From the September 2006 issue of Research Magazine • Subscribe!

While We Were Fighting

Global financial markets and the world economy approach the fifth anniversary of the September 11th, 2001 attacks against the U.S. in a healthy state. Meanwhile, the Global War on Terror, or GWOT as it is called in the Pentagon, has now gone on longer than the entire U.S. involvement in World War II (December 1941 to August 1945), showing no signs of winding down.

The terrorist attacks, coupled with the pricking of the Internet bubble in 2000, triggered a global economic downturn. Wall Street panicked after the destruction of the World Trade Center, but by early 2002 the Dow Jones Industrial Average was back at its early September levels around 10,700. Afterwards, as economic activity slowed, the Dow plunged again, dropping toward 7,000 in the second half of 2002 and again in 2003. However, over the past three years the blue chip index has gained over 50 percent of its value and in the second quarter of this year toyed with all-time highs set in late 2000.

Foreign financial markets performed at least as well, and in many cases much better. GWOT has been a low-intensity conflict, not interfering with a broadly based global economic recovery which commenced in 2004. On the contrary, much like other low-intensity conflicts of the past half-century, notably the Korean War and, at least at its initial stages, the Vietnam War, it probably contributed to global economic growth.

But in the long run war is rarely good for society -- or for the economy. GWOT has been no exception. Over the past five years, major imbalances have been created both in the U.S. and in the world economy, which may yet trigger a nasty correction.

Buying Binge

In the immediate aftermath of September 11, when the U.S. economy started to totter, President George W. Bush and other U.S. officials declared that the patriotic duty of every American was to "buy, buy, buy." And buy we did, aided by loose monetary policy, when the Federal Reserve slashed its interest rates to 1 percent.

Personal consumption, which now accounts for 70 percent of GDP, has been the single consistent driving force of the economy. From 2000 to 2005, real GDP increased by 13.4 percent, while personal consumption expanded by 16.6 percent.

There is some question about the morality of going on buying with gay abandon when the nation is fighting a war that, in Iraq and Afghanistan, has already cost some 3,000 American lives. The same goes for driving gas-guzzling SUVs and burning a quarter of the global output of crude. However, there are also negative economic consequences of runaway consumption.

The U.S. trade deficit has ballooned toward $800 trillion, measuring 6 percent of GDP. Over the past decade, imports more than doubled, while exports increased by only 50 percent. America now accounts for around 20 percent of global imports, up from 15 percent a decade ago. In large measure, the import bill has been settled with borrowed money. The U.S. became a net international debtor two decades ago, and its debt to the rest of the world has continued to mount. It jumped 14 percent in 2005 alone and stands at $2.7 trillion.

The Rise of China

One major consequence of the American consumption spree has been an increase in China's weight in the

global economy. True, China's economic development predated the War on Terror. China's GDP growth averaged 12.5 percent in 1992-1996. However, that growth rate came from a still-low base and, moreover, in the second half of the 1990s growth began to slow into the 7 percent range. Since 2002, however, the Chinese economy has been spurred once more, accelerating to an average annual rate of 9.5 percent.

While Chinese goods have been gaining market share everywhere, its export growth to the U.S. has been especially spectacular. In 2000, imports from China were 13.6 percent of total U.S. goods imports. By 2004, they exceeded 25 percent. The total value of Chinese exports jumped from $100 billion to nearly $250 billion last year. This year, that figure is on track to reach $285 billion. The U.S. trade gap with China has rocketed from $83 billion in 2000 to $202 billion last year.

China plans to nearly double its trade volumes by 2010. Fixed investment into plant and equipment has been enormous, since China has been flush with dollars from its trade surplus. The central bank has been buying up dollars for its reserves, which have swelled from $165 billion at the end of 2000 to $925 billion by mid-2006. Chinese companies have gone on an investing binge, with investment rising by 25 percent to 30 percent yearly. Foreign companies have also joined the spree, investing over $45 billion per year into China.

Ironically, prior to focusing on the War on Terror, the Bush Administration regarded China as the No 1 threat to American security. The thinking in the foreign policy establishment went as follows. With the end of the Cold War, the U.S. emerged as the world's only superpower. It was a repeat of the post-World War II situation, when Washington was in a dominant position, with a formidable economy, advanced technology and a monopoly on the atomic bomb. In the late 1940s, however, the U.S. had squandered that advantage, allowing the Soviet Union to catch up and even surpass its nuclear arsenal. The Bush White House was determined not to repeat this mistake -- and even to use military force against potential rivals if need be.

With Russia in a deep social, economic and demographic crisis, it was dismissed as a has-been. Instead, U.S. policymakers concentrated on China as the next potential superpower. In the first half of 2001, the Administration strengthened U.S. military ties with Taiwan as a potential counterweight to Beijing. It even picked a fight with China in April 2001, when a U.S. spy plane went down over China's Hainan Island.

Danger to World Stability

Now, by switching its attention to GWOT, the Bush Administration has allowed China to become a major player in the global economy.

The problem is that China is unlikely to be a force for economic stability. It has been over-investing for the past five years, massively and wastefully. Considerable overcapacity has been created across the Chinese economy, putting downward pressure on consumer prices around the world. China has been a key reason why inflation has not reared its head, despite a massive run-up in oil and non-oil commodity prices, loose fiscal policies and an enduring low interest-rate environment around the world.

So far, China's impact has been positive. However, as the Fed keeps raising its interest rates and curbing U.S. consumption, industrial overcapacity in China may come home to roost. Chinese communists have been presented to the rest of the world as a bunch of competent managers wisely shepherding China on the path of economic development. This is plain wrong. In reality, Beijing rulers are corrupt, incompetent party hacks, the direct heirs to men and women who carried out the Cultural Revolution in the 1960s. Not only hundreds of thousands of Chinese were killed in the process, but urban professionals were sent for "re-education" to dismal agricultural communes.

Today's Chinese leaders may not be repeating those foolish mistakes, but they are not omniscient either. In a crisis, China's lack of democracy and basic freedoms is likely to be a liability, not an advantage.

The problem is that China now plays a key role as a supplier of manufactured goods to the U.S. market. If it catches a cold -- which it inevitably will over the next five to 10 years -- the U.S. economy will not be able to get away with a mere bout of sneezing.

(See complete coverage of 9/11: Ten Years After on AdvisorOne.)

ALEXEI BAYER runs KAFAN FX Information Services, an economic consulting firm in New York. Reach him at abayer@kanfx.com.

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