CRS Report: RL30846 - Does the U.S. Serve as the World Economy's Engine of Growth?

Economic growth slowed considerably during the second half of 2000 in the United States. At present, most economists expect growth to remain positive in 2001; a few predict recession. Some economic commentators believe that the U.S. economy in recent years has acted as an "engine of growth" for the rest of the world by "sucking in" the world's exports. Were U.S. economic growth to slow substantially, they contend, U.S. demand for foreign imports would fall, and with it the current account deficit. Some may extrapolate this view to conclude that these effects would drag the world's economy down with the U.S. economy into a worldwide recession. An implication of this could be that American fiscal, monetary, and exchange rate policies should be coordinated with the cyclical needs of U.S. trading partners.

A major weakness in this perspective is that it neglects the fundamental interdependence between the international flow of goods and the international flow of capital. For there to be any effect of lower exports on a country's growth, the economy must be operating below its full potential. When a country is growing at its full potential, the attendant change in the exchange rate would simply change the composition of aggregate demand growth without influencing the rate of growth. Even if a country is below full potential, as many U.S. trading partners may be, economic theory holds that the negative effect of a decline in demand for a country's exports must be nearly offset by a redirection of that country's capital from abroad to home. While it is true that slower U.S. growth could slow foreign economic growth in most instances, it seems unlikely that the effects would be as serious as they are sometimes presented in the "engine of growth" argument. In any case, U.S. import demand accounts for such a small fraction of the world economy that it seems difficult to believe that the worldwide effect could be very large. A central conclusion of this discussion is that the world economy can have healthy, stable growth regardless of the state of the U.S. current account deficit, although some countries could suffer setbacks. Also, it is worth noting that there is a variety of empirical evidence at variance with the "engine of growth" proposition.

This report examines three fundamental points implicit in the "engine of growth" argument. First, it questions whether the current account deficit is caused by strong U.S. growth and weak foreign growth. Second, it examines whether foreign growth is dependent on U.S. imports and the maintenance of a large U.S. current account deficit. Finally, it reviews the proposition that a U.S. recession would cause a world recession by lowering U.S. import demand. The report concludes that to make the final argument persuasive, other factors need to come into play, such as deteriorating expectations, financial crisis, or slow economic adjustment. These other factors seem unlikely to occur in the context of slowing U.S. growth, but they are possible in a recession. This report will not be updated.

The U.S. foreign trade deficit has grown from about 0.2% of U.S. gross domestic product (GDP) at the beginning of the current economic expansion in 1991 to what is a record of nearly 4 ½% of GDP in 2000. There have been several competing explanations for this development. Popular among them is that the deficit is due to a higher rate of growth in the United States relative to growth in America's trading partners. Bruce Steinburg, one of five panelists on global business put together by Time Magazine, recently made this statement: "We have a trade deficit...because we grow faster than anybody else...(thus), getting rid of the trade deficit by growing slower than everybody else would not be a desirable outcome."⁽¹⁾

Looking at the sheer magnitude of the current account deficit and U.S. imports, some commentators have concluded that the United States serves as the "world's engine of growth." Robert J. Samuelson, reporting the views of former Treasury Secretary Lawrence Summers states, that among other factors, the American economic boom has helped the world because:

Thus, by importing so many of the rest of the world's goods, we are providing jobs and economic output to the rest of the world. Some would argue that this is especially the case since their economies are less competitive, high tech, and market oriented than ours. As a New York Times article explained,

If this theory is correct, a recession in this country, by lowering U.S. import demand, could quickly cause a domino effect leading to recession in other parts of the world.⁽⁴⁾ Financial Times columnist Martin Wolf explains how this could happen:

On its face, this argument seems plausible. If the U.S. grows faster than its trading partners, it might logically be expected that it would draw in more foreign goods and services than the other slowly growing nations would take of American goods. A growing trade surplus in these countries can be a factor, other things held constant, expanding aggregate demand for their goods and services. Thus, if this argument is correct, faster growth in the United States can be expected to expand demand and accelerate growth in foreign countries. A major implication of this argument, of vital interest to Congress, is that it makes a case that U.S. monetary, fiscal, and exchange rate policies should be coordinated with the cyclical needs of U.S. trading partners.

