Can the US economy decouple?

Last night’s Wall St trade took heart from a big jump in the Conference Board consumer confidence figures. It is great that the US has weathered its QE2 withdrawal and deficit ceiling debacle, but we should bear in mind that the index only rose to July levels, which are still very suppressed:

Despite this, yesterday the uber-optimists at Treasury based their MYEFO forecasts in part on the following:

Given the poor outlook for Europe, sustaining the global recovery in the period ahead will rely primarily on the United States and China, the two largest economies in the world.

It’s time to ask again, then, if the US economy can decouple from Europe (I will add that Treasury seems to be deliberately misleading the public here, the US and China combined might be the biggest economy but as separate entities it is the EU by a considerable distance).

For context, let’s turn to a lively discussion in the blogosphere overnight between Tim Duy and Free Exchange:

TIM DUY asks whether America’s economy can decouple from the euro-zone economy, and he posts this chart:

I share the view that America will be unable to insulate itself from European difficulties, but I don’t think the chart above explains why. Europe’s enormous output decline in 2008 and 2009 was not primarily due to the drop in American output.

European industrial orders collapsed in September. Given how tightly correlated orders were during the 2008 collapse, one might think, the drop in European orders will quickly translate into an American slowdown. As Paul Krugman wrote at the time:

One way to think about this is to ask what it would take for a U.S. recession to impose a one percent of GDP negative demand shock on the rest of the world. For this to happen, U.S. imports would have to decline from 6 to 5 – a 17% decline. Given that the typical estimate of the income demand for imports is around 2, this would require a decline of more than 8% in U.S. GDP. So it would take an extremely severe recession in the United States to produce even a moderate-sized negative demand shock abroad.

What was more important was the international financial multiplier. Financial markets are far more integrated than product markets, and they acted as a conduit of contagion from the American banking system to banks abroad. Falling asset prices in one place impact the balance sheet of leveraged institutions in another place. This transmits the crisis, which then impacts the real economy. Orders fell in both Europe and America because the financial systems in both Europe and America were simultaneously seizing up.

That’s all right, but it’s not that simple either, in my view. We don’t need a full blown credit freeze complete with Minsky moment. The US is not growing strongly nor is its consumer strong. That’s the point I made two weeks ago:

Personal income growth is running at about 3% a year, below inflation. Note as well that personal savings have begun to fall. Outside of cars and student loans, consumer credit has fallen in the last three months so I conclude that the current round of consumption is funded largely from a savings rundown, following the big spike post GFC. We’ve been here before, of course, and such cycles can run for longer than anyone expects so we can’t discount that possibility.

Here is the opposite table:

With such paltry income growth, any tightening in credit availability threatens to immediately raise savings again. That means even a modest credit squeeze emanating from Europe has the potential to snuff out the current US consumer renaissance in my view.

The word “decoupling” really should be struck from the modern economic lexicon.