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Dollar's Dip Shows Greenspan in Denial

Peter Eavis

Editor's note: This is a special bonus column for TheStreet.com readers. Peter Eavis' commentary regularly appears on RealMoney.com. To sign up for RealMoney, where you can read his commentary every day, please click here for a free trial.

Just about everyone is worrying about the tanking dollar and the enormous U.S. trade deficit. So it's high time for Alan Greenspan, the nation's central banker, to step in and tell us how we might deal with the wilting greenback.

Instead, the Fed chairman has made a speech that will go down as the one of most flagrant pieces of self-serving tripe in financial history.

The markets slumped after taking in the speech, because investors thought they detected real alarm and concern about America's deficits in Greenspan's comments. But a close reading of the text betrays something far more serious that will steadily eat away at investors' confidence in this country and its currency. The problem starts with easy credit and Greenspan's refusal to acknowledge its many side effects.

The speech, given last Friday at the European Banking Congress in Frankfurt, clearly shows that Greenspan is refusing to deal with the root cause of the dollar's slide because his policies are the main reason for its decline. Now it very much appears that Greenspan will pull up short of doing what's necessary to fix the current account deficit, because it would mean admitting that he's created the mess that led to the blowout trade deficit.

Free Money

Since Greenspan almost never admits he's wrong, the Fed -- under him or one of his acolytes (he's likely to retire in early 2006) -- almost certainly isn't going to change course. This makes it increasingly likely that America will be laid low by the mother of all currency crises before long. It's incredible to think that in a governmental system known for its checks and balances, the pride of one man could cause the fall of the world's largest economy. But that's what we're looking at here, going by the central banker's Friday speech.

Greenspan couldn't wait much longer to give this speech, with the dollar having fallen to all-time lows against the euro -- the European currency climbed to $1.31 Tuesday -- and with the current account deficit at a record 5.7% of GDP in the second quarter (the most recent number available).

Clearly, the Fed chairman had to give the appearance of concern in this speech, or else the market would have reacted twice as badly as it did. And Greenspan's worry was what captured the headlines.

Quoted just about everywhere were these words of his: "Current account imbalances, per se, need not be a problem, but cumulative deficits, which result in a marked decline of a country's net international investment position -- as is occurring in the United States -- raise more complex issues." At first glance, that comes across as opaque central-bank speak, but it's Greenspan's way of saying that it is clearly a problem if America has to keep on borrowing larger and larger sums from foreigners to pay for the consumption and investment the U.S. hasn't got the savings to finance.

But the rest of the speech was artful dissembling. To see why, we must recognize what has led us to the mess we're in. The current account deficit has grown to a grotesque size and become such a worry to the world because Americans are consuming beyond their means. They're doing that on easy credit. And the reason that credit has been so easy is that Greenspan has kept interest rates at artificially low rates.

Haste Makes Waste

Current account deficits are not so much to be feared when foreigners are pouring investment dollars into the U.S. After all, that helps make American companies more productive, which means in the future they'll have the means to pay back the foreign financing.

That just isn't happening now. American companies have a small surplus of savings. But for the first time in decades, it is households that are in deficit, points out Paul Kasriel, chief economist at Northern Trust. (By deficit he means personal income minus expenditures on consumption and residential investment.) In addition, the government also has a deficit that has been mainly created by sharply higher defense, education and health care spending under Bush.

As a result, America is borrowing from abroad to finance spending by individuals and the government. Spending by these two adds almost nothing to the productivity of the economy, and that means America is less likely to generate the extra returns needed to repay foreign financing. The large inflows of foreign capital should not be seen as a vote of confidence in the U.S. economy by foreign entrepreneurs. Nor should they be seen as evidence that foreigners are happy to finance the deficit.

That's because foreign central banks have been doing a large portion of the buying, and they are only parking the dollars that have flooded into their reserves as America sucks in goods and services from abroad.

In the 12 months ending Sept. 30, foreign nonprivate net purchases of U.S. Treasuries totaled $214 billion, compared with $78 billion in the same period ending Sept. 30, 2003. By contrast, private foreign purchases of Treasuries inched up to $167 billion from $162 billion over the same period.

In his speech, Greenspan says this: "Even considering heavy purchases by central banks of U.S. Treasury and agency issues, we see only limited indications that the large U.S. current account is meeting financing resistance." But notice that Greenspan gives no numbers to make his case there. And it is absolutely the case that, without those central-bank purchases, the dollar would be a lot lower today.

Christmas in July

Greenspan did sort of acknowledge the two main causes of this problem: the fiscal and household deficits. He's been a fiscal conservative for a long time, so he's being consistent in his speech when he calls for a budget surplus. But when it comes to the unprecedented and deeply harmful household deficit, Greenspan merely tosses in this line: "Significantly increasing private saving in the United States ... of course would also be helpful." Absolutely no mention of the Fed's role in giving people an incentive to borrow like never before and run down the savings rate to current low levels.

Greenspan then says that he has faith in the markets to restore a sustainable U.S. balance of payments without crisis, citing a Fed paper that supposedly shows this happening in many Western countries since 1980. Problem is, many of the Western countries included in that paper did go through wrenching economic slowdowns in order to cut their trade deficits. What's more, very few of them had the sort of debt levels America now has, and likely none of them had interest rates as low as they are now in the U.S.

In other words, rates in the U.S. are going to have to go up in any adjustment -- and the impact on the debt mountain could be horrible. Indeed, during the last big current account adjustment in the U.S. rates rose sharply, prompting the 1987 stock market crash.

Greenspan also argues that because the U.S. economy hasn't skidded badly since 2001 in face of many shocks, it is strong enough to withstand a current account adjustment. But the main reason the American economy muddled through is that Greenspan slashed rates and shored things up with cheap credit. But it is that cheap credit that has caused the current account deficit to balloon. Take it away, and the current account deficit will decline -- but the economy will also stop in its tracks and debt defaults will be rampant.

In his speech, Greenspan asserts that "inducing recession to suppress consumption" is not a long-term solution. But it looks like the only one left -- because of him.