For the past 60 years, Europe has always managed to muddle through its problems. This time, however, might really be different.
Why has the euro zone crisis refused to go away? Everyone panicked in September 2008 when Lehman Brothers folded, but within a few months the US government seemed to have a handle on the situation. The Dow Jones was at an absolute low in March 2009, but today it is almost double that level.
But Europe’s crisis runs deeper. At its source are two fundamental and contradictory truths. First, debt cannot be cured with more debt. Europe is facing a balance-sheet recession in which the private sector, households and the government are all heavily indebted. Tax cuts simply do not work in such a situation: People will use the money to pay off existing debt, rather than spending it. Instead, governments need to look to methods like infrastructure spending to funnel money into the economy and directly re-employ people.
Second, European countries cannot all cut their way to growth at the same time. What Germany wants, an “austerity union for all,” is what John Maynard Keynes called the “fallacy of composition” – austerity makes sense for individual nations, but collectively it is disastrous. If every country in Europe is forced to cut spending and increase taxes, the continent could very well cut its way into extended recession, or even depression. The only way for the debtors to restore balance is for the creditors to help them out a bit.
Each truth negates the other, and therefore countries need to coordinate at the European level. Both debtors and creditors have to do their part. The debtor nations in Europe – Portugal, Ireland, Italy, Greece and Spain – should implement some austerity measures. But creditors – like Germany, France, Austria, Finland and the Netherlands – also need to accept some of the responsibility.
Germans often complain that they should not be punished for making good cars, for “being productive and competitive.” I faced an angry crowd in Berlin when I made the point that there are imperfect parallels to be drawn between them and the predatory lenders in the US subprime housing market. Who is to blame, the poor person who buys a million-dollar home he cannot afford, or the banker who tells him he can afford it? In a sense, Germany did well with the previous arrangements in Europe – they provided the money to the Italians, Greeks and Spanish that allowed them to buy German products.
So if the debtors have to adjust and lower their spending, then the creditors should start spending a little more. The best thing might be for Germans to vow for the next decade to go on holiday in the Mediterranean, and Greece in particular.
But while both sides are to blame for the imbalances, politically one side has far more convincing arguments than the other. It is difficult to imagine Angela Merkel explaining to local voters, “The problem is that there is such a thing as intra-EU macroeconomic imbalances that have been building up over the past decade. It’s simple. There’s a balance of payments, with a current account and a capital account, and official international reserves, and they all add up to zero. So basically our current account was positive, only because our capital account was negative…”
It is never going to work. The German voters would respond, “Are you mad? The Greeks retire at 50 and we retire at 65. The Greeks get higher salaries than we do. The Greeks have a budget deficit of 12% of GDP, and we have a deficit of 3-4% of GDP.” What’s more convincing?
Just as in the Tea Party in the US, austerity appeals to our good housefather idea. “If I should spend within my means, so should the government.” But this idea is fundamentally false. If everyone stops spending and so does the government, then nobody is spending. And in the macroeconomy, somebody’s spending is someone else’s income.
Germany is encouraging the Greeks, the Italians, the Irish, the Spanish, the Portuguese, and for that matter the French and the Belgians to become more like them. But a Europe that is more like Germany is contradictory and quasi-impossible to achieve, unless Europe wants a huge imbalance with the rest of the world economy.
Germany can only be Germany because the others are not. It is Germany that has benefited most from the regional divergences in the European Monetary Union. Countries cannot all simultaneously export their way out of their problems – the world is not trading with Mars or Venus yet. Every creditor country needs a debtor country; every lender needs a borrower.
Lessons for China
The debtor-creditor relationship is an important intra-European story, but what does it mean for China? Just as there is a need for rebalancing public and private debt in Europe, there is a need for global rebalancing. And it is still not clear that either Europe or the world economy is moving in that direction.
There are persistent current account imbalances within the G-20. China, Saudi Arabia, Japan and Germany all have significant surpluses on their current accounts, while the US current account balance is hugely negative, and the UK is slightly negative. The trend is the same for savings: Germany is heavily in the positive, and the Chinese savings rate, which is among the highest in the world, rose from 2000 to 2010. The US savings rate has only gone down, as has the UK’s.
Within Europe, Germany can force almost all the adjustment process on the European periphery, as they are doing now. There is an asymmetric power structure in the European Union: Germany decides and the others follow, because Germany is the indispensable economic power.
The G-20 is a different story – the US is no longer the hegemon it once was, but China is far from being one itself. Global rebalancing must find a way to proceed without a single dominant power. China cannot force all the adjustment on the US, because that will lead to mutually assured destruction. China’s worst fear is that the US stimulates its economy, causing inflation and cutting the value of Beijing’s foreign reserves. Of course, if the US cuts too much and tips into another recession, Chinese manufacturers would suffer. On the other side, the US wants China to adjust by revaluing their currency and buying more American goods.
The best solutions for both China and the US are self-defeating: Either impoverish the US consumer, or impoverish the Chinese central bank asset base.
The US and China will have to agree one day. Exactly what Europe should be doing, but is not, the world as a whole needs to do. But it will be a lot harder, because it will have to be by mutual agreement.
The centrality of Europe
The financial markets are currently in a love affair with the emerging economies. I hear all the time that Europe is finished or that America’s best days are over.
That may well be true. The recent statistics are undeniable: the BRICs are growing faster, and have tremendous economic potential and population growth. Asia is the only continent where there is any optimism left.
But here’s the snapshot of the world economy: The US accounts for US$10 trillion in consumption every year, and the EU accounts for another US$10 trillion. China only accounts for about US$2 trillion. The picture is changing fast, but US$20 trillion vs. US$2 trillion is a huge difference. As a result, growth of only 1-2% in the US and Europe is more consequential for the world economy than growth of 10% in China – an important fact to keep in mind.
To be sure, south-south trade is growing. China and other emerging markets will play a bigger role in global organizations like the World Bank, IMF and the G20, and rightly so. But lack of a solution in Europe or fiscal dithering in the US is a terrible thing for the world. Europe is to blame now for being a drag on the global economy. If the euro zone does not solve its problems,
the world could well slide back into recession, with dire consequences for both the US and China.