The “threat” from austerity

June 23rd, 2010

If one were to read blogs and columns of, well, pretty eminent US economists, one would be forgiven for thinking that the next major threat to global recovery was Germany. When Angela Merkel announced that the German government would strive to achieve a fiscal balance through austerity measures, Dani Rodrik, Paul Krugman, Brad DeLong, Mark Thoma et al exclaimed in shock and disbelief. They believe that the global economy needs all the demand that it can get right now, even if this demand comes from governments spending more than they earn. And they are partly correct.

The global economy is short of demand at the moment and additional demand won’t hurt. But that’s where it ends. The global economy also needs stable governments. And with Germany’s debt inching closer to 80% of GDP, the Germans want to tighten their belt. Despite the high debt-GDP ratio, Germany has been extremely disciplined in recent years. It has generated a primary surplus for six of the last 12 years and its average fiscal deficit over the same period was 2.3% of GDP. In four of these 12 years it has ended the year with lower relative debt than the previous year.

But the “progressive” group believes that this is wrong. They use Germany’s current account surplus to assert their belief that Germany isn’t ready to pull its weight in inducing a global recovery. Germany is third on the list of nations ranked by their current account balance. The first two are China and Japan. But there are critical differences between them. China is a known currency manipulator and suppresses domestic demand as a matter of policy. By making imports more expensive and exports cheaper, it lends systemic support to the continuation of its trade support. This policy is at the root of the world’s consternation with China.

At its peak, Japan openly intervened in the currency market to intentionally weaken its currency. But since 1990, Japan has been going downhill with fiscal woes of a magnitude not imagined earlier. No one can ask the Japanese government to do more than what it already does. Which brings us to Germany. Germany doesn’t own its currency anymore and cannot manipulate its value unilaterally. It has managed to achieve its current account surplus, not through low wages and currency manipulation, but through innovation and productivity. It has remained fiscally disciplined through good times which gave it the ability to exert countercyclical support to its economy in bad times. Which it did, but if you take Dani Rodrik’s logic, it didn’t do enough.

It didn’t do enough because it didn’t allow its fiscal deficit to rise as much as the US. But Germany doesn’t own the Euro and doesn’t have the ability to monetise its way out of fiscal hell like the US. So while the US can spend merrily, secure in the knowledge that it can monetise its way out of debt servicing and current account deficits, Germany has to think of earning its way out. Or would Mr Rodrik rather see Germany in Greece’s position in a few years just so that it can help Greece recover? Does that make sense at all?

And Dani Rodrik isn’t alone. Paul Krugman also agrees.

Really? Time to get tough with what, Prof Krugman? It’s one thing to threaten a currency manipulator like China, but completely another to extend the threat to Germany. If everyone is counting on the US to become the consumer of the last resort, what steps is the US taking to protect itself? The US is able to run sustained current account deficits because, unlike other lesser nations, it owns the global currency and cannot face a balance of payments crisis. What these economists want is a continuation of the system with other nations adjusting their economic policies and costs so that the US current account balances. But why should they? Is the US doing them any favour by owning the world’s reserve currency?

If the US wants its current account deficit to shrink, the US dollar will have to stop being the world’s reserve currency. Once capital flows to the US slow down, or are denominated in another currency, the US’ ability to pay for its imports will shrink, causing the currency to depreciate and the US will be a few steps closer to a current account balance. And it doesn’t take much for that to happen. All the US has to do is institute capital controls. The US is completely and totally responsible for the position it is in. It wants the US dollar to continue as a reserve currency because it suits its profligate ways, not as a favour to other nations. Changing this is in its hands. But rather than take this route, which will require it to change its ways, the US wants its trading partners to change theirs. Rather than act to weaken its currency, the US wants its trading partners to act to strengthen theirs.

Awesome.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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The economics of plenty - II

June 16th, 2010

In my previous post, I argued for India discarding its existing economic policies formulated in times of shortages. India’s problems have changed and we now face a problem of plenty, especially when it comes to foreign exchange inflows.

Capital inflows, have outstripped our trade deficit over the last few years. However, India’s polices remain rooted in a time when capital inflows were miniscule and India was subject to a full blown balance of payments crisis.

In continuing with these policies, India is ignoring its changed position in the  world and its changed circumstances. It isn’t accounting for its strengths, overemphasizing its weaknesses, ignoring opportunities and losing sleep over threats.

India’s strength today is its population. After years of fearing India’s population problem, we are now in a beneficial demographic period. The rising middle class and its capacity to consume positions India firmly as one of the largest markets in the world.

So why does this not show in our GDP? We need to look no further than our currency. India’s weak currency policy has many repercussions and an understatement of our GDP in terms of other currencies is just one of them.

A weak currency makes all products more expensive for the domestic population. It is futile to say that it affects only imported goods. In an economy which imports most of its fuel, currency related inflation is all pervasive.

In addition, India’s domestic market for commodities is closely linked to international markets and a weak currency also causes domestic prices of locally  produced commodities to rise. If it weren’t so, most of India’s domestic commodities would be exported. These increased prices reduce the ability of our domestic population to consume, reducing domestic growth.

