from Follow the Money

What “adjustment” means

February 3, 2008

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Michael Mandel of Business Week:

As of the third quarter of 2007, the 10-year growth rate for consumption was 3.6%, vs. GDP growth for the same period of 2.9%. This difference represents an enormous gap. If consumer spending had tracked the overall economy over the past decade as it has in the past, Americans today would be spending about $600 billion less a year.

Well put. If consumption growth had tracked income growth, the US current account deficit would also be about $600b smaller.

We can debate whether the more rapid growth of consumption in the US fundamentally reflects US policies that stimulated consumption (whether fiscal loosening or low US "policy" interest rates after the .com bubble) or policies outside the US that held demand growth below income growth, freeing up funds to lend to the US. It probably reflected some complicated combination of the two, as policies outside the US that restrained demand growth pushed the US to adopt policies to spur US demand in order to maintain full employment.

Workers leaving tradables production in the US (and manufacturing in particular) had to absorbed elsewhere in the economy.

What is undebatable is that the period when US consumption grew faster than US income allowed the rest of the world -- and particularly the emerging world -- to export more than it imported. The result: a rise in the emerging world’s aggregate surplus that closely mirrors the rise in the US deficit.

Asia and the oil-exporters would not be simultaneously able to run large surpluses if US consumption growth had tracked US income growth. Instead, over the past ten years, the US saved less, allowing it to buy more.

Adjustment -- real adjustment -- requires a sustained period when US consumption grows more slowly than the overall economy. That would lead US savings to rise, and reduce the United States need to borrow from the rest of the world. That change, in turn, implies that consumption outside the US would need to grow more rapidly than income. The rest of the world will no longer be able to draw on US demand to support growth; rather, the US will need to draw on global demand to support US growth.

That will be a big change. It started in 2007. Consumption growth still exceeded GDP growth (2.9% v 2.2%). But the sharp fall in residential investment led US demand to grow more slowly than US income, and reduced the growth in US imports below the growth in US exports (2% v 7.9%). The BEA data clearly shows that the improvement in the current account deficit came from the fall in imports, not an increase in the pace of export growth. Real export growth was actually a bit slower in 2007 than its 2004-2006 average.

Martin Wolf is worried that the current US policy mix -- expansionary fiscal, expansionary monetary policy -- will work too well. He notes that global adjustment requires policies that stimulate demand in the surplus countries -- not policies to stimulate demand in the deficit country. And right now, the global policy mix is weighted too heavily toward demand stimulus in the deficit country.

He has a point. Though I spent enough time with Dr. Roubini to think that the current American policy response is needed to prevent too sharp a fall in US demand, and too quick a retrenchment by credit constrained households that can no longer borrow against rising home values.

Nonetheless, it would be mistake for the world -- after the US and the world work through their current economic difficulties -- to go back to the old habits that Dr. Mandel vividly illustrated.

US consumption needs grow more slowly than US income for a while. And in the emerging world, consumption will need to exceed income growth.

UPDATE: Peter Goodman of the New York Times takes on a similar theme. 

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