Friday, October 17, 2014

The eurozone’s German problem

There is a deal to be done to save the euro from deepening crisis. The outlines of it are generally accepted outside Germany: structural reforms in France and Italy and elsewhere combined with measures to strengthen their long-term fiscal positions; and in return, a large pan-eurozone fiscal stimulus and quantitative easing (QE) by the ECB. This offers the best way out of the current impasse in the eurozone, not just for the periphery but also for Germany. But it will take a political earthquake  for the Germans to back such a deal. Instead, the stability of the euro and the futures of the participating countries will continue to be vulnerable to the short-term exigencies of German domestic politics. This is a recipe for stagnation, deflation and political populism in France and Italy. It may culminate in a breakdown in relations between Germany and these countries and could even lead to eurozone break-up.

Why has Germany assumed such pre-eminence in the eurozone? How is it that German policy-makers from the finance minister, Wolfgang Schäuble, to the head of the Bundesbank, Jens Weidmann, can wag their fingers at everybody else for causing the eurozone crisis, while responding dismissively to any suggestion that Germany might be part of the problem? Germany’s initial pre-eminence following the crisis was understandable – it is a major creditor and in the early stages of any debt crisis, creditors tend to call the shots. However, as a debt crisis wears on, the creditors’ resolve typically weakens as the impoverishment of the debtors rebounds on the creditors politically and economically, and the debtors call the creditors’ bluff by threatening to renege on their debts.

This has not happened in the eurozone, with Germany (and other creditor states) able to subordinate the interests of the eurozone as a whole to their own perceived interests. The debtors have put Germany under little pressure to share the burden or to reform its own economy. There appear to be two principal reasons for this. One is that many members of the eurozone see Germany as a model to emulate rather than a significant part of the problem. The second reason is that even those who understand that the structure of the German economy is a threat to the stability of the euro have been circumspect about openly criticising Germany for fear of provoking a backlash against the euro in the country. This softly, softly approach has been bad for Germany itself as it has distracted attention from the country’s formidable structural problems, and encouraged a belief that the country does not need to compromise and can afford to say no to everything.

This deference to Germany is puzzling. While it is the largest economy in the eurozone, it is hardly dominant, accounting in 2013 for 29 per cent of eurozone GDP as opposed to France’s 21 per cent, Italy’s 16 per cent and Spain’s 11 per cent. Economic growth in Germany has certainly rebounded faster since the crisis than in other eurozone countries. But the German recovery now seems to have run its course, with exports to both European and non-European markets under pressure and domestic demand being held back by weak levels of public and private investment (see chart 1). Even the German government expects growth of just 1.3 per cent 2014 and 1.2 per cent in 2015.

Chart 1: Economic growth (Q1 2008 – present)

Source: Haver

Chart 2: Economic growth (1999 – present)

Source: Haver

There have been some tentative signs of rebalancing over the last 12 months – with growth in domestic demand outpacing overall economic growth. But Germany remains chronically export-dependent – its current account surplus is on course to exceed 7 per cent of GDP in 2014 for the second successive year. The country is certainly not the ‘locomotive’ of the eurozone economy, as some journalists like to call it, but a drag on it. Some German policy-makers argue that stronger domestic demand in Germany would have little impact on other eurozone economies, but they are being rather disingenuous. The government has attributed the economy’s loss of momentum over the course of 2014 to weak eurozone demand, so cannot simultaneously deny that what happens in Germany has no impact on other eurozone economies. With Germany accounting for almost 30 per cent of the eurozone economy, what happens to aggregate demand in Germany clearly has a major impact on the level of demand across the eurozone as a whole.

German policy-makers tend to bridle at any suggestion that they may be guilty of mercantilism and there is indeed little to suggest that they are consciously setting out to beggar their neighbours. But there is no denying that Germany remains dependent on foreign demand to bridge the very large gap between what it produces and what it consumes, and that this is not a replicable model. An economy as small and open as Ireland’s can rely on wage cuts and rising exports to underpin recovery. But big economies in which trade plays a lesser role cannot do this, at least not all at the same time. Eurozone member-states need to increase the size of the economic pie rather than fighting for bigger shares of a constant pie.

