- The Washington Times - Wednesday, January 19, 2005

Last week, the Department of Commerce reported that the monthly U.S. trade deficit soared to an all-time high of more than $60 billion in November — the seventh record-setting month in 2004. This means we’re buying a lot more from foreigners than we’re selling to them. Imports rose to $156 billion, while exports shrank to $95.6 billion.

When you look at the value of the dollar relative to the other currencies, it just doesn’t make sense. The dollar has been declining since 2002. The weaker the dollar, the cheaper American goods are to foreign buyers. By the same token, a weak dollar means that imported goods are expensive to the American consumer. In spite of this, the United States is still importing far more goods than it is able to export.

There is a myriad of opinions on the effect such a trade imbalance has on the economy. Some economists are predicting a recession, or worse. Other economists, such as the folks who work for the Bush administration, say the U.S. appetite for foreign goods is a testament to America’s economic strength.

Whatever your opinion on the effects of the imbalance, several public-policy observers are beginning to show concern about the trade deficit’s possible effect on U.S. interest rates. Let me explain.

The trade deficit is helping to keep interest rates low. Let’s say that China sells $100 of goods to the United States. In the same month, the United States sells China only $50 of goods. China ends up with $50 in U.S. currency.

Instead of exchanging the weak dollars, it invests the dollars in U.S. Treasury bonds. Do you see where I’m going with this? The trade deficit puts more dollars into the hands of foreigners who then buy Treasury bonds, increasing demand.

The ongoing demand for Treasury bonds is keeping the price of the bonds high and the yield down. Because long-term mortgage rates are similar financial instruments, they will move in the same direction. The trade deficit is helping to keep mortgage rates down, which in turn creates a strong housing and refinance market.

So what’s the problem?

The pessimists predict that the appetite for Treasury bonds in foreign markets eventually will dry up, regardless of the trade deficit. These folks charge that foreign central banks eventually will become satiated with U.S. Treasuries. Demand will fall, and a sell-off will occur.

Most analysts agree that such a scenario is unlikely. But, to quote Federal Reserve Board member Timothy F. Geithner, “the probability of these shocks may be low, but it is higher than it has been and higher than we should be comfortable with.”

Unlikely as it may be, a drop in foreign demand for U.S. Treasuries this year would be ill-timed. It’s a classic supply-demand situation. The United States is flooding the market with Treasury bonds to finance the budget deficit. If demand for Treasury bonds drops at a time when supply is high, prices would fall and their respective yields would soar. Bye-bye, low mortgage rates; hello, recession.

Still, other economists don’t seem worried about such an outcome. Productivity remains high, inflation is being kept at bay, and U.S.-backed investments remain among the safest on the planet.

Stay tuned.

Henry Savage is president of PMC Mortgage in Alexandria. E-mail your questions to henrysavage@pmcmortgage.com.

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