Implications of German export success

I have finally got around to reading this excellent CEPR ebook on Germany’s exceptional recovery. That German GDP growth since the Global Financial Crisis (GFC) is higher than average Eurozone growth or French growth can be seen below.

GDP growth (source OECD Economic Outlook)

However the relative performance in terms of unemployment is remarkable.

Unemployment (national definitions, source OECD Economic Outlook)

The tremendous success in reducing unemployment is discussed in two papers in the book, and both suggest that it had more to do with changes in the nature of firm-union bargaining than the Hartz reforms. (John Springford has a nice chart showing how the German Phillips curve has shifted.) I have for some time noted how wage increases in Germany after 2000 were too low in the context of a 2% inflation target, and this helped drive an export boom and is a factor behind a huge current account surplus of 8% of GDP.

Other chapters in the ebook argue that there were other, perhaps as or more important,  factors behind this export boom, and I’m convinced that other factors did play a role. However the point I want to make in this post is that, as long as these factors are permanent, they imply that the real exchange rate in Germany has to rise at some point. This is exactly the same point as saying that not all of the German current account surplus of 8% is structural. Some of that surplus is because the German real exchange rate is undervalued.

There are two ways the German real exchange rate can appreciate. The first is via an appreciation in the Euro, and the second is for German inflation to be higher than average Euro area inflation. Below is a chart of one measure of competitiveness for both Germany and the Euro area.

The level is arbitrary: it is how the two series move over time and relative to each other that matters. You can see how Germany gained competitiveness.over other Eurozone countries from 2000 to the GFC. You can also see how that gain has been partially but not fully unwound over the last 7 or 8 years. Looking at Euro area competitiveness, it is a little below its average level over the past and also its level in 2010 when I calculated it was close to its equilibrium rate to the dollar. (This work was unpublished, but uses a similar model to the one I used to calculate the optimal entry rate of Sterling into the Euro as part of the 5 tests.)

So there is perhaps some scope for a further appreciation in the Euro, but it seems unlikely that will be enough on its own to achieve the required German real appreciation. German nominal wages have increased by more than the Euro average in recent years, but the differences have been small. That difference needs to increase to get Germany's real exchange rate to sustainable levels. Germany should not think of that as a problem, but rather the way their export success has to be translated into higher incomes for German workers..

The post-Brexit vote trade boost that never was

There is still a huge disconnect between the reality of the state of the UK economy since the Brexit vote and media perceptions. I heard one presenter on BBC News say the economy is doing pretty well following the Brexit vote. The reality is very different. According to the latest CER study the economy is 2.5% smaller than it would have been without that vote, which is nearly £2000 per household. We are back in the situation we were in before the 2015 election, where the reality for most households was pretty bad but the media kept on talking about a strong economy.  

But why has the Brexit vote had such a large negative impact on the economy, when Brexit has not happened yet. When I talked about what to expect immediately after the vote, when Brexiters were arguing that the collapse in sterling would be a big boost for the economy, I tried to point out that any boost would be temporary, because sterling had fallen for a reason: trade could become more difficult. That was a major reason for the depreciation, to compensate for future trade barriers. (I elaborated here, and talked about why real wages were falling here.)

It looks like I was being too optimistic. Here, from the ONS, is the breakdown of what contributed to GDP growth in each quarter since the vote. The contribution of net trade (the yellow bars) is always erratic, but there is no clear positive contribution emerging.

This aggregate data is backed up by the survey evidence from the manufacturing sector  reported here. Many firms have already lost export orders as they were cut out of EU based supply chains because of Brexit. A recent study from INET and Cambridge found that firms were either not entering into new agreements to export products because of Brexit or were more likely to exit from such agreements. Most recently another study used statistical methods to estimate what trade would have been without Brexit, and this suggested that exports to both the EU and non-EU were not increasing as you might hope as a result of the depreciation.

That exports to non-EU countries are lower as a result of the Brexit depreciation might seem puzzling, but it is important to remember the number of trade agreements that the EU has with other countries, which we will probably lose under some types of Brexit.

What is going on here? Why are exporting firms not increasing their volume of exports in the short term to benefit from the competitive advantage they have gained at least before barriers to trade are erected? No doubt some are, but they are being offset by others that are decreasing exports because contracts are getting cancelled or it is just not worth continuing to export or enter new markets.

The reason is something that trade economists have known about for decades. Trade involves important fixed costs. Supply chains have to be established, or the infrastructure to trade in overseas markets has to be set up. That means that those setting up supply chains do not want to be changing them every year, and as a result find it too risky to include UK firms when various barriers might arise as soon as March 2019. Equally firms selling direct to overseas consumers find that the investment required to set them up is greater than any profits they might only make for a few years.

