What role did trade linkages play in the contagion of the financial crisis 2007? : a case study on the example of Germany and the United States

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UNIVERSITEIT VAN AMSTERDAM Amsterdam Business School Faculty of Economics and Business

What role did trade linkages play in the contagion of the financial

crisis 2007? A case study on the example of Germany and the United

States

Student: Alexander Ruppert Student number: 10100059

Education: BSc Economics and Business, track Economics Supervisor: Anita Kopànyi-Peuker

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ABSTRACT

This paper investigates the influence of the trade linkages on the contagion of the economic crisis between the US and Germany. This is done by examining three trade sub-channels introduced by Corsetti et al. (2000), namely the competitiveness channel, income channel and the cheap-import channel. In general, the findings suggest that the international financial crisis spread via two of the three trade channels from the US to Germany. Moreover, the data suggests the existence of a negative competitiveness channel on the German economy. Similarly, the numbers seem to support the existence of a negative income channel. At last, the data does not seem to support the existence of the cheap-import channel. Although, some of the findings support the theory of the three trade transmission channels, due to the nature of the qualitative research more statistical analysis is necessary to confirm these findings.

Keywords: Financial crisis, trade, Germany, the US, competitiveness effect, income effect,

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1. INTRODUCTION

Unfavorable events in the global financial markets dating from mid-2007, which peaked with the bankruptcy of Lehman Brothers, by that time the fifth largest investment bank in the US, in September 2008, are seen as the start to what is known as the international financial crisis (Claessens, et al., 2010). Originating from the US sub-prime mortgage crisis, the financial crisis quickly spread and contained other countries, leading to what is now considered the worst economic downturn since the Great Depression in 1929. Nearly all advanced as well as emerging economies experienced financial stress and reduced economic growth or activity (Claessens et al., 2010), which had far-reaching effects also on international trade. Following a sharp and sudden decrease in international trade activities during the last quarter of 2008, the world trade declined by around 12% in 2009 according to WTO (Chor and Manova, 2012). Similarly to others, the two biggest western economies, i.e., the US and Germany experienced significant economic troubles. For instance, in 2008 US GDP decreased by 0.29% and in 2009 by 2.80%. Although, in 2008 German GDP still grew by 1.08%, in the year 2009 Germany experienced the largest economic contraction in terms of GDP since its reunification in 1990. The GDP decreased by 5.1%.

Reflecting the scale of the international financial crisis, prior research (e.g., Rudolph, 2009) considers two main channels for its contagion and transmission, namely the capital flows and the trade channel. Moreover, the trade channel can be further decomposed into sub-channels such as the competitiveness channel, income channel and the cheap-import channel that can transmit an economic crises from one country to another (Corsetti et al., 2000;). While many papers (e.g., Longstaff, 2010) focus on the capital flow channel, this paper will examine the influence of the trade channel on the contagion of the economic crisis by looking at the trade between the US and Germany. Thus, the following research question is to be answered: What role did trade linkages play in the contagion of the financial crisis of 2007 in the US and Germany?

This paper focuses on the trade between the US and Germany for multiple reasons. First, looking at the trade and the economies, Germany is considered to be the economic heart of Europe and the US is the largest economy in the world measured in GDP. According to the

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IMF, Germany is currently the world’s 4th largest economy based on GDP. Hence, the US and Germany are both the largest western economies. Second, the trading volume both countries experience with each other underlines the importance of these two economies for each other. In 2013, the bilateral trade mounted up to 162 billion US$. That makes Germany the 5th largest trading partner for the US after Canada, China, Mexico and Japan (United States Census Bureau, 2014). Furthermore, for Germany the US is the 4th largest trading partner after the Netherlands, China and France (Federal Foreign Office, 2014). Hence, in light of the existing importance of trade between the US and Germany, it is reasonable to expect that the economic crisis is likely to spread from the US to Germany via trade linkages between the two countries.

In general, the findings suggest that the international financial crisis spread via the trade linkages from the US to Germany. When looking at every single trade sub-channel separately, the economic data on trade suggests the existence of a negative competitiveness effect. As the Dollar lost value relative to the Euro, German exports to the US decreased in mid-2008. Parts of the data seem to support the notion of Germany losing market share and the US gaining it in return through the relatively cheaper prices of US goods. However, regarding to the nature of the qualitative research more statistical analysis is necessary to confirm these findings. Similarly, the numbers seem to support the existence of a negative income effect as the income in the US measured by GDP dropped only a small amount in 2008 though not affecting German exports in 2008. Moreover, when the US GDP dropped substantially in 2009 the German exports to the US dropped substantially as well. Although there seems to be a connection between the two variables it demands further statistical research to clearly show the existence of this effect. At last, there is no sign of an increased consumption in Germany due to the cheaper US’ exports. Moreover, the data in general does not seem to support the existence of the cheap-import effect. However, similarly with the other transmission channels, a more statistical research needs to be conducted to completely confirm the findings.