A weak currency also makes it more expensive for Indian companies to buy foreign companies. While this is not an end in itself, it is a means to a very important goal; the ownership of Intellectual Property. When Tata bought Corus and Jaguar-Land Rover, it didn’t just but their capacity to produce steel and cars. It bought the technology which allowed production of superior quality steel and cars. Profits follow technology. Tata Steel and Tata Motors will show that to be true. 

And there is no better example of this than Apple. The iPhone says its designed by Apple in California and assembled in China. Guess where the profits reside. India’s technological disadvantage can only be overcome by buying technology and then developing it further. If we start from scratch, by the time we reach where the world is today, the world would have moved on.

Looking at our conundrum from another angle, the capital needs of India’s infrastructure sector cannot be met domestically. We need global savings. Our policies should reflect our need to attract savings and the strength of our domestic market.
Our current policy framework, in contrast, is making a case for capital controls which will stop global savings from reaching us, to allow us to continue exporting goods and services to other markets. Infrastructure is key to ensuring that our rural population benefits from growth. In most parts of the country rural connectivity is atrocious.
Rather than taking our prosperity to our villages, we have succeeded in bringing our rural population to our cities. In a distorted understanding of urbanisation in growing economies, we believe it is normal for our cities to grow and our villages to shrink. We seem to ignore the possibility of basic urban comforts reaching the villages instead.

If we persist with our current policies, India will always remain an infrastructure-starved nation which can only dream of inclusive growth, not achieve it. And why are capital flows inferior to trade flows? Is it because the ones we focus on are those which can be reversed easily? FII flows can be reversed at the push of a button. So we design policies to allow only those flows which are subject to substantial market costs if reversed.

If we were to look beyond these, its easy to recognise the impact of our weak currency policy on long-term stable flows. Who will want to invest in a currency, or in assets denominated in a currency which is intentionally weakened by policy. Our currency policy increases targeted returns and reduces targeted time span. So rather than
incentivizing investors to start new companies in India, we are content with
allowing them to own our existing companies. A perversity, if the stated intention is to achieve growth, isn’t it?

Times have clearly changed and our minds have to keep pace. Its not India’s growth which is at risk. As mentioned in my earlier post, India will continue to grow regardless. But whether it’ll grow enough to satisfy the needs of a young nation will depend on what drives our policies. Fear or self-belief.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal
 

 
 
 
 

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The economics of plenty

June 10th, 2010

Among other things, the Financial and Eurozone crises have imparted a significant degree of clarity to economic beliefs, despite the profusion of over-simplified economic rules which surround them. Standard debt-GDP ratios and requirements of fiscal discipline have given way to rules specific to each country’s economic situation. They have proved, with some finality that different rules apply to Europe, the US and countries like India.

Countries adopting the euro face a particularly challenging environment. Being used to the luxury of owning their respective currencies, they failed to fathom their changed circumstances after adopting the euro. Most of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) nations will default at some point. It’s no longer if… just when.

At the other extreme is the US. Despite borrowing and spending way beyond its capacity to repay, the US will not default. Neither on its explicit debt and nor on its implicit debt, not for a decade or two. Its currency is desired by the rest of the world and is, for all practical purposes, its primary export. Till such time that foreigners, including foreign governments, buy the US dollar and invest it back in the US, there is no reason for the US to default. But only till such time…. If this inflow of foreign funds stops and the US needs to earn a currency foreign to it, default would be a heartbeat away. Right now, the bigger fool theory is firmly in place. Everyone believes they will get out before getting splattered by the fan.

Which brings us to India. As one would expect, India is floundering somewhere between the two. We own our currency, but aren’t really sure how much the world wants it. Capital account flows would suggest that demand exists, but we haven’t yet reached a stage where the world wants our currency for itself and not for the assets it can buy. No one wants to own a weakening asset and we don’t want an appreciating rupee.
India has choices to make. It is at a point in its existence when it can go any way it wishes to. It could continue with policies formed during times of shortage and tweak them to reflect our current surpluses. This positions India as a producer for goods and services demanded by other nations. It would necessitate a weak currency which would assist competitiveness, but deprive the local population of the purchasing power they desperately need.

Or we can discard these policies and adopt the “economics of plenty”. This would position us as a nation of 1.2 billion consumers, not 1.2 billion hungry mouths and necessitate a strong currency which increases our purchasing power. Yes, it would increase our current account deficit but, coupled with the right policies, increase demand for the rupee as an asset in itself.

In our current policy framework, India competes in other markets for a share of their business against players who have set the rules. True progress will lie in changing the rules, in becoming the market others want to compete for. In an environment where major markets are shrinking, or growing at a snail’s pace, India’s emergence as a market will be welcomed by the world. In changing its policies to favour domestic consumption over exports, India will have to change the way it thinks. And the first change will need to be our currency policy.

India’s future lies in this choice. India will grow regardless, probably faster than most countries in the world. But, in the former we will need other markets to grant us our progress. In the latter, we will drive it ourselves.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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