It’s Greenspan’s Challenge to Sell Budget Discipline

The market made them do it. Investors liked monetary policy the way it was, and demanded continuity. The brilliant, pragmatic conservative, Paul A. Volcker, had to be replaced by the brilliant, pragmatic conservative, Alan Greenspan. Unconventional economists need not have applied.

The market probably determined the timing of the decision as well as its substance. While the Reagan Administration might have preferred to delay making a choice, the market began reacting to every twitch of the eyebrows whenever Administration officials discussed the Federal Reserve chairmanship. The resulting uncertainty was destructive. Mercifully, the Administration ended it quickly and skillfully.

Is it possible that the appointment of a conventional, responsible Fed chairman portends a move toward a more conventional, responsible budget policy? It will be difficult. Recent negotiations between Congress and the White House have spent as much time on budget process as on budget substance. Typically, budget process is something that is discussed when no one can figure out what to do about real policies.

If the market was so powerful in restricting the Administration’s choice of a Fed chairman, one might ask why it cannot also discipline budget policy. We saw some hint that it might earlier this year.

The harm done by our budget deficit has been eased greatly by the willingness of international investors to help us finance it. The availability of foreign capital has clearly limited the rise in U.S. interest rates caused by the deficit. But in the first quarter of this year, foreigners lost confidence in the dollar and, by implication, in U.S. policies. The United States experienced a flight of private capital, and the world’s central banks had to buy massive amounts of U.S. securities to prevent the dollar from collapsing. In effect, central banks replaced private investors in the financing of our fiscal profligacy.

That could not go on for long, and everyone knew it. Interest rates had to be raised in America to provide foreign investors with a greater reward for taking the risk of making dollar investments. It worked, and markets subsequently stabilized.

It is fortunate that stability could be purchased with such a small rise in interest rates (the Japanese government helped by curbing private Japanese speculation against the dollar), but it is unfortunate that a minor crisis is not sufficient to induce a significant change in budget policy on the part of Congress and the Administration. On the other hand, it is hard to wish for a severe crisis, because that is an expensive way to buy fiscal responsibility.

The current calm in foreign-exchange markets is sure to be temporary, however, and the Fed--and now Greenspan--will periodically be faced with a terrible dilemma. They can counter attacks on the dollar with higher interest rates, thus raising the risk of an American recession, or they can let the dollar fall, generating upward pressures on American prices and the threat of much instability.

One would think that the current situation is sufficiently dangerous to inspire significant action on the budget, but the linkage between fiscal policy and foreign-exchange markets is highly complex and not well understood either by the public or by Congress. Even members of the economics profession disagree strongly about the strength of the relationships involved.

Moreover, our economy has tremendous resiliency. We can abuse it with an irresponsible fiscal policy, and it shows great ability to adjust. Crises may erupt, but typically correct themselves quickly with minor falls in the dollar or increases in interest rates. In the interim the harm done by the deficit to future living standards accumulates slowly as gradually rising interest rates erode domestic capital formation and our debt to foreigners slowly rises.

The deficit disease is thus more like a cancer than a heart attack. A gradual debilitating disease is extremely difficult for our politicians to treat, because there is no traumatic event to arouse the public. Indeed, the public gives every indication that it enjoys living on borrowed money.

In Greenspan the nation has obtained an able teacher who has spent his life explaining complex economic relationships to laymen. His political skills were honed while swimming the shark-infested waters of Social Security reform after President Reagan appointed him to head a Social Security commission in the early 1980s. It was one of the few government commissions in history that was truly successful.

I do not mean to imply that Volcker lacked didactic or political skills. Quite the contrary. But we now have a new voice making the same arguments for deficit reduction, and that may lend them more force. In our complex system it may be too much to wish that one man can make a decisive difference for our policies. But we have obtained a particularly good one, and it never hurts to hope. Good luck, Alan.