Economy growing but falling dollar shows concern over debt

Despite the declining value of the dollar on world currency markets, at least one economist is optimistic about the short-term prospects for the U. S. economy. Last week, when the Federal Reserve raised interest rates, the dollar fell further against the euro and the Fed Chairman articulated concerns about growing deficits and trade imbalances, Dr. Sung Won Sohn said the economy is actually humming along and looks solid at least through 2005. Long term, however, he said the United States economy faces challenges that have serious consequences.

Speaking to a group of agri-business professionals in Minneapolis on Nov. 16, the eminent economist from Wells Fargo & Co., made two obvious observations. Dr. Sohn noted the price of oil is coming down and reminded the 600 of us in the audience that we got through the elections without a terrorist attack. “We are headed in the right direction,” he declared. Dr. Sohn said the economic growth rate for the country will come in at 4 percent for 2004 and will be about 3.5 percent for next year.

The economic fundamentals, he said, “are pretty sound.” Rising incomes are fueling increased levels of consumption. Income and spending, of course, are what make the economy go.

Dr. Sohn also said individual net worth is “very, very high.” It is averaging about five times annual income for most Americans. The question mark there is the degree to which that figure consists of real estate. On average, individual net worth is made up 34 percent with real estate. It is higher in places like New York and California. “So people worry about a real estate bust,” Dr. Sohn said. “That would be a national economic catastrophe.” He said, however, that he expects the real estate market to hold its value.

Interest rates have been inching up, Dr. Sohn acknowledged, but the effect of those increases is hardly negative. The Federal Funds rate, which is the rate the Fed changes directly, is now at 2 percent – still a historically low rate. This is the amount of interest the Fed charges banks when it lends them money overnight to balance their accounts. It ultimately affects all other interest rate pricing, like the prime, home mortgages and business loans. While the Fed Funds rate sat at 1 percent for most of the last year, the Federal Reserve was trying to stimulate the economy. It was being “accommodative,” as the economists like to say. But now the economy is improving and it no longer needs the Fed’s aggressive help; Dr. Sohn said the Fed is moving the interest rate toward “neutrality.” That is the rate at which it neither helps nor hurts the economy. Dr. Sohn said such a rate is between 3.5 percent and 4 percent; that is where he expects the Fed Funds rate to be by the end of 2005.

Dr. Sohn pointed out that at 78 years of age, Alan Greenspan is in the twilight of his tenure as Chairman of the Federal Reserve. His term is scheduled to end Jan. 31, 2006. Dr. Sohn said Greenspan is likely thinking about his legacy and does not want to close out a 19-year run with inflation out of check and rising interest rates retarding the economy. “Do you want to go out as the chairman who caused one more recession by raising interest rates too high when he went out?” Dr. Sohn asked. “No. That is one reason I think Greenspan is going to be very cautious raising interest rates.”

The Federal Reserve, however, is not the only influence on interest rates. Foreign banks, such as the Peoples Bank of China and the Bank of Japan, purchase huge amounts of Treasury bonds and U.S. securities. In fact, the U.S. needs to sell about $2 billion in such debt every day of the year to finance the budget deficit. Foreigners hold about half the country’s debt. That’s why the value of the dollar is so important. A dollar that is losing value means that investors around the world are willing to pay less for American currency. In order to attract those investors back to dollar-denominated securities, the Fed raises interest rates. When securities pay more, investors regain a desire to buy. But rising interest rates fuel inflation and make everything for Americans more expensive.

Although the dollars is falling against the euro and yen, countries like China and Japan remain willing to lend to the United States because Americans are the biggest purchasers of products made in their countries. If Japan and China were to back off from buying U.S. Treasuries, American interest rates would rise and Americans would buy fewer goods manufactured overseas (including China) and fewer Japanese cars. So the United States needs to keep borrowing to finance its deficit, and foreign countries need to keep lending to keep their economies going. It’s a dance that Dr. Sohn said may end in heartbreak.

“In the short run, it’s a win-win situation,” he said. “In the long run, clearly we have a problem. No nation can go on borrowing at a rate of $2 billion per day, 365 days per year. The Wall Street Journal calls this a moral issue. Is it right to pass this debt burden to our children and grand children? They will have to work more, perhaps 10 hours a day – four to pay debt and six for themselves. What do we do? I don’t know.”

If Greenspan indeed is winding down his career, he has a certain freedom to make bold proclamations during the remainder of his tenure. That may explain his comments in Frankfurt November 19 where he wondered aloud how long foreign investors would continue financing United States debt. The growing U.S. deficit is tarnishing the sheen on American investments. Greenspan spoke about the benefits of cutting the U.S. budget deficit, which at the end of fiscal year 2004 was $412 billion.

That deficit was one reason so many people were watching Congress over the weekend, when it approved a $388 billion spending bill. It was supposed to represent a reduction in spending, but the Associated Press reported the bill still found money for 11,772 home-district projects (sometimes referred to as “pork”) worth $15.8 billion.

The trick for American political and economic leaders will be to find ways to reduce the country’s debt while times remain good. The United States needs to send some signal that it is serious about reining in its debt. Inaction or clumsy bumbling could lead to serious economic trouble for the entire developed world.