Recent weeks have offered a range of depressing economic statistics on the US economy. Although technically the economy is not in a recession, most analysts feel the economy is on the brink of recession and most debate centres around how protracted and deep the forthcoming downturn will be.

Different Sectors of the US economy

Housing Market.

The housing market has been experiencing severe problems for over 12 months. House prices have fallen 10% from their peak and there is evidence that the fall in house prices is accelerating. [Source 1] For a long time rising house prices have enabled US homeowners to maintain high levels of consumer spending through equity withdrawal. The fall in house prices will definitely harm consumer confidence and consumer spending. The concern is that if house prices continue to fall, it will increase the number of people with negative equity and the fall in consumer spending could become quite damaging.

Credit Crisis

The troubles of America's 5th biggest investment bank, Bear Sterns, has been a significant development in the past week. It is illustrative of the problems caused by the credit crisis. Bear Sterns has lost significant investments in the subprime markets and other banks became nervous and started to withdraw their cash. The authorities hope it can be passed off as a one off, but, similar problems could potentially occur in other investment banks as well. There is still a real prospect of further credit defaults; many homeowners could soon face the prospect of higher interest rates as their introductory period ends. The blow has been softened by lower rates, but, this doesn't alter the fact many loans were inappropriate in the first place.
Students of the great depression will know how damaging any bank collapse can be to the economic system. Although Bear Sterns looks to have been rescued by J.P.Morgan there is a real danger that worse is still to come. (Forget soft landings at Guardian)

Falling Stock Markets

The falling stock markets are mainly a reflection of the economic and financial weakness. In particular the problem stems from the lack of confidence. One of the most worrying feature has been the way credit markets have 'frozen' 3 times in the past few months. The problem is even acute in triple AAA markets where loans are supposed to be very safe.

source: Economist
Note: Freddie Mac and Fannie Mae are two quasi government agencies responsible for issuing government debt.


Unemployment

Unemployment in the US is currently low 4.8% (data at US dept of Labour) However, 2008 has seen a worrying increase in unemployment and job losses. This has been particularly obvious in sectors such as construction and manufacturing. Since 2006 nearly 400,000 jobs have been lost in trade jobs (electricians e.t.c) and construction.

Weakness of the Dollar

The weakness of the economy and reduction in interest rates have only served to further weaken the US Dollar. Ironically, the dollar's devaluation is helping to boost US exports which at least help provide some growth. But, exports will not be able to take up all the slack from lower consumer spending. Also the weak dollar creates other problems such as more expensive imports and a decline in confidence about investing in the US.

The Good News on the US economy?

• Tourists are attracted to the US because of the low dollar
• Exports are rising, helping to reduce the trade deficit.
• The efforts to stimulate the economy - lower taxes, lower interest rates could prove successful in avoiding a full scale recession. However, there is also a danger that monetary policy will prove ineffective. i.e. even cuts in interest rates to 1% may be insufficient to encourage consumers to spend money. The gains from lower interest rates may not be able to offset the losses from the housing market.
  
• There is a feeling that markets may have overreacted to some of the bad news. Although others will argue that markets are still overvalued.
• GDP growth is still positive GDP stats
• However, most forecasts predict negative growth by May. The real question will be - how long lasting will the recession be?

Related:

• How long do Recessions last?
• Can A recession really be a good thing?
• Can US avoid recession?

Labels: US economy

The US economy remains the biggest and most influential economy in the world. Yet, despite its status the US economy is experiencing unprecedented problems and the threat of a recession is only one of many problems affecting the US economy. Many of the economic problems faced by the US were largely avoidable and are the result of economic mismanagement at various levels.

Fundamental Problems of US Economy

• National Debt of $10,000 bn (68% GDP
  
• Current Account Deficit $857 billion equivalent of 6.5% of GDP [1]
• Housing Market - House prices have fallen by 30% in some areas.
  
• Rising Inequality
• Devaluing Dollar - Loss of Confidence In America and America's economy. (US Dollar Collapse?)
  
