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Tuesday, September 7, 2010

The Global Economy - Old Maids Who Won't Play Anymore

(with apologies to Frederick Goodall)

By Claus Vistesen: Copenhagen

The financial and economic discourse is a funny beast really; it can, if harnessed properly, shed light on future investor and market performance, it can give a diversified and detailed picture of any given economic or financial topic, and it is a place where stories, no matter how counterintuitive and misplaced, can linger and grow for a long time.

I am focusing on the last aspect and in doing so moving in alongside Edward (here, here and here) as well as Wolfgang Munchau in pondering just why it is that people are so excited about the fact that Germany continues to experience stellar growth rates largely driven by exports. Moreover, in his latest piece, Edward once again opens up the discussion for just what it is that we are supposed to do with those global imbalances and it is here that I will also spend my time.

Of course, just what it is that is misplaced here is definitely a matter of opinion and not everyone seems to be content with neither Munchau's point (comments section) nor Edward's take on the situation. Not surprisingly, I will come out in favor of Edward's take here but I do so arguing on the basis of fact and not on the basis of some inherent hate towards Germany, Spain or any other of European economy for that matter. I would hope that this, at least, is clear for all to see.

The Problem

The fact that Germany does well is not the issue here (indeed, in isolation this unequivocally good news), but the fact that Germany is still driven by exports and the fact that Southern Europe continue to languish in uncompetitiveness tells a cautionary tale that some of the most important prerequisites for a sustainable trajectory of the global economy have not been met. So, while Edward opted to tell the same story with a chart, I will do so in words.

Before the financial crisis, the world was characterised by structural surpluses in Japan, Germany and the rest of Asia [1] to match a growing US/Anglo Saxon current account deficit. Europe as a whole was running an overall balanced current account which, however, masked notable intra-European imbalances between Southern and Eastern Europe (with external deficits) and Germany as the main supplier of credit to this expansion[2]. So, before the crisis we had export dependent Germany and Japan coupled with USD peggers in Asia (where China will soon become export dependent herself) to match current account deficits in the US/Anglo Saxon world and Eastern/Southern Europe.

This system was clearly unsustainable, but it worked as long as it did especially because of the US economy's remarkable resilience despite the huge load put on its shoulders offering capacity to the credit supplied by the surplus nations. The system however famously buckled as a result of the subprime mortgage debacle which had its origins, ironically enough, exactly, in the mortgage debt binge made possible by the flow of cheap credit to the US economy.

As a result (and most economists would agree here I think), the recovery that had to follow the crisis was closely tied to a resolve of global imbalances. Yet, the recent narration of the German economic performance on account of its strong export performance shows us that we have not really gotten anywhere.

This brings us to the problem.

Leading up the crisis, the global economy was populated by two outright export dependent economies in the form of Germany and Japan as well as a batch of USD peggers in form of China et al and the petro exporters. Today, as we all hope to muster some form of recovery we are in a situation where not only Japan, Germany and China rely on exports to power their economies so must now the US and, in effect, Europe as a whole since there is no more juice left in either Southern, Eastern or, for that matter, Anglo-Saxon Europe to run respectable current account deficits. Indeed, the continuing talk about how this and that country is now going to rely more on exports or is about to become an export powerhouse strikes me as extremely odd since no one seems to be asking the real question of who exactly are to run the corresponding deficits?

Economists trained in the art of general equilibrium would immediately point out that it does not matter much since if there is one thing that we can be sure off it is that at all points in time the sum of external deficits will equal the sum of external surpluses. I cannot but agree, but this also means that speaking of surplus nations as the good guys and deficit nations as the bad guys does not make sense. What we really need here is economies with ability to run sustainable external deficits; this basically means economies who need to borrow to maintain trend economic growth and a proper rate of investment given the intrinsic return of the economies investment pool. As such, if we look at the structural forces at play there is not so much that we can do in the near term about a number of key issues.

  • There is nothing that we can do about the great demographic shift and the fact that we are all rapidly ageing and soon will hit the threshold where we effectively become dependent on external demand in order to achieve economic growth, pay pensions, build roads etc. Germany and Japan shows us where we are headed and while timing will differ markedly it is towards their current structural setup the entire OECD is drifting
  • The US and many of the other Anglo-Saxon economies have pretty sound demographics [3], but they have overspent and over -borrowed to the extent that demographics become secondary to the massive force of deleveraging. Consequently, and while the US economy should, theoretically, be capable of providing, in a sustainable manner, some excess demand through a current account deficit the amount of private sector and, now, public sector leveraging means that they are simply tapped out. In addition, deleveraging is a slow and structural process which will take a long time and also engender behavioural changes in US consumers. In short; we cannot rely on the US consumer anymore and actually; the US economy now needs to export more than she imports in order to turn the boat around.

Old Maids who won't play Anymore

An integral part of any discussion of global imbalances has to involve a suggestion as to on whose shoulders rebalancing is supposed to occur. In this context, the debate has focused on intra G3 rebalancing as well as the need for China to loosen the peg towards the US dollar. On the former account I have called this a game of Old Maid since the real question was never which of these economies that could contribute to global rebalancing, but to whom they were going to sell their exports and thus how they would compete with each other for export market share.

