What war means for the economy

The perils of a dysfunctional economy

By Stephen Roach

Conventional wisdom holds that the war in Iraq is the root cause of the perils facing the global economy. I don’t buy that. The war may be a shock, but the peace that follows is unlikely to resolve the serious tensions of a dysfunctional global economy.

The big story is the ever-mounting and unsustainable imbalances in our U.S.-centric world. We have had a one-engine global economy since 1995: Growth in U.S. domestic demand averaged 4 percent annually from that year through 2002, double the 2 percent gains elsewhere in the world. Courtesy of bubble-induced wealth effects, Americans spent to excess. At the same time, demand in Japan and Europe was decidedly subpar, reflecting ever-deepening structural constraints.

The result: The U.S. accounted for 64 percent of the cumulative increase in world gross domestic product from 1995 to 2002 -- double the country’s share of the global economy.

This dichotomy is not without cost, nor is it sustainable. To maintain growth, a U.S. economy chronically short of savings has had to import surplus savings from abroad, mainly from Asia but also from Europe. And to attract that foreign capital, the U.S. has had to run a massive balance-of-payments deficit.

In the fourth quarter of 2002, America’s current-account deficit surged to an annualized $548 billion, a record 5.2 percent of GDP. Financing such a shortfall requires $2.2 billion of capital inflows each and every business day -- hardly a trivial consideration for a postbubble U.S. economy offering low returns.

Nor is the situation stable. As the federal budget goes deeper into deficit, the U.S.'s net national savings rate -- that of consumers, businesses and the government combined -- could easily plunge from late 2002’s record low of 1.6 percent toward zero. If that occurs, the U.S. current-account deficit could approach 7 percent of GDP. This would require about $3 billion of foreign financing every business day.

History is pretty clear on what would happen next: a classic current-account adjustment. This would entail a very different macro outcome for the U.S. -- namely, a weaker dollar, higher real interest rates and a slowdown in domestic demand.

That is precisely the scenario for which a dysfunctional world is completely unprepared. A weaker dollar would spell a higher yen and a stronger euro, which would hinder the externally led growth that Japan and Europe have grown accustomed to. A slowdown in U.S. domestic demand growth would exacerbate the problem because it undermines the world’s chief source of aggregate demand.

The pain would spread to the trade-dependent economies of Asia ex-Japan. And as the one-engine global economy started to sputter, the world would have no choice but to come up with a new recipe for global growth. This is what I call global rebalancing.

Will it occur?

There are two key conditions. The first is a current-account adjustment that forces the U.S. to start living within its means, as delineated by domestic production and income generation. Equally important, the rest of the world must press ahead with structural reforms designed to unlock domestic demand.

This could well be the toughest nut of all to crack. Japan has shown little appetite for reform over the past decade. Europe, too, has deferred reforms for far too long. And now, as the business cycle turns and unemployment rises, politicians can hardly be expected to put voters (or very possibly themselves) out of work by embracing structural reform.

So a dysfunctional world, unwilling or unable to uncover new sources of growth, may by default end up waiting for yet another kick-start from the U.S. growth engine. But that kick may be a long time in coming. Not only does the U.S. need to reconcile itself to slower domestic demand to narrow its current-account deficit, but it also faces the headache of a postbubble hangover -- a loss of the wealth that had long supported consumer purchasing power.

The days of U.S.-centric global growth are therefore numbered. The rest of the world must wean itself from the U.S. and learn to draw on internal sources of demand. A failure to do so would unmask the true flaw of a dysfunctional global economy: the inability to generate balanced and self-sustaining growth. The U.S. has carried the world long enough.

War might well exacerbate the world’s macro conundrum.Two considerations come to mind. The first is a war-related widening of the U.S.'s already-large budget deficit. President George Bush’s request for $75 billion of emergency-spending authority is just a down payment on this war. A prolonged combat effort -- to say nothing of a large, multiyear commitment to rebuilding Iraq -- could easily require several multiples of that.

