Beware of False Arguments: The Strong Euro Will Hurt
By Dr. Sebastian Dullien

In the economic policy debate, Germans tend to extrapolate their current situation indiscriminately into the future. When the economy hardly grew at all in 2002 and 2003, German economists and journalists were quick to estimate potential growth to be "below one percent." Now, with exports having grown strongly over a number of years, it is argued that the strong Euro will not hurt German exporters even at a level of $1.60. Unfortunately, the arguments for complacency towards the Euro are as dubious as those on the structural inability of the German economy to grow were five years ago.

The best example for the view of the German export sector being made from Teflon and thus invincible to a higher exchange rate comes from my former colleagues at Financial Times Deutschland (FTD)which last week published a whole page under the heading "Gute Zeiten" ("Good times"). [Note: The Euro optimism is not limited to FTD - other papers do it as well. However, the FTD piece had all the arguments most nicely summed up, but they creep up in editorials from the Frankfurter Allgemeine Zeitung to Handelsblatt.]

Basically five arguments are usually brought forward why the appreciation is harmless from a German point of view:

1. German exports are so unique that the demand for them abroad is highly (or totally) price inelastic. Experts now often cite the capital goods industry; the FTD had an example of a company making cuckoo clocks.
2. More than 40 percent of German exports are sold to our partners in the EMU and hence not influenced by the Euro exchange rate.
3. About 80 percent of purchases outside the Euro area are invoiced in Euros.
4. 75 percent of the exports not invoiced in Euro are hedged.
5. German manufacturing profits from lower oil prices as they are denominated in dollars which in turn helps them to remain competitive in the world market.

However, looking at those five arguments more in detail shows that all this might contribute to some lag between the Euro appreciation and the moment when the export sector feels the pinch, but none of them really lets one conclude that the German economy is immune to the Euro:

1. Even if German products are rather unique, I find it quite implausible that demand for them is supposed to be totally price inelastic. The depreciation of other currencies not only leads to a price effect of German exports, but also to an income effect: if they have to spend more on imports thanks to the lower dollar exchange rate, they have less real income. I cannot think of any product the demand for which is both inelastic with regard to its price and with regard to the buyer's income. Moreover, if demand for German products is that price inelastic, one should ask why German exports did so much worse than today in the 1990s. Did German companies sell entirely different products then? In addition, if export firms can keep their sales volumes and market shares up regardless of a 20 percent price increase, why haven't companies increased prices when the dollar was weak which could have boosted their profits? Is German corporate management really that incompetent not to notice that demand for their products is price-inelastic?
2. Even if 40 percent of German exports go to the rest of EMU, this does not mean that these exports are immune to a strong Euro. First, German products sold in France of course compete with imports from the U.S. into the French market. Second, if the Spanish or French economy slows due to the Euro appreciation, demand for German products there will also be hit.
3. Even if 80 percent of German exports outside the Euro area are invoiced in Euros, there still will be the price effect. Of course, the exporters do not lose money on the goods already ordered. But demand in the future will certainly be weaker (see above).
4. The hedging: yes, at the moment, 75 percent of the exports outside the Euro area might be hedged. But the nature of hedging is that you cannot do this too far into the future, meaning that most companies have not hedged their revenue further than maybe into 2009. And if you now try to hedge some sales for 2009, your bank or counterparty will take the current level of the Euro-dollar exchange rate into account.
5. Measured in Euros, German manufacturing firms may pay less for their oil. But this doesn't matter for the question whether you gain competitiveness relative to U.S. companies. Everyone is paying the same for oil in dollar terms. Depreciation of the dollar just makes the additional value added in EMU more expensive than that in the U.S. Hence, EMU companies lose competitiveness. You cannot discuss this point away.

This all does not mean that an economy might not thrive in face of an appreciation of its currency. We have seen in the U.S. in the past decade that an economy can grow briskly even in face of a strong currency if domestic demand is growing strongly. However, exactly this is not yet the case in Germany. It is very hard to imagine a situation where the export sector is immune to a strong appreciation. No matter what the optimists are saying now, at some point, the strong Euro will come back to haunt the German manufacturing industry.

Dr. Sebastian Dullien was a DAAD/AICGS Fellow in January-February 2007 and is currently a professor of international economics at the University of Applied Sciences in Berlin.

This essay originally appeared in the Eurozone Watch blog and later in the May 2, 2008, AICGS Advisor.