The beginning of each year is high season for economic forecasters. With few exceptions, Wall Street economists try to give as upbeat an interpretation as the data will allow: they want their clients to buy stocks, and gloom-and-doom forecasts do little to sell them.

But even the salesmen are predicting that the American economy will be weaker in 2005 than in 2004. I agree, and am actually on the pessimistic side: this may be the year in which we begin to pay for past mistakes.

The biggest global economic uncertainty is the price of oil. Clearly, oil producers failed to anticipate the growth of demand in China—so much for the wisdom and foresight of private markets. Supply-side problems in the Middle East (and Nigeria, Russia, and Venezuela) are also playing a role, while Bush’s misadventure in Iraq has brought further instability. While there has been some weakening of prices from their peaks, OPEC has made it clear that it does not intend to allow much price erosion.

High oil prices are a drain on America, Europe, Japan, and other oil importing countries. The increase in America’s oil import bill over the past year alone is estimated to be some $75 billion. The effect is just like a huge tax that transfers wealth to the oil-exporting countries.

If there were any assurance that prices would remain permanently above even $40 a barrel, alternative energy sources (including shale oil) would be developed. But we are now in the worst of all possible worlds—prices so high that they are damaging the global economy, but uncertainty so severe that the investments needed to bring prices down are not being made.

Meanwhile, central bankers around the world have been trained to focus exclusively on inflation. So when high oil prices drive up the inflation rate, many will most likely respond as they’ve been taught. They will recall how oil price increases in the 1970’s fueled rapid inflation, and will want to show their resolve not to let it happen again. Interest rates will rise, and one economy after another will slow.

The march towards higher interest rates has already begun in the United States, where the Federal Reserve is betting on a fundamental market asymmetry. For the past three years, falling interest rates have been the engine of growth, as households took on more debt to refinance their mortgages and used some of the savings to consume. The Fed is hoping that all of this will not play out in reverse – that higher interest rates will not dampen consumption.

Hope may not be enough. American households are far deeper in debt today than four years ago, magnifying the potential adverse effects of an increase in interest rates. Of course, American mortgage markets allow households to lock in the lower interest rates. But in economics, there is no such thing as a free lunch, and here the cost can be enormous: new home buyers will have to pay more, and thus will be less willing and able to pay as much. Real estate prices could well decline, with a strong likelihood, at the very least, of a slowdown in the rate of increase. This too will dampen demand.

This is only one of the uncertainties facing the US economy. Clearly, some of the growth in 2004 was due to provisions that encouraged investment in that year—when it mattered for electoral politics—at the expense of 2005. But there is uncertainty about how much.

Then there is America’s huge fiscal and trade deficits, which not only jeopardize the well-being of future American generations, but represent a drag on the current US economy. (A trade deficit is a subtraction from aggregate demand.) As one of my predecessors as Chair of the Council of Economic Advisers, Herb Stein, famously put it, “If something can’t go on forever, it won’t.” But no one knows how, or when, it will all end.

Indeed, President Bush has indicated an intention to spend the political capital he earned during the election; the problem is, he appears intent on spending America’s economic capital as well. His promises include partial privatization of social security and making his earlier tax cuts permanent, which, if adopted, will send the deficits soaring to record levels. What, exactly, this will do to business confidence and currency markets is anybody’s guess, but it won’t be pretty.

As a result, an even weaker dollar is a strong possibility, which will further undermine the European and Japanese economies. And this is not a zero sum situation, with America’s gains equal to Europe’s losses: the uncertainty is bad for investment on both sides of the Atlantic, and if lack of confidence in the dollar leads to a shift out of American bonds and stocks, the American economy could be weakened further.

Europe is finally beginning to recognize the problems with its macro-economic institutions, particularly a stability pact that restricts the use of fiscal policy and a central bank that focuses only on inflation, not on jobs or growth. But there is a good chance that reforms will not come fast enough to lift the economy in 2005. China – and Asia more generally – represents the bright spot on the horizon. It may be too soon to be sure, but prospects for taming the over exuberance of a year ago appear good, bringing economic growth rates to sustainable levels that would be the envy of most other countries. By contrast, the world’s other major economies will probably not begin performing up to potential in the next twelve months. They are all caught between the problems of the present and the mistakes of the past: in Europe, between institutions designed to avoid inflation when the problem is growth and employment; in America, between massive household and government debt and the demands of fiscal and monetary policy; and everywhere, between America’s failure to use the world’s scarce natural resources wisely and its failure to achieve peace and stability in the Middle East.