A more careful examination of this argument will suggest that, plausible as it may seem, it is incomplete and, perhaps, seriously deficient. For that reason, monetary and fiscal policies that are pursued by Congress for domestic stabilization purposes may have little effect on the world economy.

This report first explains economic theory as related to trade balances and their effect on economic growth. In the standard macroeconomic model, the engine of growth argument seems difficult to explain. It then overviews empirical evidence regarding the "engine of growth" scenario. The report then considers other ways in which a U.S. recession could lead to world recession, but concludes that these scenarios have little to do with the proposition that the U.S. acts as the world's engine of growth.

A country can import more than it exports, which is measured as a current account deficit, only if the difference is exactly matched by an inflow of foreign capital, measured as a capital account surplus. The foreign capital may come either from official (e.g., government or central bank) or private sources. Likewise, a country can export more than it imports only if domestic capital leaves the country and is invested in the rest of the world.⁽⁶⁾ In a floating exchange rate system, which the United States maintains with most of its major trading partners, changes in the market value of the exchange rate automatically equalize the difference between imports and exports, called "net exports," to the difference between capital inflows and outflows, called "net capital flows." Usually the capital flows are dominated by private sources, although governments intermittently intervene to influence the exchange rate.⁽⁷⁾

To understand how a trade imbalance can emerge and how it affects the economy, it will be necessary to construct two examples. The second example will explain the fragile theoretical underpinning of the "engine of growth" argument. Consider first the case in which foreigners desire to purchase American assets (e.g., stocks, bonds, and real estate). That is, they desire to use some portion of their current saving that they would have used to purchase other domestic or non-American foreign assets to purchase American assets. To purchase these assets, they must first purchase dollars in the foreign exchange market. This increases the net demand for dollars and as a result the dollar will rise in price, or appreciate.⁽⁸⁾ Dollar appreciation will produce two effects. First, foreign goods and services will become cheaper in the United States and Americans will spend more on imported goods (this will come at the expense of import substitute goods produced in the U.S.) Second, American goods and services are now more expensive in foreign countries. Foreigners thus spend less on them and the dollar amount of U.S. exports fall. The net result is that foreign capital has come to the U.S. in the form of a trade deficit; or, it can also be said, that the foreigners are financing this deficit. It is important to note that in this explanation a growing trade deficit goes hand-in-hand with an appreciation of the dollar on foreign exchange markets.

The effect of this deficit on the aggregate U.S. economy is likely to be small. While it is true that the trade deficit will decrease aggregate demand, the inflow of capital (or foreign saving) will result in lower interest rates in the United States. This will give a boost to interest sensitive spending or spending by businesses for plant and equipment and households for durable goods. The aggregate net effect is likely to be small. The trade deficit will, however, affect the composition of U.S. output. We will tend to produce fewer exports and import substitutes and more interest sensitive goods.

If the effect on the aggregate U.S. economy from the trade deficit is likely to be small, it must also be true that the aggregate effect is small on the countries that account for the trade surplus with the United States, other things being equal. What they gain in demand expansion from their trade surpluses with the United States, they lose from the demand contraction in their interest sensitivities sectors because their capital is being exported to the United States.

Should foreigners cease to lend to the U.S., the analysis above is reversed. The aggregate effect on both the United States and foreign countries is likely to be small, but they may experience transitional effects as resources are shifted among export, import competing, and interest sensitive sectors of the affected economies (this is discussed in greater detail below).

Consider now the "engine of growth" argument: the U.S. grows at a faster rate than do our principal trading partners and, for sake of argument, assume that we therefore take in more foreign goods and services than they do of our goods and services. In itself, this will not produce a trade deficit. It will produce a falling or depreciating dollar. The reason being that the net supply of dollars on foreign exchange markets will rise.⁽⁹⁾ Dollar depreciation will continue until the trade deficit is eliminated. The only way that a trade deficit can emerge in this case is for foreigners to willingly hold dollars (or dollar deposits in American banks). But note that this is in fact a capital movement to the United States and its effect both on the U.S. and foreign economies is the same as in the case above: in the U.S. it keeps interest rates from rising and sustains interest sensitive spending.⁽¹⁰⁾ Moreover, the induced capital movement will prevent the exchange rate from depreciating. In effect, the excess supply of dollars on the exchange market is being willingly held by foreigners who supply imports to the United States. Note, however, that if induced capital movements do not occur, then, no matter how much faster the U.S. grows relative to the growth of our trading partners, it will not accelerate their growth because the depreciation of the dollar will ensure that U.S. exports and imports will balance, i.e., the U.S. will not run a trade deficit. Thus, for the engine of growth argument to be relevant, the net movement of capital to the United States must be dominated by induced capital movements. This case is very difficult to make. The available data on movements in the exchange rate are contrary to what would have occurred if induced capital movements dominated the net inflow of capital into the United States. If they had dominated the net capital inflow, the exchange rate, at best, would have remained unchanged. Instead, between 1995 and 2000, the period in which the trade deficit grew from about 1% of U.S. GDP to almost 4.5% of GDP, the dollar appreciated nearly 30% in real terms against a basket of 26 currencies of the leading trading partners of the U.S.⁽¹¹⁾

