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SINCE his resignation as finance secretary on Nov. 30, Jose Isidro Camacho has been less inhibited in revealing the severe fiscal crisis that is gripping the country.

Camacho's resignation sent the peso tumbling relative to the US dollar, reflecting the market's anxieties over the government's ability to control the swelling deficit and total debt. Since then, Camacho has generated more shock waves by speaking more than just about the deficit and putting what he calls the "fiscal crisis" in the context of the political system, which is ill-suited to cope with the crisis.

It would be too shallow to consider Camacho's devastating critique as a particularistic attack on the administration whose service he left because of exhaustion. His criticism is an indictment in broad brush strokes of a system in which the government of President Gloria Macapagal-Arroyo is embedded and which has hampered efforts to carry out economic reforms.

Although during his watch, Camacho failed to curb the deficit, he can now speak with authority, informed by his frustrations in pushing reforms in the system of taxation. It is because of this fact that Camacho's criticism should be heeded seriously.

Camacho fittingly made his critique before the Philippine Economy Society. In that forum, some of the leading economists of the country joined him in criticizing the political system. Camacho called for an overhaul not just of the fiscal sector but of the entire economy, warning that "time is running out for the Philippines, a country that is lacking in confidence from both the foreign as well as local markets."

His concerns found echoes in the assessment of Gerardo Sicat, professor at the UP School of Economics and head of the National Economic and Development Authority (NEDA) during the Marcos administration, as well as that of Felipe Medalla, also a UP economics professor and former head of NEDA during the Estrada administration. The economy, said Sicat, "is drifting with no clear destination in sight." Medalla painted a grim picture of investment in the country, noting that foreign direct investments coming from Japan and China prefer to go to Thailand, Indonesia, and Malaysia over the Philippines.

From a micro-economic point of view, Camacho said that the country's huge debt, which has reached nearly 58 billion dollars, was "creating a sense of concern." He assured, however, that "we will not go under," explaining further by saying, "We are in a fiscal crisis because we've got this large deficit which compressed our expenditures."

That said, Camacho shifted his criticism toward the political system. "We have to change our political system," he declared. "We need to change our political leaders and bring back credibility, trust and sympathy and people who believe in who are leading us." He took Congress to task for failing to pass key economic bills such as the indexation of beer and tobacco taxes designed to boost revenue collection by 14 billion pesos. "We have a very high debt that is not sustainable unless we do something," he said, "and right now there is something wrong with our political system. It is too slow and is not equipped to deal with this kind of problem."

Camacho said the swelling deficit underlined the need to improve tax collection and for Congress to act on a number of tax reforms. Both Camacho and Medalla criticized the tariff and taxation structure that provides incentives to certain sectors, including the exemption from the 10 percent value-added tax given to lawyers as well as movie actors.

Several tax reform bills have encountered strong resistance in Congress, especially with elections scheduled in 2004. Congressmen are hostile to new and increased taxes, which are unpopular. But Medalla reminded the politicians that "the economy must swallow bitter medicine."

It is a sign of his frustrations with the political system that Camacho was prompted to call for change in the political system. He went as far as to say that two extremes offer attractive alternatives to the present gridlock-prone system: a shift to a unicameral parliamentary structure and a highly centralized state vesting the President with strong powers to push reforms.

The business forum provided a stage for refocusing public debate from sterile political discussions centering on presidential alignments for 2004 to more serious economic concerns. The economists' call for radical change in the political system is widely shared in the economic and business sectors.

Mr Wen goes to Washington

China’s prime minister, Wen Jiabao, has been in America where he met President George Bush. Mr Wen hopes to quell trade tensions. Mr Bush hopes to quell tensions over Taiwan

ON MONDAY December 8th, Wen Jiabao, China’s prime minister, kicked off his three-day visit to America by ringing the opening bell at the New York Stock Exchange. It was a symbolic moment—a leader of the Chinese Communist Party firing the starting gun for the capitalist running dogs of Wall Street. The running dogs clapped, and no wonder: China is good for profits. Its limitless supplies of cheap labour, its efficient production platforms and its absence of currency risk have made it an integral part of international capitalism. In recent years, multinational companies have perfected the art of assembling their goods in China, selling them back to the West, and distributing the dividends to applauding Wall Street investors.

On Tuesday, Mr Wen moved on to Washington, where his reception was somewhat less enthusiastic. Tensions are rising over trade and Taiwan. Militants in Congress decry China's unbalanced and, they say, unfair trade with America. Meanwhile, militants in mainland China denounce the Taiwanese government's provocative experiments in people power.

Last month, Taiwan’s parliament passed a law that would allow the island to hold national referendums. Nothing wrong with that, you might say. But referendums have a nasty habit of providing definitive, yes or no answers to delicate questions that might be better left unposed. For Taiwan, the most delicate question of all is its ambiguous status vis-à-vis mainland China. The possibility that the people of Taiwan could vote for independence from the mainland enraged the authorities in Beijing, who view the island as a wayward province. They condemned the referendum law as a tool for separatists. One Chinese military official, quoted by the state media, was frighteningly blunt: “Taiwan independence means war,” he said. “This is the word of 1.3 billion people, and we will keep our word.”

Stung by such outrage, the Taiwanese opposition succeeded in watering down the government’s proposal. The law, as passed, would only allow a referendum on Taiwan’s independence if China attacked the island. But Taiwan’s government may not settle for that. It has toyed with the idea of repealing the law and starting again. Taiwan’s president, Chen Shui-bian, has said he intends to hold a referendum on March 20th, the same day he stands for re-election, urging China to renounce the use of force against the island and to remove the estimated 496 ballistic missiles it is currently pointing across the Taiwan Strait.

The United States is the third corner of this awkward triangle. On Monday, it warned mainland China not to contemplate coercion. But it also told Taiwan that it does not want to see unilateral moves in the direction of independence. President George Bush confirmed that stance on Tuesday, while seated beside Mr Wen. But Taiwan's Mr Chen remains undeterred. On Wednesday, as he launched his campaign for re-election, he said the “Taiwan people have the right to say loudly that they oppose missiles and are for democracy.” Mr Bush would rather they spoke softly. As one aide confided to the New York Times, the president “isn't shopping around for another international crisis”.

Mr Bush is, however, shopping around for some concession on trade and exchange rates. China is expected to amass a trade surplus of at least $120 billion with the United States this year. Its currency, the yuan, pegged to the dollar since 1994, has followed the greenback on its long march downwards since the beginning of last year. The manufacturing states are in uproar over the migration of jobs to China and their complaints are reverberating in Washington. In response, John Snow, America’s treasury secretary, has urged the Chinese to move towards unpegging the yuan or repegging it at a less competitive rate. Last month, America opened up a new flank. It imposed import quotas on Chinese socks, dressing gowns and bras, claiming that they were disrupting America’s textiles market. Some fear that the quotas, while insignificant in themselves, might represent a shot across China’s bow—to be followed up with a full fusillade of protectionist measures if more is not done to narrow the trade gap.

But China has an ally in Alan Greenspan, chairman of the Federal Reserve, America's central bank. In a speech on Thursday, he argued that a rise in the yuan would have little or no effect on total employment in the United States. China's trade surplus with America, he pointed out, is conspicuously large only because China provides the final staging post for much of Asia's America-bound production. China imports partially assembled goods from neighbouring countries, finishes them off in its own workshops, then exports them to America. If China retreated from this role under American pressure, its place would be taken by other Asian countries, not by domestic producers in the United States.

