22 July 2018

President Trump has taken aim at Europe. In reality, however, most of his ire has been directed at Germany. The President objects to America’s $66bn bilateral trade deficit (the fourth largest amongst US trading partners), as well as Germany’s failure to meet its NATO spending commitment.  During his recent European trip, he went so far as to suggest that Germany has become a “captive” of Russia as a result of its sizeable imports of Russian natural gas.

On the other hand, German Chancellor Merkel has repeated often her belief that America has become an unreliable partner under President Trump’s leadership. And, the President’s recent European trip, especially his stops in the UK and Helsinki, would have done little to alter this perception.  She has indicated that Europe needs to forge a more independent policy course.  The recently completed trade deal between the EU and Japan is a tangible example of this posture. Most importantly, she believes the commitment to European integration must be deepened.  In particular, the effort  to reform EU institutions,  which has  lost momentum following the German election, must be reinvigorated.

There is much to admire in Germany’s economic performance, including its conduct during the recent Refugee crisis.  However, Germany’s bloated current account surplus of nearly 9% of GDP is unsustainable.  In particular,  neither the European “project” (including the future of the Euro) nor relations with the USA can be put on a sustainable path until this massive imbalance is confronted. Fortunately, the policies required to address this issue are precisely the same measures needed to tackle Germany’s other economic dilemma, e.g. the deterioration in its long-term GDP growth potential.  To be sure, Chancellor Merkel’s government is confronting domestic challenges, but it is time for Germany to act boldly once again!

Anatomy of Germany’s Current Account Surplus: Spend More!!

As I have discussed in earlier blogs, trade imbalances — either Germany’s surplus or America’s deficit — always have their roots in macro-economic issues. The fact that Germany runs a surplus with 21 of its 27 EU neighbours — not to mention enjoying a surplus with 75% of its trading partners world-wide — highlights that bilateral relationships are not the explanation.  In brief, Germany saves too much, and spends too little (the exact opposite of the USA).

The Chart above illustrates that all major segments of Germany’s economy — households, corporations, and the public sector — have contributed to this situation.  In 2000, for instance, Germany actually had a current account deficit!  Since 2000, however, households have increased net savings by nearly 3% of GDP. The aging German populace is increasing precautionary savings, fearing the pension system will not provide adequately.  However, there is more to it. The following Chart illustrates that the weakness in consumer spending reflects very modest income growth in recent years. The reasons for this will become evident soon.

Likewise, the first Chart indicates that excess savings in the corporate sector — that is, the gap between corporate savings/profits and capital investment — has expanded by over 5% of GDP.  The following Chart illustrates that firms’ profitability is not too blame, as gross savings have risen. Rather, corporate investment has slumped steadily during the past two decades.

Also, the public sector has played a role in the evolution of Germany’s excessive savings.  Between 2000 and 2008, Germany’s budget deficit averaged 2% of GDP annually. The following Chart shows Germany now enjoys a fiscal surplus of roughly 2%.  There are many reasons for this huge swing, especially concerns about the fiscal impact of future outlays for an aging population.  The shift in public sector savings has played a major role in the expansion in the external imbalance. The Chart also shows that government debt/GDP will decline sharply in coming years. Consequently, stimulative fiscal policy can/should play a central role in correcting the current account problem.

Current Account and Slow Growth: Two Problems, Same Remedy

Meanwhile, Germany’s long-term economic growth potential has slowed dramatically: now estimated at only 1-1.25% annually. To reverse this trend, measures must be taken to improve productivity, encourage investment, and boost labour supply.  Fortunately, success on all these issues will also reduce the current account surplus!

Despite Germany’s renowned high level of efficiency, productivity has slowed sharply in recent years, and has lagged well behind the USA for several decades. Rising productivity is the only sustainable path to higher consumer incomes and spending.  We have observed already the role of weak household spending in the evolution of Germany’s current account surplus.

There are several possible explanations for weak productivity growth.  However, the deployment of technology (knowledge-based capital KBC) lags well behind major competitors (Chart below).  As a result, the level of ICT skills in the German work force (information, communications, and technological) again lag behind key European neighbours. The productivity gap is especially apparent in the small and medium-sized enterprises.  Efforts to encourage entrepreneurship, including the use of venture capital, would help.

Flagging German capital spending has also contributed to both the weakness in productivity and the external imbalance. The following Chart illustrates that German investment has been lagging behind the rest of Europe, especially in the technology sectors. As a result of low investment, the OECD warns that Germany could be particularly exposed to automation in the future.

Poor demographic trends also will remain a headwind to future GDP growth. Throughout Europe, weak population growth is leading to an aging in the population.  However, the problem is most acute in Germany where the working age population is projected to decline sharply in coming decades.

Immigration can help solve this problem.  The following Chart illustrates that Germany’s local population has already fallen sharply since 2010. However, the inflow of foreign-born workers has more than offset these declines.  The adverse political reaction to the dramatic inflow of asylum seekers in 2015/16 is understandable.  However, the inflow of young, high-spending immigrants can play a role in boosting GDP growth, as well as curbing the trade surplus.

The German government can make use of its enviable fiscal situation, and implement measures to boost investment, productivity, and labour supply.  The OECD and IMF have numerous suggestions:

• Pension Reform:  Addressing concerns about post-retirement incomes would reduce the need for pre-cautionary household savings.
• Improve the opportunities for life-long learning, which lag other countries. As the  population ages, older workers must continue to renew skills to remain in the work force.
• Boost labour force participation for woman through better child care and nursery schooling.
• Increase spending on primary education, which again lags.

• Boost public sector investment, especially infrastructure and the roll-out of digital, high-speed broadband.
• Meet the NATA defense spending target.
• Reform corporate taxation.  The corporate tax rate is amongst the highest in the industrialised world.  Also, the high level of employers’ social insurance costs (tax wedge) discourage both investment and hiring.

