The shorter the war, the better the outlook. That was the theory prior to the U.S. and British invasion of Iraq. And the first days of fighting proved it, given the thunderous rally in the stock market and drop in oil prices on Mar. 21. However, by Mar. 24, the early display of military power and rapid ground gains gave way to increased enemy resistance, making it evident that "short" did not mean a week. The markets for stocks, bonds, and oil all beat an equally furious retreat.
Get used to it. The unpredictable patterns of war are now in full control of Wall Street and much of the economic outlook, and that won't change until the end of the war is in sight. February and March economic data are all but superfluous next to military events in gauging the near-term course of the markets and the economy.
But there is a new issue in the outlook. Whether the war is short or long, at its end the White House must either repair its political relations around the world, especially in Europe, or face the economic consequences of its unilateral way of thinking. Assuring that the rebuilding of Iraq is a globally inclusive effort would be a step in the right direction, a topic that was surely discussed on Mar. 26-27, when British Prime Minister Tony Blair met with President Bush.
No industrial nation needs increased globalization and its multilateral trade benefits as much as the U.S. does. The U.S. has long consumed far more than it produces. The widening trade gap has been financed in part by foreigners lending the U.S. money by buying American assets. As a result, the U.S. has racked up a net foreign debt of about $3 trillion, nearly the size of the German and French economies combined. This puts America in a position in which it must export more, while also remaining highly dependent on foreign lending as a source of capital (chart). Against those imperatives, unilateral policy is economic suicide.
THE BIGGEST IMMEDIATE DANGER from geo-economic tensions is a suddenly weaker dollar, which would negatively affect U.S. asset prices, lift inflation, and complicate Federal Reserve policy. Historically, dollar depreciation has always played a major role in correcting imbalances in international investment, and indeed, the greenback began to slide lower a year ago. So far, the adjustment has been orderly. But the war and its aftermath create the risk that, in a dangerous investment climate, people may be more hesitant to invest in U.S. assets, and the dollar will suffer.
Over the past year, the dollar's decline has been most acute against the euro, with a plunge of 25%. Compared with a much broader basket of currencies, though, the greenback has fallen only 4.5% (chart). Plus, the dollar is still more than 20% above its level of the mid-1990s, suggesting room for further downward adjustment in the coming year.
The question: Will the decline remain orderly or become sharp and disruptive? That's where diplomacy will matter. The currency markets, always a volatile arena, could punish the dollar if political rifts that threaten trade and capital flows aren't mended quickly.
The increasing urgency of America's growing external debt and its pressure on the dollar was evident in the fourth-quarter current account deficit, which showed a quarterly gap of $136.9 billion. At an annual rate, that's a record 5.2% of gross domestic product, an unsustainable trend, even given the U.S.'s high productivity, favorable cost structure, and powerful position in the world. Also, deficits of that size accruing to only one country create a threat to global economic stability.
A NEW AND DISTURBING TREND in the current account data is the growing imbalance of investment income. Because its external debt is so large, the income from interest and dividends that the U.S. pays foreigners on their holding of stateside assets now exceeds the income America earns on its assets abroad.
For all of 2002, the U.S. payout of investment income exceeded receipts by $5.4 billion, the first such deficit ever and a sharp reversal from the previous year's $20.5 billion surplus (chart, page 28). This essentially represents the cost of servicing the external debt, and its growth is now adding its own weight to the current account gap. Worse still, the burden is growing at a time when interest rates are exceptionally low. As rates rise in an economic recovery, so will this cost.
And don't expect any relief on the goods and services side of the U.S. trade accounts. The trade deficit is destined to swell further this year, if only because the math of the trade gap has become so daunting. Imports of goods and services are now 1.5 times larger than exports. That means that in the coming year exports will have to grow 1.5 times faster than imports just to keep the deficit from widening further.
The experience of the past five years suggests that won't happen. Since the end of 1997, imports have grown almost five times faster than exports. Last year, exports grew 4.3%, vs. a 10.1% jump in imports, and that was with sluggish U.S. demand. If imports increase 10% again this year, then exports would have to grow by 15% just to keep the deficit stable. Given the somber outlooks for Europe, Japan, and the rest of the world, that seems highly unlikely.
SOME ANALYSTS HAVE ARGUED that the U.S. can enjoy indefinitely the higher living standards provided by a large current account deficit and a strong dollar. That was a plausible argument during the investment boom of the late 1990s. Back then, U.S. imports were heavily tilted toward capital goods that yielded greater productivity, profits, and income. But in recent years, consumer goods, from Chinese toys to German autos, have led the boom in imports. Capital goods are a dwindling share of total imports, and the share of foreign-made consumer goods, items which have no future payback, is rising.
If the U.S. has one advantage in its trade conundrum, it's the heightened ability of U.S. exporters to compete, even at the dollar's high level. Strong productivity gains are lowering unit labor costs in the U.S. relative to the industrialized world. For example, when the dollar's exchange rate vs. the euro and the British pound are adjusted for relative labor costs, the U.S. gained a 6.5% cost advantage over Germany and a 13% improvement over Britain from early 2000 to late 2002, says economist Ian Shepherdson at High Frequency Economics.
Of course, the edge won't matter if U.S. companies don't get a chance to increase their exports. Globalization is one of those 21st century catchphrases that can mean many things, but its economic bottom line is the promotion of greater foreign trade. Global markets must be open to American-made goods. That condition is crucial to the long-run health of the U.S. economy. And it's something the White House needs to keep in mind during its postwar fence-mending.
By James C. Cooper & Kathleen Madigan