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Wednesday, April 18, 2007

Deciphering De-Coupling - A Change in the Fundamentals?

by Claus Vistesen: Copenhagen

I have been around long enough in the econ blogsphere to know a buzz-word when I see one and clearly de-coupling represents just that. In essence, the notion of de-coupling hovers around the question of how well (if at all) the rest of the world can weather a US slowdown or perhaps even a recession. Of course this discussion is intensified through the realities of the global imbalances which, at least in terms of the stylised facts, suggest that if the US consumer grinds down consumption expenditure it will have a marked effect through strong trade linkages which are proxied by the whopping US current account deficit on the one hand and the export dependent economies on the other. In short, how will we all fair if and when demand in the US finally slows down?

In this note my argument will centre on two main mechanisms. Firstly, I will draw on a flurry of recent commentary dealing with how well the world will cope in the immediate future with what seems to be an ongoing and sustained slowdown in US growth going into 2007 and beyond. Secondly and more importantly, I will assess the concept of de-coupling and in particular the idea of a re-balancing of the imbalances from a more long term and structural perspective. Crucially the relationship between the notion of de-coupling and global macroeconomic imbalances and the potential for a global re-balancing act will be explored as I believe this is a link which is often not made sufficiently explicit in the general analysis and discourse on this topic.

The Current US slowdown - A Perfect Switch of Batons?

The economic debate of late in both the econ blogsphere and in the more traditional media channels has been somewhat preocupied with the notion of de-coupling, so a brief overview of the discourse might be in order.

At the heart of this discussion stands the recent IMF World Economic Outlook 2007, and more specifically the chapter (PDF) specifically devoted to de-coupling. In the slipstream of this document many bloggers and other commentators have positioned themselves along an axis of either for or against the notion of de-coupling. The dividing line here splits some pretty hefty opinion makers. Amongst the skeptics of de-coupling we find for example, Nouriel Roubini from RGE, Stephen Roach from Morgan Stanley and Wolfgang Munchau from Eurointelligence. On the other side of the fence we find some equally impressive heavyweights like Goldman Sachs and the Economist. This list of course is far from complete, and even a bit artificial since many of the views are, as always, more nuanced and balanced than a stright pro- or contra, but putting things this way does give an idea of the extent of the controversy surrounding the current discussion. So, what does the IMF's recent research have to say about de-coupling in so far as we might consider them something of a an arbiter in the general discussion? For all intent and purposes, Nouriel Roubini's account of the IMF piece (linked above) is as a good a guide as you will get and I also believe that his review highlights the most salient point:

The world would be able to decouple from a US slowdown if the US experiences a soft landing; but the world would not decouple if the US experiences a hard landing.

Indeed, this does seem to be the message to take away from IMF's review, but I would actually take things one step further by arguing that the IMF more or less decisively argues against the notion of de-coupling. Let me try to explain. The anatomy of de-coupling in the short term, which is what we are really discussing here, rests on two points. Firstly, there is the general character of the current US slowdown, and whether this will remain restricted to the housing sector (i.e. a soft landing) or whether it will feed strongly over into the rest of the economy (i.e. a hard landing). Secondly, and more centrally in terms of the present IMF study, we need to explore and asses the transmission mechanisms and spillover linkages which are in operation between the world's large economies/regions, and crucially ask the question as to whether Europe, Asia, and to a lesser extent the rest of the Western Hemisphere, can, at precisely this juncture, unschackle themselves from a slowing US economy?

In terms of the current US slowdown the bets are still proverbially out. We all well aware of the hard landing calls which are around, and in particular Nouriel Roubini's arguments concerning the risk of a severe hard landing, but there are also plenty of contrarian voices, such as, for example, this recent note from John C. Williams of the San Francisco Fed (hat tip Mark Thoma) which offers a review of the recent evolution in US economic data and also gives a more positive immediate outlook (i.e. forecast) for the economy. In essence, the forecast translates into a soft landing for the US economy with the expectation of GDP growth at about 2-2.5% for the remainder of 2007. Interestingly enough the forecast includes a slowdown in private consumption (i.e. a spillover effect) which is then compensated by a pickup in capex. Also the recent positive employment data is cited as evidence of a strong labour market. Yet, it is important to note that there are considerable doubts attached to this rather positive outlook. There is, for example, some evidence that capex may well be winding down, which, if confirmed, would pretty much leave the US consumer as the last line of defense. On that note, recent data do suggest that this line of defense is holding up, at least for now, in the sense that consumer spending recorded a healthy growth rate in March. On the other hand readings from recent confidence surveys are not so reassuring, since they show a decline in overall consumer confidence. Lastly, vis-a-vis the employment situation, we always need to remember that this is a lagged indicator and indeed if capex were to be on a sustained downward trajectory we could expect this to show up later in the employment statistics too. So, the US economy is far from being out of the woods yet in terms of the risk of a hard landing as the housing correction still retains the potential to spill over to the real side of the economy. More importantly, however, for the notion of de-coupling; in either case how will the other economies of the world fair?

This issue is explored in some detail by the IMF, and I will not here go into the detail of the relevant chapter (see original link above), but will rather point to the two traditional and thus most debated spillover linkages from the US slowdown. The first concerns financial markets and here it is clear that the correlation and thus spillover linkages are very strong, especially in equity markets. This aspect is dealt with in more detail in the context of Europe by Wolfgang Munchau over at Eurointelligence where he argues that it is the spillover in financial markets rather than trade linkages which we should worry about in Europe. I only conditionally agree with this view.

In the first place we need to bear in mind the fact that there is no real substantial evidence that financial markets are about to crash in any meaningful sense of this word. In principle there can be no doubt about the strong linkages in equity and credit (risk) markets, but my issue with Munchau here is that the wealth effect - and especially from equity markets - is not that strong (in general), and especially not in Europe, which suggests that the real effect on the economy would probably be modest even do see rising volatility and some sort of correction.

The wealth effect from housing as an asset is probably potentially somewhat stronger both in the US and in Europe, and this does point us to another potential spillover from a US slowdown which would be an indirect derivative of any financial markets correction. As such, both Munchau and Roubini note that any continuing deflation in the US housing market will lead to a sector and economy wide credit crunch which could spill over into European asset/housing markets and if this were to happen then we would, of course, be in a hell of a bind. But this is really to beg the question as the future outlook for the US housing market is just what isn't clear at this point in time, and hence I am not sure that I buy the argument about a credit crunch spillover. Of course, there is evidence that asset market bubbles, especially in the housing sector, are somewhat synchronous events across economies. But still, I am skeptical that the as-per-usual strong correlation in financial markets also signifies a strong correlation in bursting of housing markets at this point in time.

Regarding the second strong spillover effect of trade linkages, it is important to note that this impact differs markedly from country to country. Indeed, this is perhaps where the major debate on de-coupling is taking place, since it remains unclear as to how well export dependent economies will be able to weather any hard US landing in which consumer spending winds down considerably. In the IMF study the trade linkages between the US and the rest of the world are strongly emphasized and in particular the assymmetrical nature of these linkages. Germany, for example, is often (and with good reason) singled out as a clear example of an export dependent economy does indeed export a great deal to the US, but in fact the big picture story for both Germany and Europe in general is that intra-European trade movements constitute a much more important component in GDP growth.

This fact does not, of course, nullify the importance of the US economy, but it does suggest that the picture is a more complex one. There is also a very important silver lining here in the sense that de-coupling potentially could mean two things from the point of view of an individual economy. On the one hand the export dependant economies could continue to grow in the midst of a US slowdown, but on the other a more important issue would be whether this growth continuation occured on the back of an adjustment in the overall growth path towards more reliance on domestic consumption or whether the export dependent economies are merely 'coupling' onto other importers . In terms of the latter effect, Germany seems to be a good example as is shown in the figure below.

Finally, it is course impossible to discuss de-coupling without thinking about China, since if there ever was a clear example of a strong trade linkage it is the current one between China and the US. Furthermore, while there are some signs that domestic demand is picking up in some key European countries (e.g. Germany, to some extent) and while some countries in Europe are notably running on domestic demand (e.g. Spain, France, UK, Ireland etc.) it is still far from clear whether China can suddenly change course and establish a different growth path which is not heavily driven by investment and exports. Should China slow as a result of a US slowdown (whether hard or soft landing) this would of course also have a global impact in and of itself given the growing importance of China in the overall global economy (14% of global gdp), and given the importance of export growth to China for some of the key export dependent economies . In Japan there are some signs of a mild and very welcome recovery in recent domestic demand but the underlying trend has hardly changed that much, and I would argue that with deflation in core prices looking to be sustained in the first half of 2007 the outlook is far from overwhelmingly positive here too.

In summary, I tend to side here with Stephen Roach and the way he invokes the US consumer as the major test case for global de-coupling thesis. So far, the US consumer has shown little signs of waning and until that happens it will be steady as she goes for a fast growing global economy. Another test will of course be how hard the US economy indeed hits the breaks when faced with an eventual recession, and again here I am skeptical. Ultimately the question of whether the rest of the world can de-couple at this point from any US housing correction and potential severe slowdown in the US economy masks more fundamental questions about the global economy, the driving forces behind the macroeconomic imbalances and thus the potential for the (de)-coupling of regions and economies in a longer term perspective. It is towards these questions that I will now turn.

Looking into the Future - ... towards a rebalancing of the Global Economy?

The structural nature of global macroeconomic imbalances should be well known to readers of GEM and indeed general observers of the global economy but how does de-coupling relate to this. Well, it would not be wholly unreasonable to claim that a sustained process of de-coupling - if this were to occur - would be tantamount to re-balancing. If re-balancing represents the gradual decline of the US current account deficit as a counterpart to a re-balancing of other countries' growth paths this would come very close to the claims by the proponents of de-coupling that the rest of the world now is ready to take up the baton from the US. In many ways this is also true in a global context. In fact, a large part of the world has already de-coupled to some extent, and it is clear that in the future many emerging economies will gradually increase their relative weight in the global economy. This is the part, I think, that Goldman Sachs had right with their now (in)famous notion of the the BRIC countries (although of course the R for Russia should by now perhaps have cruised steadily into the sunset, since this case is rather different from the rest).

