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.

UK government's business taskforce launches push to cut EU red tape

Today sees the release of the Business Taskforce report on cutting EU red tape in an effort to boost competitiveness. As our previous work on EU regulation suggests - the Taskforce is picking up on many of our suggestions - this is a push we are very much in favour of, particularly at a time when squeezing out every bit of economic growth possible is vital for economies across the EU.

The report proposes 30 wide ranging reforms to cut EU red tape.We're still working our way through the detailed suggestions but we've included some initial reaction below, which we'll update as we go.

• The task force backs the full implementation of the EU’s Services Directive. This could deliver up to a €230bn boost to EU GDP, according Open Europe estimates. However, we have suggested the EU should go even further and push for the introduction of the ‘country of origin principle’ which could increase further gains to closer to €300bn (2.3% of EU GDP).

• Open Europe welcomes the push to exempt small businesses from burdensome legislation, although more needs to be done to address existing issues with social and employment law.

• In a report from 2011, Open Europe estimated that EU social policy (i.e. EU social and employment legislation and EU health and safety rules) cost the UK economy £8.6 billion a year. The figure is heavily driven by a few very costly EU Directives – most importantly the Working Time Directive and the Temporary Agency Workers Directive. However, some health and safety laws stemming from the EU also represent a net cost to the UK economy. This is the case, for instance, for the Control of Vibration at Work Regulations 2005 and the Control of Noise at Work Regulations 2005.

• The task force has adopted Open Europe’s recommendation that low-risk firms be exempted from the obligation to regularly update their health and safety risk assessments.

• Looking for ways to improve EU-wide competitiveness and the European business environment, as the report recommends, rather than looking for specific UK opt-outs is likely to increase the chance of support from like-minded EU countries.

• Creation of a digital single market could be vital, particularly from the UK perspective with over 70% of UK citizens having bought products or services online but only around 10% having done so across borders.

• Open Europe recommended adopting a ‘one in, one out’ rule for EU regulation back in 2010 and continues to support such a move as suggested by the task force’s report.

• On-going assessment of the impact of regulation is vital. For example, the benefits of many regulations are based on assumptions or forecasts and while probable or viable at the time, these do not always come to pass. EU regulations on environment and climate change are a prime example of this. With circumstances shifting it is important that regulation is flexible.

• The Taskforce also adopts out proposal that Commission proposals which don't come with a robust Impact Assessment, clearly showing the need for and benefit of the law, should be dropped. We agree that more effective use of Impact Assessments is vital and giving the EU’s so-called Impact Assessment Board (IAB) more teeth (which we has long advocated) and the power to ‘red flag’ harmful EU proposals (e.g. the ban on olive oil jugs) would be a positive start. The focus of the IAB must be to ensure high methodological standards so that approval of a regulation depends on its merits, not political motives (for example, major problems with the Commission’s proposal for a financial transaction tax emerged after it had been tabled and undergone a Commission impact assessment).

These ideas deserve the support of like-minded EU member states at a time when policymakers are desperately seeking ways to improve Europe’s growth and competitiveness. It is essential that these good ideas are followed by concrete action to reduce the existing and future burden of EU law on European and British businesses.

Boom! Merkel opens up for the return of powers from Brussels

Well, here’s an essential development for those of us who think reform in the EU – including “less Europe” - is fully possible. 

Speaking on an interview to Deutschlandfunk radio and Phoenix TV yesterday, German Chancellor Angela Merkel said decentralisation of powers from Brussels should be discussed once the German election is out of the way. Merkel said:

“I believe that in Europe at the moment we have to take care to coordinate our competitiveness more closely, and for that we don’t have to do everything in Brussels.

‘More Europe’ can not only mean transferring competences from national states to Europe, but you can also have ‘more Europe’ by coordinating national political actions more intensively and rigorously with others. So we discuss if we need even more competences for Europe.

However, we can also consider whether we can give something back. The Dutch are currently discussing this. And we will also have this discussion after the Bundestag elections. Or we can give more competences to the Commission in order to set agreements on specific issues with national states.”

