I have blogged a few times on Germany’s current account surplus and how it distorts the global economy. The surplus is currently the world’s largest in absolute terms at US$350bn which is 8.5% of Germany’s GDP. Recently the IMF called for a radical shift in Germany’s trade policy before it provokes a protectionist backlash in the USA.
The fact that Germany is selling so much more than it is buying redirects demand from other countries around the world, reducing output and employment outside Germany at a time at which monetary policy in many countries has become ineffective. Furthermore the IMF has suggested that Germany should be investing more in public infrastructure to soak up excess savings and stimulate more demand in its own economy and therefore redirect spending. The underlying criticism is that Germany should stop trying to drive down its debt – German debt ratio has fallen from 81% of GDP to 60%.
A significant advantage that Germany has is that it is part of the euro currency. If Germany still had the Deutschmark the trade surplus would have no doubt increased the value of its currency making exports more expensive and imports cheaper. The value of the euro is dependent on the strength of other countries with the currency and the European Central Bank interest rate. Interest rates being -0.4% are a disguised way of holding down the value of the euro (exports cheaper and imports more expensive) and seen by some as bad etiquette for a currency bloc running surpluses near US$430bn – three times that of China.
The German viewpoint
- Germany says that it requires huge savings to prepare for the oncoming aging population.
They deemed it a fundamental error to boost spending of cut or cut taxes (expansionary fiscal policy) at this late stage of the business cycle, warning that a fiscal stimulus would destabilise Germany whilst not doing much to help the rest of Europe or the global economy.
- The German surplus is a result of millions of decisions in Germany and abroad – German products are very high quality and reasonably priced so therefore there is more demand.
Germany needs a safety-buffer with the increasing dependency ratio as by 2020 the ratio will double to one retiree to one worker.
- The euro is a free floating currency and there is no manipulation of the exchange rate. Its value reflects the strength of eurozone countries.
Policies to reduce the surplus.
Germany has little control over the value of the common currency, but it has several policy tools at its disposal to reduce its surplus.
- Increase spending in infrastructure
- Raising the wages of workers
- Increase domestic spending.
Source: Daily Telegraph – Germany rejects IMF cal for radical shift in trade policy – Friday 19th January 2018
According to the OECD the rate of growth in the eurozone has surpassed that of the US, UK and Japan and has surprised many with its resilience. However is the EU in a position of strength to cope with the challenges of another recession? The Economist ‘Free Exchange’ looked into this issue and identified some shortcomings. The crisis in the EU was severe and the impact financially was was around €1.4trn as this would have been the amount of GDP lost since 2007, assuming that most economies grow at 2% per year.
The damage was compounded by the fact that the EU’s monetary policy which has 3 main weaknesses:
1. Within the EU the printing of money is centralised through the European Central Bank in Frankfurt. Therefore countries who wanted to print more money to bail themselves out and stimulate the economy could no longer do it. Furthermore as there is no central fiscal budget it meant that individual countries were responsible for their own fiscal solvency. So if they ran up big deficits the risk of default was great and made markets react negatively to any concerning news on a country’s fiscal prudence. In reacting to this scenario the ECB said, as a last resort, that it would step in and buy government bonds to help ailing economies. On this news bond yields dropped as the ECB has brought about some stability.
2. In 2014 the EU was still struggling but was constrained by its inflation mandate. When economies go through major economic downturns they loosen monetary and fiscal policy – cut interest rates and increase government spending respectively to make up for the lost private spending. Although the ECB cut interest rates to 0% and government increased spending there was the problem of its mandate. The ECB was curbed by the 2% inflation ceiling unlike the 2% target for most other countries and by the fact that its strongest economy, Germany, was paranoid about inflation – memories of the post-war hyperinflation years. Only with the threat of deflation did stimulatory asset purchases start to happen.
3. This is the mismatch between the scope of its economic institutions and its political ones. No European institution enjoys the democratic legitimacy of a national government. The crisis meant greater reform in the financial sector but also led to increased authority of unelected institutions like the ECB. The frustration has been that countries in the eurozone have suffered significant amounts of pain by unaccountable European politicians. Countries don’t want to lose their sovereignty but it seems that any further integration is a catalyst to its demise.
The return to improving growth levels has been brought about by increasing export volumes – with a weaker euro. With consumer spending and investment on the decline foreign consumers have been the saviour of the EU. However this is dependent on global growth which cannot last forever and the euro area needs to be prepared politically to get through the next recession.
Source: The Economist – Free Exchange – The second chance. 2nd December 2017
I was teaching managed exchange rates with my AS Level class and couldn’t get away from the events in Britain on the 16th September 1992 – known as Black Wednesday. On this day the British government were forced to pull the pound from the European Exchange Rate Mechanism (ERM).
The Exchange Rate Mechanism (ERM) was the central part of the European Monetary System (EMS) and its purpose was to provide a zone of monetary stability – the ERM was like an imaginary rope (see below), preventing the value of currencies from soaring too high or falling too low in realtion to one another.
