The Wrong Time for Ballooning Deficits

By Laura D'Andrea Tyson

The fog of war has lifted, but the outlook for the American economy remains unclear. Certainly the worst-case war scenarios for the economy did not materialize: Iraq's oil supplies were not destroyed; Israel was not attacked; a major terrorist incident did not occur. But despite the war's successful and rapid conclusion, major geopolitical uncertainties persist. Scenes of looting and anarchy highlight the fact that the U.S. faces the task of reconstructing a fractured country in a failing and embittered region. The Arab world's anger at the U.S. was inflamed by the invasion, increasing the odds of terrorism. And President George W. Bush's doctrine of preemption is deeply destabilizing. It encourages other nations to resort to military action to achieve their ends, and it accelerates their efforts to obtain weapons of mass destruction to deter U.S. power.

Despite such geopolitical risks, many optimistic observers, including Alan Greenspan, believe that with Saddam's defeat, the war-related slide in spending that has bedeviled the American economy will dissipate, confidence will return, and a recovery will take hold. I hope the optimists are right, but I fear they are not. The American economy lost momentum through 2002 despite dramatic monetary easing and fiscal stimulus equivalent to about 2.4% of gross domestic product. Although the budget being debated in Washington contains large structural deficits over the midterm, they promise much less fiscal stimulus this year, when the economy needs it.

After three years of postbubble adjustments, the national savings rate is at a record low, the private sector remains heavily indebted, and investment demand shows little sign of an uptick. Meanwhile, consumers who spent strongly throughout most of this period are retrenching as job prospects dim. Optimists count on a war-related rebound in investor and consumer confidence to trigger spending. But after a series of wrenching shocks from the dot-com debacle, the stock market crash, September 11, corporate scandals, the war, and now, the outbreak of SARS, it is quite likely that we are in for a sustained period of aversion to risk and cautious spending.

Nor is the engine for America's economic recovery likely to come from the rest of the world. Japan and Germany, the world's second- and third-largest economies, are suffering from chronically weak domestic demand and policy paralysis. The Chinese economy continues to grow rapidly but remains too small to pull the global economy along with it. Asia, outside of Japan, was slated to account for nearly one-half of global growth this year, but its expansion prospects have dimmed with the spread of SARS. Looking around the world, the conclusion seems obvious: The global economy's fate depends disproportionately on what happens in America.

But will the rest of the world be willing to finance a militarily triumphant but savings-short U.S. economy? Perhaps, but this assumption is fraught with risk. By the end of 2002, the U.S. current-account deficit -- the gap between the nation's income from abroad and its spending overseas -- hit 5.2% of gross domestic product. And for the first time in its history, the U.S. began paying more to the rest of the world than it received in interest, dividends, and other investment income. By comparison, the current-account gap at the end of the first Gulf War was only about 2% of gross domestic product, and Bush Sr. had already been forced to violate his promise not to raise taxes as a way of reassuring global capital markets that the U.S. was committed to reducing its budget deficits and foreign borrowing needs.

Now, with the U.S. much more reliant on foreign savings, Bush Jr. and his supply-side advisers propose huge budget deficits -- at least $2 trillion over the next 10 years -- that will persist even after the economy fully recovers. Because those deficits will be financed partly by borrowing from abroad, that could drive the current-account gap to 7% by 2004 and 9% by decade's end. History strongly suggests that such a course is not sustainable. It's much more likely that a prolonged current-account gap over 5% will trigger a drop in the dollar's value and higher interest rates. The result: a painful period of slower growth that stems U.S. imports and brings national spending in line with national income. There are already worrying signs that foreigners are starting to shrink their massive holdings of dollars and dollar-denominated assets built up over the last 20 years. Although the dollar is still over 20% above its mid-1990s level, it has fallen by over 25% against the euro in the past year.

The course of the American economy now depends critically on how the rest of the world responds to the U.S.'s growing budget and current-account deficits. Yet President Bush boldly claims that the destiny of our nation does not depend on the decisions of others. This claim, like so many of his other declarations, flies in the face of economic reality. While other nations can't pull the U.S. out of its economic malaise, they do have the power to make it a lot worse.

Laura D'Andrea Tyson is dean of London Business School.

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