We shouldn't get overly excited – it’s only one statement – but this is the first time, to our knowledge, that Merkel has explicitly opened for the return of powers from Brussels.  This will clearly be welcomed in Whitehall.

Merkel’s comments come at an interesting time. Just this morning it emerged that the eurozone has finally emerged from recession. Is this when Merkel turns away from an inward ‘crisis containment’ policy, towards a reform agenda? This agenda would be  designed, in part, to keep the UK inside the tent (which Berlin wants for a number of reasons), and in part, to kick-start desperately needed reform for the EU to become more competitive.

What's often lost on observers of this scene is that the two go together. As people in Berlin will tell you, Merkel is convinced that Cameron is one of the few EU leaders who understands the ‘global race’. He is seen an ally in ending Europe’s dependence on cheap cash (which is why the UK government simply has to stop lecturing the Germans on the need for turning the eurozone into a debt union).

As we've argued before,  the eurozone is unlikely to take the quantum leap towards more integration, after the German elections (as some still think).  However, a window of opportunity will open up for the UK and other reform-minded governments to come up some credible and concrete proposals for change. Berlin will no doubt be listening.

Also, the October European Council is likely to be a rare occasion when EU leaders won't focus all their energy on solving the eurozone crisis – instead they can now turn to wider question of how to make the EU as a whole to work for growth and competitiveness.

Cameron has a massive opportunity here.

To temper stuff a bit. Merkel hasn't turned into a Tory MP - she chooses her words on Europe carefully. Also, the comments did not make a splash in the German press at all. None of the major newspapers reported them – they were all rather more concerned about the on-going NSA scandal, and Merkel comments on that instead.

However, it would be a typical ‘Merkel coup’ to slowly, step-by-step, start rolling out a reform agenda in the EU, which – in a German way, wrapped in pro-EU rhetoric – would also involve less Europe.

This is getting interesting. 

Mervyn King on the solutions to the eurozone crisis

The FT has just posted an interesting and lengthy interview with outgoing Bank of England Governor Mervyn King (pictured), conducted by the FT’s Martin Wolf. Many pressing topics are covered but the short discussion about the eurozone caught our eye (as might be expected).

When asked about the solutions to the eurozone crisis, King sums up the options very succinctly and without the usual qualifying statements needed by those directly involved in the crisis:

 “I think there are four [solutions]. One is to continue with mass unemployment in the south, in order to depress wages and prices until they’ve become competitive again. The second is to say, ‘Well, we have to get rid of this imbalance in competitiveness, so we need inflation in Germany.’ That seems unattractive, certainly to the Germans.

“The third is to give up on this question of restoring competitiveness quickly and accept that this is an indefinite transfer union. That requires two things: one is for people in the north to give money to people in the south; the other is for people in the south to accept the conditions imposed on them, which will limit the size of the transfer.

“The fourth is to change the membership. Now, I don’t know what the right answer is, and it will depend on their political objectives, but economics tells you that you have to have one or some combination of these.”

A very concise and accurate summary we’d say. Obviously each option can be tinkered and altered but the broad truth is all there.

However, we might go so far as to narrow the options down even further. Option one (which is currently being employed) seems unlikely to be politically or socially acceptable – countries such as Greece, Portugal and Cyprus in particular would struggle to regain competitiveness this way. It would also leave the structural flaws of the eurozone untouched, leaving it incredibly vulnerable to future crises.

Option two also seems unlikely to be sufficient, even if it were an option politically. We would say some element of it is probably necessary for the eurozone, but far from sufficient to solve the crisis. It could also create the ‘uncompetitive union’ which Germany fears most, as although internal imbalances in the eurozone may be eased the actual competitiveness of the bloc as a whole would be much worse than previously. There are also questions about how much such an approach would spillover into growth in the struggling eurozone countries - as we discussed in detail here. Again it also does not tackle the institutional flaws.

Therefore that leaves us with options three and four – something we have noted before.

Before the crisis can ever be solved the true choices facing the eurozone need to be realised. Let us hope that this weekend some of the eurozone leaders read King’s interview.

