Global crisis if Bush passes the buck

Date: 03/02/05

The first steps towards redefining Europe's relations with Washington ahead of President George W. Bush's visit to Brussels on 22 February will come on 4-5 February, when finance ministers and central bank governors of the wealthiest nations, the Group of Seven (G7), meet in London.

On issues such as co-ordination of reconstruction in tsunami-hit states and on aid to Africa, encouraging declarations can be expected. But no progress is to be made on the biggest issue on the agenda, how to head off a global economic meltdown.

Much - too much - is being made of the presence of China, India, South Africa and Brazil at the G7 meeting. On Saturday they will be tiptoeing around the fringes of the action attending an "outreach breakfast". China's finance minister and central bank governor, will, however, participate in a G7 lunch.

So, will the leaf be turned and bridges begin to be rebuilt in London? The omens do not look good and not only because of divisive geopolitical issues such as the EU's reluctance to help America escape its quagmire in Iraq, arms sales to China and worries about Washington invading Iran. Although not on the agenda, these issues will inform the mood.

Official and private forecasts for the world economy, the International Monetary Fund, the Organisation for Economic Co-operation and Development (OECD) or any global investment bank, are not predicting economic disaster this year.

The OECD's latest economic outlook, released in December, has American real gross domestic product (GDP) slipping from a robust 3.8% in 2004 to a healthy enough 3.3% this year. The eurozone, it says, will grow faster - up from 1.9% to 2.3% - a tad on the optimistic side according to most investment bank economists.

These forecasts do not even try to address the imponderables. The dollar will fall further, but how fast? How long will Asian central banks carry on financing America's current account deficit?

A New York Federal Reserve Board paper in October estimated that in 1999-2003 Asian central banks accounted for 80% of the growth to $3 trillion (2.3trn euro) of global foreign reserve assets.

The bulk of this has been poured into financing America's current account deficit, which is hitting $600bn (461bn euro) a year, and still rising. Devaluation inevitably makes the deficit worse to begin with, especially if an economy is growing. A survey of central banks released last week by Central Banking Publications suggested that these tens of billions of dollars of official flows might not be pouring so freely into the dollar.

Were China to start diversifying its $600bn (461bn euro) of reserves and stop contributing so much to financing America's current account deficit, then global economic perils, a plunging dollar, soaring interest rates, falling share prices and bursting housing and bond market bubbles, would quickly appear. Official and private economists could then kiss goodbye to their rosy projections.

Ian Morris, from HSBC, put it plainly: "In spite of sub-trend growth in the first half of 2005, the [US] current account deficit will nevertheless remain at a dangerous 6% of GDP. Further declines in the dollar are therefore likely. The only way the [current account] deficit can narrow meaningfully is through a US recession."

But a recession is not in the re-elected president's play book. To cut the trade deficit and head off protectionist pressures, President Bush wants the dollar to slump, Europe to grow faster and China to revalue the yuan and make US exports cheaper. He wants to reform social security and make permanent the tax cuts enacted during his first term. No sign of plans to cut the $400bn (307bn euro) budget deficit.

But the French and German Finance Ministers, Hervé Gaymard and Hans Eichel, said that Europe had already shouldered too much of the adjustment burden through the surge in the value of the single currency.

Could this Franco-German entente be a sign that at last the eurozone (unburdened by the United Kingdom's American liaison) is starting to speak with one voice? If so that will add to tensions this weekend in London.

The challenges the finance ministers face are formidable as it is not clear yet how to sequence or synchronise initiatives aimed at stabilising the global economy.

What if China did revalue its currency and Asian countries pegged to the yuan followed suit? Couldn't that hit the flows into the dollar and trigger the foreign exchange market turmoil everybody is trying to avoid? It is probably desirable for China to retain its peg to the dollar after a revaluation to ensure that it continues to buy dollars, US Treasury bills and helps to keep the US economy afloat.

Should not initiatives aimed at rebalancing the global economy be led by steps to reduce the US budget deficit?

But even a serious commitment to budgetary consolidation in Washington is a two or three-year project, especially in a time of heavy military expenditure.

By leading the way, the US would help to support confidence and this alone would make the problem of correcting imbalances easier to tackle.

Since the G7 disagree on who should do what, global economic stability will still be hanging by a thread when the meeting winds up.

No wonder Fred Bergsten, director of the Institute for International Economics, was warning in Davos last weekend that there could be a dollar crisis "within weeks".

• Stewart Fleming is a Brussels-based freelance journalist.

Anticipation of a meeting of Finance Ministers and Central Bank Governors of the wealthiest nations, the Group of Seven (G7), to be held on 4-5 February in London. Among the items to be discussed are the co-ordination of reconstruction in tsunami-hit states and aid to Africa, as well as the best steps to avoid global economic recession. China, India, South Africa and Brazil will be present at parts of the meeting.

• Primary Source