Rupert Cornwell: Out of America

If something can't go on for ever, it probably won't. For this insight into the human condition, we are indebted to the late Herb Stein, chief economic adviser to President Nixon and one of the most likeable men ever to practice the dismal science. And right now it applies perfectly to America's economy.

More or less ever since 9/11, its progress has resembled the theatre. Disbelief has been suspended, as debts and deficits piled up, yet no one was required to pay for them. Everyone could borrow and spend, seemingly without end. But not even the mightiest country on earth can live beyond its means for ever.

For months now, the edifice has been wobbling, ever since word first emerged of the sub-prime mortgage debacle. Last week, you could say, reality finally caught up. The battering on Wall Street, of course, makes the biggest headlines, as some of the most famous names in finance – Citibank, Merrill Lynch and Morgan Stanley among them – announced massive losses after bad bets on high-yielding securities backed by mortgages to risky borrowers who couldn't make the payments when interest rates went up.

But spare no sympathy for the fallen masters of the universe. Rising interest rates have seen two million home-owners fall behind on their mortgage payments so far this year, and almost half a million homes have been foreclosed in the past four months alone.

Then came General Motors. In recent years, we've become accustomed to bad news from Detroit. But a loss of $39bn (£18.6bn) reported by the country's largest car manufacturer in a single quarter? And GM was supposed to be the healthiest of the Big Three automakers.

It's not only stocks that have been dropping like stones. Usually Americans are pretty indifferent to the dollar. But not when the Canadian dollar is above parity with its US counterpart for the first time in a generation, when a coffee on the Champs-Élysées costs $7 – and, most alarming, oil is brushing $100 a barrel. This means not just more expensive petrol, but dearer heating fuel, food, clothing – almost anything else that's transported from one place to another.

Just to round things off, the US Treasury said national debt had jumped to $9trillion. The sum may be hard to grasp, but to put it in perspective, consider that it took from George Washington to Ronald Reagan to run up the first trillion. Under George W Bush, national debt has risen $4trillion in less than seven years.

As I said, there was always something surreal in the progress of the US economy. The country is waging war in Iraq and Afghanistan, at a cost of $600bn and counting. But does it raise taxes to pay for it? No, it cuts them.

This conjuring trick was due to two things. One was the long rise in house prices that enabled people to treat their homes like cash machines, taking out home-equity lines of credit to pay for kitchen makeovers, new cars, holidays, school fees – the good life in general.

The other has been the willingness of creditor countries such as China, Japan and South Korea to reinvest the dollars from their trade surpluses with America in US bonds. But the first of these two props has gone, and the second is looking distinctly wobbly.

The true engine of the US economy is consumer spending, which accounts for 70 per cent of the economy, and even a small decline in it can bring about a recession. Now, however, consumers are running out of untapped equity in their homes to bankroll their extravagant habits. For the first time since the Great Depression, house prices are falling over the entire country. This is the stuff of which recessions are made, when Wall Street's pain spreads to Main Street and distant financial abstractions become reality in the punter's pocket.

Testifying before Congress on Thursday, Ben Bernanke, chairman of the Federal Reserve, said economic growth would "slow noticeably" in the coming months – about as near as a central banker comes to uttering the dreaded R-word.

And if recession does come, the Fed will be in a bind. America may be the world's lone superpower, but it is also the world's biggest debtor nation. Last week, markets shivered as a lowly Chinese official hinted that Beijing's patience might not be entirely without limits. Normally a central bank cuts interest rates to revive a flagging economy. But Wall Street realises that if Bernanke does so now, the dollar would become even less attractive to hold.

At that point, creditors might diversify into other currencies, causing the dollar to fall farther and faster, and stoking new inflationary pressures in the domestic economy. And the dollar's role as the pre-eminent global reserve currency – an advantage that allows the US to pay its huge foreign debts in its own currency – could be in peril. But if Bernanke keeps interest rates where they are, he risks prolonging the economic downturn, pushing up unemployment and compounding the misery of Main Street.

Such is America's policy dilemma, and its Herb Stein moment.