Country Report December 2002

United States of America

United States of America at a glance: 2003-04

OVERVIEW The Republican president, George W Bush, will derive significant political benefit from his party's strong showing in the mid-term election on November 5th 2002, and this should boost his prospects for re-election in November 2004. As his party is now in control of both houses of Congress for the next two years, Mr Bush will be in a much stronger position to implement his domestic policy agenda. The showdown with Iraq will come to a head in the next few months. Despite a new UN resolution that lays down a strict timetable for Iraq to comply with commitments to disarm or face "serious consequences", the Economist Intelligence Unit continues to believe that the chances of this process delivering an acceptable outcome to Mr Bush are remote, and that a US-led military assault against Iraq is very likely in the first half of 2003. Fiscal policy will remain loose and interest rates will be held at or around their current low levels in 2003. GDP is forecast to grow by 2.3% in 2003 and 3.2% in 2004. Inflation will not pose a serious problem, but the current-account deficit will remain substantial.

Key changes from last month Political outlook • Following the November 5th mid-term election, a lame-duck session of the outgoing Senate hammered out a deal to create the Department of Homeland Security. Although the new department will come into being in early 2003, it will take several years to stitch together its various components. Economic policy outlook • A continuing weak economy remains one of the biggest risks to Mr Bush over the next two years. Fiscal policy is ever more likely to focus on stimulating the economy than on eliminating, or even reducing, the budget deficit. Economic forecast • Economic performance continues to be mixed, and economic prospects for 2003-04 have not improved despite some positive data released in November.

December 2002

The Economist Intelligence Unit 15 Regent St, London SW1Y 4LR United Kingdom The Economist Intelligence Unit The Economist Intelligence Unit is a specialist publisher serving companies establishing and managing operations across national borders. For over 50 years it has been a source of information on business developments, economic and political trends, government regulations and corporate practice worldwide. The Economist Intelligence Unit delivers its information in four ways: through its digital portfolio, where the latest analysis is updated daily; through printed subscription products ranging from newsletters to annual reference works; through research reports; and by organising seminars and presentations. The firm is a member of The Economist Group.

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Contents

3 Summary

4 Political structure

5 Economic structure 5 Annual indicators 6 Quarterly indicators

7 Outlook for 2003-04 7 Political outlook 10 Economic policy outlook 12 Economic forecast

17 The political scene

21 Economic policy

24 The domestic economy 24 Output and demand 26 Employment, wages and prices 28 Financial indicators 30 Sectoral trends

33 Foreign trade and payments

List of tables 12 International assumptions summary 13 Gross domestic product by expenditure 16 Forecast summary 24 Gross domestic product 27 Non-agricultural employment 28 Price inflation 29 Financial markets 34 Balance of payments 35 International trade in goods and services

List of figures 17 Gross domestic product 17 Dollar real exchange rates 25 US GDP and its components 27 Wages and prices 29 US equity prices

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Summary December 2002

Outlook for 2003-04 As the Republicans are now in control of both the executive and legislative branches of government for the next two years, the president, George W Bush, will pursue an aggressive legislative agenda that may include new tax cuts, more business-friendly laws and greater attention to defence and homeland security. Barring some cataclysmic event, such as a badly planned or executed war in Iraq or a prolonged slump in the stockmarket causing another recession, the chances of the Republicans choosing anyone else as their presidential candidate in 2004 are remote. The federal budget is expected to remain in deficit in fiscal years 2003 (October 2002-September 2003) and 2004. Interest rates will start to rise in 2004 once economic growth is more firmly established. GDP growth is forecast to average 2.3% in 2003 and 3.2% in 2004. Inflationary pressures will remain under control, but the current-account deficit will continue to be worryingly large.

The political scene Republican gains in the mid-term election on November 5th have been attributed largely to Mr Bush. His focus on security issues resonated with ordinary Americans, and homeland security and the war on terrorism will remain near the top of the political agenda for the next two years. There is a widespread perception that the Democrats have lost their sense of direction. The gubernatorial elections produced some positive results for both parties.

Economic policy The reappearance of budget deficits suggests that fiscal policy will be a divisive issue for the new Congress. Mr Bush wants to make permanent the US$1.35trn ten-year tax cut passed in 2001, and other more immediate tax cuts are also in the offing. Concern about slackening economic growth prompted the US Federal Reserve (the central bank) to cut the federal funds rate by 50 basis points to 1.25% on November 6th. The drive to improve corporate governance has been thrown into disarray by a number of high-profile resignations.

The domestic economy Despite GDP growth at an annualised rate of 4% in the third quarter of 2002, overall economic performance is decidedly mixed. Employment fell in both September and October. The Dow Jones stockmarket index is heading for its third consecutive annual decline in 2002. The airline industry is in serious trouble. The antitrust case against the computer software giant, Microsoft, has been settled finally. There has been a sharp deterioration in the financial health of corporate pension funds. The dockworkers’ dispute has been resolved.

Foreign trade and payments Bilateral trade agreements are becoming the cornerstone of the Bush admini- stration’s trade strategy on the grounds that they encourage “competitive liberalisation”. Major doubts remain about the feasibility of the timetable for a Free Trade Area of the Americas. The current-account deficit remains at record levels. Editors: Gerard Walsh (editor); Edith Hodgkinson (consulting editor) Editorial closing date: November 29th 2002 All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

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Political structure

Official name United States of America

Form of state Federal republic

Legal system Based on the constitution of 1787

Federal legislature Bicameral: Senate of 100 members directly elected on a plurality (first-past-the-post) system for a six-year term, with one-third of its members retiring every two years; House of Representatives of 435 members directly elected on a plurality basis for a two-year term. The Senate has the power to confirm or reject presidential appointments, including the cabinet, and to ratify treaties; the House of Representatives has the sole right to initiate revenue bills, although they may be amended or rejected by the Senate

Electoral system Universal direct suffrage from the age of 18

National elections November 5th 2002 (House of Representatives and one-third of the Senate); next elections due on November 2nd 2004 (presidential, House of Representatives and one-third of the Senate)

Head of state Executive president elected by popular vote via an electoral college of 538 members representing the states, for a maximum of two four-year terms. George W Bush is the current president, elected in November 2000 along with Dick Cheney as vice-president, for a four-year term ending in January 2005

State legislatures Each of the 50 states, except Nebraska (which has a unicameral system), has a bicameral legislature which follows the model of the federal legislature; the states have certain fiscal and legal rights; some states now limit the number of terms that can be served by their elected representatives

National government The administration is appointed by and responsible to the president; its senior officials are subject to the confirmation of the Senate

Cabinet secretaries Agriculture Ann Veneman Commerce Don Evans Defence Donald Rumsfeld Education Rod Paige Energy Spencer Abraham Health & human services Tommy Thoms on Housing & urban development Mel Martinez Interior Gale Norton Justice John Ashcroft Labour Elaine Chao State Colin Powell Transportation Norman Mineta Treasur y Paul O’Neill Veterans’ affairs Anthony Principi

Other offices with Environmental Protection Agency Christine Todd Whitman cabinet rank Office of Homeland Security Tom Ridge Office of Management & Budget Mitchell Daniels Office of National Drug Control Policy John Walters President’s Chief of Staff Andrew Card United States Trade Representative Robert Zoellick

Chairman of the Federal Reserve Alan Greenspan

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Economic structure Annual indicators 1998a 1999a 2000a 2001a 2002b GDP at market prices (US$ bn) 8,781.5 9,274.3 9,824.6 10,082.2 10,455.9 GDP (US$ bn) 8.8 9.3 9.8 10.1 10.5 Real GDP growth (%) 4.3 4.1 3.8 0.3 2.4 Consumer price inflation (av; %)c 1.5 2.2 3.4 2.8 1.6 Population (m) 275.7b 278.9b 281.8b 284.4b 286.9 Exports of goods fob (US$ bn) 670.4 684.0 772.0 718.8 687.2 Imports of goods fob (US$ bn) 917.1 1,030.0 1,224.4 1,145.9 1,165.0 Current-account balance (US$ bn) -203.8 -292.9 -410.3 -393.4 -494.0 Foreign-exchange reserves excl gold (US$ bn) 70.7 60.5 56.6 57.6 65.0 Nominal effective exchange rate (1995=100) 119.3 116.4 121.1 129.1 124.2 Real effective exchange rate (1995=100) 120.01 119.34 125.19 134.47 134.39 a Actual. b Economist Intelligence Unit estimates. c Seasonally adjusted.

Origins of gross domestic product 2001 % of total Components of gross domestic product 2001 % of total Agriculture, forestry & fishing 1.4 Private consumption 69.2 Mining 1.4 Federal expenditure 6.0 Manufacturing 14.1 State & local expenditure 12.0 Construction 4.8 Non-residential investment 12.2 Transport & utilities 8.1 Residential investment 4.4 Distributive trades 16.0 Stockbuilding -0.6 Finance, insurance & real estate 20.6 Exports of goods & services 10.3 Other private services 22.1 Imports of goods & services -13.7 Government & its enterprises 12.7 Statistical discrepancy -1.2

Principal exports 2001a US$ bn Principal imports 2001a US$ bn Capital goods (excl automotive) 322.3 Capital goods (excl automotive) 297.9 Industrial supplies 160.3 Consumer goods (excl automotive) 283.5 Consumer goods (excl automotive) 89.6 Industrial supplies 275.8 Automotive goods 74.6 Automotive goods 189.6 Food, feeds & beverages 49.0 Food, feeds & beverages 46.7

Main destinations of exports 2001a % of total Main origins of imports 2001a % of total Canada 22.4 Canada 19.0 Mexico 13.9 Mexico 11.5 Japan 7.9 Japan 11.1 UK 5.6 China 8.9 Germany 4.1 Germany 5.2 Total EU 21.2 Total EU 19.2 a Census basis.

