While there is relentless focus on so-called "global imbalances", there is less focus on "eurozone imbalances". Yet the biggest challenge facing the global economy lies not in the bilateral trade position between China and the US but in the trade relationship between Germany and southern European nations.
China's balance of payments current account surplus is big but, as a share of national income, it's less than Germany's. According to the IMF, China's surplus in 2010 was 5.2 per cent of GDP and Germany's 5.7 per cent. At global level, China's surplus is mirrored by the US deficit. In the eurozone, a German surplus is mirrored by deficits in France, Italy, Spain, Greece and Portugal.
Washington says a cheap renminbi fuels China's booming exports and huge current account surplus. There may be some truth in this. China's exchange rate is, nevertheless, slowly adjusting. The renminbi has gained some 25 per cent against the dollar since Beijing adopted a crawling-peg regime in 2005.
China is also going through an internal adjustment. In recent years, its inflation rate has typically been higher than America's implying that, even without a rising renminbi, Chinese goods and services are becoming slowly more expensive measured in dollars. Overall, China's large surplus is leading to the right kind of adjustment. In theory, these relative price movements should reduce China's surplus.
The same cannot be said about Germany's position in the eurozone. There is no room for adjustment of the nominal exchange rate as there isn't one. This creates a peculiarity. The very thing demanded by the US of China is what Germany seems incapable of delivering. Does that mean imbalances matter at global level but not at eurozone level? Or must the eurozone find another form of adjustment?
Adjustment absolutely must happen. Whether it's China or Germany, nations with current account surpluses must be acquiring foreign assets. A current account surplus is, after all, only a measure of the excess of domestic savings over domestic investment. By acquiring foreign assets, those running current account surpluses are likely to alter the price of those assets triggering a range of, possibly undesirable, second-round effects. Over the years, China bought huge amounts of US Treasuries and US yields fell, creating room for a big increase in demand for mortgage-backed securities which, in turn, led to the sub-prime crisis. Germany, meanwhile, invested heavily in southern Europe, sowing seeds for the eurozone mess.
To escape this mess, the eurozone's imbalances must be healed. Germany insists on a major improvement in the competitiveness of southern nations. It's the equivalent of arguing that the US should narrow its current account deficit through a fall in the dollar, making US exports cheap in global markets and raising the price of US imports. But in the eurozone there is no exchange rate. So how will adjustment take place?
Movements in the exchange rate simply adjust the relative prices of things at home compared with the prices of things abroad. There is another way of achieving the same thing. If, for example, prices and wages in one country fall relative to prices and wages in another, the first country will have become more competitive relative to the second country. It's called a "real" exchange rate adjustment. Germany would like southern European nations to pursue this option, even if it's politically and socially difficult. The option is more commonly known as austerity.
The European Central Bank has an inflation target of slightly less than 2 per cent. For southern nations to be more competitive, they must deliver inflation rates below this target. Yet if they are below average, others like Germany must be above average.
How should Germany end up with higher inflation? The answer is simple: by offering more domestic stimulus. If southern European nations need to cut costs through austerity, Germany must do the opposite. Its domestic demand needs to rise sufficiently to put upward pressure on prices and wages. And if German domestic demand is stronger, its demand for southern European exports will go up. In effect, as German prices and wages rise, southern European products will, for Germans, be more tempting.
This needs a revolution in German thinking which, at the moment, seems a million miles away. If, as is more likely, Germany insists on keeping inflation at a little less than 2 per cent, necessary adjustments in the eurozone will never happen. Southern nations will be unable to deliver a sufficient improvement in competitiveness unless they end up locked in deflation which, in turn, will make it almost impossible for them to deal with the excessive debts built up as a consequence of the widening imbalances of recent years. Default then becomes a bigger and bigger risk.
The recessionary forces engulfing the southern European nations are in danger of heading north. Recent data suggest that Germany is in danger of being dragged into recession, a reflection of faltering demand for its exports and a diminution in the supply of credit. This reveals a simple truth. If imbalances are unsustainable, something must eventually give.
Germany had a choice: boost imports through faster domestic demand growth or wait for other economies to collapse, so damaging German exporters and financial institutions. Germany's current account surplus will fall but the process looks like it's going to hurt much more than it needed to.Reuse content