less competitive eurozone: This is a point the German government has raised previously and it has some merit. Although a German reflation would aid the adjustment in other countries (as the adjustment needed to become competitive relative to Germany would be less) the competitiveness of the eurozone as a bloc would be relatively decreased since the average unit labour cost would be higher. This can be offset somewhat by a weakened currency, but given that the ECB takes no specific action to influence the euro, it is far from guaranteed.

5) Germany has had an excess of savings for a decade: While Paul Krugman is right to point out that Germany has not always run a current account surplus, it has done so for nearly the entire time the euro has existed. So why was the excessive saving in Germany not an issue previously? Obviously, global demand has fallen and domestic demand in many periphery countries has collapsed, but previously German savings were heavily invested in the southern economies (through the banking system). This no longer happens, in a large part due to concerns over the stability of the euro and these countries economies and governments. This highlights the need to address the structural flaws in the euro, improve the business climate in these economies and create a banking union.

6) You cannot have a currency with 17 Germanys: All the above said, you clearly cannot have a bloc of countries, which trades significantly with each other, all focused on creating an export model. Where would the demand come from? Clearly, Germany alone cannot provide it and being entirely reliant on external global demand is a risky strategy.

Other points to keep in mind include:

•  An obvious point which seems to be missed is that, the current account deficits of these countries have decreased while Germany's surplus has not. If it was the flip side of these deficits then it would automatically fall. The relationship between the two has become detached as Germany and other countries have taken a more global outlook.
• A weaker euro which is often also targeted in this type of debate would probably aid Germany more than others given its export base. This is linked to the impact looser ECB monetary policy which would probably weaken the euro - as such it seems strange for certain politicians to push for such action.
• To be fair to the US, it is far from alone in raising this point - the IMF and Commission have both mentioned it. That said, a singular country, even one the size of the US, commenting on another’s economic policy is different to an international institution or private sector commentator doing so.
• Germany is also not alone in coming in for flak, as has been happening for some time, the US also hits out at China's excessively weak currency.
• Martin Wolf makes a wider point, that Germany is hampering global demand. This seems more valid since it is increasingly turning away from trade with its euro partners to elsewhere.

We have pointed out many time that imbalances are a big problem in the eurozone. There is no doubt some rebalancing is needed. The Economist Free Exchange blog makes a good point, that this can be done through reforms such as tax cuts and opening up markets which would not impact competitiveness directly but would boost demand. There is also no doubt that Germany's and the eurozone's handling of the crisis has been less than stellar, as we ourselves have noted many times.

That said, pushing much of the blame onto Germany's current account surplus seems a bit misguided. Some correction is needed but it alone is far from enough to have a sizeable impact in reversing the crisis. That is exactly why more concrete progress on the banking union, structural reforms and reducing the democratic deficit is needed in the eurozone.