China's currency peg does make it more difficult for the country to manage its own money supply, Mr Greenspan pointed out. Every time the central bank, the People's Bank of China, buys dollars to keep the currency down it creates yuan. It has tried to mop up some of these extra yuan, but the money supply has still grown at an annual pace of over 20% this year. Mr Greenspan, who knows a thing or two about bubbles, worries that this rapid injection of money into the Chinese economy may cause it to overheat. If so, the Chinese authorities might choose to slow their purchases of dollars, letting the yuan rise in value—not to help America's economy, but to cool their own.

Some of China’s banks and their customers seem to be preparing for such a scenario. According to figures published on Monday by the Bank for International Settlements, $9.1 billion was repatriated to China from foreign bank accounts in the second quarter. Most analysts think these funds are coming home in anticipation of yuan appreciation. If so, Mr Snow may rue the day he lodged the thought in the minds of Chinese investors. China is the third-biggest customer for American government bonds. If it takes its money out of the market, the Treasury’s debt will fetch a lower price, and its cost of borrowing will rise—collateral damage from the Bush administration’s threatened trade war.

Relations with China

Mr Wen's red carpet

Despite economic tensions, mutual trust between America and China has rarely been deeper. Can it last?

AMID bafflement, even outrage, from congressmen whose districts have been losing manufacturing jobs in droves to China, George Bush this week laid on what one of his officials called “spectacular” treatment for China's prime minister, Wen Jiabao, on his first visit to America. It included a 19-gun salute on the White House's South Lawn, a welcome no head of government (as opposed to a head of state) has been granted by this administration. Given the growing spats between America and China over trade and exchange rates, what is Mr Bush doing cosying up to China—especially with an election due?

The answer has to do with his changed view of the world since September 11th. In fighting Islamic terrorism, America has found China co-operative. China's leaders, after all, have their own Muslim problem: restive Uighurs in the western province of Xinjiang. America's once-loud criticism of China's harsh treatment of such “splittists” and other minorities, notably Tibetans, is now barely audible.

Then there is North Korea and its nuclear-weapons programme. China's attempts since last spring to use what economic and diplomatic leverage it has left with its old and infuriating Communist ally has earned Hu Jintao, the president, and Mr Wen the respect of the Bush administration, which wants to “internationalise” the issue.

That does not mean China has been successful. Six-way talks organised between North Korea, South Korea, Japan, Russia, the United States and China broke down in Beijing in August. This week, China was trying to broker a semantic formula that would bring North Korea back for a fresh round of talks in mid-December, and was again running into trouble with the Hermit Kingdom (see article).

Nevertheless, China's efforts over North Korea reflect a profound shift in its diplomatic style, away from a prickly, reactive response to the world to something more nuanced yet assertive. And this new approach has gained Mr Wen some support from Mr Bush over the issue that China cares about most: Taiwan. The island is praised by conservative America as a democratic exemplar; but China considers it a rebel province that must one day be brought back into the fold, if necessary by force.

Back in April 2001, before his Chinese love-in, Mr Bush let drop that he would “do whatever it takes” to defend Taiwan from mainland aggression. It was not only the Chinese who were shocked. Many of Mr Bush's own diplomats tut-tutted that America's policy of “strategic ambiguity”—that is, a refusal to say exactly what its response would be to attempts by either China or Taiwan to change the island's status—had been severely compromised. Sure enough, later that day the president came out with some suitably ambiguous comments that muddied the waters again.

This week the administration publicly abandoned the “strategic ambiguity” that has lasted for a quarter-century. As Mr Bush put it, his administration's policy is now to oppose (unambiguously) any attempts “unilaterally to change the status quo”. American officials stress that this stricture applies to both sides, but, because of the way that Mr Bush said it, it did not sound that way to the beaming Mr Wen or to the furious Taiwanese.

Begin with the reasons why America felt change was called for. A senior administration official says that strategic ambiguity was failing to stop “the salami being sliced at both ends”. It was being cut away by China's military build-up on the mainland (it has 500 missiles aimed at the rebel island), and also by greater moves towards eventual independence in Taiwan.

Importantly, Mr Bush's newly unambiguous doctrine of enforcing the status quo was announced in the context of what he apparently saw as Taiwanese provocation. Mr Bush, with Mr Wen at his side, expressed his displeasure at the plan by Taiwan's president, Chen Shui-bian, to hold a referendum at the same time as Taiwan's presidential election next March. The referendum would call upon China to dismantle its missiles aimed at Taiwan, a democratic provocation that the Chinese view as a step towards independence.

Mr Bush, that great champion of democracy in the Arab world, seemed to agree that the referendum was too much. Neo-conservatives were furious. Mr Chen said he was pushing ahead with the referendum regardless: he can hardly back down now without greatly risking his re-election prospects.

However, the Chinese were delighted, which helps to explain why Mr Wen refused to get wholly agitated about the economic disputes between the two countries. America has a $125 billion bilateral trade deficit with China; China's “unfairly low” currency and “unfair” trading strategy are frequently blamed for manufacturing jobs being lost in states that are important to Mr Bush.

Last month, the Bush administration slapped protection on $500m-worth of imported Chinese textiles in a nakedly political move to protect American textile workers (although it was within the letter of World Trade Organisation rules). Meanwhile, pressure grows for a revaluation of the Chinese yuan. Half a dozen bills lurk in Congress that aim to impose tariffs on imports if China does not revalue the currency. Other resolutions would push China to open its market faster to imports.

Much of the blame that China gets in Congress for lost manufacturing jobs is misplaced. As the president's economic adviser, Greg Mankiw, has pointed out, most American jobs have been lost in industries—machinery, transport equipment, semiconductors—where Chinese competition is slight. What is more, a revaluation of the Chinese yuan would merely replace Chinese imports to America with those from other, more expensive foreign suppliers. The result of dearer imports would be more, not fewer, job losses in America.

Another factor in China's favour is the endless list of big American companies that have built up their supply chains in China—and see it as a huge market. A trade war is the last thing that Dell Computer or General Motors wants. Their voices currently seem to matter more than those of small domestic American manufacturers (tool-and-die foundries, for example) that keenly feel the Chinese threat. But with all the Democratic presidential hopefuls and plenty of congressional Republicans ready to bash China, Mr Bush will listen more to his political advisers, such as Karl Rove, than to his economists.

Trade is not the only shadow hanging over the current love-in. Taiwan, now the source of so much amity, could turn nasty. Should Taiwan's referendum go ahead (or Mr Chen's popularity rise) in a way that China interprets as a precipitous lurch towards independence, then military threats from the mainland may increase. The administration would then come under growing pressure at home to stand up for Taiwan, to China's confusion and fury.

In the longer term, geopolitical tensions could reappear between the two countries. Imagine if rotten North Korea implodes: that would probably please the Americans, because it would remove the nuclear threat, but would alarm China, because of the instability such an event would cause along its borders (not to mention the prospect of American troops in a unified Korea).

Beyond that, if America's security situation changed, so might its current bonhomie with China. Some Chinese academics, always closer to their government than are American ones, say that as soon as terrorism and rogue states recede as a threat in American eyes, Washington will revert to a tougher line on China's ambitions across the Taiwan Strait. Peace in the world, American-style, does not necessarily translate into peace in Chinese eyes.

MANILA, PHILIPPINES | Thursday, December 11, 2003

RP now in fiscal crisis

'Our political system...is not equipped to deal with this kind of problem.' -- former Finance Secretary Jose Isidro N. Camacho

Former Finance Secretary Jose Isidro N. Camacho yesterday warned that the country was suffering from a fiscal crisis, with government debt beyond manageable levels and a political system that could not bring it down nor keep it in check.

