A global malaise in 2006?

By Joseph Stiglitz

Saturday, Dec 31, 2005, Page 9

`For most of this year, Americans behaved as if they didn't really believe that oil prices would remain high, at least for a while.'

The almighty US consumer had another banner year this year, helping sustain global economic growth, albeit at a slower pace than last year. As in recent years, he consumed at or above his income level, and the US as a whole spent well beyond its means, borrowing from the rest of the world at a feverish pace this year -- more than US$2 billion a day.

A year ago, most pundits argued that this was unsustainable. It evidently was sustainable, at least for one more year. But it nonetheless remains true that whatever is unsustainable will not be sustained, which creates great risks for the US and global economy next year.

Two surprises prolonged the good times this year. First, while the US Federal Reserve continued hiking short-term interest rates, long-term rates did not increase in tandem, which allowed housing prices to continue rising. This was centrally important to sustaining global growth, for the performance of world's largest economy has been fueled by real estate in recent years, with individuals refinancing their mortgages and spending some of the proceeds, and with high prices leading to more construction.

But this is unlikely to continue. Long-term interest rates almost certainly will eventually start to rise -- and "eventually" increasingly looks like next year. If so, Americans will have to spend more money on debt service, leaving them with less to spend on consumption of goods and services. Moreover, real estate prices will most likely stop rising rapidly -- indeed, they may even decline. As a result, refinancing of mortgages will grind to a halt, leaving no money to draw out of housing to sustain Americans' consumption binge. On both accounts, aggregate demand will decline.

Is possible that the cash-rich corporate sector will more than make up for the slack by increasing investment? There may well be some increase in gross investment, as obsolete equipment and software are replaced. But there also is some evidence that innovation is slowing -- perhaps the result of reduced investment in research in the past five years.

In any case, even if firms are cash-rich, they do not typically expand investment during periods when consumption is slowing. Uncertainties about the economy are likely to insert an element of caution into companies' investment decisions. In short, it is more likely that moderating investment will exacerbate the consumer slowdown than that an acceleration of investment will offset it.

But this is not the only reason for bleaker prospects for the US and the world next year. The second surprise this year was that while oil prices increased far more than expected, the economic dampening effect seemed somewhat muted in most places, at least until the last part of the year. Because of higher oil prices, for example, the US' spending on oil imports has increased by roughly US$50 billion a year.

For most of this year, Americans behaved as if they didn't really believe that oil prices would remain high, at least for a while. This is less startling than it may appear: econometric studies suggest that it takes a year to two before the full effects of oil-price increases are felt. Now, with futures markets predicting that oil will be US$50 to US$60 a barrel for the next two years, demand for gas-guzzlers has evaporated, taking with it the prospects for US auto companies, whose corporate strategies have bet on low oil prices and the US' love affair with the SUV.

High prices are set to dampen economic performance in the rest of the world as well, although growth prospects look better than in the US. China's growth continues to astound the world; indeed, new GDP data suggest that its economy is 20 percent larger than previously thought. Moreover, China's surging growth will echo throughout much of Asia, including (in somewhat muted form) in Japan.

Europe to be a mixed picture, with the European Central Bank almost perversely raising interest rates even as Europe's economy needs further stimulation to ensure its recovery. As if that were not bad enough, Germany's new government is promising to raise taxes. Fiscal rectitude in the right place and the right time is to be commended; but this is the wrong place and the wrong time -- and Germany's recovery prospects will be dampened.

The main risk next year is that the US' long-brewing problems come to a head globally: investors, finally taking heed of the large structural fiscal deficit, the yawning trade gap, and the high level of household indebtedness, may pull money out of the US in a panic. Alternatively, rising interest rates and a downturn in the real estate market could so weaken consumer demand that the economy slips into recession, squeezing exporters in other countries that depend on the US market.

In either case, the US government, hamstrung by already-wide deficits, may feel powerless to respond with countercyclical fiscal policy. With confidence in Bush's economic management almost as low as confidence in his management of the Iraq war, there is every reason to worry that should one of these crises emerge, it will not be well managed.

But it is more likely that next year will just be another year of malaise: China's significance within the global economy is still not large enough to offset weaknesses in the rest of the world. The US, too, will manage to muddle through again -- leaving even higher levels of debt for the future.

In short, next year will be marked by mounting uncertainty about prospects for global economic growth, even as the distribution of the fruits of that growth remain dismally predictable. In the US, at least, next year is likely to be another year in which stagnant real wages freeze, or even erode, the living standards of those in the middle. And, everywhere, it is likely to be another year in which the gap between the haves and the have-nots will widen.

Joseph Stiglitz, a Nobel laureate in economics, is professor of economics at Columbia University.

Copyright: Project Syndicate