EUROPEAN ECONOMY. What drives the German current account? And how does it affect other EU member states?

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1 ISSN (online) ISSN 6-86 (prin) EUROPEAN ECONOMY Economic Papers 56 April 24 Wha drives he German curren accoun? And how does i affec oher EU member saes? Rober Kollmann, Marco Rao, Werner Roeger, Jan in Veld, Lukas Vogel Economic and Financial Affairs

2 Economic Papers are wrien by he saff of he Direcorae-General for Economic and Financial Affairs, or by expers working in associaion wih hem. The Papers are inended o increase awareness of he echnical work being done by saff and o seek commens and suggesions for furher analysis. The views expressed are he auhor s alone and do no necessarily correspond o hose of he European Commission. Commens and enquiries should be addressed o: European Commission Direcorae-General for Economic and Financial Affairs Uni Communicaion B-49 Brussels Belgium ecfin-info@ec.europa.eu LEGAL NOTICE Neiher he European Commission nor any person acing on is behalf may be held responsible for he use which may be made of he informaion conained in his publicaion, or for any errors which, despie careful preparaion and checking, may appear. This paper exiss in English only and can be downloaded from hp://ec.europa.eu/economy_finance/publicaions/. More informaion on he European Union is available on hp://europa.eu. KC-AI-4-56-EN-N (online) ISBN (online) doi:.2765/6995 (online) KC-AI-4-56-EN-C (prin) ISBN (prin) doi:.2765/776 (prin) European Union, 24 Reproducion is auhorised provided he source is acknowledged.

3 European Commission Direcorae-General for Economic and Financial Affairs Wha drives he German curren accoun? And how does i affec oher EU member saes? (*) Rober Kollmann (ECARES, Universié Libre de Bruxelles and CEPR), Marco Rao (JRC, EU Commission), Werner Roeger, Jan in Veld and Lukas Vogel (DG ECFIN, EU Commission) Absrac We esimae a hree-counry model using daa for Germany, he Res of he Euro Area (REA) and he Res of he World (ROW) o analyze he deerminans of Germany s curren accoun surplus afer he launch of he Euro. The mos imporan facors driving he German surplus were posiive shocks o he German saving rae and o ROW demand for German expors, as well as German labour marke reforms and oher posiive German aggregae supply shocks. The convergence of REA ineres raes o German raes due o he creaion of he Euro only had a modes effec on he German curren accoun and on German real aciviy. The key shocks ha drove he rise in he German curren accoun ended o worsen he REA rade balance, bu had a weak effec on REA real aciviy. Our analysis suggess hese driving facors are likely o be slowly eroded, leading o a very gradual reducion of he German curren accoun surplus. An expansion in German governmen consumpion and invesmen would raise German GDP and reduce he curren accoun surplus, bu he effecs on he surplus are likely o be weak. April 5, 24 JEL Classificaion: F4, F3, F2, E3. Keywords: Curren Accoun, inra-european imbalances, moneary union, Eurozone crisis, esimaed DSGE model (*) The views expressed in his paper are hose of he auhors and should no be aribued o he European Commission. This is he preliminary version of a paper prepared for he 59h Panel Meeing of he journal Economic Policy (CEPR, CES, PSE/ENS), April 24. We are very graeful o Refe Gürkaynak and o hree anonymous referees for deailed and consrucive commens. We also hank Caerina Mendicino and Gábor Pellényi for useful discussions. Helpful commens were also received from Tobias Cwik, Maria Demerzis, Mercedes De Miguel Cabeza, Jakob Friis, Beina Kromen and from workshop paricipans a he EEA, VfS and DYNARE conferences, and a he ECB, Naional Bank of Hungary, Swiss Naional Bank and LUISS (Rome). Research suppor from Jukka Heikkonen, Chrisoph Maier and Bearice Paaracchia is also graefully acknowledged. addresses: rober_kollmann@yahoo.com, marco.rao@jrc.ec.europa.eu, werner.roeger@ec.europa.eu, jan.inveld@ec.europa.eu, lukas.vogel@ec.europa.eu EUROPEAN ECONOMY Economic Papers 56

4 . Inroducion Germany experienced a specacular curren accoun (CA) reversal, afer he launch of he Euro (999). In he 99s, he German curren accoun was in defici, bu close o balance however, in he early 2s, he curren accoun shifed o seadily increasing surpluses, visà-vis boh he res of he Euro Area (REA) and he res of he world (ROW). During he financial crisis, German capial flows o he REA fell abruply, bu he overall German curren accoun surplus bounced back rapidly and reached record levels--85 bill. EUR in 22, i.e. 7 of German GDP--due iner alia o a rise in he surplus vis-à-vis Asia. As a resul, Germany has become one of he major surplus counries in he world. These developmens are currenly a he hear of heaed debaes abou he role of he German surplus and of inra-euro Area exernal imbalances for he crisis and he slow recovery in Europe (see Lane (22), Chen, Milesi-Ferrei and Tressel (22) and Hobza and Zeugner (23) for discussions of inra-ea imbalances). On Ocober 3, 23, he U.S. Treasury sharply criicized Germany s exernal surplus: Germany s anemic pace of domesic demand growh and dependence on expors have hampered rebalancing a a ime when many oher euro-area counries have been under severe pressure o curb demand and compress impors in order o promoe adjusmen. The ne resul has been a deflaionary bias for he euro area, as well as for he world economy (U.S. Treasury (23), p.3). In he Treasury s view: To ease he adjusmen process wihin he euro area, counries wih large and persisen surpluses need o ake acion o boos domesic demand growh and shrink heir surpluses (p.25). The German Governmen swifly rejeced he US criicism. The German Economics Minisry saed ha The Trade surpluses reflec he srong compeiiveness of he German economy and he inernaional demand for qualiy producs from Germany (Wall Sree Journal, Ocober 3, 23); he German Finance Minisry argued ha he German curren accoun surplus was no cause for concern, neiher for Germany, nor for he Eurozone, or he global economy, and ha On he conrary, he innovaive German economy conribues significanly o global growh hrough expors and he impor of componens for finished producs (Financial Times, Ocober 3, 23). The IMF has likewise repeaedly expressed concerns abou he German exernal surplus, and argued ha sronger and more balanced growh in Germany is criical o a lasing recovery in he euro area and global rebalancing (IMF Execuive Board, Augus 6, 23a). By conras o he U.S. Treasury, he IMF s policy advice ceners on srucural reforms in he German economy, such as measures o increase he produciviy of he service secor and labour force paricipaion. The European Commission oo advocaes supply side policies for Germany ha srenghen domesic sources of poenial growh agains he background of unfavourable demographic prospecs (European Commission, Aler Mechanism Repor 24, November 23). In November 23, he persisen German curren accoun surplus riggered an In-Deph Review by he EU Commission, under he Commission s Macroeconomic Imbalances Procedure. The resul of he review were published in March 24 and concluded ha he German surplus consiues an imbalance (see Box on he Macroeconomic Imbalances Procedure below). 2 The goal of his paper is o shed ligh on hese policy issues, using a sae-of-he-ar macroeconomic model. Economic heory suggess ha a counry s curren accoun reflecs domesic and foreign macroeconomic and financial shocks, and he srucural feaures of he domesic and foreign economies. An undersanding of hose shocks and srucural properies Throughou his paper, he erm Euro Area (EA) refers o he 7 counries ha were members of he Euro Area in 23. REA is an aggregae of he EA less Germany. 2 The German exernal surplus has also widely been discussed in he media. Prominen criics of he surplus include Krugman (23) and Wolf (23). 2