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Quarterly indicators 2000 2001 2002 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr Federal finance (US$ bn) Revenue 462.0 461.3 459.8 660.3 409.0 466.3 412.6 522.6 451.8 Expenditure 464.3 463.6 482.2 466.5 450.7 501.7 509.2 506.9 493.2 Balance -2.3 -2.3 -22.5 193.7 -41.7 -35.4 -96.6 15.6 -41.4 Outputa GDP at current prices (annual rates; US$ bn) 9,874.8 9,953.6 10,028.1 10,049.9 10,097.7 10,152.9 10,313.1 10,376.9 10,503.7 GDP at chained 1996 prices (annual rates; US$ bn) 9,218.7 9,243.8 9,229.9 9,193.1 9,186.4 9,248.8 9,363.2 9,392.4 9,484.0 GDP at chained 1996 prices (% change, year on year) 3.7 2.3 1.5 -0.1 -0.4 0.1 1.4 2.2 3.2 Industrial production (1992=100) 146.7 145.7 143.4 141.3 139.6 137.2 138.1 139.5 140.7 Industrial production (% change, year on year) 4.7 2.6 -0.4 -3.5 -4.8 -5.9 -3.7 -1.3 0.8 Employment, wages and pricesa Employment (m) 135.0 135.6 135.8 135.2 134.8 134.3 133.9 134.1 134.6 Unemployment actual (m) 5.71 5.61 5.95 6.33 6.86 7.98 7.97 8.46 8.19 Unemployment ratio (%) 4.1 4.0 4.2 4.5 4.8 5.6 5.6 5.9 5.7 Average hourly earnings (US$) 13.81 13.98 14.11 14.25 14.38 14.51 14.62 14.71 14.82 Consumer prices (1982-84=100) 173.0 174.2 175.9 177.3 177.6 177.5 178.1 179.6 180.4 Consumer prices (% change, year on year) 3.5 3.4 3.4 3.4 2.7 1.9 1.2 1.3 1.6 Producer prices, finished goods (1982=100) 138.3 139.9 141.8 142.1 140.6 138.4 138.4 138.8 138.5 Producer prices, finished goods (% change, year on year) 3.6 3.7 4.0 3.4 1.6 -1.0 -2.4 -2.3 -1.4 Financial indicators Exchange rate ¥:US$ (end-period) 107.9 114.9 124.6 124.1 119.3 131.8 133.2 119.5 121.6 Exchange rate US$:¤ (end-period) 0.877 0.931 0.883 0.848 0.913 0.881 0.872 0.998 0.986 Exchange rate US$:£ (end-period) 1.470 1.492 1.426 1.404 1.470 1.450 1.423 1.537 1.564 Fed funds target rate (end-period; %) 6.50 6.50 5.00 3.75 3.00 1.75 1.75 1.75 1.75 10-year Treasury bond rate (av; %) 5.89 5.57 5.05 5.27 4.98 4.77 5.08 5.10 4.26 M1 (end-period; US$ bn) 1,090.5 1,112.3 1,107.4 1,123.0 1,191.1 1,203.5 1,189.3 1,187.5 1,183.5 M1 (% change, year on year) 0.4 -3.1 -0.1 1.9 9.2 8.2 7.4 5.7 -0.6 M2 (end-period; US$ bn) 4,847.2 4,962.2 5,110.1 5,173.0 5,354.6 5,482.9 5,545.2 5,570.4 5,685.2 M2 (% change, year on year) 6.4 6.1 7.7 8.6 10.4 10.5 8.5 7.7 6.2 Share prices (1941-43=10)b 1,436.5 1,320.3 1,160.3 1,224.4 1,040.9 1,148.1 1,147.4 989.8 815.3 Share prices (% change, year on year)b 12.0 -10.1 -22.6 -15.8 -27.5 -13.0 -1.1 -19.2 -21.7 Sectoral trendsa Unfilled orders (end-period; US$ bn) 543.1 547.8 543.3 530.8 513.4 506.4 503.3 488.4 485.3 Housing starts, private (annual rates; ‘000) 1,504 1,544 1,611 1,624 1,603 1,573 1,725 1,658 1,698 Foreign tradec and payments (US$ bn) Exports foba 199.6 196.5 193.3 184.8 173.3 167.4 164.6 172.7 n/a Imports foba -314.8 -315.1 -306.3 -292.6 -279.0 -268.0 -271.1 -295.3 n/a Trade balancea -115.1 -118.7 -113.0 -107.7 -105.8 -100.7 -106.4 -122.6 n/a Services balancea 16.8 17.4 15.9 14.4 26.0 12.6 11.6 12.0 n/a Income balancea 4.1 6.7 1.0 6.0 0.8 6.5 -1.8 -6.3 n/a Net transfer paymentsa -12.9 -16.4 -11.6 -11.9 -12.4 -13.6 -15.9 -13.1 n/a Current-account balancea -107.2 -111.0 -107.7 -99.2 -91.3 -95.1 -112.5 -130.0 n/a Reserves excl gold (end-period) 55.2 56.6 53.2 53.8 59.9 57.6 56.5 63.7 64.8 a Seasonally adjusted. b Standard and Poor’s 500 composite index, end-period. c Balance-of-payments basis. Sources: Government Printing Office, Economic Indicators; Department of the Treasury, Monthly Treasury Statement; IMF, International Financial Statistics.

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Outlook for 2003-04 Political outlook

Domestic politics The Republicans scored impressive victories in the mid-term election on November 5th 2002, setting the stage for an aggressive legislative agenda that may include new tax cuts, more business-friendly laws and greater attention to defence and homeland security. They captured the Senate and strengthened their control of the House of Representatives. The results are a particular triumph for the president, George W Bush, who is the first president since Franklin D Roosevelt in 1934, and the first Republican president ever, to gain seats for his party in both the Senate and the House in a mid-term election. Mr Bush campaigned tirelessly on behalf of Republican candidates, making his administration’s policies rather than local issues a centrepiece of many races. His stellar performance is likely to strengthen his own re-election prospects in the next presidential election in November 2004. The Democrats failed to capitalise on Americans’ concern about the economy and corporate scandals, as well as national unease over security issues. Although unemployment is rising and many households’ savings have been decimated by the fall in the stockmarket, Mr Bush and the Republicans did not seem to pay a political price. The outcome of the election will encourage Mr Bush to press ahead with his agenda, especially his determination to disarm and, if necessary, overthrow the Iraqi leader, Saddam Hussein. The likelihood of a strike against Iraq in the first half of 2003, with or without the support of the UN, remains high. The 108th Congress, which will be sworn in on January 23rd 2003, will have a full programme. Tax legislation will be a priority: Mr Bush is keen to make his 2001 tax cuts permanent (they are due to expire in 2010), although this is largely a symbolic measure. More substantively, Mr Bush may push a new tax-cutting agenda to stimulate the lacklustre economy. Tax cuts for businesses and investors will be high on the list, including proposals to increase the level of stock losses that can be deducted from income taxes, raise the contribution ceiling on individual retirement accounts and cut or eliminate taxes on stock dividends. Legislation reducing business regulation is also likely, as is long-stalled bankruptcy law reform, making it more difficult for debtors to shield their assets from creditors by filing for bankruptcy. On non-economic issues, the shift of power will enable Mr Bush to gain approval for a large number of conservative judicial appointments, which require Senate approval. These may include, within the next two years, the choice of a new Chief Justice of the Supreme Court, one of the most influential posts in the US government. The president will also push for changes to health policy, including a prescription drug benefit for the Medicare programme. Indeed, healthcare measures will be important in the next session of Congress. Republicans are also expected to push for limits on the size of jury awards in damage suits, many of which are targeted at large companies that market allegedly faulty products. Mr Bush may also revive his plan for oil exploration in the Arctic National Wildlife Refuge in Alaska as part of an energy policy which

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generally puts the emphasis on domestic energy security, rather than environ- mental or conservation concerns. Still, the mid-term election results do not give Mr Bush or the Republicans carte blanche to force through an ultra-conservative agenda. In general, the US continues to be broadly a "50-50 nation" with nearly equal support for the two main parties. The Republicans will not want to move too far from the centre of the political spectrum. They will be restrained by fears that a turn to sharply conservative policies would spur a backlash in favour of the Democrats in the next presidential and congressional elections in November 2004. In any case, the Republican majority in the Senate falls well short of the 60 seats required to exercise real control and the new majority leader, Trent Lott, will need the support of centrist Democrats for important initiatives. Mr Bush faces several significant risks. As Republicans now command so many of the levers of power, they must deliver. Mr Bush can no longer blame his Democratic predecessor, Bill Clinton, for any future economic troubles. If the economy does not improve over the next 12-18 months, Mr Bush could go into the 2004 election campaign in a much-weakened condition—much as his father did a decade ago. A war in Iraq also presents clear risks. Mr Bush has, so far, managed the “war on terror” effectively. But his administration remains less than united on how to confront Saddam Hussein. Those divisions could become more pronounced as UN weapons inspectors proceed with their work in Iraq, and final decisions are confronted on military action. Mr Bush's strong hand, and the momentum he is building towards the 2004 election, could dissipate quickly if a war in Iraq were to drag on, or the US took heavy casualties.

Election watch The Republican Party’s strong showing in the November 2002 mid-term election greatly enhances Mr Bush’s chances of re-election in the next presidential election in November 2004. Mr Bush will be in a strong position to push his legislative agenda through Congress, and to share the credit for Republican initiatives in the House and Senate. Barring some cataclysmic event, such as a badly planned or executed war in Iraq or a prolonged slump in the stockmarket causing another recession, the chances of the Republicans choosing anyone else as their presidential candidate in 2004 are remote. Among the Democrats, the presidential hopes of both the Senate majority leader, Tom Daschle, and the House minority leader, Dick Gephardt, have dimmed as they are identified with the Democrats’ poor showing in the mid- term election. The former vice-president and defeated presidential candidate, Al Gore, may return to favour, after gaining respect as one of the few prominent Democrats to speak out against Mr Bush’s threat of war with Iraq and his economic policies. The former vice-presidential candidate and senator from Connecticut, Joe Lieberman, Senator John Kerry of Massachusetts, Senator John Edwards of North Carolina and Senator Christopher J Dodd of Connecticut are also considering a run for the nomination. However, none of the current crop of presidential hopefuls is generating much excitement in party circles, especially in the face of the apparent Bush juggernaut. It is possible that the party will turn to an unconventional choice, such as the governor of Vermont, Howard Dean, or the Californian senator, Diane Feinstein.

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International relations Mr Bush’s heightened stature on the international as well as the domestic stage was apparent within days of the mid-term election when the UN Security Council voted unanimously in favour of a US-driven resolution that lays down a strict timetable for Iraq to comply with commitments to disarm and to co- operate fully with UN weapons inspectors, or face “serious consequences”. Mr Bush has made it clear that he wants more than unfettered access for the inspectors; he wants to ensure that Iraq will not be able to pose a threat to the US and other countries once its facilities to produce biological, chemical or nuclear weapons have been eliminated. This will require absolutely rigorous and meticulous inspections and the full co-operation of the Iraqi government. Given Mr Hussein’s track record of deceiving the UN and defying its resolutions, Mr Bush believes the only sure way to ensure that the threat posed by Iraq is neutralised permanently is to bring about “regime change” in Iraq, with the removal from power of Mr Hussein. The chances thus remain slim that war can be averted by the return of the inspectors to Baghdad. The Economist Intelligence Unit continues to believe that a US-led military assault against Iraq is likely in the first half of 2003. Nevertheless, the UN Security Council resolution points to a new-found appreci- ation by the Bush administration of the advantages of forging a multilateral coalition against Mr Hussein, rather than moving ahead with unilateral military action, backed only by the UK, as seemed likely a few months ago. The admini- stration will continue to try to widen the number of allies willing to participate in the removal of the Iraqi regime and the elimination of its weapons of mass destruction. But Mr Bush has made it clear that the US will not require a further UN Security Council vote to approve an attack on Iraq, and that the US will act alone, if necessary. Ultimately, the Bush administration is prepared to act without the full backing of the UN; with or without its help, the outcome will be no weapons of mass destruction in Iraq in a year’s time. Nonetheless, Mr Bush’s success in achieving a consensus in the Security Council in early November suggests that the US will be able to manage any opposition among its traditional allies should it go ahead with an attack on Iraq. Even so, the Bush administration’s sympathetic stance towards Israel continues to complicate its drive for support on Iraq. Arab leaders contend that a resol- ution of the Israeli-Palestinian conflict should be a higher priority than action against Iraq, while many European governments are concerned that the over- throw of Mr Hussein would increase rather than diminish instability in the region. Just how strained these relationships become will depend on the US’s ability to implement “regime change” in Iraq in a way that limits the ripple effects, both within Iraq and in the region as a whole. Although the Bush administration’s foreign policy agenda is dominated by Iraq, its options have been complicated by several other unsettling events in recent months. A number of terrorist incidents, notably the attack on a French super- tanker off Yemen, the massive car bomb explosion in Bali, Indonesia, and the twin attacks on tourist targets in Mombasa, Kenya, suggest that al-Qaida and/or other radical terrorist groups remain active. US security agencies have also warned of the possibility of another major attack on American soil in the

