Among the most troubling imbalances in today's global economy is the massive German external current account surplus. Yet stuck within the Euro, Germany is unable to allow its currency to appreciate without at the same time making the currency it shares with those hapless economies like Spain and Italy appreciate as well. To square this circle, Germany would be doing both Europe and the global economy a great service if it were to now exit the Euro.
That Germany is running a disturbingly large external imbalance is hardly open to question. According to the most recent official balance of payments data, Germany’s external current account surplus rose to the highest level on record in March 2016. It is now on track to remain above 8 percent of GDP for the year as a whole. Making this surplus all the more troubling is the fact that it is occurring at a time that the German economy is cyclically in a very much stronger position than that of its European partners.
It is little wonder then that the International Monetary Fund considers that the German current account surplus is around 5 percentage points of GDP too high and that the German real exchange rate is considerably undervalued. Back in July 2015, the IMF estimated that the German real exchange rate was undervalued by between 5 and 15 percent. However, since then the Euro has depreciated by around 10 percent, which would make the German currency undervalued by between 15 and 25 percent according to the IMF’s methodology.
It is also little wonder that the US Treasury has now classified Germany as a country that might be gaining an unfair competitive advantage with respect to the United States by currency manipulation. It has done so in its latest currency report to Congress in which it placed China, Germany, Japan, South Korea, and Taiwan on a new currency watch list. It warned that all five countries faced extra scrutiny and potential retaliation by Washington as a result of concerns over growing imbalances in their trade relationship with the US.
The normal way to address large external imbalances while maintaining internal balance is by a combination of exchange rate adjustment and a change in domestic demand policies. In the case of Germany, this would involve an exchange rate appreciation of around 20 percent coupled with a move to a very much more expansionary fiscal policy. The change in fiscal policy would be aimed at offsetting the hit to the German economy from a stronger currency that would crimp German export growth.
The major obstacle to such a course of action is that Germany is stuck in the Euro. This necessarily means that Germany cannot get an exchange rate appreciation without forcing an equivalent exchange rate appreciation on the other 17 countries that also have the Euro as their currency. Such an appreciation would of course be the last thing that already ailing economies such as Italy, Greece, Portugal, and Spain now need. It would deal a real body blow to these economies, which are yet to regain their pre-2008 output levels.
Making matters worse, these countries are burdened with very high public debt levels and with still sizeable budget deficits. Those weak public finances do not leave them any room to use fiscal policy to offset the adverse effect to their economies that might be expected from a more appreciated exchange rate.
The most elegant way to cut this Gordian knot would be for Germany to exit the Euro. That would allow the new German currency to appreciate significantly against a Euro that would now exclude Germany. By so doing, it would also allow for the much needed external rebalancing within its own economy and the rest of the European economy, which could highly benefit from a very much weaker currency.
If the European economy is not to lose yet another decade, and if the countries in its Southern periphery are ever to dig themselves out from under their debt burdens, Europe needs to shake itself free from the currency shackle that has condemned it to poor economic performances and to an unraveling of its politics. This makes it all the more urgent that Germany exercise real leadership in Europe by now exiting the Euro.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
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