Interrelated Themes Clash in World Economy

March 17, 2010

Differences in the economic policy priorities of governments are generally rooted in bad historical experiences.  Top attention is placed on preventing whatever is most feared.  Post-WWI hyperinflation in Germany evaporated the lifetime savings of households and continues to get blamed for creating conditions that promoted political instability, then the rise of Hitler and ultimately ruin for all of Europe.  The ECB inherited from the German Bundsbank a cultural preference for low and stable inflation above all else even if that meant less growth.  Unemployment of 25% during the Great Depression plays a similar role in the United States, which is why maximizing growth in jobs is given equal footing in the Federal Reserve’s mandate with the promotion of price stability.  The Beijing government’s phobia is partly homegrown, namely the imperative for rapid growth in GDP and jobs, which is needed to avoid social instability in that country of one and a third billion people.  However, China’s policy preferences are also borrowed from Japan, which like China these days experienced extremely rapid growth in 1950s and 1960s and continuing strong rates of expansion until Tokyo officials, at U.S. prodding in the mid-1980s, agreed to a very significant advance of the yen.  These personal histories constrain what governments are prepared to concede for the common welfare of all nations.

FT columnist Martin Wolf coins a new term in today’s paper, Chermany, in an article that draws comparisons between the world’s two big surplus economies.  Politicians in China and Germany are defending their right to run continuing external surpluses, believing such to be the result of hard-earned sacrifices and responsibly frugal practices that everybody ought to emulate.   And they blindly refuse to consider the unsustainability of the status quo and the deflationary consequences for other economies and their own economies eventually if deficit nations were to follow their policy recommendations.  Current account imbalances, the result of different saving/investment tradeoffs, were arguably the main underlying cause of a series of global economic crises from the Latin American debt crisis of the early 1980s to the recent Great Recession.  That basic tension persists, meaning that regardless of whether one sees sub-trend growth stretching outward for years or anticipates a more normal V-shaped business cycle, increasingly severe boom-bust patterns will continue.

Most likely, politicians in the debtor nations will not tolerate the status quo that China and Germany seek.  Wolf opines that the European Monetary Union may be headed for a break-up but along different lines from what is generally mentioned, not with the exodus of Greece or the expulsion of Spain or Italy, but rather with Germany returning to its beloved Deutschemark and revaluing against the rest.  The Nobel Laureate Paul Krugman suggests that maybe the United States should consider imposing a draconian import surcharge on China, a similar technique to one used by Nixon in the summer of 1971 to force other governments to accept a devaluation of the overvalued dollar at the end of that year.  The common conclusion to draw from intensifying strains within Europe and between China and other economies is that protectionist warfare between countries will probably get much worse.  Protectionism played a big role in transforming a serious recession into a world depression eighty years ago.  Even before the financial crisis erupted in 2007, the Doha Round of multilateral trade talks suffered repeated breakdowns.  This was an ominous development, even though world GDP was expanding very robustly at the time.  The reduction of trade barriers had been a catalyst for strong post-WW2 growth, but it was widely understood that trade liberalization is a process that slides backward if it cannot continue to make progress.  And so it did.

The above factors paint a grim picture of the future.  Such a view is in competition with the upbeat tone of central bank watching, which is focused on an improving world economy and the timing of the normalization of monetary and fiscal policies.  Yesterday’s FOMC statement upgraded business investment to “rising significantly” and gave a vote of greater confidence to the U.S. labor market, which officials now believe to be “stabilizing.”  Despite sobering housing market statistics like the recent batch of housing starts and building permits, the Fed reaffirmed that it will be withdrawing mortgage market support at the end of this month.  Markets expect a first federal funds rate hike by late 2010 if activity trends do no worse than Fed officials now assume in their baseline forecast.  It will be the first of a series of increases.  While the increases in 2004-6 were all 25 basis points in size, moves of 50 basis points or more are at least plausible this time.  Already, one Fed official, Tom Hoenig, is worried that extraordinarily low interest rates might plant the seeds of the next financial asset bubble, and the WSJ’s Heard on the Street column today is devoted to “the lure of inflation’s siren song.”

However, China and Germany’s stubbornly rigid mercantilist policies, the persistence of huge external imbalances, and deepening protectionism sentiment suggest a wholly different policy scenario, one much more akin to Japan’s experience.  From the moment that the Bank of Japan cut its interest rate to 0.50% in September 1995, the authorities were looking for the earliest opportunity to return to normal settings.  The overnight rate never did get above 0.50% in the ensuing 14-1/2 years.  In August 2000, the BOJ tried one exit from zero interest rates.  But Japan walked into a wall of deflation, and the central bank had to retrace its steps eight months later and impose six years of massive quantitative stimulus.

The sea changes in monetary policies that all central banks are contemplating will be only possible if economic conditions permit them.  When officials speak of a highly uncertain outlook, they are acknowledging they really do not know how economies are going to absorb the removal of a tremendous amount of policy support that averted a depression and is giving the appearance of improvement now.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



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