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months ahead. Furthermore, North Korea’s stunning admission in mid-October that it has been pressing ahead with a nuclear weapons programme in defiance of international agreements poses a direct challenge to Mr Bush’s pledge to crack down on regimes developing weapons of mass destruction. Mr Bush has always said that the war on terror will be long and hard, and the confrontation with the “axis of evil” extends beyond Iraq to include North Korea and Iran. But in relation to these latter two countries, non-military options will be pursued in the first instance. The US has already started to build an inter- national coalition to urge North Korea to abandon its nuclear weapons pro- gramme. It has engaged the leaders of China, South Korea and Japan in this campaign, and Mr Bush wants their backing for the principle of disarming North Korea before proposing detailed remedies for disarmament. Allies will also be needed to encourage reform in Iran: in contrast with its policy towards Afghanistan and, to a lesser extent, Iraq and North Korea, the US is currently isolated in its assessment of Iran. Without co-operation from its allies, efforts to tighten economic sanctions against Iran are likely to be unsuccessful, but the possibility of US military action against Iran is very remote.

Economic policy outlook

Policy trends The federal budget has moved firmly into deficit and is expected to remain in deficit in fiscal years 2003 (October 2002-September 2003) and 2004. The recession in 2001 and the sluggish performance since then has eaten into tax revenue and pushed up expenditure on benefits. But there has also been a huge discretionary relaxation of policy. Tax revenue is down because of Mr Bush’s ten-year tax cut programme, the first tranche of which came into effect in mid- 2001, while spending is rising rapidly and hopes that the tax cut would result in spending discipline have been dashed. In the short term, this fiscal boost is highly beneficial to a sluggish economy, and should be welcomed. But the deter- ioration in the fiscal position is unlikely to be reversed, even when economic recovery is more firmly established. The Federal Reserve (the central bank) has little room for further monetary loosening following its decision to cut the feder- al funds rate by 50 basis points to 1.25% on November 6th. Interest rates will be kept low in 2003, but policy is likely to be tightened steadily throughout 2004 in order to bring real short-term interest rates back towards a more neutral setting.

Fiscal policy In the wake of the terrorist attacks on September 11th 2001, and in the face of a sluggish economy, fiscal policy has been eased dramatically by the federal government. Not only is defence spending rising rapidly, spending on most non- defence programmes is up sharply. Mr Bush’s plan to offset increased defence expenditure by restraining spending in other areas is not working. At the same time, tax revenue is being depressed by cyclical factors, such as higher unemployment and declining corporate profitability. In addition, several tranches of tax cuts passed as part of the administration’s ten-year tax cut plan have come into effect, and these will result in the budget remaining in deficit even when economic recovery is more firmly established. Although the deficit will be fairly small as a share of GDP (in comparison with those run during the 1990s), it will put some upward pressure on long-term interest rates by 2004.

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The fiscal year 2003 started on October 1st 2002 without one of the necessary 13 appropriations bills (spending bills) having been passed into law, reflecting budget differences between the House and the Senate. Two bills (covering defence and military construction) have since been passed, but the rest are unlikely to be dealt with until January. Meanwhile, federal government is operating on the basis of a continuing resolution, which caps annual spending at a level similar to fiscal year 2002. Since interest rates are now so low, room for further monetary easing in the absence of a terrorist attack or a banking crisis is limited. Therefore, if the economy continues to underperform in 2003 it will be fiscal policy which will have to take the strain. Some kind of fiscal stimulus package now seems likely, but its effectiveness in supporting the economy will depend on its exact com- position. Bringing forward the scheduled 2004 and 2006 income tax cuts would be highly effective, whereas measures which impact on corporate taxes or plans to make the 2001 tax cuts permanent (currently they expire in 2010) would do little to boost the economy.

Monetary policy With most monthly indicators suggesting that the economy started to slow again from September, the Federal Reserve cut its federal funds rate by 50 basis points to 1.25% on November 6th, the first cut in interest rates in 2002. This is unlikely to do much to stimulate investment spending (as firms are still burdened with significant excess capacity), but should help to prevent the recent slowing of consumer demand from turning into an outright collapse by allowing further mortgage refinancing and boosting the housing market and thus personal sector wealth. In reducing rates in November, the Federal Reserve said the risks to the economy are now evenly balanced. This is an upgrade from its previous assessment that most of the risks were on the downside. However, the Economist Intelligence Unit doubts that the Federal Reserve is really so confident about the economic outlook. Instead, we regard this “change in bias” as a warning by the Federal Reserve to financial market participants that it has very little room left for further rate cuts. Policymakers will want to preserve the few remaining interest rate cuts available to them in case of another major terrorist attack or an economic shock such as the collapse of a large financial institution. It will take most of 2003 before firms have worked off enough of their over- capacity to be willing to invest again. Consequently, we doubt that job creation will start to improve significantly before late 2003. The first rate increase is therefore not expected to occur until early 2004. However, once interest rates do start to rise, we expect them to rise steadily, reaching 5% by the end of 2004, returning real interest rates to a more normal (and broadly neutral) 2%.

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Economic forecast International assumptions International assumptions summary (% unless otherwise indicated) 2001 2002 2003 2004 Real GDP growth World 2.0 2.7 3.3 3.9 OECD 0.7 1.6 1.9 2.6 EU 1.4 0.9 1.6 2.2 Exchange rates ¥:US$ 121.5 125.5 128.8 130.5 US$:€ 0.896 0.948 1.070 1.053 SDR:US$ 0.785 0.771 0.737 0.744 Financial indicators ¥ 2-month private bill rate 0.17 0.10 0.10 0.35 € 3-month interbank rate 4.26 3.33 2.75 3.38 Commodity prices Oil (Brent; US$/b) 24.5 24.9 24.5 19.1 Gold (US$/troy oz) 271.1 308.0 307.5 290.0 Food, feedstuffs & beverages (% change in US$ terms) -1.9 15.4 14.5 0.2 Industrial raw materials (% change in US$ terms) -9.8 0.2 6.1 9.7 Note. Regional GDP growth rates weighted using purchasing power parity exchange rates. The pace of global economic growth remains weak. The recovery in most major economies seems to have slowed in the second half of 2002 and global growth is likely to be disappointing for at least the next year. Global GDP growth— measured using purchasing power parity (PPP) weights—is estimated to have averaged 2.7% in 2002, up from 2% in 2001. An acceleration to growth of 3.3% is forecast for 2003, and the pace of expansion should average 3.9% during 2004. The economic recovery in the euro zone is weakening. Confidence has been severely affected by the big falls in equity prices in Europe, and this will hold back consumption and investment growth in 2003. It will be difficult for govern- ments or the European Central Bank (ECB) to take sufficiently aggressive policy action to offset this domestic weakness, although we do expect a 50-basis-point reduction in interest rates in the next few months. Average growth in the EU as a whole in 2002 is estimated at only 0.9%, rising to just 1.6% in 2003 and 2.2% in 2004. The Japanese economy is also highly vulnerable; the yen has strengthened markedly since early 2002, eroding exporters’ price competitiveness, while demand is softening in key export markets. The weakness in the pace of OECD recovery is damaging growth prospects in the emerging world. Because OECD import demand is weak, emerging markets will struggle to increase their exports significantly. Many countries will try to boost domestic demand growth instead, but this will be insufficient to offset fully the weakness of the tradeables sector. We assume that the current stand-off between the US and Iraq will lead to a conflict in 2003, probably in the first half of the year. Uncertainty over the outlook is currently pushing up the level of oil prices by about US$6/barrel. When the conflict is over, we expect oil prices to drop back fairly rapidly towards US$20/b. In this scenario, the impact of war with Iraq on global

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economic growth is fairly modest. However, there are significant risks to this benign forecast. Economic growth Gross domestic product by expenditure (US$ bn at chained 1996 prices; % change year on year in brackets unless otherwise indicated) 2001a 2002b 2003c 2004c Private consumption 6,377.2 6,566.2 6,710.7 6,918.7 (2.5) (3.0) (2.2) (3.1) Public consumptiond 1,640.4 1,710.3 1,748.8 1,791.2 (3.7) (4.3) (2.2) (2.4) Gross fixed investment 1,627.4 1,578.2 1,610.9 1,688.2 (-3.8) (-3.0) (2.1) (4.8) Final domestic demand 9,645.8 9,855.4 10,071.0 10,398.9 (1.5) (2.2) (2.2) (3.3) Stockbuilding -61.4 -0.9 17.5 33.8 (-1.4)e (0.7)e (0.2)e (0.2)e Total domestic demand 9,584.4 9,854.5 10,088.5 10,432.7 (0.2) (2.8) (2.4) (3.4) Exports of goods & services 1,076.1 1,064.3 1,118.5 1,189.0 (-5.4) (-1.1) (5.1) (6.3) Imports of goods & services -1,492.0 -1,542.8 -1,627.6 -1,731.8 (-2.9) (3.4) (5.5) (6.4) Foreign balance -415.9 -478.5 -509.1 -542.8 (-0.2)e (-0.7)e (-0.3)e (-0.3)e GDPf 9,214.5 9,438.0 9,651.5 9,965.0 (0.3) (2.4) (2.3) (3.2) a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts. d Includes government's capital expenditure. e Contribution to real GDP growth. f Includes residual. The US economy is expected to expand by only 2.3% in 2003, accelerating to 3.2% in 2004. The short-term outlook has deteriorated significantly over the past three months as the sharp fall in the equity market has hit both the personal and corporate sectors. There is no sign of an investment recovery, and the labour market remains too weak to support a sustained rebound in consumer spending. Although we do not expect a double-dip recession, growth will remain sluggish in early 2003. Most areas of domestic demand will be subdued. The wealth destruction associated with the recent slide in US equity prices is the largest (as a share of GDP) since 1929 and is likely to depress consumer demand in the coming months, despite continued gains in house prices. The corporate sector is unlikely to resume substantial investment spending soon. The weakness of equity prices is restricting firms’ access to capital, and in any case most firms are nursing significant spare capacity and have no need to ramp up investment, particularly with the outlook for consumer demand worsening. Exporters should fare a little better as the weakness in the US dollar improves price competitiveness, but this economic boost will be tempered by the renewed weakness of many major export markets. We expect GDP growth in 2003 to average only 2.3%, well below trend. Con- sumer spending will continue to be restrained by weak employment growth and the need to increase savings in the light of declining wealth (as equity prices

