Tuesday, February 16, 2010

Greece, hanging on a cross of Euros; U.S., hanging on a dollar-yuan?

Michael Pettis,  a professor at Peking University’s Guanghua School of Management, suggests that a currency yoking together strong and weak economies, as the Euro does, imposes on the weaker countries something like the gold standard:

In the meetings where we discussed the euro I nearly always made reference to a thesis argued in Barry Eichengreen’s magisterial Golden Fetters (one of my favorite books) that the political enfranchisement after WW1 of very large segments of the population in Western democracies – most crucially the working classes, who historically bore most of the pain of adjustment – meant that the traditional adjustment mechanisms under the gold standard, which were deflation and rising unemployment, would prevent democracies ever from returning to the gold standard.  Politics would make it impossible (and probably a good thing, too).

The pain of adjusting

This has an important implication for the discussion on the euro.  Unfortunately the euro today imposes a kind of gold standard on European countries – it forces them to adjust to excessively high domestic prices, large trade deficits, and/or large fiscal deficits in the same way they would have had to adjust under the gold standard, and I don’t think that is politically likely to be acceptable.  The countries that need depreciation to regain competitiveness or monetization of the debt to regain control of the deficit will have to choose between adjusting via deflation and high unemployment or exiting the euro.  Politics makes the latter more likely.

Pettis draws an analogy between the position of weaker countries in the Eurozone relative to export power Genrmany and the U.S. vis-a-vis China and sees a similar need for trade rebalancing in the Eurozone and in the world at large:

This, by the way, seems to me to be the classic Keynes argument (although not, perhaps, the “Keynesian” argument): In a world characterized by contracting global demand and large trade imbalances, it is the obligation of the large surplus nations (and in the 1930s of course he meant the US) to stimulate domestic demand.  Asking the trade deficit countries to leverage up to stimulate demand is counterproductive and would ultimately just postpone the necessary adjustment.  Asking them to adjust via unemployment, on the other hand, makes everyone worse off. 

One might infer, though Pettis does not say so, that the Chinese pegging of the yuan to the dollar makes the two yoked currencies act on the U.S.economy something like the Euro in Greece. 

At the same time, Pettis sees two hopeful signs of global rebalancing: rising wages in parts of China, and a falling trade deficit in the U.S.  Imports fell 26% in 2009, and the trade deficit from 5.7% of GDP to 3.5%, its largest drop ever. 

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