5 is hus crucial for posiive and normaive evaluaions of he curren accoun, and for policy advice (Obsfeld and Rogoff (996), Obsfeld (22), Kollmann (998, 2, 24)). This underscores he imporance of analyzing he curren accoun using a srucural model ha capures he relevan shocks, and heir ransmission o he macroeconomy. This paper herefore sudies he German curren accoun using an esimaed Dynamic Sochasic General Equilibrium (DSGE) model wih hree counries: Germany, he REA and he ROW. The model is esimaed using quarerly daa for he period 995q-23q2. The model assumes a rich se of demand and supply shocks in goods, labour and asse markes, and i allows for nominal and real rigidiies, and financial fricions. 3 Several hypoheses abou he causes of Germany's exernal surplus have been debaed in he policy and academic lieraure. Those causes have mosly been discussed separaely, alhough in realiy hese drivers can operae joinly. Our esimaed model allows us o recover he shocks ha drive he German exernal balance and, hence, we can deermine wha shocks maered mos, and when. The model also allows us o assess wha policy measures migh bes be suied for changing he German exernal surplus. We devoe paricular aenion o he following poenial causes of he German exernal surplus: (i) In he run-up o he Euro ( ), REA ineres raes converged o German raes, an indicaion ha he Euro led o greaer financial inegraion in Europe; i has frequenly been argued (e.g., Sinn (2) and Hale and Obsfeld (23)) ha greaer financial inegraion riggered capial flows from Germany o he REA. (ii) A second widely discussed facor was he srong growh in emerging economies during he pas wo decades--german expors may have benefied paricularly from he rising demand for invesmen goods by emerging economies, given German s specializaion in he producion of hose goods; srong growh in emerging economies may have also have added o inra-ea imbalances by increasing compeiion for expors from he EMU periphery (e.g., Chen e al. (22)). (iii) The growh of ousourcing by German firms o low wage counries (noably in Easern Europe), and he German labour marke liberalizaion during he period 22-25, have ofen been viewed as facors ha raised German labour supply, and resrained German wage growh, hereby boosing German compeiiveness (e.g., Dusmann e al. (24)). (iv) Finally, i has been argued ha depressed German domesic demand (as poined ou above), and hus a high saving rae, are key drivers of he German surplus; high saving may parly reflec German households concerns abou rapid populaion ageing, following pension reforms (2-24) ha markedly lowered sae-funded pensions, and creaed ax incenives for privae reiremen saving (Deusche Bundesbank (2), Huefner and Koske (2)). Fiscal consolidaion in Germany afer he financial crisis may also have conribued o weak domesic demand (Lagarde (22), IMF (23b), in ' Veld (23)). Our empirical resuls sugges ha all of hese facors played a role in driving he German exernal surplus, bu ha heir quaniaive imporance and iming differed markedly. Mono-causal explanaions of he German surplus are, hus, insufficien: he surplus reflecs a succession of disinc shocks. According o he esimaed model, greaer financial inegraion (narrowing of he REA-German ineres rae spread) had a posiive effec on aggregae demand in he REA, which boosed REA and German GDP and raised he German curren accoun. However, quaniaively, hese effecs are raher modes, and hey operaed mainly during he lae 99s and early 2s; hus, REA-German ineres rae convergence canno explain he persisence of he rise of he German exernal surplus. We find ha srong ROW growh conribued posiively o German and REA GDP and ne expor he effec of ROW growh was sronger 3 Earlier applicaions of similar models can be found in in Veld, Raciborski, Rao and Roeger (2), Kollmann, Roeger and in Veld (23) and Kollmann, Rao, Roeger and in Veld (23). 3

6 han ha of ineres rae convergence, and i mainly affeced he German exernal balance beween he early 2s and he global recession. German labour marke reforms had a marked effec on German GDP and he German curren accoun, afer 27; hese reforms also had a posiive, bu much weaker, effec on REA GDP (due o sronger German demand for REA expors), and a weak negaive effec on REA ne expors. According o our esimaes, posiive shocks o German privae saving srongly depressed aggregae demand in Germany afer he mid-2s and lowered German GDP, while raising he German curren accoun; hese shocks also simulaed aggregae demand in he REA (due o a fall in ineres raes). All in all, he key shocks ha drove German real aciviy and he German curren accoun only had a minor effec on real aciviy and inflaion in he REA. In oher erms, real aciviy in he REA was largely driven by domesic facors raher han by German economic condiions. The key supply and demand shocks ha kep he German surplus a a high level likewise only had a weak effec on inflaion in he REA. The model also allows us o make predicions abou he fuure pah of he German exernal balance. The rise in he ineres rae spread beween he REA and Germany since he sovereign deb crisis, and pressure oward labour marke reform in he REA sugges a gradual reducion of he German curren accoun surplus. Also he effecs of labour marke reforms enaced in Germany during he early 2s are likely o be gradually eroded by higher German real wage growh, signs of which are already becoming visible (e.g. he new German Federal Governmen eleced in he Fall of 23 plans o inroduce a minimum wage law). The German fiscal sance is also likely o become less resricive, allowing a reversal of he rend decline in public invesmen. And given low ineres raes in Germany, residenial invesmen is also likely o pick up. Wha ligh do hese resuls shed on he policy debae abou he German surplus? Our findings are consisen wih he view ha adverse shocks o domesic demand were key drivers of he surplus, especially afer he mid-2s. Our analysis also suppors he official German view ha srong exernal demand and German compeiiveness gains (wage moderaion and echnological improvemens) were imporan sources of he German exernal surplus. However, srong exernal demand and German compeiiveness gains explain, a mos /3 o /2 of he surplus; srong exernal demand maered mainly before he financial crisis, while wage resrain induced by labour marke reforms conribued o he German surplus afer he mid-2s. The relaive role of hese facors has hus varied grealy across ime. Posiive shocks o he German saving rae have been especially imporan since he mid-2s. The view ha German labour marke reforms represened wage dumping a he expense of foreign economies (e.g., Flassbeck (22)) is no consisen wih our esimaion resuls, due o he very modes effecs of he reforms on real aciviy in he res of he Euro Area. Our analysis suggess ha srucural reforms o raise produciviy and labour supply in he res of he Euro Area would benefi he REA economies, and also lower he German exernal surplus. Boosing German governmen consumpion would only have a modes simulaive effec on German GDP, on he German curren accoun, and on REA GDP. Increases in German governmen invesmen would boos German oupu much more, bu would lead o an even more modes fall in he curren accoun. Measures ha raise German wages would lower German GDP and he German curren accoun. Addiional srucural reforms o boos German aggregae supply would end o furher raise he German exernal surplus, in he shor and medium erm--which conrass wih he ofen-held view ha such measures would lower he German surplus (see above). The presen paper is relaed o a vas empirical and heoreical lieraure ha has sudied sudden sops, i.e. episodes in which large and persisen curren accoun deficis 4

