Europe’s underlying problem is not budget deficits or even unsustainable debt. These are mainly symptoms. The real problem with Europe is the huge divergence in costs between the core and the periphery – in the past decade costs between Germany and some of the peripheral countries have diverged by anywhere from 20% to 40%. This divergence has made the latter uncompetitive and has resulted in the massive trade imbalances within Europe.
Trade imbalances, of course, are the obverse of capital imbalances, and the surge in debt in peripheral Europe in the past decade – debt owed ultimately to Germany and the other core countries – was the inevitable consequence of those capital flow imbalances. While European policymakers alternatively sweat and shiver over fiscal deficits, surging government debt, and collapsing banks, there is almost no prospect of their resolving the European crisis until they address the divergence in costs. Of course if they don’t resolve this problem, the problem will be resolved for them in the form of a break-up of the euro.
The best resolution, and the one Keynes urged without success on the US in the 1920s and 1930s, is that Germany take steps to reverse its trade surplus. It could boost disposable household income and household consumption by cutting income and consumption taxes, and as German household income grows relative to the country’s total production, the national savings rate would automatically drop and the trade surplus contract and eventually become a deficit. Or Germany could engineer a massive increase in infrastructure spending.
If Germany doesn’t do either, and especially if it imposes austerity, there must be a surge in unemployment for many years within Europe as German excess capacity meets dwindling demand in peripheral Europe. This surge in unemployment will force the peripheral countries into the unenviable choice either of absorbing that surge in unemployment themselves, or of forcing the unemployment back onto the core countries by abandoning the currency that is at the heart of their lack of competitiveness.
The historical precedents – and much of the commentary coming out of Germany – suggest that Germany will not take steps to reverse the trade surplus. Countries that run large and persistent trade surpluses never seem to understand that their surpluses are mainly the consequences of domestic policies that generate additional domestic growth by absorbing foreign demand.
On the contrary, they usually insist that the surpluses are the consequences of domestic virtue, and they see no reason to give up being virtuous. Surpluses, they seem to believe, are the way God rewards them for their enviable behavior, and as their surpluses decline – an inevitable consequence of the malaise affecting their trading counterparts – they actually try to limit the decline and do all they can do to prevent it from becoming a growing trade deficit.
But this violates simple arithmetic. Trade deficit nations have received capital inflows for many years from surplus nations as the automatic counterpart to their deficits. If the surplus nations ever hope to get repaid – i.e. to reverse those capital flows – then it must be obvious that the trade imbalances must also reverse.
Spain, for example, can only support net capital outflows if it is running a current account surplus. Germany can only receive net capital inflows if it is running a current account deficit. If Spain wants to repay its debt to Germany, and if Germany hopes to have its Spanish loans repaid, this can only happen if the former runs a current account surplus and the latter a current account deficit.
When should imbalances reverse?
The Germans, however, will argue that now is not the time for them to run a trade deficit, which would be the main way of running a current account deficit, presumably because their debt burden is rising, and so cutting taxes or increasing infrastructure investment will weaken their credit at exactly the wrong time. They need to continue running surpluses for a few more years, they will insist, to protect themselves from the impact of the European crisis.
This is insane. Countries cannot run surpluses forever, just as they cannot run deficits forever. For debt not to build up to unsustainable levels in the deficit countries, both deficits and surpluses must ultimately be reversed.
When is the best time to do so? Obviously the best time to do so is before the debt becomes unsustainable and there is a financial crisis. If we have already passed that point, however, as we clearly have, when is the next best time to reverse the trade imbalances?
The answer should be obvious – right now. If the present is not the right time to reverse European trade imbalances so as to allow the deficit countries to earn the wherewithal to support capital outflows, then when will it ever be the right time? And by the way, as long as we are concerned about protecting German’s credit, if Spain cannot run a trade surplus, it cannot repay the debt it owes to Germany. This also is just arithmetic.
