The Hindu Business Line : US deficits, plunging dollar can derail global economy

In a special report, without mincing words about the grim fiscal outlook, the IMF economists have called for "timely and determined" action to tackle the deficit problem in the interest of both the US and world economy.

RARELY does the superpower come under the IMF's scan or receive acid comments on its fiscal management, given its exalted status as the largest shareholder.

But the $11-trillion economy has begun running huge budget deficits. Its alarming current account imbalance is driving the dollar down and posing grave risks to the world economy. And so, it is time for the IMF to speak up.

Democratic rivals to the US President, Mr George Bush — who is seeking a second term in the November elections — have accused him of fiscal recklessness while the administration defends the massive tax cuts which, it asserts, have got the economy moving into a strong recovery.

The federal deficits projected to last till 2011, the rising public debt, and the massive shortfalls in social security and medicare programmes totalling over $20 trillion are major challenges before the administration.

The Fund sees an urgent need for establishing a credible fiscal framework to return the Budget to balance, excluding social security, over the next five-10 years. In the absence of corrective actions, the large Budget deficits can further depress savings, crowd out private investment and push interest rates upward globally.

The projected rise in the US public debt by 15 percentage points over the next decade can raise world interest rates by 0.5-1 percentage point, affecting investment and output, according to the IMF economists.

Second, current deficits with continuing pressure on the dollar can lead to disorderly exchange rate adjustments and destabilise the financial markets.

It will affect bond prices and asset prices. The dollar has been steadily falling against the euro and the yen. Since early 2002 it has depreciated by 30 per cent against the euro and 19 per cent against the yen.

The weakening of investor sentiment vis-à-vis the dollar can affect the flow of foreign finance to bridge the current account deficits.

The US has been a net debtor and is on course to increase its net external liabilities to around 40 per cent of GDP within the next few years, an unprecedented level of external debt for any large industrial country, the Fund says.

Overall, a grim picture emerges from the IMF report with implications for the world economic outlook for the medium-term. At present, however, the global environment remains favourable to recovery which again is in large led by the US. But the substantial appreciation of the euro makes it difficult for the EU to maintain the pace of growth. In August 2003, when the IMF concluded its annual "health checkup" (Article IV consultations with US authorities), the Executive Board had welcomed the emerging signs of recovery with the "exceptional stimulus" provided by the US monetary and fiscal policies but had pointedly drawn attention to the need for decisive action to re-establish a strong fiscal position.

Serious concerns were voiced even then over the worsening of the long-term fiscal balance resulting from factors including the massive tax cuts of Mr Bush (2001-03) estimated to cost $1.7 trillion over the years 2002-11 and its spillover effect on current account deficits.

The hard-won gains of the l990s (Clinton era) in fiscal turnaround have now been lost with the evaporation of the Budget surplus, the economists note in the latest report. Between 1992 and 2000, the federal Budget, including the social security surplus, moved from a deficit of 4.5 per cent of GDP to a surplus reaching 2.5 per cent of GDP in fiscal 2000.

Deficits returned from 2002 and totalled $374 billion in 2003 or 3.5 per cent of GDP and is projected at around $500 billion in 2004 exceeding 4 per cent of GDP. The strong economic growth of the l990s and the stock market boom fuelling an increase in capital gains tax had contributed to the surplus in the last decade.

The IMF economists concede that the Bush administration's fiscal policies have provided valuable support to the recovery so far but are concerned that the projected large decade-long deficits and the emphasis on cutting taxes, along with boosting defence and security outlays, will put upward pressure on interest rates and erode long-term US productivity growth which has remained high (9.4 per cent in the third quarter of 2003).

Second, unless urgent attention is given to meaningful reform for fiscal correction, the administration will not gain time to address the underlying insolvency of the social security and medicare programmes.

These two systems, according to the IMF, are already under-funded and projected to run sizeable deficits within a decade from now while the ratio of retirees to working age population is expected to rise from the present 20 per cent to 40 per cent by the middle of the century.

Unless steps are taken to adjust contribution rates and benefits, the programmes will fall into deficits to be supported by growing transfers out of federal general fund. The funding gaps will be as high as $47 trillion or nearly 500 per cent of current GDP.

Closing the fiscal gap will require an immediate and permanent hike of 60 per cent in federal income tax yields or 50 per cent cuts in social and medical benefits, the IMF said.

The US Treasury Secretary, Mr John W. Snow, does not consider the current order of deficit of about $500 billion to be "historically out of range" and says it is "entirely manageable" as it represents roughly 4.5 per cent of GDP compared with a peak of 6 per cent in the l980s.

The Administration argues that deficits resulted from the outlays on defence and security to fight terror while tax cuts helped to pull the economy out of recession. Mr Snow says the administration goal is to cut the deficit by half as a percentage of GDP within five years. With an economy expanding toward $15 trillion by 2009, deficits up to 300 billion dollar will be within limits, he said.

Meanwhile, there have been indications that Mr Bush will come up with further tax concessions when he presents the federal Budget for fiscal 2005.

He is convinced that tax cuts stimulate the economy through consumer spending and higher growth will yield larger revenues. The global impact of the US twin deficits which are inter-related is viewed with even greater concern.

The US current account deficits had risen from $394 billion in 2001 to $480 billion in 2002, and with $413 billion in the first nine months, 2003 could record a deficit well above $500 billion or 5 per cent of GDP.

These large imbalances imply that the US has a need for continuing inflows of foreign financing. The IMF Deputy Director, Mr Charles Collyns, who heads the team monitoring the US economy, says as long as funds come in, things can move fairly smoothly.

But with very large current deficits, the net external liabilities of the US are rising quite rapidly relative to both the US GDP and global savings. "There is a substantial risk that the foreign investors' appetite for US assets, and particularly US Government assets, will over time diminish."

Even the relatively orderly dollar slide has complicated macroeconomic policy management in the euro area and Japan.

(The author, a former Chief Editor of PTI, is a freelance journalist.)