Jeremy Warner's Outlook: Bush bets on twins cancelling each other out

BAE/bribery; Pre-emption rights
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The Independent Online

With President George Bush safely back in the White House, and with no need to face the voters again (American presidents are only allowed two terms), is he not duty bound finally to do something about America's terrible twins - a current account deficit matched only in its mountainous size by the Federal budget deficit? Don't bet on it.

With President George Bush safely back in the White House, and with no need to face the voters again (American presidents are only allowed two terms), is he not duty bound finally to do something about America's terrible twins - a current account deficit matched only in its mountainous size by the Federal budget deficit? Don't bet on it.

The Bush Administration has always characterised its approach to the economy as a policy for growth. If you cut taxes and raise government spending simultaneously, the result ought to be higher consumption, investment and employment. You can argue about the way the tax cutting has been directed - targeting the rich rather than the poor - but up to a point the policy seems to have worked.

When he came to power in January 2001, President Bush inherited an economy that was already sliding into recession after the excesses of the dot.com boom. September 11 sealed the economy's fate. Today, however, most indicators are pointing sharply upwards. Annualised growth has been at more than 3 per cent for a year and a half now and unemployment has fallen sharply from its peak of 6.3 per cent. Meanwhile, consumption has continued to grow strongly. The picture on investment is less encouraging, but that may be down more to the high oil price and uncertainty - now removed - surrounding the outcome of the election than anything else.

So everything is now fine on the farm again is it? Not quite. Lower taxes and higher spending has caused an ever widening budget deficit. If the fiscal stimulus now being applied works as it is supposed to, the deficit ought eventually to be eradicated by higher growth, which in turn means that the economy generates more tax. Yet so far, there is little sign of this occurring. Rather the reverse. The budget deficit is continuing to get bigger and with it American indebtedness.

The widening budget deficit meets its terrible twin in America's yawning gap in the balance of trade. Economic commentators have been saying for years now that the trade imbalance must eventually correct, most probably through a collapse in the currency, but although the dollar has fallen some distance during President Bush's first term, the current account deficit continues to grow. The Bush Administration, unlike its predecessor, has no particular attachment to a strong dollar, and would in all likelihood be more than happy to see it fall even further if that helped correct the trade imbalance and bolstered growth.

Yet so far it hasn't had to. Substantial capital inflows from China and Japan have ensured that the current account deficit is fully financed even with the dollar at its present, relatively strong rate of exchange. These inflows, moreover, have gone mainly into US Treasury bonds, helping to finance the budget deficit and keep long-term interest rates at a much lower level than would generally be appropriate for such a large and growing budget deficit. Japanese currency intervention has all but dried up over the last six months, but there's still plenty of it coming from China.

The result is a kind of a virtuous circle. China and Japan need to keep their currencies depressed against the dollar so as to ensure their exports remain competitive. So they sell their own currencies and buy dollars which in turn finances the twin deficits. President Bush might reasonably conclude that all he has to do is stay out of the way and everything will turn out fine. The conventional view in Europe is that like everything else President Bush has turned his hand to, his economic policy has been a disaster, yet the reality is that the do nothing and hope to muddle through approach has thus far served America pretty well.

Critics argue it just isn't sustainable. I wouldn't be so sure. The alternative is that China removes its currency intervention and the dollar collapses. So what? That means higher growth and a higher tax take. Theoretically it also means higher inflation and interest rates, but that's not what the bond market, with the yield on 10-year Treasury bonds again approaching record lows, is telling us will happen. On the contrary, what it tells us is that inflation and rising interest rates are not going to be a problem for the US economy for some time to come.

Markets don't always get it right, but it is no wonder that the newly re-elected President thinks the twin deficits are nothing to worry about.

BAE/bribery

Prostitutes, Rolls-Royces, skiing trips to Colorado, cash handouts and £1,000 canteens of gold cutlery - they all seem to have been part of a day's work in the long and tortuous history of the al-Yamamah arms contract with Saudi Arabia. This multi-billion pound project to equip the Saudi airforce with all the latest weaponry has kept BAE Systems in gainful employment for the best part of 20 years now. The allegations of bribery and corruption that surround it are almost as old.

Now the Serious Fraud Office has stumbled into the affair by announcing that it is probing deals between BAE Systems and two service firms for suspected false accounting. Two people were arrested yesterday, but later released without charge. BAE protests that it has never done anything illegal and that if anyone was defrauded, it was BAE itself.

All of which is perfectly true, if somewhat disingenuous. It was only quite recently made illegal for companies to bribe the officials of overseas governments. At the time these payments and favours allegedly took place, there was no such ban. Indeed, most people working in this industry would have been astonished if a little greasing of the palm hadn't taken place. Most big contracts in whatever industry they take place involve lavish entertainment of the client. The use of prostitutes in so doing may seem a trifle over the top and distasteful, but it is only a question of degree and in terms of intent it may not seem so very different from taking the client to the rugby.

As for BAE being defrauded, that too may be technically true, though given that the money allegedly used to bribe the Saudis came from the Saudis themselves, you have to wonder who was defrauding who. What's more, if you believe the BBC's account of events, BAE knew as far back as 1996 that it was making untoward payments under cover of false invoices but chose to sweep it all under the carpet.

BAE hopes to get a lot more business out of Saudi Arabia over the years ahead. The Saudis are shy and proud people, and they don't take kindly to publicity like this. Indeed, they almost certainly don't understand it, as it wouldn't happen in their country. BAE can only hope it all blows over before any further damage is done.

Pre-emption rights

Paul Myners' latest Government commissioned consultation document on the supposed iniquities of accepted City practice - this one on pre-emption rights - is a thorough and reasonable enough thrash around the issues, but it seems even less likely to prompt significant change than his tome on soft commissions.

The fact of the matter is that there is nothing wrong with the present system, which is there for the entirely laudable purpose of protecting existing shareholders from disadvantageous dilution when new equity capital is raised. If managements don't like it, they are entitled to seek a dispensation from their shareholders. Unsurprisingly, not many shareholders are prepared to give it.

The chief lobbyist for reform is the biotech industry, which complains that pre-emption rights put British biotechs at a competitive disadvantage. They point to their American counterparts, which are supposedly able to raise new equity more swiftly and at lower cost by placing it with outside investors.

Well maybe, but the much more likely explanation of why British biotechs underperform their American peers is that they are just not as good. Either way, it seems a bad reason for ripping up a perfectly good system which has actually delivered the biotech industry all the capital it could possibly need.

jeremy.warner@independent.co.uk

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