The place where the greatest danger lies is with Fannie Mae and Freddie Mac, the two giant government mortgage lenders. Their portfolios are now so large?in the trillions of dollars?that even the tiniest mistake by them could roil markets. Evidence that some of Fannie Mae?s managers may have been manipulating its finances for personal gain is reason enough to worry about what else may be going on there. That is one reason why Congress and the Bush Administration have been stepping up their oversight of Fannie and Freddie.
Another source of concern in financial markets is the impending retirement of Alan Greenspan as chairman of the Fed. Having served in this position for almost 20 years, an entire generation of bankers and bond traders have never know anyone else in this critical position during their professional lives. It is not known who his replacement will be, but even if the choice is excellent there is bound to be some financial unrest during the transition.
Lastly, there are the dreaded ?twin deficits? looming over financial markets. Huge budget and current account deficits mean that vast amounts of capital flows are necessary to keep them funded. So far, this has gone well, but that is largely because the Chinese have been so accommodating about financing them?effectively financing their own exports by buying large quantities of U.S. Treasury securities with their export earnings.
But now the U.S. is strongly pressuring China to stop doing this in order to allow its currency to rise against the dollar. It is hoped that this will reduce China?s production advantage in dollar terms and bring down the bilateral trade deficit. However, the cost to the U.S. economy if this happens could be greater than the potential gain. At least in the short run, any scale-back in China?s buying of Treasury securities might cause interest rates to spike very quickly. This could prick the housing bubble and bring down home prices, eroding personal wealth and putting a squeeze on those with floating rate mortgages.
Hopefully, this can all be managed smoothly and without either a recession or a market break. But it will take great skill and a lot of luck to avoid both.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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