Monday, January 02, 2006

Volcker: U.S. Economic Crisis Imminent

Former Fed Chairman Paul Volcker said he doesn't see how the U.S. can keep borrowing and consuming while letting foreign countries do all the producing. It's a recipe for American economic disaster and Mr. Volcker thinks a crisis is likely. Volcker believes that investor confidence could fade "at some point," he said, with "damaging volatility in both exchange markets and interest rates."

Story Continues Below

Volcker believes a serious economic crisis is likely unavoidable as the U.S. economy is struggling with what he sees as a hopelessly unsustainable relationship with the rest of the world. "If I were a biologist I'd call this a perfect example of symbiosis," Volcker said during a 2005 speech at Stanford University.

"Contented American consumers matched against delighted foreign producers. Happy borrowers matched against willing lenders. The difficulty is, the seemingly comfortable pattern can't go on indefinitely."

Experts seem to agree that the current situation can't last. But will there be a smooth and manageable rebalancing of the global economy - created by a slow drop in the dollar combined with a spike in foreign demand – or will the U.S. currency suddenly collapse, with skyrocketing interest rates that lead us into a global recession?

Volcker believes a crisis is unavoidable, and he claims that investors will lose their confidence "at some point," creating serious dilemma for "both exchange markets and interest rates." As the United States faces the threats of a potential housing bubble, a massive trade deficit and the lowest level of American savings in history, the jury is out on the Federal Reserve's actions over the past five years.

The Wall Street Journal reports that while the Fed acknowledges that its response to the 2000 Dot-Com crisis is partly to blame for current economic conditions, it claims it had no other viable course of action. The Fed slashed interest rates, and Congress provided extreme tax cuts giving American households unprecedented buying power. While the government's response did help the U.S. economy grow, it also created immense debt.

To alleviate this problem, at some point, U.S. consumers will have to curb spending and concentrate on saving – plus the economy will be forced to forego foreign investment.

Experts agree that the reaction to the economic problems after 9/11 took the country into uncharted territory. While many say the Fed's rate cuts and President Bush's tax initiatives were the right answer for recovery, no one can be sure.

"We have done what no other economy has done before, faced with an asset bubble," says Lawrence Lindsey, a one-time Fed governor and Bush adviser. "This is the first time in history the textbook economic policy ... was used, and worked. The problem is, once you finish that chapter of the economic texts, you turn the page and the page is blank - because no one has gone through the process before."

Some economists warn that the Fed has simply replaced the Dot-Com bubble with a housing bubble that is ready to burst, draining consumer spending, driving foreign investors away from U.S. markets and nurturing numerous other conditions that could lead to a serious recession.
Says Volcker: "I think we are skating on increasingly thin ice. On the present trajectory, the deficits and imbalances will increase.

"At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States and the growing world economy could fade. Then some event, or combination of events, could come along to disturb markets ..."

By contrast, Volcker's successor is perhaps a bit less circumspect. He said, "The number of forecasts of crises ... is far in excess of the number of crises that actually occur. There is something equivalent to an invisible hand which continuously is readdressing market imbalances to reach equilibrium."

Volcker, however, doesn't have as much faith in market forces, which oddly enough brings him to the conclusion that Greenspan and the Fed are doing the right thing by raising interest rates to hold down inflation.

The former Fed chairman thinks we need to make sure foreign investors hold their confidence in the U.S. because they're the ones doing all the investing. They need to know "those trillions of dollars they are piling up are going to be protected against inflation."

No comments: