Beyond Bull

The markets are bullish, the US economy is booming and everything is fine and dandy in the world economy. Or is it?

An economist visiting from outer space might take a very different view when considering the background to this latest US recovery. Indeed, if any US or International Monetary Fund economist were to look at the trend of the US balance of payments (all flows of money in and out of the US) as a case study, not knowing it was the US, he or she would be advising very severe measures, which would not fit in too well with the presidential election timetable.

Consider the figures in the latest Organisation for Economic Cooperation and Development (OECD) economic outlook. The OECD is forecasting a current account balance of payments deficit for the US of 5% of gross domestic product (GDP) this year, 5% next year and 5.1% in 2005.

One does not have to place too much faith in the precision of the projected move from 5% to 5.1% between 2004 and 2005 to draw the obvious conclusion: these deficits are alarmingly high, and there is no end in sight.

There is something very special about Republican administrations, is there not? In theory, and before they are elected, they believe in balanced budgets and sound money - or "sound money and lots of it" as people used to quip during the 1980s heyday of Milton Friedman's monetarism.

In practice they let everything go haywire. Now some observers have suggested to me that there is no problem: after all, wasn't President Ronald Reagan criticised during the 1980s for the twin deficits (budget and balance of payments) but didn't the US and world economy thrive?

The answer is: up to a point. The fact of the matter is that the borrowing spree on which the US administration has embarked makes the Reagan balance of payments deficits look like child's play.

During the dangerous days of the mid-1980s, the US recorded current balance of payments deficits of 2.8% of GDP in 1985, 3.3% in 1986 and 3.4% in 1987, after which they began to diminish. These are well below the figures quoted above for the current run of years, although the 1980s figures were considered alarming enough at the time.

Indeed, in 1985 protectionist pressures were increasing in the US and the Reagan administration, worried about the gap in the balance of payments, fathered the Plaza agreement of September 1985, under which the group of seven leading industrial countries agreed to contrive a managed decline in the dollar.

By February 1987, the decline was considered to have gone far enough, and under the G7 Louvre agreement of that month, every official effort was thenceforth put into stabilising the exchange markets. This helped to bring the current account deficit down to 2.4% in 1988, 1.8% in 1989 and even brought a move into surplus by 1990.

Despite the decline in the dollar during the past year, which has been mainly against the euro - the payments deficit prospect remains frightening, as the above OECD estimates indicate. The obvious conclusion is that the devaluation of the dollar has a long way to go.

Analysts at Goldman Sachs and elsewhere are therefore predicting that the rise in the euro also has a long way to go. Yet the anaemic state of the eurozone's "recovery" is the obvious explanation as to why Germany and France had to tear up the fiscal stability and growth pact last week.

This has already produced threatening noises from the European central bank, implying a tightening, or at the very least no loosening, of monetary policy. My conclusion is that we could be on the verge of a big currency and economic crisis, and the stock markets may have lost touch with the foreign exchange markets.

William Keegan is the Observer's senior economics commentator