Psychologists refer to the “elephant in the room” phenomenon as a condition where people talk about everything except the most important issue. I recently (January 10, 2006) attended a conference at Washington’s prestigious Institute for International Economics on the likelihood of a financial crisis in developing countries. All morning the elephant sat quietly in the room sipping coffee.

The expert panelists puzzled over why global financial markets are so calm despite rising U.S. interest rates and the record trade deficit. Interest rate spreads between the U.S. and emerging market (EM) countries are at record lows, and foreign direct investment is flowing abundantly into these countries. This rosy picture was explained by reference to permanent policy changes. EM countries have improved their macroeconomic policies; run trade surpluses; restrained spending in the boom; and improved public finances by extending debt maturities, lowering their foreign currency debt, and refinancing at lower interest rates.

However, there is another deeper cause of this rosy condition. That cause is export-led growth, which is the elephant’s name. What’s the deal with export-led growth? EM countries export manufactured consumption goods to the US, in return getting financial claims against the US. These exports generate large trade surpluses that fund improved public finances. Additionally, EM countries get large flows of foreign investment since multinational corporations are happy to build export production platforms that take advantage of cheap labor and undervalued exchange rates.

The other side of the transaction has the US getting cheap consumer goods – lots of them. It also runs a trade deficit that American banks finance by issuing dollar deposits to EM countries. To the extent that countries use these deposits to buy US debt, this lowers interest rates, which is good for the US housing market. If they buy US assets, this bids up asset prices and makes US households wealthier. The downer is that the US sacrifices its manufacturing base since existing production and much new investment are off-shored via multinational foreign direct investment.

This configuration explains the health of emerging market economies. As long as the US keeps importing, they can keep exporting and the merry-go round keeps turning. The sixty-four million dollar question is what could stop it? And if it stops, what follows?

One possible stopper is if foreign countries cease holding their earnings in dollars. This would cause the dollar to fall, raising import prices and lowering US consumer import purchases. But foreign governments have no interest in this, as it would kill their “golden goose”. Moreover, alternative yen and euro investments pay lower interest rates than dollar investments.

A second possible stopper is if the Federal Reserve raises interest rates high enough to tank the housing market, driving down house prices. This would make households poorer, likely tip the US into a recession, and reduce consumption spending. That would reduce imports, which would quickly be felt in emerging markets. This scenario is a real possibility, but policy can avoid it.

A third possible stopper is if Americans cease their consumption binge because they feel over-extended. Alternatively, local American banks may tighten lending because they doubt households’ credit-worthiness and think house prices are inflated so that housing collateral is unsound. In this case, the flow of credit financing consumption would dry up at its base, and imports would quickly fall. This is another credible scenario, and it is one that is harder for policy to impact. The Fed controls the price of credit, but a local borrower and lender must seal the deal to activate that credit. Even China’s willingness to lend to local American banks cannot force that transaction.

Once consumption spending falls, the US economy will slow, possibly even falling into recession. Imports will fall, ricocheting back to emerging market countries whose exports will tumble. On the financial side, EM countries’ trade surpluses will fall. On the industrial side, there will be excess capacity and lost jobs. Excess capacity will discourage foreign direct investment, while rising unemployment risks a return of political instability. The depth and duration of such a downturn is the next sixty-four million dollar question. That will depend on the extent of excess capacity and the scale of US household over-indebtedness. It will also depend on whether emerging economies can replace exports with domestic sales, but don’t count on that as their record is poor.