7 suddenly come o an end, due o a drop in foreign capial inflows (e.g. Milesi-Ferrei and Razin (998), Adale and Eichengreen (27), Mendoza (2), Fornaro (23)). By conras, he paper here analyzes a rapid and persisen curren accoun surge ha follows a prolonged period of curren accoun balance. In erms of relaed academic lieraure, i can be noed ha several papers have analyzed he dynamics of he curren accoun using wo-counry DSGE models (e.g., Kollmann (998), Erceg e al. (26)); by conras o he paper here, ha lieraure has ypically used calibraed (no esimaed) models, and i has absraced from housing markes and he key financial fricions considered in he presen model. Jacob and Peersman (23) sudy he deerminans of he US curren accoun defici, using an esimaed wo-counry model; ha model oo absracs from housing and financial fricions. The paper here also differs from hese sudies, by considering a hree-counry se-up. A key advanage of ha seup is ha a German rade surplus does no necessarily lead o a rade defici of he same size in oher EA counries (as would be he case in a sandard wo-counry model). Empirically, he REA rade balance is no a perfec mirror image of he German TB. Also, he REA is a less imporan rading parner for Germany han he ROW; he share of expors o he REA in German expors fell from 46 in 995 o 36 in 22, while he share of he EA in German impors fell from 47 o 37. Secion 2 describes Germany s exernal balance and macroeconomic condiions in Germany, he REA and he ROW, during he period Secion 3 provides a brief overview of our model. Secion 4 presens he model esimaes. Secion 5 concludes. 5

8 Box on Macroeconomic Imbalances Procedure: Drawing lessons from he financial and economic crisis, he European Commission has srenghened macroeconomic surveillance by inroducing he Macroeconomic Imbalances Procedure (MIP) in 2. The aim of he MIP is o idenify poenial risks o macroeconomic sabiliy a an early sage and o ensure ha Member Saes adop appropriae policy responses o preven harmful imbalances and correc hose ha have already buil up. EU Regulaion No 76/2 characerizes a macroeconomic imbalance as "any rend giving rise o macroeconomic developmens which are adversely affecing, or have he poenial adversely o affec, he proper funcioning of he economy of a Member Sae or of he Economic and Moneary Union, or of he Union as a whole." Excessive imbalances are defined as "severe imbalances ha jeopardize or risk jeopardizing he proper funcioning" of EMU. The MIP adops a graduaed approach. The firs sep is a screening for poenial imbalances agains a scoreboard of eleven indicaors, comprising he curren accoun balance, he ne inernaional invesmen posiion, he real effecive exchange rae, nominal uni labour coss, he expor marke share, he unemploymen rae, house price developmens, privae secor credi, privae secor deb, governmen deb, and financial secor liabiliies. The MIP scoreboard esablishes hreshold values for each indicaor. The resul of he screening by he European Commission is published in he annual Aler Mechanism Repor (AMR). The violaion of one or several hreshold values provides an early warning and indicaes he need for furher analysis by he European Commission in he form of an In- Deph Review (IDR). On he basis of he IDR, he Commission deermines wheher imbalances, and excessive imbalances, exis. If he European Commission concludes ha excessive imbalances exis in a Member Sae, i may, in a hird sep, recommend o he European Council ha he Member Sae concerned draw up a correcive acion plan. Afer adopion of he recommendaion by he Council, he European Commission and he European Council monior is implemenaion. Repeaed failure o ake acion can, in a fourh sep, lead o financial sancions: he European Commission can propose o he European Council o levy a fine for no aking acion. The European Council decides by reverse qualified majoriy voe, i.e. sancions are approved unless overurned by a qualified majoriy of Member Saes. The scoreboard-based AMR of November 23 concluded ha IDRs were warraned for 6 Member Saes, including Germany. The IDR for Germany has been moivaed in paricular by he breach of he curren accoun hreshold. The laer issues an aler whenever he hree-year average of he curren accoun balance as a percenage of GDP exceeds 6 or falls below -4. The curren accoun indicaor has upper and lower bounds because boh large surpluses and large deficis can be he resul of inefficiencies and adversely affec he proper funcioning of moneary union. The hreshold values esablish igher limis on he defici side. This derives from he view ha curren accoun deficis pose greaer risk for macroeconomic sabiliy han curren accoun surpluses. In paricular, large and growing deficis are associaed wih risks of sudden sops and financial conagion (European Commission (22b)). The European Commission published is IDR on Germany on March 5, 24. I concluded ha Germany is experiencing macroeconomic imbalances, which require monioring and policy acion. According o he IDR, he large and persisen exernal surplus "sems primarily from a lack of domesic demand, which in urn poses risks o he growh poenial of he German economy." (European Commission (24), p.7). The European Commission argues i would herefore be imporan o idenify and implemen measures ha help srenghen demand and he economy's growh poenial. The repor discusses measures o address he backlog in public invesmen, o furher reduce disincenives o work, o improve he business environmen in order o suppor privae invesmen, and o ensure ha he banking secor has sufficien loss absorpion capaciy o wihsand economic and financial shocks. The IDR did no include an explici quaniaive discussion of spillovers. The Commission will pu forward counry specific recommendaions o deal wih he imbalance by early June 24, for consideraion by he European Council. 6

9 2. Macroeconomic condiions and he German exernal accoun, Germany s curren accoun balance (CA) and rade balance (TB) in he period are ploed in Figure.a. The dynamics of he CA is closely linked o ha of he TB (i.e. o ne expors). Afer close-o-balance posiions in he 99s, he TB and he CA have been in persisen surplus since he early 2s. The German TB and CA surpluses peaked a abou 7 of GDP in 27, receded o abou 5-6 in he global recession of 28-9, and reached 6-7 of GDP in 22; hese persisen surpluses have led o a subsanial posiive inernaional invesmen posiion, ha amouned o 35 of German GDP in 2 (Figure.b). The balance on incomes and ransfers shows a persisen increase (from abou -2 o + of GDP) saring in 23, bu he overwhelming par of he rise in he German curren accoun since he early 2s is linked o he rise in ne expors. 4 Saving, invesmen and he German exernal balance The curren accoun equals he difference beween gross naional saving (S) and gross naional invesmen (I): CA=S-I. Figure.c plos German saving and invesmen, in of GDP (Y). (All raios of variables o GDP discussed in he following paragraphs are raios of nominal variables.) The German invesmen rae (I/Y) rae had a sligh downward rend in he 99s; i fell markedly during he early 2s, and hereafer flucuaed wihou rend around a mean value ha was abou 4 pp (percenage poins) below he mean invesmen rae observed in he 99s. The German saving rae (S/Y) closely racked I/Y unil he early 2s, bu rose markedly and persisenly during he 2s (by close o 4pp beween 2 and 22). This divergence beween saving and invesmen raes accouns for he sharp and persisen rise of he German curren accoun in he early 2s. Figure.d shows ha he persisen rise in he German curren accoun is accouned for by a persisen rise in he privae secor saving-invesmen gap. The German fiscal surplus (governmen S-I) flucuaed cyclically, bu was essenially rendless (as a fracion of GDP), and hus did no conribue o he persisen rise in he German curren accoun. Figure.e shows he conribuions of privae consumpion (C) and governmen consumpion (G), and of invesmen (I) o German ne expors: NX=(Y-C-G)-I. The (C+G)/Y raio has, essenially, been rend-less hroughou he sample period, bu exhibied some marked ransien changes (see Fig..f). 5 Saving, S, equals Y-C-G plus ne incomes and ransfers from he res of he world. The fac ha S/Y rose afer 22, while (Y-C-G)/Y has been rendless is due o he persisen rise in he balance on income and ransfers. Figure.g plos raios of German expors and impors (of goods and services) o GDP. Boh raios have seadily rended upward, doubling during he pas wo decades. The wo raios have mosly moved in andem excep in he period 2-3, when he impors/gdp raio fell, while he expors/gdp raio coninued o grow. Figure.h plos German ne expors o he REA, oal REA ne impors, overall German ne expors, and Euro Area (EA) ne expors (hese variables are repored in of EA GDP). German ne expors are highly posiively correlaed wih REA ne impors. However, he REA rade balance is no a perfec mirror image of he German TB. E.g., he German rade balance surplus remained sizable afer he financial crisis, while REA ne impors fell 4 The rise in he German ne incomes and ransfers balance is solely driven by he rise in ne financial income ha resuled from he rise in he German ne inernaional invesmen posiion. Ne inernaional ransfers are very sable across ime, and represen abou -.4 of German GDP hroughou he sample period. The ne income balance was slighly negaive during he second half of he 99s. Thereafer, ne income rose seadily, due o he rise in he German ne inernaional invesmen posiions, and reached 2.4 of German GDP in 22. Ne financial income accouns for he lion share of ne income (ne employee income is negligible). 5 Saving, S, equals Y-C-G plus ne ransfers and incomes from he res of he world. The fac ha S/Y rose afer 22, while (Y-C-G)/Y has been rendless is due o he persisen rise in he balance on income and ransfers. 7

