Monday, October 17, 2011

Global trade imbalances threaten free trade

by Simon Tilford

The developed world’s slide into recession threatens an outbreak of protectionism. Unlike in 2008, governments now have few tools with which to combat a renewed economic downturn, which raises the likelihood of it developing into a slump. If so, protectionist pressure is certain to build. The country that moves first to erect trade barriers will no doubt take the blame for the resulting damage to the trading system. But the real villains will be the countries that skew their exchange policies, tax systems and industrial structures to gain export advantage. The irony is that the countries that are most dependent on free trade – those that produce more than they consume – are the biggest obstacle to a sustained recovery in the global economy. They need to change course before it is too late: all will suffer if countries move to erect new trade barriers, but the surplus economies will suffer most.

Surplus country governments regularly exhort deficit countries to pay-down debt, save more and ‘live within their means’. But the real problem facing the global economy is an acute lack of aggregate demand. The world is awash with savings, but there is a dearth of profitable investment opportunities, which in turn reflects the weakness of consumption. The answer is not therefore for everybody to save more. This will be disastrous: it will further depress consumption and hence investment, and aggravate fiscal problems. If countries with big trade deficits (and correspondingly high levels of indebtedness) are to save more, surplus countries (those that live within their means) will have to save less and spend more.

The weakness of domestic demand in the US, UK and across much of the eurozone is hitting global demand hard, but there is nothing to offset it. The big surplus countries – Germany, China and Japan – are not taking any steps to offset the contraction in demand elsewhere. Such a state of affairs is fraught with risk. If the world is to continue enjoying the benefits of global trade and finance, the global imbalances have to be unwound.

What are trade imbalances? A country’s trade balance is a reflection of what it spends minus what it produces. In surplus countries income exceeds their spending, so they lend the difference to countries where spending exceeds income, accumulating international assets in the process. Deficit countries are the flipside of this. They spend more than their income, borrowing from surplus countries to cover the difference, in the process accumulating international liabilities or debts. Export-led growth in surplus countries feeds (and is dependent on) debt-led growth in deficit countries. It is impossible for all countries to run surpluses, just as it is impossible for all to run deficits.

Are trade imbalances sustainable? Trade imbalances and the accompanying capital flows between countries are not necessarily a problem. Fast-ageing wealthy societies tend to have excess savings and it makes sense to invest these in countries where domestic savings are insufficient to meet investment needs. Historically, this typically meant investing money in rapidly developing emerging markets. So long as current-account deficits remain modest and economies invest the corresponding capital inflows in ways that boost productivity growth, such imbalances are sustainable. But the imbalances we see today are of a different character. First, they are much bigger. The most egregious is that between China and the US, where still poor China is running a huge trade surplus with the US. Many of the other imbalances are between countries of broadly similar levels of economic development, such as those between members of the eurozone, or that between Japan and the US.

Imbalances of this scale and nature are far from benign. First, they lead to destabilising capital flows between economies. For example, the global financial crises of 2007 and the subsequent eurozone crisis were basically the result of capital flows between countries. Over-leveraged banks amplified the problem, but the underlying cause was outflows of capital from economies with excess savings in search of higher returns. Much as in the surplus economies themselves, the US, UK and the members of the eurozone that attracted large-scale capital inflows struggled to find productive uses for them: rather than boosting productivity, the inflows pumped up asset prices and encouraged excessive household borrowing.

The imbalances survived both crises, and are now growing again from an already high level. This is clearly unsustainable. Unlike in the run-up to the financial crisis, the current situation has nothing do with excess demand in the deficit countries, but is taking place against a backdrop of stagnation and falling living standards in these economies. Households and firms in the deficit countries are saving more, but there has been no offsetting decline in private sector savings in the surplus countries. Against this kind of economic backdrop, trade deficits constitute a major drag on economic activity as they drain demand and employment, forcing governments to step-in and fill the gap by running big fiscal deficits. The external demand upon which the surplus countries depend relies implicitly on unsustainable fiscal policies in the deficit countries.

How can imbalances be reduced? The deficit countries need a combination of higher net exports (export minus imports) and higher net savings (domestic savings minus domestic investment), while the surplus countries require the reverse. Put another way, the deficit countries need to get over their dependence on debt, surplus countries their addiction to exports. Deficit countries need more domestic savings and surplus countries more consumption.

Structural changes in both the surplus and deficit countries can clearly contribute to the necessary adjustments. Countries where expenditure lags output, such as Germany and Japan, could take steps to reverse the decline in wages and salaries as a proportion of national income. This would boost consumption, encourage more investment, and hence lower their corporate sectors’ excess savings. For its part, China could discourage excess savings by reducing subsidies to its corporate sector, which is sitting on very large sums of cash. The Chinese authorities could also improve the country’s social safety net and hence lower households’ precautionary savings. However, such adjustments will take time, and time is in short supply. The only way to facilitate rapid adjustment is through shifts in relative prices.

