An Outbreak of Fiscal Sanity in Europe? Insanity in the U.S.?

The recent G20 meeting in Toronto came out with a joint statement endorsing “balanced and sustainable” growth for its members. It was one of those statements that are created by committees to placate all participants and don’t really amount to anything. In this case, no meaningful agreements came out of the G20 meetings. Each government will just go back to doing what they have been doing and mouth high-sounding speeches of solidarity and fraternal love for their world co-leaders.

What really happened in Toronto didn’t come out in the official statements (they never do). But the obvious and deep division between the U.S. and Europe was the main story of the event and that was fascinating to watch.

When Obama chides Merkel for Europe’s (Germany’s) proposed attempts at fiscal responsibility and when Merkel hits Obama for the U.S.’s fiscal profligacy, then you’ve got a good story.

The big split has to do with whether the world should continue fiscal stimulus. The Obama Administration believes that it’s too soon to stop. Recent numbers have them scared about the future of the U.S. economy and it wouldn’t hurt to have some global support when they try to beggar Congress for more spending to promote economic recovery. (“See,” Geithner will say, “even the Germans are begging us to spend so we can rescue the world economy.”)

Europe has a worse problem. Well run countries like Germany (actually about the only relatively well run economy in the EU), are being dragged down by their weak eurozone members, the well known PIIGS, lead by chief pig, Greece. They are being dragged down because they are the only ones in the EU that have the wherewithal to bail out its banks who will be in jeopardy once Greece defaults on its bonds. France should be included in this as well since their banks are also big PIIGS lenders. It will cost them a lot of money because they won’t allow their banks to fail.

When the Greek crisis hit the EU came up with a credit line through the IMF which they believed was big enough to buy time to reform the PIIGS. And, a trillion dollars (€750 billion) is serious money. The EU had previously provided a credit facility of  €870 billion to its member banks in order to create liquidity.

It seems to me that Obama came back looking worse for the argument. Here is our president lecturing the Germans on how to run their country in a fiscally unsound way. He suggested that they spend more, encourage their citizens to spend more, and worry about it later. In essence he is saying that German citizens should buy more goods rather than produce them.

Merkel was not intimidated:

Ms. Merkel denied Germany is under pressure to change, predicting “a very relaxed discussion about this topic in Toronto.” She suggested that the prevailing economic theory on stimulus—that increased deficit spending promotes growth— doesn’t apply in Germany.

Continuing to run big deficits could backfire here, she said, because of Germans’ angst over their aging society and rising public debt. Fear that the German welfare state could run out of money leads individuals to save their income as a precaution, she said. If Germany cuts its budget deficit instead, “then the citizen is more willing to spend money,” she said, “because he knows that he can count on the pension, health and elderly-care systems.”

Germany is the world’s fourth largest economy, they are successful manufacturers and exporters, and their government’s deficit as a percentage of GDP in 2010 is expected to be about 5.5% versus about 10.1% in the U.S. Their fiscal stimulus was largely in the form of tax cuts rather than government spending. Manufacturing is a higher percentage of GDP than is consumer spending:

Courtesy Wall Street Journal

This all breaks down into an argument about the efficacy of fiscal stimulus. The Germans, David Cameron, the ECB, and the IMF are worried about the longer term effects of stimulus: deficits and what the impacts will be on the euro and the PIIGS. They question Keynesian spending as a cure for recession, although many of them did it (including Germany, although Merkel was a reluctant spender). German Finance Minister Wolfgang Schäuble threw a grenade at Obama and said Obama’s giant stimulus spending has had little impact on our country’s jobless rate (9.7% at the time). He’s right.

On the other side of the debate is Obama, Chinese president Hu, and France’s Sarkozy who believe in fiscal stimulus through government spending, and believe the Germans need to buy more goods from others (especially the weak EU members) to help revive the global economy. Hu was especially worried because the Chinese apparently buy the Keynesian stimulus idea and they need the EU and the U.S. to recovery quickly so China’s export based economy doesn’t tank (which it is starting to do).

