By Zac Tate, Economic Strategist, Hottinger Investment Management
Reports of troubles in the European economy usually focus on countries that lie on the periphery of the continent. Whether it was high public debt in Greece and Italy or private credit bubbles in Spain or Ireland, the implication from a lot of the commentary of recent years is that Europe’s debtors were sinful actors who needed to make amends.
But it takes two to tango, and where there are borrowers, there must also be lenders who want to lend. Few thinkers have challenged the received wisdom on why countries in Europe’s periphery chose to build up so much debt in the early years of the 21st century and what borrowers did with the money. This matters because if policymakers have got the diagnosis wrong, they will continue to prescribe the wrong medicine, with consequences for the medium-term outlook for the European economy.
The narrative of sinful debtors finds its origin in Germany. The German view is that stability comes from keeping inflation low and debts under control. This leads to greater economic competitiveness, reflected in growing exports to other states. In promoting the policy of austerity as a solution to the euro crisis, Wolfgang Schäuble, the German finance minister through much of the period, exported this Stabilitätskultur (or stability culture) to other countries sharing the single currency.
But there is a fundamental flaw in this idea if one looks at Germany’s own performance in the context of the wider European economy in the 2000s and 2010s.
From 1999, when the euro replaced national currencies, until 2012, the euro area was effectively a ‘closed economy’. This means that it ran a roughly balanced trade account – neither importing from nor exporting to the rest of the world in significant volumes; see Figure 1. It implies that any country or countries within the euro area that ran a large trade surplus would have counterparts that ran large trade deficits.
Figure 1 – The monthly trade balance of the Eurozone nations with nations in the rest of the world.
Germany and other countries such as the Netherlands significantly grew their trade surplus with the rest of the euro area between 1999 and 2012. Figure 2 shows that Germany grew its net exports of goods and services to Eurozone partners by more than they grew them to non-Eurozone partners. Their European counterparts were France, Spain, Italy, Greece and Portugal, which all ran large trade deficits with Germany.
Figure 2 – The annual trade balance of Germany with the Eurozone nations and with nations in the rest of the world.
One then must ask how this was possible. The answer, in short, is wage restraint. Wage costs are a significant factor in how competitive a country’s firms are, but the measure that really matters is (nominal) unit labour costs or NULCs. NULCs describe the labour cost to produce one unit of output, whether it is a loaf of bread, a car or a package holiday. Two inputs go into this calculation: how much a worker is paid in wages and how productive that worker is. So German wages can be significantly higher than they are in Greece, but Germans can be more competitive than Greeks because they – on average – produce more stuff.
Figure 3 shows how Germany maintained a significant competitive advantage over other European nations during the first phase of the euro. By keeping wage growth lower than their European partners, through a concerted effort by employers and trade unions, Germany was able to make its price-sensitive products more attractive to other Europeans than their own domestic alternatives. This marked the beginning of the growth of Germany’s trade surplus with the rest of the Eurozone.
Figure 3 – Nominal unit labour costs for major European countries. Index is normalised at 100 in the year 1995. It shows that nominal unit labour costs grew by over 30% between 1995 and 2007 in Italy and Spain, but remained flat in Germany.
But this leads to the fundamental flaw of Stabilitätskultur. By running trade surpluses with other European states, Germany was effectively taking demand from other countries and therefore exporting unemployment to them. This, in turn, meant that those other countries either had to compete with Germany through wage restraint in what would be a zero-sum, race-to-the-bottom game because these countries were trading within a closed economy, or would have to allow credit expansion to support domestic demand.
In other words, the policies of Stabilitätskultur, if applied to all of Europe, would cease to yield the benefits they brought to Germany. In fact, Germany needed the higher inflation and the associated credit expansion in peripheral Europe to support the further growth of its export sector.
This month, Martin Höpner, a scholar at the Max-Planck-Institut in Cologne, published a paper on the history of what he calls Germany’s “undervaluation regime”. He describes how this regime started not with the euro but in 1944 with the Bretton Woods system of fixed global exchange rates, allowing Germany to run trade surpluses by keeping inflation low and limiting opportunities for others to respond by devaluing their currency. Whereas Bretton Woods permitted occasional currency adjustments, no such facility is afforded to members of the euro. Höpner claims that Germany’s undervaluation regime has brought the euro area close to collapse.
If Stabilitätskultur was ever going to work for the euro area, then the area as a whole needed to become a net exporter, which is what happened after 2012. With Europe struggling with austerity, Germany started to grow its exports to non-Eurozone partners, including China, the Middle East, the U.S. and the United Kingdom. Italy significantly increased exports to the United States. Spain, the poster child of economic reforms, has also vastly improved its trade position; in fact, since 2011, Spain has been one of Europe’s most competitive states for keeping labour costs low, explaining why it now runs a trade surplus with states within the euro area.
Europe as a whole is now a major net exporter in the world economy, but this naturally exposes it to forces outside its control. Not least is the ability of non-euro countries to manage their terms of trade with Europe by adjusting the value of their currencies against the euro. The improvement in the area’s trade balance overplays the success of this policy as it obscures the fact that suppressed demand in Europe for many of the years since 2008 – a core consequence of Stabilitätskultur – has led to weak import growth.
It would be incorrect to heap all the blame on Germany; its trade policy is only part of the story. The missing piece is the banking sector. Of course, states that run trade surpluses also generate surplus capital that can find its way through the banking system to the regions that need to fund their trade deficits with the likes of Germany and others. But this gets it somewhat back-to-front; funds to pay for exports can, and often do, come before the resulting trade imbalance, and most of those funds that flowed to the periphery in the 2000s did not come from Germany.
A study by Alexandr Hobza and Stefan Zeugner for the European Commission in 2014 reveals that huge volumes of funding came from banks in France and the Benelux countries as well as financial institutions operating out of the City of London. Ambitious organisations were active in the inter-bank and shadow banking markets where they would issue products such as asset-backed commercial paper and repurchase agreements to mainly professional clients from around the world, thus raising capital to fund their lending in the European periphery. Lower interest rates that came with euro accession created opportunities for banks and hungry borrowers. The upshot was a huge rise in the indebtedness of households, companies and local banks in countries such as Greece, Spain, Italy and Ireland. While much of the capital was funnelled into local real estate, significant volumes supported the German export boom.
While the role of banks in the European malaise does not centre on Germany, the response to the crisis has been led by a largely German narrative that is fatally flawed.
A revised narrative of the euro crisis needs to include a more critical assessment of the role of not just Germany but also those Northern European states that belong to the so-called Hanseatic League1 and support the Stabilitätskultur. The policies that the European Union have promoted, focusing on fiscal restraint and structural reforms, came straight out of the playbook of German stability culture, which says that the German model is right for all.
But we have shown this to be impossible. The policies of the Stabilitätskultur are self-defeating and lock Europe in the slow lane of low-growth, persistently high unemployment and dependence on demand from the rest of the world. This, today, has made Europe vulnerable to the slowdown in China, trade protectionism from the United States and the prospect of a hard Brexit in the UK. With a sort of tragic irony, it has created a culture of instability, a lost generation of young, unemployed Europeans and the rise of populist forces that seek to exploit their grievances.
1The Hanseatic League includes as its members the following countries: Denmark, Estonia, Finland, Ireland, Latvia, Lithuania, the Netherlands and Sweden
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