Xi Jinping in His Own Words
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In February 2016, the Organization for Economic Cooperation and Development opined that developed country growth prospects had “practically flat-lined” and that only a stronger “commitment to raising public investment would boost demand and help support future growth.” Fast-forward some 24 months, and despite Brexit, the election of U.S. President Donald Trump, and the rise of the populist Alternative für Deutschland in Germany, the euro seems to be a much better bet than it has been in a long time. But has the euro really weathered the crisis and come out stronger? In this article, we make two interrelated arguments about the future of the eurozone.
The first is that even if the recent economic upturn continues, the eurozone could still split in two over the medium to long term thanks to a built-in design flaw in the eurozone architecture that makes it extremely difficult for the eurozone governors to deal with persistent export and import imbalances between states.
As a single-currency area, the eurozone formally has no internal imbalances. In reality, however, the persistent export surpluses it runs against the rest of the world are generated in the north and east of the eurozone, while persistent budget deficits are generated in the south, an imbalance that could yet lead to a split in the eurozone. This would result in Germany and the eastern European states keeping the euro even if France and the southern Europeans bail out. Europe would be left with two sets of countries: those in the core of the eurozone, largely in northern and eastern Europe, that would remain on the euro (or “real euro”) and those in the south that would be pushed to adopt a new currency, which we term the “nuevo euro.” (The nuevo euro countries would be unlikely to revert to their pre-euro national currencies for fear of adding to the already grave disruption caused by their break with the real euro.)
Such a split would be massively disruptive. As investors came to fear a devaluation of the nuevo euro, assets denominated in real euros would instantly become more valuable. The banking systems of nuevo euro countries would implode owing to capital flight, and the currency would plunge in value. Most important, the resulting flood of capital into core Europe would cause the value of the real euro to rise dramatically, damaging these countries’ all-important exports.
In such a world, countries on the real euro would be forced to adopt the United States’ strategy of debt management. Once the nuevo euro had stabilized at a lower real effective exchange rate (REER), investors from nuevo euro countries would want to hold real euro assets—in particular real euro government bonds—as insurance against further depreciation of their own currency. As a hedge against further devaluation, nuevo euro investors would be willing to accept very low returns on their real euro assets, much the way European investors currently hold low-interest Swiss assets and Asian countries hold U.S. Treasury bills. And just as the United States has done over the past 30 years, real euro countries could in turn invest the proceeds of these bond sales abroad in search of higher returns.
In order to pursue these returns, however, the real euro countries would open themselves up to the significant risk of their new external investments losing value because of a currency shock or other crisis. Although the United States can cope with such shocks given its size and the fact that it prints its own currency, thus making its debt problems more manageable, Germany and other real euro countries would enjoy no such luxury. By accumulating such assets, they would be exposing themselves to very large capital losses (relative to their GDP) in the event of a market shock. And since these countries have no ability to print money in order to bail out those holding such assets, a shock could be seriously disruptive. As such, real euro countries would likely resist such a buildup of external assets, preferring instead to allow their currency to appreciate strongly, at least until that really began to impact their exports.
Taken together, this would lead the real euro countries, especially Germany, to become a European version of the United States, albeit without the latter’s famous “exorbitant privilege,” whereby the United States gets to print the reserve currency, dollars, that everyone else has to earn in order to conduct foreign exchange. For the real euro countries, although their currency would be a reserve asset for nuevo euro investors, it wouldn’t buy them the “free lunch” that the United States gets from printing the dollar. Rather, it would merely expose them to more risk on their excess foreign assets.
Our second argument is that in the short to medium term, even if the eurozone generates enough growth to avoid such a split, populism in Europe remains alive and well. A populist electoral victory resulting in a Brexit-style referendum on the euro somewhere in the eurozone therefore cannot be ruled out entirely. If such a referendum was to pass, it would lead to the same capital flight and REER appreciation detailed above, albeit through a slightly different pathway. In short, for reasons of both long-term sustainability and short-term politics, the euro is not out of the woods yet.
