Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 2 December 2015

Was German undercutting deliberate?

In what I described over a year ago as the untold story of the Eurozone crisis, Germany held nominal wage increases below the level of other core Eurozone countries, gradually gaining a large competitive advantage over them. This had a number of consequences, but perhaps the most important is that when the Great Recession hit, Germany was much better placed than all the other Eurozone countries. (It is essentially a zero sum game, because the Euro exchange rate moves to influence overall Eurozone competitiveness, which is why I describe it as Germany undercutting its Eurozone neighbours.)

Up until now I have always been careful to avoid describing this as a deliberate beggar my neighbour policy. But one of the five members of Germany’s Council of Economic Experts, Peter Bofinger, writes:
“In 1999, when the Eurozone started, Germany was confronted with an unemployment rate that was too high by German standards, although it was still below the EZ average. The solution to the unemployment problem was typical of Germany’s corporatist system. Already in 1995 Klaus Zwickel, boss of the powerful labour union IG Metall, made the proposal of a Bündnis für Arbeit(pact for work). He explicitly declared his willingness to accept a stagnation of real wages, i.e. nominal wage increases that compensate for inflation only, if the employers were willing to create new jobs (Wolf 2000). This led to the Bündnis für Arbeit, Ausbildung und Wettbewerbsfähigkeit (pact for work, education and competitiveness), which was established by Gerhard Schröder in 1998. On 20 January 2000, trade unions and employers associations explicitly declared that productivity increases should not be used for increases in real wages but for agreements that increase employment. In essence, ‘wage moderation’ is an explicit attempt to devalue the real exchange rate internally.”

You still hear people say that the DM was overvalued when it converted to the Euro, but my research at the time suggested otherwise, and it is difficult to argue against the view that with today’s current balance surplus of over 7% of GDP Germany is grossly undervalued.

It is hard to overstate the importance of all this. German employers and employees connived in a policy that would take jobs away from their Eurozone partners. Whether this was done knowingly, or because of a belief is some kind of wage-fund doctrine, or something else I do not know. But it makes Germany, a country with perhaps a unique ability to cooperate on an internal devaluation of this kind, a dangerous country to form a currency union with. The thing I find extraordinary about all this is that Germany’s neighbours seemed to have let it happen without a whisper of recognition or complaint.

61 comments:

  1. Agreed. The thin red line in the last chart here:
    https://thefaintofheart.wordpress.com/2015/12/01/good-ngdp-news-from-spain-and-even-italy/

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  2. "But it makes Germany, a country with perhaps a unique ability to cooperate on an internal devaluation of this kind, a dangerous country to form a currency union with."

    Social coherence is something that is called Standortvorteil (advantage of location) in German, and because it is hard to quantify it is, unfortunately, often neglected in economic discussions, but this is an old issue. In contrast, many military historians have usually no issues to grasp this feature.

    And at least for me, it is obvious that this social coherence is not typical German, you find it in all Scandinavic countries and in Switzerland and Austria, therefore, the second half of your statement is very wrong IMHO.

    But yes, this makes such countries problematic partners in a currency union for others with a lower degree of social coherence.

    "The thing I find extraordinary about all this is that Germany’s neighbours seemed to have let it happen without a whisper of recognition or complaint."

    Again, no surprise. You may remember, that Krugman labelled Germany a country that can't compete in 1998, indicating that even very clever economists do not understand some of the basics that drive societies and may even have severe economic implications.

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    1. Worth recalling, of course, that while the German policy establishment was divided on the Euro, it was not divided on the question of having the countries "with a lower degree of social coherence" join --- apart from Kohl, no one wanted this. Said countries were, however, very keen on joining and very actively pressed for it. So maybe they made their own bed?

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  3. Well, for one of its neighbours, the Netherlands, it wasn't really contestable since wage moderation was a Dutch policy since the early 80s.

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    1. To be exact: the Netherlands did this with the Agreement of Wassenaar on 24 November 1982.
      See https://en.wikipedia.org/wiki/Wassenaar_Agreement

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  4. It's not just the issue of wage 'restraint'. German energy policy effectively charges the household sector for the costs of turning green while handing out subsidies (sorry, 'discounts') to the corporate sector.

