PRESIDENT BUSH faces four major economic challenges in his second term: the budget deficit, the trade deficit, monetary policy and social security. These are interconnected, but contradictory in some respects. His order of priorities will profoundly affect America’s performance and the prosperity of the whole economy between now and 2008.

While foreign finance ministers and central bankers have been urging the Bush Administration to focus on the budget and trade deficits first, the White House is likely to take a different view. The President made clear in last year’s campaign — and in post-election comments — that his top legislative priority will be social security reform. The US Government’s social security programme, equivalent to Britain’s national insurance, provides a state pension which is very generous to all American workers over the official retirement age, gradually being raised from 65 to 67. Mr Bush’s big idea is to offer workers the option of replacing this state pension with a private savings account, invested in shares or others assets, instead of a notional trust fund at the Treasury consisting of government bonds.

While the President has been deliberately non-committal about specific sums, he has left no room for doubt that he sees this partial privatisation of social security as the most important domestic initiative of his presidency and his main hope of a permanent place in history.

The main economic problem is that privatising social security will increase significantly the US Government’s budget deficit, since social security taxes paid by today’s workers will be reduced, while the benefits to retirees will remain unchanged. Estimates of the potential increase in budget deficits range from $100 billion to $300 billion a year, depending on how the changes are phased in.

How, then, will the Bush Administration reconcile social security reform with its second major economic objective, which is to halve the Federal government’s deficit from 4 per cent to 2 per cent of GDP? The optimistic answer is through economic growth combined with public spending restraint. Projections showing a rapidly declining deficit are likely to form the basis of the 2005 budget to be published next month but they may not be very credible to investors or foreign central bankers, given the first Bush Administration’s generally poor record in public spending control.

If the deficit reductions are unpersuasive, market attention may shift back to the third economic challenge — America’s trade gap, now running at nearly $700 billion. The continuing expansion of the US trade deficit, despite the steep decline of the dollar, has been one of the most surprising developments in the world economy during the past three years.

One of the hottest economic debates in Washington and among G7 finance ministers in the years ahead will be whether widening US trade gaps are caused by excess consumption in the US, insufficient demand in Asia and Europe, a lack of competitiveness in US export industries or a misalignment of currencies between Asia and the US.

Whatever the answer — and the true explanation probably includes all these points — continuing expansion of the US trade deficit would put the dollar under further downward pressure and could eventually pose a fourth economic challenge for President Bush.

This is the conduct of monetary and exchange-rate policy. As long as US inflation remains as subdued as it recently has been, the weakening of the dollar will be seen as a solution to the trade deficit, rather than a problem.

But if inflation begins to accelerate, a falling dollar will very rapidly become a serious problem, calling into question the very relaxed monetary policy currently pursued by the Federal Reserve Board.

So far, there are few signs of serious inflation. If this benign price behaviour continues, then Washington will probably continue to follow a policy of benign neglect towards the dollar — and the Fed will not need to worry about the monetary consequences until after the retirement of Alan Greenspan, and the appointment of a new chairman — most probably Martin Feldstein, a distinguished Harvard professor and a long-standing adviser to President Bush.

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