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The world economy is enjoying a glorious run. In 2003, 2004 and 2005, it had its best years since the early 1970s. Yet that is no encouraging parallel. The torrid expansion of the early 1970s led to a period of inflationary turmoil. We must ask whether the extraordinary growth of recent years also hides dangers – different, perhaps, but still significant. The answer, alas, is yes.

The world economy confronts a test: that of managing a decline in the huge excess of US household spending over incomes.
Martin Wolf, Financial Times September 27 2006

This excess of savings over investment in the rest of the world is not the result of high US or global real interest rates. On the contrary, real interest rates are astonishingly low.

US policymakers is to keep domestic demand at the level needed to sustain high levels of domestic economic activity, in spite of huge current account deficits. Currently, these policymakers must keep demand some 7 per cent above full-employment levels of output.

They have only two vehicles: government and private financial deficits (excesses of spending over income).

The dominant element has been the gigantic and unprecedented US household financial deficit.

The current housing slowdown may, however, induce households to reduce their spending sharply. HSBC tells precisely this story in a thought-provoking recent report (Tripping Up: the End of the US Economic Upswing, September 2006).

The argument, in essence, is that the loose monetary policy after the collapse of the bubble economy in 2000 promoted a housing-led consumption boom that is at last coming to an end.

Since imports are only about one-sixth of US gross domestic product, a reduction in household demand would improve the external deficit only a little.
But the economy would slow and unemployment would rise.

A big rise in corporate investment in the US seems implausible if the economy slows.

What we are discussing then is the possibility of a disorderly unwinding of the external deficits, the trigger being a sharp slowdown in US household demand that would stimulate domestic pressure for both a currency realignment and protection.

If US domestic demand weakened a big correction of the external deficit is exactly what most Americans would want, since that would be preferable for them to a domestic recession. They would wish to export their slowdown.

The world economy confronts a test: that of managing a decline in the huge excess of US household spending over incomes.

Will it be able to manage this easily?
The answer is: only if others are able and willing to expand demand substantially, in their turn.

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