The remainder of the paper is structured as follows. Section 2 outlines the prior research regarding the effects of trade linkages on the contagion of the economic crisis between countries. Section 3 gives an overview of the research methodology. Section 4 introduces the case context by explaining the trade and economies of the US and Germany. Section 5 summarizes and concludes the study.

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2. LITERATURE REVIEW

2.1. The meaning and existence of contagion

Prior literature has defined contagion in various ways. According to a broad approach within Eichengreen et al. (1996), contagion can be defined as an increase in probability for a crisis occurring at home when there is a crisis elsewhere. A more precise definition is given by Dornbusch et al. (2000, p. 3) who define contagion through a significant rise in cross-market linkages after an economic shock to a single or group of countries. This means that asset prices or financial flows move more aligned across different markets in relation to their co-movement in normal times. Hence, through contagion, the effect of a shock to a particular industry in a country increases the co-movement of that specific industry in another country.

Similarly to the varying definitions of contagion, there is a lack of consensus in prior research whether contagion actually exists or not. Morales and Andreosso-O’Callaghan (2014) study the effects of the US subprime market on the global economy in a worldwide setting and find no clear evidence of a contagion effect. Moreover, they come to the conclusion that the US subprime market crisis had a large influence on the world economy but these effects can be categorized rather as spillover effects. The difference between spillover effects and contagion is explained by Perry and Lederman (1998) who distinguish between them in two ways. First, they differentiate between the two channels through which spillover and contagion work. While contagion is supposed to work through trade linkages, spillovers work rather through common lenders like banks. When a country gets into financial trouble, banks and lenders might pull their money out of the country or change their lending policy. This further worsens the countries situation, which, in turn, worsens their credibility for lenders. Fearing their money, lenders might look more closely at other countries and also change their lending policy for them. Hence, these countries can also get into financial trouble. This leads to the second difference between contagion and spillover, which is related to the severity of impact or consequences for the contaminated country. While countries experiencing contagion end up in a crisis, countries experiencing spillover effect do not necessarily end up in a crisis.

In contrast to the literature that does not support the existence of contagion, many researchers find evidence on the actual existence of the contagion effect. For instance,

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Eichengreen et al. (1996) find evidence for contagion from researching thirty years of panel data from twenty industrialized countries. Additionally, they state that contagion seems to occur more easily at countries that are closely tied by international trade. These findings are supported by Haile and Pozo (2008) who, after investigating a set of 37 advanced and emerging market economies, find enough evidence to claim that countries face currency crises through unsustainable macroeconomic fundamentals and contagion, where, in most cases, contagion spreads via the trade channels. Also, Bekaert et al. (2011) suggest the existence of the contagion effect after studying the spread of crises to country-industry equity portfolios of 55 countries. Although there are different results to whether a contagion effect exists, the majority of research comes to the conclusion that there is a contagion effect. Therefore, this paper will assume a contagion effect.

2.2. Transmission channels of contagion

When assuming contagion the question arises through which channels the contagion spreads. While some of the models explain contagion through trade linkages and macroeconomic variables, others try to explain contagion through financial channels and focus more on herding behavior or the behavior of investor agents (Haile and Pozo, 2008). Kaminsky and Reinhart (2000) argue in a similar way by distinguishing between fundamental based contagion and “true” contagion. However, they add financial channels to the fundamental based contagion rather than to the “true” contagion. Hence, fundamental based contagion is described through the linkage of the crisis country to another country through trade or finance, while the “true” contagion is described when the spread of the crisis cannot be explained through common shocks but rather through psychological herding behavior from investors.

For most studies researchers conclude that trade is an important transmission channel for contagion. For instance, Eichengreen et al. (1996) conclude that the contagion of a crisis spreads more easily between two countries that are closely tied together through trade. Furthermore, Moser (2003) suggests that an economic crisis in a country negatively disturbs the exports of its trading partners through a fall in domestic demand. These trade related shock transmissions do not only work through the direct trade between two countries, but they also function through indirect trade linkages arising from common third markets. For

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instance, when a country is experiencing a crisis, its currency devalues, which makes its exports cheaper on the international market. This can have a strong effect on the demand of the exports of a competing country which products are now getting more expensive and thus experiencing a fall in demand. Additionally, Eichengreen et al. (1996, p. 5) suggest that trade, more than the change of perception on the macroeconomic factors, is the leading channel of the transmission of currency crises. Put into the context of the fundamental and “true” contagion, these findings imply that trade rather than lenders’ behavior or banks is a transmission channel for the contagion of a crisis.

