The euro was supposed to put an end to competitive currency
devaluations, and with it ‘unfair competition’. But this has not been the case.
Germany was often portrayed (wrongly) as the victim of other countries’
competitive devaluations before the introduction of the euro. But contrary to
received wisdom, Germany’s real exchange rate – which takes into account
differing inflation trends in Germany and its trading partners – did not rise
in the run-up to the introduction of the single currency. And it has fallen steeply
during the 15 years of the euro’s existence. This has handed German firms a
competitive advantage of the kind the euro was supposed to eradicate. What is
more, Germany is not under pressure to do anything about it. In fact, other eurozone
countries are being encouraged to follow suit.
The European Commission compiles so-called ‘harmonised
competitiveness indices’ for eurozone economies (see chart one). These are the member-states’ real
exchange rates in anything but name. They show that Germany’s fell by almost 20
per cent between the beginning of 1999 and the end of 2011, before edging up a bit
in 2012-13. The main reason for the decline in the country’s real exchange rate
was very low wage increases and hence weak inflation. Spain’s (and to a lesser
extent) Italy’s real exchange rates rose rapidly over the early part of the
2000s but have fallen sharply since 2008: Italy’s is now barely higher than in
1999, whereas Spain’s is up around 9 per cent. France’s real exchange rate is
actually lower now than in 1999 (or in terms of the Commission’s analysis),
its ‘competitiveness’ has improved. In short, the eurozone’s imbalances have less
to do with its Latin members allowing costs to get out of hand than they do
with Germany engineering a beggar-thy-neighbour cut in costs.
Chart one: Harmonised
(real exchange rates, quarter 1 1999 = 100)
Source: European Central Bank
To the extent that the steep fall in Germany’s real
exchange rate within the eurozone is acknowledged in Brussels and Berlin, it is
typically attributed to the need to reverse the rise in the country’s real
exchange rate in the run-up to the introduction of the euro. German firms, so
the argument goes, needed to rebuild their competitiveness after the shock of
reunification, so set about reducing costs, which led to a fall in the real
exchange rate. The problem with this analysis is that it is not corroborated by
the data. Chart two below shows the real exchange rates of Germany, France,
Spain and Italy between 1980 and 1998. Germany’s was actually lower in 1998
than it had been in 1980. There were devaluations in France in 1983-84, and in
Italy and Spain following their ejections from the Exchange Rate Mechanism (ERM) in 1992, but in each
case these devaluations were largely corrective (in response to bouts of
currency overvaluation) and by 1998 their real exchange rates were back to
where they were in 1980. Over the period as a whole, it was Germany that had
the more ‘competitively valued’ real exchange rates.
Chart two: Real effective exchange rates
(quarter 1 1980 = 100)
Source: UNCTAD, Global Development Indicators
The result is that Germany now has a hugely
undervalued real exchange rate (something that neither Italy nor Spain managed
before the introduction of the single currency). Why is Germany not accused of
engaging in a competitive devaluation, when Spain and Italy were? After all, Germany’s
real exchange has fallen sharply relative to its long-term trend, whereas
the 1990s devaluations just took the lira and peseta back down to their long-term trends.
One reason is the widespread belief that eurozone
countries do not have real exchange rates because they all share the euro. By
virtue of sharing the euro, devaluations are seen as impossible. A devaluation
is only considered a devaluation if it involves a movement in a country’s nominal
exchange rates, such as when the lira and the peseta were ejected from the ERM. But when devaluation comes about as a result of low inflation (which
in turn is usually the product of weak domestic demand), it is seen as a ‘competitiveness’ gain. However, the impact on
other countries is the same: they face a loss of price competitiveness relative
to firms based in the devaluing country and sell less to it.
Far from being considered a problem and condemned as
a ‘beggar-thy-neighbour’ strategy (as was the case with Italy and Spain),
Germany is lauded for its success in reducing its real exchange rate, and other
countries are called upon to emulate it in order to improve their
‘competitiveness’. So, in a curious reversal the country that underwent a large
competitive devaluation is not only under little pressure to reverse it but is widely
regarded as a benchmark for others.
This conflation of real exchange rates with
competitiveness has been damaging. A real or ‘internal devaluation’ of the kind
engineered by Germany in the eurozone has harmful macroeconomic effects because
it involves suppressing domestic demand and with it inflation over a long
period of time. By contrast, Spain and Italy quickly returned to growth in the
1990s following their devaluations, with the result that German exports to
these countries did not suffer. If Italy and Spain persevere with attempts to
devalue their real exchange rates rather than Germany revaluing its real
exchange rate, the result will be persistently weak demand across the eurozone,
a worsening of the currency union’s already broad-based deflationary pressures
and further increases in debt ratios.
While the Commission has criticised Germany’s
excessive and persistent current account surplus, it has been at pains to
stress that it would make no sense for the Germans to cede ‘competitiveness’.
Yet it is impossible for all members of the eurozone to enjoy the unfair
advantage of an undervalued exchange rate. The Commission’s implicit assumption
seems to be that all eurozone economies can engineer real (or internal)
devaluations, boosting their exports to non-eurozone markets and driving an economic
recovery across the eurozone. But there has already been a big swing in the
eurozone’s current account position, from a deficit of around €85 billion (1
per cent) in 2008 to a surplus of almost 2.5 per cent in 2013, as Germany’s surplus
remained very large while the deficits of the southern members-states narrowed.
It is a moot point whether the eurozone's external surplus can continue rising: it already
comprises a big drag on a fragile global economy, which the eurozone in
turn is increasingly dependent on. Moreover, an economy with a big trade
surplus tends to experience currency appreciation because demand for its
currency outstrips the supply of it, something which is now happening to the euro. A strong euro will hit demand for eurozone exports, especially the
more price sensitive ones of the currency union’s southern economies.
The eurozone needs Germany’s real exchange rate to
rise (that is, for the unfair advantage that Germany has carved out within the eurozone
to reverse), but this will not be easy. Germany’s export-led economy –
underpinned by its social partners’ ability to deliver wage restraint –
combined with rapid population ageing mean that it will generate little
inflation. The German economy is growing more quickly than the eurozone as a
whole, but Germany’s rate of inflation is barely above the eurozone average,
not least because real wages fell in 2013. More expansionary macroeconomic
policies could help. First, a combination of income tax cuts and increased public
investment would boost domestic demand (and hence inflation) without posing a
threat to fiscal stability: the country ran a budget surplus in 2013, with the
result that its debt ratio fell. Second, Germany could withdraw its opposition
to the ECB embarking on aggressive monetary stimulus, which would in turn boost
economic activity (and inflation) in Germany. The problem is that a fiscal stimulus of
this kind would contravene Germany's constitutional requirement to balance the budget.
And there is little sign that Germany will accept aggressive moves by the ECB
to reflate the eurozone economy.
For its part, the Commission needs to stop defining
competitiveness in terms of the real exchange rate. Competitiveness defined in
this way is a zero-sum game: one country’s ‘gain’ is another’s loss. If
competitiveness means anything useful it is labour productivity or total factor
productivity, not the real exchange rate which can fall simply because of wage
restraint depressing demand and leading to deflationary pressures. European member-states
cannot rely on the ECB coming to the rescue and countering the deflationary
impact of the current race for competitiveness. They should demand that Germany
do the unthinkable: lose competitiveness!
Simon Tilford is deputy director of the Centre for European Reform.