Chart 3: Current account balances (per cent, GDP)

Source: Haver

Indeed, Germany’s strong employment performance – unemployment stands at just 5 per cent and the employment rate at a record high – would look quite different were it not for that foreign demand. Employment has also risen by more that would be expected from weak economic growth, suggesting that German employers (like their UK counterparts) have been taking on more workers in preference to boosting capital expenditure (which is no higher than it was in the first quarter of 2008). Moreover, the tightness of the labour market has not yet fed through into a meaningful recovery in real wages after years of wage restraint. Real wages should rise by around 1 per cent in 2014 (after falling last year), but this partly reflects unexpectedly weak inflation. Indeed, far from experiencing a surge (as many in German commentators feared when the ECB held interest rates lower than they thought Germany needed), German inflation fell to just 0.8 per cent in September, compounding deflation pressures across the eurozone.

Germany’s public finances are in good shape, allowing it to portray itself as a saint among fiscal sinners (German policy-makers still stress above all else the role of fiscal ill-discipline in causing the crisis). The government will again run a small surplus this year (see chart 4) compared with substantial deficits elsewhere. With growth in the German economy faltering, this would be the ideal time for the government to boost its spending. And there is no shortage of things it could spend the money on. Levels of public investment are very low in Germany, even by Western European standards. Indeed, net public investment is negative (that is, Germany is not investing enough to replenish the country’s public capital stock), storing up problems for the future (see chart 5). Germany could also boost defence spending, which is languishing at just 1.3 per cent of GDP, and so help to improve its ability to play a useful role in providing for Europe’s security. Cuts in incomes taxes and/or value-added-taxes could also give impetus to the moderate upturn in private consumption that is underway, in the process helping the economy to shake off the impact of weaker exports.

Chart 4: Government deficits (per cent GDP)

Source: Haver

Chart 5: Net public investment (per cent, GDP)

Source: Haver

How is the German government likely to respond to the slowdown in Germany and the worsening crisis across the eurozone? It will probably continue to show some flexibility regarding the fiscal targets facing other members of the eurozone such as France and Italy, while sticking publicly to its hard line. There will no doubt be a bit of fiscal easing at home, but nothing dramatic, with the government citing the need to comply with a constitutionally-binding rule requiring the government to run a balanced budget, which comes into force in 2016. Taken together, these slight shifts in Germany’s position will do little to alleviate the pressures on the eurozone economy (a much bigger stimulus is required to ward off slump and deflation) or to rebalance the German economy. Meanwhile, Germany will remain the biggest obstacle to QE by the ECB, which would aim to boost inflation expectations and hence the readiness of firms and households to spend. Were Germany to support such action, other sceptical countries would no doubt fall in behind it.

If, as is increasingly likely, the ECB pushes ahead with QE despite German opposition, its effectiveness will probably be undermined by the lack of a major fiscal stimulus to the eurozone economy. The ECB may also struggle to bring about a substantial fall in the euro because of the size of the eurozone’s trade surplus, which boosts demand for euros. (The eurozone’s trade with the rest of the world would be broadly balanced were it not for Germany.) And if QE does succeed in weakening the euro without an accompanying programme of fiscal stimulus or aggressive steps to rebalance the German economy, it risks being seen by the eurozone’s trade partners as a mercantilist move in a global economy characterised by very weak demand. One consequence could be to further weaken the chance of brokering a meaningful Trans-Atlantic Trade and Investment Partnership (TTIP). It could also further unbalance the UK economy, strengthening Britain’s eurosceptics.

Germany’s current intransigence poses a far greater risk to its economic and political interests than the ‘grand bargain’ outlined at the beginning of the piece. Germany cannot afford the impoverishment of the eurozone. The rapid slowdown in world trade, in particular trade with China, has shown this. If the German economy is to grow sustainably, it will be as part of a healthy eurozone economy, in which Germany is deeply enmeshed through trade and investment. Nor does Germany’s current uncompromising stance limit the exposure of German taxpayers to bail-outs of other members. Aside from the impact that the ongoing slump across the eurozone will have on German growth (and hence public finances), debt burdens will reach unsustainable levels in more eurozone countries. The inevitable debt defaults in these countries will impose incalculable costs on the German taxpayer.

