- The Washington Times - Wednesday, May 31, 2006

Goldman Sachs Chairman Henry M. Paulson, the Wall Street heavyweight named U.S. Treasury secretary by President Bush, faces big challenges in improving the administration’s ratings on managing the economy while preventing a fall in the dollar that would damage growth.

The administration receives low approval in public opinion polls on the economy, despite robust growth of 5.3 percent at the beginning of the year and a steep decline in the unemployment rate to less than 5 percent.

Largely because of skyrocketing gasoline prices and relatively slow growth in wages, only two out of five consumers currently rate the economy as good or excellent, according to recent polls.

The sharp run-up in gas prices this spring to more than $3 a gallon prompted a big drop in consumer confidence this month, according to a report from the Conference Board published even as Mr. Paulson’s nomination was being announced at the White House.

The report dispirited financial markets and helped cause a 184-point plunge in the Dow Jones Industrial Average as investors worried that high energy prices will force consumers to cut back on spending in other areas and cause a big pullback in growth.

Mr. Bush has been dogged by high energy prices since 2003, and they are due in part to his policy of confronting major Middle Eastern producers with the war in Iraq and this year’s nuclear standoff with Iran.

Those battles have prevented development of the world’s second- and fourth-largest petroleum reserves at a time when strong economic growth in the U.S. and China is pushing up the demand for fuel.

With the dark cloud of high energy prices hanging over the economy, it will be hard to turn around the mood of the public this late in the president’s term, analysts say.

“The longer the United States remains at war, the greater the prospect for even higher energy prices,” said Joseph Quinlan, chief investment strategist at Banc of America Capital Management.

He said the heightened atmosphere of “geopolitical risks” caused by the Middle Eastern confrontations has prompted a flight by investors to hard assets like gold, copper and zinc as well as oil, and has driven up the prices of these commodities. The run-up in commodities prices, in turn, has raised inflation in the United States and elsewhere, and is forcing central banks to aggressively raise interest rates.

All this has contributed to the consumer malaise, as the growth in wages has barely kept up with the growth in inflation generally and soaring energy prices, in particular, analysts say.

At this point, Mr. Quinlan pointed out, the unpopularity of the war in Iraq is causing both economic and political fallout.

“The Republicans’ grip on power has slipped” and the GOP’s prospects in the fall congressional elections is uncertain. It will be a tall order for the president and Mr. Paulson to turn that around.

The surging price of oil has driven up the cost of oil and gasoline imports and contributed to another major problem confronting Mr. Paulson: the nation’s $800 billion trade deficit. The United States must attract financing for these yearly deficits from overseas investors, since Americans do not save enough to finance them on their own.

The Treasury is itself the world’s largest debtor, auctioning off an average of $7 billion in debt securities a week, and it will be Mr. Paulson’s task to keep the flow of financing coming into the country, analysts say. That will be all the more difficult because the dollar has been in decline this year and is making investment in the U.S. less attractive for investors in Europe and Japan whose currencies are on the rise.

Since a dollar that is too strong will encourage consumption and keep adding to the trade deficit, and a dollar that is too weak poses threats to growth and inflation, it will be a difficult balancing act for Mr. Paulson, one that Jay Bryson, international economist at Wachovia Securities, said he is well-qualified to perform.

“The United States is clearly very integrated into the world economy,” he said.

“In our view, it is important for a modern Treasury secretary to have Wall Street experience because that experience gives individuals keen insight into the interdependence of the U.S. economy with the rest of the world.”

Mr. Bryson does not expect Mr. Paulson to have trouble attracting foreign investors, although he said mounting U.S. deficits are unprecedented and unsustainable in the long run. They eventually will cause a significant decline in the dollar, slower growth and other economic adjustments, he said.

Any precipitous fall in the dollar “could be dramatic and painful,” like the financial crises that sent Argentina and Russia into deep recessions in the late 1990s — but much bigger than that, Mr. Bryson said.

National Association of Manufacturers President John Engler said he expects Mr. Paulson will be able to orchestrate continued growth in the United States as well as a lower value of the dollar that will help to trim the bloated trade balance.

Mr. Quinlan said the future does not lie entirely in U.S. hands, however. He noted that a disproportionate amount of deficit financing has come in recent years from developing countries like China, Saudi Arabia, Iran and Venezuela, most of which take a dim view of the Iraq war they currently are helping to finance.

With 70 percent of currency reserves now in the hands of these nations — mostly in dollars — they have a “potential geopolitical weapon pointed straight at the United States” and could drive the dollar down sharply if they start dumping their dollar reserves. Developing countries already have moved to reduce their dollar holdings by 10 percent since 1998, he said.

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