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remain soft). Corporate investment will therefore be sluggish, with firms reluct- ant to add to capacity until existing facilities are more fully utilised. Also, access to investment capital will remain restricted as investor risk aversion remains high. Growth in 2004 is likely to improve, to 3.2%, as investment gradually recovers and employment growth starts to accelerate. This is broadly in line with our estimate of long-run potential growth in the US. However, it is considerably slower than the growth seen at the height of the boom in the late 1990s. The only significant upside risk to the outlook for 2003 is the possibility that the federal government implements an effective fiscal stimulus package (and to be effective, this would almost certainly need to involve an immediate cut in income tax rates, rather than increasing corporate tax breaks or extending the existing temporary income tax reductions beyond 2010). However, opinions are divided on whether a fiscal stimulus package is really needed, and we are pessi- mistic on the chances of something effective being enacted in a timely manner. The downside risks are far more serious, particularly those associated with the recent sharp loss in confidence in the US economic outlook on the part of both US consumers and international investors. Given that the US personal sector saves little and is fairly highly indebted, this raises the possibility that consumers may retrench, spending far less and driving the US economy into a steep down- turn. In addition, there is also a significant risk that, as foreign investor sentiment deteriorates, capital flows into the US may weaken, with the equity market and dollar sliding even further (for example, to US$1.30:€1 with the S&P500 falling to 700 or below). This would have a beneficial impact on the US export sector as US price competitiveness improved, but a highly damaging impact on the domestic economy as the equity cost of capital rose and wealth fell. If either domestic consumers or foreign investors retrenched, some of the negative economic effects would be offset by a sharp loosening of fiscal policy. But this would be insufficient to prevent US growth from slowing markedly, and a sub- stantial recession can not be ruled out. Our assessment puts the risk of a collapse in consumer demand and sustained plunge in the US dollar and in financial asset prices over the coming months at 30%. There is also the risk that the expected war with Iraq causes a significant spike in oil prices, which would act as a tax on economic production and further weaken the US economy. We are confident that OPEC would increase oil output to make up for any Iraqi shortfall, and that supply security in the Gulf would be maintained. But clearly there is a risk that OPEC will not increase oil output and that oil supply is significantly disrupted. If this were to happen, and oil prices rise to as high as US$80/barrel or more for a prolonged period, the US economy would slow markedly. But we regard this as a small risk, and rate it at just 10%. There is also a risk that the conflict will be prolonged, resulting in a persistent oil price premium similar to the current one of US$6/b. This would act as a gentle drag on US growth during 2003-04, cutting our forecasts by perhaps 0.2% a year. In the previous Gulf war, however, oil prices fell back even before the conflict started once uncertainty over US intentions was cleared up by the posting of troops to the Middle East. It therefore seems plausible that a prolonged conflict during 2003 would not actually attract an oil price premium, provided that the end result was not in doubt and OPEC continued to guarantee global oil supply.

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Inflation Inflationary pressures have picked up slightly. In the most recent months, prices have been up at an annualised rate of almost 3%, owing both to the increase in oil prices as the threat of a US war with Iraq grows and to a slight pick-up in the core rate of price inflation (including housing, clothing and communications). The key drivers for US inflation are unit labour costs, non-labour input prices and the strength of demand. Non-labour input prices are expected to continue rising in 2003, particularly in the first half of the year. Import prices will also rise, owing to energy price developments and the weakness of the US dollar relative to 2002. Unit labour costs are also expected to rise in 2003, after declining in 2002. With employment growing again, the total wage bill will begin to rise more rapidly than in 2002, and output growth will not be strong enough to offset this increase in the cost base. In 2004, with consumer demand growing slightly more strongly and unit labour costs picking up, inflation will rise. However, we do not believe that inflation will pose a problem for either the Federal Reserve or for business. The economic upswing will be too sluggish to present any inflationary worries, and even if growth surprises on the upside, interest rate rises will ensure that inflation does not accelerate out of control. Consumer price inflation will average 2.3% in 2003 and 2.5% in 2004—rates that are well within the bounds that the Federal Reserve would be prepared to tolerate.

Exchange rates The US dollar shrugged off the recession of 2001, the September 11th terrorist attacks in the same year and even the collapse of the energy giant, Enron. However, the more recent corporate scandals and the sluggishness of the economy have led to a shift in investor sentiment against the US currency. Just as significantly, investors are starting to question the structural stability of the US economy, namely the long-standing current-account deficit and lack of domestic savings. There are, of course, many negative features in the euro zone, which have so far prevented a decisive move beyond parity for the euro. But with US investment returns set to remain low relative to recent years, capital flows into the US will be more difficult to attract. Therefore, the dollar seems to have further to fall. We tentatively project the dollar moving to an average of US$1.07:€1 in 2003, before starting to recover as the US economy improves. However, this recovery is likely to be gradual, with the dollar averaging US$1.05:€1 in 2004. It seems increasingly likely that the adjustment in capital flows into the US will take some time, and this will prevent a rapid rebound in the US currency despite the fact that the economic performance of the euro zone is also expected to be poor. Our forecast for the US dollar against the yen is somewhat different. The dollar fell sharply against the Japanese currency in the first half of 2002, mainly owing to the change in investor sentiment towards the US, but also because Japan is experiencing positive export growth following an extremely deep recession. However, the dollar is already making up some of that lost ground, with most investors now acknowledging that the Japanese economy is suffering from some extremely serious problems. Investors are therefore wary about buying yen- denominated assets. As concerns about the Japanese economy grow, and investors become increasingly uncertain about the direction of Japanese policy, it seems likely that the yen will fall back further in 2003-04.

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External sector The US current-account deficit remains worryingly large. We estimate that the deficit reached some US$494bn in 2002, about 4.7% of GDP—a ratio even higher than in 2000, at the height of the economic boom. The recession of 2001 did remarkably little to shrink the deficit, not least because so much of the rest of the world went into recession at the same time as the US. The prospects for 2003 are for the deficit to rise slightly in cash terms, remaining unchanged as a share of GDP. An expected one-off improvement in the balance on income payments—a weaker currency than in 2002 will inflate earnings on investment abroad in dollar terms—will be offset by a continued deterioration in the trade balance. In 2004, when movements in the US dollar’s value are expected to be smaller, the income balance will return to deficit, and the ongoing deterioration in the trade deficit will be sufficient to keep the current-account deficit rising in dollar terms, and broadly stable as a share of GDP. Deficits of this magnitude are worrying because they need to be funded by continued large-scale capital inflows from the rest of the world. There are some signs that foreigners’ willingness to put money into the US economy has waned; this is a key reason why the US dollar fell during 2002. In addition, the com- position of capital flows into the US has changed, away from direct investment and towards forms of capital which are more easily withdrawn. While the US is a long way from a funding crisis, it is impossible to rule out a sharp decline in the US dollar as investors opt to direct their capital to other regions.

Forecast summary (% unless otherwise indicated) 2001a 2002b 2003c 2004c Real GDP growth 0.3 2.4 2.3 3.2 Gross fixed investment growth -3.8 -3.0 2.1 4.8 Industrial production growth -3.7 -0.4 2.4 3.9 Unemployment rate (av) 4.8 5.8 5.9 5.7 Consumer price inflation (av) 2.8 1.6 2.3 2.5 Consumer price inflation (year-end) 1.5 2.6 2.4 2.7 US$ 3-month commercial paper rate 3.6 1.7 1.3 3.1 Federal government budget balance (% of GDP)d 1.3 -1.5 -1.7 -1.6 Exports of goods fob (US$ bn) 718.8 687.2 731.8 788.0 Imports of goods fob (US$ bn) 1,145.9 1,165.0 1,247.6 1,308.1 Current-account balance (US$ bn) -393.4 -494.0 -509.8 -525.9 Current-account balance (% of GDP) -3.9 -4.7 -4.7 -4.6 Exchange rate ¥:US$ (av) 121.5 125.5 128.8 130.5 Exchange rate US$:€ (av) 0.896 0.948 1.070 1.053 Exchange rate US$:SDR (av) 1.273 1.297 1.357 1.344 a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts. d Federal government, financial year (October-September).

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The political scene

Republican election victory The results of the mid-term election on November 5th have greatly enhanced attributed to Mr Bush the political stature of the president, George W Bush. Mr Bush did his utmost to personalise the campaign, appealing for allies to help him push through his programme, especially his homeland security bill, and raising a record amount of money. While some liberal commentators have portrayed Mr Bush as a warmonger offering simple solutions to complex problems, his down-to-earth style and his focus on security issues clearly resonated with ordinary Americans. Mr Bush’s popularity ratings remain high—above 60%—and after a stumbling start as president he has found his footing. Prior to the mid-term election, the 435 seats in the House of Representatives were divided between 223 Republicans and 210 Democrats, with two vacancies. The Republicans now have at least 228 seats and the Democrats at least 203, with one independent. By late November, three contests (in districts in Colorado, Louisiana and Hawaii) were still undecided. In the Senate, 34 of 100 seats were contested in the November election. Although one seat, in Louisiana, will be decided only in early December, the new Senate will most likely have 51 Republicans, 48 Democrats and 1 independent when it convenes in January. The independent is Senator Jim Jeffords of Vermont, who defected from the Republican Party in May 2001. Within a week of the mid-term election, a lame-duck session of the Senate, under Democratic leadership, hammered out a deal to implement Mr Bush’s top domestic priority, the creation of a new Department of Homeland Security. Legislation to set up the department, which brings together 22 existing federal agencies, had been stalled by a dispute between Republicans and Democrats over extending civil service collective bargaining rights to the department’s 170,000 workers. The new law has given the president most of what he wanted, allowing him to exempt unionised workers from collective-bargaining agree- ments when he determines this is justified by national security. The new department, which will almost certainly be headed by Tom Ridge, the present

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director of homeland security, will come into being in early 2003, but it will take several years to stitch together its various components. The outgoing Senate has also bowed to Mr Bush’s wishes by passing a long- delayed terrorism insurance law, under which the federal government rather than private insurers will pay the bulk of losses incurred in a terrorist attack. The measure provides for the government to contribute as much as US$100bn a year to terrorism insurance pay-outs for three years.

Security issues remain near Homeland security and the war on terrorism will remain near the top of the the top of the political agenda political agenda for the remainder of Mr Bush’s term. Furthermore, his admini- stration can be expected to take whatever action it feels is required to deal with the terrorist threat at home and abroad, with maintenance of civil liberties being a secondary consideration. Besides the threat of another devastating attack against the US or its allies, this issue has proved to be Mr Bush’s most potent political weapon, and domestic public opinion is firmly on his side. The public mood was further hardened by the sniper attacks in suburban Washington DC in early October. The US has significantly tightened border controls in recent months. For instance, citizens of all foreign countries, even those with good relations with the US, who were born in countries suspected of having terrorist links, such as Libya, Iraq, Iran and Yemen, can expect to be intensively questioned and even finger- printed on arrival in the US. The US’s determination to pursue the war on terror over a wide front was dramatically illustrated in early November when a missile from an unmanned aircraft, widely reported to be operated by the Central Intelligence Agency (CIA), killed an al-Qaida leader and five others as they were travelling by car in a remote part of Yemen. The CIA, the Federal Bureau of Investigation (FBI) and the military have all been assigned to track down al- Qaida operatives wherever they may be.

