It might do so by requiring a larger capital inflow (and thus a larger current account deficit) to make up for the shrinkage in domestic saving relative to investment caused by the growing budget deficit.

When domestic saving is inadequate to finance planned investment, investment must shrink to the savings available, or the saving must be imported from abroad via a larger capital inflow financing a larger current account deficit. The imbalances will affect and be affected by many economic variables, but the impact of the exchange rate on the current account balance is surely a principal one. Since a growing budget deficit seems inexorable, the needed saving will put upward pressure on domestic interest rates and upward pressure on the exchange rate.

Other things equal, a stronger dollar will weaken our current account balance by making imports cheaper and our exports more expensive. Bottom line: the budget deficit may strengthen the dollar. It doesn't seem right, does it?

If you are not convinced, lets start over and approach it as follows.

Without having to resort to numbers, I think we can all agree on the following:

*Consumers are stressed and will be hard pressed to increase personal saving substantially.

*The budget deficit is in the process of an historic explosion-increasing the negative saving coming from the government sector.

*National saving from those two sources is in a sharp decline.

*Other than pulling down investment drastically to match the shrunken saving, we need to borrow more saving from abroad to supplement domestic saving.

*We get more foreign saving by running larger current account deficits, which are financed by larger capital inflows. Those larger capital inflows are what we need.

*Greater capital inflows respond to many economic variables, but mainly they finance the current account deficit.

*To attract more foreign capital, we need to run a larger current account deficit.

*The main way to get an increase in the current account deficit is for the dollar to appreciate and become less competitive, i.e., stronger and for domestic interest rates to rise.

*The need for more saving, made much more acute by the budget deficit, will put upward pressure on the dollar.

*Therefore, the budget deficit will strengthen the dollar.

The national saving rate is composed of the personal saving rate, the business saving rate, and the government saving rate. The personal saving rate is disposable income minus consumption; government saving is equal to its budget surplus. A budget deficit represents negative saving by the government.

What happened in May was that the government increased its budget deficit (increased negative saving), borrowed the money, and paid it to individuals as part of the stimulus package. Since individuals saved less than 100 percent of their higher income, they added less to saving than the government subtracted from it.

Assuming no offsetting increase in business saving, the national saving rate declined in May. Chances are, however, that business saving declined as well. If so, the decline in national saving was even greater.

A decline in national saving will necessarily be matched by a decline in national investment if it isn't made up by more saving imported from abroad. We import foreign saving by running a larger current account deficit, which requires an equally larger capital inflow to finance it. For many years now, we've had to supplement domestic saving with foreign saving to finance domestic investment. This runs up our total debt owned by foreigners and increases the burden of servicing that debt in the future.

I'm sorry, but borrowing the money to save doesn't work.

The July meeting was usually close to July 4^th-closer than this one-and the British ambassador invited us to his residence for dinner on the evening between meetings. In my first few years, Alan Greenspan sat across from the ambassador of the time, and they discussed big-picture issues very eloquently. It was educational for me as well as entertaining.

The evenings generally ran too late, given the weighty matters left to be discussed the following morning. It got to be a game to see who would be the one to break the spell and announce our need to leave. The consensus of my cohort probably was that Vice Chairman Alice Rivlin was the best at it, although Mrs. Greenspan was pretty good as well. (Think about it.)

At some point the ambassador-one of them-started inviting the Governor or Deputy Governor of the Bank of England to hold up their end of the conversation. I enjoyed Eddie George more than his successor.

Eddie George was more my kind of guy, rumpled suit and all. I had made a courtesy call on him in his London office when he was preparing to leave for a small town to give a speech. I'd been doing the same thing back home and I had a well-received joke that I was willing to share with him. He already knew the joke. Unbelievable.

Before one dinner at the ambassador's residence, standing on the steps overlooking the back-yard garden with gins and tonic and such, the ambassador's wife needed a light for her cigarette. The entire FOMC fumbled around to no avail. Eddie was the only guy in the crowd with a light. Cool.

There was something very special about those evenings with the British around the 4^th of July. Both sides seemed to be over the unpleasantness surrounding that date back in 1776.  I'm glad.

