Last week I discussed the dichotomy of the global economy – strong US consumption and borrowing balanced by high savings and low domestic demand in Asia and Europe. These are not two distinct situations; they are inextricably linked. The solution to America's large trade and budget deficits is to be found in the rest of the world, which must consume more.
Let's stand back from the debate and see what the market thinks.
If the large and growing US current account deficit were a problem, the US dollar would be sliding into oblivion. It's not.
If the budget deficit were at crisis levels, US interest rates would be surging. They're not.
The market may one day think differently, but for now investors seem content to live with the risks, no doubt expecting growth will drive the economy away from the danger zone.
Despite the market's seemingly relaxed state, the current economic situation is not sustainable over the long term. But as Mark Twain said, in the long run we are all dead.
To be resolved, the gap between US domestic demand and US production must close, either by the US consuming less or the rest of the world consuming more. Only this will fix the relative imbalances that have built-up over the last four years.
The trillion dollar question is whether US domestic demand will slow to reach this equilibrium, or whether the desired relativity will be reached through faster growth in the rest of the world (mainly Japan and Europe) while US demand growth remains steady.
In other words, will the world soon enter a period of synchronised growth, or are we heading for an extended period of low growth, constrained by the global fiscal imbalance that has built up since 2002 and the reluctance of Asia and Europe to spend more and save less.
There is reason for optimism that both Japan and Europe can breakout of their low-growth traps. But rising energy prices and ageing populations mean this outcome is by no means certain.
One of the bigger obstacles is the exchange rate policies of Asia and Japan. By holding their currencies down these countries shackle the US from exporting its way out of trouble and reduce their own consumers' spending power and hence domestic demand.
This uncertainty suggests the next few years could be extremely volatile as investors grapple with the implications of each scenario.
There is a third alternative – the continuation of high levels of US borrowing funded by an Asia and Europe unable to find any domestic use for their fiscal surpluses. This is the path to ruin, and an Argentinean style of economic adjustment when the imbalances are finally unwound.
But even this scenario would take many years to eventuate and could not happen in isolation – the rest of the world would have to choose to keep feeding the beast. All that money has to come from somewhere!
In fact the US could continue on its current path for up to ten more years before fiscal debt and external liabilities exceeded 100% of GDP – a level that has triggered financial crises in other countries.
While popular with gold bugs, this scenario is improbable. This outcome would eventually see the rest of the world repudiate the US dollar and would probably be accompanied by the rapid decline of US military hegemony, since bankrupt nations can't afford large militaries. My advice to gold bugs is to be careful what they wish for!
The US current account deficit could potentially rise to 8-9% over the next few years while the underlying global imbalance of weak domestic demand in Europe and Asia is being addressed.
Many investors will panic at such a high deficit, but it is almost to be expected if US interest rates rise (thus increasing foreign debt servicing costs) before exports start growing.
Investors must see-through this effect and not be frightened by high deficits as long as the rest of the world is boosting domestic demand and fixing rigid exchange rates. Given the right policy actions in Europe and Asia, the world could then look forward to a lengthy period of sustained economic growth.
