March 3, 2014

The Economic Situation, March 2014

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The Money Tree and the Rest of the World

Quivering financial markets in a post-taper economy remind me once again to always follow the money when trying to predict where this world is headed. New Fed chair Janet Yellen spoke truth to power when she testified in February that the Fed had stopped watering the money tree and that US labor markets were a long way from normal.

But the world spoke back with its version of truth. In more fruitful days when the money tree was yielding bucks at a fast pace, investors looked to the developing world for yields well above the Fed-preferred zero point. Foreign currency values rose relative to dollars as investors fattened their portfolios, and foreign equity markets soared. The weaker dollar then enabled holders of other currencies to buy more dollarized goods. It all seemed like a dream come true, at least for holders of money-tree dollars.

Then tapering reversed all this; the money tree wilted a bit. Investors began to sell their foreign equities and buy dollars. The dollar strengthened and interest rates briefly fell a bit. Home currencies weakened in developing countries, prices for imported goods from the rest of world went up, and a dose of taper-driven inflation entered the developing world. Political instability followed.

All because there was less water for America’s money tree? Well, that has to be part of it. There are lots of moving parts in this story. We are left with the question and Janet Yellen with the challenge: what will happen as other central bankers cut off the water that feeds their money trees?

What in the world is going on? Better said: what is going on in the world? To get a handle on how the world is doing, I first provide data on the level of GDP for the 50 largest world economies. A quick glance tells us two things. First, the US economy is massive. Second, China is no slacker. A longer glance and a few back-of-the-envelope calculations tell us that the economies of the big five, when added together, yield a total that is just as large as the remaining 45 put together.

Of course, this statement can be reversed. The other 45 added together are equal to the total of the big five’s GDPs. Putting some flesh and bones on this, we can then say that when the developing world as a group begins to cough and sneeze, the big five can tell.

Wilting money trees matter at home as well as in the larger world.

Before leaving this chart, I will call attention to the arrow pointing to Greece. I do this to emphasize the smallness of the Greece economy relative to the rest of the world. So why does a Greek default matter all that much? The answer relates to who holds Greek debt and how much debt there is out there. It turns out that the small Greek economy puts out a huge amount of debt. And much of the debt is held by German banks.

So now we understand perhaps why Germany is so interested in getting the Greeks back in line.

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