To De-couple or not to De-couple ...

This seems to be one of the most pertinent questions going into 2007 with a slowing US and over at Econbrowser Menzie Chinn takes up the issue. There are a lot of important points here but let us begin with an initial outline provided by Menzie.

The dream rebalancing scenario, in which adjustment of the world's imbalances occurs without fiscal responsibility returning to America, relies upon "decoupling".

A rejuvenated Europe, stripped of structural rigidities, and a resurgent Japan equipped with a newly reformed financial system, pick up growth, and begin running bigger trade deficits. The U.S. moves to a glide path of sustainable growth with shrinking trade deficits. I remember this scenario being outlined when I was in the Government --already over five years ago now. It's similar to rosy scenarios of global rebalancing circulated these days.

As such we can say that any idea of de-coupling assumes that growth in the de-coupling economies are driven, at least to some extent, by domestic dynamics. This, as Menzie notes, is also the whole issue when it comes to re-balancing and consequently we can approach this by saying that the extent to which the Eurozone and Japan (for example!) de-couple from a US slowdown also mirrors the extent to which these economies can contribute to the re-balancing act. In short, someone needs to run a trade-deficit here and we need to ask ourselves whether the Eurozone and Japan are the best candidates at this point? I am not so sure! In terms of the more policy induced nature of the imbalances (i.e. Bretton Woods 2) the RMB remains to be pegged and Brad Setser also reports Asian CBs in general show little sign of diversification although mind you that his analysis is based on the third quarter report from the IMF. Perhaps the fourth quarter figures will show something different? Meanwhile some of the petroexporters seem more willing to bet on the Euro rather than the Dollar.

The IMF as quoted by Menzie also seems to be rather sceptical of the de-coupling scenario at this stage ...

A review of recent historical experience yields at best only mixed to weak support for the decoupling thesis. Indeed, rising shares of exports in GDP suggest coupling should be trending stronger. That said, periods of apparent decoupling can arise when divergent shocks to domestic demand are driving growth, as has been the case recently. The bottom line is that we still expect growth elsewhere to be noticeably affected by a significant change in US growth prospects.

Consequently, what I am really trying to get to here is a discussion about the big pieces of the puzzle and how they should be aligned. This is also important when it comes to the recent wobbles in the Euro/Dollar. Did we see the beginning of a dollar crash or was the dollar's slide mainly driven by interest differentials and if we go for the latter view (I do) what, crucially, do we expect in terms of interest differentials in 2007? Do we really expect the ECB to close the gap on the Fed? And what if the Euro is propped up by diversifying petroexporters? As such, we can say that the potential floor for the dollar's depreciation is represented by the potential ceiling of other currencies' appreciation. As such this discussion mirrors the de-coupling and re-balancing story to some extent. This is also essentially what I am arguing in my recent 're-balancing posts' as we can all see that the dollar must fall but who is going to take up the slack? Most people seem very interested in the Euro and it does seem as if the petroexporters (perhaps!) are beginning to diversify in favor of the Euro but this process can only go to the extent that it is internally sustainable, that is to say the extent to which the Euro can muster it. We need to think about the fact that a rising currency is a proxy for deflationary pressures in the domestic markets and consequently that export dependant economies ( e.g. Germany) will come under pressure in this case very literally since the ability for Germany and Italy to pick up on domestic demand is, at best, far from clear at this point. At the end of the day it is all well and good that people are arguing that the Eurozone needs to import more and take up the slack from the US but what if Germany and Italy for example just cannot respond to this and as a result runs into deflation? Remember here that a hawkish ECB and general fiscal tightening in 2007 are also putting a downward pressure on and growth and price levels.

This is clearly still an unrealistic scenario I would say but this could very well be a theoretical end point if the process continues. Once again, how we piece together the puzzle is important. Without a doubt I need to tread carefully here and my implied rather bearish forecast for Germany (and Italy?) going forward is not at all certain. Most notably, Sebastian Dullien from Eurozone Watch has recently argued why he believes we need to be far more optimistic on Germany.

At the end of the day I cannot yet argue that my analysis is right ... there are still too many blanks to fill in but I do believe that we need to think about this in a general sense. Things are not as straightforward as they seem.