There have been two interesting developments during the past week. First let me start with the sharp sell offs in equity markets around the world.

A couple of weeks ago the primary concern of investors and speculators appeared to be the possibility of a default by Greece and perhaps by one or two other members of the PIIGS. The EU states have reduce this possibility, for the time being, by their massive fiscal intervention. However, at first the markets feared that Greece would not follow through on its commitment to reduce its budget deficit. This has now been followed by the realization that if Greece and other members of the EU introduce drastic measures to rapidly reduce their respective budget deficits, the global economic recovery might stall. This would reduce corporate profits and equity prices.

This highlights three things: Be careful for what you ask because the consequences might be worse than the original problem. Fiscal policy still matters even when it is being conducted in reverse. And markets and economies are interdependent. There is no place to hide. Fiscal contraction in the EU does impact all economies and markets.

The paper losses in the equity markets this week greatly exceeded the potential losses from defaults by all of the PIIGS. And if the EU states all enact expenditure cuts to reduce their deficits to 3% of their GDPs within a few years, the global equity losses, not to forget the job losses, will be huge. Deficits and rising debt levels might be bad; but the economic and financial consequences of dealing with them too quickly might be even worse.

Next, there have been several stories describing how many manufacturing companies are re-locating from China to other, lower labor cost countries, primarily in Southeast Asia. Strong economic growth in China is driving up labor costs – if China is to develop a consumer market, increases in incomes and living standards are necessary – thus making China less competitive in labor-intensive manufacturing.

Many economists and other policy makers in the U.S., the EU and Canada have been pushing China to revalue its currency against the U.S. dollar in order to help eliminate imbalances such as the large U.S. trade deficit and the need for the U.S. to borrow hundreds of billions annually. The simple-minded argument behind this is that an appreciation of the Yuan will make U.S.-based companies more price competitive against Chinese-based companies, resulting in higher levels of exports to China and lower levels of imports from China.

Imports from China to the U.S. would decline, only to be replaced by labor-intensive imports form other countries. The geographic composition of the U.S. trade deficit would change but not necessarily its magnitude. On the export side, the depreciation of the Euro against the U.S. dollar has eroded most of any opportunity for U.S.-based companies to increase their sales to China (unless they create new competitive advantages).

Economists place too much weight on revaluations of exchange rates as a corrective mechanism; just as they have placed too little weight on the impacts of fiscal policies and ignored the dangers of dramatically attacking budget deficits.

I guess we are damned if we do and damned if we don’t.

Maybe we will get lucky and traders (i.e. speculators) will go away for the summer, so that markets will be able to settle down and common sense will return.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.