Europe needs to tighten monetary policy to avoid bubble

German finance minister Wolfgang Schäuble going for balanced budget

The EU’s large external surplus, in light of falls elsewhere, risks a return to conditions behind the crash, says Michael Heise.

WITH global rebalancing set to be high on the agenda at the next G7 and G20 meetings, Germany — with its persistent export surplus — will again come under pressure to boost domestic demand and household consumption. But the German consumer is a sideshow. What is needed is an investment surge in Germany and Europe, and a co-ordinated exit from ultra-loose monetary policies.

Massive external-account imbalances were a major factor behind the global financial and economic crisis that erupted in 2008, as well as in the eurozone instability that followed. Now the world economy is in the process of rebalancing — but not in a way that many people had expected.

Asia’s formerly huge external surpluses have declined astonishingly fast, and Japan’s trade balance has even slipped into deficit. China’s current-account surplus has fallen to 2% of GDP, from 10% in 2007. Investment is still the Chinese economy’s main driver, but it has led to soaring debt and a bloated shadow banking sector which the authorities are trying to rein in.

The EU, however, has built up a large external surplus, owing mainly to positive trade balances in the eurozone. The EU’s current-account surplus in 2014, at around $250bn (€181bn), will be even higher than that of emerging Asia. With oil prices still above $100 a barrel, the combined surplus of oil-exporting countries is of a similar magnitude. The US, meanwhile, continues to run a sizeable current-account deficit of around $350bn-$400bn.

The surprise here is the continued growth in the EU’s surplus. The collapse in imports suffered by bailed-out countries — Greece, Ireland, Portugal, and Spain — was entirely predictable, given how sharply their economies declined.

However, few economists expected that these countries’ exports would improve as quickly as they did, especially in a subdued international environment. While Germany’s current-account surplus is roughly where it was in 2007, the combined external balance of the bailout beneficiaries plus Italy (which has been part of the trade turnaround) has swung from a pre-crisis deficit of more than $300 billion to an expected surplus of around $60bn this year.

Looking ahead, the appreciating euro (another surprise, especially to the many observers who doubted its survival less than two years ago) will compress the eurozone’s current-account surplus to some extent. An exchange rate of close to $1.40 poses a challenge for many European exporters, including German companies. And the euro has revalued even more against the yen and a number of emerging-market currencies.

Nonetheless, the European surplus is too large to ignore, and Germany in particular will be asked once more to rebalance its economy toward higher domestic demand, which for many people implies the need for a fiscal boost. But the German government is not obliging: finance minister Wolfgang Schäuble has just presented a balanced budget for 2015 — the first since 1969. And, while some observers are calling for Germany to “end wage restraint” and thereby encourage higher household spending, this has actually happened already.

There is, however, a lot that the German government could do about investment, which has fallen by almost four percentage points of GDP since 2000, to just over 17% in 2013 — low by international standards. Berlin could shift more government spending toward infrastructure investment. But, even more important, it should improve conditions for corporate investment at home, rather than watch German businesses move their capital expenditures abroad.

Germany’s attractiveness to investors would rise with simpler and more investment-friendly taxation, improved incentives for business start-ups and R&D, less bureaucracy and red tape, and no further energy-cost increases. Getting there will take time.

However, given the favourable earnings situation and the corporate sector’s large cash balances, a rebalancing of the tax system could have a rapid impact. Investment from retained earnings should be as attractive as debt financing. And some temporary adjustments of depreciation allowances could kick-start capital spending.

The need for more investment in transport, telecoms, energy, and education certainly is not only a German issue. Given most European governments’ debt problems, the challenge is to attract more private capital into these areas. Improved regulatory conditions for long-term investments and savings would help. So would expansion of financing instruments for infrastructure investment.

Indeed, why not create European Infrastructure Bonds, backed by revenues generated by the investments or tax income from the countries that emit EIBs? This would not only spur job creation and long-term growth; it would also stem the rise in Europe’s external surplus.

However, the challenge of rebalancing the global economy is closely connected to central banks’ monetary policies. With credit and asset bubbles slowly but surely reappearing, the authorities’ main focus should be on keeping growth on a balanced and sustainable path — discouraging excessive risk-taking.

This justifies the US Federal Reserve’s gradual exit from ultra-loose policies. Somewhat surprisingly, the Fed’s reduction of its monthly asset purchases has been accompanied so far by dollar weakness against the euro, which is fostering external adjustment. Looking forward, however, this may change.

Clearly, a co-ordinated effort to limit exchange-rate variations is advisable. The fact that inflationary pressure is still low is not a reason to postpone planning an exit from ultra-loose policy; on the contrary, the time for such discussions is when inflation is low and markets are calm.

* Michael Heise is chief economist at Allianz SE.


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