Views from the World
The Main Casualties of the Credit Crisis
Anatole Kaletsky, Editor At Large, The Times
(Keizai Koho, February 2008 issue)

Most commentary on the global credit crunch has focused on the dangers to the US economy of a collapse in housing and a slowdown in consumer spending. As 2008 progresses, however, it may well turn out that the main casualties of the credit crisis are not American homeowners and consumers, but businesses and workers in the rest of the world.

While newspaper headlines all over the world were warning of a US recession and a global financial crisis, the US economy actually accelerated very strongly this summer, recording a growth rate of 4 per cent in the second and third quarters. The economic forces that made this unexpected acceleration possible present some serious challenges for America's major trading partners. Japan and Western Europe in particular must focus on these shifts in the balance of global growth more clearly if they don't want to become the biggest victims of the US housing slump.

What drove the US economy's enormous acceleration this summer was an upsurge in exports and a slowdown in imports - and these trends are likely to become even more pronounced in the near future, for reasons directly related to the property slump. A strong link has been observed over the years in most advanced economies between housing cycles and the balance of payments. When property prices boom, a country's imports tend to rise and its exports to slow down, as market forces shift labour and resources from manufacturing to housebuilding and consumption. Once house prices start to decline, the opposite effect is observed and the trade balance shifts in favour of exports. This relationship was clearly demonstrated by a detailed study of 44 housing cycles in 18 countries published two years ago by the Federal Reserve Board (House Prices and Monetary Policy. September 2005) The Fed's composite model, based on the experience of all these cycles, suggested that the US current account deficit would probably reverse most of the past four years' deterioration as if house prices declined. Since the US deficit increased by 3.5% of GDP, equivalent to around $400 billion from 2002 to 2005, a narrowing of about the same amount could be expected. A year ago, this prediction might have seemed just a theoretical speculation, but in the past few months, the narrowing of the US trade deficit - and the boom in America's export sector - have become observable facts. Since the summer of 2006, the US deficit has shrunk by 1.5% of GDP and the latest trade figures have shown US exports growing by 15% in real terms, while imports grow by only 5%. In 2008, with the dollar now at record lows, this shift in the US trade pattern is likely to move even faster, adding 1.5% to 2% to America's growth.

The good news is that this export boost will probably be enough to offset the damage done by housing slump to the US economy and job market. The bad news is that the $200 billion plus of extra economic activity gained by US businesses and workers will be exactly matched by similar losses in Europe, Asia and the rest of the world.

If this happens - and it is happening already - then the biggest impact of the US housing slump may not be on America but on its trading partners. And one of the most important questions about next year's global economic outlook is which countries and regions will suffer most from improving US trade.

Most people's instinctive answer is that the countries most threatened by the " improvement" of US trade deficit are the ones that currently have the biggest surpluses against the US - China, Japan and the oil-producing countries. But this answer is probably wrong.

Europe is likely to prove much more vulnerable than Japan, China or the Middle East to a US slowdown, just as it was in 2000-02 and in 1991-93. If the US trade deficit shrinks by $200 billion in the next year or so, simple arithmetic seems to suggest that the trade surpluses of other regions will have to fall by the same amount. Because Japan, China and OPEC are the only US trading partners with surpluses that big, it seems natural to assume that they will be the ones who suffer from the loss of US trade. But this simple arithmetic is misleading: The US trade deficit could easily shrink by $200 billion or more, even if the Chinese and Japanese surpluses stayed as big as they are today or kept expanding. This could happen if Europe moved from its present position of rough trade balance, to an American-style deficit of several hundred billion dollars.

How likely is this to happen in the next year or two? Most European policymakers and businessmen seem to think it is impossible. Europe, they say, has never had huge American-style deficits in the past, so why should they suddenly emerge now? Sadly for European exporters, the answer is quite simple: currency movements. While today's media headlines and market chatter are dominated by stories about the ?gcollapsing" of the dollar, the real currency story of the past few years has not been the devaluation of the dollar, but the revaluation of the euro and the pound. The fact is that the dollar has scarcely been devalued at all against the important Asian currencies - it is worth exactly the same against the yen as it was three years ago. The big event in the currency markets has been the enormous revaluation of the euro against the dollar, the yen and the renmimbi.

To make matters worse for European exporters, the character of America's trade adjustment is now undergoing a change. While last year's narrowing of the US trade deficit was caused mainly by a slowdown in US consumption, the global trading system is now moving into a phase where the devaluation of the dollar becomes the main driving force. This is because a currency movement typically takes two years or more to affect exports, so the full effects of the weak dollar on global trade patterns will only be felt in the two years ahead. As a result, the marginal producers of goods for the American market are much more likely to be European than Chinese. Korean or Japanese. Moreover, the biggest trade effects of the dollar's decline against the euro are likely to be seen not in the American or European market but in third countries where European manufacturers comp ete against American, Japanese and other Asian rivals on roughly even terms. These are the markets where European exporters will be squeezed out most readily by price competition from Asia and the US. In sum, it may seem natural to think of companies like Honda, Samsung or Toshiba as being most vulnerable to the present US mortgage crisis; but the real casualties of a US slowdown will probably be the likes of Volkswagen, Siemens and Alcatel.

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