Rupert Cornwell: Can the US afford a war as well as $1.2 trillion in tax cuts?

WASHINGTON - America, as George Bush never ceases to remind his fellow citizens, is at war.

He loves the depiction of him as a latter-day Churchill, aware of the mortal danger of appeasing tyrants.

Forget, however, any notion of blood, sweat and tears on the US home front.

America may be getting a war. Unlike surely every other nation at war in history, it is also getting US$690 billion ($1.22 trillion) worth of tax cuts.

"What did you do in the war, Daddy?" a Los Angeles Times columnist wickedly asked the other day, "I got a big tax cut, and passed the bill on to you." Except that the bill is already coming in.

When it came to office in 2001, the Bush administration predicted a fiscal 2004 surplus of US$262 billion. Two years later, it is expecting a deficit of US$307 billion.

So fast and so large a swing, equal to more than 5 per cent of GDP, is without precedent in US history.

And it comes before the cost of an Iraq war (estimates start at US$100 billion), and the multibillion-dollar bribes being handed out to win the support of Turkey and other key allies, are factored in.

Now tax cuts to kick start an economy are standard practice, even if they exacerbate a deficit in the short term. Few would dispute the US certainly needs a jolt.

Fourth-quarter 2002 GDP growth of 0.7 per cent was the lowest of last year; the uncertainty over Iraq, coupled with severe weather in the North East mean that the start of 2003 will probably be equally weak.

Retail sales dropped 0.9 per cent in January (and that after a pretty dismal Christmas), while the closely watched consumer-confidence index of the University of Michigan dropped this month to its lowest level since 1993.

For the first time in six months, the index of leading indicators pointed downward in February.

All the while, business holds back on new investment, while the great refinancing boom - which kept consumers in America, as in Britain, spending as they cashed in on the rising value of their homes - is losing steam.

The official expectation is that growth this year will at least match 2002's provisional 2.8 per cent. But don't count on it.

Maybe, of course, everything will perk up once Iraq is out of the way.

A quick and clean victory and the ouster of Saddam Hussein, the Bush camp fervently hopes, and corporations will dust off those spending plans, consumer confidence will return, the markets will rebound and growth will resume.

Thereafter Reaganomics will wave its magic wand; the federal deficit will disappear and everyone will live happily ever after. But it may not be so simple.

Share prices are still on the high side historically, despite the huge fall from the early 2000 market peak.

For corporations, moreover, Iraq may be a convenient excuse for doing nothing; well before Mr Bush turned up the heat on Iraq last autumn, the refusal of business investment to pick up was worrying the Federal Reserve.

And if war further destabilises the Middle East and unleashes new terrorism, all bets are surely off.

And there is another factor too - an external deficit that more than matches the internal one.

US trade deficits, of course, are nothing new. The charitable explanation of this one, as of others before it, is that while the US economy is not doing well, it is faring better than almost everyone else.

In Washington the preferred image is of America as Atlas, staggering under the weight of a world becalmed by recession.

Small wonder John Snow, the new Treasury Secretary, argued to his fellow G-7 finance ministers that a little old fashioned burden-sharing was in order.

Small wonder too, however, that several of America's partners at the weekend meeting in Paris evoked another old fashioned image - this one also dating back to the financial and economic turbulence in the 1970s and early 1980s - of the "twin deficits" of the Vietnam and immediate post-Vietnam era.

Then as well, the US ran huge trade and budget deficits simultaneously, and the global currency system was in frequent turmoil.

Like the budget deficit, today's trade figures are much larger than a quarter century ago.

The shortfall hit US$44.2bn in December alone - 10 per cent more than November - even as the dollar declined against other leading currencies, making US goods more competitive.

For the whole year, the deficit was US$435 billion, some 30 per cent greater than in 2001.

The current account deficit, which includes profits on investments, was even higher, according to estimates by UBS Warburg, at about 5 per cent of GDP, or US$500bn.

Only a net capital inflow of about US$1.5bn a day from the rest of the world currently permits the US to live in the manner accustomed.

And as the country's most venerated economic soothsayer Alan Greenspan told the Senate Banking Committee on 11 February, that state of affairs cannot continue indefinitely.

The usually Delphic Fed chairman was clarity personified as he gave the thumbs-down to the US$690bn stimulus package: "My own judgment is that fiscal stimulus is premature." He also warned that today's trade and budget deficits were ultimately unsustainable.

If unchecked, the federal deficit would reach "a certain point of no return" - just as the US confronts a pensions and benefits crunch as baby boomers start to reach retirement age.

The trade deficit was an equal concern.

Thus far the downward adjustment of the dollar has been relatively orderly but, in Mr Greenspan's words, "There are other scenarios in which there are disruptions.... How adjustments will occur is unclear. That it will occur is inevitable."

His comments, especially about those about the desirability of the tax cuts so infuriated the White House that leaks emerged of how a displeased President may not renominate Mr Greenspan for a further two years when his current term expires in 2004.

But pique does not banish the nightmare scenario - that foreign investors, who have poured hundreds of billions of dollars into the country in the belief that the US is the most dynamic economy and offers the best returns, are no longer willing to fund the deficit, at least at the current exchange rate.

At that point a vicious circle could set in, as investors became ever more wary of holding dollar debt as the currency declined.

The enormous strategic advantage of the dollar's role as reserve currency would be eroded.

In that case, the US might be hit by the sort of humiliating crisis suffered by the Thailands, Indonesias and Argentinas of this world: a flight of short-term capital and a collapse of the currency.

Would the US stance be the "benign neglect" of old, allowing the dollar to fall - and in the process dealing a heavy blow to recovery prospects elsewhere? Or would the Fed feel obliged to act, raising interest rates and delivering the coup de grace to a faltering Wall Street and the fading real estate boom? And a final point is worth remembering.

When it was the hegemonic power in the late 19th century, Britain was also the world's largest creditor.

America today is the world's largest debtor.

One day, even the all-dominant US may be forced to choose between guns and butter.

- INDEPENDENT