Old Maid is a card game where the simple task is to avoid holding a given card (often the queen of spades) at the end. Even in the company of good friends however, holding Old Maid at the end is not fun. Often, you have to buy the drinks, drop a piece of clothes, or endure other travails. And as it turns out, the global FX market is not unlike this good old game of cards where the Old Maid is proxied by having a strong currency on whose shoulders the correction of global macroeconomic imbalances must invariably fall.

In this context and while nominal exchange rates is not the best proxy for export market share the G3 fx edifice has been characterised by change of baton between the G3 currencies in terms of who is holding Old Maid*.

So far in 2010 there has been two stories. Initially, the main focus was one of a sharp depreciation of the Euro as the sovereign debt woes of Southern Europe sent the single currency reeling. That trend reversed in a nasty short squeeze which saw the EUR/USD bounce very quickly from 1.18 to 1.30 (still down on the year). From here it seems as if the EUR/USD has resumed its old ways of trading on the risk on/risk off themes. The second story which has recently gotten a lot of traction is that of the ascend of the JPY especially in relation to the USD/JPY which has recently been very close to the lows of 1995. These two stories are captured in the chart above where the JPY has appreciated notably against the USD and the Euro while the Euro (against the USD) has weakened considerably since the beginning of 2010. Among other things, this has spawned an almost endless stream of commentary concerning the possibility for BOJ/MOF intervention in the currency market through direct purchases of the USD.

In so far as goes the idea of an old maid, Japan seems to be holding it in the first half of 2010 (against the Euro and the USD) while the USD holds it against the Euro. Curiously, and just as to ram home the real economics behind this strange metaphor, it is worthwhile emphasizing how it was precisely Japan's economy that seems to have hit the breaks in H01-2010 while the European economy stormed ahead aided by a very strong Q2 performance in Germany.

Ultimately however, the idea of the Old Maid remains a trading theme with one important real economic implication. Whoever holds the Old Maid among the G3 currencies is losing market share relative to the two others vis-a-vis the emerging world and others willing or able to muster a respectable external deficit. The bottom line remains however that in the context of global rebalancing it cannot occur along the G3 axis (e.g. with German and Japan providing a boost through domestic demand). In short; these Old Maid cannot and will not play anymore

The Solution

I am not a big fan of one-off solutions and especially not when it comes to complicated problems like this. However, in relation to global currency alignments I think one big issue revolves around the need for big emerging markets such as e.g. India, Brazil and China to let their currencies go, as it were, simultaneously against the G3.

The chart above needs some explanation. First of all, 1999 = 100 and up means appreciation of the emerging market currency versus the g3 basket [4] and down means depreciation. As we can see, there has been no meaningful appreciation of big emerging market currencies vs the G3 when using 1999 as the benchmark (I use nominal exchange rates). This is exactly what has to change.

Surely, pushing those lines upwards would not solve the underlying problem in the G3 but it would address on very important obstacle to global rebalancing. In essence, it would put the burden on the broadest shoulders not because of some political/economic disdain for current account deficits in the OECD or because we should "exploit" the emerging world's increasing aggregate demand, but simply because it is what makes economic sense. In this context, I have always agreed with the now silenced blogger Brad Setser that a global currency alignment is needed. What we have debated however was rather the importance attributed to China relative to other EMs as well as the importance of demographics as an underlying driver of the shift in aggregate demand growth and/or decline.

In conclusion there are two points to take away here. Firstly, the game of old maid will continue as a trading theme and as always you want to buy whoever gets to hold it among the G3. In addition, any currency moves in an intra G3 context also constitute shifting of market share vis-a-vis global high growth economies who will, whether it be kicking and screaming or willingly, be dragged into providing more of global aggregate demand through external deficits. For this to happen sustainably however, we need to see joint appreciation of emerging market currencies against the G3 or, more intuitively, the appreciation of a basket of emerging market currencies versus the G3. Continuing to believe that domestic demand can be a growth driver in the G3 let alone the OECD is the same thing as calling on Old Maids to play a game cards which they won't and can't play anymore.


[1] - For simplicity, I will leave out pegging oil exporters here, but their role in this game is not fundamentally different.

[2] - Again, considerable complexity is left out. For example, the credit expansion in Hungary originated mainly from Switzerland (and by proxy through the Austrian banking system) and in the Baltics the Scandinavian economies supplied most of the credit (Sweden in particular).

[3] - Yes, I know the baby boomers will now become a drag and this is important but that is a bulge moving through an otherwise pretty stable population pyramid as a result of healthy immigration rates and replacement level fertility. In short; demographics in Japan are deflationary (and also in Germany), but I am not sure this is the case, strictu sensu, in the US.

[4] - This basket is created using share of global GDP of the G3 which is obviously inadequate, but let us just assume that we are dealing with economies that are either already relatively open or are going to become more open as we move forward (e.g. India).

* All data is from St. Louis Fed.