Why The Core Is Also To Blame For The Euro Crisis

Northern Europeans are quick to point at the South for destructive habits, overspending, tax evasion, you nam it.

However, Northerners are as much of the problem as they are the solution.

Germany, in particular, has benefited from an abnormally low exchange rate given the scale of its economic growth in the last 10 years, according to a report authored by current Citi economist and former FOMC economist Nathan Sheets.

Here’s an excerpt from his analysis:

We conclude that both the weaker real exchange rate associated with monetary union and the flexibility of the German export sector in meeting rising emerging market demand have played an important role in the sustained expansion of Germany’s trade balances. Our estimates suggest that in the absence of these two effects, Germany’s real trade balance would have remained in small surplus, as was the case in the years before the introduction of the euro. The nominal balance would have swung into slight deficit, reflecting a deterioration in the terms of trade in line with the secular increase in the relative price of commodities; for example, the energy import bill increased from 1.3 per cent of GDP in the second half of the 1990s to 3.8 per cent of GDP on average since 2005.


[credit provider=”Citigroup Global Markets”]

As the chart above shows, even France saw a current account surplus from 1999 through 2005. However, it is worth noting that this trend has reversed for France in the last five years, and that net exports have only grown by 40 per cent since 1999 in comparison to explosive German export growth of 100 per cent. Greek exports grew by just 30 per cent in the same time period.

German and French investment in peripheral debt has simply been out of control given the financial fundamentals of the countries banks were investing in. On average, from 2005 to Q3 2011, this table shows the extent to which investment has fuelled peripheral economic growth (data from Bank for International Settlements):

Average quarterly consolidated claims by the banking sector by country, from Q1 2005 to Q3 2011. Numbers in euros.

[credit provider=”Bank for International Settlements”]

Together this investment amounted to approximately 39% of Greek GDP, 36% of Italian GDP, and 38% of Portuguese GDP (GDP from 2010 IMF estimates). That’s a remarkably high level of investment in countries with slow growth, large, corrupt governments, and rampant tax evasion.


[credit provider=”The Economist” url=”Projected%20deficit%20spending%20from%20a%202003%20chart%20in%20The%20Economist.”]

But most importantly, Germany and France were the first and biggest offenders to the Stability and Growth Pact, the regulations that were supposed to keep eurozone countries’ spending in line under 3% on a yearly basis. Had this pact been followed, it arguably could have kept Greece, Portugal, and Ireland from amassing such large public debts

Economist and London School of Economics Professor Stefan Collignon argued in January 2004 that this violation effectively killed the Pact:

What appeared so shocking about the events in 2003 was the fact that the decision to not follow the Excessive Deficit Procedure was taken so early in the Pact’s life and as a consequence of bullying by the two largest member states and without genuine economic reasons. In other words, the procedures of the Pact have never been fully applied.

In reality, Germany (and to a lesser extent France) have not only benefited tremendously from the low exchange rate and current account imbalances offered by the inclusion of poorer peripheral states in the euro currency, by rendering the Stability and Growth pack ineffective in 2003 they discredited the very regulations meant to prevent imprudent spending.

Whether it goes quietly or kicking and screaming, Germany will eventually have to pay for this transgression. And that’s not “unfair.”