Hamish McRae: America must live within its means

What kind of recession will the next president of the United States inherit – and to what extent will the fall-out from recession shape the presidency itself?

That the US economy is moving into some sort of recession is not really in dispute. Up to now the figures suggest that it has continued to inch forward, unlike the Euro-zone, which started to contract in the second quarter of this year. But now there is widespread acceptance that it too has started to contract, and that output will continue to fall through the first quarter, maybe the first half, of next year. Beyond that – well, the forecasts are predicting a slow recovery starting some time towards the end of 2009, but forecasts have been wrong before.

Related articles

• Trouble to last for months - but rebound coming, says Paulson
• Value of pound hits five-year low against dollar
• UK recession likely, says Bank of England
• DIY chain value slashed by £540m
• Yorkshire and Barnsley building societies set to merge
• Jeremy Warner: Britain may regret oppressive approach to bank capital
• King paints bleak picture of UK economic outlook
• Mark Steel: It's all poor people's fault, isn't it?
• Debenhams pledges to cut £1bn debt burden
• Green launches attack on banks for allowing excess borrowing
• Job losses at freesheet as downturn bites
• Credit crisis diary: No need for Varsity players to get the blues
• Search the news archive for more stories

There is a temptation to assume that what any new Administration does will have a significant impact on the economy, and in the medium term there is some truth in that. A strong fiscal position makes it easier to withstand a global downturn, and fiscal policy is to a large extent controlled by the Administration, though not as closely as it is in a Western European country. But in the short run there is not a lot to be done. For example, temporary tax cuts may boost the economy for a couple for months but once they expire the economic flop may be even greater. That is what seems to be happening in the US at the moment.

What the next Administration will have to do in its early months will be to avoid mistakes. The bail-outs of the financial system have not yet run their course, as more toxic debts are likely to emerge. So far the present Administration has just about managed to patch things up but it would be good to think that the next one will do the job better. The entire US financial system has been gravely weakened, and that will inevitably lead to a weaker recovery but how weak it will be is still to play for.

There are two bits of good news here for whoever is the next president. He cannot be held responsible for the recession because it is here now, but more important, in another four years when he comes up for re-election the economy will be growing again. There is a natural economic cycle from which we don't seem able to escape, and that makes it virtually certain that the next election will be against a much more favourable background. So there will be time to fix things for the longer term.

And that really is the great challenge facing the new president. Will the US be a declining economic power or will be a resurgent one? Some serious mistakes have been made in the first eight years of this century and those now have to be corrected. Doing so will not transform the long-term outlook but it will improve it. The next Administration has no magic wand to fix the economy but it does have the authority to set the US on a more sustainable course. Indeed, trying to pump up the economy in the short term is likely to hasten the long-term relative decline.

So what's to be done? The first thing is to accept that the US is over-borrowed – at a personal level but also at a national level. The total burden of debt, if you add households, companies and government together, amounts to 350 per cent of GDP. That is higher than the 300 per cent reached in 1929 and compares with around 150 per cent in the 1950s, 1960s and 1970s.

Looked at another way, the US is consuming too much of its output: more than 70 per cent in fact, compared with 65 per cent or less for most developed countries. That money is indirectly borrowed from overseas, with the US having a current account deficit equivalent to some six per cent of GDP. So American consumers have maintained their standard of living, buying cheap goods from China, but the US has become the world's largest debtor nation.

On present trends China will take over from the US as the world's largest economy in about 20 years' time. Of course that is not certain but if the Goldman Sachs economic growth model continues to reflect correctly the way the BRICs (Brazil, Russia, India and China) are gaining growth vis-à-vis the present developed nations, something like that will happen. That raises a stark question for the US: is it really wise to be so in hock to your greatest commercial rival, the only country that has threatened your economic supremacy for more than a century?

You can explain away this dependence by saying that the Chinese, and the other Asian nations, have to invest in the US because there is nowhere else to, or that they are doing so out of confidence in the American economy. You hear these arguments in the States. More contentiously, some Americans reckon that these new investors will simply waste their money. I remember sitting in the offices of a prestigious think-tank in Washington to hear a speaker welcome Chinese investment in the grounds that "the casino's favourite customer is the inexperienced high-roller". The Chinese embassy delegation behind me said not a word.

Maybe foreign investors in the US have burnt their fingers. The sovereign wealth funds that helped rescue US banks last year have certainly lost a lot of money. But relying on the gullibility of rich foreigners seems a pretty risky policy and actually not a sustainable one. The more the economic weight of the world shifts away from the US the less likely it is to be able to attract foreign inflows of capital.

The events of the past few weeks will have had a profound impact on the willingness of the rest of the world to lend to America. This is not just about Asia. Why should a German regional bank invest in complex sub-prime US debts that it doesn't understand because some smart New York investment banker tells them they are safe as houses? Well, it won't do so again for a generation. And if foreigners stop investing their savings in the US, Americans will have to save more for themselves.

So the central challenge for the next president will to persuade the country to live within its means. That has to happen at a personal level but also at a national level. This cannot be fixed in the next four years or the next eight but a start can be made. This does however mean a slower rise in US living standards and there is no getting away from that. And that raises the biggest question of all. Is the US willing in the 21st century to cede the economic leadership that it built up in the 20th?

h.mcrae@independent.co.uk

More from Hamish McRae