Germany must abandon its record surplus and rebalance

The economy needs higher domestic investment and to tackle low pay

Anke Hassel


Discount store Aldi, a German retailer. Germany has the largest low-wage sector in western Europe © Alamy


Germany’s current account surplus, the balance of trade between exports and imports, is set to hit almost $300bn, or 7.8 per cent of gross domestic product, the world’s largest. This has drawn criticism from the Trump administration and international organisations such as the IMF.

They point to the increasing global imbalances between countries with deficits and surpluses, and the risks that high levels of overseas assets pose for the stability of financial markets.

Germany’s response is to insist on the benefits of free trade for all, the demand for high-quality German products and the needs of an ageing society.

Those arguments are not entirely convincing as high exports could partially be offset by stronger domestic demand, and higher wages would enable Germans to save for old age.

Germany is an extreme instance of the combination of high export rates and depressed domestic demand. Despite its size, it has this in common with Benelux and Scandinavian countries, also strongly export driven. Part of the explanation for Germany’s export performance is the undervaluation of the euro, but this does not explain low wage growth over the past two decades and sluggish domestic demand.

So why does Germany behave this way? Key to understanding the obsession of German policymakers and business leaders with export-driven growth is the effect of re-unification in 1990. The re-unified German economy was first hit by a major recession in 1992-93 when 500,000 manufacturing jobs were lost and the labour market of the former East Germany collapsed.

Unemployment there hovered around 19 per cent in the 1990s, despite generous early retirement and retraining schemes. By 1999 Germany was being labelled the “sick man of Europe”.

There were two important responses to this. First, manufacturing companies in western Germany and their trade unions started major restructuring efforts to regain competitiveness. This was negotiated in company-level agreements and based on the condition that employment for the core workforce of those companies was secured and that wage increases remained moderate.

The second response was to restructure the east German labour market. Wages in the deindustrialised regions of the east fell to low levels, reflecting weak industry structures and productivity.

Wage and income inequality rose across Germany during the 1990s. The size of the low-wage sector in Germany also grew, rising from 15 per cent in 1995 to 22.6 per cent in 2006, roughly where it remains today. It took Germany until 2015 to introduce a moderate minimum wage. As a result, Germany today has the largest low-wage sector in western Europe, even bigger than that of the UK.

Contrary to what is sometimes claimed, the labour market reforms of the early 2000s, named after Peter Hartz, former head of human resources at Volkswagen, did not cause Germany’s low-wage economy.

But they did reinforce pre-existing trends by cutting unemployment insurance to a comparatively meagre 12-18 months of income-related benefits. This added to pressure on big manufacturing companies to avoid lay-offs and, in turn, on unions to accept low wage increases.

In the east, the cuts in unemployment benefits and other aspects of the Hartz reforms pushed the low and medium-skilled long-term unemployed into low-paid service sector jobs. In-work benefits were introduced in a way that encouraged part-time work for the low and medium-skilled.

Wage increases have been held down by other policies. Income tax splitting for married couples results in a reduction in women’s working hours and low wage earners in Germany face the highest effective tax rate among the OECD club of mostly rich nations.

Finally, the debt brake, which came into force in 2011, puts additional pressure on the federal and regional governments to prioritise savings over investment. Compared with other European countries, Germany has a particularly bad record of public investment.

Rebalancing the economy is necessary and would benefit Germany and its trading partners. The country needs higher domestic investment and better pay, especially in the service sector. Although a tight labour market might push wages up a little, the German strategy is seen as successful at home and is firmly enshrined in laws and institutions. This means that real change will require a significant, and painful, shift in policy.


The writer is research director of the Institute of Economic and Social Research and professor of public policy at the Hertie School of Governance


The Current Account Counts

Stephen S. Roach  

china usa trade treaty

NEW HAVEN – In an increasingly interconnected global economy, cross-border trade and financial-capital linkages have come to matter more than ever. The current-account balance, the difference between a country’s investment and saving position, is key to understanding these linkages. The dispersion of current-account positions tells us much about the state of global imbalances, which are often a precursor of crises.

The same is true of trade tensions, such as those now evident around the world. Current-account disparities often pit one country against another.

Economies running current-account deficits tend to suffer from a deficiency of domestic saving. Lacking in saving and wanting to invest, consume, and grow, they have no choice but to borrow surplus saving from others, which gives rise to current-account and trade deficits with the rest of the world. The opposite is the case for countries with current-account surpluses. They are afflicted by subpar consumption, excess saving, and chronic trade surpluses.

