Hamish McRae: If they don't get tough on the US deficits, we'll know there are girly men in the White House

I'm not quite sure what a "girly man" is supposed to be, but when Governor Arnold Schwarzenegger used the expression to describe his opponents to budget reform in California, it was not intended to be flattering. It was, however, effective. He was able to put pressure on the Democrats by using his own popularity to attack them directly. The taunt was part of that: they were refusing to take the inevitable tough decisions. They came into line.

I'm not quite sure what a "girly man" is supposed to be, but when Governor Arnold Schwarzenegger used the expression to describe his opponents to budget reform in California, it was not intended to be flattering. It was, however, effective. He was able to put pressure on the Democrats by using his own popularity to attack them directly. The taunt was part of that: they were refusing to take the inevitable tough decisions. They came into line.

Well, the conventions are over and Mr Schwarzenegger has made his speech in New York in support of George Bush, again invoking his "girly men". The glide path to the November elections is set. But whoever wins will need to set about fixing the US national finances. These are not in quite as bad a mess as California's, but it is becoming clear that during the next term a start will have to be made on pulling back both the fiscal deficit and the external one. No room for girly men now.

In US domestic politics, the deficits do not loom very large. The debate about the economic implications for the election turn on issues like job creation, growth of real wages, the price of gasoline and so on. That the budget deficit has risen to nearly 5 per cent of GDP and the trade deficit is much the same does not figure directly in the debate.

It is easy to see why: neither has an obvious impact on voters now. The budget deficit will have to be serviced by future taxpayers. The external deficit is being largely financed by transfers from Japan and other Asian countries which have trade surpluses with the US and are anxious to hold down the value of their own currencies. The dollar has fallen sharply - but mainly against the euro and sterling, not against the yen and the yuan. And if Americans find it expensive to holiday in Paris, well, they ought to take their holidays in the US, shouldn't they?

The trouble with any commentary that draws attention to the twin deficits is that both have been around for a long time already and the world has not ended. So why should they matter next year?

I think it is important to make a distinction between the budget deficit and the external one. The first, at between 4 and 5 per cent of GDP, is growing faster than the economy - just as our own budget deficit, at a bit over 3 per cent, is growing faster than our economy. But in both the US and the UK, overall government indebtedness is still low compared with the eurozone economies or with Japan. So there is no immediate crisis.

The external deficit is more disturbing. The trade gap has deteriorated relentlessly, as the left-hand graph above shows. The fall of the dollar is making things worse, not better. This is partly due to the familiar J-curve effect: it takes a while for an increase in the volume of exports and a decrease in the volume of imports to compensate for the fact that the former fall in price and the latter rise.

But it is also because US imports are quite inelastic. Energy imports, for example, seem almost impervious to changes in the cost of oil - witness the steady climb of oil and gasoline prices, as shown in the right-hand chart. The dollar could fall a very long way, doing huge damage to world trade, before the trade imbalance narrowed much.

But that's just visible trade - surely trade in services matters too? Well yes, but whereas the UK has an enormous surplus on trade in services and on investment income, the US now has a deficit. It used to have a surplus but it has blown it. So the US has a much weaker international payments position than we do.

Already the dollar is inflicting pain on US consumers through its impact on energy prices. The pain rises the further the dollar falls.

The crucial question is whether there will be some trigger that will force the US to make the adjustment suddenly, or whether muddle-through will prevail. Past experience suggests muddle-through is more likely, but some kind of lurching adjustment is possible.

Which of these it will be, I suspect, will turn on whether the next President, his Treasury Secretary and economic advisers turn out to be Arnold's girly men on economic policy. The markets will want to see a turning point on both deficits.

Provided you can see the numbers moving in the right direction, you go on investing. There are plenty of underlying reasons why US Treasury securities should be more attractive than the securities issued by, say, Germany, Italy or Japan. The US has, and will continue to have, an expanding population and hence an expanding tax base. Germany, Italy and Japan will not. If the fiscal deficit improves, it becomes easier to fund the external deficit, though I am more concerned about the latter.

But there has to be action. People whose judgement I would trust assure me that, somehow or other, action will be taken in the next presidential term. That is the way the US system works.

Maybe. But wrenching changes happen too. Runs on the dollar have happened in the past. Long-term interest rates have suddenly shot up. I don't think we can discount the possibility of some sharp change in the next couple of years, maybe even a set of financial events that lead to the end of this expansion. Just as the late-1990s growth period lasted longer than most expected, so the current one could be shorter than usual.

The imbalances are certainly much worse than they ought to be at this stage of the economic cycle. Because demand was artificially inflated with a huge fiscal and monetary boost, there is now no ammunition left to keep growth going should it falter. Hence the need to be tough, or at least tougher, with the budget; and hence the need to increase short-term interest rates through the coming months.

In the presidential contest four years ago, the word in economic circles was that this was the election to lose: let someone else pick up the opprobrium for the recession that would inevitably follow the end of the dot-com boom. The lack of job creation during this recovery has undermined the incumbent's hopes of re-election, although there seem to have been just enough jobs to give him a decent chance. But if the recovery falters in, say, 2006, the winner will go down as a failure. The key is confidence in economic management - a touch of the spirit of Mr Schwarzenegger, whatever you think of his choice of insults.

So globalisation is bad? Not for Asia

As an antidote to the slightly gloomy tone of most economic analysis (including a bit above), I have been looking at the Economist Intelligence Unit's forecasts for global growth. Did you know that this year, if the EIU is right, will see the fastest expansion in the world economy since 1984? Global growth will be 4.9 per cent.

Really? It doesn't particularly feel like it here. But the important thing to appreciate is that this year is both an OK one for most of the developed world and a good one for the developing countries. We inevitably see the world economy through the eyes of the developed world. But, the US apart, most of the growth nowadays comes from what we call the developing countries - an expression that has already become a misnomer, as so many of them have either achieved developed status or are racing towards it. Large tracts of China and India are now modestly prosperous, while Malaysia and Thailand are securely middle-income countries, not really poor at all.

The OECD countries, the members of the so-called rich club, are growing at an overall rate of 3.5 per cent this year, which is fine. But the rest of the world is expanding at, yes, 6.9 per cent. The so-called transition economies (the old USSR plus Eastern Europe) are growing at 6.2 per cent.

All this is on the back of a surge in world trade, which is forecast to grow at 9.2 per cent this year. Trade in the developing countries is forecast to accelerate at 14.7 per cent.

So what is all this nonsense about globalisation being bad for the developing world? Much of it, not all to be sure, is doing wonderfully well. As anyone who has travelled much in China or India this year will testify, it is pretty thrilling to see such success first hand.

That success is built on the hard work of the people there. But it would not be possible without international trade and the market economy, and we should surely celebrate it.