John Rapley
THE YEAR 2005 has got off to a shaky start for the U.S. economy. After analysts predicted a continuation of the late-2004 rally, stock markets have slid. Meanwhile, oil prices have resumed climbing and the dollar is back in decline. The economy as a whole, though, continues to grow at a healthy if not outstanding pace. But it is finely balanced, heavily dependent on cheap credit and foreign financing.
Both of these conditions are currently in jeopardy. The U.S. Federal Reserve Board's policy of cheap money staved off a stock market crash a couple of years ago, but at the risk of a real estate bubble, not to mention a return to apparently unsustainable equity values. But an even greater risk lies in bond markets. Cheap credit led investors to bid up bond values, which drove down interest rates.
IMMENSE RUN-UP IN DEBT
As a result, real interest rates in the U.S. now stand at about zero. That is to say, inflation erodes the value of debt. This has fuelled an immense run-up in debt in the U.S. This debt has helped to keep the U.S. economy afloat, as consumers drew on credit lines to keep spending through the lean times of the post-bubble economy.
But can it last? If inflation rises, investors will quickly dump investments whose returns grow less quickly than their expenses. In the case of bonds, investors will demand higher interest rates from borrowers before they lend them money.
And once bond yields rise, interest rates across the board will go up. Should that happen, the cost of carrying debt will rise, as interest payments augment. The danger then would be that businesses would cut back on their investments and consumers would cut back on their spending, threatening another recession.
FORECASTS OPTIMISTIC
Current forecasts for inflation in the U.S. economy are relatively optimistic, with some analysts predicting that the rate will slow back down to around two per cent per year. That, I think, is rather optimistic. With the dollar declining in value, import prices are rising.
At the same time, the impact of Chinese demand has driven commodity prices up almost across the board. All in all, the input costs of American businesses have been rising sharply.
Dollar devaluation will, however, make American goods more competitive vis-a-vis their foreign competitors. On the one hand, this may be a boon to the U.S. economy, as American firms begin exporting more. But on the other, it will also give American firms more "pricing power," which is to say they'll have more freedom to pass on rising input costs to their consumers.
RISING COSTS
Optimists point out that in the 1990s, rising productivity allowed U.S. firms to absorb rising costs because they could produce more goods with less labour. As input costs rose, labour costs dropped, so one cancelled out the other. This, however, appears to no longer be the case. There is growing evidence that the productivity boom may now be running its course. Cheap American labour may well be a thing of the past.
All in all, I think there is a strong likelihood U.S. inflation will continue rising this year. If that happens, interest rates, which are exceptionally low right now, will likely rise sharply as they catch up to where they should be. A sharp rise in interest rates will likely cause a stock market correction, and possibly even a bust in the real estate market.
That will prove onerous for the US economy. The question then will be whether the rest of the world economy will be able to pick up the resultant slack in U.S. demand. Will Europeans and Asians, armed with their newly-powerful currencies, buy enough U.S. exports to keep the economy out of recession? Europe looks questionable. Asia is another matter.
The problem, though, is that Asian central banks have been intervening to prevent their currencies rising in value against the dollar. If they continue this strategy, the U.S. economy may well be headed for trouble.
In consequence, the U.S. and indeed the world finds itself in an unusual and perhaps uncomfortable position: its economic well-being will be determined largely by decisions taken by Asian bankers, and not American leaders. It is a new experience for the Americans, but one they should perhaps get used to.
John Rapley is a senior lecturer in the Department of Government, UWI, Mona.