Bilateral Trade: Does Trump Have a Point?

In past blogs, I have suggested that President Trump’s focus on bilateral trade is inappropriate, as America’s trade deficit stems primarily from its low savings rate.  Likewise, I have suggested that the US trade gap with the European Union largely reflects different savings patterns in the two areas, not market access problems.  However, there are exceptions. The following Chart shows while America’s export/import ratio with Europe is in line with the US average, the ratio is very low with Germany. This suggest that in addition to Germany’s weak spending, restricted access to the German market may be a problem. Indeed, nearly 70% of America’s trade deficit with the EU emanates from just Germany and Italy.

What’s going on?  Let’s start with trade in services where the USA has a distinct comparative advantage.  However, Germany is one of the few countries with whom the USA has a deficit in this key area. The Chart illustrates that German imports of US services are low compared to most other European countries. Even if Germany is not discriminating particularly against US services, this sector of the German economy is highly underdeveloped, e.g. services represent only 67% of GDP compared to 80% in the USA and UK. For their own national interest, deregulation and expansion of this key, job-producing sector should be a priority for Germany.  As an added benefit, if Germany imported the same amount of American services as the UK (as a percent of GDP), this would eliminate the bilateral deficit.

The following Chart provides insights into Germany’s industrial and trade strategy. First of all, Germany has a trade surplus of $75bn (nearly 2.5% of GDP) with their EU neighbours.  Such a large imbalance will remain contentious in negotiations on EU reform.  In addition, Germany runs deficits with energy-rich countries, eg Russia, Norway, and the Netherlands. Likewise, shortfalls exist with many Eastern European countries, which are a valuable part of the supply chain for Germany’s powerful industrial sector.

On the other hand, Germany’s export/import ratios are much higher for non-EU nations compared to members of the Single Market,  suggesting market access issues likely play a role. Indeed, 75% of Germany’s world-wide trade surplus emanates from non-EU nations.  Germany even enjoys surpluses with China and Japan.  Moreover, even among non-EU nations, the export/import ratio is especially high with the USA.

The USA is Germany’s third largest trading partner overall, but ranks first for German exports, and is the biggest source of the nation’s external surplus.  Analysis of trade by sector may provide a roadmap for improved trade relations.  Roughly, 75% of the bilateral trade gap is in machinery, equipment, and autos — sectors in which Germany in which Germany is able to exploit its comparative advantage.  On th other hand, my analysis suggests the USA is not able to fully take advantage of its edge in services, technology, aerospace, pharma, chemicals, plastics, energy, and agriculture.  Much work to do!

As the auto sector gets so much attention, I provide a few observations. First of all, autos represents about 40% of the bilateral trade gap. But, the USA is not alone.  Germany’s  world-wide trade surplus in autos ($140bn) represents 50% of its overall trade imbalance (machinery and equipment make up the other half). Lets face it, Germany makes good cars (my VW just celebrated its 24th birthday)! Germany should be prepared to reduce/eliminate its 10% tariff on cars, especially as I do not believe it will inspire Germans to drive more American cars (however, under WTO rules they will have to make the same offer to the rest of the world too).

How vulnerable is the German auto sector to a more aggressive American trade policy? The auto sector is very important  to Germany, representing 18% of exports or roughly 6% of GDP.  The United States accounts for 12% of German auto exports, e.g. just under 1% of German GDP.  So, the direct impact would be meaningful, but not devastating.  However, German auto companies have invested heavily in the USA, and employ 110,000 Americans in their 265 plants. German firms produce 854,000 cars in the USA, of which 40% are sold locally (e.g. 350,000 units compared to 550,000 imported from Germany to America). Germany potentially could expand production further in the USA if a trade war broke out.  A potentially more adverse effect come occur if China limits auto imports from the USA (as threatened), as much of Germany’s US-based production is sold in China.  In this case, German auto makers would likely expand activity in China, where 30% of German auto production already takes place. The USA may also retaliate by curbing auto imports of autos from China, another potential blow to German manufacturers.

Strategic Implications

• I expect the German trade surplus, as well as the bilateral gap with the USA, to remain sizeable. Germany’s fixation on a balanced budget will keep policy neutral.  Meanwhile, America’s budget deficit will expand; thereby, lowering the nation’s savings rate and boosting its trade deficit.
• Even while negotiating with the European Union, the USA is right to press Germany to boost overall spending.  In particular, Germany should deregulate its service sector, and identify reasons why spending on American technology and other products is so low.
• Expanding US agricultural sales will remain blocked by the EU’s Common Agricultural Policy. Both the US and much of the EU objects to the expansion of imported Russian natural gas via Nord Stream2 (the EU is also concerned about the impact on the Ukraine). Germany plans to eliminate its reliance on fossil fuels (and Russian imports) by 2050. Indeed, the use of renewable energy has tripled in the past decade, but only at the expense of reduced use of coal and nuclear power. Energy would seem an obvious area of US-EU trade collaberation.
• The USA is correct to insist Germany meet its NATO spending commitment, which would also boost spending and lower Germany’s trade surplus.
• While the suspect Germany is prepared to make concessions on auto tariffs, I believe the trade relations between the USA and the EU will deteriorate prior to the upcoming Congressional elections and beyond.
• German and France must narrow their difference on reform of the Eurozone architecture prior to the December EU summit.
• Unfortunately, I suspect the current weakness of Chancellor Merkel’s government will produce only slow progress on all these key issues.
• At some point, I suspect the Trump Administration will pursue a weak-dollar policy as a negotiating tool.  Expect more FX (and general market) volatility ahead.