Christopher Smallwood: Bush must act on the deficit to prevent an economic disaster for the world

If there is such a thing as a good election to lose, John Kerry at least has the consolation that this year's presidential contest almost certainly fell into that category. It is not just in Iraq that there is a huge mess to clear up. The economic legacy of the Bush first term is the worst to be bequeathed by any president since the Second World War.

If there is such a thing as a good election to lose, John Kerry at least has the consolation that this year's presidential contest almost certainly fell into that category. It is not just in Iraq that there is a huge mess to clear up. The economic legacy of the Bush first term is the worst to be bequeathed by any president since the Second World War.

The central question now is whether, freed from the all-consuming need to be re-elected, the President has it in him to take the measures necessary to deal with the huge hole in the nation's finances which his policies have created. There is still time for the fiscal situation to be put right, but if things are left to drift and the deficits continue to grow, an economic disaster for the US and the rest of the world is all but inevitable.

One way to judge how bad the Bush economic record has been is to place it in the context of previous presidencies. Start with the public finances. The first chart shows public sector deficits and surpluses going back to the time of Jimmy Carter in the 1970s. This shows that, contrary to the conventional wisdom, Democratic presidents have persistently rebuilt public finances following periods of Republican profligacy. Thus Carter took the budget from heavy deficit back to balance after the Nixon/Ford years; and Clinton turned the huge deficit inherited from the elder Bush into a significant surplus.

In this respect, the latest Bush has been true to Republican type, with the public finances deteriorating by the equivalent of 6 per cent of GDP over one presidential term - a bigger deterioration than under his father, but about the same as under Ronald Reagan in the early 1980s. In other ways, however, the performance of the younger Bush has been more alarming. Reagan cut taxes heavily in 1981 to encourage economic growth, but as he came to appreciate the budgetary consequences - as early as 1982 in his Tax Equity and Fiscal Responsibility Act - he started to reverse the cuts and put the budget back on an improving trend. And to give George Bush senior his due, even following the "read my lips, no new taxes" campaign in 1988, he pushed through tax increases to stop the deficit running out of control.

This Bush, however, has relentlessly cut taxes and increased spending throughout his administration with the single purpose of delivering a short-term stimulus to the economy and ensuring re-election. He has never considered corrective action of any kind. He has been entirely heedless of the longer term consequences of policies which have led to massively indebted households and the biggest current account deficit in the history of the world.

The history of private sector surpluses and deficits - those accruing to companies and individuals - is illustrated in the second chart. The private sector was typically in surplus (income exceeding expenditure) until the latter part of the 1990s, when the economy was overtaken by "irrational exuberance". The stock market soared and companies and households took on unprecedented amounts of debt to sustain a wave of spending.

Then came the stock market crash. The private sector began to draw in its horns, cutting spending and borrowing and starting to rebuild savings, thus slowing the economy down. Step in George Bush (tax cuts) and Alan Greenspan (interest rate cuts) to stop this happening and keep people spending. It worked, but created a situation in which there is both a substantial public sector deficit and a significant private sector deficit. As the chart illustrates, this has simply never happened before.

A further outcome of this remarkable achievement was the record current account deficit - chart three - which reflects the other two and which is associated with a dollar which has been sliding in value, almost continuously, since Bush took office. It has lost a quarter of its value in four years. Altogether, quite a record.

Conventional economic opinion has not yet woken up to what all this means for the US economy during a second Bush term. "Consensus forecasts", which incorporate the views of the leading economic groups, suggest that the US will continue to grow well - in excess of its 3per cent plus trend rate - over the medium term. Seen in the perspective presented here, however, this looks extremely unlikely. The impact of tax cuts aimed at the election has largely expired and rising oil prices are in effect imposing a new tax on households. Interest rates are rising instead of falling. Debt payments as a proportion of household incomes have reached an all-time high. The private sector can therefore be expected to resume the process of putting its finances in order, which Bush interrupted, and this means the American consumer will no longer be in a position to drive the economy forward. Slower consumer demand will mean slower growth.

And this in turn means the hole in the government's finances is set to grow. At the same time, demands from Iraq will go on rising. And then there are the President's tax cut plans. There are two responses to this situation. One is to follow the examples of Reagan and Bush senior and change course, introduce spending cuts and tax rises, and at least halt the rise in the deficit. The second is "benign neglect", allowing the deficit to drift higher.

If Bush would change tack and adopt the first approach, the ultimate crisis could still be avoided and the famous "imbalances" adjusted reasonably smoothly. In this case, with the government helping to moderate demand, the Federal Reserve would need to raise interest rates only moderately, and hence could avoid the sort of shock to heavily indebted consumers which really would precipitate a recession. At the same time, the current account deficit could be stabilised and put on an improving trend, which would strengthen confidence in the dollar, halt the currency's decline and avoid the "dollar collapse" scenario which would be associated with rising bond yields and further cuts in consumer and business borrowing.

But if no corrective action is taken we can rely on none of this. An acceleration in the dollar's decline, sharply rising interest rates and bond yields, an abrupt response by consumers, a rise in protectionism in response to a combination of current account deficits and job losses - all these will then be very much on the cards. And all this against the background of massive budget deficits which, at the end of the day, would still have to be corrected, completing a crisis scenario.

Bush is therefore facing a crucial test. Does he understand the necessity of repairing America's finances, and does he have the political courage to tackle the problem? There has not been a single sign that the answer to either of these questions is yes, although he does have the opportunity to change tack now that he no longer faces re-election. We simply do not know.

What is, or should be, clear is that even if the nettle is grasped, growth in the US economy is likely to remain subdued while the imbalances are resolved. To put it in the inimitable words of the President himself: "There may be some tough times here in America. But this country has gone through tough times before, and we're going to do it again". Take comfort, John Kerry.

Christopher Smallwood is economic adviser to Barclays plc. This is a personal view.