Germany has become accustomed to being top of the class in Europe, the economic musterkind, or model pupil, of the Continent. But it was recently reprimanded by the United States Treasury for running a large trade surplus and imposing a “deflationary bias” on the euro zone. Germany was then told by the European Commission that the country could face action under the European Union’s “excessive imbalance procedure,” which gives the commission the right to demand action to address large trade surpluses and deficits.
This has not gone down well. Many German politicians and business people have responded with assertions that the surplus is mostly with the rest of the world — not the euro zone — and so has little impact on the zone’s struggling periphery; that the surplus reflects Germany’s competitiveness; and that deflation in Greece, Italy, Portugal, Spain and other countries is a good sign, as it indicates that their economies are becoming more competitive.
The Germans are wrong on all three counts.
There are two ways in which Germany’s external surplus adds to deflationary pressure, making it harder for the euro zone’s struggling periphery to recover. First, the euro has risen in value as the euro zone’s surplus has grown. An economy with a big trade surplus tends to experience currency appreciation, because demand for its currency outstrips the supply of it. A strong euro hurts demand for euro zone exports, especially the more price-sensitive ones of the southern European member states, and lowers the prices of imported goods, reinforcing deflationary pressure. Second, weak domestic demand (the flip side of the trade surplus) means that annual consumer price inflation in Germany has fallen to little over 1 percent.
Indeed, it is the weakness of Germany’s domestic economy as much as the prowess of its exporters that has driven the country’s surplus to around 7 percent of gross domestic product. German domestic demand rose by just 0.8 percent over the last year, despite very low unemployment and easy money from the European Central Bank.
The result is that Germany is doing little to provide any offsetting stimulus to the depression in the periphery, making life in southern Europe even more difficult. Less than a third of Germany’s surplus is now with the euro zone, compared with over three-fifths before the financial crisis. This is partly because German exports to countries outside the euro zone have risen strongly. But it also reflects the impact of Europe’s economic slump: German exports to the zone’s depressed periphery have shrunk by more than the periphery’s exports to Germany have risen.
German policy makers argue that stronger demand in Germany would be of little benefit to the currency union’s peripheral economies. After all, Spain’s exports to Germany only constitute 4 percent of Spanish G.D.P. This argument misunderstands how rising wages and inflation in Germany could help the currency bloc to recover. After almost 15 years of wage restraint, Germany’s labor costs have fallen by 16 percent compared with its euro zone partners. As a result, German goods are artificially cheap, crowding out its partners’ goods from both euro zone and world markets. If German labor costs rose, Spanish, Italian and French manufacturers would be able to retake market share. Their exports to euro zone economies and to the rest of the world would rise more rapidly, and the risk of deflation would diminish.
To pull off what Germany did in the run-up to the financial crisis — cut costs relative to the rest of the currency union and rely on exports to offset the weakness of domestic demand, but without suffering deflation — the peripheral euro zone economies need much stronger German domestic demand. After all, that is how Germany was able to do it: Demand was strong (and inflation robust) elsewhere in the euro zone. If Germany is to help stabilize the euro zone economy, demand must rise strongly relative to supply in the German economy (that is to say the external surplus must shrink). If it does not, the periphery will only be able to recoup competitiveness through falling wages and prices.
Deflation in the euro zone periphery should not be welcomed as an adjustment in relative prices and hence in competitiveness. Deflation is making debts unmanageable. It pushes up real interest rates (further depressing economic activity), and can undermine the effectiveness of monetary policy. Moreover, the lower the inflation rate, the bigger the primary budget surplus a government needs to run in order to prevent the stock of public debt to G.D.P. rising, hastening the point at which debt becomes unsustainable.
What can the Germans do to rebalance their economy? More expansionary fiscal policy would help, particularly if this took the form of cuts in consumption taxes and lower taxes for people with low incomes. But fiscal policy alone cannot reflate the German economy because the obstacles to stronger domestic demand are to a large extent structural. One is the country’s system of collective wage bargaining, which delivers wage restraint even when the labor market is tight and corporate profits are at record levels. Last week, the new grand coalition agreed to introduce a minimum wage, which is a welcome first step, but negotiated wage settlements also need to rise strongly.
Another problem is poor productivity (and low wages) across much of Germany’s services sector. Liberalization would boost investment and wages here in the longer term.
The United States is right to single out Germany for criticism. And the European Commission needs to stick to its guns and demand that Germany address the structural problems behind the imbalances in its economy. These pose as big a threat to the euro zone’s future as those of Italy or France, and need to be approached with the same urgency.
Simon Tilford is deputy director and John Springford is a research fellow at the Center for European Reform in London.