Europe must wake up to China's role in debt crisis
Over recent weeks, as Europe's power brokers have forced Greek politicians to enact new austerity measures against bitter popular opposition, there has been a great deal of misguided talk about how China could bail out the euro zone's debt-stricken economies.
Forget about China riding to Europe's rescue. What no one seems to have considered - not the handful of senior officials who now make up the euro zone's political elite, not the 199 members of the Greek parliament who voted in the new austerity bill, not the tens of thousands who protested against it in the streets of Athens, and certainly not the 300 million or so ordinary citizens who inhabit the euro zone's other member states - is how China's economic rise contributed to the continent's debt crisis in the first place.
China has been blamed before for causing America's subprime debt crisis. The idea there was that China's lack of a social safety net, coupled with Beijing's low interest rate and currency policies, pushed household and corporate savings in China well above the rate needed to fund domestic investment.
This savings glut unleashed a flood of liquidity on to global financial markets, which depressed long-term interest rates in the US, igniting the housing boom and prompted investors to take ever greater risks in their search for yield.
The result was a classic credit-fuelled investment bubble, which eventually burst, triggering the crisis.
This notion that Chinese government policies could have caused the US crisis gets short shrift from many prominent economists. For example, in a paper published last month, World Bank chief economist Justin Lin Yifu placed the blame firmly on the interest rate cuts that the US Federal Reserve made following the dotcom bust, coupled with an excessive demand for credit from American consumers.
Lin may be China's best-known economist, but there is a basic flaw in his reasoning here. If the credit boom's main cause was excessive demand, then the price of credit - as represented by long-term interest rates - would have risen, despite the Fed's short-term rate cuts.
In fact, between 2001 and 2005 the spread between long-term and short-term US interest rates collapsed. In 2006 the US yield curve even inverted as long-term rates remained stubbornly low, even though the Fed steadily raised short-term rates in an effort to contain demand.
This decline in the price of credit demonstrates that the driving force behind the US boom and bust was not excessive credit demand, but rather excessive supply - from China's savings glut.
A similar pattern shows up in Europe. In the 1980s the social democratic governments which replaced the earlier military dictatorships in Greece, Spain and Portugal established generous welfare states, largely to undermine support for local communist parties.
With changing demographics, those welfare provisions became more expensive to finance. However, following the euro's introduction, the flood of liquidity into euro assets prompted by China's savings glut helped to depress long-term interest rates in Europe just as it did in the US.
By 2005 the yield on five-year Greek government bonds had collapsed to just 2.6 per cent, a scant 0.5 of a percentage point above benchmark short-term interest rates.
That decline allowed Greece and other European governments to ramp up their borrowing to fund unsustainable social welfare programmes, just as China's emergence as an exporting juggernaut rendered many of Europe's domestic industries deeply uncompetitive.
In short, European governments and their voters failed to recognise what Indian essayist Pankaj Mishra describes as 'the extent to which welfare state liberalism depended on ... the continuing economic somnolence of the 'East'.'
Today Europe needs urgently to wake up to the fact that China and other East Asian economies are no longer asleep. In a world in which Europe's economic competitors provide minimal social safety nets for their populations, many European countries can no longer afford their own lavish state welfare provisions, especially if they are funded by debt.
This is a deeply unpopular message. But if Europe's southern periphery is ever to escape the debt trap it has fallen into, it cannot look to China for assistance.
Instead, it must recognise that China's economic emergence is one of the main reasons the region is in its current hole, and act quickly to restore its lost competitiveness.