There is a long-standing debate over who is to blame for this state of affairs – the deficit countries, which draw freely on the saving of others to finance economic growth, or the surplus countries, which choose to grow by selling their output in foreign markets. This blame game, which has long been central to disputes over international economic policy and trade tensions, is particularly contentious today.

The United States has the largest current-account imbalance in the world. It has recorded a deficit for all but one year since 1982, the sole exception being 1991, when foreign contributions to its military campaign in the Persian Gulf underpinned a miniscule surplus (0.05% of GDP).

During the 2000-2017 period, the US amassed $9.1 trillion in cumulative current-account deficits. That is larger than the $8.9 trillion of cumulative surpluses run collectively by the three largest surplus economies – Germany, China, and Japan – over the same period.

Many observers believe that the US is doing the rest of the world a huge favor by running chronic current-account deficits – namely, supporting the large surplus countries, which tend to suffer from a shortfall of domestic demand. Others, including me, are more critical of America’s long-standing penchant for excess consumption and the role that surplus economies play in enabling it. While there is undoubtedly some validity to both points of view, I worry more about the destabilizing role of the US.

America’s consume-now-save-later mindset, which is at the heart of its current-account deficit, is deeply embedded in its political economy. The US tax code has long been biased toward low saving and debt-financed consumption; the deductibility of mortgage interest, the absence of any value-added or national sales tax, and a dearth of saving incentives are especially problematic.

So, too, are the wealth effects from a profusion of recent asset bubbles. Aided and abetted by the Federal Reserve’s über-accommodation since the late 1990s, there was no stopping the interplay between America’s asset-dependent economy and an equally pernicious leverage cycle underwritten by bubble-inflated collateral. Why save out of income when frothy asset markets can do the job? The preference for asset-based saving over income-based saving is central to America’s current-account deficit.

The surplus countries have been delighted to go along for the ride. It didn’t matter that the US consumption binge was built on a foundation of quicksand. Excess export growth in the large surplus economies enabled the excesses of the world’s largest consumer.

That was especially the case in China. Spurred by Deng Xiaoping’s “reform and opening up,” China’s export sector increased sixfold – from 6% of GDP in 1980 to 36% in 2006.

Mirroring America’s massive current-account deficit, China’s current account went from relative balance in 1980 (+0.1% of GDP) to a massive surplus of 9.9% in pre-crisis 2007. The same was true in major developed economies, albeit to a lesser extreme: Germany’s export share of GDP went from 19% in 1980 to 43% in 2007, while Japan’s went from 13% to 17.5% over the same period.

In many respects, a marriage of convenience between the surplus and deficit countries eventually blossomed into full-blown codependency. But then, with the wrenching global financial crisis in 2008, the music stopped. Since then, frictions between deficit and surplus countries have intensified, now risking the possibility of a full-blown trade war.

President Donald Trump’s administration has played an especially antagonistic role in asserting that the US is being victimized by large trade deficits. Yet America’s trade gaps have, in fact, been spawned by a chronic deficiency of domestic US saving. Despite the government’s recent upward revision to a still-depressed personal saving rate, the overall US national saving rate, which drives the current account, remains woefully deficient, averaging just 1.9% in net terms (adjusted for depreciation) over the post-crisis 2009-17 period. That is less than one-third the 6.3% average during the final three decades of the twentieth century.

Large and growing federal budget deficits over the next several years will only exacerbate this problem. Blaming China misses the obvious and important point that the Chinese current-account surplus has fallen sharply in recent years, from 9.9% of GDP in 2007 to an estimated 1% in 2018. In 2017, China’s current-account surplus of $165 billion was well below that of Germany ($297 billion) and Japan ($195 billion).1

As China presses ahead with consumer-led rebalancing, it will continue to move from surplus saving to saving absorption, with the distinct possibility that its current account will shift into permanent deficit (a small deficit actually was recorded in the first quarter of this year). That will leave a deficit-prone America with one less surplus country to draw on in funding the growth of its saving-short, excess-consumption economy. Maybe the rest of the world will step up and fill the void. But with the Trump administration now disengaging from globalization, that seems less and less likely.

