It’s hard to imagine that a US-centric global economy wouldn’t be at risk in the aftermath of a bursting of the US housing bubble. Lacking in internal support from private consumption, the non-US world remains heavily reliant on selling exports to wealth-dependent American consumers. As the United States now comes to grips with the aftershocks of another post-bubble shakeout, so, too, must the rest of the world.
There’s no consumer in the world like the American consumer. In 2005, US personal consumption expenditures totaled $8.7 trillion. At market exchange rates, that was about 20% higher than consumption in Europe, a little more than three times that in Japan, nine times that in China, and fully 17 times consumption levels in India. The comparisons are equally striking when private consumption is expressed as home-currency shares of each economy’s respective GDP – 70% for the US in 2005, 54% in Europe, 57% in Japan, 38% in China, and 64% in India. Putting it another way, one measure of America’s “excess consumption” – defined in this case as the difference between growth in consumer outlays and disposable personal income – was about $210 billion in 2005, or almost half of total consumption in India.
Post-bubble shakeout: domestic consumption
In my previous essay (see: Where next as the US housing bubble bursts?, I concluded that over-extended US consumers would be quite exposed to the correction in the US residential property market that now seems to be unfolding. Downside adjustments to US consumption stem from three macro forces – a negative wealth effect traceable to a flattening out of home prices, multiplier effects attributable to the employment cutbacks in construction activity, and possible increases in income-based saving to compensate for the loss of asset-based saving. During the ascendancy of the Asset Economy over the past 10 years, average growth in real consumption (3.7%) exceeded that of real disposable personal income (3.2%) by 0.5 percentage point per year.
In light of the post-housing bubble headwinds noted above, I could easily see a reversal in this relationship, with consumption growth falling short of real income growth over a protracted period of time. Moreover, to the extent that the direct and indirect effects of weaker construction activity depress baseline income generation, the consumption outcome could be under even greater pressure. All in all, I wouldn’t be surprised if real consumption growth in the US averages 2.0% to 2.5% over the next couple of years – about 1.5 percentage points slower than the vigorous asset-dependent growth trend of the past decade.
Should it occur, such a 40% haircut to the US consumption growth rate would have important consequences for the remainder of a US-centric global economy. In large part, that’s because the non-US portion of the world is very much lacking in domestic consumption support of its own and, as a result, remains heavily dependent on exports, much of them to the US. For example, over the 2003-05 time period, real growth in private consumption expenditures averaged just 1.2% in the Euro area, Japan, and in Asia’s newly industrialized economies (i.e., Korea, Taiwan, Hong Kong, and Singapore). By contrast, export volume growth averaged 7.1% in the same three regions over the past three years – fully six times the pace of consumption growth.
Meanwhile, in the US, there was much closer alignment between export and consumption growth over this same period – 5.7% average growth in exports versus 3.5% growth in consumption. This underscores a sharp dichotomy in the balance between external and internal demand in the developed economies: For the non-US portion of the advanced world, the spread of export over consumption growth over the 2003-05 interval was nearly six percentage points – almost triple the 2.2 percentage point spread in the US. Consequently, with the world’s dominant consumer likely to retrench in the aftermath of a bursting of its housing bubble, the rest of the world can hardly be expected to sidestep this blow.
Post-bubble shakeout: the developing world
Vulnerability is not only a problem for the consumption-short economies of the developed world but is also a big risk in the export-led developing world. That’s especially the case in China. Exports now account for more than 35% of Chinese GDP and the largest portion goes to the US – close to 40% when transnational shipments from Greater China (Taiwan and Hong Kong) are included. The rest of Asia is in a similar position. According to Andy Xie, about 10% of the total GDP for Asia ex Japan is earmarked toward shipments to the US (see Andy’s 22 August 2006 dispatch, “Asia: The Decoupling Myth”). If anything, that estimate probably understates the Asian dependence on end-market demand from the US. China’s ever-expanding Asian supply chain means that component producers such as Korea, Taiwan, and even Japan are vulnerable to a consolidation of US consumption.
The same, of course, can also be said for non-Asian external sourcing of Chinese materials requirements – a pipeline that now stretches into South America (i.e., Brazil), Australia, Canada, and, more recently, Africa. In short, if the American consumer sneezes, economies in both the developed and the developing world could easily catch a cold.
Post-bubble shakeout: global rebalancing
A bursting of the US housing bubble could give rise to alternative rebalancing scenarios in world financial markets. If the US consumer retrenches gradually, the ensuing rebalancing would most likely have benign implications for asset prices – that is, foreign investors will probably not lose confidence in dollar-denominated securities. However, in the event of a sharp and abrupt pullback of the post-housing bubble American consumer, a more disruptive strain of global rebalancing could be unleashed – as foreign investors draw into question both the return and the relative interest rate advantages of investing in US assets. In that latter case, both the dollar and longer-term US real interest rates could come under serious pressure.
It is important to stress that the sharp consumer retrenchment scenario does not require a precipitous decline in US housing prices. As noted above, my baseline guesstimate translates a flattening out of housing values and a concomitant cyclical decline in residential construction activity into a 1.5 percentage point slowdown in trend consumption growth. The saving response of saving-short US households undoubtedly is pivotal to any pullback. A modest increase in the preference for saving shouldn’t do serious damage.
However, a sharp increase in the personal saving rate implies a more severe consolidation in consumer demand – an outcome that could very much unsettle foreign investor appetite for dollars. The degree of global imbalance – a record gap between surpluses and deficits that could well exceed 6% of world GDP in 2006 – is hardly comforting when contemplating the downside to financial markets under more severe consumer-adjustment scenarios.
Post-bubble shakeout: a silver lining?
All this sounds terribly bearish for the global economy and world financial markets. Yet that need not be the case. I continue to bank on the more benign rebalancing option – drawing comfort from a newfound commitment by the stewards of globalization (i.e., the IMF, G-7 finance ministers, and major central banks) to tackle the weighty problems of global imbalances (see: Is the global economy really on the mend?) Significantly, this commitment doesn’t guarantee immunity to the global growth dynamic in the aftermath of a bursting of the US housing bubble.
In fact, as the excesses of the wealth creation cycle come to an end, I continue to believe that weaker US and global growth remains a distinct possibility. But with the global authorities now determined to deal with imbalances on more of a multilateral basis, there is good reason to hope that a crisis-prone strain of global rebalancing can be avoided. For a US and world economy that is about to experience another post-bubble shakeout, that could well be an important silver lining to otherwise dark clouds.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum