Can the U.S. Decouple?
I usually do not watch financial markets on a day-to-day basis -- with respect to those who do, to me there are more important things in life -- but today has been very much exceptional. Political uncertainty is rising across the Continent, and as I've documented, macroeconomic conditions remain poor and appear to be worsening in the Eurozone periphery. Therefore, the first thought on my mind this morning is decoupling: how bad do things need to get in Europe before they get bad here, in the United States? Is decoupling possible? Upon what conditions is successful decoupling conditional?
What I found may surprise you -- it certainly surprised me. I had thought of the 2008 recession as the proof that decoupling was impossible. Europe thought in early 2008 that it was immune from the problems in the United States, only to be brought low by the acute stage of financial crisis in October. Asia thought robust real and nominal growth would save its hide; then massive swings in trade volumes created sudden slowdowns in output there, although conditions rapidly improved (although I note that since the rebound in 2009, recovery in Asia has been remarkably weak.) The lesson economists were supposed to learn, I thought, was that globalization in trade and finance has rendered the world's economies so interconnected that (1) decoupling is impossible and (2) that if anything, globalization has magnified and not diversified market risk.
A more careful examination of the data, however, pokes important holes in that "story." I took four stock market indexes -- the S&P 500 in the U.S., the FTSE in the U.K., the CAC40 in France, and the DAX in Germany -- and computed rolling coefficients of determination for the percent change over the timespan of 26 weeks (two fiscal quarters) from January 2000 to April 2012. The green line is the average of these coefficients of determination during this time period.What I found was that the capacity to decouple is conditional. (Decoupling events look like a sharp drop in the graph above.) If Europe is "merely" in recession, even if it is deep, then the data do not suggest that the U.S. is necessarily dragged down with it. It will decouple. That is where we are as of late April -- largely decoupled from European macroeconomic conditions. See how the average coefficient of determination is historically low?
Importantly, however, the capacity to decouple does not mean we will decouple. Macroeconomic policy matters; when policy generates the same macroeconomic conditions in the U.S. as in the E.U., then the results are similar even when they don't have to be. This is why the average coefficient of determination is near-zero right now: no global financial crisis, and vastly different macroeconomic policy and conditions between the U.S. and the E.U.
However, the U.S. does not seem able to decouple from Europe in the event of financial crisis. As the average coefficient of determination for the relationship between changes in the S&P and in the three E.U. indexes rises, so does the frequency of large-magnitude changes in the mean value of these four stock indexes. This should make sense: when "financial crisis" grabs headlines, it tends to move markets across the world in the same ways. When conditions are more normal, then stock markets tend to be governed by more local or regional macro concerns which do not as easily or as sharply transmit themselves across borders.From an American policy standpoint, then, the Eurozone's recession is relevant only to the extent that it puts sovereign debt in question and destabilizes financial markets. There is not terribly much for the U.S. to lose or gain given macroeconomic deterioration or progress in the E.U. Macroeconomic policy is by no means ideal in the U.S., but it is far better than in the E.U., and sufficient for decoupling.