This graph illustrates the difference between actual GDP and potential GDP. It also indicates how much Real GDP growth has lagged behind potential growth. This means the US economy currently has substantial spare capacity. This is reflected by a rise in unemployment and factories operating below full capacity.

The Real potential GDP illustrates the long run trend rate of growth which is the average sustainable rate of growth over a period of time. Notice how the recession has reduced the growth of potential GDP from 3% to 2%.

What are the Implications of Growth well Below Potential Growth?

• High Spare capacity
• High rates of unemployment likely to persist
• The economy needs to grow substantially quicker than average to regain ‘full employment’
• Growth of 1-2% would not solve the spare capacity and unemployment of the US
• Growth could be temporarily above the long run trend rate fo 2.5% without causing inflation.
• This large amount of spare capacity may encourage policy makers to pursue a more expansionary fiscal and monetary policy – taking into account limitations of budget deficit.

More on the Current state of the US Economy and prospects for 2010

I will be doing a similar overview of the UK economy soon.

Firstly, I cannot offer a professional opinion on the best time to buy US dollars. I don’t think anybody will be able to tell you the ‘best time to buy US dollars’ with any certainty. If you go to different economists you will get different forecasts for the US dollar in 2009.

I have tried predicting exchange rates – sometimes they turn out right sometimes they turn out wrong.

My feeling is the dollar will continue to be weak in 2009 because

• Interest rates 0 – 0.25%
• Economy still declining, more bad news could come in 2009
• US public sector debt continues to grow at an alarming rate.
• Quantitative easing is increasing monetary base and this is liable to depreciate the value of the dollar.
• Current account deficit persists.

The fundamentals of the economy point to a weak dollar. But, even when fundamentals are weak this is not a guarantee of the dollar’s devaluation. In particular it is hard to spot a strong currency as many economies face difficulties.
The Euro is starting to look overvalued as the Euro economy goes into recession.
Last October the dollar rallied because people still saw the dollar as a safe haven compared to emerging economies.

Related

• US Dollar 2009
• US Dollar Collapse?

On the same day, the price of Gold increased $44.30 to settle at $909.

Whilst gold and oil increased in price, the dollar fell to its lowest value against the Euro for a month. The US currency has now lost 6% in value since Sept 11th.

The reason is that Gold and oil are seen as a substitute to investing in dollars. With so much uncertainty surrounding the US economy, investors are looking for alternatives to the dollar – which many feel could fall in the coming months. Investors are nervous about the dollar because of the government’s ambitious $700bn bail out plan for the beleaguered financial system. The plan would increase the nation’s debt ceiling by 6.6% to $11.315 trillion. With such a large deficit, the dollar becomes less attractive.

There is also growing criticism of the $700bn plan to bail out banks. US house sales are still weak putting pressure on another US interest rate cut.

The Cost of Government Bailouts

The dollar has been falling for many reasons. These are some of the factors which would stop the dollar falling and lead to a recovery in the value of the dollar.

Higher Interest rates. US interest rates have been cut to 2% in an effort to stave off a US recession. This causes an outflow of hot money. If interest rates were raised it would encourage people to save in the US and cause an appreciation.

Recovery in US economy. The US fear recession because of a declining housing market, this is leading to lower interest rates and lower confidence about the US economy. If the economy recovered, interest rates would increase and people would have more confidence in buying dollars.

Fears Over the Euro. The main beneficiary of the falling dollar has been the Euro. People are increasingly seeing the Euro as an alternative reserve currency to the dollar. Therefore, investors have been switching out of the Dollar. However, confidence in the Euro may be misplaced. The Euro economy is not much stronger than the US. Many European economies face the prospect of falling house prices; also the strength of the Euro is causing problems for exporters. Arguably, the Euro is overvalued on economic fundamentals – the dollar looks cheap on purchasing power parity. Maybe the sell off of dollars has been overdone.

Improvement in US Current Account. The fastest depreciation in the dollar came when the US had a current account deficit of over 6% of GDP. However, the depreciation in the dollar is helping to improve the current account. If the current account continues to improve as domestic spending falls, the dollar should recover.

