The Euro Crisis and Wealth Transfer

THE rhetoric around the euro crisis is apocalyptic, comprising discussions about the currency’s survival, a new financial crisis, and a default by other sovereign governments.

It also presents a stern morality tale, since the Greek crisis is ultimately about living beyond one’s means.  Since its adoption of the euro, Greece has had an artificially high exchange rate, encouraging excessive spending.  Greece was not alone.  Spain and Ireland did the same, as did states with separate currencies, such as the UK and US, and this profligacy in turn may have led to the humbling reality of the financial crisis.   

This episode in the financial crisis soap opera seems peculiarly European, and yet it casts light on the role of Asia in the world economy.  In this context, the application of a piece of economic theory – that of factor price equalisation – is illustrative.  Factor price equalisation is a trade theory which suggests that given free trade the prices of core factors such land, capital and labour in different trading states will come to equalise.  If the theory is correct and given that many millions of Chinese and other workers have entered the global labour market, movement towards the equalisation of factor prices should have taken place in the world economy in the last two decades.  

So what actually happened?  First, the massive glut of cheap manufactures in Asia resulted in a real increase in wealth in that region; strong trade figures resulted in capital transfers from rich countries to Asia, often returned as purchases of sovereign debt.  Second, data from economies such as the US suggests that real incomes stagnated in the last decade, hinting at a relative decline in living standards in line with factor price equalisation; certainly manufacturing in the US and elsewhere has struggled to compete with China with jobs losses resulting.  Third, in this context consumers, companies and governments throughout Europe and the US turned to easy credit (subsidised in effect by the recycling of Asia’s surpluses) to pay for perceived needs, such as wars in Iraq, pensions at 50 and healthcare from cradle to grave.  This easy credit disguised the day to day consequences of a transfer of wealth to Asian states and of a relative decline in the price of labour in the purchasing countries.   Finally, the collapse of Lehman Brothers and subsequent financial crisis pulled back the curtain on reality.   

Even those countries with strong current and trade accounts, such as Germany, are no exception to this trend.  In the last decade, Germany’s export strength (particularly in machine goods) has relied on two key premises.  First, Germany has benefitted from its euro membership, since the value of the euro has probably been lower than the deutsche mark would have been; dragged down, as ever, by the likes of Greece.  Second, in 2005 former German Chancellor Gerhard Schroder introduced some employment measures which in effect pushed down German wages. For instance, he created a system whereby workers might sacrifice days at work on an individual basis so that companies did not have to cut jobs.  As such, Germany held down its exchange rate, nominally in terms of the euro and really in terms of wages, thereby responding to the challenge posed by trade in Asian goods.  This could be taken as a movement towards factor price equalisation.  

In the well-balanced world of economic theory, the counterpart of this contention is visible in the much trumpeted rise of China’s yuan and the wage inflation which troubles factory managers in Guangdong province.  That is not to say that these trends of rapid growth and transfer of wealth will necessarily continue.  China, for one, faces severe challenges, in the form of excessive municipal government debt, massive misallocation of capital, a flawed banking system and a tricky prospective transition to increased domestic consumption.  Yet unless it reverts to isolationism or collapses, both unlikely, the pressures inherent in the price of Chinese labour will continue to ripple throughout the world economy.  

The financial crisis, then, is not simply a matter of bank regulation.  It is a symptom of broader changes at work in the world economy.  The European countries and the US must innovate and cut costs in order to maintain competitive advantage.  In its acceptance of this brutal reality, Germany has taken the lead.  Greece, by contrast, is learning the hard way.