Such outlays, in conjunction with ill-timed proposals for costly tax reforms, could take the U.S. budget deficit up to 5 percent of GDP -- precisely the recipe for an ever-widening current-account deficit. The dollar would bear the brunt of this, turning the screws tighter on the rest of the world.

The second consideration is that the conflict in Iraq could spell trouble for globalization. The war threatens to undermine political support for the supranational alliances that have long bound the world together. That possibility, combined with the potential trade frictions arising from a weaker dollar, a supercompetitive Chinese economy and the outsourcing of white-collar jobs to nations like India, portends tough times ahead for globalization. Moreover, the war could push an already weak world economy into its second recession in three years. During recession nations look inward to matters of self-interest; only in good times do they tend to look outward to collective interests.

Ironically, the feel-good “victory recovery” that financial markets are craving could exacerbate global imbalances. That would be especially true if the U.S. led the way not just on the battlefield but also in restarting the timeworn U.S.-centric growth dynamic. The U.S.'s current-account conundrum would only intensify as a resurgence of domestic demand boosted imports.

Sadly, that would provide yet another excuse for the rest of the world to rely on externally led growth and defer the reforms needed to unlock domestic demand. The last thing this dysfunctional world needs is to go back to the well of U.S.-centric growth.

Stephen Roach is chief economist and director of global economics at Morgan Stanley.

Policy tools might still save the day

By John Llewellyn

The economic outlook is not all gloom and doom. The war in Iraq is dampening business and consumer confidence around the world, and the weakness of the U.S. economy reflects a number of internal problems, including the deflating of the technology bubble. Yet U.S. economic policy in the form of interest rate and tax reductions has proved very effective at staving off recession in the face of large, negative shocks. Moreover, that policy has further to go -- if necessary -- to stimulate the economy.

The global economy should be picking up steam, accelerating to a 2 to 2.5 percent annualized growth rate by the fourth quarter, giving growth for the year of 1.5 percent. The U.S. should speed up to a 3 to 3.5 percent annualized growth rate by the fourth quarter, for an output gain for the full year of about 2 percent. The euro zone looks likely to grow by just 1 percent this year, and Japan by perhaps 1.5 percent. Emerging markets should fare somewhat better, with Latin America growing by about 2 percent, Eastern Europe nearly 4 percent and Asia ex-Japan about 6 percent.

This subdued recovery -- the projected U.S. growth rate is one of the weakest in 50 years -- needs to be seen in perspective. It would follow one of the mildest slowdowns on record and represent a victory for policymaking. Left unchecked, negative forces almost certainly would have produced global recession.

These forces are worth dwelling on. There was the collapse of the stock market bubble; the retrenchment of business investment, particularly in the U.S.; the rise in oil prices to above $30 a barrel; the corporate governance scandals; and all the uncertainties that surrounded the buildup to war. Collectively, these factors would have led to global recession had it not been for massive countervailing monetary and fiscal policy, particularly in the U.S.

Fiscal policy contributed about 1 percentage point to U.S. growth in 2001 and 2002. The combination of tax cuts and increased government spending provided the largest fiscal policy stimulation over a two-year span in 50 years. Monetary policy, too, made an important contribution: about 2.5 percentage points to U.S. growth and about one half of a percentage point to euro-area growth last year.

Positive forces persist. Monetary policy will contribute about 1.5 percentage points to GDP growth this year, the result of lagged effects and further cuts (actual and projected) in official interest rates. In Europe, where real rates are at a 23-year low, the effect of past cuts and additional reductions this year should add a further one half percentage point or so to GDP gains this year.

