THE day after the US presidential election, I argued that there might be one consolation for the Democrats in the victory of George W. Bush: 2004 was probably a good year to lose an election in the US, just as 1992 was in Britain. For the problems facing the US were now so daunting that whichever party tackled them could have its popularity destroyed for years to come. Judging by last week’s inauguration speech, President Bush is not troubled by any such doubts — but then, neither was John Major in the spring of 1992.
Leaving aside the most daunting test, which is how to win the “war on terror” and emerge with honour from the Gulf quagmire, Mr Bush must cope with six major economic challenges in the years ahead: the budget deficit, the trade deficit, monetary policy, social security, tax reform and the costs of war. The problems are interconnected but the policies the President will need to overcome them are contradictory in many respects. How Mr Bush and his economic advisers decide to respond will largely determine the US economic performance, and also the prosperity of the whole world economy, for the rest of this decade.
European and Asian finance ministers and central bankers insist that Mr Bush must make the budget and trade deficits his first priority, and US diplomats have given some lip service to these concerns, especially ahead of the G7 meeting in London next week. In private US officials take a different view.
The President has said that his top legislative priorities of the second term will not be budget reduction, but social security and tax reform. To the extent that he may decide to tackle the budget deficit, it will not be over worries about the budget’s relation to trade gap, but because he wants to justify a cut in government spending which he sees as an end in itself. The US Government’s social security programme, similar to Britain’s national insurance, provides a generous state pension to all Americans who have paid taxes during their working lives. Mr Bush plans to offer workers the option of redirecting part of their social security contributions into personal savings accounts, which can be invested in shares or other high-return assets, instead of a notional “trust fund” of low-yielding government bonds.
While Mr Bush has been non-committal about the precise sums that he wants to rebate from social security taxes for workers who invest in personal retirement accounts, he has presented this plan as the most important domestic political initiative of his presidency. His advisers have suggested that privatising social security, which is by far the biggest spending programme administered by the US Government, could earn Mr Bush a place in the history books, alongside Franklin D. Roosevelt who created social security and inaugurated the US welfare state.
The trouble with this view is that privatising social security will significantly increase the 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 budget deficit increase range from $100 billion (£53 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 big objective, which is to halve the federal Government’s deficit from the present $400 billion, or 4 per cent, to about 2 per cent of GDP? The optimistic answer is through rapid economic growth combined with restraint in public spending. Projections in the 2005 Budget, to be published next month, will show a steeply declining deficit, settling in 2008-09 at about $250 billion, or about 2 per cent of GDP. But will these be credible to investors and foreign central bankers, given the first Administration’s generally poor record in public spending control? Probably not, for at least three reasons.
First, the projections will likely omit the $100 billion to $200 billion annual cost of the social security reforms, because these have not been finalised and are bound to be presented as theoretically self-financing.
Secondly, the Budget will probably underestimate the cost of additional tax cuts promised or strongly implied by the President. The most important of these is a reform of the alternative minimum tax (AMT), a provision of the US law that allows the Internal Revenue Service to collect a minimum share of every taxpayer’s income, overriding any exemptions, allowances and other shelters that they would otherwise enjoy. Because of the proliferation of tax shelters, as many as a third of US taxpayers could soon be subject to the AMT, a system originally designed to catch only a small proportion of the richest and most sophisticated tax avoiders. But easing the burden of the AMT will either mean giving up hundreds of billions of dollars of revenue or removing many of the tax concessions introduced in Mr Bush’s first term.
Thirdly, the Budget will make assumptions about reducing spending that are unlikely to be fulfilled. Congressional lobbyists are working hard to preserve all the new business subsidies created by the first Bush Administration, and most Washington insiders believe that defence contractors will prove adept in protecting themselves from leaks, suggesting $30 billion in Pentagon cuts. On closer inspection, these proposals, which purportedly show Mr Bush is serious about controlling the Budget, are mild. The $30 billion is a cumulative reduction spread over six years, with most of the tough measures postponed until 2008 and 2009 and no reductions at all this year. Moreover, these figures exclude Iraq spending and assume large cutbacks in hardware programmes that have been under threat for years but always saved at the last minute.
Assuming that budget deficit reductions prove illusory, market attention will shift to the President’s next economic challenge — the US trade gap, now running at an annual $700 billion. The widening of the trade deficit, despite the decline of the dollar, is now the most potentially destabilising event in the world economy. Economists can debate whether the trade gap is caused primarily by excessive US consumption or the pegging of the Chinese and Asian exchange rates or insufficient demand in Asia and Europe, but the market implications are the same. Unless something happens soon to reverse the trend of the deficit, the dollar will experience continuing downward pressure and its fate could become the dominant economic issue of this Administration, as it was in the Nixon and Carter years.
During the next few months the policy towards the dollar and the trade gap will almost certainly remain one of benign neglect. But how long this can last will depend on the prospects for inflation in the US.
As long as inflation remains subdued, say below 3 per cent, the weakening of the dollar will not be seen as a problem. Instead it will continue to be viewed as a solution, not only to the trade deficit but also to the lack of employment in the US industrial heartland and the refusal of the European and Japanese authorities to act more aggressively to stimulate domestic demand. Only if US inflation accelerates will the falling dollar be seen as a worry, but if inflation starts to accelerate while the dollar is still falling, Mr Bush will be in trouble. There is nothing more devastating to economic policy than the combination of falling currency and accelerating prices. If a big budget deficit, a loose monetary policy and a costly war are thrown into the cauldron, the result is a real witch’s brew.
Luckily for the President there are few signs of serious inflation at present. The hope in Washington must be that, by the time inflation rears its head, US industry will be so competitive that even a modest tightening of monetary policy will be enough to turn the market in favour of the dollar. If Mr Bush is lucky this may happen, but if inflation starts to accelerate before the dollar and the US trade account have found a solid footing, the President’s political victory could turn into an economic nightmare. Mr Bush likes to compare himself to Roosevelt and Winston Churchill, but he should also remember John Major after the 1992 election and Jimmy Carter after 1976.
