Global Malaise in 2006?

The almighty American consumer had another banner year in 2005, helping sustain global economic growth, albeit at a slower pace than in 2004. As in recent years, he consumed at or above his income level, and the United States as a whole spent well beyond its means, borrowing from the rest of the world at a feverish pace in 2005 – more than $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 in 2006.

Two economic surprises prolonged the good times in 2005. First, while the US Federal Reserve continued hiking short-term interest rates, long-terms 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.