The overall outlook? The equilibrium price for internationally traded oil is probably in the low $20s, so if crude prices retreat toward that level, the removal of the $10-a-barrel war premium would by itself contribute one quarter to one half of a percentage point to world GDP growth over the coming year. A satisfactory end to hostilities in the Middle East could conceivably cause the major stock markets to rally by 10 percent. In OECD countries this would encourage businesses to restart capital spending and would strengthen consumer confidence. We estimate that if everything more or less goes well, the upper boundary to our world economic growth forecast would be 2.7 percent.

Of course, everything may not turn out all right. Continuing war in Iraq, an oil price stuck in the $30s (or higher), sagging stock markets or a further blow to business and consumer confidence could result in the lower boundary of our forecast: a mild global recession.

Policy activism can still work to prevent such an outcome, however. Much of conventional demand management has been used up. Yet there is still room for the Federal Reserve Board to cut U.S. interest rates, and even more leeway for the European Central Bank to do so. And even if rates fell to zero, central banks could resort to unorthodox monetary policy.

They could extend open-market operations out along the yield curve to reduce long-term interest rates. If the global economy were plagued by deflation, central banks could purchase an expanded range of assets, from equities to foreign bonds, to turn inflation positive and real interest rates negative.

In such a scenario, the problem would not be the lack of policy instruments but rather the willingness of policymakers to use them. The Bank of Japan under former governor Masaru Hayami, for example, doggedly resisted calls to loosen monetary policy by purchasing a wide range of assets. But the activist mind-set at the Federal Reserve today would almost certainly lead to the government’s undertaking Fed-financed asset purchasing if deflation was considered imminent. Such a policy would almost certainly provoke a depreciation of the dollar and cause a redistribution of growth to the U.S., principally from Europe. Such a shift would hardly worry Washington given today’s strained transatlantic relations. Europe, however, might find it difficult to coordinate a similarly aggressive monetary policy response between the ECB and the euro zone’s 12 finance ministries.

Governments also could initiate an additional, substantial fiscal stimulus, in the form of either tax cuts or spending increases. At the moment, they are reluctant to do so, both in Europe and in the U.S. But if the situation became sufficiently serious, they would almost certainly change their stance. Tax cuts might be of limited effectiveness if consumers’ pessimism led them to save rather than spend. Increased government expenditure, however, would almost certainly work, at least in the short term. Few firms would refuse to take up a government contract merely because of the way in which it was being financed.

The world economy is on a cusp. Policy seems to have done enough to prevent recession and, provided that there are no further shocks to confidence, to ensure a progressive pickup in activity. But economies remain vulnerable to fresh shocks and to the growing perception that conventional macroeconomic policy has less ammunition than it once did. Policy is by no means finished, however. There is much that it could do, if needed, to support aggregate demand further.

John Llewellyn is global chief economist at Lehman Brothers.

Juggling imperial ambitions and deficits

By David Hale

The unfolding Anglo-American victory has removed the greatest risk that Iraq posed to the global economy -- the possibility of an oil price explosion. The allied forces have captured oil fields responsible for 60 percent of the country’s production and are moving closer to the Kirkuk field, which is responsible for an additional 17 percent. As the Iraqis inflicted only modest damage on the fields, the country could resume exporting oil this autumn. Such a development should encourage oil prices to drop back to a range of $20 to $25 a barrel from a peak of $40 a month ago.

The other consequences of the war are still evolving. In constrast to the 1991 Gulf War, the impact of this victory will be less clear-cut. There are concerns about the danger of new terrorist attacks. The war has produced great divisions in the Western alliance, which might have a spillover effect on other areas of policy, such as trade, while undermining the U.K.'s attempts to play a leadership role in Europe. The U.S. is occupying Iraq, not liberating Kuwait, so it will have to assume the cost of a potentially long military presence there.