10 sharply. The rise in German ne expors o he REA only accouns for abou one half of he deerioraion of he overall REA rade balance beween he 99s and 28. The EA as a whole ran a rade balance surplus hroughou he sample period. During he sample period, he share of he (fas-growing) ROW in oal German foreign rade has risen seadily. The share of expors o he REA in German expors fell from 46 in 995 o 36 in 22, while he share of he EA in German impors fell from 47 o 37. Real aciviy in Germany and in German expor markes Figures 2.a plos volume series of GDP, privae consumpion, governmen purchases and invesmen for Germany (compared o he base year 995). German privae consumpion growh in real erms has been lower han real GDP growh since he mid-2. (The sabiliy of he raio of nominal consumpion o nominal GDP documened above reflecs a gradual rise in he raio of he German CPI o he German GDP deflaor.) More srikingly, however, real invesmen demand has almos had a fla rend beween 995 and 22, experiencing mainly emporary ups and downs. Figure 2.b plos year-on-year (YoY) growh raes of real GDP in Germany, he REA and he ROW. (ROW oupu is aggregae real GDP in 4 indusrialized and emerging economies, including EU members who are no EA members; see Appendix.) Oupu growh flucuaions have been highly synchronized across hese counries/regions. However, German real GDP grew noiceably less han REA and ROW GDP during The gap in growh raes was especially sizable in During ha period Germany was someimes referred o as he laggard of Europe (Sinn, 23). Since 26, German GDP has grown faser han REA GDP, excep during he Grea Recession of 29. ROW growh has markedly exceeded REA growh since he early 2s. REA-German ineres rae convergence The creaion of he Euro eliminaed exchange rae risk, and reduced financial ransacion coss across member counries. The dae of he launch of he Euro (..999) was announced by he European Council in December 995. Unil 995, he shor erm nominal ineres on governmen deb was markedly higher in he REA han in Germany; see Figure 3.a (mean REA-German ineres rae spread: 2.3 p.a. in ). The German nominal ineres rae had a fla rend beween 995 and 999, while he REA nominal rae fell rapidly, and hus converged o he German rae. The REA-German nominal ineres rae spread was (essenially) zero when he Euro was launched in 999. Beween 999 and he financial crisis, he ineres rae spread remained very small; a posiive spread emerged again afer he erupion of he sovereign deb crises in some REA counries (2). Exchange raes and inflaion Due o srong domesic demand (fuelled i.a. by expansionary fiscal policy) he Deusche Mark (DM) appreciaed agains REA currencies beween German Reunificaion (99) and 995. The DM hen depreciaed agains he REA unil he launch of he Euro, bu ha depreciaion only parly undid he srong pos-reunificaion appreciaion (see Figure 3.c). I has been argued ha Germany enered EMU a an overvalued exchange rae--and ha hence low wage and price growh was needed o re-esablish German compeiiveness (inernal devaluaion) afer he launch of he Euro (e.g., Louanges (25) and Caron and Hervé (22)). The real exchange rae of Germany ploed in Figure 3.d is consisen wih ha view. The Deusche Mark appreciaed in real erms agains boh he REA and he ROW, afer Reunificaion. Real appreciaion peaked in 995; he German real exchange rae agains he REA was sill above pre-unificaion levels when German-REA bilaeral exchange raes were frozen a he beginning of 999. Afer he launch of he Euro, German real depreciaion vis-à-vis he REA has coninued via lower German inflaion (see Figure 3.b): he average 8

11 annual growh rae of he GDP deflaor afer 999 was.75 in Germany, and 2.49 in he REA. The nominal (effecive) exchange raes of Germany agains he ROW depreciaed much more srongly han he German-REA exchange rae, beween 995 and 2; he German-ROW exchange rae hen appreciaed, by more han 7, unil 28. Since he financial crisis, he exernal value of he Euro has flucuaed widely, around a sligh downward rend (Fig. 3.d.). Due o nominal ineres rae convergence, he lower German inflaion implied ha he German real ineres rae was higher han he REA real ineres during he firs years of he Euro. The financial crisis led o a rise in German inflaion, and o a sharp reducion in REA inflaion. Labour marke reforms As a response o sagnan real aciviy in he early 2s, he German governmen implemened a far-reaching labour marke deregulaion in 23-5 ( Harz reforms) ha included a reducion in unemploymen benefis and measures such as a re-organizaion of labour placemen and of job raining schemes o improve job maching. Fig. 4.d plos he German average unemploymen benefi raio (raio of unemploymen benefi o wage rae). The benefi raio fell permanenly in 24-5, from 62 o 53. German labour marke reforms arguably weakened he bargaining power of German rade unions. The fracion of wage earners who are union members fell seadily from 29 in 995 o 8 in 2 (OECD (23)). I has been argued ha he growh of ousourcing by German firms o low wage counries, noably in Easern Europe, also reduced German rade union power (Dusmann e al. (24)). These developmens may have conribued o he very low growh of wages and of uni labour coss in Germany and hus o low German inflaion (see below). These facors raised he compeiiveness of German exporers, relaive o he res of he EA. Wages and uni labour cos Nominal wage growh has been markedly lower in Germany han in he aggregae EA during mos of he Euro-era (see Fig. 4.a). Beween 22 and 2, real wage growh has also been lower in Germany han in he EA. In fac, German real wage growh was negaive during par of his period (Figure 4.b). As a resul of hese developmens, he German labour share (share of wage income in GDP) fell seadily, from 57 in he early 99s o 49 in 28. Nominal uni labour cos (ULC, raio of nominal compensaion per employee o real GDP per person employed) was essenially fla beween 995 and 27, or fell slighly, and only sared o rise (by abou +) afer he financial crisis (Fig. 4.c). By conras, nominal ULC rose seadily in he REA, beween 995 and 28, bu has been sable consan since hen. Demographics and pension reforms One prominen candidae for explaining he German exernal surplus is populaion ageing. Empirical research by he IMF (23b) provides evidence for a srong posiive impac of projeced ageing speed on he curren accoun balance. Based on a sample of 49 counries (986-2), he IMF finds ha a percenage-poin increase in he old-age dependency raio (defined as he number of people aged 65 and above, relaive o he working age populaion) relaive o he counry average increases he curren accoun balance by.2 percenage poins. In Germany, he dependency raio increased by percenage poins beween he mid-99s and 22 (Figure 5.a). Projecions (German Council of Economic Advisors (2)) poin o an increase by around 2 percenage poins wihin he nex 2 years, due o he reiremen of he pos-war baby boom cohors. Imporanly, he speed of populaion ageing is higher in Germany han in mos oher major economies. Higher fuure old-age dependency raios imply lower fuure per-capia pension enilemens or higher fuure financing coss in a PAYG sysem, which boh reduce fuure disposable income and provide an incenive o increase privae savings. 9

