The Goldilocks Economy

It sounds like a recipe for economic disaster: oil prices soared, while central banks across the world hiked interest rates. But last year the global economy defied gloom-and-doomsayers and continued to grow robustly. The combination of big-spending U.S. consumers and a booming China that feeds the Western appetite for low-priced products resulted in a second consecutive year of worldwide growth, estimated at more than 4%. That's the strongest two-year growth period in three decades, and there's more good news to come: the world economy is on track to enjoy another bumper year in 2006 as this twin American-Chinese engine continues to power ahead.

That upbeat forecast — albeit with some significant caveats — emerged from a lively discussion of Time 's Board of Economists at the World Economic Forum in Davos, Switzerland, last week. "The outlook is basically for another Goldilocks kind ofyear," is how Laura D. Tyson, dean of the London Business School and a former White House economist, summed it up. The U.S. economy is expected to slow somewhat but still grow at around 3%, while China could notch up another year of scorching 9% growth.

This year there are even encouraging signs of vitality in Japan and Germany, the world's second and third largest economies, which have struggled for years to break out of their torpor.

Lurking in the background, however, are a few threats as ominous as the three bears. The worldwide supply of oil can barely keep pace with the huge surge in demand that has been the force driving up prices to more than $60 bbl. — and which potentially puts the world at the mercy of politically fickle energy producers from Russia to Iran. "We will have some shocks because supply is so tight," warned Min Zhu, executive assistant president of the Bank of China. He's also expecting a surge in volatility in financial markets this year and, like the other panelists, worries about how successfully the untested new governor of the U.S. Federal Reserve, Ben Bernanke, will deal with unforeseen problems. Jacob A. Frenkel, a former governor of the Bank of Israel who is vice chairman of insurer American International Group, is concerned about increased calls for protectionism, including by U.S. Senator Charles Schumer. Most worried of all is Stephen S. Roach, chief economist at U.S. investment bank Morgan Stanley who for several years has warned that the U.S.'s borrowing and consumption binge will come to a bad end, including a likely fall in the value of the dollar. The problems haven't gone away even if the dollar remains buoyant, he said, warning of a "dangerous degree of complacency" among investors. "The weakest link in the global growth chain in 2006 is the most important link, and that is the American consumer," Roach cautioned.

If the economy does continue to hum along, it's partly by accident. What's conspicuously absent, the economists agreed, is a constructive dialogue between policymakers in both China and the U.S. that would put the two nations' increasingly interdependent economic relationship on a more balanced footing. Under this scenario, the U.S. would curb consumption and start saving more, while the Chinese — who have been buying hundreds of billions of U.S. securities, especially U.S. Treasury bonds — would save less and do more to boost their domestic demand. That would go a long way toward reducing the U.S.'s $800 billion current-account deficit without harming world economic growth. Frenkel called this sort of cooperation "the tango principle." The trouble is that the Chinese seem to be making most of the moves on their own. "Systemic issues for the world require systemic attention by the world," Frenkel said. "If you can dance a tango without talking to one another then so be it. But the track record isn't good."

Despite all the concern, there's a lot to cheer about. The Board of Economists' most dire predictions last year — including a drop in the value of the dollar, a sharp increase in long-term U.S. interest rates and the bursting of the U.S. housing bubble — didn't come to pass. Indeed, the dollar rose in value and the yield on 10-year bonds barely budged, despite a series of interest-rate hikes by the Federal Reserve that were followed at the end of the year by a rate hike by the European Central Bank. Most significantly, there's still no strong evidence of a resurgence of inflation even though oil prices have more than doubled in two years. Tyson said that the increase in global competition on companies has led to an "amazing moderation of wages" in the U.S. and Europe. And Frenkel said the U.S. economy's ability to shrug off huge oil price rises "shows that it is capable of absorbing economic shocks to a much larger degree than what was typically assumed." Referring to incoming Fed chairman Bernanke's academic speciality, Roach even quipped: "He's the world greatest inflation-targeter with no inflation to target."