What might happen to the rest of the world if the U.S. entered a recession? The "engine of growth" argument maintains that if the U.S. demand for foreign goods fell when U.S. growth slowed, as it would fall for domestically produced goods, then the U.S. current account deficit would shrink and the growth of aggregate demand would slow for our major trading partners as well. This argument ignores the likelihood that a U.S. downturn would cause the inflow of foreign capital to our economy to drop as well and be redirected to investment in its foreign source, which would expand foreign aggregate demand.⁽¹²⁾ The inflow of foreign investment would not remain unchanged in a U.S. economy that has fewer profitable opportunities (in the short term.) Thus, theory indicates the negative influence of a U.S. recession on a foreign country's export growth would be largely offset by a positive influence on a foreign country's capital investment, as foreign interest rates fell and spending on capital equipment and durable goods increased.⁽¹³⁾

The argument also neglects the point that foreign governments are free to influence their domestic demand through expansionary monetary or fiscal policy to offset a decrease in export demand. The "engine of growth" theory seems to assume either that governments would not react or expansionary policy would have no effect. For very small economies, the effects of expansionary policy may be dominated by external factors, but not in the large economies of most major U.S. trading partners like the European Union and China.

To summarize, economic theory suggests that the long run economic growth is unrelated to whether a country runs a current account deficit or surplus. Only the short run growth of aggregate demand can be affected by the current account and exchange rate. This is because the positive effect that a current account surplus endows to the export sector is largely offset by the negative effect it places on domestic investment through the accompanying capital outflow. These effects cannot dominate the pattern of long run demand growth because exchange rates, interest rates, and prices adjust to keep economies at equilibrium. In the short run, the increase in demand caused by a current account surplus slightly exceeds the decrease in demand caused by a capital account deficit.

If a country has underutilized resources, then this increase in demand can stimulate output growth in the short run. When Western European growth was sluggish in the mid-1990s, the stimulus of strong U.S. import demand was stronger than it is now that Western Europe is approaching full employment. Likewise, export growth was a positive factor in ending the recessions of Mexico in 1994 and East Asia in 1997, but is less important today as their economies strengthen. But if a country is already at "full employment," as the United States has been since at least 1997, then the increase in demand would exert upward pressure on prices and interest rates. These upward pressures will dampen spending in other sectors of the economy, changing the sources of demand growth but not the rate of growth.

In the current U.S. context of full employment, theory suggests that the combination of a current account deficit and a strong exchange rate has three beneficial effects. First, by slightly restraining demand, they reduce inflationary pressures in the economy. Second, economists are concerned with what an economy can produce only because it makes the pleasure of consumption possible. When an exchange rate appreciates, as has been the case of the dollar since the mid-1990s, it allows more consumption for the same amount of production by making imports cheaper. Finally, if the capital inflows are financing a sustainable capital boom, then the future productive capacity of the U.S. economy will be greater since American workers have more capital with which to work.

The theoretical case against the "engine of growth" proposition has been laid out above. It can also be questioned on empirical grounds. First, as Table 1 illustrates, for most countries, exports to the United States make up a small fraction of their GDP. Mexico, Canada, and South East Asian countries are notable exceptions. For these economies, U.S. import demand is a large enough source of production that a sudden change of U.S. import demand could be felt on the overall economy.⁽¹⁴⁾ But it is hard to extrapolate the importance of the United States to the few countries highly dependent on its imports to an argument that the U.S. is the world "engine of growth" since all of these highly trade dependent countries combined represent a very small portion of world GDP.

