Pressure Allies, But Right Our Own Ship

Voodoo economics is on the way out; the stock market crash is the starkest rejection of confidence in Reaganomics. Federal Reserve Chairman Alan S. Greenspan deserves credit for the masterly handling of first aid.

But even if it seems that further devastation of wealth is averted for the moment, the problems of the U.S. economy remain unresolved. These problems will keep testing financial fragility and foreshadow collapses perhaps as bad as even last week’s.

Our basic problems are four: Real interest rates are much too high, the dollar remains starkly overvalued, the budget deficit continues unsustainably large and productivity growth has almost vanished.

These problems are the aftermath of a policy that has promoted consumption, excessive borrowing and financial engineering at the expense of investment in research, education and productive assets. A country where people get rich on paper even as they spend more than their income, year after year, should have been cause for alarm much earlier.

The crash has warned us that our lasting wealth is based on productive effort, not on the paper profits made in speculative markets.

The value of the dollar today is barely back to the level of the late 1970s, before our overvaluation started. Competitiveness is restored, but the broad professional consensus is that dollar depreciation has not gone nearly far enough to restore balance in our international accounts. But the Administration, for election-year reasons or otherwise, has become entangled in an exchange-rate agreement with our trading partners apparently without getting much in return. Foreign savers have long stopped lending to us and now it is only other nations’ central banks that, through their $100-billion intervention already this year, keep the dollar up.

For two years we have been told that our trading partners are already expanding their economies at full speed. But they haven’t; in fact it was Germany’s perverse increases in interest rates that started off the interest spree that sent the market tumbling. All evidence is that our trading partners, for the time being, have gotten the better part of the deal, and our shortsightedness and ineptitude has put us on the brink of a real world crisis.

Defense of an overvalued dollar has required high interest rates. But in the face of poor trade numbers, even high interest rates will not check speculative attacks for long; interest rates then have to rise ever more to hold speculators at bay, paying them to hold on to a hot potato. The stock market reacted to this prospect in the obvious way: Rising interest rates makes quality bonds more attractive than stocks and hence lead to selling.

The dollar and interest rates do not explain the fantastic size of the crash, but they tell us how it got under way and what needs to be repaired to avoid an even worse decline.

Before the crash the recipe would have been easy: a firm plan for deficit reduction, a strong reduction in interest rates to sustain economic growth and replacement of excessive consumption by increased investment. A gradual but certain 30% reduction in the dollar would have ensured increased competitiveness and hence external balance improvement. Such a package, enacted over the past year, might have ensured a soft landing for our economy. Financial fragility would have been healed by steady economic performance.

Now, after the crash, our options are much more difficult. The crash will weaken consumer spending and hence slow down the economy. Early tax increases are therefore impossible.

What we need now is worldwide policy coordination to restore confidence in business conditions and asset markets. The risk is not inflation (just as it was not in 1929) but rather loss of confidence. But our actions on interest rates and the dollar are limited by what other countries are willing to do.

Large cuts in our interest rates, not matched abroad, would send the dollar into a tailspin and drive down foreign stock markets into an open-ended collapse. Coordination is essential, but all our experience has been dismal.

There is a need now to put decisive pressure on Germany and Japan to stop dragging their feet. They have to step up growth. Lower worldwide interest rates are a must.

The threat of 1929 should frighten even their dogmatic, narrow-minded leaders into realizing that parochial hang-ups about the evils of money growth are out of order at this point.

If we manage to correct our budget and our external balance, we avert the risk of much larger financial problems down the road. But our standard of living will be less than during the Reagan fling. Now we have to start to pay the bills. That makes it even more important to nurture the reliable sources of growth: education, research, technology, product development, marketing--those fields where our trading partners have left us far behind in the past decade. Unfortunately it will take much time and effort to catch up.

It takes steady, hard work to win in this international long-distance race. But that contrasts sharply with the culture of capital gains, junk bonds, leveraged buyouts and other financial exotica that captured corporate imagination in the past.