When looking at trade as a transmission channel, Corsetti et al. (2000) describes three main channels through which the contagion can work. These three channels are competitiveness effect, income effect and cheap-import effect. The competitiveness effect occurs when a country devalues its own currency and therefore decreases the price of its own goods on the international market. This would shift demand away from competing products from competing countries. Additionally, the devaluation of the own currency in turn makes the foreign currency more expensive and hence imports more expensive. Moreover, if the devaluing country plays a major role in that industry it can lower prices for the whole international market or industry. Corsetti et al. (2000) also describes the second trade channel, the income effect. The income effect occurs when through a crisis the income level in a country substantially decreases. This, in turn, will lower demand for imports in the crisis country and can therefore affect a country that heavily exports to the crisis country. The last trade channel by Corsetti et al. (2000) is the cheap-import effect. It works in a similar way through similar mechanisms as the competitiveness effect. When a country is devaluing its currency its own exports become cheaper for other countries. This improves the exporting countries’ terms of trade because the demand for their exports increases through lower prices and the demand for imports decreases. On the other hand, imports from the crisis country are now a lot cheaper for other countries and can possibly finance higher levels of consumption.

3. RESEARCH METHODOLOGY

To answer what role trade linkages played in the contagion of the economic crisis from the US to Germany, first an economic and trade profile is developed for both countries using

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descriptive statistics. To develop the profiles, yearly time-series data on GDP as well as on GPD growth are used. Furthermore, yearly time-series data on exports between the US and Germany and world exports are examined. This gives a general view on the economy as a whole, incorporating the effects of the crisis through trade. The exports are grouped into industries so that comparisons between the different industries and the values of exports can be drawn. More specifically, the industries are grouped into 97 different categories following the Harmonized Commodity Description and Coding System also known as the Harmonized System (HS-Code). Using this data, trends on international trade as well as the bilateral trade between Germany and the US can be discovered.

After that, the three transmission channels, namely competitiveness effect, income effect and cheap-import effect, and their possible influence on the German economy are analyzed. The competitiveness effect is analyzed using monthly time-series data on the Dollar-Euro exchange rate to investigate the effect of the devaluating Dollar on the German trade and economy. Moreover, monthly time-series data on German exports to the US as well as a cross-correlation between the data on German exports to the US and Dollar-Euro exchange rate are used. At last, quarterly time-series data on the share of world exports between Germany and the US are investigated. To examine the income effect, yearly time-series data on German exports to the US and yearly GDP growth data are used. Finally, for investigating the cheap-import effect, yearly time-series data on exports from the US to Germany and yearly time-series data on German private consumption are used.

The relevant data originates from various sources. German, US and World exports come from the International Trade Centre Trade Map database, while the data on the Dollar-Euro exchange rate is collected from the OECD.stat database. Lastly, the data on German private consumption is collected from the World Bank’s World Development Indicators database. The aforementioned data is collected for the years 2006 to 2011, i.e., for one year prior to the emerging crisis in 2007 till the point in time when the bilateral trade between Germany and the US reached the pre-crisis level. The data on German and the US GDP and GDP growth are collected from the World Bank’s World Development Indicators database for the years 1990 to 2013 to give a broad view on the economic developments of both countries.

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4. CASE STUDY ANALYSIS

4.1. Germany – GDP and trade

German economy can be seen as an open economy (Mueller, 2007). It is also the largest economy in Europe. Since the reunification of East and West Germany in 1990, Germany has experienced a fairly stable economic growth (see Figure 1). According to the World Bank, over the past 23 years, Germany has experienced a negative GDP growth only during three years (see Figure 2).

