Germany's Surplus Isn't the Problem

By SIMON NIXON

Nov. 10, 2013 9:06 p.m. ET

The Wall Street Journal

On almost any measure, the euro zone is in better shape than a year ago—and much better shape than many expected, not least those who were predicting its imminent collapse.

The currency bloc is out of recession; Spain and Portugal are growing; the Greek government expects growth to return next year. Yields on peripheral government bonds have fallen sharply. And the euro zone is embarking on a major integration project—banking union—that it hopes will restore confidence in the region's banking system and allow credit to flow again.

But every silver lining has a cloud. In recent weeks, critics have identified a new euro-zone fault line: Southern Europe, they say, is being strangled by a combination of deflation and German mercantilism. The U.S. Treasury last week pointed to Germany's vast current-account surplus of 7% of gross domestic product in 2012 as evidence that the country should be doing more to boost domestic demand and reduce its reliance on exports at a time when other euro-zone countries are being forced to implement austerity policies.

But to some European eyes, this new assault is as misdirected as past criticism of the euro zone's crisis response. It's true that annual euro-zone inflation fell to just 0.7% in September, well below consensus forecasts of 1.2%. That prompted the European Central Bank to cut its refinancing rate to just 0.25%. But few economists think the euro zone is on the brink of a Japanese-style deflationary spiral in which consumers hold off purchases in expectation of falling prices.

The euro zone's current low inflation is different. To the extent that low inflation in Southern Europe is the result of domestic policy as opposed to external factors such as the recent fall in energy costs, it partly reflects consumer prices adjusting to falls in real wages. This is healthy. In a currency union, falling labor costs are one of the main ways countries can regain competitiveness. It would be more worrying if wages were falling and prices still rising—as they have been in Greece—since this indicates a lack of flexibility in markets and a rising burden of private-sector debt.

Of course, it doesn't help that the euro appreciated over the summer. But euro-zone policy makers blame this largely on the U.S. Federal Reserve's decision to keep printing money alongside concerns that the U.S. might even default on its debts. The best help the U.S. could give Southern Europe would be to stop weakening the dollar.

What is less certain to help Southern Europe is action by Berlin to reduce Germany's current-account surplus. German policy makers are bemused by the suggestion that Germany's surpluses pose a similar problem to those of China in the last decade. After all, Germany doesn't operate a fixed exchange rate and isn't accumulating vast official reserves. Its surpluses are the result of competitiveness gains painfully achieved via a decade of reform and wage restraint during the years when it was seen as the "sick man of Europe."

What does the U.S. want Germany to do? Quit the euro? Make itself uncompetitive again, perhaps by forcing up wages? How would that help Southern Europe? Indeed, in an increasingly integrated single market, focusing on Germany's surplus in isolation is simplistic. Other member states have benefited from German competitiveness gains because they are integrated into Germany's supply chain or have received direct German investment.

Perhaps the Treasury thinks Germany could help Southern Europe by embarking on a public-spending splurge? But Germany fiscal policy is hardly contractionary: Whatever government emerges from the current coalition talks is likely to pursue a balanced budget. Only the most fervent Keynesians would argue that Germany, with a government debt-to-GDP ratio of 82%, has fiscal space to fund a stimulus package. It's hard to find policy makers in Southern Europe clamoring for a new German road-building program.

Besides, this focus on Germany's current-account position risks obscuring the real issues. A sustained recovery in Southern Europe hinges on businesses having the confidence to start investing again after five years of underinvestment, including in Germany. This in turn will give consumers the confidence to start spending, causing deflationary pressures to ease and Germany's current-account deficit to shrink.

But for businesses to start spending, they need confirmation that governments are serious about tackling the root causes of the crisis: That means creating a credible banking union and pushing ahead with structural overhauls to boost competitiveness.

Both objectives currently hang in the balance. Over the next few weeks, euro-zone leaders face difficult decisions on bank resolution arrangements and common backstops for the ECB's forthcoming comprehensive assessment and stress testing of bank balance sheets. Done properly, this exercise will drive the recapitalization and restructuring needed to revive funding markets and ensure banks are able to support a recovery.

Indeed, there are signs that in some countries, efforts to clear up the banking system are already delivering results. The recent fall in Spanish bank deposit rates may deliver a bigger economic boost than last week's ECB rate cut as it feeds directly to bank profits and the pricing of new loans, while the surge in investor appetite for Spanish assets will help banks deleverage. But other peripheral-country banking systems remain stressed.

Meanwhile progress on reforms has been patchy: Spain has gone furthest toward restoring its competitiveness, reflected in buoyant exports; Portugal and Greece have also made valuable changes. But Italy has failed to make any improvement to its competitiveness or productivity since the start of the crisis.

But this too may be changing: The current Southern European governments know what they need to do—and they have all survived political crises this year and appear to be much more stable than seemed possible a few months ago. Even in Italy, some argue that the waning influence of former Prime Minister Silvio Berlusconi is creating political space for more radical reforms.

Even so, the domestic obstacles to reform are considerable. Recent history suggests external pressure can certainly play a useful role in pushing Europeans to act decisively. But those efforts would be better directed to urging weak economies to make themselves strong, rather than urging Europe's strongest economy to make itself weak.

Write to Simon Nixon at simon.nixon@wsj.com