D.C. Dispatch January 17, 2006

The risks to the U.S. economy are a lot bigger than most people, and most governments, seem to believe.

A Seasonal Shot of Necessary Gloom

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If it's the first Wealth of Nations column of the new year, it must be time for the customary warning about dangerous "imbalances" in the world economy. Yes, one's heart sinks at the prospect—there is no need to say that the credibility of such long-repeated warnings has fallen almost to zero—but somebody has to do it. As the president would say, it is hard work, so make allowances for that as well. The economy refuses to cooperate: It just keeps growing, with low interest rates, low inflation, and next to no unemployment. What could be better? Other countries would love to have America's economic problems.

Things look so good that Democrats are struggling to convey disappointment and anxiety. Assorted experts and commentators insist on pointing up the dangers—but they do that, don't they?

We dealers in seasonal gloom, if we are doing our jobs properly, labor under another difficulty. As this column likes to remind readers, there is no certainty that things are going to go badly wrong. This is an annoying complication, but the fact is that things are very rarely programmed that way. After the event, people tend to believe that things had to turn out the way they did. But history is not preordained, and economic history is no exception. The role of contingency—of plain luck—is greatly underestimated.

It sounds like an evasion, but in thinking about America's economic outlook, the intelligent question is not, "What will happen?" One cannot know for sure (though apparently there is money in pretending to). The question is whether people are adequately apprised of the risks—whether they are more optimistic about the economic outlook, both for the country and for themselves, than they ought to be. And the answer is that the risks are a lot bigger than most people, and most governments, seem to believe.

The first step is to understand that the pattern of this present expansion, both in the United States and in the world economy as a whole, is extremely odd. The main peculiarity is the combination of: A) America's voracious appetite for foreign capital, and B) low interest rates. Household saving in the United States is roughly zero; and the government is a net dissaver—still borrowing heavily, despite the growth in revenues collected from a growing economy. The country is therefore having to import capital from the rest of the world, and at an unprecedented rate.

You would normally expect this demand for capital to push up the price of capital (interest rates). And this, if it happened, would cause problems—in local housing markets, for instance, where prices have soared partly because interest rates have been so low for so long. If interest rates were as high as one might expect them to be, given America's demand for foreign capital, company and consumer spending would be hit as well. All of a sudden, we have plenty to complain about.

So it is good, though very strange, that world interest rates are so low. Why are they so low? And will those helpful conditions last?

Some would answer that money has stayed cheap because the Federal Reserve Board ordained that it should be so. And this is true, up to a point. The Fed can control America's short-term (not long-term) interest rates, and America's rates have a big influence on global short-term rates. Politicians and pundits who believe that there is nothing to worry about focus on this point. This situation cannot turn sour, they believe, so long as the Fed keeps interest rates down. And in keeping interest rates low, they assume, the Fed is unconstrained: As long as it does not get itself into a lather about the (imaginary) risk of inflation and just resolves to keep interest rates down, all will be well, regardless of how much America is borrowing from abroad.

This is wrong. The Fed is much more constrained—by necessity, much more passive—than the optimists believe. If the global capital market should tighten, putting pressure on global interest rates, and the Fed then tried to resist the implications of that for the domestic economy by lowering America's short-term rates, the dollar would very likely fall. A gradual dollar decline would be all right—welcome, in fact—but a steep, sudden drop, which is a real possibility, would threaten to raise prices and force the Fed to think again. To keep inflation in check, it would be forced to push interest rates up, despite the bad consequences.

In short, the Fed is not in a position to underwrite an indefinitely extended expansion based on heavy external borrowing. The key questions therefore remain: Why has the global capital market remained so benign, and will this situation last?

There is no simple answer to the first question. Whether any particular country is, on balance, supplying capital to, or demanding capital from, the rest of the world depends on many factors. China's saving has recently been colossal—on the order of 50 percent of gross domestic product. But its rate of investment has not been much less, at about 45 percent of GDP. So China's net contribution of capital to the rest of the world, while still large, is not as vast as it is sometimes made out to be. If China began to save less, and maintained its remarkable rate of investment (an admittedly improbable scenario), then this would surely have a big impact on the global capital market—and not for the good, so far as global interest rates are concerned.

Many other relatively poor economies are saving a lot, relative to what they are investing (a further oddity, since investment opportunities in such countries ought to outstrip locally available capital). In Europe and Japan, confidence is weak and investment is lower than you would expect under current circumstances. The high saving of many poor countries, combined with weak investment in many rich ones, is helping to keep the global cost of capital low. As a result, for the time being, America can borrow what it needs without forcing interest rates higher.

While this cannot last indefinitely—the United States cannot keep adding to its foreign debt at the present rate without limit—one cannot be sure when, or how abruptly, the pattern will change. Some modes of adjustment would be much easier for the United States to live with than others. A flight from dollar assets, on fears of an impending fall in the currency, might spur a worst-case scenario: Fears of a weaker dollar would become self-fulfilling; interest rates would have to rise, to brake the currency's decline and curb any consequent inflation; the housing market and Wall Street would be very much at risk.

A more gradual adjustment based on a revalued renminbi and faster growth in Europe and Japan would be easier to contend with—though this prospect also carries the danger of higher global interest rates (because it would diminish the rest of the world's surplus of capital over investment). Higher American saving—by households and by the government—would be especially helpful in that regard, narrowing the gap between saving and investment in a way that would put downward, not upward, pressure on the cost of money.

A globally coordinated plan to stabilize the world economy along such lines is unlikely to happen until we are perceived to have reached a crisis point, and quite possibly not even then. So the Bush administration, instinctively and often rightly unilateralist in any case, should be urgently examining the steps it can take by itself to tilt the balance of economic risk in the right direction. The obvious sensible step is the one already mentioned—the single action that is most likely to lessen the financial risks just discussed and that is, it so happens, in the power of Congress and the administration to take without requiring any other country's cooperation or agreement: Reduce the budget deficit.

If the government cut its spending and/or raised more in taxes, its own demands on the capital market—currently running at more than 3 percent of national income, and otherwise expected to rise—would decline. That would push global capital markets back toward balance, which would be good for the country, and do it in a way that lessened the pressure for higher interest rates instead of adding to it.

You knew that was coming, of course. Indulge me. Since this was the first Wealth of Nations of 2006, it also had to include a summons to fiscal responsibility. A depressing and meaningless ritual, you say, a folk-custom that has outlived its usefulness? One of these days (in January 2007 if not sooner) I might remind you of that.

Clive Crook is a senior editor of The Atlantic and a columnist for National Journal. This column appears every other week in National Journal, a weekly magazine covering politics and government published in Washington, D.C.