12 In Germany, he pension replacemen rae (raio of he average pension o he average wage income per employee) has fallen by 3 pp beween he lae 99 s and 22 (Figure 5.b). Public pension reforms enaced in Germany beween 2 and 24 sipulae a rise in mandaory public pension conribuions and in he reiremen age, as well as reducion of pension benefis (hese changes are being phased-in gradually); in addiion, he reforms have provided new ax incenives for privae pension saving (Deusche Bundesbank, 2; Huefner and Koske, 2). 3. Modeling he German curren accoun: key relaionships This Secion discusses he main relaionships in our model ha allow us assess he role of he key poenial drivers of he German curren accoun discussed in he previous Secion. We solve he model by linearizing i around a deerminisic seady sae; he linearized model is esimaed wih Bayesian mehods, using quarerly German, REA and ROW daa for he period 995q-23q2. We begin our esimaion sample in 995q in order o include he pre-euro convergence of ineres raes in our sample; by 995q he creaion of he Euro was highly likely; he dae of he launch of he Euro was officially announced in December 995, as menioned above. (As a robusness check, we also esimaed he model for ; he key resuls remain unchanged.) The Appendix provides a complee descripion of he model and of he economeric mehodology. Our model builds on he EU Commission s Ques III model (Rao, Roeger and in Veld (29)), an empirical New Keynesian Dynamic General Equilibrium wih rigorous microeconomic foundaions. Recenly, much research effor has been devoed o he esimaion of macroeconomic models of his ype; see, e.g., Chrisiano, Eichenbaum and Evans (25), Kollmann, Roeger and in Veld (22), Kollmann, Rao, Roeger and in Veld (23), Kollmann (23). This class of models is widely used for research and for macro policy analysis. The lieraure shows ha his class of models capures well key feaures of macroeconomic flucuaions in a range of counries for example, hese models ypically generae second momens (sandard deviaions and correlaions) of key macro variables ha are close o empirical momens. This is also he case for he model here (see Appendix). 6 Our model assumes hree counries: Germany, he REA and he ROW. The German block of he model is raher deailed, while he REA and ROW blocks are more sylized. The German block assumes wo represenaive households: One household has a low rae of ime preference and holds financial asses ( saver household ). The oher household has a higher rae of ime preference, and borrows from he saver household using her housing sock as collaeral. We assume ha he loan-o-value raio (raio of borrowing o he value of he collaeral) flucuaes exogenously, and ha he collaeral consrain binds a all imes. (This srucure, wih paien and impaien households and exogenous loan-o-value shocks, builds on Iacoviello and Neri (2).) Boh households provide labour services o goods producing firms, and hey accumulae housing capial worker welfare depends on heir consumpion, hours worked and sock of housing capial. The paien household owns he German goods producing secor and he consrucion secor; in equilibrium, he paien household also holds financial asses (governmen deb, foreign bonds). 6 There are few empirical macro models for Germany. Pylarczyk (25) esimaed a wo-counry DSGE model wih daa for German and he Euro Area. His model is more sylized han our model; no daa on he exernal balance are used--no implicaions for he exernal balance are discussed. However, Pylarczyk s parameer esimaes share some of he broad feaures of our esimaes, e.g. his resuls also suppor gradual demand adjusmen (consumpion habi persisence) and nominal sickiness.

13 German firms maximize he presen value of he dividend sream paid o he paien (capialis) household. We assume ha German firms ren physical capial from saver households a a renal rae ha equals he risk-free ineres rae plus an exogenous sochasic posiive wedge; ha wedge hence creaes a gap beween he marginal produc of capial and he risk-free ineres rae. This is a shor-cu for analyzing financial fricions facing firms (e.g., Buera and Moll (22)). German firms expor o he REA and he ROW. The producion echnology allows for variable capaciy uilizaion and capial and labour adjusmen coss; household preferences exhibi habi formaion in consumpion (i.e. sluggish consumpion adjusmen o income shocks). These model feaures help o beer capure he dynamics of he German curren accoun and of oher German macro variables. The German block also assumes a governmen ha finances purchases and ransfers using disoring axes and by issuing deb. The German block assumes exogenous shocks o preferences, echnologies and policy variables ha aler demand and supply condiions in markes for goods, labour, producion capial, housing, and financial asses. The models of he REA and ROW economies are simplified srucures wih fewer shocks; specifically, he REA and ROW blocks each consis of a New Keynesian Phillips curve, a budge consrains for a represenaive household, demand funcions for domesic and impored goods (derived from CES consumpion good aggregaors), and a producion echnology ha use labour as he sole facor inpu. The REA and ROW blocks absrac from producive capial and housing. In he REA and he ROW here are shocks o labour produciviy, price mark ups, and he subjecive discoun rae, as well as moneary policy shocks, and shocks o he relaive preference for domesic vs. impored consumpion goods. 7 All exogenous variables follow independen univariae auoregressive processes. In oal, 46 exogenous shocks are assumed. Oher recen esimaed DSGE models likewise assume many shocks (e.g., Kollmann (23)), as i appears ha many shocks are needed o capure he key dynamic properies of macroeconomic and financial daa. The large number of shocks used here is also dicaed by he large number of observables used in esimaion (as he number of shocks has o be a leas as large as he number of observables o avoid sochasic singulariy of he model). In order o evaluae alernaive hypoheses abou he causes of he German exernal surplus, daa on a relaively large number of variables have o be used we use daa on 44 macroeconomic and financial variables for Germany, he REA and he ROW (see Appendix). We now provide a (slighly) more deailed overview of key model componens: Moneary policy Moneary policy in he Euro Area is described by an ineres rae (Taylor) rule. We assume DE ha he pre-999 policy rae is he German shor-erm governmen bond rae, denoed by i +. During EMU (999-), he policy rae is aken o be a weighed average of i DE + and of he REA REA shor-erm governmen bond rae, i + : EA DE REA i+ = si+ + ( s) i+, () where s=.275 is he average share of German GDP in EA GDP during he sample period. The policy rae is se as a funcion of he lagged policy rae, of he year-on-year Euro Area inflaion rae (GDP deflaors), of he year-on-year growh rae of Euro Area real GDP, and of 7 We se each counry s ne foreign asses (NFA) a zero in seady sae (and hus he seady sae curren accoun and ne expors oo are zero). In he long run, NFA is expeced o converge o is seady sae however convergence is slow. Shor- and medium erm model dynamics hus does no depend on he assumed NFA seady sae; our esimaion resuls are robus o assuming non-zero seady sae NFA.

