Hamish McRae: G7 might be satisfied with progress, but the real challenge comes next year

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The finance ministers of the Group of Seven meet in Washington this weekend for the half-yearly IMF meeting. It is one of those regular "how are we doing?" gatherings that are useful more for what is learned by the participants than what is said in the official statements afterwards.

As always, the communiqué is written well in advance and will stress the fact that a global recovery is securely in place, that at present the goal of low inflation is secure and that the greater stability on the foreign exchanges is welcome. But it will also give some hints of the finance ministers' concerns, which include (of course) global imbalances and the danger of overheating in China, but also the poor performance of some regions, including core Europe.

The debate however has been given a new twist this week by the flurry of concern on Wall Street about the possibility of rising interest rates and, from a UK perspective, the cautious minutes of the Bank of England's Monetary Policy Committee on the case for further rises in rates here.

The imbalances first. Three months ago it seemed that the persistent twin US deficits - in the budget and the current account - were at last about to trigger a collapse of the dollar as foreigners failed to cover the deficits by ploughing money into US assets. The dollar duly fell quite a bit, but recently has recovered and is currently close to a four-month "high" against the euro.

So the evidence of the markets has to be balanced against the reality of the deficits. The balance of payments problem first. Maybe the figures for the external deficit are wrong - always a possibility - or maybe, provided it does not grow, it will be possible to finance it for a while yet.

But is it possible to finance the domestic deficit? Intellectually the two are linked but if you look at the pattern of both since 1990, they show very different patterns. As you can see from the top right hand graph, the deterioration of the current account has been pretty much a straight line, while that of the domestic deficit has been a swing from deficit to surplus and back.

The shiver through the US markets this week was driven not by fears about the external deficit but rather concerns about domestic inflation and consequently the impact on long bond yields. This may seem a bit odd when viewed from this side of the Atlantic. After all, there is nothing that a few curbs on spending and a modest increase in taxes couldn't fix. The external deficit by contrast looks a real peril. But the reality is that it is in the self-interest of the other countries that rely on exports to the US, Japan and China in particular, to finance the US current account deficit. Otherwise their currencies would soar and their domestic growth, fragile in the case of Japan, would be hit.

Moral: there are forces already at work that will correct the US domestic deficit but I'm not so sure about pressure on the external one.

The other huge imbalance is Japan. Not China? No, China has a big trade surplus with the US but is in deficit with the rest of the world. Indeed it may slip into overall current account deficit this year. Japan, by contrast, has a persistent current account surplus, which is just about manageable, and a dreadful domestic deficit, which is not (see bottom right graph).

The external deficit has been offset by purchases of foreign assets, mostly US ones. Investing 2-3 per cent of your GDP abroad is not unprecedented: the UK exported an even higher proportion of its GDP in the 1900-1913 period. But for a mature developed country to run a deficit of some 7 per cent of GDP for several years in peacetime is literally unprecedented - there is no historical precedent. The ageing of the Japanese population makes the mathematics even worse, for the workforce is already starting to shrink.

But to curb the size of the deficit at this moment would be to derail the incipient recovery. Maybe something can be done if the present growth phase continues but the Japanese imbalance is arguably more dangerous to the world economy than the US one.

Europe does not suffer from imbalances, just lack of consumer demand. Growth this year is still officially expected to be close to 2 per cent but the economics team at HSBC, which has a very good record, has just cut its estimate to 1.4 per cent. Consumer spending is very weak, raising doubts about the long-term ability of Europe to grow much faster. The HSBC forecast for 2005 is only 1.5 per cent.

This poor performance is not so much an imbalance in the world economy, more a reflection that Europe cannot contribute much to world growth in the foreseeable future.

And us? Our most disturbing imbalance is shown in the bottom right graph. We should be somewhat concerned about a current account deficit stuck at 2 per cent of GDP. We should be a bit worried about the ballooning fiscal deficit, now more than 3 per cent of GDP. But the little chart there shows how the relationship between the growth of earnings and the rise in house prices has come unstuck in the past two years.

Most of us focus on the great British house price debate by looking at the ratio between earnings and prices, or the "affordability" index which relates mortgage payments to earnings. On the first, prices are about five times earnings, close to the late 1980s top of the market. On the second, thanks to the fall in interest rates, things look more sustainable. But I am grateful to GFC Economics for noting this different way of looking at the relationship. If that really is a useful fix, then the rise in prices through the 1990s was completely reasonable. Only very recently has the relationship broken down. GFC's view is that while the monetary committee indeed faces a dilemma, made worse by contrast between the stable performance on current inflation and the surge in asset prices, there is a case for an early rise in rates.

We'll see. The thing to look for will not be what the G7 ministers say this weekend but rather how the markets react next week. If the markets get it into their head that the US Fed has to do more than a token tightening of policy this summer then, well, the next few weeks could become rough. If long-term interest rates in the US rise significantly, however the Fed responds, the idea will take hold that other countries too will face a similar rise. Central banks only control short-term rates. The markets determine long-term rates. The markets may do the tightening for the banks.

To be clear: the world economy this year is all right, for growth - strong in some parts of the world, modest in others - is secure. That confidence will be reflected this weekend. Problems are for next year and it will be intriguing to see what the finance ministers think about that.