• Record Debt Levels - Past growth has been financed by consumer borrowing and
• Credit Crunch - Loss of confidence in banking system due to bad loans
  

Housing Boom and Bust

House Prices - Boom and Bust

The US Housing Market is a classic example of an avoidable asset price boom and bust. Various factors allowed house prices to rise much faster than incomes creating an asset which was fundamentally overvalued. As house prices fall to correct the imbalance, there will be a marked slowdown in consumer spending and could tip the economy into recession.

Why did the Housing Bubble Occur?

1. No regulation of Subprime mortgages. Simply put, the mortgage industry was able to sell mortgages with casual disregard for whether they could be paid back. This is a simple recipe for future mortgage defaults, home repossessions and declining house prices. In Europe, this mortgage mess would not have occurred because the mortgage industry is closely regulated to prevent this kind of mis selling. The US mortgage industry was irresponsible, but, the government are also to blame for allowing irresponsible practices to occur.
2. Low Interest Rates. In 2001 interest rates were cut to stimulate growth, with interest rates so low, people felt mortgages were affordable; wrongly assuming they would not increase. Alan Greenspan never saw the housing market as an overvalued asset bubble and thus did not nothing to prevent it.
   
3. Adjustable Mortgages. To avoid volatility in the housing market, European economies (except the UK) generally promote more fixed rate, long term mortgages. This insulates against interest rate induced volatility and helps create greater stability (although it is fair to say many European economies have experienced a booming housing market)

Trickle Down Effect and Rising Inequality

Graph showing rising inequality in the US

Since 1980 inequality in the US economy has increased. Even Alan Greenspan has admitted that rising inequality in the US "is a very disturbing trend"The fastest income growth has been focused in the highest earners Yet, income tax cuts have also been repeatedly been targeted at high income earners. In real terms the minimum wage has failed to keep up with growth in real incomes. At the same time more people have moved into part time / unskilled / low income jobs. The effect has been to create a two tier labour market. One highly paid with job security; the other low paid with little security. Although, unemployment figures are low, this hides a large amount of temporary, low paid and insecure jobs. The fundamental problem is that the government have shown little regard for effectively reducing relative poverty. It has been low on the agenda and the national debate in US has tended to ignore this problem

Further reading: inequality in the US Economy

Budget Deficit and National Debt

US National Debt - $9,007.7 2007 Bureau of the Public Debt (65% of GDP)

It doesn't take a genius to work out that if you cut taxes for the rich and increase spending, you will get an increase in the government deficit. But, with the exception of the Clinton administration, recent American Presidents have casually disregarded any aspiration for fiscal responsibility. Despite a looming demographic problem, the Bush's and Reagan have allowed the size of the budget deficit to increase. This budge deficit puts upward pressure on interest rates, increases consumption at the expense of private sector investment and means future generations will be forced to pay back a higher interest payments. The National debt is even worse when the governments liabilities for public sector pensions are included. Furthermore, the ageing population will aggravate the national debt in the future. An ageing population places higher demand on health care and pensions, and pays less tax.

The deficit was created with little long term benefit. The deficit has not been used to stimulate demand in a recession, it has not been used to invest in public services. When Bush, cut taxes for high income earners in 2001, it was a badly targeted expansionary fiscal policy - it did nothing to increase the long term productive capacity of the economy. The increased spending on military hardware benefits the economy little save a small group of defence companies.

The problem is that now the US economy faces a real recession, there is little scope for expansionary fiscal policy. The next President will face real difficulties in reducing the national debt because demographics will work against fiscal stability and the deficit will worsen because of the stage of the economic cycle. One of the most damaging economic legacy of the Bush era is a burgeoning national debt with little hope of fixing it. This will be a constraint to future growth. The national debt will require either higher taxes and lower spending, or it will put upward pressure on interest rates crowding out private sector spending.

Current Account Deficit

The US Current Account deficit stands at over 5% of GDP (down from 6.5% in 2006). It is true in an era of capital mobility a current account deficit is easier to finance. But, if you maintain a deficit of over 5% for a prolonged period of time, it is unsurprising if, eventually, you face difficulties in attracting the necessary capital flows. Because Asian investors are becoming more cautious over the prospects in the US deficit, capital flows are slowing down contributing to the devaluing dollar. The current account deficit shows that there is a fundamental imbalance between consumption and domestic production and could act as a contstraint on future growth.

Devaluation of Dollar.

