W.HEN AMERICA Sneeze, the rest of the world catches a cold. But what if you have a fever? After a busy 2020 in the GDP America is down 3.5% and is on the brink of a robust rebound in 2021 by simply getting back to something normal with vaccination. But it could do more than just that. If the Covid-19 bill is passed by President Joe Biden, the total impetus could exceed $ 2.5 trillion this year. This could easily lead to production exceeding the “potential” level estimated by the Congressional Budget Office: that is, the amount the economy can produce without an increase in inflationary pressures. This possibility has some American economists looking for signs of accelerating price and wage growth. America does not work in a vacuum, however; Should overheating occur, the effects are not limited to the limits. Depending on how the recovery plays out, a hot American economy could be a boon to the rest of the world – or another source of concern.
In a closed economy that does not trade with the rest of the world, spending too little will lead to job losses and price pressures, while too much should drive employment and ultimately prices. However, in an open economy, some of the effects of shifts in demand are having an impact on the rest of the world. For example, a sharp drop in spending may be associated with a drop in import demand. In this case, some of the pain of a break-in is exported abroad. During the 2007-09 global financial crisis, problems in financial markets wreaked havoc around the world, but even countries relatively isolated from these problems felt cold thanks to trade ties with America and Europe. It is estimated that around a quarter of the decline in American demand and a fifth of the decline in European demand was borne by other economies and transmitted through trade.
An increase in demand should work in a similar way, but in the opposite direction. When Americans spend more, some of it goes overseas: for example, by buying foreign goods or spending on services – including tourism – that should bounce back with the pandemic restrictions lifted. An analysis of the IMF In 2017, it turned out that an American incentive was mostly spending (as opposed to tax cuts) and a value of 1% GDP increases the production of the average country by 0.33% in the first year. Countries with closer trade ties have a bigger impact. For example, the impact on the Canadian economy is estimated to be nearly three times the average. When the combination of reopening and stimulus revives the American consumer, the effects are quickly felt around the world.
The extent to which this is felt depends crucially on the political reaction at home and abroad. Tax effects are stronger if the recipient countries operate below potential themselves. American spending is therefore more likely to spill over to the rest of the world when its recovery is much stronger than that of its trading partners. Typically, spillovers provide a strong incentive for governments to coordinate their stimulus efforts so that some tight-fisted economies (such as those in Europe) cannot ride free from the generosity that comes from more generous ones. In fact, Janet Yellen, America’s Treasury Secretary, urged her counterparts in the February 12th G7 group of countries to make it big on stimuli. Countries where free travel with Ms. Yellen could be in hot water: The Biden government has promised to be strict with countries with large, persistent trade surpluses.
However, as America approaches overheating, reluctance to spend elsewhere may be less of a nuisance than usual, as demand-hungry countries act as a relief valve to build up pressure at home. According to work by Jane Ihrig, Steven Kamin, Deborah Lindner, and Jaime Marquez of the Federal Reserve, the growth in world trade appears to have enhanced its ability to relieve pressure. They believe that the expansion of trade has helped weaken the link between changes in domestic demand and corresponding shifts in total output, with net exports bearing a greater share of the adjustment burden to changes in domestic spending. For example, in the late 1990s, measurements of domestic demand grew even faster than real GDP (which grew even with a quick clip). However, inflation remained relatively subdued, partly because the US current account deficit rose. Similarly, a surge in imports this year could allay potential inflationary pressures in America while giving a boost to weaker trading partners.
Built to overflow
The biggest uncertainty about the global impact of a hot American economy is the Fed’s response. Recent work by Kristin Forbes of the Massachusetts Institute of Technology suggests that domestic inflation is more responsive to global factors over time – including the extent of the economic doldrums affecting the entire world economy. However, wage inflation still appears to be primarily responsive to domestic conditions. The Fed could therefore fend off the price hikes later this year, assuming that short-term price pressures will not result in sustained inflation until the American labor market and global economy have fully recovered. A dovish Fed should create a weaker dollar and easier financial conditions around the world, adding to the boost Americans get from buying more goods from abroad.
A really fast-paced economy, however, could test the Fed’s patience, especially if a yawning current account deficit and rising asset prices cause it to worry about an increase in financial risk. The specter of American interest rate hikes could frighten global markets and force emerging economies to adopt less stimulating financial and monetary policies. A bit of demand from America seems insignificant in comparison. It still seems unlikely that the Fed will suddenly become hawkish. But when America’s temperature is high enough, the rest of the world can break into a cold sweat. ■
This article appeared in the Finance & Economics section of the print edition under the heading “Radiation Energy”