It consisted of a currency band with a ‘Ceiling’ and a ‘Floor’ through which currencies cannot (or should not) pass and a central line to which they should aspire. The idea is to achieve the mutual benefits of stabel currencies by mutual assistance in difficult times. Participating countries were permitted a variation of +/- 2.25% although the Italian Lira and the Spanish Peseta had a 6% band because of their volatility. When this margin is reached the two central banks concerned must intervene to keep within the permitted variation. The UK persistently refused to join the ERM, but under political pressure from other members agreed to join “when the time is right”. The Chancellor decided that this time had come in the middle of October 1990. The UK pound was given a 6% variation
Although it stood apart from European currencies, the British pound had shadowed the German mark (DM) in the period leading up to the 1990s. Unfortunately, Britain at the time had low interest rates and high inflation and they entered the ERM with the express desire to keep its currency above 2.7 DM to the pound. This was fundamentally unsound because Britain’s inflation rate was many times that of Germany’s.
Compounding the underlying problems inherent in the pound’s inclusion into the ERM was the economic strain of reunification that Germany found itself under, which put pressure on the mark as the core currency for the ERM. Speculators began to eye the ERM and wondered how long fixed exchange rates could fight natural market forces. Britain upped its interest rates to 15% (5% in one day) to attract people to the pound, but speculators, George Soros among them, began heavy shorting* of the currency. Spotting the writing on the wall, by leveraging the value of his fund, George Soros was able to take a $10 billion short position on the pound, which earned him US$1 billion. This trade is considered one of the greatest trades of all time.
* In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to that third party. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than it received on selling them. Wikipedia.
A lot of economics textbooks focus on the damaging effect of a current account deficit but what about a current surplus? Also in the media a lot is spoken of a country’s trade deficit and the concern that it is borrowing from abroad to finance current purchases of goods and services. China’s surpluses have been a big talking point but it is Germany with a current account surplus since 2002 (introduction of the Euro) with a 2015 surplus of 8% of GDP which has taken the limelight – see graph from The Economist.
A lot of students taking the subject for the first time believe that a trade surplus is good and a trade deficit is bad. However, as in a lot of areas of economics, you can’t categorically say they are good or bad. For instance, a deficit might be caused by importing vast amounts of capital goods which will create value in the economy through jobs and goods which can be sold domestically or overseas. The capital goods can also increase the level of productivity and improve competitiveness of such goods. In some respects deficit countries can be better off than surplus countries, as they are consuming more goods that they are producing.
Is a trade surplus good or bad?
For a lot of countries the purpose of exports is to generate revenue so that they can buy imports of goods which they may not produce – or could produce but relatively less efficient. In China a surplus does keep the export sector industries employed but suggests there is a strong presence for saving or weak domestic demand. More balanced trade would increase the level of imported goods into a country and increase real incomes as the value of its currency rises. This will allow for more inflows of foreign capital from abroad stimulating growth in the domestic economy. It would help a sluggish world economy if surplus countries, like China and Germany, were to spend more on imports.
Reasons for Germany’s trade surplus.
There are three main reasons for Germany’s ongoing trade surplus:
- Since the advent of the Euro in 2002 its value has been very weak. This is because the Euro is valued in relation to the entire 19 country eurozone and given the economic condition of the other member states, Germany’s strength in trade is not significant enough to boost the currency. If Germany still had the Deutschemark today it would be no doubt stronger and therefore reduce export competitiveness. It has been calculated that the Euro gives Germany about a 20% price advantage compared to what it would have had if it was still using the Deutschmark and has the largest foreign exchange advantage of any country in the world, with the possible exception of China.
- Another reason is that the German government has been running a very tight fiscal policy and also keeping the wages levels down. In the wake of the worries over the eurozone, Germany slashed its public expenditure with reducing public infrastructure spending and been more focussed on running surpluses. This is all very well but they are taking money out of the system which leads to less demand in the global and European economy.
- The lower cost of imports of oil and gas increased the trade balance in 2015 by around 1.2%. Without the decline in oil and gas prices, the trade surplus would have fallen compared with the previous year.
Germany’s trade surplus is a worry for countries in the EU as well as overseas in that it is importing demand from other countries and reducing output and employment. This is especially prevalent when you consider that monetary policy in a lot countries has become ineffective. When this happens expansionary fiscal policy – dropping taxes and increasing government spending – is way of trying to boost demand but even though the fiscal position of the German economy is very healthy they are doing the opposite and being prudent. Germany is one of the few major economies in a position to easily and cheaply increase demand.
With the departure of the UK from the EU there have been many questions asked about the future of UK trade. No longer having the free access to EU markets both with imports and exports does mean increasing costs for consumer and producer.
