By Taimur Ahmad
global economy faces its gravest challenge in years as a
sharp US slowdown looms. The adjustment could get ugly
The US current account deficit has carried on for years
without apparent ill effect. But if you think global
imbalances have ceased to matter, think again: storm clouds
are gathering and this time, the adjustment could be
Analysts have long pointed out that, in the event of a US
economic slowdown, the deficit would diminish. A slowing
economy should help reverse the unprecedented flows of
capital from developing economies in recent years. But fears
are growing that, far from a slowdown, theres a real
danger of a sharp US downturn and a possible hard
landing for the Chinese economy to boot.
Given the magnitude of the imbalances, we cant be
confident at this point that we will avoid a disorderly
adjustment, says former US Treasury secretary Larry
Summers in an interview with Emerging Markets. A sharp
reduction in the US current account deficit, he says, would
have a contractionary effect on the global economy.
Housing market concerns
Worries are mounting too that the US economy could be savaged
by a US housing market collapse that the
orderly housing slowdown predicted by Federal
Reserve chairman Ben Bernanke could become a full-blown
crash. If it caves in, it could bring down the rest of the
economy with it. The question is, what kind of slowdown
will we get and how deep will it be? says Bill Rhodes,
senior vice-chairman of Citigroup.
House prices have been rising at unprecedented double-digit
rates in recent years, giving homeowners massive windfalls
and supporting a wave of investment in new construction.
However, the number of unsold new homes is now at a 10-year
high. The market is decelerating. If prices merely flatten,
the economy could slow sharply as consumer spending and
construction are squeezed. If house prices fall as a result
of higher bond yields, the American economy could even dip
The housing market has turned, and the bubble is about
to burst, Stephen Roach, chief economist at Morgan
Stanley, tells Emerging Markets. No one has any
knowledge of how its going to burst. But it could knock
1-1/2% off US consumer demand.
Higher energy prices, rising debt-servicing burdens and
negative personal saving rates increase the chances of sharp
declines in US consumption and GDP growth.
In terms of global impact, its a big deal because
the US consumer is the worlds consumer, Roach
says. Export-dependent developing economies will be hit
hard. The impact could be huge.
The world economy is getting a wake-up call, and the
days of complacency are over, Roach says.
Citigroups Rhodes says that the spectre of stagflation
is back. If you do get a sustained [US] slowdown,
capital expenditure is not going to be able to pick up. The
danger we have is a return of stagflation.
The consensus has tended to be that there will be an orderly
unwinding of global imbalances. Of course, less spending and
more saving is just what America needs to reduce its
current-account deficit. But thats just one
Ken Rogoff, Harvard professor and former IMF chief economist,
believes there are two triggers for a severe adjustment: a
slowdown in US housing prices with the knock-on effect on
consumer spending; and a sharp slowdown in the Chinese
economy. He says it remains very much an open question what
will happen if the global financial system is stress
tested, by a housing price collapse in the United
States combined with a sharp slowdown in growth in
Risk of reversal
Theres a significant risk that the US current
account might start reversing, Rogoff tells Emerging
Markets. I wouldnt say the odds of a sharp
reversal are 50/50, but this has been a serious risk for some
Theres no question in my mind that an element of
housing prices is speculative. In the US especially that
would have a negative impact on consumption that could shrink
the current account by 2-3%, he says.
The risk of a crash in China is larger than it was two or
three years ago, says Rogoff: China is overheating.
They lack the range of instruments [to slow down in an
A crash would lead to ripple effects in commodity producers
such as Brazil and Africa. The worlds big oil producers
would also feel repercussions from a Chinese slowdown, as
would Chinas Asian suppliers, such as Japan, Korea and
Were running real risks. Just how great the risks
are I dont know, but theyre certainly larger than
we need to be running, says Summers.
Chinas trade surplus doubled in 2005 to exceed 7% of
gross domestic product, according to the IMF, making it a key
part of any resolution of the imbalances. Chinas
central bank governor Zhou Xiaochuan, who represents one of
five economic areas participating in the IMFs latest
efforts to resolve the imbalances, says an adjustment is
necessary and desirable. The problem is the US current
account deficit is close to 7%, so having some kind of
adjustment I think is good, he told Emerging Markets in
an interview earlier this year.
The White Houses economic team is not blind to the
dangers: I do share those concerns about global
imbalances, says Matthew Slaughter, a member of the
White Houses Council of Economic Advisers. The
rate of increase of the US current account deficit cannot and
will not continue indefinitely.
But what of the housing crash? On this, the White House takes
a more optimistic view. A bit of moderation in
residential investment demand is what we see, says
Slaughter. This would help us reduce the US current
How likely is a disorderly unwinding? They are
legitimate fears and real, and a part of the broad concern I
have. What happens if we do get a sharp adjustment? I think
about the asset transactions that support global imbalances.
A sudden adjustment is something that would entail a sharp
shift in investor demand away from US assets. Can such a
scenario arise? Yes. How likely is it to arise? In light of
the open and deep US capital markets, thats a scenario
that looks less likely.
The US needs to attract roughly $8 billion of foreign capital
a day to finance its current account deficit. Any substantial
reduction of that inflow could send the dollar into tailspin.
A gradual, medium-term depreciation of the greenback is the
best-case scenario for an orderly resolution of imbalances.
Rogoff argues that boosting demand in Asia and Europe could
help offset some of the impact of a US slowdown, as would an
appreciation of Asian currencies. More flexibility in
exchange rates in Asia, demand-driven growth in Asia and
Europe. And for the US to start saving more.
Slaughter thinks that the changes that need to be made in
order to redress the precarious international financial
architecture will be global in nature. There is no one
country responsible for global imbalances. But for the US, in
a macro sense it would be to close the trade deficit, to have
faster export growth, slower import growth from a rebalancing
of US aggregate demand away from the rest of the world, more
towards domestic production.
The task for the US is much harder than other
countries, although some people pay a lot of attention to
China, but the imbalance in China seems not that
serious, Zhou says.
To correct the imbalances to a tolerable level is not
very difficult: increase international demand, try to reduce
excessive precautionary savings rates and expand currency
flexibility, says Zhou. The other option is [for
China] to have a more open-door policy, including more market
access for foreigners into the Chinese market, to increase
the imports, Zhou adds.
So, what needs to be done? There is less mystery in
what should be done than in the politics of getting it
done, says Summers. The current account deficit
very importantly reflects developments in other parts of the
world in a kind of investment shortage relative to the
supply of savings in other parts of the world.
Although much is made of what other countries notably
China should do to address imbalances, attention is
now turning to new US Treasury secretary Hank Paulson and how
he might handle the USs precarious international
financial position. Paulson faces the task of minimizing the
fallout from the inevitable adjustment.
The actions the US takes will have a very
important impact on whether these imbalances are
corrected, Summers points out. Its very
important for [incoming Treasury secretary] Paulson to have
control over fiscal policy, says Rogoff. I would
hope that Paulson was given a promise that he would be a
major player and have an impact.
As far as the US government is concerned, says Rogoff:
Any steps it can take to put social security, Medicare
on track would be desirable.
But others remain sceptical about the authority US Treasury
can be expected to muster as the Bush administration enters
its terminal stretch. [US Treasury secretary]
Paulson will be a spokesman not a policy-maker, says
Harvard economist Richard Cooper. [former Treasury
secretary Paul] ONeill ran into trouble, then [John]
Snow was brought in as a spokesman. Nothing Ive seen
suggests Paulson has a wider charge. Snow has followed a
straddle between irrational pressures from Congress and
sensible policy. I hope Paulson is at least as skilful,