This means that German reluctance to put into place policies that reverse the trade imbalances within Europe is illogical. As the market has already indicated by its panic over European credit, German credit will be far more seriously damaged by defaults in the peripheral countries than by a cut in domestic income and consumption taxes, or by a surge in domestic infrastructure investment.
To make matters worse, it seems that not just debt prices but also credibility are in free fall. Here is an astonishing quote from Christian Noyer, the Governor of the Bank of France and an ECB policymaker, according to an article in Saturday’s Telegraph:
“The downgrade [of France] does not appear to me to be justified when considering economic fundamentals,” Mr Noyer said in an interview with local newspaper Le Telegramme de Brest. “Otherwise, they should start by downgrading Britain which has more deficits, as much debt, more inflation, less growth than us and where credit is slumping,” he went on.
This was followed by the no less astonishing comments by François Baroin, French finance minister, who said: “The economic situation in Britain today is very worrying, and you’d rather be French than British in economic terms.”
Wow. This kind of fighting among countries is childish but unfortunately all too predictable given the historical precedents. The English probably started the fight with some skeptical comments by Mervyn King, the Bank of England governor, about the health of the euro (not that he was wrong, just very indiscreet), but the French response has been a little out of control.
Aside from the fact that Mr. Noyer seems to have a limited concept of sovereign credit (France is not being considered for downgrading because of its explicit government deficits or its high inflation), these various statements should worry anyone who believes that the European crisis cannot be resolved without cooperation among European policymakers. If they are so obviously squabbling, the skeptic in me wonders whether they really believe they can resolve the crisis, or whether they have already given up and are now preparing to assign blame.
Time to devalue the RMB?
There isn’t nearly as much (at least visible) antagonism and undermining behavior among Chinese policymakers, but I worry that there is nonetheless the same lack of logical thinking among them in regards to their “right” to a trade surplus – although at least they are not facing massive defaults in the countries to whom they have lent. As China’s trade surplus declines dramatically, more and more people within the country are calling for interventionist steps to halt the decline, including depreciating the RMB, or at least halting its appreciation.
The rapid contraction in China’s trade surplus, they say, is evidence that China is rebalancing too quickly. Already the Ministry of Commerce is issuing warnings. This article is from Friday’s People’s Daily:
China’s trade will face ”very severe” conditions in the first quarter next year, a spokesman for the Ministry of Commerce said yesterday. “The external economic climate will become very complicated next year, and net exports are set to slow,” Shen Danyang said. “We will further accelerate reforms to achieve a better balanced trade and make overall trade remain a positive contribution to the economy.
For trade to make a positive contribution to growth, of course, China must maintain a trade surplus – in a world of stagnant demand, only net demand from trade, that is a trade surplus, can contribute to growth. Trade deficits reduce demand, and I suspect that in spite of long insisting that the US trade deficit has not been negative for US growth, the Ministry of Commerce is unlikely to be as forgiving of a Chinese trade deficit.
But we would have to ask the same question of China as we would of Germany: if now is not the right time for China to run a trade deficit, when its reserves are sky high, when rebalancing the Chinese economy away from investment to consumption is more urgent than ever, when global imbalances have thrown the world into crisis, when will it ever be the right time?
Not next year, apparently. There is developing in Beijing, I think, almost a panic about global economic prospects and the impact of the European crisis on China. This panic is going make the rebalancing process harder than ever because a Chinese rebalancing almost necessarily requires a rapid slowdown in growth as investment decelerates sharply long before a rise in consumption can take up the slack. Weakness in the export sector makes the slowdown all the more costly.
Certainly the focus of the very important central economic work conference that ended this week suggests that maintaining growth is the key. Here is Saturday’s description in the People’s Daily:
China’s economic objective in 2012 will be to seek relatively fast growth while maintaining stable consumer prices, said a government statement issued yesterday, wrapping up the three-day central economic work conference.
