Nov. 15 (Bloomberg) -- Americans' appetite for imported goods and the Bush administration's penchant for spending more than it takes in are heightening the risk of a further decline in the dollar, a rise in interest rates and slower economic growth.

Concern among economists is intensifying because the U.S. trade deficit, a record $496.5 billion last year, is forecast to keep growing. The trend is surprising economists such as Edward McKelvey of Goldman, Sachs & Co., who thought a decline in the dollar would shrink the gap by making imports more expensive and U.S. exports cheaper. The dollar has fallen 18 percent since 2002 against a basket of six major currencies.

The $120 billion spent so far on the Iraq war, along with borrowing to finance highways and Social Security, is prompting experts including former Treasury Secretary Robert Rubin to wonder if foreigners may lose confidence in U.S. investments. Losing the $2 billion the U.S. attracts daily from central banks and overseas investors might create a "debt maelstrom," Federal Reserve Chairman Alan Greenspan said in September.

"If markets begin to fear long-term fiscal disarray and if foreign providers of the capital inflows we are now so dependent on share this fear and also become concerned about our currency, then the markets may begin to demand sharply higher interest rates for long-term debt, with all the problems that may lead to for markets and our economy," Rubin, chairman of the executive committee at Citigroup Inc., said in a Nov. 8 speech.

Harvard University professor Kenneth Rogoff, former chief economist at the International Monetary Fund, says the dollar is likely to fall another 15 percent to 20 percent on a trade- weighted basis over the next two years. Should the markets overshoot, as Rogoff said often happens, the U.S. currency risks plunging 30 percent to 40 percent. The fallout would send interest rates and inflation higher and bring on recessions in Europe and Japan, which are dependent on exports to the U.S.

Projected Deficits

Goldman Sachs expects the U.S. trade deficit to reach $613 billion this year and top $670 billion in 2005. The current account deficit, the broadest measure of trade because it includes the interest on investment flows, grew to a record $166.2 billion in the second quarter, equivalent to 5.7 percent of the nation's $11.6 trillion economy.

Goldman Sachs predicts the current account imbalance will reach $759 billion in 2005, up from a projected $663 billion for 2004. The U.S. government wrapped up its fiscal year on Sept. 30 with an unprecedented $413 billion budget shortfall.

Worst-Case Scenario

The deficit may increase as some 77 million baby boomers retire between now and 2030 and there are fewer workers to pay Social Security taxes. President George W. Bush said after winning re-election that he is considering changes to the Social Security retirement system.

"The fiscal deficit is a very good reason to dump U.S. assets this minute," Laurence J. Kotlikoff, chairman of the Boston University economics department and author of "The Coming Generational Storm: What You Need to know About America's Economic Future," said in an interview. "The long-term implicit debt is $51 trillion," including the long-term costs of Medicare, Medicaid and Social Security. "That's what really worries me, the unofficial implicit debt."

Greenspan warned in testimony before the House Budget Committee on Sept. 8 that the record budget deficit was a "problem of potential instability."

"We must not even get close to those types of scenarios because if you get into that sort of debt maelstrom, it is a very difficult issue to get out of," Greenspan testified.

Minutes of the Fed's Sept. 21 policy meeting released last week described the current account deficit as "worrisome."

`Unstable' Situation

The nation's low savings rate and fiscal deficit create an "unstable" situation, Fed Governor Edward Gramlich said in a Nov. 13 speech at the University of Michigan. "If we were any other country in international history, it would have long ago been stopped," Gramlich said.

Rogoff says such worst-case scenarios are unlikely, in part because the U.S. still is growing faster than other economies and as such remains able to draw investment from foreigners. The question, he said, is how rapidly the current account gap will shrink once it begins falling.

Rogoff now expects the dollar to decline by twice the 15 percent that he and Maurice Obstfeld, an economics professor at the University of California at Berkeley, laid out in a paper two years ago and updated last month.

"We looked at the problem in 2002, and we think it's gotten worse," Rogoff said.

