Who is Afraid of the Mercantilists?

I came across this very interesting article titled “Who is afraid of the mercantilists?” Here are some quotes: 

"The key difference between mercantilists and free traders is one of outlook. Free traders see consumption as the goal of the economy. Mercantilists believe it is production”.

“Our intuition tells us that power should be in the hands of the producers. The free traders should be the supplicants, desperate for specialty steel and consumer electronics, desperate for loans so they can live beyond their means. But surprisingly, control of the relationship, even if they don’t realise it, lies with the consuming nations”.

“Today the producers need the consumers more than the other way around”.

“Should the euro dissolve into its constituent parts, the southern periphery will immediately become much more competitive in world markets.  The revived D Mark, no longer held down by Spanish weakness, would appreciate dramatically, bad news for Germany’s manufacturing export sector”.

“Our natural intuition is that the creditor has the whip hand but that assumption may well be out of date.  These days, China needs America, Germany needs Spain, more than the other way around.  Don’t fear the mercantilists”. 

All of this sounds quite plausible and reminds me of what I have written on other occasions: should the Eurozone collapse, the relatively happier people will be in the periphery because they are not worse off than they already are and with a cheap local currency (and quite a bit of hard currency cash stashed away at foreign banks), they have better prospects for the future. The core, on the other hand, will lose jobs and will have to write-off gigantic sums of loans to the periphery.

This view, however, leaves out a very important element in the equasion of cross-border capital flows because it only focuses on the trade account and not at all on the current account. It is the current account (and not the trade account) which eventually drives cross-border capital flows.

Take an island in the South Sea which produces next to nothing. The people there live on the agricultural products which they produce and little else. They cannot import products because they have no foreign currency for it. Thus, their living standard is very low. Then tourism starts and brings tons of foreign currency which allows the islanders to import every product that they could possibly desire. So, you have an economy with an enormous trade deficit and yet, it doesn’t have to import capital because it gets the foreign currency which it needs out of operations (tourism revenue is part of the current account). The living standard, formerly extremely low, explodes without the islanders having to borrow money.

In simple terms, the current account consists of the trade balance (manufacturings) and the services balance (i. e. tourism, shipping). If the services balances makes up for what is ‘lost’ in the trade balance, the economy does not need to borrow abroad.

The relative importance of the trade versus the services balance is one of domestic employment. It could be that the services surplus does not generate as much employment as is lost through the trade deficit.

Now, there are about 80 million Germans generating horrendous current account surpluses. Just picture that half of those Germans were to spend their vacations in the periphery and spend about 10.000 Euro per head. The horrendous current account surplus would be wiped out overnight; Germans would have a lot of fun as tourists in the periphery; and the periphery would not have to borrow abroad while still having substantial trade deficits. They could maintain their living standard.

What is my point? The process of recycling trade surpluses to trade deficit countries does not necessarily have to come by way of cross-border capital flows. It can also come through the services balance and when those services are tourism, both the paying and the receiving side have a lot of fun.