Figure 1. Germany’s GDP, 1990–2013 (in trillion US$)

Source: The World Bank, 2014

In 1993, the GDP growth was around -1%. Researchers (e.g., Jacobi and Kluve, 2006) attribute this negative growth to the reunification and the resulting increase of unqualified labor force coming from East Germany. Furthermore, the one-to-one exchange rate of the Deutsche Mark to the East German Mark placed a heavy burden on the productivity, and made competing for many East German productions impossible (Sinn, 2002). The years from 1994 to 2003 show a small yet positive growth, which is attributed to high long-term unemployment rates and stagnating real wages (Krebs and Scheffel, 2013). After the years of high long-term unemployment and low economic growth, the German government started to implement a large set of labor market reforms called the Hartz Reforms in 2003 (Jacobi and Kluve, 2006). This resulted in an increase in economic growth. In the year 2009, Germany

0 500 1.000 1.500 2.000 2.500 3.000 3.500 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13

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experienced the largest economic contraction in terms of GDP since the reunification. GDP decreased by 5.1%, which can be attributed to the global financial and economic crisis (Carstensen et al., 2009).

According to Mueller (2007), about one third of German GDP comes from exports. Thus, exports play a crucial role for the German economy. As displayed in Appendix A, Germany’s largest export goods from 2006 (one year prior to the crisis) to 2011 (one year after the economic contraction) are Machinery, nuclear reactors and boilers. During that period they make up an average 18.62% of German exports to the whole world. At the same time these goods make up 14.06% of world exports in that specific industry. The second largest export goods are Vehicles other than railway and tramway, which make up an average of 16.99% of German exports during that period, and 20.44% of the world exports in that industry. Finally, the third largest export group for Germany is Electrical and electronic equipment, which make for 10.51% of German exports to the world and 8.27% of world exports in that specific industry. According to the numbers, Germany is a global player in these industries and hence plays an important role in the international exports in these industries.

Figure 2. Germany’s GDP growth, 1990–2013 (in annual %)

The importance of the trade between Germany and the United States of America becomes clear when looking at the volume they trade with each other. The US is the 4th largest trading partner for Germany after the Netherlands, China and France (Federal Foreign Office, 2014) in terms of import and export volume. According to Appendix B, Germany’s largest export industries to the US are Vehicles other than railway and tramway, Machinery,

-6 -4 -2 0 2 4 6 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13

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nuclear reactors and boilers and Electrical and electronic equipment. The exports to the US in industry Vehicles other than railway and tramway make up 1.91% of the total German exports and a total of 11.17% of German exports in that specific industry. Furthermore, Machinery, nuclear reactors and boilers make up an average of 1.54% of German total exports and 8.27% of total exports in that industry. At last, Electrical and electronic equipment make up 0.61% of German exports and 5.83% in that industry’s exports. Again, these numbers outline the importance of German exports to the US making up from around 6% to 11% of German exports in that industry. Therefore, a decrease in exports to the US can significantly influence the German economy.

4.2. US – GDP and trade

The US is the largest economy in the whole world. The current GDP amounts up to 16.8 trillion US$. According to the World Bank, the US economy is nearly twice as big as the second biggest economy in the world, i.e., China (with the respective GDP of 9.24 trillion US$). Moreover, the difference is even larger when comparing the US GDP with Germany’s GPD. The US economy is around 4.7 times larger than the German economy. Hence, the US is dominating the world economically.

Figure 3. US GDP, 1990–2013 (in trillion US$)

Similarly to the Germany, the US GDP growth has been fairly stable during the last 23 years (see Figure 4) with a slightly negative GDP growth in 1991. Moreover, Kilian (2008) states that this was an effect of the Persian Gulf War and the resulting oil supply shock.

0 2.000 4.000 6.000 8.000 10.000 12.000 14.000 16.000 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13

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During the years 1992 to 2000, the US economy witnessed a stable positive economic growth with minimum of 2.71% and a maximum of 4.85%. In 2001, then GDP growth fell below 1% (0.95%). Furthermore, Makinen (2011) argues that this can be attributed to the tightening of credit from the Federal Reserve starting in mid 1999 continuing into 2000. The terror attack of 9/11 could have elevated this effect on a small scale. During the years 2008 and 2009 the US experienced a negative GPD growth for the first time since 1991. In the midst of the financial and economic crisis the US GDP decreased by 0.29% in 2008 and by 2.8% in 2009.

Figure 4. US GDP growth, 1990–2013 (in annual %)

During the period of 2006 to 2011, the largest export industry in the US is Machinery, nuclear reactors and boilers, making up 15.28% of the US exports and 11.09% of the total exports in the whole world (see Appendix C). The second largest industry, i.e., Electrical and electronic equipment, makes on average up to 8.43% of the US exports and 9.03% of the world exports. The third largest export goods are Vehicles other than railway and tramway, which constitute as 8.27% of the US total exports and 9.36% of world exports. These numbers show that German exports in these industries (except Electrical and electronic equipment) play a more important international role as they have more market share.