New Zealand’s Experience
A similar situation arose in 1973 when the UK joined the then called European Economic Community (EEC). As part of the Commonwealth New Zealand had relied on the UK market for many years but after 1973 50% of New Zealand exports had to find a new destination. However with the impending loss of export revenue New Zealand had to make significant changes to its trade policy. In 1973 the EEC took 25% of New Zealand exports and today takes only 3%. Add to this the oil crisis years of 1973 (400% increase) and 1979 (200% increase) and protectionist policies in other countries and the New Zealand economy was really up against it.
What did New Zealand do?
1. It negotiated a transitional deal in 1971 with agreed quotas for New Zealand butter, cheese and lamb over a five-year period, which helped to ease the shift away from Britain.
2. New Zealand was very active in signing trade deals of which Closer Economic Relations with Australia was the most important in 1983. The other significant free trade deal was with China in 2008. Below is a list of New Zealand’s current free trade deals and a graph showing the changing pattern of New Zealand trade:
With brexit around the corner it will be imperative that the UK starts to develop trade links with non-EU countries of which New Zealand might be one. The UK is the second largest foreign investor in New Zealand and its fifth largest bilateral trading partner.
The impact of Brexit on the New Zealand economy should be limited when you consider the following statistics:
- 3.5% of total exports from NZ go to the UK – mainly sheep and wine.
- 2.7% of total imports from the UK to NZ – mainly transport goods
- 6.7% of all short-term visitor arrivals come from the UK
When the UK joined the EEC (as it was then know as) in 1973 there was a major shift away from trade with the Commonwealth. However New Zealand has been able to move away from the traditional dependency of the Commonwealth to become increasingly integrated to the Asia Pacific region.
Reserve Bank of New Zealand
The RBNZ is a good position even with a record low OCR of 2.25% which paradoxically is among the highest in the developed world. By not being aggressive with OCR cuts the RBNZ has the ammunition to stimulate aggregate demand further which is in contrast to the European Central Bank and the Bank of Japan who are in negative territory. With the turmoil in Europe over Brexit the US Fed will most likely hold off on a rate hike to ease the pressure on markets – it may even cut the US Fed rate.
Gold and Sterling – US$ rate
The graph below shows the reaction to the Brexit – GBP drops significantly against the US$ and gold, as a safe investment, appreciates in value. The uncertainty that surrounds Brexit saw more investors buy gold, which rose to about $1,315 an ounce on June 24th, up by 4.7% on the previous day. This was the largest increase since the global financial crisis in 2008. The rise was in stark contrast to the plunging pound, which tumbled to its lowest level in 30 years.
Below is video from the FT looking at Five Consequences of the UK’s exit form the EU.
On Thursday the UK vote whether to stay or leave the European Union. Below are some consequences and also a good video clip from the FT.
Remember the line in Monty Python movie ‘Life of Brian’, ‘What have the Romans ever done for us?’ This can be applied to the question of a British exit from the EU – ‘What has the EU ever done for us?’ Below is an informative video clip from the FT with a bit of humour. The questions in the Pub Quiz are:
- Which country I am describing in the year it joined the EU? Is the poorest European nation – incomes slipping behind its European competitors by £185 per year. Regular power cuts.
- In 2015 who was richer? The average person in German, France and Italy or England, Scotland and Wales?
- What caused Britain’s improved performance?
- How has Britain’s membership of the EU improved economic performance?
- Has the EU made Britain richer?
Basically the answers suggest that EU membership has been very beneficial to the British economy.
It seems that in Europe negative interest rates are common place. Below are the current rates of some central banks:
European Central Bank -0.3%
Swiss National Bank -0.75%;
Danish Central bank -0.75%
Swedish Central Bank -1.1%
Why are they in negative territory?
For all these countries it is the the exchange rate against the Euro that is important. Negative interest rates weaken a country’s currency and make imports more expensive and exports cheaper. Furthermore central banks could be trying to prevent a slide into deflation, or a spiral of falling prices that could derail the recovery.
In theory, interest rates below zero should reduce borrowing costs for companies and households, driving demand for loans. In practice, there’s a risk that the policy might do more harm than good. If banks make more customers pay to hold their money, cash may go under the mattress instead. Janet Yellen, the U.S. Federal Reserve chair, said at her confirmation hearing in November 2013 that even a deposit rate that’s positive but close to zero could disrupt the money markets that help fund financial institutions. Two years later, she said that a change in economic circumstances could put negative rates “on the table” in the U.S., and Bank of England Governor Mark Carney said he could now cut the benchmark rate below the current 0.5 percent if necessary. Deutsche Bank economists note that negative rates haven’t sparked the bank runs or cash hoarding some had feared, in part because banks haven’t passed them on to their customers. But there’s still a worry that when banks absorb the cost themselves, it squeezes the profit margin between their lending and deposit rates, and might make them even less willing to lend. Ever-lower rates also fuel concern that countries are engaged in a currency war of competitive devaluations. Source: Bloomberg
Another satirical clip from Clarke and Dawe of ABC in Australia, this time on the crisis in Greece and understanding Grexit. Interesting use of the word ‘Grexitentialism’.