When the US sneezes the world catches cold

Continued. Read Part I of the article here

It is said that when the US sneezes the world catches cold. This was true before but the world has started to think that it can decouple itself from the US economy. Here the umbilical cord is the US dollar; once that is cut, slowly but surely the decoupling will take place; with dire consequences for the US. As I mentioned before, already some important oil producing nations have decided to abandon the dollar. Others have decided to de-peg their currencies. Others such as China have started thinking about reducing their reserves in dollars. Once others begin to do the same the dollar will cease to be the international reserve and trade currency of choice. Meanwhile, major trading partners have to just bite the bullet and accept the consequences of holding to the dollar.

You know the saying that if you owe the bank one hundred thousand dollars you are in trouble, but if you owe the bank one hundred million dollars, the bank is in trouble. Currently US owes foreigners over two trillion dollars. In addition many trillions of dollars are also held in foreign central banks. These countries are in trouble and they will try hard to stabilise the US economy, if only for saving their own money.

But they don’t do this out of love. They just need stability to reduce their dollar holdings gradually and hence save as much of their reserves as possible. If they mention this openly, the dollar will collapse over-night and they lose. So the long-term plan would be to reduce their exposure to the dollar as gradually and as quietly as possible. This of course doesn’t mean that the value of dollar will not fluctuate; it simply means that over time dollar will become just like any other currencies and will be treated similarly. The Federal Reserves will no longer be able to just print money and refuse to publish the M3 statistics.

US will also need to begin building reserves in other currencies. Today US dollar has no backing. People accept dollar on faith alone. Imagine if that faith suddenly disappears. Will you exchange 1 kg of green paper for 1000 Microwaves? I doubt it.

But meanwhile the world’s economy will experience the negative effects from the US economic downturn. The most affected areas will be China and other Asian “emerging” economies and European Union.

The case for the European Union is straight forward. A flight from dollar to Euro makes the EU’s export much more expensive, just when one of its biggest trading partners “US” goes into recession. European Union will also feel the pains of financial crisis of the US. Many EU financial institutions had invested in US and now they will have to accept the losses. So we will see a down ward trend in Europe, but not as severe as the one in US. In addition European Central Bank has still a lot of room for manoeuvre. It can reduce interest rates substantially. EU also has smaller total deficit than US. Most importantly, most of the EU countries have solid social security nets in place which will dampen the effects on their citizens.

China on the other hand lacks this social security net, but has large foreign reserves. Most of this reserve has been the result of its exports. Last year its trade surplus with US was over $200 billion. This surplus will diminish substantially over the coming year, unless of course the US continues to spend the money that it doesn’t have. But in general, a recession in US and a slowing economy in EU will impact China negatively. Its exports will decline and its unemployment will increase, something that the Chinese government is very sensitive to. China suffers from double digit unemployment rate, something that the Chinese government is reluctant to discuss openly. For example in 2004 the RAND estimated the actual Chinese unemployment to be 23%. Things haven’t improved that much since then. Even if the unemployment rate was down to 15%, it still presents a very large number.

So China will most likely embark on large infrastructure projects to keep unemployment levels stable. The government will also try to improve its social security programs and pay more attention to the interior of the country, where the benefits of double digit growth has not reached yet. The economic growth will also be reduced to single digits, relieving some pressure off the oil prices.

India will fare worse than China simply because its population growth is higher than China while it lacks the Chinese reserves and resources. According to the Indian government forecast, India needs to create 10 million new jobs per year to keep its unemployment rate steady. But others put that figure at 15 million. An Indian national report on employment situation has warned that nearly 30% of the country’s 716 million-strong workforce will be without jobs by 2020. This of course is a conservative estimate based on continued solid economic growth; something that, at least with the current economic outlook, is highly unlikely.

Stock-market: The Near Term-outlook