Economic threats must be addressed

By David Crane

The revelation of a major terrorist plot to bomb transatlantic air flights between Britain and the United States is just the latest in a succession of threats to the world economy.

Earlier this past week the U.S. Federal Reserve decided against raising interest rates, despite concern over rising inflation, due to its fears over future risks to the economy.

At the same time, continued conflict between Israel and Hezbollah fighters threatened to spill over into a wider war and higher oil prices.

Then there is the danger of civil war in Iraq and intensified fighting in Afghanistan, nullifying any hopes of an end to these conflicts any time soon. Yet to be resolved is the dispute over Iran's nuclear program.

In many respects, what is most amazing is that the international economy is so resilient in the face of so many uncertainties, which also include the big U.S. budget and current account deficits, weak growth in Europe, a Chinese economy that is overheating, and the breakdown in the global trade talks at the World Trade Organization.

Yet it would be a huge mistake to become complacent. There are big issues that won't go away. In fact, the longer the delay in addressing them, the greater the eventual pain of adjustment.

From an economic point of view, the biggest challenge is to correct the continuing high U.S. budget and trade deficits, which at some point threaten to bring down the entire global economy if not addressed.

The central banks of Asia, notably Japan, China and Taiwan, as well as the big oil exporters in the Organization of Petroleum Exporting Countries, are keeping the U.S. economy going, and the U.S. dollar stronger than it should be by financing huge U.S. deficits made possible by their own excessive trade and current account surpluses.

But a continuing buildup of U.S. government debt, with that debt held increasingly outside the United States by foreign governments, is clearly not sustainable. Foreign holdings of U.S. government debt totalled $2.4 trillion (U.S.) at the end of last year, and that amount continues to increase.

Interest payments last year totalled $114 billion (U.S.) and, with both the total level of debt expected to grow and with interest rates expected to climb, there's a serious question as to how long this pattern can continue.

U.S. government interest payments to foreigners, mainly foreign governments, are already greater than U.S. government spending on education, training, and employment and social services.

As the International Monetary Fund warned in its World Economic Outlook this year, these imbalances are the biggest vulnerability in the global economy. But resolving them will be enormously difficult since the rest of the world depends on the U.S. appetite for imports.

Canada is no exception. Last year, U.S. imports of goods and services totalled $2 trillion.

So a decision by the United States to unilaterally eliminate over a number of years its budget and trade deficits would hit other countries, including Canada, hard. The U.S. dollar might have to depreciate up to 40 per cent against its main trading partner currencies and the U.S. economy would go into recession.

There are three risks, according to Bank of Canada Governor David Dodge:

The U.S. moves to reduce consumer and government spending in order to increase domestic savings, with overall U.S. spending falling without a corresponding increase in spending in the rest of the world. This could push the global economy into a long phase of slow growth and periodic recessions.

Investors, notably foreign central banks, could "dramatically reduce their exposure to the United States, which could cause major disruption in world financial markets," and which could spill over into trade in goods and services, triggering an even more severe economic crisis.

These kinds of risks and events could prompt a rush to protectionist policies, "which would exacerbate the damage to the global economy."

All of the other issues we face, such as terrorism, disarray in Iraq and the threat to world oil supplies, make dealing with the more fundamental challenges of imbalances all the more difficult. Yet delay will only make future adjustment even more difficult.

The G-8 nations are not capable of solving these issues by themselves. We need a wider group of nations, perhaps working through the IMF, to find co-operative ways to share the pain before we end up with a global recession that could be the worst since the 1930s Great Depression.