In particular before the financial crisis, some economists argued that current account imbalances are not very worrisome, as such imbalances are the result of transactions between “consenting adults”. [2] Provided that the public sector deficit is not excessive, the current account balance is the result of transactions between optimising, forward-looking households and firms.
The view was defended by the former British Chancellor of the Exchequer Nigel Lawson at the 1988 annual IMF and World Bank meeting in Berlin, and became known as the Lawson doctrine. In his inaugural Adam Smith Lecture in 2010, Lord Lawson reformulated his view.[3] In his opinion, current account imbalances are the result of global capital flows searching for investment opportunities. He sees them as “a fact of economic life in a globalised word economy, rather than a dangerous effect that has to be remedied.”
The Great Recession and the subsequent European sovereign debt crisis have drastically changed the perception of the role of the current account, in particular in a currency union. After all, a current account deficit needs to be financed even in a currency union.
It is true that the creation of the eurozone has led to larger and deeper financial markets. Before the debt crisis, this allowed firms to borrow more cheaply, in particular in the southern European countries, resulting in substantial current account deficits. However, because of market fragmentation, it became increasingly difficult for the southern European countries to attract foreign capital during the sovereign debt crisis. To prevent financial stability risks from materialising, public funds were used to substitute for the dried-up private funds.
Moreover, the dividing line between public and private debts becomes hazy precisely in crisis situations. For example, during the Great Recession, because of nationalisations, private sector debt often ended up in the hands of the public sector.
Bundesbank research shows that the adjustment of current account deficits is significantly hampered in countries that are members of a monetary union.[4] This is in particular the case in comparison to a floating exchange rate regime, where current account imbalances are adjusted by means of changes in the exchange rate. But the adjustment is also slower than in a fixed exchange rate regime. In such a regime, national central banks sell foreign currency or raise key interest rates. These policies led to a tightening of credit demand, which ultimately reduces demand for goods and services.
In EMU, the adjustment process is slowed down because, by definition, there is no exchange rate adjustment. Policy operates through the single monetary policy through harmonised short-term interest rates and liquidity assistance measures of the European System of Central Banks (Eurosystem). It cannot be taken for granted that monetary policy at EMU level would be fully in line with the needs of a country with a huge current account surplus and major labour market bottlenecks. As a result, the adjustment needs to come from prices and wages, which tends to be slow. In addition, the bigger the share of intra-eurozone trade, the more it slows the adjustment.
The Bundesbank researchers conclude that “it is still an open question whether the characteristics of the monetary union are indeed amenable to smoothing necessary corrections and limiting spillovers to other EMU countries, or whether they merely aggravate existing imbalances and delay necessary structural reform.”
Five years on, we have more insight in the question. The southern European deficit countries have indeed slowly adjusted and they now all have current account surpluses. However, they paid a heavy price. Only in Spain and Portugal, GDP is above the pre-crisis peak. By contrast, in Greece, GDP is still around 25% lower than the pre-crisis peak. Moreover, the unemployment rates in Italy, Spain and Greece are still above 10%. Lastly, all these countries struggle with a substantial public sector debt overhang. In Greece, public debt is still around 170% of GDP. One may question if this outcome has been optimal. In a recently carried out survey among economists based across Europe on Germany’s trade surplus, more than two-third of the respondents agree or even strongly agree with the proposition that Germany’s current account surpluses are a threat to the eurozone economy.
Some even consider the German current account surplus bad for the world economy. According to the former Fed Chair Ben Bernanke it contributes to the global saving glut.[5] Nobel Prize laureate Krugman calls the Germany fiscal surpluses an international version of the paradox of thrift.[6]
How should policy adapt?
One of the weaknesses of EMU, or by extension, any fixed-exchange rate regime, is that debtor countries have to adapt, while creditor countries are not under any pressure to reduce their surpluses. Already John M. Keynes had perceived the danger of deflationary tendencies in a fixed exchange rate regime during the Bretton Woods negotiations.[7] He thought that the desire of hoarding money was much stronger than the desire to invest because of the risk involved. Investment comes in bursts of optimism, called animal spirits. A country with a deficit loses foreign exchange reserves and has to deflate its domestic prices. By contrast, a country with a surplus can accumulate liquidities without limit.