Largest Partners
Canada	37.9%
Mexico	25.6%
Japan	3.2%
China	4.6%
Germany	3.0%
United Kingdom	3.9%
Selected Countries
France	2.1%
Korea	8.9%
Malaysia	26.7%
Thailand	12.5%
Phillippines	17.3%
Brazil	2.4%
Russia	3.9%

Source: International Monetary Fund, Direction of Trade Statistics, June 2000 and International Financial Statistics Yearbook, 2000.

Note: This table lists the largest trading partners of the United States and other countries of interest.

Second, there are empirical examples that seem to be at odds with the "engine of growth" argument. For example, consider the case of Japan. It is one of the three largest trading partners of the United States and has had a long run bilateral current account (trade) surplus with the U.S. Yet this large trade surplus and the acceleration in the U.S. growth rate in the last half of the 1990s have done little to help the Japanese economy out of its decade-long stagnation.

The experience of the late 1980s suggests that the engine of growth theory has already been put to the test. Recall that the U.S. trade deficit fell from a high of 2.8% of GDP in 1987 to 0.2% in 1991 (in real or inflation adjusted dollars, it fell from $142.3 billion to $20.7 billion). If a growing U.S. trade deficit is a job creator for the world economy, a contracting trade deficit should destroy jobs and cause unemployment. Yet, there is little evidence to suggest that the economies of U.S. trading partners suffered massive unemployment during the 1980s as a result of the fall in the U.S. trade deficit.⁽¹⁵⁾

Finally, there is the cyclical timing evidence. The last time U.S. GDP contracted was 1991. Among the countries listed in Table 1 (excluding China and Russia), only Canada, the United Kingdom and the Phillippines experienced a contraction in that year. Interestingly, the Canadian and U.K. contractions were quite similar in percentage terms (1.9% vs. 1.5%) even though Canadian exports to the U.S. as a percentage of GDP are about 10 times larger than are U.K. exports to the U.S. as a percentage of its GDP. While this evidence may suggest that the U.S. economy has a large effect on Canada, in fact, while the U.S. economy expanded in 1990, albeit at a slow rate, the Canadian economy contracted.⁽¹⁶⁾ Experts at the time did not attribute the downturn in each country to economic conditions in the United States.⁽¹⁷⁾

In the previous, somewhat mechanical, argument, changes in a country's current account due to a change in U.S. growth have only a slight effect on its economic growth due to a natural equilibrating process. Thus, the effects suggested in the "engine of growth" argument are accurate but possibly greatly overstated. This report next explores three factors beyond the mechanical argument that could lend additional credence to the "engine of growth" argument. Recessions occur because at times the equilibrating process does not adjust quickly or smoothly. However, all three arguments only become significant during rather extraordinary recessions. Thus, the three exceptions are important in theory, but are likely to be of little practical importance in the current context of slowing, but still positive U.S. growth.

In an ideal frictionless economy, resources can be shifted costlessly from industry to industry in response to changes in supply and demand. This simplification is one of the assumptions that suggests a sudden decrease in U.S. import demand would be nearly costless for both foreign economies and the U.S. economy. In reality, of course, resources cannot be shifted without cost if U.S. spending is suddenly shifted from investment towards exports (and vice versa for foreign spending): capital investment becomes prematurely obsolete, resources are lost when bankruptcies occur, unemployment occurs as the flow of labor to more efficient positions takes time, and there are learning curves in new profit opportunities. These factors can all be thought of as a temporary decrease in the productivity of the resources that are being shifted, in this example from U.S. investment to U.S. exporters.⁽¹⁸⁾

Slow resource reallocation could be problematic if the current account and dollar declined suddenly. It is possible that if foreign investment fell very suddenly, negatively affecting U.S. aggregate demand, when the dollar depreciated to compensate for the fall in investment demand, exports could not quickly increase because of slow resource reallocation.⁽¹⁹⁾ As a result, temporarily there would not be enough of a positive stimulus to aggregate demand to offset the negative stimulus of lower foreign investment.⁽²⁰⁾

However, the importance of current account adjustment problems should not be overstated. The beauty of a market economy is that resources are always being reallocated to their most efficient use. The macroeconomic effect of a small change in the exchange rate is no different from the allocative effects of a change in preferences from one class of goods towards another. For example, in the past 50 years, demand for services has grown relative to the demand of goods, shifting a vast amount of resources from production of the latter to production of the former. Yet our economy on a whole is arguably none the worse because of it. And while Table 1 illustrates that sluggish resource allocation could be a significant factor for a few small countries that are highly dependent on U.S. trade, it is important to remember that even a large and sudden decline in U.S. import demand would still represent only a small fraction of world economic activity.

