At the NATO meetings late last month, the German media reported that President Trump had called the Germans “bad” for running trade surpluses with the U.S. The president threatened trade restrictions, focusing on German automobiles. Needless to say, this comment caused a minor international incident.
Although such incidents come and go, it did generate a more serious question…are German policies causing problems for the world? In this report, we will review the saving identity we introduced in last month’s series on trade and discuss how Germany has built a policy designed to create saving. We will move the discussion to the Eurozone and show the impact that German policy has had on the single currency. From there, we will try to address the question posed in the title of this report. We will conclude, as always, with market ramifications.
The Saving Identity
In the month of May, we published a four-part report on trade that is now combined into a single report.1 In that report, we introduced the saving identity.
(M – X) = (I – S) + (G – Tx)2
The saving identity states that private sector domestic saving (I – S) plus public sector saving (G – Tx) is equal to foreign saving. If a country is running a positive domestic savings balance, either by investing less than it saves or by running a fiscal surplus, it will run a trade surplus (X>M). In public discussion, trade appears to be all about jobs, relative prices, trade barriers, etc. However, regardless of how nations interfere with trade, the saving identity will always be true. As we noted in the aforementioned report, tariffs, exchange rate manipulation and administration barriers will, in the final analysis, be explained through the saving identity.
In the process of economic development, nations must build productive capacity through investment. Both public and private investment are necessary for success. Public investment in infrastructure, roads, bridges, canals, etc., are critical to supporting private investment. In capitalist societies, a legal framework to adjudicate contract disputes and support the enforcement of agreements is also necessary and mostly provided by the public sector. Private investment usually occurs along with public investment. But, all investment requires funding, which comes from saving. That saving can come from both domestic and foreign sources.
Usually, nations that are building productive capacity create policies that either generate domestic saving or attract foreign saving. There are various policies that can support the effort to build saving. Trade restrictions can restrain consumption by raising import prices. High taxes are sometimes used to create public saving; savings schemes to funnel household saving into the private market are also used. And, through a trade deficit, foreign saving can be acquired.
Depreciate the dollar: The administration could start “jawboning” the dollar lower through public pronouncements and could intervene directly in the currency markets to push the dollar lower. However, the most effective way to weaken the dollar would be to deliberately appoint dovish governors to the FOMC. President Trump has three openings on the committee now and will likely have two more next year. By filling the committee with governors committed to reflating the economy, the dollar would likely weaken and improve American trade competitiveness.
Of the three, we believe the most likely is currency depreciation. A stronger euro would lead to a narrower trade deficit with the Eurozone and avoid the political problems and retaliation that come with trade barriers. Given Germany’s preference for a strong currency, we would not expect much pushback from Berlin. A weak dollar policy would be opposed by the establishment wing of the GOP but the nationalist wing would likely come to embrace such a policy. For this reason, investors should probably expect a weak dollar policy to evolve in the coming months.