U.S. Debt Overseas Stirs up Trouble at Home BusinessWeek 562002

1
U.S. Debt Overseas Stirs up Trouble at Home
BusinessWeek (5/6/2002)

• Its Analysis Main Results

2
The most crucial structural problem facing the
U.S. economy was its huge trade deficit

• The huge trade gap reflected the result of
  overconsumption, as indicated by the low savings
  rate in the U.S.
• Due to the persistent trade gap, U.S. external
  debt continued to rise, and the country grew ever
  more dependent on foreign capital to finance its
  economic growth. Recent U.S. data showed that
  about 40 of the increase in capital investment
  was financed by foreign capital.
• The Fed chairman Greenspan warned that such a
  large trade gap could not continue to widen
  indefinitely. At some point, foreign investors
  might become less willing to hold
  dollar-denominated assets. This could set the
  dollar up for a hard landing.

3
A sharp fall in the dollar would not be in our
interests

• A steep slide in the dollar would be very
  negative for financial markets. To reduce losses
  in currency exchange, foreign investors would be
  compelled to cut their positions on
  dollar-denominated assets (including stocks and
  bonds). Global financial markets could then face
  considerable turmoil.
• With the instability in the dollar value, the
  U.S. would not be able to attract the capital
  inflows needed to finance its trade deficit.
• A steep decline in the dollar value would lead to
  significantly higher inflation in the U.S. as
  prices of imports rose. This would force the Fed
  to raise interest rate much higher and that could
  send the U.S. economy back into recession.

4
The renewed growth in the U.S. economy would add
to our trade deficit problem

• As the U.S. economy grew, interest rates would
  start to rise soon and that would support a
  stronger dollar. In anticipation, traders were
  enticed to increase their dollar positions, thus
  pushing the dollar value actually higher. A
  stronger dollar made U.S. goods less competitive
  in prices compared to foreign-made goods. This
  would hurt exports and encourage imports,
  resulting in an even larger trade deficit.
• As the U.S. economy got better, demand for
  imported goods (including consumer goods, capital
  goods, and raw materials) would rise, outpacing
  export growth. This would cause the trade gap to
  widen further.

5
The Fed faced a monetary policy dilemma

• The Fed could try to induce a gradual weakening
  of the dollar by delaying interest rate
  increases. However, this would lead to an even
  faster economic expansion, thereby causing import
  demand to soar. As a result, the U.S. trade
  deficit would still get larger, and the dollar
  would be put at a greater risk for a sharp
  correction later.
• On the other hand, if the Fed raised interest
  rates to moderate the economic expansion, the
  dollar would get much stronger. A stronger
  dollar would make U.S. goods more expensive on
  international markets. This would decrease
  exports and increase imports, further widening
  the trade gap.