Nikkei Business., 14th December 2005

US consumption has been the driving force for the world economy since the recession of 2001. As the US household savings’ rate has fallen to zero, this is bound to change. Consumption is still robust, but will falter once savings rise. House prices are the key to savings. When they rise, Americans get richer, without having to save. Once they stop, the need to save will become increasingly obvious and consumption will weaken.

The prolonged rise in US house prices may now be coming to an end, but the evidence seems to vary from month to month. Sometime during 2006, however, a slowdown is likely. This is because a continued rise will start to have an impact on inflation. Interest rates are thus likely to keep rising until house prices stabilise. As UK experience shows, the end of a housing boom need not be followed by a crash. But the UK also shows that savings tend to rise within a few months after house prices stabilise.

As the US economy slows, demand in the rest of the world needs to pick up. The ideal situation is one in which a slowdown in US domestic demand is exactly balanced by a rise in the rest of the world. Such a smooth adjustment is rare, but there are some encouraging signs that it might happen this time.

The world economy continued to grow well in 2005, overcoming two important negative factors. These were the rise in the oil price, which caused a huge rise in OPEC’s net exports, and a bout of relative weakness in China’s domestic demand, which had a similar impact on China’s net exports.

The poor quality of Chinese data means that there is even greater uncertainty about the state of that economy than there is over those of America and Europe. But some improvement in domestic demand in China is indicated by both retail sales figures and imports. Next year OPEC countries should also start to spend more. The past pattern has been for their spending to catch up with increases in oil prices with a time lag. As it is now more than two years since the current rise started, the benefits of improved demand from OPEC should be felt in 2006.

In Europe the picture is mixed. In the Eurozone there are signs of demand picking up, while the UK remains weak. The overall pattern therefore is one in which some weakness in US consumer demand is likely next year, but it could well be offset by improved demand in China, OPEC and the Eurozone. It is very important for Japan that this balance continues, as the economy remains fundamentally dependent on exports, as the recent flat data on consumption shows.

If this balance can be achieved, it promises to help with one of the major imbalances in the world economy, which is the large US current account deficit. This looks easier in general terms than it is likely to prove in practice. In broad terms, the balance looks reasonably straightforward. All that is needed is a rise in US net exports, which exactly matches the rise in US household savings and a fall in the rest of the world’s net exports, which exactly matches the rise in domestic demand outside the US.

While this is far from simple, as there is no automatic system in place to help, there are additional problems to be overcome. If a rise in US net exports is to occur without a US recession, there needs to be a change in the amount and direction of US investment.

The supply of goods and services needed to match the growth of US demand has, in recent years, come from both domestic and foreign sources. Foreigners have provided much of the goods, while domestic sources have satisfied needs that cannot be imported, such as health and retail services. If demand weakens in the US, these so-called “non-traded goods and services” cannot be exported. The US will need therefore to switch its output from non-traded to traded goods.

This sort of switch requires incentives, money and time. The key incentive is for the profitability of traded goods to improve, relative to non-traded ones. For this to happen, the dollar will have to weaken and this will create many additional problems, such as increased inflationary pressure. As time is also needed, it will be important that the required changes in international demand should take place slowly. Rapid change is unlikely to be smooth.