Earlier this week, the Federal Reserve exuded optimism about the short-term outlook for the U.S. economy. On Tuesday and Wednesday, Alan Greenspan took to Capitol Hill and painted an upbeat picture of U.S. economic prospects, arguing that the "prospect for sustaining solid economic growth…are good." Also on Wednesday, the Federal Reserve released its so-called Beige Book, its regular review of economic conditions across the country. In it, the Fed showed that growth in the first few months of the year was solid especially in the following economic sectors – retail, manufacturing, mining, energy, tourism and services.
While we applaud the growth, we are concerned about the obstacles that remain to durable strong growth, if positive policy measures are not taken. Much of the recent growth has depended largely on a housing boom that is significantly affected by rising interest rates. In addition, America's near-record trade deficits, made worse by soaring budget deficits, could discourage investments in the U.S. – investments that are crucial to keeping interest rates down and the economy growing.
Much of the recent economic growth has been driven by an unprecedented refinancing boom. Households took advantage of lower mortgage rates and rapidly rising home prices by refinancing their mortgages. In 2003, households added more than 2 percent to their disposable income from borrowing against the equity of their homes. Thus, mortgage refinancing sustained consumption levels, despite the fact that the recent recovery experienced the worst job market recovery since WWII and households saw few, if any, income gains. However, recent trends in housing are cause for concern in an economy that still has to prove it can sustain job creation. While households had an extra $99 billion to spend in the second quarter of 2003 as a result of the refinancing boom, this amount had shrunk to $47 billion in the fourth quarter. As mortgage rates continue to rise, the amount of cash that is added to households' coffers is likely to decrease. In April, the IMF issued its most recent World Economic Outlook. In it, it warned that higher interest rates could lead to "financial volatility and adversely affect the recovery" in many countries, especially by putting a damper on the housing market.
A number of factors can contribute to higher mortgage rates in the coming months. Among them are fears that the U.S. will not be able to reign in its rampant trade deficit. In 2003, the trade deficit and the broader measure of external imbalances, the current account deficit, reached new record highs. Throughout all of 2003, the trade deficit was well above 4 percent of GDP, and the current account deficit was close to or exceeded 5 percent of GDP. Many countries that experienced financial crises in recent years had substantially smaller external imbalances as a recent study by the Center for American Progress showed.
The external imbalances of the U.S. economy – near record high trade and current account deficits – are especially worrisome in light of high long-term structural budget deficits. As the government continues to borrow large amounts of money, investors may consider the U.S. a less-than-ideal place to invest as long-term interest rates are higher than they otherwise would be, thus slowing economic growth. In other words, "the risk of a fall in confidence by international investors is clearly larger if they have a more pessimistic view about the rate at which U.S. deficits will be reduced," says the IMF. Consequently, less money could find its way into the U.S., potentially putting upward pressure on interest rates in the U.S.
Higher interest rates in the U.S. could potentially result in a number of adverse effects, all resulting in slower growth. The refinancing boom that has sustained U.S. consumption throughout the recession could slow down further. Additionally, the costs of investments would rise, reducing capital outlays by businesses. Also, because of the integration of international financial markets, global interest rates could rise by half a percentage point above where they otherwise would have been, according to estimates by the IMF. This could slow growth abroad, thus putting a damper on U.S. exports, which are already growing at anemic rates due to slow growth abroad and a high value of the dollar.
Policymakers need to keep their eyes on the ball of durable strong growth. Notwithstanding the strong U.S. growth that the Fed describes in its recent Beige Book, the risks to economic growth are real and require policy attention. First and foremost, the labor market, which has so far seen only one good month the past three years, needs to be stronger. To sustain consumption, without relying on an unsustainable refinancing boom households need more well-paying jobs. This could be achieved through the combination of some public policy measures, such as more public investment as well as minimum wage increases. However, public expenditure increases need to be considered in light of the expected fiscal imbalances, requiring a reversal of some of the tax cuts of the past few years to put the U.S. back on a path of fiscal responsibility, while supporting job creation. And lastly, policymakers need to address the looming external imbalances through a number of policy steps, including a stricter enforcement of existing trade agreements. If risks to durable growth are not addressed, recent economic improvements could be short-lived.
Christian E. Weller is a senior economist at the Center for American Progress.