G20: Conflicts now need to be resolved, not papered over

Perhaps the greatest danger for the upcoming G20 meeting is that politeness will prevail, with leaders diplomatically and prudently stepping back from the sharp accusations traded in the last couple of weeks. It would be a mistake, because the escalation in the rhetoric was simply a symptom of the seriousness of the issues which have to be dealt with at a global level, and cannot just be politely wished away.

The clearest signal is the virulence of the accusations hurled at the Federal Reserve after its decision to launch a second round of quantitative easing. Major powers such as China and Germany have accused the US of engaging in a misguided attempt to depreciate the dollar, with little or no concern for the consequences this could wreak upon the global economy and financial system. The criticism, shared by a number of economists, rests upon a sound logical argument: US banks and corporations are already sitting on large amounts of excess cash which they are unwilling to respectively lend and invest—he problem here is lack of confidence, not lack of liquidity; households are still in a much-needed deleveraging phase, and unlikely to borrow and spend more; academic literature convincingly demonstrates that recoveries after a recession-cum-financial crisis tend to be weaker and more prolonged than usual. In sum, with both short and long-term yields already very low, there is little reason to hope that pumping more money into the system will successfully speed up the recovery of US domestic demand. Therefore, the criticism goes, QE2 is nothing more than competitive currency depreciation in disguise; worse, it is being pursued with complete disregard of the fact that liquidity will leak out of the US into the global financial system, fuelling bubbles in commodities and in emerging markets assets. Some official statements from China and Germany, amongst others, have all but explicitly accused the US of recklessly jeopardizing global financial stability just as we are emerging from one of the worst crisis of the modern era. Brazil has adopted a similarly critical stance.

The US, for its part, pins the responsibility on the countries which are still running large current account surpluses, China and Germany in primis. Here again the underlying logic is sound: if US consumers need to deleverage further and save more, somebody else has to step up to plate to drive global growth; an acceleration in domestic consumption by surplus countries would do the trick, while at the same time reducing the global macro imbalances which have proved to be a source of financial instability. Surplus countries should therefore stimulate domestic demand, and in the case of China allow their exchange rate to re-align. The US has recently gotten India on its side, and by focusing on Germany it has attempted to divide Eurozone countries on the issue: Germany’s CA surplus was partly built on the back of unsustainable consumption in peripheral Eurozone countries, sowing the seeds of the current turmoil in sovereign debt markets.

Attempts to divide the Eurozone on the issue of current account balances have been only partly successful. Eurozone policymakers have already moved away from the fiction that external balances within a currency union are irrelevant, and are building CA balances and measures of competitiveness in a revamped framework of economic governance. Moreover, Germany has de facto taken some responsibility by underwriting intra-Eurozone rescue mechanisms such as the European Financial Stabilization Fund. In fact, it seems most likely that Eurozone members will prefer to treat CA balances as a domestic issue. China is encouraging this by positioning itself as a visible potential buyer of peripheral Eurozone sovereign bonds, which could help defuse the tensions linked to intra-Eurozone imbalances.�

On the eve of the G20, we are at an impasse. The US has tried to shift the focus away from exchange rates and onto global rebalancing, suggesting numerical targets for CA balances; the proposal has been dismissed by China (which said it smacked of central planning) and Germany (normally a fan of numerical targets, as for budget deficits and inflation). The IMF will most likely take responsibility for flagging unsustainable imbalances and needed policy corrections, a process that will be both controversial and unenforceable.

This is not an academic debate, but reflects a very worrying situation: international policy cooperation is on the verge of disintegrating as the main players on the global scene now view economic growth as the paramount objective to be pursued in full independence. And yet international policy coordination is much more sorely needed now than two years ago, when the synchronized post-Lehman downturn made it natural for all countries to react in the same direction. German Chancellor Angela Merkel correctly identified the main danger in her Financial Times interview a few days ago: it is protectionism, the logical next step if countries continue to see growth as a zero-sum game, and a step that would be extremely damaging in both the short and long term.

The US is right in pointing out that its consumers can no longer pull the global economy along, not for a while. But that is just another way of stating that the pre-crisis global growth model is broken and needs a careful re-adjustment. Low interest rates, excessive credit growth, asset bubbles and unsustainable accumulation of private sector debt have been the drivers of record growth in a number of advanced countries, not just the US, and emerging markets have benefitted greatly from it. Generating robust and sustainable growth should now be a common concern.

By launching QE2, the US has showed a worrying impatience with the strength of the recovery. The crisis has likely reduced—albeit temporarily—the economy’s potential growth rate, making it impossible to re-attain quickly a pre-crisis pace of growth which was in itself unsustainably boosted by a credit bubble. But patience does not mean resignation. The US should continue to aim for the strong growth that its extremely flexible economy can generate—this is in everybody’s interest. Germany is right to be proud of the competitiveness of its industries, and China is right to want to rebalance its growth model at the right pace. But both need to acknowledge that a healthy US economy and smaller global imbalances are in their interest as well.

The global financial system is still fragile, and large public sector debts in advanced economies, compounded by looming age-related costs, are dangerous landmines. Tensions in the Eurozone’s sovereign debt markets have surged anew in recent weeks as Germany has tabled the issue of an orderly resolution mechanism for unsustainable public debts, while markets watch nervously to see whether Greece, Ireland and Portugal can generate sufficient growth while reducing their fiscal deficits. We have seen just six months ago how a genuine sovereign debt crisis in Europe could send destabilizing shockwaves across the global financial system. And if the US were to find itself mired in stagnation with a still abnormally high budget deficit, confidence in US Treasuries might eventually be shaken—an eventuality that no one should be able to contemplate with any degree of comfort.

G20 policymakers should aim for more than papering over the conflicts with vague commitments not to engage in competitive exchange rate depreciations. They should tackle the issues head on; they should agree to work on reducing global imbalances, including via supporting stronger demand in countries with large current account surpluses; and they should commit to monitor equally closely developments in global asset markets, to ensure excess global liquidity does not lead to a replay of the crisis which we are just coming out of. They should show they realize that we are all in it together.