The Long term decline in the dollar

The recent devaluations of the dollar partly reflects changes in the trade cycle; i.e worsening prospects of growth and falling interest rates make it less attractive to buy dollar assets. But,in addition to short term factors, the falling dollar is also symptomatic of the structural weaknesses in the US economy. It is becoming less competitive compared to its trading partners.

Confidence in America and the Dollar

Because the US economy is weakening, the dollar no longer seems so attractive. The financial losses resulting from the subprime crisis even raise the riskiness of any US assets. Because the US is the strongest economy it seems inconceivable that the US could default on its loans. But, some believe it is now at risk of defaulting.

Further Reading

• Boom and Bust in US Housing Market
• Reasons for Fall in US Dollar
• Debt in US
• Essays on Recession
  

Sources

[1] Current Account deficit 2006 Economist (Since 2006, the current account deficit has decreased to 5.5%

• US External Debt as a % of GDP
• Federal Debt at Treasury Direct

Image Sources:

• US House Prices
• Long Term Dollar
  
• Current account deficit
• Inequality - Federal Reserve Bank of San Francisco
  

Labels: US economy

What Would be the Effect of a US recession on the Japanese and Chinese economies?

With the US heading towards recession, or at least a marked slowdown in growth. There are concerns about how much a US recession would effect the rest of the global economy.

1. Exports To US.

32% of Chinese Exports go to the US. If there was a slowdown in US consumer spending this would adversely affect the Chinese manufacturing industry.
23% of Japanese exports go the the US, in particular the automobile industry is heavily reliant on the US economy.
The Export sector are crucial to both Japan and China.

2. Japanese subsidiaries in the US.

Many Japanese firms have subsidiaries in the US. These subsidiaries would be directly affected by a US recession. It would mean that the main companies would have less potential to invest, because their profits are lower.

3. Global Confidence.

Although the US economy is less important than in the past, a US recession would still have a major impact on economic confidence around the globe. In particular a US recession may lead to lower European growth which will harm both China and US.

Reasons not to Be Worried About US Recession

1. Inflation.

The Chinese economy is growing too fast. It is close to overheating, therefore, a slowdown in exports to the US, may help to reduce inflationary pressures.

2. Chinese Middle Classes.

Global economic growth is becoming less dependent on the US consumer. There is a growing Chinese and Indian middle class, which provides a new potential for the purchase of manufactured goods.

3. Helps to reduce global trade imbalances

The long period of US growth has been at the expense of a deterioration in the US current account. US growth has been financed by borrowing from China and Asia. A slowdown in the US economy would help to rectify this growing imbalance.

References

• Would a US recession negatively effect Japan?
• Warnings of US recession
  

Labels: US economy

See also: Why Fed cut interest rates

1. Weak Dollar.

The dollar has been very weak against the Euro, Yen, and Canadian dollar for several months. Reducing interest rates will further weaken the strength of the US dollar.

As US interest rates fall, it becomes less attractive to save money in the US. Therefore, there is an outflow of hotmoney from the US to other countries. This further weakens the dollar, and increased the cost of importing raw materials

2. Inflation

Reducing interest rates may cause inflationary pressures to increase. This is because it increases consumer spending and weakens the dollar. Both of which have inflationary pressure. However, others argue that if the economy is heading towards recession, inflation is not the primary problem.

3. Rewards Bad Lending.

The argument is that in recent years credit markets have performed poorly. Basically, too many bad loans have been given out. In particular, the sub prime mortgage market has helped to give mortgages to those who couldn't really afford the mortgage. By cutting interest rates aggressively it is responding to the failures of these credit markets. If interest rates are cut, the banks and consumers may not learn their lesson. Some argue that it is better to have some short term pain so that markets learn the lesson of irresponsible lending and so the crisis is not repeated in the future.
Of course, this is a more controversial argument and you are unlikely to see it repeated by many leading US politicians.

Labels: US economy

1. They are concerned about the economy slowing down and possibly heading into recession. - Is US economy heading towards recession?

