Wealth of Nations January 2006

A Seasonal Shot of Necessary Gloom

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

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.

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