However, there are some caveats I feel the need to add about this debate. The first of these concerns the notion of de-coupling in relation to one of the structural pillars of global imbalances; Bretton Woods II. It is important I think to realize the constraints which exist on the potential scope of any re-balancing (and thus de-coupling) in a world where the dollar peggers remain ardent financers of the US current account deficit. In fact, currency movements and trends in monetary policy are good measures through which to examine the viability of a sustained process of de-coupling and re-balancing. As such the current course of monetary policy in the large Central Banks are to some extent consistent with the the de-coupling thesis. The Fed has been on hold since the housing correction began at the end of Q3 2006, while the ECB has continued with its much publicised normalization process. This has of course materialised itself in an appreciation of the Euro relative to the Dollar but the main question remains, how far will/can this go?

What I am driving at here is that we only need to examine the Eur/Usd notch up to become aware that a sudden any serious and sustained decline in the value of the Dollar would, all things being equal, require an appreciation of the Euro and perhaps even the Yen which at the end of the day would be seem to be wholly unrealistic given the economic fundamentals of the Eurozone and Japan.

This is just another reason why I have a hard time seeing how, for example, China would be able to diversify into Euros to any great extent since this would more than likely prompt the ECB to reduce interest rates and thus the yield for which such a diversification would have been justified in the first place. Of course, all this could be avoided if the dollar peggers chose to let their respective currencies float more freely against the dollar as an alternative to the accumulation of dollar denominated debt. Yet, would this really make the imbalances go away? The answer to this question is also the answer to the question of what drives capital flows between global regions and countries in the long run and here I think that especially one account is sorely missing in the mainstream debate.

This consequently brings me to the second caveat in the general debate on de-coupling where I believe that the role of demographics should be attributed much more importance as an explanatory factor of the global economy and thus also the notion of de-coupling. What might demographics help us with here? Well, first of all it should perhaps not be considered odd that demography does not have a very high ranking amongst most economics comentators since demographic variables possess relatively little (if any) explanatory power in relation to short term economic fluctuations and as such whether or not the world will de-couple from the current US slowdown might be considered to have little if anything to do with demographics. I do think however that demographics can provide one indicator of how a de-coupling process (or lack therof) might play out should the US economy really hit a hard landing. So what am I saying here about demographics?

What I am suggesting here is that we look at how demographics and more specifically the issue of ageing affects capital flows in the longer run, and since ageing after all is a global and enduring phenomenon I do not think that it is an unreasonable starting point for exploration. Basically, I am referring to demographics above when I speak of the fundamentals of the European/Eurozone and Japanese economy and why I do not believe these two global economies will be able to bear the burden of global re-balancing and thus sustainable de-coupling where the latter here represents an economy's ability to create domestic demand to, at least to some extent, offset a growth path driven by exports. I have conceptualized this argument on several occasions but perhaps never better than in the case of Japan where capex and exports seem to drive the brunt of net real GDP growth. We should thus ask ourselves whether in the behaviour exhibited by Japan is not in fact endemic to any rapidly ageing economy where capex and productivity cannot be sufficiently channeled into the domestic economy as a result of a shrinking consumption base and whereby the economy reverts to exports in order to grow.

In summary, in this second part of my note I have tried to provide a longer term perspective on de-coupling and global re-balancing. I have argued that there are structural forces at play which hint that what constitutes conventional wisdom perhaps needs to be revised. Specifically, I have argued for the unlikelihood of an imminent dollar crash even if the Fed was forced south by increasingly deteriorating fundamentals in the US economy. Lastly I have argued for the inclusion of the demographics into the discourse on the global economy to a much larger extent than is currently the case.

Summary - Questions, not Answers

In this note, I have explored the notion of de-coupling in an imminent perspective of the US slowdown as well as in a more broad and longterm strucutural perspective. On the former account I positioned myself alongside the consensus skeptics towards de-coupling and most notably, I tend to agree with Stephen Roach that de-coupling will only be tested on the back of a sustained drop in US consumer spending over several quarters. On the latter account I have argued that de-coupling is often not well understood in a structural perspective since it is important to take into account the global imbalances and their structural nature. Moreover, I have argued that de-coupling in a world where Bretton Woods II soldiers on is not justified given the fundmentals of the Eurozone and Japanese economies. Lastly, I have proposed the more formal inclusion of demographics into the general debate on de-coupling and global imbalances and specifically a consideration of how demographics over time might represent a strong explanatory variable in terms of the account of international capital flows.

I leave this note on an open string. I clearly have my perception of the world and others have their's but particularly in terms of demographics I believe the case is strong for more scrutiny as to how population ageing and other demographic variables influence the much debated notions of de-coupling and global imbalances.