German politicians, like all politicians, are focused on getting re-elected, and they believe that their current approach to the eurozone is the best route to that. But long-term threats eventually become immediate threats. Germany needs a proper debate about the choices facing it, much as the German government has repeatedly demanded of the French, Italians and others. Unfortunately, there is little sign that this will happen without greater outside pressure. The French and Italians need to force this debate by making clear to Berlin that it cannot assume that the euro will endure in its current form without Germany making significant compromises. By ending their deference to the German government, they would hopefully expose the weakness of Germany’s bargaining position and prompt a more objective discussion within Germany of its own structural problems and how they play into the eurozone crisis. There is a risk that such a confrontation could play into the hands of the right-wing Alternative für Deutschland (AfD), which has already tapped into anti-euro sentiment. But Germany’s domestic politics should not be allowed to stand in the way of a solution to the crisis, any more than French or Italian politics should be allowed to do so. If Germany really is as pro-European as its politicians argue, its grand coalition should be able to convince enough Germans that a grand bargain is in the country’s own interests.

Simon Tilford is deputy director of Centre for European Reform.

Thursday, October 16, 2014

Would Britain’s trade be freer outside the EU?

In the ‘Brexit’ debate, there are two ideas that simply will not die, however much evidence is thrown at them.

The first is that Britain could leave the EU and then opt back in to those areas of the single market that it liked. The CER’s commission on the economic consequences of leaving the EU, which reported in the summer, explained why this would not happen. The remaining EU countries would not let Britain cherry-pick: the four freedoms of goods, services, capital and labour come as a package. And, in order to maintain undiminished access to EU markets – perhaps by joining the European Economic Area – Britain would have to sign up to all the EU’s rules and standards, but would have little influence over them. For a country so unhappy with ‘rule from Brussels’, it would be an odd choice to cede more power over the regulation of its economy.

The second idea, which is usually put forward after the first has been debunked, is that Britain outside the EU could compensate for any higher trade costs with Europe by signing free trade agreements (FTAs) with other countries. What follows is an attempt to test this proposition empirically.

Economists at the World Bank have put together a database that measures how costly trade in goods is between all the countries in the world. Trade costs can come in various forms. One cost is taxes on imports: tariffs. Another arises from non-tariff barriers, like quotas restricting imports, or national regulations that prevent imported goods, made to different standards, from being sold. Still another is distance. It costs money to transport goods from one country to another, so distant countries will tend to trade less than neighbouring ones. The World Bank’s researchers have quantified these costs. With their data, it is possible to compare the EU’s performance at cutting these costs for Britain – this, after all, is the point of the single market – compared to other countries.

Chart 1 shows the World Bank’s estimates of trade costs between Britain, the EU, the rest of the OECD and the eight emerging economies with which Britain conducts most trade: China, India, South Africa, Russia, Nigeria, Brazil, Malaysia and Indonesia (listed in order of how much they trade with Britain). Britain’s trade with non-European members of the OECD is more costly than it is with the EU: barriers to trade with these countries are equivalent to 98 per cent of the value of the goods traded, compared to the EU’s 85 per cent. In other words, these trade costs would add 98 pence to the price of a good produced in Britain for £1. The cost of trade with emerging economies is higher still. And costs have fallen less with Britain’s most important trade partners outside Europe – both developed and emerging – than with the EU since 1995, the first year for which there is data.

Chart 1. Trade costs between Britain and the EU, the rest of the OECD, and emerging economies.

Source: CER analysis of World Bank ESCAP database.

The cost of Britain’s trade with the EU, on the other hand, dropped by 15 percentage points between 1995 and 2010 – although the decline stopped after 2007. And since the EU is Britain’s largest trading partner, this fall is all the more valuable. Chart 2 shows by exactly how much. It weights trade costs between Britain and other countries by the amount of trade conducted with them. Since around a half of all Britain’s trade is with the EU, that fall has cut the total cost of Britain’s trade by 0.4 percentage points a year. The small declines in the cost of trade with the rest of the OECD, emerging economies and the rest of the world are less valuable, not only because they have been smaller, but also because Britain conducts less trade with those economies.

