Monday, May 7, 2012
The Golden Rule Reinterpreted
In an April speech in Berlin, Dr. Andreas Dombret, a member of the Executive Board of the Deutsche Bundesbank (the German central bank), offered a startlingly frank assessment of the current problems in Europe. Although his comments were meant to apply to the tensions and imbalances that exist between the northern and southern tier of the 17-member eurozone, they shed inadvertent light on the broader global economy.
Rebuffing calls that Germany do more to support the faltering southern economies, Dr. Dombret said:
...Exchange rate movements are usually an important channel through which unsustainable current account positions are corrected....In a monetary union, however, this is obviously no longer an option. Spain no longer has a peseta to devalue; Germany no longer has a deutsche mark to revalue. Other things must therefore give instead: prices, wages, employment and output. The question now is which countries have to shoulder the adjustment burden. Naturally, this is where opinions start to differ. The German position could be described as follows: the deficit countries must adjust. They must address their structural problems, reduce domestic demand, become more competitive and increase their exports.
In economics it is axiomatic that positive and negative current account balances will ultimately be offset by changes in relative currency valuations. The currencies of surplus countries are supposed to rise and the currencies of the deficit countries are supposed to fall. But the current global political alignment has altered this process. Like many of his German and continental peers in government and finance, Dombret is likely in favor of maintaining a common currency at all costs. But as he outlines, when currencies fail to adjust something else has to give. He insists that the giving come from those who have been getting.
Given their weak economies and strained fiscal positions, it should be evident that citizens of Greece, Portugal, Spain and Italy have been living beyond their means. Their relative prosperity over the last decade has largely been maintained by the purchasing power of the euro which itself has been buoyed by the strong German economy. Rather than forcing Germans, whose savings rates and current account surplus results from years of fiscal prudence, to lend even more money and suffer higher inflation so that the southern tier can receive more monetary stimulus, Dombret argues the citizens of deficit economies must spend less while working, producing and saving more. In other words, their living standards must match their productivity.
Economic dynamics do not change with scale. And as it happens, there is a much bigger and equally flawed currency bloc in the world than the one Dr. Dombret is seeking to cure. In that larger bloc, the exact same dynamic of surplus and deficit nations is playing out within an inflexible monetary straightjacket.
In order to maintain exports and to manage economic expectations, many nations (most notably China) have instituted fixed exchange rates between their own currencies and the U.S. dollar. Although this system is not governed by a formal treaty like the one that binds the 17-nation eurozone, it has given rise to a virtual bloc of currencies that are unnaturally tethered, even while the underlying economics are drifting apart. And although there has been some recent flexibility from China on exchange rates, there is nearly universal consensus that these movements would be far more pronounced absent significant central bank manipulation.
Like the nations of southern Europe, the United States consumes far more than it produces. But rather than closing the gap by producing more and consuming less, both have followed a far less painful path. They have borrowed instead. Who can blame them? After all, it's far more enjoyable to consume than produce. And as we have seen in many financial arenas, a borrower will tend to borrow for as long as a lender is willing to lend, especially if there are no immediate adverse consequences.
Both Germany and China produce more than they consume. It is from these resulting surpluses that the deficit nations are borrowing. But these two creditor nations are currently showing different policy drifts with respect to their hard-earned savings. In Europe, German leaders are showing increasing reluctance to sacrifice the living standards of their own citizens to perpetuate an imbalanced economic system. The Chinese on the other hand appear to heartily encourage such a policy. This difference can be attributed to their respective political systems. In Germany, public opinion matters. In China, not so much.
The currency peg of the Yuan against the dollar, which China has enforced with varying degrees of exactitude over the past few decades, has helped the Chinese government exert greater influence over the growth and contours of its economy. But the policy has created hardships for Chinese citizens (such as disproportionately low rates of consumption and high rates of inflation). But lacking any means to overtly influence public policy, Chinese citizens have had little choice but to take it on the chin. German citizens on the other hand are much freer to voice their discontent. And in fact, fears of a voter backlash have been determinative in setting Berlin's agenda.
The question for the global economy is whether China will become more like Germany, or Germany more like China. From my perspective the answer is clear. German leaders are unlikely to risk the scorn of voters by repudiating their cultural aversion to overly accommodative monetary policy. In China, the decisions will be more pragmatic. Currently Beijing perceives advantages in the status quo. But ultimately the costs, in terms of increasing foreign exchange reserves and rising inflation, may force its hand. When that happens, the United States and Southern Europe will be in the same boat.
To many, the “Golden Rule” is an idea that underscores the value of civility and fair dealing. But there is another, less magnanimous definition: “He who has the gold makes the rules.” In the current global economy, the surplus countries have the gold and sooner or later we will be living by their rules.
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