Thus, the negative effect of resource reallocation on productivity is likely to be negligible unless the change in import demand is very great and sudden. And the change in import demand is unlikely to be very great unless the U.S. experiences a recession. Even then, it is unlikely to be very sudden: people's consumption habits change slowly in response to price changes. When applied to the price of foreign exchange, this observation is popularly known as the J-curve. The J-curve is based on the empirical observation that following a large currency devaluation current account deficits often rise before they fall as consumers initially purchase the same quantity of imports at a higher price.

Economists can estimate with fair accuracy economic effects that are based on the assumption of rational, informed market participants. However, this assumption precludes the possibility of sudden shifts in expectations (e.g., consumer confidence.) Thus, although expectations play an important role in determining short-run aggregate demand in reality, a systematic estimation of the effects of changing expectations on spending, saving, and investment patterns is impossible. Growth that is slower but still positive is unlikely to affect expectations significantly enough to alter the standard outcome described above. But a sudden and serious U.S. recession could negatively influence foreign expectations, notably among foreign investors and exporters, in a way consistent with the argument that U.S. recession could lead to foreign recessions. For the recession to spread widely abroad, not only must expectations about the U.S. economy deteriorate, expectations about major foreign economies must deteriorate as well. If foreigners reacted to deteriorating U.S. growth by acting with extreme risk aversity in their own countries, it could cause balance sheet and credit constraints that resulted in a serious contraction in investment demand in foreign countries and a related decline in foreign economic growth. Likewise, if foreign investors suffered losses in a U.S. recession, the "wealth effect" could slow foreign consumption growth.

The most compelling scenario in which the United States could cause a worldwide recession would be a crisis in the U.S. financial system. Major recessions - from the Great Depression, to Japan's problems in the 1990s, to the Asian Crisis of 1997 ⁽²¹⁾ - have financial crises at their heart. The recessionary effects of financial crises are best understood as a breakdown in the reallocation of resources, particularly the vital reallocation of resources from saving to investment. Because a large amount of U.S. net investment is financed by foreigners, these foreigners would be as adversely affected as American owners of U.S. capital, causing spillover effects to foreign economies. Likewise, American capital is an important source of investment in many foreign economies, and this source could dry up in the context of a U.S. financial crisis. This would be more problematic for countries that are net international borrowers, like Central Europe and Latin America, than countries that are net lenders, like the European Union and Japan. For these reasons, a U.S. financial crisis would be likely to cause a world recession. But economists grant little if any probability to this scenario occurring at present.⁽²²⁾ The U.S. financial sector is less reliant on banking and supervised with greater sophistication than those countries that have suffered from financial crisis in recent years. However, financial crises are, by their nature, unpredictable.

It has been argued that the U.S. acts as an engine of growth for the rest of the world through our import demand. One implication of the argument is that a U.S. recession, by lowering import demand, would cause a world recession, or at least a recession in some of our major trading partners.

Economic analysis suggest that the effects on U.S. aggregate demand of an increase in net exports would be mostly canceled by a decrease in interest sensitive (mainly investment) spending. When an economy is at full employment like the United States at present, then the effects cancel each other out entirely in the aggregate. Similarly, foreign countries at full employment would be unaffected by a change in U.S. import demand, and countries below full employment would be likely be less affected than is commonly thought. Thus, the "engine of growth" argument is not persuasive without introducing further circumstances. The empirical record bears this out - there have been nine recessions in the United States since World War II, but not a single world recession during that time period.

Once further circumstances are introduced, then the scenario becomes more convincing. If a U.S. recession was caused by a serious domestic financial crisis, it would be likely to have spillover effects to the world financial system. If the recession were sudden and large, then the reallocation mechanism is likely to slow and work with temporary efficiency losses. Changing expectations can work in mysterious but important ways on economies.