There are three ways of bringing about these movements in prices, or shifts in countries’ so-called ‘real exchange rates’. The fate of the international trading system could depend on which is chosen. First, domestic prices can fall in the deficit countries. This comes about through declining costs and prices, as wages are cut and governments pursue fiscal austerity. Higher unemployment encourages households to save more, and the price of imported goods rise relative to domestically-produced ones.

This is basically what is being attempted in the eurozone. Trade imbalances are to be addressed by deflation in the deficit countries. Policy across the eurozone as a whole has a strongly deflationary bias, as much in the surplus economies as the deficit ones. This implies very weak economic growth, falls in prices (relative to the outside world) and higher unemployment. It also implies higher savings as governments tighten fiscal policy, companies sit on cash rather than investing it and fearful households boost their savings and rein in consumption. The risk is that the deficit countries’ debt burdens will increase further (as the value of their debts grow, while their incomes fall), exacerbating their fiscal problems and undermining their ability to pay their creditors. Far from taking up some of strain from the Americans, the eurozone is trying to run a big surplus with the rest of the world, adding to trade tensions.

Given how indebted the deficit countries are (in terms of public and private debt) rebalancing needs to take place through a combination of movements in nominal exchange rates (where possible) and somewhat higher inflation in the surplus countries. Very low interest rates and quantitative easing in the US is pushing up inflation in countries with currencies linked to the dollar – first and foremost China. The US has little option but to continue pumping dollars into its financial system, in order to compensate for the drag on its economy from the trade balance, and some of this money will continue to leak out to China. However, concerned at the rise in inflation, the Chinese authorities are taking robust steps to slow their economy by clamping down on the amount state-owned banks can lend. Easily the least damaging adjustment in the eurozone would be through higher inflation in Germany. But there is little sign of this. And if there were, the European Central Bank would raise interest rates.

Finally, changes in relative prices can be brought about by movements in nominal exchange rates. For example, the Chinese could allow the renminbi to rise against the dollar or Germany could withdraw from the eurozone and reintroduce the D-mark, which would then appreciate sharply in value. Movements in nominal exchange rates offer by far the least damaging route to the needed rebalancing. It would avoid deflation in the deficit countries or inflation in the surplus ones.

The Chinese government is somewhat schizophrenic about the potential impact of renminbi revaluation. On the one hand it maintains that it would not make any difference, because the deficits in countries like America reflect the latter’s lack of savings, which would not be affected by an appreciation of the Chinese currency. On the other hand, it argues that a stronger renminbi would hit the Chinese economy hard and be disastrous for global economic growth. In short, the Chinese government is dependent on the others running up debt, but at the same time condemns them for doing so. Movements in nominal exchange rates may yet be the mechanism by which the German trade surplus is cut. The current eurozone strategy of deflation in the deficit economies rather than reflation in Germany threatens to force economies out of the currency union. This would open the way for a rebalancing of the German economy, but at enormous political and economic cost to Europe.

Surplus country governments, notably the Chinese and German ones, often warn of the risks of protectionism. They fail to make the connection between the structures of their economies and the trade deficits (and rising indebtedness) of others. As a result, they are the real threat to the international trading order. If the US cannot rebalance its economy and get it growing sustainably, there is a real risk it will opt for protectionism. Other countries with big trade deficits could quickly follow suit. The resulting rebalancing would be brutal for the surplus countries, and many of the benefits of global trade and finance would be lost. To prevent this, the G20 needs to agree a global strategy to rebalance demand. This would require the surplus economies to acknowledge that they are part of the problem and to develop strategies to reduce their export dependence.

Simon Tilford is chief economist at the Centre for European Reform.

Tuesday, October 11, 2011

Britain, the City and the EU: A triangle of suspicion

by Philip Whyte

After years of mutual suspicion, Britain and its EU partners seemed in early 2009 to be converging in an area of policy where they had often been at odds – financial regulation. The Turner Review, Britain’s official report into the financial crisis, accepted that ‘light touch’ regulation had failed, and recognised that the UK would have to accept greater supervisory integration at EU level if the single market in financial services was to survive. Fast-forward two years, and it is hard not to be struck by a paradox. The UK has abandoned its ‘light touch’ regulatory regime and signed up to greater supervisory integration at EU level. Yet far from narrowing, the Channel looks as wide as ever. So what went wrong?

Part of the answer is to be found in continental Europe. Since the financial crisis, politicians in Germany and France have seen it as their task to bring Britain and the City of London to heel. France’s President Sarkozy has spoken of the “death of unregulated Anglo-Saxon finance”, while Chancellor Merkel has declared that Germany will no longer be dictated to by the City of London. The eurozone debt crisis has only reinforced continental suspicions of Britain and the City, because politicians in Berlin, Paris and elsewhere view both as a threat to the euro’s existence. They think that the City is home to ‘speculators’ who are bent on destroying the euro; and they believe that it marches to the tune of a eurosceptic government and a local media that is hostile to, and ignorant of, the EU.

