Thursday, June 24, 2010

The “threat” from austerity

If one were to read blogs and columns of, well, pretty eminent US economists, one would be forgiven for thinking that the next major threat to global recovery was Germany. When Angela Merkel announced that the German Government would strive to achieve a fiscal balance through austerity measures, Dani Rodrik, Paul Krugman, Brad DeLong, Mark Thoma et all yelped in shock and disbelief. They believe that the global economy needs all the demand that it can get right now, even if this demand comes from governments spending more than they earn.

And they are partly correct. The global economy is short of demand at the moment and additional demand won’t hurt. But that’s where it ends. The global economy also needs stable governments. And with Germany’s debt inching closer to 80% of GDP, the Germans want to tighten their belt. Despite the high debt-GDP ratio, Germany has been extremely disciplined in recent years. It has generated a primary surplus for 6 of the last 12 years and its average fiscal deficit over the same period was 2.3% of GDP. In 4 of these 12 years it has ended the year with lower relative debt than the previous year.

But the “progressive” group believes that this is wrong. They use Germany’s current account surplus to assert their belief that Germany isn’t ready to pull its weight in inducing a global recovery. Germany is third on the list of nations ranked by their current account balance. The first two are China & Japan. But there are critical differences between them. China is a known currency manipulator and suppresses domestic demand as a matter of policy. By making imports more expensive and exports cheaper, it lends systemic support to the continuation of its trade support. This policy is at the root of the world’s consternation with China.

At its peak, Japan openly intervened in the currency market to intentionally weaken its currency. But since 1990, Japan has been going downhill with fiscal woes of a magnitude not imagined earlier. No one, can ask the Japanese Government to do more than it is already. Which brings us to Germany. Germany doesn’t own its currency anymore and cannot manipulate its value unilaterally. It has managed to achieve its current account surplus, not through low wages and currency manipulation, but through innovation and productivity. It has remained fiscally disciplined through good times which gave it the ability to exert countercyclical support to its economy in bad times. Which it did, but if you take Dani Rodrik’s logic, it didn’t do enough.

It didn’t do enough because it didn’t allow its fiscal deficit to rise as much as the US. But Germany doesn’t own the Euro and doesn’t have the ability to monetize its way out of fiscal hell like the US. So while the US can spend merrily, secure in the knowledge that it can monetize its way out of any debt service and current account deficit, Germany has to think of earning its way out. Or would Mr. Rodrik rather see Germany in Greece’s position in a few years just so that it can help Greece recover? Does that make sense at all?

And Dani Rodrik isn’t alone. Paul Krugman has this to say about China & Germany.

Really? Time to get tough with what, Prof. Krugman?

If everyone is counting on the US to become the consumer of the last resort, then what steps is the US taking to protect itself? The US’s ability to run sustained current account deficits is because, unlike other lesser nations, it owns the global currency and cannot face a balance of payments crisis. What these economists want is a continuation of the system with other nations adjusting their economic policies and costs so that the US current account balances. But why should they? Is the US doing them any favor by owning the world’s reserve currency?

If the US wants its current account deficit to shrink, the US dollar will have to stop being the world’s reserve currency. Once capital flows to the US slow down, or are denominated in another currency, the US’s ability to pay for its imports will shrink, causing the currency to depreciate and the US will be a few steps closer to a current account balance. And it doesn’t take much for that to happen. All the US has to do is institute capital controls.

But rather than take this route, which will require it to change it’s ways, the US wants its trading partners to change theirs.Rather than act to weaken the US Dollar,  the US wants its trading partners to act to strengthen theirs? While the end effect will be the same, the responsibility of action changes completely.

The US is completely and totally responsible for the position it is in. It wants the US dollar to continue as a reserve currency because it suits its profligate ways, not as a favor to other nations. Changing this is in its hands and yet, it want others to compensate for its inaction.

Awesome.

A version of this post appeared on my Business Standard Blog on June 23, 2010

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