Economic Rebalancing in Europe requires Germany to reduce Inequality at Home (UPDATE May 2014)

EU finance chiefs finally struck a bail-in deal for failing banks in the early morning of June 27. With this necessary (but not sufficient) step toward cleaning up Europe's banking sector out of the way, EU policymakers now need to tackle the fundamental causes of the euro crisis: the economic imbalances reflected in (still) widening current account imbalances in the eurozone (see "Euro Crisis Sees Reloading of Germany's Current Account Surplus").

Yes, it is true that the trade accounts of the countries in the Southern European periphery have improved. But that is largely due to lower import demand as a result of the collapse of the economies. Meanwhile, Europe’s export champion Germany continues to generate record export volumes and widening external surpluses, the last one at 7% of 2012 GDP or €240bln, globally the biggest in absolute terms. (see “Dissecting the miracle”) 

Just as powerful cars are mistakenly interpreted as a sign of the owner’s potency, Germans (mostly men) view their country’s superior export performance as a reflection of Germany’s economic potency. Yet, with each %age increase in Germany’s external surplus, the centrifugal forces tearing apart the common European currency zone are getting stronger. Hence, for those interested in preserving the euro and in maintaining the current euro membership intact, it is absolutely essential to reduce the economic imbalances in the euro zone. This requires:

(a) a correct analysis of developments that generated and still generate economic imbalances in Europe, and
(b) based on this analysis, a course of action for an economic rebalancing in the eurozone.

An excellent article by Michael Pettis, former JPMorgan trader/Managing Director and currently a professor of finance at Beijing University, does a pretty good job at both. The article has mysteriously disappeared from the internet, but his analysis can also be found in his book:

Pettis analysis starts with a real-world observation of the relationship between income concentration and national savings: As more and more wealth is concentrated in the hands of fewer people, consumption declines and national savings (defined as total production minus investment minus consumption) goes up, because the wealthier a person gets, the smaller the share of income he consumes. Hence, it is structural imbalances like income concentration and inequality in a country that determines national savings rates, not old-fashioned thrift. "In other words, national savings may have very little to do with household preferences and a lot to do with policy distortions."

When national savings are higher than the amount an open economy can or is willing to consume or invest profitably at home, the 'excess' savings are 'exported', e.g. as credits to foreigners to finance imports from the creditor country. The creditor country's current account then shows that its net export of savings (less net returns on investments) exactly equals its net export of goods and services: it has a current account surplus.  A current account deficit reflects the reverse: a shortfall of national savings compared with the country's consumption and investment needs, reflected in a shortfall of exports vs. imports. 

Germany is a case in point: following reunification in 1990 Germany ran current account deficits, importing capital to fund the reconstruction investments in the delapidated former DDR. To restore the usual current account surpluses, in 2003 Germany's powerful export lobby initiated and pushed through parliament a package of economic policy measures designed to improve competitiveness: Agenda 2010 restrained the growth of German wages and non-wage costs, causing the household income share of GDP and household consumption to drop and German savings rates to rise. As national savings soared, the German economy exported large and growing amounts of savings, financing the import of German consumption goods in the Southern European periphery and investing them badly in US mortgage-backed securities and sovereign bonds of eurozone countries (helped by financial regulations which treated sovereign bonds as 'risk-free' investments). As a result, while Germany's current account balance increased to 7.5% of GDP by 2007, offsetting current account deficits emerged elsewhere in the euro zone (15% of GDP in Greece, 10% in Portual and Spain, 5% in Ireland). 

(a) Summing up the analysis for Germany: as Agenda 2010 was implemented, the GDP-share of household income and household consumption declined. National savings rose because government consumption and investment also declined due to fiscal austerity and a lack of demand from the household sector. Income inequality skyrocketed as Germany's exporters garnered an ever larger share of income due to the booming exports to the Southern European periphery financed by Germany's excess savings. The result: large and growing economic imbalances in the eurozone, the danger of which is slowly being realized even in Germany (see "Der Fluch des guten Geldes", Manager Magazin, 18. Juni 2013).

b) A course of action for economic rebalancing in the euro zone would require reversing most, if not all, of the policies that led to this dangerously explosive situation. Michael Pettis correctly suggests that "the European crisis cannot be solved except by forcing down the German savings rate". Lowering the German savings rate can only be achieved by allowing German lower and middle-income households a much larger share of Germany's GDP. These income groups desperately need higher wages and a reinstalment of the social security benefits they had before Agenda 2010 (more generous pension and unemployment benefits a.o.). A cut in consumption taxes combined with a drastic increase in income taxes for higher income groups, a wealth tax, and a tax on financial transactions would complete the project.

By contrast, the Convergence and Competitiveness Instrument pushed by the Merkel government, i.e. Agenda 2010 re-loaded for the eurozone, would produce a contractionary shock not only for the eurozone but globally as the eurozone is the second largest economy in the world. It would:

- depress euro zone wages and generate euro zone current account surpluses 

- raise the value of the euro and increase the risk of deflation 
  (market data of May 2014 already confirm this expected development)

- persistent euro zone current account surpluses risk damaging trade relations with countries outside of the euro zone