FIZZLE? AUGUST STEPHEN ROACH

There is nothing like the seduction of a boom. The recent vigour of global economic growth is a siren song. By International Monetary Fund metrics, world gross domestic product growth probably averaged 4.8 percent over 2003-06, the strongest four years since the early 1970s.

As tempting as it is to extrapolate this into the future, that may be a serious mistake. There is a much better chance that global growth has peaked and the boom is about to fizzle.

The world’s main growth engine, the US, is slowing. That is the verdict from the labour market, with job growth in the past four months running 35 percent below average since early 2004. It is the verdict from the housing market, where an emerging downturn in residential construction activity is knocking at least 1 percentage point off the GDP growth trend of the past three years. And notwithstanding July’s temporary bounce-back in retail sales, it is a message from the consumer, whose inflation-adjusted spending growth fell to 2.5 percent in the spring period – one percentage point below the heady trend of the past decade.

America’s slowdown represents an important transition in the sources of economic growth, away from the vigorous wealth creation of asset bubbles – first equities, then housing – and back towards more subdued labour income generation. The delayed impact of higher interest rates is also taking a toll. Even though the Federal Reserve has put its two-year monetary tightening campaign on hold, there is a risk it has already gone too far. The confluence of higher energy prices, rising debt-servicing burdens, and negative personal saving rates reinforces the possibility of a pullback in discretionary US consumption and GDP growth.

This is an equally critical transition for the global economy. The world is about to lose significant support from the key driving force on the demand side of the equation – the American consumer. In a post-bubble climate, US households will be unable to save through asset appreciation, prompting America to increase income-based saving and reduce its claim on the pool of global saving. That points to a long-awaited reduction in the big US current account deficit – initially painful for export-dependent economies elsewhere in the world but ultimately a welcome resolution for global imbalances.

But who ill fill the void as the US consumer pulls back? The simple answer is; maybe no one. Europe, the world’s second largest consumer, is an unlikely candidate. Surprising economic growth on the Continent this year may be borrowing from gains that might have otherwise occurred in 2007. The European economy is about to be hit with a “triple whammy”: a big tightening in fiscal policy, the delayed impact of monetary tightening, and the drag of a stronger euro. Growth in the eurozone may exceed 2.5 percent this year, marking the strongest gain since 2000. Next year, it could slip back below 1.5 percent.

Do not count on a rejuvenated Japanese economy to fill the gap either. In dollar terms, Japanese personal consumption is only 30 percent of that in America; that means every 1 percentage point of slower consumption growth in the US would have to be replaced by about 3 percentage points of acceleration from Japan. As a weak second quarter GDP report indicates, such a surge is unlikely, especially as Japan copes with a stronger yen and higher energy prices. While growth in Japanese GDP should exceed 2.5 percent this year, in 2007 it could slow to less than 2 percent.

Nor are the two dynamos of developing Asia – China and India – likely to counter the slowing trend in the developed world. China has a seriously overheated economy. With real GDP surging at an 11.3 percent annual rate in the spring period and industrial output growing at a record 19.5 percent year on year in June, Beijing has little choice but to introduce tightening initiatives. A failure to do so could see trade protectionism squeezing exports and a deflationary overhang of excess capacity leading to an investment bust. China must shift its economy towards private consumption, a sector that sagged to just 38 percent of GDP in 2005. (A healthy rate would be at least 50 percent.)

All this points to a moderation of China’s growth beginning in 2007, with attendant reductions in its voracious appetite for commodities. That should spawn additional ripple effects in commodity producers such as Australia, Canada, Brazil and Africa. The world’s big oil producers would also feel repercussions from a Chinese slowdown. As would China’s Asian suppliers, such as Japan, Korea and Taiwan.

India is far too small to pick up the slack – less than half the size of China on a purchasing power parity basis. After more than 15 years of reforms, its growth has broken out to the upside – averaging 8 percent in fiscal years 2004-5. There was hope that a rebalancing from services to manufacturing would provide new impetus to growth, and the government seemed willing to tackle deficiencies of infrastructure, foreign direct investment, and saving. Unfortunately, the reformers have been stymied by the politics of coalition management. Imperatives of fiscal consolidation, with the delayed effects of recent monetary tightening, could also tip growth risks to the downside.

There is a deeper meaning to the coming slowdown. The global boom of the past four years was never sustainable. It was supported by the excesses of the liquidity cycle, which arose from emergency anti-deflationary actions of the world’s big central banks. The ensuing vigour of global growth was dominated by the US consumer, but America’s binge came at the cost of a record drawdown of domestic saving funded by the capital inflows of a record US current account deficit. The boom was balanced precariously on unprecedented global imbalances.

Excess liquidity bought time for a precarious world. As central banks move to normalise monetary policy, that time has run out. Without the unsustainable support of asset bubbles, it is back to basics – with aggregate demand supported by more modest labour income generation rather than the excesses of wealth creation. So much for the artificial boom of an unbalanced world. It could be about to fizzle out.

Note: This appeared as an editorial feature in the 14 August 2006 edition of the Financial Times.