Germany may have the strongest economy in the troubled euro area, but the euro has not been a massive “free lunch”, as some critics claim. Germany’s strength has come at the cost of many painful years of sacrifice.
It is certainly true that the country is benefiting disproportionately from its membership of the single currency. Financing costs have fallen dramatically, partly as a result of the European Central Bank’s zero-interest-rate policy but also because safe-haven flows from the heavily-indebted peripheral countries like Ireland, Spain, Portugal and Greece have pushed bond yields to record lows. Meanwhile, the euro is probably far weaker than the Deutsche Mark would have been, providing a powerful boon for German exporters.
But it wasn’t always like this. In the five years following reunification in 1990, Germany’s real trade-weighted exchange rate rose by 20%. The corporate sector responded by cutting labour costs aggressively, helping the real exchange rate to decline. Even so, when Germany joined the euro in 1999, it did so with an overvalued exchange rate against the rest of the euro area.
Between 1999 and 2007, German wages per employee rose by 10.5%—roughly the same as the increase in employee productivity. By contrast, wages per employee in France and Italy jumped by 37.5% and 40.6%, respectively, even though their productivity growth was weaker than Germany’s. This left France and Italy at a competitive disadvantage, not only within Europe, but also against the outside world.
So is Germany’s experience a useful template for the periphery today? The answer is yes and no. Yes, to the extent that Germany showed that it is possible to engineer a successful internal devaluation within a monetary union. No, in that the challenge facing the periphery today is far more daunting. There are several reasons for this.
First, Germany pursued its internal devaluation at a time when the global economy was strong. This helped dampen the impact on output and jobs.
Second, while cutting wages can help to make a country more competitive, it also makes it more difficult to stabilize household and public-sector debt ratios (because lower wages reduce personal incomes and tax revenues).
Third, in order to realign their exchange rates within the euro area, the peripheral countries need to improve their competitive positions against Germany (from very poor starting points). Although German wage settlements have picked up recently, this will not be easy.
Hence, while Germany’s experience offers some guidance for the periphery today, the path ahead will be long and arduous. But there are ways to push this process along. One is to shift the tax base away from labour, by lowering company social contributions, and toward consumption, by raising indirect taxes. So far there has been little progress in this area.
The other channel is a weaker euro. Although this is not a panacea for the euro area, it can help—by boosting the competitiveness of the periphery against countries outside the euro area, and by providing room for wages to rise in Germany without destroying its competitive position against the rest of the world. In this respect, the euro’s recent decline to a ten-year low is a helpful development. Still, the single currency will probably have to fall farther to help the euro area out of its current predicament.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Darren Williams is Senior European Economist at AllianceBernstein.