Europe

Moves toward the approval of the Lisbon Treaty could create a stronger European partner for Washington in global affairs, says CFR’s Charles Kupchan. But he cites a competing trend toward stronger nation-states in Europe.

I tend to agree with the FT’s leaders – especially their leaders on the world’s macroeconomic imbalances -- more often than naught. But not always. On Friday an FT leader warned about the risk of financial deglobalization: “Finance is deglobalising out of fear and because of national policies. Neither will be fully undone without political choices that look unlikely, at least for now …. But unless policymakers come up with better global regulation that works we may have to settle for permanently less globalised finance.” (emphasis added) That didn’t ring true to me. At least not fully. The tone of the leader seemed to long for a return of the pre-crisis world, one where huge quantities of funds flowed across borders, albeit one with better global regulation. Yet just as trade probably rose to a level that could only be supported if US households continued to run up an unsustainable level of debt, cross-border financial flows likely reached levels that could only be sustained if the global financial system remained over-leveraged. The goal shouldn’t be to return the boom years, but rather to return to a more sustainable level of cross-border flows -- or at least a system without the excesses that contributed to the current crisis. Remember, the rise in cross-border capital flows prior to the crisis was associated with a rise in the amount of leverage in the system, as a host of institutions tried to support bigger balance sheets without increasing their equity. That rise in leverage sustained a lot of cross border flows. To be concrete: US financial institutions sponsored offshore special investment vehicles (SIVs) that often borrowed short-term from American investors to buy longer-term US debt. They were offshore largely because they were off balance sheet. If the same activity had been performed on the banks domestic balance sheet – with more short-term wholesale borrowing to support a larger securities book – cross-border flows would fall. But regulators also would have had a lot more information about the build-up of risks in the global system. Taxpayers might not think that is a bad thing. European institutions seem to have been supporting bigger dollar balance sheets than they could finance entirely in the offshore “euro-dollar” market. Some were borrowing large sums from US money market funds – and then using the proceeds to invest in longer-term US paper. Sometimes securities insured by AIG’s now notorious credit products group, a little trick that allowed the banks to minimize the amount of capital that they had to hold against their dollar book. A bit less of this wouldn’t necessarily be a bad thing. AIG hasn’t worked out so well for the US taxpayer, and the big dollar books of European banks haven’t worked out so well for European taxpayers. And then, of course, there are the cross-border flows associated with tax avoidance. The huge rise in transatlantic flows over the past several years produced by the expansion of the cross-border operations of leveraged intermediaries ultimately didn’t produce a more stable financial system -- only a more opaque system. Far less risk from the U.S. housing boom was transferred off the financial sector’s books that most expected. Even some of the risk theoretically shifted to European banks ended up coming back to the US through AIG. The main reason why cross-border exposure fell in the fourth quarter, incidentally, was a fall in lending among the major economies – not a fall in lending from the major economies to the emerging world. To be sure, lending to the emerging world fell – but the $300 billion fall in exposure to developing countries in the fourth quarter cannot explain the $4800 billion overall fall. The large two-way global flow between the emerging world and the advanced economies also -- at least in its old guise -- also didn’t necessarily result in a more stable global system. Take the surge in private money flowing into China. That rise in private inflows was offset by a rise in state outflows. Private money wanted to finance more investment in China, yet China’s government was trying to damp down investment by suppressing domestic credit growth (through the high reserve requirement) and pulling money out of China to invest abroad (through the CIC and other state institutions). Fewer inflows and fewer outflows would result in less total capital flows -- and somewhat slower growth in China’s reserves/ state assets. But that might not be the worst thing in the world, particularly if it was the result of an adjustment in China’s exchange rate that reduced the incentive for speculative inflows into China. A huge rise in private inflows that leads to an offsetting rise in official outflows doesn’t accomplish much, economically speaking -- even it pushes up total global capital flows. Indeed, smaller aggregate outflows from China wouldn’t necessarily be a bad thing. The large aggregate outflow from China over the past few years hasn’t been driven, generally speaking, by private Chinese demand for the rest of the world’s securities, or even a desire on the part of Chinese savers to diversify their portfolios. Rather Chinese demand for the rest of the world’s financial assets was driven by China’s government, as it bought foreign securities as a byproduct of its effort to hold China’s exchange rate