Rethinking German Economic Policy

Desmond Cohen

When I was student at the LSE many years ago I shared lodgings with a German exchange student from the University of Munich, son of the Bavarian Minister President and leader of the CSU. He later became a Professor of Statistics and what I recall was his amazement at reading Keynes General Theory of Employment with the insights that it gave into the workings of capitalism, and what was needed for an optimal macroeconomic policy. This piece of personal history has helped me understand to a degree why Germany insists on economic policies that have been denounced by many – including Krugman, Stiglitz and Soros.

It is only too evident that economic policy in Germany remains rooted in pre-Keynesian ideas that most macroeconomists rejected many years ago, and this helps explains the German Government’s intransigence in the face of persistent criticism – including now from the IMF.

It has not been prepared to listen despite the fact that its policy stance has directly contributed to years of low economic growth and high unemployment in the EU, especially for other Eurozone countries. In turn, this has undoubtedly been a factor in the rise of right-wing populism throughout Europe.

Germany has been running a current account surplus on its balance of payments since at least the 1980s – apart from a dip in the size of the surplus in the years after re-unification. In 2016 the external surplus was 8.8 percent of GDP and, although the intra-Eurozone surplus has been reduced somewhat in recent years, it remains high. The external surplus has increased with the rest of the world and especially with China. Berlin argues that this experience is the outcome of structural reforms of the labour market which have increased competitiveness, and that these are precisely the polices that other countries need to implement IF their external position is to be improved.

Structural reforms in labour markets may well be part of the solution for other Eurozone countries such as France, Italy and Spain. But there is counter evidence that suggests that differences in unit labour costs [and thus international competitiveness] are not the whole or even main part of the problem. Standard economic analysis makes it clear what the problem is and where the solutions lie. Most economists would accept that in the case of a structural external imbalance [Germany] there should be significant changes in domestic economic policy. Obviously not all of the adjustment can fall on those countries with external deficits although in practice this is what has happened since 2008 [with disastrous effects socially and economically in the so-called periphery countries]. Again this is a problem discussed by Keynes who argued for ‘symmetric adjustment’ with both surplus and deficit countries taking appropriate policy action.

So what should Germany do to deal with its structural external surplus? In Keynesian terms what we have is an excess of savings over investment of which the counterpart is an excess of exports over imports. So in part the problem is that Germany is not spending enough and the domestic savings rate is too high. So action could be taken to increase domestic expenditures for example on investment in infrastructure where there is a need for a great deal of replacement. German economists have suggested that some €100 billion of annual investment is warranted and, taken with other economic measures, imports would then rise, reduce trading partners’ current account deficits.

Equally, German wages have risen far too slowly relative to productivity growth and need to rise much faster. Raising wages would also reduce international competitiveness thus affecting export growth and also further reflate domestic demand. Discretionary saving rates are too high and social policy should be adjusted e.g. through increasing state pensions as a means of inducing more consumer spending. Euro Area Interest rates are already at their minimum either at or close to zero so cutting them further as a means of deterring saving through monetary policy isn’t really feasible.

The IMF has estimated that Germany’s real exchange rate is undervalued by 15-20 percent and this has undoubtedly contributed to its trading success. At the same time the Euro’s rate has been too high for periphery countries which would have been better able to export their way out of their current account deficits with a lower rate.

What to do? In part the solution lies in better understanding of the economic relationships as mapped out initially by Keynes. Germany has an excess of savings over investment and the answers lie in reflating German demand through measures to increase domestic investment and expenditure generally – both personal and governmental. For Government this would entail a weaker fiscal balance via an increase in deficit financing of expenditure mostly on public investment. A higher rate of economic growth would thus be part of the package as a means of reducing the external deficit from which the population in general would gain. What is the point of accumulating assets and claims on foreigners through running large structural external deficits unless these savings can then be used to finance domestic expenditure in the interests of Germans as a whole?

There are policy changes that Germany can and should implement that will generate ‘a Pareto improvement’ with which there are gainers and no losers. German citizens would benefit from higher wages, improved levels of employment, better social services and pensions and generally higher levels of wages. Everyone else would gain since higher demand in Germany would increase imports and adjust intra [and extra] current account imbalances. Not least would be the gains in reduced levels of unemployment and a reduction in demands for further austerity in deficit countries.

Undoubtedly much of the recent populist pressure in many EU countries has had its origins in austerity and the losses of productive employment. Anything that strengthens democratic systems in Europe is vital and changing current German economic policies should be part of the general reforms needed across the EU. But, as Keynes noted, there are many policy-makers who remain slaves to the ideas of out of date scribblers and if policy is to become relevant to modern needs then ideas must change. This is a lesson still to be absorbed in Germany – and in the EU Commission.