There has been a lot of talk about global imbalances, with most opinions varying from somewhat important (us) to very important (many global policymakers). Here’s Jean-Claude Trichet, for example, president of the European Central Bank, as reported by Reuters:

“The G20 has to address the issues of the domestic large imbalances between savings and investments, and of the set of unsustainable external imbalances.

“We know that these imbalances have been at the roots of the present difficulties. If we don’t correct them, we’ll have the recipe for the next major crisis. And this of course would be totally unacceptable.”

People agree what the biggest imbalance is: it’s over-consumption in the United States and over-saving in China, thanks to an artificially low renminbi/yuan, which creates an artificially high dollar.

Yet in the same statement, “Trichet said U.S. policy makers’ commitment to a strong dollar was important in keeping currency markets and the global economy stable, repeating a long-held position.” Separately, French finance minister Christine Lagarde said, “Everyone needs a strong dollar.” Tim Geithner, like every senior government official for decades, has been repeating that we have a “strong dollar policy,” whatever that means.

But if no one wants the dollar to depreciate — which is the standard solution to a trade imbalance — what does it mean to be against global imbalances? No one will come out in favor of tariffs. Using fiscal policy to encourage domestic sourcing of goods and services did not go over well with the Europeans. I guess that leaves exhorting Americans to buy less and save more, which is a little like asking Goldman to pay smaller bonuses.

So the EU complains about our huge trade deficits and overconsumption, yet at the same time (along with China) seems to desperately want us to continue to play that role. This is a convenient position, since it allows them to blame us  for the financial crisis, while continuing to export to us. (Germany, the largest economy in Europe, is surprisingly export-dependent, compared to the U.S. and the U.K.) Unfortunately, it’s also logically inconsistent.

By James Kwak (with a major assist)

Not so much.

On this side of the Atlantic, the Obama administration and the Fed have been working night and day in an attempt to turn around the economy: Fed funds rate reduced to zero, $800 billion stimulus package, new plan to aid struggling homeowners, new plan for buying toxic assets, new budget, decision by the Fed to buy long-term Treasury bonds, new domestic regulatory framework outlined this week, etc. We’ve been plenty critical of various aspects of the U.S. response, but at least they’re trying.

(Continental) Europe, by contrast, has decided they’ve done enough and it’s time to sit back and watch.

First, in an interview for Monday’s Wall Street Journal (no-subscription-required summary here), Jean-Claude Trichet, head of the European Central Bank, said that no new measures are needed to combat the global economic crisis. Then Mirek Topolanek, the prime minister of the Czech Republic and the president (in this rotation) of the European Union called the U.S. emphasis on fiscal stimulus “the way to hell.” And all of this is coming in the week leading up to the next G20 summit. What happened to diplomacy?

While it is relatively easy to write off a prime minister whose government collapsed on Tuesday night, there is a very real divide between the United States and, in particular, Germany, the heavyweight in the European economy. And it’s very clear that the Germans (and the French) do not want to spend more money, increase their budget deficits, or do anything except talk about international financial regulation.

I think there are three possible reasons for this attitude.

1. The Germans believe that the economy will recover on its own from this point. Given that not even the optimists in the Treasury Department believe this, I don’t see how this could be the case.
2. They are so afraid of any risk of inflation that they would rather suffer through an extended recession and high unemployment. This could be possible, although misguided, especially since Germany is already in worse shape than the U.S., with its economy expected to shrink by 3.8% this year (vs. 2.5% for the U.S.).
3. They realize that their economy is driven by exports, and therefore they are planning to free ride off of the U.S. stimulus package. In this scenario, Germany gets to contain its national debt and minimize the risk of inflation, while letting other countries turn the global economy around.

Now, we’re not blameless here, what with our “Buy American” provision in the fiscal stimulus. But at least our government isn’t closing its eyes and assuming the problem will go away.

The latest credit default swap data for European banks bring Rudi’s perspective to mind – for the United States.  We’ve debated this week what to do about U.S. banks, arguing about which unappealing options are less bad.  In my view, the choice is not “nationalize vs. don’t nationalize,” but rather “keep our current partial nationalization/bottomless pit subsidy system vs. start down the road to reprivatization.”

But, honestly, this entire debate may be overtaken by events. 

Economic developments in East-Central Europe are very bad.  Almost everyone will get IMF loans but, be that as it may, there is a big contraction underway.  Nonperforming loans will increase for the West European banks lending to East-Central Europe or lending to firms that are (or were) exporting.  Prominent European governments will struggle to afford the implied bailouts – remember, back in October these governments made it quite clear they are on the hook if their banks come under pressure.  At the same time, of course, we have a nose dive in property in Ireland, Spain, and the UK.

My point is not that Europe is in big trouble, with no plausible regional rescue mechanisms in place.  This is completely obvious – the debate among prominent Europeans is now whether or not to send distressed eurozone members to the IMF, and on what basis.

Focus on this instead: the European banking and fiscal fiasco is a dagger pointed at the heart of major US banks, which have a great deal of exposure – one way or another – to much of Europe.  Ask any U.S.-based ”global bank”.

