No One but U.S. Treasury Wants Interest Rate Cuts

When the finance ministers and central bank presidents of the seven leading economies (G-7) met in April, U.S. Treasury Secretary Nicholas F. Brady’s efforts to get agreement on a coordinated reduction in interest rates was rebuffed decisively by the Germans and Japanese.

The press played up the political aspect. They saw the rebuff as a defeat for the United States. They missed the more important change--a further shift in economic policy toward medium-term strategies aimed at lower inflation.

The U.S. Treasury is now the odd man out in economic policy. Its argument to the G-7 was a familiar one: The cure for recession is economic stimulus. Secretary Brady’s proposal called on the Europeans and the Japanese to join the United States in raising money growth rates to lower interest rates. By rejecting the U.S. proposal, the Europeans and the Japanese showed that they do not hold the policy view that still dominates the U.S. Treasury Department.

The main issue is the choice between using monetary policy for short-term fine tuning of economic activity or as a medium-term strategy to control inflation. The United States proposed faster money growth to boost spending and get a short-term increase in employment. Faster money growth would also increase inflation, not immediately but after several quarters. Many of the advocates of short-term fine tuning dismiss the problem by contending that they can take care of inflation later.

Past experience doesn’t give much reason to believe that claim. The persistent inflation of the 1970s and 1980s began with efforts to trade off lower unemployment for higher inflation. Once inflation rose, policy shifted the other way. To fight inflation, policy-makers reduced money growth and raised interest rates.

The result was higher inflation and unemployment. Although the Germans and Japanese had begun to reject short-term fine tuning by the 1970s in favor of a medium-term strategy, the U.S. Treasury was able to cajole and persuade them to join us in expansionary policies in the late 1970s and again in the mid-1980s. Each time, these actions were followed by higher inflation in all three countries. Consumer price inflation for the most recent 12 months--3% in Germany, 4% in Japan and 5% in the United States--is in part the residue of the last effort to coordinate expansion.

German and Japanese opposition to short-term coordinated expansion is not new. German central bankers have made this argument since the 1970s. In their view, monetary policy should be used to prevent inflation. With low inflation, the private sector will keep the economy growing. Departures from full employment will be temporary and self-correcting. Unemployment compensation and other pieces of the social society net will prevent hardship during periods of slack. Since inflation produces distortions and uncertainty that discourage investment, price stability encourages productive activity.

This view has spread. Nowhere is the change more dramatic than in France. German central bankers used to say privately that, when inflation reached 3%, the French stepped on the monetary accelerator while they hit the monetary brakes. Even after 1979, when France and Germany joined the European monetary union, France continued to inflate. To keep the monetary union working, it devalued repeatedly.

The two countries differ no longer. For more than five years, France has followed a consistent, medium-term strategy to lower inflation to the German level and avoid devaluation of the franc. Average growth of a broad measure of money has been less than 3% a year since 1986, and the rate of increase in consumer prices for the past two years is within one-half percent of the comparable German rate. This year, France may have a lower inflation rate than Germany.

Rejection of fine tuning is not limited to France, Germany and Japan. Holland has typically followed German monetary policy closely. So has Austria. Switzerland has generally followed inflation policy of its own making. Belgium and Italy, longtime members of the group that tried to fine tune, have joined the sound-money group. Recently, Spain, Britain and Sweden took the plunge.

The U.S. Treasury Department stands alone among major countries in advocating a return to the policies that failed in the past and have been abandoned elsewhere. Although unemployment has remained below 7% in this recession, the Treasury wants more stimulus. That would be a mistake. A modest recovery with declining inflation will prove more durable and beneficial to consumers and producers than a quick spurt in demand followed by higher inflation.

So far, the Federal Reserve has chosen a medium-term strategy to slow inflation and, gradually, restore price stability. It has followed a policy of disinflation for four years. Wage rates, commodity prices and consumer prices show signs that inflation will fall below the 4% to 5% range in which it has remained since the mid-1980s.

To get these long-term benefits, the Federal Reserve must reject the Treasury’s advice as decisively as the G-7 has done and let the Treasury remain the odd man out. The result will be inflation in the 3% to 3 1/2% range and falling.