From the May 2008 issue of Research Magazine • Subscribe!

Is America Irrelevant?

Robert Reich's recent commentary on "Marketplace," a public-radio business program, addressed the impact of the impending U.S. economic recession on emerging economies.

Gone are the days when, if the United States sneezed, emerging economies came down with a terminal case of pneumonia, noted the eminent economist who served as Labor Secretary in the Clinton Administration and currently teaches at Berkeley. Unlike previous business cycles, the rest of the world will actually shrug off a U.S. economic downturn. At least commodity exporters and such newly developed economies as China will. Oil exporters in the Middle East and elsewhere are flush with petrodollars and China has what Reich calls sino-dollars. All those countries continue to invest and employ their workers, regardless of what happens in the United States. Investment in emerging economies, Reich pointed out, has been growing at double-digit rates in inflation-adjusted terms, compared to only around 1 percent in rich counties.

Reich painted a gloomy picture of those countries marching forward economically, leaving slumping America by the side of the road. With emerging economies powering ahead, commodity prices will remain elevated, stoking a continued boom in emerging economies while delaying an eventual U.S. business recovery.

There are other economists who believe that emerging economies no longer depend on the United States the way they used to. But their view is more sanguine. They believe that the ongoing boom in China and elsewhere will help the United States recover. They will keep buying American goods, especially if the dollar continues to weaken. Over the next five years, the Chinese government plans to spend $100 billion on its railways, while India has earmarked nearly half a billion dollars for infrastructure projects. Saudi Arabia plans to spend a cool $1 trillion in the next decade and a half.

This should shield U.S. construction equipment manufacturers, for instance, even if the U.S. construction industry remains in the doldrums. Fred Bergsten, who heads the Peterson Institute for International Economics in Washington, D.C., believes that emerging economies could mitigate the impact of the internal recession at home.

Still Pretty BigBut this is not a universal view among economists. Many of those, who worry about the impending U.S. downturn, come from India, China, Russia and other emerging markets. They presumably know their domestic situation better.

Indeed, in Asia minus Japan, exports accounted for 55 percent of regional GDP last year. The region is more heavily dependent on the export sector than it was at the start of the decade, when only 40 percent of its GDP came from exports. The United States accounts for 20 percent of world imports. It consumes nearly one-third of the world's oil. Asian exports have become more diversified, and trade among neighbors now accounts for the largest proportion of the region's trade ever. Still, Asian countries rely on the United States for 17 percent of their exports -- or for 8 percent of their GDP.

The United States alone makes up 22 percent of world GDP. U.S. consumers bought $9.5 trillion worth of goods and services last year. Consumers in China and India, whose combined population is nearly 10 times as large as that of the United States, spent just $1.7 trillion.

Dangerous InvestmentIn March, Marketplace ran a series of shows from Dubai, one of which described how China now dominates trade in goods with the Middle East. The bilateral trade increased tenfold over the past decade, and petrodollars from the Gulf have been used to improve port infrastructure in China. Chinese goods are now increasingly trans-shipped through Dubai to other parts of the Middle East and Africa.

The moral of the report, however, was not so much how such trade flows are expanding but how little the United States participates in this trade.

Some economists argue, however, that the United States is not only present in all such trade transactions, but looms large in them. Economist Gary Shilling estimates that as much as 50 percent of demand in emerging economies in Asia is due directly or indirectly to their exports to the United States.

In other words, trade between Dubai and China, and re-exports of Chinese consumer goods and cars to Egypt, Sudan and sub-Saharan Africa have been able to grow so rapidly because U.S. consumers have been buying so much Persian Gulf oil and Chinese consumer goods. Moreover, by running current account surpluses, the United States has also provided massive quantities of dollars for China to invest into its productive infrastructure and for Middle East oil exporters to accumulate large caches of investment funds. Finally, even though no U.S. company is a counterparty in these transactions, trade between Dubai and China is likely to be conducted in dollars. The dollar may have weakened against other world currencies in recent years, but it still remains the universal currency of international trade -- because those trading partners trust the U.S. dollar far more than they do each other's currencies.

If U.S. demand sags, there is hardly any question that both commodity exporters and Chinese manufacturers will suddenly get poorer -- probably much poorer. The booming trade between China and Dubai will become a lot less lively.

Worse, if the United States buys less of the world supply of oil and consumer goods, and if a decline in revenues in developing countries hits their demand as well, all that double-digit growth in investment -- pace Reich -- could come to haunt Chinese manufacturers. Investment is a good thing, of course, but only as long as goods and services produced as a result of that investment generate enough money to pay for that investment. There is, after all, too much of a good thing. Overinvestment is not just bad -- it can be catastrophic.

In an environment of excess supply, producers can't sell their products to repay their debt and to compensate their investors. They begin to lower prices to draw down inventories, and as a result begin to put out of business their healthier competitors. Overproduction crises could be quite severe and they inevitably trigger financial crises, since it is the banks who lend to producers that end up holding the bag.

This is what happened in the early 1990s in Japan, triggering a severe bad debt crisis in the banking system, which the Japanese monetary authorities only recently were able to resolve. A similar overinvestment crisis hit Asian Tigers and Cubs, as the rapidly growing Pacific Rim nations were known back then, in 1997-1998, resulting in a severe economic downturn and a near-collapse of many regional financial markets.

However, the scope of overinvestment in Japan in the early 1990s and on the Pacific Rim later in that decade never came close to the kind of investment growth in Asia, Latin America and Eastern Europe over the past five years. If U.S. demand growth is removed from the equation, business disruption in those regions could prove quite severe. Moreover, when those previous crises hit, the global financial system was fundamentally sound. Now, a crisis in Asia, for instance, could come while the U.S. Federal Reserve and central banks in Europe are grappling with financial woes at home, exemplified in mid-March by the collapse of the venerable investment bank Bear Stearns.

The United States is not only the world's largest consumer, but it is also the linchpin of the world economy. The dollar is central to the global financial system. To hope that the rest of the world can survive a serious U.S. downturn unscathed is like saying that a high-stakes poker game can go on uninterrupted on the top deck of the Titanic while its hull is taking on water.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past five years, 2004-2008.

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