Thought du Jour

NYU economist Michael Spence points out some inconvenient truths regarding exchange rates and the US trade deficit with China.

Japan, South Korea, and Taiwan – all relatively high-income economies – have a large trade surplus with China. Germany has relatively balanced trade with China, even recording a modest bilateral surplus in the post-crisis period.

The US has a persistent overall trade deficit that fluctuates in the range of 3-6% of GDP. But, while the total reflects bilateral deficits with just about everyone, the US Congress is obsessed with China, and appears convinced that the primary cause of the problem lies in Chinese manipulation of the renminbi’s exchange rate.

Michael Spence, “The Exchange-Rate Delusion“, Project Syndicate, 19 December 2011.

Michael Spence (born 1943) won the 2001 Nobel Memorial Prize in Economic Sciences, jointly with George Akerlof and Joseph Stiglitz, for “analyses of markets with asymmetric information”.  Spence is best-known for his job-market signaling model, which shows that schooling can be valuable as a screening device, as a signal of skill levels, even if schooling contributes nothing to the development of skills.

NYU economist Nouriel Roubini describes four options for the eurozone in this time of crisis.

Symmetrical reflation [the first and best option] … implies significant easing of monetary policy by the European Central Bank; provision of unlimited lender-of-last-resort support to illiquid but potentially solvent economies; a sharp depreciation of the euro, which would turn current-account deficits into surpluses; and fiscal stimulus in the core if the periphery is forced into austerity.

Unfortunately, Germany and the ECB oppose this option, owing to the prospect of a temporary dose of modestly higher inflation in the core relative to the periphery.

The bitter medicine that Germany and the ECB want to impose on the periphery – the second option – is recessionary deflation: fiscal austerity, structural reforms to boost productivity growth and reduce unit labor costs, and real depreciation via price adjustment, as opposed to nominal exchange-rate adjustment. ….

If the peripheral countries remain mired in a deflationary trap of high debt, falling output, weak competitiveness, and structural external deficits, eventually they will be tempted by a third option: default and exit from the eurozone. This would enable them to revive economic growth and competitiveness through a depreciation of new national currencies.

Of course, such a disorderly eurozone break-up would be as severe a shock as the collapse of Lehman Brothers in 2008, if not worse. Avoiding it would compel the eurozone’s core economies to embrace the fourth and final option: bribing the periphery to remain in a low-growth uncompetitive state. This would require accepting massive losses on public and private debt, as well as enormous transfer payments that boost the periphery’s income while its output stagnates.

Italy has done something similar for decades, with its northern regions subsidizing the poorer Mezzogiorno. But such permanent fiscal transfers are politically impossible in the eurozone, where Germans are Germans and Greeks are Greeks.

Nouriel Roubini, “Down with the Eurozone“, Project Syndicate, 11 November 2011.

Roubini predicts that the third option will prevail and “eventually lead to the eurozone’s disintegration”.

NYU economist Nouriel Roubini is worried that there is no credible lender of last resort in the eurozone, so Italy may have to leave the monetary union, triggering its break-up.

With interest rates on its sovereign debt surging well above seven per cent, there is a rising risk that Italy may soon lose market access. … [A] forced restructuring of its public debt … would not resolve its “flow” problem, a large current account deficit, lack of external competitiveness and a worsening plunge in gross domestic product and economic activity.

… [L]ike other periphery countries, [Italy may] need to exit the monetary union and go back to a national currency, thus triggering an effective break-up of the eurozone.

Until recently the argument was being made that Italy and Spain, unlike the clearly insolvent Greece, were illiquid but solvent given austerity and reforms. But once a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable.

Nouriel Roubini, “Why Italy’s days in the eurozone may be numbered“, The A-List, Financial Times, 10 November 2011.