Will 2008 Be a Year of Growth or Hardship?

By Stephen Clayson
19 Dec 2007 at 02:30 PM GMT-05:00

LONDON (ResourceInvestor.com) -- The past few years have been characterised by good times for the world economy. Despite soaring oil prices, growth has been robust and inflation has not been an issue. Thanks to the resurgence of China there is now a new engine of world growth, and the effects of this sea change are being felt in all corners of the globe.

The effect on world economic growth of China’s return has been such that the recession that could have followed the bursting of the dotcom bubble never really bit, and the first years of the new millennium have been economically pretty benign. But this year, there is a feeling in some quarters, although by no means all, that the economic plain sailing may have to come to an end, at least temporarily.

Good times for the mining industry seem set to roll on. Despite the pressure felt by base metal prices in the past few weeks, there will be no return to the bad old days of the 1990s just yet. The fundamental clash between years of underinvestment in producing capacity and extraordinary demand growth hasn’t gone away.

Despite the underwhelming performance of gold so far this month – the smaller than hoped for cut in U.S. interest rates earlier this month facilitated a mini-rally in the dollar and stymied my hope for US$900 an ounce gold by Christmas – next year could be a halcyon one for the yellow metal.

Economic weakness in the U.S. will persist into next year and the Federal Reserve will likely be forced into making further cuts in interest rates. Although rates may fall elsewhere too – they have already begun to fall in the U.K. and may begin to fall in the eurozone – it is the U.S. economy that ultimately is at the heart of the sub-prime mortgage crisis that has been the big short term economic story of the second half of 2007.

Falling U.S. home prices spurred by sub-prime mortgage defaults, which are followed by repossessions and rushed sales, will rattle the U.S. consumer. Further falls in the dollar, which will come despite the palliative effect that its depreciation to date has had on the U.S. trade deficit, has the potential to generate a great deal of inflationary pressure in the U.S., but with the economy still weak, the Fed will be stuck between a rock and a hard place.

On the one hand, the Fed needs to stimulate economic activity, but on the other it has to control inflation and combat a perception that cheap money courtesy of Alan Greenspan’s Fed contributed to the U.S. housing boom, and now to the bust.

Why must the dollar keep falling? Because though the depreciation of the greenback so far has made a dent in the U.S. trade deficit, the deficit is still running at an unsustainable level. Furthermore, the dollar has yet to fully adjust to the reduced importance of the U.S. in the world economy and the arrival of the new engine I mentioned in this article’s opening paragraph.

Ultimately, the dollar still retains the support, for now, of East Asian governments and of the major oil producers. Until there is a decisive shift in the attitudes of these parties, particularly the former group – who choose to prop up the dollar in order to safeguard U.S. demand for their imports - then the greenback can’t complete the adjustment it needs to make.

But the willingness of overseas governments to fund U.S. borrowing will diminish as the country becomes a smaller part of the global economy, and sooner or later, the big players in the dollar prop-up game will look for something smarter to do with their money. That shift, if it takes place in 2008, won’t just be the story of the year, but of the decade and beyond.

The expectation of this impending rebalancing remains the major driver of the gold market, while the base metals and many other commodities ultimately depend on the health of that new engine, although tough economic times in the U.S. are unhelpful.

The economic tenor of 2008 depends on whether that engine can keep pulling the rest of the world along even while another great engine, the U.S. economy, is spluttering. The need for the dollar to fall further just makes things harder.