Friday, November 18, 2011

The "Chermany" Problem of Unsustainable Exchange Rates

Martin Wolf coined the term "Chermany" in one of his Financial Times columns in March 2010. China and Germany have been running the largest trade surpluses in the world for the last few years. Moreover, one of the reasons they both have such large trade surpluses is that the exchange rate of their respective currencies is set at a low enough level vis-a-vis their main trading partners to assure a situation of strong exports and weaker imports. Germany's huge trade surpluses are part of the reason that the euro-zone is flailing. Could China's huge trade surpluses at some point be part of a broader crisis in the U.S. dollar-denominated world market for trade?

Start with some facts about Chermany's trade surpluses, using graphs generated from the World Bank's World Development Indicators database. The first graph shows their current account trade surpluses since 1980 expressed as a share of GDP: China in blue, Germany in yellow. The second graphs shows their trade surpluses in U.S. dollars. Notice in particular that the huge trade surpluses for Chermany are a relatively recent phenomenon. China ran only smallish trade surpluses or outright trade deficits up to the early 2000s. Germany ran trade deficits through most of the 1990s. In recent years, China's trade surpluses are larger in absolute dollars, but Germany's surpluses are larger when measured as a share of GDP.

Those who have trade surpluses, like China and Germany, wear them as a badge of economic virtue. Those with trade deficits, like the United States, like to complain about those trade surpluses as a sign of unfairness, and wear our own trade deficits as a hairshirt of economic shame. In my view, the balance of trade is the most widely misunderstood basic economic statistic.

The economic analysis of trade surpluses starts by pointing out that a trade surplus isn't at all the same thing as healthy economic growth. Economic growth is about better-educated and more-experienced workers, using steadily increasing amounts of capital investment, in a market-oriented environment where innovation and productivity are rewarded. Sometimes that is accompanied by trade surpluses; sometimes not.China had rapid growth for several decades before its trade surpluses erupted. Germany has been a high-income country for a long time without running trade surpluses of nearly this magnitude. Japan has been running trade surpluses for decades, with a stagnant economy over the last 20 years. The U.S. economy ran trade deficits almost every year since the 1980, but has had solid economic growth and reasonably low unemployment rates during much of that time.

Instead, think of trade imbalances as creating mirror images. A country like China can only have huge trade surpluses if another country, in this case the United States, has correspondingly large trade deficits. China's trade surplus means that it earns U.S. dollars with its exports, doesn't use all of those U.S. dollars to purchase imports, and ends up investing those dollars in U.S. Treasury bonds and other financial investments. China's trade surpluses and enormous holdings of U.S. dollar assets are the mirror image of U.S. trade deficits and the growing indebtedness of the U.S. economy.

For the European Union as a whole, its exports and imports are fairly close to balance. Thus, if any country like Germany is running huge trade surpluses, it must be balanced out by other EU countries running large trade deficits. Germany's trade surpluses mean that it was earning euros selling to other countries within the EU, not using all of those euros to buy from the rest of the EU, and ending up investing the extra euros in debt issued by other EU countries. In short, Germany's trade surpluses and build-up of financial holdings are the necessary flip side of the high levels of borrowing by Greece, Italy, Spain, Portugal, and Ireland.

Joshua Aizenman and Rajeswari Sengupta explored the parallels between Germany and China in an essay in October 2010 called: "Global Imbalances: Is Germany the New China? A sceptical view." They carefully mention a number of differences, and emphasize the role of the U.S. economy in global imbalances as well. But they also point out the fundamental parallel that China runs trade surpluses and uses the funds to finance U.S. borrowing. They write: "Ironically, Germany seems to play the role of China within the Eurozone, de-facto financing deficits of other members."

Of course, when loans are at risk of not being repaid, lenders complain. German officials blames the profligacy of the borrowers in other EU countries. Chinese officials like to warn the U.S. that it needs to rectify its overborrowing. But whenever loans go really bad, it's fair to put some of the responsibility on the lender, not just the borrowers.

If a currency isn't allowed to fluctuate--like the Chinese yen vs. the U.S. dollar, or like Germany's euro vs the euros of its EU trading partners--and if the currency is undervalued when compared with wages and productivity in trading partners, then huge and unsustainable trade imbalances will result. And without enormous changes in economic patterns of wages and productivity, as well as in levels of government borrowing, those huge trade imbalances will eventually lead to financial crisis.

A group of 16 prominent economists and central bank officials calling themselves the "Committee on International Economic Policy and Reform" wrote a study on "Rethinking Central Banking" that was published by the Brookings Institution in September 2011. They point out that most international trade used to be centered on developed countries with floating exchange rates: the U.S., the countries of Europe, and Japan. A number of smaller economies might seek to stabilize or fix their exchange rate, but in the context of the global macroeconomy, their effect was small. There was a sort of loose consensus that when economies became large enough, their currencies would be allowed to move.

But until very recently, China was not letting its foreign exchange rate move vis-a-vis the U.S. dollar. As the Committee points out: "While a large part of the world economy has adopted this model,
some fast-growing emerging markets have not. The coexistence of floaters and fixers therefore remains a characteristic of the world economy. ... A prominent instance of the uneasy coexistence of floaters and fixers is the tug of war between US monetary policy and exchange rate policy in emerging market “fixers” such as China." The Committee emphasizes that the resulting patterns of huge trade surpluses and corresponding deficits lead to spillover effects around the world economy.

The Brookings report doesn't discuss the situation of Germany and the euro, but the economic roots of an immovable exchange rate leading to unsustainable imbalances apply even more strongly to Germany's situation inside the euro area.

The world economy needs a solution to its Chermany problem: What adjustments should happen when exchange rates are fixed at levels that lead to unsustainably large levels of trade surpluses for some countries and correspondingly large trade deficits for others? Germany's problems with the euro and EU trading system are the headlines right now. Unless some policy changes are made, China's parallel problems with the U.S. dollar and the world trading system are not too many years away.