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Analysis
US-German stand-off is all about the euro

US-German stand-off is all about the euro

European rebalancing incomplete, debts becoming unsustainable

by David Marsh

Mon 4 Nov 2013

A combined broadside by the International Monetary Fund (IMF) and the US Treasury against Germany’s high current account surpluses looks like another sign of divergence between Berlin and Washington. In reality, the spat has much to do with the future of the euro – and it does not bode well.

Last week’s unusually fierce criticism of the Germans in the US Treasury’s semi-annual currency report was followed up by the IMF’s First Deputy Managing Director David Lipton, who in a speech in Berlin urged Chancellor Angela Merkel’s government to reduce Germany's export surplus to an 'appropriate rate' to help spur euro bloc growth instead of deflation.

The row throws up parallels to episodes near the end of the Bretton Woods system 45 years ago, when the US lined up with Britain and France to accuse the Bonn government of damping world growth through a badly-constructed economic policy and heaped pressure on Germany to revalue the D-Mark to curb its export surpluses. Using similar language to that deployed in Berlin last week to refute latest American criticism, the Bonn government resisted, only to give in the following year. Today’s German decision-makers will probably prove more stubborn.

Many people believe the euro bloc’s crisis is over. Last week’s IMF-Treasury attack shows it’s not. The stand-off between euro creditors and debtors is getting more entrenched. Hard-pressed peripheral countries are slowly confronting the reality of at least another five years of high unemployment, low growth and constant harassment by creditors before they can turn the corner. Europe may face similar trying times to the period in 1968-73, which saw the collapse of the post-Second World War Bretton Woods system of fixed exchange rates.

There are three major differences, none of them positive. First, compared with the divided post-war Federal Republic, now-united Germany can stand up to the US with greater independence. Indignation in Berlin over US espionage against Chancellor Merkel demonstrates the growing German-American political divide. Second, this time around, it’s not just America’s European allies but also, behind the scenes, China, too, that's joining anti-German monetary complaints. Third, the intertwining complexities of the euro bloc and of Berlin coalition politics rule out the possibility of any constructive answer to US-led demands for German reflation.

The US Treasury Department last week identified Germany's export-led growth model as a major factor responsible for the 17-nation euro bloc's weak recovery. The US identified Germany ahead of its traditional target, China, and the other perceived problem country, Japan, in the 'key findings' section of its currency report.

'Germany's anaemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment,' the Treasury said. 'The net result has been a deflationary bias for the euro area as well as for the world economy.'

There are irrefutable parallels to the 1968 currency dispute. Instead of revaluing the D-Mark, the Grand Coalition in Bonn under Chancellor Kurt Georg Kiesinger decided on a package of border taxes in the form of a 4% levy on exports and a rebate of the same size on imports, which Bonn said was a more flexible method of countering currency inflows. (Intriguing parallels to the 'capital flow management measures' sanctioned by today's IMF to curb inflows and outflows.')

This formed the prelude to a highly-strained international monetary conference in Bonn convened by German finance minister Karl Schiller in November 1968, when the crisis came to a head. The Germans again refused to revalue the D-Mark, and the French delegation reluctantly agreed to devalue the French franc – a decision immediately blocked by President Charles de Gaulle. The following year, the franc was indeed devalued and the D-Mark revalued. With American finances under strain from the Vietnam War, and growing exchange rate pressures caused by an undervalued Japanese yen and D-Mark, Bretton Woods stumbled through its final years before the progressive collapse in 1971-73.

The similarities to current circumstances are striking. The IMF’s latest world economic assessment paints a gloomy picture of euro rebalancing. The sharp fall in peripheral countries’ current account deficits has been largely due to cyclical factors. 'The implication is that current account deficits could widen again significantly when cyclical conditions, including unemployment, improve, unless competitiveness improves further.'

The IMF foresees that Germany will continue with current account surpluses of around 5% of GDP at least until 2018 (compared with 7% last year). The IMF’s key indicator of vulnerability – the net foreign liability position – will continue up to 2018 at more than 80% of GDP in Greece, Ireland, Portugal, and Spain, as growth remains low and unemployment persists at high levels. The worst-off debtors, Portugal and Greece, will both remain with net liabilities above 100%. The German net foreign asset position is expected to rise to an astonishing 75% of GDP by 2018.

Just as with the D-Mark at the end of Bretton Woods, the 'German euro' within monetary union is significantly undervalued. Without the problem countries, the exchange rate of a European currency bloc of northern creditor nations grouped around Germany (the euro 'hard core') would be closer to $1.80 than the present $1.38.

The euro is too strong for permanently-indebted peripheral countries, and not nearly strong enough for Germany, whose burgeoning exports outside the euro area are bolstered by the German currency’s intrinsic under-valuation. Even after three and a half years of overt euro crisis, Europe remains beset by distortions in competitiveness, indebtedness and underlying economic conditions that exceed anything seen under Bretton Woods.

Distortions of this sort are unsustainable. They can be cured only by sustained growth, adjustments in foreign exchange rates or a debt write-down. Since, under current conditions, the first two solutions are not available, the probability of substantial debt restructuring in the euro bloc next year now looms still larger.

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