In praise of agnostic opportunism: managing risk as the traditional economic paradigm breaks down.

Recently, a former U.S. G7 official (who now advises a veritable "who's who" of the world's top financial traders) offered over coffee a rather startling observation: "You know, in the years since leaving government, my biggest surprise is that the real traders out there--the big players who pull the trigger--ask so little about the U.S. current account and budget deficits. Fed policy? The Treasury and the dollar? The ECB? The BOJ? Iraq? Those top the list, but never the U.S. imbalances. Wall Street and Washington live in two separate worlds."

He's right. The U.S. budget and current account deficits represent for most mainstream thinking two stubborn, long-term problems. Those who maintain otherwise are the lunatic fringe, purveyors of policy quackery. After all, entire public policy and academic careers have been built around the premise that the evil twin deficits equal certain economic calamity: The theory: once the ballooning U.S. current account deficit becomes high enough, a vicious cycle sets in. International cap ital markets panic. The dollar free falls. The Federal Reserve ratchets up short-term interest rates, tanking the economy and thus furthering the dollar's weakening. The result: a downward spiral of uncontrollable madness.

Along the same lines, the domestic budget deficit represents just as deadly a threat. Close your eyes and imagine it's the year 2001. You are fore-warned that George W. Bush is about to completely lose control of the congressional spending process on top of a series of tax cuts. The budget deficit zooms to $500 billion. You must be assuming that by now soaring U.S. real interest rates are shutting down the economy as the ballooning deficit soaks up the final bit of savings to finance increased government borrowing.

You assumed wrong. The United States today despite the twin deficits enjoys the strongest economy in the industrialized world with historically low interest rates and inflation? And, in a curious way, this surprising development may have significant bearing on how the next Chairman of the Federal Reserve is chosen.

True, maybe it's all a matter of time before calamity strikes (and moreover nothing here is meant to suggest that huge budget deficits in particular are wonderful). But a couple of months ago, the dollar began a sudden surprise weakening against the euro? The G7's current account worriers, a lot of them European, went ballistic. But just as suddenly the dollar reversed this trend and began steadily strengthening. And what about the level of the current account imbalance? It remained unchanged the entire time. Another theory is that the doom and gloom will set in once the economy really takes off, but it's getting awfully late. We're already several years into recovery with some reasonably robust growth. Plus, the large European economies seem actually to be becoming weaker over the past year.

So if the traditional paradigm has broken down, the question is why most of the world's premier experts blew the call. One theory is that the policy world simply failed to appreciate how overwhelmingly powerful the United States is economically. U.S. Export-Import Bank President Philip Merrill wrote recently in this publication (Winter 2004) that as awesome as America's military might is as demonstrated during the recent Afghan and Iraqi wars, "the military power of the United States pales by comparison to its economic power." Merrill adds that while events unfolding in the Chinese economy may be exciting journalistically, with analysts describing the coming Chinese challenge to America, China today, size-wise in economic terms, represents roughly only three Hollands.

But it's not just size. Look at the major economies of the industrialized world and, with the exception of the United States, all remain slavishly dependent on exports as their main--if not only--dominant economic engine. As the world's major consuming economy, the United States finds itself in a distinctive position. Economic analyst Criton M. Zoakos points out that foreign economies have become so export-dependent on the United States that their pricing power vis-a-vis their U.S. customers has been significantly diminished. He also suggests that were their surpluses with the United States to vanish overnight, Europe and China today would be in deep recession. Japan would be experiencing close to zero percent growth.

Getting in on the act, the Federal Reserve on November 22, 2002, issued an important report suggesting that the fundamental global imbalance is not the U.S. current account deficit but the gap between Europe's and Japan's low rates of growth and return on capital as compared to those of the United States. In other words, greedy, all-consuming, non-saving Americans may not be appealing, but they are not the overriding cause of the imbalance: instead it's more the flood of foreign capital pouring in seeking higher rates of return and safety. The fact is, a significant part of the world needs America's markets both to sell to and to invest into. This is likely to be the case for quite a while--at least until the Chinese or Indian economies find themselves twenty times larger and significant global consuming forces. In the mean time, is it any wonder so many around the world hate being so dependent on America?

Notice how America's positioning has affected the workings of the G7 process. If you have followed international debt and foreign exchange markets closely in recent years, what's clear is that a lot of informal, behind-the-scenes "understandings" now exist. These understandings may be the force helping to break down the traditional economic paradigm. No, I'm not talking about awkwardly worded phrases written out in G7 communiques. These are simple, unspoken assumptions, Kabuki-style understandings in a system in which body language is often the main communicating tool.

Clearly, one of the new subtle body-language messages is that if you want a wide-open door to sell your goods in America, you had better buy the securities (read that U.S. Treasury securities). Another subset: if you want to manipulate your currency artificially against the dollar, you had also better buy the securities. Economist Milton Ezrati identifies (page 48) the emergence of a new "dollar bloc" which is leaving Europe at a disadvantage. In a lot of ways, the international trade debate has indeed been transferred to the financial world, what some have labeled the "new currency protectionism." But whatever it is, these subtle unstated understandings, while hardly anyone's original intention, have evolved into a fact of life for today's policymakers.

That is why the choice of the next Chairman of the Federal Reserve is perhaps significantly more complicated than in the past. Fred Barnes in his article (page 12) reports that the Bush high command admits to having done virtually no thinking about a successor to Alan Greenspan who retires in 2006. Alan Murray (page 16) reports that former Treasury Secretaries Robert Rubin and Lawrence Summers top the list for Senator John Kerry but adds that it is far from clear whether either policy heavyweight is available. This situation is troubling and it may be that the next President will have no choice but to ask the U.S. Senate to hold off thinking about confirming a replacement. Chairman Greenspan would be forced to stick around as caretaker through 2008 (a solution that would allow the winner of the 2008 presidential contest the sensible job of picking his or her own head of the central bank and having to live with the results).

Great policymakers know when to act and when sometimes to do absolutely nothing, to do no harm. That is the genius of Alan Greenspan. Rules are important but the rules, as he presciently has figured out, are forever breaking down at least in the short run which is probably the only time period that really matters. Therefore, the game is to manage downside risk. As for the evil twin deficits, they must be taken seriously, but not if that means setting in motion a series of off-the-shelf monetary and/or foreign exchange policy changes based on some no-longer-workable paradigm. In other words, sometimes it's best to stay loose and let the Kabuki dance run its course. Let body language do the talking.

The Next Fed Chief: Not the Time to Learn on the Job

It may be that the next President will have no choice but to ask the U.S. Senate to hold off thinking about confirming a replacement. Chairman Greenspan would be forced to stick around as caretaker through 2008 (a solution that would allow the winner of the 2008 contest the sensible job of picking his or her own head to the central bank and having to live with the results).

--DAVID M. SMICK Editor and Publisher, The International Economy