by John M. Curtis
(310) 204-8700

Copyright November 20, 2004
All Rights Reserved.

iving another ominous sermon, Federal Reserve Board Chairman Alan Greenspan delivered his latest doom-and-gloom prophecy, warning markets about ballooning federal and trade deficits. Greenspan sees the dollar's slide, hitting new recent lows against the euro and Japanese yen, as causing a liquidity crisis, pushing foreign investors to bail-out of U.S. treasuries, federally insured investments and U.S. equities. Even with low yields, foreign investors park capital into U.S. investments as a safe harbor from global instability. Since the dollar devalued, U.S. holdings are no longer a secure place for foreign investors. When the dollar deflates, foreign investors get hurt, leading to mass liquidations. Greenspan fears a cash-crunch, causing interest rates to jump. “We cannot become complacent. History is not an infallible guide to the future,” warned Greenspan.

      All signs point toward a steady rise in interest rates, something that threatens today's fragile bull market, real estate and, yes, the overall economy. Since June 30, Greenspan has hiked the federal funds rate four times to 2%, not, as some would have you believe, to contain inflation but to (a) prop up the sagging dollar and (b) stop an exodus from U.S. treasuries. “Greenspan frightened the markets by raising the specter of a dollar-panic,” said Peter Morici, former director of the Office of Economics at the U.S. International Trade Commission, concerned that Greenspan's public remarks will drive a foreign stampede out of the stock market. Greenspan's comments to bankers at an economic summit Frankfurt caused a precipitous drop in the DOW and tech-rich Nasdaq. His concern about the dollar's devaluation eclipses worries about economic growth, including inflation.

      Tinkering with interest rates has always been the Fed's weapon for controlling inflation. Setting monetary policy, namely, playing with interest rates, are the levers with which the Greenspan either juices or mucks up the economy. Since 2001, Greenspan pushed the pedal to the metal, lowering interest rates to 45-year lows, hoping, as witnessed in recent months, to stimulate growth. Together with President George W. Bush's tax cuts, the economy still lumbered along, staggering out of a stubborn recession and sluggish economic growth. Until recently, the economy was stuck in neutral, failing to add enough jobs and expand at a brisk pace. Record federal budget and trade deficits now throw a monkey wrench into Greenspan's plans, forcing the Fed chairman to set monetary policy to stop the dollar's current freefall—yet hiking rates could torpedo economic recovery.

      When the U.S. trade deficit hit $166 billion, the dollar hit all-time lows against the euro and Asian currencies. China, in particular, with whom the U.S. has the largest trade deficit, holds billions of dollars in U.S. treasuries. With the dollar's slide, foreign investors are taking a beating, putting the brakes on future purchases of U.S. treasuries. When the stock market hit bottom in 2003, some economists worried about deflation, a kind of endless recession causing equity markets to contract. To combat this, Greenspan lowered rates, eventually pushing the federal funds rate to 1%. He could have taken it down further. When the gross domestic product responded, economists—and of course the White House—breathed as sigh of relief. But now, with Greenspan raising rates to stop the dollar's slide, economic recovery is in doubt. Should the stock market go down, all bets are off.

      Declining equity markets, sluggish economic growth, tax cuts and, yes, the costly war on terror, have contributed to record federal budget deficits. Now projected at $413 billion, any reversal in fortune, especially in the stock market, could have catastrophic effects. “No nation in the history of the world has ever escaped this level of indebtedness—annual and cumulative—without severe and totally involuntary adjustment,” said Harry Chernoff, an economist with Pathfinder Capital Advisors, warning about dire consequences of today's record deficits. Greenspan had to intervene against the dollar's slide to protect foreign investors, especially China from pulling the plug on U.S. treasuries. So far, China refuses to float its currency, worried that it would price itself out of the market. Despite its adverse effects, Europe has also done very little to bolster the dollar.

      Caught between a rock and a hard place, Greenspan has no choice but to continue hiking rates to prop up the sagging dollar. Neither China nor Europe has done much to help the weak dollar, leaving only the Fed to intervene. Greenspan walks a razor's edge trying to bolster the dollar at the peril of U.S. equity markets and overall economy. “The Chinese have created a Frankenstein's monster. If they go cold turkey and stop financing the deficit, the dollar will collapse and they'll lose their export market, which will mean riots in the streets,” said Morici, now an economic professor at the University of Maryland. With the war in Iraq costing untold billions, the White House has to rethink its ambitious plans and do its part to help the sagging dollar. Raising rates is bad medicine for the stock market and U.S. economy. But without fiscal discipline, Greenspan has no other choice.

About the Author

John M. Curtis writes politically neutral commentary analyzing spin in national and global news. He's editor of OnlineColumnist.com and author of Dodging The Bullet and Operation Charisma.

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