Excess German Savings, Not Thrift, Caused the European Crisis

Employment policies and the savings rate

It is tempting to interpret Germany’s actions as the kind of far-sighted and prudent actions that every country should have followed in order to keep growth rates high and workers employed, but it turns out that these policies did not solve unemployment pressures in Europe, and this is implied in the second sentence of Martin Wolf’s piece. Germany merely shifted unemployment from Germany to elsewhere. How? Because Germany’s export of surplus savings was simply the flip side of policies that forced the country into running a current account surplus.

To explain, let us pretend that Europe consists of only two countries, Spain and Germany. As we have already shown, forcing down the growth rate of German wages relative to GDP caused the household income share of GDP to drop. Unless this was matched by a decision among German households to become much less thrifty, or a decision by Berlin to increase government consumption sharply, the inevitable consequence had to be a reduction in the overall consumption share of GDP, which is just another way of saying that the German national savings rate had to rise. During this period, by the way, and perhaps as a consequence of restraining wages, Germany’s Gini coefficient seems to have risen quite markedly, and the resulting increase in income inequality also affected savings adversely.

As German savings rose, eventually exceeding German investment by a wide margin, Germany had to export the difference, which its banks did largely by making loans into the rest of Europe, and especially those countries that were financially “shallower”. Declining consumption left Germany producing more goods and services than it could absorb domestically, and it exported excess production as the automatic corollary to its export of savings.

Of course the rest of the world had to absorb excess German savings and run the current account deficits that corresponded to Germany’s surpluses. This was always likely to be those eurozone countries that joined the monetary union with a history of higher inflation and currency depreciation than Germany – countries which we are here calling “Spain”. As monetary policy across Europe was made to fit German needs, which was looser than that required by Spain, and as German savings were intermediated by German banks into Spain, the result was likely to be higher wage growth, higher inflation, and soaring asset prices in Spain.

In fact this is exactly what happened. Spain and the other peripheral European countries all saw their trade deficits expand dramatically or their surpluses (many were running large surpluses in the 1990s) turn into large deficits shortly after the creation of the single currency as their savings rates shifted to accommodate German exports of its excess savings.

The way in which the German exports of savings were absorbed by Spain is at the heart of the subsequent crisis. As long as Spain could not use interest rates, trade intervention, or currency depreciation to block German exports, it had no choice but to balance the excess of German savings over investment. This meant that either its investment would have to rise or its savings would have to fall (or both).

Both occurred. Spain increased investment in infrastructure and in real estate (and less so in manufacturing, probably because German growth occurred at the expense of the manufacturing sectors in the rest of Europe), but it seems to have done both to excess, perhaps because of the sheer amount of capital inflows. After nearly a decade of inflows larger than any it had ever absorbed before, Spain, like nearly every country in history under similar circumstances, ended up with massive amounts of misallocated investment.

But this was not all. If the savings that Germany exported into Spain could not be fully absorbed by the increase in Spanish investment, the only other way to balance was with a sharp fall in Spanish savings. There are two ways Spanish savings could have fallen. First, as the Spanish tradable goods sector lost out to German competition, Spanish unemployment could rise and so force down the Spanish savings rate (unemployed workers still must consume).

Second, Spain could have reduced household savings voluntarily by increasing consumption relative to income. Higher Spanish consumption would cause enough employment growth in the services and real estate sectors to make up for declining employment in the tradable goods sector.

Raising consumption

Not surprisingly, given the enormous optimism that accompanied the creation of the euro, the latter happened. As German money poured into Spain, helping ignite a stock and real estate boom, ordinary Spaniards began to feel wealthier than they ever had before, especially those who owned their own homes. Thanks to this apparent increase in wealth, they reduced the amount they saved out of current income, as households around the world always do when they feel wealthier. Together the reduction in Spanish savings and the increase in Spanish investment (in infrastructure and real estate) was enough to absorb the full extent of Germany’s export of excess savings.

But at what cost? The imbalance created within Europe by German policies to constrain consumption forced Spain into increasing consumption and boosting investment, much of the latter in wasted real estate projects (as happened in every one of the deficit countries that faced massive capital inflows). There are of course no shortage of moralizers who insist that greed was the driving factor and that Spain wasn’t forced into a consumption boom. “No one put a gun to their heads and forced them to buy flat-screen TVs”, they will say,

But this completely misses the point. Because Germany had to export its excess savings, Spain had no choice except to increase investment or to allow its savings to collapse, with the latter either in the form of a consumption boom or a surge in unemployment. No other option was possible.

To insist that the Spanish crisis is the consequence of venality, stupidity, greed, moral obtuseness and/or political short-sightedness, which has become the preferred explanation of moralizers across Europe begs the question as to why these unflattering qualities only manifested themselves after Spain joined the euro. Were the Spanish people notably more virtuous in the 20th century than in the 21st? It also begs the question as to why vice suddenly trumped virtue in every one of the countries that entered the euro with a history of relatively higher inflation, while those eastern European countries with a history of relatively higher inflation that did not join the euro managed to remain virtuous.

The European crisis, in other words, had almost nothing to do with thrifty Germans and spendthrift Spaniards. It had to do with policies aimed at boosting German employment, the secondary impact of which was to force up German national savings rates excessively. These excess savings had to be absorbed within Europe, and the subsequent imbalances were so large (because German’s savings imbalance was so large) that they led almost inevitably to the circumstances in which we are today.

