China and Germany Committing to Overwhelming Deflationary Impact

Martin Wolf, from the Financial Times writes today that Germany and China are committing to a deflationary scenario. Citing Wolfgang Schäuble, Germany’s finance minister three main points last week: (1) combining emergency aid for countries running excessive fiscal deficits with fierce penalties; (2) suspending voting rights of badly behaving members within the eurogroup; (3) allowing a member to exit the monetary union, while remaining inside the European Union, Wolf says that suddenly, the eurozone is not so irrevocable because... Germany has said so.

According to him, three points can be drawn from this démarche:

(1) it will have an overwhelmingly deflationary impact;
(2) it is unworkable;
(3) it might pave the way for Germany’s exit from the eurozone.

Wolf introduces 'Chermany', "a composite of the world’s biggest net exporters: China, with a forecast current account surplus of $291B this year and Germany, with a forecast surplus of $187B" (he alludes to 'Chimerica' is a term used to describe the fusion between the Chinese and American economies. 'Chindia' describe the composite new Asian giant, China + India).

Although China and Germany are very different they share some characteristics:

• they are the largest exporters of manufactures
• they have massive surpluses of saving over investment
• they have huge trade surpluses
• they believe that their customers should keep buying, but stop irresponsible borrowing.

Wolf states that since their surpluses entail others’ deficits, their position is incoherent.

"Surplus countries have to finance those in deficit. If the stock of debt becomes too big, the debtors will default. If so, the vaunted “savings” of surplus countries will prove to have been illusory: vendor finance becomes, after the fact, open export subsidies.

Wold is doubting that the open global economy is going to survive this crisis and thinks the eurozone may also be in some danger.

"If Germany gets what it wants, the world’s second-largest economy would play an altogether negative role in the search for a way out from the global slump in aggregate demand. The eurozone would not be exporting the demand the world now needs. It would export excess supply, instead".

Registered FT users may read the full article.

On the topic of Greece being forced to sharply cut its deficit (not feasible, see our post yesterday), Wolf suggests to imagine that "weaker eurozone countries were forced to contract their fiscal deficits sharply. This would surely weaken the entire eurozone economy. But the result would also be fiscal deterioration in Germany and France. Imagine that Germany then did don the hair shirt. Would it instruct France to do the same? After all, France already has a general government deficit forecast by the Organisation for Economic Co-operation and Development at close to 9 per cent of gross domestic product this year. Does Mr Schäuble imagine France could be fined? Surely not. Yet it is not Greek public finances that threaten the stability of the eurozone. These are a mere bagatelle. The threat is the public finances of big countries. Since Germany could not force such countries to behave and has no chance of expelling any member it disapproves of from the eurozone, it would have to leave itself. That is the logic of Mr Schäuble’s ideas. This must be obvious to him, too".

"Germany is in a supposedly irrevocable currency union with some of its principal customers. It now wants them to deflate their way to prosperity in a world of chronically weak aggregate demand. [China's] Wen has the same idea. But the economy he wants to pursue this goal is the US. Fat chance!"

US Proteccionism

Mr Wen's remarks were well publicized yesterday: “What I don’t understand is depreciating one’s own currency, and attempting to pressure others to appreciate, for the purpose of increasing exports. In my view, that is protectionism.” He also insisted he was worried about the safety of China’s dollar investments.

Wolf ends:

"Behind all this is a fundamental divide. Surplus countries insist on continuing just as before. But they refuse to accept that their reliance on export surpluses must rebound upon themselves, once their customers go broke. Indeed, that is just what is happening. Meanwhile, countries that ran huge external deficits in the past can cut the massive fiscal deficits that result from post-bubble deleveraging by their private sectors only via a big surge in their net exports. If surplus countries fail to offset that shift, through expansion in aggregate demand, the world is inevitably caught in a “beggar-my-neighbour” battle: everybody seeks desperately to foist excess supplies on to their trading partners. That was a big part of the catastrophe of the 1930s, too.

In this battle, the surplus countries are most unlikely to win. A disruption of the eurozone would be very bad for German manufacturing. A US resort to protectionism would be very bad for China. Those whom the gods wish to destroy, they first make mad. It is not too late to look for co-operative solutions. Both sides have to seek to adjust. Forget all the self-righteous moralising. Try some plain common sense, instead".