All this would not matter so much in terms of GDP if similar things were happening to imports, but the most recent study I surveyed suggested this was not happening so much to imports. An important reason why exports are hit more than imports is specialisation. Increasingly there are products which the UK does not produce, so it is more difficult to substitute from overseas to domestic production. In contrast exports are generally competing with producers from many countries, so substituting from a version of the product coming from the UK is much easier. That I believe is an important reason why sterling fell so much after the Brexit vote.

Although all this is painful for people in the UK, it is also interesting for a macroeconomist. We have a ‘natural experiment’ involving a future event, but with the complication that what the future event exactly is remains uncertain. The negative impact on investment is exactly what we would expect: it is always safer to wait and see. The negative impact on exports is rather different from what standard models would imply, but can be explained by well known trade theory. The impact on consumption has perhaps been less than many expected, but that could be explained by many having incorrect expectations of what Brexit means for their future incomes. All this shows how important expectations are and how misleading naive expectations processes would be, but also why it is often important to allow for how distorted information sets can generate errors from rational expectations.  

Why Brexit has led to falling real wages

This might seem easy. The depreciation immediately after Brexit, plus subsequent declines in the number of Euros you can buy with a £, are pushing up import prices which feed into consumer prices (with a lag) which reduce real wages. But real wages depend on nominal wages as well as prices. So why are nominal wages staying unchanged in response to this increase in prices?

Before answering that, let me ask a second question. Why hasn’t the depreciation led to a fall in the trade deficit? Below are the contributions to UK GDP from the national accounts data. Net exports are very erratic, but averaging this out they have contributed nothing to economic growth since the Brexit depreciation.

The belief that the depreciation should benefit UK exports is based partly on the idea that exporters will cut their prices in overseas currency terms, making them more competitive. Yet at the moment UK the majority of exporters seem to be responding to the depreciation not by cutting prices but by taking extra profits. If they keep their prices constant in overseas currency terms (from currency denomination data almost as many exports are priced in overseas currency as imports), sales will stay the same but profits in sterling will rise.

While this helps account for the lack of improvement in net trade, it increases the puzzle over why nominal wages are not responding to higher import prices. If exporting firms profits are rising because of the depreciation, why not pass some of that on to their workers?

One perfectly good answer is that the labour market is weak, and what has stopped real wages falling further is that firms do not like to cut nominal wages. In these circumstances there would be no reason for exporters to share their higher profits with their workforce. So the immediate impact of the depreciation has not been a decline in the terms of trade (export prices/import prices), but instead a shift in the distribution between wages and profits. But many people believe that, with unemployment falling rapidly, the labour market is not weak.

There is another reason why exporters might be increasing profits but not sales, and not passing higher profits on to higher wages, which goes back to a point I have stressed before. We need to ask why the depreciation happened in the first place. To some extent the markets were responding to lower anticipated interest rates set by the Bank of England, but there is more to it than that. Brexit, by making trade with the EU more difficult, will reduce the extent of UK-EU trade. Furthermore there are two reasons why Brexit is likely to reduce UK exports by more than UK imports.

The first is specialisation. Because countries tend to specialise in what they produce, they may not have firms that produce alternatives to many imports, making substitution more difficult. The EU produces many more varieties of goods than the UK, so they are more likely to be able to substitute their own goods to replace UK exports. The second is the importance for UK exports of services, and the key role that the Single Market has in enabling that. On both counts, to offset exports falling by more than imports after Brexit we need a real depreciation in sterling. Exporters will have to cut their prices in overseas currency terms, and a depreciation allows them to do this.

Of course Brexit has not happened yet. We still get a depreciation because otherwise holders of sterling currency would make a loss. So firms do not need to cut their prices in overseas currency yet, allowing them to make higher profits. But these higher profits will be temporary, disappearing once Brexit happens. It would therefore be foolish to raise wages now only to have to cut them later when Brexit happens (no one likes nominal wage cuts). To restate this in more technical language, when Brexit does happen the UK’s terms of trade will deteriorate as a response to export volumes falling by more than import volumes. Firms are in a sense anticipating that decline in the terms of trade by not allowing nominal wages to rise to compensate for higher import prices.

So before Brexit happens we are seeing a distributional shift between wages and profits, but once Brexit happens profits will fall back and we will all be worse off. For Leave voters who think this is all still just ‘Project Fear’, have a look at the national accounts data release that the chart above came from. It shows clearly that UK growth in the first half of this year has been slower than that in the US, Germany, France, Italy and Japan by a wide margin. What Leave campaigners called Project Fear is real and it is happening right now, but do not expect your government or some of your newspapers to tell you that. 

The Brexit depreciation and exports

I’ve read a number of people say, observing the lack of growth of UK exports, that this illustrates how depreciations have little impact on trade flows these days. This is a classic case of reasoning from a price change. I think the phrase ‘never reason from a price change’ was popularised by Scott Sumner, although I got it from Nick Rowe.