The financial markets are concerned about U.S. unilateralism because they perceive it as opening the door to a new age of imperialism that could have significant economic consequences. After a great peace dividend following the end of the cold war, U.S. defense spending is now increasing dramatically. The upsurge of the defense budget will magnify the federal deficit and increase the risk that the current-account deficit will expand further. During the cold war, U.S. allies often helped to shoulder the burden of the country’s military spending. Germany, for example, had a formal program in which it engaged in financial transactions, such as stockpiling dollars at the Bundesbank, to offset the cost of U.S. defense spending. During the 1991 Gulf War, the U.S. received huge subsidies from Germany, the Gulf states, Japan and Saudi Arabia to help pay for the cost of evicting Saddam Hussein from Kuwait. The U.S. will receive no subsidies to pay for this war. If the occupation meets great resistance and proves to be expensive, the U.S. will also have to assume all of the costs. The markets would regard such a development as negative because of the potential consequences for the budget deficit. In fact, Congress would probably respond to a high-cost war by scaling back the Bush tax cut proposals that were designed to bolster the equity market.

In congressional testimony in February, Federal Reserve Board chairman Alan Greenspan suggested that geopolitical uncertainties have been the major cause of the U.S. economy’s recent weakness. But several other factors have also played a role. During the past three years, the U.S. stock market has declined by an amount equal to 90 percent of GDP, compared with 60 percent after 1929. The Sarbanes-Oxley legislation enacted by Congress last summer has made many corporate managements highly risk averse. The economy enjoyed 3 percent growth during 2002 as a result of extraordinary monetary and fiscal stimulus: The Fed slashed interest rates to 1.75 percent, while households benefited from the tax relief enacted in May 2001. Spending on defense and homeland security, coupled with the tax cuts, turned a budget surplus equal to 2 percent of GDP into a deficit now approaching 3 percent of GDP. If policy becomes less stimulative, there is a risk that consumer spending could slow before investment spending revives. As a result of the economy’s vulnerabilities, the impact of the war on U.S. fiscal policy could become an important factor in determining the outlook for both 2003 and 2004. If Congress fails to enact the Bush fiscal stimulus because of concern about rising defense spending, the economy could fail to rebound as decisively as the financial markets are now anticipating.

The American people have supported the Iraq war because of the events of September 11. But it is far from clear that they will be prepared to support a prolonged military presence in Iraq if they perceive it to be expensive. The U.S. does not have a clear strategy for managing Iraq’s future. The country’s oil production is worth only $25 billion per year, or one third of what President George W. Bush has so far asked Congress to allocate for the war. The introduction of democracy could produce a Shiite government that might align the country with Iran. The new Iraq will be less of a menace than it was under the leadership of Saddam Hussein, but there is no guarantee that it will be a U.S. ally indefinitely.

The markets have rallied on positive news about the military conflict. But the sustainability of that rally will hinge upon how the U.S. reconciles its new imperial ambitions with the realities of large fiscal deficits and unprecedented current-account deficits at a time when its international alliance structure is greatly weakened. The war will bolster President Bush’s popularity, but its cost could put his fiscal strategy at risk.

David Hale is chairman of Prince Street Capital and ChinaOnline.

Investing in a colder climate

By Adam Seitchik

The beginning of the Iraq war brought with it a sharp rally in stocks and a sell-off in bonds. One week before the breakout of war, the Brent oil price was $34 per barrel; two days into the coalition invasion, the price had plunged $9, and the deeply oversold Dutch, French and German stock markets bounced more than 20 percent in just seven trading days. This phenomenal rally, albeit from deeply oversold levels, represents more than two years of long-term average total return.

Yet no matter what the ultimate outcome is in Iraq, the following negative trends have constrained stock market returns in the past few years and are not going away in the near future:

* From helpful disinflation to worrisome deflationary risks;

* From a U.S. investment and consumer boom to a tech wreck with few remaining drivers of global growth;

* From a market focused on quarterly operating earnings to one focused on questions about long-term valuation, profit growth, balance-sheet stress and earnings quality;

* From the “unspent ammunition” of 6.5 percent U.S. interest rates and massive budget surpluses to rates of 1.25 percent and exploding fiscal deficits;

* From a restructuring Europe with an emerging culture of equity to a belief that the core of Europe is aging rapidly and reforming too slowly;

* From a postcold war peace dividend to the U.S. identification of an “axis of evil” and the war on terrorism, an unfunded and ill-defined conflict that will last for years to come; and

* From rising stock weightings and overfunded pension plans to a structural reduction in equity allocations and onerous long-term pension contributions.