Chart 2. Countries' contribution to falling UK trade costs, annual average, 1996-2010.

Sources: CER analysis of World Bank ESCAP database and ONS UK trade data.

However, this is all about the past: one might argue that, after it left the EU, the UK could simply sign an FTA with the Union to secure the existing economic benefits of European integration. Although a Britain outside the EU might be able to negotiate such an agreement, British goods and services could only be sold in EU markets if they met European rules. If Britain’s antipathy to EU rules led over time to its adopting different rules for products sold on the domestic market, trade costs with the EU would increase.

Consider an optimistic scenario after a British exit. The EU does not impose the common external tariff on Britain’s goods, but trade costs do not fall as quickly with the EU as they had before, because Britain refuses to sign up to all future rules of the single market in order to secure access. And let us assume that the fall in trade costs forgone would only be worth 0.2 percentage points a year, since initiatives to deepen the single market have stalled since 2007. In ten years, this would amount to a missed opportunity in the form of a 2 percentage point reduction in the total cost of Britain’s trade.

Could Britain not easily sign FTAs elsewhere in the world to make up for these forgone gains? The answer has to be no.

While Britain’s trade with the rest of the world is growing faster than with the EU, Europe will continue to be its largest trade partner for decades to come. The rest of the world’s contribution to the total reduction of Britain’s trade costs was less than one-third that of the EU, between 1996 and 2010 (Chart 3). This means that any attempts to reduce the cost of trade through FTAs with non-EU countries would have to be very effective to make up for forgone trade with Europe.

Chart 3. Countries' total contribution to falling UK trade costs, 1996-2010.

Sources: CER analysis of World Bank ESCAP database and ONS UK trade data.

This would not be easy. Australia and Canada’s free trade agreements with the United States offer a rough guide to the size of the gains that the UK might make by signing a similar agreement with its second largest trade partner. Canada signed the North America Free Trade Agreement (NAFTA) with the US and Mexico in 1994. Australia’s FTA with the US came into force in 2005. Chart 4 shows the changes in Canada and Australia’s total costs of trade that can be accounted for by the US in the years after their agreements. The US accounts for 55 per cent of Canada’s trade, but the cost of trading with the US went up slightly between 1995 and 2008 – albeit from a very low base. Most of Canada’s trade gains from NAFTA arose from falling costs with Mexico. Australia’s trade costs with the US fell after its FTA came into force. But because Australia’s trade with the US only accounted for between 7 and 10 per cent of its total trade over the period, the US FTA did not bring down its total cost of trade very much – around 0.06 percentage points a year. The UK conducts a similar proportion of its trade with the US as does Australia – 8.5 per cent – so one could expect similar, small gains from any FTA signed with the US after Britain had left the EU.

At best, these gains would be far smaller than the opportunities forgone with the EU. At worst, they would make little difference, since tariffs between non-European OECD members are low, and it is very difficult to persuade countries as unwilling to share sovereignty as the US and China to agree to common standards and rules.

Chart 4. The US contribution to Australia and Canada’s total trade costs after FTAs were signed, annual average.

Sources: CER analysis of World Bank ESCAP database, Statistics Canada and Australia Foreign Affairs and Trade statistics.

Britain’s choice is this: it can choose to stay in the single market – a very deep FTA, agreed with its largest trade partners, and one with a proven track record in reducing the cost of trade. Or it can leave it, and try to sign dozens of free trade agreements with less certain benefits to make up for the opportunities forgone in Europe. The conclusion should be obvious: free traders should support Britain’s continued membership of the EU.

John Springford is a senior research fellow at the Centre for European Reform.

