Bush's electoral economics is bad for trade

Comment: Don't you just love the foreign exchange markets? One day we're told the strength of the US economy justifies a rising…

Comment: Don't you just love the foreign exchange markets? One day we're told the strength of the US economy justifies a rising dollar, the next worries about a trade war and the rising current account deficit threaten a greenback collapse, writes Cliff Taylor.

A cynic might think that some investors were trying to give verbal support to their current position in the market - or that dealers were trying to talk the currency up one day and down the next, to encourage as much business as possible.

Or maybe it's just that no one is sure what's going to happen next. The ostensible trigger of the latest dollar decline was the Bush administration's decision to impose tariffs on textile and lingerie imports from China. This focused attention on the risk of escalating trade tensions, already evident in rows over US steel tariffs and EU rules on GM foods, and on the stalled world trade talks.

The move to slap the tariffs on Chinese goods is further evidence of "election economics" in the US. Mr Bush has cut taxes to spur economic growth and, together with lower interest rates, it appears to be working. But his latest tactics do carry considerable risks.

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Following the move to protect the steel industry from imports, the administration is now doing the same for clothing and textiles, playing to the gallery to give short-term protection to US jobs. The political argument is that the gain from protecting certain industry sectors - which tend to be concentrated in certain geographic areas - will outweigh the dispersed cost in terms of higher prices to consumers and business.

In seeking such short-term political advantage, however, the Bush administration is highlighting some longer-term economic risks. The obvious one is rising trade tensions and a drift to protectionism. The Bush administration remains committed to free trade, a spokesman said after the announcement of the tariffs on Chinese goods; this has about as much credibility as Michael Smith saying he supports the Hanly report.

A drift to protectionism and selective tariff barriers would deal a heavy blow to international economic confidence and long-term growth prospects. Its likely impact on the dollar is unclear, as by definition other countries would also be affected.

If the US were to lead the way by imposing significant tariffs, it could hit growth by affecting consumer income and pushing up business costs. In turn this could depress US growth and the dollar. So far, however, the scale of the tariffs imposed would not have a significant impact on overall demand through this channel.

More importantly in the short-term is that the latest events have thrown the spotlight on the key area of dollar vulnerability - the huge current account balance of payments deficit.

As written here recently, the deficit is now above 5 per cent of US gross domestic product, requiring a huge inflow of foreign capital to fund it - not far off $50 billion a month at the moment.

So long as foreign capital keeps flowing in - either through foreign firms investing in US operations or overseas funds going into US financial assets - this is no problem. But fears of a weakening dollar will not encourage such investment.

And increasingly, investors believe the Bush administration wants to see a weaker currency to boost economic growth. The decision to put tariffs on Chinese imports reinforces the view that parts of US industry are finding it difficult to compete at current exchange rates.

Figures this week, meanwhile, showed a substantial drop in net capital investment in the US from $50 billion in August to just $4.2 billion in September. Whether this is merely a monthly blip or a signal of a cooling of foreign investors towards US assets remains to be seen.

Trade tensions, if they flared, could also affect capital flows into the US. For example, China is a substantial investor in the US markets as it recycles its massive trade surplus into capital investments in the world's biggest financial markets.

Ironically, much of the surplus is on trade with the US, causing the tensions which led to the tariff announcement and which have spurred US demands for the Chinese to allow their currency - currently pegged to the dollar - to revalue.

Building trade tensions might encourage Chinese and other overseas investors to put their cash elsewhere.

What we are seeing is a dangerous mix of electoral economics and longer-term imbalances in the US economy. By trying to boost the short-term position of the economy, Mr Bush risks highlighting underlying weaknesses and affecting the confidence of international investors on whom the US now relies.

It may blow over. A full-blown trade war would be in no one's interests. And recent US economic indicators have been encouraging, suggesting an economic pick-up which may make the Bush administration less jumpy.

But there is no doubt that the current account deficit is a potential cause of instability. If it were to spark a sharp dollar decline this would damage EU - and Irish - economic growth prospects.