BERLIN — Foreigners will eventually sour on U.S. bonds and the dollar because of America's bulging trade and budget deficits, posing significant risks to the nation's economy, Federal Reserve Chairman Alan Greenspan said Friday in remarks that rattled financial markets.
Greenspan told a banking conference in Frankfurt, Germany, that international investors were likely to either unload their dollar-denominated investments or demand higher interest rates. Either scenario would present problems for an economy that is heavily dependent on foreign capital to fuel its free-spending ways.
Some countries have "defused" their trade deficits without significant consequences, Greenspan noted. But, he warned, "we cannot become complacent. History is not an infallible guide to the future."
The Fed chief's concern about the deficits is not new, but his remarks were interpreted by some traders as a warning that a day of reckoning was drawing closer. And they came against the backdrop of the dollar's continued weakness in international currency markets.
After Greenspan spoke, the dollar dropped to its lowest level against the Japanese yen in more than four years. The dollar also fell against the euro, which hit the highest point in its five-year history this week. The stock market fell sharply. The Dow Jones industrial average dropped 115.64 points, or 1.1%, to 10,456.91.
"Greenspan frightened the markets by raising the specter of a dollar panic," said Peter Morici, former director of the Office of Economics at the U.S. International Trade Commission.
The Fed chief also seemed to be practically guaranteeing higher interest rates, saying that investors who weren't hedged against a rise were "desirous of losing money."
Earlier this month, the Fed raised its benchmark short-term rate for the fourth time since June, to 2%. After the market digested Greenspan's latest comments on rates, which weren't part of his prepared remarks, yields on Treasury securities jumped. Another rate increase is expected at the Fed's next meeting Dec. 14.
But it was Greenspan's remarks on the dollar that sparked the most reaction.
The federal government spent $413 billion more than it raised through taxes in the fiscal year that ended Sept. 30. The current account deficit, the broadest measure of the nation's trade balance with the rest of the world, was a record $166 billion in the second quarter. The current account deficit is now approaching 6% of U.S. gross domestic product, another record.
Increasingly, the U.S. buys products from other nations, particularly China, but sells them relatively little in return. Foreign countries instead take their dollars and buy U.S. Treasury securities. These investments allow Americans to enjoy tax cuts, cheap imports and low interest rates in a time of war.
Even if the current account deficit stops increasing, Greenspan said in his speech, foreign investors are likely to realize they have put too many of their eggs in the dollar basket.
As a result, he said, they will "eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk."
As interpreted by Lehman Bros. chief economist Ethan Harris, Greenspan was saying what many economists and currency strategists have been saying recently: "The current account deficit is too big, and asking foreigners to lend us $600 billion a year to cover it is creating great risk for the dollar."
Harris, attuned to Greenspan's often-Delphic pronouncements, said he heard "a subtle language change" from the chairman's previous remarks on the subject.
"Before it was, 'There will be a day of reckoning but I don't know when,' " the economist said. "Now it's, 'There's going to be a day of reckoning and we're worried about it.' He's saying the market should worry now."
The Bush administration has been quietly supportive of the dollar's recent drop, which could shrink the trade deficit by making U.S. exports less expensive abroad and raising the price of imports. That's one reason almost everyone on Wall Street expects the decline to continue.
The question that divides them is whether the descent will be slow and orderly, or quick and panicky.
Joel Prakken, an economist with Macroeconomic Advisers, is in the first camp. "If you look around at the world's economies, there's really none better than ours," he said. "It's not like in the 1980s, when people thought the Japanese or the Germans were going to rule the world, and people wanted to invest in them."
Harry Chernoff, an economist with Pathfinder Capital Advisors, expects the situation to get more unpleasant.
"No nation in the history of the world has ever escaped this level of indebtedness -- annual and cumulative -- without a severe and totally involuntary adjustment," he said. "The only question is whether we manage our crisis into a catastrophe or whether the international financial community clamps down on us before we have the opportunity to make things even worse."