Why Germany is not a model for Europe

Written by Philip Whyte [1], 10 November 2010
From Der Tagesspiel

Germany's economy has been winning numerous plaudits of late. It is not hard to see why. Previously much-vaunted economies "Ireland, Spain, the UK and the US, to name just four" lived way beyond their means for far too long. Germany, by comparison, looks to have been the very model of virtue. Its frugal households and firms have saved more than they have spent. Its economy is widely hailed as being 'competitive'. And its economic growth model appears to have been vindicated by the strength of the recovery in 2010. Germany, it would seem, is the EU's benchmark, the country that other economies in the region urgently need to emulate.

It is a compelling-sounding narrative, and there is no shortage of people who subscribe to it. The question is: does the story really make sense? Germany boasts numerous top-class companies producing manufactured goods that are rightly admired the world over. Nothing seems more natural, therefore, than to think of the German economy by analogy. It has become common to describe Germany as being 'super-competitive' as if it were a giant version of Volkswagen. The huge trade and current-account surpluses that it generates are held up as evidence that the country is 'beating its competitors' and winning the battle for global market share.

This line of thinking may seem seductive. But it is really a textbook case of the pitfalls of reasoning by analogy. Countries are not companies. Trade balances are not profit and loss accounts. And there is no relationship between productivity and trade balances. Productivity across the German economy as a whole may be high by international standards. But this is not the reason the country runs a trade surplus. Productivity, after all, is even higher in France and the US “ and both of these countries run trade deficits. Contrary to popular thinking, Germany does not run large external surpluses because it is more productive than its trading partners.

Why did Germany start running large external surpluses from the early 2000s onwards? Current-account balances reflect the difference between savings and investment (or between total spending and output). Germany ran surpluses because, as a country, it spent less than it earned. Countries such as Ireland, Spain and the UK ran external deficits because they spent more than they earned. Given the financial difficulties in which the deficit countries now find themselves, it is not surprising that many people are drawn to the conclusion that all countries must learn to 'live within their means' or, to put it differently, that they should be more like Germany.

The injunction that countries should all live within their means may sound sensible. But it faces an insurmountable obstacle: it happens to be impossible in principle. The reason is that it violates a basic accounting identity:current-account balances, globally, must sum to zero (because every country cannot run a surplus at the same time). Surplus countries and deficit countries are mirror images of each other. It is precisely because deficit countries spend more than they earn that countries with external surpluses, such as Germany, can do the reverse. So thrift and profligacy are joined at the hip: Germany can only be its prudent self because others are not.

It is impossible, then, for Germany to be a model for all countries simultaneously. Ireland, Greece and others need to become more prudent (or German). But they can only do so if Germany becomes less so. German officials sometimes contest this point. They accept that the world cannot collectively copy Germany (because the world cannot run a trade surplus with itself), but they point out that the eurozone can (because the eurozone can run a trade surplus with the rest of the world). Another way of stating the official German position is that eurozone countries with trade and current-account deficits can reduce these without Germany playing any offsetting role.

Are German officials right? The answer is: yes in principle, but probably not in practice. The practical problem is that the eurozone’s economy is two and a half times the size of China's. If southern European countries are to close their external deficits without any offsetting decline in Germany’s external surpluses, the rest of the world will have to absorb a huge shift in the eurozone's external position, from broad balance to large surplus. We cannot casually assume that the rest of the world could to do so easily. Some regions (like Africa) are too small; others (like the US) are too indebted; and others still (Asia) are as export-dependent as Germany.

In the end, there are two reasons why an unreformed Germany should not be a template for the eurozone. The first relates to the demand side of the economy. A eurozone that turned itself into a larger version of present-day Germany would suffer from chronically weak domestic demand: it would be too reliant on potentially unsustainable external demand to grow at all. The second reason is that establishing an unreformed Germany as a benchmark might divert attention away from supply-side challenges in Germany itself. Notwithstanding the strength of its economic recovery in 2010, Germany’s longer-term growth prospects are modest.

Fashionable as it has become to do so, it is misleading to look at Germany's external surpluses through the prism of the country’s so-called 'competitiveness'. Germany's large trade and current-account surpluses are as much a reflection of domestic weakness as of external strength. If consumers had been more confident in the future, or businesses had had more reason to invest domestically, Germany would not be running such large surpluses. The belief that the German economy would be weaker if its trade and current-account surpluses declined is therefore mistaken: a smaller trade surplus could actually be the sign of a stronger domestic economy.