Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 24 January 2016

German exports and the Eurozone

I have argued that the low level of German wage increases before the financial crisis were a significant destabilising influence on the Eurozone, which also indirectly contributed to Germany taking a hard line on austerity. The basic idea is that Germany gained a significant competitive advantage over its Eurozone neighbours, which it has since been unwilling to unwind (through above average German inflation). What this competitiveness gain did was lead to very healthy export growth and a large current account surplus, and that additional demand meant that Germany did not suffer as much as its neighbours from the second Eurozone recession that policy created. Peter Bofinger has made a similar argument.

This argument is often criticised on the grounds that Germany’s healthy export growth was not primarily due to any competitive advantage, but instead was the result of non-price factors like strong demand from China for the type of goods Germany produces. This and other criticisms were recently made in a paper by Servaas Storm. One of the points made by Storm has itself been criticised by Thorsten Hild, and Hild’s point is entirely correct (see also Storm’s reply here). But the issue about what was the primary cause of strong export growth remains.

Trying to disentangle how much of German export growth was due to the competitiveness advantage they gained would require some econometric analysis which unfortunately I do not have time to undertake. But the point I want to make here is that if there has been a permanent positive shift in Germany’s exports (i.e one unrelated to price or cost competitiveness), then this strengthens the argument that I have been making. Before we get there, it is worth going through the basic macroeconomics involved.

Every country will tend towards some long run level of competitiveness. There are many ways of describing why this is: the need to obtain a balance between the production and demand for domestically produced goods, or the need to achieve a sustainable current account deficit. There are many reasons why this long run level of competitiveness could change over time, but in the absence of a plausible story about why that has happened to Germany (or equivalently, why a 7% of GDP current account surplus might be sustainable) it seems reasonable to assume that it has remained unchanged.

So if an economy in a monetary union, like Germany, moderates wages so that it gains competitiveness in the short term (where the short term could last a decade), this gain has to be unwound at some point. Just as the decline in competitiveness in the periphery needs to be reversed by creating below Eurozone average inflation there, the opposite applies to Germany.

Now suppose there has in fact been a permanent upward shift in the overseas demand for German goods. In the long run if nothing changed we would have an imbalance: the demand for German goods would exceed the supply, or the current account surplus would be unsustainable. The way the economy reacts to get rid of that imbalance is through additional German inflation. Not only must past gains in competitiveness be reversed, but competitiveness must decline even further to reduce the demand for German goods.

For those brought up on a mantra of the need to constantly improve competitiveness, this may seem perverse: getting punished for making goods other countries want. But of course it is not punishment at all. A decline in competitiveness is the same thing as an appreciation in the real exchange rate, and this makes consumers better off, because overseas goods become cheaper (in the jargon, there is a terms of trade gain). It is time for Germany to export a bit less, and start enjoying the benefits.

Posting note

For various reasons over the next month the frequency of posts may diminish. Don’t go away - I will be back.  


  1. Might sound a bit daft to praise a Mertonian Prof for this exemplary blog but yes, I have enjoyed your posts very much and will await your return.

    Best of luck in whatever you will be doing. Will be looking forward to reading your future blogpost on overseas currency activity of UK banks! :D

  2. This is a well-known point that has been reitersated by Heiner Flassbeck ( over and over again, at least since 2009 and taken up by many.

    In view of different labor market institutions in the different countries of the Euro zone and the German obsession with austerity a possible solution would be to write all labor contracts in each country or region in terma of a local wage unit, like Deutsche Mark, Franc, or Peseta, and determine the exchange rate between these units and the Euro such that exports equal imports. This would mimic flexible exchange rates but would preserve the convenience of a common currency (the Euro). I myself proposed that remedy ("regional wage indexation") in 1995 when the opponents of the Euro pointed to the unavoidable problem that wage developments would necessarily diverge among the Euro countries, simply because of differences in labor market instutions.

  3. Yeah, super solid. Course you could just say ... "austerity does not work at the macro level" and "spending = income". And leadership demands sacrifice and flexibility you evil selfish German morons. But econometrics kinda does it softer, I guess.

