Prospects for the US economy

In the latest NYT Economic View column, Tyler Cowen argues that the distortions and excesses that bedevil the US economy today can be resolved only if there occurs a fundamental shift in the spending habits of American consumers.

But any such changes at this point of time may be easier said than done, and may even rebound badly. As the economy falters and threatens to slip into a recession, any dramatic change in the consumption (or saving) habits carries major risks. As the graph below shows, consumption is far and away the major determinant of the US economic growth, contributing 72% to the GDP growth in 2007-08.



With business investment weak, inventories falling and the housing market continuing to fall, the only hope lies in exports and government spending. The weak economies in US and Europe, are likely to have knock on effects on growth in the emerging economies. This will adversely affect one of the last remaining engines of US economic growth, exports, and leave government spending as the single most important determinant in the fortunes of the US economy in the immediate future. Here too, the signals are not encouraging given the less than desired (or expected) results from the first round of fiscal stimulus. In any case, there are many contrasting views on the efficacy of any fiscal stimulus led demand management and government spending led pump-priming.

As Cowen argues, the age profile of the American population will come in the way of increasing savings. In other words, thanks to an aging population, the US economy is today at the other end of the savings-consumption cycle. The solvency induced credit squeeze will ensure that lending institutions will be wary of counter-party risk and therefore not effectively allocate investment resources. The American economy is more deeply integrated with the financial markets than other economies, and is therefore most vulnerable to any solvency induced liquidity-trap that would starve the corporate sector off credit.

As the Economist points out, there are also significant similarities between the US situation today and the Japanese economy in the early nineties. Average house prices nationwide rose by 90% in America between 2000 and 2006, compared with a gain of 51% in Japan between 1985 and early 1991, when Japanese home prices peaked.



The similarities do not end there. Like the Fed, the Bank of Japan too cut interest rates aggressively in response to the crisis, reducing it from 6% in July 1991 to 1.75% by the end of 1993. Two years after American house prices started to slide, the Fed funds rate has fallen from 5.25% to 2%. The cyclically adjusted budget deficit (which excludes the automatic impact of slower growth on tax revenues) increased by an annual average of 1.8% of GDP in 1992 and 1993—similar to America’s budget boost this year. Like Japan, US is also on negative real interest rate territory, leaving little room to manouevre with monetary policy.

Though there are significant differences, including major mistakes made by Japan like raising taxes that nipped off any recovery, there exists a real threat of a Japan style economic downturn.

The best that can be done is to buy time (by a mix of monetary loosening and targetted fiscal stimulus) and then use it productively to quickly wring out the excesses in the financial system and piggyback on hopefully robust enough economic growth in China led emerging economies, while at the same time praying that commodity and energy prices fall and stabilize at lower levels (so that inflation does not open up another battlefront). In otherwords, avoid a hard landing by forcing a softer landing!