Keynes sought to repair this asymmetry between creditors and debtors in his 1941 plan for a Clearing Union. Surplus countries were not anymore allowed to hoard their surplus or lend them out at punitive rates. These funds were to be made available to debtors through the mechanism of an international clearing bank. The Keynes Plan was vetoed by the US, which did not accept that its “hard-earned” surpluses to be automatically placed at the disposal of “profligate” debtor countries.[8] It is unlikely that Germany would agree with a policy along the lines of Keynes Plan. However, as Martin Wolf justly remarks, “the eurozone will fail if it is run for the benefit of creditors alone”. [9]
For the moment, the only way to persuade creditor countries to increase their spending is to exercise peer pressure on them. In the recent past, IMF, OECD and ECB have all called on Germany to use the available fiscal space.[10] The European Union has a formal process to monitor countries with balance of payments imbalances. As part of the annual macroeconomic imbalances procedure (MIP), the European Commission has identified Germany as a country with imbalances in its large current account surplus.[11] It recommends Germany to strengthen private and public investment, to improve the efficiency and the investment friendliness of the corporation tax system, to create conditions to promote higher wage growth, and to reduce disincentives to work more hours, in particular for low-wage and second earners. Failure to follow the recommendations exposes the country to the possibility of sanctions, including fines.
The results of the MIP are mixed. According to the European think-tank Brueghel, Germany has one of the lowest implementation rates of country specific recommendations (CSR).[12] That is not very surprising, as the CSR does not play any role in German politics. The coalition agreement, concluded in early 2018, includes an investment programme in particular in digital infrastructure without making any reference to the MIP. Moreover the government remains fully committed to fiscal consolidation and maintaining a budget surplus.
Peter Bofinger, a frequently dissident voice in Germany’s Council of Economic Experts, attributes Germany’s reluctance to reflate its economy to Walter Eucken’s influence on macroeconomics.[13] Walter Eucken (1891-1950) is considered as the father of Ordoliberalism. He rejected demand management, fearing that this would lead to state socialism. His views were formed in Nazi Germany that implemented Keynesian ideas even before the publication of the “General Theory”.
Michael Burda (Humboldt University of Berlin) does not share the view that German economists would reject Keynesian demand policies.[14] It is taught in all macroeconomic courses in German universities. In his opinion, the rejection of demand management is simply national interest. Germany is a much more open economy than other large European countries, and would less benefit from such a policy.
This view is also shared by the President of the Bundesbank, Jens Weidmann.[15] According to model simulations, an additional wage increase in Germany of 2 percentage points, would have hardly any effect on the peripheral eurozone countries. Only Ireland could expect a moderate lift. By contrast, the German economy would suffer. Employment would ultimately fall by as much as 1% and output by 0.75%. A credit-financed increase in public spending would boost activity and exports in the periphery countries even less. The reason is that the import share of German public demand is only 9%, compared with 21% for private demand and 41.5% for German exports.
For the German authorities, the solution is supply side reforms. The painful Hartz labour market reforms between 2003 and 2005 have laid the basis of Germany’s turnaround in economic performance almost a decade later. This explains why Germans have less patience with short-term policy solutions, such as fiscal stimulus, and put the emphasis on structural reforms.[16]
Weidmann calls in particular for structural reforms in the services sector in Germany and the rest of the European Union. This would strengthen Europe’s growth potential. In a report commissioned by the European Policy Centre, Copenhagen Economics estimates that the digital economy can boost EU GDP by at least 4 percent in the longer run [between 2010 and 2020] through the creation of a Digital Single Market.[17] This would not only strengthen the growth potential of Germany but even more so that of those European countries specialised in (digital) services. The further opening of the German services sector to foreign providers may lower the Germany’s current account surplus because of a widening deficit on the services balance.
Given current policies, it is likely that Germany’s current account surplus will diminish in the coming years thanks to increased public spending and higher pay settlements. Removing the rigidities in the services sector might also contribute. Nevertheless, given the country’s demographics, the German current account is likely to remain firmly positive in the foreseeable future.
