Refusing to learn from past mistakes and not addressing the root causes that brought about today’s global financial crisis repeats the cycle of economic growth, inflation, deflation, recession, depression, and return to growth with more frequency than desired and necessary.
“Can a team [any economic team involved in resolving the financial crisis] that is positively steeped in history—particularly the history of the 1930s— avoid the mistakes of that era and engineer a quick recovery from a Depression-size shock?” ask the experts of the Squam Lake Working Group on Financial Regulation, a nonpartisan task force aligned with the Center for Geoeconomic Studies at the Council on Foreign Relations in a series of working papers.
Answers to the global financial crisis have been stimulus packages and financial bailouts, but the experts say that those rarely address the real root of the economic dilemma.
Trade Imbalance Equation
Imbalance between exports and imports is one of the major causes, which must be addressed to prevent future financial crises similar to the one the world is experiencing at present, the experts argue.
The United States is one of the main players in the imbalance and savings modus operandi. In March 2009, the U.S. trade deficit amounted to $27.6 billion, according to the latest U.S. Census Bureau’s international trade imbalance information.
The March imbalances were caused mostly by the combination of $15.6 billion with China, $4.4 billion with the European Union, $3.9 billion with Mexico, $2.6 billion with Japan, and $ 2.4 billion with OPEC countries. There were some surpluses, with Australia at $1.1 billion, Hong Kong at $1.5 billion, and a few other countries, which stopped the trade imbalance from reaching record levels.
Global trade imbalances, if they are allowed to continue at the present rate, will “imperil future economic growth,” argue the researchers at the Council on Foreign Relations. “The ultimate responsibility for tackling imbalances rests with national governments.”
Exchange Rate Manipulation
Exchange rate manipulation is a major cause in the trade imbalance equation. China, out of most of the world’s economies, is notorious for manipulating the value of its currency to improve trade scenarios.
Guidelines and rules prevent most countries from entering the protectionism game, but no such civility exists when it comes to exchange rates.
“Countries can keep their money cheap to boost exports, even if they risk exporting trouble at the same time. Indeed, this is a fair description of China’s behavior over much of this decade,” when it comes to exchange rate manipulation, according to the Squam Lake Working Paper series.
The researchers argue that should the United States, Germany, and Japan follow suit and manipulate exchange rates to boost exports, the world is in for a rude awakening.
Most countries appear to remember the historical lesson about exchange rate manipulation in the 1930s by New Zealand and Denmark, when the two countries repeatedly devaluated their currencies downward to increase the exportation of their butter, which was quite damaging to both countries.
Other examples in the early 1980s include Mexico, Argentina, and Chile. Their exchange rates were held at arbitrarily low levels for no other reason than to gain an unfair competitive advantage over trading partners.
For China, exchange rate manipulation has been a great advantage in accumulating trade surpluses, especially with the United States.
In China, “current policies have been successful in delivering rapid growth and development, so China’s government is reluctant to make anything more than gradual changes” in their exchange rate policy, exacerbating the trade imbalance problem for the West, according to the working papers by the Squam Lake Working Group on Financial Regulation.
Countries look outward, not inward, and see export growth as the greatest hope toward economic recovery. Therefore, as long as export growth models are dangling before exporting countries’ eyes, none will even try to search for a better and more desirable model.
“The trouble is that other major economies harbor the same hope. Angela Merkel, the German chancellor, has stated categorically that Germany likes its export-led growth model and has no plans to change. Japan, to its credit, has passed a hefty stimulus, allowing government spending to replace exports, but it cannot sustain this policy because its national debt is astronomical,” Sebastian Mallaby, director at the Council on Foreign Relations, wrote in his Op-Ed “Repeating a 1930s Mistake?”
Rapid Buildup of Debt
The difference between savings and investments, represented by an increase in debt, precipitated in part today’s financial crisis.
To lower taxable income, it is in the best interest of a U.S. firm to pile on as much debt as possible. The U.S. government penalizes Corporate America for investments financed through equity with a 42 percent effective tax rate on taxable income, while debt-based investments can be used to lower one’s effective tax rate significantly.
The U.S. government is a prime example for financing shortfalls in taxable income by amassing a national debt, which reached $11.3 trillion by the end of May 2009, according to the U.S. National Debt Clock. The national debt includes all obligations held by the U.S. states, foreign governments, and all industries and individuals.
So far, foreign governments have been willing to finance America’s budget shortfalls. The reason is that the U.S. is ahead of the game compared to other countries in the ability to pay back loans given the breadth and liquidity of its government securities markets.
“However, ultimately there is a limit to the willingness of other countries to hold U.S. assets,” the Squam Lake Working Group report concludes.
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