The Wild Wild West

When the German Finance Minister, Wolfgang Schäuble, labelled American economic policy as ‘clueless’ on November 5th, some very sad people got very excited, myself included. It’s not often in the world of economics that we get a fist-fight. That means when the gloves do come off we need to cash in. Ever the opportunist I intend to do just that.

The outburst from Mr Schäuble came after an eventful week in America. The Midterm elections on Tuesday 2nd saw the Democrats lose control of the House of Representatives and Barack Obama forfeit some of his power to pass legislation. Ben Bernanke, clearly missing the spotlight, decided to announce on Wednesday that the Federal Reserve would increase quantitative easing in America by an extra $600 billion. Top that Mr President.

It was this final development that prompted the complaints from Germany. The concerns of the German Finance Minister were echoed by the head of the Chinese central bank, Zhou Xiaochuan. The Chinese employed a little more tact than Germany, stating that America had acted selfishly. Nevertheless, in world politics that represents strong language. Particularly when we consider the tensions already present between American and China. Why have both nations decided to attack this move so stridently?

There are two possible reasons. First, Germany and China argue that the vast injection of money into the American economy will spill over into the world economy and cause a rapid rise in inflation. This is undoubtedly a possibility when the Federal Reserve decides to create an extra $600 billion of the world’s reserve currency. Theoretically, more money chasing the same number of goods (the economy’s productive capacity remains the same after the Federal Reserve’s announcement) requires that prices rise to return markets to equilibrium. While this theory tends not to hold for small injections of money by central banks, $600 billion ought to do the trick.

The second justification for the German and Chinese qualms pertains to currency effects. Mr Schäuble and Xiaochuan are concerned, rightly, that a large expansion in the supply of dollars will reduce the price of the dollar relative to other currencies. This depreciation in the dollar will make American goods more competitive in foreign markets and make imports much more expensive in America. This represents a loss of business for both China and Germany.
The fact that China and Germany have screamed the loudest is no coincidence. They represent two of the largest ‘surplus economies’ in the world. Both have generated growth through exports and a strong trade surplus with other countries. The fear for China and Germany is that the move in America will make them less competitive in their strongest export market. As exports drive their economies, this cannot be good news.

Consequently, it would seem there is really one reason why Germany and China object. That they are concerned about inflation creeping up in the world seems unlikely. Given China has an inflation rate close to double digits already, it is hardly cynical to question their concern for inflation. So it seems China were nearer the mark when they claimed the move was selfish, than when Mr Schäuble declared it was clueless.

However, this move is anything but selfish. A healthy American economy is vital to the world recovery. The American consumer has provided the market for world producers in recent history. With American growth stubbornly low and a newly divided government, the Federal Reserve’s move may be exactly what America and the world needs to inject some economic growth.

Additionally, while western excess in borrowing led to the ‘Great Recession’ of 2007, so did the saving of Germany, China and the other surplus nations. Trade between countries is measured by the ‘Balance of Payments’. While individual countries can run surpluses on their balance, the world as a whole cannot. As the name suggests, the balance of payments, must balance. If the move by the Federal Reserve does reduce the gross trade surpluses held by China and Germany, then the world economy will begin the essential rebalancing to avoid a repeat of this financial meltdown. In the meantime, let’s enjoy the fight.