Quotes of the Day

2004 was a year for the record books — the world economy grew at its fastest rate in almost three decades. And most observers predict that growth in 2005 will continue to be relatively robust in Asia, the U.S. and even laggardly Europe. The developed world, to paraphrase British Prime Minister Harold Macmillan's 1957 proclamation to his countrymen, has rarely had it so good. Why, then, are so many economists so nervous? Because even good times harbor real threats. Oil prices remain perilously high, well over $40 a bbl. since July. The dollar, despite some recent signs of life, has dropped by more than 40% against the euro since it began falling three years ago, and interest rates are creeping up: last week, the U.S. Federal Reserve raised rates for the sixth time in seven months. And lurking in the background is a two-headed beast that shows little sign of being tamed: America's soaring budget deficit, which is expected to exceed $400 billion this year (not including the forecast $100 billion-plus costs of military operations in Iraq and Afghanistan), and its record $660 billion current-account deficit, which means that U.S. imports of goods, services and money exceed exports in an amount equal to about 6% of the total U.S. economy. To cover the bill, foreign creditors must invest in that much American debt and assets. If they were to stop doing so, an unprecedented crisis could ensue.

Economists, of course, are famously dismal, so maybe it's no surprise that when Time's annual Board of Economists roundtable met during the World Economic Forum in Davos late last month, the discussion focused less on what is going right in the global economy than on what's wrong — and how serious the longer-term impact could be for everyone. Will the U.S. be able to continue sucking in the savings of people around the world to finance its profligacy? What is the likelihood that President George W. Bush — or the financial markets — will take corrective action? And could the twin deficits ultimately destabilize not just the U.S. but the entire global economy?

These questions were also on the table at last week's meeting of G-7 finance ministers in London, and for some, they have a historical echo. The two Americans on the panel, Jeffrey Sachs, the director of Columbia University's Earth Institute, and Laura D'Andrea Tyson, a former national economic adviser to President Bill Clinton who is now dean of the London Business School, see some eerie similarities with economic conditions of almost 20 years ago. As Ronald Reagan began his second term in 1985, the dollar was sliding and the U.S. was running up big deficits as a result of tax cuts and increased military and other spending. Back then, the American economy entered a turbulent decade of budget consolidation that included a short but potent recession, and bitter battles over spending cuts. Tyson and Sachs today believe President Bush may be in for an equally turbulent ride in his second term. With the Bush Administration doggedly pursuing a massive plan to overhaul the nation's Social Security system, and likely to face stiff resistance, tackling the deficits does not seem high on the agenda. Tyson said that "if there's anyone who believes" the Bush Administration will make a serious effort on the deficits, "I didn't find them." And unless priorities change, she expects interest rates in the U.S. to continue rising steadily until they hit around 5% — double their present level — and both she and Sachs predict painful budget cuts and a U.S. recession in the medium-term. "There'll be a wearing and exhausting process ahead. We're only in the first stage and it'll get ugly before it gets better," Sachs said.

Sachs and Tyson are both Democrats, although Sachs insists his work is strictly nonpartisan; their Republican counterparts argue that the U.S. economy is going to keep humming along despite red ink and higher rates. That view was seconded last week by Federal Reserve Chairman Alan Greenspan, who suggested in London that tighter U.S. fiscal policy could stabilize or even shrink the U.S. current account deficit. Time's economists don't buy that — but, mindful of the alarmist predictions of two decades ago that turned out to be wrong, neither Sachs nor Tyson is forecasting a calamity such as a market crash or a full-scale depression. They also expect that the wider damage will remain limited. "The U.S. deficit is really bad news for Americans, but it's absorbable in the world economy," said Tyson.

Others find even that tepid prediction to be overly optimistic. Moisés Naím, a former Venezuelan Trade Minister who is editor of the Washington-based magazine Foreign Policy, agreed that the world economy was unlikely to crash. "But there's no doubt that America's adjustment is going to have consequences," he said. "U.S. interest rates matter to the rest of the world. They are a conveyor belt that is going to transmit shock waves to others." Rising interest rates could choke off consumption by American households, sharply curtailing imports from China, Germany and other countries that have been the motor for these nations' economies. As Paul Achleitner, a board member of Germany's insurance-giant Allianz, put it: "We must thank the U.S. consumer for all they have done in the past decade or so in terms of driving the [world economy] forward."