down. Call it subsidized financial globalization: China’s government pulled money out of China and invested it abroad on terms that imply likely financial losses to achieve its policy goals. Back when money was flowing into China in early 2008 and late 2007, reserve growth and other government outflows were close to 20% of China’s GDP. The gross capital outflow from China then -- almost all a government flow -- was comparable in scale to total gross inflow to the US in the boom years before the August 2007 subprime crisis. Gross inflows to the US peaked in early 2007, incidentally ... The huge flows of the pre-August 2007 reflected a world where lot of too-big-to-fail financial firms were able to gear up in large part because they were perceived to have a government backstop. These financial flows were in a sense larger than could be supported in a truly unfettered market, as key institutions were operating with a level of leverage and balance sheet opacity that we now know only worked with implicit (and now explicit) government support. And in other cases, the high level of flows reflected large government-driven flows that were in some sense unnatural. The outflow from China wasn’t a market flow. A total collapse of global capital flows wouldn’t be a good thing. But returning to the frothy flows of the bubble years -- an era where I think a strong case can be made that a set of distortions pushed aggregate global flows above their natural level -- would not necessarily be a good thing. Not unless cross-border flows rest on a stronger foundation than they do now. The goal should be a happy median, one where a high level of cross-border flows doesn’t reflect a high level of leverage -- -and one where emerging economies don’t just recycle private inflows back into demand for US Treasuries. The FT leader assumes that absent government pressure more money would be lent across borders, and thus attributes the recent fall in cross-border flows to government intervention. I would start with the opposite presumption: absent government intervention in the third and fourth quarter – the bailout of AIG, big swap lines and the G-7’s commitment to avoid another Lehman – more large global institutions would have collapsed, leading to an even sharper fall in cross-border exposure. A set of financial institutions that were operating globally lacked enough capital to buffer themselves against what should have been a fairly predicable shock;* their near-collapse --not government intervention to prevent their total collapse -- is the main reason why cross-border flows have come to a standstill. * A large fall in US home prices after a large run up in those prices shouldn’t have been a total surprise. UPDATE: I edited out a section of the original post that focused on two-way flows to the oil exporters. The post was too long, and the subject is a complex one worth its own post.

China doesn’t exactly want to make it easy to evaluate the size of its stimulus. Bragging about the small size of your fiscal deficit -- especially in relation to the US deficit -- suggests a rather modest effort. A bigger Chinese deficit afterall would allow the US to run a smaller deficit without shortchanging global demand. The IMF’s analysis – which looks at the change in the balance of the general government – puts China’s stimulus at about 2% of its GDP in 2009 and 2010, roughly the same as the US effort in 2009 and less than the US effort in 2010. Given China’s current account surplus, its abundant domestic liquidity (the government – per Stephen Green of Standard Chartered) had deposits at the central bank equal to 9% of its GDP, and limited government debt (at least explicit debt), China could and should do more. And maybe it is: telling the state banks to lend to support local infrastructure projects could be considered a form of stimulus (the TALF could be considered such a stimulus too; both try to keep the flow of credit going to sectors that will spend or invest). It just isn’t the kind of stimulus that looks likely to spur China to consume more. And it isn’t clear how quickly those infrastructure projects will be started, and thus provide real support for activity. At this stage, though, I would be happy if China just did enough to keep its current account surplus from rising. That is the acid test. So long as the surplus is rising, China is subtracting from global demand growth not adding to it. China could meet its 8% growth target without any contribution from net exports if all other parts of China’s economy kept growing at their previous pace – and with private investment growth slowing, that requires a surge in public investment or a big increase in consumption. But I would note that net exports can mechanically contribute to growth if imports fall faster than exports – not just if exports grow faster than imports. But China isn’t the only part of the world that needs to do more. Europe’s economy contracted as fast as the US economy in q4. But Europe’s combined stimulus looks to be significantly smaller than either the US or Chinese stimulus. Bruce Stokes of the National Journal/ Congress Daily did the leg work: The International Monetary Fund has called for a global fiscal stimulus of 2 percent of GDP. In 2009, U.S. and Chinese stimulus spending is likely to match or exceed that target. European stimulus will total less than half that amount. And spending in Brazil, South Korea and South Africa will also fall below the IMF goal, according to estimates by the IMF and J.P. Morgan. … "In proportion of GDP," Jean