This is the final post in a series on how a weaker global economy can threaten the strengthening recovery in the US. The first post in the series is the introduction, which is followed by three parts. Part I, delves into the drivers of growth in the US and in the rest of the world. Part II explains the basics of an open economy and analyzes the recent rise of the US dollar and the role of the trade balance in the US economy. This post, Part III, ties it all together by discussing the importance of demand to the US and global economies.
In an economy that is in dire need of consumer demand to sustain growth, a rising trade deficit driven by both declining exports and rising imports signals worries. The extent to which the rise in the dollar is sustained as a result of strong US demand, it could shift an increasing amount of US demand abroad as foreign products (imports) become cheaper for US consumers. This is the real threat of a weak global economy slowing down the momentum of the US economy. It comes down to demand.
As described in Part I, precious consumer demand is appearing to finally return in the US. Consumer demand encourages the virtuous cycle – more demand leads to more business activity to meet that demand, which drives business to hire more workers, which increases employment and income, which creates more demand – that keeps an economy thriving. We are seeing early signs of this in the US, yet it has still been largely absent in other major economies like the euro area, Japan, and China.
With a stronger dollar, the price of imports drops for US consumers and reduces export competitiveness for US firms (see Part II). With a lack of demand in foreign markets yet rising demand and consumer spending in the US, foreign exporters will increasingly look to the US as an export market in competition for US demand. The more US demand is absorbed overseas, the less it is absorbed in the US and the less strength it has in stimulating the virtuous cycle that every economy seeks to fulfill.
Most worrisome would be if US consumers revert back to spending beyond their means and lenders finance a growing trade deficit with debt. After all, US households have gone through (and in some cases are still going through) a painful deleveraging (reducing debt) process that included a large number of home foreclosures and credit defaults. The benefit now is an average US household with 26 percentage points less debt as a percent of its disposable income, according to a recent McKinsey report on debt and deleveraging. It would thus be much less likely for the US to return to a credit-fueled expansion in the same manner as it had in the pre-crisis years. Yet with very low interest rates, strong purchasing power of foreign goods through a favorable exchange rate, and a global economy eager for scarce consumer demand, one must keep a watchful eye.
Over the medium to long term, if income inequality remains stark, education and health care costs remain high, and wage growth does not pick up at a sustainable rate, the US could indeed find itself in the same precarious position that it found itself in back in 2009. The difference would be a government with debt already over 100 percent of GDP and a Federal Reserve with a massively larger balance sheet, already low interest rates, and inflation below its target. This means that both the government and the Federal Reserve would have much less firepower to respond to crises.
The good news is that these are only possibilities if the weakness in the global economy indeed takes hold in the United States and if the rising dollar indeed derails current US momentum. Currently, net exports contribute roughly the same share of US growth than they have before the crisis. The rise of the dollar is nonetheless a sign of US strength based on consistent job growth, output, and a potentially resurgent US consumer. In a historical perspective, the dollar has been at least as strong in different periods (although in different global contexts). Lower oil prices are in the US economy’s favor and the US is emerging as a dominant player in the energy economy through its production of shale oil and gas. New consumer protection laws are also in place and banks have higher capital requirements, although the extent to which new laws passed since the financial crisis are effective is a subject of debate.
Policymakers can avoid the short and long term risks associated with a continued rise of the dollar in a relatively weak global economy. Abroad, leaders should further commit to their pledges to increase investment and make the reforms necessary to provide a more credible outlook for their economies. Such investments and reforms have been outlined and made clear in various international fora like the G-20 and the IMF. In the US, policymakers should counter any tendency for credit-driven rises in consumer spending and real estate prices, take full advantage of historically low interest rates to finance badly needed, growth-enhancing infrastructure investments, and do everything in its power to reverse the decline in inflation. This could mean that the Federal Reserve would need to hold off on raising interest rates.
Relatively weak economic growth elsewhere in the world poses a threat to the momentum in the US if parts of the world do not pick up pace soon. If the current environment stubbornly persists, further risks could emerge that are reminiscent of the risks associated with the magnitude of global imbalances in the pre-crisis years. Groups like the G-20 are now becoming increasingly important, and their action plans to stimulate demand are becoming increasingly important not just for the US, but for their respective economies as well. As we push further along in 2015, the US economy is expected to continue to outperform the global economy, and it is in everyone’s interest for the others to catch up.
This concludes the series on the risks of a weak global economy on a strengthening US economy.
Part III: The Quest for Demand and the US Consumer