Wealth of Nations March 2005

America's Economy: More Fragile Than It Looks

Steps to curb the budget deficit would make the U.S. economy, and the world economy, much safer.

How fragile is America's economic recovery? So far, it is holding up pretty well. Investment seems to be reviving, taking up the lead, as the country's maxed-out consumers start to curb their spending. That is good. Growth is steady, employment high, and inflation (so far) surprisingly well suppressed. Yet financial markets are jittery, the budget deficit looks immovable, and the country's foreign borrowing is running at unprecedented levels. Ought one to be worried, or not?

The Federal Reserve Board seems unsure: It has been sending mixed messages. Chairman Alan Greenspan says that all is well so far as growth, inflation, and external borrowing are concerned. Then he furrows his brow and voices grave concern about the budget deficit.

That is an inconsistent position, on the face of it. If external borrowing—currently running at more than 6 percent of gross domestic product—is not a problem, then one wonders why the budget deficit should be. If the world is content to lend America colossal sums of money very cheaply, and to keep on doing so year after year, then the deficit is not an issue. Indeed, to the extent that it has been created by lower taxes (which Greenspan applauds—he wants President Bush's cuts to be made permanent), then an indefinitely financeable budget deficit and the foreign borrowing that goes with it are sensible policy. Tax cuts spur growth; and the global capital market has an insatiable appetite for American debt. Great: Lie back and enjoy it.

Unfortunately, Greenspan is right about the budget deficit. Why? Because he is wrong about the external deficit. His lack of concern about that is a big mistake. The present huge flow of lending from abroad is not guaranteed to last. If foreigners' appetite for American assets should diminish—and, sooner or later, it will—the result will be some combination of further downward pressure on the dollar (leading, in turn, to higher inflation) and higher interest rates (leading to slower growth).

Either of these outcomes, or some combination of the two, might be perfectly manageable if it happened gradually, but there is no assurance of that. Typically, in fact, such rebalancings happen abruptly, triggered by lurches in financial-market sentiment. That is why steps to curb the budget deficit would make the American economy, and the world economy, much safer.

To be sure, the Bush administration is right to call on Europe and Asia to change their own economic policies as well. They undoubtedly should.

A few years ago, the European Union's governments adopted what they called the "Lisbon agenda"—a program of supply-side economic reforms (with the emphasis on market deregulation of one kind or another) designed to spur growth. Virtually nothing has come of it. The big European economies are also struggling because of lack of domestic demand. This is partly a consequence of their adopting the single currency, which has made it impossible to get monetary policy right country by country: For the moment, the E.U. is too little integrated for one monetary policy to be right for every member. Germany, for instance, needs lower interest rates, but it cannot get them. Demand is weak, too, because fiscal policy cannot respond flexibly to these new conditions. That is another aspect of the way the Union's economic arrangements have been put together—another unforced error.

And it has consequences for the United States, because a misfiring European economy is not demanding enough imports from America. That worsens America's trade deficit and adds to the need for foreign borrowing. Asian economies, especially China, are making the problem worse as well—in their case, by resisting the upward appreciation of their currencies against the dollar that is the natural counterpart of their enormous trade surpluses with the United States. If their currencies strengthened against the dollar, American goods would be cheaper for Asians to buy. America's exports would rise, and that too would help stabilize the world economy.

Even though all of this is true, the fact remains that America's budget deficit is probably the single greatest destabilizer in the world economy at present. Reducing that deficit is America's responsibility—and America would be the principal beneficiary of doing so. Others' failures to do what is in their own interests, and in the broader global interest as well, is no excuse for the United States' leaving that problem unaddressed.

The administration would argue, of course, that it is working very hard to get the budget deficit down. Its aim, it says, is to halve the deficit by 2009, which sounds quite impressive. In fact, as Ed McKelvey of Goldman Sachs argues in a recent research note circulated by the bank, that is a pretty modest ambition. Halving the deficit by 2009 ought to be an easy thing to do—and one could well question whether that timetable reflects an adequate sense of urgency. But the real problem is that the administration's plans, as they stand at present, are extremely unlikely to achieve even that limited objective.

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