But blaming falling U.S. import demand for causing world recession in these scenarios appears to be akin to "killing the messenger." The root of the problem in these scenarios is either sluggish adjustment, deteriorating expectations, or financial crisis. In these circumstances, falling import demand is a symptom, rather than a cause, of worldwide economic downturn caused by unrelated factors. Once in a downturn, changes in the current account become a mechanism to alleviate recessionary pressures, by increasing aggregate demand through net exports, rather than to exacerbate them as the "engine of growth" argument posits. In any case, most countries trade far too little with the United States in relation to their overall economy to generate the purported results.

What implications does this argument have for U.S. policymakers? It implies that the world economy can have healthy, stable growth regardless of whether the U.S. current account is in deficit. Thus, U.S. policy regarding fiscal and monetary policy, the current account, and the exchange rate need not fear that its effect on the rest of the world will be serious.

1. ^(back)Time Select Global Business, Time Magazine, December 18, 2000, p. B4. This argument was also made by Patricia Pollard in "Growth and the Current Account Deficit," National Economic Trends, Federal Reserve Bank of St. Louis, December 2000.

2. ^(back)Robert J. Samuelson, "Flying on one engine," Washington Post, January 18, 2001.

3. ^(back)David Sanger, "Slowdown at Home Spells Risks Abroad for Bush," New York Times, January 7, 2001.

4. ^(back)A rule of thumb definition of a recession is two consecutive quarters of negative growth.

5. ^(back)Martin Wolf, "It's Not the End of the World," Financial Times, December 12, 2000.

6. ^(back)While it may be premature to do so, it is worth mentioning that in terms of the Samuelson quote above, this discussion means that expanding U.S. trade deficits in the aggregate do not provide desperately needed dollars to repay debts. It is foreign loans to the United States that make the trade deficit possible.

7. ^(back) For those countries that have a fixed exchange rate with the United States, such as China and Argentina, differences between net exports and net private capital flows must be reconciled by official capital flows in order to maintain the exchange rate at the fixed value. When these countries have current account surpluses with the United States, their Central Banks accumulate U.S. assets. The Chinese Central Bank's recent accumulation of dollar assets (notably, U.S. Treasury securities) has the same effect on the U.S. economy as if a private citizen in China purchased the stocks and bonds of American firms. In both cases, the American capital stock is expanded through foreign saving. For more information, see U.S. Library of Congress, Congressional Research Service, America's Growing Current Account Deficit: Its Cause and What It Means for the Economy, by Gail Makinen, CRS Report RL30534; and The U.S. Trade Deficit in 1999: Recent Trends and Policy Options, by Craig Elwell, CRS Report RL30561.

8. ^(back)It is very important to note that this transaction must increase the net demand for dollars on the foreign exchange markets. Many transactions that are thought of as being a part of the international flow of capital do not go through the foreign exchange market and do not have the effects described above. For example, consider the case in which an individual in Hong Kong desires to buy a home in California and uses his dollar account in a New York bank to make the transaction. This gives the appearance of an international flow of capital but it does not go through the foreign exchange market since dollars are exchanged for dollars and, hence, will have no effect on the net demand for dollars. The result of this transaction is that American liabilities to foreigners go from being short-term to being long-term liabilities. A variation on this theme is that the individual in Hong Kong could have acquired a dollar deposit in New York owned by a French citizen. Again, this transaction will not go through the foreign exchange market and will have no effect on the net demand for dollars.

9. ^(back)The U.S. supplies dollars to the foreign exchange market when we buy foreign goods and they demand dollars when they purchase our goods and services. Since we are assumed to be buying more of their goods due to faster growth than they of ours, the net supply of dollars increases and the price of the dollar falls.

10. ^(back)Economists distinguish between these two types of capital movements. The type of capital movement in the first example is called an autonomous capital movement while the latter is called an induced capital movement (in the sense that it is induced by a prior movement in goods and services).

11. ^(back)An argument can be made that the "engine of growth" proponents have interpreted the data incorrectly. It is frequently the case that high rates of growth produce high real interest rates. If these rates attract capital from abroad, one will observe that high rates of growth go hand-in-hand with a trade deficit. One could infer a cause and effect relationship between these two variables even though none exists. In this case, the capital movements are autonomous, not induced, and therefore have very little effect on aggregate demand in the rest of the world. Thus, it would follow that the U.S. does not represent an engine of world growth.