Who’s next in line in the eurozone crisis? Portugal and Slovenia are the prime candidates

In anticipation of tomorrow's eurozone finance ministers meeting (which will discuss finalising the Cypriot bailout and potentially extending the bailout loans given to Portugal and Ireland) Open Europe has published a new briefing looking at who might be next in the eurozone - our prime candidates are Portugal (for the second time) and Slovenia.

Key points

Both Portugal and Slovenia could need external assistance of some sort.

Portugal 

• Domestic demand, government spending and investment are contracting sharply, leaving the country heavily reliant on uncertain export growth to drive the economy. 
• By cutting wages and costs at home (internal devaluation), Portugal has in recent years improved its level of competitiveness in the eurozone relative to Germany. However, this trend actually started to reverse sharply in 2012, meaning that the divergence between countries such as Portugal and Germany has begun growing again – exactly the sort of imbalance the eurozone is seeking to close. 

• In its austerity efforts, Portugal is now coming up against serious political and constitutional limits. For the second time, the country’s constitutional court has ruled against public sector wage cuts – a key plank in the country’s EU-mandated austerity plan – while the previous political consensus in the parliament for austerity has evaporated.
• In combination, it will be increasingly difficult for Portugal to sell austerity at home and consequently to negotiate its bailout terms with creditor countries abroad.
• Portugal may well need some further financial assistance before long. It is unlikely to take the form of a full second bailout, but could involve use of the ECB’s OMT bond-buying programme, assuming Portugal can return to the markets fully beforehand (even briefly). 

Slovenia

• Slovenia is not Cyprus – in fact it is much more like Spain. Its banks are significantly undercapitalised with toxic loans now standing at 18% of GDP. Banks only have provisions to cover less than half the potential losses resulting from these loans.

• At the same time, a heavily indebted private sector is now desperately trying to get debt off its books, which alongside continued austerity and lack of investment, have caused growth to plummet.
• Though a full bailout is unlikely, the country could soon need an EU rescue package worth between €1 billion and €4 billion (between 3% and 11% of GDP) to help restructure the country’s bust and mismanaged banks.
• Such a plan is likely to include losses for shareholder (bail-ins) but, unlike in Cyprus, it may not hit large (uninsured) depositors and there will be no attempt whatsoever at taxing smaller (insured) depositors.

To read the full briefing, click here.

It only took 37 years but the “Multi-speed” patent is good news for Europe

They’re still those who talk about a “multi-speed” Europe as something of the future. Well, first, as ever, multi-speed is an inappropriate expression – the point is that the end destination for different EU countries no longer is the same (i.e. the Eurozone and the UK). Secondly, different levels of participation are already a fact of life in the EU.

This week's decision by EU ministers to launch the EU’s unified patent court is a case in point. The Court is set up to police the EU’s new single patent system, which was agreed in 2011 under enhanced cooperation. Spain and Italy have already said they won’t take part (though curiously Italy signed this week's agreement, but says it will have none of the unitary patent system). In addition, Poland and Bulgaria didn’t sign the agreement, but remain open to joining later. The reasons for not signing vary, from principal language concerns (the working languages will be English, French and German only) to cost concerns. Incidentally, we note that the Polish government has been pretty critical of those who do not support ‘more Europe’, but in a short period of time, it has now ditched the single EU patent and vetoed the EU’s carbon roadmap.

In any case, this is flexible Europe in action.

Overall, the single patent will massively reduce cost. From 1 January 2014, inventors and SMEs will now only have to apply for and register the patent once, and gain protection in all member states. This will reduce the burden on entrepreneurs/innovators and slash the cost of patent enforcement. The establishment of this Court excludes the ECJ, which is a positive step, though there’s currently a pending court case brought by Spain and Italy who say the whole affair violates EU law.

As agreed by the European Council in June, the seat of the Court’s central division will be in Paris but two other thematic divisions will be created: one in London for chemicals and human necessities, the other in Munich for mechanical engineering.

It only took 37 years. But better late than never – and credit to EU ministers for making this happen, and the Commission for pushing it.