Decoupling, the Theory That Won't Die

There once was a popular theory on Wall St. which predicted economic fluctuations in the U.S. had become "decoupled" from the rest of the world.

The idea was that a downturn in the U.S. wouldn't slow the global economy since new powerhouses like China and India had matured to a point where they weren't as dependent on U.S. demand for growth.

Then came the subprime fiasco, wiping away trillions of dollars in e-paper wealth and seemingly vanquishing proponents of decoupling. After all, isn't globalization the most powerful economic force today? And as business ties become more closely linked across nations, so should the ebbs and flows of connected economies.

But decoupling has legs, and maybe for a good reason: it could actually be true. Last month, for example, Standard & Poors reported that despite the global economic turmoil, Asian economies should continue to grow at a solid pace this year. And new research from I.M.F. economists offers a more nuanced view of the decoupling-convergence divide.

M. Ayhan Kose, Christopher Otrok and Eswar Prasad examined the business cycles of 106 countries between 1960 and 2005 to find out how changes in growth in each country was affected by global conditions. Pre-1985, the period before globalization really took hold, global fluctuations accounted for an average of 15 percent of the changes in a country's GDP growth. After 1985, that figure dropped to seven percent. Industrialized and emerging economies saw even larger drops.

But at the same time, the movement of output for countries in the same economic stratosphere became more closely linked. For example, pre-globalization, six percent of an industrialized country's output was influenced by the performance of its peers. After the world got Aunt Jemima-ed, that figure rose to 11 percent

Still, the combined influence of global and group factors was slightly less than it was prior to the current period of globalization, the researchers found.

The implication is that despite the rise in trade between China and industrialized nations like the United States, the countries' business cycles are no more linked than they were before globalization. The main reason, the researchers argue, is that China's trade with its peers has grown even more:

While there has been a sharp increase in intra-group financial linkages among industrial countries, intra-group trade linkages have become particularly strong among [emerging countries] during this period. For example, the share of intra-group trade in the total international trade of [emerging countries] doubled from less than 18 percent in 1984 to 36 percent in 2005. During this period, [emerging countries'] trade with the group of industrial countries as a share of the [emerging countries'] total trade has declined from 70 percent to 50 percent.

What this means for the current U.S.-led downturn is unclear, however. Since today's woes are more driven by the Wall St. economy of financial flows rather than the "real" economy of consumer spending -- at least up to now -- the potential damage from spillover effects is more mysterious. But while it may seem that decoupling failed this time around, it's not necessarily the case that it did. The research hints the current downturn could've been even worse.