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Happy Days (Are Here Again?)

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Anyone reading the headlines of a major world newspaper would think that the worst is over for the global economy. In Europe, the Greek haircut has been “successfully” carried out and bond prices have fallen from the red zone of the fourth quarter last year. The US economy keeps adding jobs while the housing market appears to have touched bottom. Fears of a Chinese “hard landing” appear to have been exaggerated, while Japan has been plodding along for so long that it is easy to assume that they will continue to do so.

Yet while the sun shines overhead, dark storm clouds ring our horizon on all sides. We are in the eye of the storm, but the wind is rising again. Part of the problem is that we are all attempting to use the same medicine to cure very different ills. The label on that bottle of snake oil is “Exports”.

Exporting Our Way to Disappointment

President Obama has announced the goal of doubling exports. Germany insists that growth in Europe must come from exports driven by increased competitiveness. China refuses or is unable to restructure its economy around internal demand, so it must grow through exports. Japan is moving back to the export-growth model after attempting and failing to stimulate internal consumption, and due to the urgent need to balance their vastly increased energy imports since the Fukushima disaster with increased exports. (1)

It is inevitably true that someone’s exports are someone else’s imports, and that the dollar value has to match exactly. It is mathematically impossible for every country on earth to run a current account surplus; someone must import more than they export, so that someone else can export more than they import.

Where does this leave us? On the road to disappointment.

The Fundamental Things Apply (As Time Goes By)

The fundamental laws of economics are implacable, and we cannot escape them by government fiat. Advanced nations must come to the realization that exports are not the solution to the debt crisis we face. Nor can we focus exclusively on local solutions to a global problem, one caused by imbalances inherent in the world economy.

Each of the key markets in the global economy faces a unique situation and unique difficulties, yet they are all attempting to apply the same cure. Let´s examine each of them in turn:

The United States

  • The United States is rapidly deleveraging and the household savings rate remains high, but the mortgage situation remains unresolved and will continue to act as a break on domestic consumption; (2)

  • The Fed and the Treasury continue to push a weak dollar, depressing demand for imports;
  • Growing production of shale oil and gas is reducing US dependence on foreign energy imports, and the US may soon become a major exporter of natural gas to Asia; (3)

 

  • Running large current account deficits will be politically unacceptable for either party;
  • Yet the United States does not need to become an exporter on the order of China, Japan or Germany thanks to the strength and size of its internal demand. The US needs to balance the current account to avoid increasing debt levels, and half of the trade deficit comes from energy imports. (4) Thus the US should be focusing firstly on energy independence. The other half mainly comes from China. This will be equally difficult to reduce, but not impossible with intelligent and long-term reforms to corporate taxes, public infrastructure and R&D investment, and a sound industrial policy aimed at attracting investment from key industries and their supply chains;

 

  • Thus the US, while unlikely to become an export powerhouse, is also unlikely to return to being the “buyer for the world”.

China (5)

  • China has been attempting to “rebalance” its economy in the wake of the 2008 crisis and the subsequent collapse in exports to its traditional markets. So far, this effort has been a failure;
  • The private saving rate has actually increased over the past 3 years, meaning Chinese consumers aren’t going to be driving internal demand anytime soon;
  • Government spending is also contracting. China spent heavily during the crisis in a largely successful effort to keep GDP growing, but invested in largely unproductive infrastructure projects and uncompetitive SOE. China now has a burgeoning public debt – mostly non-performing – which it does not want to see grow any larger to avoid damage to the financial system; (6)

 

  • Additional fiscal stimulus will only exacerbate inflation trends, which will further damage private consumption and impose unwanted and potentially dangerous hardship on lower income Chinese; (7)

 

  • China urgently needs a liberalization of its financial sector, to ensure a far more efficient use of capital and investment returns than is currently the case. China must also liberalize its foreign direct investment and procurement policies, allowing easier access for foreign firms to the Chinese market. Only thus can China make a fair case for increasing exports to the US and Europe. Otherwise, it will risk escalating already tense trade relations.

