Graph 1: Net barter terms of trade of goods and services for West Germany, 1985=100 (European Economy 1995)
Terms of trade and the West German economy
The terms of trade are referred to as an 'esoteric problem in the pure theory of international trade and a highly charged emotional issue in world politics' by Ronald Findlay (1981). The terms of trade are an index of a country's exports against its imports, and thus are useful for cross-national trade comparisons. There is a great variety of indices which are designed to measure the terms of trade and to relate them to possible gains from trade - Viner (1937) lists not less than seven of them. Most important is the commodity or net barter terms of trade index, to which this text refers unless otherwise specified.
The net barter terms of trade index is calculated as the ratio of the relative change in the price of the exported goods and services basket to that of the corresponding import basket (of one country). It indicates the change in the value of the export basket, expressed in units of import baskets, and is equal to the ratio of the so-called unit values of exports and of imports.
In trade theory, the terms of trade are the solution to the problem of finding an equilibrium vector of relative prices for a world market of traded goods and internationally mobile factors and national markets for non-traded goods and immobile factors. They are determined by the consumer preferences, factor endowments, technology of production and income distribution in the trading countries. The terms of trade are usually regarded as an exogenous parameter for a 'small' open economy.
Changes in the terms of trade have been a controversial topic in international economics and particularly development economics since Prebisch (1950) and Singer (1950) independently postulated a continuous deterioration for primary goods versus manufactured goods. The debate about trends and volatility of the terms of trade between developing and industrial countries did not only produce a temporary anti-trade bias of government policy in many less developed countries but also a huge amount of literature. Still, little study has been pursued in the area of the welfare implications from a movement in terms of trade. And rarely - only with the exception of the oil crises - has the focus been the situation of an industrial country.
Graph 1 depicts the development of the terms of trade for an industrial country, West Germany. In the last ten years, from 1985 to 1995, West Germany experienced an improvement of its terms of trade of almost one fifth. This change is the topic of this project, which tries to work out its causes and consequences. As can easily be seen in graph 1, the choice of the benchmark year 1985 is crucial to the observation of an almost 20 percent increase. But the period 1985-1995 is of special importance to the country and therefore justifies this (biased) choice. In October 1990, the mid point of the chosen period, West Germany was united with the former German Democratic Republic. East Germany represented an economic area of one fifth of the population and one third of the area of Germany. The unification had a strong impact on the whole of Europe.
The East German demand, mainly for specific consumer goods like automobiles, certain food items and electronics, induced an economic growth in West Germany which exceeded that of the previous fifteen years. The boom years of the late 1980's were surpassed in 1990 and 1991 as a consequence of the so-called Sonderkonjunktur (exceptional GDP movement) of the unification - contrasting to adverse movements in most industrial countries. However, large financial transfers of some 5% GDP to the East represented a serious financial burden to the government and the private sector: higher social contributions, higher taxes and less public spending in the western parts of the country all contributed to the 1993 recession and to huge lay-offs in response to the increased cost pressure. The turmoil in the West German economy was mirrored by an important shift in its external balance. A large decrease in the traditional trade surplus and even a current account deficit after 1990 emphasise the economic relevance of the 1985-95 period.
Possible explanations of the movement
One might try to investigate the changes of the terms of trade for West Germany by using a theoretical model of trade. One could argue that West Germany gained far more labour than capital with the unification, and proceed to search for the subsequent economic consequences. In addition, though, to the methodological problem of comparing the pre-1990 West German situation with that of post-1990 united Germany consistently, all theoretical models of trade need many assumptions to be applicable. Therefore this piece puts more emphasis on empirical data than on a theoretical framework. West Germany's imports and exports are considered first. Although the terms of trade refer to goods and services, only the trade in goods is explicitly mentioned due to a restricted availability of data. Import and export of services account for about one third of total West German trade, but they mainly consist of capital gains from foreign investment and tourism. These aspects are interrelated with the development of the German mark which is dealt with later.
Standard International Exports Imports Ex/Im Trade Classification ratio SITC 0+1(food, tobacco) 33227 60786 0,55 SITC 2+4 (natural 13549 29700 0,46 resources) SITC 3 (oil) 8111 44792 0,18 SITC 5 (chemicals) 82373 53974 1,52 SITC 6 (manufactured 108699 104382 1,04 goods) SITC 7 (machinery, 326689 217940 1,49 electric appliances) SITC 8 (various finished 74594 102534 0,72 products) weighted average 1,05
Table 1: West Germany's exports and imports of goods by Standard International Trade Classification groups 1992 (Statistisches Bundesamt 1993)
West Germany's imports
West German unit values of imported goods changed significantly more than those of the exports from 1985. This indicates their dominating relevance for the development of the terms of trade of goods, and as well for the terms of trade of goods and services. West German imports reached unprecedented heights after the unification. The boom of 1990-92, stimulated by the unification, implied increasing aggregate demand in West Germany, whilst East German demand absorbed much of West Germany's output. This caused the general procyclical rise in imports to be more pronounced than usual. Thus - whilst European countries with high foreign debt suffered from the effect of rising German interest rates - the trade partners with high international competitiveness gained from a 'locomotive' effect of the German unification. In many European countries it eased a decreasing domestic demand, which in return helped to reduce or avoid price effects of the German demand.
