Trade and fiscal imbalances could be pushing the global economy toward a tipping point, warns Morgan Stanley economist Stephen Roach. To avoid it, he says the U.S. dollar must go lower and U.S. interest rates must climb.

“A record $61 billion trade deficit for February is only the latest in a long string of warning signs for an unbalanced US and global economy,” Roach says in a new research note. “The rebalancing required to temper these deficits requires significant adjustments in macro policies. Yet with America’s fiscal and monetary authorities basically frozen at the switch, politicians are asserting greater control over the adjustment process — firing one protectionist salvo after another.”

Roach says the latest trade numbers in the U.S. were simply terrible. Annualizing the February numbers puts the US trade deficit at a record 6.0% of GDP — up dramatically from the 4.8% gap only 12 months earlier, he reports. “In macro terms, trade and current-account deficits are emblematic of an economy that is living beyond its means — as those means are delineated by a nation’s domestic income-generating capacity,” he adds. “And if there is anyone in the U.S. guilty of living beyond his or her means, the American consumer certainly gets the prize.”

Consumers are drawing sustenance from the equity bubble and more recently from the property bubble, Roach explains, “As a result, the income-based personal saving rate has plunged toward zero and households have taken on record debt loads as they extract newfound purchasing power from increasingly over-valued homes.”

“It is simply unprecedented for the world’s leading economic power to be running chronic trade deficits that have now turned America into the largest foreign debtor in history,” Roach says. “The only way it can continue is if the capital providers of the world — especially Japan and China — continue to suppress domestic consumption and recycle surplus saving into dollar-denominated assets.”

But, if the world puts its excess saving to work at home rather than in the United States, U.S. real interest rates will finally adjust — as will the spending and import dynamic of the American consumer, he notes.

“As the great powers gather for another G-7 meeting this weekend, one hopes there will be an active debate on these matters,” he says. “Unfortunately, if past performance is any guide, that is unlikely to be the case.”

“For a U.S. economy that is living dangerously beyond its means, the tough love of fiscal and monetary discipline is the only way America will ever make lasting progress on the road to rebalancing. A further decline in the dollar is needed, as is a meaningful increase in real US interest rates,” he concludes. “The longer we wait, the more treacherous the endgame.”