“The theme of next year’s economic and social development is to make progress while maintaining stability, which means to maintain basically steady macroeconomic policy, relatively fast economic growth, stable consumer prices and social stability,” the statement said.
That sounds pretty reasonable. However the Financial Times’ version of the story, perhaps not surprisingly, is a little more explicit:
China’s ruling Communist party wrapped up its most important economic meeting of the year with an agreement to focus on maintaining fast economic growth in the midst of what it described as an “extremely grim and complicated” global outlook. The annual three-day Central Economic Work Conference for top Communist officials sets policy for the coming year and this meeting clearly signalled that the leaders of the world’s second-largest economy are concerned about a slowdown in growth.
“Growth has replaced inflation as Beijing’s top policy concern,” said Qu Hongbin, co-head of Asian economics research at HSBC. “The economy is likely to slow further, calling for more aggressive easing measures.” At the same conference last year, China’s leaders explicitly named taming inflation as the key policy goal for 2011.
The slowdown in growth is worrying an awful lot of people in Beijing and with all this concern, of course there is a lot of attention on trade policy. Will the RMB appreciate or depreciate in 2012? Within China many are going to argue that the rapid decline in the trade surplus, coupled with unmistakable evidence of flight capital, means that the PBoC should devalue the RMB. Others within China will argue that debt levels and domestic imbalances are so worrying that the RMB should continue appreciating in order to speed up the pace of rebalancing.
If this were the whole extent of debate, it would be pretty easy to guess that the former side would win, but of course there is also international pressure. Foreigners are going to argue that China’s maintaining a trade surplus will simply subtract from foreign growth, and given higher unemployment and lower growth in the US, Europe, and much of the developing world, China has no natural right to insist on a trade surplus at their expense.
With the trade environment getting worse all the time, I suspect that international pressure is ultimately going to decide the issue. If China depreciates it will almost certainly set off furious retaliation – and remember, surplus countries always lose trade wars. Deficit countries often win, at least in the near term.
11 Responses to “If No Trade Reversal Now, Then When?”
It is foolish to suggest that Germany boost disposable household income and household consumption by cutting income and consumption taxes, or that Germany could engineer a massive increase in infrastructure spending. After all Germany’s debt burden is above 80% of GDP – not including risks from the ESM and EFSF- and thos policies would without a doubt raise German debt.
Of course you are right that trade imbalances inevitably need to turn around. But the only way to do this in an environment of high public debt and fixed exchange rates (Euro!) is to introduce tarifs which is not allowed within the European market. Tarifs as opposed to the meassures you suggest boost tax revenues, thus enhancing the governments leeway to cut consumption taxes without raising debt. Else, countries may wait and hope that another country will do the necessary, thereby breaking the law. All European countries do the later rather than the fromer, fretting repercussions from their European peers if they do something that might be necessary but is whithout a doubt illegal.
What we really need is a European consensus to reintroduce tarifs and to do so in a cordinated and peaceful way.
BTW: I am German and I do not think in any way that it is a virtue to run a trade surplus. What Germans really resist is to reduce trade imbalances _by_the_means_suggested_ in the anglosaxian blogosphere because all of those suggestions raise German debt.
Wow. And what if Eurozone countries economical data were to be considered globaly instead at state level ?
Answer this question and you'll know when.
@ Stephan: I am German as well, and I agree that the reduction of the German trade surplus should be accomplished without increasing German (sovereign) debt. However, introducing trade tariffs, which are normally not a first best trade policy, should be out of the question. Remember the 1930s? Furthermore, I question that tax reductions will cause a drop in the savings rate, and thus lead to increased consumption. An income guarantee such as a minimum wage might be more suitable to increase consumption since it promises to give an incentive for reducing precautionary savings.