Merkel told her world co-leaders that Germany was not going to do that. They were opting for fiscal sanity.

What happened at the G20 meeting? They came out with a compromise statement that tried to cut between the two competing ideas: reducing deficits yet mindful of a need for stimulus spending.

The meeting’s concluding statement, a compromise between two competing visions of the international economy, masked divisions between the U.S. and Europe evident in the run-up to the summit. The U.S. has warned that moving too fast to cut deficits and reduce stimulus spending could risk another global recession. European nations, especially Germany, have cautioned that moving too slowly could produce unsustainable debt loads, higher interest rates and even defaults.

With each side pushing, the U.S., and Europe cut what a U.S. official called a “combo deal.” The U.S. agreed to make the goal of halving deficits a G-20 initiative, in exchange for G-20 support for language making growth the top priority, said a European official. President Barack Obama has already made similar deficit commitments back at home. …

A G-20 statement called the global recovery “uneven and fragile” and said that to sustain growth, “we need to follow through on delivering existing stimulus plans, while working to create the conditions for robust private demand.”

And how exactly do you create conditions for “robust private demand?” They view deficit cutting as “growth friendly.”

Let me give you the background to that statement.

First, the news came in that the EU recovery was stagnating:

Released Monday, the Conference Board’s Leading Economic Index for the euro zone dropped 0.5% to 109.7 in May, the first fall for 14 months. The index is an amalgam of eight indicators of activity and is designed to predict future activity.

And,

World trade volumes fell in April for the first time since January, an indication that the economic recovery may be losing momentum. Figures released by the Netherlands Bureau for Economic Policy Analysis, also known as the CPB, Thursday showed trade volumes fell 1.7% in April from the month earlier, having risen 4.0% in March.

They declined for the same reason we are declining: the artificial stimulus wore off and left no real sustainable organic growth.

Then two influential institutions came out cautioning countries on fiscal deficits and that they will inhibit growth. First the IMF reported:

The International Monetary Fund estimates that global growth in five years would expand 2.5% faster if the U.S. and other wealthy countries slash budget deficits more deeply than they are planning, and if China and other large emerging countries do more to boost domestic consumption.

Forget why they say this because their comments about Chinese consumers and consumption taxes are mostly wrong. They think China should increase consumption and take up the slack caused by reduced government spending. Obviously wrong. It’s as if we are all one international economic aggregate and that isn’t true. Why does Germany do just fine by exporting and China doesn’t? It could have something more to do with governments’ share of their economies’ GDP.

Then the ECB, the European Central Bank under Jean-Claude Trichet came out and said:

Jean-Claude Trichet, the European Central Bank president, has put himself on a collision course with the US by arguing strongly that tighter fiscal policies are the best way to foster growth in industrialised economies. Firm control of government spending and tax policy was essential to restore the confidence of households, business and investors, Mr Trichet told the European parliament.

It is as if fiscal sanity is breaking out in Europe. Budget cutting is “growth inducing?” What will we hear next, stimulus is wasteful?

Where will this all end up? Germany will cut spending, perhaps raise taxes, and bring its budget deficit more in line. Maybe France and some other EU members will do the same thing. Greece has too many structural issues and will fail to reform sufficiently to prevent default. Germany will not bail them out further, but they will support their banks who lent to Greece. The euro will remain under pressure until the markets see results from fiscal sanity. Don’t buy Greek bonds. Spain? Maybe they’ll survive without a default. Portugal? Probably no. Ireland, Italy, probably yes. Germany will recover more quickly than the other major economies. China will have a real estate crash, more fiscal stimulus, and they won’t recover until the U.S. and the EU recovers.

Obama’s spending alternatives are limited, so another small stimulus package will be a token to his supporters. But he won’t cut the deficit to the 4.2% of GDP he promised to his G20 friends (from the current 10.1%). He won’t raise taxes soon because he wants to be reelected. The economy will stall for reasons I have previously discussed. That leaves inflation and he’ll do it.