The eurozone's ruinous embrace of 'competitive devaluation'
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 ‘competitiveness’ indices
(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)
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.