Intervention of Central Banks. So far, Central bankers have been content to leave the dollar to market forces. However, there may come a point when Central bankers think ‘enough is enough’ and they take steps to intervene in the market such as buying dollars. If there is co-operation on an international level, this may be sufficient to restore confidence in the dollar and revert its decline.

Improved US competitiveness. If US productivity improves relative to other countries this would help make US goods more attractive and increase demand for the dollar

Firstly, it may come as a surprise to most people, but, the US is not officially in a recession.

According to the latest statistics provided by the Economist April 24th 2008

• US economic growth is 2.4% year on year.
• In the last quarter, growth is 0.6%. This is still a long way off the technical definition of a recession – negative economic growth for two consecutive quarters.

Nevertheless people have been predicting that the US will soon enter into recession. This is because

1. Credit Crunch. Banks have lost money in lending subprime mortgages, which involved high levels of defaults. It is not just mortgage companies who have been affected, but, banks who lent to the mortgage companies. The result is that there is a shortage of funds for borrowing and bank lending has become more difficult.

2. Housing Crash. This is probably the biggest factor dragging the US towards a recession. House prices are falling because

1. Shortgage of mortgage funding
2. decline in confidence
3. Prices became overvalued.
4. Increase in supply now accompanies falling demand

Falling house prices creates:

• Negative wealth effect – much less chance to remortgage and gain increased equity
• Falling confidence – both these cause lower aggregate demand and lower growth.

Rising Debt levels The past few years have seen a rise in debt and decline in savings ratio, reflected by the growing current account deficit. This means there is little scope for increasing consumer spending. As confidence in the housing market and wider economy falls, consumers are looking to increase savings and deal with their debt, rather than further increase it.

Rising Cost Push Factors. Rising prices of oil and food are increasing the costs of production (for A level students it causes the AS curve to shift to the left leading to higher prices and lower output)

There are more factors, but, I feel that it is the housing market and decline in consumer spending which is the major factor in threatening a recession.

I wrote this in 2007, but the factors are still pretty relevant today – Is US heading towards a recession?

• Iraq War and US Recession

The Dollar still is the world’s reserve currency. With about 67% of the world’s currency reserves held in dollars. 

The reason foreigners often hold US dollars

• Historically, it has been seen as a safe, secure and strong currency.
• Because most other people hold currency in dollars, people may think there is strength in numbers
• Most commodities priced in US dollars. Most commodities such as oil and gold are priced in US dollars, so this gives an additional reason to hold currency in US dollars, minimising transaction costs of getting dollars to buy commodities

See: Why the US Dollar may lose its place as the world’s reserve currency.

How does the holding of dollars by foreigners affect the welfare of American? – will answer soon.

In this essay, I have explained why the US is facing a recession.

As I often teach Monetary and fiscal Policy, I am quite interested to see how effective the attempts to avoid recession will be.

From a textbook perspective cutting interest rates and pursuing expansionary fiscal policy should increased Aggregate Demand and therefore increase economic growth. However, it is likely that the US may still go into recession, despite the attempts to increase AD. This shows a practical limitation of fiscal and Monetary policy. This is where you can get evaluation marks.

However, even if the US economy does go into recession, it would be fair to say that the recession would have been much worse, if they hadn’t tried to use expansionary fiscal and monetary policy.

China certainly exports alot to the US. Exports to US totalled $295bn in 2007 (they were 32% of exports

US trade with China TOTAL

•  US exports to China $58,340.1m
• Chinese exports to US $295,817.6 m
• Trade Deficit -$237,477.5m

Source US Trade

However, US is not the only trading partner of China. China has many other markets.

Also with the Chinese economy growing at around 10% a year. A fall in exports to the US, may just slow down growth by 1 or 2 %. This may be beneficial because it will avoid inflationary pressure in China.

