Global economy rebalancing the hard way

By Emily Kaiser - Analysis

WASHINGTON (Reuters) - The credit crisis is accomplishing something that years of scolding failed to do: curbing U.S. consumption and paring the piles of excess cash amassed in China and oil exporting countries.

While economists have long argued that such a rebalancing was badly needed to safeguard global growth, it is happening so fast that it threatens to deepen the downturn.

In a perfect world, debt-laden U.S. households would gradually build up their savings as China redirected some of its wealth toward faster domestic growth, while the global economy kept growing at a sustainably healthy clip.

Instead Americans, who lost nearly $3 trillion in wealth in a single year, have curbed spending at the sharpest rate on record, China's exports are falling faster than its economy can adjust, and a global recession looks increasingly likely.

World finance leaders who are debating how best to put public money to work to limit the economic fallout must walk a fine line with ugly consequences on either side. Do too little to boost growth and the recession deepens. Do too much and the cycle of easy borrowing and spending that contributed to the credit crisis could start all over again.

"Clearly, we don't want our consumers to be over-levered and coming back to a more normal savings rate is an appropriate process," said Neel Kashkari, the U.S. Treasury official who oversees the government's $700 billion financial rescue fund.

"The challenge for policy-makers and for legislators is we don't want that correction to happen too quickly where it becomes destructive to the economy as a whole and we suffer grave economic consequences."

That is precisely why the U.S. Federal Reserve, Treasury and many of their counterparts around the world have committed trillions of dollars in public funds to counteract the worsening recession.

HOW DID WE GET HERE?

Backed by cheap and abundant credit, U.S. consumers ramped up borrowing over the last decade to fund a spending spree that helped drive a surge in global growth.

The side effect was a mounting U.S. current account deficit and swelling surpluses elsewhere. Many economists warned that it was only a matter of time before the pattern reversed and wreaked havoc on the world economy.

Indeed, until the financial turmoil struck in 2007, the International Monetary Fund viewed that imbalance as one of the biggest threats to economic stability, if not the biggest.

"Economic downturns are often driven or exacerbated by the elimination of unsustainable imbalances in the real economy. This cycle is no different," Citigroup economists wrote in their 2009 annual economic outlook.

Data released this week suggests the reversal may be happening far faster than policy-makers would like, putting pressure on them to come up with an even stronger response.

U.S. household borrowing declined in the three months that ended in September, the first quarterly drop in Federal Reserve records dating back to 1952. Household wealth as of September was down $2.8 trillion, or 11 percent from a year earlier -- a big reason why consumer spending is slipping.

China's November exports dropped unexpectedly, posting the biggest year-over-year decline since April 1999.

Oil prices have fallen by about $100 per barrel since July. At the current level of just under $50, countries including Kuwait and Saudi Arabia may have to dip into reserves to balance their budgets, according to figures from the Institute of International Finance.

The IIF thinks the current account surplus in the Gulf Cooperation Council countries, which includes many of the world's largest oil exporters, will shrink to $48 billion next year from an estimated $321 billion this year.

WHERE TO NOW?

With U.S. consumer spending, oil prices and Chinese exports all declining in tandem, the pieces are in place for the gap between debtor and creditor nations to narrow.

It may be necessary, but it won't feel very good.

Merrill Lynch economist David Rosenberg said the slide in housing and stock markets will force U.S. consumers to step up savings, prolonging the recession through the end of 2009.

"The buy now, pay later days are largely gone," he said.

That may pile pressure on U.S. President-elect Barack Obama's administration to up spending even more. If they overdo it, they could end up stalling the rebalancing and laying the groundwork for another bout of boom and bust.

To be sure, this is a longer-term worry for officials who have every reason to be preoccupied with solving the crisis at hand. But for investors who missed the warning signs of this financial upheaval, it may pay to monitor whether today's efforts are in fact striking the right balance.

The best scenario may be a long, drawn out recovery that irons out the imbalances and gives policy-makers enough time to gradually wean the global economy off of government money.