"We could not deny the numbers, right now, we have a fiscal crisis. The situation is not a mere problem, but a crisis that needs to be solved immediately," he told a forum of the Philippine Economic Society.

"We have a very high debt that is not sustainable...unless we do something [to make it manageable]. And right now, there is something wrong with our political system. It is too slow and is not equipped to deal with this kind of problem," he warned.

Finance department data showed public sector debt has totalled PhP5.162 trillion, even greater than the value of the economy's total output. These debts cover liabilities of the bureaucracy, as well as of state-run financial institutions and corporations.

Unless the government started spending within its means, Mr. Camacho said, it would be saddled with too much debt soon. Latest estimates indicated that total public sector debt could reach PhP7 trillion by end-2010.

Growing debt impacts on borrowing cost and on the government's capital spending -- factors that affect economic growth.

"The borrowing cost is creeping because of the loss of confidence," Mr. Camacho said.

For this year, debt servicing cost the country around PhP357 billion, or 46% of the total budget. Interest payments alone ate PhP185 billion, about a quarter of total government spending.

"At present, we are suffering from expenditure compression, where allocations for capital expenses are very small and we don't have the means to change that. We rely on private consumer money for total economic expenditures," Mr. Camacho said.

THE ONLY WAY TO GO

For the fiscal situation to improve, Mr. Camacho said, the government should focus on improving tax collection. In particular, Congress must act on a number of tax reforms.

For one, Philippine tax on imported products, including petroleum, have been among the lowest in the region, he said. "We have to increase the taxes on several industries. That's the bitter pill that we have to swallow," he added.

Early this year, Albay (southern Luzon) Rep. Jose Clemente S. Salceda claimed that even if all taxes were collected, the government would still be short of money and would need borrow to pay for its expenses.

He noted that the latest National Tax Research Center study showed the government in 2002 failed to collect about PhP87.2 billion in income tax, and PhP56.9 billion in value-added tax.

Mr. Salceda also raised the possibility of the government becoming a perpetual borrower. "The implication of the...study is that even if we collect all revenues possible, the government would still incur a deficit. That could mean the government is structurally fiscally insolvent and that we could be in perpetual deficit," Mr. Salceda said.

Tax research center executive director Lina D. Isorena earlier reported that in the last five years, the government failed to collect PhP634 billion in potential taxes on business and professional income as well as value-added tax. -- Eric S. Boras

Restoring Faith in the Philippines
Posted: 2:49 AM | Nov. 28, 2003

Victor Agustin
Inquirer News Service

IF YOUR faith in the Philippines has been badly battered of late by toxic/comic politics, peace and order problems, mass stupidity, and inane media reporting/commentaries (ouch!), go and examine the third-quarter growth figures of the economy, available at www.nscb.gov.ph.

For those who have neither the time nor the resources to go websurfing, here are some of the striking, and confidence-building statistics:

Overseas Filipino workers sent home 111 billion pesos in the July-September quarter, pushing up the personal consumption expenditure index (money spent on food, transportation, mobile-phone text messaging and calls, and miscellaneous "pa-pogi, pa-kikay" services) by 4.9 percent.

All these remittance money sloshing within the system in turn propelled spending in transportation and communication by 13.3 percent.

And the money left over after all that personal spending eventually spilled over to education and medical/health, pushing this sub-sector's growth by 5.4 percent.

Even without the overseas remittances, the domestic economy easily overcame political and bureaucratic incompetence, kidnappings, bombings, and military mutiny.

Agriculture, fishery, and forestry sectors grew 5.5 percent in the same period, boosted by a 20.4-percent growth in production of "palay" [rice before milling] despite a drought in the first half of the year.

"This was the highest growth recorded for palay in the last 16 quarters," reported the National Statistical Coordination Board (NSCB), belying claims by opposition Senator Edgardo Angara that the administration of President Gloria Macapagal-Arroyo was neglecting the agricultural sector.

Coconut, pineapple, mango, cassava and "camote" [sweet potato] posted modest growth while sugarcane whipsawed from double-digit growth in the first half of the year to a 19.3-percent contraction in the third quarter.

Typhoon "Harurot" (international codename: Imbudo) devastated the northern regions of Ilocos and Cagayan Valley in July, damaging cornfields, and the sector continued negative growth at 5.4 percent, from negative 5.6 percent a year earlier.

Livestock and poultry production managed to outpace population growth by 3.3 and 2.6 percent, respectively. Fishery grew by 4.7 percent, with the aquaculture sub-sector (mainly tilapia, milkfish and catfish farming) wriggling out a 1.2-percent growth.

Forestry production posted a statistical fluke, 313.3-percent value growth, mainly due to the resumption of newsprint harvests from the PICOP tree plantation in the southern region of Caraga.

Manufacturing growth picked up pace to 4.4 percent from 2.7 percent a year ago, fueled by a 15.5-percent surge in the production of petroleum and coal, a 120.9-percent leap in basic metals, a 40.3-percent jump in machinery, and a 16.3-percent rise in miscellaneous manufactures.

Modest growths were also registered in chemicals, textiles, wood/cork products, furniture/fixtures, food, and electrical machinery.

On the negative side, tobacco manufactures (52.5-percent decline), metal industries (down by 17.8 percent from a growth of 8.5 percent), non-metallic mineral products, footwear, beverage, leather/leather products, and rubber products continued to show declines.

Mining and quarrying continued with their, to quote NSCB, "hot streak of double-digit growth" of 17.8 percent, mainly due to the significant strides in crude oil/gas, gold, and chromium production. The sector saw the entry of two gold producers as well as the revival of three other mining companies, which offset cutbacks in the production of copper, nickel stone, and quarrying/clay/and sandpits.

The belt-tightening measures of the government impacted heavily on the construction sector, declining overall by 10.7 percent in the third quarter from a 3.0-percent growth in the same period last year.

The contraction, however, was offset by the healthy growth in the real estate industry, which surged by 9.7 percent from a meager 0.3-percent rise a year ago.

"Ownership of dwellings and real estate started to pick up" with a 4-percent growth from last year's 2.1 percent, the NSCB said.

More important, the broad-based electricity, gas, and water consumption index likewise rose by an encouraging 3.0 percent.

The persistent negative chatter from banking/finance is belied by the sector's growth of 6.5 percent.

Bolstered by fee-based activities, securities/treasury trading, and increased lending, banks led the by industry growth with 6.5 percent in the quarter compared to 3.9 percent a year ago. Similarly, non-banks jumped by 9.6 percent from 2.7 percent growth.Even the highly competitive insurance industry posted a 4.9-percent growth.

Real investments in durable equipment, mainly computers/office machines, leaped by 19.8 percent, the highest since 1993.

Still, expenditures on fixed capital formation altogether posted a more modest 1.3-percent growth.

Capital investments on breeding stocks, orchard, and reforestation went up by a more encouraging 4.2 percent.

What is worrisome in the long run is that despite the weaker peso, the country's top exports such as semiconductors, consigned finished electrical machinery, and garments shrunk by 10.9 percent from an 11.3-percent growth last year.

Electrical machinery exports have by now contracted nine of the last 10 quarters, dropping like a stone by 42.8 percent in the last quarter from a 13.9-percent increase last year.

The weak manufactured exports are somehow offset by the remarkable rise in the miscellaneous services sector, mainly call centers, which posted a 55.5-percent growth.

