The IMF recently published its Economic Outlook for Germany. The report itself is quite long but a brief description of the key points can be found here. I have written before on the problems caused by Germany’s supposedly ‘prudent’ saving behaviour and export prowess, and the IMF covers this issue quite well, although as a report focused on one country, it does not consider the global implications. Here I want to focus on one aspect of the report: the financial imbalances of Germany’s economy and their relationship to both inequality and future growth prospects, both domestically and in the rest of the world.
In macroeconomics, one can consider the financial balances (net borrowing or net lending) of the three main sectors in the economy as a whole: the private sector (firms and households together), the public sector (government) and the foreign sector (the rest of the world). Together these balances can be used to analyse the total flows of expenditure and income between the three sectors, both within that economy and between that economy and the rest of the world.
If a sector runs a financial surplus over a particular period, its income for that period will exceed its expenditure and it will either be accumulating financial assets from another sector or paying down debt owed to another sector. For example, if the government runs a surplus, then revenue from taxation will exceed public spending and it will be able to pay down government debt held by the private sector, either domestically or abroad.
If the foreign sector runs a financial deficit, then its expenditure exceeds its income and it will be running a current account deficit with the country in question. By implication, this country will be running a current account surplus with the rest of the world (the foreign sector).
The three financial balances sum to zero, so that changes in one affect changes in one or both of the others. This says nothing about how such adjustments take place in terms of economic behaviour; it remains a mere identity.
If, for example, the financial surplus of the private sector increases due to a rise in private savings, then either tax revenue will fall relative to public spending, increasing the government’s deficit or reducing its surplus, depending on the initial position; or foreign income relative to foreign spending will fall, and the current account surplus will rise or the current account deficit will fall, again depending on the initial position; or some combination of the two will take place, in order to maintain the identity.
In Germany, the private sector is a substantial net saver (it runs a financial surplus). Both firm and household income exceed their spending. Another way of putting this is that domestic private savings exceeds domestic private investment.
The German government is also a net saver, and it can therefore be described as running a budget surplus.
The foreign sector, or the rest of the world, is in substantial deficit with Germany, with the latter therefore described as running a large current account surplus. A current account surplus is equal to the capital account deficit. Thus Germany is a substantial net lender to the rest of the world.
In terms of our financial balances identity, the sum of the private, government and foreign surpluses (the foreign surplus being negative, representing a deficit with Germany) is equal to zero.
The IMF report describes how the German economy slowed in 2018 due to weakening external demand. Export performance has been strong since 2000, interrupted of course by the financial crisis of 2008, and reflected until recently in a rising current account surplus, domestic demand has been relatively weak.
Wage growth for the lowest earners has been stagnant or falling, contributing to surging corporate profits, while investment has been weak. This is reflected in the financial surplus of the corporate sector, which has to a significant extent accrued to the richest households as increased wealth rather than being reinvested. Since the wealthiest households consume a lower proportion of their income and wealth than the poorest, this has also weakened consumption and domestic demand, and has left overall growth in demand overly dependent on exports. For a large economy and for the rest of the world, this trend is unsustainable.
Thus rising German household income and wealth inequality during the past two decades has weakened economic growth. The dependence on external demand, while often touted as Germany’s exporting might, is now proving to be a weakness as growth in world trade slows.
Of course, the flip side of a large current account surplus is the rest of the world’s current account deficit with Germany. The rest of the world is a net borrower from Germany. If these borrowed funds went into productive investment abroad then they would contribute to rising output and productivity and therefore be sustainable, but as in the run-up to the financial crisis, substantial amounts have been used to finance unproductive housing bubbles and rising consumption.
As the fourth largest economy in the world, Germany has a key role to play in driving global growth. However, German domestic demand remains too weak to do so and its large current account surplus continues to make growth in the rest of the world too dependent on an unsustainable trend of rising debt.
As the IMF report argues, Germany could reduce inequality by adopting policies which boost the incomes of the poorest households, and reduce its current account surplus in the process. Wage increases for the poorest households, who are more likely to spend rather than save the increased income, should increase consumption and domestic demand, which will also tend to increase imports relative to exports and therefore reduce the current account surplus.
Of course, substantial wage increases could reduce the competitiveness of the affected firms and sectors if they are exporters and are forced to raise prices. On the other hand, higher wage costs could lower profits, while for the economy as a whole, higher consumption would boost profits for firms producing goods for consumption. The overall impact may thus be uncertain.
However, it remains the case that Germany needs to rebalance its economy so that it is less dependent on foreign demand and more on domestic demand. At the moment, rebalancing via reduced foreign demand for exports is being forced on it, so if Germany wishes to sustain growth and employment, it has no choice but to boost domestic demand via increases in private and public consumption and investment.
Germany also needs to raise its productivity growth, which has been held back by weak private and public investment in capacity, skills and infrastructure. The government therefore has an important role to play in all this.
The key to rebalancing the German economy, and by implication the rest of the world, and contribute to reducing the dependence of growth in the latter on unsustainable rises in debt, lies in a major adjustment in the private sector financial balance, and the effect this has on domestic demand, demand for imports, and the current account.
As a member of the eurozone, Germany cannot revalue its currency against some of its major trading partners. A substantial boost to domestic demand driven in part by faster wage growth is the only fruitful alternative. In the absence of this Germany will be hamstrung by weakening global demand which is now hitting exports and exposing the relative weakness of domestic demand.
Reducing inequality while raising growth in output and productivity would seem to be a win-win for ordinary Germans, not least the poorest among them, and the country as a whole, as well as the rest of the world. Reducing the related financial and economic imbalances and the associated risks demands such a strategy.