That Healthy Decoupling

By: Angel Ubide

The concept of decoupling became one of the casualties of the post-Lehman global economy. Until then, there were heated debates about whether the rest of the world would be able to cope with the slowdown in the United States – and the evidence was clearly in favor of it, as the US started it slowdown in 2005 while the global economy accelerated during 2005-2007.  After the Lehman’s bankruptcy global activity came to a sudden stop, hitting some innocent bystanders, such as Japan and some emerging markets, with one of the largest economic contractions ever recorded. Decoupling, thus, was a myth.

 

Not so fast. The concept of decoupling is only valid when there is an idiosyncratic shock – such as the slowdown in the US housing market that created a localized economic downturn in the US. At that point, this shock can indirectly affect other economies via trade or financial markets; if these economies are able to offset the negative impact of the shock with their countercyclical policies, then there is decoupling.

 

Otherwise, there is not.  If, however, the shock is global – such as the massive increase in global risk aversion that followed Lehman’s bankruptcy – then there is no possible decoupling: all countries are hit at the same time, and affected depending on the structure of their economies.  The shock is global, there is no transmission across countries or the possibility of offsetting it.

 

With this in mind, the existence of decoupling depends critically on the ability of countries to offset the imported shock with countercyclical economic policies. And there is the key element of this crisis. Back in 1997-98, emerging markets were not able to implement countercyclical policies; they were in fact forced to adopt procyclical policies, such as sharp interest rate increases to control their collapsing exchange rates, which aggravated their woes. Their policies could not decouple.

In 2007-08, however, emerging markets have been able to apply countercyclical policies thanks to the massive improvement in their policy frameworks over the last decade. For all the criticism of the Washington Consensus, all those countries that have followed it and applied rigorous fiscal discipline, liberalized internal markets and adopted credible and independent monetary policies have been able to slash interest rates drastically and, at least, allow fiscal automatic stabilizers to work.  Capital inflows have continued, and their currencies are appreciating again.

 

And as a result of this discipline over the years most emerging markets are recovering much faster than expected and will likely exit this crisis with a set of macroeconomic fundamentals much sounder than those of the G7.  The message is very clear: well done, emerging markets, for ensuring with your past discipline that your policies can decouple. 

 

This decoupling is also very healthy for the global economy. It allows emerging markets to exert some much needed discipline over the G7.  In fact, the lack of decoupling over the last decade allowed for the accumulation of unchecked excesses that, combined with regulation too focused on market discipline, resulted in the boom and bust that we have witnessed.  It is very healthy that emerging markets are publicly casting doubts over the soundness of the policy settings in some G7 countries and the outlook for their currencies, because this may be the only way for these G7 countries to achieve the needed domestic political consensus to implement the required reforms.    The euro area created the Stability and Growth Pact, and the Lisbon Agenda, to replace the lack of market discipline in individual countries generated by the creation of the euro.  The G20 process, and the policy decoupling of emerging markets, is providing some additional discipline to the G7 countries.

 

For the first time in many decades, the world will have to deal with several leading economies that will be competing in a more equal footing. The euro is a reality, Japan has exited its lost decade, despite the recent economic shock, and emerging markets have mostly emerged.  The abnormality of the unique position of the US as the only economic locomotive has mostly ended with this crisis.  This will allow the US to focus on solving its domestic problems with less concern that the needed restructuring will unduly drag global growth, and hopefully deliver a more balanced global economy.  This will also imply that countries that don’t rise to the occasion will run the risk of lagging behind for a long time. The different approach to plant closures across the Atlantic in the restructuring process of the auto industry is a very clear signal that some European countries have not yet realized the competitive threat they are facing.

 

Decoupling, that myth, is happening, is healthy, and badly needed. 

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