Still, coming from a low base, the growth of the call center industry is barely enough to cover for the export shortfall, even when combined with the robust performances of crude coconut oil, petroleum naptha, banana/plantain exports.

Tourism, which accounts for 34.4 percent of the total-exports-of-services-sector, still failed to provide a quick fix, further dropping by 9.3 percent from a negative 3.9 percent last year, because of SARS and the country's Wild, Wild West image.

Cocktales may be reached by e-mail at cocktales_pdi@yahoo.com or at cocktales_pdi@hotmail.com.

I’d buy that for a dollar (and two dimes)

The euro is worth $1.20 for the first time in its history. That may hurt Europe. Will it help America?

TIME to hail the almighty euro? During trading on Friday November 28th, the currency was worth $1.20 for the first time in its history. Europe's exporters will bewail (not hail) this development, but for everyone else involved in the European project, the currency's strength will bring some satisfaction. After being introduced at a rate of $1.17 in 1999, the euro slumped to become worth less than 83 cents the following year. But the euro’s weakness in those humiliating days was not evidence of a congenital defect in the new-born currency. Rather, it reflected the unusual strength of its older rival, the dollar. Likewise, the euro’s rise since February 2002 should not be taken as a great vote of confidence in the economies of the euro area. It is, instead, the flipside of the dollar’s fall.

What is pulling the dollar down? For one thing, America is currently spending over $500 billion more per year than it produces. To finance this unprecedented current-account deficit, it needs to attract about $2 billion of foreign capital every business day. Much of that capital comes from Europe. Every month from January to August of this year, Europeans poured an average of $28 billion (net) into American stocks, bonds and notes. But in September they reversed course, selling off $403m. Their second thoughts are easy to explain: if the dollar loses value, Europe’s dollar investments are worth less in their own money. But some wonder if Europe’s doubts will endure beyond that one month. Since September, after all, America has posted breathtaking third-quarter growth rates and healthy corporate profits. Surely the prospect of higher returns will entice Europeans back into American assets, despite the Damoclean dollar hanging over their heads? Maybe, but this week’s currency traders don’t seem willing to bet on it.

Of course, one reason the dollar has fallen so sharply against the euro is that it cannot fall freely against Asia's major currencies. China’s authorities have kept the yuan controversially pegged to the dollar and Japan’s have spent well over ¥13 trillion ($120 billion) so far this year to keep the yen's value down. Asia’s central banks do not buy dollars as a rational investment; they are not looking for the best mix of risk and return. They are buying dollar assets to keep their own currencies competitive. If they think the dollar is going to fall, they may well buy more of them, rather than less.

Some, such as Peter Garber of Deutsche Bank, see Asia’s official purchases of dollars as part of a grand bargain: Asia ploughs its savings into America, and America, in return, remains open to the products of Asia’s export industries. But protectionist pressures rising in Congress raise worries that America may fail to keep its side of the bargain. If so, the central banks of Asia, the dollar’s most loyal customers, may threaten to switch, or at least spread their allegiance to euros. That would put intolerable pressure on the dollar. It would also drive up American interest rates, as Asian capital flowed elsewhere.

Though they will welcome the dollar’s steady decline, America’s authorities must tread carefully. Washington may complain about Asian currency manipulators, but without them the dollar could easily go into free fall. As Stephen Jen of Morgan Stanley points out, Washington’s best hope for a soft landing is for East Asia to try but fail to resist the dollar’s fall. America wants enough Asian money flowing into American assets to keep yields (and therefore interest rates) down, but not so much as to keep the dollar up. In so far as a “dollar policy” exists, it is being set in Tokyo and Beijing, not in Washington.

The American economy’s third-quarter growth has been revised up to a dizzying 8.2% on an annual basis. But do bond investors believe in the Bush Boom?

AS A young bond trader, Buttonwood was given two pieces of advice, trading rules of thumb, if you will: that bad economic news is good news for bond markets and that every utterance dropping from the lips of Paul Volcker, the then chairman of the Federal Reserve, and the man who restored the central bank’s credibility by stomping on runaway inflation, should be treated with more reverence than a Papal injunction. Today’s traders are, of course, a more sophisticated bunch. But the advice still seems good, apart from two slight drawbacks. The first is that parsing utterances from the present chairman of the Federal Reserve, Alan Greenspan, is of more than passing difficulty. The second is that, of late, good news for the economy has not seemed to upset bond investors all that much. For all the cheer that has crackled down the wires, the yield on ten-year bonds—which you would expect to rise on good economic news—is now, at 4.2%, only two-fifths of a percentage point higher than it was at the start of the year. Pretty much unmoved, in other words.

Yet the news from the economic front has been better by far than anyone could have expected. On Tuesday November 25th, revised numbers showed that America’s economy grew by an annual 8.2% in the third quarter, a full percentage point more than originally thought, driven by the ever-spendthrift American consumer and, for once, corporate investment. Just about every other piece of information coming out from the number-crunchers shows the same strength. New houses are still being built at a fair clip. Exports are rising, for all the protectionist bleating. Even employment, in what had been derided as a jobless recovery, increased by 125,000 or thereabouts in September and October. Rising corporate profits, low credit spreads and the biggest-ever rally in the junk-bond market do not, on the face of it, suggest anything other than a deep and long-lasting recovery. Yet Treasury-bond yields have fallen.

If the rosy economic backdrop makes this odd, making it doubly odd is an apparent absence of foreign demand. Foreign buyers of Treasuries, especially Asian central banks, who had been hoovering up American government debt like there was no tomorrow, seem to have had second thoughts lately. In September, according to the latest available figures, foreigners bought only $5.6 billion of Treasuries, compared with $25.1 billion the previous month and an average of $38.7 billion in the preceding four months. In an effort to keep a lid on the yen’s rise, the Japanese central bank is still busy buying dollars and parking the money in government debt. Just about everybody else seems to have been selling.

These are old figures, of course, and coincided with the peak in yields. Perhaps foreign investors thought that the recovery was for real and disliked the historically meagre yields available on government debt. But the fact that overall portfolio flows slowed in September suggests that foreigners have not been overly enthused by the American economy’s prospects, or at least the price at which they can buy into them. Or perhaps they disliked the fact that their IOUs are denominated in a currency which the issuer seems determined to devalue: the dollar has fallen by 11% in trade-weighted terms since the start of the year.

Whatever the explanation for their desertion, foreigners seem to be back buying Treasuries, even though the recovery seems still more firmly entrenched. Or perhaps domestic investors are rediscovering the joys of a fixed rate of interest: even commercial banks, which have reduced their holdings of Treasuries by $62 billion since the middle of June, have been tip-toeing back in.

The simple explanation for this renewed enthusiasm is that investors sense a chill beneath the warm glow of the numbers. One cold wind blowing across this particular recovery is that Americans are up to their necks in debt. With short-term interest rates at a 45-year low, households are spending some 13% of their disposable income on servicing their debts—a higher number even than in the sharp recession of the early 1980s, when the Federal funds rate topped 13%. How much longer can they carry on spending at this rate, let alone increase it? If they don’t, then someone else will have to spend on their behalf.

The government, perhaps? The Bush administration has turned a budget surplus of 2.4% of GDP into a deficit that official numbers say will amount to 4.3% of GDP next year. Not much room, in other words, to raise spending. Nor do American companies have oodles of money to play with. For all the talk of restructuring, they continue to increase their borrowing, though at least a slowdown in the rate at which they borrow and better profitability mean that their dreadful financial ratios are starting to look better than they were. Whether they will continue to do so is another matter.