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    1. Without those subsidies there would be no 20 Gigawatt photovoltaics plus in China 2015 (mostly build by chinese manufacturers by the way), because PV were still too expensive - now it has become cheap. So what's wrong with that ? The fact that those modules aren't build in Spain ? It could have been possible.

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    2. Let's be fair. The owners of nuclear and fossil generators have received more than 500 billion EUR as support. This was also financed by the housholds, but did not appear in your electricity bill.

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  5. There is no Ohm's Law in economics, there is no Boltzmann's constant in economics. Economics has never advanced from the hypothesis stage, if it ever really got that far.

    The normal scientific progression from Hypothesis to a Theory to a Law that actually works, just hasn't happened in economics. So the next time you are formulating a national budget, call the Accountants not the Economists. Accountants understand Balance Sheets, Economists don't. ;-)
    http://heteconomist.com/from-the-lost-book-of-noahs-wife-economics-in-ancient-eschatology/comment-page-1/#comment-612286

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  6. Is there really something objectionable about trade unions seeking full employment and working with employers towards this end?

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    1. SWL definitely thinks so.

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    2. 1) It makes good sense from German employers point of view. They get lower costs immediately and gain a competitive advantage over their competitors in other Eurozone countries

      2) From the employees point of view it is less clear: there is a trade-off between lower incomes and more employment

      3) But from a monetary union point of view it is deeply disruptive. Employers and employees in other EZ countries are hit. If they try to retaliate it becomes like a fixed exchange rate system with periodic sequences of competitive devaluations. That is why economics call it beggar my neighbour.

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    3. Supposing that German trades unionists are not less effective negotiators than other trades unionists then they will ensure that the trade-off you refer to in 2 will not be to the detriment of employees. The goal of full employment surely remains a good one. If the effect is to increase unemployment in other countries, doesn't the fault lie in those other countries (whose unions, for instance, apparently prefer higher wages for their present members over generally higher levels of employment)?

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    4. Ultimately, isn't it, the issue is simply this one.

      http://www.irisheconomy.ie/index.php/2015/11/30/the-euro-debate-and-the-abuse-of-language/

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    5. @patrick amon:
      - "doesn't the fault lie in those other countries (whose unions, for instance, apparently prefer higher wages for their present members over generally higher levels of employment)?"
      If everybody does it, then it becomes a 'race to the bottom'. No country will reach full employment, actually the opposite happens.

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    6. Thanks, Anonymous. I had to think about it for a bit, but yes, that seems right.

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  7. One reason for no complaints being made by fellow members of the eurozone may be a kind of soft 'bribery' based on dangling the prospect of lucrative positions in institutions such as the European Commission. For example, here in Finland it is clear that the political elite prizes EU positions much more highly than, say, being Prime Minister of Finland (would this even be imaginable in the UK?) This means that they are ready at every turn to prioritise EU, and particularly eurozone, goals way above the welfare of their fellow Finns. I would not be surprised if the same is true of other eurozone countries.

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    1. Wasn't the real bribe the prospect of lower interest rates, monetary credibility, and lower inflation --- which all of the countries got?

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  8. In Italy, the "untold story of the Eurozone crisis" has been repeteadly told in the last years (for instance Bagnai (2012) Il tramonto dell'euro).

    "The thing I find extraordinary about all this is that Germany’s neighbours seemed to have let it happen without a whisper of recognition or complaint."

    Maybe it could be interesting to know for you that the fact that such a crisis would have happened and that it would have damaged Italy was recognized and described in 1978 (!) by Luigi Spaventa in a famous speech in the Italian Parliament, when Italy joined the European Monetary System.

    Here is a link to the speech (in Italian):
    http://gondrano.blogspot.it/2014/01/il-cambio-e-la-piu-endogena-delle.html

    In the same days, the same thesis was put forward by Mario Monti (!) in an Italian financial newspaper.

