Is Trichet’s Optimism Justified?

Our next anniversary guest post is from the estimable Mark Thoma.

The Fed and the ECB have different economic outlooks for the U.S. and European economies. For instance, the Financial Times reports:

Fed and ECB diverge on economic outlook, by Chris Giles and Ralph Atkins, Financial Times: The Federal Reserve and the European Central Bank painted contrasting pictures of the US and European economies… Together, the statement by Jean-Claude Trichet, ECB president, and the speech by Mr Bernanke indicated that European interest rates were likely to rise while there was no urgency for further US rate rises.
Mr Bernanke gave an optimistic assessment of the US economy’s ability to continue rapid economic growth without triggering further inflationary pressures. … Across the Atlantic, Mr Trichet announced big upward revisions to the ECB’s inflation forecasts … and called for “strong vigilance” to defend price stability – code words used to signal an interest rate increase in early October. … Mr Trichet’s comments followed the unexpected strength of the eurozone recovery in the second quarter, and ECB fears about the impact on inflation
in 2007… Eurozone consumers’ fears about inflation increased in August to the highest level since the introduction of euro notes and coins in 2002…


Bloomberg also notes Jean-Claude Trichet’s fear of inflation:

ECB’s Trichet Says Oil, Wages Are Inflation Danger, by Isabella Lamera and John Fraher, Bloomberg: European Central Bank President Jean-Claude Trichet is concerned rising oil prices and faster economic growth will boost wage demands and inflation in the dozen euro nations… Dangers … include ”the possibility of second- round effects on wages and prices of past oil price increases and the improving labor markets,”… Trichet is toughening his inflation-fighting rhetoric … Trichet said yesterday the ECB will show ”strong vigilance” against inflation, suggesting the central bank will raise interest rates next month. …
For now, Trichet is optimistic about prospects for the euro region even as
the U.S. shows signs of slowing. ”Economic activity is becoming more broadly based” in Europe’s domestic economy, Trichet said…

Is Trichet’s optimism justified in light of signs of a slowdown in the
U.S.? It depends upon how severe the U.S. slowdown is, should it occur, and the extent to which it spreads to Europe, Asia, and other regions. In the U.S., there are clear signs of a slowing housing market  causing to worries about a slowdown in the U.S. economy more generally. Some economists such as
Nouriel Roubini are predicting a severe crash in the housing market followed by a general recession. Others such as and Brad DeLong are also worried about a recession in the near future, but there are also those who believe a softer landing is the probable outcome where the economy glides to a lower, non-inflationary level of growth. But nearly all observers see worrisome risks. If housing does slowdown or crash as many are predicting and as the
evidence suggests, what will it take for the U.S. economy to avoid a recession? If a recession does occur, will it also affect Europe, Asia, and other regions of the world?

If Housing Crashes, How Can the U.S. Avoid a Recession?

On the first question, how to avoid a slowdown if housing begins to fade, the equation Y = C + I + G + NX from principles of macroeconomics is helpful [i.e. income or GDP (Y) = consumption (C) + investment (I) + government expenditures (G) + net exports (NX = Exports - Imports)].
If housing slows down, investment, I, will fall since housing is counted as part of investment. There are several ways to offset this decline. Business investment, another component of I, could increase and there are some signs of sputtering growth here, but I’m not counting on this to bail us out in the event of a large housing decline.
Another possibility is that consumption, C, could increase but with U.S. consumers already taking on massive debt to finance consumption, it’s difficult to see how consumption could increase much more. If anything, the worries are that consumers might back off due to declining confidence, declining housing markets stripping them of equity financed consumption, and rising interest rates lowering demand for consumer durables. Thus, while business investment and household consumption could offset part of the decline in residential investment, counting on a rise in consumption and investment, C + I, to offset the decline in the housing market doesn’t look very promising (see Nouriel Roubini for an analysis of the impact of housing on employment). And given how far taxes have been cut already, and the emerging pessimistic outlook for the economy among businesses and consumers, there’s not much that tax cuts can do to help either.
As for monetary policy, I am not confident that it can be implemented quickly enough to reverse a decline once signs of a recession are evident, but even if it could be, it’s hard to see how cuts in the short-term interest rate will recreate the housing boom or cause business investment to suddenly jump to a higher level.
That leaves increases in G and NX as possible offsets to falling residential consumption. However, due to the deficit in the U.S., the ability to us deficit spending, G, to offset the fall in residential investment and stimulate the economy is limited. That leaves NX. Net exports, NX, could increase due to strong output growth in the rest of the world increasing the demand for U.S. goods. Net exports could also increase due to depreciation in the dollar.

