Who is calling the shots?

[john birchall]

Letter from an Economist – 16th February 2004.

Who really is calling the shots?

Everybody would like China to revalue its currency. Alas, those in power in Beijing will not allow this and few can design a way of making them change their minds. Despite all the collective muscle of the G7 it is incapable of making the fastest growing and ultimately most powerful economy in the world change its mind.

Within Europe the value of the Euro is causing concern but those in Frankfurt with control over short term interest rates are reluctant to cut rates. In the US the value of the dollar has moved from its prominent position in the news at the close of 2003 and has been replaced by both Iraq and the Presidential Election campaign. So, what is happening in the normally turbulent foreign exchange markets?

If we go back to the time when economics was undergoing a sea change and by this I refer to the early 1980’s it was the US who appeared weak. Its federal budget deficit was exploding as Reagan cut taxes and boosted defence expenditure. At that time the US needed close allies to support the value of the dollar. Japanese savings played a large part in maintaining capital flows and some even joked (possibly in bad taste) that Pearl Harbour could never be repeated as the Japanese owned much of what might be bombed! Germany too assisted the dollar and allowed it to move through difficult period. The behaviour of the current administration in Washington leaves one asking if the US no longer considers the impact of its economic policies on its allies to be a major cause of concern when protecting domestic interests.

Today, the US reigns supreme and cares to ignore how a weak dollar impacts on the economies of mainland Europe. I have suggested before that it is the Chinese who the US fears both as a trading power and the only possible ‘superpower’ to emerge as this century proceeds. Maybe Donald Rumsfeld meant that all of Europe was ‘old’ and that it’s Asia who is ‘new’? If this is correct then we are witnessing a significant change in how post war (1945) economics is evolving and we need to think carefully about who is ‘calling the shots’.

The current malaise of the monetary authorities in Europe might be a realistic reaction to the changes that were introduced in the early years of this century. To be fair they might be waiting to see what happens as events such as the Euro settle down and we can analyse the impact they have had. The enlargement, due in June, may also be playing on their minds. But one also could interpret this as being something of a ‘rabbit in the headlines’ syndrome with no one quite knowing what to do next. One thing is certain currency dealers seldom reward apathy and often an inability to react to market trends results in sharp currency depreciation.

We also need to consider if the advent of the Euro is ever going to turn its zone of influence into another US style economy. If it does then the economic geography of the EU is about to undergo a significant change. Integration must surely result in leaner and more efficient business within the EU and with national or possibly regional specialisation. The extent to which a considerable pool of cheap and enthusiastic labour will drive down costs remains to be seen but the EU population movements could emerge as part of a rival major economic structure to the Hispanic invasion that is driving much of the growth in the US. It is interesting to note how few registered jobs the US economy is creating each month and one wonders if that is partly caused by the low paid jobs being taken by illegal immigrants!

But back to Europe and it’s less than warm relationship with macro policy. It is interesting to note that Bush has gone for a quasi Keynesian approach of tax cuts and a hope that the multiplier effect will be both quick and large. Within the EU such a move is either not possible or not wanted. The US has added some other weapons to its economic armoury in a historically low interest rate and a low valued dollar. In short, a period of economic nationalism is in place and it’s not simply a ploy for election year. What has happened is an introductory lecture on how to boost economic activity within an economy but no one is mentioning inflationary pressures! If these do arise they will be after the election and might even be someone else’s problem to solve.

One fact on which most commentators agree is that Europe is losing out to the macro policy of the US and it seems confused as to how to react to this. It seems unlikely that the central authorities will spend reserves to boost the Euro; though the Japanese have been very active in the market in recent months trying to keep the Yen from surging in response to the low dollar. No, those pulling the levers in Brussels and Frankfurt seem content to turn a little further on in their basic economics text and hope that expensive exports will be offset by the benefits of cheaper imports. If exports are to grow then it will be the result of world growth and that requires the US and China to be left alone to sort out their problems in their own way. Perhaps this reaction is based on a belief that all is well with a one size fits all approach to European monetary policy? If so, then some of those responsible for economic planning must raise a concern that the system designed to move smoothly into a twelve nation currency zone has within it some serious problems?

Some US economists do describe Europe as a market that has reached saturation and will not record high growth rates again. Whatever the political risks they see the Far East as the area into which US capital should flow and believe that external policy should be directed at supporting this. Added to this they consider Europe to be the consequence of an ageing population, whose zeal for capitalism has declined. It is not difficult to understand why the Tiger Economies attract such attention. Perhaps only the very basic economies of the EU, for example Bulgaria and Romania will see capital flows from New York etc?. Elsewhere, some US-based investors point to regulations and social market features as restricting their desire to invest in Europe.

It appears that economics and its content are changing and Europe, including the UK needs to watch very closely and note who is driving what and why.