The narrative emanating from Brussels since the start of 2017 is that with an increasingly robust economic recovery, all is returning to normal. Forecasts do indeed look brighter than they have for a decade, and, politically speaking, the French and Dutch general elections both saw defeats for populists, suggesting that the center will hold. This narrative is reassuring. Given recent populist electoral successes in Austria, Germany, and the Czech Republic, however, and the looming Italian elections with several anti-euro parties in the mix, it could be complacent. As such, and despite the turn to growth, the euro’s future is by no means secure. A comparison of Europe’s financial crisis and aftermath with what happened in Asia a decade ago shows why this is the case.
In the 1990s, a number of Asian countries received large capital inflows from the developed world as part of that decade’s mania for emerging markets. Indonesia, Malaysia, Thailand, and South Korea, like peripheral eurozone countries in the first decade of the twenty-first century, were places where developed world investors could seek higher rates of return than were available in their own countries. As a result, these Asian states accumulated liabilities in foreign currencies, mostly dollars, that took the form of government bond purchases and external lines of dollar-denominated credit. When liquidity evaporated in 1997, they were unable to print the money to pay their debts. To avoid a repeat of this fiasco, all the countries affected by the crisis began, by 1999, to run structural export surpluses and accumulate massive foreign exchange reserves as insurance against future shocks.
In response to its own crisis in 2011, Europe pulled the same macroeconomic trick. Between 2001 and 2016, according to data from Haver Analytics, the eurozone shifted from a trade surplus of under one percent of GDP to one of close to 3.5 percent. But although the entire eurozone’s export surplus in the first quarter of 2017 was 90.9 billion euros, 65.9 billion of that surplus against the rest of the world came from Germany alone. Germany may be legendarily efficient, but how does less than 30 percent of the eurozone generate over 70 percent of the surplus? The answer points to a structural tension that could prove to be the real undoing of the euro.
In the first decade of the twenty-first century, central and eastern European economies ran large current account deficits—that is, they imported more than they exported. These deficits were driven by an influx of capital from Germany, as German export firms invested in rebuilding the capital stocks of these central and eastern European countries and integrating them into German supply chains. Because most of this was equity investment in the form of plant and equipment, and in moving plant and equipment to eastern Europe from Germany, and since equity is more resistant to shocks than debt, once global export markets recovered after 2011, these economies boomed. According to our own calculations based on data from the UN and the Atlas of Economic Complexity, an average of 25 percent of the exports of Austria, the Czech Republic, Hungary, Poland, Romania, Slovakia, and Slovenia go straight to Germany. Like East Asia a decade before, these countries now run structural trade surpluses and rely on tight public spending at home to keep costs down and exports competitive. But what about other countries in Europe, such as France, Italy, and Spain, whose growth models are much more dependent upon internal consumption and domestic demand, and for whom the budgetary squeeze in the years following the financial crisis contributed to extremely low growth or no growth at all? Can they too profit from austerity-driven exports?
Even if the recent economic upturn continues, the eurozone could still split.
AN ABUSIVE RELATIONSHIP
The short answer is “No.” Italy has barely grown in over a decade and is now running a small external trade surplus. Spain has gone from a trade deficit of around ten percent in 2007 to a surplus today of around two percent. The big outlier in the eurozone is France, which used to run a trade surplus but now runs twin budget and trade deficits of around 3.5 and 2 percent, respectively. Given the common eurozone pressures to export one’s way to growth, the result of the eurozone governments collectively doing too little to boost domestic demand, both France and the other larger consumption-led states will have little option but to try to improve their trade competitiveness over the next few years and grow through exports. Spain has been able to do so, but mainly because imports have fallen as consumption declined and unemployment rose, depressing labor costs and improving export competitiveness. Italy is stuck.
This amounts to a structural problem. The Germans and the central and eastern Europeans are running an export surplus against the rest of the eurozone, and at the end of the day all surpluses and deficits must sum to zero. But the EU’s fiscal framework makes it hard for eurozone countries such as France to run budget deficits to offset the depressing impact on their economies of their trade deficits with the rest of the eurozone. The resulting message to these countries—you must engage in ongoing austerity so the Germans and others in northern and central Europe can grow—is populist dynamite, because in such a world permanent austerity becomes the government’s de facto policy regardless of whom you vote for.
