Land softly, soon, or the bubble will burst

Imbalances in the glittering Anglo-Saxon economies are setting the stage for a potentially painful downturn
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The Independent Online

Which G7 country has a record trade deficit, the lowest ever personal savings rate, a record corporate financial deficit, and the highest ever level of household debt, either in money terms or as a share of GDP? This basket case is actually the high-performance US economy. And it is these imbalances that Alan Greenspan has begun to fret about in his recent public statements indicating the need for higher interest rates.

Economists have become increasingly nervous about these adverse side-effects of the Great American Boom. They can be blamed on the fact that there are no signs at all of a slowdown in demand growth. Last year the economy expanded 4.0 per cent, its eighth year of growth. Many forecasts pencil in not a slowdown but rather a fresh acceleration this year, even though the Fed has clearly signalled that interest rates will climb until they finally have an impact.

The astonishing growth and employment record in the US is in turn due to the glittering stock-market performance, which, even though now narrowly focused on technology stocks, has boosted wealth. Household net worth has rocketed from nearly five times household income in the mid-1990s to about seven times income by late 1999. The effects of this increase in wealth account for both the buoyant US economic performance and for the increasing signs of strain.

Mr Greenspan has drawn the connection between improved productivity growth, share prices and consumption. His public musings on the adverse effects of what increasingly seems to be a genuine productivity miracle, along with last week interest rate rise, have had scant impact on the stock market, however.

"He must now be wondering whether predictability is not an entirely good thing either. Could it be time to shock the markets with firmer action to slow the economy down?" says Mark Cliffe, chief economist at ING Barings.

The need for a slowdown is evident in those financial imbalances. The increase in wealth due in large part to share prices has made US consumers confident enough to build up their indebtedness too. Higher borrowing has cut measured saving and led to a consumer demand growing in excess of domestic supply.

The same pattern holds for the corporate sector. Investment spending has reached 18 per cent of GDP, the highest since the end of the First World War. While this has made the productivity revolution possible, it has also occurred at the same time as corporate America has been buying back equities, and has therefore been in the aggregate debt-financed. The corporate sector as a whole has been spending in excess of its income too.

With private demand growth running ahead of supply, and only partly offset by a government surplus, the resulting surge in imports has caused the trade deficit to explode. That, in turn, has been financed by the continuing willingness of foreigners to buy US assets. The US, the world's biggest creditor nation before the end of the Cold War, has plunged increasingly into the red.

Although foreigners have sold US Treasury bonds, they have invested massively in corporate America. In the last quarter of 1999 there were net direct investment inflows of $13bn, $58bn in purchases of corporate bonds and a record $33bn in purchases of equity.

This is all fine as long as this link in the chain - the willingness of foreigners to finance US consumption out of income it has not earned yet - continues to hold. The concern is that history offers no example of a set of imbalances of this magnitude not leading to an asset price crash and recession.

There is a sobering message in the fact that four countries have private sector debt in excess of 150 per cent of GDP. Two, Japan and Korea, have seen their asset price bubbles burst, the other two are the US and UK. The imbalances in the Anglo-Saxon economies now look to many economists like Japan or Sweden or the UK in the late 1980s.

George Magnus of Warburg Dillon Read turns further back in history for enlightenment, noting that the phenomenon bears a resemblance to Karl Marx's theory of over-investment as the explanation for economic cycles. At some point, the rate of profit is bound to fall, with a subsequent and possibly painful business cycle downturn.

Ian Harwood of Dresdner Kleinwort Benson adds that the recent surge in the margin debt of American households gives extra cause for concern. Borrowing on margin for stock market investment has reached $250bn, a steady climb since early 1997 having turned exponential since late 1999. He points out that this is clear evidence that consumers are growing increasingly speculative.

Others are not so convinced that a crash landing is in prospect for the US economy. Richard Jeffrey, an economist at Charterhouse, argues that the imbalances can unwind over time as long as share prices do not collapse too precipitately, puncturing private sector wealth. The UK has a more serious problem, he argues. "There is a bigger problem in the UK where excessive demand growth has been driven by the wealth effect of rising house prices. That is an illiquid market - you can't sell a bedroom off to pay off your debt."

A hard landing is therefore more likely to correct the economic imbalances on this side of the Atlantic, he argues, and the longer the Bank of England delays slowing demand growth the harder it will be. The latest MPC minutes suggest at least some of its members see a need to slow demand growth further. And the minutes of the last Federal Reserve interest rate meeting indicate the hawkish tendency is gaining the upper hand, so further interest rate increases in the US are on the cards. As trade and financial imbalances increase in both cases, engineering a soft landing soon could be the best way to prevent a hard landing later.

d.coyle@independent.co.uk

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