“The Bank of Japan holds reserves of $823 billion; the People's Bank of China holds $769 billion; Taiwan's central bank holds $252 billion. The vast bulk of those reserves are invested in U.S. Treasury bonds and other U.S. securities, such as bonds issued by the mortgage finance company Fannie Mae”- Washington Post 19/11/05
By buying up US treasury bonds economies such as Japan, China and Korea have been able to keep their exchange rate with the $ favourable through keeping demand for the $ high. This has enabled these countries to maintain substantial current account surpluses with the US by running a capital account deficit with the US.
A current account deficit for the US during years of economic expansion is not a bad thing as imports provide price competition, which limits inflation and, without increasing prices, provides goods beyond the economy's ability to meet supply. However if the US were to be hit by a recession caused by an exogenous shock e.g. Stock Market Crash causing a decline in GDP the US would want to boost demand within the economy by increasing X and decreasing M.
Y↑ = C + I + G + (X↑ – M↓)
The Treasury could make US goods more price competitive to countries abroad by devaluing it’s currency through a reduction in the interest rate (r). A “run on the dollar” would ensue meaning the relative value of the dollar declining as expressed in other currencies like the Euro or Pound.
Y = C + S + T – Personal Income
Y = C + I + G + (X-M) – Open Economy
Equilibrium: C + I + G + (X – M) = C + S + T
I + G + X = S + T + M
Injections = Leakages
A decrease in interest rates leads to: -
I + G + X↑ = S + T↑ + M↓
A run on the dollar would occur from the central banks selling dollars in large amounts because of the lessening return offered to them by the declining interest rate and confidence in the $. Hence M↓ and US goods becoming more price competitive abroad X↑. As more income flowed into the country there would be more tax receipts lessening the budget deficit.
The increase in the Price Competitiveness and exports of American goods can be seen in the Real Effective Exchange Rate.
For example: Car Retails for £10,000 and $20,000 with an Exchange Rate of £1:$1.50
REER = (1.5* 10000)/20000 = UK Good Costs $15000/US Good Costs $20000
Dollar depreciates against the Pound to an Exchange Rate of £1: $2.50
REER = (2.5 * 10000)/20000 = UK Good Costs $25000/US Good Costs $20000
As can be seen a decline in the REER has increased the Price Competitiveness of the US good as compared to the British Good. It then follows that the US will export more cars to Britain (X↑) and import less cars from Britain (M↓)
Data Source: http://www.eh.net/
As can be seen from the chart the US is far and away the main trading partner of the EU accounting for almost a fifth of it’s international trade. If the US were to head into a recession followed by a run on the dollar this could have very negative impacts for EU exporters and the economy as a whole.
EU (Xt) = f (REER, World Demand)
EU (Mt) = f (REER, Income)
The above is a demand function for EU imports and exports. If the US were to enter a recession then overall world demand would decrease causing a decline in demand for EU exports from the US. If the $ were also to depreciate this would cause a decline in EU exports to the US as they would become less price competitive with domestically produced goods. The EU would also import more from the US as the price of US exports would start to become more favourable with the EU domestic market compared with the domestic market.
The exports negatively affected would only be those which are price elastic in demand to US consumers (e.g. Luxury goods like cars). Other exports which are essential and price in-elastic (e.g. food) would likely be unaffected and these good would be demanded regardless of cost. This is known as the “Marshall Lerner Conditions”.
The country within the EU which has the biggest trade surplus with the US ($41.5 Billion in 2006) is Germany so it would be expected that they would suffer the most from a decline in US demand for exports and depreciation of the $. The UK and France are the next biggest trading partners and as such would similarly be adversely affected when the US went into recession. Empirical evidence would show if theory actually reflected reality.
The graph shows for Germany there was no correlation between the $/DM exchange rate and domestic economic growth.
The graph shows for France that there was no correlation between the $/Franc exchange rate and domestic economic growth.
The UK was the only country which showed a pattern between GDP growth and the £/$ exchange rate. The graph shows that there is positive correlation between a weak pound and high growth rates for the UK which is what theory would suggest. Therefore if the $ were to depreciate substantially it would be the UK which would suffer the most and may go into recession.
Comparing EU/US growth rates demonstrates for the past 25 years US economic cycles and EU economic cycles diverged more than they converged.
Mr Schumacher argues that the correlation between US and eurozone growth can vary, and that when there has been a strong correlation, it might have been because both regions were hit by a common shock. – FT 05/12/06
The graph does correlate strongly in 1992 and 2001 however this could have been caused by both countries receiving the same exogenous shock. Domestic consumption has usually been far more important to EU growth prospects than its Balance of Payments with the US.
Joaquin Almunia, the European Union's monetary affairs commissioner, said last month: "So far our estimate for the net impact of the US slowdown on the European economy is not very important because our growth is mainly based on internal demand."- FT 05/12/06
Conclusion
It is hard to derive what would happen to the EU economy if the US $ were to fall and the US were to suffer a recession. Many factors affect EU growth which I have not researched (e.g. Depreciation of the $ causing $-denominated Oil prices to rise). It is usually assumed that if the US economy is faltering and its currency falling this would have a knock on bad effect for the EU economy. However I feel the effect is marginal as even though the EU may export less to the US because of this its exporters would instead look elsewhere for new markets as world GDP and demand has been steadily increasing for many years.