Table 1 shows the commodity structure of German exports and imports of goods, for 1992, but the proportions of the different commodity groups are representative. Though oil and related imports do not (SITC 3) form a particularly large part of the total import volume, the high volatility of oil prices and its influence on the prices of imported chemicals and energy intensive goods results in its important contribution to changes of the terms of trade. The oil crises of 1973 and 1979 evidently led to unfavourable terms of trade movements. The reverse oil price shock of 1986 was not as disruptive as the adverse movement of the 1970's crises, but it is likely to have caused much of the enormous terms of trade improvement of that year, which again makes 1985 as the starting year of the observed period so crucial. The fall of the unit value of imports from 1985 to 1987 is the most pronounced movement of either export or import unit values between 1985 and 1995 and the unit prices have stabilised since then. The oil price hikes during the Gulf crisis 1990/91 were only temporary and did not induce such a lasting change in the terms of trade.
The Prebisch-Singer hypothesis of long-run deterioration in the terms of trade for developing countries could - if true - imply that a part of the increase in West Germany's terms of trade is caused by this alleged trend. However, if one excludes oil imports, it seems extremely unlikely to be a viable explanation. Only a small proportion of West German trade occurs with developing countries and no underlying positive trend is visible in the long-run development of the terms of trade for West Germany (see graph 1).
Graph 2: Terms of trade for the European Union in extra-EU trade by SITC groups, 1985=100 (eurostat 1994, eurostat 1995)
West Germany's exports
Mendoza (1995) uses a Granger-Sims causality test to determine, if it is exports or imports that mainly govern the terms of trade for West Germany. He calculates the F-statistic for the hypothesis 'exports cause the terms of trade' as 2.757 in contrast to only 0.169 for import-domination. Though this result seems to contradict the above interpretation of the unit value's movement, which refers to the short period 1985-1995, and though it is not statistically significant, it emphasises that exports also play an important role.
More than 50 percent of West German exports are destined for the European Union. The rather stable EU-demand provides a solid basis to profit from the often more volatile extra-EU trade. West Germany regularly gains market shares if and when imports to partner countries are increasing rapidly. This indicates a high flexibility of the German industry. The West German export industry is rarely hindered by government rulings - it enjoys a risk bonus and a head start on politically turbulent countries like China or Iran.
German exports have a favourable, very specialised commodity structure. The strong emphasis on investment goods implies a high sensitivity to international growth. On the other hand it also yields all the benefits of a low elasticity of demand.
The terms of trade for commodity groups which have particular importance for West German exports - chemicals, manufactured goods, machinery, cars and some finished goods (SITC 5-8) - have not improved that much for the whole of the EU (see graph 2). Either Germany's position in intra-EU trade improved significantly, or Germany's terms of trade in the mentioned product classes are better than those of the EU average. This seems likely as West German exports are very specialised within the one-digit SITC groups. Machines for various purposes and motor vehicles reach export/import ratios of up to 2.7 and account for almost 40 percent of West German exports. West Germany does not enjoy an international monopoly in these areas, but continuing specialisation in particularly skilled labour and capital intensive goods has surely contributed to the favourable terms of trade movement.
The German mark
The D-Mark appreciated significantly between 1985 and 1995, especially after re-unification. Amano and van Norden (1995) show that the real exchange rates of the Canadian and the US dollar are cointegrated with terms of trade variables and that causality runs from the terms of trade to the exchange rates. A similar result was given by Koya and Orden (1994) for New Zealand and Australia. In spite of open capital markets and flexible exchange rates, monetary and portfolio balance effects seem in those cases to have little importance - terms of trade shocks appear as exogenous determinants of the exchange rates.
The value of the mark shows an analogous movement with West Germany's terms of trade, but in the German case it is not evident that causality runs only from the terms of trade to the exchange rate. Just like exogenous terms of trade shocks can induce exchange rate changes, an exogenous currency shock, for example that of 1990, has terms of trade implications. The appreciation of the mark is very likely as much a consequence of changed preferences of international capital markets, of a reappraisal of the German economy after the unification, of the increasing role of the German Bundesbank and the anchor function of the mark in the European Monetary System, as it is a response to changing terms of trade. In probability, the stronger D-Mark induced favourable terms of trade movements for West Germany, especially in the years 1992 and 1993.
