U.S. Needs Strong Demand Abroad
Washington has embarked on three major policy changes that are highly desirable and badly needed for the long run: reducing the structural budget deficit, reforming the tax system and reducing the exchange rate of the dollar. But as welcome as these changes are for the longer run, they pose problems for the immediate future.
Only the lower dollar promises to stimulate U.S. demand and economic expansion in the near term, and it adds nothing to demand in the world as a whole. A lower dollar helps expansion here by reducing our trade deficit only to the degree that it weakens expansions in foreign economies by reducing their trade surpluses. The other two policy changes--budget deficit reduction and tax reform--will weaken U.S. demand by late this year and weaken total world demand in the process. That weakness must be offset by stronger demand from other sources or it will slow expansion and possibly tip the United States and world economies into recession.
What is the potential list of other sources of demand? There is always the possibility of a spontaneous burst of optimism from business and consumers. Such bursts, both positive and negative, do occur and make economic forecasting the hazardous business that it is. But a fortuitous positive burst is not something to count on. Rather, the impending weakness arising from changes in U.S. fiscal policy needs to be offset by lower interest rates worldwide and more expansionary budgets abroad.
Reversal of Previous Policies
This prescription implies a reversal of the policies of the past several years. In the first half of the 1980s, the economies of Europe and Japan tightened their own fiscal policies while enjoying the rising export demand that came from the strongly expansionary fiscal policy pursued in the United States and the soaring dollar exchange rate that came with it.
This strategy, which produced a roughly neutral fiscal push for the industrial world as a whole, provided enough demand in Europe to maintain expansions but not at a fast enough rate to keep unemployment from rising.
Now that trip is over. With U.S. fiscal policy turning the other way and the dollar down sharply, European economies will have to expand domestic demand just to maintain their growth rates of recent years. To grow faster so as to reduce unemployment, they will have to stimulate domestic demand even more. That is the clear message behind the U.S. attempt at the Tokyo summit to achieve better policy coordination.
Yet despite the clear need for this kind of policy change as viewed from this side of the Atlantic, Europe’s policy-makers appear reluctant to use the traditional tools of fiscal and monetary policy to provide the boost that will be needed by their own and the world’s economies. In light of the fact that average unemployment in Europe has risen every year for a decade, this reluctance is puzzling. In part it stems from questionable theories that view unemployment as structural or unresponsive to demand for other reasons. But mostly it stems from a continuing fear of inflation.
Inflation had become a serious problem in the 1970s, and the policy emphasis in most European countries shifted to restraint and a tolerance of high unemployment as a necessary cost of bringing inflation under control. But now the extended period of rising unemployment has brought inflation down to a much lower plateau in most countries and to near zero in some. Restrictive policies had a big effect in reducing inflation initially. The continuation of those policies has yielded less and less further improvement. What motion remains in the wage-price treadmill appears to be remarkably unresponsive to continued high unemployment.
Reducing unemployment may always carry some risk of more inflation. But the present is certainly a time when that risk is modest and the costs of not taking it are great, especially for the European economies. The inflation “habit” has been broken. With an enormous pool of unemployed, pressures from tight markets are minimal or non-existent.
Problems With Unilateral Action
With European currencies now appreciating and oil prices sinking, the downward pressure from foreign prices will help moderate the overall price level. Thus, as appropriate as the emphasis on fighting inflation was in the past, it is now time to redirect demand management in Europe toward more expansion and lower unemployment.
What if, despite the case just presented, Europe’s policy-makers continue to resist a policy of aggressively lowering their interest rates or making their budgets more expansionary by lowering taxes or raising public spending? U.S. authorities could still push down interest rates here. Such lower rates would provide a further lift to the demands for homes, consumer durables and business investment and could, if pushed far enough, offset the drag from the budget and tax reform. But policy-makers are cautious about reducing interest rates here without corresponding reductions in rates abroad because they fear such a unilateral monetary easing might lead to a precipitous decline in the dollar.
Whether that concern is justified is debatable. But it does exist, and for reasons that can be understood. One stated aim of U.S. policy is to eliminate, or at least sharply reduce, the U.S. current account deficit--the sum of the deficit on merchandise trade, services and earnings on capital--which grew by $120 billion between 1982 and 1985.
Reducing the current account deficit will require some combination of a lower dollar, making U.S. goods more competitive and faster expansions abroad, increasing foreign demands for U.S. goods and services via a faster growth in foreign incomes. U.S. policy would like to get help from both sources rather than relying on massive dollar depreciation alone because depreciation adds upward price pressure in the U.S. economy. This is why it is reluctant to take unilateral steps that could depreciate the dollar too far.
Thus, to an unusual and uncomfortable degree, U.S. economic prospects for 1987 are tied to economic policies that will be pursued abroad. Taken in isolation, our budget tightening and tax reform will produce a sharply restrictive shock to the economy in the near term. Although the lower interest rates and lower dollar that have already been achieved will help offset that downward shock, they may not be enough.
If a significant expansion in world demand, originating from policy changes abroad, is not forthcoming, U.S. policy-makers will face the uncomfortable choice of leading the way with interest rate reductions and a much lower dollar or risking a fall into recession.