The chillest wind of all is the rising protectionist nonsense sweeping Washington as it prepares for an election year. Undeterred by having its steel tariffs recently declared illegal by the World Trade Organisation, the administration last week slapped quotas on a range of Chinese textiles, including bras, capping (cupping?) the rise in their imports. And this week it imposed stiff tariffs on Chinese television sets.

We are meant to laugh this off as a bit of electioneering hokum: the administration’s heart, we are supposed to believe, lies with free trade. But George Bush is a man who wants to get re-elected and seems prepared to sacrifice the long-term economic good—assuming (a big assumption) he knows how it is best served—to get back into the Oval Office. Mr Greenspan, who has forged a career out of obscure, elliptical comments, had this to say, and it needed no deciphering: “It is imperative that creeping protectionism be thwarted and reversed.”

Fed up with protectionism

THE United States spends over $500 billion more each year than it produces. It gets away with this vast current-account deficit by selling American IOUs to foreigners. Many, including the International Monetary Fund, wonder how long this arrangement can continue and fear what will happen when it stops. But Alan Greenspan, chairman of the Federal Reserve, America's central bank, thinks the deficit is relatively harmless. At a conference on Thursday November 20th, he argued that borrowing from foreigners is easier than ever before thanks to the greater openness, transparency and unity of the world's capital markets.

But not everyone in Washington agrees. Manufacturers and their champions in Congress blame the trade deficit on an overvalued dollar that makes American exports uncompetitive on world markets. In response, the Bush administration has attended to both the cause and the symptoms of their complaint. It addressed the dollar’s overvaluation in Dubai in September, when it invited the finance ministers of the G7 group of rich nations to sign a communiqué declaring that exchange rates should be left to the markets. Last year, it gave America’s ailing steel manufacturers some more direct support by slapping tariffs on imports of steel. Now, it is turning its attention to textiles.

On November 18th, Grant Aldonas, under-secretary at the Department of Commerce, announced new import quotas on Chinese dressing gowns, knitwear and bras, capping their growth next year to just 7.5%. Mr Aldonas invoked a clause in China’s treaty of accession to the World Trade Organisation, which allows America to constrain import surges that threaten to disrupt domestic markets. The bra-buying public, benefiting from cheap Chinese imports, may not have noticed any market disruption. But America’s textile firms, suffering from plant closures and job losses, would disagree. Now, the Commerce Department has shown that it is willing to use every device at its disposal to ward off the menace of cheap dressing gowns.

Mr Greenspan seems more concerned by the menace of protectionism. Long a champion of free and unfettered markets, he rounded off his speech on Thursday with an uncharacteristically rousing call to arms. “It is imperative,” he declared, “that creeping protectionism be thwarted and reversed.”

The quotas announced on Tuesday were in themselves only a small creep forward for protectionism. They cover only a few products, although the limits they impose will pinch tightly: China’s exports of cotton bras to America, for example, grew by nearly 32% in the first nine months of this year, according to the American Manufacturing Trade Action Coalition. The symbolism of this protectionist gesture is probably of more consequence. It shows that America is willing to shield its textile workers from foreign competition even after the mesh of quotas that currently trammel the global textile industry is undone next year. This prospect alone is enough to weigh on the plans, expectations and share prices of Asia’s light manufacturers. The gesture is also weighing on fraught Sino-American trade relations. The day after the quotas were announced, China cancelled a trade mission to the United States to buy American cotton, wheat and soyabeans. It also seized the occasion to announce that it is considering retaliatory measures against America’s illegal steel tariffs.

Chinese exports of textiles may be surging. But of greater significance to America's deficit are signs that European exports of capital may be starting to ebb. According to figures released on November 18th, foreigners poured just $4.2 billion (net) into American stocks, bonds and notes in September compared with over $50 billion the month before. America has not seen such a sharp turnaround in capital flows since the terrorist attacks of September 11th, 2001. The volte-face was most striking among European investors. Over the first eight months of this year, according to Morgan Stanley, Europeans made net purchases of American assets averaging around $28 billion per month. In September, they stopped buying and started selling, offloading a net $403m.

The news that America was trying to repel imports and failing to attract capital took a heavy toll on the dollar. On November 19th, the greenback fell to a three-year low against the yen and an all-time low against the euro. It soon rebounded a little, as the Bank of Japan conspicuously failed to deny rumours that it would intervene to support the dollar. But the Japanese central bank cannot prop up the dollar single-handedly. Of all the American securities held abroad, nearly half are in European hands, according to Morgan Stanley. If Europeans start selling (or even stop accumulating) these holdings, the Japanese authorities will struggle to fill the breach.

On their own, however, September’s figures are only a portent, not a proof, that the world is starting to lose its appetite for American assets. Monthly figures on capital flows are always quite volatile. September’s numbers may also reflect an initial over-reaction to the G7’s Dubai communiqué, released towards the end of that month. Investors may soon return to the fold now that the American economy is so clearly outstripping its rivals in Europe and Japan.

As Mr Greenspan said on Thursday, it is hard to know when a country’s flow of deficits and its stock of foreign debts become unsustainable. And when they do, it is hard to know whether they will unwind gently or abruptly. He himself suggested that, provided markets for goods and capital remain open, flexible and unfettered, market forces will be enough to “defuse” the deficit “incrementally”. But not everyone in Washington seems as willing to leave the markets to their own devices. Some seem to think Mr Greenspan’s “incrementalism” needs a jolt from a bit of protectionism.

The world economy

Boom or gloom?

STOCKMARKETS are sliding again; the gold price this week hit a seven-year high of $400 an ounce; and the dollar slumped to a new low against the euro. “So what's new?” you might ask: the world economy clearly remains fragile. What is new, however, is the recent batch of better-than-expected figures on economic growth around the globe. Not only has the American economy rebounded, but Japan and the euro area are also now growing again, albeit more slowly. The news from some emerging economies is even more bullish. Many economies in Asia and Latin America enjoyed their fastest growth for years in the third quarter. Adding it all together, the world economy as a whole probably enjoyed its fastest growth for two decades (see article). So why have financial markets got collywobbles?

One explanation is that share prices had risen ahead of themselves. Another might be worries that America's rebound is unsustainable, being based on a seemingly reckless fiscal policy, unusually low interest rates, and a consumer borrowing binge. If these sources of growth dry up, one of the few remaining policy tools is the dollar. This week it fell to another all-time low against the euro. Foreigners are less eager than they used to be to finance America's current-account deficit, and in an election year America seems prepared to do anything to support jobs, including letting the dollar tumble and erecting protectionist barriers.

Many American economists and policymakers have long argued that the current-account deficit does not matter. Thanks to America's superior economic performance, they say, foreign investors are eager to buy dollar assets. But that no longer seems true. Net inflows of investment into American bonds and shares plunged from $50 billion in August to only $4 billion in September, the lowest level since the crisis caused by the collapse of Long-Term Capital Management in October 1998. The very suggestion that foreigners might not continue to buy dollar assets in future was enough to make some investors sell this week. A cheaper dollar will help to reduce America's external deficit, while at the same time supporting growth. The risk is that if the greenback falls too fast, bond yields could rise, choking off recovery.

That is why Washington cannot afford careless talk or gestures, such as its announcement this week that it plans to impose new quotas on imports of Chinese textiles. Following America's action earlier this year on steel tariffs, this sparked concerns that the government is desperate to protect jobs at any cost. And that cost could be high if it tries to hobble China.

