Hamish McRae: The American consumer will decide how fast the world begins to slow down

How quickly will things slow? It is clear that growth in just about every large economy in the world has this year been rather faster than most people expected. It is also clear that next year will see some sort of slowdown. But there is a huge difference between growth coming back to trend, maybe a bit below, in a controlled and orderly way, and it falling really very sharply. And that raises the question: if we underestimated growth this year, might we be overestimating growth next?

How quickly will things slow? It is clear that growth in just about every large economy in the world has this year been rather faster than most people expected. It is also clear that next year will see some sort of slowdown. But there is a huge difference between growth coming back to trend, maybe a bit below, in a controlled and orderly way, and it falling really very sharply. And that raises the question: if we underestimated growth this year, might we be overestimating growth next?

Of course there can be no answer yet. Forecasters are very bad at gauging growth a year forward. We will know when we know. But what is worth doing is charting the risks and trying to identify the links between those risks, so that we get some early feel for the nature of the slowdown.

The starting point has to be America. The reason, aside from the sheer size of the United States economy, is that the willingness of the American consumer to buy foreign goods has driven growth throughout the rest of the world. China, Japan and Germany are all export-led economies and without US demand would be in grave trouble.

For example, Germany this year will grow by about 1.5 per cent. That may not sound great but is a lot better than people expected a few months ago. But there has been virtually no increase in domestic consumption: this modest growth is the result of higher exports.

Within the US, the economy is seen almost entirely through the prism of the election. A brief visit to Washington last week brought few insights as to the medium-term trend of the economy because everyone was focused on the next two months.

The expected increase in interest rates by the Federal Reserve next week is not seen as a show-stopper because it is already factored into the markets. But other economic issues, from job creation and housing starts to the price of fuel, are all discussed in terms of hurting or helping the President's chances of re-election. The huge issue of the federal budget deficit gets a mention, for there is a lot of speculation as to how it will be tackled in the next term. But that is seen through domestic political eyes: what might either candidate do to make a difference? The external deficit, which preoccupies the rest of the world, does not get much of a mention.

Yet it is the external deficit that makes the world economy so vulnerable. Global growth has been on the back of a rise in the deficit, which is now more than 5 per cent of the United States' GDP. (In the second quarter it was $166bn, which works out at 5.7 per cent of GDP.) As you can see in the top graph, this is way beyond the peak size of the deficit in the middle 1980s, the time of the Plaza Pact to cap the dollar and head off a trade war with Japan. It is also higher than it was during the late 1990s boom.

Those of us who have worried about the deficit for a long time, yet seen it funded year after year by the rest of the world, can be accused of crying wolf. The reason why the deficit was so easily covered was that there has been a large flow of investment funds into the US. The balance of payments has to balance so a current account deficit is always associated with a capital inflow. Foreign money went into the US to get a share of the greatest boom on earth. Net long-term private sector capital flows reached 4 per cent of US GDP in 2000, matching the current account deficit (see middle graph).

The flows since then have continued but they have changed in nature. Long-term private sector money has fallen back (though it is still positive), while short-term and government money has risen. In the late 1990s, the US was able to finance its current account deficit because foreign businesses thought it was a good economy in which to invest. The dollar duly rose. Now the dollar is being propped up by hot money and foreign governments, in particular Japan and China, who need to export to the US and don't want the dollar to fall too much. These flows are now more than 3 per cent of GDP (see bottom graph). That is the key link in the world economy and the key vulnerability.

Growth in the US has been facilitated by very low interest rates but it could not have continued for so long had those two countries not been prepared to pump in funds to prop up the dollar - and so underpin their own exports. So what happens next?

The Bank Credit Analyst team in Montreal, which prepared these graphs, notes that the foreign central banks can carry on financing the deficit for a considerable time but that eventually the US current account deficit must contract. History suggests that a sharp fall in the dollar will play some part in this process.

So I suppose there are two key things to look for in the coming months. One is the resilience of the US consumer in the face of rising interest rates. The other is the dollar.

The more evidence there is that consumers will keep going, albeit at a slower pace, despite more expensive money, the stronger US growth will be. But the stronger the growth, the greater the strain on the current account, increasing the potential for that sharp fall in the dollar. Such a fall would of course undermine Continental European growth, which as noted is over-dependent on exports.

You cannot predict how all this will play out. All that can be done is to point to the risk. It would not be in the self-interest of China or Japan to make any sudden shift in policy but there may be some willingness to let their currencies rise a bit. The yen in particular looks likely to climb. Were the dollar to fall, the eurozone countries would have to find ways of boosting domestic demand. Lower rates? It really is not clear that these would help much and, in any case, the European Central Bank is constrained by average inflation above the 2 per cent ceiling. The UK cannot help much, as we are making our own adjustment to higher rates and the end of the housing boom.

The balance of probability is still that the world will manage to make the gradual adjustment to slower growth next year without some wrenching event, such as a collapse of the dollar. Here in the UK growth looks like being close to 3.5 per cent this year. So coming down to, say, 2.5 per cent would be a reasonable figure if the global adjustment were indeed a gradual one. But there are not many potential good surprises - the most obvious would be a fall in the oil price to below $30 a barrel - and there are several bad ones. Maybe the year we should be concerned about is not 2005 but 2006 ... but that does not bear thinking about just yet.