Germany is the 5th largest trading partner, in terms of import and export volume for the US after Canada, China, Mexico and Japan (United States Census Bureau, 2014). When looking at the exports from the US to Germany during the period 2006 to 2011 (see Appendix D), the biggest export group is Vehicles other than railway and tramway, which represents

-4 -3 -2 -1 0 1 2 3 4 5 6 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13

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0.58% of US total exports and 7.05% of the total exports in that specific industry. Furthermore, the second largest export group to Germany is Machinery, nuclear reactors and boilers which makes up 0.58% of total US exports and 3.65% of the exports in the industry. Finally, the third largest export group, i.e., the Optical, photo, technical, medical, etc. apparatus, makes up 0.44% of US total exports and 7.73% of industry’s exports. Again, these numbers illustrate the importance of the German exports to the US as the German exports to the US generally make up a larger share of total exports and of exports in the particular industry than vice versa.

4.3. Competitiveness effect

As suggested by Corsetti et al. (2000) the competitiveness effect occurs when a country’s currency devalues and therefore the price of its own goods decreases on the international market. This would shift demand away from competing products in competing countries while at the same time raising the relative prices of foreign goods. Moreover, if the devaluing country plays a major role in a specific industry it can lower prices for the whole international market or industry. In the context of this study it means that German products lose competitiveness through the increase of the relative price compared to US products. Therefore, the American demand for German exports is likely to decrease, hence having a negative effect on the German economy as a whole.

Figure 5. Exchange rate, 2006–2011 (in US$/€)

Source: OECD.Stat, 2014 1 1,1 1,2 1,3 1,4 1,5 1,6 1,7 Ja n ua ry 20 06 M ar ch 20 06 M ay 2 00 6 Ju ly 20 06 S ept e m b e r 20 06 N o ve m be r 2 00 6 Ja n ua ry 20 07 M ar ch 20 07 M ay 2 00 7 Ju ly 20 07 S ept e m b e r 20 07 N o ve m be r 2 00 7 Ja n ua ry 20 08 M ar ch 20 08 M ay 2 00 8 Ju ly 20 08 S ept e m b e r 20 08 N o ve m be r 2 00 8 Ja n ua ry 20 09 M ar ch 20 09 M ay 2 00 9 Ju ly 20 09 S ept e m b e r 20 09 N o ve m be r 2 00 9 Ja n ua ry 20 10 M ar ch 20 10 M ay 2 01 0 Ju ly 20 10 S ept e m b e r 20 10 N o ve m be r 2 01 0 Ja n ua ry 20 11 M ar ch 20 11 M ay 2 01 1 Ju ly 20 11 S ept e m b e r 20 11 N o ve m be r 2 01 1

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As can be seen on Figure 5, the US$ devalued heavily compared to the Euro from June 2007 to April 2008. The exchange rate started to increase (i.e., the Euro got more expensive relative to the US$) from the beginning of 2007 and peaked at 1.58$/€ in April 2008. With this increase in exchange rate one would expect German exports to become more expensive and hence decrease. Similarly, Auboin and Ruta (2011) argue that exchange rate volatility has a small but negative effect on trade in the short-run, though it does depend on a range of factors such as the currency in which exports are paid.

Figure 6. German exports to the US, 2006–2011 (in thousand US$)

Source: International Trade Centre, 2014

When looking at the total exports from Germany to US (see Figure 6), it can be seen that the exports were fluctuating mildly over the years 2006 to 2011. But when looking at the volume of exports after June 2008, a significant decrease can be seen. Hence, although the exchange rates started to depreciate heavily in mid-2007, the trade started to drop not before June 2008. From theory, an increasing exchange rate (which means a devaluated Dollar) should cause a decrease in German exports to the US. This should be reflected in a negative correlation between the exchange rates and German exports to the US. However, this negative correlation seems to appear only when inducing a lag into the correlation (see Figure 7). According to Figure 7, the exchange rates are positively correlated to exports from Germany to the US at the same point in time, but negatively correlated to each other after a lag of 7 to 11 months. This shows the existence of a delayed reaction of one series to the other series, which causes the response to be spread in time.