M i xed fo rt u n es fo r th e B u sh While Mr Bush is riding high in the opinion polls, the record of senior members team of his administration is more mixed. The vice-president, Dick Cheney, has kept a low profile in recent months as the Securities and Exchange Commission (SEC) investigates accounting practices at the oil services supplier Halliburton in the late 1990s, when Mr Cheney was the company’s chief executive. Mr Cheney, who has emerged as the most powerful vice-president in recent history, is also at the centre of a controversy over the influence of Enron, the bankrupt Houston energy trader, on the Bush administration’s energy policies. Colin Powell, the secretary of state and a moderate voice on Iraq and the Middle East, seemed to be losing influence earlier in 2002 to the administration’s hawks, notably Mr Cheney and the defence secretary, Donald Rumsfeld. However, Mr Powell’s star has brightened dramatically in the wake of the administration’s success in obtaining a unanimous UN Security Council resolution for action against Iraq. Mr Powell is widely credited with dissuading Mr Bush from unilateral action against Mr Hussein, and then crafting the diplomatic strategy which led to the UN Security Council resolution. However, questions remain about the strength of the administration’s economic team, including the Treasury secretary, Paul O’Neill, the chairman of the Council

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of Economic Advisers, Glenn Hubbard, the White House budget director, Mitchell Daniels, and Mr Bush’s top economic adviser, Lawrence Lindsey. None has emerged as an effective spokesman for the administration’s economic policies, which could turn out to be the weakest spot in Mr Bush’s armour in the November 2004 election. In spite of a lacklustre performance, Mr O’Neill is likely to stay on to shepherd Mr Bush’s tax reforms through Congress. But Mr Daniels may leave the White House within the next year or so if he heeds pressure to run for governor in Indiana in 2004. The fate of Mr Lindsey, one of the most vocal supporters of further tax cuts as a means of stimulating the economy, is uncertain.

Democrats lose their sense of The election results present a huge challenge for the Democrats. Although the direction gap between the two parties in terms of congressional seats remains relatively small, there is a widespread perception that the Democrats have lost their sense of direction, with a dearth of both imaginative policies and bold leadership. During the campaign, the Democrats failed to present an alternative vision to Mr Bush’s. They were unable to exploit voters’ concern about the state of the economy and the spate of corporate scandals. Nor has the party presented any plans of its own to combat terrorism or to deal with Mr Hussein. During the 18 months that the Democrats held the majority in the Senate, their behaviour in Congress was perceived as negative, either blocking Republican legislation in the House of Representatives, or forcing the Bush administration into infrequent compromises. The Democrats are likely to spend the next few months in a period of intro- spection and infighting between liberals and centrists as they seek a formula to make a greater impact on the electorate. On the legislative front, they will be torn between obstructionism as they seek to differentiate themselves from Mr Bush and the Republicans, and a realisation that the party has been hurt politically by its blockage of bills in the outgoing Congress. The fallout from the elections began within days of the votes being counted with the resignation of Dick Gephardt, the long-serving minority whip in the House. Mr Gephardt, who may seek his party’s presidential nomination in 2004, has been succeeded by Nancy Pelosi of California. Ms Pelosi, who has a reputation as a liberal on social issues, could further divide the party. Tom Daschle, who now reverts to being minority leader in the Senate, is likely to retain his position.

Governor elections produce While much of the attention in the mid-term election focused on contests for the positive news for both parties House and the Senate, the outcome of some of the 36 races for state governor was also potentially of national significance. A governorship carries consider- able power and profile, and has traditionally been a favourite launching pad for a presidential bid. Among recent presidents, Bill Clinton, Ronald Reagan and Jimmy Carter, as well as George W Bush, were previously state governors. On the Republican side, the biggest winner was Jeb Bush, governor of Florida and the president’s younger brother. In spite of being the Democrats’ prime electoral target, the younger Mr Bush managed to pull off a comfortable win. A strong performance by the president over the next few years could encourage

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Jeb Bush to run for the presidency himself in 2008. The Democrats were not left empty-handed in the governors’ races, regaining the top job in several important states, including Illinois, Michigan and Pennsylvania. Ed Rendell, the incoming governor of Pennsylvania, is especially well regarded. (The new governor of Michigan, Jennifer Granholm, is not eligible to run for president because she was born in Canada.) However, the governors, new and old, face daunting challenges over the next two years that could tarnish some previously unblemished records. The states are struggling to reconcile spiralling demands for expanded public services with stagnant revenue. Ballooning welfare rolls as a result of rising unemployment is also putting a strain on state budgets. Many governors will thus face the un- pleasant choice between raising taxes and cutting back services; some may be forced to do both, putting their re-election hopes at risk.

New national election In a postscript to the controversy over voting procedures that dogged the 2000 standards are established presidential election, the outgoing Congress has passed a law establishing national election standards and earmarking almost US$4bn to help states modernise their voter registration and polling systems. Under the measure, states with punch-card and lever voting machines, similar to those used in the hotly contested vote count in Florida in November 2000, will receive federal assistance to buy machines that allow voters to correct mistakes on ballot papers before they are cast. Mr Bush signed the law in late October. To help verify voter identification, each state is required to set up a computer- ised voter registration list linked to its drivers’ licence agency no later than the mid-term 2006 election. In response to allegations that many qualified voters were not allowed to cast ballots in 2000, the law provides that provisional ballot papers will in future be issued to people who claim to be eligible to vote but whose names do not appear on electoral rolls. These ballots would be put to one side while election officials decide whether they are valid. At least one machine at each polling station will have to be accessible to the disabled. At the same time, however, the law tightens identification requirements for voters.

The FBI’s annual report shows The incidence of violent and serious crime in the US rose in 2001 for the first first rise in crime in ten years time in ten years, according to the FBI’s annual crime report. The FBI gave no specific reasons for the reversal, but other experts ascribed it to a variety of factors, including: the slack economy and rising unemployment; cutbacks in welfare programmes as a result of a squeeze on state and municipal finances; a higher incidence of drug-trafficking; a bigger population of teenagers; and a diversion of law enforcement resources to combating terrorism in the wake of the terrorist attacks on September 11th 2001. Based on seven different types of crime, the FBI said that crime rose by 2.1% in 2001. The number of murders was 2.5% higher than in 2000 at 15,980 (5.6 per 100,000 inhabitants), while burglaries went up by 2.9% to 741 per 100,000, motor vehicle thefts by 5.7% to 431 per 100,000, robberies by 3.7% to 149 per 100,000, and rapes by 0.3% to 32 per 100,000. Among robberies, bank hold-ups rose especially sharply. The murder statistics do not include those killed in the September 11th attacks.

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Regionally, the biggest increases in crime rates were in the west. In contrast to the overall increase, the crime rate in the north-east US fell by 1.9%, with New York, Washington DC, Philadelphia and Baltimore all posting lower murder rates. New York reported 649 murders in 2001, down from 673 the previous year. The biggest increase in the murder rate was in Las Vegas, with a jump from 90 to 133. Other cities reporting significantly higher murder rates were Phoenix (Arizona), St Louis (Missouri) and San Antonio (Texas).

Economic policy

More tax cuts are in the offing A continuing weak economy remains one of the biggest risks to Mr Bush over the next two years. With the strong mandate provided by the November 2002 mid-term election and doubts about the efficacy of monetary policy in bolstering growth, the president and fellow Republicans in Congress are sure to become more assertive in pushing their fiscal agenda. The only question is what their priorities will be in terms of specific initiatives. Fiscal policy is likely to focus more on stimulating the economy than on eliminating, or even reducing, the now-substantial federal budget deficit. With the Republicans’ inherent distaste for big government, Congress and the administration will try to keep the lid on public spending in most areas, with the notable exception of domestic security and the military. A prolonged war in Iraq could be especially costly and could significantly widen the budget deficit. Rather, the emphasis will fall on supply-side measures, reminiscent of those adopted by the Reagan administration, which are designed to put more money into taxpayers’ pockets, both in the short and long term. Mr Bush is certain to push Congress to make permanent the US$1.35trn tax cut passed in 2001, which is currently due to expire after ten years. Other, more immediate, tax cuts are also in the offing. Among those under discussion are further cuts in personal income tax rates, a lower tax rate on dividends and an increase in the allowable deduction for capital losses from the current level of US$3,000. The terrorism insurance bill, passed by Congress in late November, is seen as an important measure to stimulate the construction industry. Mr Bush has also indicated that he will move towards simplifying the tax code, and at least a partial privatisation of Social Security, the public pension system, to give Americans a measure of flexibility in administering their own invest- ment accounts. However, proposals to privatise Social Security will be strongly opposed by the Democrats, and are likely to be delayed until the stockmarket shows signs of sustained recovery. More likely in the immediate future is an increase in the contribution ceiling on individual retirement accounts.

Federal budget will remain in The federal budget for fiscal 2003 (October 2002-September 2003) has been deficit in fiscal 2003 among the victims of Washington’s focus on Iraq and partisan bickering ahead of the mid-term election. Congress had yet to approve the budget when the new fiscal year began on October 1st, and little progress has been made since then. Instead, both houses of Congress have passed “continuing resolutions” which allow government departments to continue operating without the normal bills that authorise spending programmes. By the time the 107th Congress adjourned

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in late November, only two of the 13 spending bills required to implement the new budget, relating to defence and military construction, had been passed by both houses. According to the White House’s Office of Management and Budget, the federal deficit in fiscal 2002 was US$159bn, a dramatic deterioration from the US$127bn surplus recorded in fiscal 2001. Given the recent slackness in the economy, the 2001 tax cuts and higher spending on defence and homeland security, a deficit of a similar magnitude to that in fiscal 2002 is likely in fiscal 2003. The White House has projected a shortfall of US$109bn, while the non-partisan Congressional Budget Office’s estimate is a more gloomy US$145bn. The reappearance of budget deficits suggests that fiscal policy will be a divisive issue for the new Congress. A priority for Mr Bush is to make permanent the US$1.35trn in tax cuts approved in 2001. However, if the economy remains weak and the budget deficit widens further, the Republicans could come under pressure to divert some of the sharp increase in defence spending to social programmes. Democrats are sure to resist any attempt to extend the 2001 tax cuts, and are likely to push instead for extra spending, such as a government- funded programme to provide prescription drugs to the retired.

