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Wednesday, March 26, 2003

The Curse of the Twin Deficits

The Economist neatly divides economists into two camps: those who believe that the fundamental problem is uncertainty generated by the war, and those who foresee more fundamental problems. The former group seem to believe that once the war is over the US economy will pick up again quickly and the bad times will become history. This view seems horrendously naieve on two counts: firstly it seems to lack any depth analysis of the current US and global economic situation, and secondly it seems to conveniently forget that the kind of geopolitical uncertainty which Greenspan among others has been referring to extends well beyond the borders of Iraq. Which is only another way of saying that even if the fundamental problem were only confidence and security, this problem is likely to continue long after open hostilities in Iraq come to an end.

The second group is preoccupied by structural imbalances. Clearly the leading voice here is that of Stephen Roach, although recently Alan Greenspan has seemed to be moving more in this direction (there are of course plenty of other 'academic' economists who share this view but they attract far less media attention). This group seem to be concerned by three things: the ongoing impact of a debt-deflation shock following the bursting of the asset bubble, the structural imbalance represented by the US current account deficit, and the growing problem of the US government budget deficit.

To this second group I would like to add a third sub-group. Those economists who are worried by all three previously mentioned factors, but who feel that the killer-app that really settles it is the demographic one. The structural problems of the US economy would, in my view, be serious but containable were this 1973 and not 2003. Were we now back in 1973 the war and all its attendant problems (oil price hike, consumer confidence, dislocation in global markets, declining dollar, rising deficit) would (as it did) bring inflation, but that this inflation would then be containable. (You see I am a good Keynesian at heart, and in any event I do believe the argument that we have become much better at containing inflation's 'ills'. With deflation it is another matter!). It would be containable because there would be large younger generations with the capacity to borrow heavily from the future to buoy up the economy of the present. But this is not the situation today. The younger generations are smaller, and their forward looking credit reduced, especially if what we have lying out there in front of us is growth slowdown and deflation. This is the big liquidity constraint our economies face. The theory available to us for understanding this process may still be weak, but the evidence and the facts are not. Japan has been mired in an 'unexplicable' deflation trap for over a decade now, Germany seems well on the way to entering, and, if my analysis is correct, we should see Italy joining the club in the not too distant future. Stephen Roach pleads, hope against hope, for alternative global engines. But none emerge (except, of course China and India, but that is another story, for another day - although clearly both of these factors may be jobs-negative for the US, in China for manufacturing, and in India for services). It is simply not credible to imagine that (with the possible exception of the UK) structural reform in the EU and Japan will produce a major growth spurt. If they can hold the boat together rather than watching it fall steadily apart then in my book they will be doing well. Bottom line: even giving some ground to the most bullish accounts of the current US prospects it is hard to see strong growth emerging in an increasingly arthritic global economy.

In spite of everything, the American economy has been growing somewhat faster than most of the big industrial economies, and most forecasters still reckon on a reasonably healthy pace of expansion this year. There are now two risks threatening these optimistic assessments, though. One is a difficult, lengthy war which could damage morale at home. Some sectors of the economy—particularly those, like airlines, involving foreign travel—are already braced for more trouble as nervous Americans stay at home. Business investment has yet to recover from the aftermath of the dotcom bubble. Another spectacular terrorist attack on American soil would also knock domestic confidence.

The other risk facing America is one that divides economists into two clear camps. Some argue that the uncertainties caused first by the prospect of war and now by the conflict itself are the only obstacle to a sustained recovery. They believe that once the fighting is finally over, growth will quickly pick up. But another group believes that the American economy is plagued by structural imbalances which could continue to constrain growth even after the war is over. The current-account deficit, now around 5% of GDP, is a key factor: if capital flows into America slowed even more sharply, or dried up, the adjustment involved in reducing the current-account deficit could be painful both for America and the rest of the world.

The other imbalance that troubles economists is the American government’s deficit. Under the Bush administration, large projected surpluses have turned rapidly into deficits as far as the eye can see. The huge $726 billion tax cut which President George Bush has been seeking—the second since he took office just over two years ago—has pushed off into the far distance any serious prospect of moving back into surplus.

Among those who have expressed concern about this is the influential chairman of the Federal Reserve, Alan Greenspan. He worries that such large deficits could crowd out private-sector investment and push up interest rates in the longer term. While on balance Mr Greenspan is optimistic about America’s economic prospects once the current geopolitical uncertainties have ended, assuming they do, he has also raised the possibility that other measures will be needed to stimulate the economy. But Mr Greenspan cautioned against the president’s latest stimulus package because he thinks it is too soon to know what measures might be needed, and because he is no fan of large government deficits.
Source: The Economist

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