Flip side of Italy’s woes is a German economy with a suspect engine
Last week I wrote about the inter-relationship between Italy’s financial plight and its underlying economic difficulties, now finding expression in its government’s conflict with the EU. It has been told by the EU to come up with a different budget. If its budget isn’t modified, the EU will probably reject it. We shall see if the Italians bend the knee to Brussels.
But the Italian difficulties represent only one side of the euro problem. The flip side is to be seen in Germany and, contrary to popular misconceptions, it isn’t rosy either. On the face of it, Germany is an amazing economic success story. The economy is growing strongly and unemployment is only 3.4pc.
Yet recent German economic performance is not outstanding. Since the formation of the euro in 1999, Germany’s economy has grown by about 32pc while the poor old UK has grown by 43pc. Meanwhile, the figures for the US and Canada are 49pc and 53pc respectively. In the same period, Sweden has grown by 56pc and Switzerland by 46pc.
Yet it is when you look at the figures for consumption that it really dawns on you that things aren’t quite right. Since 1999, spending by German consumers has risen by only 20pc. How come the discrepancy between GDP and consumption? This is explained largely by the shift in the trade balance. Since the euro was formed, Germany has gone from a small deficit of about 1pc of GDP to a whopping great surplus of almost 8pc of GDP.
The explanation for relatively weak consumption is largely not more saving by German consumers, whose caution is legendary; rather, German workers have not been paid that much. Since the formation of the euro, the average real pay of German workers has risen by only 23pc, or 1.2pc per annum. It is German companies that have done spectacularly well, largely thanks to strong exports, greatly helped by subdued wage increases and the competitive euro. Meanwhile, the government’s budget is in surplus to the tune of 1.3pc of GDP. The German economy is completely lopsided with excessive reliance on exports and domestic demand too weak.
But some day German workers will benefit, won’t they? Perhaps. The counterpart to these huge current-account surpluses is the build-up of claims on other countries. These are effectively IOUs from countries that have bought German goods, well in excess of what Germany has bought from them. But debts aren’t always repaid, as Germany should know.
Within the euro system there is a special sort of IOU. These are the so-called Target2 balances, representing claims by one central bank on another as a result of imbalances in the flow of money between member countries.
This is how it works. Suppose someone withdraws euros from an Italian bank and deposits them with a German bank. The German bank now has surplus euros and the Italian bank has a shortage of euros. Through their respective central banks and the ECB, the euros are recycled from the German bank to the Italian bank.
But someone has replaced a claim on an Italian bank with a claim on a German bank. Matching this switch, the German central bank has acquired a claim on the ECB and the ECB has acquired a claim on the Italian central bank. That doesn’t sound to me like an equal exchange.
The scale of these claims is staggering. Germany has net claims on other countries within the Target2 system of some €1,000bn. That amounts to roughly 30pc of German GDP. The Target2 liabilities of the Bank of Italy come to almost half that figure. The stock of both German claims and Italian liabilities is far greater now than it was at the height of the euro crisis in 2012.
If Italy were to leave the euro, would it fully honour these debts? The lawyers will tell you that legally it must. But then that’s why they are lawyers. If I were the ECB I would not want to bank on it – as it were. What will happen if the stand-off between the Italian government and the euro authorities continues and the Target2 balances get ever larger? And suppose that there is a run on the Italian banks. The Bank of Italy cannot issue euros. It would be the ECB that would have to provide the dosh. Would it? These problems for Germany and Europe have arisen from the abolition of the Deutschmark. The exchange rate is a hinge that allows countries as different as Germany and Italy to be different, yet to remain connected. Without it the union must break.
The replacement of the Deutschmark by the euro has also been responsible for a significant global problem, namely the fact that the eurozone as a whole is running the largest current-account surplus in the world, thereby acting as a deflationary force and contributing to the growth of protectionist sentiment, especially in the US.
The solution is obvious: bring back the Deutschmark. But I wouldn’t hold your breath. Germany does not want to be the cause of another major European upset. If Germany doesn’t leave the euro, then Italy should. As and when either of these happens there will be financial mayhem across Europe. But carrying on with the current system would be worse.
Apparently the UK’s policy establishment wants us to stay in the EU, if not permanently then at least for as long as possible. If we leave without a deal on a continuing close relationship they are worried about “disruption”. Disruption? Has anyone in Whitehall noticed the storm gathering across the channel? I would have thought that the sensible thing for us would be to clear off out of it PDQ, before the balloon goes up. Still, I am a humble economist, not one of our Olympians charged with the task of managing Brexit. They evidently understand these complex European economic matters in a unique way.
Roger Bootle is chairman of Capital Economics
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