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It's a small (and sometimes shaky) world after all: Exogenous shocks in a global economy

economy shocks graphicStudents are growing up in an increasingly interconnected world, with many national economies reliant on trade with international partners and vulnerable to events that occur in far-flung places. Reading the news these days, we are continually reminded of these linkages. Along with every announcement of a new development in Greece's sovereign debt crisis comes a report on the wildly swinging U.S. stock markets reacting to the announcement.

Of course, it hasn't been only the euro zone crises affecting the U.S. economy. Several other exogenous shocks occurred earlier in the year that not only affected the markets but also partly contributed to the weakening of economic growth, according to Galina Alexeenko, Atlanta Fed regional economic information network director. Said Alexeenko, "Such events are called 'exogenous shocks' because they are born from events outside the economic system." Because of increasing globalization, such shocks have greater-than-ever potential to spread around the globe.

The effect of exogenous shocks
One such event that had far-reaching effects was the triple whammy that hit Japan this past spring. On March 11, a 9.0-magnitude earthquake occurred off the main island of Honshu. Within minutes, a ferocious tsunami hit portions of the island and went as far inland as six miles, covering a total area of about 217 square miles. These natural disasters led to the world's worst nuclear disaster in 25 years, when at least two of the reactor cores at the Fukushima nuclear power plant experienced explosions and three had partial meltdowns.

Looking at the effects of the Japanese catastrophe on the U.S. economy is a good lesson on globalization and exogenous shocks. According to Alexeenko, the Japanese crisis significantly affected the U.S. economy in a couple of different ways. The first sector that registered the shock was the financial market. Almost immediately after the Japanese disaster, "the market tanked," she said. "Boom—all gains were erased for the year. But the markets soon recovered."

However, the shock to the supply chain has been more significant and longer term. Supply chain disruptions resulting from the Japanese disaster, which occurred in electronics and auto parts, have been particularly damaging to the U.S. auto industry, explained Alexeenko. Rolling power outages, factory damage, infrastructure damage, and displaced residents forced many industries—including, most significantly for the United States, auto parts makers—to cut production following the tsunami for an extended period. Consequently, as the International Monetary Fund wrote in its July 2011 World Economic Outlook, "according to some estimates, the number of cars manufactured worldwide may have dropped by up to 30% in the two months following the Japanese earthquake and tsunami because of supply-chain disruptions."

U.S. economic data show clear evidence of these disruptions. For example, auto and parts production dropped nearly 7 percent from March to April, and did not begin to recover until July. Given that the U.S. auto industry is a sizeable share of the manufacturing sector, the drop in autos and parts production in turn caused a 0.6 percent contraction in the manufacturing sector in April. Motor vehicle assemblies fell by nearly 1 million units (at an annual rate) in April.

In addition, consumer spending on autos and parts fell in the second quarter— reflecting the decline in auto production—and in turn caused growth in inflation-adjusted consumer spending to decelerate substantially, to an annual rate of 0.7 percent (compared to 2 percent historical average). Overall consumer spending increased by only $16 billion (annual rate) as spending on autos and parts fell by $26 billion (or at a 26 percent annual rate). And because consumer spending accounts for about 70 percent of the U.S. economy, weaker consumption growth resulted in a rapid deceleration in the overall GDP growth in the second quarter.

Finally, a diminished supply of autos caused prices of new vehicles to jump 2.6 percent between February and May. This jump was the largest three-month increase in 30 years.

By Nancy Condon, Extra Credit managing editor, Federal Reserve Bank of Atlanta

November 3, 2011