Pisani-Ferry, director of the Brussels think tank Bruegel, wrote on the National Journal economics blog last week, "the size of the stimulus packages put in place in Europe [is] at best half the size of the U.S. and, unlike [the American effort] several of them are rear, rather than front-loaded." While Germany’s spending will amount to 1.4 percent of GDP in 2009, French outlays will total only 0.8 percent, and Italy has not put forward any meaningful fiscal boost at all … "Any way you slice the numbers," wrote Ted Truman, a senior fellow at the Peterson Institute for International Economics, on the National Journal blog, "policymakers are falling short of real ambition in the face of the worst global downturn since the Great Depression." That won’t cut it. Especially if Europe isn’t willing to do much to help Eastern Europe avoid a sharp adjustment, one that will cut into Eastern Europe demand for western European goods. Germans don’t want to bailout profligate governments (and profligate banks that financed profligate households) in the East. But their profligacy provided the demand that spurred Germany’s exports. Bailing out the East is an indirect subsidy for a host of German jobs …. The G-20 still has some work to do if it wants to live up to its November commitment to take the steps needed to support global recovery. Policy makers, in my judgment, still haven’t gotten ahead of the forces that are driving a global contraction in demand. * The IMF estimates of the size of different stimulus packages, as of the end of January, is on p. 18 of this document. The IMF estimated the global stimulus at 1.5% of world GDP. Other estimates have a higher number. ** UPDATE. Tao Wang of UBS estimates that China’s actual fiscal stimulus in 2009 will be a bit less than 2% of China’s GDP. "Not all of the RMB4 trillion will be spent by the government. Of which, the central government plans to take on its budget RMB 1.18 trillion (of the RMB 4-trillion package), breaking down to RMB 104 billion in Q4 08, RMB 487.5 billion in 2009, and the rest in 2010. All of this is supposed to be additional spending. We think the actual impact of the funds disbursed in Q4 08 would be mostly felt in 2009, and this year’s budgeted increase is likely front-loaded. Combining the two, the fiscal stimulus stemming from the RMB 4 trillion plan felt this year is roughly RMB590 billion, or 1.8% of 2009E GDP. "

Charles A. Kupchan, CFR senior fellow for Europe studies, says Obama’s "popularity and the departure of President Bush" create a "window of opportunity to improve relations between the United States and Russia and between the United States and the European Union.

The thesis that China and America should be viewed as a single economy – or at least as a single currency area – is due for a comeback. After flirting with change, the RMB is once again pegged tightly to the dollar. 6.85 is the new 8.27. I would not be surprised if China’s external surplus and the United States deficit prove to be roughly equal in size in 2009 The obvious argument is that while the US runs a big deficit, Chimerica doesn’t. East Chimerica’s surplus offsets West Chimerica’s deficit. No worries. At least so long as China’s government is willing to finance the US. The fact that the Chimerican currency union required unprecedented growth in China’s reserves was always my main objection to the Chimerica thesis. A currency union in theory shouldn’t require that kind of government intervention to keep in balance. But Chimerica never was really financially integrated. Back when the RMB was (correctly) considered a one way bet, China erected capital controls to keep American (and other) capital from speculating on its currency. And for most of this decade, the net outflow from China to America came not from a desire on the part of Chinese savers to hold dollars but rather from a desire of China’s government to hold the Chinese currency down against the dollar. That policy required that China buy dollars in the foreign exchange market, and in the process finance the US deficit. However, another objection may be more important. The argument that Chinese and America formed a perfect union – with US spending generating demand to offset Chinese savings, and Chinese savings financing the borrowing associated with US spending – hasn’t quite worked for the past couple of years. It leaves out Europe. And Europe, not the US, was the big spender in the world economy in 2006, 2007 and the first part of 2008. My colleague at the Council’s Center for Geoeconomic Studies, Paul Swartz, has produced a clever graph (available on the CGS website) showing that the growth in Asian exports hinges on the growth in US and European imports. Makes sense. Paul also plotted Asian export growth against American import growth and European import growth separately -- and the chart of European import growth against Asian export growth highlights just how large Europe’s contribution to Asian export growth has been recently. This shouldn’t be a surprise. The depreciation of the Japanese yen and Chinese yuan against most European currencies over the past several years (and yes, I know that things changed in the past few months) was the big currency move of the past several years – at least as economically significant as the depreciation of the dollar against the euro. That depreciation produced the expect result: a surge in European imports from Asia, and a big increase in Europe’s deficit with Asia in general and China in particular. That is a clear change from earlier