2. The main concern in the US economy at the moment is the state of the Housing Market and sub prime mortgage industry. Mortgage defaults are on the rise and US Housing prices are falling. The Fed is concerned that problems in the Housing market will spread to the rest of the economy. If house prices fall, people feel less wealthy and less confident. Therefore, there is a reduction in consumer spending. - Boom and Bust in US Housing Market

3. By cutting interest rates, they have reduced the cost of mortgage payments. This should help to increase disposable income of homeowners. It will also help reduce the number of mortgage defaults, which are causing severe problems for the US banking industry (and indirectly causing problems for UK banks like Northern Rock.

4. Economic Growth has slowed down in the US, inflation is below target.

5. Current Account deficit may improve. The US has a very large current account deficit (just under 7% of GDP) cutting interest rates will weaken the dollar, helping US exports become more attractive. This may reduce the current account deficit. Although, it is worth pointing out this is not the main reason that the FED cut interest rates (the deficit has been large for a long time)

Labels: US economy

The fall in the dollar Continues. It has reached a new low of 1.39 US$ to a Euro.
Against the £, the dollar has fallen to $2.03

Reasons for Fall in the US Dollar.


Related Posts on the dollar

• The effects of a devaluation in the dollar
• Is the US economy heading into recession?
• Will the dollar continue to fall?
  

Labels: US economy

Assess the likely implications of a devaluation in the dollar. (12)

Should we concerned about a rapid devaluation in the dollar?

Benefits of devaluation

Economic Growth

If the dollar becomes weaker, exports become cheaper leading to an increase in demand for US exports. This can help to increase AD and improve the rate of economic growth. This may be important, because problems in the US housing market are threatening the rate of economic growth. Falling house prices are potentially reducing consumer spending, therefore, a rise in exports could help to boost economic growth and prevent any move towards a recession.

Balance of Payments.

The US has a large current account deficit (7% of GDP) therefore a devaluation will help to improve and reduce the current account deficit. However, a devaluation alone is unlikely to solve the problem. Also, there is evidence that demand for exports and imports is relatively inelastic; therefore, any devaluation will have a small impact on the value of exports and imports. It is argued that the fundamental reason for a deficit is the low levels of domestic savings and consequently high levels of consumer spending.

Inflation

A devaluation may lead to increased inflationary pressures for 3 reasons:

1) Increase in exports causes rising AD and therefore could lead to demand pull inflation.
2) Imported goods will be more expensive. American consumers would definitely experience a rise in price for many imported manufactured goods and imports of raw materials could increase costs of business.
3) It is argued a devaluation reduces the incentive, for manufacturers and exporters, to cut costs and become more efficient.

However, the impact of a devaluation depends on the state of the economy. As previously mentioned, the US economy is slowing down; therefore inflationary pressures are subdued and therefore inflation is unlikely to occur.

• Will the US dollar continue to fall?

Labels: exchange rates, US economy

In recent months the US housing market has seen significant falls in house prices, combined with record levels of mortgage defaults. Many economists and housing experts have suggested it is a bust that was inevitable to occur. This short article looks at why the US Housing Market has gone from boom to bust.

Why US Housing Market has Declined

1. House Prices Rose at Unprecedented Levels.

Historically US House prices have increased at a similar rate to rents, however in the last period of the housing boom the ratio of House prices to rents had grew at a rate of 78%. (1)
The ratio of House Prices to Income has also increased significantly from the long term average. In 1952 house prices relative to income was 100% in 2002 the ratio was 190%. (2) This increased to over 200% by the end of the housing boom.

The effect of rising house prices was that it was increasingly difficult for first time buyers and those on low incomes to buy a house. It also means that those with mortgages pay a higher % of their income in mortgage payments. This means they are more vulnerable to any changes in the housing market.

2. Aggressive sale of Sub Prime Mortgages.

Usually when house prices rise, demand moderates. However in the case of the US housing market, mortgage lenders were desperate to maintain sales. Therefore they just found new ways to sell the more expensive houses.
In particular mortgage lenders did several things to maintain sales amongst those with poor credit, low income and higher risk see example of inappropriate selling of mortgages (3)

3. Increased Promotion of Discounted mortgages.

Basically this means for the first year or two the home owner gets an introductory interest rate, making mortgage payments cheaper and more affordable. However after 2 years the interest rates jumps to the standard variable rate. Unfortunately because of the way mortgages were sold, these facts were not always made clear; meaning many households on low incomes took out mortgages they would later struggled to pay. This will become an increasing problem throughout 2007 as more mortgages end their introductory period.

