What a Week: Greenspan Trips the U.S. Dollar

Although the U.S. is unlikely to default on its debt as emerging-market borrowers have in the past, drastic changes will be needed as the country runs out of credit abroad.

"The adjustment -- likely both a recession and/or a sharp fall in the dollar and/or a sharp increase in real interest rates -- needed to stabilize the U.S.' external debt-to-GDP ratio would feel like a crisis," Roubini and Setser wrote.

Some argue that the dollar will never crash because so many investors around the world are attracted to U.S. companies which are in many cases more efficient and profitable than competitors elsewhere. It's a red herring, as foreign investment in U.S. equity is but a sliver of overall foreign investment in dollars.

In 2003, for example, foreign investors liquidated a net $63 billion of equities while buying $242 billion of debt securities. And that's in large measure because the financing load has been carried more and more by foreign central banks eager to weaken their own currencies relative to the dollar to spur exports. Central banks held $934 billion of the $3.4 trillion of Treasuries outstanding at the end of 2003 and are projected to own $1.2 trillion of $4.3 trillion at the end of this year.

It's a trend that can't continue to keep up with U.S. borrowing needs even if the foreign central banks wanted to continue their currency manipulations. China and Japan would have to add $350 billion a year for the next four years to keep the U.S. afloat, Roubini and Setser wrote.

Greenspan didn't offer much policy advice in his speech Friday except a throwaway line that the government ought to reduce its budget deficit.

Before he steps down in 2006, maybe he'll reveal if there's any more he knows that he ain't said.

Then again, the current dollar crisis can in many ways be tracked back to Greenspan's constant decision to add liquidity after economic shocks, as Street Insight contributor Allen Gillespie noted on Friday. All those interest rate cuts helped fuel the Internet bubble and the long-running rallies that continue in bonds and housing.

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