Thursday, October 02, 2014

Why devaluing the euro is not mercantilism

The value of the euro is a topic of constant debate in European policy circles. The debate follows a regular pattern: French or Italian policy-makers bemoan the strength of the euro because it hurts their exports; German policy-makers rebuff such claims; the European Central Bank (ECB) claims it is not aiming for a particular value of the euro as its mandate is focused on price stability only; and international commentators point out that the eurozone is simply too large to pursue a purely export-oriented strategy anyway. All sides have a point. But more expansionary monetary policy is necessary to kick-start a broader eurozone recovery, in part via a boost to exports from a lower exchange rate. This is not a mercantilist strategy as imports are likely to grow, too, when incomes recover. The recent fall from $1.37 in early July to $1.27 at the time of writing is a good start but the ECB needs to be innovative and drastic to lower it further and start a proper recovery.

A major benefit of having a national currency is that it devalues in times of economic weakness, thereby boosting exports. Such devaluations are usually not the main aim of monetary policy-makers but a side-effect of more accommodative monetary policy (or the expectation thereof): the central bank lowers interest rates, which leads investors to search for higher yielding assets abroad, and this weakens the currency. Besides its effect on exports, a weaker currency usually leads to higher inflation too, as imports – such as energy – become more expensive. The combination of stronger economic growth via exports and higher inflation via imports is what the central bank was after. The currency is thus one of many ways in which monetary policy actions affect the economy.

Currently, the euro is too strong for the eurozone. While there are various ways to estimate the ‘fair value’ of a currency, the easiest way is to look at current inflation rates and growth prospects. Both are, for various reasons, at exceptionally weak levels in the eurozone. Given that weakness, monetary policy is too tight, and the euro would be weaker with a more appropriately aggressive monetary stance. If the euro is too strong for the eurozone as a whole, it is certainly too strong for its weaker economies such as Italy. When France and Italy bemoan the strength of the euro, they are in effect calling for a more expansionary monetary policy. The currency is just a catchy way of phrasing that.

For Germany, the euro could in fact be higher than it is now; most estimates consider a value of around $1.40 as appropriate – despite disappointing German growth and inflation. The reason is that the demand for German goods from outside the eurozone, for which the exchange rate matters, is hardly to blame for low growth and inflation. The causes are rather the weakness of demand from within the eurozone, one of Germany’s main export markets, and of domestic German demand, which is growing on the back of moderate wage growth and record employment but not fast enough. A higher euro by itself would do little to weaken the German economy.

A stronger euro would give consumers a boost in real income, though. After all, a stronger euro buys more iPads and holiday trips than a weaker one. This is the first reason why Germany rebuffs demands to devalue. The second is that it involves further easing of monetary policy, which at this point, after interest rates are already at zero, means buying risky private assets and, more importantly, sovereign bonds – which Germany strongly resists. However, given that Germany would clearly benefit from a stronger eurozone economy, more monetary easing and a weaker euro is ultimately in Germany’s self-interest.

The ECB claims that it is not aiming for a particular value of the euro, and that its sole objective is to deliver an inflation rate of “below, but close to, two per cent”. While this is true, the euro’s value has an impact on the inflation rate and growth: if the currency’s value falls, it lowers the prices of export and raises those of imports. A rule of thumb is that a 10 per cent fall in the trade-weighted exchange rate of the euro leads to higher inflation of 1 percentage point. The ECB’s own estimates, for example, show that a euro value of $1.24 at the end of 2016 (down from the $1.34 at the time of this estimation, and corresponding to a 3.9 per cent decline in the trade-weighted exchange rate) increases inflation by 0.2-0.3 percentage points.

Since most other transmission channels of monetary easing do not seem to be working as expected or hoped, the currency remains an important way to stimulate the economy, and ECB president Mario Draghi has made similar points recently. But will it work to boost European exports, or even: should it? After all, the eurozone is a large part of the world economy, and an export-led growth strategy would have to be absorbed by the rest of the world via imports, which might be impossible or at least unsustainable.

It might seem counter-intuitive, but an export-led recovery, driven by a depreciation of the currency, does not necessarily lead to an increase in net exports (that is, exports minus imports). The reason is that more export revenues might be used to import goods from abroad. This is especially true in a depressed economy where imports have already massively contracted: incomes are low, and hence consumption, investment, and imports are depressed such that a gain in income boosts all three, leading to a virtuous circle of growing domestic incomes and more imports. The effect on the trade balance is ambiguous. The exchange rate depreciation can thus be a kick-starter for a broader monetary policy-led recovery, without driving the export surplus to unsustainable levels. In fact, it can reduce it.