Suspicions of the ‘Anglo-Saxon world’ explain at least some of the measures which have emerged from the EU’s machinery. The directive on alternative investment funds was a response to longstanding Franco-German concerns about the power exercised by hedge funds in London and New York. Likewise, more recent proposals to introduce a tax on financial transactions reflect an enduring ambition by some governments to curb ‘speculative activity’ in the world’s largest financial centres. Since the UK is disproportionately affected by such measures, it has unsurprisingly showed less enthusiasm for them than other EU member-states. Inevitably, this has made the UK looking like the country of old: that is, isolated and fighting to dilute EU initiatives targeting the financial sector.

From London’s perspective, all of this can seem a bit galling. The problem is not just that some EU measures have been the product of continental politicians playing to their domestic galleries, or that they affect Britain more than other EU countries. It is that some governments have tried to occupy the moral high ground while doing less than the UK in areas of greater importance. A case in point is the recapitalisation of banks – a crucial task since 2008, but one where a number of EU countries have (until very recently at least) been guilty of a combination of denial, foot-dragging and obfuscation. Seen from the UK, the reluctance of certain EU governments to tackle the weakness of their banking systems bears more responsibility for the eurozone crisis than speculators in the City of London.

None of this is to say that the UK has reverted to its traditional role as an uncritical defender of the interests of the City. If there ever was an identity of interest between the British government and the City, this is no longer the case. These days, the City is a ‘national champion’ that attracts the hostility rather than the respect of the general public. The UK realises that it has a comparative advantage in a sector that imposes large costs on society when things go wrong. The principal thrust of policy since 2008 has therefore been to try and reduce the vast contingent liability that the financial system places on British taxpayers. This was the main rationale of the Vickers Commission, which recommended that UK banks should keep their retail operations separate from their investment banking ones.

Few detached observers can seriously doubt that Britain’s era of ‘light touch’ regulation is over. The UK does not need to be cajoled by other EU countries into regulating banks and the City. It has implemented reforms before similar measures were even proposed at EU level (sparking European grumbles about British unilateralism); and in some areas (such as the structural separation of retail and investment banking activities), it intends to go further than other EU countries can countenance. The City’s future, it follows, is being decided by decisions in London as much as those in Brussels: hedge funds have relocated abroad in response to the perceived deterioration of Britain’s tax environment, while large UK banks have periodically threatened to follow suit in response to the Vickers reforms.

But if political rhetoric is anything to go by, perceptions in other member-states have yet to adjust to this new reality. In many quarters, the UK continues to be portrayed at best as a recalcitrant country that has failed to learn the lessons of the global financial crisis, at worst as a hostile force that wishes to protect the interests of ‘speculators’ and the City the better to destroy the eurozone. Quite why the UK would benefit from the collapse of the eurozone – an event that, as the British government has repeatedly made clear, would be catastrophic for the UK economy – is not entirely clear. But lurid assumptions about the ‘Anglo-Saxon’ world are still a remarkably familiar background factor across Europe, shaping how many politicians think about financial regulation and the eurozone crisis.

The truth of the matter is this. There is no question that the UK is more ambivalent about the financial sector and the City than it has been in the past. But the UK does not believe that this justifies ill-conceived and costly initiatives that reflect political grandstanding in other EU countries; or, for that matter, that this gives carte blanche to other countries to drive financial activity away from London. Other EU countries have a justifiable interest in what happens in the City. It is less clear that they have legitimate grounds for pushing old hobby horses that win political points at home, do little to promote financial stability, yet inflict disproportionate costs on the UK (as host to Europe’s largest financial centre). The EU’s recently-proposed financial transactions tax looks like a case in point.

Philip Whyte is a senior research fellow

Monday, October 03, 2011

Eurozone crisis: Higher inflation is part of the answer

by Simon Tilford

The biggest challenge facing the eurozone is how to generate economic growth. Whatever its leaders agree in terms of fiscal targets and surveillance will achieve little in the absence of growth. Excessively restrictive fiscal policy is clearly one obstacle to such growth, but the European Central Bank’s obsession with inflation is another. Of course the central bank must guard against excessive inflation, but it is a big problem when its fear of inflation blinds it to the much more serious threats confronting the eurozone economy. Indeed, somewhat higher inflation may be part of the solution to the crisis facing Europe. If policy continues to be directed at ensuring inflation of "below, but close to 2 per cent", countries such as Spain and Italy will struggle to regain competitiveness within the eurozone and their debt burdens will be unsustainable.

