The global locomotive loses steam

May 3rd 2005
From The Economist Global Agenda

For several years, America—and particularly the American consumer—has been powering global economic growth. Now, however, the locomotive seems to be losing momentum. Estimated GDP growth for the first quarter was a disappointing 3.1%, and other indicators look decidedly soft

IN CERTAIN quarters in America, a dreadful word is once again being whispered. “Stagflation”, that puzzling combination of high inflation and economic stagnation, was once thought impossible. The 1970s disproved that painfully, but most thought the phenomenon had been banished when the government got a firmer grip on fiscal and monetary policy. Now, however, all the economic data indicate that America has hit another economic soft patch, even as resurgent inflation begins to nibble at purchasing power and push the Federal Reserve to raise interest rates. Higher oil prices, gaping foreign-exchange imbalances and disappointing jobs data—could the dark days of the 1970s be returning?

Hardly. Economic growth, 3.1% for the first quarter, according to an estimate released on Thursday April 28th, may not be quite as fast as the nation has got used to (see chart). But it doesn’t compare to the economic era between the first oil shock in 1973 and the successful assault on inflation by Paul Volcker, the then Fed chairman, in the early 1980s. That period saw three recessions, double-digit inflation and unemployment mostly in the 6-10% range. Now, America is seeing moderate GDP growth, moderate core inflation (3.3% for the three months to March) and a 5.2% unemployment rate. Even oil prices are less painful than in the bad old days: in real terms, they were nearly twice as high in the 1970s.

But if the hour of doom is not quite at hand, there are still good reasons to worry. Though a 3.1% growth rate would be envied in most European countries, it is probably still below the natural rate at which America’s economy can grow without touching off inflation; that rate is estimated to be 3.5-4%. The rapid pace of America’s economic recovery, and its voracious appetite for imports, have been among the strongest pillars underpinning global growth in recent years. Of the other big economies, only Britain is in relatively good health; France, Germany and Japan are ailing. But should America falter, Britain’s economy is neither big enough nor sufficiently import-hungry to take up the slack.

So far, America’s consumers have saved the day, spending big even through recession, high oil prices and a costly war in Iraq. But to do so, they have taken on a lot of debt, drawing down home equity and piling into credit cards. Low interest rates have kept their monthly payments modest, even as their debt has shot up. But as interest rates rise—on Tuesday, the Fed was expected to agree an eighth successive quarter-point increase in its federal funds rate, to 3%—this well of consumer demand seems to be running dry. Moreover, payments on credit-card debt and adjustable-rate mortgages will squeeze consumers when interest rates increase further, as most economists reckon they will.

By this stage in the economic cycle, the job market should have been taking the slack, boosting consumer confidence—and incomes. But though the slowdown of 2000-01 did not feature the heavy job losses common in earlier slowdowns, employment figures have not yet picked up as they should. Though the unemployment rate has remained surprisingly low throughout, this is deceptive. It stayed low partly because of a big rise in people who had given up looking for work.

The number of people claiming disability benefits has also increased; these are no longer counted in the labour force. A better measure of the employment picture is payrolls, which only surpassed their February 2001 peak in January of this year. Since the working-age population has grown over those four years, this means the jobs picture is still decidedly troubling.

The most likely explanation for sluggish recovery in payrolls comes from Erica Groshen and Simon Potter of the Federal Reserve. They argue that while most unemployment in earlier slowdowns was cyclical—firms laying off employees who would then get their jobs back (or ones very like them) when the economy picked up—in the last two it has increasingly been structural, meaning that people need to switch sectors, locations or skills in order to find a job. Since it takes much longer to do the latter, payrolls are not rebounding as they used to.

No longer shopping till they drop

Already, the numbers show that consumer spending is weakening, with growth falling to 3.5% in the first quarter from 4.2% in the previous one; the latest figures show consumer confidence down sharply. Further moderation is expected, as high oil prices and rising debt payments curtail disposable incomes. There had been hope that businesses would step in to help, but the latest figures make that unlikely. Inventories rose sharply in the first quarter; if goods that were stockpiled rather than sold are left out, GDP grew by only 1.9%. In April, manufacturing activity grew at the slowest pace since July 2003. And durable goods orders fell in March for the third month in a row, with a particularly sharp fall of 4.7% in non-defence capital goods, an indicator of business-investment levels. Shipments of those goods also fell. With less capital equipment, and inventories piling up in their warehouses, companies seem set for lower production in the months ahead. That, in turn, will make the jobs outlook less sunny.

There are other clouds on the horizon. Though the impact of higher oil prices has probably already made itself felt, this could change if oil prices rise. Though inflation remains moderate, it is still high enough that the Fed will need to control it by raising interest rates, even if growth is slowing down. And there are also worries about America’s increasingly frothy housing market and surging current-account deficit.

Still, if the future looks darker than the recent past, this may be because in many ways the recent past has been unusually bright. While Alan Greenspan, the Fed chairman, did not quite engineer the “soft landing” that many had hoped for at the height of the boom, he has presided over a slowdown that could barely be called a recession, and a quick recovery. Cheap Chinese imports have helped America avoid the high inflation that would otherwise have been the natural result of the extremely low interest rates enjoyed since 2001. Those low rates have also enabled Americans to increase their spending without increasing their incomes. Tax cuts, financed by foreign investors who buy American bonds at bargain rates, have even put a little extra money in their pockets. After such halcyon days, it is undoubtedly hard to return to modest growth and consumer spending. But barring an oil shock or some other external crisis, Americans can keep their bellbottoms in the wardrobe.

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