Rebalancing at Europe's expense

By: Kevin O'Rourke

There is widespread agreement that one of the root causes of the Great Credit Crisis of 2008 was the interaction between global imbalances and under-regulated financial systems. The savings of surplus countries created a wave of money which washed into deficit countries, looking for high returns while simultaneously helping to keep interest rates low. Where financial industries were allowed sufficient latitude, the result was excessive leverage and risk-taking, and ultimately catastrophe.

It might therefore appear to be good news that these imbalances contracted sharply during 2008-2009. According to the IMF, the US current account deficit shrank from 4.9% of GDP in 2008 to 2.6% in 2009, while the Japanese surplus fell from 3.2% of GDP to 1.9%, and the Chinese surplus fell from 9.8% of GDP to 7.8%. The Eurozone current account was fairly balanced before the crisis, and remains so, but within the Eurozone imbalances also fell: the German current surplus contracted from 6.4% of GDP to 2.9%, while the Irish deficit fell from 5.2% of GDP to 1.7%.

A recent paper by Richard Baldwin and Daria Taglioni points out, however, that these shrinking imbalances represent nothing more than the inevitable arithmetic consequence of the largest collapse in world trade since World War II: at its trough, in May 2009, the volume of world trade was more than 20% lower than at its peak in April 2008. The Baldwin-Taglioni argument is a simple one, and can best be illustrated by a hypothetical example. If a country is initially running a deficit of 20, with imports of 100 and exports of 80, and if both imports and exports then decline by fifty percent, to 50 and 40, the deficit will also decline by fifty percent, to 10. Of course, as Baldwin and Taglioni point out, if both imports and exports subsequently recover to their initial levels, the deficit will return to its initial level as well.

There is general agreement among trade economists that the trade collapse of 2008-9 was due to a collapse in demand, particularly for durable goods whose consumption could easily be postponed. Vertical supply chains then implied that falling trade volumes were transmitted rapidly across the globe. The implication is that once the world economy starts to recover, world trade will recover rapidly, and indeed this is already happening: world trade volumes are up 8% since May. Not surprisingly, trade imbalances are beginning to increase as well.

To be sure, trade imbalances may not return to their original levels, since part of the adjustment required to unwind them is now taking place. In particular, the dollar has been depreciating on world currency markets, although crucially not against the renminbi. A falling dollar is one of the things required to rebalance the world economy, along with a shift in expenditure away from deficit countries towards surplus countries. The fact that the dollar is falling is thus, taken in isolation, a positive development.

Nevertheless, simple arithmetic dictates that trade imbalances will grow from their current low levels in the months ahead, and this is politically dangerous. Deficit country economies remain extremely fragile, and even if they avoid a double dip recession their unemployment rates will continue to rise well into next year. Several commentators have pointed out that the coincidence of rising imports, the maintenance of the renminbi peg to the dollar, and lengthening dole queues, will only serve to increase protectionist pressures in the United States. It seems clear, however, that these pressures will be even greater in Europe, and in particular in the Eurozone.

 In well-known work published in 2005, Maurice Obstfeld and Kenneth Rogoff estimated that if US, Asian and European imbalances were all to go to zero, the Euro would have to rise by 28.6% against the dollar in real terms, and depreciate by 6.7% against Asian currencies. However, if Asian currencies were to remain unilaterally pegged to the dollar, then the burden of adjustment would fall largely on Europe: the elimination of the US current account deficit would then be associated with a real appreciation of the Euro of roughly 60%. Since Asian currencies would be depreciating, Asian surpluses would rise under this scenario, while Europe would experience an exploding current account deficit.

The world has changed since 2005. It remains true however that if the dollar continues to depreciate, and the renminbi follows it down, rather than appreciating as is required, then the Eurozone economies will be severely damaged. The possibility that an inflation hawk like Axel Weber will be at the head of the ECB during such an adjustment should make Europeans even more worried. But our trade partners should also worry, since history shows that exchange rate misalignments are a frequent cause of protectionism, especially at times of rising unemployment. Since not all EU countries are members of the Eurozone, there might even be negative consequences for the Single Market.

If we want to avoid such dangerous territory, two things need to happen. First, we need a renminbi appreciation, and the sooner the better. Second, the ECB must not be over-hasty in adopting an exit strategy. Rising unemployment and the potential fragmentation of the international economy, rather than inflation, are what should continue to concern policymakers for some time to come.

 

Kevin O’Rourke is a Professor of Economics at Trinity College Dublin, and a co-organiser of the CEPR’s Economic History Initiative.

 

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