This is a book that should be read by: (a) politicians, central bankers and anybody else involved in macroeconomic policy; (b) all economists; (c) all students of economics; and (d) everybody else.

[amazon_link id=”0691158681″ target=”_blank” ]The Great Rebalancing: Trade, Conflict and the Perilous Road Ahead for the World Economy [/amazon_link]by Michael Pettis is as sharp and clear as a cut diamond in its analysis of the continuing global imbalances. The author brings logic, accounting identities and clarity of thought and language to bear on the issue of prospects for the global economy, putting most other commentators into the shade.

He also provides a small but fundamental shift in perspective: the questions of balance of payments and capital flows are approached in terms of global general equilibrium – in other words, everything is connected. Thus Greece’s problems are not only caused by Greek tax avoidance or low productivity, but by German domestic policy choices too. Pettis writes: “I extend our basic knowledge of open economies and apply it to the global economy as a single closed system in order to show the many surprising ways policies and conditions are related.” Every country affects all others through the capital and current accounts. And the balance of payments balance – a large current account surplus requires large capital exports to a large current account deficit (group of) countries. A large gap between domestic savings and investment, or correspondingly between GDP growth and consumption growth, will result in a current account gap.

The book looks at two broad sets of imbalances, US-China and Germany-Eurozone periphery. “Very large persistent surpluses and deficits are almost always the result of distorted policies in one or more countries.” The distortions he identifies are the investment-driven focus of Chinese policy, at the expense of domestic consumers, brought about by ultra-low interest rates on savings in domestic banks (there being no alternative investment opportunities for most Chinese people). In Germany, rather than this Chinese-style direct financial repression, the distortion has been ever since reunification in 1990 constraining wages and consumption growth in order to favour employment and exports, with production growing faster than consumption.

Pettis is keen to point out that to analyse the Euro crisis in terms of thrifty and productive Germans versus idle, spendthrift Spaniards or Greeks is nonsense. The references to culture and morals in trying to explain what has happened in the global economy are misplaced. Given a persisting German savings surplus, perforce exported, the Euro periphery countries have only four options: 1. use German capital exports to fund investment, paid for by debt; 2. let consumer borrowing rise to spend more; 3. devalue or impose trade restrictions – both ruled out by Euro and EU membership; 4. engineer a recession to cut domestic production. When the debt levels required by opting for (1) and (2) got too high, only (4) remained available, as (3) has seemed unthinkable. But the book goes on to argue that unless the Germans will accept that the burden of adjustment must fall on their domestic policy, default and the break-up of the Euro are inevitable. “It is impossible to expect Spain to repay its debt to Germany unless Germany runs a trade deficit and Spain a trade surplus.” The echoes of the 1930s (when France played the role of Germany today, complacent about its economic strength until the strains reached breaking point) are horribly clear.

Pettis is a little more optimistic about the prospect of a policy adjustment in China. A renminbi revaluation would help ordinary households at the expense of the central bank and the very wealthy. Slower GDP growth and lower exports would actually enable faster consumption growth, and would make for greater social stability. Combined with a slow but effective rebalancing of US policy, this part of the global imbalance could be worked out in a reasonably orderly way.

However, the book ends with some gloomy predictions. Pettis concludes that there has been hardly any adjustment, post-crisis, in the global economy. Unless Germany and China, as well as the US and Euro periphery, adjust their policies, then:

– German growth will slow sharply and its banks will suffer large losses

– much of peripheral Europe will both default and abandon the Euro

– China could adjust still but is running out of time, and unless it writes down bad bank debts and transfers some state and corporate wealth to households it will end up with a ‘lost decade’

– the world economy will be weak for many years

– trade tensions will increase

– but, one way or another, the world economy will rebalance.

“Major imbalances are unsustainable and will always eventually reverse, but there are worse ways and better ways they can do so…..Any policy that does not clearly result in a reversal of the deep debt, trade and capital imbalances of the past decade is a policy that cannot be sustained.”  Unfortunately, he ends, that isn’t what’s happening.

There is one idea buried away here that seems to me to hold out a spark of hope. Given that the persistent surplus countries seem determined not to reverse their anti-consumptionist policies, and to continue running current account surpluses, it is inevitable that something will erode the value of the Euro periphery assets held by German banks – default, devaluation, inflation in the periphery. Alternatively, Germany could grant assets to the struggling countries – something akin to the Marshall Plan, Pettis suggests. Given the deeply-held worldview Germans clearly hold about the superiority of their approach to the economy, maybe the idea of a Marshall Plan to save the Euro is the one idea that could catch on there?

It will be obvious that I think this is an excellent book, albeit very gloomy indeed. Its logic seems irrefutable: the unsustainable is not sustained. The only question is how the global rebalancing will come about, and it doesn’t look a pretty prospect.

