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Thursday, December 11, 2008


beggar thy neighbor

paul krugman on a newsweek interview with german finance minister peer steinbrueck.

The world economy is in a terrifying nosedive, visible everywhere. Yet Mr. Steinbrueck is standing firm against any extraordinary fiscal measures, and denounces Gordon Brown for his “crass Keynesianism.”

You might ask why we should care. Germany’s economy is the biggest in Europe, but even so it only accounts for about a fifth of EU GDP, and it’s only about a quarter the size of the US economy. So how much does German intransigence matter?

The answer is that the nature of the crisis, combined with the high degree of European economic integration, gives Germany a special strategic role right now — and Mr. Steinbrueck is therefore doing a remarkable amount of damage.

the stand of mr steinbrueck and indeed the government of angela merkel appears measured and principled.

For a while the position in Brussels and a few other places has been "We're now very much for setting up large-scale spending programs, but we're not really going to ask what the exact effects of those might be. And since the amounts are so high, well, let's get the Germans to pay because they can." Ms. Merkel and I are trying to calm them down a bit just now, and understandably that's getting us criticized.

The speed at which proposals are put together under pressure that don't even pass an economic test is breathtaking and depressing. Our British friends are now cutting their value-added tax. We have no idea how much of that stores will pass on to customers. Are you really going to buy a DVD player because it now costs £39.10 instead of £39.90? All this will do is raise Britain's debt to a level that will take a whole generation to work off. The same people who would never touch deficit spending are now tossing around billions. The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking. When I ask about the origins of the crisis, economists I respect tell me it is the credit-financed growth of recent years and decades. Isn't this the same mistake everyone is suddenly making again, under all the public pressure?

It's the yearning for the Great Rescue Plan. It doesn't exist. It doesn't exist!

i can only with great difficulty envision any federal department head in america, a country which has grown far more demotic than many european states, actually telling people to take their medicine. right or wrong, kudos to steinbrueck for having the courage of his convictions -- though i suspect he does so in the belief that germans aren't facing the brunt of the disease and is telling others in the eurozone to swallow hard.

but -- while i agree with steinbrueck that the assertion of keynesian acolytes regarding the absolute need for speed is likely a manifestation of the inability to accept the inherent inefficacy of stimulative policy in the face of a large systemic delevering in its early and most momentous phases -- there is also i think little doubt that his nation, along with other large creditor states such as china, japan and the petrodollar states are the key component of any successful plan to invigorate the global economy. and they aren't living up to their responsibilities.

keynes argued rightly for a global rebalancing -- something which can only be accomplished by closing large current account gaps. the ways in which this can be done are currency adjustments -- which surplus nations accepting stronger currencies, and vice versa for deficit nations -- and demand management -- which means relative increases in domestic demand in surplus nations and increased relative savings in deficit nations.

this was in cataclysmic manner accomplished in the 1920s and 1930s -- which in time saw, for example, the german mark weakened considerably against the american dollar, a resulting relative increase in european export competitiveness vis-a-vis the united states, a closure of the massive interwar american trade surplus with europe, and a relative reduction in the standard of living for european consumers (in spite of a tremendous demand collapse in the united states in the early 1930s). in a very important article, michael pettis addressed these issues recently.

it certainly seems that the imbalances that led up to the current crisis were in many ways similar to the imbalances of the 1920s – with a few countries, dominated by one very large one, running massive current account surpluses and accumulating, in the process, rapidly growing central bank reserves. ...

I can’t help thinking that there is an important lesson in here for us. In the 1930s it was noteworthy that the current account surplus countries like the US and the net exporters in Latin America suffered more deeply from the crisis than did current account deficit countries, especially, it seems, once barriers to trade were imposed. The extreme case of the latter was Germany. As I understand it Germany imposed trade restrictions early, in which German imports were largely paid for in export credits, so that Germany more or less ran a balanced trade account after many years of large deficits. It was the first country to emerge from the Great Depression – in fact I don’t really think there was a depression in Germany to speak of – in part, I think, because its low savings and high trade barriers permitted the investment multiplier to work very effectively.

The US, on the other hand suffered a deep crisis in the 1930s, and its imposition of trade tariffs made things worse, not just because impediments to trade are costly to the global economy, but rather because it eliminated the ability of the US to absorb expanding demand from other countries and to force other countries to absorb excess US production. Once international trade is eliminated, in other words, US excess production over consumption had to be resolved wholly within the US, and that meant that either the US engineered a substantial increase in domestic demand by fiscal means, as Keynes demanded, or that it adjust via a collapse in production. It did the latter.

I am worried about some of the conclusions I might be drawing. The first conclusion, I think, is pretty clear and I have already discussed it. Demand has to expand and it isn’t like to be households or businesses that do the job. The burden must fall on governments to expand fiscally.

On that point I think most people agree with me generally, but are less convinced than I am that the main role in resolving the global demand problem must fall on the current-account-surplus countries, whose high savings rate must decline. They have produced more than the world is currently able to consume, and if they do not boost demand significantly, they will be forced to cut supply significantly.

that is now where germany, china and japan are -- facing surprisingly steep domestic recessions that they anticipated least, supposing their conservative financial system positioning would keep them above the fray. it hasn't. with private sector demand fading sharply in all three nations, governments are hesitating to move in to aggressively manage domestic demand -- indeed are instead broadly trying to bolster exports where they are addressing anything at all.

this begs for a trade war.