14 a random disurbance. 8 (The average sovereign bond rae defined in () racks very closely he acual ECB policy rae, during he period ; correlaion:.97.) Ineres rae spreads We assume ha he uncovered ineres rae pariy condiions ha link German, REA and ROW ineres raes are disurbed by exogenous shocks (e.g. McCallum (994), Kollmann (22)): EA ROW EA, ROW EA, ROW i = i + E ln e + ρ, (2) i = i + E ln e + ρ, (3) REA DE REA, DE REA, DE + + +, where e jk is he nominal (effecive) exchange beween counries j and k, defined as he price of one uni of counry-k currency, in unis of he counry-j currency. The rae of depreciaion of he EA currency agains he ROW currency is a weighed average of he raes of appreciaion of he German and REA currencies (vis-à-vis he ROW): EA, ROW DE, ROW REA, ROW lne+ = s ln e+ + ( s) lne+. (4) EA, ROW, ρ and ρ REA DE are exogenous saionary disurbances ha drive wedges beween he (average) EA ineres rae and he ROW ineres rae, and beween he REA and German ineres raes; hose wedges can reflec limis o arbirage (due o ransacion coss or shorsales consrains), biases in (subjecive) expecaions abou fuure exchange raes, or risk, premia. In wha follows, we will refer o EA ROW, ρ and ρ REA DE as risk premia., Since he inroducion of he Euro, REA DE DE, ROW e has been consan; hus lne + = REA, ROW lne + holds afer he launch of he Euro. During he run-up o he Euro ( ), he bilaeral REA/German exchange rae only showed mued flucuaions (see Figure 3.c). We assume ha agens believed he REA/German exchange rae o follow a random walk REA, DE during he ransiion period, i.e. ha E ln e + =. This assumpion allows o, consruc a ime series for he German-REA risk premium: ρ REA DE REA DE. = i+ i 9 + We feed he REA-German risk premium ino our model o assess he effec of he convergence of REA and German ineres raes on macroeconomic variables and he German exernal balance. Our ROW empirical measure of he ROW ineres rae i + is he shor-erm US governmen bond rae; EA, ROW he USD exchange rae is aken as our empirical measure of e +. Invesmen in producive capial and firm financing condiions In he model, German good producing firms ren he physical capial sock from he paien (capialis) households. Goods producing firms equae he marginal produc of capial o he renal rae. The renal rae equals he risk-free ineres rae plus an exogenous random posiive wedge. The producion funcion is subjeced o exogenous oal facor produciviy (TFP) 8 We assume ha in (before he launch of he Euro), he Bundesbank se moneary policy for all counries in he (fuure) Euro Area. The parameers of he policy rule are assumed o be he same in and in (any discrepancies beween Bundesbank and ECB policy rules are hus capured by he residual of he policy rule). Assuming insead ha pre-999 he Bundesbank responds only o German oupu and inflaion would be echnically challenging, as his would inroduce a break in he policy rule. Sandard soluion and esimaion algorihms for linear(ized) models (as used here) require equaions wih ime-invarian coefficiens. 9 During he run-up o he Euro, he (fuure) member counries already made a commimen o keep sable bilaeral exchange raes. The Maasrich Treay sipulaed ha a (fuure) member counry of he Euro Area had o absain from devaluing is currency for a leas wo years (before joining he EA), agains any oher member counry. Hence, i seems reasonable o assume ha expeced exchange rae depreciaion was zero (or close o zero) in During his period he REA nominal exchange rae appreciaed slighly agains he DM (by 3.85). The compounded REA-Germany ineres rae differenial was much greaer:

15 shocks; he accumulaion of producion capial is affeced by shocks o invesmen efficiency (e.g., Fisher (26) and Jusiniano e al. (28)). Fiscal policy The governmen purchases domesically produced and impored inermediae goods ha are used for governmen consumpion, and for invesmen in public capial; he governmen also pays unemploymen benefis and pensions o households. Governmen spending is financed using axes on consumpion, labour income and capial income, and by issuing public deb. All governmen spending iems and he ax raes are se according o feedback rules ha link hose fiscal variables o he sock of deb (in a manner ha ensures governmen solvency), and o real oupu. The fiscal policy rules are also affeced by exogenous auocorrelaed disurbances. Exernal demand condiions and foreign rade shocks Consumpion and invesmen are composie goods ha are produced by combining locally produced and impored inermediae goods ha are imperfec subsiues. The volume of German foreign rade, hence, depends on he relaive price beween German and foreign (REA and ROW) goods, and on domesic and foreign absorpion. We use daa on foreign real aciviy and on he foreign price level, in he model esimaion. We refer o shocks o foreign real aciviy as exernal demand shocks, as hese shocks affec he demand for German expors. The model also assumes preference shocks ha shif he desired combinaion beween domesic and impored inermediaes, and shocks o he marke power (mark up) of exporers. Labour marke reforms and wage resrain In he model, he governmen pays unemploymen benefis o unemployed workers (hose benefis are equivalen o a subsidy for leisure). We capure he effec of he German labour marke reforms by reaing he unemploymen benefi raio as an auocorrelaed exogenous variable. We feed he hisorical benefi raio (Figure 4.d) ino he model. We assume ha German wages are se by a labour union ha acs like a monopolis in he labour marke. Union power, as manifesed in he wage markup (i.e. markup of he real wage rae over workers marginal rae of subsiuion beween consumpion and leisure) follows an auocorrelaed process. Privae saving and financial condiions shocks To capure he rise in German privae saving, he model allows for exogenous shocks o households rae of ime preference, referred o as privae saving shocks. We also assume ha he loan-o-value raio faced by impaien households (borrowers) is ime-varying. Pensions To keep he model simple, we assume infiniely-lived German households (i.e. we do no consider overlapping generaions). Each household has a fixed ime endowmen ha is normalized a uniy. Tha ime endowmen is used for marke labour, leisure and reiremen. We assume ha ime spen in reiremen (R) is exogenous. In he empirical esimaion, we ake he fracion of he populaion in reiremen as a proxy for R. The pension paid o a given household is modeled as a governmen ransfer; he pension is proporional o R and he marke wage rae, w: pension= rr *R*w, where he pension replacemen rae rr is an exogenous random variable. We use he empirical replacemen rae (Figure 5.b) as a measure of rr, in he model esimaion. 3

16 4. Resuls The Appendix repors poserior esimaes of all model parameers. The esimaion indicaes ha he German seady sae income share of financially unconsrained households ( savers ) is high (.54). German households exhibi relaively srong habi persisence (habi parameer:.7), and so do REA and ROW households (habi parameers:.67 and.9). German households have an ineremporal subsiuion elasiciy below uniy (.58). The German (Frisch) labour supply elasiciy is.82. German nominal wage and price sickiness is moderae: he average price-change inerval is 3 quarers, while he average wage-change inerval is 2 quarers. (Despie he modes degree of nominal wage sickiness, he impulse responses show ha he real wage rae exhibis subsanial sluggishness.) The subsiuion elasiciy beween domesic and impored producs is high (2.) in Germany, close o uniy (.3) in he REA and below uniy (.74) in he ROW. To explain he key mechanisms operaing in he model, we now presen impulse responses o seleced shocks. We hen describe shock decomposiions of hisorical ime series, implied by he esimaed model. All model properies are evaluaed a poserior esimaes (modes) of he model parameers. Oher deailed esimaion resuls are repored in he Appendix. 4.. Impulse response funcions We now discuss dynamic responses o shocks ha maer mos for he German exernal balance. We begin by discussing shocks o German aggregae supply (shocks o German TFP and invesmen efficiency, and o German unemploymen benefis), and hen discuss German saving shocks, shocks o German governmen consumpion and invesmen, a shock o he REA-Germany risk premium, and a ROW demand shock. Posiive German aggregae supply shocks: TFP and invesmen efficiency increase, unemploymen benefi raio Figure 6.a shows dynamic responses o a permanen rise in German TFP. In he shor-run, price sickiness and capial and labour adjusmen coss preven a rapid expansion of German oupu. Hence, he shock riggers a gradual increase in German GDP (he maximum response of GDP is reached 5 years afer he shock), and of he German real wage rae. Due o habi formaion in consumpion (and because of he presence of collaeral-consrained households), aggregae German consumpion oo rises very gradually in fac more slowly han GDP; hence, he German saving rae (nominal saving/nominal GDP) rises. On impac, he German labour inpu falls slighly, due o he sluggish adjusmen in aggregae demand--employmen only rise wih a four quarer delay. Producive invesmen in Germany oo falls slighly, on impac, before rising. Imporanly, invesmen rises less han GDP (due o srong invesmen adjusmen coss) and, hence, he invesmen rae (nominal invesmen/nominal GDP) falls. The shock also leads o a gradual fall in he German price level, and o a depreciaion of he German real exchange rae vis-à-vis he REA. The policy ineres rae falls, bu only very slighly, as EA moneary policy arges EA-wide aggregae GDP and inflaion. Due o he gradual fall in he German price level, he German (expeced) real ineres rae rises, which also conribues o he iniial fall in German producive invesmen. The sluggish rise in German absorpion and he improvemen in German price compeiiveness (fall in he relaive German/REA oupu price) implies ha German ne expors and he German curren accoun rise persisenly. The rise in German ne expors is accompanied by a persisen fall in REA ne expors. Domesic demand in REA increases suppored by he decline in he policy rae. 4

