In hindsight it is becoming clear that the strong economic growth over the past two years depended on bringing in large quantities of capital from the rest of the world. But with the sharp rise in oil prices and the slow but noticeable pullback by foreign investors and lenders, that growth formula is now in jeopardy.
Oil prices hit new highs Friday in New York trading, topping $55 a barrel. Some of that is surely speculative. But as Fed Governor Ben S. Bernanke acknowledged last week, the signal from the energy futures market is that even when that speculative bubble bursts, oil prices are likely to fall to around $40, or twice the level of the 1990s.
"The recent rise in oil prices has thus been large enough to constitute a significant shock to the economic system," Bernanke told a college audience Thursday.
Even more worrisome was a report from the Treasury that the steady flow of foreign capital used to finance the U.S. current account deficit is drying up.
Foreign net investment in U.S. stocks has slowed to a $600 million-a-month average so far this year, which as Morgan Stanley's Stephen Roach points out is not only well below the bubble peak of $14.6 billion but significantly short of the $5.7 billion average of 2001 through '03. That shift alone goes far toward explaining why the Dow Jones industrial average ended the week at the lowest point this year, off 10 percent from its February peak.
At the same time, the willingness of foreign private investors to lend their money to Uncle Sam by stocking up on Treasury bonds came to an end in August when those investors sold more bonds than they bought. As a result, the world's largest economy now relies on foreign central banks -- most of them Asian -- to keep it afloat. And even that is driven by the political imperative to keep those export economies in high gear by propping up the dollar and depressing the value of their own currencies.
Despite those efforts, however, the dollar exchange rate is falling, most noticeably in Europe, where the euro closed the week at $1.26 for each dollar. The steady rise is already putting the brakes on industrial output in the euro area, while in Britain the government estimated third-quarter growth at 0.5 percent.
So far, growth in the U.S. economy is still running at between 3.5 and 4 percent -- enough to keep profits healthy but not enough to add significant numbers of new jobs. But John Makin of the American Enterprise Institute warned last week that the risks are growing for a recession in 2005 if oil prices don't recede and foreign investors continue their retreat from dollar assets.