2008: Year of Reckoning?

The remarkable expansion in World output since 2003 has existed in tandem with so-called global imbalances – huge current account deficits in the U.S. matched by surpluses practically everywhere else. Foreigners have invested in dollar-denominated assets, and this inflow of money has financed Americans’ expenditure in excess of income, which is reflected in the U.S. current account deficit. The upside of this enlarged expenditure is that, along with the dynamism of the emerging economies, it has served to propel vigorous global demand and growth.

Admittedly, the American propensity to swallow other people’s savings–its role as the chief engine of global growth notwithstanding– has troubled many analysts. But for every apprehensive view of global imbalances, there have been one or more explanations of why those imbalances are not only good but also sustainable. These endorsements have relied on a host of theories: the global savings glut; the U.S. as indispensable world banker; superior U.S. productivity and return on capital; the might of financial globalization; and even the dark matter in the U.S. international asset position. These theories all assume that because of its size, flexibility and institutional arrangements the U.S. economy is capable of offering investors– foreign and domestic–a huge menu of assets with unbeatable risk-adjusted returns. Thus, the U.S. could maintain a substantial current account deficit for many years, and the global economy, to keep expanding, could count on the powerful U.S. engine.

Recently, however, the basic assumption underlying this belief has been called into question, as market confidence in a wide array of assets offered in U.S. financial markets abruptly collapsed. The meltdown of the subprime mortgage market, big banks moving huge, exotic assets onto their balance sheets and looking desperately (and expensively) for fresh capital, and the Federal Reserve cutting interest rates and seeking new ways to inject liquidity into markets are all part of the credit-crunch drama.

Recklessness on the part of some financial intermediaries and ratings agencies may have helped create the current mess, but we should not ignore the turmoil’s primary macroeconomic causes. Lax monetary and fiscal policies played into the U.S. economy’s seemingly insatiable absorption of the vast pool of foreign savings, which in turn was made possible by key rigidities in the other major countries’ economic policies. The underpricing of risky assets in which markets indulged themselves was the end result of too much liquidity chasing too few sound investment opportunities. In other words the U.S. economy’s present illness stems from having too much of a good thing.

The questions now are: Is the correction of the imbalance firmly under way, how far can it go and what effect will it have on U.S. economic growth and the global economy? It seems clear that the adjustment has started, but there is much uncertainty over its likely extent and the cost it will impose in the short term on world economic activity. For one thing, we don’t yet know how badly hurt the U.S. financial system really is; there could well be more skeletons in the banks’ and other intermediaries’ closets. In addition to watching the mortgage-backed security markets, we should pay close attention to the credit card and auto loan sectors. Keep in mind that owing to the dismal situation in the real estate market, consumers can no longer obtain liquidity from home equity. In fact, reputable experts fear that home prices could plunge an average of 15% or more before they start to recover.

Tough Choices

A slowdown in the U.S. economy for 2008 now appears inescapable. And the probability of a serious recession cannot be ignored. At this point the best possible scenario would be one in which a mild reduction in GDP growth–in conjunction with a cheaper but not collapsed dollar–brings about a sufficient correction in the U.S. current account deficit, without investors running away from dollar assets en masse. The fundamental policy challenge for the U.S. and others will be to avoid a more traumatic adjustment. American authorities will have a tough job, considering that their policy margins are truly narrow. There’s only so much that can be done with monetary policy without risking serious undesirable consequences, such as fueling inflationary expectations or creating severe moral hazard. Furthermore, calls to loosen fiscal policy in order to reduce the likelihood of a recession should be resisted. That course of action would worsen, not improve, the already weak national savings rate in the U.S., which is at the root of the ongoing tribulations.

The task will prove equally daunting in other places. It is not true that other significant economies have been decoupled from the American economy. In fact, thanks to globalization, national economies have become more interdependent. This has been positive for growth but has also entailed downsides and has exacerbated policy challenges. Chief among these is the need for more, not less, macroeconomic policy coordination, an undertaking that unfortunately has been stubbornly resisted by today’s economic powers. Had the U.S. acted earlier to fix its fiscal deficit and raise domestic savings, had the EU and Japan made more progress in adopting pro-growth reforms and had China boosted consumption and allowed more flexibility in its exchange rate, we would, with reasonable certainty, be cheering in a prosperous new year instead of fearing that 2008 will be a year of reckoning.