17 The ne effec on REA GDP is small, iniially posiive bu urning negaive in laer years and noe ha he reducion in REA GDP is markedly smaller han he rise in German GDP. The prediced fall in foreign GDP in response o a posiive shock o home produciviy is a common feaure of open economy DSGE models (e.g., Backus, Kehoe and Kydland (992), Kollmann (23)). By conras, he sign of he ne expors response hinges on he speed of adjusmen of consumpion and invesmen, and is hus parameer-dependen. Our model esimaes sugges very sluggish German consumpion adjusmen (srong habi effecs) o a German TFP increase. In he absence of habi formaion, absorpion would iniially rise more srongly han curren GDP, due o consumpion smoohing by local households who expec heir fuure income o rise more han curren income, and hus ne expors and he curren accoun would hen fall (e.g. Obsfeld and Rogoff (996)). Figure 6.b shows dynamic responses o a posiive shock o German privae secor invesmen efficiency (producion capial). Qualiaively, he response of mos variables are similar o he responses o a posiive TFP shock: he invesmen efficiency shock raises German real GDP, consumpion and invesmen. However, German oupu rises less srongly, while consumpion rises by less, invesmen rises by more han in response o a posiive TFP shock. The posiive invesmen efficiency shock riggers a fall in he relaive price of invesmen goods, relaive o he GDP deflaor. This negaive price response implies ha a posiive invesmen efficiency shock riggers a fall in he (nominal) invesmen rae. The change in he saving rae exceeds he fall in he invesmen rae, and hus he German curren accoun rises. Figure 6.c repors dynamic responses o a German labour marke reform capured here by an exogenous permanen reducion in he German unemploymen benefi raio (unemploymen benefi divided by wage income per employee). The benefis cu raises German labour supply, which lowers he real wage rae. I hus leads o a long-lasing expansion of German employmen, and of German GDP, and o an improvemen in German compeiiveness. Alhough he compeiiveness gain is persisen, i is gradually eroded as real wages adjus in he longer run. The lower unemploymen ransfer paymen reduces he consumpion of collaeral-consrained German households. Aggregae consumpion iniially declines bu rises (above he unshocked pah) afer six years (due o he increase in GDP which raises he consumpion of saver households). However, consumpion adjuss sluggishly o he rise in GDP, and he German saving rae rises persisenly. German invesmen falls, on impac, due o a rise in he German real ineres rae, bu invesmen increases in he mediumerm, as he (permanen) rise in he German labour supply riggers a permanen rise in he German capial sock. REA oupu rises slighly in he shor erm, and hen falls slighly below is unshocked pah. German ne expors increase, while REA ne expors fall. The effecs of his shock on German GDP and on German ne expors are hus similar o he responses riggered by a posiive TFP shock--bu noe ha he German benefis reducion raises REA oupu in he shor run. Posiive German aggregae supply shocks are, hence, a candidae for explaining he acceleraion of German GDP growh afer 25. These shocks are also consisen wih oher salien facs abou he German economy afer 25: a high rade balance (and curren accoun) surplus, low inflaion (relaive o he REA) and a high saving rae. Posiive German privae saving shock, shocks o pension replacemen rae and o old-age dependency raio The oher shocks discussed below (excep he saving shock) oo move he German GDP and rade balance (and curren accoun) in he same direcion. In he model, he German curren accoun is hus procyclical, consisen wih daa. 5

18 Figure 6.d shows dynamic responses o a posiive German privae saving shock, namely a persisen fall in he German subjecive rae of ime preference. The shock riggers a longlasing reducion in German aggregae consumpion, and i hence raises he German saving rae. The resuling increase in he marginal uiliy of consumpion raises households (desired) labour supply, which induces a gradual fall in he German (real) wage rae, and in he German price level. Because of sluggish price and wage adjusmen, he shor- o medium-erm response of German GDP and employmen is, however, dominaed by he fall in consumpion i.e. GDP and employmen fall iniially, before rising above heir unshocked pah (due o he increased labour supply). The rise in privae saving lowers he nominal ineres rae, however he fall in German inflaion leads o an iniial rise in he German real ineres rae, and German invesmen falls on impac (bu hen increases). REA aggregae demand rises (due o fall in EA-wide ineres rae), and REA ne expors fall (also because of a fall in German demand for REA goods). Iniially, REA GDP is slighly posiive, bu hen falls slighly below is unshocked pah. A cu in he pension replacemen rae oo raises German GDP, he German saving rae (due o fall in consumpion) and ne expors. A posiive shock o he old-age dependency raio (i.e. o he number of German reirees) lowers German employmen (due o labor supply reducion) and oupu; consumpion and invesmen fall oo, bu more gradually han oupu, and hus German nex expors (and he curren accoun) fall. (The hisorical decomposiions of he curren accoun discussed below show ha shocks o he pension replacemen rae and o he number of reirees had a smaller role for he German saving-invesmen gap han rae-of-ime preference shocks.) German fiscal shocks Figure 6.e repors responses o a posiive shock o German governmen consumpion. The shock raises German GDP, bu crowds ou German consumpion and invesmen, and i reduces German ne expors, and raises REA oupu. A Euro rise in governmen purchases raises German oupu by.56 Euro, lowers German ne expors by.35 Euro, and raises REA GDP by.2 Euro. Thus, German expansionary fiscal policy lowers German ne expors, bu only has a very small effec on REA GDP. In order o reduce German ne expors by of GDP, a fiscal impulse worh 2.85 of GDP would be required, which amouns o a 5 increase in governmen purchases. In oher erms, even very sizable fiscal policy shocks only have a modes effec on ne expors (and on he curren accoun). (Modes rade balance responses o fiscal shocks in he same range are also repored by oher empirical sudies; see, e.g., Beesma and Giuliodori (2)). Figure 6.f shows dynamic responses o a posiive shock o German public invesmen. The shock has a sizable effec on German GDP ha grows over ime. Privae consumpion increases, and German ne expors fall slighly during he firs 4 years afer he shock. Iniially, privae invesmen falls, bu in he medium erms privae invesmen rises, as he rise in governmen capial raises he produciviy of privae producion capial. REA GDP falls, in he very shor erm, bu rises subsequenly. Fall in spread beween REA bonds and German bonds Figure 6.g shows dynamic responses o a persisen fall in he REA-German bond spread, (risk premium) ρ REA DE REA DE = i+ i+. The shock riggers a persisen fall in he (nominal and real) REA ineres rae, and a rise in he EA policy rae. REA absorpion and GDP and he The responses of real aciviy are mued by a rise in he policy rae. When moneary policy is consrained by he zero lower bound (ZLB), he ineres rae fails o rise, and REA GDP increases already on impac. 6

