Deficits spell trouble for the world

The most troubling imbalance in the world today is the private sector financial deficit in the US

AS WE ENTER 1999, many economic commentators have argued that the global economy - and more particularly the UK - will be "lucky" to avoid a fatal accident this year.

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.

Start your day with The Independent, sign up for daily news emails
News
Nick Clegg on the campaign trail in Glasgow on Wednesday; he says education is his top priority
peopleNick Clegg remains optimistic despite dismal Lib Dem poll ratings
Arts and Entertainment
Buttoned up: Ryan Reynolds with Helen Mirren in ‘Woman in Gold’
filmFor every box-office smash in his Hollywood career, there's always been a misconceived let-down. Now he says it's time for a reboot
News
people
News
Actress Julianne Moore wins the Best Actress in a Leading Role Award for 'Still Alice' during the 87th Annual Academy Awards in Hollywood, California
people
Sport
Ross Barkley
footballPaul Scholes says it's time for the Everton playmaker to step up and seize the England No 10 shirt
News
'We will fix it': mice in the 1970s children’s programme Bagpuss
science
Life and Style
2 Karl Lagerfeld and Choupette
fashion
ebooks
ebooksA special investigation by Andy McSmith
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

SThree: Graduate Recruitment Resourcer

£20000 per annum + commission: SThree: Sthree have an exciting opportunity for...

Recruitment Genius: Telesales Executive - OTE £32,000+

£18000 - £32000 per annum: Recruitment Genius: A Telesales Executive is requir...

Ashdown Group: Marketing Manager - B2B, Corporate - City, London

£45000 - £50000 per annum + benefits : Ashdown Group: A highly successful, glo...

Neil Pavier: Commercial Analyst

£50,000 - £55,000: Neil Pavier: Are you a professionally qualified commercial ...

Day In a Page

War with Isis: Iraq declares victory in the battle for Tikrit - but militants make make ominous advances in neighbouring Syria's capital

War with Isis

Iraq declares victory in the battle for Tikrit - but militants make make ominous advances in neighbouring Syria
Scientists develop mechanical spring-loaded leg brace to improve walking

A spring in your step?

Scientists develop mechanical leg brace to help take a load off
Peter Ackroyd on Alfred Hitchcock: How London shaped the director's art and obsessions

Peter Ackroyd on Alfred Hitchcock

Ackroyd has devoted his literary career to chronicling the capital and its characters. He tells John Walsh why he chose the master of suspense as his latest subject
Ryan Reynolds interview: The actor is branching out with Nazi art-theft drama Woman in Gold

Ryan Reynolds branches out in Woman in Gold

For every box-office smash in Ryan Reynolds' Hollywood career, there's always been a misconceived let-down. It's time for a rethink and a reboot, the actor tells James Mottram
Why Robin Williams safeguarded himself against a morbid trend in advertising

Stars safeguard against morbid advertising

As film-makers and advertisers make increasing posthumous use of celebrities' images, some stars are finding new ways of ensuring that they rest in peace
The UK horticulture industry is facing a skills crisis - but Great Dixter aims to change all that

UK horticulture industry facing skills crisis

Great Dixter manor house in East Sussex is encouraging people to work in the industry by offering three scholarships a year to students, as well as generous placements
Hack Circus aims to turn the rule-abiding approach of TED talks on its head

Hack Circus: Technology, art and learning

Hack Circus aims to turn the rule-abiding approach of TED talks on its head. Rhodri Marsden meets mistress of ceremonies Leila Johnston
Sevenoaks is split over much-delayed decision on controversial grammar school annexe

Sevenoaks split over grammar school annexe

If Weald of Kent Grammar School is given the go-ahead for an annexe in leafy Sevenoaks, it will be the first selective state school to open in 50 years
10 best compact cameras

A look through the lens: 10 best compact cameras

If your smartphone won’t quite cut it, it’s time to invest in a new portable gadget
Paul Scholes column: Ross Barkley played well against Italy but he must build on that. His time to step up and seize that England No 10 shirt is now

Paul Scholes column

Ross Barkley played well against Italy but he must build on that. His time to step up and seize that England No 10 shirt is now
Why Michael Carrick is still proving an enigma for England

Why Carrick is still proving an enigma for England

Manchester United's talented midfielder has played international football for almost 14 years yet, frustratingly, has won only 32 caps, says Sam Wallace
Tracey Neville: The netball coach who is just as busy as her brothers, Gary and Phil

Tracey Neville is just as busy as her brothers, Gary and Phil

The former player on how she is finding time to coach both Manchester Thunder in the Superleague and England in this year's World Cup
General Election 2015: The masterminds behind the scenes

The masterminds behind the election

How do you get your party leader to embrace a message and then stick to it? By employing these people
Machine Gun America: The amusement park where teenagers go to shoot a huge range of automatic weapons

Machine Gun America

The amusement park where teenagers go to shoot a huge range of automatic weapons
The ethics of pet food: Why are we are so selective in how we show animals our love?

The ethics of pet food

Why are we are so selective in how we show animals our love?