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December 28, 2005

David Smith's EconomicsUK has just added a discussion forum to its content - I thought I'd take on his question regarding the future of the US economy next year:

A big current account deficit, high inflation and what some see as a housing bubble. Will 2006 be the year when the US economy comes down to earth, or can it carry on going from strength to strength?

My response, also posted in David Smith's forum, follows (although here, I've added links for reference):

It seems to me that the first two items you note as challenges for the US economy are closely interlinked. Both have been highly driven by two factors: the devaluing of the US dollar, which has made products exported into the US much more expensive, and the high world demand for oil combined with hurricane damage to the US' oil production infrastructure. While the oil supply shortage (and corresponding links to the current account deficit and inflation) will be corrected as damaged facilities are repaired over time, the more serious concern will be whether the US will continue policies pursuing dollar devaluation. My guess is that the US dollar will stabilize this year, reducing the growth of both the current account deficit and inflation.

The housing bubble situation is another story - in the world of real estate, it's all about location, location and location. As it stands, where the housing bubble appears to have been greatest, it already appears to have ended (in the northeast and on the west coast). Meanwhile, high growth areas (such as the southwest) should continue to see continued growth in housing values, although at slower rates as interest rates have risen.

2006 should see economic growth in the US slow as other sectors of the economy begin picking up the slack as the recent boom in the US real estate market leaves off. With investors not having the single booming market of real estate in which to invest, look for more general growth in other sectors - particularly in manufacturing. For example, all those orders Boeing has taken this year will begin turning into dollars as those aircraft are built and delivered. This increase in production will have the benefit of also reducing the current account deficit, as the majority of these newly produced aircraft will be exported (remember, the dollar devaluation policy does benefit US manufacturing exports). As a result, I would expect that aerospace, which has been a huge, missing piece of the US economy for the last several years, will gain considerable strength in the next year.

Update: An informed reader, pointing to a recent paper from the American Enterprise Institute, has confirmed that the US dollar, while still much weaker than in recent years, appears to have stabilized in value in this year and has even gained in strength relative to other major world currencies. Oddly enough, I think this only makes my predictions more valid, but let's see how long those hold up....

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