0 2000000 4000000 6000000 8000000 10000000 12000000 Ja n ua ry 20 06 M ar ch 20 06 M ay 2 00 6 Ju ly 20 06 S ept e m b e r 20 06 N o ve m be r 2 00 6 Ja n ua ry 20 07 M ar ch 20 07 M ay 2 00 7 Ju ly 20 07 S ept e m b e r 20 07 N o ve m be r 2 00 7 Ja n ua ry 20 08 M ar ch 20 08 M ay 2 00 8 Ju ly 20 08 S ept e m b e r 20 08 N o ve m be r 2 00 8 Ja n ua ry 20 09 M ar ch 20 09 M ay 2 00 9 Ju ly 20 09 S ept e m b e r 20 09 N o ve m be r 2 00 9 Ja n ua ry 20 10 M ar ch 20 10 M ay 2 01 0 Ju ly 20 10 S ept e m b e r 20 10 N o ve m be r 2 01 0 Ja n ua ry 20 11 M ar ch 20 11 M ay 2 01 1 Ju ly 20 11 S ept e m b e r 20 11 N o ve m be r 2 01 1

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-0,15 -0,1 -0,05 0 0,05 0,1 0,15 0,2 0,25 0,3 0,35 0,4 -20 -18 -16 -14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18 20 C o rr el at io n b et w een ex ch an g e r at e and e x por t Lag in months

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Figure 8. Share of exports in Machinery, nuclear reactors, boilers, etc., 2006–2011 (in %)

Another part of the competitiveness effect is the competition between both countries in the same industries. With the devaluation of the Dollar, German products got more expensive relative to the US products. Hence, one would expect to see a decrease in the share of German exports in the world exports. This movement becomes evident when looking at the three largest exports groups in Germany.

When looking at Germanys most important export group, i.e., Machinery, nuclear reactors, boilers, etc. (see Figure 8), it can be seen that Germany lost around 0.64% market share from Quarter 3, 2008 to Quarter 4, 2008 while the US gained around 1.02%. Generally looking at the graph, it appears that if Germany loses market share the US gains market share.

Figure 9. Share of exports in Vehicles other than railway and tramway, 2006–2011 (in %)

Source : International Trade Centre, 2014

0 2 4 6 8 10 12 14 16 18 Q 1, 20 06 Q 2, 20 06 Q 3, 20 06 Q 4, 20 06 Q 1, 20 07 Q 2, 20 07 Q 3, 20 07 Q 4, 20 07 Q 1, 20 08 Q 2, 20 08 Q 3, 20 08 Q 4, 20 08 Q 1, 20 09 Q 2, 20 09 Q 3, 20 09 Q 4, 20 09 Q 1, 20 10 Q 2, 20 10 Q 3, 20 10 Q 4, 20 10 Q 1, 20 11 Q 2, 20 11 Q 3, 20 11 Q 4, 20 11 US Germany 0 5 10 15 20 25 Q 1, 20 06 Q 2, 20 06 Q 3, 20 06 Q 4, 20 06 Q 1, 20 07 Q 2, 20 07 Q 3, 20 07 Q 4, 20 07 Q 1, 20 08 Q 2, 20 08 Q 3, 20 08 Q 4, 20 08 Q 1, 20 09 Q 2, 20 09 Q 3, 20 09 Q 4, 20 09 Q 1, 20 10 Q 2, 20 10 Q 3, 20 10 Q 4, 20 10 Q 1, 20 11 Q 2, 20 11 Q 3, 20 11 Q 4, 20 11 US Germany

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When looking at the second largest export group for Germany, i.e., Vehicles other than railway and tramway (see Figure 9), a similar picture arises. From the graph it appears again that when Germany loses market share the US gains market share. In a same vein with Machinery, nuclear reactors and boilers, Germany lost around 0.72% market share from Quarter 3, 2008 to Quarter 4, 2008, while the US gained around 0.96%.

When graphing the third largest German exports industry by market share (i.e., Electrical and electronic equipment) against the US, a different picture to the two aforementioned industries arises (see Figure 10). Both the US and Germany have lost market share but the graph does not seem to follow the two previous ones. The graph does not follow opposite lines but move more aligned with each other.