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  9. It was deliberate in the sense that wage moderation was seen as the surest way to a more competitive economy in the light of the enormous costs of reunification. The policy was taken from the Netherlands, where it has successfully been implemented in the late eighties (Poldermodel)

    This doesn't mean it was a deliberate beggar-thy--neighbour policy. Perhaps wages in other European countries rose too fast? The insinuation in this article - Germans 'connived' to take jobs from Eurozone partners is unwarranted and, frankly, disgusting.

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    1. I don't understand. In macro terms it is exactly equivalent to beggar my neighbour devaluations within a fixed rate system. German employers and maybe employees are gaining at the expense of other EZ countries.

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    2. "In macro terms it is exactly equivalent to beggar my neighbour devaluations within a fixed rate system. German employers and maybe employees are gaining at the expense of other EZ countries."

      The beggar my neighbour part would be IMHO the share that happened with no wage increase in the affected EU countries, i.e. the share that was caused by German reduction of wages.

      However, we see at the same time an increase of wages in the southern European countries, this with stagnating or decrasing relative competitivenes of these countries.

      Is Germany responsible for this part? How much did this contribute to the whole problem?

      Or more generally: How did these countries plan to react to changing situations when they were applying for Euro zone membership?

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    3. "Is Germany responsible for this part?" I do not argue here that it is. I have often argued that fiscal policies should have been much tighter in these countries.

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  10. Right on. There's no doubt that this is what effectively happened (intentional or not). There's interesting stuff to read on the industrial relations systems inside the Eurozone and what they tell us about the ability for wage moderation / internal devaluation in the past, present and future (http://www.mpifg.de/people/mh/paper/Hoepner, Lutter 2014. One Currency and Many Modes of Wage Formation.pdf).

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  11. This is unlikely to be "deliberate beggar-thy-neighbour", people talk about this in naive supply/demand closed economy terms. "If you make jobs cheaper then there will be more of them."

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  12. This is common knowledge, I am not sure what is particularly new about it, since it formed the basis for the later german Agenda 2010 reforms as well.

    What it does not follow at all from what you quote is that this pact in any way or form targeted the other Eurozone economies. The obvious targets were in reality the non-Eurozone soon-to-be EU countries like Poland, Hungary or the Czech Republic, which were causing a relatively significant displacement of production facilities from West Europe (obviously from Germany first and foremost, because of its focus on industry) to Eastern Europe, chasing the cheap labour that was becoming available there, as well as the threat of China, which was at the time (and today) the ever omnious spectre of even cheaper labour.

    As things went, it was obviously the very much correct decision, since it left Germany slightly better prepared for worldwide shocks like the GFC. The rest of the Eurozone and the EU understood at least theoretically that they also needed to do something to improve their competitivity (as seen in the 2000 Lisabon Strategy), but Germany was one of the few countries which actually implemented some reforms (albeit not necessarily those of the Lisbon Strategy, but rather more pragmatic ones) in order to achieve that goal.

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    1. I think you do not get the macroeconomics. The EZ as a whole is like a flexible exchange rate economy, and standard theory (which has to be right at least in the medium term) is that attempts to become more competitive by cutting wages will be offset by nominal exchange rate appreciations. So this has to result in a within EZ transfer.

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    2. Mainly Macro5 December 2015 at 02:16

      Does this mean that the Euro - in spite of Draghi's flood of QE - is too strong because of the Northern countries' export strength? So they should try to weaken its rate of exchange? The Americans will be delighted.

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  13. As Martin Wolf has pointed out, the Euro was forced on Germany and the would-be members were not aware of its economic consequences whereas German policy makers were.

    Under Euro rules, the only way of raising competitiveness and employment is internal devaluation. So Germany’s neighbours let it happen without a whisper of recognition or complaint because they became aware that Germany was following the rules and they were not.

    To criticize that reminds one of Quintin Hogg Lord Hailsham's famous words.

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    1. The reference is lost on me, as is also the references to rules. If there is any rule in this respect, it is that countries should aim for the average EZ inflation rate. Everyone is happy to condemn the EZ periphery for ignoring this, but why does the point not also apply to Germany?