[This analysis] suggests that although a collapse in world trade might be bad for the global economy overall, the pain will not be evenly distributed, and some countries might even benefit, and in that case they may actually move to restrict global trade. Current account deficit countries will suffer much less from anti-trade policies, in other words, and may even benefit because it gives their domestic fiscal policies greater traction. This may encourage them to attack trade if the global economy gets much worse.

As things currently stand, for example, fiscal expansion in the US has a much lower multiplier because in an open economy it is not US savings that matter but rather global savings, and global savings rates are much higher than domestic savings rates. In addition, a boost in US demand is exported through the current account deficit to other countries. Will the US continue to accept these limitations off trade if the US is forced to bear the brunt of the effort to increase global demand, or will at some point protectionist legislation become irresistible?

I think this is sort of what happened in the 1930s. The US refused to bear the brunt of the adjustment which, as the leading creator of global overcapacity it should have. Countries like Germany that opted out of the system seemed to bear little of the pain. When the US government enacted Smoot-Hawley, as a way of forcing even more of the US adjustment onto the rest of the world, it made it very easy for the rest of the world to opt out of the trading system, thereby forcing the full adjustment onto the US. In fact the US ended up bearing more than its full share of the adjustment because the decline in international trade actually made things worse for everybody.

The collapse in global trade forced most of the economic adjustment onto countries, like the US, whose excess savings and rapidly rising capacity created the global overcapacity problem in the first place. The Great Depression was brutal for the US and for some Latin American countries, but not nearly as bad for continental Europe and I think barely noticed in corporatist Germany and Italy. What if current account deficit countries conclude today, like they seem to have done in the 1930s, that by restricting trade they can force most of the global adjustment onto the current account surplus countries? That would be devastating for Asian exporters and especially China.

dani rodrik is also talking about this, as pettis notes, whereupon he says:

I have had a number of conversations with US and European officials in the past two weeks, and I get the impression that there is going to be a substantial hardening, especially in Europe, of positions on international trade, and I suspect that European officials are nowhere near as committed to keeping the market for global trade open as American officials are, but even American officials will turn against trade if popular discontent rises enough.

The reason that I am very uncomfortable with the whole line of reasoning Dani Rodrik, I and others have been following is that I do firmly believe that active international trade is in the long-term interests of the world, and especially in the long-term interest of very poor countries like China. In the short term, however, I think it would be dishonest to say that reducing trade cannot create any benefits – it can help many trade-deficit countries struggling with insufficient domestic demand by diverting domestic demand that used to go abroad.

and it is with that context that pettis stands horrified by the trade numbers released by china yesterday -- less for its shocking decline in YoY exports than an ominous collapse in imports of (-18%), suggesting a staggering collapse in domestic demand, and a record $40bn monthly trade surplus, suggesting that china is shifting the entire load of demand management onto deficit nations. this policy, pettis suggests, can only incite a trade war in 2009 which will decimate china.

In October China’s trade surplus was $35.2 billion, the highest every reached by any country at any time in history. In November that record was smashed. In the last three months China’s trade surplus has been $96 billion, nearly equal to the $100 billion from the first six months of 2008.

The headlines in China and around the world have been dominated by the contraction in Chinese exports, and this certainly is a bad number, but it cannot be a surprise and it is not the number on which we really should be focusing. The trade surplus is much more worrying, and soon enough that is what all the headlines will be reporting. Remember that the trade surplus is the measure of Chinese overcapacity that is being exported onto the world economy, but the world economy is looking for ways to increase net consumption, not net production. While demand in the rest of the world is shrinking, China is providing even more overcapacity, which means effectively that not only is China not absorbing its share of the demand/supply adjustment, it is exacerbating the imbalance. Other countries are going to have to withstand a faster decline in production than otherwise.

I know that China is facing a real problem of economic slowdown, one that seriously worries policy-makers. The other guest on the CCTV show last night was the chief economist of a large local securities firm, and he accomplished the not-inconsiderable feat of making me sound like an optimist. But still, it is wholly unrealistic to assume that the rest of the world will accept that they must bear more than 100% of the adjustment in order to pull China out of its trouble.

much the same dynamic as is playing out between china and the united states is also playing out between germany and its eurozone compatriots, less currency manipulation.

so i think the comments of steinbrueck might be reconsidered in another light rather than principled. the courage of his convictions may end up being as suicidal for germany as for china. germany does not have the option within the eurozone to devalue its currency as a form of trade barrier as china has begun to, so euro nations will be protected on that front. but all euro parties may have to accept that absorbing german overcapacity is necessarily a eurozone project in need of german participation. refusing to expand spending in germany could easily lead to a devastatingly rapid adjustment as export demand collapses in deficit nations. and from brussels looking out, the EU as an aggregate net importer and deficit entity might even see this as reason to fire the first shots in a global trade war -- amplifying the harm to germany.

as such, with the world quickly now moving away from open trade and toward beggar-thy-neighbor, the economic assault that is following on the heels of the financial barrage may fall particularly hard on germany and china.

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