French Finance Minister Christine Lagarde’s call for Germany to increase its spending has generated an inordinate amount of confusion even among seasoned economists (Fuhrmans 2010). Here is my attempt at clarifying the debate.
In her interview with the Financial Times on March 14, Mrs Lagarde made a number of seemingly reasonable points. She pointed out that current accounts have diverged within the Eurozone but “it takes two to tango” and both surplus and deficit countries should contribute to their elimination. She also noted that Germany’s success at lowering labour costs created a situation of unsustainable surpluses and went on to suggest that Germany could boost demand. In answer to the question: “Is it necessary for Germany to boost domestic demand?” she said: “there needs to be a sense of common destiny”.
Unfortunately, none of these points are valid – at least as stated.
The idea that we should not rely on deficit countries to eliminate imbalances on their own goes back to Keynes’ position during the Bretton Woods conference. In Europe it reminds us of the bilateral obligation to defend exchange rate parities within the European Monetary System. With such a pedigree, who can disagree? Well, soft references can be misleading. Like Mrs Lagarde, Keynes was concerned about world deflationary forces in a word of fixed exchange rates, which can be one way of thinking of the monetary union. But the Eurozone is not the world, so the current accounts of its members do not have to sum up to zero.
Individual countries do face budget constraints and, it is true that deficit countries are likely to reach a limit before surplus countries, but the idea that this is a case for policy coordination must be stated in a different way. This must rest on the existence of externalities. Does the German surplus affect Greece’s or Portugal’s deficit? The answer is obviously yes to both – in the “Keynesian” short run. If the debate is about exit strategies, then, national strategies ought to be coordinated. But the criterion should not be current account positions because this is not a binding constraint at the relevant horizon. Instead the focus should be on the ability to conduct expansionary policies. In 2008, as the recession was taking hold, the European Commission called for fiscal policy coordination based on room for manoeuvre of individual fiscal spaces. The same now applies to exit strategies. The least budgetary hard-pressed countries – do they exist? – should make up for the contractionary efforts of countries like Ireland, Portugal and Greece. In this sense, there is room for coordination and Germany is among the countries that can afford to play the locomotive role. This would in fact serve German interests well because the last thing that we need now is a stall in recovery.
Finger-pointing without evidence
This recommendation, however, should be kept clearly separated from two issues that are often conflated – the current account and competitiveness. Since the creation of the euro, relative unit costs have diverged within the Eurozone. Without the exchange rate option, those changes that are not justified by improved market position will have to be corrected. The correction is bound to be asymmetric – because, again, the Eurozone is not the whole world. Countries like Germany, Austria and, until recently, Ireland, have gained in competitiveness through wage moderation, productivity gains, or both. There is no reason why they should reduce this advantage with regard to the rest of the world. One of the advantages of the monetary union is that it removes the temptation to use the exchange rate to achieve international competitiveness. This strategy has proved to be self-defeating, as depreciations breed inflation and lessen incentives to seek competitiveness by tying wages to productivity. Eurozone countries that have let their labour costs rise will have to recognise that supply-side policies are the only way of restoring sustainable competitiveness.
A striking feature of the Eurozone’s experience over its first ten years is that some countries have systematically exhibited current account surpluses while others have undergone continuous deficits (Mongeli and Wyplosz 2009). It turns out that there is a link between these deficits and surpluses and the pattern of relative labour costs. While this association might appear to support the view that relative competitiveness drives current account positions, it is possible that causality could run in the other direction – or both observations might just reflect a common cause. For example, it may be that countries with relatively strong domestic demand undergo higher inflation and therefore competitiveness losses. So unless evidence on causality is provided – and so far it has not been – the view that it is German current account surpluses that cause deficits in the Club Med countries is simply unsubstantiated.
Europe is not the world
As noted above, there is no formal link between deficits and surpluses in the Eurozone because the area’s balance is not constant. It turns out that the area’s overall current account has remained close to balance over the last ten years. Remarkably, this situation has been maintained even as the euro fluctuated quite widely – a reminder that current accounts depend on many more variables than the exchange rate. Indeed, the current account balance represents a country’s net saving, which reflect deeper choices irrespective of competitiveness. Currently the Germans save and the Greeks borrow. The Greeks could save as well, as could all Eurozone member countries if they wished to, in which case the overall account of the Eurozone would be positive. In the long run, this would not have an impact on growth and employment because other areas in the world would be doing the borrowing. This is why telling Germany that it must durably reduce its current account surplus – that it is unsustainable – is unwarranted. In fact, with a quickly ageing population, Germany would be well-advised to save for a couple of decades as the demographic transition takes place. Of course, this recommendation applies to most Eurozone countries as well.
Fuhrmans, Vanessa (2010), “German Exports Spark a Debate”, Wall Street Journal, 16 March.
Mongelli, Francesco Paolo and Charles Wyplosz (2009), “The Euro at Ten: Unfulfilled Threats and Unexpected Challenges”, in: Bartosz Mackowiak, Francesco Paolo Mongelli, Gilles Noblet and Frank Smets (eds), The Euro at Ten – Lessons and Challenges, European Central Bank.