19 (relaive) REA price level rise, while REA ne expors fall. The rise in he policy rae riggers a sharp and persisen fall in German invesmen, and a fall in German consumpion. The German invesmen rae falls, while he saving rae rises. German GDP rises due o srong REA demand, and German ne expors increase. The effecs on German and REA ne expors are very persisen. These predicions are consisen wih a number of developmens in he run-up o he Euro when he REA-German ineres rae spread fell rapidly: namely rapid REA growh and a worsening of he REA rade balance. However, empirically German ne expors were basically fla before he launch of he Euro, which suggess ha oher facors mus have off-se he effec of he spread shock on German ne expors. Posiive shock o ROW (Res of World) aggregae demand Finally, Figure 6.h shows responses o a rise in ROW aggregae demand riggered by a persisen rise in he ROW subjecive discoun rae. The shock raises ROW absorpion, which increases demand for German and REA expors, and hus German and REA GDP rise. This riggers a rise in he EA policy rae, which reduces German invesmen by increasing financing coss. Again, he German invesmen rae falls, while he saving rae rises. ROW ne expors fall, while German and REA ne expors rise. Hence, he ROW real aciviy shock is consisen wih high German ne expors and low German invesmen Hisorical decomposiions To quanify he role of differen shocks as drivers of endogenous variables, we plo he esimaed conribuion of he differen shocks o hisorical ime series. Figures 7.a-7.e show hisorical decomposiions of he following German macroeconomic variables: he curren accoun (divided by nominal GDP); he saving rae; he invesmen rae; year-on-year real GDP growh; and year-on-year inflaion (GDP deflaor). Figures 8.a-8.b show decomposiions of he REA rade balance (divided by REA nominal GDP) and of REA real GDP growh. The lines wih black lozenges show he hisorical daa. In each Figure, he horizonal line represens he seady sae value (of he variable ploed in he respecive Figure). (In he model, he seady sae year-on-year growh rae of German and REA GDP is.8; seady sae annual inflaion is 2.) For each period (quarer), he verical bars show conribuions of differen (groups of) shocks o he hisorical daa. For he sake of legibiliy, relaed disurbances are grouped ogeher (see below). Verical bars above he horizonal (seady sae) line represen posiive shock conribuions o he variable considered in he Figure, while bars below he horizonal line represen negaive conribuions. Sums of all shock conribuions equal he hisorical daa. We plo he conribuions of he following (groups of) exogenous shocks originaing in Germany: () TFP and invesmen efficiency (see bars labeled echnology ); (2) Wage mark up ( Labour wedge ); (3) Unemploymen benefi raio ( Unemploymen benefi ); (4) Old-age dependency raio ( Reirees ); (5) Pension replacemen rae; (6) Subjecive rae of ime preference ( Privae saving ); (6) Fiscal policy; (7) Firm finance wedge; (8) Household loan-o-value raio and risk premium on housing capial ( housing financing condiions ). In addiion, we show he conribuion of disurbances o: () REA-German ineres rae spread ( REA risk premium ); (2) shocks originaing in he REA and ROW, and shocks o he relaive preference for German vs. impored goods ( Exernal demand and rade ). The remaining shocks are markedly less imporan drivers of German variables, and are hence combined ino a caegory labeled oher shocks. 2 2 Also included in oher shocks are he base rajecories, i.e. he dynamic effecs of iniial condiions (i.e. of predeermined saes in he firs period of he sample). 7

20 Figures 8.a and 8.b (decomposiions of REA ne expors and GDP growh) show he conribuions of he (groups of) shocks originaing in Germany, as well as he conribuions of REA aggregae demand shocks and of REA aggregae supply shocks, and of REA exernal demand and rade shocks (ROW aggregae demand and supply shocks, and shocks o he relaive preference for REA goods vs. goods impored by he REA). The hisorical decomposiion shows ha he following shocks had a noiceable posiive effec on he German curren accoun, a differen imes: (i) posiive German echnology shocks, beween he lae 99s and he global financial crisis; (ii) he fall in he REA-German risk premium, beween 995 and 999; (iii) posiive exernal demand shocks, due o srong ROW and REA growh, especially in 24-8; (iv) he 23-5 German labour marke reforms (capured in he model by he reduced generosiy of unemploymen benefis); (v) sizable posiive shocks o he saving rae, from 24 o he end of he sample; (vi) a rise of German firms invesmen wedge, afer he collapse of he do-com bubble, and in he afermah of he global financial crisis. German echnology shocks had a persisen posiive effec on he German invesmen rae, according o he esimaed model, and boosed he German curren accoun by up o.5 of GDP during he early 2s, i.e. during he phase during which he curren accoun rose sharply. The posiive conribuion of echnology shocks o he German curren accoun beween he early 2s and he financial crisis mainly reflecs he fac ha hese shocks (in paricular invesmen efficiency shocks) lowered he German invesmen rae (see above discussion of impulse responses). During he 29 financial crisis, TFP and invesmen efficiency fell noiceably in Germany his explains why he influence of echnology shocks on he German curren accoun has been much weaker since he crisis. Aggregae supply shocks were key drivers of German GDP: he booms in 2-2 and are boh accouned for by sizable posiive supply shocks. Aggregae supply shocks also had a noiceable effec on German inflaion: posiive echnology shocks in he firs half of he sample period lowered German inflaion; negaive echnology shocks during he Grea Recession prevened a drop in inflaion. The convergence of REA ineres raes o German raes had a persisen small bu noiceable posiive effec on German curren accoun beween he lae 99s and he mid- 2s (see bars labeled REA Risk premium shocks in Figure 7.a). Ineres rae convergence increased REA demand and hus REA impors from Germany. Because of moneary policy ighening in response o ineres rae convergence (see Figure 6.g), German aggregae demand fell, in response o convergence, which led o declining domesic demand and a rise in German saving. As discussed above, ineres rae convergence occurred rapidly afer he creaion of he Euro had irrevocably been announced in lae 995 ineres rae convergence had ended when he Euro was launched on This explains why he impac of ineres rae convergence on he German curren accoun was sronges beween 999 and 22 (accouning for abou + of he curren accoun/gdp raio). However, during ha ime he German curren accoun was sill negaive he curren accoun acually fell slighly beween 998 and 2. According o our esimaes, ineres rae convergence had a very small posiive effec on German GDP (due o sronger REA demand for German expors), uni labour cos and inflaion. The convergence of REA ineres raes o German levels had a markedly sronger negaive effec on he REA rade balance ineres rae convergence conribued especially o he sharp fall in REA ne expors in (see Figure 8.a). Ineres rae convergence also conribued o he boom in REA aciviy (see Figure 8.b). According o one prominen hypohesis, REA-German ineres rae convergence riggered a massive capial ouflow from Germany ha sharply lowered domesic German GDP and invesmen growh 8