Mervyn King on eurozone

Late on Wednesday evening at the American Academy in Berlin-Wannsee, speaking to an audience composed of German and American economists and Atlanticists, Mervyn King was able to do something he could not do during his ten years at the helm of Britain's central bank: Speak bluntly.

"The Eurozone has been pursuing a finger-in-the-dyke strategy," King said - a strategy in which rescue policies have been designed on the fly to help whichever euro area country was most at risk at a given moment - adding that "the eurozone has not resolved its underlying problems."

Loose monetary policy - i.e. ultra-low interest rates and 'quantitative easing' - can provide temporary support, but cannot solve Europe's structural economic problems, King said. Moreover, keeping interest rates very low causes further problems down the road.

Regional imbalances between spending and saving

The fundamental reason for weak global growth, according to King, is that major regional imbalances between spending and saving have built up over the past quarter-century or more. Some countries, like China and Germany, have saved too much and spent too little; others have borrowed too much and spent more than they produced.

These imbalances are unsustainable in the long term. By over-consuming, people in countries with low savings rates get ever farther into debt - which amounts to "borrowing demand from the future," King said.

Businesses worldwide have recognized that people in those countries will be able to consume less in future. That, King said, is the trap we find ourselves in - and then explained his views on how we got into it.

The consequences of Chinese and German surpluses

In some countries, notably China, Germany, and the Netherlands, the economy as a whole produced more than it consumed. This manifested as a massive surplus of exports over imports.

In financial terms, Chinese, German and Dutch trade surpluses, combined with high savings rates and relatively weak domestic consumption, led to a very large-scale export of savings from those countries to global capital markets. This continued for many years.

The consequent abundance of globally available financial capital caused a worldwide fall in real interest rates (interest rates net of inflation), which had "enormous implications," according to King.

Low interest rates led to increases in demand for bank debt, and encouraged over-borrowing and over-consumption. It also led to increases in the price of assets like houses: The lower the interest rate, the higher the nominal price a buyer is able to pay for a house, whilst keeping the size of the monthly loan repayment constant.

Rising asset prices, in turn, generated ever-higher demand for more debt, in a self-reinforcing spiral. The ratio of debt loads to the price of underlying assets rose, as did total debt levels.

When the global financial crisis of 2007-8 caused people to realize that asset prices were over-valued, regional real estate bubbles burst and asset prices suddenly declined, leaving millions of people with a debt overhang. Borrowing and consumption declined, and jobs disappeared.

Exchange rate flexibility prevents problems

Throughout his talk, King emphasized the virtues of flexible exchange rates - both as a way of automatically compensating for differences in productivity between countries, and of preventing the build-up of trade imbalances.

It was China's adoption of an effectively fixed, low Renminbi exchange rate with the US dollar that led to its huge export surpluses. Similarly, the big net surpluses earned by export-oriented industries in Germany and the Netherlands were due partly to those countries' membership in the euro area. Had they kept their own national currencies, the dollar price of German and Dutch goods on global markets would almost certainly have been higher.

In combination, the export surpluses generated by these artificially low exchange rates led to the consequent global flood of excess savings that led, in turn, to too-low interest rates globally.

And it was the eurozone's adoption of a single currency for widely disparate national economies, without concomitant eurozone-wide wage, price, investment or banking policy coordination, that led to divergences in competitiveness and to the consequent depression in eurozone periphery countries after a decade-long binge of over-borrowing ended.

No easy way out for the eurozone

How might the eurozone's problems be resolved? King identified four options, none of them pleasant:

1. Continued high unemployment in periphery countries until wages and prices fall enough to regain eurozone-wide competitiveness. This might entail a further decline in average wages of 20 percent or so in those countries. Unfortunately, high unemployment entails weak domestic demand, which works against recovery.

This is the policy pathway currently being pursued, but: "There's a limit to the economic pain that can be imposed before there's a bad reaction," King said, pointing toward increases in the support in nationalist parties of the left and right in many European countries.

2. A period of high inflation in Germany, accompanied by wage and price restraint in the eurozone periphery.

3. Large-volume fiscal transfers from North to South, indefinitely: the dreaded 'transfer union'. This would necessarily entail imposition of "significant conditionality" on recipient countries, King said - i.e. it would entail their giving up economic policy sovereignty.

4. Breakup of the eurozone - messy, murky, difficult.

If Lord King's analysis is correct, creating a common currency before creating an effective political and economic union was a major mistake - and so far, the eurozone has not done well at dealing with the consequences of that mistake.