Deficits: Economists Hot, Candidates Cool
Heads you win, tails I lose: Watching the financial markets react to trade figures has become that kind of proposition. When the February trade deficit, announced in April, was higher than expected, it was taken as a sign that the economy was running too hot; the financial markets slumped. When the March trade deficit, announced in May, was lower than expected, it was taken as a sign that the economy was running too hot; the financial markets slumped. This raises an interesting question that may shed some light on the April trade figures due this week: What kind of trade number could make these guys happy?
Answer: The number that could make them happy is not a trade number at all. What would make them happy is a lower budget deficit. The markets have caught on: Reducing the trade deficit is a risky business unless the other deficit also comes down. But this is an election year, and the message from Washington to New York is loud and clear: We’ll take our chances--the budget crisis can wait.
Here is what the markets have figured out, even in a rare week when Wall Street looked bullish. If the trade deficit fails to go down, that is bad, because it means that the problem is not going away. On the other hand, if the trade deficit goes down because exports are rising (as has been the case recently), it means that foreigners’ consumption of American goods is going up. Meanwhile, however, Americans’ consumption of American goods is not dropping. And so the financial markets worry that the economy will overheat, that inflation will restart and that the end result, when the Federal Reserve administers the bitter medicine of tight money, will be a recession.
The point is, Americans are consuming more than they produce. That’s the trade deficit. There are three ways to get it down: consume less, produce more--or both. As of now, the United States has been using method two, producing more. Exports have been soaring. This is good news, as far as it goes--but only if the economy can accommodate all that increased production without running into shortages and starting a wage-price spiral. In recent months, unemployment has fallen to about 5.5%, and signs were accumulating that inflation may be gathering its forces; so the markets were worrying that the limits to higher production may be drawing near.
Exports probably cannot solve the trade problem alone--not without risking a bout of inflation. Meanwhile, imports (read: Americans’ consumption in excess of their production) have remained stubbornly--almost embarrassingly--high, despite the lower price of the dollar and thus the higher prices of foreign goods in this country. Consumption has to come down, but consumers refuse to cooperate.
What to do? There isn’t much government can do about changing consumers’ habits and there is probably even less that it should try to do. The government can do a lot about its own consumption, though, at least in theory: It can reduce spending or raise taxes and thus reduce consumer spending. Translation: It can cut the budget deficit.
Lawrence H. Summers, an economist at Harvard University, has pointed out that no matter what happens to the trade deficit, the only way to put the economy back on an even keel is to reduce the federal budget deficit. At least implicitly, the financial markets understand this. And that is why their ostensibly fickle behavior is a kind of back-door call for a lower budget deficit: They want to see the trade deficit go down as a result of applying the brakes to American consumption.
So, for that matter, does much of the rest of the world. In May, two of Europe’s most important financial leaders--British Chancellor of the Exchequer Nigel Lawson and European Community Commission President Jacques Delors--warned darkly that Americans’ consumption spree has to end, lest international trade imbalances not be corrected or the world shoots off into another big round of inflation. Indeed, inflation, Lawson said, “looks to be a greater danger than world recession.”
Whether or not the Europeans and the financial markets are right to fear economic overheating, there is enough evidence to worry about. And there is good evidence, too, that the United States is on its way to repeating the same mistake that got it into this mess in the first place: running a loose fiscal policy (that is, big budget deficits) and compensating with a tight monetary policy.
If the government won’t squelch consumption by reducing the budget deficit, that ultimately may mean the Federal Reserve will have to do it by tightening the money supply. This could induce a recession, which would probably indeed reduce the trade deficit--but at a very high price. If it did not induce a recession, it would be because the Fed’s tight-money policy drove up interest rates, attracting foreign lending and keeping the trade deficit high--the story of the early 1980s all over again. In short, fiscal policy, not monetary policy, is the tool of choice for easing the United States out of the crevasse it is in.
From an economist’s point of view, what all this adds up to is clear: Right now--not next year--is the best time to reduce the budget deficit. Doing so would make room in the economy for the export boom. It would help relieve the Fed of having to make money scarce in order to keep the economy from overheating, and thus could extend the economic expansion. It would delight Wall Street and the bond markets.
An economist’s point of view, however, has certain disadvantages in Washington, among them irrelevancy. What with the presidential election, nothing is going to be done about the budget deficit this year, meaning that the earliest the effects of a big deficit reduction could ripple out into the economy will be more than a year from now. That may still be in time to beat inflation to the punch--or it may not be. Either way, by deferring the inevitable, the United States is pushing its luck.