The painful start to this new century has brought with it a profound change in the investment landscape. Uniquely in the postwar period, an investment bust, not a consumer slowdown, caused the economic recession and stock market correction. Deflationary forces intensified, beginning with the bursting of the Japan bubble in the early 1990s, accelerating during Asian, Russian and Latin American currency devaluations and coming to a head with the recent collapse of technology investment.

If there is any good news in all of this, it is that the spectacular overvaluation of equity markets is largely, if not fully, corrected. We believe that the stock market lows of the past nine months will hold, because even the most conservative approach to stock valuation suggests that stocks offer a 3 to 5 percent premium versus bonds in a variety of markets. At the lows in March, markets as diverse as Australia, Italy, Japan and the U.K. had dividend yields equal to or in excess of the local government bond yield. In some countries higher yields for stocks than bonds will limit the amount of forced selling of equities by heavily regulated insurers.

Our belief in the attractiveness of stocks versus bonds in the long run assumes that the world economy will grow modestly over the next decade, without deflation. The risks of deflation are real, but our core view is that the Western world will avoid a Japan-style deflationary trap. Assuming that the normalized growth of the global economy plus inflation will be 4 to 5 percent over the next ten years, stocks with high yields become attractive to economic buyers eager to arbitrage the relative value between real and financial assets. Under positive growth scenarios, stocks offer a healthy premium to bonds, especially when trading down to the lows of the range they have been in since last summer.

Our tactical models suggest that stocks became cheap in the latter part of the first quarter versus corporate bonds for the first time since 1998. However, we do not believe that a tactical trading opportunity marks the beginning of a new, long-term bull market in stocks. The challenges of weakish global growth, mediocre valuations and a more dangerous geopolitical landscape will be with us for some time. At the beginning of the year, we suggested stocks could rise 5 percent (in Japan) to about 8 to 10 percent (in Europe and North America) this year, and we reiterate those forecasts. Government bonds are well supported by low central bank interest rates, but total return is capped by starting yields of only 4 percent in the West (0.7 percent in Japan). Corporate bonds offer better yield and return prospects than government debt.

The great bull market at the end of the last century was built on very cheap valuations. For 20 years there were no two consecutive calendar years with negative stock market returns. U.S. stock valuations inflated from a trailing price-earnings ratio of 6 all the way to a record P/E of 45 at the end of the tech bubble. U.S. government bond yields in the early 1980s peaked at more than 15 percent and have now come down to about 4 percent. Pessimism was built into asset prices after the stagflation of the 1970s, but the 1980s and 1990s were an era of deregulation, lower inflation and the proliferation of democratic capitalism.

Although excessive valuations have been corrected and we therefore expect long-term positive returns to both stocks and bonds, the bear market will not be followed by an extended bull market, because valuations for stocks have been corrected only to normal, not cheap, levels. For example, despite a 50 percent drop in the Standard & Poor’s 500 index, the dividend yield rose to only about 2 percent. The trailing reported P/E ratio is not yet 6, as it was at the beginning of the bull markets in 1950 and 1980 -- it is 28.

At current market levels dividend yield plus dividend (or earnings) growth should create annualized returns to stocks that are attractive relative to bonds in the long run but still below 10 percent on average. Real estate and bonds, even if they continue to offer positive long-term returns as we expect, are nearing the end of what have been phenomenal bull markets.

Investing in benchmarks during the bull market made sense. Stocks, bonds and eventually real estate all soared. As it becomes clear that benchmark returns to stocks and bonds will be not only volatile but much lower on average than in the 1980s and 1990s, the industry is slowly confronting the need for a greater focus on total return and managing short-term volatility.