Can Strong Growth in the Rest of the World Save the U.S. from a Recession, or Would a Recession Spread Outside U.S. Borders?

Will strong economic growth in the rest of the world, e.g. in Europe as predicted by Trichet and others, bail the U.S. economy out should housing decline? That depends on the answer to the second question posed above, whether a recession in the U.S. will spread to Europe and Asia. There are differing views on this. Nouriel Roubini is insistent that the world cannot decouple from the U.S. and will, therefore, also experience a decline should the U.S. experience a recession. If this is the case, then the U.S. cannot rely upon an increase in exports to pick up the slack from falling investment in housing. Here’s Nouriel:

Ugly Reality #4: The World Will not Decouple from a U.S. Slowdown/Recession Because When the U.S. Sneezes the World Gets the Cold.
There is a now another fairy delusion in the market that the rest of the world will somehow weather the coming U.S. recessionary tsunami. … The argument now presented in the most reputable research shops of the most reputable global investment banks is that, even if the U.S. slows down the
world will "decouple" (to use the arguments strongly presented by Goldman Sachs) from the U.S. slowdown and will keep on growing at a perky rate in Asia, Europe, emerging markets and Latin America.
The argument is that there is enough domestic demand momentum in the four leading Asian economies (China, India, Japan and Korea) and there is now such a resilient recovery of growth in the Eurozone … that the rest of the world can happily weather the U.S. recessionary tsunami. In JP Morgan’s terminology, this "decoupling" is termed as the "rotation in global growth" from U.S. to Asia and the Eurozone. Others refer to it as the "locomotive" switch with a switch in the growth locomotive from the sputtering U.S. one to the perky ones in EU and Asia.

I have already written extensively twice – starting with by my June 14th
essay 12 Reasons Why the World Will Not De-Couple From the Coming U.S. Growth Slowdown…Or “Why When the U.S. Sneezes the World Gets the Cold” – on why the world will not decouple from the U.S. recession. The markets are still in the hope of a U.S. soft landing and in the hope that, if a soft landing is at risk, the Fed will come to the rescue. The reality that the coming U.S. economic developments will hit and hurt the rest of the world has not yet registered in the minds of investors where the "decoupling" or "rotation" fairy tales still dominate. But there will be no decoupling…

And in my recent blog last week, I elaborated in more detail how … 12 specific factors will lead to a slowdown of growth in China, Japan, the rest of Asia, Europe, emerging markets and Latin America. The world will not be able to decouple from the US slowdown. The effects of the US slowdown on global growth may be delayed by quarter or two, as Asia and Europe are now in a cyclical recovery; but each one of these region has its own individual macro vulnerabilities that will
rapidly emerge and spread once the US slowdown and recession is underway.

Under this scenario, the recession will spread to Europe and because of that, there will be no
increase in export demand from Europe sufficient to offset the fall in housing investment in the U.S.

Can a Fall in the Value of the Dollar Save the U.S. from a Recession?

What about the other mechanism for increasing net exports, a fall in the value of the dollar? Martin Feldstein is a bit more hopeful. He believes a fall in the dollar is inevitable and that, when it occurs, Europe and Asia need to focus on policies to stimulate domestic demand to offset the fall in their net exports caused
by the falling dollar:

