Saruhan Hatipoglu (sshatipoglu@beri.com)

COUNTRY ROADS, TAKE ME HOME:

The Second Coming of George W. Bush and Economic Challenges

©2004 BERI S.A - December 2004

Will the Real Middle America Please Stand Up?:   More than a month has passed since the critical U.S. elections, and the dust has finally settled, thankfully much faster than it did four years ago when the U.S. had wakened with lingering uncertainty in that cold November morning in Washington, D.C.  America has spoken this time, and it has spoken clearly. Although some political analysts to this day claim that the country is still divided and that the election was close, the reality is a Republican landslide with three more seats in the House and four in the Senate for the Grand Old Party, whose presidential candidate received 286 electoral votes.  To add insult to injury for the Democrats, President Bush also won the popular vote by a 3.32 million margin.

Faith and family, correctly stated by former President Bill Clinton, are why the Democratic Party lost the elections in 2004.  To the Europeans the reason was God, gays, and guns.  The party failed to reshape itself and move away from the image of an iconoclastic group of nonbelievers, which was tantamount to accepting defeat in the locker room before the match even began.  It was not the uneasiness of changing presidents during wartime, nor was it the economy that determined the outcome of this year’s election.  After all, it was clear that Iraq would be a medium-term disaster, and signs of a vibrant economy were far and away.  Yet, the architect of the chaos in Iraq and the economic uncertainty at home and in the world won the presidency because the decision was considered to be a simple choice between “good and evil,” and Middle America had made that choice a long time ago, as BERI had predicted in June.

A Political Walk in the Park Until 2008:  With a fresh mandate in hand, President Bush will undertake with great ease substantial reform measures long promised to Wall Street and other interest groups during his second term, while further weakening the Democratic Party.  For example, one of the controversial issues of the previous four years, partial privatization of Social Security, will gain pace in the coming months.  The objective is to enhance Wall Street profits through fees required to manage the proposed new accounts.  Secondly, the Bush administration will make previously granted tax cuts permanent.  This move will not only create more sympathy for the White House but it will also automatically reduce any potential social spending programs that the Democrats might want to introduce because of the disastrous budget deficits.  Permanent tax reductions will experience minimal problems in the Republican-dominated Congress.

Finally, the war against terrorism will continue as usual.  Some analysts predicted a tone-change on this matter during the second term.  However, the recent appointment of Condoleeza Rice as secretary of state and retaining Donald Rumsfeld as the secretary of defense are clear indications that Mr. Bush has no intention of listening to other tunes.  The hard policy stance in Iraq and other troubled areas will remain, which will result in growing defense-related expenditure.  Politically, Mr. Bush is indeed in a very comfortable position, but the policies that he is advocating signal distressing times, particularly at a time when the world economy needs balanced leadership with a clear direction.

Worst Kind of Poverty:  All of the above-mentioned reform and policy measures are almost certain to move along, creating a huge pressure on the already ballooned fiscal deficit, which reached US$412.6 billion in FY2004 according to U.S. Treasury officials (US$374.3 billion in the previous year).  “Public debt is a public curse, and in a Republican government a greater curse than any other,” said James Madison.  Indeed, every indication today is that the curse will go on for four more years under the Bush administration.

Just weeks before the elections, Treasury Secretary John Snow wrote a disturbing letter to the U.S. Congress informing representatives that he suspended federal contributions to the civil service retirement fund so that a default can be avoided by the Treasury.  Days after the Bush victory, the House of Representatives voted to increase the debt ceiling to US$8.2 trillion (an additional US$800 billion), which enabled the Treasury to continue borrowing.   Substantial tax cuts, sustained growth in spending, particularly defense (U.S. is increasing its force in Iraq by another 12,000), and modest economic expansion will take their toll on the budget in the next two years.  The shortfall is expected to rise to an estimated US$500 billion in 2005 and US$575 billion in 2006.

This is the government’s side of the story, but how about the people?  It is fair to argue that Senator John Edwards’ “Two Americas” story is not adequately describing America.  There are Three Americas today: The “Have’s,” “Have Not’s” and “Have Not Yet Paid for What They Have’s.”  It is this third category that is quite worrisome, particularly at a time when the future course of the economy is uncertain because of rising interest rates. American homeowners are encouraged by the rapid increase in housing prices, an excessive and troublesome 13.1% annual growth in the third quarter of 2004.   Maybe it is premature to label the robust housing market as yet another excess asset market, as was the stock market four years ago, but this growth in value is not a normal development and, given economic conditions and the upward trend in interest rates, is prone to a harsh reversal.  To add fuel to the fire, American consumers, who are increasingly basing their consumption on asset ownership, are not ready for such a downturn in the real estate market.  The personal savings rate was an inadequate 0.2% in October.

