When the US has a cold, the rest of the world catches... ?

If the US has a recession, what will be the effect on the rest of the world? This question has bounced around for some time now.

In one corner are the optimists. The lack of demand from the US will be largely replaced by an increase in demand from Asia, they argue, so that the world economy will continue to grow unabated. It's a nice story, but seems a little optimistic in my view. For a start, the largest Asian economies- Japan and China- look unlikely to take up any slack from the US. The latest macro news from Japan was weak- GDP decreased 1.2% last quarter.

For China's part, a substantial increase in domestic consumption would be required for it to provide much imputus to global growth. Increased consumption is the flip-side of decreased savings.... and China's disproportionate savings rate is due to deeper structural problems, which show no likelihood of abating any time soon. In an economy with poor quality, expensive, inadequate health care, rational consumers will always tend to oversave... the alternative is the possibility of premature death, for want of effective health care.

So if Asia can't replace a lack of demand from the US, what about Europe? Europe is already running on all cylinders, and significantly outperforming the US economy at the moment- despite a much lower population growth rate that would normally result in lower economic growth on average. To expect more from Europe may be to expect too much.

The bigger concern is that a recession in the United States might have serious negative consequences for Asia, leading to a further slowdown in world growth. Both Japan and China depend heavily on exports to the US for their own domestic economic health, lending credence to this argument. If so, hang on for a rollercoaster ride of an economy for the next couple of years!

For a related viewpoint, see Menzie Chinn's analysis here.