  4. Apparently trade deficits are really bad. But nobody can explain to me why a cross-country border trade deficit is so awful, but a intra-country trade deficit isn't. Something that is particularly obvious when they start talking about the Eurozone - not realising that those countries are now states in a union, not countries!

    Waving the 'transfers' hands doesn't really cut it in a time when transfers are being slashed to the bone.

    1. Actually it's the other was round.
      And the Eurozone isn't a union. Just a region with a common currency.

    2. Among other things, labor mobility between countries is a lot lower than within countries, for a variety of rather intractable reasons.

    3. "Among other things, labor mobility between countries is a lot lower than within countries, for a variety of rather intractable reasons."

      Go on.

    4. For sure. It seems a lot easier for someone to move from Gdansk to London than from Hull or Grimsby. I would not be surprised with higher costs and intense competition among lower wage earners if this has been made even worse. There are native Londoners, however, moving out to Essex - where there is no work.

  5. Some questions on this:

    1) Storm argues that the fall in German ULC results from German wages failing to rise in line with German productivity rather than German wages falling relative to elsewhere in the Eurozone and Hild appears to accept that. Many observers have noted that in the US wages have risen more slowly than productivity for even longer. Are there similar causes, e.g. weakening unions?

    2) Productivity is not just a matter of the 'supply side'. High external demand for German investment goods encourages movement of resources into that high productivity sector so increasing measured productivity at an economy-wide level. What is your view of the likely macroeconomic impact on Germany of the slowdown in China and its transition towards a less investment-intensive economy?

    3) I would suggest that a trade surplus of a country within a currency union could be sustained for longer than it could outside such a union as any upward pressure on the currency would depend on the overall balance of the union, rather than just that country. Would you agree?

    4) What is your view on the likely macroeconomic impact of migration into Germany?

  6. The last paragraph needs to be emphasised over and over. What is the point of creating a huge trade surplus if not to eventually spend it? Or is the point to mindlessly lend cash to other countries to the point that they cannot repay?

  7. Really good analsys if you asume free market. But German's competitivness was not due to market freedom, it was due to Hertz reformes, which is not market's doing, it was political doing. It was strong German political institutions that created it.
    As such, strong political institutions kan keep German competitivness forever(i mean; long term).
    Competitivness will deteriorate only in models of free market, not those that include functioning public institiutions.
    If German's establishment is keen on merchantilist policies then they will stay overly competitive no matter markets.

    The ways that Germans are preventing market destroying their competitivness is by forcing other EU memebers on austerity and by offering lower prices in order to close foreign production. This way perifery will never achieve production capacity (without production there is no competition) needed for reduction of German exports. And Also German manufacturing is offering lower prices to destroy production in competitive countries; steel makers in UK and USA are closing and surendering the market to German's steel makers who survived.

    This way German is succesfully staying "competitive" by destroying competition and preventing the rise of new production. This enables them to stay competitive in long term too.

    Your models should not assume only free markets, because that barely exists anywhere. Please incorporate more of real world into your models.

    1. You probably mean Hartz. And it may be added that Hartz was procecuted with 44 criminal offenses including bribery, confessed, and was punished with 2 years in jail suspended and 300.000€ fine. But the job was done.

  8. Recent trade data suggests that Germany’s trade with the euro-zone is roughly in balance. Its c/a surplus is mainly due to trade with countries outside the euro zone.

    The argument about Germany deliberately gaining competiveness vis-à-vis other EMU members by wage moderation appears bizarre. “Germany” does not set wages. The government is constitutionally barred from intervening in private sector wage negotiations. Wage negotiations are a complex process involving many different wage agreements with different durations, a myriad of opt-outs, most negotiated by unions, some not. With this in mind, the argument can only be valid if there is a powerful central entity in Germany that somehow would have pushed through moderate wage increase across the board.

