Feb. 9 (Bloomberg) -- Federal Reserve Chairman Alan Greenspan, speaking in London last week, put the best face he could on the outlook for the burgeoning U.S. current account deficit.

Currency markets, perhaps misled by the seemingly hopeful tone of Greenspan's remarks, responded by bidding up the value of the dollar. They should have listened more closely to all his carefully worded caveats and conditional phrases.

Perhaps the Fed chairman was wary about triggering another sell-off of the dollar similar to that which followed his speech last November. His statements then were interpreted by some market participants as an effort to talk down the dollar to aid in reducing the current account deficit.

Meanwhile, at a conference at the San Francisco Federal Reserve Bank the same day as his London speech, numerous economists predicted that the current account deficit is likely to worsen until foreign investors become unwilling to finance it.

For example, economists Nouriel Roubini of the Stern School of Business at New York University and Brad Setser of University College, Oxford, argued, ``The U.S. is currently financing itself by selling low-yielding dollar debt which offers foreign investors little protection against a future fall in the dollar.

``Yet the United States' large trade deficit and rapidly rising external debt to GDP ratio imply that a large future fall in the dollar will be needed to reduce the U.S. trade deficit to more sustainable levels,'' Roubini and Setser said. Eventually the prospect of such losses will cause investors to shy away from dollar assets, they argued.

Trade Deficit

In his Feb. 4 speech, Greenspan ticked off several major reasons why the U.S trade deficit isn't likely to shrink anytime soon. His suggestions regarding why the trade and current account balances might improve were all highly problematic.

The first negative, a very big one, was the fact that U.S. imports are so much greater than exports that ``exports must grow half again as quickly as imports just to keep the trade deficit from widening -- a benchmark that has yet to be met,'' Greenspan said.

Imports and Exports

In the first 11 months of last year, imports totaled $1.6 trillion, 65 percent more than exports of $1.04 trillion. Exports rose 12 percent, compared with the same period in 2003, and the trade deficit would have stabilized if the increase in imports could have been held to only 8 percent. In reality, imports jumped by 16 percent.

A second negative he cited is the U.S. tendency to import more than its trading partners do when their respective growth rates are the same. On top of that, of course, is the fact that the U.S. economy lately has been growing much faster than its industrial nation partners, he said.

A third negative from Greenspan was that the surge in world oil prices has also helped deepen the trade deficit.

So what seemed upbeat in the speech?

Well, the selling prices of European exports to this country have gone up hardly at all, compared with the big rise in the value of the euro against the dollar. That's because European exporters have been willing to see their profit margins shrink rather than raise their prices and lose market share in the U.S., though that may be coming to an end.

`May Be'

``We may be approaching a point, if we are not already there, at which exporters to the United States, should the dollar decline further, would no longer choose to absorb a further reduction in profit margins,'' the Fed chairman said.

Note the ``may be.'' And note the further cautionary sentence, ``Increases in import prices lower the quantity of imports but leave the resulting value of imports uncertain.'' That is, even if the real value of imports were to fall, their nominal values might not. If the nominal trade deficit did not fall, the need for foreign financing would not either.

In the case of Europe, which was the focus of this part of Greenspan's speech, his point could be moot because profit margins of exports may be expanding again. Late yesterday, the value of the euro had dropped to $1.2767, about 6.4 percent from its peak of $1.3537 on Dec. 30. The Fed's raising its target for the overnight rate by a quarter-percentage point to 2.5 percent last week also lent support to the dollar, of course.

Budget Deficit

As positive developments, Greenspan also mentioned the possibility that the federal budget deficit may be about to decline and that household saving may turn up again as the huge wave of home mortgage refinancing begins to ebb.

Actually, any noticeable reduction in the federal budget deficit appears to be a remote possibility for either fiscal 2005, which ends Sept. 30, or fiscal 2006, given the negative reaction in Congress to many of the spending cuts proposed this week by President George W. Bush in his 2006 budget.

Certainly equity extraction by homeowners when they have refinanced mortgages to take advantage of lower interest rates has given households more cash to spend. And since that cash, the result of capital gains or past payments to mortgage principal rather than part of current income, isn't part of current income, the spending reduces saving as a share of disposable personal income.

The implication of Greenspan's analysis on this point is that such spending will fall as refinancing ebbs. He doesn't venture to suggest by how much.

Predictions Difficult

The whole speech stresses the large number of uncertainties in any analysis regarding trade and current account deficits.

``The interaction of a wide range of economic forces, which adjust at national borders to create what we call the current account balance, has proved difficult to predict with any precision, primarily because of the difficulty of forecasting exchange rates,'' he said. ``These same forces have lessened our ability to anticipate the consequences of a buildup of either a surplus or a deficit.''

``Numerous issues that have arisen with respect to the adjustment of the U.S. current account remain unresolved,'' Greenspan concluded. ``One is the effect of Asian official purchases of dollars in support of their currencies. Such intervention may be supporting the dollar and U.S. Treasury bond prices somewhat, but the effect is difficult to pin down.''

Pin it down or not, Chinese authorities have shown no willingness to stop interventions to keep their currency tightly pegged to the dollar.

Over the weekend, Zhou Xiaochuan, governor of the People's Bank of China, said in Hong Kong, ``We are doing the preparation work to reform our currency regime. Of course the preparation work is subject to evaluation and the right time.''

That ``right time'' isn't likely to come this year, and maybe not in 2006 either. In any event, it's not going to help reduce the U.S. trade or current account deficit anytime soon.

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net.

Last Updated: February 9, 2005 00:05 EST