4. Increased use of Variable Adjustable Mortgages.

In 2002 interest rates were very low (1%) This made adjustable mortgages very attractive. Therefore more people could afford to get a mortgage. However interest rates have since risen considerably since their historical low, significantly increasing the cost of mortgage payments. The rise in Adjustable mortgages is most prominent amongst low income families. Fixed rate mortgages would have been safer, but mortgage companies have not been pushing these since they tend to look for best short term chance of selling a mortgage. (The growth in ARMs between 2000and 2004 accounted for about two-thirds of the relative increase in variable interest debt.) (4)


5. Rising Interest Rates.

In 2002 because of weakness in other areas of the economy monetary policy was loosened. This was perhaps a good strategy regarding economic growth and inflation, however it ignored the micro implications for the housing market. Low interest rates were a real stimulus for those on low income and bad credit records to buy a house for the first time. However as interest rates have increased from 1% to 5% it has significantly increased the cost of mortgage payments for homeowners. A 2% rise in interest rates can increase the cost of mortgage interest payments by 40% (5)


6. Speculation

Rising house prices did encourage an element of speculation into the US Housing Market. Estimates suggest 25% of house purchases in 2005 were influenced by speculation (5) The Housing market was providing greater returns than the stock market, therefore this encourages buy to let investors. As house prices start to fall this section of the market changes completely.

7. Excess Supply

The boom years encouraged an excess of new houses being built. The supply of housing now exceeds the demand, therefore the price of housing is likely to continue to fall (6)


Footnotes


(1) (2) End of US Housing Boom

(3) House Prices tied to sham mortgages

(4) US Housing Market

(5) House Crash Continues

(6) Excess Supply in US Housing Market


Related links on US Housing Market

• US Housing Market
• Dangers of Sub Prime Mortgages
• Will US crash occur in UK

Next blog post: Effect of Falling House Prices on the Economy. Will it cause Recession?

See also:

• Is US recession likely to occur?

Labels: US economy, US housing Market

A look at factors that have contributed to the US current account deficit which has been over 6% of GDP for several years

1. US consumer spending has been rising rapidly due to a combination of
   
   • Tax cuts
   • Low interest rates
   • Rising house prices (although this is now being reversed)

Therefore with rising consumer spending the US has been increasing the value of imports bought into the economy. Furthermore the US has a high marginal propensity to import. Many luxury good like electrical goods and cars tend to be imported. It is these kinds of goods which are bought when incomes rise.

2. Decline in competitiveness. US manufactured goods have been losing comparative advantage to Asian economies. The primary reason is that wage costs in US are much higher than Asian economies. In particular China has seen its trade surplus with America grow due to its low labour costs.
   
   
3. Dollar Relatively High compared to current account deficit. Dollar has not devalued as much as you would expect for an economy with a large current account deficit. The US has remained an attractive location for Capital investment. In particular China has been buying a lot of US government securities. Therefore this inflow of capital has financed the current account deficit and encouraged America to keep buying imports. The inflow of capital has also enabled interest rates to remain low. Because China has bought so many US government bonds the US has been able to finance its national debt whilst keeping interest rates low. These low interest rates have encouraged consumer borrowing and consumer spending; a major cause of the current account deficit. In the past 12 months the dollar has been in decline but to reduce the current account deficit it would need to fall by more than 20%

Labels: current account, US economy

Due to China's huge current account surplus there stock of foreign currency reserves continues to mount. Jin Renqing a Chinese Minister recently announced plans to create a special agency to look into the best way to invest their $1,000 bn foreign currency reserves.

Upto now the Chinese have invested a significant % in United States Treasury bonds. This is seen as a low risk investment strategy. However for various reasons the Chinese are likely to diversify their investments. For example they could take holdings in companies around the world. In particular they are likely to invest in commodity producers. Chinese rapid growth is causing the demand and price of commodities to rise. In the long term this will give China greater political sway over other countries who benefit from their investment. Up to now the Chinese have taken an inward looking approach to world affairs. But this could change as they increasingly flex their economic muscles.