The Bundesbank's legacy is clearly visible in the ECB's official strategy. The central bank's interpretation of price stability means it has the most restrictive target or 'reference value' of price stability of any major central bank. Given that many eurozone countries have historically been prone to high inflation, the ECB’s determination to build a reputation for guaranteeing price stability is understandable. Officials from the bank never tire of saying that ensuring low inflation is the best contribution the ECB can make to economic growth. Price stability is important, of course. But a reference value of under 2 per cent and no accompanying mandate to ensure an adequate level of economic activity (such as that faced by the US Federal Reserve) is too restrictive. It is damaging in a number of ways for a currency union such as the eurozone.

First, it increases the risk that interest rates will be raised in response to temporary shocks – such as higher oil prices – that do not threaten medium-term price stability. This was illustrated by the ECB's decision to raise interest rates in July 2008, when the eurozone economy was already contracting. Perhaps more egregious was its decision to raise interest rates in July 2011, despite strong evidence of a slowing economy, against the backdrop of a deepening sovereign debt and banking sector crisis, and in the face of very restrictive fiscal policy across the currency union. The ECB’s decision to raise rates despite these headwinds raises serious concerns over its mandate. The central bank is unlikely to cut interest rates at this week’s meeting because eurozone inflation currently stands at 3 per cent. This is largely because of higher energy prices whose impact on the consumer prices index will weaken sharply from early next year.

Second, an inflation target of below, but close to 2 per cent leaves very little room for adjustment within the currency union. Since countries such as Spain and Italy cannot devalue, they can only improve their 'competitiveness' by cutting their costs relative to Germany. Such a strategy will lead to deflation and debt traps unless German inflation rises more quickly than the current projections of around 1.5 per cent per annum. The eurozone would be better off with a symmetrical eurozone inflation target of 3 per cent with the inflation rate allowed to deviate by no more than 1 percentage point in either direction. Such a target would make it much easier for a member-state to hold its inflation rate (and wage growth) below the eurozone average without risking economic stagnation and deflation.

Although a target of under 2 per cent might have been appropriate for the Bundesbank, it is ill-suited to the eurozone. Unlike Germany, the eurozone is a largely closed economy (exports account for a similar proportion of GDP as they do in US) and hence cannot rely to anywhere near the same extent as Germany on exports to close the gap between output and expenditure. The currency union as a whole cannot expect to export its way out of trouble – it needs robust growth in domestic demand.

If the ECB had to take economic activity into account, not only would eurozone interest rates be lower, but the central bank would also be pumping money directly into the eurozone economy. Much like the US Fed, the Bank of Japan and the Bank of England – all of whom like the ECB face economies struggling with the aftermath of financial crises and the associated collapse in aggregate demand – the ECB would be engaged in so-called quantitative easing (QE), the unsterilised purchasing of government debt and other assets. By bringing down public and private borrowing costs and boosting the volume of credit, QE could strengthen economic activity and guard against the risk of deflation.

Supporters of the ECB's current mandate would no doubt argue that the Fed's dual target of inflation and employment has caused it to pump up one bubble after another. The Fed is forced to sacrifice the principle of sound money on the altar of short-term pump-priming. The result is an unbalanced US economy, excessive debt, and a world awash with dollars. This, in turn, puts downward pressure on the US currency, threatening international monetary stability. But this is a largely self-serving analysis. Had the Fed not kept interest rates very low and pumped money into its economy, the world would have had an even bigger problem: the US economy would have slumped, and its trade balance swung into surplus.

The eurozone is essentially trying to ensure monetary stability in Europe at the cost of higher debt elsewhere: the crisis strategy for the currency union is for everyone to save more, and spend less – to 'live within their means'. This implies the eurozone running a huge trade surplus with the rest of the world. But this will not be possible. East Asia is pursuing a similar strategy to the eurozone. And the US economy is simply too indebted and not big enough to act as the consumer of last resort for both East Asia and Europe.

The ECB should not be responsible for setting its own mandate. One option would be to transfer responsibility for this to the Euro Group, which would agree decisions by qualified majority. Such a move would not necessarily require a new treaty; a unanimous decision in the Council could be enough. Unfortunately, there is no chance of this happening. Reforms of eurozone governance will not include reform of the ECB since several eurozone governments, not least the German one, are steadfastly opposed to such a move.

This leaves the currency bloc vulnerable to slump and on-going crisis. Fiscal policy is highly contractionary. The monetary policy stance is restrictive, given the depth of the economic weakness. The currency union as a whole cannot export its way out of trouble. Structural reforms should help to boost growth in the medium to long term. But such reforms need to be accompanied by investment if they are to deliver on their potential and with demand so weak investment will be thin on the ground. It is beholden on those governments that oppose greater monetary stimulus to explain how the eurozone economy is to grow and how the necessary adjustment in price and labour costs between the participating economies are to be made.

Simon Tilford is chief economist at the Centre for European Reform.