The Eurozone and the US Downturn

Over at Afoe Mark Thoma had an interesting guest post last week on whether the eurozone will be affected by any possible downturn in the US. This same post was picked up by New Economist,as it is by Claus Vistesen at Alpha Sources.

Personally I think I think that Nouriel Roubini's view (which comes up in the post) that the rest of the world may not be able to decouple from the US is a mistake. In a sense the world already has decoupled. If you look at the fact that global growth this year is likely to be in the 5% region, while the US might grow say 3.5%, and Japan say 2.5% and the eurozone say 2.0%, then it is clear that someone somewhere else is now doing the heavy lifting. Most likely candidates are places like China, India, Brazil, Turkey and a string of other developing countries like Argentina and Chile who are to some extent riding the commodities boom generated by the aforementioned.

This is a sea-change from the 1995-2000 period, when US growth did account for a huge proportion of global GDP growth. I think this de-coupling will become even clearer after the next recession (which could be 2007 or 2008, we have no crystal balls, but I would pencil something in for 2007, especially if the collsion with Iran continues its course). The next upswing will surely be pulled by the new Growth Pandas (or if you like growth giant pandas).

The big issue is going to be how you square the circle on trade and capital flows.

Of course recognising that there are new growth engines at work isn't quite the same thing as saying that it doesn't matter to the rest of the world what happens in the US. Obviously if consumption in the US is sufficiently affected then this will be noticed in Germany, Japan and China.

One important point that isn't being noticed (or isn't being given sufficient importance) is that three of the G7 economies are going to have severe fiscal tightening in 2007 to accompany high oil prices and raised interest rates (Japan, Germany and Italy).

So the machine isn't going to be pulled in this direction. This tightening isn't, as Rogoff suggested frustrating, it is, unfortunately, entirely in the logic of things since these three economies have lived through the good times of this upswing with sustained fiscal deficits, and their budget liabilities with their aged populations mean that some time or another they have to change course. At least for the time being the plan is to change course in 2007 (this may, of course, be revised in the face of inclement weather).

But the big underlying issue is that these elderly economies cannot sustain strong internal demand, and can only live by trade exports and by the export of capital which is a spin off of the high savings rates. (In the case of Italy this is less clear, since the trade surplus has collapsed, but the gap is currently being made up by cheap finance from the eurosystem which goes to pay for Italian government spending).

Anyway, the real probem as I see it is this one. Most of the developing countries need to be export driven, and when they are not buying raw materials and equipment they will have an in-built tendency towards deficit during the development process. At the same time the elderly part of the G7 needs to run surpluses for quite other reasons. So this leaves us with very few countries to balance the books. The UK is undoubtedly one that can run a deficit, France could too, but the big big customer is undoubtedly the United States.

And this is the importance of the argument about housing, since if people stop recycling equity then demand for goods from abroad is likely to drop. This can then have a whole domino impact across the global economy, which far from encouraging investment in the US to take up the slack can have exactly the opposite effect as companies across the globe slash prices to offload unwanted excess output, thus discouraging further investment in the US. The recent surge in capital investment in Japan should fill one with a little foreboding in this regard. As should the recent marked fall in machine orders in Japan serve as a warning.