this decade. Back in 2003 and 2004 and even 2005, it really was the US consumer that was driving the expansion of global demand. The coupling of China’s export machine to European demand explains why China’s exports and surplus were both able to increase over the past couple of years even thugh the US non-oil deficit peaked in late 2005/ early 2006. It doesn’t take that much leg work (the data tables at the end of the IMF’s World Economic Outlook are always a good place to start … ) to figure out that a swing in Europe’s current account balance made this possible. Let’s say that the US runs a $500 billion current account deficit next year, and the United States’ bilateral deficit with China is around $250 billion. Let’s also assume that China runs a $500 billion current account surplus next year (that makes the math easy – and it isn’t out of line with China’s November trade surplus). That implies that China is running a big surplus with the world not just the US. And Chimerica only works, in some sense, if China lends the (large) surplus it earns with the non-Chimerican world (and Europe in particular) to the US, allowing the US to run a deficit with the non-Chimerican world. To make everything (too) neat, let’s assume China runs a $250 billion surplus with Europe and its trade with the rest of Asia and the oil exporters is balanced. And let’s assume that Europe runs a $150 billion surplus with the US and a $100 billion surplus with the oil exporters (offsetting its deficit with China) – and that the US has a $150 billion deficit with Europe and a $100 billion deficit with the oil exporters. That simplifies a lot. It leaves out private inflows and outflows for one, which can drive China’s reserve growth above or below its current account surplus. It also leaves out Chinese purchases of European assets and European purchases of US assets. It ignores intra-European flows – and reduces Asia to China. But it captures something important as well. China’s surplus can expand even in the absence of a rise in the United States deficit if Europe’s deficit rises, for one. And in my little thought experiment, the global flow of funds only balances if China lends its surplus with Europe to the US. Or, to put it a bit differently, if Chieuropa lends to the US …

European affairs analyst William Drozdiak says Barack Obama’s administration will lead Washington to demand from Europe more troops for Afghanistan, a coordinated economic stimulus package, and help resettling Guantanamo detainees.

CFR’s James Goldgeier and Charles Kupchan discuss the effect of the global financial crisis on Europe.

The authors of the IMF’s World Economic Outlook have a difficult job. They have to forecast the trajectory of the global economy -- itself not an easy task. Their forecast will be judged and evaluated in real time. But the work according to a schedule set by the need to consult the IMF board and the demands of physical rather than virtual publication. In practice, that means that the forecast never fully reflects the most recent data. "IMF Board" time, "internet" time and "market" time are all very different things. Sometimes that doesn’t matter. But right now is one of the times when it does. A lot happened this September. And I suspect that much of what has happened isn’t reflected in the IMF’s forecasts. Specifically, I now expect a larger fall in US output and a larger fall in the US current account deficit -- and for that matter, the combined current account deficit of the US and the EU -- than the IMF currently forecasts (see the WEO’s data tables). In the past I have argued that the IMF has had a tendency to forecast problems like the US current account deficit away, and in effect assume that the US current account deficit would tend to shrink even if neither China nor the US adjusted their policies. The IMF has also tended to downplay the role the official sector has played in financing the US. Now I suspect that there will be more adjustment than the IMF expects. Specifically, the IMF now forecasts that the 2009 US current account deficit will fall to $485b in 2009 (around 3% of US GDP)-- well below its 2006 peak of $790b, and down from an estimated $665b in 2008. The deficit has been running at around $700b, so the IMF is forecasting a fall in the deficit in the second half of the year (see Table A10). That fall seems reasonable. Indeed, the fall in the United States external deficit could be much bigger: -- the IMF forecast is based on a $100 a barrel average oil price. If oil stays around $90 a barrel, the US deficit would be about $50b smaller (and the surplus of the oil exporters would be reduced by around $150b). -- The credit crunch could cut into investment, reducing demand for imports -- Households seem to have, at least temporarily, stopped spending, pushing savings rates up and cutting into imports. A rise in the fiscal deficit could help offset the slowdown in consumption and fall in investment -- and the pace of US export growth will almost certainly slow as the world slows (the dollar’s recent rebound doesn’t help either). But all in all, it would seem to me that the US deficit could fall by more than the IMF forecast -- in a rather abrupt adjustment triggered by a sudden fall in US household consumption. The IMF forecasts that the EU’s 2009 deficit to be about $220 billion, roughly the same as the $230b deficit forecast in 2008. That implies the IMF now expects the combined deficit of the US and Europe would fall, and the combined surplus of the emerging world would shrink. That is