Christopher Smallwood: 'Rebalancing' of the US economy still has a long way to go

Cuts in interest rates and taxes have kept the show on the road, but can only defer the inevitable correction

The degree of unanimity displayed by the current crop of economic forecasts is remarkable - and alarmingly complacent. It is not just that practically everyone expects next year to be better than this; the predictions suggest that during the years which follow, the recovery will simply roll on. The reason? A belief that the United States is poised to expand strongly once again and will pull the world out of recession as it does so.

Not surprisingly, some of the headiest comment comes from those with a vested interest, to use the current vernacular, in "sexing things up". The US Treasury Secretary, John Snow, appointed with a remit to ensure President George Bush's re-election next year, has described the American economy as "a coiled spring". Alan Greenspan, chairman of the Federal Reserve, also called the turning point in the current cycle a few days ago, and released forecasts to Congress suggesting American growth could bounce back into the 4 per cent range next year.

The consensus of private forecasters isn't far behind. They suggest not only a spritely bounceback across the Atlantic to growth in excess of 3.5 per cent; they also suggest that US growth will exceed 3 per cent a year thereafter, in line with the economy's enhanced potential, indefinitely. And as America goes, so will go the world.

The idea that, after three years of downturn, things can only get better is one everyone wants to believe. But a sober look at the evidence suggests to me that - following the enormous, protracted and unprecedented spending spree which the 1990s witnessed - the adjustments necessary to stabilise the US economy sufficiently to enable it to embark on another period of strong and sustained growth will take much more than three years to accomplish.

The first chart illustrates how the extraordinary US expansion of the 1990s was generated. American consumers and companies alike displayed ever-increasing confidence as new technologies boomed and the stock market soared. Mr Greenspan's "irrational exuberance" took over, and both households and corporates spent wildly and ploughed ever more deeply into debt. The private sector as a whole, which had started off with a traditional surplus of income over expenditure of about 5 per cent of GDP, plunged into an unprecedented deficit of about the same size.

The tide of tax revenues generated by this expansion of spending wiped out the budget deficit that Bill Clinton had inherited, but strong spending growth also produced a ballooning hole in the balance of payments, which headed for 5 per cent of GDP - the biggest the world has ever seen.

It couldn't possibly last, and from 2001, as the markets crashed, companies and consumers, living well beyond their means, had to start the process of restoring a sustainable relationship between their expenditures and their incomes. The cutbacks involved would have pushed America into recession, had not the federal government itself swung into deficit, slashing taxes to keep growth going. Following the latest round of tax cuts, the budget deficit is projected to rise to $475bn (£294m) - the highest in American history.

Where do these dramatic swings leave the American economy now? Does this collection of record deficits sound like a new, solid base from which another phase of sustained growth can successfully be launched? I don't think so.

In historical terms, the private sector is normally in solid surplus, and over the medium term the spending of American households can be expected to be brought into a more normal relationship with incomes so that that position is restored. The chart shows that this "rebalancing" process still has a long way to go, and as private spending continues to be reined back, this is bound to have a depressing effect on the economy, unless it is offset by other types of spending.

The gap could only be filled by the public sector or exports. But the federal deficit is already running at record levels which attract increasing concern. It is unlikely that Congress will allow significant further rises to take place, beyond the current round of tax cuts. As for exports, the problem is that overseas markets are so flat. The slide in the dollar would normally help, but the dollar devaluation has been mainly against the euro - about 25 per cent as the second chart shows - and growth has virtually stopped in euroland, with Germany in outright recession. So even following the dollar's devaluation, European markets are unlikely to offer American exports opportunities for vigorous growth.

The fact is, America has almost run out of options. Almost, but not quite. The chart also shows that over the past 18 months the correction of the private-sector deficit, which was proceeding vigorously, has paused for breath. Essentially, consumers have been induced to carry on spending and put off sharp reductions in their borrowing for the moment by Mr Greenspan's policy of aggressive interest rate cuts.

Together with the tax cuts, this policy has so far kept the show on the road, but it can only defer the inevitable correction, probably at the expense of a worse downturn in the end since indebtedness will then be higher. Moreover, the Fed's base rate is now a mere 1 per cent and must soon stop falling (in fact, long-term interest rates, which determine mortgage rates, are starting to rise), which means that the ultimately inevitable move back to a sustainable pattern of household finances must shortly resume.

So what do we conclude? The stimulus to the economy from the substantial tax cuts which are about to take effect, together with any further boost which the Fed can deliver by way of lower interest rates, may well result in a surge in growth between now and next year's election. This may ease problems in the rest of the world, and the markets may conclude that happy days are here again.

But the apparent recovery will be a false dawn. By the time of the election, the federal deficit will have reached or exceeded its acceptable limits, so that no further fiscal action will be possible to offset the renewed contraction of the private-sector deficit - as households and companies resume the business of pulling back their spending into line (at least) with their incomes.

And that process still has a considerable way to go, because, as the chart also makes clear, the private sector has so far managed to move only half way back towards the sort of financial surplus which is normal, since the deficit hit its peak in 2000. This illustrates how wide of the mark is the central idea that implicitly underlies those optimistic forecasts - that three years of downturn must surely be enough to counter the damaging effects of the over-borrowing and overspending of the 1990s.

In fact, it may take as long again before the American private sector is restored to robust financial health. Quite contrary to the consensus, a reasonable expectation is that, with all other ammunition used up following a short-lived election boom, the growth achieved by the American economy will fall well short of its potential rate (reckoned to exceed 3 per cent) for several years ahead. And unfortunately, as goes America, so will go the world.

Christopher Smallwood is Economic Adviser to Barclays.

Stephen King is on holiday.

Comments