Thus benchmark investing, the dominant and profitable management style of the bull market, is under serious review. Well-thought-out benchmarks match long-term assets to liabilities, but institutional investors are under pressure to avoid the kind of volatility that leads to punishing, unplanned contributions to underfunded pension plans, or forced selling by insurance companies to manage regulatory surpluses.

A market-directional, benchmark-focused approach may struggle to provide satisfying total returns with acceptable volatility in a rapidly changing environment. For example, a lowactive risk, benchmark-relative portfolio doesn’t have the flexibility to move sharply away from struggling sectors, countries and stocks.

As the industry confronts the limitations of benchmarks, we expect to see more client interest in concentrated portfolios, long-short structures, overlays and other strategies that allow the investment manager to shift risk away from volatile benchmarks toward attractive investments with good total-return prospects.

Underneath lower-return benchmarks lies ample opportunity. With the U.S. now burdened by large current-account and budget deficits, the world must depend on new sources for growth. The dollar has begun a long-term downtrend. Asia ex-Japan is now 20 percent of global GDP and growing rapidly, representing a promising source of new demand. Since the end of the bull market, resource companies and defensive consumer stocks have outperformed cyclical growth sectors like technology and telecommunications by 60 percent. Ignored sectors such as resources and security may become the new, long-term leadership in this darker era.

There may be other surprising winners in this new investment regime. The trick will be not only identifying these new types of opportunities but having the flexibility to exploit them.

Adam Seitchik is chief global strategist at Deutsche Asset Management.

Learning to profit from geopolitical risk

By Philippa Malmgren

Professional investors and traders seem to think that the markets and world growth prospects will return to normal when the war in Iraq ends. All geopolitical risk, they believe, is bad news. The sooner it goes away, the better. But some offhand dismissals of this kind of risk prevent markets from understanding the true nature of the war on terror. Market players need to grapple with the complex, multilayered strategies that underlie President George W. Bush’s actions in Iraq. In doing so, they will understand that geopolitical risk is unlikely to subside after Iraq. Yet, far from being bad news, this risk may provide the foundation for a powerful recovery of the world economy. After all, risk always brings opportunity.

The war in Iraq reflects a larger strategy, one that itself reflects the president’s mandate from the American public, as this White House understands it. The American public wants him to prevent another 9/11, whether from al-Qaeda or anybody else. The president has argued that the criterion for determining how to deploy resources must be to determine which threat looks most imminent. By that measure, and based on intelligence the market will never have access to, Iraq jumped to the top of the list.

But, many argue, surely Palestine is the problem. By attacking Iraq, the president will only incur the wrath of the Muslim community, which holds the U.S materially responsible for the terrible condition the Palestinians find themselves in today. Palestine is in fact part of the plan, as it has been all along. By removing Iraqi state sponsorship of terrorism, the U.S. would weaken the power of Yasser Arafat.

The president could not create an independent, democratically controlled Palestinian state any other way. To directly attack Arafat as a terrorist would be in keeping with the image of a U.S. that sides with Israel against the interests of the Muslim community. But an America that liberates a Muslim Afghanistan and frees the Muslim population of Iraq from sponsors of terrorism who retain power by oppressing their own people -- that is another matter. That is an America that can create the conditions under which the Palestinian public can devolve power away from Arafat, toward a new government that has no ties to terrorism.

The markets are so closely watching the media coverage of Iraq, in the hopes that they can discount when the war will end, that they have failed to notice that the U.S. has achieved exactly what it wanted in Palestine in recent weeks. The Palestinians have created a prime ministership that didn’t exist before. And they have placed a moderate with no ties to terrorism in that role. Further, the president has succeeded in forcing Yasser Arafat to devolve even more power to the new leader so that the new government can be ready to assume the full responsibility of running the new Palestinian state when it comes into being. The “road map” for Palestine is not a knee-jerk U.S. response to the current engagement in Iraq. The Bush administration began talking about this plan in the autumn of 2001 and more broadly in June 2002. The engagement in Iraq is part of that road map as well as an effort to manage the direct threat to the U.S.

