....Despite the positive economic signs and market gains of the fall, several problems could derail the recovery next year.

For example, while Fed interest rate hikes are meant to slow borrowing and reduce spending to curtail inflation, a spike in rates caused by bond-market jitters could reduce consumer and business spending too much. In addition, in recent years the vibrant housing market has helped sustain the economy. But economists at the University of California, Los Angeles, recently forecast a drop in housing starts next year, due to high prices and rising interest rates. Millions of Americans have taken adjustable-rate mortgages on their homes; they will see their monthly payments rise in tandem with the Fed moves, leaving those households with less spending money.

Wharton finance professor David Musto said higher mortgage rates, falling home prices, or both, could have ripple effects that are not well understood. People stuck with homes that are not worth as much as they owe, and people worried about the high payments they would face with new mortgages, might opt to stay put rather than take new jobs. "People migrating to their most productive use is, of course, good for the economy," he said. "If they are not doing that ... we will see if that turns out to be a serious thing."

Beyond the other obvious hazards - a worsening situation in Iraq or a major terror attack on the U.S - Marston worries about the danger that the dollar will continue falling against foreign currencies.

A low dollar helps American companies sell goods and services abroad by making them cheaper to foreign buyers. But the U.S. also relies on foreigners for loans, in the form of Treasury bond purchases, which make American deficit spending possible.

As the dollar becomes less valuable, foreign investors, including governments in China, Japan and elsewhere, could worry that they are losing money on Treasuries. Should they reverse course and start selling Treasuries, the dollar would fall further. To attract investors, Treasury-bond yields would then have to rise, causing interest rates for mortgages and other loans to go up as well, dampening U.S. economic growth. "I think the dollar is a concern," Marston said.

The fate of the dollar is tied to two worsening deficits. The federal budget deficit results from the government spending more than it is taking in. The current account deficit is caused when Americans - their government included - spend more than they earn, financing the difference with loans from foreigners.

To avert a damaging slide in the dollar the government must tackle the two deficits, and the key to that is to reduce the federal budget deficit, Marston said. The current level of foreign financing of U.S. debt is "not sustainable," heightening the risk of a depreciation in the dollar. Now that the U.S. is in economic recovery, "the government ought to straighten out this fiscal deficit."

"Straightening out this fiscal deficit" still appears to be a lower priority for the administration than the war on terror (with which I agree) or tax reduction (nice personally, but you can't have it both ways, can you?):

The White House is telling federal agencies to expect lean budgets next year, with congressional aides and lobbyists saying President Bush appears ready to propose freezing or even slightly cutting overall domestic spending.
Targeted would be all annually approved programs except for defense and domestic security. Excluding those two would leave a part of the budget the administration estimates will total $388 billion for the fiscal year that began Oct. 1. Also excluded are automatically made payments like Social Security and interest on the federal debt.
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