German Chancellor Angela Merkel studied physics, not philosophy, but German university studies usually include some study of logic. Yet she apparently fails to recognize the logical fallacy in the economic strategy she advocates, not only for the country she heads, but for Europe as a whole.
Unfortunately, neither Europe nor the world can export itself out of recession and government austerity is not likely to spur consumption or investment in time to prevent further economic downturn.
Germany is the second-largest exporting nation in the world, shipping nearly 90 percent of what China does even though the German population is only 1/16th the size. That means Germany’s net exports are high, and it runs a large surplus in its “current account.” That is, all of its short-term financial inflows from other nations, including their payments for German exports, are far larger than Germany’s short-term financial outflows. This means it must run a deficit in its capital account, which tabulates all international movements of investment principal. German capital is lent or invested in other countries.
In practical terms, that means Germany exports goods and services to Greece, Spain, Portugal and myriad other countries. It receives money from these countries that flows back when German banks make loans to businesses in those countries or to their governments.
This is exactly the same as our country importing a great deal from China and our import payments to China flowing back here to buy U.S. Treasury bonds.
Merkel perpetuates the mercantilist fallacy debunked by Adam Smith 236 years ago that an export surplus always represents good morals as well as good policy. She portrays Germany as particularly virtuous in the ongoing global financial debacle and argues everyone else should follow its example. This is logically and operationally impossible.
Any country’s production of goods and services falls into four categories: consumption, investment, government and net exports.
Consumption goods — food, clothing, shelter, etc. — meet the needs and wants of the country’s populace. Investment in this case does not mean stocks and bonds but rather new factories, machines and infrastructure. Government is all government spending on goods and services, but not income transfers like Social Security, student financial aid or farm subsidies. Net exports are the value of exports minus imports. (In the United States net exports have been negative for years, as they were for much of the 1800s.)
All of these must sum up to Gross Domestic Product, the total dollar value of all final goods and services a country produces. (“Final” excludes double counting; we count the price paid for a hamburger but we don’t also count the cost of the bun, the flour that went into the bun, the wheat into the flour or the fertilizer used to grow the wheat.)
If one category falls without another one increasing, the total output of the economy falls. And while it would take another column to explain this fully, when output falls, so does the total income received by the population.
Thus if investment in new plants and equipment or consumption fall, as they both have in the United States, Germany and many other nations over the past three years, either government spending or net exports must rise. If they do not, GDP and hence incomes must fall.
Merkel and some other European leaders at the recent G-20 meeting in Toronto think that government spending must fall and taxes rise. If they are right, and consumption, investment or net exports rise in response, GDP can hold its own or rise. Incomes can rise. Prosperity can return.
The problem is that the historical record of either consumption or investment rising during recessions in response to government spending cuts or tax increases is not just thin, it is nonexistent. And history is full of examples where such austerity measures further depressed both consumption and investment. (One does not have to be a die-hard Keynesian, and I certainly am not one, to read history this way. Experience is pretty clear.)
Merkel and some other Europeans argue that this time it is different. Smaller government budget deficits will so revitalize public confidence that both consumption and investment will rise as a result. Perhaps, but I am skeptical, as are most economists.
If the government part of total output falls and consumption and investment do not increase, then net exports must rise. Merkel sees this as both possible and virtuous for all.
The problem is that the world as a whole is subject to another simple limit. Net exports have to sum to zero. What one country exports, another must import. This is root of Merkel’s “fallacy of composition,” a mistaken belief that what may be true for one nation, especially in the short and medium term, is necessarily true for all. It is impossible for all countries to simultaneously increase their net exports. (In the case of current-account-deficit countries like Greece and the United States, it means decreasing the size of those deficits.)
One unspoken fantasy for European fiscal hawks is that the United States will act as the “consumer of last resort” for the whole world, increasing our imports so that they can reduce government spending without reducing their nations’ output and incomes. It has done so during past shallower and briefer downturns. But it cannot do so for the entire world on an extended basis. The outlook for the global economy already was somber and odds are that this policy tack will make things even worse.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.