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The Eurozone’s giant sucking sound

2013/11/04

Originally published on Eurointelligence.com on August 28, 2012 (see archive.org version). It has been used as a source in Dimitris N. Chorafas’ book Breaking up the Euro: the End of a Common Currency (August 2013)

As reported two weeks ago, Germany’s current account surplus is projected to exceed 6% for 2012, likely triggering a warning from the European Commission. Such large German current account surpluses are not new, what’s new is that since November 2011 the European Commission’s Macroeconomic Imbalance Scorecard includes a 6% threshold on the three-year moving-average current account balance (the threshold for deficits is 4%). Here I will argue that Germany’s persistently high current account surplus is dangerous for the stability of the Eurozone and corrective government action is needed (in principle concerted Eurozone government action, but in practice requiring that the German government ‘own’ the policy).

To bring the point home, let’s start with a chart of Germany’s sector balances over the history of the Eurozone:

DE

Here the private sector balance is imputed from the accounting identity

(current account surplus) = (government surplus) + (private sector saving)

while all the other data are from Eurostat. The GDP growth figures for 2012-13 are, obviously, projected.

The salient features of Germany’s sector balances are that there is a persistent private sector net-saving position (averaging over 7.5% of GDP over the past 10 years) and a persistent current account surplus (averaging over 5.9%, with lesser variation, over the past 8 years). The German government deficit oscillates in response to the business cycle and essentially accommodates variations in the private sector net-saving position. It almost looks like a current account surplus around 6% is a German government policy target and, in any case, the German economy Ministry considers the persistence of the current account surplus “a very positive development”. To the contrary, this “development” could be described as the “giant sucking sound” of Germany draining the economic life out of the rest of the Eurozone.

For, consider the equivalent data for the 17-nation Eurozone:

EZ17

The salient feature of this chart is that the Eurozone’s current account balance is essentially zero, and that therefore the Eurozone’s aggregate government deficit is nearly equal, euro for euro, to the Eurozone’s aggregate private sector net-saving position. Also, these symmetric government/private sector balances fluctuate much more for the whole Eurozone than they do for Germany. The fact that the Eurozone current account is neutral (as is the trade balance) indicates, on the one hand, that the Euro exchange rate responds to “fundamental” trade and capital flows, and that Eurozone foreign reserve policy is not introducing an exchange rate bias. On the other hand, it also implies that Germany’s current account surplus is matched, almost euro-for-euro, by the current account deficit of the rest of the Eurozone with Germany.

Now, because Germany’s GDP is 1/4 to 1/3 of Eurozone GDP, Germany’s 6% current account balance represents a 2% to 3% current account deficit of the rest of the Eurozone with Germany. As the German economy continues to lead growth rate statistics among Eurozone member states, Germany’s GDP share continues to increase towards 1/3 of Eurozone GDP, and so the average current account deficit of the rest of the Eurozone countries grows towards 3%, ultimately with Germany as the Eurozone’s external balance remains neutral.

Now, coming back to our accounting identity,

(government deficit) = (current account deficit) + (private sector saving)

If Eurozone countries (except Germany) have a persistent current account deficit averaging close to 3% (and, on current trends, soon to exceed it), and at the same time the government deficit must remain below 3%, it becomes mathematically impossible for the Eurozone private sector (outside Germany) to net-save. This is unsustainable, because if the private sector is dissaving eventually it will become insolvent

Take, for example, France:

FR

If France were to bring its Government deficit below 3%, it would destroy the ability of the French private sector to net-save, assuming the current account deficit stays on trend (and it should: Germany’s 6% current account surplus is as stable as if it were a successful policy target, and the Eurozone’s neutral current account balance is consistent with the ECB pursuing a non-interventionistic foreign reserve policy).

One consequence of the basic sector-balance identity is that a current account surplus provides “policy space”. That is, the higher the current account surplus, the more options the government has to meet fiscal constraints (such as the Maastricht deficit limit) while allowing its private sector to remain solvent by net-saving. Thus, the European Commission’s current account balance limits (+6% and -4%) are much more lax on the surplus side than on the deficit side. A country with a 4% current account deficit faces strong policy constraints without the need for additional sanctions: the deficit is the penalty, so to speak. By contrast a country with a 6% current account balance has ample fiscal policy leeway. It would make much more sense for the European Commission to reverse the current account limits (4% on surpluses and 6% on deficits), but one suspects that the long-term stability of the German surplus around 6%, rather than any macroeconomic stability analysis, dictated the European Commission’s definition of the Macroeconomic Imbalance limits last November.

In the absence of a fixed-exchange-rate regime, such a large and sustained current account imbalance would represent a strong pressure to revalue the German currency relative to the Eurozone average, which would in turn act to reduce the current account imbalance. In other words, floating exchange rates in Europe would naturally lead to a negative feedback loop on intra-EU current account imbalances.

It appears some EU-level mechanism should be instituted to recycle what are clearly unsustainable (but sustained) German current account surpluses, given that the adjustment of exchange rates is not allowed. Thus, If the solvency of the private sector of the Eurozone-ex-Germany is to be preserved and the ability of Eurozone governments to return to the Maastricht limits is to improve, that is, if the Eurozone is to survive, it must become a transfer union. And rather soon.

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