Crisis in Europe & “The Great Rebalancing” by Michael Pettis

This week the European Crisis reemerged. The European Union acted with utterly inconceivable stupidity in confiscating a portion of monies of depositors in Cyprus banks. Reportedly this was a German decision that was imposed on Cyprus in a do it or go bankrupt fashion demonstrating that the European Union is becoming a German-led autocracy rather than a union of nations.

Interestingly, this is a part of the thesis laid out by Professor Michael Pettis in his recent book The Great Rebalancing – Trade, Conflict, and the Perilous Road Ahead for the World Economy. We have been familiar with the writings of Professor Pettis for several years, especially regarding the Chinese economy. So we were eager to read his book in which he outlines his global perspectives. This is a book that serious students should read and keep handy over the next few years.

                                                              

In this article, we will focus on Chapter 6 – The Case of Europe. Prof. Pettis demolishes the popular concept that Germany is strong today because of German values of hard work & savings, while Southern Europe is a mess because of social attitudes of relaxed work ethic and a penchant for spending.  As he writes,

• “One of the clearest ways to see how distortions in consumption in one country can cause distorted savings in another is by examining Europe since the creation of the euro. This is perhaps most obvious when we examine Spain, a country that, before the crisis, had unlike Germany, low government debt and fiscal surpluses and did not seem to be a model of spendthrift laziness.”

Spain, in other words, did not have problems that are popularly believed to be the cause of the problems of Southern European countries. So what happened?

Free Trade Zones – Germany-centered EU vs. U.S. Centered NAFTA

Think back to 1994 and the crisis in Mexico. The Clinton Administration created Brady Bonds to bail out Mexico and established the North American Free Trade Agreement. In the 1940s, America established the Marshall Plan to help post WWII-Europe to get back on its economic feet. Both were very successful programs. One main reason is that America, the center of the programs, was an Importer of goods from the zones and ran a trade deficit with the other countries in the programs. In addition, the various nations kept their own currencies.

The European Monetary Union essentially created a free trade zone centered around a united Germany. Unlike the U.S., Germany became the chief Exporter of the zone rather than an importer. And all nations in the EMU adopted a common currency, the Euro.

Prof. Pettis writes:

• “One of the automatic consequences of these policies was that Germany began running large trade surpluses to generate domestic growth and higher employment….Because those large German surpluses had to result in trade deficits elsewhere. Thanks to Europe’s monetary policies driven by the needs of Germany – a strong euro and lower interest rates – the deficits showed up primarily in peripheral Europe.”
• “It was not primarily the consequence of Spanish policies, nor even the consequence of Spain’s relaxed Mediterranean culture.”

Options for Spain & rest of peripheral Europe

According to Prof. Pettis, Spain & others had only four options to choose from in dealing with the German surpluses:

• “German capital exports to Spain at very low interest rates (thanks to German rates being low), relative to Spanish prices, could fund a real estate boom that forces up Spanish investment sufficiently to absorb the increase in German savings exported abroad”
• “Another way to absorb the excess German savings is for Spanish savings to drop. Spain can allow domestic consumption, for example, to rise faster than GDP.”
• “Spain could also have refused to absorb excess German savings..For example, it could have cut fiscal spending and raised taxes enough…”
• “Spain could also in principle have refused to absorb excess German savings by lowering labor costs or by devaluing its currency against Germany’s currency or could have imposed trade barriers.”

As Prof. Pettis points out, Germany would have had to adjust under options 3 or 4 with either a rise in domestic unemployment or with an increase in state investment. But, as he then adds:

• “Of course under the conditions of membership in the eurozone, Spain was not able to exercise either of these options (3 or 4)”.

Two Choices left for Spain

According to Prof. Pettis, unless Germany changes, the only two choices left for Spain are:

• “Either Spain must accept stagnant economic growth and unemployment levels of 20% or more for many years,”
• “Or Spain must leave the euro… and devalue its currency.”

Too late for Spain & others in peripheral Europe?

Prof. Pettis writes:

• “Spain is already past the point at which it can recover on its own. In fact, I believe it is moving inexorably toward crisis.”

He adds:

• “It is very hard to stop the process once it begins, and it is probably already too late for Spain and much of peripheral Europe, but while Europe stumbles toward debt crisis, Spain is trying to distance itself from countries like Greece, Portugal, and Italy. It wants to be seen, in other words, as one of the virtuous countries that work hard, save, and repay their debts, and not one of the vicious ones.”
• “But this strategy is the wrong one. Spain and the rest of peripheral Europe are suffering from the same set of problems, and these often enough have little to do with virtue or vice….”

So what is necessary in his opinion?

Two-Sided Adjustment

Prof. Pettis dismisses

• “…exhortations that Spaniards become as virtuous, thrifty, and hardworking as Germans. Virtue has nothing to do with it, and in the face of rising unemployment it is meaningless to ask Spaniards to work more, nor can Spain escape from the mess by convincing its population to spend less.”

Why?

• “…reduced Spanish consumption will simply cause Spanish (and German) unemployment to rise even further.”

Why is a two-sided adjustment between Germany and Spain necessary?

• “Without a change in German policies, there is little Spain can do to improve matters. It is impossible to expect Spain to repay its debt to Germany, in other words, unless Germany runs a trade deficit and Spain a trade surplus.”

This applies to all European countries that face trade deficits with Germany:

• “Their problems cannot be resolved in an optimal way unless Germany reverses these policies. For this reason the deficit countries must band together and force a sharing of the adjustment cost across Europe.”

Back to Germany vs. USA

The basic thesis of Prof. Pettis is summed up by him as:

• “These problems are often the consequences of many years of bad policy, driven just as much by bad German policies as by bad policies [in Spain & peripheral Europe]. If this is indeed the case, the problems of Spain and peripheral Europe can best be addressed only with a German adjustment at least as serious as the adjustment in peripheral Europe. Germany must stimulate domestic consumption and reverse its trade surplus, as difficult as this will be.”

Do Germans concur? Not according to Professor Pettis,

• “But Germany refuses to do so, implicitly insisting that most of peripheral Europe’s problems were caused by misguided policies in those countries, and so also insisting that all the adjustments be made by Spain and peripheral Europe.”

America understands this basic reality instinctively, that for a free trade zone to succeed, the dominant country at the center of the zone has to be a net importer & consumer economy and not an exporter. Germany doesn’t understand it and that is why the EMU is likely to fail and fail with serious repercussions across the globe.

By the way, China, another dominant mercantile country, doesn’t get it either. But that is a topic for our review of Chapter 4 of The Great Rebalancing by Michael Pettis.

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