    What did happen in the 1990s was an external shock, the onset of capitalism in Eastern Europe which over time evolved into the “extended workbench” of Germany industry. Many unions accepted lower pay, longer hours in exchange for safeguarding jobs in Germany. In times of rising unemployment (it peaked only in 2005!) it obviously made a lot of sense for the unions to compromise (union flexibility is higher in Germany than e.g. in France) when faced with further job losses or lower pay. But this I would argue was entirely unrelated to monetary union.

    It is obvious that this development as a side effect has strengthened Germany’s “competitiveness” inside the eurozone. But given the way wages are set it is difficult to argue that Germany can somehow undo this excess competitiveness through the wage setting process. It is even highly questionable if this would be good advice.

    For the textbook explanation to work, you need a high level of price elasticity for German exports. There is research out there that suggests that this is not the case.

    1. Anyone familiar with German law and politics knows you are right. But you have no hope of convincing SWL.

    2. "The government is constitutionally barred from intervening in private sector wage negotiations. Wage negotiations are a complex process involving many different wage agreements with different durations, a myriad of opt-outs, most negotiated by unions, some not. With this in mind, the argument can only be valid if there is a powerful central entity in Germany that somehow would have pushed through moderate wage increase across the board. ... But given the way wages are set it is difficult to argue that Germany can somehow undo this excess competitiveness through the wage setting process."

      You must be kidding! It is true that Germany did not engage in wage moderation with a view to improve international competitiveness. It did so in response to high unemployment, believing that lower cost of labor would bring about higher employment. But your statement sounds like public policy can't do anything about wages! Markets don't exist in some pristine institution-free environment characterized by preferences and technology; they are embedded in and shaped by in social and political institutions. Labor market policies and public sector wage setting obviously do affect wage bargaining. Policy was not passive; the wage moderation was intentionally created. And policy could bring about wage inflation too.

  9. Let me add a view from the practical experience of having dealt with hundreds of Mittelstand companies in Southern Germany during the 2000s. Companies with export ratios of 80-99%. These companies make machinery & equipment for which there is very little, if any, demand in Germany. They are typically high-tech machinery & equipment.

    I would like to know what benefit the German economy would derive if such companies were to voluntarily reduce their competitiveness in the markets where their customers are. Yes, the could reduce their competitiveness by increasing domestic costs such as salaries & wages but chances are that they would then soon pay a lot less salaries & wages because they wouldn't need the full staff any more. Or is the assumption that Germans, once they have more income, will buy some of that machinery & equipment which is no longer sold to overseas markets?

    1. Don't hope SWL will believe you. He has staked his reputation on believing the contrary. His is the clearest case I know of an economist whose macroeconomics are overwhelmed by his moral and political convictions. C'est magnifique, mais ce n'est pas la guerre.

    2. SWL do any of your colleagues or students go out and study the reasons for German and north European export competitiveness? How do they do this with a centralised wage bargaining system - that works with socially desirable results? Sure this is arguably micro, but it is important for understanding the macro? Do you really think it is because of exchange rate policies and mercantilist policies to reduce labour costs?

      Going out and investigating, literally understanding the production methods and the social context is what real empirical work is about. Talking to business. Talking to unions. Talking to banks. Watching the process in action. Getting the documentation. Talking to historians and country specialists about why the country works this why. It is about the field work, not just doing stochastic tests on huge amounts of numerical data. Theory is only there for reference. It is not there to frame your analysis. This is how the social sciences should work. Do any economists have the intellectual curiousity to want to understand what really goes on? Or are they just happy with their rational expectations models?

  10. To these naive ears this sounds remarkably like Varoufakis' take on the situation.

  11. I’d like to think your argument through. It would be great if you could clarify “Every country will tend towards some long run level of competitiveness.” Competitiveness is an imprecise term; different authors use it for different things; and sometimes the same author uses it for different things within the same article. Here you use competitiveness as another word for “international relative price” and the statement could be rephrased as “For every country there exists a long-run equilibrium real exchange rate”? Is that what you mean?

