Federal deficit significant to local economic fortunes

At the recent annual Northern Colorado Business Report Economic Forecast 2005 (Jan. 18), a question was directed to me asking ?What?s the effect of the large U.S. budget deficits on the Northern Colorado economy?? Answering this question nicely extends the subject of my first column (Jan. 21) to the other primary influence of the national economy on the local economy.
My answer explained that large national budget deficits affect the local economy primarily via increased interest rates. Let me explain why I think it is inevitable that interest rates are headed up, perhaps sharply.
The value of the U.S. dollar dropped sharply in 2004, primarily because the trade deficit was very large for most months of the year, setting new records in some months. Another factor is the diminished image of the United States, thus reducing demand for all things American.
A trade deficit means that the United States is importing more goods and services than it exports. When goods are imported from other countries, they are purchased using the currency of that country. Importers sell (trade) dollars for the other countries? currency so they can buy goods or services to import for the pleasure of U.S. consumers and businesses.
As more and more dollars are traded abroad, supplies grow in foreign central banks. Concurrently, supplies of the foreign currency fall because they are being circulated to produce the goods that are being exported. This is a normal supply/demand situation, so as the supply of dollars grows, its value falls and vice versa for the foreign currency. Thus, the exchange rate changes and the value of the dollar falls vis a vis the foreign currency, for example, the euro.
This trade deficit must be at least partially offset by a currency surplus, i.e., foreign countries must send dollars back to the United States. They do this by buying U.S. government securities, money that the U.S. government uses to finance the deficit, i.e., we?re using foreign central banks to cover our deficit.
But what if other countries no longer want to do this at a level adequate to cover our huge deficit? Many reasons may trigger this response: the U.S. economy heads into a recession; other countries lose confidence in our leadership; the dollar continues to drop, reducing the value of the bonds they already hold; or their portfolios become too concentrated in U.S. securities. At least one of these reasons, or others, will probably become important in 2005.
When this happens, U.S. citizens will be required to take up the slack by buying U.S. government securities. The only way we can be convinced to do this is by offering us higher interest rates to divert funds from more lucrative business investments and from greater consumption. Thus, interest rates must go up. I think they will go up between 0.75 and 1.5 percentage points in 2005.
Higher interest rates mean that mortgage rates will go up, rapidly slowing refinancing and new home construction. Fewer people will take less money out of their houses to fund more consumption. The rate of increase in home prices will slow. Business investment funds will begin to dry up, and fewer new business investment projects will be deemed profitable.
The greater the federal deficit and the more years it persists, the worse the effect on the economy will be, both nationally and locally.

John W. Green is a regional economist who compiles The Northern Colorado Business Report?s Index of Leading Economic Indicators. Green, a Fort Collins resident, was previously chairman of the University of Northern Colorado economics department.