America has long been the primary engine of the global economy, but increasingly China and the rest of Asia have become a second important engine of growth. By some measures (based on purchasing-power parity) China has accounted for a slightly bigger slice of global growth than America in recent years. For many economies, exports to China have given a bigger boost to growth over the past year than have exports to America. In the past 12 months, China's imports have risen by 40%, America's by a paltry 2%. Japan's exports to “Greater China” (also including Hong Kong and Taiwan) are now bigger than those to America.

If the overhang of consumer debt does eventually cause America's recovery to sputter, then the world economy will be better off if China's economy remains robust. Aeroplanes are always safer with two engines than with one.

The mutual-funds scandal is merely the latest in a long line of embarrassments that have eroded trust in America’s financial intermediaries. The small investor has every reason to feel aggrieved

THE road from house prices in Chiswick to the scandal unfolding in America’s $7 trillion mutual-fund industry may seem long and winding, but Buttonwood thinks otherwise. Once the proud owner of a house in west London, divorce, alas, means that he has to rent: vertiginous house prices deter him from dipping his toe in the market for now. There are, of course, many reasons for the upwardly mobile price of property in London, but the wealth of the good folk who have toiled in the City these few years past is undoubtedly a big one: 40% of the purchases of prime properties in the middle of London in the boom years were by City types, though as these have been culled, so prices have dropped off a bit. For purely domestic reasons, Buttonwood fervently hopes the cull continues. The same is true of Wall Street, broadly defined, which has generated huge wealth for those who work in it, and helped drive up the price of Manhattan property.

But the friction costs of capitalism have been unduly high. Neither the City nor Wall Street has earned much for those that use their services. Quite the contrary, indeed: all the main stockmarket indices, a reasonable enough proxy, are still far from their peaks of a few years ago. The wealth of those that have handed over their money to be invested by experts seems to have shrivelled at about the same rate as it has grown for those that do the investing, and the hoards of expensive hired hands that have advised them, worked for them or apparently kept an eye on their activities. The mutual-fund scandals demonstrate, first, that a gluttonous financial-services industry has been more concerned to make money for itself than for those whose capital it looks after; second, that most of this is done entirely legally, by getting clever people to get round outdated rules; and third, that wise investors would have left the casino long ago: greed and a congenital inability to save has kept their money on the table.

Simply put, the mutual-fund scandal is about one group of active investors trading at old prices at the expense of smaller, more passive investors. The scam comes in two varieties. The first, called market timing, is generally legal, though many funds promise not to engage in the practice in their prospectuses. In this, a hedge fund, say, would buy or sell a mutual fund at the previous day’s price and sell (or buy) a similar basket of shares in a foreign market when prices have moved. The arbitrage is, of course, much easier (which is to say more profitable) if the hedge fund is arbitraging, say, a Japanese fund, whose price is set many hours before. The second type of scam is called late trading, and is illegal. This is generally a domestic ruse, in which the hedge fund trades on an old price but with new information after the market has closed. A bevy of mutual-fund bosses, including those of Strong and Putnam, have been forced to walk the plank. Congress is now considering legislation that would clamp down on mutual-fund abuses.

Holders of mutual funds lose out from such activities in dribs and drabs, since they are not able to take advantage of these price discrepancies. As Charles Biderman, the head of Trim Tabs, an advisory firm, puts it: “It’s like taking pennies from checking accounts. In aggregate, it’s a lot of money.” It may or may not be a coincidence (it probably isn’t) that the bosses of these funds were paid a lot of money. Lawrence Lasser, the erstwhile head of Putnam, has earned over $100m over the past five years and may be entitled to many millions more; Putnam’s funds, be it noted, have made a scant 2.9% annual average return over the past five years, according to Morningstar, a research firm. The bosses of funds benefited either indirectly, because the funds were given more money to manage (and thus more fees), or directly, because they invested in the hedge fund that was trading against the mutual fund. There were, in other words, many reasons why mutual-fund executives turned a blind eye to such practices. Arthur Levitt, a former head of the Securities and Exchange Commission, America’s main (though toothless) market regulator, has called it the worst financial scandal in 50 years.

The competition is stiff. Much as Wall Street is keen to draw a line under this latest scandal, you do not need to be unduly perspicacious to find links between this one and other, very recent scandals. For one thing, shareholders have lost out in all of them. In the scandals that engulfed Enron, WorldCom et al, the firms’ bosses—who were, lest we forget, employed by shareholders—lied, or at the least were economical with the truth about the state of their businesses and the balance sheets that financed them. The incentives were clear: the many millions of dollars that they could earn. In these scams, companies were assisted by accountancy firms (who were, again, supposed to be keeping tabs on companies for shareholders), eager for fees from tax and consultancy work.

And then there is Dick Grasso, the former head of the New York Stock Exchange. He was forced out because he was due to be paid $188m, which seemed a lot to investors who had seen the value of their investments eroded in recent years, and indeed to anyone else who might wonder why the head of a glorified utility that simply provides a forum for investors to buy and sell their shares should be paid so extravagantly. Though Mr Grasso originally offered to give up $48m of his money in an attempt to keep his job, he is now, public-spirited man that he is, fighting for all of it.

Last but far from least are the investment banks, bedevilled by conflicts of interest and staffed by clever people after a fast million. Wall Street investment banks were instrumental in inflating the stockmarket bubble. The role of analysts, who touted stock after stock while at the same time rubbishing many of them in private, has already been put under the microscope by the energetic Eliot Spitzer, the New York attorney-general, who forced the big Wall Street banks to cough up $1.4 billion in fines. Such sums are modest compared with the squillions that they and their employees have made, and none has admitted wrongdoing.

But what of the role of the investment bankers who advised companies to acquire and merge, despite a wealth of academic evidence that mergers destroy value for shareholders in the acquiring company? Such advice was entirely legal; the firms involved could always have sent the bankers packing. But the firms’ bosses got a bigger toy to play with, and a change in ownership allowed them to exercise (legally) the stock options that they had told investors weren’t a cost. Any financial economist worth his salt knows that they are, but so great was the pressure by companies on America’s Financial Accounting Standards Board not to treat stock options as an expense that they were (again, legally) not treated as a form of compensation, and shareholders were milked.

So there you have it. Just about everybody involved in the financial-services industry has been keen to make as much money as they could as soon as they could from the bull market. The losers have been pension funds whose future returns will be curbed by all those deals that shouldn’t have been done, all those businesses that shouldn’t have been started, and all that money that has been paid to venal people who have bilked them for all they could. A subset are those that have invested their money in equity mutual funds in the hope that the bull market would continue ad infinitum and thus save on their behalf. For now this hope is intact, despite the evidence that fund managers care more about their own finances than those of their investors. In October, according to Trim Tabs, American equity mutual funds enjoyed a near-record net inflow of $25 billion-30 billion. For anyone tempted by the thought that this means the good times will continue to roll, the record was set in February 2000. And, of course, there is Buttonwood, who is still waiting for house prices in Chiswick to fall to levels he can afford.

The world economy is picking up. American firms are hiring again. But Alan Greenspan is still sitting on his hands

THE Australians are a competitive lot. Their cricketers reign supreme and their rugby players are currently vying to win the World Cup. Australia’s central bankers are no slouches either. On Wednesday November 5th, they pipped their counterparts at the Bank of England in the race to be first to raise interest rates this year. To some surprise, they lifted the official cash rate from 4.75% to 5%, breaking the trend of flat or falling interest rates in the rich world. To no surprise at all, the Bank of England followed close behind, raising its repo rate on Thursday from 3.5% to 3.75%.

