Hope and Danger in the U.S. Economy


The U.S. is growing briskly, China is booming, and Japan is finally headed for a prolonged period of economic expansion. Even the euro zone shows some signs of life. As a result, economists predict, the world economy will grow by 4.3% this year, up from 3.4% in 2003 and 2.9% in 2002. No wonder many attendees at the World Economic Forum (WEF), which kicked off in the fashionable Swiss ski resort of Davos on Jan. 21, are in relatively optimistic mood.

"I'm bullish about the U.S. economy, and because the U.S. is the world's locomotive, I'm bullish about the global economy," says Jacob A. Frenkel, chairman of Merrill Lynch International (MER). America's expansionary monetary and fiscal policies are driving the entire world forward, Frenkel argues. "U.S. policymakers have acted quickly and flexibly enough to get the country out of the bind and go forward," he asserts. "As a result, the appetite of investors and business for risk has returned. Things have become more dynamic."

"RUNNING ON FUMES." Still, some economists in Davos are concerned that the global recovery is threatened by huge imbalances in the U.S. Those include more than the vast current-account and government deficits, which are expected this year to top 4.9% and 4.5% of gross domestic product, respectively. "There is the rapid depletion of savings and the rising tide of private indebtedness," says Morgan Stanley Chief Economist Stephen S. Roach. "The engine of the global economy, the U.S., is running not on gas but on fumes -- on little more than tax cuts and borrowing."

Consumer demand is still strong in the U.S, but it's decidedly anemic in most other countries, which rely on their exports to the U.S. for growth. And it means America runs a vast balance-of-trade deficit that it relies on foreign investors, most notably Asian central banks, to finance.

That could cause problems if Asian central bankers, especially the People's Bank of China and the Bank of Japan, lose their appetite for U.S government securities. Indeed, they may lose it eventually if U.S. interest rates stay low, and the returns they get on their dollar-denominated assets remain minimal. The result could be a plunging dollar, turbulence in the currency markets, and growth-squeezing interest rate increases.

STILL BUYING AMERICAN. "The imbalances could eventually cause disruption in the financial markets," warns Laura D. Tyson, dean of the London Business School and a former chairman of the Council of Economics Advisers (as well as a columnist for BusinessWeek). "And the threat is growing. U.S. government spending is growing at six to seven times the rate it grew at under the previous Administration."

Of course, Federal Reserve Chairman Alan Greenspan argues that the current-account deficit isn't much of a problem because foreign investors are eagerly buying U.S. assets even though interest rates are at their lowest level for decades. And figures released by the U.S. Treasury on Jan. 16 seem to support his point of view. They showed that last November, foreigners bought $87.6 billion more U.S. securities than they sold. That amount is more than twice as much as the U.S. needed to finance its $38.1 billion trade deficit that month.

At the same time, the trade gap seems to have stopped growing in recent months. In November, it actually narrowed for the first time in months.

"CHASING THE MOMENTUM." The lion's share of the capital flowing into the U.S. is invested in Treasury bonds and notes by Asian central banks. They need to buy dollar securities to keep their currencies from rising against the greenback and maintain the competitiveness of their exports in the U.S. Asia's central banks now own more than $1 trillion of U.S. government paper.

However, Greenspan can also take comfort because the November statistics show that foreign private investors -- especially European institutions -- have also moved heavily back into the U.S. In particular, foreign private investors bought almost $9 billion of U.S. equities after selling $1.2 billion in October and $6.2 billion in September.

What's attracting the Europeans? Strong economic growth Stateside and the superior profitability of U.S. companies. "People are chasing the momentum in earnings," says Richard Lacaille, chief investment officer at State Street Global Advisors in London. "If you look at U.S. companies, there has been much sharper growth in earnings per share, better productivity growth, and a more supportive environment in terms of monetary policy."

Maybe. But markets have a habit of changing course at breakneck speed. And even the bullish Frenkel accepts that the U.S. trade deficit is "one of the most dangerous problems" facing the world economy. "But that won't be resolved until the budget deficit is reduced," he says. "And that's not going to happen in a U.S. election year." ByDavid Fairlamb in Davos, Switzerland


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