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International Economic Update

September 3, 2009

Ailing Global Economy Limps Toward Recovery

The outlook for U.S. and global growth remains uncertain, but the prospects have improved somewhat. The banking sector appears to have stabilized, but significant levels of slack have accumulated during the current recession (especially in the advanced economies), contributing to the perception that inflation may remain below its long-run trend for a while. The trade deficit reversal in the U.S. has translated into a strong positive contribution of net exports to GDP growth. To some extent this shielded the economy from the decline of residential investment since 2006, at least until the recession also spread to nonresidential investment in the second half of 2008.

The Rate of Economic Decline Is Slowing Down

The cautious optimism of the latest growth forecasts is based on signs that the rate of decline of economic activity is moderating in the advanced economies (and rebounding in the emerging ones) and on the perceived stabilization of the banking sector.

• Industrial production fell steeply during the current cycle, but now appears to be headed for a worldwide rebound (Chart 1). Emerging economies are leading the return to growth.
   
• Interest rate funding spreads have come down, even though banking risks have not dissipated. The three-month U.S. Libor–OIS spread (an indicator of the banks' credit risk) has declined to 20 basis points, while the average from Jan. 2, 2002, to July 31, 2007, was 11 basis points (Chart 2).

The impairment of the bank lending channel has a direct impact on the transmission mechanism of monetary policy and can trigger a negative feedback loop with effects on investment and costs through the capital structure and leverage of the private sector. From that perspective, restoring the health of the financial system is a top priority to facilitate a return to "normalcy" in the conduct of monetary policy, as well as to mitigate the real effects of the current recession. Since the G-20 meeting in London (April 1–2, 2009), the debate has moved from containment to resolution of the banking crisis, and more efforts have been spent on regulation as a building block of a stable financial system.

In spite of these developments, the recession is not quite over yet. Beyond the myriad of financial initiatives, most economies also rely on substantial monetary and fiscal intervention. We know that the patient can walk with crutches, but the question is how well is the healing taking place and how long should we keep the patient using those crutches?

The Adjustment Is Ongoing

The U.S. has arguably experienced a buildup in investment (initially software and equipment and later residential) and consumption durables since the mid-1990s, mirrored by a widening trade and current account deficit. Other advanced economies such as Spain and the U.K. have also experienced ballooning trade deficits. A standard view is that trade deficits occur whenever a more productive location (or certain key sectors within it) attracts more foreign resources.

This is the subject of ongoing controversy. Sectoral productivity gains could account for the domestic demand switch toward durables and certain types of investment, while gains relative to the rest of the world may explain the global shift of resources reflected in the trade deficit. The subsequent reversal, in turn, might be due to a narrowing of these gains. However, others would argue that the shift was caused by factors such as international relative price movements unrelated to productivity[1], nontradables (for example, housing) and finance, and imperfect competition.

In any event, investment in the U.S. went toward equipment and software in the '90s, but the slump after the 2001 recession also had a significant impact on investment in structures. A compositional shift toward residential investment and the continued growth in consumption durables maintained the buildup in investment until early 2006 (Chart 3). Since then, the resources that the U.S. previously attracted have gradually diminished, and the economy entered into recession.

• The gradual reversal in the real trade deficit since 2006 has continued even in the current recession. It has been led by a long swing of the real exchange rate (Chart 4).
   
• Net exports have positively contributed to GDP growth in all quarters since first quarter 2006, with the exception of third quarter 2006, first quarter 2007 and third quarter 2008. Net exports have partly compensated for the negative contribution of residential investment since first quarter 2006 (Chart 5).
   
• The deterioration in nonresidential private investment accounts for most of the GDP decline since third quarter 2008 (Chart 5 and Table 1).

The composition of trade is skewed toward capital goods (and consumption durables), and that makes trade more volatile and procyclical at business cycle frequencies. The U.S. trade decline accounted for by capital goods (excluding auto) has not been particularly unusual, but the negative contribution of the auto sector and industrial supplies has been more significant than in the last recession (Charts 6 and 7).

