Stephen King: Sprint start for US recovery doesn't guarantee success in long run

There are reasons to doubt the true underlying health of the US economy
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The Independent Online

Well, you've got to hand it to them. When the Americans want to do something well, they like to give the impression that they'll do it really well (even if, as we're now discovering in Iraq, hope and reality are often two completely different things). While Europe's economy is still struggling to get its running shorts on, America has already heard the starting pistol and is heading off down the track at a rapid rate of knots. Germany and France might still be scratching their heads, trying to remember the last time they had a decent economic expansion, but America seems never really to have forgotten. How else can we account for the 7.2 per cent annualised rate of economic growth recorded by the US in the third quarter of this year?

Those of you who read this column regularly will have guessed that I'm a bit of a sceptic about the US economy, so I reckon I have some explaining to do. How can my scepticism fit with the evidence that so clearly states that the US economy has come through difficult times in a remarkably fit state? Other countries can only but dream about growth on this scale: for the US, though, it is, apparently, part of a "new economy" reality.

When I look through the details of the third-quarter numbers, it's difficult to know what to criticise. On the whole, growth was very well balanced. Consumer spending was very strong, up 6.6 per cent at an annualised rate, but consumers were not the only source of strength. Business investment has recovered rather nicely, with an annualised gain of 11.1 per cent in the third quarter. Meanwhile, the trade position showed a remarkable improvement, with exports up 9.3 per cent and imports up only 0.1 per cent. The only real area of weakness was investment in business structures - factories and offices - which fell back in the third quarter, consistent with the roller-coaster ride seen in earlier quarters.

Overall, then, the third quarter was a story of strong domestic demand combined with a rapidly improving trade position. Perhaps, then, it's time to declare a miracle: after all, which other economy could deliver all of this at once? Few countries spring to mind. So maybe it's time to admit that America has finally discovered the secrets of economic success. Let's hope, then, that US policy-makers will share these secrets with the rest of us.

Before I go too far down that route, though, let me put my sceptical hat back on once more. Although, on the surface, the US story looks very impressive, I am less sure that the underlying picture is quite so healthy. Take, for example, the strength of consumer spending. Consumers were clearly happy to spend in the third quarter, but why did they spend quite so much? After all, although the GDP numbers were very strong, the labour market failed to get any share of the improvement. There was no job growth whatsoever in the third quarter and, at the same time, wages grew only modestly, particularly when adjusted for the effects of inflation.

So why did consumers spend? The answer boils down to a simple bribe: the Bush tax cuts hit home in the third quarter. American consumers, true to form, spent the whole lot. Good news for growth in the third quarter, perhaps, but what happens next? As the right-hand chart shows, the rise in consumer spending in the third quarter was associated with a stable saving ratio (a measure of the proportion of post-tax income that is saved rather than spent) - which is just a fancy way of saying that all of the boost to income as a result of the tax cuts was spent. Longer term, though, I would expect the saving ratio to rise: it just doesn't make sense for an ageing population to fritter away its income before it gets round to retiring. And there are already signs that the consumer boom story might finally be drawing to a close.

First, although there will be a few more pre-election hand-outs heading in the consumer's direction in the first quarter of 2004 - courtesy of President Bush - the basic truth is that tax cuts will be less generous in the future than they've been in the recent past. After all, the US administration will soon have to deal with the consequences of a rapidly rising budget deficit.

Second, consumers have spent not just because of tax cuts but also because of mortgage refinancing, a reflection of persistently falling interest rates. However, as interest rates have stopped falling, mortgage refinancing has dropped by about 80 per cent over the last quarter or so, emphasising the gravitational truth of "what goes up, must come down". This must surely imply that consumers are no longer in a position to spend as if tomorrow never mattered.

What, though, should we make of capital spending? Surely the rise in capital spending over the last couple of quarters demonstrates beyond any doubt that a recovery is now truly under way? In normal circumstances, I would have to admit that the pick up in capital spending would seem to be good news. I'm not sure, though, that everything is as it seems. Certainly, capital spending has accelerated. This does not, however, sit very easily with the remarkably low levels of capacity utilisation in the US economy. Why would companies choose to invest when they've already got plenty of excess capital sloshing around?

One possible explanation is related to price - more specifically, that the price of capital goods is collapsing relative to the price of labour. Because of technological progress, companies are strongly incentivised - wherever possible - to replace labour with capital. As a result, it's possible to see a rapid acceleration in capital spending without any corresponding improvement in the labour market, a key feature of US experience in the third quarter.

In other words, there are reasons to doubt the true underlying health of the US economy. Sure, if you throw enough tax cuts at the problem, you're bound to see an initial knee-jerk positive reaction. But, unless the tax cuts stimulate a broader positive multiplier effect for the economy at large, it may be they merely feed the illusion of lasting economic health.

If you don't believe me, have a look at the experience of the US economy on each of the occasions over the past 15 years when growth in any one quarter has exceeded 5 per cent on an annualised basis. Growth in the following quarter has averaged just 2.7 per cent. Yes, the number is positive, but were the fourth quarter of this year to record a figure that low, the alarm bells would, once again, start to ring. Confidence in healthy recovery is all very well when you've just been through a very solid quarter of growth, but somehow I doubt the debate on the strength of the US economy really has come to an end. This is not to argue that the US economy will face a "double-dip" recession: rather, I want to suggest that the knee-jerk "all our troubles are over" view of the world is a long way from the truth. As the American economic athlete heads off down the track, it might be wise to remember that economic success is more like a marathon, not a 100 metres dash.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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