It's not the end of the world
Martin Wolf, Financial Times, December 13, 2000

Think the unthinkable. Suppose the US economy were to fall into recession. The probability is uncertain, but bigger than zero. Since it is good to be forearmed, let us examine what this might mean for the world.

Assume that the US private sector financial deficit, now at a record level of almost 6 per cent of gross domestic product, went into reverse, as the share of investment in GDP fell and the savings rate rose. Over the long term, the private sector financial balance has averaged not a deficit, but a surplus of between 2 per cent and 3 per cent of GDP. A return to the historic mean would entail a huge reduction in demand. An overshoot, quite normal during recessions, would generate a still bigger fall.

If the shift happened quickly, a recession would be inevitable. But it would be cushioned by a weaker fiscal position and an improvement in the current account. A conceivable outcome would be elimination of the current account deficit, along with a big budget deficit.

What might this scenario mean for the world? This was examined in my article, "The mother of all meltdowns", referred to in my column last week (FT, December 6) on the risks of a hard landing.* The means by which a US recession would be spread to the world are four: trade; capital flows and exchange rates; commodity prices; and contagion.

Foreign Policy
September/October 2000

Start with trade. Suppose that a US recession reduced imports of goods and services by 20 per cent in real terms and raised exports 5 per cent, over just a few years. Such an adjustment would be the smallest needed to eliminate the current account deficit.

Direct demand for the rest of the world's output would be reduced by about 1.3 per cent over the relevant adjustment period. The effect would be biggest on Canada, Malaysia, Mexico and Thailand, where the direct impact of the shift in trade balances on GDP would be between 3 per cent and 8 per cent of GDP.

Yet these are exceptional cases. The direct reduction in the GDPs of the western hemisphere and developing Asia would be about 2 per cent, although there would be a bigger effect on Hong Kong, South Korea, Singapore and Taiwan.

Central and eastern European countries in transition would not be too hard hit by the trade effect, since they do vastly more of their trade with the European Union: Poland exports as much to Denmark as it does to the US. The direct impact on the euro-zone, Japan and the UK would also be small - a little over minus 0.5 per cent of GDP. Only 2.3 per cent of the euro-zone's GDP is exported to the US; for the UK, this ratio is 2.8 per cent; for Japan, it is 3.1 per cent.

Thus, provided the US trade adjustment occurred over a few years, most countries should easily avoid recessions caused directly by changes in trade balances.

The second channel would be a weak dollar. If inward capital flows were interrupted, as seems probable, the dollar could fall by a third, or even more, against the yen and the euro. Similar declines have occurred in the past. The fall would be accelerated by the inevitable reduction in short-term US interest rates. The currencies of most emerging market economies would presumably weaken with the dollar. Argentina would be ecstatic.

A serious weakening of the dollar would create a big challenge for Japan. The Bank of Japan might be forced to support open-ended exchange-rate intervention. The euro-zone would also be squeezed by a falling dollar. But it is in a far more comfortable position than Japan. Provided the European Central Bank cut interest rates promptly, it could shield the euro-zone and help stabilise the world economy.

The third channel would be commodity prices, particularly oil. A big US slowdown would have a powerful effect. The oil market, in particular, is finely balanced, with price-elasticities of demand very low in the short term. Oil prices could weaken quickly. This would reduce inflationary pressure, making it easier for the Federal Reserve and other central banks to respond. Lower oil prices would also directly benefit many emerging market economies but damage the prospects of oil-exporting countries.

The last and almost certainly most important channel would be financial. The biggest danger is contagion, particularly via stock markets. With the exception of the Japanese stock market, markets have long tended to take their cue from Wall Street. Canada and the UK would be particularly hard hit because of their close links to Wall Street. But in 1999 the ratio of stock market value to GDP in the euro-zone was half that of the US or the UK. Moreover, most of these holdings are corporate, not personal. Thus, even a steep decline in stock markets should have a much smaller impact on spending in the euro-zone than in the US.

The bottom line, then, is that a US hard landing would have a sizeable impact on the rest of the world economy, but would create benefits and opportunities along with the problems and challenges. Provided other countries responded in a sensible way, the world could adjust. Growth outside the US should remain positive, except perhaps in Canada, Mexico and several of the smaller export-dependent east Asian economies, particularly if the currencies of emerging market economies were to fall with the dollar and the ECB reacted positively. Japan could face a big crisis - but only because it is so fragile already.

This reasonably relaxed view assumes there are no wider political and policy repercussions. In the US, the disappointment might prove devastating, because unexpected: investors would be bitter; start-ups would stall; unemployment would soar; the reputation of Alan Greenspan, the Federal Reserve chairman, would be in tatters; the next president could be a one-term wonder; and protectionism would increase. At worst, the US might abandon its promulgation of an open, market-based world economy.

Similar doubts might emerge elsewhere. Since the slowdown would come so soon after the financial crises of 1995 and again of 1997 and 1998, governments in emerging-market economies would come under strong pressure to be more inward-looking. Led by France, the EU might promote the cause of a more dirigiste and egalitarian approach to the economy. The US model would lose some of its allure.

If the outcome were to include an ill-considered turning away from the world market by the globe's weaker economies, it could be a tragedy. No less tragic would be a protectionist reaction in the US. But none of this has to happen. The world economy could cope with even a US recession. It is the job of policymakers to ensure that it does.

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