Germany and the US: Tale of Two AAAs

Handelsblatt, Jul 13, 2015
by Vincent J. Truglia
Germany and the United States are among the few countries left in the world with top sovereign credit ratings. But while the outcome may be the same, a closer look reveals that the two countries’ AAA status is based on very different economic and social circumstances. Taking into account the longer-term risks both economies are facing, the US could be in a better position than Germany to maintain its stellar rating going forward.

Germany’s economic strength stems from its extraordinary international competitiveness. It is an export-driven economy, while US growth is dependent on domestic demand. Despite slower global growth, Germany’s current account surplus is larger than China’s. The sum of exports and imports of goods and services as a percentage of GDP currently amounts to nearly 90 percent which points to an extremely open economy. The fact that this number is 20 percentage points higher than prior to the financial crisis indicates that the German economy has become even more dependent on international trade in recent years. For the purposes of sovereign risk assessment, this shows the enormous flexibility and competiveness of the German export sector.

Being an export powerhouse has allowed Germany to avoid many of the problems encountered by other Eurozone countries. Since the export sector has performed so well, the German government has been able to undertake fiscal measures, which now put the country’s overall general government debt-to-GDP ratio on a declining trajectory. Since a government’s fiscal position is key to the risk of possible default, Germany remains the safest country within the Eurozone as regards the risk of default on its government bonds.

The United States has a fundamentally different economic structure. The US is a continental country. The economy is driven by domestic demand, and exports are often only an afterthought. The openness of the economy is now around 30 percent, not very different than prior to the financial crisis. Unlike the average German, most Americans, except for those involved in international finance or the export sector, do not pay much attention to the exchange rate because it has little impact on their day-to-day lives. The US can sustain a current account deficit as long as domestic demand is on track.

There is another reason why the US is able to sustain large current account deficits in the $400 billion range (down from as high as $798 billion in 2006). In other countries, the obligation to fund such large deficits would pose a major economic risk. However, despite a large net external debt resulting from these deficits, the US regularly has a surplus on its investment income account. A major reason for that is that international investors view the US as a safe haven and are willing to accept smaller returns for the promise of long-term stability. That translates into the US earning far more on its foreign assets than foreigners earn on their US assets. Consequentially, unlike for other countries, large current account deficits do not pose a threat to the US economy.

The US government’s fiscal position also differs from Germany’s in fundamental ways. Using traditional methods to calculate the US general government debt, the debt-to-GDP ratio is enormously overstated. The reason behind this is the US government’s peculiar way of accounting for its national pension fund (Social Security) and similar obligations. The US includes many future liabilities in its debt statistics, despite the fact that these liabilities are not real. They are an accounting fiction that was created to make Social Security look like an insurance program, when in reality it is a pay-as-you go pension system, as in most advanced industrial countries.

When we exclude these notional trust funds from the debt numbers, making them more comparable to how we measure other countries’ debt, we find that the debt-to-GDP ratio is on a downward trajectory, which began in 3Q14. The explanation for the turnaround is that US federal government deficits have fallen dramatically in recent years, from a peak of 9.8 percent in 2009 to 2.8 percent in fiscal year 2014. It is expected to decline further to 2.6 percent in fiscal year 2015. This indicates remarkable fiscal flexibility.

In the end, despite differences in the sources of their economic strength, German Bunds and US Treasury securities remain among the world’s safest investments. Nonetheless, if we compare the risks facing both countries, the US is in a stronger position over time: For one, it has its own currency. And looking ahead, it has very favorable demographics. By 2050, the US will have a younger population than Mexico or China.

On the other hand, Germany’s membership in the Eurozone exposes it to substantial external risks. The currency bloc poses a contingent liability on German taxpayers if additional and larger bailouts of other Eurozone members should be required. Germany’s worrisome demographics are its biggest domestic risk in the long-term. Despite in-migration, its population size is stagnant and likely to decline in coming years, making the burden of its generous social safety net problematic in the medium-to-long run.

Despite their recent stable economic performance, the United States and Germany need to manage political risk in order to maintain their AAA status in the long-run. German leaders will need to find a way to deal with the crisis in the Eurozone and they will have to start the difficult process of reforming the country’s social safety net to adapt to changing demographics.

While US leaders do not have to face contingent liabilities emanating from their country’s currency and demographics, ongoing political gridlock continues to be a danger to the US economy, especially when it comes to entitlement reform. However, in the US, entitlement reform should prove somewhat easier than in Germany. Social Security only needs some minor tweaking, while the reform of Medicare (medical insurance for seniors) and Medicaid (medical insurance for the poor) is more closely related to overall healthcare reform in the US, which has only just begun.

In the end, political will and leadership will ultimately play a big role in whether both countries can maintain their current top ratings.

Originally written in English by Vincent Truglia. Translated to German for publication by Handelsblatt.