Japan

  • Japan is facing current account deficits for the first time in decades. This is largely due to the explosive growth in fuel imports in the wake of the Fukushima nuclear disaster and the decision to close almost all of the country’s nuclear plants;
  • Japan cannot run both a fiscal deficit and a current account deficit for fear of a collapse in the careful balancing act that has allowed the government to maintain an extremely high debt-to-GDP ratio for more than a decade; (8)

 

  • Despite efforts by the government to stimulate domestic demand and consumption, Japanese consumers still have a high savings rate. If domestic demand is unlikely to increase to absorb production, and the current account must be balanced to avoid large cuts in public sector spending, government is left with the option of restarting the export engine;
  • Japan’s switch away from nuclear power, though a political necessity, is an economic mistake. Japan’s current account woes arise from the large-scale shift to hydrocarbons to fuel the economy, which exposes the Japanese economy to the vagaries of oil markets. (9)

 

Europe

  • The Euro Zone remains divided by a robust, growing Northern cluster of countries and an anemic periphery burdened with high levels of public and private debt, weak current accounts and a lack of competitiveness. The periphery states are generally in recession already;
  • As a condition of continuing funding the periphery bailouts, Germany and other Northern cluster states are insisting on extensive and prolonged public sector fiscal adjustments to bring deficit levels down to near zero. These measures are exacerbating the economic downturn and driving peripheral countries further into recession;
  • Without the possibility of currency devaluation, periphery nations can only regain competitiveness through internal (wage) devaluation. This is inflicting considerable social pain and raising the political cost of further austerity to local governments (see here);
  • The combination of cuts to public sector investment and research, as well as a general lack of liquidity for businesses, necessary investments in productivity enhancing infrastructure, technology and human capital are not being made in the peripheral nations, mitigating the effects of a wage devaluation;
  • The collapse in internal demand in the periphery nations, and the lack of liquidity to consumers means that exports are the only realistic means of economic growth. However, most periphery exports are intra-European, implying that the export-focused Northern cluster must either strongly stimulate internal demand, or that extra-European exports must rise significantly. The former is unlikely. In fact, Germany is actively pursuing the opposite policy. The export destinations for the latter solution are not clear;
  • Europe is particularly vulnerable to an exogenous price shock arising from a spike in oil prices. Of the major European markets, only France is relatively insulated from this due to the extensive use of nuclear power to provide electricity. Germany is in the process of shutting down her nuclear power industry; Italy, Spain, Portugal, Greece and Ireland are all highly sensitive to the price of oil. (10) The current average price of $125/bbl for North Sea Brent will accentuate the recession in these countries. Any sustained increase or a short-term, extreme spike in prices, could drive wide segments of Europe into technical depression;

 

  • European states face the stark choice of moving to full political union (“United States of Europe”) or watching the currency union fall apart. Either of the two outcomes would be “stable”. European leaders seem decided on the first course, with the Merkozy-designed fiscal pact being the first step. Greater centralization of regulatory, especially in the financial sector, and fiscal powers in the European Parliament would be the next, with a “EU VAT” being a logical next step.At least partial harmonization of corporate and individual tax regimes and entitlement programs would be another one. A political union without the power of the purse and real influence over major policies would otherwise prove as disastrous as the currency union without a real lender of last resort and without internal stability mechanisms is proving. The not unthinkable alternative would be to reintroduce at least some national currencies: an expensive option, but not one which would automatically sink the European integration project. The current situation, however, is inherently unstable and unsustainable. The sooner the Europeans admit this, the sooner they will get to work on the real solutions to their problems.

The “Rest of the World”

There are more than four export destinations in the world, of course, but most of these don’t count for much on a global scale. They can be divided into three broad categories:

  • Wealthy, but unequal. Russia, Saudi Arabia, the Gulf States. These are the energy exporting nations who are flush with cash. They have the means to consume, but the wealth is so concentrated in political and business elites, that the impact of that wealth on internal demand is barely felt. Most of it goes into sovereign wealth or private hedge funds, which, if anything, only exacerbate global financial imbalances;
  • Big, but poor. Brazil, India, Mexico, Indonesia. These are countries with 100+ million inhabitants who could generate significant consumer demand if they weren’t still so poor. Despite tremendous progress in recent years, these nations are not yet capable of driving world economic growth, either singly or in combination;
  • Too small, or too poor, or both. This is everybody else. It includes wealthy small nations like Israel or Canada, as well as really poor nations of all sizes. Even if all of these were pulling in the same direction, they would not make much difference in the global demand curve.

