September 27, 2010Same problem, Different solutions ...
There are two massive fixed exchange rate blocs operating in the world economy today, and both of them face severe strains and conflicts. The eurozone is beset by problems which are typical of fixed rate blocs in the past, with the main surplus country (Germany) refusing to increase aggregate demand, thus forcing the deficit countries to reduce demand in order to stay within the currency arrangement. This, they appear willing to do, or at least to try.
Meanwhile, the China/US bloc also has a (nearly) fixed exchange rate, and once again the surplus country (China) is refusing, or is unable, to expand domestic demand enough to eliminate the trade imbalance. But, in this case, the deficit country (the US) is increasingly unwilling to accept the consequences, and is adopting policies which are designed to break up the bloc altogether. Two blocs with somewhat similar problems, but very different responses and outcomes for the deficit countries.
In making this analogy, it is of course important to accept that the institutional arrangements surrounding the world’s two major blocs could hardly be more different, with the eurozone established as a single currency area, while the Sino/US bloc is officially a linked but flexible exchange rate area. But the critical feature of both areas is that nominal exchange rate adjustments are not permitted to equilibrate trade imbalances within either of the two blocs, so a persistent pattern of large current account imbalances has emerged. Germany and China are the two economies where chronic surpluses have emerged, while the Club Med economies and the US have the corresponding chronic deficits.
This pattern of trade deficits can only persist as long as there are offsetting capital flows within the two blocs, and for many years this was the case. The required capital flows within the eurozone, from Germany to the peripheries, were facilitated by the existence of the single currency, which created the illusion that investments in the deficit countries were largely risk free. In the Sino/China zone, the required capital flows were mainly driven by the foreign exchange intervention of the Chinese central bank, which resulted in huge official flows from China into US Treasuries. These equilibria persisted for many years, so the trade imbalances within the two blocs just grew and grew.
Eventually, the imbalances grew to be so huge that strains developed on both the currency systems. In Europe, these strains showed in the bond markets of the deficit countries, because the required internal capital flows were no longer available at “normal” bond spreads. One solution to these problems would have been for Germany to reduce the trade imbalance within the bloc by increasing the growth in its aggregate demand, and possibly by accepting a rise in the German inflation rate. However, the recurring pattern which has emerged from previous fixed exchange rate regimes, like Bretton Woods, is that the surplus country usually refuses to do this, and Germany has followed this pattern.
Consequently, the European deficit countries have faced a stark choice - either leave the euro and devalue, or reduce the trade imbalance by deflating. So far, they have chosen the “hard currency” path of deflating, though there are questions about whether this path will in the end prove feasible.
Now let’s compare this with the Sino/US currency bloc. Once again, the surplus country (China) is failing to eliminate the trade imbalance through a sufficient rate of increase in domestic demand. Although the Chinese current account surplus has declined in recent years, the IMF suggests that it will rise from $334bn in 2010 to $759bn in five years’ time. So far, this has not caused intolerable financing pressures on the US, because China is willing to continue to finance much of the US deficit with official capital flows. But China’s willingness to persist in this endeavour is beginning to fray at the edges, which is why they are diversifying their reserve holdings into yen and euros. And the US is becoming increasingly unwilling to accept the consequences of the overvaluation of the dollar against the renminbi, which is transferring economic activity out of North America towards Asia.
The strains within the Sino/US bloc are not yet forcing the US, as the deficit country, to reduce demand in order to keep the system intact. In fact, it is rather the reverse, with the US deciding that it needs to stimulate its economy, despite the large trade imbalance which it is continuing to run. In doing this, it is fully aware that it is running the risk that its trade deficit will no longer be financeable without a currency devaluation. Far from disliking that option, it seems actively to want it to happen, with Congress trying to force China to revalue the RMB against the dollar, and the Fed on the verge of launching QE2. So in the Sino/US currency bloc, the deficit country is refusing the “hard currency” option, and is choosing (if it can) to break the bloc by devaluation.
The IMF has suggested that a better way forward would be for the surplus countries, Germany and China, to relieve these pressures by boosting domestic demand, and are trying to persuade the G20 to agree to such a package at the summit in South Korea in November. A co-ordinated policy shift in which the surplus countries raise demand, the deficit countries cut their fiscal deficits, and the RMB is revalued, is likely to be optimal for all parties.
It would be nice if this could happen. Nice, but not very likely.
http://www.einnews.com/europe/newsfeed-europe-economy