The Unbearable Lightness of the US$:  Nothing is wrong or alarming in an orderly US$ depreciation, particularly when a sizable current account deficit needs correcting and foreign investment, portfolio and direct, is flowing in to finance the difference.  However, capital inflows seem to be missing in the equation, which is undermining the long-held belief that the US$ is a hegemonic currency.  Take China, for example.  Despite official denials, some members of the monetary policy committee confirmed that China reduced the proportion of foreign exchange reserves held in US$.  Furthermore, in October, the Chinese government showcased a very successful €1 billion bond issuance in which European investors offered more than €4 billion for the 10-year bond.  This was a strong signal for other Asian central banks that have been purchasing large sums of U.S. bonds and treasuries that there is life outside of the US$.  To top it all off, China officially asked the U.S. to take “appropriate actions” to halt the slide of the US$, its strongest signal that a basket of currencies is a viable alternative to its currency peg to the US$.

A growing current account deficit, no evidence of significant job creation, and a substantial budget shortfall are all issues that foreign investors are watching closely.  In the good old days, Washington, D.C., did not attach much value to foreign repercussions to such internal developments because it could always fall back on the huge appetite of foreign investors for US$ securities.  But, “how hungry are they now and what would they like to consume?” is the key question that needs to be answered. The U.S. dollar’s destiny lies in that very crucial answer.

Investment Destinations and Appetite:  A number of studies indicate that there is no decline in global foreign savings, particularly portfolio investment.  On the contrary, numerous reports found that international savings are actually growing, largely an outcome of the globalization process.  The question is not whether there are adequate levels of investment funds but rather where these overseas savings will be channeled in the near future.  Not too long ago, the answer was obvious. With a strong financial market and profit incentives, the U.S. was the top choice.  Today, the decision is not as obvious because of the potential exchange rate volatility and the loss of capital in bonds as interest rates rise.

A growing number of portfolio investors are looking to other currencies and markets to diversify their holdings, which will place additional pressure on the US$ and reduce the level of flows required to finance the substantial current account gap. Confidence in the U.S. market is not as strong as in the past, and this is not only the case for portfolio investment.  A study by A.T. Kearney found that the U.S is losing its relative attractiveness as a direct investment destination.  The Foreign Direct Investment Confidence Index (FDI CI), released in October, showed that the U.S. is being challenged by evolving economies like China and India.  China maintained its place as the most attractive destination position by Global 1000 CEOs and India jumped from 6^th to 3^rd place immediately behind the U.S.

“China has already proven to be a more attractive FDI destination than the U.S. based on the views of senior executives from the world’s largest companies, but now India is getting closer, and there is a widening of alternative investment destinations for multinational companies,” said Jonathan White, an Associate of A.T. Kearney and the manager of the FDI CI.  Although a higher percentage of executives feel confident about the global economy, the same survey found that 51% of participants still see currency and interest rate volatility as “critical risks to operations.”  Specifically, 41% of top global investors are concerned about the US$ volatility, while only 7% think that the widening U.S. budget deficit constitutes a problem. The impact of budget deficits on American interest rates and currency movements is substantial but received minor attention from top executives.  Mr. White said, “Currency strength is a reflection of confidence in a specific market. From a corporate investor perspective, profitability is seen as more easily affected by changes in currency movements than by longer term developments such as budget deficits.” This might be true for CEOs, who are feeling pressures to improve their P&L statements in the short run.  But, a substantial current account shortfall, a deteriorating US$ partly due to shifting investor perceptions, and a large black budget hole might just be the early warnings of a perfect storm and more volatility of the US$.     

Conclusion:  Because of the economic challenges ahead of the U.S. and current plans of the administration, it is difficult to maintain a positive outlook for the U.S. and global economy.

v     President George W. Bush was not reelected because he has done a competent job in managing the U.S. economy during the past four years. He was reelected because the damage he has inflicted on the economy was not strong enough to overcome the faith and family values that he has regularly espoused during his first term.

v     Mr. Bush was not reelected because of his success in the war against terrorism and in Iraq.  He was reelected because his critical failures on these issues did not overshadow his strong religious convictions.

It is no longer the economy or national security that makes the difference for the American people.  It is a new era, where religion, faith, and family play the pivotal role in politics.  At a time when the world is in search of certainty and confidence, economic priorities are taking a back seat to issues of a more intangible nature in Washington, D.C.  And, that is one dangerous game.  

DIRECTOR'S PERSPECTIVE Last Updated 16 December 2004