Is The Eurozone Turning Into Germany?

It has been pretty clear since at least the spring of this year that the ECB was keen to see the euro weakening. At the time the euro stood near to $1.40. Policymakers in a number of euro area member states issued calls for a more competitive exchange rate, directing barely hidden criticisms in this regard at the ECB.

The ECB itself ever more forcefully asserted that international factors, including euro strength, were largely responsible as the bank’s price stability misses got ever crasser. Either through direct references to the euro’s exchange rate expressing discomfort about its strengthening, or by highlighting that the prospective monetary policy stances on either side of the Atlantic were on diverging paths, inviting the markets to bet on the dollar and against the euro, Mr. Draghi applied his magic in talking the euro down.

The latest package of ECB easing measures introduced in early June steered the euro overnight rate closer to zero, raising the euro’s attractiveness as a funding currency for carry trades. All along Mr. Draghi has held out the prospect of some kind of quantitative easing even beyond the credit easing measures promised to be unleashed in the fall. As inflation has declined even more and the so-called recovery stalled once again, the beggaring for a weaker euro has brought some visible success: in late August the euro was approaching the $1.30 mark.

Should The Euro Weaken?

Should the euro have weakened, should it weaken even more? The euro area as a whole, which is the relevant entity here, does not lack international competitiveness. Most common measures suggest that the euro is valued about right in its recent range. Certainly the euro area’s soaring current account surplus together with inflation close to zero – and lower than in competing economies – suggest otherwise. Are the world economy and global trade booming and overheating so that more relief through even bigger euro area export surpluses might seem warranted and welcome?

Quite the opposite. Given that world trade seems to be stuck in quasi stagnation while economies around the world are struggling to gather their own strength to achieve more than generally disappointingly meager growth, seeing the euro area become an even bigger drag on global growth can hardly be seen as welcome at all. In fact, by now, the euro area authorities may have used up, if not vastly overstretched, their global partners’ patience by contributing less than nothing to global growth since 2008 while running up a current account imbalance of close to $400bn this year (IMF forecast of April 2014).

Note that the euro area’s imbalance today is about two thirds of the size of the US current account deficit at its 2006 peak level, and it is also in the same order of magnitude as China’s current account surplus at its 2008 peak level. One may recall here that the US and China stood at the center of heated debates about global imbalances prior to the global crisis; global current account imbalances widely judged to have played a crucial role in the subsequent global crisis. As called for in a commitment made by the G-20 members, both countries have sharply reduced their external imbalances since.

The US external deficit has declined to just under $400bn in 2014, very similar in size to the euro area’s surplus, while China’s current account surplus is forecast to be a little over half of the euro area’s surplus this year. It is noteworthy that in China’s case the decline amounted to a fall from over 10 percent of GDP at its peak to around 2 percent of GDP this year, a truly drastic adjustment in so few years. As a share of GDP the US imbalance was halved. Meanwhile, Japan’s huge pre-crisis current account surplus has shrunk to near balance today.

Is The Eurozone The New China?

Of the main players only the euro area has failed to abide by the rules and stick to global commitments. Prior to the global crisis the euro area authorities proudly asserted that they were no party in global imbalances as the currency union’s external balance was roughly balanced. Until 2012 the ECB’s annual reports continued to refer to global imbalances and their potential unraveling as a major risk to the global growth outlook. Then, in its 2013 annual report, the ECB all of a sudden went silent on the matter. For the euro area is on course to become the biggest imbalance in the world this year, with the IMF forecasting a continued rise in the euro area’s external imbalance to $500bn over the course of the next five years.

Apparently, from the euro area authorities’ perspective, that’s still not big enough. And it’s actually true, at least by German standards, that is, a notorious current account surplus of around 7 percent of GDP since 2007, the euro area’s imbalance still seems fairly small today. It would need to climb to over $1tn to end up being in the same ballpark as Germany’s. And that’s actually a rather important though generally underappreciated point.

Quite a few commentators seem to suggest that the euro area should beggar its return to recovery and prosperity by freeloading on global growth. On this view, a weaker euro is just the way to go. We only need some more of it. Alas, they may be missing something important here: the order of magnitude involved in the free-loading, and the supposed counterpart source as growth sponsor to be found somewhere in the rest of the world.

Will The Eurozone As A Whole Become Like Germany?

At the start of EMU Germany’s current account was in near balance, similar to the euro area until recently. By that time Germany had already embarked on its treacherous mission: to “restore” its competitiveness by means of wage repression and fiscal austerity. These policies had the predictable consequence of suffocating domestic demand, and Germany famously became the “sick man of the euro”. But Germany got lucky as its suicidal policies did not kill the patient in the end. For this was the time of the global economic boom, when bubbles in the US, UK, and euro periphery sponsored German exports. So Germany emerged as the phoenix from the ashes in 2007 with a gigantic current account surplus and a balanced public budget. Nothing much has changed since then. German domestic demand, which had been stagnant for much of the 2000s, is barely above its pre-crisis peak even today.

Essentially, the euro area as a whole is trying today to repeat the German feat; or, rather, it has been trying, predictably unsuccessfully, since 2010. Not only is the global economic context rather different from what it was when Germany alone went for it. The euro area as a whole is also somewhat bigger than Germany: namely by close to a factor of four. So how much more is the euro supposed to weaken, I am wondering? Or, put differently, how much more does the euro area have to shrink itself before it can make the German mercantilist strategy work globally? In short, bare any miracle, it’s not going to work.

Interestingly, Mr Draghi implied and partly spelled out the unspeakable in its recent Jackson Hole speech. Finally acknowledging that the euro area suffers from a lack of aggregate demand, he suggested that the euro area has to try harder to achieve a properly growth-friendly fiscal stance for the area as a whole, which would imply that Germany would need to depart from its perversely tight fiscal stance; even if Mr. Draghi did not say so explicitly. Mr. Draghi also lent his support there to a €300 billion public-private investment program proposed by the incoming European Commission President Jean-Claude Juncker.

That, rather than a weaker euro, is at least and at last pointing in the right direction. The euro area is still way too large to prosper on net exports. The euro area has to stop suffocating domestic demand but nourish it instead. Now!