Is Germany a Currency Manipulator?

Peter Navarro, the head of the Trump administration’s newly created National Trade Council, touched off a controversy on January 31 by telling the Financial Times that Germany is using a “grossly undervalued” euro to “exploit” the United States and its European Union partners. At one level, Mr. Navarro merely repeated a position laid out in greater detail in his September 2016 commentary on the Trump economic plan. Furthermore, his central economic assertion—that “while the euro freely floats in international currency markets, this system deflates the German currency from where it would be if the German Deutschmark were still in existence”—is uncontroversial. If Germany were to leave the euro area, German exports would become more expensive and German imports cheaper, reducing the German current account surplus—although the surplus also derives from deep structural reasons, including demographics.

But Mr. Navarro’s comments are worrisome because of two other assertions in his September 2016 piece, both of which seem to underpin the thinking behind his criticism of Germany. First, that freely floating currencies would eliminate trade imbalances—and by extension, that trade imbalances are a manifestation of “currency manipulation.” Second, that Germany’s euro membership, as a policy choice that keeps Germany’s exchange rate undervalued, is an act of currency manipulation. Both these assertions are incorrect.

Freely floating currencies are consistent with large, persistent deviations from trade and current account balance. The reason is that freely floating exchange rates are shaped not only by demand for and supply of currency associated with trade but also with the demand for currency associated with investment flows. The recent behavior of the US dollar, which floats freely vis-à-vis the euro, is a case in point. Following President Trump’s election, the euro depreciated by about 6 cents (it fell from $1.10 per euro to $1.04 per euro, before recovering slightly) because of fiscal expansion and corporate tax cuts expected from the Trump administration. This strengthening of the dollar will further increase the German bilateral current account balance vis-à-vis the United States. In this sense, the economic policies expected from President Trump have, over the last few months, done more to raise German competitiveness than any action of the European Central Bank (ECB) or the German government.

Germany chose to adopt the euro more than 20 years ago. Its motive was not to enhance German competitiveness but to strengthen European economic and political integration. Like all other euro members, Germany entered the currency union at the—unmanipulated—market exchange rates prevailing at the time. In fact, the initial consequence of euro membership was not to make Germany more competitive. Quite the reverse: Because of north-south capital flows and faster productivity growth in the poorer euro member countries, Germany quickly became overvalued within the euro area, triggering a recession in 2003. The euro’s undervaluation today is largely a consequence of the euro crisis. So the assertion that German euro membership constitutes currency manipulation is baseless for two reasons: Euro membership did not reflect any decision, on behalf of the German government, to steer its exchange rate in any particular direction. Nor is Germany’s competitiveness a structural feature of euro membership. Euro membership merely implies that the real exchange rate—Germany’s price level relative to others, expressed in a common currency—takes longer to adjust to shocks and crises than would be the case in a floating system.

The new administration’s economic policies toward Europe are not yet clear. As in many other areas, however, the administration has doubled down on a statement that many observers would have put into the category of pre-election hyperbole. As a result, the chances that the US Treasury will label Germany a currency manipulator have increased. But as my colleague Fred Bergsten pointed out in a recent podcast, labeling any country that way does not compel the administration to take any specific measures.

If the diagnosis is that euro membership constitutes currency manipulation, will the administration call for Germany’s exit from the euro? Such an exit would disrupt Europe economically and politically, and wreak havoc on the world economy. Any export gains that the United States might expect from a stronger German currency would be more than offset by the collapse of purchasing power in Europe. Or will Washington impose a tariff specifically on Germany? Doing so would be even more reckless. Not only would it be illegal under World Trade Organization rules but also the European Union would almost surely close ranks and retaliate. The result would be a major trade war.

There is, conceivably, a more hopeful outcome. The United States has complained about the German current account surplus for years, and so has the European Commission. The result of these complaints has been a set of policy recommendations directed at Germany: raising public investment, especially in infrastructure and education at the municipal level; increasing competition in business services; increasing incentives for later retirement; and reducing disincentives to work for second earners. Most of these policies make sense. They would reduce the current account surplus and stimulate growth in Germany and the euro area. Yet, the German government has refused to implement them, partly because of the Ministry of Finance’s obsession with balanced budgets, and partly because these reforms are politically difficult, even—and especially—in Germany. If the Trump administration were to throw its political and economic weight behind these reforms, it would be good for Germany, Europe, and the United States.

Jeromin Zettelmeyer, senior fellow at PIIE, is a former director-general for economic policy at the German Federal Ministry for Economic Affairs and Energy.