THE HOLIDAY SEASON has suffused the stock market, which has bubbled exuberantly to its highest level in 3 1/2 years. Americans who own stocks can count themselves a bit richer, which means they can spend a bit more freely, which means that corporate profits will brighten -- which means that the stock market might just keep heading up. But this perpetual motion machine has a flaw in its engine. The more it accelerates, the nastier the potential consequences if it seizes up.
The flaw is that American consumption is based on borrowing: People are spending money that they don't actually have. The nation's net borrowing from foreigners has risen to a massive 6 percent or so of gross domestic product, up from 4 percent in 2000, a level that was then considered dangerously high. The more consumers fling credit cards around this holiday season, the bigger will be the savings deficit -- and the greater the crunch if foreigners tire of lending the money needed to keep the machine humming along.
Raghuram Rajan, the International Monetary Fund's chief economist, discussed this conundrum recently in the (London) Financial Times. As an international civil servant, he sought not to be alarmist: America's unsustainable dependence on foreign savings could be corrected, he argued, so long as global policy took three sensible steps. Europe and Japan should boost growth through a mixture of structural reforms, lower interest rates and budget deficits: This would suck in extra U.S. imports, boosting American incomes and so cutting the country's dependence on loans. China and Southeast Asia should allow their currencies to rise against the dollar, so boosting U.S. competitiveness: Again, higher U.S. earnings would cut the need to borrow. The United States, for its part, should raise its savings rate by shrinking its budget deficit.
This anti-alarmist prescription is not terribly comforting. Europe and Japan may lack the political will to carry out the structural reforms necessary to boost growth. East Asians may choose to keep their currencies weak against the dollar to boost exports. And the Bush administration shows few signs of tackling the budget deficit. Despite President Bush's talk of halving it over five years, he faces large bills for the Iraq war but refuses to reconsider his enthusiasm for tax cuts.
Mr. Bush declares that his tax cuts are fueling the economy and that reversing them might slow it down. But this defense, like the stock market's holiday exuberance, seems disconnected from reality: To correct its addiction to foreign borrowing, the United States actually needs a mild economic slowdown. If savings have to rise, consumption has to fall commensurately, and lower consumption will mean lower economic growth. Mr. Bush can effect this transition smoothly via government policies -- if not by raising taxes, then perhaps by requiring extra individual savings in private accounts (those savings would have to come on top of any diversion of Social Security taxes). Or he can look the other way and wait for the markets to force an economic slowdown in their own way, and at a time that no one can predict. That latter course, which would involve a further fall in the dollar and a jump in long-term interest rates, could be considerably more painful.