Federal funds rate cut to 1.25% Concern about slackening economic growth, not only in the US but also in on November 6th Europe and Japan, was reflected in the Federal Reserve Board’s surprise decision on November 6th to cut its key federal funds rate by half a percentage point to 1.25%. This was the first reduction in the rate since December 2001 and the biggest cut since the immediate aftermath of the September 11th terrorist attacks. The Federal Reserve’s decision followed a lively public debate on whether a rate cut was needed at all and, if so, how large it should be. Proponents of a cut pointed to the need for stimulatory measures to counter mounting evidence of a slowing economy, and also to put pressure on the European Central Bank (ECB) to revive the euro zone by lowering interest rates. Others, however, have main- tained that, as in Japan over the past decade, monetary policy has become less relevant in persuading consumers and businesses to loosen their purse strings, and that the emphasis should rather fall on a combination of higher govern- ment spending and lower taxes. This camp has also contended that by bringing down interest rates from already low levels, the Federal Reserve gives itself less room for manoeuvre in coming months if the economy is still in the doldrums. The Federal Open Market Committee stated after its November 6th meeting that while growth in productivity continued to support economic activity, “greater uncertainty....is currently inhibiting spending, production and employment”. The committee specifically cited “heightened geopolitical risks”, generally taken to mean the threat of war against Iraq and further terrorist attacks on US interests. The committee added that, with the large rate cut, the risks were evenly balanced between its dual long-term goals of price stability and sustainable economic growth. The latest statement was in sharp contrast to the one issued after the Federal Reserve’s previous meeting on September 24th, when interest rates were left unchanged on the grounds that “aggregate demand is growing at a moderate

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pace”. However, the committee did acknowledge that the risks at that time were weighted “mainly toward conditions that may generate economic weakness”.

Drive to improve corporate The drive to improve corporate governance standards has been thrown into governance is in disarray disarray by a series of mishaps at the Securities and Exchange Commission (SEC) which culminated in the resignations of both the commission’s chairman, Harvey Pitt, on November 5th, and the first head of a high-profile new agency to oversee the accounting profession, William Webster. The Public Company Accounting Oversight Board was established in the wake of widespread criticism that conflicts of interest among auditors and lax super- vision of the accounting profession contributed to the collapse of companies such as Enron and WorldCom. Mr Pitt initially pledged that the composition of the new board would find universal favour and, according to numerous published reports, promised to support John Biggs, head of a large pension fund, as the board’s first chairman. But Mr Biggs has been a strong proponent of reform in the accounting profession, and the profession lobbied hard against his appointment. Mr Pitt then backtracked on his commitment to Mr Biggs, voting in a 3-2 majority at the SEC to give the job instead to Mr Webster, the 78-year-old former director of the CIA and the FBI. The SEC split along party lines on Mr Webster’s appointment, with the two Democratic members publicly criticising their three Republican colleagues, including Mr Pitt, for succumbing to outside pressures. Less than a week after Mr Webster’s appointment, the SEC’s inspector-general was asked to examine allegations that Mr Pitt withheld information from his fellow commissioners that Mr Webster had earlier chaired the auditing committee of a technology company that is facing fraud charges. Mr Pitt, who had already become a controversial figure at the SEC, announced his resignation as the results of the mid-term election started to come in on the evening of November 5th. The commission’s chief accountant, who was closely identified with Mr Pitt, also stepped down. A little more than a week later, Mr Webster resigned from the accounting board. No replacements for any of these positions had been announced by late November. The future of the campaign against corporate wrongdoing is now uncertain, and will depend heavily on the priorities of Mr Pitt’s successor. Prior to Mr Pitt’s departure, the SEC called for public comments on proposals that would bar company officers and directors from improperly influencing or misleading auditors into signing false financial statements. Public companies would also have to publish an internal control report by management and disclose whether they had adopted an ethics code for senior executives, and if not, why not. Some critics, including a Democratic member of the SEC, have questioned whether an ethics code would have much effect benefit without strict enforce- ment measures. Given Republican majorities in both houses, the new Congress may be less aggressive in tightening corporate governance standards. The Republicans, normally considered the party most sympathetic to big business, were luke- warm towards new restrictions until the collapse of WorldCom in June 2002 put

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renewed pressure on Congress to pass the Sarbanes-Oxley Act on corporate governance. Unless a major new scandal surfaces, corporate governance issues are unlikely to be near the top of the new Congress’s agenda.

The domestic economy Output and demand

Economic performance is The US’s current economic performance is decidedly mixed. On the one hand, decidedly mixed recent data give little cause for celebration, although the double-dip recession foreseen by some economists has so far been avoided, and there has even been the occasional bright spot. Growth in the third quarter of 2002 was stronger than the second. But it was propped up by heavy spending on motor vehicles and other consumer durables, and there is significant though not yet conclusive evidence that consumer spending and housing, two of the mainstays of growth in recent years, may be running out of steam. On the other hand, tentative signs have appeared of a pick-up in business investment, which has been in a deep slump for the past two years. According to the Commerce Department’s Bureau of Economic Analysis, real GDP expanded at an annualised rate of 4% in the third quarter of 2002, up from a 1.3% increase in the previous three months. The bulk of the growth came from higher household spending, outlays on equipment and software, government spending, inventory building and exports. These were offset by another steep drop in non-residential construction, and a modest rise in imports.

Gross domestic product (% real change at annualised rate unless otherwise indicated) 2001 2002 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr Private consumption 2.4 1.4 1.5 6.0 3.1 1.8 4.1 Durable goods 11.5 5.3 4.5 33.7 -6.3 2.0 23.1 Non-durable goods 2.3 -0.3 1.3 3.6 8.0 -0.1 0.9 Services 0.6 1.5 0.9 2.1 2.9 2.7 2.2 Government consumption & investment 5.7 5.6 -1.1 10.5 5.6 1.4 3.1 Federal 9.5 6.0 1.2 13.5 7.4 7.5 4.3 State and local 3.8 5.4 -2.3 8.9 4.6 -1.7 2.4 Private fixed investment -2.2 -11.1 -4.3 -8.9 -0.5 -1.0 0.1 Non-residential -5.4 -14.5 -6.0 -10.9 -5.8 -2.4 -0.7 Residential 8.2 -0.5 0.3 -3.5 14.3 2.6 2.1 Final domestic demand 2.2 -0.2 0.0 4.6 2.6 1.2 3.7 Change in stocksa -26.9 -58.3 -61.8 0.4 -28.9 4.9 15.5 Total domestic demand -1.4 -1.5 -0.1 3.0 5.6 2.6 4.1 Exports of goods & services -6.1 -12.4 -17.2 -9.6 3.5 14.2 3.3 Imports of goods & services -7.9 -6.8 -11.8 -5.3 8.5 22.2 2.3 GDP -0.6 -1.6 -0.3 2.7 5.0 1.3 4.0 a Chained 1996 US$ bn. Sources: Commerce Department; Haver Analytics.

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Consumer spending, which makes up about two-thirds of total GDP, climbed by an annualised 4.1% in the third quarter, well above the second-quarter advance of 1.8%. The acceleration was almost entirely attributable to an annualised 23.1% spurt in outlays on durable goods, including motor vehicles, up from 2% in the previous three months. Spending on non-durables edged up by only 0.9% at an annualised rate in the third quarter, compared with a marginal decline in the second quarter, while the pace of spending on services slowed to an annualised increase of 2.2%, from 2.7%. Uncertainty about consumer demand has been heightened by the recent trend of the Conference Board’s monthly consumer confidence index. The index tumbled for five consecutive months from June, reaching 79.4 in October, its lowest level in nine years, and even lower than the level immediately after the terrorist attacks of September 11th 2001. The board ascribed the drop to rising unemployment, the threat of war with Iraq and the prolonged slide in financial markets. The index bounced back to 84.1 in November, but the increase was seen to be below economists’ expectations. Retail sales in October were unchanged, although optimists took comfort from the fact that, excluding the automotive sector, sales edged up by 0.7%, which was slightly above market expectations. Motor vehicle sales fell by 2.1% during the month, and there was also a slight drop in demand for furniture. However, electronics and appliance sales posted a small gain, and sales of clothing climbed by a solid 4%. Sales of food, groceries and health and personal care products also rose. Some economists have attributed the surge in demand for clothing to unseasonably cold weather, rather than an underlying rebound in consumer spending. Motor vehicle sales are clearly slowing after a year of frenzied buying spurred by discounts and low-interest financing deals. According to preliminary estimates, car sales in the three months to November averaged about 15.9m units a month, down from 17.7m units between June and August.

A series of reports have pointed to a mixed performance in the manufacturing sector. According to the Commerce Department, manufacturing orders rose by 2.8% in October, following declines of 5.3% in September and August in 0.4%. Durable goods orders also rose by 2.8% in October, but only after the biggest fall

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for the year (4.8%) in September. Industrial production dipped by 0.8% in October, following a 0.2% drop in September, marking the third consecutive month of declines. October’s fall was also the biggest since September 2001.

Investment is weak, but Fixed investment, other than housing, contracted at an annualised rate of 0.7% in federal spending is strong the third quarter of 2002, following a 2.4% drop in the second quarter. The easing in the decline reflected an annualised rise of 6.6% in spending on busi- ness equipment and software, up from a 3.3% gain in the previous three months. Investment in factories and other non-residential buildings and structures tumbled by an annualised 20.6%, following a 17.6% fall in the second quarter. The housing market, a pillar of strength for the economy in recent years, shows signs of running out of steam. Residential investment rose at an annualised rate of 2.1% in the third quarter, compared with a second-quarter increase of 2.6%. There was further evidence of a slowdown in October, when housing starts plunged by 11.4% from September’s 16-year high to an annualised, seasonally adjusted 1.6m units. The drop was the biggest in almost nine years, and was especially pronounced in multi-family units, such as apartments and condom- iniums. The drop in construction comes in spite of extremely attractive mortgage rates. The average rate on a 30-year mortgage fell to 5.94% in the third week of November, the lowest point since Freddie Mac, the mortgage guarantee company, began compiling these rates in the early 1970s. Federal government spending remains a significant source of growth, although the rate of increase dipped to an annualised rate of 4.3% in the third quarter of 2002 from 7.5% in the previous three months. The third-quarter advance was attributable to a 7.1% rise in defence outlays, about the same as the previous three months. Non-defence spending shrank fractionally in the latest quarter, after rising by almost 7% in the second. Spending by state and local govern- ments, many of which are in dire budgetary straits, rose by an annualised rate of 2.4% in the third quarter, compared to a drop of 1.7% in the previous three months. Inventory building had a significant impact on third-quarter growth, with private business inventories expanding by US$15.5bn (at chained 1996 prices). The rise in private inventories added 0.45 of a percentage point to the real change in GDP. Inventories had risen by US$4.9bn in the second quarter, after falling by US$28.9bn in the first. Exports of goods and services rose by an annualised rate of 3.3% in the third quarter of 2002, a far smaller gain than the 14.2% posted in the second. In a sign of slowing domestic demand, imports rose by a modest 2.3% at annualised rate, following a sharp increase of 22.2% in the second quarter.

Employment, wages and prices

Employment fell in September The absence of a convincing rebound in business activity, combined with a and October drive by many companies to improve productivity and boost profits, is reflected in a loss of jobs in September and October 2002. The pace of wage increases has also slowed, while slack demand is discouraging businesses from raising prices.

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The unemployment rate edged up to 5.7% in October, from 5.6% in September. Businesses cut 5,000 jobs in October, with the losses mainly in manufacturing (49,000), construction and temporary employment services. Companies as diverse as Xerox (office equipment), United Airlines, Black & Decker (appliances) and Morgan Stanley (investment banking) have announced substantial cuts in their workforces in recent months. On the brighter side, labour productivity continues to be impressive, as com- panies take swift action to hold down their costs by shedding unneeded workers. Productivity, as measured by output per hour worked, grew at an annualised rate of 4% in the third quarter of 2002, up from 1.7% in the previous three months. The gain of 5.3% in the year to September 2002 was the highest in 19 years.