Treasury is constructing an elaborate transfer mechanism through which big banks can be kept in business, thanks to the public purse, without the taxpayer acquiring a majority of the common stock.  The contortions required are striking.  But this entire approach is predicated on a rosy stress scenario, which assumes the global economy cannot get much worse, at least in the short run.

It may soon be time to wake up.

• Disproportionately large banking sectors (the Iceland problem) in some countries, such as the U.K.
• High exposure to U.S.-originated toxic assets (up to 50% of those assets, I have heard estimated).
• Major exposure to emerging markets, primarily Eastern Europe and secondarily Latin America, which have been harder hit by this crisis than anyone else.
• Higher pre-crisis national debt levels (for many but not all countries).
• For countries that use the euro, no control over monetary policy.

On top of these structural problems, there is denial:

The IMF says European and British banks have 75pc as much exposure to US toxic debt as American banks themselves, yet they have been much slower to take their punishment. Write-downs have been $738bn in the US: just $294bn in Europe.

Finally, whatever you want to say about the inevitability of the decline of American hegemony, the U.S. dollar and U.S. Treasury bonds still play a unique role in the global economy, which probably allows us to take on more debt than other countries without crippling our economy through currency depreciation and high interest rates. Or, as Yves Smith puts it, “The nice thing about having the reserve currency is the US isn’t worried about that sort of thing…..yet.”

Update: Arnold Kling linked here, and added this great comment:

It’s been years since I read Steve Roach describe the United States as the “tallest pygmy” in world currency markets, and it’s a metaphor that just seems to always apply.

While we can surely agree that regulatory failings (and more) in the US are at the epicenter of the crisis, we are facing a global problem precisely because other countries’ banks are involved either directly (because they bought a lot of claims on assets that went bad; see your domestic regulators for details on how that happened) or indirectly (because they finance trade with the US/Europe, and this is now slowly markedly).  And we should no longer think of this as a supply side problem in the credit market; increasingly, consumers and firms around the world want to spend (and borrow) less. 

And here’s the point about Europe – perhaps the reason there is so much anger and even some denial.  European governments have a lot of debt – in the case of some weaker eurozone countries, this stands at over 90% of GDP.  Fiscal policy did not prepare for a financial sector problem of the current magnitude and the way in which bank recapitalization was handled recently has only exacerbated the underlying solvency issues.  As a result, there is very little room for a meaningful fiscal stimulus; if governments attempt even more, there will be issues of confidence.  Quite probably there will be pressure for austerity even at current debt levels.

The Europeans really need to get organized to provide more support to weaker EU countries and the weakest eurozone members.  Try to deliver this message at every opportunity.  If you get shouted down, keep at it.

According to an FT chart (sorry, can’t find the link), Greece also has to raise 20.3% of its GDP in debt next year (the equivalent figure for the U.S. is 10.3%), so the spread should only get bigger.

The Eurozone is based on the idea that a single monetary policy can serve the interests of all of the member countries. The problem is that when macroeconomic conditions vary widely between countries, they will have different interests. In a severe crisis, some countries may be tempted to (a) engage in quantitative easing (of the sort the Fed is beginning to do) or (b) implement a large fiscal stimulus (of the sort that Pelosi, Reid, and Obama are about to do). (a) is impossible for a Eurozone member, and (b) is constrained by limits on deficit spending, although I believe those limits are honored more in the breach than in practice.

In any case, the potential problems are getting big enough that Martin Feldstein has weighed in as well. Hopefully this will draw more attention to the issue. It may still be a low probability, but the economic and political consequences of undoing the greatest step toward European integration in, oh, the last thousand years would be huge.

By contrast, the UK and Italy recently had unexpected trouble selling 3- and 4-year bonds, respectively, having to offer 10 basis points over similar existing debt. Mind you, this isn’t Iceland and Hungary we’re talking about here, but two members of the G7. Basically, investors are getting worried that deep recession (which crimps tax revenues) and large bailout packages, piled on top of existing debt, are creating the risk that at some point governments will either default on their debt or, in the case of the UK (which still controls its currency), inflate it away. The same concern can be seen in credit default swap spreads (remember Friday’s post?). Italy’s have climbed from single digits for most of 2007 and 40 bp in the summer to 141 bp.

In the US, the low Fed funds rate (currently 1.0%) limits the potential benefit of further rate cuts. Europe still has a ways to go; so far, with the UK and the Eurozone set to contract in 2009, there’s no evidence that they couldn’t go further.

Update: What he said. (He, in this case, being James Surowiecki of The New Yorker.)

There are steps that policy makers can take now to reduce the threats of national defaults and of a fragmentation of the Eurozone. We discuss the situation and our policy proposals in a new op-ed in The Guardian.

Update: Martin Wolf’s latest column for Wednesday’s paper, just out (Tuesday evening in the US), takes similar positions.  In the column, Martin discusses how the deepening crisis over the last week has led him to change his position.  Many in European leadership positions follow Martin’s views closely, so hopefully his forceful arguments will have an immediate effect.