Stephen King: Is America's economy really too big to go down the drain?

The US will only be able to expand so long as the rest of the world is prepared to provide the funds
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"It's too big to fail." A common enough argument, perhaps, but also one that smacks a little too much of complacency. After all, one might have thought that the New York power supply was "too big to fail" but fail it did. A foreigner - not, though, a jaded Londoner - might have thought that the London Underground was "too big to fail" but it, too, gave up the ghost for a short time last week. The US army is "too big to fail" in Iraq although recent developments do, somehow, make you wonder.

The biggest example of all, though, may be the US economy, the $10 trillion powerhouse that dominates the world stage. Can it fail? The answer, surely, is a resounding "no". It's not in the interests of US politicians for the US economy to fail. Nor is it in the interests of beleaguered Europeans, facing a moribund domestic economy. After all, who else would they be able to export to? And Asian economies certainly would not want to see the US economy failing: they have become increasingly dependent on inflows of US capital which, in turn, have led to rising incomes and better jobs.

So, hang out the bunting, get the music on, it's time to party. The US economy appears to be recovering. US consumers are still spending, the government has its foot on the accelerator, companies have regained their appetite for investing and growth is picking up. Europeans can lick their lips at the thought of more export demand and Asians can look forward to their own slice of the pick-up in US capital spending. Once again, the US has come along to save the world.

There is, however, a little snag with this story. The US did well in the late 1990s in part because other countries were happy to lend to it. This can be seen most obviously through the growth of America's current account deficit. America was spending more than it was producing and it needed foreign resources to fund the gap. Put another way, America ran a capital account surplus: there was more capital flooding into the US from the rest of the world than capital leaving the US to go elsewhere.

It's not the first time that the US has managed to pull off this trick. The US has run large current account deficits - or capital account surpluses - in the past. However, previous US recessions have taken away this dependency on foreign capital: the US would end up back in current account surplus, no longer dependent on the rest of the world's savings. This "no such thing as a free lunch" model provided a degree of constraint on what the US could get away with: a recession was a timely reminder that the US could not realistically expect to consume beyond its means on an indefinite basis.

The left-hand chart shows why this story worked so well. In all previous US recessions, the growth of domestic demand - consumption, government spending and investment - ended up weaker in the US than in other industrialised countries. Rather than the rest of the world ending up in bed with a cold as a result of a US sneeze, this was more a case of US pneumonia with the rest of the world suffering only a few limited aches and pains.

This time round, though, the story is very different: the US has only had a very mild dose of flu; other parts of the world, notably Europe, have ended up in the economic equivalent of intensive care (see right-hand chart). The US may have had a recession but, on this occasion, the recession did nothing to remove America's dependency on the savings being made in other parts of the world. The usual closure of the US current account deficit has, therefore, not taken place. Should we worry?

Let me first make the positive case, the argument that suggests that an ever-wider US current account deficit is a good thing.

From a US policy-making perspective, the case for a bigger current account deficit rests on three foundations. First, there's the simple argument that, if the rest of the world is not prepared to play its part in stimulating global growth, the US might as well just get on with it. If the wider current account deficit can't be financed through foreign capital and the dollar has to come down, this might also be a good thing: a lower dollar might, for example, force the Europeans into loosening policy more aggressively than might otherwise have been the case.

Second, there's the economic supremacy argument: if the US can offer better growth than anyone else, it makes perfect sense for foreigners to buy US assets and, hence, support continued US economic expansion.

Third, there's the "wise investor" argument: that although capital continues to pour into the US on a net basis, the returns on US capital invested abroad are higher than foreign returns invested in the US. As a result, the cost of financing the current account deficit is not so high after all. It's a bit like borrowing some money from one bank, spending some of it but re-investing the rest in another bank at such a high rate of interest that you are no worse off.

Now let me say what's wrong with these positive arguments. First of all, the idea that the US can save the rest of the world is a little bit topsy-turvy. The US will only be able to expand so long as the rest of the world is prepared to provide the necessary funds. The problem, however, is that an expanding US current account deficit requires more and more funds each year. No bank, surely, would agree to such an arrangement and it is difficult to see why the rest of the world will be prepared to plough more and more of its savings into the US economy in the years ahead. At some point, the US has got to deliver decent returns to its foreign creditors, which seems to undermine the "wise investor" argument outlined above.

Then there's the economic supremacy argument. The main reason for US growth out-performance in recent years has been consumer spending: overall growth might be stronger in the US but it is difficult to see why the rest of the world should see the advantages of funding yet another Uncle Sam car purchase - the ultimate depreciating asset. Foreigners will ultimately expect to see some return on their investments: if the benefits reside instead with US consumers, it's less likely that capital will continue to flow into the US.

As for the wise investor argument, why not just cut out the middleman? It may be true at the moment that returns on US investments made abroad are higher than returns on foreign investments made in the US. But it is difficult to see why the rest of the world should be content with this arrangement forever. Either the rest of the world will invest the money itself, thereby cutting out the US as a middleman, or the US will eventually recognise that its investments abroad have become excessively risky (and I'm thinking here not just of economic risk but, increasingly these days, of political risk as well).

That the US is showing signs of recovery seems to be good news. That the recovery is happening against the background of a very large current account deficit is more disturbing. We may think of the rest of the world as being dependent on the US but, increasingly, the US itself is dependent on the rest of the world. This delicate balancing act may not continue forever: someone may eventually fall off the high-wire and, so far, it's not at all obvious that there's any form of safety net below. Too big to fail? I hope so, because failure is just too painful to contemplate.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com

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