AMERICAN DOUBTS
The focus on American risks to the global economy is especially conspicuous, since last year's board reflected a widespread — and correct — assumption that U.S. growth would be significant and serve as an engine for the rest of the world. The concerns expressed at the time were largely about whether the Chinese economy risked overheating and whether Europe could pull itself out of a rut. Now "the perception has changed," said Pascal Blanqué, chief economist at France's largest bank, Crédit Agricole. Even though U.S. economic growth of about 4.4% last year far outpaced European growth of about 2%, "the U.S. is now more criticized, while Europe is starting to be credited for positive steps in the right direction." Significantly, he noted that the European Central Bank recently voiced open criticism of U.S. deficits for the first time. In a financial stability review published in December, the Frankfurt-based bank described the deficits as "posing a significant risk for global financial stability." Europe, by contrast, continues to run a relatively tight fiscal policy. Until the Federal Reserve's most recent increases, European interest rates have also tended to be higher than those in the U.S., and unlike spend-happy Americans, European households stash away substantial amounts of their earnings into savings. In the euro zone, about 14% of household income is saved, compared with less than 2% in the U.S.

The Bush Administration foresees a pain-free fix: continued growth, it argues, will automatically reduce the size of the budget deficit. Indeed, U.S. Treasury Secretary John Snow argues that the trade deficit is partly the result of lopsided growth. "We are growing faster than our trading partners, and we are creating more disposable income than they are," Snow said last month. "We need Europe to be more of an engine of growth and we need Japan to be more of an engine of growth." But Time's experts aren't convinced, and expect Bush will have to pare spending regardless of how strongly the economy grows. Already there are signs that momentum may be slowing: the estimated 3.1% annualized growth rate posted in the fourth quarter is the weakest in two years. Naím even predicts a battle in Washington between fiscal conservatives, who advocate a hands-on approach to managing the budget, and what he calls "starve-the-beasters" — more ideological proponents who would like nothing more than to see some public programs bankrupted. (Here, too, there are echoes of the Reagan years.) Naím expects that the fiscal conservatives will be defeated in this contest.

And none of the group, not even Tyson or Sachs, is completely ruling out a serious rupture. A devastating terrorist attack, the bursting of the bubblelike housing price increases in some parts of the U.S. and Europe, a change of policy by central banks in Asia to limit their dollar purchases — any of these could unnerve financial markets and trigger a bigger worldwide reaction, they agreed. Sachs said it would just take two or three such events to come together, "and things get a lot worse. That's not a high probability, but it can't be written off."

EASING UP ON CHINA
If there's a big question mark over the U.S., the panel's predictions for Europe and Asia are less fraught than they were a year ago. China continues to grow fast: last year its economy expanded by a breathtaking 9.5%, about the same as the last several years. The country is still sucking in huge amounts of energy and natural resources to fuel its manufacturing boom. That in turn is a significant factor in the rising prices for oil, steel and some other commodities, which is good news for producers, but — especially in the case of oil — is raising fears of a worldwide resurgence of inflation. China also has a fragile banking system that is lumbered with bad loans and a weak capital base. Thus far, fears of a "hard landing" appear to have been overblown. And the government has taken measures to curb some of the wilder excesses, including tightening conditions on some bank loans and raising interest rates to stave off inflation. But the Chinese government clearly has its limits. There was broad agreement among the panel that Chinese authorities have little interest in unlinking their currency from the dollar, despite consistent pressure to do so from the U.S. "The sanguine view is that it is not in the interest of the Asians to break the dollar link," said Tyson.

