In Chapter 6, “Restoring International Balance in the World,” Temin and Vines use their model of internal and external economic balance to analyze the state of the global economy in the aftermath of the recent financial crisis. The main players in their story are East Asia (especially China), the United States, and Europe (especially the 17 nations of the European Monetary Union).
Since the 1980s, more countries in East Asia have adopted a path to growth similar to that of Britain, Germany and Japan before them, the model of rapid industrialization and expansion of exports. Rather than letting their currencies float in a way that might limit exports by making them more expensive, they pegged their currencies to the dollar at a low exchange rate, making exports cheap and imports expensive. The price they paid for that was relatively low wages and consumption for their own people, even as their export-based economies took off. Rather than spending the dollars they earned from their exports to boost their own standard of living, they lent them back to us to sustain our standard of living. They saved and lent more so that Americans could borrow and spend more.
Meanwhile, as I described in the previous post, the United States became relatively less competitive in world markets. It tried to keep its economy going by living beyond its means, importing more than it exported, having government spend more than it taxed and consumers spend more than they could afford. When the financial system collapsed under the burden of excessive and increasingly risky debt, the Great Recession ensued. Although a recovery is underway, the United States may now be forced to adjust to its uncompetitive position in another way, through fiscal austerity and high unemployment. The Federal Reserve is trying to reduce unemployment by keeping interest rates low, but it may be reaching the limit of what monetary policy alone can do. The dilemma of fiscal policy is that in the long run, spending has to fall and/or taxes have to rise to reduce debt, but in the short run, either of these measures can increase unemployment. “The US position is perhaps as bad as anywhere, in that there may be too-rapid removal of the stimulus in the short run but no coherent fiscal stabilization plan for the long run.”
The global situation is complicated by the economic condition of Europe. The European Monetary Union was formed in 1999 by twelve countries, later expanded to seventeen. Having monetary unity–a common currency–without political unity turned out to be tricky. It did promote cross-border economic activity by eliminating the confusion and risk of companies having to deal with many different floating currencies. It also seemed to provide some defense against inflation, a central preoccupation of policymakers at the time. “Gradually a view grew…that other European countries could latch themselves onto Germany by forming the European Monetary System, and that by doing so they could assume the anti-inflation credibility of the Bundesbank.” Economic policy in the Eurozone would have four main components: (1) the European Central Bank would pursue inflation control as its prime objective; (2) governments would try to maintain balanced budgets, as opposed to using fiscal policy to stimulate their economies; (3) those in a position to influence wages and prices would try to control them to maintain their country’s competitiveness; and (4) interest rates would be similar among countries. Only the first of these policies–fighting inflation–turned out to be very successful.
Differences in competitiveness among European countries undermined the system, especially the difference between Germany and the GIIPS countries–Greece, Ireland, Italy, Portugal and Spain. Having a common currency turned out to be very much like being on the gold standard before the Great Depression. The less competitive countries had trouble making their exports cheaper or imports more expensive to move toward external balance. With nominal exchange rates fixed, they could only reduce real exchange rates by reducing wages and prices, which would provoke internal resistance. As in the United States, it was easier to maintain demand by running up debt, enabled by global financial institutions seeking high returns while underestimating risks. “Capital inflows enabled increased expenditures, which strengthened the boom in these countries and made inflation worse. The opposite was true in Germany. High real interest rates and outflows of capital, organized by the German banking system, meant that German savings were not used at home but flowed to the European periphery.” So just as Chinese thrift financed American spending, German thrift financed GIIPS spending.
When the global financial crisis struck, the risks inherent in this situation became apparent, leading investors to demand a substantial risk premium–a higher interest rate–to continue lending to the indebted economies:
If a country earns less than it spends for many years because it is uncompetitive, it will be out of external balance, and it will accumulate foreign debts to pay for its imports. Tax revenues will shrink, and the government’s budgetary position will become difficult. There will be political pressures on the government to spend more to counteract the loss of activity caused by the loss of competitiveness, making the fiscal position worse. Financial markets will begin to fear that the country’s government might default on its debt, and a sovereign risk premium will emerge.