Central bankers in Sydney and London share similar hopes and fears. On the one hand, their interest-rate decisions represent two votes of confidence in the world economy. America, an important trading partner for both countries, is growing strongly. Japan, the most important trading partner for Australia, is also showing signs of a durable recovery. With growth robust, the motivation for low interest rates is less obvious, and their disquieting consequences more apparent. When you make borrowing cheap, people do more of it. In Australia, consumer debt is growing by more than 20% per year. In Britain, total lending to individuals was 14% higher in September than it had been the year before.

Whether or not consumers can sustain these liabilities depends in large part on what happens to the other side of their balance sheets. Property is by far their most important asset. In Australia, house prices were 18% higher in June than a year earlier. In Britain, they stood over 16% higher in October, compared to a year ago, according to both the Halifax and the Nationwide, two big mortgage lenders. Debts are easy to acquire and service as long as interest rates are falling and asset prices rising. The first of those trends has now reversed. Everyone now waits, with bated breath, for the second to reverse too.

The bushwhackers at the Reserve Bank of Australia have beaten a path, but will anyone other than the Bank of England follow them down it? Last week, America’s Federal Reserve, like a stuck record, repeated that it will keep rates on hold for a “considerable period”, despite GDP growth of 7.2% (at an annual rate) in the third quarter. On Thursday, the European Central Bank (ECB), chaired for the first time by its new president, Jean-Claude Trichet, also decided to keep rates on hold. Mr Trichet may have read the European Commission’s gloomy autumn forecast, which predicted growth of just 0.4% for the euro area this year. At that rate of growth, the area’s economies will lose more jobs than they will create this year, leaving 8.8% of the labour force jobless.

But the growth gap between Europe and the United States may narrow somewhat in the coming months. America’s great wave of recovery in the third quarter should slow down even as it broadens out. Consumer spending was already slowing in September, slipping by 0.6% over the month. Initial reports from chain stores and carmakers suggest October was no better. If consumers have peaked, however, businesses are just getting started. Strong sales are filtering through, with a lag, into strong investment. Businesses will also need to rebuild their inventories, run down to very low levels in the summer.

Europe, meanwhile, shows signs of speeding up. The continent may be resistant to structural reform, but it is not immune to cyclical recovery. Euro-area GDP figures for the third quarter are not out yet, but monthly surveys of purchasing managers suggest growth of about 2% at an annual rate. The same surveys also show that October was the strongest month for a year or more in both manufacturing and services. As a consequence, European managers are feeling quite mellow about their prospects for a fruitful autumn. Surveys by Germany’s IFO and France’s INSEE report a rise in business confidence, and a Goldman Sachs measure of the desire to merge and acquire suggests that growing numbers of executives are looking beyond their own businesses, for better or worse, and thinking about taking over someone else’s.

Indeed, some analysts expect the ECB to tighten rates before the Federal Reserve. Demand may be growing more quickly in America, but so is the ability to meet that demand. Figures released on Thursday, for example, showed that output per hour grew by 8.1% in the third quarter, at an annual rate. As a result of this productivity boom, the output gap—the difference between what the economy is producing and what it could produce at full employment—still yawns more widely in America than it does in Europe. Goldman Sachs reckons that actual GDP is 2% below potential in America and just 1.1% below in the euro area. With so much slack in the economy, America can continue to grow at astounding rates without putting upward pressure on prices.

In a speech on Thursday, Alan Greenspan, the Fed chairman, said the chances of a “notable pick-up in hiring” were improving. Those odds improved further on Friday, when the Bureau of Labour Statistics reported that firms had added 126,000 workers to their payrolls in October—about twice as many as analysts had expected. The bureau also revised up previous figures, reporting a payroll gain of 125,000 for September and a gain of 35,000, rather than a loss of 41,000, for August. After cutting their payrolls throughout the first half of this year, then, firms have now added to them for three months straight.

The American labour market may just have turned the corner, but it remains quite slack. More people are joining the payrolls, but more people are also entering the labour force, which tends to grow by about 1% per year. October's hiring did make some impression on America's unemployment rate, bringing it down from 6.1% to 6%, but that still leaves it 2% higher than it was when George Bush took office. To cut unemployment significantly, payrolls will need to keep growing at the current rate or faster for many more months.

Until unemployment falls significantly, the output gap narrows and prices firm up, the Fed will not raise interest rates. But it needs to get that message across to the over-eager players in the markets, who seem ready to dump their Treasury bonds if Mr Greenspan so much as twitches. Thus, even as talk of deflation dies down and the economy grows at rates not seen since the 1980s, the Fed insists that the “upside and downside risks” to growth remain “roughly equal”. It has come to the point where sending the right signal to the markets is more important than offering an accurate description of the state of the American economy. Cary Leahey of Deutsche Bank accuses Mr Greenspan of “finding the grey lining in the silver cloud”.

With their rate hikes this week, central bankers from Australia and Britain have got the ball rolling. The euro area’s monetary guardians may take up the running some time next summer. Meanwhile, the Americans, as ever, are playing a different game.

President George Bush has laid out an ambitious vision for a free and democratic Middle East. But with America still struggling to bring order to Iraq, success will not come easily

TWENTY years from now, will President George Bush be seen as a visionary who helped bring democracy to the Middle East, or as a case study in American hubris? On Thursday November 6th, Mr Bush made a bid for future glory, laying out a vision for democracy and freedom in a region long dominated by tyrannical regimes. “Iraqi democracy will succeed, and that success will send forth the news, from Damascus to Tehran, that freedom can be the future of every nation,” he told an approving audience at the National Endowment for Democracy (NED).

Mr Bush argued that his notion of a democratic Middle East is on a par with Ronald Reagan’s expectation, in the early 1980s, that freedom would take root in the Soviet Union. Mr Reagan’s sceptics were proved wrong; so too were those who said Germany and Japan, respectively emerging from fascist dictatorship and empire, could never become proper democracies after the second world war. As for the Middle East, Mr Bush firmly rebuffed the notion that Islam, the region’s dominant religion, was “inhospitable to representative government”. Morocco and Bahrain, he noted, were making progress with political reform.

Mr Bush has a penchant for setting bold policy goals—and making them work. Recall that he pushed through two giant tax-cut packages, when many Republicans thought one would be plenty. But bringing democracy to the Middle East will be much, much harder. For one thing, it will mean rethinking America’s alliances in the region. Iran and Syria, which were mentioned in the speech, already know they are not among Washington’s favourites. But laying the foundations for democracy also means dealing more firmly with Saudi Arabia and Egypt, America’s chief Arab allies in the region (Iraq aside). The Bush administration has already been pressuring the repressive Saudis to introduce political reforms, with some success. But moving too fast could cause the Saudi regime to topple, thus creating new dangers in a country that fielded almost all of the September 11th hijackers. Already, commentators in the Middle East are howling about Mr Bush's hypocrisy, citing America's support of Saudi Arabia and other cruel regimes, and its backing of Israel at the expense of Palestinians.

The most important element of Mr Bush’s Middle East vision was, in fact, barely mentioned in his speech, except by implication. Iraq will be the linchpin of any plan to democratise the region. America had little difficulty ousting Saddam Hussein’s brutal regime, but it is having trouble making Iraq peaceful and restoring its sovereignty. This will raise questions, in the short term at least, about America’s ability to spread democracy outwards from Iraq. Guerrillas are having a good deal of success targeting Iraqi “collaborators” and American occupiers, who are dying almost every day. Indeed, hours after Mr Bush’s speech a Black Hawk helicopter crashed in northern Iraq, killing at least six soldiers. This was the week’s second deadly helicopter crash: militants shot down a Chinook five days earlier, killing 16 troops.

