Thomas Palley

Over the last year, as the U.S. economy has slipped toward (and likely into) recession, there has been much talk of decoupling. According to this idea the global economy has decoupled from the U.S. economy and can continue growing even if the U.S. goes into recession.

That idea is now proving fragile. Instead of decoupling, the global economy is showing signs of a concertina effect. Thus, as the U.S. economy grinds to a halt, much of the rest of the world seems to be also slowing and bumping in behind.

Ever since the East Asian financial crisis of 1997 the U.S. has served as the locomotive of the global economy. This locomotive role has had U.S. consumers engage in a ten year consumption binge financed by debt and rising house prices. That binge pushed the household saving rate to record lows, and it also resulted in record U.S. trade deficits.

Trade data show the U.S. has run large trade deficits with every major industrial region of the global economy – Europe, Japan, China, East Asia, Canada and Mexico. That pumped spending into these regions, fuelling their growth.

This economic arrangement has created a dependence on the U.S. market, and that dependence has been further deepened by policies of export-led growth. Unable or unwilling to grow their own domestic markets, countries have relied on policies that explicitly promote exports.

In many developing countries these policies have had the added benefit of attracting foreign direct investment (FDI). Thus, exports have kept factories busy, while the prospect of future exports has tempted companies to relocate production facilities to developing economies.

In effect, developing countries have gotten a twofer – export led growth plus FDI. Meanwhile, the U.S. economy has benefitted from cheap imports, but its manufacturing sector has been eroded and consumers have loaded up on debt in an unsustainable fashion.

The bursting of the U.S. house price bubble has shifted this process into reverse, slowing U.S. import growth and replacing financial exuberance with financial fear. But rather than global decoupling, there are signs of a shared global slowdown.

The NAFTA economies of Canada and Mexico are clearly vulnerable because of their large trade dependence on the U.S. and their tight integration into the U.S. supply chain. In Europe, Ireland, Spain and Italy are either in recession or on the cusp of recession. Growth has also slowed sharply in the U.K. and France, and Japan has also lowered its growth outlook.

Germany, which is Europe’s largest economy, was supposed to replace the U.S. locomotive. However, it is one of the world’s most export dependent economies. German growth has kept going longer than other European economies because of low consumer debt and export growth to OPEC economies, but Germany is now also slowing. Moreover, its policies of wage restraint and hyper-export competitiveness pose a menace rather than a help to the overall European economy.

The hope that China could pull East Asia through a U.S. slowdown was always a fiction. A quick inspection of China’s trade shows that its trade deficits with other East Asian economies are derived from its trade surpluses with the U.S. China assembles imported parts from the rest of East Asia and sells the assembled product in U.S. markets. That means when the U.S. slows, the slowdown ripples back via China into the broader East Asian economy.

The commodity exporting economies of Australia, Latin America, and Africa have all done well from the commodity price boom. However, if the industrial economies of North America, Europe and East Asia slow, that can be expected to negatively impact commodity prices and exports.

Closer co-movements of national economies are a logical consequence of corporate and financial globalization since it makes economies more inter-dependent. Those co-movements can become a concertina when they are driven by a common factor such as export-led growth that relies on debt-financed U.S. consumers serving as buyer of last resort.

The key to avoiding a concerted global downturn is for developed economies to sustain confidence in financial markets, resist misdiagnosed calls for a war on inflation, and initiate policies that strengthen demand. Meanwhile, developing countries must continue spending even as their exports to the U.S. slow. These countries now have the foreign exchange reserves to ride out a weakened trade outlook. The open question is whether they have the sources of internal demand.

Developing that internal demand is a core problem. However, it remains off the development policy agenda because the current paradigm is obsessed with the supply-side and neglects development of the demand-side. As long as that is so, the global economy will remain beset by an unstable and inadequate configuration of demand.

Copyright Thomas I. Palley

This entry was posted on Monday, September 8th, 2008 at 6:41 am and is filed under Economics, Globalization. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.