Uncle Sam's rich uncles overseas

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It's an odd situation. Foreigners have in effect been financing 43 percent of the cost of the Iraq war, a war many of them oppose. Now they will help to finance the federal government's cost of Katrina, a disaster their press tells them was badly managed initially.

But can these foreign investors be trusted to keep helping to maintain the United States economy?

In fiscal 2006, starting next month, Katrina may add as much as $200 billion to the federal deficit. The total deficit could reach $500 billion, Washington experts reckon. Katrina could cost a trillion or so in the years ahead.

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So far, foreign banks, pension funds, insurance companies, and other private investors seem content to invest in the US by buying up almost half of Uncle Sam's new Treasury bonds and notes at weekly auctions.

In a way, they don't have much choice.

In London, Citigroup economist Richard Reid notes that investment is "a relative business." Foreign investors see that a 10-year Treasury note yields about 4.2 percent. That compares with 1.2 percent for a Japanese equivalent and 3 percent for a similar euro note.

Despite Katrina, the US economy has an underlying real growth rate in gross domestic product (the output of goods and services) of 3 percent or so. Japan and Europe are growing decidedly more slowly. Furthermore, the US has a resilient economy. It historically has bounced back quickly from hurricanes and other damaging natural events.

And, as foreign investors see it, the US capital market is so huge and flexible they can sell their dollar assets quickly should they want to - "in the morning," as Washington economic consultant Harald Malmgren puts it. "The US market remains a secure place, with legal protections" for foreigners as well as Americans, he notes.

But, despite relatively low unemployment, low interest rates, and substantial economic growth in the US, some economists worry that Katrina could be the straw that breaks the camel's back - the one that seriously damages the economy.

"We are consuming more than we produce," notes Clyde Prestowitz, president of the Economic Strategy Institute in Washington. In fact, the huge trade deficit of the US indicates Americans consume 7 percent more than they produce, borrowing the money to pay for it.

"That's unsustainable," Mr. Prestowitz says. "There is an unpleasant adjustment in our future. We will have to adjust our lifestyles to our means. There will be a sharp recession if not a depression."

"Never in modern history has the world's leading economic power tried to do so much with so little," writes Stephen Roach, chief economist of Morgan Stanley, a New York investment bank. "Now Washington is upping the ante as it opens the fiscal spigot to cope with post-Katrina reconstruction at the same time it is funding the ongoing war in Iraq. Could this be a tipping point for America's shoestring economy?"

Many economists anticipate Katrina depressing US output for a quarter or so. Then they see reconstruction in the South lifting GDP for a while.

But even optimists have concerns.

Mr. Reid, for example, suspects that the extra foreign financing needed by the US after Katrina could sink the dollar a little against the euro - the currency of 12 European nations. By the end of 12 months, it could take $1.32 to buy a euro instead of about $1.24 these days.

If foreigners buy fewer Treasuries, it will put upward pressure on US interest rates, says Michael Cosgrove, an economist at the University of Dallas in Irving, Texas. So far, foreigners have bought so many Treasuries that they have become de facto financial "partners" of the US, not just "holders" of its debts, he adds. As of June, Far Eastern nations alone held $1.2 trillion in Treasuries.

Mr. Cosgrove says China's decision this summer to put its central bank reserves in a "basket" of currencies, rather than in dollar assets alone, was the result of a "wrongheaded policy" of the Bush administration to pressure China for a revaluation of the yuan. If OPEC nations decide to price their oil in a basket of currencies rather than dollars - then bond yields in the US could rise a full percentage point. That would be a blow to the American economy.

In real terms, most US consumers have already been hit by Katrina. Energy prices of all sorts are higher. Farmers may have trouble exporting their crops with all the disruptions in the Mississippi transport corridor. Extensions of tax cuts, many for the well-to-do, may not happen. Taking account of lost housing, buildings, and wetlands, a less-watched measure of economic welfare - the Genuine Progress Indicator - is likely to dip.

"More spending," warns Michel Gelobter, director of Redefining Progress, an Oakland, Calif., think tank, "does not mean more progress." [Editor's note: The original version misnamed Michel Gelobter.]

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