Over the last decade the global economy has been on a dynamic path with ever-increasing US current account deficits financed by emerging market surpluses. This report argues that the forces driving this development are now abating and might even reverse soon, forcing an adjustment in asset markets and the global economy. The global supply of savings is likely to shrink soon, with investment in emerging markets growing strongly and consumption in oil rich countries adjusting gradually to the windfall from high oil prices. This combination should lead to higher real interest rates and a cooling of the housing price bubbles that have developed in many areas; with asymmetric effects on the US economy which should slow much more than the eurozone. A gradual resorption of the US external deficit is thus possible without a crash of the USD.
The key issue for this gradual adjustment is whether US policy-makers will accept a prolonged period of weaker growth, because a reduction of the growth rate in domestic demand by about 1 percentage point over several years is a conditio sine qua non for a reduction in the US external deficit towards more sustainable levels. Since this lower US growth will likely drag down global growth, a cautious approach to the reduction of the US current account deficit is likely, with the adjustment taking place over a few business cycles. If, however, the process is unduly delayed by US policies resisting this necessary slowing down of domestic demand growth or by the rest of the world failing to pick up the baton, the odds of a disorderly adjustment will increase dramatically. In fact, it is extremely important that the US deficit starts shrinking soon in light of the report’s finding that the underlying external financing needs are probably even larger than officially reported.