Wednesday, 14 December 2011

Who's Got the Newest Euro-Kit?

It doesn't seem like a rash assumption that in 2012 there is more likely to be a shortage of demand than supply for most goods and services in the Eurozone. Who sort of company, and what sort of country, does that suit best?

The standard answer – and it's not wrong – is that in these circumstances, operating margins get squeezed, and consequently the winner will be the one who can maximise asset turns. Any company (or country) which has been investing heavily on the expectation of maintaining operating margins is going to be profoundly disappointed and possibly financial threatened.

But the standard argument misses one crucial point: the company/country that's been investing most heavily recently may have a larger stock of capital on which it must raise asset turns, but it will also have the newest stock of capital equipment. And if the world is one in which labour markets are sticky (wages difficult to cut, employees difficult to fire) and fx rates similarly sticky, the later the generation of equipment, the better. In cases where there are few other avenues of comparative advantage, arming your workers with the newest generation of equipment could be the difference between competitive success and failure.

The caveats that this will prove most important in countries with sticky labour markets and no room for currency fluctuations directs our attention immediately to countries within the Eurozone. Of the large Eurozone economies, neither Italy nor Spain is likely to be a position to respond to deteriorating market conditions with anything more than lunges for survival. But we need not assume that Germany, France and the Netherlands will necessarily be in survival-only mode. So which has the newest capital stock?

We can estimate the average age of capital stock by by extending my usual technique of depreciating all fixed capital spending over a ten year period. When we do, this is what we find.
This chart tells us something rather important: whilst Germany still has, on average, just about the oldest capital stock of these three countries, the difference – which is an important element of comparative advantage – has narrowed dramatically since the financial crisis. As of September, the estimated average age of Germany's capital stock was 3.89 years, now virtually indistinguishable from its Netherlands neighbour, but only very slightly older than France's average 3.83 years. During the pre-crisis years of 2005-2008, the age gap between Germany and France averaged 0.32 years, and the age gap between Germany and the Netherlands averaged 0.19 years. What's more, these are necessarily slow-moving trends, and it's very likely that when the final data for 2011 is published, we'll find Germany has newer capital stock than the Netherlands. By the middle of 2012 we should expect it to have a newer capital stock than France.

This represents a structural sea-change in comparative advantage within the Eurozone, in Germany's favour. Having deflated its way back to competitive equality, those same forces are now entrenching a new comparative advantage. It is extremely difficult to see how France and the Netherlands can be expected to recoup the ground they are losing right now, except by developing competitively flexible labour markets. Let me put this in plain language: we should expect the growth differentials between Germany and even its financially-confident neighbours to widen from here in a way simply not seen since the introduction of the Euro. German economic dominance over the Eurozone will grow inexorably.  

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