23 March 2017

Two developments occurring over the weekend have the potential to put the United States on a collision course with its trading partners.  In order to win US approval, the communique released following the G20 meeting in Baden-Baden softened its previous commitment to countering “all forms of protectionism” – a pledge widely regarded as having limited the severity of the  all too recent recession caused  by the financial crisis.  Instead, policymakers agreed only to “strengthen the contribution of trade to our economies”.  This shift appears both to reflect the Trump administration’s scepticism about the multilateral approach to trade issues, and also its emphasis on “putting America first”.   President Trump’s preference for dealing with trade issues on a bilateral basis focused considerable attention on last Friday’s meeting with German Chancellor Merkel in Washington.   And, despite the President’s much lauded deal making prowess, the two leaders did not appear to make much progress in allaying American concerns about it $65 billion deficit with its fifth largest trading partner.

The US-German trade relationship provides important insights into what results to expect from the new Administration’s shift towards bilateralism.  Before we do so, however, it is important to emphasize the importance of this relationship to both countries.  The United States is Germany’s top export market, accounting for 9% of sales abroad.  As foreign trade represents nearly 40% of German GDP, exports to the USA total nearly 4% of German GDP.   Meanwhile, total trade between the two nations totals $164 billion, and represents 4.5% of overall US foreign trade (as the US is a less open economy, this represents a much lower percent of GDP than in Germany).  In addition, cumulative German foreign direct investment in the United States totals $255 billion, and German companies employ 700,000 American workers (well over 100,000 in the auto-related sectors).   Meanwhile, American firms have invested $108bn in Germany, and employ 700,000 local staff.  In other words, there is much at stake.

In addition to shifting the focus from multilateralism to bilateral relations, the Trump Administration’s approach has emphasised “fair” rather than free trade.  The exact definition of “fair” has not yet been offered, but Treasury Secretary Mnuchin has suggested on several occasions that fair is associated with “balanced” trade.   In 2016, the United States had a world-wide trade deficit totalling $734bn (representing 4% of GDP), and experienced shortfalls with over 150 individual countries. Meanwhile, the overall German external surplus reached a staggering 8% of GDP, with surpluses in 173 different nations.

The wide proliferation of these deficits/surpluses would suggest that there is must be an alternative explanation for these imbalances other than specific and wide spread episodes of unfair treatment.  Rather, macroeconomic factors always lie at the heart of such broad-based imbalances.  Specifically, countries with chronic external deficits save less than they invest, or in other words they either run public sector deficits or private sector savings are insufficient to fund a desired level of domestic investment. That is, they live beyond their means.  In countries like Germany, on the other hand, the combination of private and public sectors savings in excess of that needed to meet their investment needs produces external surpluses.  In other words, Germany spends less than it produces, and does not enjoy the standard of living commensurate with their productive abilities.

Only addressing these savings/investment dynamics will lead to durable changes in each country’s external imbalance.  The American savings deficiency stems from a combination of its government budget deficit (the fact that the government and current account deficits are roughly the same size reveals something) and a chronically low household savings rate.  Indeed, the US consumer saves only about 5% of disposable income, roughly half Germany’s 10%.  Indeed, the paltry level of public and private US savings requires that the America run a current account deficit to pave the way for the borrowing from abroad needed to finance its domestic investment.  If Americans saved more, both the trade deficit would be lower and domestic investment higher.  Fiscal policy under the Trump administration, however, appears likely to become more expansive; thereby further reducing the nation’s savings ratio.   Without success in producing higher US savings, efforts to reduce the bilateral deficit with Germany (or any other country) will only increase the deficit elsewhere or lead to higher inflation.

It is quite right for the United States to pressure Germany to reduce its bloated surplus.  But, rather than cajoling German corporate leaders, the focus should be on encouraging Germany to pursue policies aimed at reducing its excessive level of savings.   The US would find wide spread support for this effort, as European partners (e.g. Greece amongst others) and the IMF have been highly critical of weak German spending for many years (decades, in fact).  With government finances much improved in recent years, Germany could be more expansive. German authorities, however, have resisted this pressure choosing to prioritise the near term consequences of both its aging population and the integration of the dramatic increase in immigration.   In this context, it is not unfair for the United States to encourage Germany to meet its NATO defence spending pledge.

However, Germany could increase private domestic spending in several ways.  First of all, the German consumer should be encouraged to enjoy the fruits of her labours by lowering the savings rate.  Furthermore, Germany’s level non-residential investment is now amongst the lowest in the OECD.  In particular, knowledge-based capital investment lags the US, UK, and the northern European nations.  Likewise, Germany’s service sector remains underdeveloped and heavily regulated.  Deregulation and improved productivity in this area could create jobs and spending; thereby, creating new export opportunities for US technology, capital goods, finance, and service firms.

Strategic Issues

• Is Germany a Currency Manipulator? Absolutely not (I am sure they wish they could from time to time)! However, it is true that the Euro is considerably undervalued – by 10% on a trade-weighted basis and probably more versus the US dollar. And, while trade patterns are meaningfully affected by exchange rates, capital flows determine currency values.  Indeed, the greenback continues to strengthen despite its twin deficits, as the US has had little problem attracting the needed capital inflows. In addition, in light of the current debate about US corporate tax reform, one should be sceptical of the claim that the border adjustment tax would be fully offset by an equal appreciation of the USD.
• I am sceptical that much progress will be made in either Germany or the USA towards addressing the macro imbalances behind their global and bilateral trade imbalances.  Although, I believe progress towards an FTA between the USA and EU would be useful, I doubt this will occur near term.  The July G20 meeting in Hamburg will be an interesting occasion to get more insights into the Trump trade vision.  I was encouraged by the leaders’ lengthy discussion of training and apprenticeship as a necessary policy response to rising inequality caused in part by globalisation.
• I anticipate US fiscal policy to become more expansive. If so, US Federal Reserve would likely tighten policy more than expected.  As  experienced during the Reagan years, this mix is likely to produce further USD strength (approaching parity). This outcome will be supported as Germany keeps pre-election fiscal policy neutral, and the ECB remains highly accommodative.  If the United States becomes more protectionist, this will pave the way for a weaker dollar eventually, but that is a story for another day.
• As the German and European recovery gain momentum, I expect that relatively lower equity valuations and the ECB’s more accommodative monetary stance (and perhaps a reduction in European political risk) will result in an outperformance of European stock markets compared to the USA for the remainder of 2017.