The Odd Couple

by Edward Hugh

The modern world moves at a breathtaking pace, even when most of us find ourselves on holiday. No sooner do we receive, read and start to digest one set of economic data than we find ourselves pushed to think about what the next set will look like. The clearest recent illustration of this undoubted reality is to be found in peculiar twist of events which meant that just as the news reached us that the German economy had expanded at a record rate in the second quarter, at almost the very same moment Federal Reserve officials meeting in Washington decided to significantly downgrade their economic outlook for the United States, saying the “pace of recovery in output and employment had slowed in recent months” and was likely to be “more modest” than anticipated in the near term. But this followed a month of May when it seemed Europe’s economies were on the brink of disaster, while over in the United States some sort of recovery was on the cards.

So what is going on here, does the earth switch it’s magnetic pole every six months, with what went up last time round now going down? Or could it possibly be some kind of common thread here, one common factor which unites the unprecedented expansion we have just seen in Germany, and the fears of renewed recession in the United States. Well, as it happens, indeed there could, and it has a name – the Greek debt crisis.

Structural Problems In The Currency Architecture?

So what is the link? Well, the fact of the matter is that we live in a bi-polar world, at least as far as currencies are concerned. Until our current global financial architecture evolves into something more sophisticated, we have two main currencies which rival one another for pride of place in central bank reserves and investment portfolios: the euro and the dollar, and when one of these goes up, the other must come down, and vice versa. It is as simple, and as complicated, as that.

Prior to February, and the outbreak of the European Sovereign Debt Crisis the US economy was seen as the weaker partner, and the euro was priced at a relatively high level. Then the euro slumped (falling at one point from around 135 to 120 to the US dollar in a matter of weeks) as attention focused on what appeared to be significant weaknesses in the Eurozone infrastructure. As a result of the change German exports boomed, while the US economic recovery steadily started to grind to a halt.

And with the rise of the dollar the global economy started to fall back into dangerous – pre crisis – habits. The US trade deficit started to open up again, and one exporting nation after another started to see yet one more time the US market as the global economy’s consumer of last resort. Indeed the US June trade statistics reveal the extent to which American consumers are once more sucking in large quantities of imports as their spending power recovers, while weak demand in the rest of the world coupled with the comparatively high dollar has been keeping a brake on American exports.

As the New York Times put it in an editorial, “China is mopping up demand everywhere you look with its artificially cheap supply of goods, while Germany, the world’s other exporting power, is cutting its budget and relying on foreign demand to drive its economic rebound. This isn’t sustainable”.

And the numbers prove the point. The United States trade deficit ballooned to $49.9 billion in June, the biggest since October 2008. In July, one month later, China recorded a $28.7 billion trade surplus, the biggest since January 2009. In the first five months of the year, Germany’s trade surplus, driven in large part by demand for machine tools in recovering Asian economies (many of them busily sending exports to the US), rose 30 percent compared with 2009.

And this impression is only confirmed when we come to look at the latest revision for US GDP in the second quarter. According to the revised data, US GDP increased at an annualised 1.6% rate (as compared with the 9% annual rate in Germany), after registering a 3.7% rate in the first quarter, according to the Bureau of Economic Analysis (BEA) today. The second-quarter growth rate was revised down by 0.8 percentage point from the “advance” estimate (of 2.4%), in part as a result of the new data on imports for June. The US Bureau of Economic Analysis report stated that slower GDP growth primarily reflected a surge in imports compared with the previous quarter and a slowdown in inventory investment. In fact, real exports of goods and services increased at a 9.1% rate in the second quarter, compared with an increase of 11.4% in the first, while real imports of goods and services increased by 32.4%, compared with an increase of 11.2% in Q1.

Effectively the American economy is simply too weak to carry this additional load, and is now showing signs of heading back towards recession, forcing the Federal reserve, which only a few months ago was moving towards a tightening in monetary policy to fend off inflation to now re-assert its policy of quantitative easing to avoid any possibility of a drift towards deflation.

Meanwhile the German economy turns in a 2.2 per cent quarterly growth spurt, unified Germany’s best-ever performance. The annualised 9 per cent growth rate, is, as the Financial Times noted, virtually unprecedented in developed economy terms. Such dramatic changes, rather than reassuring us that all is well, only lead to even more doubts. Is it really desirable for an economy to shoot forward so dramatically, only to fall back again in the second half, which is what almost everyone (Monsieur Trichet included) expects to happen?

