Jeremy Warner's Outlook: Abby's bullish view clouded by deficit worries

Apocalypse now
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The Independent Online
Abby Cohen, the chief equity strategist at Goldman Sachs, was in characteristically bullish mood about the US stock market at a conference hosted by the investment bank in London yesterday.

Abby Cohen, the chief equity strategist at Goldman Sachs, was in characteristically bullish mood about the US stock market at a conference hosted by the investment bank in London yesterday.

With US growth likely to continue to exceed that of other large industrialised nations, her view was that the S&P 500 would rise by about 10 per cent this year not withstanding any further fall in the dollar. Ms Cohen's reputation has been somewhat tarnished by the bear market of the past five years, which she failed to see coming, but she's right about the US economy and she may well be right about the stock market.

Yet as she herself admits, there are huge uncertainties. The biggest unresolved question is the future path of the federal budget. This has been the hot subject of debate from the moment President George Bush, with his tax- cutting, free-spending ways, first entered the White House four years ago. With eagerly awaited proposals for reforming the social security system now just a few months away, it's about to become a whole lot hotter. US opinion formers can talk about little else.

Broadly speaking, Mr Bush is planning to privatise the pensions system so that the 6 per cent of earnings that workers are currently required to pay for social security benefits are instead paid into private pension plans. This is Mr Bush's proposed solution to the problem of an ageing population. In the jargon, he wants to transfer from a "pay as you go" system of state pensions funded out of taxation to a funded system where the money paid in tax is saved for the individual until he retires.

As things stand, there's little detail to tell us how these proposals would work in practice, but what we do know is that the transitional cost of the change will be enormous. This is because the social security element of tax paid by new entrants to the workforce will in future go into their own private pension plans, which means there will be less tax to pay the pensions of those who have already retired. Transitional costs have been estimated at between $1trillion and $2trillion over 10 years. So how does Mr Bush plan to pay for it? Certainly not by raising taxes. Instead he will just borrow it, and hope that in the meantime economic growth comes to his rescue.

No wonder more fiscally conservative Republicans are so nervous. The way things are going there is some chance Mr Bush will end up bankrupting the nation. The read-through of all this to the performance of the stock market is unfathomable. All that extra money going into equities rather than taxes ought to be quite healthy for stock market valuations. Yet it will count for nothing if the budget deficit, already out of control, careers into the path of an oncoming train.

Pension costs are regrettably only part of the problem of an ageing population. There is also the Medicare and Medicaid budgets to take account of, much of which already goes on the elderly. Do the maths. Last year, social security, Medicare and Medicaid absorbed some 42 per cent of federal spending. By 2030, the number of elderly is expected to double and with it, the cost of social security, Medicare and Medicaid will rise from 7 per cent of GDP to 13 per cent.

Here in Britain, the chairman of the Pensions Commission, Adair Turner, has said that the "leave things alone and hope to muddle through" approach to ageing is not an option. Yet there are large elements of that approach in what Mr Bush is proposing to do with the Medicare budget. Nor in Britain are the healthcare costs of an increased elderly population much commented on. As in the US, the focus of debate is very much on what to do about pensions. The ageing element in the rising costs of health care, which in Britain are almost entirely state funded, has to date been largely ignored.

Mr Bush reckons that strong economic growth, which feeds through to higher tax revenues, will sort out these costs. Maybe he's right, but here's a concluding thought for all those who think America's supposed technological lead will see the country through. The US's once mighty trade surplus in "advanced technology products" has over the past 12 months been transformed into a deficit of $37bn, with exports down more than one-fifth on five years ago. The only areas of the economy showing a significant trade surplus are raw materials, agricultural produce, scrap and waste. These are more the characteristics of a Third World country than an advanced industrial one.

Abby Cohen may be right about the stock market for the next 12 months. But for the longer term, who knows?

Apocalypse now

The most apocalyptic warning of the week came from Bernd Pischetsrieder, the chairman of Volkswagen. The European car industry, he said, would be dead within 50 years unless urgent action was taken to improve its competitiveness. The VW chief made his comments at a press conference to launch a European Commission working group to look at ways of revitalising the industry.

Early indications are encouraging, with Günter Verheugen, the EU's new industry commissioner, promising a bonfire of regulation. The industry wants concessions over as many as 90 different EU laws, which it claims hits profits and ties the hands of European producers. Yet how committed Mr Verheugen is to delivering is open to question. Everything Mr Verheugen has said so far is strongly suggestive of a corporatist and protectionist approach to European industry.

In a recent interview, he suggested the Commission might take a more relaxed view of mergers than has been the case in recent years so as to allow for the creation of some European champions. And though Mr Verheugen may be in favour of lifting some of the more onerous restrictions that European law puts on car manufacturers, he seems to be against much else in the liberalising agenda.

For instance, the EU is planning to break the link between car makers and showrooms by ending the manufacturers' exemption from competition laws. By the sound of it, this too will become part of Mr Verheugen's bonfire if he gets his way. Nor is he likely to back proposals to strip car makers of their exclusive right to sell spare parts, from bumpers to bonnets. The new industry commissioner is sending out mixed messages. On the one hand he seems aware of the damage that over- regulation is doing to the industry, and seems determined to do something about it; on the other he wants measures that give protection to indigenous car producers. As for the idea of European champions, Mr Verheugen seems to be living in a bygone age. The idea that you can improve the competitiveness of industries at home and abroad by allowing consolidation has been almost wholly discredited by experience. It is quite astonishing to see anyone still peddling the theory.

This is particularly the case in the automobile industry where the consolidation of Britain's car companies into a single entity ­ British Leyland ­ all but destroyed indigenous car manufacturing in Britain. Today, Britain has a thriving car industry once more, but it is in large part built on Japanese technology and management. It is no accident that Japan has managed to produce three world-class car makers, for it has deliberately encouraged vibrant competition between them at home. From there they have spread their wings and conquered the world.

Interestingly, the fortunes of one of these companies, Nissan, was revived by a French company Renault, which has some of the most efficient and productive car plants in the world. The threat to the European car industry from China, which is streets behind in delivering European or Japanese levels of productivity and reliability, is much exaggerated.

Indeed, the quickest way to ensure Mr Pischetsrieder's prediction comes true would be to encourage Renault into a merger with VW or Citroen. It would be madness. Peter Mandelson should make it one of his first tasks as the new Trade Commissioner to have a word in Mr Verheugen's shell-like.

jeremy.warner@independent.co.uk

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