Thursday, 23 October 2014

IS/LM in the Eurozone and Germany´s surplus

The title is a reference to Lance Taylor´s seminal “IS/LM in the Tropics”[1] , the diagrammatic tool stems from Jeffrey Frankel´s paper on optimal sterilization policies in emerging countries, a debate to which I contributed almost a quarter of a century ago[2]. However, quite exceptionally for this blog, this entry is neither on the tropics nor on emerging countries. It is on the dismal zone, better known as Eurozone. The model will illustrate Bundesbank boss Jens Weidmann´s cynical statement about the Euro borrowed from Fisherman´s Friends drops and applied to the Euro: “Ist er zu stark, bist Du zu schwach”[3].

Germany has maintained a large surplus on the current account of its balance of payments – oscillating between six and eight percent of GDP in recent years - although the Eurozone outside Germany weakened, China´s merchandise imports stagnated and other large emerging markets (Russia, Brazil) were in trouble. As demonstrated by Patrick Artus´ team at Natixis Economic Research, the German surplus can be explained neither by a drop in its domestic demand (as is often done) nor by improved terms of trade. It is largely due to improved market shares and trade balances with the United States, Japan, non-euro-zone Europe and China, which has offset the deterioration in its trade position in the euro zone. As will be shown below, Germany´s hyper competitiveness slows down the depreciation of the Euro, required by the rest of the Eurozone to make it a bit less dismal.

IS/LM in the Eurozone

The Eurozone is illustrated by the familiar textbook macroeconomic general-equilibrium model, with the IS, LM, and BP curves denoting goods market, money market and balance of payments equilibrium, respectively. Demand for output Y is shown on the horizontal axis, with the price level predetermined in the short run. A move to the right on the y-axis thus denotes only employment gains (and no inflationary pressure), a move to the left employment losses. Y is the sum of domestic aggregate demand and the trade balance (net foreign demand for domestic output). The interest rate i is presented on the vertical axis; as the Eurozone has open capital markets, the interest rate i is equal to i*, the international rate. The overall balance of payments, BP, the sum of the trade balance and the capital account, is horizontal: the capital account rules, the current account follows, and a rise in i above i* sucks in infinite capital inflows (as long as the Eurozone is still ´investible´).
Germany´s surplus is so huge that it translates into a surplus of the Eurozone. The IS curve shifts to the right as the trade balance improves, putting upward pressure on the interest rate and therefore on the capital account. As the Euro is a flexible currency (outside the Eurozone), money inflows (not trade) will appreciate the Euro. In the model, the currency will appreciate far enough to return the trade balance, the IS curve, and domestic aggregate demand back to point A. In plain words, Germany´s improved trade balance has to be ´paid´ by even more depressed demand in the rest of the Eurozone. Maybe, Jens Weidmann should have said: “Is Germany too strong, it should abstain from using the Euro”?

[1] Lance Taylor (1981), „IS/LM in the Tropics: Diagrammatics of the New Structuralist Macro Critique”, Economic Stabilization in Developing Countries, Vol 502, Brookings Institution, Washington DC.
[2] Jeffrey Frankel (1997), „Sterilization of Money Inflows: Difficult (Calvo) or Easy (Reisen)?“, Estudios de Economía, Vol. 24.2, December, pp. 263-285.
[3] Interview Jens Weidmann „Ist er zu stark, bist Du zu schwach“,  in Süddeutsche Zeitung, 22.5.2014; see