The Myth of ‘Decoupling’
Thursday, January 24, 2008
Despite what you may have heard, global economic linkages remain strong, writes DESMOND LACHMAN.
Hope springs eternal on Wall Street. As recession indicators proliferate and global equity markets swoon, many investors still cling to the belief that this time around the rest of the world will somehow “decouple” from U.S. economic weakness. A main pillar of this belief is the view that China and the other emerging market economies in Asia will maintain their impressive growth momentum despite a slowdown in the Western industrialized economies.
If this were true, we would have much less reason to be concerned about a hard landing for the U.S. economy, since that landing would largely be confined to the United States. It would also be less severe than otherwise would be the case since it would be cushioned by economic strength abroad.
Sadly, the “decoupling” thesis has little support in theory or in practice. Its proponents overlook the fact that during the past five years the U.S. economy grew faster than all the other G-7 economies. During that time, America’s economy remained the principal generator of global aggregate demand, accounting for around one-fifth of global imports and 25 percent of global production. This evidence suggests that, as in the past, if the U.S. economy sneezes the rest of the world will catch a cold.
To be sure, the dip in U.S. housing construction at the start of 2007 did not have much impact on U.S. imports, since America’s housing activity is primarily domestic in nature. However, weaknesses in the housing market are now spilling over into the rest of the economy, which is far more import-intensive than the residential construction sector. Meanwhile, declining home prices at the national level are now damaging consumer sentiment and exacerbating credit problems in the U.S. banking system.
Proponents of the 'decoupling' thesis overlook the fact that the U.S. economy has grown faster than all the other G-7 economies and remains the principal generator of global aggregate demand.
As the credit crisis deepens and banks tighten their lending standards, we can expect more troubles for the non-housing economy. These troubles will be amplified by high global oil prices and a continued drop in housing prices (under the weight of unsold inventories and the resetting of the adjustable rate).
More telling for the rest of the world economy has to be the pronounced weakening in the U.S. dollar since it peaked in 2002. Over the past five years, the dollar has lost around one-third of its value on a trade-weighted basis, as foreigners have grown increasingly reluctant to fund America’s huge current account deficit. This has led to a marked improvement in U.S. global competitiveness, which has helped U.S. exports but hurt foreign economies.
Judging by the rapid pace of dollar depreciation since the onset of the subprime mortgage crisis in August 2007, we can expect the dollar to fall a lot further as the Federal Reserve continues to reduce interest rates aggressively. This will almost certainly deal a further body blow to the European and Japanese economies, whose currencies bear the brunt of U.S. dollar depreciation in a world where many non-Japanese Asian countries manipulate their currencies for competitive advantage.
A number of the shocks presently affecting the U.S. economy are global in nature, and are already slowing European and Japanese growth. The credit crunch flowing from America’s subprime woes is causing a global increase in market interest rate spreads and a global tightening of bank lending standards. This is hardly surprising: almost half of all U.S. asset-backed subprime mortgage securities were distributed abroad.
While the dollar’s decline will make the recent spike in oil prices more sorely felt in America than it is abroad, the oil shock will have global consequences. After all, while the dollar lost about 10 percent of its value in 2007, international oil prices roughly doubled. That leaves oil prices very high even in non-dollar terms.
The “decoupling” optimists are ever hopeful that China’s rapid growth, together with the rest of Asia’s emerging market economies, will offset any U.S. economic downturn. But they tend to forget that Asia is filled with export-dependent economies: in some countries, exports to the United States alone account for more than 10 percent of annual GDP. The “decouplers” also forget how relatively small these Asian economies still are, at least in relation to the G-7 industrialized economies. Even the vaunted Chinese economy is barely 15 percent the size of the U.S. economy.
Speaking of China, can it really expect to continue increasing exports by 30 percent a year at a time when the industrialized countries are slowing rapidly? In an American election year, one cannot discount the possibility of a large political backlash against China, which is viewed as pursuing a mercantilist trade policy at the expense of U.S. workers. China is acutely vulnerable to a rise in Western protectionism.
Indeed, those who peddle the “decoupling” myth distract attention from what are still very strong global economic linkages. In the process, they undermine the case for a coordinated policy approach to address today’s international economic challenges.
Desmond Lachman is a resident fellow at the American Enterprise Institute.
Image by Shutterstock/Dianna Ingram.