A sharp US downturn could spell disaster for the world economy. A careful policy response is now more urgent than ever
As the world braces for the impact of a stalling US economy, it also awaits the long-anticipated “rebalancing” with an odd mix of anxiety and self-assurance. Optimists now pin their hopes on a global economy’s ability to power ahead without a US engine in the lead. But they’re right to be anxious: the situation is without precedent. Moreover, for optimists’ faith to be born out, offsetting any slowdown in US demand requires faster growth of demand in the rest of the world. Countries – most significantly China - will have to consume more, and fast. Yet even then, the shockwaves of a US slowdown could be vast and unpredictable.
Last September, Barry Eichengreen, professor of economics at UC Berkeley, warned in an Emerging Markets op-ed that the best advice for the global economy, as the US housing market downturn gathered pace, was to “fasten your seatbelts.” A year later, the economist is sounding the alarm bells again – this time over the magnitude of the fallout.
“I’m not believer in decoupling,” says Eichengreen. “If the US has a recession the rest of the world will slow significantly.” He believes the probability of a recession is “greater than 50/50, not less, as [former Fed Chairman Alan] Greenspan says, because I think a housing recession and a credit event together are really a fatal cocktail,” he says. “If we had one and not the other there would be grounds for optimism but we have both.”
He points to negative trends in fixed investment, inventory investment and consumption. “It’s only net exports that give the US a hope of staying out of recession,” says Eichengreen. “That’s kind of a thin reed to cling to for an economy that’s used to motoring along on the basis of domestic demand, not export demand,” he says.
He is not alone in this view. Former US Treasury secretary Larry Summers also believes the US economic outlook has deteriorated significantly. “You have a housing sector that’s in very serious trouble, you’ve got the consumer quite dependent on housing and so likely to be quite impacted by what happens in housing. You’ve got some evidence of declining orders for various kinds of capital equipment,” he tells Emerging Markets. “One worries about where the demand impulse is going to come from,” adds Summers, who puts the odds of a recession in the US economy at “approaching 50%.”
Edward Lazear, the chairman of the president’s Council of Economic Advisers, says recession fears are overblown. “I don’t think so much in terms or recession versus non recession,” he tells Emerging Markets.
“If you look at the indicators from the real economy, it’s pretty much on track.” Although the housing market has weakened, Lazear points out that “it had been weak for about a year and a half and that’s not an outgrowth of this particular set of events, but rather the cause of it.”
“I judge the economy by two things primarily – are people working and are their wages growing, and are businesses making money? On both of those criteria we’re doing quite well.” He points out that unemployment is low and wages are fast at, 2.3%. Moreover, corporate profits remain high, he says.
But even Lazear acknowledges the risk of recession – which he says most people concur is around a third. “I just think in terms of growth rates. If we had a growth rate of 1% for a couple of years I wouldn’t be too happy about that, whether you call it a recession or not, I wouldn’t be say that we we’d have a great economy.”
Lazear nevertheless points out that consumption data looks encouraging. From third quarter data, “it looks like consumption is going to be considerably stronger [than previous quarter]. And again, all during this period in which housing prices have been either falling or stagnant - so it’s not like this effect hasn’t had some time to play through,” he points out.
Asian key
While forecasters weigh the probabilities, policy makers gear up for tough decisions ahead. The argument that Asia is immune to a US slowdown often points to the rapid growth in intra-Asian trade, but neglects the fact that what Asia is trading with itself are parts and components that are assembled and sold to the US and, increasingly, to Europe. “Intra-Asian trade is simply derivate to a large extent on the US demand for the final good,” says Eichengreen.
How China responds is critical. Rebalancing towards stronger domestic demand and a smaller current account surplus has long been domestically desirable for China. Indeed, as US demand slows, precisely this rebalancing has gained urgency. But the problem is the importance of domestic consumption to China’s economic growth has dropped in recent years: Household consumption as a percentage of gross domestic product dropped from 46.4% in 2000 to 36.4% in 2006, leaving the mainland with one of the lowest consumption-to-GDP ratios in Asia.
The other concern is the health of China’s economy itself. The biggest worry, as Harvard University’s Ken Rogoff has warned, is that the economy is overheating and inflation surging out of control. In August consumer-price inflation jumped to 6.5%, up from 1.3% a year earlier and its highest for more than a decade. If China slams on the brakes, its economy could suffer a hard landing, as happened after past episodes of inflation.
The US slowdown so far largely reflects a collapse in house-building, but if consumers cut their spending, the impact on Chinese exports would be harsher. The World Bank estimates that if American consumption falls by the equivalent of 1% of GDP, this could knock 0.2-0.5 percentage points off China’s GDP growth, depending on how much the Federal Reserve does to cushion the downturn.