For this reason the European crisis cannot be resolved except by forcing down the German savings rate. And not only must German savings rates drop, they must drop substantially, enough to give Germany a large current account deficit. This is the only way the rest of Europe can unwind the imbalances forced upon the region in a way that is least damaging to Europe as a whole. Only in this way can countries like Spain stay within the euro while bringing down unemployment.

But lower German savings don’t mean that German families should become less thrifty, only that the average German household should be allowed to retain a much larger share of what Germany produces. If Berlin were to cut consumption taxes, or cut income taxes for the lower and middle classes, or force up wages, total German consumption would rise relative to GDP and so national savings would fall – without requiring any change in the prudent behavior of German households.

To ask Spanish households to be more “German” by saving more is not only impractical in an economy with 25 percent unemployment (it is hard for unemployed workers to increase their savings), it is counterproductive. Lower Spanish consumption can only cause even higher Spanish unemployment, until eventually Spain will be forced to abandon the euro and so regain control of its ability to absorb or reject German imbalances. This abandonment of the euro will be driven by the political process, as those in the leadership (of both main parties) who refuse to countenance talk of leaving the euro lose voters to more radical parties until they, too, come around:

The latest opinion polls show the PP has lost 10 percentage points of support since Rajoy’s election in November 2011. Support for the main opposition group, the Socialists remains unchanged, while backing has been growing for smaller, more radical, parties. More than 68 per cent of Spaniards say the government is doing a bad or very bad job, while the latest official forecast shows that a quarter of the workforce will still be out of work three years from now.

An article in this week’s Economist suggests that Spain is indeed becoming more “German” and so that this is reason for hope:

Is Spain the next Germany? It may not feel like that to the 26% of Spaniards who are unemployed. GDP shrank by 0.8% in the fourth quarter of 2012. Yet in some ways, Spain resembles the Germany of a decade ago, when Gerhard Schröder brought in reforms to turn the sick man of Europe into its strongest economy. The efforts by Mariano Rajoy’s government to loosen labour laws and cut public spending are aimed at a German-style miracle.

…Joachim Fels, chief economist at Morgan Stanley, is one of several backers of the Germany theory. “Spain is doing a lot of the things Germany did ten years ago, but in a much shorter time span and tougher global conditions,” he says, pointing to falling labour costs, rising exports and booming Spanish car factories. But, he adds, “Spain becoming Germany is really a two- to four-year story.”

The global constraints

The problem with this argument may be, however, that the global conditions that allowed Germany to grow by exporting savings to Spain cannot be replicated. If Spain were to make its workers more competitive by reducing wage growth relative to GDP growth, it would implicitly be forcing up its savings rate to generate employment. To whom would Spain export those savings? The world is awash in excess savings, and unlike in pre-crisis days, there are no countries with booming stock and real estate markets willing to fund another consumption binge. This means that Spain and Europe are expecting to recover by exporting unemployment, but to whom?

In fact this is the great worry that Martin Wolf expresses n the conclusion to his article:

A big adverse shock risks turning low inflation into deflation. That would aggravate the pressure on countries in crisis. Even if deflation is avoided, the hope that they will grow their way out of their difficulties, via eurozone demand and internal rebalancing, is a fantasy, in the current macroeconomic context.

That leaves external adjustment. According to the IMF, France will be the only large eurozone member country to run a current account deficit this year. It forecasts that, by 2018, every current eurozone member, except Finland, will be a net capital exporter. The eurozone as a whole is forecast to run a current account surplus of 2.5 per cent of GDP. Such reliance on balancing via external demand is what one would expect of a Germanic eurozone.

If one wants to understand how far the folly goes, one must study the European Commission’s work on macroeconomic imbalances. Its features are revealing. Thus, it takes a current account deficit of 4 per cent of GDP as a sign of imbalance. Yet, for surpluses, the criterion is 6 per cent. Is it an accident that this happens to be Germany’s? Above all, no account is taken of a country’s size in assessing its contribution to imbalances. In this way, Germany’s role is brushed out. Yet its surplus savings create huge difficulties when interest rates are close to zero. Its omission makes this analysis of “imbalances” close to indefensible.

The implications of the attempt to force the eurozone to mimic the path to adjustment taken by Germany in the 2000s are profound. For the eurozone it makes prolonged stagnation, particularly in the crisis-hit countries, highly likely. Moreover, if it starts to work, the euro is likely to move upwards, so increasing risks of deflation. Not least, the shift of the eurozone into surplus is a contractionary shock for the world economy. Who will be both able and willing to offset it?

The eurozone is not a small and open economy, but the second-largest in the world. It is too big and the external competitiveness of its weaker countries too frail to make big shifts in the external accounts a workable post-crisis strategy for economic adjustment and growth. The eurozone cannot hope to build a solid recovery on this, as Germany did in the buoyant 2000s. Once this is understood, the internal political pressures for a change in approach will surely become overwhelming.

As long as it is part of the euro Spain has no choice but to respond to changes in German savings rates. There is nothing mysterious about this process. It is simply the way the balance of payments works, and thrift has nothing to do with it. If Germany does not take steps to force down its savings rate by increasing the household share of GDP, then either all of Europe becomes like Germany, in which case growth slows to a crawl and some other country – maybe the US? – will be forced to resolve Europe’s demand deficiency either through higher unemployment or through higher debt, or Europe must break apart to free Spain and the other peripheral countries from German savings imbalances.

I don’t imagine the rest of the world can absorb demand deficiency from a Germanic Europe, and if Europe tries to force it the result will almost certainly be an eventual collapse in trade relations, so either Germany rebalances or Europe breaks apart. It is hard for me to see many other options.

About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

Be the first to comment

Leave a Reply

Your email address will not be published.


*