If the China loose their appetite for low interest bearing dollars it could mean that US interest rates will have to rise, to attract other investors. It will also make it difficult to finance the current account deficit. Therefore the dollar is likely to fall further.

However the Chinese own so many dollar assets they have a vested interest in preventing a significant fall in the dollar. With nearly $1 trillion to invest they are likely to continue buying bonds.

See also: Why US dollar likely to depreciate

source: China to open fund for investment at NY Times

Labels: Chinese economy, US economy

A current account deficit measures the balance of trade in

• goods
• services
• Net Investment incomes

A deficit on the current account means a country is importing more than we are exporting. This will have to be matched by a surplus on the financial and / or capital account.

The financial account comprises of 2 main features:

• a) Short Term Capital flows e.g. hot money flows and purchase of securities
• b) Long Term Capital flows e.g. investment in building new factories

Some economists argue we need not worry about a Current Account Deficit. This is because:

1. If a current account deficit is financed from long term capital inflows then this can be beneficial for the economy. Inward investment can increase the productive capacity of the economy.

2. In an era of globalisation it is much easier to attract sufficient capital flows to finance the deficit.

3. If the deficit gets too large it will cause a devaluation which helps to reduce the deficit. Also when there is a slowdown in consumer spending the deficit will fall.


Reasons to Worry about a Current Account Deficit.

1. There could be problems financing the deficit in the long term. A short term deficit is not a problem, but if you have a deficit of over 6% of GDP then it is a problem if you rely on Capital flows. A significant part of the current account deficit in US is finance by Chinese investors buying US securities, at relatively low interest rates.

2. Most countries would not be able to borrow such large amounts at low interest rates. The US currently can because the US is seen as the World’s reserve currency. However if attitudes to the US economy change and investors lose their confidence in the US economy, they will stop buying US debt. This will cause 2 problems.

1. US interest rates will need to rise to attract enough people to buy the debt. These higher interest rates will reduce demand in the economy. Higher interest rates will particularly hurt American consumers who have large amounts of debt at the moment.
2. If capital flows can’t be attracted then the dollar will continue to devalue further. This could cause inflationary pressures, interest rates may need to rise to stabilise the dollar.

Basically to correct the deficit would be a painful experience for the US economy and result in a slowdown or possibly recession

3. In the US the current account deficit is to a large extent caused by excess spending in the economy. It is partly caused by government borrowing which increases Aggregate Demand in the economy and hence growing demand for imports. A large current account deficit is often a sign of an unbalanced economy. It could be a sign of structural weakness and an uncompetitive manufacturing sector.

4. A deficit on the current account increases foreign liabilities. In the beginning a current account deficit could be just a deficit on buying goods. However over time the deficit will be increased by the interest payments on the capital surplus. Foreigners invest in the US. On these investments they receive interest payments or dividends. These dividends count as a debit on the current account. Therefore the longer the deficit goes on the higher the level of investment income debits will be accrued. This means that in the future the economy will need to attract capital flows just to pay off the investment income. As well as the deficit on goods and services.

See also

• Is the US economy heading towards recession?
  
• Do Current Account deficits matter?
• Do Current Accound deficits matter? Axel Merk, May 23rd 2006

Labels: current account, economics explained, US economy

Is the US economy set for further growth or is a recession an inevitability for an economy that has been living beyond its means for a long time?

With Alan Greenspan suggesting the US economy has a 33% chance of entering into recession it is worth considering whether this is a realistic prospect or just a controversial parting shot from the 81 year old former Chair of the Federal Reserve. Alan Greenspan is held in high regard as an economist, some even credit him with “saving the US economy”. However his track record on economic predictions is mixed. He did predict a dotcom bubble bursting, (although it was 4 years before it occurred)

Reasons why the American Economy may enter a Recession.

1. Falling House Prices. After several years of a booming housing market. House prices are now starting to fall in most US states. Falling house prices will have a significant impact on consumer spending. As house prices fall, people can no longer remortgage to have extra capital to spend. Also falling house prices have a significant impact on consumer confidence. As housing is the biggest form of wealth it will adversely impact on the financial situation of most households. [1] America's past growth has been maintained by strong consumer spending, if this falters economic growth is likely to do the same.
   

