America and Europe live on tick

In: Uncategorized

3 Oct 2011

This is my regular weekly Perspective column for Fund Strategy magazine.

It is often forgotten that there are common elements to the euro­zone crisis and the economic plight of America. One of the most striking is the role of what could be called “vendor finance”.

The term is more widely used in relation to consumer credit. Perhaps the best-known example is in car purchase. Someone wants to buy a car manufactured by, say, Acme Motors but cannot afford it. Step forward Acme Credit, which will helpfully provide a loan to allow the consumer to buy the latest Acme vehicle. Such arrangements have become so common they are taken for granted. But to earlier generations it would have appeared peculiar and perhaps even immoral for the same company to produce a product and give the consumer the cash to buy it.

In relation to America, the vendor financing relationship is perhaps clearer than in the eurozone. It is well known that many developing nations, most notably China, are essentially subsidising consumption in America. Foreign buyers are in effect providing cheap credit to America with their purchases of treasury bonds.

The trend is clear to see in what are known as the Tic statistics – the Treasury International Capital data collected monthly by the Treasury department and the Federal Reserve. According to the data for July the biggest foreign holder of treasuries, with about $1.2 trillion (£776 billion) out of a total of $4.5 trillion, is mainland China (see chart). If Hong Kong is included, the Chinese total goes up to about $1.3.

The general pattern is for relatively poor countries, including China and Brazil, to be subsidising the richest country in the world. Despite all the talk of China’s rapid economic growth, the average American is still more than 10 times as rich as the average Chinese. GDP per head in America was $46,860 last year. At current prices, it was $4,382 for China, according to the latest figures from the International Monetary Fund. Even leaving aside any moral qualms, this is a strange state of affairs.

In the eurozone there is also a vendor financing relationship, but the direction of financial flows is reversed. Germany, the core country of the eurozone, is subsidising the weaker economies in the bloc. Not only Greece and Portugal but also Italy and Spain have benefited from Germany’s largesse.

Until recently, Germany was in effect underwriting consumption in the European periphery, and in the process making it easier for southern Europeans to buy German products. More recently it has played a central role in bail-out packages for troubled eurozone members.

Although the principle was the same as the trans-Pacific relationship, the mechanism was different. Rather than ­Germany buying foreign government bonds, the eurozone structure itself facilitated vendor financing. Germany’s position as the anchor of the bloc gave many other member states access to credit at lower rates than otherwise. As a result, the eurozone periphery enjoyed a consumer boom, even while the German government insisted on austerity at home.

Despite the turmoil of the past three years, the vendor financing relationships have, with modifications, remained intact. Cheap Chinese credit helped to fuel the American sub-prime mortgage boom, yet the economy survived the collapse of Lehmans and other Wall Street institutions.

The eurozone is also still being underpinned by German credit, although in a modified form. The Bundesbank has started to buy large amounts of bonds issued by other eurozone members to help them avert collapse.

There are at least two ways this peculiar state of affairs can be understood. Some will no doubt read the prevalence of vendor finan­cing in the world economy as a moral failing. If only everyone had upheld the so-called Protestant ethic, working hard and avoiding debt, the world economy would not be in such a mess.

A more convincing view is to see such imbalances as symptomatic of fundamental structural shifts in the global economy – most strikingly, a dramatic relative decline of America compared with China. Although America is still the world’s largest economy by far, China is catching up fast. America could, of course, restructure its economy in an attempt to make itself more competitive. But it has preferred to avoid difficult challenges and live off Chinese credit instead.

Germany has practised a different form of evasion. It has preached austerity at home while promoting consumption overseas. Although its economy has real strengths, notably manufacturing exports, the headline figures can flatter its overall performance. Germany’s trade surplus is at least in part the result of it curbing consumption at home. It would be far better if it could restructure the more domestically orientated side of its economy to make it more vibrant.

The key to tackling the turmoil in the world economy lies in the politics of the developed nations. Although there are important structural differences between the main advanced economies, all the nations involved have a key feature in common. In every case the political class has preferred to evade difficult decisions about economic restructuring by extending credit. By doing so they have succeeded in postponing hard choices, only for these to reappear in a more virulent form later on.

Western leaders are discovering what many other borrowers have experienced. If they do not create the means to repay their debts, then payback will be even more painful.