“I have a suspicion that there’s a little less decoupling than many people suppose and that the US is still a very important driver of what happens in the global economy, if the US were to go into recession I think it would have fairly serious consequences,” says Summers.
Slippery greenback
Charles Dallara, chairman of the Institute for International Finance, a global industry association, argues that the recent market turmoil hasn’t just clouded the outlook for US growth but has also complicated the “rebalancing of global growth and the orderly depreciation of the dollar – both of which have begun to moderate the current account imbalances.”
“We need to be mindful,” says Charles Dallara. “We’re still in a world where current account imbalances can be a signal of instability. I think it would be a mistake if we take our eye of the ball of a coordinated approach to dealing with resolving these global imbalances,” he says.
Of greatest concern is the potential for a loss of confidence in the US dollar that could send tremors across a fragile global financial system.
“You ain’t seen nothing yet,” says Eichengreen “The dollar has to fall further. As the US economy slows, to keep our production running, we’re going to have to export more and those exports are going to have to get more competitive.”
The Fed has a delicate judgment to make between saving the US economy and risking confidence in the dollar. It cannot risk a big rise in long-term interest rates, in response to loss of confidence in US price stability and an exchange-rate collapse.
“I think the risks are greater than they have been in the past because they’re much more coincident with US weakness than they have been in the past,” says Summers. “The worst of all situations is one in which the external imperative points towards tighter policy and the internal imperative points towards looser policy and the central bank can only move one way,” says Summers.
He adds: “The magnitude of reserves that have accumulated [in Asia], the size of the continuing current account imbalances suggests that we’re probably running a risk that we don’t need to be running.”
To some extent, the dollar’s 8% slide over the last year helps the US economy more than the strong one the US administration publicly endorses. Given the need to offset weak demand at home with a jump in net exports, it also not entirely unwelcome.
But the extent of the currency’s decline is still very much a source of concern. It has also put pressure on the euro and has sparked fears among the region’s exporters and politicians after the single currency hit a record high against the dollar. Jean Claude Juncker, the chairman of the Eurozone finance minister’s group said that the euro’s rise “worries us a lot” and that it was no longer acceptable that Europe is bearing the brunt of “the consequences of the existing global imbalances.”
“I’d really like to hear Henry Paulson saying loud and clear that a strong dollar is good for the American economy,” French finance minister Christine Largarde has said.
Outgoing IMF chief Rodrigo De Rato has also weighed in with his assessment that US dollar is overvalued. “We still see room for further [dollar] depreciation and if you look at future markets, you will see that markets are more or less seeing the same.”
The Fed will have an uphill battle to convince those who have put their faith in the dollar that it’s safe: if dollar holders conclude its store of value is no longer guaranteed, they will dump both the currency and dollar-denominated assets.
Nevertheless the latest IMF data show global reserves in the 12 months through the second quarter up by $1,100 billion, suggesting the global policy makers are for now still bailing out the dollar to a large degree.
China wish
The flipside to this is the Asian response. China, which has grown by double digits for the past five years, continues to come under fire for its dependence on exports. The G7 wants China to import more and help ease trade and financial imbalances in the global economy by letting its currency, the yuan, rise faster. The yuan has gained a further 7.8% against the dollar since it was revalued by 2.1% in July 2005 and cut free from a dollar peg to float within tightly managed bands.
But the US says the yuan remains far too cheap, given China’s record $1.434 trillion stash of foreign exchange reserves and a current account surplus that the World Bank expects to reach 12% of national income this year — unprecedented for a major economy
China, says Eichengreen, must finally let its currency rise against the dollar. “This always sounds disingenuous coming from an American but the events of the last two months have really highlighted that there is a sound fundamental argument for letting Asian currencies move,” he says.
But the chances of that happening now are another thing. China’s central bank governor Zhou Xiaochuan pointed out in an interview with Emerging Markets earlier this year that while he does not rule out a further appreciation of the yuan, exchange rate flexibility will be determined by the ability of the economy to tolerate the effect.
“When we observe that the Chinese economy can absorb the impact of exchange rate flexibility, then we will enlarge it,” he said. “The major policy consideration is that along with enlarging [exchange rate] flexibility, we are going to be more dependent on the supply/demand relationship.”
“Unless the Chinese allow the exchange rate to go up, I’m worried about the stability of the economic system,” Alan Greenspan, the former Federal Reserve chairman, said during a speech in London this month. “The exchange rate will create more economic problems than they know.”
Greenspan added, in a recent interview with Emerging Markets: “A revaluation of the currency is to China’s advantage, but what is to China’s advantage, is to the US advantage, and therefore to the advantage of everyone.”