A touch on the brakes

In one of the most trailed decisions in its history, the US Federal Reserve yesterday raised interest rates by 0.25 per cent. The world will now wait anxiously to see whether this decision will slow US economic growth without triggering a domestic recession which could eventually drag the rest of the world down with it. It is all too easy to envisage a disaster scenario in which interest rate increases puncture the stock market boom everywhere and turn the US spending boom into reverse. This in turn could induce a recession that brings down the dollar, triggering more increases in interest rates and a resurgence of inflation. Under the doomsday scenarios the Federal Reserve is damned if it does and damned if it doesn't. If it raises rates and a recession follows, then it will be blamed - yet if it does nothing and a recession still follows, it will be castigated for inertia.

The US economy is now in its (unprecedented) eighth successive year of economic growth without so far rekindling inflation. It is a sort of miracle. Fuelled by increases in business investment as America exploits its monopoly of the internet, the economy has expanded by 4 per cent for the past three years while most of the rest of the world has stagnated. But in a real sense the US economy has been living on borrowed time. Its citizens, caught in the euphoria of ever rising stock markets, have gone on a huge spending spree by drawing down their savings - and more. In the latest quarter the US savings rate fell to an unprecedented low of minus 1.2 per cent of disposable incomes. No one worries while stock market gains (not counted in the savings figures) are high. But if the stock market collapses consumers may stop spending and rebuild their savings. If that happens it could topple the US economy into recession over time and batter output around the world, which has been supported by the American public's ravenous appetite for imports.

Optimists think that the US lead in information technology, coupled with global deflationary forces, has removed the need to worry. Whereas the Fed thinks the sustainable non-inflationary rate of growth is around 3% (2% growth in productivity and 1% growth in the labour force) optimists think the true rate of productivity growth, thanks to the internet, is 3 per cent - enabling growth of 4 per cent without triggering inflationary wage demands. They are right that the benefits of the internet (lower prices and cutting out the middleman) are profound and probably under-recorded. But this doesn't mean an economy as huge as the US can live on tick for ever with a huge $270bn trade deficit around its neck. It is true that the economy has some assets including an exploding budget surplus (which Republicans fear will be used as a war chest for re-electing the Democrats) but that doesn't mean that the US economy has discovered the secret of perpetual motion.

The Federal Reserve under the astute guidance of Alan Greenspan, its widely admired chairman, was right to raise interest rates yesterday to cool down the economy before it implodes. Whether he succeeds will be decided in the first instance not by the economics text books but by the individual decisions of millions of investors in the US and around the world. Whatever the outcome of that process, the best course for Europe is to expand demand quickly in order to mitigate the effects of a sharp US slowdown. The US economy has been the locomotive of world growth for too long. It is time some one else took the strain. And in view of the grave risks to the US economy, the sooner the better.