Subprime saga strains economic decoupling theory

By Emily Kaiser and Kevin Plumberg -Analysis

WASHINGTON/NEW YORK (Reuters) - The subprime saga has dented a popular theory that the United States is ceding its position as the engine of the world economy, casting doubt on whether global growth can withstand a U.S. downturn.

As recently as June, economists at several major investment banks argued that the rest of the world was decoupling from the U.S. economy as rising powers such as China pulled their weight and a global investment boom kept money flowing.

U.S. officials from President George W. Bush on down have pointed to the strong global economy as a key factor that would help the United States weather a housing downturn, while some European leaders argue that U.S. problems won't infect the global economy.

However, as credit problems that began in the U.S. mortgage sector spread across the globe with surprising speed, ensnaring financial firms from Australia to France, that decoupling thesis looks unlikely to hold up, at least for now.

"In this situation, we are coupled, all of us," said Milton Ezrati, chief economist with Lord Abbett & Co. "If the liquidity mess drags us down, it would drag us all down together."

The decoupling idea gained proponents after a year of below trend U.S. economic growth, culminating in an anemic 0.6 percent annual rate in the first quarter, did not significantly alter expectations of robust global expansion. The government reported on Thursday second-quarter U.S. growth accelerated to a 4 percent rate, but analysts expect much slower growth for the rest of year.

Even now, the International Monetary Fund still expects the global economy to grow by more than 5 percent this year and next, which would amount to five straight years of growth of around 5 percent.

However, recent financial market turmoil highlights just how intertwined the global markets are, and suggests the world economy may not be able to escape a U.S. downturn triggered by tougher borrowing conditions for consumers and businesses.

STRESS TESTING

Stephen Jen, global head of currency research at Morgan Stanley, was one of the staunchest supporters of the decoupling theory but acknowledged it is undergoing a major test that depends almost entirely on how the U.S. stock market responds to its troublesome sibling, the credit market.

"If you have a severe correction in the U.S. equity market and severe correction in the credit market, you are going to see the same thing echoed in the entire world, and a broader slowdown than the theory would suggest," Jen said.

World stock markets have outperformed U.S. equities by a factor of two since a global bull market began in 2003. But a significant move lower in the U.S. stock market would likely weigh on consumer spending -- a longer-term phenomenon that could affect other economies.

Another factor that could seriously undermine the decoupling theory is if China's economy slows substantially -- something Jen said is unlikely because of the government's tight controls on its markets, but still worth monitoring.

On the basis of purchasing power parity, China's gross domestic product as a share of world output has risen to more than 15 percent from 9.8 percent in about a decade. Meanwhile, the U.S. share has slipped to 19.6 percent from 21.1 percent.

China's rise is a key reason why global economic growth has held up even as the U.S. economy sputters.