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    2. Prof. Wren-Lewis,

      Clearly, we are using the word "rules" with different meanings. There are two kinds: Descriptive rules say: If X happens, then Y happens. Normative rules say: In a situation X, one should do Y.

      I used the word in a descriptive way: That's how things work in the Euro area.

      You speak in a normative sense: If Southern countries of the EZ ruin their competititivity, Germany and the Northern countries are morally obliged to do the same and raise their unemployment rate.

      Forgive me if I think that deserves Lord Hailsham's words about Labour supporters. You will find them in Wikipedia.

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    3. Now you are ranting. Have not time to read Wiki.

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    4. Mainly Macro7 December 2015 at 09:00

      You're quite capable of a good rant yourself.

      In your time, you said German economic policy was based on greed or ignorance (with the baneful effect of almost full employment and almost no inflation...).

      You also said that the nations of the Euro periphery, if adequately informed about macroeconomics (sc. by yourself or your ilk), could rightly accuse Germany of stealing some of their jobs.

      And to top it off, your present postdeclares that German employers and employees (those dastardly unions!)connived in a policy that would take jobs away from their Eurozone partners.

      You will have guessed by now what Lord Hailsham said. I find it more apposite day by day.

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  14. I think it is not correct to claim that Germany tried to "steal" the jobs from other european countries. If Germany had pursued a middle-of-the-road policy with regard to wage increases, how many jobs would it have lost by now? Maybe 2-3 million at most? That's just a small share of the jobs the other european countries lost all together. And would those jobs, all together, have gone to other european countries or maybe partly to other regions of the world?
    And if one looks at this chart:
    https://moneyandblogging.files.wordpress.com/2013/08/eurozone-country-unemployment-rates.jpg

    it does not look like the wage restraint policy had an immediate effect. In fact, Germany topped the chart in 2005 and 2006. The peak in 2005 rather seems to imply that the Hartz reforms caused the decrease in unemployment. The real divergence only starts in late 2007.

    It seems to me that Germany, in contrast to some other countries, was able to adjust to the new era of globalized competition and wage restraint probably played a part. The financial crisis probably also refuted the housing bubble-based economic models of other countries who did not complain before 2008 because they were living very well with it. Germany should have complained more about these models before the crisis, not the other way round.

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    1. " Germany should have complained more about these models before the crisis, not the other way round. "

      True. But imagine what those other countries would have said.

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    2. Sounds logical for swabian housewifes. But pretty far from reality since there is no consideration of exchange rates.

      If one reduces wages to gain competitivness, resulting in growth of exports, currency will revaluate to maintain balance by cheapen imports at the expense of domestic demand.

      Competing with China e.g. solely on basis of loans - well, good luck with that.

      " Germany should have complained more about these models before the crisis, not the other way round. "
      Germany fed those bubbles. The enormous export surplus requires an enormous amount of debt.
      In the end the Germans provided both, goods and money to buy those, in exchange for the dubious title Exportweltmeister.
      Since that title turned into a national sanctury they could have thrown all their excess exports in the sea. Wouldn't make any difference.

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  15. In theory the pact hardly changes the total wage bill, doesn't it? It seems intended to change the distribution of the wage bill, not its aggregate amount: some of incumbent employees' wages are redirected to pay people who would be unemployed without the pact, so at the aggregate level the cash flow between German corporates and German workers is unchanged by the pact. If it works as intended by redirecting the unemployed to productive investment, it should also be wage inflationary in the mid to long term (reduces supply of work and increases demand for work = higher prices).

    (Whether it works that way or not does not matter given our host is trying to find out the intention.)

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  16. Hello,
    I am a high school economics student, and I have a few questions. Could other Eurozone countries respond to this by lowering minimum wage and creating new jobs? ( I know, easier said than done)
    Also, is this undercutting leading to an increase in Germany's GDP?
    Thank you.

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    1. Good questions. I hope you will get an answer.

