Fed chief shakes markets

Federal Reserve Chairman Alan Greenspan shook financial markets yesterday with a warning that foreign nations may tire of financing the huge U.S. trade and budget deficits.

The dollar, stocks and bonds all plunged after he told the European Banking Congress in Frankfurt, Germany, that the U.S. currency will keep dropping and interest rates will have to rise considerably to keep attracting the foreign funds needed to finance the deficits.

The U.S. budget deficit last year reached a record $413 billion and is projected to stay above $300 billion a year unless budget policies are changed. The trade deficit is running at $600 billion a year — nearly 6 percent of the nation’s economic output.

“Given the size of the U.S. current-account deficit, a diminished appetite for adding to dollar balances must occur at some point” among foreign investors who have accumulated trillions of dollars in claims against the U.S. government and residents by financing the debt, Mr. Greenspan said.

Private investors from around the world already pulled back in a big way when the dollar started falling precipitously a year ago, forcing central banks — primarily those of China and Japan — to step in to keep propping up the dollar and financing the deficits.

History shows that most countries have a preference for keeping their investments at home and will not continue to underwrite spending in the United States indefinitely, he said.

While the United States has detected only “limited” resistance in trying to finance the deficits so far, the Fed chairman warned against “complacency” because odds dictate that the unprecedented torrent of cash coming in from overseas will not continue.

Stocks fell after Mr. Greenspan’s warning, with the Dow Jones Industrial Average ending down nearly 116 points at 10,456.91.

Interest rates on short-term Treasury bills soared to a three-year high at a debt auction by the Treasury Department — the first since Congress Thursday night passed an $800 billion increase in Treasury’s borrowing authority to a record $8.14 trillion.

More than a quarter, or $2.23 trillion, of that debt has been accumulated since President Bush took office. The deterioration of the budget outlook — from $5.6 trillion of projected budget surpluses in 2001 to $2.3 trillion in debt today — is the steepest in modern times.

Action is needed to dramatically reduce the deficit and increase U.S. savings and investment so the U.S. economy is not so dependent on outsiders who may decide to withdraw their funds at any time, Mr. Greenspan said.

“Reducing the federal budget deficit, or preferably moving it to surplus, appears to be the most effective action that could be taken,” he said.

The alternatives — “inducing recession to suppress consumption” and investment — “obviously are not constructive long-term solutions,” he said.

Efforts to promote higher private savings rates “would be helpful,” although corporate savings in the United States already has risen to levels not seen in decades and is unlikely to increase substantially, he said.

Efforts by Congress and the administration in past years to increase personal savings through tax preferences — including the creation of 401(k) retirement accounts — have failed to raise the personal savings rate or even arrest its decline in recent years.

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