Ahead of Alan Greenspan's testimony on Capitol Hill today, here's a Cassandrian update on possibly portentous economic news. On February 16 Greenspan pronounced himself puzzled that even as the Fed inches up short-term interest rates, the market insists on pushing long-term bond rates *down*. What the hell does this mean? Well, it could be a sign that investors are worried about the future of American finances. Bonds are usually considered a safe investment--they don't pay off spectacularly well, but they pay consistently. That long-term rates are *low* indicates that there is a high demand for these bonds--they sell well even at low interest rates. Hence investors may be looking to sock away money in safe place as a US--perhaps world-wide--economic decline seems more likely.
One of the reasons for pessimism is the slide of the US dollar against most other currencies. Foreign central banks, particulary those of Asia, help prop up the value of the dollar by buying up large numbers of them for their reserves. But as the dollar continues to slide, these banks effectively lose money they could have kept if they had held their reserves in other currencies. Recently the South Korean central bank announced that it was going to start to diversify its currency holdings by not purchasing more dollars. This led to fears in currency markets of a more general sell-off of dollars by Asian central banks, which would send the dollar's value through the floor. Nothing of this sort happened, but it is enough of a concern for the world economy that Asian central banks are setting up a 'discussion group' to talk about ways to stabilize the value of the dollar. The Australian Finance Minister said recently that he was worried about the increasing risk of a US financial meltdown, though the Australian PM discounted such fears as 'alarmist.'
So why would a collapse of the US dollar be a big deal? It could, for one thing, make US goods cheaper abroad and help reduce the trade deficit. Not such a bad thing, eh? But if the dollar tanks, suddenly investments in US, whether in new factories or in securities, are far less attractive. Running huge budget and trade deficts, the US depends on foreign investment to buy it's IOUs. If US investments were not very attractive because of sinking dollar, they could only attract capital by raising interest rates. That would hurt consumer credit spending and the real estate market, two sectors underpinning the US's current economic growth. So a falling dollar could send the US, and probably much of the rest of the world, into recession. Even if the Bush administration seems not to think that chain of events is likely, other governments seem to think it's a possibility worth planning for.