This has shown up recently in what is called "quantitative easing," where the Fed continued to expand the money supply after short-term interest rates hadbottomed out. Specifically, the Fed started purchasing longer-term securities (mainly 10-year) as well as mortgage-backed securities with the goal of pushing down longer rates in general and mortgage rates in particular. It appeared to work for a while, with both 10-year bonds, and mortgage rates falling. Then those rates began backing up, which led virtually everyone on cable TV to conclude that inflationary consequences were the culprits.

This may well be the correct explanation, and it may even be a complete explanation. But, I doubt it, especially the complete part. What am I thinking?

First, monetary ease has not been nearly as great as everyone assumes from hearing others say it. The spike in the monetary base is largely the result of a build-up of "excess reserves." The early rapid growth in measures of money has largely been reversed. Given the collapse in the velocity of money and other deflationary forces in the economy (mainly housing and everything related to it), I don't think monetary expansion has been excessive.

Second, in focusing on credit rather than money, the expansion in Federal Reserve credit has not fully offset the contraction of credit in other areas, such as the commercial paper market. Total credit is down, not up.

Third, the banking system is still under stress, especially many banks below the too-big-to-fail 19 with over $100 billion in assets that took the "stress test."

Fourth, Treasury borrowing to finance the explosion in the budget deficit has grown accordingly. Other things equal, more borrowing by the Treasury not offset by reductions elsewhere puts upward pressure on interest rates.

What all this adds up to is the possibility that massive Treasury borrowing combined with a not-too-easy monetary policy is behind the upward pressure on longer-term interest rate.This is an alternative to the thesis that rate increases were driven by inflationary expectations. However, the two explanations are not mutually exclusive. They can operate together. I tend to think that not-to-easy monetary policy and massive Treasury borrowing accounts for more of the rise in rates than a rise in inflationary expectations. But, even I'm wrong about the "more," those factors are still likely to have played a significant minority role.

In referring to the WSJ editorial and similar arguments, Mr. Bernanke said he believed such critics are "not particularly well informed" and that "as a Committee, we should continue to remain patient and not choke off growth unnecessarily."

Mr. Bernanke continued: "In particular, though of course we have to be vigilant to detect any change in the inflation trend, the odds of inflation rising significantly any time soon from its current very low level seem small." He went on to support his case.

These bones were dug up by the WSJ because its editors believe there are lessons to be learned that are relevant to the current debate on when the Fed should begin shifting its stance away from monetary ease.

Of course, in reading Mr. Bernanke's remarks at that FOMC meeting in December 2003, I was overwhelmed by curiosity about what I said at that meeting. "Enough about him; lets talk about me." (Coincidentally, the December 9 FOMC meeting in 2003 was Tim Geithner's first meeting as President of the New York Fed.)

I looked my remarks up in the transcript, and I wasn't embarrassed. My statement during the first go-around discussed the economy from the viewpoint of the Dallas Fed and its territory (Texas and part of New Mexico and Louisiana).

My remarks relevant to the policy decision in this part of the meeting are quoted below:

"The two issues that this Committee needs to address are (1) when and if this improved economic outlook might translate into higher inflationary pressures, and (2) when monetary policy will need to shift into a less easy posture. A third issue involves how to manage that policy shift without unduly disrupting financial markets and thereby the recovery.

As I look at the balance or risks going forward, it seems to me that the risks on both growth and inflation have become much more evenly balanced or are approaching balance."

                                         ……

"I don't think it is unreasonable to expect that services inflation could end up a lot closer to goods inflation as a result of these developments. That is just one more reason that I'm reluctantly thinking about raising interest rates at this time."

"Rapid GDP growth is not our enemy, though I'm willing to concede that rapid growth sustained primarily by substantially negative real interest rates may prove to be a problem. But that problem is not imminent given the degree of productivity growth and the slack in the economy and our ability to capitalize on the slack in the economies of other countries. I believe that the outlook for growth in real GDP is either balanced or biased toward more growth, and I think the outlook for inflation is now balanced."

["Balanced" represented an increase in the outlook for inflation from previously.]

"With regard to the "considerable period" of accommodative policy that we've mentioned in our press statement, I think we have to honor that promise when it comes to policy changes in the next little while. But I believe it's time to withdraw that phrase, even though the initial market reaction will likely be negative. The clock doesn't even start until that phrase has been removed from our statement. That phrase has become a liability to our credibility."

