South-Western College Publishing - Economics  
A New Concern at the Fed
Subject Foreign Debt
Topic International Finance
Key Words

Foreign Debt and Interest Rates

News Story

Fed chairman Alan Greenspan and his Fed colleagues may be changing their previously stated position with respect to the effect of foreign debt on the U.S. economy. When considered along with the record U.S. budget deficit, growing foreign debt appears to worry them more now than in the past.

Currently the U.S. federal budget deficit continues to grow; it hit $413 billion in 2004. The nation also faces a low and falling national savings rate and a huge trade and financial deficit with the rest of the world. We import far more goods than we export, and foreigners hold much of our foreign debt in the form of U.S. Treasury securities.

Chairman Greenspan noted in November that foreign claims on U.S. assets--basically the country's net indebtedness to the rest of the world - reached one-quarter of the nation's gross domestic product in 2004. Government reports predict that, if the current trend continues, the trade deficit this year is almost certain to exceed $600 billion. Should that number become a reality, it would represent nearly 6 percent of the U.S. economy.

This figure, when coupled with other national imbalances (such as the large and growing national trade deficit) has given Mr. Greenspan reason to reflect. "This situation suggests that international investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk," Mr. Greenspan said. He further stated that such action on the part of foreign investors would make the cost of foreign debt "increasingly less tenable."

In economic terms, this is a restatement of a time-honored truth: Any borrower who runs up large debts becomes a bigger risk to lenders and will eventually have to pay higher interest rates for the privilege of borrowing. In other words, Greenspan is warning that rising budget and trade deficits come with a price - higher interest rates.

In the published minutes of the Fed's policy meeting of December 14, other Fed members' concern is evident. The minutes stated, "a number of participants voiced concerns about domestic and global financial imbalances." Furthermore, some members of the Federal Open Market Committee (FOMC), which sets Fed policy, indicated that the odds of "significant deficit reduction over the next few years were remote."

These growing imbalances in important economic variables may just end the honeymoon between the Federal Reserve and the Bush administration. Recent Fed policies have been supportive of the administration, but the new rumblings coming out of the Fed seem to be warning the administration that it needs to work harder on reducing deficits on both the trade and budget fronts, both at home and abroad.

Questions
1.

Using any source available, find out who the members of the Open Market Committee of the Fed are.

2. Mr. Greenspan suggests that foreign investors may "adjust" their holdings of dollar-based assets. Which way do you think they will adjust and what effect would this have on the U.S. economy?
3. If "significant deficit reduction" is not achieved, what policy steps do you think the Fed will take?
Source Edmund Andrews, "Deficits May be Wearing Thin at the Fed," The New York Times Online, January 23, 2005.

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