Baker Gambling on Deficit Cuts : Dollar’s Plunge May Avert Slump but Risks Inflation

By allowing the dollar to decline against foreign currencies, the Reagan Administration may have helped avert an economic downturn next year that many analysts initially considered an almost inevitable consequence of Wall Street’s crash.

But it is not out of the woods yet.

Still lurking is that equally feared economic danger--inflation--which all but dropped out of sight during the stock market’s rout. A lower dollar feeds inflation by forcing up the prices Americans must pay for imports and, indirectly, for the domestic goods that compete with imports.

Treasury Secretary James A. Baker III has a plan. After conceding publicly this week that he has no choice but to let the dollar fall for now to avoid a recession, he is gambling that the Administration can quickly reach agreement with Congress on a package to reduce the chronically massive federal budget deficit.

“Simply allowing the dollar to fall is not a lasting solution,” said Alan Stoga, senior economic analyst at Kissinger Associates in New York. “Our need for foreign capital is still high and, without an early agreement on the budget deficit, there’s the risk of another financial crisis even worse than the last.”

Thus, the Administration’s stakes in the current budget negotiations with Congress are huge. “It is essential,” Assistant Treasury Secretary David Mulford acknowledged in congressional testimony, “that the current negotiations between the Administration and the Congress result in further progress.”

After almost two weeks of sputtering, those talks finally showed signs of progress Friday, as House Republicans, apparently with President Reagan’s support, proposed a $30-billion package that included tax increases, which have always been anathema to Reagan.

High deficits tend to be inflationary because they tempt the Federal Reserve to print the money the government must spend but does not raise through taxes. And analysts say the prospect of a falling dollar and rising inflation might cause foreigners, who have flooded the United States with their investments in recent years, to pull those investments out.

Luring Foreigners Back

If the retreat from the dollar turned into a rout, the Federal Reserve would have no choice but to push up interest rates in an effort to lure foreign investors back.

As interest rates begin rising sharply, the United States would once again confront the combination of slowing economic growth and rising inflation that plagued the economy in the late 1970s and ended in one of the worst recessions of the post-World War II era.

One way or another, steps will be taken in the United States this year to trim the budget deficit. If Congress fails to enact deficit-cutting legislation, the new Gramm-Rudman law will automatically impose $23 billion in spending cuts during the current fiscal year.

Yet Administration officials assert that they cannot afford to let the deficit talks fail. Only if the talks succeed, they acknowledge, can they ask Japan and West Germany to keep reducing interest rates at home--an important ingredient in Baker’s recipe for resolving the U.S. economic predicament because it would stimulate worldwide economic growth

“The markets are focusing more attention on the budget negotiations than is warranted,” one Administration official complained. “But the pressure is so intense that the United States simply won’t be able to negotiate credibly with (Japan and West Germany) unless we can show that the legislative and executive branches can work together.”

Interest Rate Cuts

Administration officials are cheered by the decisions in West Germany on Thursday and Japan on Friday to reduce interest rates. Those steps helped prevent the dollar from plunging Friday below the historic lows it hit on Thursday.

That helps buy time to cobble together a new international agreement aimed at stabilizing the dollar at a level consistent with a plan to balance slower domestic growth in the United States with faster economic activity abroad.

However, foreign officials are demanding that the United States act before the finance ministers of the seven leading industrial democracies meet to hammer out a new international economic accord.

“Any international package has to be based on the Americans’ taking the steps to put their house in order,” Nigel Lawson, Great Britain’s finance minister, told the House of Commons Thursday. “To have a meeting now, when that is not in place, would have a devastatingly counterproductive effect on world markets.”

Appetite for Foreign Funds

Most analysts contend that the underlying source of anxiety in financial markets that led to last month’s stock market crash was fear that the United States showed little sign of reducing its appetite--fed by its budget deficit--for foreign funds.

“Financial markets look ahead at a delicate balance between debt and the ability of the economy to sustain it,” argued John Makin, senior economist at the American Enterprise Institute here.

Makin called Congress’ decision in September to weaken the deficit-reduction targets of the Gramm-Rudman law a disaster. “It signaled to financial markets that fundamental action on deficit reduction would be postponed,” he said, “creating a no-win pattern for the American economy.”

But as soon as reports emerged from Congress suggesting progress toward an agreement to reduce the deficit, credit markets responded favorably and interest rates declined.