The US recession, will lead to further weakening of the dollar. It will create further upward pressure on the Chinese Yuan, even though the Chinese are reluctant to do this.

Overall: The Chinese economy is growing sufficiently fast to avoid being adversely affected by a US recession. However, if the US recession spread to the rest of the world, it would be much more serious.

• Affect of US recession on China and Japan 

If the US economy entered into a recession the main effects on other countries would be:

1. Decline in exports. American consumers are a key component of world trade. If there was a decline in exports to America it would lead to lower growth in countries like Vietnam. In certain sectors it could cause a rise in unemployment. There could also be a negative multiplier effect ‘knock on effect’/ The initial fall in exports could cause a bigger fall in Aggregate Demand.

However, it depends on what % of exports are to America. For Vietnam, exports to the US are important, but not a huge %.This page shows that Vietnam exports to us totalled $7.6bn in 2005. link US – Vietnam trade

This is not a huge amount, it is about 20% of exports.

It depends on how the rest of the economy is affected. For example if domestic demand remains strong then this might offset any fall in exports

It depends on whether Vietnam is able to increase its exports to other Asian economies. For example, it may be that China’s economic growth takes the place of US exports. China is nearer.

2. Effect on Exchange Rate.

The economic decline of America has led to a long term devaluation of the dollar. If the US enters recession, interest rates will fall and there will be a bigger fall in the dollar. This may cause a rise in the Vietnam currency making its exports to US less competitive.

3. Has the US economic decline been overstated?

The other thing I should say, that it is perhaps premature to talk of America’s economic decline. True the dollar has been devaluing and they may enter recession. But, they are still one of the most powerful economies. When people talk of America’s economic decline they really mean ‘relative economic decline’. In other words the US takes a smaller share of world trade, but the economy is not actually contracting

See also: what went wrong with the US economy 

Main Exports from Vietnam

• garments
• footwear
• seafood
• coffee beans
• crude oil
• rice

Will Vietnam roar again at BBC

According to some doom mongers the US is already in recession. They point to the ‘collapsing’ housing market and the rise in ‘repossessions’
The irony is that US economic growth has remained unexpectedly high at 4.9% in 3rd quarter of 2007. Growth has averaged over 2.1% since 2001 (US economic snapshots)

Unemployment remains at 4.5%, although this masks some disguised unemployment, – it is hardly the sign of a full blow recession.

Nevertheless there are several warning signs that could push the US into recession by the end of 2008

Why US Recession is Likely

House Price Fall.

US house prices fell by 4.5% in 2007. (In some cities they fell by more). Falling house prices reduces consumer wealth and consumer confidence; this will lead to lower spending. (Consumer spending has been the main driving force behind the US economy in recent years)
There are also concerns that the fall in house prices could accelerate due to the glut in house supply and the fact more people are coming to the end of cheap mortgage terms.

House Repossessions.

There has been a record rise in home repossessions. The foreclosure rate on homeowners has risen to a 17 year high of 5.59%.

Global Credit Crunch

Due to mortgage repossessions, especially on sub prime mortgages, banks have had to write off a lot of bad debts. This has caused an increase in the cost of lending. For example, 3 month dollar Libor spreads have jumped by 60 to 80 basis points in recent months.

Slower Growth in Asia and Europe

Growth in Japan and Europe may be also sluggish in 2008. Both the Eurozone and Japan are struggling from strong currencies.

Weakness in the Dollar.

The weakness in the dollar is due to fundamental economic imbalances such as the large current account deficit. There are concerns that if the dollar keeps devaluing the Federal reserve may be reluctant to cut interest rates. Because cutting interest rates will lead to a weaker dollar. However, if they fail to cut interest rates it is more likely to slow down the economy.

Slowdown in Job Creation

Although more jobs have been created due to a rise in the population. There is evidence of a slowdown in job creation which could be an indicator of recession. – Job creation slowdown at N.Y.Times

Forecasts for US economy

Morgan Stanley is the first major Wall Street bank to warn that it is may now be too late to stop a recession, – Morgan Stanley issue recession warning