This arrangement creates the obvious risk that France, or more likely Italy, will eventually elect a populist government. Emmanuel Macron’s victory in the French presidential election in May was seen as a rejection of populism, but he has yet to persuade the Germans to agree to the deep eurozone reforms necessary for his agenda to move forward, and it is doubtful that he will be able to do so. If Macron fails, the next French president could be a populist of the left or right committed to holding a referendum on French membership in the eurozone. Meanwhile the Italian economy is still in deep trouble. At its current rate of growth, between one and 1.5 percent, it will take several more years for it to return to its 2007 size, and its banking system is a mess. The next Italian general election, or the one after that, could still bring a party into government intent on calling a referendum on the euro. What would happen then?
The threat of France or Italy (or both) leaving the euro could, in theory, prompt Germany and its allies to accept a substantive pooling of risk within the eurozone to head off any exit, perhaps through the issuance of common eurozone debt or a combination of large-scale debt write-downs and more expansionary fiscal policies, which would help the debt-burdened countries of southern Europe. Doing so, however, would require a seismic shift on the part of the Germans, who have staked out a position based on austerity and fiscal discipline. Indeed, it is more likely that the German government will double down on existing policy. By doing so, however, it will make these eurozone referendums all the more likely.
If a referendum in France or Italy went ahead, the outcome would not really matter, as the simple announcement of such a vote would prompt investors to move their deposits from the referendum country’s banks—and possibly those of every other peripheral EU state—into banks in Germany and other core European states to guard against devaluation. The scale of this capital outflow would dwarf the ability of the European Central Bank (ECB), let alone local banks and governments, to stabilize the situation. And even if states tried to stem this outflow through the imposition of capital controls, this very imposition would effectively sound the death knell for the currency union. Although the process would be hugely disruptive, eventually a core group of countries would emerge, based around Germany, that remained on the original euro, at the same time as more peripheral states such as France, Greece, Italy, and Spain adopted a weaker currency, the nuevo euro.
A RELUCTANT HEGEMON
Such a split would be especially difficult for Germany. First, yields on German accounts would fall sharply as the country’s banks pushed down interest rates in order to deter further capital flight into the country. The influx of cash would cause the real euro to appreciate, and although Germany could simply allow this to happen until real euros became expensive enough to deter the purchase of German assets, such a rise in value would massively disadvantage the exports of the real euro countries. In all likelihood, Germany and its allies would suffer a precipitous drop in exports and industrial production, while the strength of the real euro would push down German inflation as the price of imports dropped, compounding pressures on the country’s banks. Germany would thus be faced with an invidious choice—the reluctant hegemon’s dilemma. It could either learn to cope with a hugely overvalued currency and deflation or issue tons of new sovereign debt to soak up foreign demand for its assets.
There is currently a shortage of German sovereign debt because the country is running a sizable budget surplus and the ECB is buying up much of whatever debt is available as part of its program of quantitative easing. But in this scenario, with exports and domestic production taking a massive hit as a result of a eurozone split, a large debt-financed fiscal stimulus would be much more appealing, even in Germany. Of course, Germany would have to run sizable fiscal deficits on an ongoing basis in order to satisfy foreigners’ desire to hold German government debt, and not just as a temporary response to an economic shock, which could be a hard policy to follow even if it allowed exports to recover.
Faced with such a dilemma, Germany will not be able to pull off the United States’ trick of accommodating huge demand for its debt without suffering much upward pressure on its REER. The German economy is only one-fifth the size of the U.S. economy, which means that Germany will never be able to issue as many bonds as the United States does Treasury securities. And unfortunately for Germany, this flight into German assets could be happening at precisely the time that the Trump administration is making investors question how safe U.S. assets are relative to German ones.
