The Long View: ‘An accident waiting to happen’?

By Philip Coggan, Investment Editor

Financial Times

Published: November 7 2004

Be careful what you wish for. Having won re-election, President George W. Bush may face a very difficult second term in office.

Second terms have proved difficult in the past. Bill Clinton's second administration saw him face impeachment over his affair with Monica Lewinsky, Ronald Reagan was dogged by the Iran-contra scandal, and Richard Nixon was forced to resign in the light of Watergate. The curse could strike Bush from one of several directions.

Terrorism is an obvious danger. Bush says that he has made America safer by his actions in Iraq and Afghanistan, but an attack on the US mainland would undermine that case.

Another potential quagmire is foreign policy. Bush will clearly want to extract American troops from Iraq within the foreseeable future, but will he be able to leave a stable regime behind? If the aftermath is chaotic, with Sunni fighting Shia, and both fighting Kurds, the stability of the entire Middle East may be affected.

And the US may decide to do some destabilising of its own. It was interesting to see Republican strategist Jim Pinkerton saying on TV that he expected the US to take military action against Iran next year.

Such speculation may be ill-informed. Most people in the markets will be hoping that the Bush foreign policy is calmer in its second term than in its first. But clearly, if further action in the Middle East is planned, stock markets will be nervous. Investors will opt for the safe haven of Treasury bonds, whether they yield 4 per cent or 3 per cent.

Perhaps President Bush will be too busy with domestic policy to contemplate further adventures abroad. The US economy may be growing healthily with relatively low inflation and unemployment, but under the surface, problems are visible.

“In my view, the US economy is an accident waiting to happen,” says Stephen Roach, the Morgan Stanley economist. “That's the message to be taken from a record shortfall in national saving, a record current account deficit, record levels of household indebtedness, a record deficiency of personal saving and outsize government budget deficits. Never before has the US pushed the envelope to this degree on such a wide array of economic imbalances.”

As Roach notes, very little of the election campaign was devoted to these issues, for understandable reasons. Almost any reduction of these imbalances will see Americans worse off, whether because they receive fewer benefits, or pay higher taxes or because the economy slows as savings rise and consumption is cut. That is one problem with the democratic process.

The first Bush administration was a mixed bag in terms of economic policy. Equity markets generally welcomed cuts in capital gains tax and on savings, and an expansionary fiscal policy helped cushion the blow after the bursting of the dotcom bubble.

But the thrust of the tax cuts was aimed at the better-off. This is understandable in one sense (they pay most of the taxes) but not in terms of stimulating the economy in the short term, since poorer people have a higher propensity to spend.

And the effect was to dissipate the good work done in cutting US government debt during the Clinton era. It was not that long ago that there was talk of eliminating all government debt within 10 years. Now there are deficits stretching out into the future, a problem that will only be made worse if the first term's tax cuts are made permanent. All this comes at a time when the US's underlying fiscal position is deteriorating because of the ageing of the baby-boomer generation.

With the Bush administration unlikely to restrain demand by raising taxes, it seems likely that the US current account deficit will rise unchecked. In the circumstances, it may well be that the dollar has to fall further, in part because even Asian central banks cannot absorb all the surplus dollars being created, in part because a falling dollar is the only way of keeping the deficit under control.

Financial markets certainly seem to take this view. It was expected that, after the US election, there might be a relief rally in the dollar. But the rebound was short-lived. On Thursday, the dollar dropped to its lowest trade-weighted level since 1996. Gold, which has recently acted as a hedge against the dollar, reached a 16-year high at more than $430 an ounce.

Unfortunately, it would take a very big fall in the dollar to make much of a dent in the trade deficit. The Organisation for Economic Co-operation and Development (OECD) has estimated that a 22.5 per cent decline in the trade-weighted dollar would cut the deficit by just 1 per cent of Gross Domestic Product (GDP).

There is a chance, of course, that the deficit could continue to be funded at the current level. The US is lucky that the dollar is the global reserve currency. Asian central banks have been happy to use their foreign exchange reserves to buy Treasury bonds. This arrangement could last for several years but there is a risk that it could break down at some point in Bush's second term.

Were it to do so, Treasury bond yields would move sharply higher, since private investors might demand higher rates to fund the full deficit. That will be a big risk for an economy in which debts are so high. According to Morgan Stanley's Roach, over the past four years the expansion of household liabilities has been 65 per cent larger than the growth in US GDP.

The danger would be a sharp recession. The trade deficit would narrow, but that would not comfort the electors. In such circumstances, President Bush would have no-one else to blame, since the Republicans control both houses of Congress.

Lest this be seen as a party political point, the same problems would have faced Kerry if he had been elected, and he did not have a very convincing plan for dealing with them. From the market's point of view, at least Kerry would have faced a Congress from the other party, which might have limited the scope for the ambitious spending plans of either side. But it is easy to imagine that Kerry would have ended up as a one-term president.