The Rising Risk of a Hard Landing

It never fails. Every presentation or speech I have made on the economics of global rebalancing over the past three and a half years almost always ends with the same question: "When will these adjustments ever occur?" The history of the past few years is littered with false alarms over the coming US current account adjustment. Call it the "boy-cries-wolf syndrome". The longer the world endures mounting imbalances without suffering any serious consequences, the more the financial market consensus believes this disequilibrium is sustainable.

Yet there are new and increasingly urgent grounds for concern. Global imbalances continue to compound at an alarming rate. But there is a dangerous asymmetry in the mix of these imbalances. America's record current account shortfall will account for about 70 per cent of the total deficit positions in the global economy in 2005. By contrast, the incidence of surpluses is far more diffused: it takes some 10 economies to account for 70 per cent of the total global current account surplus in 2005. The world, in effect, is balanced on the head of the US external-imbalance pin. Washington is quick to point the finger elsewhere in blaming a growth-starved world for these imbalances. But in the end there can be no mistaking the disproportionate share of the blame that falls on a US economy that is short of savings.

And the situation is likely to go from bad to worse. In large part, that is because America's national savings outlook is about to enter a new phase of deterioration. In a post-Hurricane Katrina, energy-shocked climate deterioration is likely in all three big components of domestic US saving - for households, for the government sector and for businesses. American consumers were already running a negative personal saving rate before the energy shock intensified; to the extent that households now attempt to defend their lifestyles in the face of energy-related shortfalls of disposable income, the personal saving rate should move deeper into negative territory. At the same time, Katrina-related recovery and reconstruction costs could add at least one percentage point to the federal budget deficit in 2006. And the business-sector savings cushion seems likely to diminish as the combination of rising energy prices and mounting unit labour costs puts a dent in corporate profit margins.

This could take a savings-short US economy to an important flashpoint. America's net national saving rate - which has averaged a record low of 1.5 per cent of gross domestic product since early 2002 - could well pierce the "zero" threshold at some point over the next year. That would imply that the world's economic leader is not even saving enough to cover the replacement of its worn-out capital stock.

There is also reason to worry about global imbalances from the other side of the equation. The impacts of America's increased draw on the global savings pool are likely to be compounded by recoveries in several key surplus economies. That is true in Japan and could well be the case in Germany. To the extent that recoveries in Germany and Japan rely increasingly on support from domestic demand, surplus saving will be absorbed. That would then leave them providing less capital to fund America's ever-deepening savings shortfall. Moreover, China - the third largest surplus saver in the world - is very focused on stimulating domestic private consumption. To the extent China succeeds in its own rebalancing, that will put downward pressure on its saving - undermining yet another key source of funding for America's gaping current account deficit.

This is where the asymmetries in the mix of global saving could come into play. If the world's dominant deficit economy - the US - goes even deeper into deficit at the same time that the world's leading surplus economies start to absorb their domestic saving, the noose will tighten on America's external financing pressures. This raises the distinct possibility that these pressures will have to be vented in world ­financial markets in the form of a classic current account adjustment - complete with a weaker dollar and higher US interest rates. As long as the rest of the world was in an excess saving position, a big repricing of dollar-denominated assets could be avoided. But now, with surplus economies beginning the long march of absorbing their excess saving, it could well become all the tougher for the US to avoid this treacherous endgame.

Sure, this is all theory, leaving unanswered the key question of what it will take to spark the adjustments implied by this theory. There are several possible event risks, or shocks, that I believe would be capable of triggering the rebalancing. They include an energy shock, an outbreak of US protectionism, the bursting of the US housing bubble, a US inflation problem and the uncertainty that always arises during the transition to a new Federal Reserve Board chairman. All of these potential risks have two things in common - they are not a stretch and they could shake the confidence factor that underpins overseas investor appetite for ­dollar-denominated assets.

In the end, the history of economic crises is clear on one important thing: the longer any economy holds off in facing its imbalances, the greater the possibility of a hard landing. In my view, an unbalanced world has waited far too long to face up to the heavy lifting of global rebalancing. I would reluctantly conclude that there is now about a 40 per cent probability of a hard landing at some point in the next 12 months.