By Wolfgang Münchau
Published: June 7 2009 19:03 Financial Times
Let me attempt, perhaps foolhardily, to map out a scenario of how the global economic crisis could evolve in continental Europe.
Even if we assume a recovery elsewhere, Europe’s economy may be stuck at low growth for some time. To understand why, it is perhaps best to look at sectoral balances for households, companies and the public sector.
The current account can be expressed as the difference between national savings and investments. Of the world’s 10 largest economies, the US, the UK and Spain used to run the largest current account deficits before the crisis. The US household sector has been shifting from a negative savings rate before the crisis to a positive rate of 4 per cent of disposable income now. The US corporate sector used to have a large negative savings rate, but this has almost disappeared. So far, the increase in net savings in the US private sector has been balanced by increased borrowing from the US government.
I am making three assumptions: the first is that the return to a positive US household savings rate is permanent – even under a scenario of a strong economic recovery. US households will take time to repair their balance sheets after the housing and credit disaster. Second, I also expect US companies not to return to the high level of borrowings that prevailed before the crisis. Third, I expect the US government to reduce its deficit after 2010. The recent rise in long-term bond yields should serve as a reminder that deficits cannot go on rising forever.
Taking all three factors together, the US will shift from a strongly negative current account balance towards neutrality, perhaps even a small surplus for a short period. I expect similar shifts in the UK and Spain at different magnitudes.
Among countries with large current account surpluses, the three biggest are China, Japan and Germany. I am focusing on Germany here. The German household sector will maintain its high savings rate. The German government increased its deficit during the crisis, but is now looking for a quick fiscal exit strategy. The Bundestag has recently voted through a constitutional balanced-budget clause, which requires cuts in the deficit almost right away. Japan will probably maintain its larger fiscal deficit for longer, but if we take Germany, China and Japan together, we will not see a sufficient and sustained fiscal expansion to compensate for the sectoral shifts elsewhere.
Global current account surpluses and deficits add up to zero. So if everybody is saving more, who will be dissaving? It will have to be the corporate sector in the countries with large net exports. So if the US, the UK and Spain are heading for a more balanced current account in the future, so will the surplus countries.
The current account balance can also be expressed as the sum of the trade balance, net earnings on foreign assets, and unilateral financial transfers. In several countries, including the US and Germany, the gap between exports and imports serves as a good proxy for the current account. A fall in the trade deficit in the US, UK and Spain implies a fall in the combined trade surplus elsewhere. And as some of the shifts in the US and the UK are likely to be structural, this will have long-term effects on others. In particular, it means the export model on which Germany, China and Japan rely, could suffer a cardiac arrest.
What about the argument that a large part of German exports goes to the rest of the eurozone? This is true, but there are imbalances within the eurozone too. Spain has been running a current account deficit of close to 10 per cent of gross domestic product. As that comes down, so will Germany’s equally unsustainable intra-eurozone surplus.
Through what mechanism will this export-sector meltdown come about? My guess is that in Europe it will happen through a violent increase in the euro’s exchange rate against the US dollar, and possibly the pound and other free-floating currencies.
Exchange rate devaluation would greatly help the US and others to reduce their current account deficits, but it will impair the economic recovery in countries with large trade surpluses and free-floating exchange rates. Last week’s remarks by Angela Merkel, who criticised the Federal Reserve and other central banks for running inflationary policies, sharpened investor perceptions of transatlantic policy divergence and decoupling. Many investors are now starting to bet on a strong appreciation of the euro – the last thing Ms Merkel wants.
Neither Germany nor Japan is politically equipped to deal with an exchange rate shock. China may continue to manage its exchange rate, but the Europeans are much less likely to intervene in foreign exchange markets. For the time being, the governments of the classic export nations cling on to their export-based economic model, the model they know best. Their only strategy, if you call it that, is to hope for a miraculous bail-out from the US consumer – which is not going to happen this time.
If my predictions prove correct, Germany will be down and out for a long time with a huge and still unresolved banking crisis, an overshooting exchange rate and lower net exports, presided over by politicians who panic about domestic inflation. This will not end well.