Ignoring the Biggest Mistake

Eighty years ago, three major policy mistakes turned the stock-market crash of 1929 into the Great Depression of the 1930s: a tight monetary policy, a restrictive fiscal stance and a wave of protectionism that paralyzed the world's greatest wealth-creation machine, the exchange of goods and capital across national borders. This time, central bankers and politicians around the world are deftly avoiding the first two mistakes.

However, there is a rising risk that a collapse in cross-border commerce could critically deepen and prolong the downturn. Countries are not shutting their borders to trade in the old-fashioned way through tariffs, import quotas or other such instruments of economic torture. Even the approaching avalanche of national subsidies to national producers, which can distort global competition as badly as tariffs do, is not the major threat to watch. At least in Europe, the key risk stems from an abrupt reversal of financial globalization. As stricken banks strive to bring money home, some of the cross-border flows of liquidity that grease the global production process are drying up.

To understand the issue, look at Europe's biggest economy, Germany. Household debt is low by international standards, and corporate balance sheets are healthy, with the ratio of corporate debt to annual gross value added at 204 percent, close to that of the United States (180 percent in 2007) and far below that of the euro-zone average, 243 percent. At first glance, Germany should not have been vulnerable to a credit crunch. Yet the German economy fell off a cliff in the final quarter of 2008, with the total value of goods and services produced contracting at an annualized rate of 8.2 percent, versus drops of 3.8 percent in the United States and some 5 percent in the euro zone outside Germany. Moreover, Germany exports just more than half of what it produces, and in December exports of goods had fallen by 14 percent below their average for the July-through-September period. Judging by the 24 percent plunge in export orders during the same period, worse is to come.

This is happening in Germany and other export-oriented nations because trade is intricately linked to finance. At the simplest level, some institution has to provide a financial bridge for the period between the production of a good in one country and the point in time when it is sold somewhere else. In normal times, and between countries and firms with a solid reputation, the financial side of such transactions hardly ever poses a problem. But times are not normal. Ever since the global financial system suffered the equivalent of a heart attack in September, banks are scrambling to survive. As they usually deem their exposure to foreign markets as more uncertain than their business at home, they naturally curtail their cross-border lending even more than their domestic activities. National governments in Europe and elsewhere have gone out of their way to support their banks. But the shelters they have provided are national shelters. Banks in, say, the staid old economies of Germany, Italy and Austria are thus inclined to bring assets home.

One way to do so is to finance fewer exports to, and investments in, their more dynamic but also more volatile neighbors such as Hungary, Poland and Romania. To make matters worse, many European governments, such as Britain's, have told their banks in no uncertain terms that they ought to keep lending to consumers and businesses at home. But the more governments try to prop up local lending, the greater the urge for banks to reduce their exposure to risks elsewhere. The ax thus falls most heavily on cross-border financial flows.

In the end, such financial protectionism is self-defeating. As the example of Germany shows, trying to maintain a minimum supply of credit at home does not prevent an economic slump if your major customers abroad cannot get the short-term finance they need to buy your exports. And if the export machine stutters, domestic investment into export-oriented industries collapses as well. Indirectly, the major trading nations of the world, from Germany and Japan to many of the smaller European and Asian countries, are among the major victims of the global credit crunch, although in their domestic statistics they may record only modest tightening of credit conditions.

Tackling financial protectionism is not easy. But it is urgently needed. So far, most initiatives aim to increase national export-finance-guarantee schemes. That is helpful, but hardly enough. The European Commission, as the guardian of free economic exchanges in Europe, should make sure that no national bank-support program provides any incentive, directly or indirectly, to favor domestic lending versus lending across borders in Europe.

More important, G20 leaders preparing for their April summit in London should put aside the usual stale talk about exchange rates and focus on the real issues that are disrupting the flows of commerce and capital around the world. A code of conduct against financial protectionism and a multilateral insurance scheme for cross-border financial flows could go a long way to further reduce the risk of the current deep recession morphing into an even more sinister depression.