Is It the Best of Times or the Worst?
The continuing implosion of the U.S. housing market has caused many forecasters to trim their economic-growth estimates for this year and next. Although none is openly using the R-word, most expect a period of substandard growth extending at least through the first half of 2008. The great uncertainty in the economic outlook is the extent to which housing-related woes and the associated financial-market turmoil might impact other sectors, notably business investment and consumer spending.
August’s roiling of global financial markets highlighted another aspect of the U.S. housing-market meltdown: the fact that growing international trade and cross-border financial flows have made the world’s economies more interdependent. More than ever before, events in one country can spill over into others.
Over the past year, in two editions of its World Economic Outlook, the International Monetary Fund (IMF) has explored how closer economic ties among nations have changed global business cycles. This article summarizes some of the key points made in those very interesting articles.
As worrisome as the current housing and financial-market turmoil may be, it comes during a time of phenomenal worldwide economic activity. The pace of economic growth is the highest in 30 years, and the extent to which countries across the globe are sharing in the prosperity, as measured by the low dispersion in growth rates, seems unprecedented. The volatility of the growth—both across the globe and within most countries—has been moderating since at least the early 1980s, so much so that economists have dubbed the phenomenon “the Great Moderation.” In most countries and regions of the globe, according to the IMF analysis, economic expansions appear to be lengthening, while recessions are getting shorter and milder. Latin America and Japan are notable exceptions. Deep recessions—those resulting in an output loss of at least 3 percent—seem a thing of the past in most large developed countries, including Japan, as well as in China and India.
A hallmark of recent global prosperity is an improvement in monetary policy. Following the abysmal performance of the 1970s, monetary policy in most advanced countries has focused primarily—if not solely—on achieving and maintaining reasonable price stability. Governments gave their central banks more autonomy, and central banks improved the clarity of their operations. More recently, central banks in emerging and developing countries have been showing similar improvements in their monetary policies. Fiscal policies, which can have monetary implications, have likewise improved, becoming less volatile. Advances in countries’ financial infrastructures also seem important. Financial development can aid investment by spreading risk and can help households smooth their expenditures across good and bad times. Much of the moderation in world output volatility reflects a reduction in the volatility of consumption spending, as the IMF shows.
While global business cycles may have become more docile, they haven’t lost their bite. The world remains susceptible to economic developments in the United States; if anything, globalization has probably increased that vulnerability. The extent to which a U.S. economic slowdown spills over to the rest of the world depends, of course, on how hard the United States is hit. Historically, when the United States slips into recession, growth in other countries and regions of the world significantly slows, but usually most other economies do not likewise experience a recession. The extent of the economic moderation in any one country mainly depends on its trade and financial ties with the United States. Other industrialized countries, Latin America, and, to a lesser extent, Asia seem to bear the brunt of a contraction in U.S. economic activity. Over the past year or so, as its housing-sector problems have unfolded, the United States has avoided a recession, but the rate of U.S. economic growth has fallen below its potential pace. The IMF suggests that when this happens, the global effects are fairly negligible and limited to other industrialized countries.
These global spillovers depend on many mitigating circumstances, but generally they slosh through two conduits: trade ties and financial linkages. The first is straightforward. When U.S. economic activity contracts, U.S. imports fall. The IMF suggests that the relative importance of this conduit may be waning somewhat. Regional trade ties—transactions with nearby neighbors—are growing more rapidly for most countries than trade with the United States. Nevertheless, the United States offers a huge market and remains the export destination for nearly 20 percent of all internationally traded goods. In addition, the recent sharp and broad-based depreciation of the dollar is likely to ramp up any trade-related spillovers stemming from a weaker pace of U.S. economic growth.
Financial linkages, however, seem a much more important channel for the transmission of international shocks than trade ties, especially among the large developed countries. Claims on the United States represent a huge share of foreign portfolios, and, likewise, U.S. investors maintain substantial claims on foreigners. Prices of like financial instruments are highly correlated across global markets, and as the IMF reports, this correlation seems to increase in weak markets. When shocks occur in one segment of the global financial market, such as the commercial paper associated with subprime lending, they can quickly spill across a broader array of assets with similar risk profiles. Uncertainty and any associated flight to quality can dry up market liquidity and quickly affect real business investment and consumer spending across countries with strong financial linkages.
So we are left wondering: Is this the best of times or worst?
1. International Monetary Fund. April 2007. “Decoupling the Train? Spillovers and Cycles in the Global Economy,” World Economic Outlook, pp. 121–160.
2. International Monetary Fund. October 2007. “The Changing Dynamics of the Global Business Cycle,” World Economic Outlook, pp. 67–94.