Trump’s Currency War Against Germany Could Destroy the EU

It’s just over a week after Donald Trump’s inauguration, and his administration has already indicated that it is preparing for global economic war. The currency war the White House has in mind is clearly aimed not just against China — which has long been suspected of “cheating” in order to win the globalization game — but also Germany: On Tuesday, Peter Navarro, the head of the new National Trade Council, claimed that Germany is using its currency to “exploit” both its neighbors and the United States. The White House evidently thinks of the European Union, and the monetary union that established the euro currency, as essentially a mechanism to protect German interests and extend German power — as an instrument of Germany, as Trump himself put it.

This fear of Germany is both an outlandish expression of paranoia and an idea with a long pedigree among some establishment economists and policymakers. Nobody doubts that the White House has tools at its disposal to strong-arm Germany into changing its economic policy, including its commitment to the euro, which currently binds the European Union together — indeed, the Trump administration already seems to be doing just that.

The first version of such criticism directed at Germany came in the late 1970s and was focused on the European Monetary System (EMS), which preceded the existence of the euro. The EMS was a fixed (but adjustable) exchange rate system that reproduced most of the features of the global Bretton Woods system established in 1944 and was designed by Europeans as an immediate reaction to the mismanagement of the U.S. dollar under President Jimmy Carter. Dollar weakness sent floods of capital — short-term money — into Germany, pushing up the Deutsche mark against the French franc and vastly complicating trade relations within the European customs union.

But there was always a suspicion that Germany was trying to get long-term trade advantages from linking the currencies. In the early 1980s, the former British Labour Party politician Denis Healey convinced himself that the EMS was a German racket after then-German Finance Minister Manfred Lahnstein told him that Germany expected to get a competitive edge by limiting the scope for other currencies to depreciate; since Germany had lower rates of wage inflation than France and much lower rates than the Mediterranean countries, a locked currency would guarantee increased export surpluses, at the price of misery elsewhere. The suggestion was that the EMS, and then later the euro, would allow Germany’s grasp for European economic primacy to succeed at the end of the 20th century and in the new millennium where a similar German military plan had failed one century earlier.

The odd thing about this theory is that it has been far more current in Britain and the United States than in continental Europe. If the power grab is what the Germans were aiming at, wouldn’t other countries be able to get some whiff of the nefarious plot? And more importantly, if this were really a strategy, it would be a pretty short-sighted one (not really that much better than the disastrous Schlieffen Plan of 1914 to defeat both France and Russia at the same time). Plunging one’s neighbors into national bankruptcy is not a good way of building any kind of stable prosperity.

From the German point of view, the goal of having a single currency is not just to make ordinary transactions easier but to remove the suspicion of trade advantages when nonfixed currencies move against each other. For instance in 1992-1993, when Spain and Italy left the EMS, French farmers immediately began to demand protection against cheaper wine from the south.

Previous U.S. administrations — including Barack Obama’s — have long worried about the size of German current account surpluses: the investment surplus by Germans abroad that corresponded to the amount that they were underconsuming in goods and services. But they read them differently — not so much as evidence of trade manipulation but of a wrong approach to economic policy that placed a brake on the world economy as a whole. Washington did attempt to counteract this. At the 2010 G-20 summit in Seoul, there was a brief, but ill-fated, attempt by the United States to encourage a limit on the size of current account surpluses to 4 percent of GDP. Germany’s surplus is about to overtake China’s in absolute size and as a share of GDP is now much larger. The IMF estimates Germany’s 2017 surplus as 8.1 percent of GDP while putting China’s at only 1.6.

Navarro’s criticism of the “undervalued euro” is that the currency union is a permanent way of keeping what is really the Deutsche mark lower than it should be. As an alternative, it is plausible to look at Switzerland, whose export-driven economy has similarities to Germany’s and which also runs a big current account surplus. Since the financial crisis, the Swiss franc appreciated significantly against both the dollar and the euro. For some time, the Swiss National Bank tried to hold the franc down, with a peg of 120 against the euro, but it unpegged in January 2015 (though it still intervenes to stop over-rapid rises in the currency). But its current account surplus is still enormous — bigger in share of GDP than Germany’s with 8.95 percent forecast for 2017.

In short, Switzerland’s current account balance reflects deep imbalances between high savings and low domestic investment — and not simply trade manipulation. And it is not easily adjusted even by a currency appreciation of the size that Switzerland undertook, which brought acute pain to some major sectors of its economy, including tourism and now also watches.

The dynamite in the German case lies in the domestic politics. In order to stop the franc from rising, the Swiss central bank intervened to acquire foreign assets, mostly euro-area government bonds — rather like China buys U.S. Treasury bills. And Germany also has the equivalent in the eurozone: The German central bank is building up large claims against southern Europe in the European payments system TARGET2. At the end of 2016, they amounted to 754 billion euros, higher than the peak during the euro crisis of 751 billion euros in August 2012. The goal in this case is not to keep the German exchange rate down (that can’t be done since this is a currency union) but to stop the euro from breaking up.

Germany’s TARGET2 balances are not an intended policy by Berlin, but the consequence of money leaking out of southern Europe after the ECB’s attempt to stimulate growth there by asset purchases (quantitative easing). And that quantitative easing arose out of pressure from southern Europe – but also from the United States – to do something to rescue the euro. So the German claims arise because of the inherent logic of the system rather than because the German government or central bank is trying to manipulate anything.

Navarro and Trump’s demand is so effective because it points to an underlying political weakness of the German position. The buildup of Germany’s TARGET2 claims on southern Europe is much more uncertain and more unpopular in Germany than China’s dollar assets or Switzerland’s reserves are in those countries. Germans are not worried that they are too successful as exporters, but they are deeply concerned about the quality of assets purchased with their current account surplus: U.S. subprime mortgage paper before 2008, southern European debt after the financial crisis. German taxpayers face a potentially large bill but one that would only be due if the euro collapsed.

In fact, the American attack plays into German domestic politics, and into critics of Angela Merkel, and sets the stage for an election campaign that will be fought around two policies — the euro and refugees — on which the American government will play an opposition role. The likely new U.S. ambassador to the EU, Ted Malloch, says he would bet on the euro collapsing and that he wants to “short the euro.”

But what would be the consequences of a euro breakup? It would weaken Europe as a competitor but also make it more unstable as old national rivalries are unleashed again. In the past, Americans saw Europe as a pole of stability in an uncertain world. The new vision wants European instability, political as well as economic. The end result is that Europe would be more fractious — indeed, more like Donald Trump’s America.

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