The Great Rebalancing (part 4)

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Pettis’s analysis of the European debt crisis is based on the same principles as the rest of his analysis. Crises are caused by economic imbalances. These are both trade imbalances and complementary gaps between savings and investment:  “Any policy that affects the gap between savings and investment in one country must affect in an opposite way the gap between savings and investment in the rest of the world.”

In the European case, the players are on the one hand northern European countries that produce more than they consume, save more than they invest domestically, and run trade surpluses; and on the other hand the mostly southern European countries that consume more than they produce, save less than they invest domestically, and run trade deficits. As usual, Pettis discourages us from attributing the crisis to the moral superiority of the first group of countries over the second:

Confused moralizers love to praise high-savings countries (let us call them all “Germany”) for their hard work and thrift, and deride high-consuming countries (which we will call “Spain”) as lazy and too eager to spend more than they earn. The world cannot possibly rebalance, they argue, until the latter become more like the former….The high German savings rate…had very little to do with whether Germans were ethnically or culturally programmed to save—contrary to the prevailing cultural stereotype. It was largely the consequence of policies aimed at generating rapid employment growth by restraining German consumption in order to subsidize German manufacturing—usually at the expense of manufacturers elsewhere in Europe and the world.

After German reunification in the early 1990s, Germany adopted a set of policies designed to promote productivity and competitiveness and combat unemployment. It held down consumption with wage constraints and high taxes, while using tax revenue to build infrastructure. It succeeded so well that it became a large net exporter of goods and capital to other countries in Europe. But in accordance with Pettis’s inexorable economic logic, other countries had to be net importers of goods and capital, with consumption greater than production and savings less than investment.

In those respects, the relationship between Germany and Spain resembles the relationship between China and the United States. However, one of the mechanisms by which countries like Spain became so heavily indebted is different. The US and China have two different currencies, one artificially strong because of the dollar’s traditional role as the primary reserve currency of the world, and the other artificially weak because the Chinese government wants to favor exporters over consumers. That helps make Chinese exports cheap and US exports expensive. Before the financial crisis, the demand for dollar-denominated assets like US stocks, bonds and mortgage-backed securities pumped up asset prices and held down interest rates, making Americans feel richer than they were and making it easier for them to borrow.

A different currency mechanism helped create the European imbalances–the European Monetary Union! Here I found Pettis a little vague on the mechanics, but here’s how I understand it: If each country had its own currency, and each currency were valued realistically relative to the others, then countries would find it harder to become too indebted. Less competitive countries would have weaker currencies, and they couldn’t afford to import very much, or borrow without paying high interest rates. The adoption of the strong Euro–which became the world’s second most desired currency after the dollar–created an illusion of financial strength in the less competitive economies, helping them to spend more and borrow at low interest rates. They could grow their economies, although like the US they relied on growth in the nontradable goods sector that sometimes took the form of housing bubbles. Stronger economies like Germany were only too happy to export their products and their excess savings to support the high levels of spending and debt. Only after the formation of the EMU did Spain, Italy, Portugal and Greece routinely run large deficits. “German anticonsumption policies force up the German savings rates and the German trade surplus, and European monetary policies force those surpluses onto the rest of Europe.”

Pettis sees only three possible resolutions to the European crisis:

(1) a reversal of the trade imbalances, which requires that Germany stimulate demand to the extent that it runs a large trade deficit, (2) many years of high unemployment, including, soon enough, in Germany, or (3) the breakup of the euro and sovereign debt restructuring for much of peripheral Europe including, possibly, France.

The second route is the familiar idea of imposing more austerity on the debtor countries. They got themselves into this mess, so the story goes, and so they should pay down debt and reduce consumption. The problem is that the Europe’s economy depends on the consumption of the deficit countries in order to balance the frugality of the surplus countries. If everyone tries to be frugal at once, aggregate demand will collapse, causing high unemployment throughout Europe.

Pettis much prefers the first route of higher German spending, although he admits it would require “a radical change in German understanding and commitment to Europe.” But “if Germany were to stimulate domestic consumption massively by reducing income and VAT taxes, turning its trade surplus into an equally large deficit, Spain and the other deficit countries of Europe would be able to grow their way back into health and earn the euros to repay their external debt.”

If Germany cannot make the transition to a higher-consumption society, and deficit countries cannot accept a crushing burden of austerity, then the EMU may not survive. Indebted countries would then suffer a loss of buying power as they returned to their own weaker currencies. Creditors in richer countries would also be hit, since they would have trouble collecting their debts. Since both kinds of countries share the responsibility for creating the problem, Pettis sees a certain logic in both having to share the consequences:

This makes it illogical for Germans to insist that the peripheral countries have any kind of moral obligation to prevent erosion in the value of the German banks’ loan portfolios. It is like saying that they have a moral obligation to accept higher unemployment in order that Germany can reduce its own unemployment.

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