The forces that lowered the US saving rate are now being reversed. House prices nationwide are down from the peak reached in the middle of last summer. The Federal Reserve has reversed its low interest rate policy… It will only be a matter of time until the household saving rate is at least back to the 2.4 per cent level of 2002. To convert this higher saving to a reduction in the current account deficit requires increased exports and a shift in Americans’ spending from imports to domestically produced goods and services. A lower dollar will provide the necessary incentive for both of those changes to occur.
Natural market forces are already causing the dollar to fall against the euro, the yen and other currencies. The dollar’s fall is responding to the narrowing gap between US interest rates and those in Europe and Japan. …
Past experience shows that a more competitive dollar can substantially reduce the trade deficit. The last big fall of the dollar, a 37 per cent decline in the mid-1980s, was followed by a 40 per cent fall in the trade deficit.
A lower US trade deficit will of course mean a decline in the exports of our trading partners around the world. Countries that lose exports need to adopt policies to stimulate domestic spending in order to prevent a decline in their GDP and employment levels. Where this all ends will depend not only on market forces but also on the policies of the governments and central banks of Europe and Asia. It will be tempting but wrong for them to resist the decline in the US trade imbalance by using a combination of monetary policy and exchange market intervention to prevent the dollar’s shift to an appropriately competitive level.
Without that competitive dollar, the higher saving rate in the US will mean slower US growth and rising unemployment. If that happens, the American political process is likely to turn to protectionist measures to shrink the trade imbalance and maintain employment. It would be far better to allow the natural market forces to bring about the needed currency realignment. Instead of seeking to resist the dollar’s shift to a more competitive level, governments in Europe and Asia should focus on developing policies to maintain aggregate demand in their individual economies as their export sales decline…

Feldstein ends with:

Resolving the massive trade imbalances without a global cyclical downturn can be achieved, but only if countries approach this challenge in a constructive way.

Thus, he sees hope that NX can be stimulated sufficiently to offset declines in U.S consumption and housing investment. I am not as confident as Feldstein is that net exports can pick up the slack even with the implementation of policies in Europe and Asia to stimulate aggregate demand. I also agree with Roubini that a U.S. slowdown has the potential to spread beyond U.S. borders, though not to the same degree that he does.
Part of the reason for some optimism that European aggregate demand can remain robust in the face of a U.S. slowdown comes from Brad Setser, though there are questions about how much the U.S. will benefit from growing demand in Europe:

Europe, engine of global demand growth …, by Brad Setser: That isn’t a headline that you see in mainstream economy commentary. The standard story – one that is echoed in communiqué after communiqué – goes something like this.
Global rebalancing – code for a set of changes that will slow demand growth in the US and increase demand growth outside the US to help reduce the US deficit and the rest of the world’s surplus – requires policy changes in Asia, the US and Europe. Somehow, the oil exporters usually get left out despite having a bigger surplus than anyone else.
What does Europe need to do contribute more to global demand growth? Reform its labor and product markets. It hasn’t done so. So it won’t be able to contribute to global rebalancing. One problem. The story isn’t true. Not right now. Europe may not have reformed. But it sure has contributed to global demand growth over the past year and a half. My evidence? European imports. Imports are the most direct way Europe contributes to global demand growth. And they are way, way up. …
It isn’t all oil either. China doesn’t export oil. And European imports of Chinese goods are growing faster than US imports of Chinese goods. … And Europe, unlike the US, pays for its imports with a hard currency backed by real export capacity, not just a comparative advantage at producing debt …
The facts are pretty clear. Europe has delivered a big impetus to global demand over the past 18 months. Despite the absence of the labor market reforms…
So what is the problem? I can think of two. First, Europe’s mini-boom may be ending. The data is contradictory. Some German business confidence data is encouraging; other German business confidence numbers are not so encouraging (hat tip, Claus Vistesen). The same forces that pulled down the US housing market may eventually hit Spain and France. Second, Europe’s mini-boom helped China increase its surplus more than it helped the US reduce its deficit. …
US exports to Europe are up. But nothing like Chinese exports! To bring about true global rebalancing, European imports not only need to boom. That already has happened. But the US needs to benefit far more than it has from that boom. …

So where does this leave us? Should a slowdown in housing occur in the U.S., I am not confident that offsetting changes in aggregate demand from other sectors, the foreign sector in particular through changing imports an exports, will be sufficient to offset the decline. And should a decline occur, it stands a good chance of spreading to Europe and Asia causing further problems for all U.S., European, and Asian economies.
Returning to the the original question, should Trichet be optimistic that Europe can weather a U.S. slowdown? I believe there is reason for be wary. Given th long lag between the time that interest rates are changed and the the response of inflation, output, and other macroeconomic variables, if I were in Trichet’s shoes, I would think hard about holding interest rates steady for now and waiting to see how events unfold. The rise in inflation and inflationary expectations and the relatively accommodative stance for interest rates make that strategy hard to pursue, but it’s still worthy of serious consideration.

