Calling Europe’s problem a balance of payments problem as Martin Wolff and some others are doing is a mistake. It confuses cause with effect. BOP imbalances are the SYMPTOM. The causal variable is ‘competitiveness.’ It is the competitiveness differences across the Zone. The Zone has gone wrong by making itself a slave to the currency instead of to true integration. Economies in the Zone sacrifice everything to hold the euro 'peg'. It makes no sense, especially since the euro peg is now the cause of their pain as it truly is.
We can engage in revisionism but we cannot run time backwards. We are where we are and the Zone cannot undo its terrible mistake. It is all but impossible to heal the rift from within. I do not see Germany relating nor do I see Mediterranean countries undergoing a generation of austerity just to keep the euro peg. I see chaos.
Learning from the Euro-undoing
The e-Zone problem is a microcosm (well maybe a Macro-cosm....) of the world economy where, similarly there are no burdens placed on surplus countries to adjust. In the Zone this manifests itself as competitiveness issues as the ECB held macro inflation in check but country by country results undermined the system probably though fiscal excess but also because of poor integration. Germans took the opportunity to cement their position as the most competitive Zone nation and now seem to be in the cat bird's seat of supreme competitiveness. But it’s still a seat on the good ship Titanic and as things worsen Germany will increasingly be called upon to do the bailing. In the end Germany's maneuvering to be the most competitive did not serve it well. It was poking holes in the sides of the same ship that it occupied. By undermining its neighbors competitive position too badly it undermined itself.
Away from the Zone where exchange rates are flexible competitiveness problems are not such an issue, or at least, they take on a different dimension. In this environment policy options are greater. But the global system has not prospered and has built up its own set of rigidities and imbalances because surplus countries are not forced to adjust and the US, the reserve currency takes the other side of the currency value that other nations select. Some countries select a policy of export led growth and ignore their too-low exchange rate. They ride the trade surplus to prosperity. A country that is piling up forex reserves, and does not take that as a sign of an undervalued currency simply undermines the system. Its surplus takes the form of a deficit elsewhere.
Fixed as in set; flexible but broken
So in EMU the adjustment mechanism is fixed in the sense of being ‘set’ or ‘rigid’ while outside the Zone the adjustment mechanism is flexible but nonetheless is broken.
We have created systems without rules, or at least without rules that any one will obey or will be forced to obey (who would force them?) WTO does not even require market-determined exchange rates for its rules to apply. It’s as mad as the e-Zone having had no real fiscal rules (Mass-trick- right).
While I see lots of fingers being pointed what is clear and consistent is that we have invented systems with flaws. EMU has painted itself into a corner (or coroner?). I don’t’ see how it survives unless it can break apart and reform.
ECB bond buying or more LTRO is just more of the junkies fix; it is not a solution but will deepen and worsen the problem.
Why Free is so expensive
Apart from the Zone there are similar issues that go unresolved and that undermine and destabilize the global trading system. NOT agreeing to anything may be worse than agreeing to something that countries don’t want. But trade, even ‘free trade,’ requires rules. Trade may be free, as in ‘free of restrictions’ but it must also be free it the sense than it is supported by other free markets. And when exchange markets are not free and are meddled with they are not efficient and free trade conducted on such a base is a disaster.
How it actually works
We should ponder how we are getting to equilibrium or what passes for that in this system. Since surplus countries won’t appreciate their currencies to trim their surpluses, deficit countries get larger deficits. And goods stay so cheap that deficit countries simply over-consume. They consume so much that they become debt-saturated while financing their ‘cheap’ purchases. Some figure it out before it is destructive; others don’t. Economists generally defend this excess consumption by looking at the ‘consumer surplus’ accruing to the purchaser of the cheap goods but only because they think in terms of the commodity markets and forget about financing. But it’s in the financing of the excessive consumption where the real evil is being done. In our financial crisis the developed world took it on the chin. China has turned to a domestic demand model, away from a model based on export-led growth, not out of the goodness of its heart, but because it saw that the US has become nearly debt saturated and China does not want to absorb a. lot more US debt. It knows the price of its chronic surplus policy is chromic deficits for the US and more debt issuance. This is how equilibrium is being foisted on the system: It is happening because of debt saturation and because the current account signal is being ignored.
‘No rules’ does not mean no consequences
So in the end having a system without rules is not the same as having a system without consequences. It may be hard to figure out the consequences in such a poorly articulated system, but in time the system will tell you. EMU is finding out. The rest of us are finding out and still we have no solutions.
We need to go back to a rules-based system. We need cops and penalties. We don’t need gold we don’t need fixed exchange rates just need rules and to have them followed.