The dream rebalancing scenario, in which adjustment of the world’s imbalances occurs without fiscal responsibility returning to America, relies upon “decoupling”.
A rejuvenated Europe, stripped of structural rigidities, and a resurgent Japan equipped with a newly reformed financial system, pick up growth, and begin running bigger trade deficits. The U.S. moves to a glide path of sustainable growth with shrinking trade deficits. I remember this scenario being outlined when I was in the Government –already over five years ago now. It’s similar to rosy scenarios of global rebalancing circulated these days.
The newly released IMF “Financial Market Update” (December 2006) includes two interesting graphs. The first shows current forecasts for output in key regions.
Figure 1: Source: IMF “Financial Market Update” (December 2006).
What is more interesting, in some respects, is the distribution of the forecasts. Figure 2 demonstrates that the bimodal 2007 US growth forecast distribution of July has transformed — and downshifted — to a unimodal distribution in November. In other words, the extreme optimists have been persuaded that growth is slowing. In Europe, the optimists are in ascendence, with the entire distribution of forecasts shifted upward.
Figure 2: Source: IMF “Financial Market Update” (December 2006).
So what are the prospects for an acceleration of growth? According Deutsche Bank’s World Outlook article “If the US sneezes, will the world still catch a cold?” (December 18):
- The risk of a faster pickup or slowdown in the US raises the question to what extent such surprises could spill over to the rest of the world. Recently diverging trends in US and foreign growth (and interest rates) have raised questions about a possible decoupling or drop in sensitivity of the rest of the world to what is happening in the US economy.
- A review of recent historical experience yields at best only mixed to weak support for the decoupling thesis. Indeed, rising shares of exports in GDP suggest coupling should be trending stronger. That said, periods of apparent decoupling can arise when divergent shocks to domestic demand are driving growth, as has been the case recently. The bottom line is that we still expect growth elsewhere to be noticeably affected by a significant change in
US growth prospects.
It might be useful to think about why high comovement is likely to occur. In the most basic Keynesian analysis, increases in aggregate demand get propagated via exports — i.e., the other country’s imports. In principal, movements in exchange rates, and other asset prices, can mitigate the direct Keynesian effects.
The authors (Peter Hooper and Torsten Slok) argue that decoupling can occur, depending upon the nature of the shocks; however, the fact that export intensity has been rising over time makes it less likely that decoupling can occur. While allowing the recent evidence of decoupling (namely the breakdown of the correlation between the Ifo index from the ISM purchasing managers index (PMI) in the past half year) is interesting, they point out that when the demand shocks go in the same direction (as DB predicts) then decoupling is more difficult. A VAR analysis indicates a one standard deviation shock to the PMI residual results in a 1.7 ppt reduction in the US PMI, and an eventual 5 ppt reduction in the EU-12 PMI-proxy after about a year. Other regions experience a smaller reduction.
To the extent that shocks to the PMI are demand shocks, decoupling might be difficult to accomplish.