The Debt and Deficit Clocks Are Ticking

Greenspan warns U.S. on trade deficit threat

In remarks that roiled the financial markets, pushing the value of the dollar ever lower, Alan Greenspan warned that America's reliance on foreign capital poses a risk to the domestic economy.

The Federal Reserve chairman, in a speech at the European Banking Congress in Frankfurt, Germany, said foreign investors could grow tired of financing the U.S. current account deficit. That could lead them to unload their dollar-denominated assets, such as U.S. stock investments, and put their money in other countries.The amount of foreign investment flowing into the U.S. has a big impact on the health of the overall economy. If it sinks, the stock and bond markets could get hurt, interest rates could shoot up and the value of the dollar could extend a long downward spiral.

The current account deficit that Greenspan cited in his speech Friday is considered the best measure of a country's international economic standing.Like the trade deficit, it tracks goods and services, but also includes investment flows between countries. The deficit grew to a record $166.2 billion in the second quarter. For all of 2003, it was more than $500 billion.

Although Greenspan said there is little sign so far that overseas investors and central banks have lost faith in the U.S. economy, his warning rattled Wall Street and currency markets.The Dow Jones industrial average tumbled nearly 116 points, its largest decline in two months. The dollar dropped to 103.10 against the Japanese yen from 104.18 Thursday, and fell to $1.3020 per euro from $1.2961.

"Given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point," Greenspan said. "International investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk, elevating the cost of financing the U.S. current account deficit and rendering it increasingly less tenable."Although Greenspan didn't specifically address interest rates or the value of the dollar--"Forecasting exchange rates has a success rate no better than that of forecasting the outcome of a coin toss," he said--investors read between the lines."He's telling people rates are going to keep going higher and the dollar is going to keep going lower," Scott Gewirtz, co-head of U.S. Treasury trading at Deutsche Bank Securities in New York, told Bloomberg News.

As the trade deficit grows, more dollars leave the U.S. So far, foreign investors have recycled this money by buying U.S. Treasury securities--which finances the government's budget deficit--or stocks, corporate bonds and other dollar-denominated investments.The recycling has helped keep interest rates low and buoyed the stock market. Were overseas investors and central banks to reduce their buying or unload their investments, it would cause stocks and bonds to sink and interest rates to soar."Greenspan is saying that day might not be far down the road," said Ken Goldstein, an economist for the New York-based Conference Board, a private research group.Marc Pado, U.S. market strategist for investment firm Cantor Fitzgerald, said the growing deficit could "deter future investments," though he does not expect overseas investors to dump their current assets.The slide in the dollar has unnerved investors recently because it raises the cost of foreign goods, from Japanese cars to Canadian lumber to German pharmaceuticals.Gita Gopinath, assistant professor of economics at the University of Chicago Graduate School of Business, said a continuing rapid decline in the dollar's value "will have an inflationary effect on the economy."That's because more expensive imports allow domestic producers to raise prices, something that has been impossible for years because of competition at home and abroad.

A cheaper dollar does have some benefits. It has been good for U.S. manufacturers because it makes their products less expensive in foreign markets. That can help exports and narrow the trade gap.Manufacturing and agricultural exports, both important sectors of the Midwest economy, especially benefit, as do the jobs such exports generate."There has been a lot of talk about outsourcing labor overseas," said Pado. "A falling dollar works against that trend."Greenspan also said the Bush administration should work to reduce the country's budget deficit. "Reducing the federal budget deficit--or preferably moving it to surplus--appears to be the most effective action that could be taken to augment domestic saving," he said. Personal savings in the U.S. rose at a 0.4 percent annual rate in the third quarter, the lowest on record. (source: Chicago Tribune)

----------------
And yet, the debt ceiling was raised by the Republicans this week in their lame duck session. I guess many of our senators and congressmen don't read reports by the Fed very often.