Economic View: Money men Bush-whacked

It is all change in the US administration's economic team. The two high-profile resignations on Friday of Paul O'Neill, the Treasury Secretary, and Lawrence Lindsey, director of the National Economic Council, will mean that the President has, so to speak, cleared out his "recession team" and will now appoint the recovery one.

The first reaction of the financial markets on Friday was one of mild relief. Markets were down but that was because of the worse-than-expected employment figures, which pointed to a slower-than-expected recovery. The relief was understandable for Mr O'Neill was somewhat gaff-prone, particularly over the level dollar. Like all industrialists (he used to be head of Alcoa) he is a cheap currency man; companies make more money in the short term if the currency of head office is weak, for they can earn more on their exports. And so he tended to give the impression that the US would deliberately try to have a weaker dollar policy. That was never true, but it did stir up the markets. Certainly he was less obviously impressive than his two predecessors, Robert Rubin (ex-Goldman Sachs) and Larry Summers, now president of Harvard. But being an adept talker is not the same as having good judgement. If you look at what he actually said and his record in pushing legislation through Congress, he has really been pretty competent.

As for Larry Lindsey, well he proved to have very good judgement about the economy. I recall having dinner with him along with a mutual friend a few months before George W Bush was elected and when the US economy was still booming. He warned us that a US recession was inevitable, given the excesses of the current boom. I asked him what George W's reaction to this had been.

"Well," the presidential candidate had said, "if you are right, Larry, I'm not sure I want this job."

So is this a case of shooting the messengers? To some extent, yes. It will take some days before the US press machine extracts all the details of the run-up to the resignations but it does seem pretty clear that George W felt he needed a new team in place a clear two years before he had to face re-election.

In political terms that does make sense, but in economic terms the implications are less clear. After all, while the nearest UK counterparts are Gordon Brown and Ed Balls, in the US the role of the treasury secretary and economic adviser are less important than here. The economy, though, is vastly more important – and notwithstanding those bad numbers yesterday, quite encouraging.

There is clearly some sort of recovery under way. The latest OECD forecasts are shown in the left-hand chart: solid consumption growth has pulled the economy through the dip, and if those figures are right, a decent recovery will be in place by 2004. These numbers tally with most other mainstream forecasts and in electoral terms they look pretty good. But given the inaccuracy of previous mainstream forecasts, which unlike those of Larry Lindsey completely failed to predict recession, they have to be taken with a pinch of salt. What can go wrong?

There are two dogs that are barking in the night. One is the spectre of deflation, the other the weakness of the current account.

Deflation at the moment is confined to goods (middle graph) for services are still rising in price. But that has implications for US tax revenues, for unlike much of the rest of the developed world, which have some form of VAT, the US does not have an effective way of taxing services. So there is a double problem. One is the danger that goods deflation could spread to services; the other that even if it does not, it cuts away from tax revenues and will force sharp cuts in state and municipal spending.

The current account deficit has so far been reasonably easily financed because the US is perceived as a better bet for investment than continental Europe or Japan. (It is not necessarily better than East Asia, but there is no single currency there in which to invest, nor are capital markets broad enough to absorb footloose funds.) But at some stage, which could of course be a long time away, the current account deficit will have to be corrected. It really does not make sense that the world's richest country should rely on the rest of the world to do its saving for it. This is a time bomb, albeit with a long fuse.

So it is a mixed inheritance for the new economic team. The worst of the recession is almost certainly past. While there may be a double dip – a few months of very slow growth – some sort of recovery looks secure. But the pace of recovery is likely to disappoint – I think those OECD numbers will turn out to be over-optimistic – and there are still big imbalances that will have to be corrected.

The new team will therefore need patience. Indeed the US as a whole needs patience: in practical terms the country needs several years when consumption will grow more slowly than the overall economy. That will not be popular; people like consuming, as we here know very well too. Meanwhile, the new team will have to work hard to win the trust of the investors who have continued to cover the external deficit, taking a leaf out of the Rubin/Summers book, who carried the respect of the international banking community.

From our own point of view we should hope for a continued recovery, not only because the US is our largest single export market but because there is not much other demand about.

But we should not assume that shooting the messengers will speed the recovery. There is no political fix; there is only the hard slog.