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Germany And the Role of Exports In Modern Economies

The list on the right is mostly for fun. But consider the relative rankings of the big 5: US, China, Japan, Germany and UK. Let's pull out the relative rankings for exports to GDP:

Germany	45.6
United Kingdom	28.4
China	22.6
Japan	16.2
United States	13.5

Surprised? I'd wager very few could put these in their proper order. Most would list China first, with maybe Japan second. Very few would guess that Germany was number one, and even fewer would have had them there by such a convincing number -- nearly double the rest.

It isn't well understood that the EU is Germany's private export market. Because of economies of scale, no other member nation can compete with Germany on the number of automobiles, or nearly anything else, produced. Because of the role of technology, a lot of modern production has the tricky economic model of it costs you $1 billion to get the first item off the production line. The remainder of the production run costs $0.25 each. Your average cost per item is hugely tied to how many you can produce and sell. Germany simply produces more goods at a lower cost than the rest of the EU. The rest are limited to specialty markets or ones in which they have a large historical advantage.

There is a second advantage Germany possesses: When they swallowed East Germany from the Soviet Empire in 1991, they made a deal with the labor unions not to raise wages in the west for a while. Even now, wage growth in Germany is lower than the rest of the EU, leaving labor costs below their major competitors. Germany knew exactly what they were doing when the EU was created. The EU prohibits intra-EU tariffs, but allows the EU to erect external barriers to outsiders, like China, Japan and the US. So everyone who is a threat to Germany has artificial barriers to compete. The EU is Germany's private playground.

The problem Germany faces is their markets are tired. Northern Europe is doing OK, but southward there are massive problems. The Greek problems are well-known, but Greece accounts for only about 2% of the EU's GDP. Waiting in the wings to leave are the UK, Spain and Italy. That trifecta would have a massive effect on Germany. Check out my article on China Debt to understand what happens when an export-driven economy suddenly loses markets. It's not pretty.

This is why Germany reluctantly agreed to prop up the Greek economy. No one thinks the current round of support will be sufficient. Helping Greece is not popular with German voters. But Germany was terrified that a Grexit would lead to others following suit. The amount of money to keep the tiny Greek economy afloat while the other economies improve (hopefully) was a much smaller cost than letting other members of the EU see Greece leave the EU and possibly start to do better.

There is an even greater threat to Germany's economy than a shrinking EU. Inflation in the EU is horribly close to zero. Commodity prices across the world are in retreat. We know that crude oil is less than half of what it was a year ago. Copper is down about 25%, ditto for lead, zinc and tin, nickel is about half and aluminum down 20%. Virtually all the commodities needed to manufacture things are down sharply for the year as a result of falling demand around the world. Commodity producing countries like Brazil (-2.26%) are expecting negative growth this year and next.

The threat of falling commodity prices is two-fold: first, it is a sign of structural weakness in the world economy. Particularly for export-driven economies like Germany's, it is bad news. The second issue is one most people don't understand too well -- when consumers worry about deflation, they put off purchasing. If you expect inflation, it is better to buy now than wait when prices are higher. But expect deflation, and consumers put off purchasing, waiting for lower prices. This can be crushing for world economies. Fortunately, no one living today has lived through a long period of deflation. There are a few who suffered for about 5 years during the Great Depression, but there aren't even many who can remember that.

Over the past 800 years there have been four periods of inflation, followed (the first three times) by longer periods of deflation/stability. While prices have averaged about a 1% per year increase, it has been shorter periods of massive inflation followed by longer periods that start out with sharp deflation and flatten out into a period of stability. I am well aware of the "this time it is different" crowd. So are central bankers and they are still terrified. GDP growth in the central group of the EU remains stubbornly below 1%. France and Canada have slipped into recession. The Producer Price Index for the year ending July is negative .8%. China's stock market remains a horror show, threatening economies all across the globe. Unlike most of the last 65 years, not a single central banker is worried about inflation. The are praying for it.

If you think central bankers aren't worried about deflation, then why are world interest rates at virtually zero? When we had inflation in the 1970's we also had double-digit interest rates. Remember? We have zero percent interest rates today because central bankers expect inflation to be zero. Actually, they don't expect that. They *hope* for that and fear that any deviation will be negative (deflation). Over the past 5 years, almost every central bank forecast of inflation from every industrial nation on earth has been wrong -- in some cases massively wrong. And not a single one guessed too high.

To get an idea of how devastating deflation can be, consider the fate of Japan for the past 25 years. The recession of 1990, while hardly a blip on most world economies, tipped over Japan's economy. The minor recession caused lower than expected exports, which caused Japan's major corporations to slip into negative equity. Banks were forced to call in loans, which forced corporations to sell off most of their non-Japan holdings that had been acquired during the boom. Then they were forced to shutter factories and lay off workers. Real estate prices dropped in Japan and the NIKKEI 225 stock market index plunged from just under 40,000 to about 14,000 in 1995. Imagine if your retirement portfolio declined by 60%. Even now in 2015, the NIKKEI is still fluttering around 20,000, about half of its value 25 years ago. Put it into perspective, it took 26 years from the US peak of 1929 to be surpassed in 1955 -- and this was with World War II sandwiched in the middle. At about the same time, Japan is about half of the all-time high. Japan has been suffering deflation for 25 years as the economic bubble has been squeezed out of its economy.

If this is, indeed, the end of our 119 year inflationary session, the next few years promise to be a horror show. We hope the world economic stage can remain stable enough for us to get by this crisis. While a deflationary spiral will be exceedingly harmful for all the economies of the world, it will hit the large exporters the hardest, as it did th US in the 1930's. But wherever you live, it won't be pleasant.

September 13, 2015

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