The depreciation of sterling happened because of Brexit. Some of the depreciation might have been a result of the expected cut in UK interest rates, which means it should be temporary. The rest was to compensate for the impact of Brexit on UK trade. In both cases, therefore, exporting firms in aggregate get a temporary boost to their competitiveness (or profitability of trading), which will come to an end when interest rates rise again or Brexit actually happens, perhaps imposing tariffs or other costs that reduce competitiveness.

The temporary boost to competitiveness/profitability will be good for firms that already compete in overseas markets. But I learnt many years ago when I estimated aggregate trade equations that a lot of the effect from a depreciation comes from firms trading in new markets that they had previously considered unprofitable. To do that requires some investment: in distribution and marketing, for example. A firm is unlikely to make that investment if the gain in competitiveness is temporary.

This helps explain an otherwise puzzling feature of aggregate trade following a depreciation that - unlike Brexit - leads to a permanent improvement in competitiveness. It takes many months before the full improvement in trade volumes comes through. If it was just a matter of goods getting cheaper and people buying more of them you would expect a fairly instantaneous impact, but if firms are having to invest to expand markets, the full impact will take longer to come through. [1]

In the case of Brexit the gain to competitiveness is temporary. It is a mistake to start with the depreciation, and then be disappointed by the lack of any reaction. Once you ask why there has been a depreciation, it becomes clearer why any gain to exports is likely to be modest. [2]

[1] As tariff changes are perhaps likely to be more permanent than exchange rate changes, this may also help explain the puzzle discussed here.

[2] This argument apart, one other thing you quickly learn if you monitor aggregate trade is how erratic it is. We will not know for sure what the impact of the Brexit depreciation has been until well after Brexit itself.  

The Single Market was Mrs Thatcher’s great achievement for the UK

Parliament should be able to vote on whether leaving the EU means destroying this legacy.

The story of how Mrs Thatcher helped in the creation of the Single Market is told by Helene Von Bismarck here. She believed it would be of great benefit to the UK, and she was right. Here is a nice chart from this CBR report I discussed in my last post.

It shows the share of UK exports as a percentage of the GDP of the area exported to, for both the EU and the rest of the world. The rapid increase in the UK export share, doubling between 1990 and the beginning of the financial crisis, has to be largely down to the Single Market. [1]

But didn’t the CBR report say that the benefits of the Single Market had been exaggerated by the Treasury? Yes it did. Here is some of its reasoning. That growth in UK export share after the Single Market is not as impressive as it looks, because there is an underlying 6% 3.5% ** positive trend in the share relative to non-EU penetration, which you can detect before we joined the EU. That looks pretty on a picture, until you realise it is nonsense. A 6% 3.5% trend rise in an export share will imply that at some point not too far away UK exports to the EU will be as high as total EU GDP. UK exporters are just not that much better than exporters in other countries. There is no underlying trend rise in the UK’s export share.

As I say in The Independent, the rationale for going down the route of leaving the Single Market is completely wrongheaded. First, the Brexit vote was close - hardly a ringing endorsement for undoing Thatcher’s legacy. Second, all the evidence we have is that large numbers of Leave voters are not prepared to accept a reduction in their living standards as a price for reducing immigration, a reduction which is in the process of happening right now as a result of the collapse in Sterling. If you say we have no real evidence for this, show me your evidence that the referendum vote was a vote to leave the Single Market. If May really believes it when she says that the recent strength of the economy has convinced her that the costs of Brexit will not be that great, she is a fool. Third, the logic of saying that we cannot accept Single Market rules because we would have no say in what they are makes no sense because we will be worse off not accepting them. Once again, a majority of the country does not want to ‘take back control’ if it costs them money.

I say in The Independent that this is happening because May wants to finally show that she can bring down immigration, after 6 years trying and failing. It is also because she thinks she has to do this to keep her party together. But what Brexit means should not be up to the Prime Minister, particularly one who cannot be objective about immigration and who is a hostage to the Eurosceptic half of her party. The Single Market decision should be up to parliament. Leaving the Single Market was not on the referendum ballot paper, so it is not the ‘will of the people’. It does not follow automatically from the Leave decision, as many Leave campaigners correctly assured us before the vote.

Parliament should decide on whether we leave the Single Market as part of leaving the EU, not Theresa May. That is what living in a parliamentary democracy is all about. If the government denies MPs the chance to vote for leaving the EU but against leaving the Single Market, then that is effectively a coup against our democracy. MPs should block approval of invoking Article 50 until they get the opportunity to vote, in a way that is binding on the Prime Minister, to stay in the Single Market.

** I made a mistake in the original version of this post: corrected figures and clarifying text are in italics. For more details see this post

[1] The chart also casts doubt on the argument that being in the EU has held back UK exports to the rest of the world. This share was falling before we entered the EU, but has stabilised while we were a member.  

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.