Speaker Pelosi,

First, I wanted to offer my congratulations regarding the recent election.  You were one of the architects of our victory, for which I and the American country as a whole are extremely grateful.

However, you will assume power at a very difficult economic time.  Below are the problems you face.  None offer easy answers.  In fact, solving these problems will cause a fair amount of pain and difficulty, which may harm our majority's future electoral prospects.

First I discussed the ruinous federal budget situation.  Below is a discussion of the trade deficit, which is just as dangerous.

The Trade Deficit

Although the trade deficit contracted last month, it is still on path to set another record this year.  To the uninitiated the trade deficit is a theoretical construct devoid of any real world application.  The reality is it is a very real situation that can cause serious harm to an economy.

The trade deficit means the US consumers more than it produces.  Here's a simple explanation.  Suppose you and your neighbor regularly buy and sell goods to and from one another.  You sell apples to your neighbor and your neighbor sells oranges to you.  However, you regularly buy more oranges from you neighbor than the apples your neighbor buys from you.  Therefore, on a monthly basis you have a net capital outflow - money going to your neighbor.  Where does this money come from?  Well first you draw down your savings.  However, your savings eventually runs out.  Therefore you essentially borrow money from your neighbor to pay for the excess oranges you buy.  At some point your neighbor will wonder when he's actually going to get paid for all the oranges he's sold you.  To compensate for his risk (the risk of not getting paid), your neighbor will eventually start to charge you a higher interest rate on the money he has lent you.  Eventually, your neighbor will call in all the notes he has lent you, forcing you to either pay the entire bill or declare bankruptcy.

Former Fed chairman Paul Volcker laid out the problem about a year and a half ago:

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 sense of 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.

Not a pretty picture is it - especially when the capital markets start to lose faith in the dollar?  That has already started to happen to a small degree.  Various central banks (China, Russia, Japan, South Korea, Taiwan and several smaller countries) around the globe have already started to diversify away from the dollar as their primary reserve currency, opting to create a portfolio composed of dollars, yen and euros.  There is - in essence - a giant game of international chicken going on right now as central banks attempt to get rid of any risk associated with a possible run on the dollar without they themselves causing the initial panic.  It's a difficult game that offers not easy solutions.

As with the budget deficit, there are no simple or easy answers to this problem in the short run.  However, in the long run there are some good possibilities and options.

Increasing energy independence will help.  As the Federal Reserve Bank of San Francisco recently noted:

Oil prices have almost quadrupled since the beginning of 2002. For an oil-importing country like the U.S., this has substantially increased the cost of petroleum imports. International trade data suggest that this increase has exacerbated the deterioration of the U.S. trade deficit, especially since the second half of 2004. One factor can explain this evolution: The real volume of U.S. petroleum imports has remained essentially constant. One explanation for why the demand for petroleum imports has not declined in response to higher prices comes from a model in which firms are fairly limited in their ability to adjust their use of energy sources, such as oil, in the short term.

Secondly, measures that will force China to allow its currency to rise to market rates will help to alleviate some of the problem with Chinese imports.  However, this is not a cure-all.  It will help, but it will not solve the problem.  A simple revaluation will lower the trade imbalance with China; it will not solve it.

Third, it is imperative we start to move from a consumption-based economy to a more balanced economy of production and consumption.  Currently, 70% of US GDP growth comes from consumer spending.  This has resulted in policies that promote consumption at the expense of savings.  The US savings rate has been negative for the last 5 quarters.  Therefore, policies that promote savings will slow consumer spending, which will in turn lower consumer consumption, which will in turn lower the trade deficit.  This will lower overall GDP growth in the short-term.  However, it will also allow the US to build-up savings reserves.  This will increase banking reserves increasing the pool of capital banks have available to lend.  This will help to lower interest rates, encouraging business borrowing which will increase our productive capacity.

Finally, we must develop policies that promote the creation of business that increase our exports.  There are several areas that come to mind: alternate energy, nano-technology and stem cell based business.  (I am sure there are countless others; however, these three spring to mind).  These are businesses that play to American's technical know-how and which our sophisticated capital markets can finance.

None of these proposals will solve the problem overnight.  In fact, these are policy answers that will require up to a decade to successfully implement.  However, they will help to gradually lower the problem.  It will take discipline and concerted effort.  However, if you implement them they will solve the basic problem and take downward pressure away from the dollar.