The Deficit Debacle

As the second term of U.S. President George W. Bush gets under way‚ the foreign-policy challenges he and his administration face remain familiar ones: quelling insurgents in Iraq; deterring North Korean and Iranian nuclear ambitions; building a durable peace between the Israelis and Palestinians; and foiling al Qaeda and other terrorist operations before they strike.

But balancing the U.S. budget? Nowhere to be seen. The U.S. budget deficit may not fill an audience in Europe or Asia with the sort of fear‚ loathing‚ and hysteria that other Bush initiatives are known to induce‚ yet it may have the most direct impact on world politics of all Bush’s policies in the next four years. Any success the United States has in reining in its mounting budget and trade deficits will have repercussions everywhere. In particular‚ three of the world’s most important economic drivers — Europe‚ Japan‚ and China — will be required to adjust their policies in response‚ and those policy changes will‚ as always‚ produce winners and losers in a volatile political mix‚ with potentially serious implications for all three.

The economic restraints on Bush’s second term are real. In his first term‚ the federal budget swung from a 2.4 percent surplus of gross domestic product (GDP) to the 3.5 percent deficit the United States finds itself with today. Much of that was a necessary and largely benign adjustment to a fierce economic slowdown. But some of the drop was Bush’s own doing‚ notably deep‚ long-term tax cuts that must be addressed now that the economy is into its third year of recovery. The U.S. international accounts are also perilously out of balance‚ with imported goods and payments overseas exceeding exports by about 6 percent of GDP. And‚ at more than $420 billion‚ the U.S. budget deficit is not far off from where it was in the mid- to late-1980s when it caused financial dislocation around the world. With the world’s economic interdependence far greater‚ though‚ the risks are now much more acute than they were 20 years ago.

Bush acknowledges that something must be done and says he is committed to halving the fiscal deficit. But constrained by the fact that he campaigned as a tax cutter‚ and with a solid Republican majority in both houses of congress‚ the president will face pressure to reduce spending. It could entail raising the overall tax take as a proportion of U.S. national income‚ even if only by accelerating growth. Although politically problematic‚ Bush could achieve a higher tax take under the general heading of tax reform. The administration and congress are considering a number of proposals‚ including a flat tax and a national sales tax. Either could provide the opportunity to raise a little more for the Treasury without having to break any promises.

However it comes‚ any significant fiscal belt tightening in the United States during the next four years is in the long-term interests of the rest of the world. A reduction in the U.S. fiscal deficit should help stabilize international capital flows‚ halt the dollar’s slide‚ and boost exports of economic partners. But‚ in the here and now‚ the political costs will be brutal — and not mainly for Americans. As the U.S. fiscal deficit narrows‚ government borrowing abroad should increase. And as the United States increases its national savings by consuming less‚ the rest of the world will need to ease fiscal policy to maintain levels of global saving and investment. Put another way: If the United States is to halve its fiscal deficit in the next four years‚ it would remove a sizeable chunk of money from the global economy that has driven global growth these last four years.

Many have criticized what they see as the profligacy of U.S. economic policy during Bush’s first term. For some time now‚ it has become an axiom of international economic policy discussions that the United States needs to show more leadership by cutting its budget deficit. To be sure‚ many critics remain skeptical that Bush will do much to fix the country’s economic ledger in this term. But let’s assume that he is true to his word and moves aggressively to rein in the worst excesses of the U.S. fiscal position. What happens to the rest of the world if the United States gets serious about putting its economic house in order?

EUROPE’S POLITICAL BLOODLETTING

In theory‚ if the U.S. fiscal deficit shrinks‚ European deficits should grow. On its face‚ that may sound like good political news for governments in France‚ Germany‚ Italy‚ Spain‚ and elsewhere. No candidate ever lost votes by promising more spending or lower taxes. The European economies are still experiencing only a fragile recovery‚ and hard-pressed German and French workers would surely favor an economic stimulus in the form of more money in their wallets.

But there is a political problem. The Stability and Growth Pact — the European Monetary Union’s fiscal plan that took effect with the euro’s launch six years ago — requires governments in the eurozone to keep deficits below 3 percent of GDP and public debt below 60 percent of the size of the economy. The pact all but collapsed last year when France and Germany decided to ignore its strictures and faced no consequences‚ eliciting much resentment from Europe’s smaller states. New rules currently in discussion would permit countries to run deficits in exceptionally weak periods of growth. But the deficits major European economies would be forced to run in the wake of a shrinking U.S. deficit are far greater than those being contemplated. Smaller countries‚ especially those in Eastern Europe that have endured strict fiscal policies in preparation for European Union (EU) membership‚ will rightly resent evidence of others getting preferential treatment. So‚ as Europe adjusts to U.S. fiscal policy‚ European political fissures are sure to widen.

Political harmony in Europe would hardly be the only casualty. Although monetary policy is set for the whole of the eurozone by a single central bank‚ fiscal policy is still made by 12 separate national governments. This situation was always likely to create tension‚ as fiscal policy clearly affects monetary policy and vice-versa. That was why the Stability and Growth Pact was adopted in the first place. But as the last year has shown‚ a pact is still not enough to ensure coordination of economic policy. If the pact’s rules are eventually honored most often in the breach‚ they will become meaningless — and European economic cooperation will have suffered a serious blow.

What’s more‚ the European Central Bank (ECB)‚ already aghast at what it sees as an epidemic of fiscal laxity among European governments‚ may brake any further economic growth in the eurozone by threatening to raise interest rates sharply. The euro and the ECB are already unpopular in much of Europe. If the ECB is unable or unwilling to cut interest rates‚ and the euro continues to rise against the dollar‚ the political fallout could be even more unpleasant. Populist politicians in the sluggish European economies will have a juicy target: a central bank that prioritizes the pursuit of aggressive inflation-cutting goals above jobs and growth. In Germany‚ criticism of the ECB is already widespread‚ with Chancellor Gerhard Schröder’s government expressing increasing concern about European monetary policies. That could get a lot worse.