Implications for the West German economy
The attribute 'favourable' has been used several times to describe an increasing net barter or commodity terms of trade index for West Germany. However, in spite of the extensive literature in response to the Prebisch-Singer hypothesis, there is no comprehensive approach that fully incorporates the various welfare implications of terms of trade 'gains'. John Stuart Mill (1844), the great pioneer in the terms of trade context, rejected the conclusion that a favourable movement of the commodity terms of trade necessarily indicates actual financial gains from trade. Lutz (1994) recommends an examination of the income terms of trade, i. e. the net barter terms of trade times the volume of exports, as they measure the relative purchasing power of a country's exports. He succeeds to establish a significant link between income terms of trade volatility and lower growth rates.
Mendoza (1995) claims within his real business cycle framework, that terms of trade shocks account for 45-60 percent of GDP variability. He calls them the most important exogenous variable in the context of economic growth next to the productivity shocks that are essential to real business cycle theory. However, although terms of trade movements do certainly have welfare and gains from trade implications, Findlay (1981) states that there is no unambiguous indicator of them.
To correctly analyse the implications of the favourable terms of trade development for West Germany between 1985 and 1995, would first require an exact disintegration, into direct exogenous terms of trade changes and indirect terms of trade changes, which are a consequence of other exogenous shocks, like changes in tastes or technology. This is rarely possible. However, the magnitude of the fall of the unit value of imported goods in 1986 and the notable appreciation of the German mark after the unification suggest mainly direct terms of trade shocks, possibly supported by endogenous changes due to the specialisation and flexible technology of the West German export industry.
Germany in all likelihood, did benefit from the improvement of its terms of trade. The increase in the income terms of trade was even greater than that of the net barter terms. This means that the purchasing power of German exports was boosted in the analysed period. Relatively cheap imports contributed to the strong position of the West German economy before the unification, which was crucial for the eventuality of a quick unification with the weak East German economy. Subsequently later with the high increase in demand and need for, imports in the wake of the 'unification boom' they became even more important. They helped to smooth the economic turmoil which was induced by the East German aggregate demand shock and the increase of taxes and social contributions. Many trade partners profited from the post-1990 development in West Germany, which by the help of the favourable terms of trade obtained the requisite imports of goods, services and also capital at a relatively low price.
To actually measure the gains from a favourable terms of trade movement is difficult. In national income statistics one can occasionally find terms of trade adjustments of the gross national disposable income. The adjustment term is derived by taking the difference between the figure obtained by deflating the current value of exports of goods and services by an index of import prices and the current value of exports deflated by an index of export prices. The adjustment figure represents an 'invisible' increase of disposable income, which is a consequence of the increased purchasing power of exports. For Germany, a positive adjustment of about 4.5% of GDP would have to be taken, if unit value price indexes are used, for the terms of trade calculation (other indices like that of direct importer and exporter prices lead to even higher figures). This figure is not surprising, given the importance of foreign trade for the German economy - exports account for more than one third of West German GDP. Changes in the composition of exports and imports, distributional and other dynamic aspects of a terms of trade fluctuation can of course not be captured by this type of comparative static. Hence one needs to be very cautious when speaking of gains of a certain percentage of GDP. Still, one can conclude from the above number that a positive and significant contribution to German welfare has been made by the recent terms of trade improvement.
The interpretation of reasons for, and consequences of the significant improvement of the terms of trade for West Germany between 1985 and 1995 is difficult and ambiguous because of the complex interrelation between the relevant economic variables. To date there has been little literature produced regarding the terms of trade from an industrial country's point of view. Even the related problem of deriving the connection between the terms of trade and exchange rates of two countries has not yet been solved, as both Koya and Orden (1994) and Amano and van Norden (1995) concede that their results may only hold for countries with closely linked monetary policy and business cycles. It is even more difficult to distinguish which of the dynamics of an economy can be attributed to terms of trade movements and which terms of trade movements are a result of more general economic dynamics. The topic has much potential for further research.
This piece has tried to work out some aspects of the West German economy and its foreign trade which clarify causes and consequences of the important change in the terms of trade for West Germany from 1985 to 1995. It was not possible to establish an explicit chain of cause and effect. Still, it seems certain that the mentioned import unit value and oil price fall, the specialised structure and elaborated technology of German exports and a partly exogenous appreciation of the D-Mark are major reasons for the terms of trade improvement. Its consequence was a positive contribution to the economic 'preparation' for and the realisation of German economic unity. A precise quantification of this contribution and a detailed list of consequences could not be presented. It is impossible to split up the complex dynamics of West Germany's real world economy, like those of a theoretical model.
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