Hardly aday goes by without the Global Financial Crisis (GFC) making the news â€“ moreloans for Greece, debt levels in the UK, slowing economic activity in America, inflation concerns in China and so on.
Why hasthe GFC continued to have to such negative economic effects? The blame isoften put on factors such as greedy bankers, poor financial regulation,political pressure to expand lending for housing (in the USA), overly generouspensions, a bloated public sector in southern Eurozone countries, and risibletax collection mechanisms (particularly in Greece). Most of these problems existedfor decades before the onset of the GFC. To be sure they contributed to thecurrent malaise, but there was a far more fundamental cause.
The GFC waspreceded by the accumulation of two extremely large global imbalances that hadamassed over many years, caused by inappropriate exchange rates. The first ofthese was the huge trade surplus amassed by China (assisted by Japan and the Asian tigers) and its mirror image â€“ the American deficit â€“ caused by China’s exchange rate policy which prevented the yuan from appreciating against the dollar. An exchange rate is the price of one currency relative to another. (We find Australia expensive because we get only 77 Australian cents for our kiwi dollar, whereasnot so long ago it was over 90 cents). By keeping the price of Americandollars high when expressed in yuan, it made importing expensive in China, which discouraged spending by households and encouraged savings. The other side ofthis effect was cheap Chinese imports for Americans. Not surprisingly China accumulated vast trade surpluses (see figure).
Thesecond major imbalance is a parallel situation within the EU. A savings glutin Germany, also caused by an over-zealous approach to exporting and saving,reinforced by other northern European countries, found ready demand in the southernEuropean countries with their low real interest rates and increased buyingpower. In this case the common Euro currency had (and has) exactly the sameeffect as a fixed exchange rate â€“ the southern Europeans could not devalueagainst Germany. The â€˜one size fits all’ approach to monetary policy hasmaterialised as a â€˜one size fits nobody’ monetary policy.
While thosenominal exchange rates didn’t change, real exchange rates did. The realexchange rate is the nominal exchange rate adjusted for differences in relativeprices between countries. It is the real exchange rate that determinesfundamental international competitiveness. Low inflation in Germany following a decade of low wage growth, combined with high inflation in southern Europe, made German products more price competitive.
This shiftin competitiveness needs to be reversed for the Euroland imbalances to bealleviated. Under freely floating exchange rates Greece, Portugal and Spain could devalue, but this option is not available within the euro mechanism. Thusthe only way for the real exchange rate to fall is by reductions prices and wages,labelled as austerity in the European press. But this is a very painful way toadjust to imbalances. An easier way for this to occur would be if Germany allowedits real exchange rate to rise â€“ by raising wage rates and reducing tax ratesfor example â€“ thereby encouraging imports and domestic consumption, anddiscouraging exports.
Betweenthe USA and China a similar realignment of real exchange rates is occurring,but by a different mechanism. Greater currency flexibility from Beijing combined with higher Chinese inflation have reduced the nominal and real value ofthe dollar against the yuan. Slowly China’s exports are becoming lesscompetitive in the USA. The Chinese external surplus has already declinedsubstantially (see figure), attenuating the savings glut. To further reducesavings China also needs to stop using savings to prop up poorly performingstate companies and local government, and introduce more social welfare such aspensions. These changes would encourage more spending by households. The Americantrade deficit would improve and another large global imbalance would bemitigated.
So whatare the prospects for the next few years? Because the USA-China imbalanceseems to be correcting faster than the intra-Eurozone imbalance, we can expectthe USA to see economic growth before the EU. Nevertheless a sharp American slow-downin 2012 is likely if fiscal policy is tightened too soon. Private debt levelsare also still too high, though much more sustainable than they were.
Thelesson for the Eurozone is that fixed exchange rates between very dissimilareconomies do not work in the long term. Perhaps the Eurozone needs to split intotwo currency blocks as the best route back to economic growth for all of itscitizens, and to national solvency as well for the southern Europeans. Theglobal imbalances arose through inflexible relative prices (that is exchangerates); they won’t disappear without relative price adjustment.
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