In the final part of his two-part series on the US economy, Paul Tansey, Economics Editor, says there is light at the end of the tunnel

As 2008 approaches, the future of the US economy is finely balanced. After years of sustained expansion, growth in the world's largest economy is slowing down.

The fallout from the subprime lending crisis will dictate whether this slowdown tips the US into recession during 2008.

The fate of the US economy is not an academic issue for those working and living in the Republic. If the US sneezes, the Republic catches an economic cold. The US buys more goods from the Republic than any other country, and is also the main source of foreign direct investment inflows into the State.

As measured by real Gross Domestic Product (GDP), the US economy expanded by 3.3 per cent in 2006.

A year ago, it was expected that it would pause for breath during 2007, before picking up again in 2008. Thus, in December 2006, the OECD was forecasting US GDP growth of 2.4 per cent in 2007 and 2.7 per cent in 2008.

The subprime crisis has put paid to such optimism. Last month, the International Monetary Fund (IMF) forecast that US growth would reach just 1.9 per cent this year.

More importantly, it revised downwards its projection for US growth in 2008 from 2.8 per cent to 1.9 per cent.

Three main factors account for the downward revisions in US growth prospects.

First, new-housing completions have fallen sharply, echoing the Irish experience. The impact of reduced house-building activity has been so pronounced that it has subtracted one percentage point from the annualised GDP growth rate in the US in each of the last six quarters.

Second, consumer spending is flattening out, principally reflecting a weakening in consumer confidence. Recent figures from the US Commerce Department show that retail sales volumes increased by just 0.2 per cent in October following a gain of 0.7 per cent in September.

The third and final factor centres on the effects of the sub-prime crisis. With glum regularity, the major US and European banks are announcing write-downs on their subprime and related lending. Interest rate spreads have widened, and businesses are finding it more difficult to negotiate bank loans.

Yet this represents only the first shock-wave sent out by the subprime crisis.The second, and decisive, effect will be the response of ordinary US consumers to the subprime meltdown.

In the first instance, this will be shaped by the extent to which mortgage borrowers can keep up their repayments through 2008.

US mortgages have become much more expensive in recent years as the Federal Reserve Board gradually levered up interest rates. In the two years to July 2006, the Fed raised interest rates 17 times, from 1.0 per cent to 5.25 per cent.

Mortgage interest rates followed suit, with the result that many borrowers found themselves unable to maintain repayments. More than 2.2 million US households are now in default on their mortgages. As can be seen from Table 1, those in default constitute a small, but noticeable, proportion of the 78 million US households that either own or are buying their own homes.

In addition to those already in default, a further 2.25 million sub-prime borrowers with adjustable rate mortgages face substantial increases in their mortgage payments by the end of 2008.

Many of these subprime borrowers were offered low introductory or "teaser" interest rates to sign up for a mortgage. Checks on their credit histories and on their ability to meet mortgage repayments out of their current incomes were less than exhaustive.

In large measure, the fate of the US economy in the year ahead is in their hands. If they default in large numbers not only will they add to the already burdensome pressures on the US banking system, but the subsequent wave of foreclosures would cause major reverberations through the whole of the US economy.

With inventories of unsold homes already high in the US and house prices weakening steadily, fire sales of homes repossessed by financial institutions would both stifle hopes of any pick-up in housing construction and accelerate the fall in house prices.

Most important of all, the resulting fall in housing equity for all homeowners would act as a major depressant on US consumer spending next year. While house prices were booming, US households were much quicker than their Irish counterparts to cash in a part of the rising equity in their homes to finance current consumer spending. Steeply falling house prices would call time on household spending financed by such "wealth" effects.

However, the recessionary case is by no means cast-iron. Two developments may come to America's aid in seeking to stabilise the subprime crisis and to stave off a descent into recession.

First, the cost of money in the US is on the way down. The Fed at last relented on the interest rate front during September, cutting the Federal Funds rate by half a percentage point to 4.75 per cent. A further cut to 4.5 per cent followed in October.

Lower interest rates will not only serve to relieve the financial pressure on mortgage borrowers, but they may also act to stimulate industrial investment.

Second, the Global Competitiveness Report 2007/2008, published recently by the World Economic Forum, ranked the US as the most competitive economy in the world. The Republic languished in 22nd place. The recent steep decline in the dollar's value on foreign exchanges will act to reinforce the US's competitive advantage on world markets. With the global economy remaining relatively buoyant, a rapid growth in US exports next year would offset the relatively flat domestic economic outlook.

So the jury remains out on the direction of the US economy in the year ahead. The chairman of the Federal Reserve Board, Dr Ben Bernanke, holds the view that things will get worse before they get better. He said that in the months immediately ahead, the US economy would slow noticeably and inflation would accelerate.

But there was a sliver of light at the end of the tunnel, as he added: "Our current calculation is that things will flatten out in the second quarter of next year."

That's some distance away and while a week may be a long time in politics, six months is an epoch in economics.