Date created: 5/4/05
Last modified:5/4/05
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John Quiggin

And now for the hard bit

Australian Financial Review

4 November 2004

Having won a second narrow victory, George Bush has now to deal with the problems created by his first term in office. Iraq is the most obvious and pressing, and attracted most substantive attention during the campaign, along with irrelevancies like the candidates’ Vietnam War records, and the never-ending culture wars over issues like gay marriage.

By contrast, the economy was barely an issue, a point illustrated by Bush’s wins in depressed manufacturing states like Ohio and Indiana.

The US economy has managed a modest recovery since the 2001 recession, but only through an unsustainable growth in public and private consumption, reflected in the budget and trade deficits (it’s tempting to call them twin deficits, but the trade deficit grew steadily through the late 1990s when the budget was in surplus.

At 3.6 per cent of GDP the budget deficit is not huge for an economy that has still not recovered the ground lost during the 2001 recession, particularly with respect to employment. What is striking is the shift from solid surpluses in the late 1990s to chronic deficits, with no credible plan to restore balance.

When Bush took office in 2000, the Congressional Budget Office was predicting a cumulative budget surplus of $5.6 trillion over the period 2001-10. Now, after deficits of $1.2 trillion in Bush’s first term, the CBO projects cumulative deficits of $2.3 trillion over the next ten years. A more realistic projection of current policy, allowing for Bush’s tax cuts being made permanent, and for expenditure growth in line with GDP, implies a cumulative deficit of $5 trillion, and public debt equal to 65 per cent of expected GDP.

During the campaign, Bush claimed to have a plan to cut the deficit in half, but few took this seriously. Now, with no need to worry about re-election and control of both Houses of Congress, he might introduce radical spending cuts. On past form, however, he will trust to luck, and leave the deficit for his successor to deal with.

An even bigger problem is the external deficit on trade in goods and services, which attracted hardly any attention during the campaign, except with regard to the periphera; issue of outsourcing. The fundamental problem is that the US has stopped saving. The household savings rate has fallen virtually to zero, while the public sector is in chronic deficit. As a result, even with relatively weak investment, it is necessary to borrow massively from abroad to finance current consumption. Private investors are increasingly unwilling to invest in US assets. The slack has been taken up by Asian central banks, most notably those of China and Japan.

As yet, thanks to low interest rates, the deficit on the income account has remained modest, so that the current account deficit is only marginally greater than the trade deficit. But, as Australian experience shows, this is not a sustainable position. Continued trade deficits lead to a steadily growing net overseas debt and an accelerating current account deficit.

As the late Herbert Stein, chairman of the Council of Economic advisors under Nixon and Ford, used to say, if a trend can’t be sustained, it won’t be. Since it’s impossible to run consistent large trade deficits, a return to balance is inevitable. But there’s nothing in Stein’s observation to suggest that the process of adjustment will be smooth, or pleasant.

Even with a return to balance on the trade account over the next decade, the accumulation of debt would amount to around 80 per cent of GDP, implying a stable current account deficit of about 5 per cent of GDP. This is a sustainable position, but there is not much margin for error.

Bringing exports and imports back into balance within ten years, and without a recession, will be a difficult task. It will require a further depreciation of the $US against the euro and yen, and an end to the pegged exchange rate with China. A steady depreciation will imply an increase in US interest rates, which is necessary in any case if household savings rates are to increase.

The problem is to avoid the financial crisis that would arise if foreign lenders suddenly lost faith in US dollar assets. What is needed is a combination of short-term repairs to the budget and a coherent plan to deal with the long-term problems of Medicare and Social Security. There is no indication that Bush has such a plan, or even that he perceives the need for one.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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