The biggest threat Germany and Europe have identified overseas goes by the name of IRA (Inflation Reduction Act) and is the pride and joy of the Biden administration. It is by no means only about reducing inflation, first and foremost it is about reducing the dependence of the US on foreign imports. China is at the forefront of this, but Europe is by no means off the hook either. The recent joint trip to Washington by the German and French economy ministers shows that they are trying to limit the damage to Europe.

What is at stake is not easy for Europeans, and especially Germans, to understand because they have been telling themselves for decades that they are the greatest free traders of all in spirit and in deed. The fact that free trade can never be a one-way street is impossible to convey to them. Only when they are world market leaders in pretty much every product imaginable the world will be in good shape. The fact that the countries that are not world market leaders everywhere see this less positively and want to change it is, in their understanding, only because the others are protectionists in disguise.

Surpluses and deficits

Sometimes a few numbers are worth a thousand words: the American current account deficit, roughly speaking the balance of exports and imports of goods and services, amounted to 217 billion US dollars in the third quarter of 2022. Europe also recorded a deficit in the same period, but only one of €90 billion. However, this is at most half the truth. In the third quarter of 2021, the American deficit was also 220 billion, but the Europeans recorded a surplus of almost 75 billion. If you go back ten years, you will see that the Europeans always had surpluses and the Americans always had deficits. You can also go back 40 years with the USA and you will find large deficits almost every quarter and almost every year.

Now Europe is a heterogeneous entity and it is by no means the case that all countries have surpluses. However, the largest European country, Germany, had an annual surplus from 2004 onwards that was over €100 billion. Since 2014, the €200 billion per year has been exceeded and between 2015 and 2021, the German surplus was even always over €250 billion. Only last year, the enormous price increase of imported raw materials (the deterioration of the so-called terms of trade) led to a halving of the German surplus. Besides Germany, the Netherlands is the second chronic surplus country.

Surpluses are not a sin, Germany is always saying, they are just proof that the division of labour works: Some are more efficient than others, and if the products of the more efficient are bought more often than those of the less efficient, that can only be good for everyone in the end. This overlooks one small point, namely the basic principle on which the entire idea of free trade and even the market economy rests.

Companies and countries

Companies that want to be successful in international trade can gain absolute advantages over their competitors. They must then be cheaper for the same quality of product, which is achieved precisely through innovation and higher productivity. This means that competition between companies in the international arena is no different than at the national level. The absolute advantages create incentives for other companies to imitate and eventually catch up with the successful competitor.

However, what is true for companies vis-à-vis other companies cannot be true for countries vis-à-vis other countries. If many companies in a country are efficient, i.e. successful in the sense of an increase in productivity, wages in the country as a whole will rise so much under reasonable economic conditions that the productivity advantage no longer works in favour of the companies in that country in an international comparison. Higher nominal wages compensate for higher productivity. Despite the higher productivity, unit labour costs and prices then rise just as much in the “efficient” countries as in the countries with lower productivity growth. The “efficient” country cannot rely on absolute advantages and higher competitiveness. Only its standard of living rises faster than elsewhere.

If, however, wages do not rise in the country that has advantages in productivity, inflation differentials between countries result, which bring absolute advantages for all companies in a country, regardless of whether the individual companies are efficient or not. The fundamental principle that only those companies that are actually more productive than their competitors can temporarily gain absolute advantages is then broken.

Trade and finance belong together

Therefore, all inflation differentials, no matter what their causes, must necessarily be compensated by the monetary system. The currencies of countries with low inflation rates must appreciate and vice versa. Only with constant real exchange rates, i.e. constant competitive positions of countries, is the free trade doctrine at all compatible with the principles that also apply within national economies. The positions of companies change at constant real exchange rates in the same way as in a single market. This preserves the benefits of competition without causing entire societies to fall behind and fall into economic distress. Location competition of countries is a bad violation of free trade and of the idea of fruitful competition of companies in general.

Fifty years after the end of the Bretton Woods system, it is important to understand, especially in the surplus countries, that trade and finance cannot be separated. The global trading system must be complemented by a monetary system that ensures that no country has absolute advantages or disadvantages in the long run. This means that no country should have permanent current account deficits and none should have permanent current account surpluses. Deficit countries like the USA are legitimised to take all kinds of measures to reduce deficits, even those that in themselves have a protectionist effect.

Germany must reduce its surpluses…

Germany gained absolute advantages in the early 2000s under the guise of the euro by not raising wages as much as they should have for years, given German productivity growth and the European inflation target. Since the valuation of the euro was based on the average of European inflation rates, German wage dumping was not offset by a corresponding appreciation of the euro. This created an absolute advantage over the Europeans who were members of EMU and over all other trading partners.

The surpluses created jobs and income in Germany at the expense of its trading partners. What weighs even more heavily in the corset of the European Monetary Union is that it was the foreign debt that went hand in hand with the surpluses that allowed Germany to keep the debt of its own national budget within narrow limits over the past ten years. All countries that, like France and Italy, could not rely to a similar extent on foreign debt, had to use public finances much more to stabilise the national economy and collided with the rule on debt limitation in the European treaties.

…and find a domestic economic development strategy

Europe needs a new beginning that, as in the USA, focuses on the domestic market and less on the world market. But this can only succeed if Germany leads the way with a completely new economic policy orientation. The incomes of the great mass of people must be put into the foreground. What is needed is not the best low-wage sector in the world, as a Social Democratic chancellor once proudly called it, but the best participation of all citizens in economic progress.

If social democrats would finally understand what the economy is all about, that would be a truly social democratic programme. Social balance is not only good for the social conscience, it is the decisive prerequisite for successful economic activity. However, one has to say goodbye to dogmas about international trade. If the American IRA gave an impetus to this, it could be beneficial for Germany and Europe.