On Nov. 12, the dollar fell the most in five weeks against the yen and weakened against the euro. The Commerce Department released figures two days earlier showing that the U.S. trade deficit -- the gap between what the country buys from abroad and what it exports -- was $51.6 billion, the third-widest ever. The dollar briefly fell to $1.30 against the euro, its lowest ever.

Losing Ground to Imports

Goldman Sachs estimates that the trade deficit exerted a "drag" on U.S. economic growth of about 0.6 percent in 2004 and will hold down growth by 0.2 percent in 2005.

U.S. industries such as agriculture and automaking are continuing to lose market share, said Matthew Slaughter, an economics professor at the Tuck School of Business at Dartmouth University in Hanover, New Hampshire. General Motors Corp. and Ford Motor Co. lost ground to import brands in October. In June and in August, the U.S. imported more food products than it exported for the first time since 1986.

Oil, which soared to a record $55 a barrel in October, is only part of the reason, Goldman Sachs' McKelvey said.

Catherine L. Mann, a former Fed staff economist and now at the Institute for International Economics in Washington, cites other reasons the trade deficit persists.

Depreciation Not Uniform

Much of the dollar's depreciation since 2002 has been against the euro and hasn't affected the currencies of most of Asia -- and especially China -- where so much of what American consumers buy is made, she said.

Also, U.S. consumers, buoyed by tax cuts, the lowest interest rates in 40 years and cash from refinancing their home mortgages, stayed on a spending binge through the recovery from the 2001 recession, while consumers in Europe and much of Asia remained hesitant. "There's been a lot of impetus going into import-buying, while demand for U.S. exports hasn't been all that strong," Mann said.

On Friday, Japan said its economy expanded at a 0.3 percent annual rate, less than the 1.1 percent rate in the previous quarter. Economic growth in the 12-nation euro region slowed in the third quarter to 0.3 percent after expanding 0.5 percent in the previous three months. The U.S., by contrast, grew 3.7 percent at an annual rate in the third quarter. It expanded 3 percent last year and is forecast to grow 4.3 percent in 2004.

Few Options for Bush

At the same time, the dollar remains high against currencies such as the Japanese yen and the Chinese yuan, denying U.S. exporters an edge they would have received had those currencies risen. The yuan is fixed at 8.3 to the dollar. The U.S. Treasury Department has said it is confident the Chinese will soon allow the yuan to rise.

President Bush has few options to help bring the trade deficit down.

One would be to reduce the budget deficit, which adds to U.S. savings and relieves the government from having to borrow so much from abroad. Another would be to encourage a further decline in the value of the dollar, something McKelvey said may be risky should the currency slide too rapidly.

A third would be to encourage U.S. trading partners to stimulate more demand in their own countries, in hopes of spurring sales of U.S. exports. Treasury Secretary John Snow made such a pitch at the last meeting of the Group of Seven industrial nations' finance ministers.

Deficit Keeps Growing

After the dollar's 30 percent decline against the currencies of U.S. trading partners between March 1985 and March 1988, the trade deficit shrank to $31.1 billion in 1991, from a peak of $151.7 billion in 1987.

McKelvey said that a decline in the value of the dollar makes the trade deficit increase initially, as import prices rise, bloating the value of goods from abroad. After 18 months or so, consumers cut back on purchases of imported goods and the trade deficit begins to shrink. When that happens, the current account begins to narrow.

This time, the trade deficit has kept on growing.

"We thought we'd see more by now than we have, but we really don't have a significant improvement," McKelvey said.

Economist Mann dismisses predictions that continuation of the U.S.'s current account deficit will eventually scare away investors. "You have to ask the question, where are the investors going to put their money instead?" she said. "It's very hard to spin a scenario that makes other parts of the world look more attractive than the United States."

Stephen S. Roach, chief economist at Morgan Stanley & Co. in New York, says "the pressures are building for a major adjustment" next year. "That's what the recent decline in the dollar is all about," Roach wrote in a Nov. 12 letter to clients. "Global imbalances have now gotten to the point where something has to give."

To contact the reporter on this story:
Art Pine in Washington at  apine@Bloomberg.net.

To contact the editor of this story:
Kevin Miller at  kmiller@bloomberg.net.

Last Updated: November 15, 2004 00:14 EST

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