Bush banks all on the 'J curve' effect By PROF SIR DONALD MACKAY|28 Feb, 2005 http://business.scotsman.com/index.cfm?id=221362005 BY FAR the biggest challenges facing the world economy are the growing financial imbalances within and between the developed economies and, collectively, the large trade balance between them and the rapidly growing Asian economies. If not corrected by sensible policy responses, then they will be corrected by a good deal of economic pain all round. So, what needs to be done, by whom? The answer lies in the three "Rs" - retrenchment by the United States, revaluation by China and reform by the European Union. Waiting for the latter is rather like Waiting for Godot and just as unproductive. As for China, she will take her time. So, for the immediate future at least, we are heavily dependent on the US. The huge US fiscal and trade deficits dwarf the financial deficits of the other major economies. And over the past three years the dollar has been weakening against the other major currencies. This is part of a necessary cure for the deficit problem. But fiscal retrenchment is now a matter between the president and Congress. This has to be addressed in the short and long term if the deficits are to be corrected. In economics, as in foreign policy, President George Bush appears the true son of Ronald Reagan, not his father who, you might recall, dubbed Reagan-omics as "voodoo economics". The younger Bush has raised government expenditure and cut taxes. In consequence, as the accompanying diagram demonstrates, the substantial fiscal surplus he inherited from 2000 has been turned into an even larger deficit and the current account deficit is now close to 6 per cent of GDP. Under the Bush presidency, as under Reagan, the fiscal deficit has ballooned, due to higher government expenditure and lower tax rates. However, Bush did inherit an economy teetering on the edge of recession and it required an additional fiscal stimulus, not- withstanding the pre-existing trade deficit. The Reaganomics part of this was the cut in tax rates (now to be extended into the future) rather than depending solely on raising government expenditure, as per the style adopted in the UK. The tax cuts do appear to have had a favourable impact on tax revenue. This held up better than expected in the past year and the US recovery appears robust and ongoing. Moreover, without the US acting as a recovery engine, the world economy would be in a much greater mess. Yet the US cannot go on running a trade deficit on the current scale. The first part of the necessary corrective action is already in place - the US Treasury Secretary has gamely prattled on about the administration's commitment to a strong dollar but the first requirement for correcting a large trade deficit is a weaker currency. This past three years against the euro (representing the main trading party to the US), the dollar has fallen by a third and, on a wider trade-weighted basis, it has fallen by roughly half of this amount. Will this work? Initially a weaker dollar will worsen the trade balance. Imports cost more and exports cost less in US dollars but volumes adjust more slowly than prices. This is a well-known phenomenon, called the "J curve". The balance of trade worsens as the economy slides down the downward part of the curve and, then, as import volumes grow more slowly and export volumes rise more quickly, the trade balance improves as the economy moves to the upward sloping segment of the "J curve". The sceptics are not impressed. They point out that this is the mother and father of all "J curves". In November 2004, the US recorded its highest ever trade deficit. This was more than offset in November by a large inflow of capital in US bonds and equities. Yet, this is only sustainable if foreign investors believe that appropriate action will be taken to reduce financial imbalances. To date there is no convincing evidence that the policy is working. Nor can the policy work unless measures are taken to correct the huge fiscal deficit. With the economy close to full employment, it is necessary to reduce the fiscal deficit to create the capacity for exports to grow and import substitution to occur. And here we are particularly dependent on Bush; only he has the political clout to achieve the appropriate degree of fiscal restraint. So the deficits problem is as much a question of political economy as it is a question of economics. In his budget proposals to Congress, Bush has proposed the abolition or reductions in 150 expenditure programmes. Last time round, he proposed to eliminate 65 programmes and managed to get rid of only four, so why should we believe he will be more successful now? The short answer is that the president appears determined to reduce the deficit in his second period in office and has the political muscle to do it. Moreover, in addition to the essentially short-term proposals contained in his budget proposals, he is determined to reform social security through private retirement accounts. These offer greater individual choice, including the need to avoid buying expensive annuities that cannot be passed on to the next generation. He is also on the side of the angels in pointing out what should be self-evident to the richer industrial economies of the west. This is that our population dynamics - above all, a fall in the ratio of workers to pensioners - will demand that state pensions become less generous relative to employment incomes and/or that the average retirement age rises. Bush faces an electorate which, relative to the more short-sighted electorates of western Europe, is rather better at figuring out the need to take a long-term view of social security issues. If he is to win through he will need to show real progress on four domestic issues. First, the budget must begin to slow the loss of red ink. Second, the trade balance must begin to respond along the upward slope of the "J curve". Third, progress must be made in reforming the US social security system. Fourth, the US economy must continue to grow. My betting is that Bush will secure greater fiscal restraint and that, on the monetary side, Alan Greenspan, at the Federal Reserve, will continue to tighten interest rates. If so, the dollar seems unlikely to continue to fall against sterling and our exchange rate may come under pressure. But, be warned, there is no good economic model for predicting exchange rates. � Prof Sir Donald MacKay is chairman of Scottish Mortgage Investment Trust ------------------------ Yahoo! Groups Sponsor --------------------~--> Has someone you know been affected by illness or disease? Network for Good is THE place to support health awareness efforts! http://us.click.yahoo.com/RzSHvD/UOnJAA/79vVAA/NJYolB/TM --------------------------------------------------------------------~-> �������������������������������������������������������� This is ZESTEconomics. Post economics-related articles and event info to [email protected] If you got this mail as a forward, subscribe to ZESTEconomics by sending a blank mail to [EMAIL PROTECTED] OR, if you have a Yahoo! 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