If investors began to flee U.S. bonds, the pressures on Germany would become global. It would be expected to act like a local hegemon—issuing debt and buying external assets with the proceeds, as the United States does today. But unlike the United States, it would get little of the upside from doing so, such as paying significantly lower returns to foreigners than it earns on its foreign assets. Specifically, in order to prevent the value of its currency from rising to dangerous levels, Germany would have to allow its external balance sheet (the assets it buys abroad with the proceeds it gets from selling all those new bonds) to balloon. Germany would simultaneously experience a combination of a very sizable currency appreciation anda very large increase in its exposure to external risk.
In the long term, such a combination of outcomes would not be uniformly bad. Export competitiveness would take a hit, but the flip side would be a big boost to domestic consumption as the prices of imported goods and services fell. This would in turn help rebalance these economies away from their dependence on exports. But as a country with a big surplus of external assets over liabilities, Germany already has significant exposure to foreign risk, which would only increase in this scenario. Moreover, Germany has a poor record of choosing which foreign assets to invest in. German banks have tended to either recycle the country’s excess savings into low-risk, low-return, fixed income assets abroad or lend them to foreign banks. Unlike U.S. banks, they have generally not invested in equities and other high-earning assets. As a result, the Germans have earned disappointingly low returns on their foreign assets when times were good and suffered losses when (as in the pre-euro period) the mark appreciated in real terms or (after the introduction of the euro) financial and fiscal crises reduced the value of its external assets.
If Germany is to enjoy some quasi-hegemonic exorbitant privilege, then it will have to become much better at generating returns on its foreign assets during the good times. What, then, would be the likely balance of privilege and burden for Germany after a messy eurozone breakup?
If investors began to flee U.S. bonds, the pressures on Germany would become global.
Given the size of its economy, Germany’s foreign risk, relative to its GDP, would quickly come to exceed that of the United States, meaning that it would suffer much more in any future global economic or financial crisis. Germany would have to accommodate a much sharper real appreciation of its currency than would the United States in the event of a crisis, and its success in doing so would depend to a large extent on whether it embraced structural changes toward more consumption-led growth or resisted this shift and tried to defend its export-led model. Put another way, Germany would have to choose between becoming a kind of enlightened regional economic hegemon and doubling down on its export-driven mercantilism. The challenges facing the central and eastern European economies sharing Germany’s currency would be even starker, as demand for their exports would be more sensitive to an appreciation of real euros.
A NEW HOPE?
A eurozone breakup would undoubtedly be disruptive for Europe, but it wouldn’t necessarily be all bad. Such an unraveling would force Germany and other states with large structural current-account surpluses to rebalance their economies. To contain their exposure to foreign assets, they would have no choice but to allow their currency to appreciate, hitting exports and boosting domestic consumption. And their need to provide safe assets without igniting an explosion in the size of their banks’ balance sheets would force them to issue more debt, reversing the unnecessary austerity that has wreaked so much damage in the eurozone since the onset of the financial crisis. The countries with excess savings—those using real euros—would be left to address the deflation problem they have done much to create, rather than force indebted countries to deal with it through punishing internal devaluations, as they do at present. The problem is how to get there from here without destroying the EU.
It might be possible to engineer such a split by design, but that would require a high degree of cooperation between participating countries and unprecedented dexterity by the ECB together with the national central banks. Moreover, there is little political will for such a move. But in all likelihood, if a single country was to call a referendum on its membership in the eurozone, it would destabilize the power relationships that underpin the EU. This would be a tragedy. The EU badly mishandled the eurozone crisis and appears to be in denial about the scale of the challenges it faces. But the EU still provides the best hope of reconciling globalization with the requirements of national politics.
All of which brings us full circle. The creators of the euro burdened Europe with a currency that can realize its full potential only with a degree of political integration that appears beyond the ability of its participating countries. Yet it is also all but impossible to dismantle the eurozone without imperiling the EU and, with it, political stability in Europe. As we have argued, growth within an unbalanced union can still lead to a split, with populism the trigger. If that happens, Germany’s likely inability to play the role of regional hegemon would make the U.S. dollar ever more indispensable and the U.S. economy still more central to the global one, even if it does shift to more overtly antiglobalist policies under Trump. Indeed, German weakness might ultimately be what allows the current system to continue on, despite the best efforts of those in Washington.