In this way, the road to peace in Palestine runs through Baghdad. It also runs through Iran and Syria. Traders should study a map of the region. By bringing democracy to Afghanistan and Iraq, the U.S. will effectively squeeze the Iranians. Iran is on the edge of a democratic revolution, anyway. Regime change all around Iran will be difficult for its leaders to ignore. And if they try to ignore the pressures for change, the U.S. will confront them. The groundwork is already being laid: In recent weeks the United Nations has found Iran to be in clear violation of its commitments on nuclear weapons. Iran has a long history of sponsoring terrorism. So it is difficult to imagine that the war on terror can end without a change of attitude in Iran and Syria. Secretary of State Colin Powell recently warned both countries to cease and desist in their support of terrorists.

Wealth creation is also a critical part of the president’s plan. It is no accident that the sponsorship of terrorism has mainly sprung from Middle Eastern states that have youthful populations living in abject poverty despite huge national oil wealth. The failure to spread the wealth has created huge resentment among the poor and the young. In the absence of a job or even the hope of a job, young people turn to terror. The administration hopes that new democratic regimes in the oil-wealthy countries will work harder to spread the benefits to the broader population. It is certainly true that the administration expects any new Iraqi government to live up to this hope. The Saudis are getting the picture as well. The royal family has endangered itself by failing to invest enough in the country’s youth, who have increasingly become supporters of terrorism.

Investors have accepted the statements of many Muslim and Arab countries at face value. But a more careful review reveals that countries like Saudi Arabia have been begging the U.S. for years to do something about Saddam Hussein and state-sponsored terrorism.

Many investors may take a cynical view of the grand plan. First of all, they may not accept it simply because the White House has not articulated it very well. Or maybe the president has actually talked about the plan repeatedly but many have written him off to such an extent that they do not bother to listen to him. They wait until the vice president or another “credible figure” says the same thing before they pay attention. Of course, this approach plays right into the president’s greatest strength. He has won a governorship and the presidency and triumphed on many policy issues, precisely because his opponents underestimated him.

Some investors say that this war on terror is too expensive and will hurt the economy. But why do they assume that the public would prefer less expensive, less effective options to contain the new threats? So far there is a willingness to pay almost any price to be free from these new threats. Nor do these investors ask about the cost of inaction. Does anyone really believe that terrorist threats to the U.S. economy will just disappear on their own?

Traders and investors may argue that these countries do not want democracy, that they will not know what to do with it and that these efforts will fail. That may be true, but Americans cannot imagine that it is better for these countries to never have had the chance.

And, if our efforts are successful, the possibility of a better future for the region may indeed be real. Investors should hope so. For if the master plan for the region never had any hope of achieving these grand aims -- free democratic governments across the region, greater distribution of wealth, an independent Palestine -- then the market would be right to fear the future. A war in the Middle East would increase the risk of terrorism and increase the risk premium for the world economy.

But if the administration’s grand aims are actually achieved, it will be almost impossible for any trader to argue that a free independent Palestine does nothing to diminish the risk of terror. Nor will it be easy to argue that a broader distribution of wealth will do nothing to diminish the risk of terrorism. Nor will it be easy to explain why the market kept discounting higher terrorism risk when in fact the risk was diminishing. Far from being on the brink of disaster, the world economy may be about to benefit from all these efforts.

This is why the Federal Reserve Board implicitly told us all in its last statement that we should learn how to manage geopolitical risk instead of trying to avoid it. There will be more geopolitical risk to come, and it may bring extraordinary opportunities.

Philippa Malmgren, former special assistant for economic policy to President George W. Bush, is president of Canonbury Group.