Danger that Europe and the US will go to war over trade

By HAMISH MCRAE

There has been a sudden and inevitable change of pace.

President George Bush has switched his attention from the war to the economy and his tax cuts; the Prime Minister, Tony Blair, has switched his attention to mending fences at the European summit.

For both, though, there needs to be some better economic growth if their reputations are to continue to shine.

But surely the world economy moves in step? Well, not really.

Go back over the past 40 years and the European and North American cycles have frequently diverged, as you can see in the top graph.

For example the early 1990s recession hit the eurozone two years after the US, and while during the 1990s the US grew faster than the eurozone, it also suffered a sharper recession in 2001.

(The eurozone as a whole did not go into recession, only some members such as Germany.) Most recently the US has recovered while the eurozone has failed to do so.

But is the US recovery sustainable? That is really the most important question facing the world economy.

The Bush Administration's policy is to give it a boost from tax cuts.

Will that work? Of course no one can know.

The wonderful, terrifying thing about economic relationships is that they are continually shifting.

What works in one set of circumstances and in one country does not work in another - or even the same country at a different time.

But we do know it matters.

The US is the world's largest importer and those imports fluctuate more violently than the economy as a whole.

It remains the main engine of global growth but one that is liable in the short term to swing about.

In recent months the propensity to import will have been reduced by the fall in the dollar, making imports relatively more expensive.

But what about US demand more generally? The tax cut package has been targeted towards the rich, which in theory should mean that it is an inefficient way of boosting demand.

Put money into the pockets of the poor, so the theory runs, and they will spend it; hand it to the rich and they may simply save more.

In the short term that may well be right.

In the next few months retail sales in the US seem likely to be weak, in the light of poor consumer confidence (though that was up a touch this month).

This drag on the economy may be exacerbated by the need to run down retail stocks, which look high in relation to current sales.

So I don't think we should expect too much joy from the US consumer through the summer.

The question more is whether the tax cuts will revive business sentiment.

Whatever view you take of this Administration - and within the States, opinion is unusually polarised - it must be good for the economy if the business community feels it has the president on its side.

"Old America", East coast professionals, the Hollywood elite and the trade unions, may be hostile.

However the "New America" of small businesses, entrepreneurs and recent immigrants is the engine of job creation and growth.

There should also be some help from still-lower interest rates.

Some calculations by Capital Economics here in London suggest that headline inflation could be less than 1 per cent by the end of the year.

Core inflation at 1.7 per cent is at a 37-year low and falling energy prices should help further.

It that turns out to be right, the way would be clear for further interest rate cuts: Capital Economics forecasts a Fed Funds rate of only 0.5 per cent by the year end.

That leads to what, for the world as a whole, must be the greatest imponderable of all.

Will the US retain the confidence of foreign investors? There is a geopolitical element here.

Most investors are not politically minded but the fact remains that US military activity overseas, however successful it may be, has to be financed from abroad.

The twin deficits of the balance of payments current account and the fiscal position are about 4 per cent of GDP - the current account a little more, the budget a little less.

In the opinion of JP Morgan the main culprit for the current account deficit is flagging foreign demand.

It thinks that it will stabilise at about its present level and that there are no signs of stress on the financing front.

A gradual decline in the dollar, continuing demand from abroad for US bonds and a switch by Americans from investing abroad to investing at home should, it reckons, combine to permit a gradual adjustment.

That may well turn out to be right.

If the US can finance its external deficit it should have little difficulty in financing its domestic one, which unlike the external deficit has recently been in surplus.

But there are obvious dangers.

The self-confidence with which the US regards itself is not mirrored everywhere else in the world and it will be investors in Europe, Japan and the rest of East Asia who determine whether the US can keep up its borrowing spree.

This is why the tax cuts are so important.

They are seen as an internal policy measure, not an external one, and of course that is what they are.

In as far as they are successful, though, they will have external consequences.

If they are successful in pushing the US economy to have yet another year of out-performance vis-a-vis the eurozone they will tend to make the current account deficit even larger.

Faster growth in 2003 is already widely accepted: the eurozone will be pushed to reach 1 per cent growth while the States ought to manage somewhere between 2 and 2.5 per cent.

But suppose in 2004 the US does more than 3 per cent and the eurozone less than 2 per cent - what then? Well, the current account deficit continues to widen, the dollar to weaken, eurozone exports to remain slack - you see the point.

As long as the US is allowed to run this external deficit by the rest of the world, it can carry on growing faster ...

and be snooty about the performance of old Europe and old Japan.

This cannot be a stable situation.

In Athens yesterday the patching-up was political.

That presumable will be successful for there is no point in EU members continuing to quarrel with each other.

In any case the balance of power is shifting.

But quarrels with the US, particularly on the trade front, seem likely to get worse, not better.

American contempt for old Europe and European distaste for new America must be greater than at any time for a generation.

There are sufficient simmering disputes (genetically modified food, steel, agriculture of course) for bad tempered debate to become destructive trade conflict.

And that would be really alarming for the world economy for all those forecasts of 3 per cent growth in 2004 would fly out the window.

- INDEPENDENT