Mervyn King was Bank of England governor from 2003 to 2013 – before, during, and after the global financial crisis. He sees four main policy options for resolving the eurozone’s problems – and all four are nasty.
Late on Wednesday evening at the American Academy in Berlin-Wannsee, speaking to an audience composed of German and American economists and Atlanticists, Mervyn King said: “The Eurozone has been pursuing a finger-in-the-dyke strategy.” He said – a strategy in which rescue policies have been designed on the fly to help whichever euro area country was most at risk at a given moment – adding that “the eurozone has not resolved its underlying problems,” DW reported.
Loose monetary policy – i.e. ultra-low interest rates and ‘quantitative easing’ – can provide temporary support, but cannot solve Europe’s structural economic problems, King said. Moreover, keeping interest rates very low causes further problems down the road.
Regional Imbalances
The fundamental reason for weak global growth, according to King, is that major regional imbalances between spending and saving have built up over the past quarter-century or more. Some countries, like China and Germany, have saved too much and spent too little; others have borrowed too much and spent more than they produced.
These imbalances are unsustainable in the long term. By over-consuming, people in countries with low savings rates get ever farther into debt – which amounts to “borrowing demand from the future,” King said.
China, Germany Surpluses
In some countries, notably China, Germany, and the Netherlands, the economy as a whole produced more than it consumed. This manifested as a massive surplus of exports over imports.
In financial terms, Chinese, German and Dutch trade surpluses, combined with high savings rates and relatively weak domestic consumption, led to a very large-scale export of savings from those countries to global capital markets. This continued for many years.
The consequent abundance of globally available financial capital caused a worldwide fall in real interest rates (interest rates net of inflation), which had “enormous implications,” according to King.
Low interest rates led to increases in demand for bank debt, and encouraged over-borrowing and over-consumption. It also led to increases in the price of assets like houses.
When the global financial crisis of 2007-8 caused people to realize that asset prices were over-valued, regional real estate bubbles burst and asset prices suddenly declined, leaving millions of people with a debt overhang. Borrowing and consumption declined, and jobs disappeared.
Exchange Rate
Throughout his talk, King emphasized the virtues of flexible exchange rates - both as a way of automatically compensating for differences in productivity between countries, and of preventing the build-up of trade imbalances.
It was China’s adoption of an effectively fixed, low Renminbi exchange rate with the US dollar that led to its huge export surpluses. Similarly, the big net surpluses earned by export-oriented industries in Germany and the Netherlands were due partly to those countries’ membership in the euro area. Had they kept their own national currencies, the dollar price of German and Dutch goods on global markets would almost certainly have been higher.
Eurozone Problems
King identified four options, none of them pleasant:
1. Continued high unemployment in periphery countries until wages and prices fall enough to regain eurozone-wide competitiveness. This might entail a further decline in average wages of 20 percent or so in those countries. Unfortunately, high unemployment entails weak domestic demand, which works against recovery. This is the policy pathway currently being pursued.
2. A period of high inflation in Germany, accompanied by wage and price restraint in the eurozone periphery.
3. Large-volume fiscal transfers from North to South, indefinitely: the dreaded ‘transfer union’.
4. Breakup of the eurozone – messy, murky, difficult.
If Lord King’s analysis is correct, creating a common currency before creating an effective political and economic union was a major mistake – and so far, the eurozone has not done well at dealing with the consequences of that mistake.
