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 per cent to 40 per cent. 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 behaviour, 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 Germany’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 The Telegraph:
"The downgrade [of France] does not appear to me to be justified when considering economic fundamentals,” 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 in the Financial Times by the no less astonishing comments by Franois 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 sceptical 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 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 sceptic 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.
Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets.