As goes the US consumer, so goes the world economy. This, in
any case, is the way it has been now for nearly a decade. The
growth of US consumer demand has been extraordinary, with
household saving rates as conventionally measured actually
falling below zero. Low interest rates have allowed families to
refinance their residential mortgages and increase their
spending on other items. Soaring house prices have made them
feel richer and further spurred private spending, not least on
home improvements and new houses.
All this is changing now that interest rates are rising. Many
households have refinanced their homes using variable-rate
mortgages or instruments involving balloon payments. Now the
bill is coming due. This has had a predictably negative effect
on consumer confidence, which fell by nearly 7% in May
according to the New York-based Conference Board. Residential
construction and sales are notoriously sensitive to interest
rates. Not surprisingly, there are growing signs that the
overheated US housing market is cooling off.
How worried should we be? For the last few years, the US
economy and by implication the world economy has been carried
on the back of the American housing market. If house prices now
tank in the United States, won’t they drag down US
and global growth?
Lessons from Australia
One way of gauging the consequences is by looking to Australia.
That country experienced a housing boom even more dramatic than
America’s but on an earlier cycle. In Australia,
house prices have risen by some 70% since early 2001. There
were all the signs of an overheated market, with families
desperately piling into the market for fear of having to pay
even higher prices in the future, and small investors betting
on further increases buying multiple homes and
Since 2004, the market has cooled off, and housing construction
is down sharply. In 2005 house prices in Sydney fell by nearly
5% – and in certain parts of the city by considerably
more. Only the continued buoyancy of prices in Perth, in the
far west of the country, has prevented prices nationwide from
falling more dramatically. All this offers a hint of what the
US has in store.
Happily, however, the Australian economy has skated smoothly
through these obstacles. (They don’t call it the
happy country for nothing!) GDP growth ran at 2.7% in 2005
– not exceptionally fast but more than respectable.
Maybe this shows that consumers are not really so sensitive to
the end of a housing boom; maybe it means that we
shouldn’t worry so much about the US housing
market after all.
But this reading of the record would be wrong. In fact,
Australian consumers have not been immune to the end of rising
housing prices and to mounting levels of debt. After having
risen for several years, consumer sentiment fell sharply at the
outset of 2005. Household consumption rose less than household
income, and the growth of retail sales –sales of
big-ticket items like motor vehicles in particular –
So why is the Australian economy holding up so well? The answer
comes in two parts. First, strong commodity prices are a boon
for Australia. The country is a big producer of aluminium,
copper, nickel, coal and iron ore, all of which are in strong
demand globally, and especially in neighbouring China. To
Australians it seems as if there is no end to
China’s demand for these commodities. As a gold
producer, Australia benefits from the run-up in the price of
the yellow metal; as a sugar producer, it even benefits from
the fact that sugar is used in the production of ethanol, a
substitute for gasoline.
Thus, just as consumer demand has slowed, business investment,
in the commodity-producing sector in particular, has
accelerated. Talk about fortuitous timing! Even the strength of
house prices in Perth can be explained on these grounds, given
the importance of commodity production in Western
The other part of the answer is stimulus from fiscal policy.
Seeing the slowdown in the growth of consumer demand, the
government has moved to cut income taxes. Just last month it
announced its intention to lower the top two personal marginal
income tax rates and increase the income thresholds at which
personal tax rates apply. Thus the component of domestic demand
– consumer spending – most in need of
strengthening will be supported directly.
In addition, the government trimmed taxes on pension funds and
increased corporate depreciation allowances. It also announced
big increases in spending on infrastructure, health, defence,
border security, skill development and childcare. In the face
of this, it is no surprise that demand has continued to
Notice, however, that neither response is available to the
United States. The US depends more on exports of manufactures
and services and less on commodities. If anything, its growth
prospects are dimmed by high commodity prices, and because of
the fiscal profligacy of earlier years, it has no scope for
further tax cuts now. Australia was smart enough to run budget
surpluses in good times; one can only wish that the United
States had been so forward looking.
All this suggests that the United States will not be cushioned
from the effects of the end of its housing boom.
Australia’s experience suggests that the growth of
US consumer spending will slow, and unlike Australia, there
will be little that the US government can do to offset this.
For the global economy, this suggests that the best advice is
"fasten your seat belts".
Barry Eichengreen is George C Pardee and Helen N Pardee
Professor of Economics and Political Science at the University
of California, Berkeley