It's the economy, stupid

With George Bush directing all his energies towards foreign policy, the foundation of America's strength - its economy - is suffering, writes Mark Tran.

The US Federal Reserve meets today to consider interest rates amid renewed turmoil on the financial markets. Leading UK shares are heading for another six-year low, after another sell-off yesterday on Wall Street.

As one dealer in London said: "There's a continual drip, drip of bad news every day, and no sign of much good news anywhere on the horizon."

The bad news is hard to avoid. George Bush seems bent on pursuing a vendetta against Saddam Hussein despite strong international opposition. The prospect of conflict has pushed oil prices to over $30 a barrel on fears that war could disrupt oil supplies. With the global economy in a fragile state and with demand for energy in the west hitting peak demand with the onset of winter, higher oil prices could be a killer blow for economic recovery.

Coupled with the threat of war and its attendant uncertainties is anaemic growth in the US, the pillar that props up the global economy. That pillar looks increasingly wobbly.

Throughout the year, economic experts from the International Monetary Fund and the Bank of England have been paring back their 2002 growth forecasts for the US. In the latest downward revision, the bank earlier this month downgraded its US forecast to 2.3% from 2.8% in August.

The lowest US interest rates for 40 years have helped keep the American economy afloat, especially through strong consumer spending. But companies are still struggling to make profits in an environment of low prices while saddled with debt accumulated in the 1990s boom. Analysts thought companies would be over the worst by now, but the stream of profit warnings and credit downgrades shows no sign of drying up.

As long as companies struggle to make profits, the US economy is overly reliant on consumers buying houses and cars. But consumers eventually will run out of steam as their personal debt builds up, so unless the corporate sector perks up, there is a real threat of a double dip recession.

Throw in the mix what Mr Greenspan has described as "infectious greed" on Wall Street and corporate boardrooms, no wonder stock markets are being ground down.

There is also a downside to US consumption. Americans are buying huge amounts of imports and services so that the US current account - the broadest measure of the US trade balance - has reached record levels. The current account has reached 5% of gross domestic product, a point that rings alarm bells among economists.

The nightmare scenario is that foreigners lose faith in the US economy and pull their money out, for any number of reasons - falling share prices, a terrorist attack, a collapse in consumer confidence, or a messy war in Iraq. Investor flight from the US could sent the dollar plummeting, push up interest rates (to defend the dollar) and tip the economy into another recession.

That is the difficult background against which the Fed meets today. Analysts do not expect Fed chairman, Alan Greenspan, and his colleagues to cut rates any further from their 40-year low of 1.75%.

Such a move might hurt more than help. Another cut would have limited effectiveness as the cost of borrowing is so low anyway, while underlining the seriousness of the situation and so further frightening investors.

In unveiling its new foreign policy doctrine, which amounts to a policy of hit them before they hit you, the Bush administration stated that the US "possesses unprecedented - and unequalled - strength and influence in the world". The foundation for that strength is the American economy, but right now that foundation looks decidedly precarious.

What is particularly worrying for leading economists such as Paul Krugman is that the Bush administration does not seem to be paying much attention to the economy. This inattention could come back to haunt the White House.

The earliest indication of how the electorate judges the administration's priorities - war in Iraq or prosperity at home - will come in the November midterm elections. It will be interesting to see whether the voters choose guns or butter.

· Mark Tran is business editor of Guardian Unlimited