The Wars of Austerity

I have become increasingly less hopeful about prospects for a rapid recovery from the global recession. Coordinated fiscal expansion ($5 trillion) by the world’s leading governments arrested the downward slide, but failed to produce a healthy rebound. The current frustration is summed up by The Economist’s recent cover headline: “Grow, dammit, grow.”

There are two reasons to be pessimistic. The first reason is the premature withdrawal of the “stimulus” measures agreed upon by the G-20 in London in April 2009. All the main countries are now committed to slashing their budget deficits.

The second reason is that nothing has been done to address the problem of current-account imbalances. Indeed, the talk nowadays of currency wars leading to trade wars is reminiscent of the disastrous experience of the 1930’s.

The problem of current-account imbalances is closely linked to the existence of a world savings glut. One part of the world, led by China, earns more than it spends, whereas another part, notably the United States, spends more than it earns. Provided the surplus countries invest in the deficit countries, these imbalances pose no macroeconomic problem.

Indeed, this was the nineteenth-century pattern. A system of foreign investment, pivoting on London, channeled the savings of rich (or surplus) countries to the poor (or deficit) countries. Despite many financial crises and defaults, this creditor-debtor relationship worked, on the whole, to the benefit of both sides. Rich-country investors earned a higher rate of return than they would at home, and poor-country recipients raised the development finance they needed. There was no persistent tendency to deflation.

The current system is superficially similar, but with one crucial difference: the flow of saving now goes from developing countries like China to rich countries like the US –that is, from countries where capital is scarce to countries where it is abundant. The global savings glut is the result of this perverse relationship.

Unlike Great Britain in the nineteenth century, China does not view its surplus as an investment engine. It undertook reserve accumulation in the late 1990’s as a form of self-insurance against capital flight. Reserve accumulation was also a by-product of China’s deliberate currency undervaluation to promote export-led growth strategy.

The result is that China and other East Asian countries own a large and growing stock of US Treasury bills. Through financial intermediation, these government securities helped finance the western consumption and speculative boom that collapsed in 2008.

Cheap money in the West was the “correct” Keynesian response to the flood of saving from the East. But, because there were insufficient outlets for “real” investment in countries that already had all the capital they could use, cheap money proved to be a dysfunctional way of dealing with the problem of excess saving.

The recession reinforced the pattern of poor countries lending to rich ones. With vigorous recovery in East Asia and stagnation in the West, global imbalances have grown. And, as former US Federal Reserve Chairman Alan Greenspan recently noted, “US fixed capital investment has fallen far short of the level that history suggests should have occurred, given the dramatic surge in corporate profitability.” In short, we are heading full steam ahead into the next collapse.

There are two broad strategies for unraveling the linked problems of current-account and saving-investment imbalances. The first is to weaken China’s incentive to accumulate reserves.

In April 2009, Zhou Xiaochuan, Governor of the People’s Bank of China, proposed the creation of a “super-sovereign reserve currency” to remove the “inherent risks” of credit-based national reserve currencies. This new currency, to be developed from the International Monetary Fund’s Special Drawing Rights (SDRs), would in time entirely replace national reserve currencies.

A “substitution account,” housed at the IMF, would enable countries to convert their existing reserve holdings into SDRs. The principle behind this is that collective insurance would be cheaper, and therefore less deflationary, than self-insurance. A reduced Chinese appetite for reserves would be reflected in an appreciation of its currency and a reduction in its trade surplus.

This far-sighted Chinese proposal never left the drawing board. Instead, the US has brought intense pressure to bear on China to revalue the renminbi. The result is a war of words that could easily turn into something worse.

The US accuses China of undervaluing its currency, while China blames loose US monetary policy for flooding emerging markets with US dollars. The US House of Representatives has passed a bill that would allow duties to be imposed on imports from countries, like China, that manipulate their currencies for trade advantage.

Meanwhile, the dollar’s depreciation in anticipation of further quantitative easing has caused East Asian central banks to step up their purchases of dollars and impose controls on capital inflows, in order to prevent their currencies from appreciating. As Asian countries try to keep capital out, the West moves towards protectionism.

We can learn from the experience of the 1930’s. A rising tide lifts all boats; a receding one ignites a Hobbesian war of each against all.

This brings us back to the premature withdrawal of fiscal stimulus. With aggregate demand depressed in Europe and the US, governments turn naturally to export markets to relieve unemployment at home. But all countries cannot simultaneously run trade surpluses. The attempt to achieve them is bound to lead to competitive currency depreciation and protectionism.

As Keynes wisely remarked, “If nations can learn to provide themselves with full employment by their domestic policy…there would no longer be a pressing motive why one country need force its wares on another or repulse the offerings of its neighbor.” Trade between countries “would cease to be what it is, namely a desperate expedient to maintain employment at home by forcing sales on foreign markets and restricting purchases.” It would become, instead, “a willing and unimpeded exchange of goods and services in conditions of mutual advantage.”

In other words, today’s turmoil over currencies and trade is a direct result of our failure to solve our employment problem.