Bush Needs Decisive Change of Course

George W. Bush wants to start privatising Social Security, reform the tax code and undertake new foreign policy initiatives in his second term. But he faces two severe international economic threats that could derail the US and world economies and take his own agenda along with them. Each will require a substantial mid-course policy correction by the administration and substantial co-operation from key countries.

The most acute risks are posed by the large and rapidly growing US current account deficits. They exceed 6 per cent of gross domestic product and are on a trajectory to reach 10 per cent - more than $1,000bn annually - within the next few years. The US already must borrow $5bn from the rest of the world every working day (to finance America's own foreign investments as well as the trade imbalance).

The good news is that the current orderly decline of the dollar, if continued for another six months at its recent pace, could achieve the cumulative decline of 30 per cent from its early-2002 peak needed to restore a sustainable US external position by cutting the external deficits in half. But the decline could just as easily turn into an overshooting freefall that would shatter confidence, drive US interest rates towards double digits and crash equities a la Black Monday in 1987. Or it could stall, thereby storing up bigger problems a year or so out if other countries block the counterpart rise in their own currencies.

The root cause of the problem is low US national saving, which requires the US to borrow massive sums abroad and thus run large current account deficits. There is unfortunately no reliable policy instrument to enhance US private saving. Hence Mr Bush and his strengthened majorities in Congress must promptly launch a credible programme to cut the US budget deficit decisively during his second term and set the stage for restoring the surpluses he inherited in 2001. A failure to do so would undermine global confidence in US economic management and the long-run outlook for the nation's economy, risking acceleration of the dollar's fall and a very hard landing.

With strong fiscal action at home, the US administration could credibly ask key countries, especially in Europe, to implement structural reforms and expansionary macroeconomic policies to offset the cuts in their trade surpluses and growth rates that will result from the rise in their currencies. Participation in such international arrangements, to maintain global growth while achieving the needed adjustment, could help governments elsewhere overcome internal resistance to essential policy changes.

China is central to the currency component of the solution because it continues to strengthen its competitiveness by riding the dollar down. This severely truncates the adjustment process because other Asian countries fear losing competitiveness against China and thus block their own appreciations against the dollar. Fortunately, the sizeable appreciation that is needed for international reasons would simultaneously help China cool its overheated economy by damping demand for its exports, countering its alarming inflationary pressures and stopping the inflow of speculative capital that promotes excessive monetary expansion. Beijing can act independently of any foreign pressure by rejecting US and International Monetary Fund entreaties to float its currency and opting instead for a substantial one-shot revaluation.

The acute risks stemming from the global imbalances are compounded by the prospect of a renewed sharp rise in energy prices. Despite the decline from their recent peak, global oil prices could soar to new highs of $60-70 per barrel within the next year or so even without prolonged supply interruptions. Global demand continues to rise rapidly. Investment in new production has lagged badly. Increased crude oil output will take years to come on stream. Shortages of refining and other infrastructure in the US boost product prices. Political uncertainties in producing regions could continue or even increase. This year's oil price jump has already cut a full percentage point off the US and world growth outlook for 2005. Oil at $60-70 per barrel would double that loss. Rising energy prices and a falling dollar would reinforce each other as in the 1970s and raise the spectre of renewed stagflation.

When oil prices start rising again, the Bush administration should announce its willingness to exchange 100m barrels of light crude from the Strategic Petroleum Reserve for 100m barrels of heavy crude. This would alleviate severe refining constraints and could bring prices down by $10-20 per barrel. For the longer run, the US should adopt a gasoline tax of $1 per gallon to curb demand and put downward pressure on world prices. It should work out a North American energy strategy that promotes greater investment in energy production and distribution in all three North American Free Trade Area countries. It should assemble a coalition of big energy importers (including China and India) to counter the cartel of the Organisation of the Petroleum Exporting Countries with an offer to stabilise prices in the range of $22-28 per barrel traditionally advocated by Opec, mobilising for that purpose the 1.5bn barrels held by importing governments.

Both the global trade and energy problems are greatly intensified by overt manipulation of key prices by key players. China and other Asian countries intervene heavily to block currency adjustment. Opec producers have suppressed energy investment and output for 30 years. The Bush administration and other market-oriented governments should be particularly eager to counter these blatant price distortions.

Previous Republican administrations have responded to circumstances such as those facing Bush II by dramatically altering their policies, especially on exchange rates and trade. After almost three years of "benign neglect" of the dollar, the Nixon administration terminated gold convertibility and imposed an import surcharge to achieve a needed devaluation. The Reagan administration, after the pure "benign neglect" of its first term, engineered a dollar decline of 30 per cent through the Plaza Agreement. It is virtually inconceivable that the Bush administration could skate through four more years without addressing these issues decisively. Hence it should promptly launch decisive new economic and energy policies to protect the US and world economies along with its own hopes for a successful second term.