Also, I think that the whole issue in Europe is one of productivity. Germany greatly increased its productivity after a lost decade (the 1990s). On an international scale it is only rational that cheap and good products are preferred. As a nominal devaluation is impossible for single members of EMU, only the painful real devaluation remains. Therefore, more recourses should be used to find a way how Germany (core Europe) can mitigate the pain in peripheral Europe without increasing its (their) sovereign debt
Second, I would like to introduce another point. It is well known that the German population is aging. A relative increase of retired people could have a significant impact on capital flows as earlier investments (abroad, e.g. Spain) are liquidated. Thus, there might be a "natural" effect German capital flows.
True, Germany has large surplusses and they should vanish. But increasing German government debt is not necessary. It would be much easier to find agreement among Euro countries that Germany may impose export taxes vis-a-vis deficit countries. With non-Euro deficit countries similar agreements may be found.
For the Euro zone wouldn´t it be of some help in the medium term, especially for peripheral countries with competitiveness problems who want to remain in the Euro zone, if Germany would do two things: one, induce, howsoever, its exporting companies to tentatively and step by step over a few years increase their Euro export prices, in order to achieve a measured reduction in German net export, while by same means increasing their profit margin? And two, for its export companies "sort of fix against depreciation the Euro rate to the US$" at e.g. 1,30 and in case the Euro depreciates, say to 1,25, to put an export tax on export contracts denominated in Euro to countries which use US$ or are pegged to US$, so that prices in US$ stay the same (in this case 4% tax (1,25*1,04=1,30))? Of course this would have to be adjusted/reduced accordingly for countries which depreciate against the US$. If it is done carefully, it would also be good for Germany´s terms of trade as well as a tax revenue would be welcome.
A beginner such as myself would think that increased Productivity would lead to reduced prices, given an adequate level of competition in the economy. Looking at the latest available OECD datasets, this does not seem to happen, at least within the Eurozone. Take Germany, France, Italy, Spain. I have normalised the figures as a percentage of the highest scorer.
Productivity – GDP per hours worked:
France 100, Germany 93, Italy 76, Spain 82
Comparative Price Levels:
France 100, Germany 93, Italy 87, Spain 88
A beginner such as myself would conclude that the ‘superior productivity’ in terms of GDP value, was more due to the higher local price levels, rather than to the superior Northern European personal attributes. Could one of the experts on this Blog enlighten me?
I'm curious as to why Germany has to do all the adjusting–by whatever means. Why is Germany more productive and the deficit countries less so? I know capital intensity is part of it but so are other aspects of efficiency, such as the absence of the kind of massive and massively inefficient public sectors in the periphery countries. If they could find the political will (or otherwise be forced by events) to follow through with austerity measures, however painful, such as the elimination of bloated public service payrolls and reduce transaction costs, shouldn't their export performance improve vis-a-vis Germany, therefore reducing the imbalances? I wish to add that I am approaching the problem from the point of view of conventional economic theory and real-world examples, not Republican Party ideology!
China obviously is a different kettle of fish because it's not part of a currency union but there are so many distortions in the Chinese economy that they should be doing more adjusting–in the direction of increased domestic consumption as a share of GDP–than their deficit trading partners, it seems to me. I am aware that this could raise the cost of financing the US federal budget deficit but that's no worse than other prescriptions.
I do not understand why Germans should consume more by themselves or why people in the U.S. should consume less in order to solve the global imbalances. Germans always have been inventors of great machines and tools and it is natural that these things are exported to other countries which are less inventive in that respect. The point here is that other countries are unable to come up with something else which Germans would value and take in exchange for their great machines. The Anglo-Saxon world seems to be obsessed with financial services and just keeps looking at numbers and accounts. Numbers are irrelevant in the real world. What counts is value. And that is purely subjective. Germans could in exchange get their CO2 free energy supply which they so much desire, for example. Germans could also get back services for the elderly. Germans could also outsource military protection. By historical standards there have been lots of inventors elsewhere in this world and I just wonder where they all have gone? Probably to Wall Street where they design worthless financial services. That is something which Germans probably will not value in exchange for their products.
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