Not only does the German performance seem exaggeratedly large, at the other end, on Europe’s periphery, the result was lamentably small. Greece naturally exceeded everyone’s expectations, on the downside, with a 1.5 per cent quarterly contraction (a 6 per cent annual rate), but Spain remained at the bottom end of the range, with a 0.2 per cent expansion, as did Portugal. Undoubtedly the Greek contraction will slow as the year advances, but the outlook there continues to be preoccupying. Only today the Greek manufacturing PMI, which showed the contraction in Greece’s industrial sector accelerated again in August, has reminded us of just how difficult it is going to be for the country to return to growth, and especially if the external environment now starts to deteriorate.

As the FT’s David Oakley said yesterday, in many ways Germany could be said to have had a “good crisis”, since the Greek issue pushed the Euro down and German exports up, while the current flight to safety is driving down the yield on German bunds to record lows even as it pushes up the spreads for peripheral Europe sovereigns. Among other impacts this gives German companies an even greater competitive advantage as their capital costs come down even while those for their competitors go up.

Spreads – which are the additional borrowing premiums countries have to pay over benchmark Bunds – hit a fresh record of 357 basis points in Ireland this week, following problems in Allied Irish bank and a Standard & Poor’s downgrade. In Portugal and Spain, spreads have been creeping back up, and are now once more close to their all-time highs. Spain’s 10-year bonds are trading at about 192 basis points above Germany, compared with 57 at the start of the year while Portugal is trading at 333 basis points, compared with 67 on January 1. The following chart shows how peripheral spreads have evolved since the start of the year (they have been indexed to 1st January). As is evident they shot up in May, then came down to lower levels in July, but during August they have once more been climbing.

All three economies are experiencing extremely weak growth and Ireland is even flirting with deflation. Higher government borrowing costs can harm economies in a number of ways, from higher borrowing costs for companies to added pressure on a country’s public finances as more is eaten up in interest charges, leaving less for public services and stimulus. Effectively the presence of a large spread differential means that monetary policy is applied unevenly across the Euro Area, despite the “one size for all” objective of the ECB. And doubly so with a credit crunch which means some banks struggle to finance as a backdrop.

Japan Trapped On The Ropes

And as if all of this wasn’t enough, Germany’s main competitor in Asia (where German exports have been clocking up large increases) has been effectively KO’d by the flight to safety produced by the Sovereign Debt Crisis. Japan’s exchange rate against the USD dollar is now hovering around a 15 year high.

The consequence of this is not hard to predict, while Germany clocks up record exports to China and other parts of the continent, the Japanese “recovery” is gradually grinding to a halt, as the latest manufacturing PMI report only confirms.

We Need To Seriously Address The Imbalances

At the end of the day it is hard to avoid the conclusion that we continue to live in a very unbalanced and essentially economically unstable world, where currency valuations and economic growth rates fluctuate with unnerving rapidity. Not only that, the recent Federal Reserve meeting seems to have constituted some sort of defining moment, the point when everyone finally recognises that the long promised recovery was no longer simply weeks or months away, and that emerging from the trough in which the developed economies find themselves is going to involve a long period of slow and painful effort, one where we will also need time to clean up the mess we have made in cleaning up the original mess, assuming that is that we have the dynamism and energy to do so.

On thing is clear, the old habits won’t work any better now than they did before 2007, and external deficits which were not sustainable then will not be sustainable now. So we need a new model, a model in which the emerging markets will have a much larger role to play than ever before. And if we are to move towards a more sustainable future, then we need to move beyond those simplistic headlines stressing the virile nature of Germany’s export prowess. There is no doubting the efficacy and competitiveness of many German companies, but for that very reason that country needs to shoulder more of the responsibility for sharing the burden which is involved in finding solutions. Here in Europe we don’t only need sacrifices in the South, some of them also need to be made in the north. German industry is enjoying real and tangible benefits (via artificially low interest rates and an undervalued currency) from the mess that the Greeks created for themselves, but in the interest of all European some of those benefits need to be ploughed back in again, since if Greece is allowed to fail, no one will be the winner.

Looking beyond Europe we need to think about how to best aid and abet the emerging economies in their quest for growth and better living standards. Earlier in the crisis I asked Nobel Economist Paul Krugman a question which is very much to the point. “At a time when the financial crisis is generalised across all developed economies – whether because those who borrowed the money now have difficulty paying back, or those who leant it now struggle to recover the money owed them – to which new planet are we all going to export?”

My response to him back in January was that maybe we don’t need to look so far afield. Many developing economies badly need cheap and responsible credit lines, and access to state-of-the-art technologies, so why not accept the world is changing, and go for some sort of New Marshall Plan, one capable of generating a win-win dynamic which would be in all our interests? At the time the proposal seemed totally unrealistic and unobtainable. Now, with every day which passes it starts to look essential. And who knows, maybe the rise of a number of other major economic powers would help solve that bipolar currency problem which is currently causing our policymakers so many headaches.