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ECONOMIC ANALYSIS – Balance of payments is key to US economy’s coming downturn

The year began with a dramatic reassessment of the prospects for the US economy. Before Christmas, forecasters were predicting a slowdown after four years of exceptionally strong growth, but most still expected GDP to rise by 3%-3.5% – roughly in line with the long-run trend. Following a run of weak economic indicators and a surprise cut in interest rates, views are becoming more bearish. The consensus forecast has now dropped to 2%-2.5%, and more evidence of economic weakness could see further downgrades. Market analysts now see the main challenge facing the US Federal Reserve as avoiding outright recession.

Readers of this column should not be surprised by this chain of events. For over a year, I have been warning of the risks that followed the US economy’s strong expansion since the mid-1990s. These risks do not arise from the normal source of economic instability – inflation. US inflation has been subdued and remains so. Rather, the issue is the financial imbalances which have built up during the boom.

Two key problems stand out. First, the collapse in the personal savings ratio, which dropped to a 67-year low towards the end of last year. As consumers benefited from the rising US stock market, they saw less need to save and were more inclined to borrow. At some point, saving and borrowing will need to return to more normal levels.

A related problem is the yawning deficit on the current account of the balance of payments. The surge in spending over the past few years has sucked in imports. Last year, the deficit totalled 4.5% of GDP – a postwar record. This excess spending has to be financed by borrowing from abroad – but overseas investors will not continue to fund the gap indefinitely. Sooner or later, it will need to narrow significantly.

The US Federal Reserve is hoping that it can unwind these imbalances gradually and avoid a sharp correction that results in a recession. A slowdown in the growth rate is a key element in this scenario, as is a weaker dollar. Slower growth and a subdued stock market are required to encourage consumers to rebuild their savings, while a weaker dollar will be needed to rebalance the external account. But if recession is to be avoided, confidence must not be allowed to fall too sharply. Similarly, a falling dollar or a stock market “correction” must not be allowed to lead to a financial crisis.

Even this “softish” landing is likely to involve a more pronounced and prolonged slowdown than many thought likely last year, and the downward revision in growth forecasts for 2001 and 2002 is partly a recognition of this.

The other issue underpinning current concerns about the US economy is the knowledge that it is very precariously balanced – and there are four factors that could cause its wobble to become a tumble into outright recession.

The first is that the Fed may not be able to arrest the spiral of declining confidence once it becomes established. It was this risk that Alan Greenspan and his colleagues were trying to head off by their sudden interest rate cut in January. The jury is still out on whether they have succeeded.

A second risk is the possibility that the US economy is unbalanced by an unexpected shock. The candidates here are various – from problems in the US banking sector to a new crisis in Japan or other Asian economies.

One worry in the wake of Greenspan’s move was that he knew something about imminent problems in the US financial system. Fortunately, these fears have so far proved unfounded.

A third scenario is that US inflation could emerge as the dollar weakens and other one-off factors helping to hold down inflation wear off. The need to worry about inflation would limit the Fed’s capacity to cut interest rates to head off a decline in confidence and a weakening economy. At present, this seems a low risk, but it cannot be ruled out.

The final and most alarming worry is that the Federal Reserve is attempting an impossible task in its effort to steer the economy towards a soft landing. In the winter of 1998-99, the Federal Reserve cut interest rates to head off the effects of the Asian crisis, but this simply encouraged the stock market to race ahead again and consumers renewed their spending spree.

In the current situation there is a similar risk. Growth may be sustained by interest rate cuts but this could simply delay the necessary correction of the underlying financial imbalance. If this proves to be the case, the recession will probably be delayed, but the correction – when it comes – may be even more dramatic.

Because what happens in the US has such a deep impact across the globe, the upshot of the US troubles is that the world economy is in for a nail-biting ride over the next couple of years. If the US avoids full-scale recession, a healthy European economy should allow the UK to shrug off the impact of slower US growth. But more severe economic weather across the Atlantic would surely leave its mark on this side too.

Dr Andrew Sentance is chief economist at British Airways.

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