2. House Prices could have further to fall. Looking at historic house price to earnings ratios the average US house price has been overvalued for several years. For the house price to earnings ratios to return to normal, house prices may have to fall by more than 18%. [2] Note the Japanese housing market provides a recent precedent for those who don’t believe house prices can fall for a long time.

3. Mortgage Lenders going Bust. Due to a record levels of default on sub prime mortgages, the number of mortgage lenders going out of business is at an all time high. [3] This has also changed other financial markets attitude to risk. Banks and stock markets will be much less willing to lend on dubious terms. The net effect is that investment and consumer spending will grow much slower, or even start to fall.

4. Current Account Deficit. The US current account deficit is currently 6.5% of GDP. [4] For a long time some economists have said there is nothing to worry about. The deficit has been financed by Chinese investors willing to buy US assets, even with a relatively low interest rate. However increasingly Chinese and Asian investors are seeking to diversify out of the US dollar. The dollar is losing its “safe haven” status. Partly because of events in Iraq and Afghanistan but also because of a realisation that the US economy is not as dominant as it used to be in the past. If the Chinese start buying less US securities it will cause a further devaluation in the dollar and also require higher interest rates to attract people to buy sufficient US securities. The higher interest rates will exacerbate any fall in US consumer demand.

5. Budget Deficit. The US has a twin deficit. As well as a balance of payments deficit. They also have a budget deficit. The effect of this is that it puts upward pressure on interest rates. Higher interest rates are required to attract investors to buy bonds and securites. Having such a large deficit also leaves the government less room for manoeuvre in terms of expansionary fiscal policy. If the US economy does start to slow down there is little scope for further tax cuts and increases in government spending.

6. High levels of debt. High levels of debt make the US economy susceptible to increases in interest rates. Higher interest rates may be necessary because of the twin deficits and falling dollar. Even a small rise in interest rates could have a significant adverse effect on heavily indebted consumers.
   
   
7. Falling Stock Market. By itself a falling stock market doesn't cause a recession, but it is indicative of the change in confidence and mood of the US economic situation that US share prices have fallen sharply since last week.
   

Reasons why the US economy may not enter recession.

1. High Economic Growth. Economic growth is still positive and inflation is under control. Current economic statistics are generally good, despite growth being revised downward. The Fed still expects growth of 2.75% - 3% next year

2. The Global economy is no longer dependent on US consumers. Economic growth in Asia and particularly China means that there is a growing Chinese middle class who will be increasingly willing to buy US exports in the future. It is possible the trade deficit could change over time. Especially as devaluation makes the US dollar more attractive.

[1] US house price sales fall 17%

[2] US house prices 18% overvalued

[3] US Mortgage lenders going bust

[4] US current account deficit

Other References

• Greenspan predicts US recession
  
• US economic data at Economist
• America’s Economy at Economist
  

Labels: Economic News, recession, US economy

Since 2001 the dollar has been in steady decline. Against the £ the dollar has fallen from a low of £1 = $1.45 to close to the £1 = $2 mark. Against the Euro the $ has also depreciated from 0.85 to the present level of 1 Euro to $1.35.

From several perspectives the fall in the value of the dollar appears to be following basic economic fundamentals and whilst these imbalance continue the dollar may continue to fall.

Firstly the US current account deficit is remaining at record levels. The exact amount of debt with the rest of the world is predicted to be around $710 billion for 2006 [1] Basically this means America is importing more than it is exporting, causing an outflow of money. In recent years this huge level of debt has been bought by countries like Asia who have been happy to buy into the dollar for its perceived status as a “stable and secure” currency. However there is increasing evidence Asian bankers are no longer so confident in the American economy. Thus they are seeking to divest from the dollar and reduce their dollar holdings. As this occurs the dollar will have to fall as there is insufficient buyers of American debt.[2]

Secondly the future for economic growth is no longer looking so positive. Growth forecasts have recently been downgraded. The OECD has downgraded is growth forecasts for the US economy from 3.6% to 2.4%. Pessimists such as Nouriel Roubini, of Roubini Global Economics [2] are predicting a recession in the US by the middle of 2007. An important factor in declining growth forecasts is the falling US consumer confidence.

