The Feldstein Solution to the Euro Crisis: Unleash a Global Trade War

Just when you thought the euro debate couldn’t get any more inane, in steps Martin Feldstein with his answer to the euro area crisis.

For the euro area to become strong again, the euro must become weak, he opines. The problem, you see, is that countries like Italy, Spain and France have current account deficits that have to be closed, and these countries lack their own exchange rate. Achieving competitiveness by depressing domestic wages and prices means high unemployment for an extended period. Bad policy.

To avoid that, the euro should depreciate against other currencies, reducing these countries’ trade deficits against non-EMU countries. The Harvard professor is thinking of:

a trade-weighted decline of 20 per cent or more. That could imply a euro-dollar exchange rate below its initial value of $1.18 per euro.

There are a number of reasons why this is not, as claimed, ‘the way forward’. In fact this seemingly innocuous suggestion poses grave risks to the entire global economy.

Let us start with the simple fact that the euro area aggregate trade and current account position is, and always has been, close to balance. The imbalances are intra-EMU imbalances. (Somehow Feldstein omits to mention this simple fact.) The obvious policy recommendation, one would have thought, is to have faster wage and price growth and faster-growing demand in EMU countries with surpluses (most importantly Germany) and slower wage and price increases in deficit countries. Indeed, the professor has thought of that, but he immediately rules this path out:

Some economists and officials in countries with trade deficits argue that Germany should expand to increase demand for their products and allow a faster rise in wages to reduce its trade advantage. Not surprisingly, Germany rejects these suggestions.

Feldstein seems happy to take ‘Nein!’ for an answer. He does not appear to imagine that what he calls ‘Germany’ might consist of different groups with different interests: I can assure him that German workers and their unions are certainly keen to have faster wage growth after years of moderation. Now I readily accept that their influence on German policymakers is limited, but Prof. Feldstein is used to lecturing governments. Why he does not seem to think it worth pointing out to German policymakers that it is in the interest of the country to resolve the euro crisis and that higher domestic incomes and employment, to the extent that demand is boosted, is actually a sweeter pill and an easier political sell than putting money into rescue funds for indebted banks and countries. Would he be so reticent if a recalcitrant German government were refusing to embark on a labour market reform of which he approves?

Nor does he discuss another obvious solution: the ECB should permit faster aggregate inflation, so as to enable competitive rebalancing without massive deflation and prolonged recession in the deficit countries. Presumably he thinks that here, too the answer would be no. (Here he is at least on stronger ground: the euro area architecture is such that the ECB is independent, has been allowed to define its own inflation target and, in short, can cock a snook at the elected representatives of the people of the euro area if it so chooses.)

But the real problem is at another level. Even if Feldstein is correct about ‘German’ and ECB intentions, he has not thought through the consequences of his policy recommendation.

Let us suppose that there is indeed no competitive rebalancing within the euro area. The euro instead depreciates or is depreciated – Feldstein never actually specifies how this is to come about – and the euro area begins to run persistent surpluses. How big would they need to be? The short answer is: too big for comfort. Let’s keep it simple and just focus on the three deficit countries he mentions, Spain, Italy and France, and on Germany. Assume that (as Feldstein says) intra- and extra-EMU trade each accounts for about half of these countries’ foreign trade. Then Spain, Italy and France would need to run surpluses with the rest of the world of, say, 3% of GDP, given that they are still running large deficits with Germany (don’t forget, there is no competitive rebalancing between them and Germany) in order to run even small overall surpluses.

For precisely the same reason (no internal rebalancing) there will be a corresponding further improvement in German competitiveness with the rest of the world, and a further substantial increase in Germany’s already large trade surplus with the rest of the world; and the same would be true of all the other EMU countries, whatever their starting point.

This means that, from an initial situation in which the euro area’s current account is balanced, it would have to run overall surpluses with the rest of the world of perhaps 5-6% of GDP. And this means that the euro area’s trading partners will have to accept an increase in deficits (or a decline in surpluses) of the same order of magnitude. But while Feldstein posits a simple ‘Nein’ from Germany and the ECB to internal rebalancing, he apparently assumes that the euro area’s trading partners will just take this attempt to poach global demand lying down.

The USA, Japan, and non-EMU European trade partners such as the UK all face high unemployment, deficient aggregate demand and real or imagined constraints on domestic macroeconomic policy.  All of them want to see net exports growing as fast as possible. (China is a slightly different case, as it does need to rebalance towards domestic growth rather than net exports,  but all are agreed that this should be a gradual process. There are serious concerns about bursting bubbles, a hard landing and serious social unrest in China.) The USA already has a substantial trade deficit with the euro area, and the dollar is almost certainly overvalued (albeit more against Asian currencies than against the euro). Is he unaware that President Obama has an explicit policy of export-led growth? And given the political opposition to further domestic stimulus, that makes a lot of sense.

What Feldstein is unwittingly recommending is a modern version of the competitive devaluations and trade protectionism that contributed to propagating and deepening the Great Depression. Already we have worrying signs of an imminent possible trade war between the US and China. It is inconceivable that other countries would stand idly in the current environment by while the euro area rebalances at their expense.

If a (small) devaluation of the euro were to come about as a byproduct of energetic attempts by the ECB to stimulate the euro area economy and avert a sovereign debt crisis by buying large amounts of peripheral-country bonds that would be an entirely different matter. The lower euro would go hand in hand with higher demand and the impact on the current account would be ambiguous and small. Martin Feldstein is explicitly calling for (substantially) bigger trade surpluses. It is a hugely irresponsible course to recommend. Instead he should be lending his weight to those trying to urge sense on European and German policymakers, persuading them of the urgency of rebalancing the European economy at the highest possible levels of output and employment.

The global economy is in a very precarious state. To say we need global beggar-thy-neighbour policies like a hole in the head doesn’t even come close.