Argentina and Japan are cases in point. In 2002, when Argentina devalued its currency, exports were a main driver of the recovery for the first six months, growing by an annualised rate of 6.7 per cent. Thereafter, however, imports grew by a whopping 50 per cent (annualised) during the two years between mid-2002 and mid-2004, making net exports a drag on growth and reducing the trade surplus considerably. Japan has recently embarked on a large devaluation experiment, as part of ‘Abenomics’. While the verdict is still out on whether it has been successful in boosting growth and inflation, it has certainly not, despite a massive devaluation of the yen, led to a surge in Japan’s trade balance (see chart one).

Chart one: Japan’s trade balance and exchange rate

Source: Haver

Of course, each case is special. The eurozone periphery has high levels of foreign debt and thus needs to pay down its debts (see chart two). This requires a positive trade balance for a while. Most eurozone countries are rapidly aging societies and therefore have fewer investment opportunities than the rest of the world. This means they should aim to invest abroad, again requiring a trade surplus. In addition, Germany’s current account surplus seems to be stuck at an extraordinarily high level, adding to the current account surplus of the eurozone which has now reached more than 2 per cent of GDP (up from roughly zero pre-crisis).

However, the current account surplus is unlikely to rise if and when more aggressive monetary stimulus depreciates the euro. As argued above, the depressed economies of southern Europe suggest that a boost to demand in the eurozone will reduce the trade surplus. The effect on the German current account surplus is ambiguous but a weaker euro might help to reduce it, too, if the boost to Germany’s exporters and the rest of the eurozone strengthens the German economy, leads to higher wages, and thus to higher incomes and more imports.

Chart two: Net foreign asset positions in million euros

Source: Haver

Overall, there is a strong case for more currency depreciation and hence, more aggressive monetary policy. Now that the euro has weakened, it seems that past ECB actions are finally working their magic via the currency channel. This downward trend is unlikely to continue for much longer, however. Currencies have a tendency to overshoot: investors first get out of low interest rate areas, causing the currency to fall, before it slowly appreciates. Japan has seen its currency constantly appreciate in the face of low growth, very low inflation and even lower interest rates.

The eurozone must avoid this Japanese trap. The ECB’s newest measures are unlikely to be enough to lower the euro further than the current $1.27, or to sufficiently stimulate the economy otherwise. First, its latest attempt to encourage banks to lend to firms (so-called TLTROs) has been underused by banks so far (the next round is in December), in part because demand for new lending from firms is low and the prospects of the eurozone economy do not suggest demand will increase by itself soon. Second, the ECB’s plan to buy private assets, while a good start, will not be effective if it remains a stand-alone measure, without the ECB pushing up inflation and income expectations of firms and households.

In order to provide the necessary stimulus to weaken the euro, the ECB needs to take two actions. First, it should make clear that it intends to make up for excessively low current inflation (just 0.3 per cent in September) with somewhat higher inflation in the future, such that two per cent inflation over the next five years is reached on average. This will increase future inflation, lower real interest rates and push down the euro. This approach is called price-level targeting. Second, in order to make its commitment to this price-level target credible, the ECB should announce unlimited purchases of assets of its own choosing – preferably domestic private and foreign public assets – until the target has been reached.  As the ECB has learnt when its famous OMT programme arrested panic in bond markets, threats of unlimited intervention by a central bank are much more effective than limited fiddling in financial markets. The Swiss were successful with a similar strategy of a credible promise and unlimited purchases in containing the appreciation of the franc.

With these two measures – the first innovative, the second drastic – the ECB will succeed in providing the monetary stimulus needed to put the eurozone on a path toward a proper recovery, including a weaker euro and potentially a lower trade surplus. Without more ECB action, however, the euro might well increase in value again, weakening exporters, lowering already too-low inflation and destabilising the eurozone economy further. The political backlash against the euro and the EU could become impossible to contain. It’s time for the ECB to really do whatever it takes, yet again.

Christian Odendahl is chief economist at the Centre for European Reform.