I’d not come across Michael Pettis before, but looking him up now find that his previous book, [amazon_link id=”0195143302″ target=”_blank” ]The Volatility Machine[/amazon_link], analysing emerging market financial crises, also attracted rave reviews. He was previously at Bear Stearns and Columbia University and is now a professor at Peking University – he blogs on China’s economy. His work obviously deserves to be widely read and above all, please, in policy circles.

[amazon_image id=”0691158681″ link=”true” target=”_blank” size=”medium” ]The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy[/amazon_image]

It seems a bold mission, to propose a solution to the Euro crisis in 80 pages. All the more so when the authors of The Euro in Danger: Reform and Reset, Jagjit Chadha, Michael Dempster and Derry Pickford, compare the present situation in Euroland with Lord Palmerston’s verdict on another European crisis: “Only three people…have ever really understood the Schleswig-Holstein business – the Prince Consort, who is dead; a German professor, who has gone mad; and I, who have forgotten all about it.”

This short book or long pamphlet also acknowledges that, as in the old joke, if you wanted to get to a sustainable Eurozone currency union, you wouldn’t be starting from here. It has some extraordinary charts, including one recording the movement of Target 2 balances, another showing the movement of unit labour costs – the message of every one of them is a story of dramatic divergence between the core and the periphery since 2009.

Nevertheless, the authors argue that the Euro should be saved, and they have some proposals for doing so. Their suggestion is what they describe as the ‘reset’ option: the peripheral countries should be allowed out temporarily in order to return as members when certain conditions, including those elusive structural reforms in labour markets, had been met.

Meanwhile, the book argues, the monetary union of the core Euro states should be strengthened, with steps towards full banking union and the ECB to act as a classic lender of last resort in future crises, an independent fiscal monitoring body, and a European Sovereign Bankruptcy Court. The authors would also ban certain derivatives transactions including the ‘Tobashi swaps’ used to hide the scale of Greek and Italian sovereign debt (widely sold, the book reports, by Goldman Sachs, Morgan Stanley, JP Morgan Chase, Deutsche Bank, Bank of America, Merrill Lynch, Nomura…..).

As for the ‘reset’ option, this would require temporary departure for the Eurozone and devaluation before joining a crawling peg against the Euro, a haircut on sovereign debt, monitoring of fiscal policy by an independent body, and increased reserve and capital requirements for domestic banks, as well as economic reform.

Reading about such details always makes me feel about as well-informed about the Euro crisis as I am about Schleswig-Holstein. The one thing that’s perfectly clear to me is that the peripheral countries will need to default in some form, as their debt burdens are unsustainable. Others who are more expert than I am will be better placed to evaluate the specific proposals in this book. It does all seem entirely level-headed, but one has to wonder about the political feasibility of sensible reforms.

One of the books I’m currently reading, Dominic Sandbrook’s [amazon_link id=”0141032154″ target=”_blank” ]State of Emergency[/amazon_link], is too big to carry around so on the Tube I’ve read [amazon_link id=”184954400X” target=”_blank” ]Greekonomics: The Euro crisis and why politicians don’t get it[/amazon_link] by Vicky Pryce. It’s an excellent contribution to understanding the Eurozone crisis.

Pryce is Greek by origin and so has the authority to criticise her native country about its genuine faults – clientilism is one of the major issues she highlights. However, she rejects two arguments sometimes heard: that the Greeks are to blame for the crisis because they’re lazy and expected to consume without producing; and that the Euro crisis is all the fault of the peripheral indebted nations – Portugal, Ireland and Spain as well. She writes: “While the political, administrative and judicial systems in Greece are dysfunctional, there is potential in sectors of the economy which could be harnessed to drive a more prosperous future.”

In fact, politics is the major theme of the book: it argues that the Euro’s creation was a political project not rooted in sound economic analysis. The initial hubris involved in launching the single currency was followed by a failure to either plan for the inevitable tensions or crises, and total failure to enforce and implement the structural reforms that might have made the Eurozone economically viable. She makes a forceful case. Before the Euro was launched, while seeing it as mainly a political project, I thought the macroeconomic inflexibility it involved would be more than offset by supply-side improvements, including the achievement of a genuine single market without currency barriers. This optimism was obviously misplaced. Indeed, we are still seeing in the crisis countries how hard it is politically to deliver structural economic reforms.

What to do next? Pryce argues, first, that European leaders need to recognise that if Greece leaves, the Euro itself will collapse, at huge economic cost. And, secondly, that a large chunk of the peripheral country debts will have to be written off. Germany cannot avoid either accepting partial default or the collapse of the Euro. However, she is optimistic about the scope for continuing progress on productivity in Greece.

No doubt some readers will disagree with parts (or all) of her analysis, but the book sets out the debate very readably, and underlines the links between the political and the economic forces at play –  links everybody overlooked in those long-ago pre-crisis years.

[amazon_image id=”184954400X” link=”true” target=”_blank” size=”medium” ]Greekonomics: The Euro crisis and why politicians don’t get it[/amazon_image]