Sunday, April 22, 2007

Could Rest of World Strength Save U.S. Economy From Recession?

As most readers know, I recently wrote a article about why a U.S. recession is likely in 2007, an assessment I haven't changed. However, then as now, I emphasized that it was only likely, not certain. The reason is that it is possible that the U.S. could be as lucky as Australia was in 2005 and be helped by some positive shock. I mentioned one of these possible shocks, falling oil prices, and this is in fact a factor which has helped the U.S. economy already quite a bit as oil prices -in sharp contrast to other commodity prices- is in fact down more than 10% compared to last year.

There is however, another factor which could and are indeed helping the U.S. economy. That factor is cyclical strength in the rest of the world. The other two large power centers of the world, Europe and East Asia is enjoying strengthening growth. While this will limit the decline in oil prices and is contributing to the rally in other commodity prices, the overall net effect of this on the U.S. economy is clearly positive for several, related reasons.

First, because this will increase U.S. net exports, something which will limit the downside to GDP growth when investments decline. The 3 month moving average of the trade deficit is in fact down by $5 billion compared to last year, and so net exports is already strengthening growth.

With the U.S. dollar falling and with domestic demand being far weaker than in the rest of the world, it seems likely that the trade deficit will continue to fall.

But it is not just through higher net exports that rest of the world strength will limit the downside in the U.S. economy. Almost as important is the effect on income flows and balance sheets. We are often told by the financial press that profits of U.S. companies remain strong. Well, actually profit growth isn't really that impressive at 6-7%, but it is nevertheless much stronger than what one would have expected from a economy poised to go into a recession. But the fact is that profits are in fact falling for the domestic operations of non-financial companies. That aggregate S&P 500 profits are up 6-7% reflect booming profits of financial companies and more importantly booming profits of foreign subsidiaries of U.S. companies. Companies like Coca Cola and McDonald's have reported that their profits remain strong mainly because of their foreign operations. This in turn reflects both the high economic growth outside of the U.S. and also currency effects of a falling dollar. The dollar profits of a U.S. company operating in Europe will be increasing at double digit levels even if the profits in euros are flat.

This will in turn also help strengthen U.S. stock prices, and this is one of the reasons why U.S. stocks rallied the previous week. Moreover, as stock prices outside of America also rise, particularly in dollar terms, the value of foreign stocks held by U.S. companies and households also rise, thus helping U.S. households to afford to spend more than their disposable income.

All of this illustrates a fact I discussed last month: that globalization is a factor which have contributed to reducing cyclical swings in the economies of the world.

Will it be enough to prevent a recession? Time will tell. I regard as unlikely, but certainly possible. And even if it doesn't prevent a recession, it will certainly make it a lot milder than it otherwise would have been.


Anonymous Joe T. H. said...

I suppose one could never completely discount the possibility of a recession, but I don't think it's going to happen because the fast-growing developing world has an even faster growing consumer demand for durable and non-durable goods from the developed economies.
I'm not sure you're giving that factor the credit it's due because it'll probably be the saving grace for the slower-growing rich economies of the world. Just like you said, look at corporate profits for globalized companies. Caterpillar had amazing profit growth, but it was all due to growing demand outside the US, not for its domestic operation.

2:11 AM  
Anonymous Anonymous said...

Oughtn´t this lead to higher inflation and interest rates (generally) than it otherwise would have been?

Göran, Sweden

9:01 AM  
Anonymous Anonymous said...

so arguably, globalisation and the fast growing developing world could postpone recessions in rich developed countries indefinitely or at least for a very very long time. What happens if the huge economic engine of developing China hits a recession? And how probable is that anyways?

10:44 AM  

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