Germany Is The New China

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Summary

Trump's trade adviser Peter Navarro complains about an unfair competitive advantage for Germany.

He has a point, and this has much to do with the internal workings of the eurozone.

There are signs some of it might be unwinding, and the ECB might be forced to remove stimulus, which will boost the euro.

We think it's going to last quite a bit longer, but there are risks of serious clashes within the ECB.

Here is Trump's trade advisor Peter Navarro (from Business Insider):

US President Donald Trump's trade adviser Peter Navarro told the Financial Times that Germany is using a "grossly undervalued" euro to its advantage against other nations in the European Union and against the United States. The euro jumped after the report crossed the wires, and touched a five-day high of 1.0764 against the dollar.

Guess what? While we often disagree with Navarro, especially on his stance on China, in this case, he is right. The facts are hard to ignore. Here is Germany's trade surplus:

What you see is that at the start of the euro, Germany basically didn't have a trade surplus; now it's a whopping 9% of GDP. How did this happen?

This isn't actually that hard to explain. When the prospect of the euro materialized and it became clear that countries like Italy, Spain, Ireland, Portugal, and a little later even Greece were going to join, this had a large effect on capital flows.

Basically, by joining the euro, the exchange rate risk was removed at the stroke of a pen for these countries. Many of these countries had significantly higher interest rates compared to Germany, for two reasons:

  • To compensate for higher inflation that these countries generally suffered from.
  • To compensate for the significantly higher risk that their currencies would be devalued (simply to restore competitiveness after a period of higher inflation compared to their trade partners).

By joining the euro, both of these seemed to wither. Not only was the exchange rate risk removed, but also by "outsourcing" their monetary policy to the newly formed European Central Bank ("ECB"), their monetary affairs would be run in a more responsible manner and their money would be as sound as that of Germany.

After all, the ECB was modeled on the Bundesbank, with a single mandate (to keep inflation in check), with a no-bailout clause, and under the leadership of people (like Duisenberg and after him Trichet) who had adopted Germany's hard money stance.

After all, that was the trade-off. Germany had only joined the euro if the ECB would be as good as the Bundesbank, and that was how the ECB was designed.

Unfortunately, enjoying the sound money policy of the ECB didn't prove enough for the peripheral countries for them to get their inflation rates down to those in Germany. In fact, quite the opposite happened.

These peripheral eurozone countries experienced an influx of capital (mostly banks from the center lending money) as capital started to flow from center to periphery to benefit from the higher interest rates and the disappearance of the exchange rate risk and the prospect of sound money.

These capital flows, starting well before the euro was actually formed, drove down interest rates in the periphery. They caused a public spending binge in a country like Greece and to some extent Portugal, and a private sector credit boom in countries like Spain and Ireland.

With these booms, these countries did not manage to get their inflation rate down to German levels, hence they accumulated a loss of competitiveness. Their growing trade deficits were just the mirror image of their increasing capital account surpluses.

GIPS = Greece, Ireland, Portugal, Spain

The music stopped with the financial crisis, but by then, most of these countries had accumulated a 20% or even 30% loss of competitiveness. This was also because Germany had embarked on a policy of wage moderation exactly at the time the peripheral countries experienced a boom.

Deflationary Bias

Having given up their currencies, there was no quick fix to restore this loss of competitiveness. Instead of devaluation, these countries embarked on a tortuous process called "internal devaluation." Basically this is a deflationary policy in order to restore competitiveness by undercutting German wage and price growth.

A symmetric currency union puts equal pressure on surplus and deficit countries to restore balance. However, within the eurozone, it was only the deficit countries doing the adjustment. There was no reflationary effort from the likes of Germany.

This made adjustment that much more difficult, for two reasons:

  • German inflation itself was very low, giving the deficit countries a particularly hard target to undercut.
  • German reflation would have boosted import demand from these countries and help restoring their gaping trade deficits.