Nor will the trans-Atlantic trade relationship emerge unscathed. If the United States tightens its belt and begins to reduce its current account deficit‚ any corresponding reduction in Europe’s trade surplus with the United States will increase protectionist pressures across Europe. Against the current backdrop of anti-American sentiment‚ job losses for German and French manufacturers will surely strengthen calls for the EU to toughen its stance on trans-Atlantic trade. The sight of American exporters eagerly gaining market share in a European economy whose hallmark is high unemployment will not be welcome to European voters. None of that is to say Europe is incapable of making the necessary economic adjustments. But it will only come with serious political bloodletting.

AN ENFEEBLED JAPAN

No country probably fears a drop in U.S. deficits more than Japan. If Bush follows through on his pledge to cut the U.S. deficit in half‚ it will likely push Japan closer to a real political crisis‚ especially if the government does not preemptively speed up the reform process. Paradoxically‚ it has been historically strong American demand for Japanese imports — driven in part by the mounting U.S. budget deficit — that has allowed Japanese politicians to avoid dealing with the underlying structural weaknesses of Japan’s economy. But they may not be buffered from these political pressures for much longer.

Unfortunately‚ Japan is in no condition to counter a declining U.S. deficit with a fiscal expansion of its own. The Japanese fiscal deficit is already more than 9 percent of its national income; indeed‚ its long-term fiscal outlook is even bleaker than Europe’s. And monetary easing is also impossible‚ given that the Bank of Japan is already keeping interest rates at near rock-bottom levels.

In difficult situations such as these‚ it is hard to break bad habits. Japanese politicians will once again be tempted to absorb the blow by keeping the yen competitive against the dollar through heavy currency intervention. Voters and powerful business interest groups would certainly welcome the move‚ as it would maintain the export-led growth that has lifted Japan out of its 10-year slump in the last two years. It would‚ however‚ create real strains across Asia‚ and quite possibly with the United States as well. If the yen fell against the currencies of its major Asian partners‚ resentment at Tokyo’s persistence in exporting its way out of economic woes at the expense of the rest of region will surely intensify. Asia’s other economies would feel the squeeze even more‚ because the shrinking U.S. deficit means less American demand for foreign imports. And‚ as Japanese companies seek to shift their exports to other‚ faster growing Asian markets‚ governments across the region would cry foul.

Of course‚ a better but less immediate way for Japan to help rebalance global growth is for Tokyo to accelerate structural reforms. These could include reforming the labor market‚ pension system‚ and banking sector to encourage further savings. But‚ in the end‚ if Japan wants to counter a smaller U.S. budget deficit‚ it must turn to the Japanese consumer. When Americans are saving more and spending less‚ Japan will have no better policy response than to encourage their own domestic consumption. Japan has shown few signs in the last decade that it is serious about implementing reforms that would encourage such domestic spending. As U.S. demand drops off‚ Tokyo will no longer be able to procrastinate. And as Japan’s population ages rapidly‚ increasing the necessity of retirement savings‚ the need for reform aimed at stimulating spending will only grow.

THE CHINESE PUZZLE

Perhaps the largest and most unpredictable changes that U.S. deficit slashing would induce will come from China. The interdependence of the United States and China in economic‚ financial‚ and monetary terms has been the single most important international economic development of the last five years. China is now estimated to run an annual trade surplus with the United States of more than $150 billion. With all those excess dollars it receives‚ Beijing buys up U.S. assets‚ especially Treasury bills. And‚ to keep its currency from rising against the dollar in the face of such a large surplus‚ China actually buys up even more U.S. currency. It is an inherently unstable situation that cannot continue forever.

In Beijing‚ authorities are already facing the need to cool the country’s rapid growth. If U.S. domestic demand slows‚ as it must in the next few years‚ China’s continuing expansion will be essential to sustain global growth. But to prop up global demand‚ China will need to take some bold and politically risky measures of its own. For example‚ its currency policy will finally have to change. Revaluing the yuan or letting it float will allow imports from the United States and the rest of the world to become cheaper in China’s growing domestic market. But doing so brings its own dangers: namely‚ that the large amounts of foreign investment pouring into China will dry up. These funds have financed much of the country’s construction boom‚ and have helped mask some deepening problems at Chinese financial institutions. If the foreign investment tap slows down‚ the risks to China’s investment and its banks are obvious. Mountains of bad loans will emerge from banks’ balance sheets like submerged icebergs.

To maintain its near double-digit growth‚ China could try its own fiscal expansion to offset the U.S. contraction. But increased government spending is not an appealing option for the People’s Republic‚ given the already unsteady state of Chinese public finances. The nightmare scenario could entail the double whammy of slowed growth combined with deepening financial problems. If China’s increasingly affluent middle-class households turn anxious about putting their savings in shaky banks‚ Chinese politics could turn even more unpredictable than the country’s balance sheets — something no one in the upper reaches of the Communist Party wants to see anytime soon.

Last year‚ the International Monetary Fund warned that "large U.S. fiscal deficits… pose significant risks for the rest of the world." Of course‚ this statement is true. U.S. fiscal deficits cannot be allowed to grow unchecked‚ and many finance ministers‚ trade officials‚ and economists have suggested that there is something wrong with a U.S. economic leadership that has allowed the global financial system to become so unbalanced. But be careful what you wish for. If the United States ever tackles its mountain of debt‚ the rest of the world may not be ready for the political avalanche that will follow.