That resistance has important consequences. The Chinese yuan's exchange rate against the dollar — fixed at 8.28 yuan to the dollar since 1994 — is widely seen as undervalued, which enables Chinese manufacturers to sell their products to American consumers at highly competitive prices, fueling the U.S. trade deficit. But overall, the growth of China as a market is still seen as beneficial for the Asian economy, which needs all the help it can get following December's devastating tsunami. Thanks in part to the Chinese boom, Japan, which was stagnant for much of the 1990s, is growing again. China last year overtook the U.S. to become Japan's biggest trading partner. China accounted for 20.1% of Japan's total trade, compared with 18.6% for the U.S. The panelists expect Asian cross-fertilization to continue; indeed, Sachs said that the closer integration of Asian economies will help them to keep at bay future external shocks such as the 1997 currency crises in Thailand, Indonesia and elsewhere. "Asian integration will be a powerful force to avoid swings," he said.

The outlook appears relatively good for Europe, too, despite the huge revaluation of the euro against the dollar, which Tyson, among others, last year warned would hamper economic growth. The Europeans have so far managed to keep their economic recovery on track — slow, perhaps, but definitely better than a recession.

How did that happen? The euro's rise, in theory, made European exports far less competitive. But so far that effect seems to have been mitigated by the overall increase in worldwide demand for goods. Exports from Germany, Europe's biggest economy, soared by 10% last year to a record €731 billion, and its trade surplus increased by 20% to €155.6 billion, according to the Federal Statistical Office. Blanqué — who last year asked the world to "be patient with Europe" as it put its economic house in order — now says he sees signs that the Continent has finally "caught the train." He describes Germany's export performance as "remarkable," and says he expects the 12 European nations that have adopted the euro to experience growth of about 1.7% this year, about the same as in 2004, with the pace picking up in the second half of the year.

That level of growth is still relatively weak by U.S. or Asian standards. And it seems to have little effect on stubborn unemployment in Germany and other parts of the euro zone, where the jobless rate is currently just below 9%, unchanged from a year ago. But some of the panelists were heartened by what they see as genuine efforts by governments across the Continent to tackle some persistent problems, including a lack of labor mobility and unsustainable health-care and pension systems. In Germany, Chancellor Gerhard Schröder has introduced a slew of new measures designed to create jobs, including unpopular cutbacks in unemployment benefits. And in France, the government of Jean-Pierre Raffarin has triggered protests by proposing to allow employees to work more than 35 hours a week, and has begun revamping the system of state-funded medical benefits. "One of the big issues is that we are no longer in the analysis, or paralysis-through-analysis, phase where politicians and others keep arguing about what the problems are. We are moving into the implementation phase," said Achleitner.

There are still some big risks for Europe. Blanqué said continuing employment growth is essential if the economy is to grow, coupled with a decline in oil prices and a more stable dollar. He worries that companies in Europe remain cautious about investing, and are instead focused on reducing debt. "There's this great American saying that nobody has ever shrunk their way to greatness," quipped Achleitner, in agreement. But he said he's seeing a new mood among European companies. "People are starting to think they are coming to the end of their shrinking exercises and need to put on the growth hat."

Given the continuing high cost of labor in Europe and the strong euro, some of that growth is likely to come from overseas. Naím speculates that European firms will increasingly acquire companies in places where it's less onerous to do business, such as the U.S., and move their base there. And he worries that if the euro continues to strengthen, European protectionism could grow. "A euro of $1.40 or more for a couple of years is going to generate as much pressure on governments for protectionism as it is going to generate pressures toward deregulation," he said.

But such concerns pale in comparison with fears about what could go wrong if nothing is done about the U.S. fiscal and current account deficits. "The war is being paid for by borrowing. The increase in drug benefits is being paid for by borrowing. Nobody's been asked to do anything," Sachs worries. That, he and his Board of Economist colleagues agree, will have to change. But if America faces some belt tightening in the years to come, does it necessarily follow that the rest of the world will feel the pinch? "Providing this doesn't end in a very painful balance-of-payments crisis for the U.S." — meaning that the world suddenly stops financing its deficits and Washington has to take radical action to prevent an economic collapse — "I think the rest of the world can absorb it," said Tyson. The rest of the world is hoping that she's right.

• PETER GUMBEL
• TIME's panel of experts sizes up the global economy