Basically, the whole eurozone suffered from a deflationary bias, which is one reason explaining why it was doing so much worse compared to the US.

The ECB rising rates in 2011 didn't help either, and it had to hastily reverse that policy.

Debt Dynamics

The deflationary effort in a bid to restore lost competitiveness also had another effect: it wreaked havoc with debt dynamics. Deflationary policies produced very low, or even negative nominal GDP growth, which produced a "denominator effect" as debt/GDP spiraled upwards due to a stagnant or falling GDP.

The exploding debt actually made these countries doubling down on the deflationary policies (although many were forced through conditional bail-outs).

Enter the ECB

Things threatened to escalate when bond yields in these countries spiraled out of control and the ECB had to intervene with Draghi's "whatever it takes."

That stopped the rot on the bond markets, but it still left the eurozone with a depressed periphery, lingering in a deflationary slump.

In the end, the ECB tried to at least raise the inflation, which in some of these countries had even gone negative, by embarking on a substantial asset purchasing program. This program has actually been fairly successful:

  • It managed to increase inflation and growth.
  • It managed to get the euro down.

With the proviso that it's difficult to assess quite how much this is due to the ECB as there are always other factors at work (like a lessening of the austerity policies and a strengthening dollar due to the Fed ending its asset purchasing policies).

However, several problems remain:

  • Since German inflation has been so low, none of the peripheral (deficit) countries have recouped much of their lost competitiveness, resulting in Germany (but even more so the Netherlands) basking in outsized trade surpluses.
  • The one-size-fits-nobody policy of the ECB is too tight for much of the periphery and too lax for some of the core countries, most notably Germany.

The whole constellation has produced a two-step boost to German exports:

  • First, the loss of competitiveness of the periphery versus Germany.
  • Second, the reflationary ECB in reaction to the slump in the periphery has helped getting the euro down.

So Peter Navarro is actually right here. But things are moving fast. Consider the following figure:

Inflation is shooting up in Germany, and the Germans are recriminating ever stronger against the asset buying and negative interest rates of the ECB.

Many in the currency markets seem to think that this will induce the ECB to end its reflationary efforts sooner rather than later, but this isn't necessarily the case. We have already noted that higher German inflation helps the adjustment process within the eurozone, lessening the burden of the deficit countries.

However, should the increase in German inflation continue, this is likely to lead to a worsening rift between the center and the peripheral country representatives within the ECB. If the US is piling on the pressure, complaining about the cheap euro, this process might accelerate.

In fact, there was a notable rise in inflation for the whole eurozone, but the ECB isn't likely to start tightening policy, as there wasn't much of a rise in core inflation.

The nice thing is that growth is also accelerating a bit, higher inflation and higher growth is just what the doctor ordered for the peripheral countries to reduce their debt burden, and if this can be done whilst gaining competitiveness on Germany, all the better.

However, before one rejoices in the higher growth (from the BBC):

Analysts also questioned whether the recent improvement could be sustained. "While recent economic news points to improved growth, we suspect the eurozone may find it difficult to sustain this momentum amid appreciable political uncertainties during 2017 and likely reduced consumer purchasing power due to higher inflation," said Howard Archer, chief UK and European economist at IHS Global Insight. "Consequently, we suspect that eurozone GDP growth in 2017 will be no more than 1.6%. We also see growth at 1.6% in 2018."

Conclusion

Peter Navarro is right that Germany is benefiting from a cheap currency. Germany not only accumulated a substantial competitiveness advantage over much of the rest of the eurozone, but it also benefited from ECB actions to end the deflationary rot in the eurozone periphery insofar as that contributed to a lower euro.

There are those that argue that escalating German inflation might very well lead the ECB to abandon its reflation efforts sooner rather than later. While we see the problem, it's a little early for that conclusion as higher German inflation actually helps the intra-eurozone adjustment. The Germans simply have to gnash their teeth for a little longer, we're afraid.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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