The more soldiers (and Iraqi helpers) die, the more America emphasises that it is determined to succeed. “The failure of Iraqi democracy would embolden terrorists around the world, increase dangers to the American people and extinguish the hopes of millions in the region,” Mr Bush told the NED.

Most Americans, especially among Mr Bush's supporters, believe that the occupation of Iraq is worthwhile. But some are becoming more sceptical. A Washington Post/ABC poll, released this week, found that fewer than 15% of Americans think Iraq is the most important bit of the war on terror—a seeming repudiation of Mr Bush’s argument that the country is a “central front” against terrorists. The cost of war is one worry. On Thursday, Mr Bush signed a bill authorising $87.5 billion in extra spending for Iraq and Afghanistan (but mostly for Iraq); this money will increase America’s already huge deficit. Families of American soldiers who return in body-bags are usually patriotic, but some are beginning to wonder why none of Saddam’s chemical and biological arsenal has been found.

America’s inability to find weapons of mass destruction (the chief justification for war with Iraq) is a sore point for Mr Bush. By embracing the goal of a democratic Middle East, he is continuing his post-war effort to persuade Americans that ridding Iraq of tyranny is worthy of American sacrifice, weapons or no weapons. Europeans and Arabs will be sceptical as usual, but his speech will surely please neo-conservatives in his administration, whose ambitions extend well beyond Iraq.

Yes, America is different. But it always has been. Mostly, the difference is good for the world, not bad

UNTIL a little over two years ago, the fashionable topic for debate in conferences, opinion pages and even bars around the world was whether globalisation was really Americanisation, and whether that was a good or a bad thing. Now, few pundits anguish about whether their countries are having to become more like America. The fashionable source of anxiety in both Europe and Asia is whether America is becoming so different from everywhere else that it is becoming a problem for the world, not a solution. It is not just a reckless Bush administration leading America astray, in other words. On this view, the United States is now inherently assertive and unilateralist, and so can no longer be trusted to lead the world. Instead, it should be feared.

Inevitably, Iraq is the crucible for this debate, though other events and actions—the Kyoto Protocol, the anti-ballistic missile treaty, the International Criminal Court, Guantanamo Bay, federal budget deficits, even cotton subsidies—are being called in as thesis reinforcements. Yet Iraq ought also to cast this debate in a colder, more sobering light. Will it be better for the world if America succeeds in bringing stability, prosperity and even democracy to Iraq, or if it fails? Is it American competence that is feared, or incompetence? If America, under George Bush or a Democratic rival, were to withdraw hastily under the pressure of attacks such as the downing in Iraq on November 2nd of a military helicopter (see article), would that be an encouraging sign of humility or a devastatingly irresponsible act? Given that foreign voices were so keen to disparage America for withdrawing from Somalia in 1994, for failing for years to intervene in the Balkans, for having “allowed” the Taliban to take power in Afghanistan, and for being reluctant recently to send troops to Liberia, why should so many be hostile now to intervention in Iraq?

One answer to this final question is that incoherence is one of the luxuries of impotence. Those who cannot, or will not, take responsibility themselves feel free to snipe at those who do. Another is that it is natural to feel afraid when dramatic, ambitious actions are being undertaken, for the consequences of such actions can themselves be dramatic. But a further answer is that to the outside world America is a strangely puzzling country—strangely, given the openness of its society and the abundance of information about it—and at times the puzzlement turns to worry. This is one of those times.

Such times have, however, occurred ever since the country was founded. As our Washington bureau chief writes in his survey this week, “A nation apart”, the very phrase “American exceptionalism” that is so often heard these days was first coined by Alexis de Tocqueville in 1835-40, when that brilliant Frenchman wrote his “Democracy in America”. Many of the things he pointed out then as profound differences between America and other countries continue to be remarked upon today—its vociferous democracy, its decentralisation, its liking for voluntary associations, the intensity of its people's religious belief. Even during the cold war, which critics like now to describe as a time when fear of the Soviet Union acted as a bond between Americans and others, today's sorts of worries were commonplace. Graham Greene's “The Quiet American” (1955) complained that naive American idealists did more damage than good. Countless films, whether made by Americans or by foreigners, raised worries about a sinister military-industrial complex, about reds-under-the-bed obsessiveness, about zealotry.

Two other things, though, need also to be observed. One is that in recent years it is true that some of America's distinctiveness has become more marked. That is so in economics (working hours, productivity, innovation), society (population growth, religious belief, patriotism) and politics (a win-at-all-costs partisanship). Indeed, the combination of demographic vitality and productivity-led economic vigour is likely to make America even stronger in future, not weaker, despite the fact that high federal budget deficits could force some strength-sapping tax rises (see article). At least in economics, other countries are again going to have to try to follow some of America's example, if their living standards are to be kept high and unemployment low.

The second observation, though, is that some elements of American distinctiveness divide America just as much as they divide it from others. Religious, puritanical, conservative Americans (mainly Republicans) are ranged against more secular, hedonistic, tolerant ones (mainly Democrats). Until the 2002 mid-term elections, carried out under the shadow of September 11th, successive polls had showed America to be a “50-50 nation”. Both parties can find trends that could favour them in future: demography could favour Democrats, while economic drive and patriotism may favour Republicans. In America's cacophonous and hyper-active democracy, this means that actions and adventures tend to be self-regulating, at least over a period of years. Yet that offers both reassurance and worry: it may moderate excesses, and curb the influence of lobbies such as the religious right; but it could also encourage cutting and running from messes overseas.

If that were to occur, it would be a disaster for America and a tragedy for the world. The basic dilemma that was faced in Afghanistan and Iraq was that doing nothing and intervening both looked bad and risky options, but that doing nothing looked worse. In the Middle East as in Central Asia, intervention has been painful and progress has been stumbling. But despite the continued instability in both countries, life is better in both than before the intervention occurred; and much, much better than if al-Qaeda's terror camps had been left in place or if Saddam Hussein had been left in power. As the next leader argues, more needs to be done in Afghanistan, and at least some of it is likely to be. In Iraq, however, if the casualty toll among American forces keeps rising it could well prompt influential voices in Washington, including among Republicans, to press Mr Bush to declare victory and retreat.

Fortunately, he is unlikely to. The flip side of some of the things critics dislike about him—a black-and-white view of the world, a tin ear for dissenting views—makes him also show a stubborn determination. Put more favourably, he is a man with a sense of duty. Put more cynically, perhaps, he is a man who will be keenly aware that early withdrawal will look like failure, and such failure would be politically suicidal.

By intervening in Iraq, against the majority of world opinion but with the courage of its own convictions and the support of a few allies, America showed that it was indeed a different nation from others: one prepared to shoulder responsibilities and to do what it thinks is right. Such behaviour is alarming precisely because it is bold and, by today's standards, different. It is never likely to bring forth a cascade of praise or gifts. It was done, however, in a way likely to reinforce the concern, as administration officials poured abuse on their foreign critics and, through their violations of human rights, damaged America's own moral authority. Now, though, the argument has to be won by creating facts on the ground. If the facts are of failure, America will be likely to shrink back into its shell. But success is there to be had. It will take a long, costly and painful effort. Only once it is done, however, will hope be restored and danger dispelled.