Figure 10. Share of exports in Electrical and electronic equipment, 2006–2011 (in %)

Summing up the data and insights it seems as if there is a negative competitiveness effect. The Dollar lost value relative to the Euro and hence German exports to the US decreased in mid-2008. Moreover, there is a negative lagged correlation between the exchange rate and German exports to the US. The lag can be explained by the four reasons outlined by Junz and Romberg (1973). Moreover, the behaviour of German trade exports and the exchange rate follows the theory of competitiveness effect by Corsetti et al. (2000). Though, trying to find evidence for a competitive advantage through the devaluation of the Dollar for the US and hence the loss of German competitiveness is difficult. Parts of the

0 2 4 6 8 10 12 Q 1, 20 06 Q 2, 20 06 Q 3, 20 06 Q 4, 20 06 Q 1, 20 07 Q 2, 20 07 Q 3, 20 07 Q 4, 20 07 Q 1, 20 08 Q 2, 20 08 Q 3, 20 08 Q 4, 20 08 Q 1, 20 09 Q 2, 20 09 Q 3, 20 09 Q 4, 20 09 Q 1, 20 10 Q 2, 20 10 Q 3, 20 10 Q 4, 20 10 Q 1, 20 11 Q 2, 20 11 Q 3, 20 11 Q 4, 20 11 US Germany

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graphs seem to support the notion of Germany losing market share and the US gaining in return through the relative cheaper prices of US goods, though reasons for that are not clear. Overall, Germany has been losing market share in all of their fifth largest exports groups as well as the US. Hence, it seems like there is a negative competitiveness effect, but more research is needed to clarify the causation for changes in trade patterns.

4.4. Income effect

Compared to the competitiveness effect, the income effect is somewhat easier to estimate. By theory, the income effect occurs when through a crisis the income level in a country substantially decreases. This, in turn, will lower demand for imports in the crisis country and can thus affect a country that heavily exports to the crisis country (Corsetti et al., 2000). Therefore, in the setting of this paper, the second transmission channel, the income effect, is assumed to be negative as the decrease in the US GDP can be interpreted as a decrease in income, which will lead to a decrease in the demand for German exports. This in turn has a negative effect on the German economy that exports largely to the US.

Looking at the data, the theory seems to be supported. In 2008 US GDP decreased by 0.29% and in 2009 by 2.80%. The exports from Germany to the US still grew in 2008 by 5.64% but dropped heavily in 2009 by 27.9%. In return, the German GDP dropped substantially by 5.1% in 2009. These numbers seem to support the existence of a negative income effect as the income in the US measured by GDP dropped only a small amount in 2008 though not affecting German exports in 2008. Moreover, when the US GDP dropped substantially in 2009 the German exports to the US dropped substantially as well. Although there seems to be a connection between the two variables it demands further statistical research to clearly show the existence of this effect.

4.5. Cheap-import effect

The last effect is the cheap-import effect. As described within Corsetti et al. (2000), this effect occurs when a country faces a devaluation of its currency, which leads to its own exports becoming cheaper for other countries. This improves the exporting countries’ terms of trade as the demand for their exports increases through lower prices, and the demand for imports decreases. On the other hand, imports from the crisis country are a lot cheaper after the

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devaluation process for other countries and can possibly finance higher levels of consumption. In this setting it would mean that there is an improvement regarding the US terms of trade with Germany while the US exports to Germany increase and, in turn because of the cheaper US products enable a higher consumption in Germany.

Looking at the data, part of the theory seems to be confirmed. In 2006, Germany exported goods to the US worth of $89.082 billion while the US exported goods worth of $41.159 billion to Germany. Therefore, the US had a trade deficit of $44.744 billion with Germany. Furthermore, in 2007, Germany exported $94.164 billion to the US while the US in return exported $49.419 to Germany. These numbers further increased in the year 2008 but dropped substantially in 2009 in the midst of the economic crisis. In 2009, the German exports went down to $71.498 billions while the US exports went down to $43.306 billions just to start to recover in 2010. This means that the American trade deficit with Germany went down by 36.7% in 2009 compared to the pre-crisis levels in 2006. Although, the terms of trade with Germany improved for the US, the exports from the US to Germany did not increase but decreased. Therefore, the terms of trade only improved because of the decrease in German exports but not due to the increase of the US exports to Germany. Theory though explains that through the cheaper relative prices the US exports should increase while imports to the US decrease. Looking at the German private consumption, the theory does not seem to be confirmed either. By theory, the cheaper imports from the US are supposed to finance a higher consumption level but the data shows a different picture. From 2007 to 2008, consumption increased by around 8.06%. However, in 2009 it decreased by 4.94%. Moreover, from 2009 to 2010 consumption started to increase by the small amount of 0.87% and in 2011 by 2.3%.

Figure 11. German private consumption, 2006–2011 (in million US$)

1500000 1600000 1700000 1800000 1900000 2000000 2006 2007 2008 2009 2010 2011

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Hence, there is no sign of an increased consumption due to the cheaper US’ exports. Moreover, the data in general does not seem to support the existence of the cheap-import effect. However, similarly with the other transmission channels, a more statistical research needs to be conducted to completely confirm the findings.