12. ^(back)Imagine that instead of being directed home, the foreign country's capital was directed to a third country. In this case, would the effect change? It would not because the current account-capital account link must hold with the third country as well. A sudden inflow of the foreign country's capital to a third country would result in an appreciation of the third country's currency relative to the foreign country. This would increase the third country's demand for the foreign country's exports.

13. ^(back)If foreign investment in the U.S. did not fall when the demand for imports fell at the current exchange rate, then the dollar would need to appreciate until the current account and capital account had equilibrated. This would make imports cheaper, increasing their purchase, and (if it increases the probability of future depreciation) it would make foreign investment in the United States more expensive, decreasing its flow. This would reverse the initial decline in U.S. import demand, and its effect on foreign growth. The end result on growth is the same as if investment demand declined initially.

14. ^(back)For countries with very high U.S. exports as a percentage of GDP, consider what is actually at risk. For example, such a high percentage of Canada's GDP coming from exports to the U.S. implies that the risk to the Canadian economy of a U.S. slowdown is remarkably great. However, nowhere near this much of Canadian GDP would be placed at risk if U.S. import demand fell. First, a fall in import demand would likely affect a small fraction of those imports. Second, through currency adjustment, much of the negative effect would be offset by higher Canadian investment or higher Canadian exports to other countries. As explained below, the problem for countries like Canada is that a significant enough amount of resources could be reallocated between the export and investment sectors, and that reallocation could be sluggish enough to hurt short term growth.

15. ^(back)The U.S. dollar depreciated from roughly October 1985 to April 1988. During this time, Italy was the only G-7 country to experience increasing unemployment. The rest, including Canada, experienced decreasing unemployment. Source: OECD Economic Outlook 67, June 2000.

16. ^(back)The data for this comparison are taken from International Monetary Fund. International Financial Statistics Yearbook for 1999.

17. ^(back)The OECD attributed the Canadian and UK downturns to the need to curb inflationary pressures. In both countries, surging demand growth in the late 1980s caused the inflation rate to accelerate and monetary policy to tighten. In the Canadian case, real (or inflation adjusted) short term interest rates were pushed up from a range of 3% to 5% in 1986-88 to a range of 5% to 11% during 1988-90. In the UK case, real rates were increased from about 3% in 1988 to about 10% in 1989. Had the monetary authorities responded with greater alacrity to the on-set of the inflationary pressure, downturns might have been avoided. Source: OECD Economic Survey: Canada, (Paris: 1991); OECD Economic Survey: United Kingdom, (Paris: 1993).

18. ^(back)For this factor, a sudden increase in U.S. demand for foreign goods is equally disruptive to foreign economies.

19. ^(back)In the standard macroeconomic model, the Mundell-Fleming model, a recession causes the dollar to depreciate because recessions cause interest rates to fall. Falling interest rates reduce net capital inflows, decreasing demand for the dollar.

20. ^(back)While this argument is possible, note that the assumptions it relies on suggest that it cannot spread recession to foreign countries as the "engine of growth" argument suggests - if the investment effect trumps the export effect, then foreign countries that investment is now redirected towards (from the U.S.) will receive a positive stimulus to growth. There can be a negative effect for the U.S. or the rest of the world - but not both.

21. ^(back)At first glance, the Asian Crisis seems quite compatible with the "engine of growth" scenario. In Asia, the sudden devaluation of Asian currencies went hand in hand with domestic financial crisis. In fact, one fundamental reason that the devaluation did not have the positive effect on demand that the basic model suggests is that the liabilities of Asian firms were denominated in dollars. The devaluation meant that the cost of the firms' liabilities in terms of the local currency soared - sending the firms and the banks that lent them money into bankruptcy, which triggered the financial crisis. There is a very important reason a financial crisis in the U.S. could not happen for this reason: the liabilities of U.S. firms are not denominated in a foreign currency, they are denominated in dollars. The devaluation of the dollar would have no effect on the ability of U.S. firms to service their debts to foreigners. Therefore, if a financial crisis were to accompany a depreciating dollar in the U.S., it could not be for the reason seen in Asia.

22. ^(back)For a dissenting opinion on the health of the U.S. financial system, see Richard Cookson, "The Party's Over," The Economist, January 25, 2001.

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