The U.S. Economy
I have had conversations with many of you recently relating to the state of the U.S. economy, especially as we head into another year. The predominant feeling expressed has been that while, on the surface, the economy looks vibrant, at deeper levels all is not well. Many of you harp on the loss of manufacturing jobs, others look at the increasing wealth gap, and then there is a group lamenting the trade gap.
I intend to answer you all over the coming week or so, and with that in mind I want to start with the trade gap. As a reference point I am including this link to Ken Rogoff’s article earlier this month: Project Syndicate .
One of the salient features of the American economy for some time now has been the almost total lack of savings. It seems that Americans just do not see a need to save anything. Instead they consume all their income and more — at least one month recently the savings rate was negative — which boosts GDP to the heady growth rates we have seen in several recent quarters. There is nothing new in this growth role for American consumers: consumption accounts for about two thirds of the total economy, a greater percentage than is commonly found abroad.
Most experts point to this rate of consumption as unsustainable: there surely must come a point at which consumers feel over-stretched and start to save for the future. Yet this argument has been made over the years and proven false each time.
This business cycle one of the supports for consumption has been the strength of housing prices. High and rising house prices have given home owners a source of cash: they translate their equity into consumption via equity loans. Presumably the bouyancy of the housing market has allowed home owners to access this cash without worrying about the added indebtedness created at the same time.
Another source of cash for the economy has been the constant inflow of foreign capital, which is the inverse of the trade gap. The larger the dependency we have on foreign goods, the larger our need to import the cash to pay for it. The huge run up in our trade deficit means that the American economy now absorbs two thirds of the world’s free capital. In effect foreigners are postponing their own consumption in order to allow Americans to continue their binge. It is highly unusual, in historical terms, for the world’s largest economy to be a net importer of capital. This is especially true when the capital imported is spent on consumption rather than on building productive capacity for future wealth. This availability of foreign capital has enabled the American government to undertake incredibly loose fiscal policies: it has reduced its revenues while increasing its outlays thus creating huge external deficits. Another way of looking at this is to say that the Americans have not had to face hard choices: they can continue to consume, run large entitlement programs and have massive defense spending without constraints.
A link between the housing market and the foreign capital inflow is the exceptionally low interest rate environment we have experienced over the past few years. The inflow of capital has kept rates down when they might have risen, which has perpetuated the rise in house prices.
My emphasis on these two issues is to expose the risk: namely that if foreign capital were to find alternative homes in, say, the re-emerging Japanese economy or in a recovery of consumption in Western Europe, then in order to maintain the inflow needed to finance the reckless fiscal policies now in place interest rates would have to rise. This could dampen, if not destroy, the housing market and end the consumption binge. America would fall into recession.
I suppose the lesson of this is that the American economy is highly dependent on foreign investor’s confidence, and their willingness to invest here as opposed to elsewhere. I would have thought that an administration whose attention is so adamantly on security would not have let its economic future be dictated abroad. But it has, and that is the major risk as we enter 2006.