Related to this is a signal that the previous ebullient housing market may have at last turned the corner. Whilst new house prices continue to rise. The median price of old houses have fallen by 3.5% since last year. Whilst a fall of 3.5% may not sound that much, it is the biggest on record. Also rising house prices have been a key factor in maintaining consumer spending in recent years. The level of personal debt amongst US consumers is at another all time high. The ratio of consumer debt to disposable income has risen from 62% in 1980 to 127% in 2005 [3]

Thus a fall in house prices will have a powerful knock on effect on the rest of the US economy as consumers struggle to refinance and meet levels of debt. Another consequence of this high level of consumer debt is that the US economy will be particularly sensitive to any rise in interest rates. Higher interest rates would be one solution to a falling currency and may be necessary to attract investors to finance America’s trade deficit. Although the prospect of the Fed raising interest rates is remote at the moment. Continued falls in American dollars would cause a rise in the long term interest rates on American secutities.

However some economists argue that prospects for the dollar may not be as bad as some predict. Firstly as Anatole Kaletsky argues [4] in an era of globalisation and deregulated financial markets, trade deficits are not as difficult to finance as they used to be. Empirical evidence suggests that trade deficits are very unreliable as a guide to exchange rate movements. Firstly one of the few countries with a current account surplus is Japan. Their current account surplus has been growing and yet the Yen is one of the few currencies to have fallen against the dollar. [4]

Secondly although American growth is slowing at the moment it is not doing much worse than the EU and Japan economies. The gap in interest rates between the 2 economic areas is still only about 2%. If there are good reasons for the dollars weakness there are less good reasons for the strength of the EURO. Also some American economists such as Ben Bernanke of the Federal reserve remain optimistic about the state of the US economy arguing growth is only marginally below trend rate.

However it is important not to underestimate the importance of general market sentiment regarding the American economy. Political problems such as in Iraq have to an extent undermined America’s standing as a leader of the World in both an economic and political sense. For 50 years America has been the undisputed global economic superpower, but slowly perceptions are changing that the era of the dollar may becoming to an end. As people switch out of dollars it could create a powerful multiplier effect as investment bankers are reluctant to hold onto their dollar assets.

America to a large extent can’t avoid a period of adjustment as it seeks to deal with its triple deficits, trade deficits with the rest of the world, consumer debt, and US government debt. Whether the period of adjustment is gradual or painful will depend upon 2 things. Firstly how significant will be the fall in US house prices and consequent fall in consumer confidence. Secondly it will depend on the attitude of Asian bankers, in particular the Chinese. Since they hold so many $ assets they may try to manage a gradual devaluation, a continuation of the past 5 years. However if the dollar does lose its status as the reserve currency of the world, there could be a growing stampede as America’s creditors seek to cash in their cheques. This would exacerbate the fall of the dollar, causing real economic hardship for America and the rest of the world.

The only thing for sure is that European consumers are likely to be get some real bargains from shopping in America for the considerable future.

References

[1] http://www.cbsnews.com/stories/2006/01/12/business/main1203762.shtml

[2] http://www.economist.com/finance/displaystory.cfm?story_id=8361260

[3] Available at http://www.federalreserve.gov/releases/Z1/Current/

[4] http://www.timesonline.co.uk/article/0,,630-2485597.html - Demise of Dollar greatly exaggerated

[5] Falling US stock Market adds to pressure on the US economy

[6] Why the dollar is falling so fast

[7] Dollar falling on weakening trade figures

Labels: Chinese economy, dollar, US economy

After several years of rapid growth in US House Prices. The US housing market has taken a sharp reverse in fortunes. The number of new houses being built has fallen considerably and in many states of the US house prices are now falling. There are concerns that this fall in house prices will leave the US consumers with negative equity and therefore could cause a fall in Consumer spending. In recent years it has been consumer spending that has been the main determinant of US economic growth. It has also played a key role in global economic growth. However although falling house prices will cause a significant reduction in US consumer spending the effects on the global economy are less than they may have been a decade or so ago. Emerging markets like India and China are seeing a developing middle class with an apetite for luxury goods. Thus if the US was to go into recession it need not cause the world to follow. It is also worth remembering the Japanese economy is starting to recover, the main driving force there is, at the moment, consumer spending.

Labels: Housing Market, US economy