4 thoughts on “Is Trichet’s Optimism Justified?

  1. What will the oil exporters, Japan and China do with all their dollars if the dollar drops?

    According to Warren Buffett, their best bet is to buy (stocks in) American companies. Perhaps investment(I) will be raised from the outside?

  2. Hi Mark,

    Just a couple of points.

    “Nouriel Roubini is insistent that the world cannot decouple from the U.S.”

    I think this is a mistake. In a sense the world already has. If you look at the fact that global growth this year is likely to be in the 5% region, while the US might grow say 3.5%, and Japan say 2.5% and the eurozone say 2.0%, then it is clear that someone somewhere else is now doing the heavy lifting. Most likely candidates are places like China, India, Brazil, Turkey and a string of other developing countries like Argentina and Chile who are to some extent riding the commodities boom generated by the aforementioned.

    This is a sea-change from the 1995-2000 period, when US growth did account for a huge proportion of global GDP growth. I think this de-coupling will become even clearer after the next recession (which could be 2007 or 2008, we have no crystal balls, but I would pencil something in for 2007, especially if the collsion with Iran continues its course). The next upswing will surely be pulled by the new Growth Pandas (or if you like growth giant pandas).

    The big issue is going to be how you square the circle on trade and capital flows.

    One important point that isn’t being noticed (or isn’t being given sufficient importance) is that three of the G7 economies are going to have severe fiscal tightening in 2007 to accompany high oil prices and raised interest rates (Japan, Germany and Italy).

    So the machine isn’t going to be pulled in this direction. This tightening isn’t, as Rogoff suggested frustrating, it is, unfortunately, entirely in the logic of things since these three economies have lived through the good times of this upswing with sustained fiscal deficits, and their budget liabilities with their aged populations mean that some time or another they have to change course. At least for the time being the plan is to change course in 2007 (this may, of course, be revised in the face of inclement weather).

    But the big underlying issue is that these elderly economies cannot sustain strong internal demand, and can only live by trade exports and by the export of capital which is a spin off of the high savings rates. (In the case of Italy this is less clear, since the trade surplus has collapsed, but the gap is currently being made up by cheap finance from the eurosystem which goes to pay for Italian government spending).

    Anyway, the real probem as I see it is this one. Most of the developing countries need to be export driven, and when they are not buying raw materials and equipment they will have an in-built tendency towards deficit during the development process. At the same time the elderly part of the G7 needs to run surpluses for quite other reasons. So this leaves us with very few countries to balance the books. The UK is undoubtedly one that can run a deficit, France could too, but the big big customer is undoubtedly the United States.

    And this is the importance of the argument about housing, since if people stop recycling equity then demand for goods from abroad is likely to drop. This can then have a whole domino impact across the global economy, which far from encouraging investment in the US to take up the slack can have exactly the opposite effect as companies across the globe slash prices to offload unwanted excess output, thus discouraging further investment in the US. The recent surge in capital investment in Japan should fill one with a little foreboding in this regard.

    Well, I said just a couple of points and I seem to have gone on a bit. Anyway thanks for the stimulating post.

  3. edward

    you make this sound like an international race to the bottom. if you are correct, then no currency is king.

  4. “then no currency is king.”

    At the moment you are right, there is a neck and neck going nowhere. If the eurozone eases back the dollar will rise, not fall, and the yen will try as hard as it can to trawl the bottom.

    The new kings will be the yuan and the rupee, back by the enormous economies which will be backing them 10 to 20 years from now.

    At the same time I want to emphasise I am not predicting gloom and doom, just adjust your belt a little, I’m sure there is plenty of slack there. Or practice a bit of calorie restriction, that is supposed to be good for your health :).

    But seriously, I don’t forsee a big global downturn, just a slackening in the pace of growth, especially in Japan, Germany and Italy, with some easing off in the US. We could have a close call with recession in the US, but then things will pick up again, the momentum in India and China is just too strong for this not to happen, but in the meantime the world will have changed.

    Of course this isn’t a race to the bottom, for them it is a race to the top. It’s called ‘global rebalancing’. And good luck to them, they’ve been the underdogs for long enough.