Pettis: 8 reasons why the eurozone must rebalance or die ...
“Let me smile with the wise, and feed with the rich.”
-Samuel Johnson
Michael Pettis is a professor at Beijing University, and one of the best global macro analysts out there, in my opinion. His recent piece, titled, “If no trade reversal now, then when,” should be required reading for anyone who wants a clear summary of Eurozone problems without becoming mired in all the stuff of breaking news.
Bullet point summary of his recent piece:
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Capital Inflow Imbalances: “Trade imbalances, of course, are the obverse of capital imbalances, and the surge in debt in peripheral Europe in the past decade – debt owed ultimately to Germany and the other core countries – was the inevitable consequence of those capital flow imbalances”
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Cost Imbalances: “While European policymakers alternatively sweat and shiver over fiscal deficits, surging government debt, and collapsing banks, there is almost no prospect of their resolving the European crisis until they address the divergence in costs.”
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Re-balance Inflow Imbalances: “The best resolution, and the one Keynes urged without success on the US in the 1920s and 1930s, is that Germany take steps to reverse its trade surplus.”
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No balance, no jobs: “If Germany doesn’t do either [boost disposable household income and consumption or engineer massive infrastructure spending] and , and especially if it imposes austerity, there must be a surge in unemployment for many years within Europe as German excess capacity meets dwindling demand in peripheral Europe”
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Bingo! You can insert Germany or China here as your poster child: “Countries that run large and persistent trade surpluses never seem to understand that their surpluses are mainly the consequences of domestic policies that generate additional domestic growth by absorbing foreign demand.”
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Growth balance is the only way debt repayment happens: Trade deficit nations have received capital inflows for many years from surplus nations as the automatic counterpart to their deficits. If the surplus nations ever hope to get repaid – i.e. to reverse those capital flows – then it must be obvious that the trade imbalances must also reverse.
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Perfect summary example here; can insert Greece, Ireland, and Portugal in place of Spain: Spain, for example, can only support net capital outflows if it is running a current account surplus. Germany can only receive net capital inflows if it is running a current account deficit. If Spain wants to repay its debt to Germany, and if Germany hopes to have its Spanish loans repaid, this can only happen if the former runs a current account surplus and the latter a current account deficit.
The chart below we have used in our webinars/seminars in the past; it visually tells the story as laid out by Professor Pettis—a story that once you understand, everything else about the periphery debt-cum-banking crisis falls nicely into place.
Germany’s surplus is the orange up-sloping line. The down-sloping deficit lines represent the periphery countries. Notice, if you will, the year Germany’s balance went into surplus and started ramping up nicely—1999. I think that was around the time the euro started to be introduced to the continent. Is it a coincidence?
When you think about the surplus/deficit math, I think it adds validation to the view German industrialists knew very clearly the tradeoff for giving up the D-mark—a captive continent that could never compete with them on product labor cost. The German banks, and banks elsewhere across Europe, were very much in on the inside game which foresaw the periphery nations needing large and ongoing loans to buy all these Germany goods. And of course, since these periphery countries would be guaranteed to borrow near German interest rates, as a perk of being part of the single currency system, this game would go on for decades. And of course this “guarantee” of the single currency allowed banks to sell massive amounts of Credit Default Swaps with little or no concern—a virtual money printing machine it was.
But, a little reality bite got in the way of all those plans; it was called the Credit Crunch. It is why we have always viewed the Credit Crunch as a sea change event in the global economy, and the catalyst for a major change in trend in many key asset classes, and especially the US dollar.
The Trillion dollar question is this: Is Germany willing to transfer 5-10% of its GDP to the periphery countries in order to sustain demand for Germany goods; or alter its growth model by stimulating consumer demand to drive Eurozone rebalancing and a glimmer of growth hope for the periphery?
Mrs. Merkel, your call! Stay tuned.