Dear Crowne Gold Clients;

By Paul A. Volcker
The Washington Post
Sunday, April 10, 2005

http://www.washingtonpost.com/wp-dyn/articles/A38725-2005Apr8.html

The U.S. expansion appears on track. Europe and Japan may lack
exuberance, but their economies are at least on the plus side. China
and India -- with close to 40 percent of the world's population --
have sustained growth at rates that not so long ago would have
seemed, if not impossible, highly improbable.

Yet, under the placid surface, there are disturbing trends: huge
imbalances, disequilibria, risks -- call them what you will.
Altogether the circumstances seem to me as dangerous and intractable
as any I can remember, and I can remember quite a lot. What really
concerns me is that there seems to be so little willingness or
capacity to do much about it.

We sit here absorbed in a debate about how to maintain Social
Security -- and, more important, Medicare -- when the baby boomers
retire. But right now those same boomers are spending like there's
no tomorrow. If we can believe the numbers, personal savings in the
United States have practically disappeared.

To be sure, businesses have begun to rebuild their financial
reserves. But in the space of a few years, the federal deficit has
come to offset that source of national savings.

We are buying a lot of housing at rising prices, but home ownership
has become a vehicle for borrowing as much as a source of financial
security. As a nation we are consuming and investing about 6 percent
more than we are producing.

What holds it all together is a massive and growing flow of capital
from abroad, running to more than $2 billion every working day, and
growing.

There is no sense of strain. As a nation we don't consciously borrow
or beg. We aren't even offering attractive interest rates, nor do we
have to offer our creditors protection against the risk of a
declining dollar.

Most of the time, it has been private capital that has freely flowed
into our markets from abroad -- where better to invest in an
uncertain world, the refrain has gone, than the United States?

More recently we've become more dependent on foreign central banks,
particularly in China and Japan and elsewhere in East Asia.

It's all quite comfortable for us. We fill our shops and our garages
with goods from abroad, and the competition has been a powerful
restraint on our internal prices. It has surely helped keep interest
rates exceptionally low despite our vanishing savings and rapid
growth.

And it's comfortable for our trading partners and for those
supplying the capital. Some, such as China, depend heavily on our
expanding domestic markets. And for the most part, the central banks
of the emerging world have been willing to hold more and more
dollars, which are, after all, the closest thing the world has to a
truly international currency.

The difficulty is that this seemingly comfortable pattern can't go
on indefinitely. I don't know of any country that has managed to
consume and invest 6 percent more than it produces for long. The
United States is absorbing about 80 percent of the net flow of
international capital. And at some point both central banks and
private institutions will have their fill of dollars.

I don't know whether change will come with a bang or a whimper,
whether sooner or later. But as things stand, it is more likely than
not that it will be financial crises rather than policy foresight
that will force the change.

It's not that it is so difficult intellectually to set out a
scenario for a "soft landing" and sustained growth. There is a wide
area of agreement among establishment economists about a textbook
pretty picture: China and other continental Asian economies should
permit and encourage a substantial exchange rate appreciation
against the dollar. Japan and Europe should work promptly and
aggressively toward domestic stimulus and deal more effectively and
speedily with structural obstacles to growth. And the United States,
by some combination of measures, should forcibly increase its rate
of internal saving, thereby reducing its import demand.

But can we, with any degree of confidence today, look forward to any
one of these policies being put in place any time soon, much less a
combination of all?

The answer is no. So I think we are skating on increasingly thin
ice.

On the present trajectory, the deficits and imbalances will
increase. At some point, the confidence in capital markets that
today so benignly supports the flow of funds to the United States
and the growing world economy could fade. Then some event or
combination of events could come along to disturb markets, with
damaging volatility in both exchange markets and interest rates.

We had a taste of that in the stagflation of the 1970s -- a volatile
and depressed dollar, inflationary pressures, a sudden increase in
interest rates, and a couple of big recessions.

The clear lesson I draw is that there is a high premium on doing
what we can to minimize the risks and to ensure that there is time
for orderly adjustment. I'm not suggesting anything unorthodox or
arcane.

What is required is a willingness to act now -- and next year, and
the following year, and to act even when, on the surface, everything
seems so placid and favorable.

What I am talking about really boils down to the oldest lesson of
economic policy: a strong sense of monetary and fiscal discipline.
This is not a time for ideological intransigence and partisan
posturing on the budget at the expense of the deficit rising still
higher. Surely we would all be better off if other countries did
their part. But their failures must not deflect us from what we can
do, in our own self-interest.

A wise observer of the economic scene once commented that "what can
be left to later, usually is -- and then, alas, it's too late." I
don't want to let that stand as the epitaph of what has been an
unparalleled period of success for the American economy and of
enormous potential for the world at large.

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The writer was chairman of the Federal Reserve from 1979 to 1987.
This article is adapted from a speech in February at an economic
summit sponsored by the Stanford Institute for Economic Policy
Research.

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