• The rate of decline in trade has appreciably slowed in the U.S., as the negative contributions of the auto sector and industrial supplies have mostly vanished in the second quarter of this year (Chart 6 and 7).
   
• The trade decline seems to be bottoming out in most countries, although the dislocation has been quite significant. Capital goods export-dependent countries have been especially affected (for example, Japan and Germany), more so than in the U.S. (Table 1).
   
• Countries with large current account deficits (but not only the U.S.) have enjoyed positive contributions from net exports, while countries with prior surpluses have compounded the fall in nonresidential investment with a negative contribution of net exports (Table 1).

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The tendency to "make hay where the sun shines" [2] means that a speedy U.S. recovery grounded on stronger productivity gains relative to the rest of the world could signal a return to a widening trade deficit. However, a lot depends on the strength and shape of the U.S. and world recovery. In that regard, the investment path will be crucial. In fact, the recovery could still be sluggish as financial systems remain impaired, unwinding of the current account deficit continues in the U.S. and other advanced economies, and capital gets reallocated or installed capacity remains permanently offline.

Drop in Global Inflation Is Significant

The outlook for inflation has improved, and most forecasts suggest that the advanced economies will avoid a protracted period of deflation (Chart 8). However, inflation in the advanced economies could still remain below 2 percent for quite some time based on the substantial slack that has accumulated in the current cycle.

• Commodity prices, especially crude oil, have rebounded since hitting bottom in the winter of 2008. The oil price spike was an important contributor to the increase in worldwide headline inflation in 2007–08.
   
• Capacity utilization rates have fallen around the world (Chart 9), especially in sectors producing capital goods and industrial supplies.[3] Most measures of output gap available remain unusually high.

While slack is conventionally assumed to diminish cost pressures, the output gap is a hard-to-measure indicator of inflation arising from the much-debated view that a trade-off between nominal and real variables exists and "remains stable" over time. Inflation itself will depend on the ability and willingness of central banks to: (a) withdraw in a timely manner the liquidity that has been pumped into the banks (when the patient can walk without crutches), and (b) restore or reshape the transmission mechanism of monetary policy through the financial system. It will also depend on the actual shape of the recovery.

Concluding Remarks

One possible interpretation of what is happening in the current recession is that financial constraints or other demand factors are forcing capital and employment to remain idle or underutilized. If this view is correct, policies designed to support demand and remove the "constraints" could lead to a quick, strong recovery. Governments' dissaving through discretionary spending and multiple support initiatives to lending-constrained banks or to "dysfunctional" markets could be argued as reasonable prescriptions from that perspective. Low short-term rates and quantitative or credit easing, with the additional goal of avoiding a prolonged period of deflation, would also be sensible.

Another possible interpretation is that after a period of investment buildup and/or a misallocation of investment, the size of the capital stock or its composition are not "right." It could also be the case that relative productivity gains (actual or prospective) no longer justify the shift of resources to investment in the U.S. The costs associated with restructuring or relocating capital could be burdensome and delay the recovery. Demand-driven policies would be less helpful in this case, if they delay the necessary adjustment.

Time will tell how well the patient has healed.

—Enrique Martinez-Garcia and Janet Koech

About the Authors

Martinez-Garcia is a research economist and Koech is a senior research analyst in the Research Department at the Federal Reserve Bank of Dallas.

Notes

1. After all, we observe that U.S. terms of trade excluding oil have gradually improved without a break since the mid-1990s.
2. See "International Business Cycles: Theory and Evidence," by David Backus, Patrick J. Kehoe and Finn E. Kydland, in Frontiers of Business Cycle Research, Thomas F. Cooley, ed., Princeton: Princeton University Press, 1995, p. 340.
3. In the U.S., for example, the 40-year average capacity utilization rate for primary metals is 79.9 percent while the July 2009 number is 47.4. The 40-year average for machinery is 78.3, while the July value is 56.4. The 40-year average for motor vehicles and parts is 76 and the July reading is 45.3, coming up from 37.6 in June.

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