History suggests that current-account imbalances ultimately matter a great deal. A still-unbalanced global economy may be forced to relearn that painful lesson in the coming years.


Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist, is a senior fellow at Yale University's Jackson Institute of Global Affairs and a senior lecturer at Yale's School of Management. He is the author of Unbalanced: The Codependency of America and China.

 Let The Emerging Market Bailouts Begin: “We Don’t Have Much Choice”

To understand why Europe is watching Turkey’s financial crisis with alarm, you just have to see this chart:


Bank exposure to Turkey emerging market bailout


Spanish – and to a lesser extent French and Italian – banks have lent a lot of money to Turkey.

So as that country spins closer to default, those banks and their governments are in danger of having massive holes punched in their financial structures.

With Greece its usual mess and Italy’s bond yields spiking, the last thing Europe needs is a banking crisis. So, as today’s Wall Street Journal reports, the Continent is looking – as it always does – for Germany to step in and fix things:

As Turkey Teeters, Germany Considers Offering a Financial Lifeline
ISTANBUL—The German government is considering providing emergency financial assistance to Turkey as concerns grow in Berlin that a full-blown economic crisis could destabilize the region, German and European officials said. 
While the talks are at an early stage and may not result in any aid, the possibilities being discussed range from a coordinated European bailout similar to the kind deployed during the eurozone debt crisis to project-specific loans by state-controlled development banks and bilateral aid. 
Berlin fears a meltdown of the Turkish economy could spill over into Europe, cause further unrest in the Middle East and trigger a new wave of immigration toward the north. 
“We would do a lot to try to stabilize Turkey,” a senior German official said. “We don’t have much choice.” 
Other European governments have grown equally concerned. Hosting his Turkish counterpart in Paris on Monday, French Finance Minister Bruno Le Maire said it was important to support Turkey’s efforts to repair its economy. 
Why You Should Care About Turkey’s Meltdown
But economists say it is too early to pin down how much money Turkey, a member of the North Atlantic Treaty Organization, might need because much of its potentially troubled debt is in private hands. They have pointed to Argentina, a smaller emerging economy facing similar problems, which received a $50 billion credit line from the International Monetary Fund in June. 
Two senior officials in Berlin said German Finance Minister Olaf Scholz had discussed some of the options with his Turkish counterpart Berat Albayrak in recent conversations. 
Such aid would mark a striking rapprochement between Germany and Turkey, which despite having been close allies for over a century have become increasingly estranged in recent years as Turkish President Recep Tayyip Erdogan’s rule has grown more authoritarian. 
Mr. Erdogan is due to visit Berlin on Sept. 28. Financial aid will be on the agenda a week earlier, when Messrs. Scholz and Albayrak are expected to meet in Berlin to prepare the president’s trip. 

Germany’s attitude contrasts with that of the U.S., which has shown little interest in calming markets as they pummeled the Turkish currency, the lira, earlier this month.  
On the contrary, President Trump, locked in a dispute with Mr. Erdogan over the detention of a U.S. pastor in Turkey, has piled sanctions and new tariffs on the country. 
German officials said such policies might have amplified Turkey’s woes and reduced market confidence. 
“This is an absolutely insane and ill-informed policy,” said one senior German oficial. 
Berlin’s main concern is that a crisis could undo a landmark deal with Turkeyunder which Ankara has cracked down on Europe-bound refugees passing through its territory in exchange for funding. Germany experienced a popular backlash after the country took in nearly two million asylum seekers since 2015. 
The collapse of the lira—it has lost 40% of its value against the dollar this year—has pushed up inflation and put pressure on companies and individuals who have loans denominated in foreign currency. The threat of mass defaults, in turn, has been weighing on Turkish Banks. 
Ultimately, however, Europe may find it inevitable to provide some form of assistance to Turkey, a senior EU diplomat in Ankara said. 
“We cannot just sit and watch Turkey go down the drain. The migration pressure and the geostrategic importance, as well as the economic links, are too important,” this person said.

Note that the first step in the process doesn’t involve any actual money changing hands.

Germany just announces that it’s “considering” helping out and hopes that this will be enough to stabilize the Turkish lira, giving its government breathing room to bring its finances – and its relationship with President Trump – back into balance.

This step usually fails, alas, because by the time a country enters a currency crisis as severe as Turkey’s, everyone understands that its problems are deep-seated and systemic, and thus not something that a little breathing room will fix.

Next up apparently will be an emerging market bailout in the form of a Europe-wide set of loan guarantees (managed and backstopped by Germany) that will, hopefully, not have to be activated.

This might work if the guarantee is big enough relative to the debts coming due. But in effect the result is the swapping of Spanish loans to Turkey for German loans. And there’s a limit to how much of the world’s debts even Germany can take on.

Turkey, meanwhile, is just the beginning. Tunisia is teetering, Brazil’s currency is falling, and a big chunk of the Middle East has external debt but little in the way of resources to cover it.

Brazilian real to USD emerging market bailout


By the time this latest emerging market bailout is complete, the amount of debt added to developed world balance sheets could be enough to spread the pain pretty widely.


Beijing's Banking Overhaul

China is considering a central bank reform to give itself more clarity and control.

By Phillip Orchard        


The Chinese central bank is quietly considering a change that says a great deal about the progress and perils of China’s broader reform project. According to Caixin, Beijing may abolish the nine regional branches of the People’s Bank of China, each of which oversees several provinces, and replacing them with more than 30 provincial-level branches – effectively returning to a system it abandoned in 1998. The plan is expected to kick in by the end of the year.

Now, we realize that a bureaucratic overhaul in China is not very dramatic. But as we discussed following President Xi Jinping's overhaul of the state bureaucracy during the spring, Xi is in a make-or-break wrestling match with the system he heads, and there are still several rounds to go. China is a big and unwieldy place that's ill-suited for micromanagement. Chinese history is littered with sclerotic, unresponsive governments getting blindsided by crises bubbling up from the provinces. And if the Communist Party of China has any chance of surviving amid slowed growth and trade tension with the West, it will need all the help it can get.
 
Reversing Course
On the surface, at least, this change seems like an admission of defeat. Until 1998, the PBOC had a branch in each of China’s 31 provincial-level administrative units (i.e., provinces, autonomous regions and biggest cities) that answered directly to the central bank leadership – a similar structure to the one under consideration. The problem with this setup was that local governments simply proved too adept at hijacking monetary policy and financial resource allocation to support their immediate interests, often at the expense of Beijing’s macroeconomic goals. Part of the problem was that the incentives of local governments and provincial PBOC branches were too tightly aligned. The quickest way to gain promotion up through the Chinese system, whether as a local administrator or a central bank branch official, was to ensure that your province was producing sparkling economic data. PBOC branches were also too dependent on assistance from local governments, which since the 1980s have had considerable sway over local economic activities and ample wariness of prying eyes, to be able to carry out their mandate.

Thus, a province’s success was the branch’s success, creating incentives to overlook financial risk and support reckless lending and development in the name of economic growth. (And, if all else failed, there were mutual incentives to simply cook the books.) In other words, what Beijing wanted from the bank branches was a clear view into local economic activity and prudent allocation of liquidity. What it got was regulatory capture. This was just the latest manifestation of an age-old problem in China, where the center has always struggled to control the country’s disparate parts.

And so, in an effort to boost the central bank’s independence, the PBOC was restructured to resemble the U.S. Federal Reserve. The provincial branches were abolished, replaced by nine regional branches responsible for overseeing several provinces. More than 300 municipal sub-branches and more than 1,000 county-level sub-branches remained, but their responsibilities were confined to financial supervision, with little ability to alter policy or issue credit independently – and thus leaving local governments with less influence over the PBOC. But this system fostered its own problems. In particular, the regional branches have reportedly struggled to uniformly meet the needs of multiple provinces, in which economic conditions could vary widely.
 
What Has Changed Since 1998
That the PBOC is reversing course says three things about China’s reform effort. The first is merely that the party leadership feels it now has the tools to prevent regulatory capture and keep local governments in check. For example, Xi’s sweeping anti-graft campaign has extended to every conceivable level of government and, increasingly, into the private sector and civil society as well. Of the nearly 1.5 million officials jailed, purged or otherwise disciplined, the vast majority have not been the high-profile “tigers” (i.e., senior officials ousted, at least in part, as threats to Xi’s consolidation of power), but rather lower-level “flies” – those with the most ability to gunk up the machinery of governance and hijack reform implementation. And Xi’s domestic surveillance apparatus is only growing: In March, Xi unveiled a new and improved National Supervisory Commission, which will embed units across the national, provincial, city and county levels to try to ensure adherence with contentious reforms. Already, this has shown some success in reducing the common practice of lower-level governments cooking their books to stay in Beijing’s good graces.

