Next US president facing deficit hangover

Economics: The US electorate goes to the polls next Tuesday with most of the interest here centred on the implications for American foreign policy and the "war on terror".

Whoever wins, however, will take over the world's biggest economy at a crucial point - with the US economic recovery at risk of running out of some steam and the future clouded by massive deficits on the federal budget and on the current account of the balance of payments.

Both camps are promising both to reduce the deficit and keep the economy growing. That's elections for you, of course.

However, while the US economy is likely to have average growth of a very respectable 4.5 per cent or so this year, higher oil prices and rising interest rates could see this slow in 2005. AIB Treasury, in a note yesterday, predicted US growth could slip to 3.5 per cent next year. And slower growth will make it more difficult to tackle the federal budget deficit.

The Bush camp is, not surprisingly, taking the "growth will cure it" route, saying that making recent tax cuts permanent can spur the economy and reduce the deficit. John Kerry, on the other hand, wants to roll back the tax cuts for those earning more than $200,000 a year - but also says he would spend more on health.

Neither is terribly convincing in pledging to halve the federal budget deficit - now around 3.6 per cent of GDP - over the next five years. Kerry's plans are a bit more concrete perhaps. And as Niall Dunne of Ulster Bank markets points out in an analysis of the issues, the last Democratic White House under Clinton had a good record on the federal finances.

Kerry has promised new measures to control spending and says he would reinstitute pay-go budget rules, to require any extra spending or tax cuts to be offset by savings or new revenues elsewhere. However, equally Kerry has the Democratic wish list of social spending commitments in his manifesto.

Either way there is a good chance that whoever is in power will be forced into a bit of heavy trimming in their early years in office to try to stop the deficit from growing out of control. And they will be starting from a much worse position than our Government did when it embarked on its bit of post-election pruning.

Perhaps an even greater focus of the markets is the deficit on the current account of the balance of payments. This mainly reflects the fact that imports into the US are much larger than the exports it is selling overseas. While the budget deficit is a trifling $400 billion plus, the current account deficit was $530 billion last year and is likely to exceed $600 billion this year.

The two deficits are connected - in that excess Government spending pushes up US imports and swells the current account deficit. However, the causes of the current account gap are wider and for this reason it is not as directly influenced by Government policy as the federal deficit.

The "disaster scenario" in relation to the current account is fairly well peddled at this stage. Traditional economic theory would suggest that a weaker currency would help to lower the current account deficit by boosting exports and by making it financially more attractive for US citizens to buy domestically produced goods.

A weaker dollar against the euro would hit European exporters and threaten growth in the euro zone, which is already lacklustre enough. And if it occurred quickly, a dollar drop could be destabilising. In particular, it would threaten to damage the confidence of overseas investors who put capital into the US and effectively wind up "funding the deficit". And in turn this would put pressure on the US Federal Reserve Board to push up interest rates more quickly than they would otherwise have planned.

So far, such a destabilising dollar collapse has been avoided. However, over the past couple of years the dollar has been on a downtrend, particularly against the euro, with the single currency rising from around 86 cents in January 2002 to around $1.25 now. The Bush White House has been quite happy to see this, as it boosts American growth.

One policy area relating to the current account deficit which will come sharply into focus after the election is US pressure on China to allow its currency - variously known as the renminbi or the yuan - to float upwards. This would effectively devalue the dollar and make Chinese exports less competitive.

However, it would also cut the attractiveness of investment in US markets for investors from the Far East - and if capital from the Far East isn't available to fund the deficit, then where will it come from?

Kerry has taken a particularly strong line on this issue on the campaign trail, but whoever gets back into the White House is likely to pursue this agenda with increasing vigour, particularly if growth starts to slow.

The view of Niall Dunne of Ulster Bank is that a Bush victory might give the dollar a short-term boost, but that over the next few years "there's little the next president can do to prevent the dollar weakening further." His view is that the decline might be more orderly under a Kerry White House, which has more credible deficit reducing plans.

So the next president may face a few difficult years on the economy. Pressure will come on to cut spending to control the deficit, particularly if defence costs remain high. Growth is likely to slow.

And in the background is the question of how the current account deficit will be trimmed. Here maintaining confidence will be key for the new administration - the vicious cycle of dollar decline, falling investor confidence and rising interest rates must, at all costs, be avoided.