In the 1890s British economist John Hobson explained how excess savings could lead to economic instability. He argued that rising income inequality in England and the U.S. had forced a decline in consumption relative to production in those countries. Rich people, after all, save a much greater part of their income than poor people, and so consumption had dropped relative to production.
But this left the rich with a problem. If consumption is growing too slowly, there is no point in investing the higher savings in factories at home. In that case, Hobson pointed out, excess savings must be invested abroad.
This solves two problems. It creates profitable foreign investments for the excess savings, and it keeps local factories running as they sell their products to foreigners. Countries that export savings automatically must run trade surpluses while countries that receive those savings must run trade deficits.
But, Hobson pointed out, this is not sustainable. Countries that import foreign capital to finance trade deficits eventually find their debt levels are too high, and they cannot continue borrowing. In that case they must sharply reduce their consumption or face a crisis.
In the 1920s John Maynard Keynes, picking up from Hobson, argued that the surplus countries whose policies had created too high savings had to take steps to increase consumption and force down their savings rate. If the surplus countries refused to increase consumption quickly enough, Keynes explained, factories would have to close and fire their workers.
As workers lose their jobs, consumption drops, which causes savings automatically to rebalance. The rebalancing, in other words, occurs whether or not the surplus countries play their part, but if surplus countries refuse to boost consumption quickly enough, the rebalancing occurs in the form of rising unemployment.
But there is more. Keynes also explained that at first unemployment in the deficit countries would rise sharply, but at some point they would discover that intervening in trade, for example by raising tariffs or devaluing their currencies, would cause the unemployment to shift to the surplus countries. Keynes concluded that international trade would suffer as deficit countries protected themselves by intervening in trade.
He was right. Global trade collapsed in the 1930s and while at first the deficit countries suffered terribly, after they devalued their currencies their economies improved dramatically and it was surplus countries, like the U.S., that suffered the most.
Today the world is again behaving exactly as Hobson and Keynes described. As Berlin enacted policies aimed at restricting wage growth in the late 1990s, German savings rates rose dramatically. Unlike 100 years ago, savings rose not just because of rising income inequality but mainly because the state and business sectors grabbed a growing share of the economy.
Their growing share left German households with a smaller share of the economy, and as a result their consumption grew much more slowly than the economy. This automatically forced up their savings rate (savings is simply production minus consumption).
As they had no choice but to export these savings abroad, by lending huge amounts of money to Spain and other European countries, after running huge deficits in the 1990s, they almost immediately began to run huge trade surpluses. This came at the expense of other European countries. Spain’s’ trade deficit, in other words, was an automatic consequence of German policies in the late 1990s.
Once again, after many years of trade deficits and rising debt, the process has been brought to a halt. Debt has soared, and now countries like Spain have been forced into cutting consumption and raising their savings rate.
And once again these countries must choose between accepting unemployment at home or shifting unemployment to Germany. For now, they have chosen to accept high unemployment at home in order to save the euro. If they are willing to do so for many years, Europe will finally adjust with little harm to Germany and the euro will remain intact, although their economies will be devastated.
If they decide, however, that they can no longer bear the pain alone and choose to leave the euro, unemployment will shift, just like in the 1930s, from the deficit countries to the surplus countries. Spain, in other words, is facing today the same difficult decision between monetary stability and many years of unemployment.
In the next few years one country after another will find the pain of unemployment too high and so will leave the euro. As each country leaves, it will force even more unemployment onto countries that remain within the euro. There are many benefits for Spain to remain within the euro, but there are also many costs and they are likely to rise in the next few years.
Pretending otherwise is irresponsible. Without a huge increase in German spending there is no way to eliminate many years of unemployment, in which case Madrid must decide as soon as possible whether the pain will be paid by German households or by Spanish households.