The fiscal fallacy of decoupling from America

By: Wolfgang Munchau

If the US economy tanks, what will happen to the rest of us? Some investment bankers have argued that this time we can easily decouple from the US. This view is rooted in the assumption that the indefatigable Asian consumer and the resilient European corporate sector have made us all less dependent.

 

I do not buy this argument because it does not quite square with what we know about globalisation. The world has become more, not less integrated, in terms of trade and financial linkages. The large world economies do not all have the same growth rates, nor do they share the same business cycles. But surely we are not fully decoupled. Some countries may be more shock-resistant than they used to be, but in a globalised world shocks also spread more easily. The answer depends on which of those two effects weighs more strongly. I suspect it is the latter.

 

 

When we talk about decoupling, we first of all need to be clear on what exactly we want to decouple from. The term only makes sense in the context of a US recession, or sharp slowdown. There would be no need to decouple from a minor mid-cycle slowdown, the kind that is predicted by the Federal Reserve and other forecasters. If the US economy were to go into recession, house prices would probably fall some more, as would equity prices. Corporate bankruptcies would probably go up, as would credit spreads. The exchange rate of the dollar against the euro and sterling would probably decline. A US downturn is an economic and financial package deal, and it is this combined package that Asia and Europe would have to decouple from – if the decoupling theory is correct.

 

The good news is that our defences have improved. Many European countries have adopted an improved macroeconomic framework. Many members of the eurozone are now enjoying a previously unknown degree of macroeconomic stability. The UK has an independent central bank. Fiscal policy in Europe is far from perfect, but at least subject to a reasonably robust medium-term framework. And there is no question that Asian countries are also financially and economically more resilient today than 10 years ago.

 

The bad news is that in a globalised world there are more channels that can spread disaster. The classic trade channel is perhaps no longer the most important. Of course, US consumers will consume and import less during a recession and this will affect global demand. But I suspect that the financial and asset price channels will turn out to be far more important.

 

One of the most potent promulgators of global shocks is the housing market. This may come as a surprise, since property markets are mostly local. But there is a surprisingly high degree of correlation between US and European house price movements. As ever in such a debate, one has to be careful not to confuse correlation with causality. Of course, a decline in US house prices does not actually cause a decline in European house prices, even if it precedes it. They have a common cause: cheap credit in the early part of the decade created housing bubbles on both sides of the Atlantic. The world’s central banks pricked those bubbles by steering interest rates back towards neutral levels. In the present cycle, European interest rates followed US rates with a lag of about one year. This suggests that the full impact on the European property market has yet to show through.

 

Another example is the US subprime crisis, relating to junk mortgages to customers with poor credit ratings. Through some modern financial innovations such as collateralised debt obligations (CDOs), the impact of such local shocks is spread widely around the world. The spread of risk can be a source of stability, but it can turn into a source of instability if it spreads contagion. CDOs are complicated financial vehicles that buy in cash flows, such as mortgage payments, and turn them into tranches of securitised debt. These are then sold to global investors, such as hedge funds, which are lured by the high returns these instruments offer. To the extent that some of these CDOs contain significant chunks of subprime junk, this means that European investors are also indirectly exposed to the subprime crisis. Just talk to these guys about decoupling!

 

What about the equity markets? There is some research evidence to suggest that US price movements actually cause price changes in Europe*. Also, I would suspect that European and Asian investors are not immune to a sudden change in expectations by US investors about long-term profits growth.

 

Alan Ahearne, research fellow at Bruegel, the Brussels-based think-tank, argues that the reasons the Europeans will not decouple may come down to old-fashioned animal spirits. Rightly, or wrongly, he says, business leaders around the world see the US as a locomotive for the global economy. Who wants to decouple from a locomotive?

 

I tend to go along with that view. The world economy is highly inter-dependent through a variety of real and imaginary channels. A sharp US recession is the one event where decoupling is most needed, and least likely. If on the other hand US growth remains robust, there is no need to worry about decoupling in the first place. Decoupling is either improbable or irrelevant.

* The latest IMF World Economic Outlook, Chapter 4. www.imf.org

Copyright The Financial Times Limited 2007

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