Non-agricultural employment (m unless otherwise indicated; seasonally adjusted) 2002 Apr May Jun Jul Aug Sep Oct Goods producing 23.91 23.87 23.86 23.81 23.80 23.77 23.70 Service producing 106.78 106.83 106.88 106.98 107.11 107.13 107.20 Total 130.68 130.70 130.74 130.79 130.91 130.90 130.90 Change in monthly employment ('000) -21 22 34 54 123 -13 -5 Unemployment rate (%) 6.0 5.8 5.9 5.9 5.7 5.6 5.7 Participation rate (%) 66.8 66.8 66.6 66.5 66.6 66.8 66.7

Source: Bureau of Labour Statistics.

Inflation is not considered to Despite an unexpected surge in wholesale prices in October, inflation remains a be a threat distant threat for the time being. The absence of strong inflationary pressures was a significant influence in the Federal Reserve’s unexpectedly large 50-basis- point cut in short-term interest rates on November 6th. The Federal Reserve’s chairman, Alan Greenspan, said in testimony to Congress in mid-November that the risks of a renewed burst of inflation were so far out on the horizon that the Federal Reserve was confident that remedial action could be taken in good time, if the November rate cut turned out to be too large.

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The consumer price index (CPI) rose by a modest 0.3% in October to stand 2.1% higher than in the year-earlier period, compared with a 0.2% advance in September (1.5% higher than a year earlier). Half the October increase was due to a 1.9% spurt in energy prices, reflecting the prospect of war with Iraq. Petrol prices jumped by 3.8% in October, bringing the increase since October 2001 to 7.2%. Excluding food and energy prices, the CPI edged up by just 0.2% in October 2002, following a marginal 0.1% rise in September. The producer price index, however, shot up by 1.1% in October (up by 0.6% on the year-earlier period), the biggest jump in almost two years. The increase was only 0.1% in September, and there had been no change in August. The jump in October was almost entirely the result of a sharp rise in costs of fuel, cars and trucks, with the latter reflecting higher prices for the new model year. Excluding volatile energy and food prices, the core rate of wholesale inflation rose by 0.5% in October (up by 0.5% on a year earlier), compared with 0.1% in September.

Price inflation (seasonally adjusted unless otherwise indicated; % change year on year) 2002 Apr May Jun Jul Aug Sep Oct Consumer pricesa 1.6 1.2 1.1 1.5 1.7 1.5 2.1 Food & beverages 2.5 2.0 1.7 1.5 1.3 1.3 1.0 Housing 2.4 2.2 1.9 2.0 2.1 2.3 2.6 Apparel -2.4 -2.0 -2.8 -3.2 -1.7 -1.7 -2.1 Transportation -1.5 -3.3 -3.1 -0.5 0.5 -1.0 1.8 Medical care 4.6 4.7 4.5 5.0 4.7 4.7 4.9 Recreation 1.3 1.3 1.3 1.2 1.1 1.0 1.0 Education & communication 2.0 2.5 2.4 2.6 3.0 2.7 2.2 Energy -8.1 -12.2 -11.3 -5.4 -3.0 -4.9 3.0 Core inflationb 2.5 2.5 2.3 2.3 2.4 2.2 2.2 Producer prices (finished goods)c -2.1 -2.7 -2.1 -1.1 -1.5 -1.8 0.6 Core producer pricesbc 0.3 0.1 0.2 -0.2 -0.3 -0.4 0.5 Month-on-month inflation (% change) Consumer prices 0.5 0.0 0.1 0.1 0.3 0.2 0.3 Core consumer prices 0.3 0.2 0.1 0.2 0.3 0.1 0.2 Producer prices (finished goods) -0.1 -0.4 0.1 -0.1 0.0 0.1 1.1 Core producer prices 0.1 0.0 0.1 -0.3 -0.1 0.1 0.5 a All urban consumers. b Excluding energy and food. c Not seasonally adjusted. Source: Bureau of Labour Statistics. Financial indicators

Dow Jones index is set for Financial markets have been exceptionally volatile in recent months with third annual decline investors torn between hopes of lower interest rates and an end to the bear market in equities on the one hand, and evidence of a continued weakening in the economy and anaemic corporate profits on the other. On Wall Street, the Dow Jones industrial average fell to a five-year low of 7,286 on October 9th, but then staged a spirited rally, advancing for seven consecutive weeks. The index ended October at 8,397, about 10.6% higher than at the begin- ning of the month. This followed a 12.3% fall during September. During November, however, the advance petered out, in spite of sizeable swings within

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individual trading sessions. In spite of the October rally, the Dow Jones index appears set to drop for a third consecutive year, the first time this has happened since the early 1940s. It stood at 10,022 at the start of 2002. Other major market indices have followed a similar pattern. The broader S&P500 index stood at just over 900 in late November, after touching a low for the year of 777 in early October. The technology-heavy Nasdaq composite index has been even more choppy, falling to 1,114 on October 9th, equal to about one- fifth of its March 2000 peak of just over 5,000. By the last week of November, it had recovered to over 1,400.

Financial markets (monthly averages) 2002 Apr May Jun Jul Aug Sep Oct Share price indices Dow Jones industrials 10,165.2 10,080.5 9,492.4 8,616.5 8,685.5 8,160.8 8,048.1 % change, year on year -0.7 -8.4 -11.8 -17.5 -15.8 -9.8 -12.7 S&P 500 composite 1,112.0 1,079.3 1,014.0 903.6 912.6 867.8 854.6 % change, year on year -6.5 -15.0 -18.1 -25.0 -22.6 -16.9 -20.6 Nasdaq composite 1,758.8 1,660.3 1,505.5 1,346.1 1,327.4 1,251.1 1,241.9 % change, year on year -9.1 -23.9 -28.7 -33.8 -31.2 -20.5 -25.0 Government bond yields 3-month Treasury bill 1.7 1.8 1.7 1.7 1.6 1.7 1.6 10-year Treasury bond 5.2 5.2 4.9 4.7 4.3 3.9 3.9 30-year Treasury bond 5.8 5.8 5.7 5.6 5.2 4.9 5.1

Source: Haver Analytics.

The bond market has also been unusually turbulent as investor sentiment has swung between optimism and pessimism over the outlook for the economy. The yield on 10-year Treasury bonds reached a 40-year low of 3.6% in early October, but was pushed back above 4% within days by the sharp rally on the stock- market. Since then, the 10-year yield has see-sawed around 4%, tugged between, on the one hand, the lacklustre economic outlook (reinforced by the Federal Reserve’s decision to cut short-term interest rates), and, on the other, the rally in

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the stockmarket. Unusually wide spreads between blue-chip Treasury securities and corporate bonds have signalled uncertainty about the health of many companies’ finances.

Sectoral trends

The airline industry is in More than a year after the shock of September 11th 2001, US airlines and their serious trouble suppliers remain under intense pressure. The airlines’ financial results for the third quarter of 2002, usually the strongest period of the year, were among the worst of any sector. Competition remains intense, and the carriers’ inability to raise fares has resulted in continued cost-cutting and job losses. AMR Corp, the parent of American Airlines, the world’s biggest airline, suffered a US$924m loss in the third quarter of 2002, and said it would buy no new aircraft in 2004-05. UAL Corp, United Airlines’ parent, has warned that it might be forced to file for bankruptcy protection unless it obtains an emergency loan from the federal government. United laid off 9,000 workers and cut 6% of its flights in late November as part of its battle for survival. Delta Air Lines, the third biggest carrier, reported a third-quarter loss of US$326m and announced plans to eliminate up to 8,000 jobs. Delta said it would ground its entire fleet of MD-11 aircraft and defer deliveries of new aircraft in an effort to save costs. The US airline industry is expected to rack up losses of about US$7bn in 2002. The airlines’ continuing woes stem from a variety of causes. The slowdown in the US economy has not only shrunk traffic, but also encouraged many business travellers, traditionally the airlines’ most profitable passengers, to save money by flying economy rather than business class, or to switch to the growing ranks of no-frills carriers. Meanwhile, concerns triggered by the September 11th terrorist attacks appear to have discouraged many Americans from taking holiday trips far from home. On the cost side, the airlines have been hit hard by the surge in oil prices, and by severance costs for the growing numbers of laid-off workers. The airlines’ difficulties have had a ripple effect on companies that depend on their business. Boeing, the world’s biggest aircraft maker, reported a 43% drop in third-quarter profits, and said that it expects deliveries to fall to about 280 aircraft in 2003, from 380 this year and 527 in 2001. The tough times facing the aerospace industry were also underlined by Honeywell, a supplier of electronic equipment, which said it was laying off as many as 5,000 people as a result of a one-third slump in sales to commercial aircraft manufacturers.

Antitrust case against The long-running antitrust case against the computer software giant, Microsoft, Microsoft is settled finally appears to have come to an end with a court decision on November 1st to up- hold a November 2001 settlement between the government and the software giant. The decision rejected the demands of nine states that the company be more severely penalised. It is unclear whether these states will appeal the latest decision; if they do, their chances of success seem slim. The settlement does rein in Microsoft to an extent, but Microsoft had avoided the draconian remedies, including splitting the company in two, which were requested by the states. Microsoft has called the settlement “a tough but fair compromise”, though critics maintain that the deal is likely to bring few changes in the company’s behaviour.

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In essence, the settlement makes it more difficult for Microsoft to force customers not to promote competing applications and programmes. Microsoft must provide competitors with more information about some of its software products, notably its operating systems. In August 2002 Microsoft said it would make some of its computer code available to other software developers and make it easier for computer makers to sell machines that feature competitors' software. The settlement will last for five years and will be overseen by a three- member compliance committee, with the court reserving the right to make changes and extend the original terms of the settlement if necessary. The extent to which the settlement will break Microsoft’s stranglehold on computer operating systems, browsers and other software is hotly debated. However, there are growing signs that market forces are starting to loosen Microsoft’s grip. The Linux operating system, which is an alternative to Microsoft’s Windows programme and is available free of charge, has gradually been gaining market share. Furthermore, some of the biggest computer makers have recently agreed to install the WordPerfect word processing software in a number of their models in preference to Microsoft Word.