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    2. 1) Yes, but its a poor instrument as the impact on other wages may be small

      2) Yes in the medium term. However cutting wages may have depressed domestic demand in the short term.

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    3. Interesting answers.

      1) Are new jobs without impacting other wages bad? It seems rather like a good idea.

      2) In the medium term, Germany's GDP rises. So limiting wage growth in the short term sounds like good investment. And lowering domestic demand in the short run doesn't seem have to have harmed Germany, has it?

      On the whole, SWL seems to endorse German unions' strategy.

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  17. There are many articles by now that argue convincingly that the German trade surplus is largely the result of weak domestic demand. The wage moderation "successfully" depressed domestic demand, but played a small role in Germany's export performance. The proximity to Eastern Europe, the geographical specialization of exports, the product mix -- these and other non-price factors really explain the export performance.

    The question then is: what's the effect of a German domestic demand shock on Greece, Portugal, and Spain in terms of the trade balance and employment? The estimates of demand spillover effects that come out of standard DSGE models or multi-country input-output models suggests that spillover effects from Germany to the South are fairly small.

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    1. I think you do not get the macroeconomics. The EZ as a whole is like a flexible exchange rate economy, and standard theory (which has to be right at least in the medium term) is that attempts to become more competitive by cutting wages will be offset by nominal exchange rate appreciations. So the German 'policy' has to result in a within EZ transfer alone.

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    2. I think here you are putting too much faith in the magic of foreign exchange markets. How wonderful and stable the international monetary system would be if automatic adjustment mechanisms always served to correct external imbalances. I do not take for granted that trade flows, i.e. the euro area's current balance with the ROW, determine the value of the euro. My operating assumption is that the value of the euro is determined in financial markets, by whimsical money managers. The trade balance is perhaps one of a thousand factors investors pay attention to when making portfolio decisions.

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  18. So what? The german labour unions prefer less unemployment for all employees to higher wages to some employees with protected jobs. That is a reasonable choice. If the economy is going well companies still have to compete for labour and wages would rise. That is called capitalism and where it works that way people are normally better off.

    The reason wages don't rise in Germany are not the relatively moderate labour unions but the free movement of labour between countries that have strong labour unions and job protection and therefore more unemployed people. They are moving to countries like Germany and are the cause for stagnating wages. A tenured economics professor should see this - unless he has an ideologically tainted view of the world...

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    1. Benefitting from undervalued currency on expense of other countries, especially if they ought to be your partners, is not capitalistic. Mercantilism is more suitable.

      The current political situation within Europe concerning refugees and migration is directly linked to this and the German policy on Europe in general. Other countries are taking their chance to pay them back by adopting their strategy: your problem, not ours - deal with it.

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    2. banana,

      You don't know much about mercantilism, do you?

      Look it up.

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    3. Please tell me how the German economic policy (huge export surpluses, internal devaluation by wage moderation + basically undervalued currency) does not match the definition of mercantilism.

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    4. Sorry banana,

      the irony is lost on you: We have the current surplus, because Germany is NOT mercantilistic. Internal devaluation is not an essential feature of mercantilism.

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    5. As I said, look it up

      http://www.econlib.org/library/Enc/Mercantilism.html

      and then tell the world what's mercantilist in German policy.

      In school, German pupils are taught that mercantilism is unproductive and self-defeating.

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    6. Agreed, since money from export surplus is invested abroad.
      But the advantage from undervalued currency in combination with this huge export surplus is still leaving a distinct smell.

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  19. Enno Schröder
    " The estimates of demand spillover effects that come out of standard DSGE models or multi-country input-output models suggests that spillover effects from Germany to the South are fairly small."

    Very true. But don't expect SWL to believe it.

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    1. It is completely beside the point. We are talking about gaining a competitive advantage over EZ neighbours.

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  20. This is worth a look at. The ECB didn't used to publish this chart as the whole lot sums to zero (across the 19 national central banks); on its own Balance Sheet.
    http://digressionsnimpressions.typepad.com/digressionsimpressions/2015/12/the-euro-survival-explained-in-one-graph-which-also-helps-explain-why-the-crisis-will-not-go-away.html (HT Mike Norman).

