THE EUROZONE´S STARK LESSONS FOR THE G20 / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

The eurozone’s stark lessons for the G20

By Alan Greenspan

Published: November 10 2010 23:00

As the Group of 20 meets to seek common ground on protecionism, this year’s euro  crisis will hover over their deliberations. The crisis that erupted in Greece has again exposed the fragility of a key element of currency-pooling arrangements: the important value created by a pooling of interests tends to be distributed disproportionately in favour of the financially less collegial members of the pool. Thus, unless restrained, too often, some members will try to exploit their advantage, as Greece brazenly did in recent years.


The restraint imposed on the euro area by the stability and growth pact was supposed to limit euro-denominated sovereign borrowings.

Fortunately, threats to European monetary union, so far, have been successfully fended off by the herculean actions of the European community assisted by the International Monetary Fund. Currency problems have now spread to the global financial system which, like the euro area, requires adherence to certain rules to sustain it. It is not only the well publicised friction between China and America – both may be right about each other – but also by the drive for competitive export advantage through currency manipulation in a world where a zero global current account balance permits none.


China has become a major global economic force in recent years. But it has not yet chosen to take on the shared global obligations that its economic status requires. Chinese policymakers still believe, incorrectly in my view, that if they cannot keep their currency suppressed and exports booming, their country faces economic contraction and dreaded political instability. But China also realises it needs the global market to prosper, and should widespread protectionism take hold, its prosperity would likely be one of its large casualties. China seems to be seeking a balance in which the renminbi appreciates against the dollar, but only modestly.


America is also pursuing a policy of currency weakening. The suppression of the renminbi and the recent weakening of the dollar are, of necessity, producing firming exchange rates in the rest of the world to, as they see it, the rest of the world’s competitive disadvantage. Something has to give in this arena of zero-consolidated current account balances.


One of the least heralded events of the past two years has been the recovery and vigour of global trade. The ratio of global exports to gross domestic product that fell sharply during the crisis had fully recovered by the second quarter of this year. Preliminary estimates for the third quarter, however, suggest a modest slowing.


For a half century or more, global trade has risen faster than GDP. That is one reason the Chinese development model, based on rapidly increasing global export markets, and earlier, the paradigm of the Asian tigers, have been so successful. But even without protectionism, there are clear upside limits to the growth rate of global trade. Protectionism would accelerate that slowing.


As G20 members gather, they appreciate that despite heated political rhetoric, protectionism has failed to emerge in full force. This may have been one of this year’s most pleasant surprises. The G20, in April 2009, in perhaps its most productive meeting, emphasised support for unfettered global trade. The need to convert those uplifting words to immediate action will dominate this week.


The global trading system can tolerate a modest amount of protection and still, in conjunction with the financial system, tend to direct much of the world’s savings to the most potentially productive investments. Typically, that elevates global productivity growth and living standards. But the flaws in the global trading system are large and worrisome.


We should not wish to inhibit those market-determined capital flows that reflect the cross-border shifting of resources that enhances global productivity. These flows are the big determinants of desirable realignments of exchange rates over time. But we should discourage reserve accumulation whose sole purpose is to suppress exchange rates for competitive export advantage. This, of course, has been the market-distorting consequences of China’s accumulation of over $2,000bn of reserves since 2000.


What the G20 can initiate through the IMF is a set of rules that limits the accumulation of reserve assets and sterilisation of capital inflows. China may need an officially sanctioned extended adjustment period, and provisions may be required to deal with unsterilised capital inflows threatening smaller markets. But that would be far easier to monitor and control than a stability and growth pact that requires control of central government revenues and spending.


Delimiting a country’s ability to suppress its exchange rate (reserve accumulation limits) or to blunt the effect of unwanted capital inflows (sterilisation) may not fully dissuade a country bent on other protectionist forms. But if the G20 is serious in pledging to sustain open multilateral trade and the international financial system that fosters it, it should be willing to forgo an element of sovereignty to achieve net gains for all.


The writer is former chairman of the US Federal Reserve


Copyright The Financial Times Limited 2010