Hamish McRae: The growing problem of America

Will political disruption push the US more towards a protectionist society?
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What happens in American politics is hugely important to Britain for the most obvious of reasons, hence the wall-to-wall analysis of the midterm elections. But it is also important to the American economy, and hence to the world economy, and there has been much less dissection of the consequences there.

However, the financial markets, ahead of the elections, had already made up their minds. They were thrilled. Whatever the precise tally at the polls there would be a more bipartisan approach. Put bluntly, America would have weak government for the final two years of the Bush administration. Wall Street went to a new "high". As far as the markets were concerned, weak equals good.

But is this right? What are the economic prospects for the final two years of this administration, and what might this mean for the rest of us? The starting point has to be that the US expansion has been running for about five years, which puts it well into middle age, but if it follows the pattern of previous cycles, it does not yet feel particularly "elderly". Trying to predict the timing of economic cycles is a mug's game: because both policymakers and ordinary people adapt their behaviour to their perceptions of the cycle, things never turn out quite as expected. Every cycle is different as to both timing and amplitude.

Thus at the moment the US economy is being slowed by a housing slump: prices are, on average, falling. But few people think this will signal the end of the expansion; most expect the economy will keep growing next year, albeit at a slower pace. If the fall in house prices becomes really serious, everyone assumes, almost certainly correctly, that the Federal Reserve will cut interest rates to rescue the market. But it will do that on purely economic grounds, not political ones. The Fed, remember, is truly non-partisan.

So in all probability the twilight years of this administration will be playing out the twilight years of the expansion. A weaker president will not be able to do anything dramatic, and that will be good news. It will be particularly good news for one key concern in the US: the state of the federal budget. Much has been made of America's "twin deficits", the fiscal deficit and the current account deficit. But within the US the current account deficit does not feature large in the political mix - as an outsider I think it should, but it doesn't. On the other hand, the domestic fiscal deficit does attract a lot of attention, particularly since it soared under the first Bush administration.

President Bush inherited a fiscal surplus, but a combination of the 2001 recession and large tax cuts pushed it into a deficit of 3.5 per cent of GDP. In the past year there has been strong growth in tax revenues, with the effect that despite higher-than-expected military spending, the deficit is now narrowing fast: it should be down to about 2 per cent of GDP this year. That would be much lower than any large European economy, including this one. It is worth pausing for a moment and recognising that the US economy is so huge that the country is able to fight a middle-sized war and still cut its budget deficit.

Under a weak administration, unable to engineer any significant increases in spending, the deficit should continue to narrow. That will encourage financial markets, and should underpin their present optimistic tone. From a purely practical point of view, if the federal government reduces the rate at which it is borrowing, that leaves more money to go into other assets.

The external deficit - the one that Americans don't worry about - will, I think, become more of an issue. It is huge. Something like 7 per cent of GDP is borrowed every year. In a nutshell, the countries of the rest of the world lend the US the money to enable it to keep buying their goods. The two principal lenders are China and Japan.

So the two final years of this administration will be shaped by what the foreign lenders to the US do with their money. They may continue to pile into US government securities, building up their foreign exchange reserves, as they have up to now. But there are increasing signs that they would like to diversify into other assets, maybe denominated in euros or in sterling, or maybe simply other assets in dollars. It was put to me in Beijing 10 days ago that it did not make sense for China to get such low returns on its dollar assets. But were Chinese interests to try to buy up US companies, I am not at all sure that the States would react well to that. Political opposition has already scuppered Chinese plans to buy an independent US oil company and Dubai's plans to buy US ports.

I can see a growing problem here. A weak administration will be prey to political resentment. There was huge resentment against Japan in the 1980s when it sought to buy up swathes of US assets, unfairly (as it was seen) depressing its currency to boost its exports and hold down its imports. The resentment against China is likely to be greater. Already there is concern about the level at which the yuan is pegged against the dollar, and in particular the slow easing of that peg.

The point is that Americans may not worry about the current account deficit as such. However they do worry about consequences of that deficit if it means foreigners buying their companies on the cheap. That concern swiftly translates into protectionism. An America that becomes more focused on itself will become a more difficult trading partner. Virtually all administrations since the Second World War have understood that it is overwhelmingly in US self-interest to support an open world trading system. Strong administrations have been able to promote it. A weak one can't.

So what does all this mean for us? The lags in economics are pretty long. Unless the US housing market really "tanks", bringing a sharp fall in consumption with it, the US economy and the global economy march on reasonably strongly for the next couple of years. Here in Britain our economy marches on too. We are very open to global trends, perhaps more so than any other large economy, including the US. If financial markets continue to be strong that helps us too, for we have a large financial sector relative to the rest of the economy - or at least it helps the economy of London and the South-east. Our big problem is not growth, but the unbalanced nature of that growth.

But the thing to look for, and indeed worry about, over the next two years will not be the minutiae of economic growth statistics here or in the US. It will be whether the political disruption in the US pushes the country more towards an inward-looking and protectionist society. If it does, then maybe the next two years will be okay, but we should worry about the decade beyond. The detail of US politics does not matter; the big direction towards openness or against it, truly does.