Business Outloook: How the Global Economy Is Rebalancing

Looking back, it seems so clear: The wildly lopsided global economy was headed for trouble. By 2006 the U.S. trade deficit had ballooned to 6% of gross domestic product, a gap comparable to those of some Third World countries, except that the U.S. accounts for 21% of world GDP. Imports flooded ashore and dollars rushed abroad, greatly inflating trade surpluses overseas. In return, foreign currencies poured in, providing the capital America needed to finance its credit boom and devil-may-care consumption.

The worst U.S. recession since the 1930s has been a cruel way to rebalance the world economy, but it's working. Through the second quarter the trade deficit had fallen to 2.4% of GDP, and America had cut its need for foreign capital by 56%. Now comes the hard part: holding on to or maybe extending that progress as a U.S. and global recovery takes hold.

The July trade report was good news for the near-term outlook, but it also suggested the road to rebalance will not be easy. A third consecutive monthly rise in exports showed the global recovery was gaining steam, and the second month of higher imports implied firmer U.S. demand. But the monthly deficit widened by $4.5 billion, the most in a year, to $32 billion, as a jump in imports overtook a strong gain in exports.

So, here we go again? Not necessarily. In the past, the trade deficit has typically widened sharply in a recovery, as the U.S. turned up in advance of other economies, causing imports to run ahead of exports. This time—with the global stimulus efforts kicking in and the financial markets healing—Asia, the Americas, and Europe are all accelerating together. A synchronized rebound will lift world trade broadly, much to the benefit of U.S. exports. At the same time the rebound in U.S. spending will be muted by tight credit and heavy consumer debt, limiting import growth and restraining the trade gap.

The global recovery is already starting to power U.S. exports. Shipments of goods, adjusted for inflation, rose at a 14% annual rate in the three months through July, after collapsing last autumn. Exports of industrial materials and capital goods, especially to emerging markets, account for the lion's share of the recent growth.

Export strength should broaden as developed economies—including Europe and Canada, which buy a third of U.S. exports—shift from recession to recovery. Economists say growth of key U.S. trading partners picked up to about a 4% annual rate last quarter, and they expect that pace to continue in the second half. The August index of export orders from the Institute for Supply Management surged to a level indicating further solid gains.

In addition to global growth, the dollar continues to do its part in the rebalancing act. The greenback's long-term decline, which makes U.S. goods more competitive, totaled 26% against all currencies from 2002 to 2008. That slide stopped temporarily last year as a flight to safety lifted the dollar, but the greenback is now retreating, and the decline should continue. The Federal Reserve's aim to keep U.S. interest rates exceptionally low compared with rates abroad makes dollar-denominated assets relatively less attractive.

One fear is that foreign investors will stop buying U.S. debt, just as Washington needs to borrow more. Such a turn could lead to a dollar collapse, causing spikes in long-term rates and inflation. But although Uncle Sam may be borrowing more, consumer credit has plunged, sharply reducing the U.S.'s need for foreign capital. The balance-of-payments deficit, which is essentially foreign lending to the U.S., shrank to $98.8 billion in the second quarter, from a peak of $214.8 billion nearly three years ago.

The less the U.S. needs to borrow from abroad, the less downward pressure on the dollar—and the greater the balance in the global economy. Maintaining a better balance in the long run will be difficult, however. Export-intensive nations, such as China, must boost their domestic demand, and the U.S. must hold its hunger for imports in check while exporting more. Unfortunately, old habits die hard.

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