Unwinding Global Imbalances

Several readers pointed to a recent post by Michael Pettis, which mainly discussed how expected wage increases in China are a hopeful sign that China is taking steps to become more consumption-oriented. But as much as this is a move forward, changing the mix of China’s composition of demand is at least a decade-long project unless the powers that be move aggressively to hasten it. As much as I have seen some commentators argue that China understands the need to move away from an export/investment driven model, there does not seem yet to be much in the way of official action along these lines.

But I found Pettis’ discussion of Eurowoes to be useful, and start with his punch line first:

You can’t run large trade surpluses if your trade partners are no longer able or willing to run the corresponding trade deficits.

This is a non-trivial observation. It is common to blame the debtor (after all, they are the ones that welches on its obligations), but like many things in life, parsing out responsibility is often more complex than it appears on the surface.

Let us consider the sad example of Lucent. During the dot-com era, a myriad of obviously-never-gonna-make-a-dime-in-profit companies were accorded all kinds of bizarre adulation, including sycophantic coverage in the business press and IPOs at delusional valuations. So the whole business model was greater-fool theory. And it wasn’t just the poor dumb stock buyers who were duped, but vendors. I am not familiar with the details of the arrangements, but when Carly Fiorina was head of marketing at Lucent, she ramped up sales (and her compensation along with it) by selling equipment by the boatload to these ultimate dot-bomb enterprises in return for paper of various sorts that proved to be worthless. One of my buddies had the misfortune to ride the stock down from $100 a share to $1.

And it wasn’t just Lucent. McKinsey, like many other consulting firms, was desperate to have a robust dot-com business, and similarly sold took equity in lieu of fees. I am told by ex-partners that it took $200 million in writedowns.

So if you think of the surplus country as having put itself in the position of being a vendor (not exactly correct, but a useful way to reframe the problem), it is not in a vendor’s interest to keep selling to a deadbeat, or someone who for other reasons is no longer a suitable outlet for your product. So Pettis’ point is that Germany really does need to do something, which is consume more:

Unfortunately the euro today imposes a kind of gold standard on European countries – it forces them to adjust to excessively high domestic prices, large trade deficits, and/or large fiscal deficits in the same way they would have had to adjust under the gold standard, and I don’t think that is politically likely to be acceptable. The countries that need depreciation to regain competitiveness or monetization of the debt to regain control of the deficit will have to choose between adjusting via deflation and high unemployment or exiting the euro. Politics makes the latter more likely.

There is one other way out, perhaps. Martin Wolf discussed it last week in an important Financial Times article called “Europe needs German consumers”. Wolf argued that trade imbalance within Europe helped to create the subsequent and damning financial imbalances, and that without resolving the trade imbalance it is pretty pointless to talk about fiscal belt-tightening and lower wages as the means by which the problems of outer Europe will be resolved….

This, of course, is the intra-European version of the global imbalance debate. It is simply another way of saying that policies in major trading nations that constrain consumption and subsidize production – in effect trading off lower household income for higher domestic employment – must have the reverse impact on trading partners who implicitly made the opposite trade-off, giving up employment in exchange for higher consumption. As long as those trading partners were able to use the recycling of surpluses to leverage up domestic demand, and so boost domestic employment through debt-fueled growth, the adverse employment effect was hidden.

Once the leverage process started to unwind, however, the deficit countries would inevitably see a surge in domestic unemployment. The best way to deal with the problem is to have both sides unwind the mechanisms that created the mirror trade-offs. Germany must put into place policies that trade higher consumption for lower employment, and use debt to force employment up, so that deficit Europe can gain employment, albeit at the expense of a lower share of consumption.

Germany might not like reversing this trade-off, which was the source of much of its recent growth (almost 70% of its growth since 1997), but in the longer term it will be much cheaper than bailing out the European countries, or allowing them to exit the euro messily and anyway force the reversal of the trade-off on Germany.

Pettis argues that boosting consumption is a cheaper course of action (and will ultimately be forced on Germany regardless) he does not acknowledge a wee timing problem. The budgetary and bond market pressures on Greece are near-term, while (even assuming there was a political consensus for dramatic change) shifting gears in an economy is a protracted exercise. So while this type of change is the ultimate way out this conundrum, I am skeptical that it can happen quickly enough.


Originally published at Naked Capitalism and reproduced here with the author’s permission.