Deficits spell trouble for the world
The most troubling imbalance in the world today is the private sector financial deficit in the US
Monday 11 January 1999
Even so, most of the mainstream forecasting groups, such as the International Monetary Fund and the Organisation for Economic Cooperation and Development, assume in their central projections that the world will stay lucky.
At Goldman Sachs, we expect the world as a whole (including emerging economies) to grow by 2 per cent - roughly the same as last year, with the UK growing by 0.5 per cent.
In one sense, though, the pessimists are undoubtedly right. Although economists always seem to argue that times are "particularly uncertain", there is clearly a greater number of identifiable downside risks to the global outlook than normal this year - notably, the Brazil debacle, the so-called "death spiral" into deflation in Japan, and a spontaneous decline in equity markets.
Any of these events could occur without much warning, tipping the world from benign low inflation into malign outright deflation.
Although analysts at Goldman Sachs are often depicted as crazily optimistic on financial markets, we certainly recognise that these are threats which no-one should dismiss lightly.
There are obvious symptoms of extreme froth in share prices, and the rapid growth in the global money supply indicates that there might be much more "leverage" supporting equities than is commonly assumed.
Furthermore, with almost every international economist willing to agree that the world looks riskier than usual, it is quite surprising that risk premia in both bond and equity markets should have fallen to abnormally low levels.
Yet it is not enough simply to point to imbalances that might, one day, lead to trouble. These imbalances have been around for several years, and those commentators who have been most worried about them have now completely missed one of the greatest bull markets in the 20th century.
As usual, the real problem in assessing the outlook for 1999 is to judge whether this will prove to be the year when these imbalances will finally need to be corrected.
The most extreme, and most troubling, imbalance in the world system today concerns the private sector financial deficit in the United States. The private sector in this regard is defined to include both corporations and households, and its financial deficit is the difference between income and expenditure - ie free cash flow. By definition, the sum total of the financial deficit of the private sector and the government taken together is equal to the balance of payments deficit.
In most economies in the post-war era, the private sector has typically run a financial surplus in order to build up its stock of assets. Usually, these private sector surpluses have been matched by similar sized government deficits, and balance of payments positions have therefore been roughly in equilibrium.
The present situation in the US is, however, very different. Over the past few years, private expenditure has risen much more rapidly than private income, so the financial deficit of the private sector has risen to all- time record levels.
With the government having eliminated its own budget deficit, the private deficit has, of course, triggered an equally large amount of red ink in the balance of payments statistics.
Put simply, Americans have been spending more than they earn, driving the trade figures into deficit. This imbalance has in turn been financed by foreigners acquiring a mountain of American assets.
So far, these developments have protected the world from a major recession. To illustrate how important this has been, a sudden elimination of the US private sector deficit would impart a negative shock to global GDP of something close to 2 per cent (including multiplier effects).
Still worse, in a crisis situation the US private sector might well decide to shift back into substantial financial surplus, in which case the shock effect might reach a remarkable 4 per cent of global GDP. This is far and away the largest accident that is waiting to happen to the world economy.
But this certainly does not mean that it must happen, not this year at least. As early as 1994, American households were already running a record financial deficit, with pessimists warning even then that it would not prove sustainable.
But in the ensuing four years, the deficit has more than doubled, without any ill-effects so far. Furthermore, there are some economists who would argue that the private sector deficit is a natural consequence of the government sector moving into surplus, since the elimination of the budget deficit will reduce the expected level of taxation.
If this argument is valid, it implies that a private sector financial deficit might prove to be a permanent feature of the American landscape.
But this will surely prove over optimistic. Not only will the budget surplus itself probably prove a temporary product of the economic boom, but there are elements of unsustainability in the private sector's behaviour.
Excessive private spending has no doubt been connected to the remarkable surge in share prices, which may or may not prove sustainable. Furthermore, it is not clear that foreigners will remain willing to lend money to the US on the scale required to perpetuate these imbalances.
The betting must therefore be that, one day, this episode will end in a crisis, just as it did in the case of the UK in the late 1980s. But what will be the trigger for such a crisis? There are three possibilities.
First, the dollar might decline precipitously in a familiar, old-fashioned balance of payments crisis. But it seems doubtful whether this will happen in the immediate future, since there are excess savings in the world system, and few attractive investment opportunities outside of the US.
Second, inflation in the US might start to rise, forcing the Federal Reserve to increase interest rates, thus killing the boom in American asset prices. But a rise in US inflation seems most improbable this year, given the strong deflationary forces emanating from overseas.
Third, some foreign shock - most likely emanating from Brazil or Japan - might puncture confidence in the growth of the US economy, and remove some of the froth from equity markets.
Although this is the most likely crisis to happen this year, it can probably be addressed by further monetary easing by the central banks, as in the aftermath of the Asian and Russian crises. Thus, while it may be the most likely to happen, it may not be powerful enough to prove fatal. That is why central economic forecasts assume - albeit nervously - that a crisis correction of the US deficit will not be visited upon the world this year.
The UK may not prove quite so fortunate. Although the deterioration in household and corporate finances in this country has not touched the ludicrous extremes seen in the late 1980s, or indeed those seen in the US today, the private sector will need to cut its spending sharply this year in order to return its financial position to normal. This threat may be smaller than in the past, but it still spells trouble for the British economy in 1999.
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