NEW YORK (Money Magazine) - A new set of challenges is emerging for the economy and the financial markets. Intense geopolitical uncertainties have given way to vigorous debate over the declining dollar and the significance of our exploding trade and federal budget deficits.

This debate is directly related to concerns about the slow recovery in business spending, the ongoing effort to crack down on corporate fraud and the risks and benefits of the new tax cuts.

Markets and the economy • Pop goes the housing market? • Consumer confidence falls • Getting ready for warnings

For the July issue of Money, I turned to one of the country's most experienced and most respected financial authorities for his insights on these issues and more.

Gerald Corrigan, a managing director at Goldman Sachs, served as president and chief executive officer of the Federal Reserve Bank of New York from 1985 through 1993. He is truly one of Wall Street's wise men.

DOBBS: Where is the economy headed?

CORRIGAN: Well, I may surprise you a little bit because I'm someone who tends to be quite cautious, but I think that the likely scenario looking out over the balance of this year is that the economy is poised to provide a little upside surprise. My best guess right now is that we're likely to see [gross domestic product] growth around 3 percent in the second half of the year. Now it's going to be choppy from month to month, and maybe even quarter to quarter, because we've got a lot of noise out there.

Q. What will drive the economy?

A. In the period immediately ahead, for the economy to get to something like the 3 percent growth that I was talking about...we don't need miracles. All we need is a continuation of respectable performance in the consumer sector. I also think we'll get some inventory bounceback.

We'll obviously continue to get some [increased spending] at the federal level, though not at the state and local level. But the real wild card is whether, and to what extent, the second half of the year will see even a modest recovery in business fixed-investment spending.... [If] something in the area of 5 percent or so does materialize, I don't think getting to something like 3 percent in GDP terms is going to be all that difficult.

Having said that...I do not think we're likely to see any material improvement in labor market conditions in that time frame. The pressures on costs and cost cutting are just dominating that picture.

Q. What are your thoughts about the recent decline of the dollar?

A. What we have seen so far is what I would certainly describe as a relatively modest and orderly fall in the exchange rate of the dollar, particularly vis-a-vis the euro. I emphasize orderly because there is always a risk that a decline in the value of the dollar could have adverse knock-on effects for other financial markets.

Certainly, we have not seen that, and that's good. On the other hand, the decline of the dollar should help stabilize or maybe even bring about some modest improvement, over time, in our external trade and current-account deficits.

Q. We're also seeing a significant slowdown in capital flows, particularly from Europe, to our bond and stock markets. How concerned are you about that?

A. That is in some ways what is fundamentally at the heart of the correction that we've seen, especially in the dollar-euro exchange rate. It's important as a matter of perspective to keep in mind that -- particularly in the second half of the '90s and even into 2001 -- a very substantial fraction of the flows from Europe into the United States were directed at mergers, acquisitions and fixed assets rather than portfolio investment.

Those trends inevitably run their course, so it's not a huge surprise that we're seeing that kind of adjustment. And frankly, I think the likelihood is that even if there are some further exchange-rate adjustments, I don't see a material risk that this thing gets out of control. I still think the short-and medium-term prospects for the U.S. economy are better than those of our industrial-nation partners. As long as that's the case, it's hard to see how this could turn into a disorderly correction.

Q. Are you concerned about the impact of the soaring trade deficit?

A. It certainly is a concern, particularly over the medium term, but I think we have to keep in mind a very, very basic point: The U.S. external deficits are fundamentally being driven, and have been driven for a long time, by the simple fact that our economy has performed so well relative to others.

What we really need to get some meaningful medium-term adjustment in those deficits is much better performance in other economies, especially in the other industrialized countries. That relative growth phenomenon is more important to the trend in current-account deficits than is the exchange rate within a fairly wide band of exchange-rate changes that would otherwise be consistent with financial stability.

Q. Turning from the trade deficit to the budget deficit, do you believe that tax cuts are needed to boost the economy, and what risks do they raise in terms of the federal budget deficit?

A. It's not hard for me to see a situation in which the fiscal 2004 deficit could be above $500 billion. That's not a forecast because there are too many unknowns right now.

But it certainly is not beyond the realm of possibility. In these circumstances, I think the first order of business is we have to re-create some meaningful form of hard discipline on the spending side of the equation.

I don't know whether that takes the form of an aggressive renewal of the spending caps which go back to the early '90s and which actually worked quite well for a very long time, but some initiative is needed. I have to confess that under these circumstances and the fact that I don't see the economy falling off of a cliff, I am somewhat less than enamored by further tax cuts in this environment.

Q. What is your outlook for equities?

A. If you look at the backward-looking valuation numbers, whether it's P/E ratios or something more complicated, the market is fairly well priced today. I think it comes down squarely to the question of the economy in general and profits going forward in particular.

I'm modestly upbeat on the economy. In that economic environment, with continued strong productivity growth and continued aggressive work on the cost side of the ledger in corporate America, I think that we can get respectable increments in profits over the period ahead, and that obviously has to be good for equity markets.

Q. We've seen a historic settlement between regulators and the 10 largest Wall Street firms. Corporate America seems to be adapting well to the Sarbanes-Oxley reforms. Give us your view about the integrity of the markets and the level of enforcement.

A. Corporate America's adjustment to Sarbanes-Oxley is going at least as well as we could have expected. I also think that, by and large, the other regulatory changes were fundamentally on the mark, although there's always the danger of some overreaction. But by and large, I think we are in the advanced stages of restoring the basic core discipline that is needed.

Q. What risks remain?

A. When you look at the case studies of scandals or worse, one of the things that leap out is the extent to which what I call the "critical control executives" in corporate America were either ignored or were co-opted by events.

And by control executives, I mean people who run controller's operations, run risk-management operations, run internal audit operations. The point is that for any system of accounting regulation or governance to work well, the people who are responsible for these tasks have to have the independence, they have to have the stature, they have to have the clout to do it right and to stand up to the business guys when necessary.

Corrigan also points out that there are critical issues to be faced in accounting. As he put it, "we need to square the circle" between domestic and international accounting practices, between accounting rules and principles, and so-called historic cost accounting and fair market value accounting.

Corrigan calls this "tough stuff," and I agree. But as we've seen so often in recent months, this economy and market continue to be surprisingly effective in overcoming challenges.

Lou Dobbs is the anchor and managing editor of CNN's Lou Dobbs Moneyline.