A Difficult Rebalancing Act

Martin Wolf looks at the possibility of a U.S. led worldwide economic slowdown and what might be done to avoid it:

A slowing US could brake the world, by Martin Wolf, Commentary, Financial Times: The world economy is enjoying a glorious run. In 2003, 2004 and 2005, it had its best years since the early 1970s. Yet that is no encouraging parallel. The torrid expansion of the early 1970s led to a period of inflationary turmoil. We must ask whether the extraordinary growth of recent years also hides dangers – different, perhaps, but still significant. The answer, alas, is yes.

To doubt the resilience of the world economy must now look perverse. Since 2000, it has overcome so many obstacles: post-bubble traumas in Japan; the bursting of a global stock market bubble in 2000; the terrorist attacks of September 11 2001; a US recession; years of stagnation in the eurozone; wars in Afghanistan and Iraq; real oil prices at levels close to those of the late 1970s; and the failure to complete the Doha round of multilateral trade negotiations. Yet, in spite of all this, world economic growth was 4.1 per cent in 2003, 5.3 per cent in 2004 and 4.9 per cent in 2005, measured at purchasing power parity exchange rates. ...

How has it been possible for the world economy to leap over so many hurdles?

We can offer three answers: first, the power of the underlying drivers of economic expansion – US productivity growth, globalisation and the rise of Asia; second, the ability of central banks and fiscal authorities to exploit the credibility they won in the 1980s and 1990s in response to the shocks of the 2000s; and, not least, the role of the US as borrower of last resort. ...

At present, perhaps one-seventh of the rest of the world’s gross savings (and a higher proportion of its net savings) are being absorbed by the US current-account deficit. ... The challenge for US policymakers then is to keep domestic demand at the level needed to sustain high levels of domestic economic activity, in spite of huge current account deficits.

Currently, these policymakers must keep demand some 7 per cent above full-employment levels of output. They have only two vehicles: government and private financial deficits (excesses of spending over income). In the past five years, both have contributed. But the dominant element has been the gigantic and unprecedented US household financial deficit (see chart). Meanwhile, foreigners and companies have been providers of funds.

The current housing slowdown may, however, induce households to reduce their spending sharply. ... Consumption will no longer grow faster than incomes, but more slowly instead. ... [T]he economy would slow and unemployment would rise. One response – another big fiscal boost – would seem irresponsible. Persistently high inflation might curtail another possible response – a sharp cut in short-term interest rates ...

Imagine that these events occurred in the run-up to the next presidential election. The calls for a weaker dollar and protection against imports would jump to deafening levels. This pressure would be directed against China...

What we are discussing then is the possibility of a disorderly unwinding of the external deficits, the trigger being a sharp slowdown in US household demand that would stimulate domestic pressure for both a currency realignment and protection. ...

The rest of the world may no longer need further increases in the US external deficit. But it would not want to see it contract too brutally or too quickly either. If US domestic demand weakened, however, a big correction of the external deficit is exactly what most Americans would want, since that would be preferable for them to a domestic recession. They would wish to export their slowdown.

In short, the world economy confronts not just a risk, but a test: that of managing a decline in the huge excess of US household spending over incomes. Will it be able to manage this easily? The answer is: only if others are able and willing to expand demand substantially, in their turn. What are the chances of that? It is hard to feel optimistic.

There are quite a few interrelated imbalances to be concerned about. There is the external imbalance reflected in the current account, and I don't disagree with Martin Wolf's conclusion here. There are also internal imbalances such as the budget deficit and overinvestment in housing fueled by low interest rates.

On housing, will it be an orderly slowdown or an all out bust? That's the question, and Nouriel Roubini certainly has an opinion. I was one of the people who advocated raising interests rates to rebalance the economy and correct resource misallocations -- let the air (i.e. resources) out of the housing "balloon" slowly so that it can reinflate other sectors of the economy that are flat and in need of pumping up. But there is a limited absorption rate in these other sectors and if the air escapes too fast or if the balloon pops, it will be lost rather than reabsorbed.

So far, although a lot of people have their ears covered, there's been no loud pop. However, the hissing sound is certainly getting louder making it hard to feel optimistic that displaced resources from the housing sector will be easily reabsorbed.