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.