important. The US deficit actually peaked in 2006 at just under $800b. It has been falling since. But the $125b improvement in the US current account deficit has been offset, in a global sense, by a $170b deterioration in the EU’s deficit (it went from $60b in 2006 to a forecast $230b in 2008). Yes, Virginia, exchange rates do matter: this deterioration in the EU’s overall balance followed the appreciation of most European currencies The combined deficit of the US and EU consequently rose over the past two years even as the US deficit fell, allowing -- in a broad global sense -- Asia’s surplus to rise even as the oil exporters surplus rose. Indeed, in aggregate, Europe (not the US) has been the driver of global demand growth over the last four years. From 2004 to 2008, the US current account deficit rose from $625b to $665b while Europe swung from a $65b surplus to a $230b deficit. That is close to $300b swing in the current account balance of the EU (the swing in the eurozone’s balance is far smaller). From say 2002 to 2005 the US did drive global demand growth, but starting in 2005 the EU picked up and from 2006 through 2008 it carried the baton. In 2008, the IMF forecasts a combined US and EU external deficit of around $900b -- up from $450b in 2002 (see Table A10). What about the other side of the ledger? Well from 2002 to 2008, the Middle East’s surplus increased from $30b to $440b -- and emerging Asia’s surplus increased from $65 billion to an estimated $380 billion. The simultaneous increase in the Gulf’s surplus and China’s surplus explains why the combined deficit of the US and Europe became so large -- it was the only way the global economy could balance. The IMF’s data also leaves no doubt that the surplus in both the Gulf and emerging Asia reflects an savings glut not an investment drought. In both regions investment is well above its levels in the 1990s. Savings just increased more (see Table A16). Looking forward, the IMF doesn’t expect much adjustment in Asia. Its surplus is expected to remain roughly constant in nominal terms -- in large part because China’s surplus is expected to remain constant. I agree. Export growth will slow, but so will import growth -- and import prices. On balance emerging Asia’s surplus might end up falling by a bit more than the IMF forecasts as the US and Europe slow dramatically. The Middle East’s surplus is expected to fall from $440b to $365b. That is a meaningful fall -- but it still leaves the Middle East’s surplus well above its 2005 and 2006 level of around $250b. Personally, I would expect a bigger fall -- in part because I do not current expect oil prices to average around $100 and in part because I expect domestic spending and investment and thus imports have increased by more than the IMF assumes. Forecasts for the Middle East are particularly challenging because the region generally doesn’t release timely balance of payments data! The IMF’s data tables also are loaded with information about the composition of capital flows to and from the emerging world: Table A13) shows clearly that net capital outflow from the emerging world that corresponds with the emerging world’s estimated $870b current account surplus in 2008 is entirely an official flow. The IMF expects $1270b in outflows from the growth in the emerging world’s reserves and another $160b in "official" outflows (largely the Gulf’s sovereign wealth funds). That implies that the governments of the emerging world are on track to about $1.4 trillion in US, European and Australian assets -- along with a few Japanese assets.* The detailed data tables includes estimate of for the oil money that has been channeled through the Gulf sovereign funds (an estimated $150b in 2008) as Asia’s 2008 reserve growth ($750b). In 2009, the IMF expects the Gulf funds to get another $115b -- and Asia to add about $550b to its reserves. Net official flows from the emerging world to the US and Europe would remain over a trillion dollars -- though they would fall back from the 2007 and 2008 levels. For once I even think there is a risk that the IMF may have over-estimated official asset growth. The IMF assumed large net private flows would combine with the emerging world’s current account surplus to drive the enormous growth in the emerging world’s reserves and official assets. Net private capital inflows to the emerging world were forecast to top $500b in 2008 -- just off the record $630b in inflows in 2007. However, over the last several months -- and particularly over the last few weeks -- much of the private money that flowed into the emerging world in 2007 and the first part of 2008 started to flow out. That will cut into official asset growth. As a result, the US almost certainly will rely less on central banks and sovereign funds for financing in 2009 than it did in 2007 or the first half of 2008. That will be true even as the US dramatically scales up Treasury issuance, and the size of the US budget deficit rises. For the first time in a long time, private American households seem to have decided that they need to save a bit of money rather than spend all they take in -- and for the first time in a long time private US savers seem to want to hold low yielding US treasury bonds. And I increasingly suspect that one consequence of United States and Europe’s recent financial crisis will be a smaller deficit in both regions, and a smaller surplus in the emerging world. NOTE: I added the graphs to this post several hours after I initially put up the text; creating the graphs took a bit of time.