Second, it says that Xi isn’t done peeling away layers of the bureaucracy that have the capacity to dilute the center’s power and subvert its reform initiatives. With the PBOC, this process has been underway for some time. By 2004, according to unnamed officials quoted by Caixin, the regional branches had largely been defanged, with the sub-branches taking primary responsibility for local execution of monetary policy and financial market supervision. The regional branches had become redundant middle men. Given the scale and complexity of risk in China’s financial system, any bureaucratic bottlenecks, turf wars or conflicting regulations are threats to the party’s agenda that it cannot abide.

Indeed, this is just part of a much broader effort to overhaul China’s sclerotic and chronically overmatched financial supervisory system. For much of the past year, Xi has been gradually wringing the primary institutions responsible for provincial development into submission. In March, for example, Xi stripped the all-powerful National Development and Reform Commission – which has dominated economic planning in China since the Mao era, but which had become rife with corruption – of a wide range of its powers, including some of its oversight responsibilities. The party has also been inserting political committees into state-owned enterprises, which likewise are principal agents for local development. Perhaps most important, the party has been reining in local governments’ ability to sidestep restrictions on how they raise funding and how it’s spent.

Notably, the Communist Party has also focused on tightening its control of the PBOC itself, while simultaneously expanding the bank’s powers to allow it to function as China’s core policymaker on a range of economic matters. (Unlike the Federal Reserve, the PBOC has duties far beyond monetary policy.) Its new powers have come at the expense of China’s top insurance and banking regulatory bodies, which have been merged and stripped of any major role in drafting new laws and rules for the finance sector. In other words, Xi has become confident enough in his control over the PBOC to use it as the party’s pre-eminent tool to rein in other institutions. And by doing away with the regional PBOC branches, the provincial branches will be empowered to carry out Beijing's wishes more capably at lower levels. Theoretically, at least, this new system will allow Xi’s writ to be felt more clearly down the line.
 
Reform Whack-a-Mole
The third thing this move tells us is that the CPC’s ambitious economic reform agenda is turning into a game of whack-a-mole, with each success breeding a new problem somewhere else. And this game is going to become only more difficult as growth slows in China and as the sting from the trade war worsens.

For example, the success of Beijing’s sweeping deleveraging campaign and crackdowns on shadow lending has come with downsides. For one, China is grappling with a liquidity crunch that risks sparking a cascade of defaults. For another, the crackdown on shadow lending has merely pushed firms, local governments and investors to look for loopholes and embrace even riskier or more opaque fundraising channels.




 


 

This risk has been most evident in the private sector, with dozens of firms defaulting on dollar-denominated debt in recent months and a wave of online peer-to-peer lending platforms going belly up since June, leading to small-scale protests by burned investors in Beijing and Shanghai. Meanwhile, at least four times in the past month, Beijing has issued pleas for Chinese banks to boost lending to small-to-medium enterprises, as anxiety among banks about slowing growth, increased regulatory scrutiny and uncertainty stemming from the trade war has compelled them to focus on lending to safer assets such as SOEs, which banks think Beijing would rescue in a crisis.

 


 

With heavily indebted local governments, meanwhile, Beijing is simultaneously cracking down on their traditional forms of financing, such as banning state-owned banks from lending to what are known as “local government financing vehicles,” but also making it easier for banks to purchase bonds issued by local governments and help accelerate infrastructure investment (which contracted year-over-year for the first time in modern Chinese history in July). Notably, Beijing is still trying to get a handle on just how big of a risk local government debt poses to the Chinese economy. According to Reuters' calculations, China’s outstanding local government debt rose 7.5 percent to 16.47 trillion yuan ($2.56 trillion) at the end of 2017 from the previous year. Yet, in July, Caijing reported that authorities have launched yet another nationwide investigation into hidden local government debt, suggesting that things might be considerably worse.

In short, Beijing needs the PBOC to have a better understanding of conditions on the ground and the authority to adapt on the fly. Uncertainties surrounding the trade war only heighten this need, given that Beijing has only limited ability to anticipate how hard any particular sector will be hit and for how long. And considering the high degree of variance in economic risk profiles from one province in China to the next, the regional banks had become blunt hammers at a time when scalpels are needed.