  12. We may agree on the basic conclusion (that German wages are too low), but for different reasons. I would say German wages are too low in the sense that the standard of living of the German population is too low relative the economy’s productive capacity. Higher wages would mean higher domestic demand and higher imports – the German surplus would shrink. Unfortunately this process would contribute very little to export growth and trade balance adjustment in Spain, Portugal, France, Italy, Greece.

    1. "Unfortunately this process would contribute very little to export growth and trade balance adjustment in Spain, Portugal, France, Italy, Greece."

      Why would it not? Historically, prior to monetary union, higher wages in Germany, caused by the high value of the Mark, led to considerable German investment in manufacturing industry in the rest of the EU.

    2. I had in mind short-run final demand spillovers from Germany to the European South. These are small.

      I also had in mind the alleged rebalancing of competitive positions that relative wage adjustment is supposed to bring about, which I think is totally overrated.

      You refer to German foreign direct investment in the EU in response to higher German wages. I don't know about that. Not sure if domestic wage growth is among the principal determinants of foreign direct investment.

  13. I completely agree with this piece. I am consistently amazed at how educated people still think that the net liability position and credit buildup of the periphery vis a vis Germany are due to some kind of culture of frivolity within those countries. A simple analysis of relative Unit Labor Costs, and thus real exchange rates since the introduction of the monetary union and the subsequent capital flows that followed make it pretty clear that a large portion of Germany's prosperity is the other side of the exact same transaction that created the imbalances in the periphery. Obviously, without a monetary union, the nominal exchange rate, one would expect, would have done the adjustment to correct this growing imbalance.
    Professor, I have two questions for you:
    1) Do you think the Eurozone is on the right fiscal path to correct these imbalances i.e. do you think that policies to boost wages, boost domestic investment and boost consumption in Germany are sufficient to offset the consolidation and real wage deflation in the periphery in a way that will allow the Eurozone to resolve these imbalances whilst growing at or near potential?
    2) Do you see a material risk for the US economy if instead of the periphery rebalancing vis a vis Germany, further depreciation of the Euro just results in the periphery rebalancing their external position via the rest of the World and Germany seeing their asset position expand even further? Do you think the US will have the credit impulse to absorb both its own domestic production and the glut of demand that would be exported from Europe in this scenario?

    1. You are "consistently amazed at how educated people still think" etc.

      I am deeply amazed that you think Germany is to blame if the periphery priced itself out of the market.

    2. "Germany seeing their asset position expand even further?"

      You cannot fix this problem by moving around the existing assets and liabilities into a new combination.

      The assets that are backed by liabilities that cannot be repaid must be dealt with, and there are only two ways to do that:
      (i) replace the liability with one that can be repaid (Eurobonds) - or the ultimate perpetual liability (Euros). Only the ECB can do that really.
      (ii) allow the asset and the debt to fail and eliminate each other, ie default.

      It's time for the Euro leaders to pick with one they want.

      The Germans et al lent the money and the assets they think they own are just as dodgy as the debts on the other side.

      Both should be eliminated via the standard bankruptcy and liquidation process for Banks and States.

      Except that the Euro elite were/are in such religious rapture that they genuinely believed that crises were impossible and forgot to design the limited liability system for banks and states.

      We either need a *bankruptcy* mechanism for states and banks putting in place, which would allow the debts and corresponding assets to be eliminated from the system in the usual fashion.

  14. I find all this talk about competitiveness a total nonsense. This talk makes sense only in a level playing field. If businesses pay to the banks 1% in Germany, 3% in France, 5% in Italy and 7% in Greece and the manufacturing profit margin is very risky 9% for all (the numbers are hypothetical but not so far from reality) and there is no cross border lending why all this nonsense talk? Idem for the ECB rates; they can get them as low as they wish, nobody will notice. Here, the hardliners of the ECB have a point. If the ECB wants level playing field and real transmission of their policies they ought to pay the extras in capital costs for everyone outside Germany. Then we talk.

  15. ...or just import more....then rebalancing will happen!


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.