The indebted countries of Europe are now turning toward austerity, as is the United States, but the European countries are having it forced upon them suddenly as a condition of financial assistance from the rest of Europe. This has led to large reductions in spending and increases in unemployment. Temin and Vines argue that stronger economies, especially Germany, need some expansion of demand in order to compensate for austerity elsewhere. Otherwise, aggregate demand will fall for Europe as a whole, contributing to global recession. Germany has the potential to become the next hegemonic power, acting for the good of other countries, but so far has not embraced that role.
Germany is forcing a speedy and unprecedented degree of austerity adjustment on the GIIPS. But Germany is not ensuring a correspondingly rapid expansion of demand at home. Instead, it is using its competitive position to ensure that it grows rapidly by means of an export surplus. The external surplus of Germany, caused by an overly competitive position and inadequate internal demand, is making it impossible for the GIIPS to achieve either internal or external balance.
Now let’s combine the European story with the US-China story to see the three regions in combination. The US dollar and the European euro have a floating exchange rate, and that tends to avoid persistent external imbalances where either the US or Europe is unable to pay for its exports with its imports. (According to the Swan IB/EB model, weak demand for either’s products would push down its exchange rate, making its exports more attractive.) But in relation to the Chinese renminbi, both the dollar and the Euro are too strong, damaging the competitiveness of both the United States and Europe. That gives both Europe and the United States an incentive for fiscal caution, if they want to avoid a trade deficit and excessive debt. The northern European economies, especially Germany, have exercised that caution for a long time, while the Americans are just starting to. That’s why the Western trade deficit encouraged by the East Asia trade surplus and weak currency has become largely an American problem. “Low demand in China causes a current account surplus between China and the rest of the world. But Europe’s high savings means that Europe does not run a deficit. The surplus of China is mainly maintained at the expense of the United States. This is the story of the US deficit.”
So here’s the problem: Countries that have been running deficits, notably the United States and the GIIPS countries of Europe, need to pay down debt and move toward austerity, at least gradually. But countries with surpluses, notably Germany and China, cannot maintain their frugality at the same time. If all countries try to curb spending and import less than they export, aggregate demand cannot absorb productive capacity, global output will fall, and global recession will occur. No matter how sensible austerity seems to each country considered alone, global austerity will bring them all down together. The Chinese will need to raise wages and produce more for domestic consumption. The Germans will need to save less and spend more, risking inflation, and it will also need to take the risk of lending to troubled economies so that they can hold down unemployment while they make the transition to greater competitiveness. No other country is in a better position to take those risks. During the Great Depression, Germany made a bid for hegemonic power through military conflict and lost. Now it has an opportunity to assume hegemonic power through peaceful cooperation, resulting in a win-win.
By the way, I wish the authors had given more attention to the qualitative ways of increasing competitiveness. They focus primarily on quantitative adjustments–lowering the nominal exchange rate, lowering costs of production, and so forth. But if a debtor nation can invest in new activities that can find a global market, it may be able to increase exports without just weakening its currency or cutting costs. It can move away from living on credit without moving toward too much austerity. The authors seem to share that goal, but they don’t discuss that way of achieving it.
Although they see a significant risk of continuing global recession, Temin and Vines try to end on a hopeful note. They cite the collaborative process by which the G20 financial leaders (finance ministers and central bank governors from 20 nations representing about two-thirds of the world’s population) have formulated global economic objectives and engaged in an ongoing assessment of progress toward meeting them. In 2011, the G20 Mutual Assessment Process analyzed the policies of seven countries (US, Germany, France, UK, China, Japan and India) and made recommendations similar to those of this book. The authors also report that things are moving in the right direction in China, with expansion of domestic demand, rise in the real exchange rate, and decline in the trade surplus. They remain concerned about trends in the US and Europe, however:
The pressure for austerity, reducing domestic demand, echoes the policies of the early 1930s that led to the Great Depression. And the absence of a hegemon makes it harder to come out of these troubles into anything like the golden age of economic growth that followed the Second World War. We hope that our exposition will help national leaders adopt policies that point us toward the restoration of international economic balance and prosperity.
Beneath the Surface 