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  21. I'm not an economist, but the whole causation sounds good, basic and correct. But what SWL doesn't care about, doesn't even mention, is the historical context, neither past nor future. I wonder if he wants to get to the Guiness Book for most obtrusive repetition of tautologies.

    In 1990 Germany embarked on a mission to warp about 16.5 Million people from a pretty low income level to one of the top levels worldwide. And this had to happen FAST. Thinking about a country in the center of Europe with Germany's size and history that fails to level its domestic polarity is left as an exercise to the reader. What solving this problem meant to the - at that time not even existing - Eurozone and its future members was totally unclear and secondary to the german electorate.

    In the not to far future, huge amounts of Germans (the big post war cohorts born from 1955 to 1970) will retire. They will start to spend their massive savings. The working population is going to shrink likewise. Both factors will "solve" the trade surplus problem very fast, in fact turning it around.

    Giving an answer to the final question, i suppose - in contrast to the author - Germany's neighbors take these two factors in account.

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  22. Heiner Flassbeck is arguing equally for 20 years now, most forcefully on his blog. Almost nobody in Germany is listening to him. He tried to change course being Finance Minister Lafontaines vice-minister in Germany 1998/99 (I remember with pleasure the wage rises we - the civil servants - got in 1999-2000 which might have been a consequence of the effort to prevent the dangerous developements we are facing now). Unfortunately they threw Lafontaine and consequently Flassbeck out of office in 1999 (well, officially he wasn't sacked but resigned). We all know btw that the anglosaxon financial elites feared and loathed Lafontaine as "the most dangerous man in Europe" (headline The Sun) because he threatened to dry out their most profitable fx business.

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  23. Germany's wage policies in the 1990s were quite sensible. If you had to choose between large scale job losses and wage moderation, you go for the latter. Luckily Germany has reasonable unions,such a policy would obviously never have worked in France. If we are to treat the euro area as one single economic area, why blame the one country that did the right adjustments and not about the many others that welcomed low interest rates and did not care about the impact EMU would have on their economies (e.g. no external devalution)?

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    1. You don't understand SWL. He would say that was entirely beside the point

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  24. "German employers and employees connived in a policy that would take jobs away from their Eurozone partners."

    That is not correct. Wage moderation followed a broad change labour market and social security legislation. It was a deliberate policy - not intended at gaining a competitive edge over Eurozone partners but to correct inefficiencies in the social security system and to lower unemployment.

    I cannot see why increasing potential output by lowering the NAIRU should be a beggar-thy-neighbour policy in a monetary union. Indeed, it would also have worked to lower unemployment and to raise GDP if Germany was a closed economy!

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    1. I seriously doubt the last statement, considering this chart:
      http://www.tradingeconomics.com/embed/?s=deuca2gdp&d1=19900101&d2=20151231&h=300&w=600&ref=/germany/current-account-to-gdp

      Leaving aside all the other implications of that assumption, a big part of those surpluses would have had to be soaked up by domestic demand to reach at least zero.

      Quite unlikely.

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    2. From a purely theoretical point of view, I cannot see the point of your objection. Lowering the NAIRU always lowers unemployment and increases GDP, regardless whether your are in a closed or in an open economy. The transmission channels may be different.

      From an empirical perspective, recall that there were also other forces at work that helped to improve German competitiveness vis-à-vis the rest of the Euro zone.

      In particular, EMU worked as a huge monetary stimulus for the periphery countries - implying lower unemployment and higher wage growth there - while it dampended activity in Germany - implying higher unemployment and lower wage growth in Germany. Indeed, implementation of the - extremely unpopular - labour market reforms in 2004 can be read as a direct reaction to rising unemployment.

      In addition, the German manufacturers are particularly specialized on capital-goods (cars, machinery). Car firms
      such as VW had long-standing relations with and also production facilities in China. Therefore, German exports benefited more from the take-off in China then other Euro area countries.

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