In any case, all of these nations are not pulling in the same direction. Many of them also have export oriented economies, especially in Asia. South Korea could be added to the “Japan” summary, and Vietnam to the “China” summary without the analysis changing fundamentally.

Making Cents of It All

World leaders are living in a fool’s paradise. Each major economy wishes to significantly increase exports while reducing imports and public spending, which we know to be mathematically impossible.

The “rest of the world” is not an option. Those that are not are too poor, too unequal, or too few to absorb the enormous quantities of goods and services that need to be exported for the advanced economies to move into high gear growth are also attempting to export their way to wealth.

So what can we expect?

  • Export winners will continue to win. That means China, Japan, Taiwan and South Korea will maintain their share of global exports. Unfortunately for China, this doesn’t mean that global exports will rise to the extent these countries need to maintain internal political and economic stability. The possibility of the Chinese balancing act getting out of hand and generating internal political instability cannot be dismissed, nor a Japanese failure to control their current account and deficit, leading to a financial crisis in the country. To the extent that China will push for more exports to the US and Europe, which will attempt to resist increasing imports, expect trade relations to continue to deteriorate;

 

  • The Buyer of Last Resort is gone for good. “Gone for good” being a euphemism for the foreseeable future, which in economics should really be no more than 5 years or so. Although US households and businesses are aggressively deleveraging, it is unlikely that consumer spending will grow robustly enough to absorb the world’s excess production. Too many American households remain either underwater on their mortgages, or without the inflated equity that underwrote so much US spending on credit. This is most likely a generational shift. Though the United States has made progress in overcoming the Great Recession, but it still faces persistently high under- and unemployment, a structurally weak job market, stagnant real wages, low but persistent inflation, and a housing sector in disarray. The increasingly venomous political climate threatens to torpedo the urgent need for government reforms in fiscal policy, industrial policy, the financial sector, entitlement reform and productivity enhancing investments. The biggest risk to the US remains in the inadequately reformed financial sector, especially the mortgage market. However, if Republicans win both the Executive and Congress in the general election, and they implement the tax and spending cuts they have been irresponsibly calling for, there is a real possibility of the United States falling back into recession due to a collapse in public sector spending;

 

  • Short Europe. Europe will continue to be the weakest link. As the Northern tier countries maintain stable economic growth and low unemployment, the periphery countries will move from one crisis to another as immense social and political pressure builds within them. Economic performance in the periphery markets will remain anemic, unemployment and emigration will continue to undermine growth and private sector liquidity will remain in short supply (for the example of Spain see here). Even assuming the Euro Zone avoids collapse, a two-track Europe will struggle to contain the widening split between tiers. The main short-term threat now comes from the possibility of exogenous shocks, especially a spike in oil prices. The long-term threat is the political instability generated by never-ending austerity. How will Spain, Portugal or Greece maintain an unemployment rate over 20% for another half decade without enormous social upheaval? Recent strikes and unrest are the tip of the iceberg. This situation will likely continue for at least another 5 years.

It is far too early to pop the champagne cork just yet. We are closer to 1935 than to 1945. If history teaches us anything, it is that large structural imbalances more usually end in crisis more often than in successful resolution through adjustments to the status quo. We must learn from history or pray that we are wildly and undeservedly more fortunate than our forefathers.

Sources and Notes:

(1) Michael Pettis wrote an excellent article on EconoMonitor regarding the situation in China and the brewing crisis in Japan. http://www.economonitor.com/blog/2012/03/the-japan-debt-disaster-and-chinas-nonrebalancing/
(2) OECD Economic Outlook No. 90: Statistics and Projections Database, 16 December 2011
(3) World Bank World Energy Statistics 2011
(4) U.S. Bureau of Economic Analysis dataset
(5) China 2030: Conference Edition. The World Bank and the Development Research Center of the State Council, PRC. http://www.worldbank.org/content/dam/Worldbank/document/China-2030-complete.pdf
(6) IMF World Economic Outlook database, September 2011
(7) IMF World Economic Outlook database, September 2011
(8) IMF World Economic Outlook database, September 2011
(9) OECD International Trade dataset (MEI)
(10) World Bank World Energy Statistics 2011

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