Sharp financial deterioration The turbulent stockmarket and the spate of corporate accounting scandals have in corporate pension funds raised troubling questions about the financial health of many corporate pension funds. The problem has its origins in the long bull market of the 1980s and 1990s, when investment returns were sufficiently high for many companies to halt contributions to their pension funds. Some went even further, withdrawing amounts that were considered surplus to the funds’ future liabilities to retired employees. But with the recent drop in share prices, many pension funds are now underfunded and companies are being called on to make up the deficits at a time when many can least afford it. According to a study by the investment bank Credit Suisse First Boston, pension plans offered by 360 of the companies in Standard & Poor's 500 index are underfunded by about US$243bn. Concerns about the health of the funds are exacerbated by accounting rules that allow companies to estimate their pension funds’ average annual return over a period of time, and then classify those amounts as profit, no matter what return has actually been realised. According to one estimate, 50 of the largest US com- panies counted US$54.4bn of pension fund gains as profits in 2001, when the funds actually racked up losses of US$35.8bn. Some companies, such as General Motors, IBM and Lucent Technologies, are starting to face up to the problem, but at significant cost to their profitability. General Motors has topped up its pension fund by US$2.2bn this year. Nevertheless, Standard & Poor’s downgraded General Motors’ credit rating by two notches in October, largely owing to the jump in the company’s under- funded pension liabilities to an estimated US$21bn at the end of 2002, from US$9bn a year earlier. IBM said in October that it would add US$1.5bn annually to its pension fund over the next three years, equal to about 20% of its free cashflow over the past 12 months. The pension fund losses, if they are not reversed soon, could have wider implications, forcing companies to cut back capital spending plans, reduce costs generally, and scale back dividend payments. Pension plan members are to

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some extent protected by the Pension Benefit Guarantee Corporation, a govern- ment agency, which insures pensions to a limit of US$42,954 a year. However, the corporation only insures traditional “defined-benefit” pensions; these plans have increasingly been replaced over the past decade by “defined-contribution” funds, which are more vulnerable to swings in the stockmarket. The Pension Benefit Guarantee Corporation, which is funded by employer premiums, had a surplus of US$4.8bn on June 30th 2002, half the level a year earlier. It is currently paying the pensions of close to 400,000 retired people, up from 268,000 in mid-2001.

Dockworkers’ dispute has For the first time in more than three decades, the president invoked emergency been resolved powers under the Taft-Hartley Act to limit the damage caused by a potentially costly labour dispute. Operations at 29 ports along the Pacific coast came to a standstill in early October after the Pacific Maritime Association, which represents shipping companies and terminal operators, locked out 10,500 members of the International Longshore and Warehouse Union (ILWU). Although the work stoppage itself lasted less than two weeks, it has had numerous knock-on effects on the wider economy, including possible shortages of some Christmas goods, and a distortion of monthly trade figures in the third and fourth quarters. The immediate cause of the lockout was a slowdown staged by the dock- workers after the two sides failed to agree on a new labour contract to replace the one that expired on July 1st 2002. However, wider issues were also at stake, notably the introduction of new technology to enhance the productivity of some of the country’s most highly paid blue-collar workers. ILWU members earn an average of about US$67,000 a year, and some senior foremen make as much as US$160,000, equivalent to a senior management job. One point of dispute was whether jobs created by new technology should be unionised. The president, George W Bush, used powers under the 1947 Taft-Hartley Act to reopen the ports after 11 days, amid growing concern that the labour dispute could have serious ripple effects throughout the economy. Not only was the closure of the ports estimated to be costing the economy roughly US$2bn a day, but the administration argued that the lockout could hurt national security, because the armed forces and defence contractors rely on commercial ships that use West Coast ports. The Taft-Hartley Act was last invoked by a former president, Jimmy Carter, in 1978 to end a work stoppage in the coal industry. The court injunction obtained by the Bush administration provided for an 80- day “cooling-off” period to allow employers and the union more time to negotiate a settlement. Employers continued to accuse workers for several weeks of conducting an illegal slowdown, causing a backlog in vessels outside the west coast ports. However, the union and the employers' association finally hammered out a tentative six-year contract on November 24th, which includes pay increases but also gives employers freedom to introduce new technology. Details of the agreement had not been made public as this report went to print.

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Foreign trade and payments

Increased focus on bilateral The return of a Republican majority in the Senate has buoyed hopes of a more trade deals trade-friendly Congress over the next two years. With the help of Republicans in Congress, the Bush administration is likely to use the trade promotion authority (TPA) granted in August 2002 to pursue bilateral trade deals with a number of countries. Under TPA, Congress has the power to approve or reject trade agreements, but not to amend them. However, the drive towards freer markets will continue to be slowed by powerful business groups, such as farmers, seeking protection from imports or subsidies on US exports. Bilateral agreements have become a cornerstone of the administration’s trade strategy on the grounds that they encourage, in the words of the US trade representative, Robert Zoellick, “competitive liberalisation”. In other words, if one country enjoys the benefits of free trade with the US, pressure will increase on its main trading partners to seek similar access. The Bush administration also sees the bilateral agreements as a stepping stone towards more complex and time-consuming multilateral negotiations, such as the Free Trade Area of the Americas (FTAA) or the global talks under the auspices of the World Trade Organisation (WTO) that began in Doha, Qatar, in December 2001. As an example of the type of bilateral agreement being sought by the US, the administration announced in late November that it had concluded the outlines of a free-trade deal with Singapore. The pact will not be finalised, however, until the two countries can agree on a way to deal with US concern about Singapore’s controls on capital flows in the event of a 1998-type financial crisis. The US is also in the process of negotiating deals with Chile, Australia and several Central American countries. The talks with Chile, which began in the mid-1990s, have been stalled by environmental and labour issues, which have been of special concern to Democrats in Congress. Tensions between the US and its trading partners have abated in recent months, owing partly to the passage of TPA. The law is seen as an important victory for Mr Bush and has deflected some of the criticism towards US trade policy earlier in the year, following the imposition of steep new steel tariffs and the passage of a controversial farm bill, which includes massive increases in subsidies to US farmers. The impact of the steel tariffs has been blunted by hundreds of exemptions, but the threat of retaliation by the EU remains real.

Major doubts remain over Less encouragingly, recent events in Latin America, combined with the US’s feasibility of FTAA timetable focus on the war against terror, have thrown a shadow over Mr Bush’s drive to tighten trade links in the western hemisphere. The Bush administration con- tinues to push for an FTAA by January 2005 covering all the region’s 34 countries with the exception of Cuba. In an effort to demonstrate the US’s goodwill, Mr Bush has extended the list of products that Bolivia, Colombia, Ecuador and Peru can export to the US duty-free. The administration has also said that it will ask Congress to earmark up to US$140m to compensate Latin American countries for the administrative costs of a free-trade deal. However, the chances of meeting the 2005 deadline have receded markedly. Brazil’s newly elected president, Luiz Inacio Lula da Silva, and his Workers’ Party

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have shown little enthusiasm for the FTAA. The party’s election manifesto described the proposed free-trade area as a process of “economic annexation” of Latin America by the US. Recent economic upheavals in Argentina, Venezuela and Ecuador will also limit these countries’ room for manoeuvre in negotiating an ambitious free-trade pact. The situation will be clarified in mid-2003, when final offers are published by all parties. Meanwhile, some of the US’s own recent pronouncements do not seem conducive to an early agreement. The Bush administration has offended some of its Latin American partners by insisting that reductions in customs duties should be phased in at a varying pace, country by country, with poorer, smaller economies reaping the benefits most quickly. The powerful and protectionist US farm lobby could also be an obstacle in offering greater access for many of the products of most interest to the Latin American participants in an FTAA, such as sugar, soybeans and citrus. The US is also resisting demands by Latin American countries to include its controversial farm subsidies in the free-trade talks. Protectionist pressures on the administration are sure to grow as the 2004 presi- dential election draws closer.

Record current-account deficit In spite of a 4% decline in the trade-weighted value of the dollar, the current- in the second quarter of 2002 account deficit widened to a record US$130bn in the second quarter of 2002, from US$112.5bn in the first quarter, according to the Department of Commerce’s Bureau for Economic Analysis. The shortfall in trade in goods rose to US$122.6bn from US$106.4bn, with a 4.9% rise in goods exports offset by an 8.9% advance in imports. The jump in imports was largely attributable to higher oil prices, although imports of consumer goods and motor vehicles and parts also rose significantly. However, the surplus on trade in services grew by 18% to US$12bn. The deficit on income flows rose to US$6.3bn in the second quarter, from under US$1bn in the previous three months. The deterioration was partly the result of a sharp increase in payments on foreign-owned investments in the US.

Balance of payments (US$ bn; seasonally adjusted) 2000 2001 2002 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr Goods: exports 196.5 193.3 184.8 173.3 167.4 164.6 172.7 Goods: imports 315.1 306.3 292.6 279.0 268.0 271.1 295.3 Trade balance -118.7 -113.0 -107.7 -105.8 -100.7 -106.4 -122.6 Services: credits 73.7 72.7 71.9 69.1 65.6 68.6 71.1 Services: debits 56.3 56.8 57.5 43.1 52.9 57.7 59.0 Services balance 17.4 15.9 14.4 26.0 12.6 10.9 12.0 Income receipts on US investments abroad 90.6 83.0 74.8 67.2 58.7 58.1 60.6 Income payments on foreign investments in the US 83.9 82.0 68.8 66.3 52.2 59.0 66.9 Investment-income balance 6.7 1.0 6.0 0.8 6.5 -0.9 -6.3 Net transfers -16.4 -11.6 -11.9 -12.4 -13.6 -16.0 -13.1 Current-account balance -111.0 -107.7 -99.2 -91.3 -95.1 -112.5 -130.0 US assets abroad -174.1 -215.8 -80.0 25.0 -100.1 -25.9 -140.8 Foreign assets in the US 284.5 302.5 181.6 17.9 250.8 113.5 221.2 Capital-account balance 110.4 86.7 101.6 42.9 150.7 87.6 80.4 Statistical discrepancy 0.3 20.8 -2.5 48.3 -55.8 24.7 49.4

Sources: Department of Commerce; Haver Analytics.

Country Report December 2002 www.eiu.com © The Economist Intelligence Unit Limited 2002 United States of America 35

The recent turbulence on financial markets was reflected in flows on the capital account. Net foreign purchases of US stocks totalled US$11.4bn in the second quarter of 2002, down from US$25bn in the first three months of the year. But net foreign purchases of US corporate and other bonds soared to a record US$92.3bn, from US$46.1bn. Meanwhile, inflows of foreign direct investment slowed to just US$1bn in the second quarter, from US$16.2bn in the first. Overall, US-owned assets abroad increased by US$140.8bn in the second quarter of 2002 after a rise of US$25.9bn in the first quarter, while foreign-owned assets in the US increased by US$221.2bn compared with a rise of US$113.5bn in the first.

International trade in goods and services (US$ bn net; seasonally adjusted; balance-of-payments basis) 2002 Mar Apr May Jun Jul Aug Sep Goods -36.6 -40.1 -41.7 -40.6 -39.0 -42.3 -41.8 Services 4.1 4.2 4.0 3.9 4.0 4.1 3.8 Total -32.5 -36.0 -37.7 -36.8 -35.1 -38.3 -38.0

Sources: Department of Commerce; Haver Analytics.

Recent foreign trade patterns reflect the economic sluggishness both in the US and its main trading partners, with the decline in the dollar being a secondary influence. The dollar depreciated by about 15% on a trade-weighted basis in the first 11 months of 2002. However, imports were inflated in August and September 2002 by stockpiling ahead of the closure of west coast ports as a result of a labour dispute. On a monthly basis, the trade deficit reached an all-time high of US$38.3bn in August, and eased slightly to US$38bn in September. After climbing during the first half of 2002, exports slipped back in both August and September, reaching US$82.2bn in the latter month. September’s imports totalled US$120.2bn, down from US$120.8bn in August.

Country Report December 2002 www.eiu.com © The Economist Intelligence Unit Limited 2002