Price Distortions Will Cost Dearly

The theories of the economics profession haven’t had much of a track record in the past few years, but one fundamental truth endures: Relative prices do count. If the price of anything declines enough, people will use more of it and less of other goods or services; if its price rises, its use will decline.

If one price is artificially forced up or down, it will distort the production process for that item, and, if that price is central to the functioning of the economic system, it will eventually distort the behavior of the entire economy.

For much of the 1970s, it was tax rates that were too high and were distorting economic activity. Investment took place in hard assets instead of productive facilities, and tax avoidance--some would say cheating--became a national pastime. One of the Reagan Administration’s first orders of the day was to attack this problem, and tax rates fell significantly, particularly at the upper end.

Indeed, the Treasury proposal to cut the top marginal rate to 35% from 50% struck fear and loathing into the heart of the tax-shelter industry; a reduction to 25% would essentially wipe out that sector of society.

Overvalued Dollar

But the reduction in that distortion was simply replaced by another equally serious problem--namely, the overvaluation of the dollar. The tax cuts left a gaping void that was supposed to be filled by spending cuts, but none were forthcoming; total government spending adjusted for inflation has now risen at an annual rate of 4.6% for the five years of the Reagan Administration--including the projected fiscal 1985 figures--compared to an average increase of 3.6% during the administrations of Eisenhower through Carter. Furthermore, the deficit problem will snowball in the future because taxes have been uncoupled from inflation but--at least for the moment--spending has not.

The tremendous void of the deficits had to be financed somehow. At first, economists thought that high interest rates would result in an increase in domestic saving, but nothing of the sort occurred. Indeed, the personal saving rate in February declined to 5.2%, compared to almost a 7% average over the post-Korean War period. Thus, the only place to turn for financing was the foreign sector, and here the results have been spectacularly successful--about $100 billion per year in foreign investment for both 1983 and 1984.

The problem with this “solution” is that the carrot needed to attract these funds was a combination of unusually high interest rates and an overvalued dollar. This overvaluation of between 35% and 40% has led to an equally serious distortion in our economy, causing large chunks of our manufacturing sector to relocate overseas.

For a while this drain was thought to be confined to the grungy, smokestack industries of Middle America, which were unloved and unwanted because they (a) polluted the atmosphere, (b) deserved what they got because they had failed to modernize or (c) had priced themselves out of world markets because of overly generous wage rates. However, the exodus of jobs did not ravage only Middle America but also spread to the high-tech industries as well, endangering what had been thought to be a “safe” lead in engineering and product development.

Classical international trade theory teaches that, even if one country can produce all goods cheaper in terms of labor inputs, the exchange rate will adjust so that each country has a comparative advantage in producing some goods. However, with the dollar so grossly overvalued, the United States found itself in the theoretically impossible situation of being at a disadvantage in the production of virtually all goods.

Furthermore, this trend will worsen. During the past two years, many firms have moved their manufacturing operations offshore, and many of the biggest and most famous companies are simply assembling and distributing goods produced overseas.

Move Operations Abroad

However, until late last year, other firms tried to maintain their domestic plants, hoping that the surge in the dollar was temporary and would return to normal when interest rates declined. The moment of truth came last fall, when short-term interest rates declined more than 3% but the dollar continued to strengthen. As a result, most manufacturing firms had to face the stark choice of moving operations to a foreign country or going out of business entirely.

The decline in the dollar in recent weeks is unlikely to improve matters. Just as the distortions caused by the tax code during the 1970s are still with us today, the shift to overseas production facilities is not something that can be easily reversed. Those firms that shut down their plants in the Midwest and moved to Brazil, South Korea or Taiwan certainly will not reverse course because the dollar declines 10% or even 20%. They are now firmly ensconced overseas for the long run.

Similarly, the industrialized and Third World nations that were able to establish beachheads in this country certainly will not give up their hard-won market share even in the face of a substantial downward tilt in the dollar. The net trade deficit will continue to worsen for years, and the U.S. economy will become a net debtor nation this year. This will result in decimation of the U.S. manufacturing sector until this country no longer has the capacity to produce what it needs. Foreign countries can then jack up prices to their U.S. customers, similar to the strategy used by the Organization of Petroleum Exporting Countries.

Yet, because the overvalued dollar has filled the gap caused by the budget deficits, the Federal Reserve Board cannot afford to let it sink too far, lest that critical foreign source of financing disappear. The dollar will probably stabilize for the next six months but then weaken further as the economy heads into the doldrums late this year.

That will force the Fed to tighten, which will eventually throw the economy into a recession sometime in 1986. While the recession will not be very deep because most of the excesses associated with higher inflation never got started in this business cycle, it is likely to drag on for quite some time because of the continuing loss of production to foreign countries.

How does all this square with the stock-market prediction I made three months ago in this column--namely, that the Dow would rise to 1,400 sometime before midyear and then return back to 1,200 by the end of the year? The Dow stuttered badly as interest rates rose unexpectedly in February, but that was an overreaction to a phantom tightening by the Fed that never occurred, and interest rates will decline in the second quarter by about the same amount that they rose in February.

This will spur the stock market to higher levels by midyear, although an increase all the way to 1,400 now seems much less likely than it did at the end of last year. However, during the second half of the year, the increase in interest rates will once again send stock prices back down to their levels at the beginning of the year.

It passes for conventional wisdom that a weaker dollar will help the profits of large multinational corporations that draw much of their earnings from overseas. However, like so many other propositions, this one only holds if everything else remains equal. Slower growth domestically will produce a weaker dollar. In fact, that is the major factor likely to push the dollar lower later this year.

It will be closely followed by tighter monetary policy, both in order to keep the dollar from slipping further and to offset the higher inflation engendered by the declines in the dollar that have already occurred. Of course, that will worsen economic performance even more.

Thus, the bills from the government’s profligate spending spree are finally starting to come due. They will be paid in the form of an accelerating drain of jobs to foreign countries and a tight monetary policy until the next recession.

Furthermore, because these jobs are lost indefinitely, the decline of the dollar will not be accompanied by a significant improvement in net exports but only by higher inflation and tighter money. Such results are invariably the case when fundamental relative prices are distorted for several years.