Some clarification and expansion of my recent off-consensus analysis of the implications of the European debt crisis is in order. In short, I noted that lower energy costs and interest rates were generally positive for the US. Responses came from Scott Sumner, Felix Salmon, Ryan Avent, and Paul Krugman.
The context in which I considered my remarks are well described by Michael Pettis, in his rebuttal to claims that China should avoid currency revaluation in light of the Euro's decline. He argues that the Euro's decline makes the a shift in Chinese currency policy all the more critical. In his summary:
5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences. Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly. The most obvious are current account deficit countries like the US.
A collapsing trade surplus in Europe needs to be met with an expanding trade surplus somewhere else, and my view is that the US is the most likely candidate, especially as the trend is already in place - the external sector is a drag on growth, despite all expectations that a sustained rebalancing will occur in the wake of the US financial crisis.
I think that the decline in oil prices and interest rates is one mechanism by which markets essentially offset some the contractionary consequences of the European debt crisis. Like the declining Euro, they are price signals that correspond to propping up demand elsewhere, such as the US, thereby allowing the US to absorb the European contraction via an expansion in the US current account deficit. Thus, the surprising effect of the crisis is that US demand growth is higher than would otherwise be the case, even as global growth in aggregate suffers.
Pettis argues, I think correctly, that this sets the stage for a rather nasty increase in trade tensions:
I don’t really see how the numbers are going to work. Europe, China and Japan are all implicitly demanding that the US trade deficit rise to help them through their domestic employment problems. The US has its own domestic employment problems and is determined to bring the trade deficit down. Both sides cannot win and there doesn’t seem to be much serious attempt at global coordination. In fact the easiest part of any global coordination – that between surplus Europe and deficit Europe – has already degenerated into a nasty round of accusations, counter-accusations and insults.
Note that Pettis is hinting at one of Ryan Advent's criticisms regarding domestic employment problems:
For another, it seems unreasonable to expect personal consumption to power recovery all the way back to full employment, no matter what interest rates or oil prices do. Household balance sheets are simply too stressed. Consumption can act as a bridge from government-driven growth to export- and investment-driven growth, but little more, and export- and investment-driven growth is looking dicier now than it was a month ago.
I agree - it seems ludicrous to expect the US consumer to continue to power forward sufficiently to hold the US economy and the global economy together. Yet, I suspect that it is the course of least resistance, or at least appears to be at the moment. For what it's worth, consumer spending growth has been on something of a tear - a trend that stretches back to the middle of last year. One can argue that this spending is simply propped up by the expansion of government debt rather than private debt, but note that that dynamic becomes more sustainable given lower interest rates. It is almost as if market participants are encouraging the US government to take over where the Greeks, Spanish, etc. let off. Indeed, it seems to be clear evidence that public debt is nowhere near crowding out private spending in the US. Room for more, not less.
Is this economically healthy? No, no, no. Felix points out that an expansion of the US imbalance now only implies higher interest rates later. The adjustment will come, and will only be more difficult in the future. That is a story I have told many times, but I have to add this - going bearish on US debt has been risky. Like Japan, economists keep saying the end is near, but it has not yet happened. Timing is everything.
Sumner argues that declining commodity prices in response to demand shock are rarely a good thing, and the recent episode is another reason to believe that central bankers are failing to support nominal GDP growth. With respect to my earlier argument, I see no reason why a decline in energy prices due to a demand drop in Europe cannot be a net positive for the US. But, nonetheless, I agree with Sumner's broader point regarding the need for more aggressive monetary policy:
It’s true that US exports to Europe are modest, but if the strong dollar is symptomatic of unintentional tightening of monetary policy, despite low rates, then it may not be good news at all.
He reiterates the point here. The European Central Bank, in particular, should be working more aggressively to counter deflationary pressures internally. But, alas, policymakers don't want to be seen as bailing out weaker members for fear of losing credibility. One of the cut of your nose to spite your face situations. Likewise, with the US facing ongoing disinflationary pressures, the Fed arguably should be expanding policy more aggressively. In theory, the two expansions could leave the relative currency prices unchanged, yet sink both against other trading partners.
This, of course, brings us back to the apparently intractable Chinese currency issue. A Dollar and Euro depreciation against the renminbi and other emerging market currencies looks like a nobrainer approach to preventing an intensification of global imbalances. Moreover, it just makes economic sense given relative inflation trends. Consider today's Wall Street Journal:
U.S. inflation slid last month to its lowest level in 44 years, highlighting a potentially troublesome unevenness in the global recovery.
Inflation has sped up in booming economies such as China and Brazil, while in many developed nations like the U.S., prices remain tame, even flirting with deflation in some cases.
The U.S. government reported Wednesday that consumer prices, excluding volatile food and energy, rose a meager 0.9% in April from a year earlier. It is the latest sign that high unemployment and excess production capacity are holding down wages and prices in much of the developed world.
At the same time, emerging economies are taking steps to contain high inflation in their booming markets—moves that some economists worry could dampen demand for exports, which many developed countries are depending on to help fuel their recoveries.
Note that US Treasury Secretary Timothy Geithner said again this week that Chinese currency policy is set for a change:
The Treasury chief also yesterday reiterated his call that China will abandon its exchange-rate peg. The government is moving toward changes in currency policy that would allow market forces to play a greater role, he told reporters after the speech.
Of course, Geithner says things like this a lot. And one gets the expected pushback from China:
Yuan forwards weakened for a second day after Chinese officials said the nation won’t yield to global calls to end a 22-month peg, damping speculation next week’s U.S.-China trade talks would trigger appreciation.
China won’t succumb to external pressure and will modify the currency based on the economic situation, Assistant Finance Minister Zhu Guangyao said in Beijing today. Stability between the world’s major reserve currencies will aid the global economic recovery, he said at a briefing to discuss the May 24- 25 Strategic & Economic Dialogue in Beijing…
“Only the authorities of a sovereign country have the right to decide how to form the exchange rate,” Zhu said. Countries should “work to maintain the stability of exchange rates between currencies so as to create a favorable environment for the global economic recovery,” he said.
Note that Chinese policymakers hold all the cards regarding any policy shifts. They know that Giethner is not going to push for capital controls, nor will he request the Fed to beginning stockpiling renminbi on Treasury's behalf. The latter policy - a tit for tat response to Chinese dollar accumulation - would be interesting to say the least, but no US policymaker wants to be accused of initiating a chain of competitive devaluations that will only end badly.
Sorry if this rambled a bit; external adjustment stories on a global scale tend to get messy. Which I imagine is why we have yet find a sustainable path to resolving imbalances.