5. CONCLUSION

This paper tried to estimate the impact of trade linkages between the US and Germany during the contagion of the economic crisis. This was done by examining three trade sub-channels introduced by Corsetti et al. (2000), namely the competitiveness channel, income channel and the cheap-import channel.

In general, the findings suggest that the international financial crisis spread via two of the three trade channels from the US to Germany. As the Dollar lost value relative to the Euro, German exports to the US decreased in mid-2008. Moreover, parts of the data seem to support the notion of Germany losing market share and the US gaining it in return through the relatively cheaper prices of US goods. Therefore, the data suggests the existence of a negative competitiveness channel on the German economy and for the transmission of the economic crisis. Similarly, the numbers seem to support the existence of a negative income channel as the income in the US measured by GDP dropped only a small amount in 2008 and therefore did not affect German exports in 2008. Though, when the US GDP dropped substantially in 2009, the German exports to the US dropped substantially as well. At last, the data does not seem to support the existence of the cheap-import channel. Although, the terms of trade of the US with Germany improved, there is no sign of an increased consumption in Germany due to the cheaper US’ exports. However, due to the nature of the qualitative research more statistical analysis is necessary to confirm these findings.

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APPENDIX A: EXPORTS FROM GERMANY TO THE WORLD; FIVE LARGEST INDUSTRIES DURING

YEARS 2006 TO 2011

2006 2007 2008 Industry Trade volume ($ millions) Share of DEU total exports (%) Share of world exports (%) Trade volume ($ millions) Share of DEU total exports (%) Share of world exports (%) Trade volume ($ millions) Share of DEU total exports (%) Share of world exports (%)

Machinery, nuclear reactors, boilers, etc 211640.57 19.08 14.94 252678.03 19.11 14.71 277403.61 19.13 14.53

Vehicles other than railway, tramway 197047.33 17.77 22.15 238900.05 18.07 21.00 246572.48 17.01 19.92

Electrical, electronic equipment 123119.09 11.10 9.10 141144.77 10.68 9.07 148849.76 10.27 8.50

Plastics and articles thereof 51562.03 4.65 15.92 61090.88 4.62 15.18 66288.58 4.57 14.68

Pharmaceutical products 43452.53 3.92 15.78 55275.14 4.18 16.37 64127.30 4.42 16.32

Optical, photo, technical, medical, etc apparatus 45448.17 4.10 13.73 53107.74 4.02 14.73 56947.26 3.93 13.47

2009 2010 2011

Plastics and articles thereof 51257.95 4.57 13.95 59903.47 4.76 13.14 68777.96 4.66 12.96

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APPENDIX B: EXPORTS FROM GERMANY TO THE US; FIVE LARGEST INDUSTRIES DURING YEARS

2006 TO 2011

2006 2007 2008 Industry Trade volume ($ millions) Share of DEU total exports (%) Share of DEU industry exports (%) Trade volume ($ millions) Share of DEU total exports (%) Share of DEU industry exports (%) Trade volume ($ millions) Share of DEU total exports (%) Share of DEU industry exports (%)

Organic chemicals 4942.57 0.45 17.72 4200.82 0.32 13.78 8057.32 0.56 22.15

2009 2010 2011

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APPENDIX C: EXPORTS FROM THE US TO THE WORLD; FIVE LARGEST INDUSTRIES DURING

YEARS 2006 TO 2011

2006 2007 2008 Industry Trade volume ($ millions) Share of US total exports (%) Share of world exports (%) Trade volume ($ millions) Share of US total exports (%) Share of world exports (%) Trade volume ($ millions) Share of US total exports (%) Share of world exports (%)

Aircraft, spacecraft, and parts thereof 66753.30 6.44 39.83 75952.36 6.53 37.42 68320.43 5.30 31.67

Mineral fuels, oils, distillation products, etc 34940.26 3.37 4.50 42015.52 3.61 4.05 73848.83 5.73 5.12

2009 2010 2011

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APPENDIX D: EXPORTS FROM THE US TO GERMANY; FIVE LARGEST INDUSTRIES DURING YEARS

2006 TO 2011

2006 2007 2008 Industry Trade volume ($ millions) Share of US total exports (%) Share of US industry exports (%) Trade volume ($ millions) Share of US total exports (%) Share of US industry exports (%) Trade volume ($ millions) Share of US total exports (%) Share of US industry exports (%)

2009 2010 2011

What role did trade linkages play in the contagion of the financial crisis 2007? : a case study on the example of Germany and the United States