Chairman Greenspan proposed no change in the target fed funds rate at this meeting, along with a statement to be released with the decision. Not being a voting member in 2003, instead of voting, I gave a statement of support as follows:

"I support your recommendation. I would have preferred to eliminate the ‘considerable period' phrase, get it over with, and start the New Year out with a clean slate; but I support your recommendation."

Following the policy meeting, we discussed the FOMC's communication practices. I made the following remarks during that discussion:

"I agree with Cathy [Cathy Minehan, President of the Boston Fed] that the statement should be shorter and simpler-very much so. As I've long argued, I don't think we did ourselves a favor when we started announcing a bias vote. I would recommend not having a bias vote. If we don't have it, then we're not being nontransparent by not releasing it. If it's fairly obvious which way policy ought to be going at a meeting, I think we ought to just go there rather than do nothing and promise, through a bias vote, that we will likely do it next time. Whenever we act, people on the outside know pretty much the same information we do; they don't really need that much of an explanation of why we voted the way we did. So I think we leave ourselves much more flexibility if our announcements have fewer moving parts, and we have fewer ways to make a mistake if we just leave out the bias. If doing that requires releasing the minutes earlier, fine. That's all right with me. But I don't think we even have to do that. I'd just say that we've found recently that the lengthy press releases and announcements of various biases have not served us very well and we preferred to go back to the old system."

Increased Powers for the Fed

The rhetoric so far is exaggerating the extent of new powers for the Fed. Since the major investment banks converted to bank holding companies (BHC), the Fed already is the primary regulator, at the BHC level, of the largest financial institutions. Nonbanks like AIG  would represent some expansion, but even that was taken on last year on an emergency basis.

A New Consumer Protection Agency

If I were still president of the Dallas Fed, I'd be happy to lose this function for selfish reasons. Consumer "advocates" are very aggressive and often abusive in their approach. Good riddance!

For the good of the country, however, putting this function into a specialized agency that doesn't have other responsibilities that bring balance into the picture is a bad idea. Over time these advocates will find themselves pushing on an open door, and the agency itself will become an advocate of proposals that appear consumer friendly on the surface, but will likely have adverse unintended consequences for consumers.

Abolishing the Office of Thrift Supervision

This isn't necessary on quality grounds. They do as good a job as the bank regulators. Hopefully, their personnel can be folded into the new banking agency.

The elimination of the federal thrift charter may be a good idea. Thrifts are currently prevented by their charters from diversifying sufficiently out of real estate lending. Morphing them into banks will make them safer.

More to come later.

Since short-term rates under the Fed's influence are near zero, a policy of targeting longer-term interest rates represents an effort to change the term structure of interest rates or the slope of the yield curve as it is usually put today. This policy is usually treated as unprecedented. Not so. A similar policy, but for different reasons, was undertaken in the 1960s and was called "Operation Twist."

In the early 1960s, especially around 1963, the Fed purchased longer-term U.S. securities to put downward pressure on longer term interest rates considered important for domestic growth while trying to keep short term rates high enough to prevent a capital outflow. The balance of payments constraint imposed by fixed exchange rates precluded an across-the-board reduction in interest rates.

Sometimes the Fed would purchase longer term Treasury securities while selling shorter maturities at about the same time. The Fed had two interest rates policies at the same time: short rates targeted the balance of payments while long rates targeted domestic demand and growth. As indicated above, this policy of pushing down long rates while supporting short rates came to be known as "operation twist."

Operation twist was deemed necessary because fixed exchange rates imposed a discipline on policy that the Fed doesn't have today with flexible exchange rates, although many pundits wish that constraint were still there.

If operation twist was successful in achieving its objectives, it was only mildly so. The historical verdict was that it made little difference.

A companion program to sustain our balance of payments without adopting policies that would hurt the domestic economy came along later in the 1960s. Called the "Voluntary Foreign Credit Restraint" program, or VFCR, its objective was to jaw bone banks into "voluntarily" limiting capital outflows. I was assigned to that program briefly, and it was the only assignment in my long tenure at the Fed that I found distasteful. Fortunately, it went away before it did much damage.