The US economy: back on track?

Will Hodges asks whether Warren Buffett's investment in US railroads signals a healthy future for the world's largest economy

One of the biggest stories to hit the business press last week was the news that the world's greatest investor, Warren Buffett, had bought Burlington Northern Santa Fe, the second largest US rail operator, in a deal worth a reported 44 billion dollars. Buffett described his latest purchase - the biggest of his 55-year investment career - as an "all-in wager on the US economy".

Buffett, or the "Oracle of Omaha" as he is often known, based the purchase on the belief that the long-term prospects for the US economy are good. He has rarely been proved wrong. In his mind the railway sector is an industry on the rise and its growth will be driven by a recovery in the country's industrial sector as well as strong long-term demand for consumer imports from Asia.

It was not the only piece of positive news surrounding the economy to emerge in recent weeks. A fortnight ago, the US recession officially ended after four quarters of negative growth. The country's GDP grew by 3.5 per cent on an annualised basis - its highest rate of increase for two years.

Yet, while confidence is returning, the events of the past two years remain fresh in the memory. On Thursday the US Federal Reserve Bank voted to keep the Federal Funds Rate - the US equivalent of the Bank of England's interest rate - at what it called "exceptionally low levels" for the foreseeable future (which means at least a further six months).

This raises the question of whether the US is really on the path to recovery or has the weakness in its economy merely been papered over by a record stimulus package and the optimism of a new, charismatic young president?

The next few years are likely to be critical. Economists and financiers remain divided on the short-term future. Some, like Buffett, believe the US will pick up where it left off: unemployment will fall from its current high, consumer spending will recover and manufacturing and industrial production will return to pre-downturn levels. China will continue to ship the manufactured goods which eagerly find their way into suburban malls and households. Normal service will be resumed.

However, many forecasters don't share this optimism. Some predict what is described as a 'U-shaped' recovery - meaning a slow and sluggish return to growth. They expect US unemployment, which is currently 10 per cent and rising, to remain uncomfortably high for several quarters, causing ongoing weakness in consumer spending. This is likely to mean that the economy will continue to be propped up by low interest rates and fiscal stimulus. This outlook would represent something similar to the predicament experienced by Japan in the 1990s, known as the "lost decade", when the after-effects of a burst credit bubble left the country with more than ten years of weak business confidence and meagre economic growth.

A worse scenario has also been suggested: the dreaded "double dip" recession, which you will no doubt hear more of over the coming months. This would see the US make a steady return to growth on the back of low rates and loose monetary policy, only to slump once more into recession around 2011 as the Federal Reserve turns off the tap by raising rates and cutting fiscal support.

To prevent the last of these possible outcomes and break the cycle of boom and bust, some believe the very structure of the US economy must change and accept the changes which are set to see the 21st century belong to Asia. More so than any other economy, the US is fuelled by its consumers. Household spending accounts for more than 70 per cent of GDP. In Japan, the world's second largest economy, the ratio is 60 per cent. In China, it is just 35 per cent.

In the country that invented the credit card, high levels of personal and household debt have been encouraged as a means of fuelling spending and stoking the economy. Individuals have been helped in this respect by the flow of cheap consumer goods from China and other developing markets, which have kept costs low and inflation at bay. This has suited China, which has kept exports cheap by deliberately depressing the value of its own currency, the renminbi. The Asian giant has used the revenues gained from its export sector to develop other areas of its economy.

However, this symbiotic relationship hit the skids when the US credit bubble burst in 2007 and companies stopped importing. Many question whether it will ever return. In the post credit crunch world the roles of both the US and China may change. Having fallen in value by 14 per cent since March, the US dollar is expected to remain weakened in 2010 while the Chinese remimbi is likely to undergo a revaluation in 2010 which would strengthen it in relation to other currencies.

This may turn out to be a blessing in disguise for the US economy. Having long relied on a strong currency and cheap imports for its growth, a weak US dollar would instead stimulate the US's own export sector. This may see the country develop from a major net importer towards a more sustainable role as an exporter of goods such as coal, grains and industrial goods, which it has in plentiful supply. The country's large coal reserves may prove to be a major asset over the next few years; coal consumption in India and China is booming and domestic production is unable to keep up with demand. As the US reduces its fossil fuel consumption due to reduced industrial output and a move towards more environmentally friendly sources of energy, its surplus supply is likely to head east to the Pacific Basin.

Such a transition is known by economists as "rebalancing". A healthier trade balance would help to reduce the country's growing debt burden. While still not as high as Britain's, the US's current 9.9 per cent budget deficit is its highest for several years and illustrates the long-lasting impact of the fiscal stimulus measures introduced to stop the slide into a major economic depression.

The country's public debt level is also a growing concern. Over the past decade the country has borrowed more and more money from China and other developing countries to fund its budget shortfall caused by the growing costs of its military campaigns and its expensive and inefficient healthcare system. US national debt increased by 75 per cent in the 1990s and this year stood at 88 per cent of GDP, its highest level since 1955 (when Buffett was 25 and the country was recovering from the Second World War). The International Monetary Fund expects this level to rise to 112 per cent in 2014, far eclipsing the UK's own much-maligned public debt ratio, which is forecast to peak at about 100 per cent.

It is hard to know how the government will reduce this debt burden. With unemployment still high, tax receipts are down but Obama will be wary of raising corporate tax levels while business confidence remains shaky. Moreover, the Democrats will be loath to abandon plans for their much touted universal healthcare programme, expected to costs upwards of 900 billion dollars. Increased exports should help but are unlikely to make a significant dent.

While all this may sound pessimistic, it should be noted that the US has endured far greater hurdles in the past and gone one to re-stake its claim as a an economic superpower. Born in 1930, Warren Buffett will be too young to remember the Wall Street Crash and the depression that followed, yet he will have been fully aware of how the country re-asserted itself in the post-war era and shook off its debt hangover.

At 79, however, it is possible that Buffett has already had his time in the sun. Perhaps his country has too.

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