Uncertainty Shifts to China

Now that the dollar has dropped 43% from its high against the euro, the process of global financial rebalancing is seriously underway. The United States’ trade and current account deficits have begun to shrink relative to American and world GDP. Asian current account surpluses are about to start to shrink as well, especially if growth slows markedly in America in the aftermath of the end of its housing boom.

At the moment, Europe is feeling most of the pain, as the euro’s value has risen furthest and fastest against the dollar. But Latin America and Asia will start to feel distress as well, as the decade-long US role as the global economy’s importer of last resort comes to an end.

As long as imbalances of world trade and capital flows unwind slowly and smoothly, the magnitude of any global economic distress should be relatively small. Of course, it will not seem small to exporters and their workers who lose their American markets, or to Americans who lose access to cheap capital provided by foreigners. But the next few years are certain to bring up a more threatening and more serious political-economic problem than the unwinding of global imbalances.

Yes, the US might enter a small recession – the odds are roughly 50-50 of that happening. Yes, an American recession might spill over to the rest of the world and cause a worldwide recession. And yes, global economic growth over the next five years is unlikely to be as rapid as growth in the last five years. A formal recession, however, is not an overwhelming probability, and is likely to be small. The prospect of a truly hard landing – that global investors wake up one morning, suddenly recognize the US current account’s cannot be sustained, dump dollars, and bring about a crash of the global economy – is becoming less likely with each passing day.