With the Fed as Anchor, Low Inflation Will Keep U.S. Economy Afloat

When it comes to the effect of the Asian crisis on U.S. trade performance, there are plenty of pessimists. They predict that the dollar’s recent appreciation against other world currencies, fueled in part by massive devaluations in Asia, will cause the U.S. trade deficit to soar. Then, they say, protectionist tensions will rise and the stage will be set for even bigger financial trouble down the road.

Such fears are understandable, but the doomsayers give too little credit to the Federal Reserve under Chairman Alan Greenspan. The Fed’s success at wringing inflation out of the system has left the United States well positioned to absorb the effects of the Asian crisis, even with the dollar’s recent rise.

One way to explain Greenspan’s feat would be to look at Germany’s decades of stable prosperity. For much of the post-war era, the deutschmark rose steadily against the currencies of Germany’s trading partners, particularly the United States. Yet through most of that period, the German economy remained competitive and its exports grew steadily.

The secret to this success? A social consensus against inflation, enforced by Germany’s stability anchor, the Bundesbank. German firms became more efficient to remain profitable. Even more important, Germany directly offset much of the appreciation of the deutschmark with its low inflation rate. Foreign firms found that with production costs at home driven up by inflation, their products were still not competitive in Germany, even as their currencies declined against the mark.

The same forces are at work in the United States. The Federal Reserve Bank of Dallas, which tracks the dollar’s value against virtually all of America’s trading partners, reports in its trade-weighted index that the dollar rose almost 14% in nominal terms from the start of 1990 until July 1997, when the Asian crisis erupted. Yet the dollar’s real value barely changed due to America’s low inflation rate compared to its trading partners. While the U.S. trade deficit has risen sharply in the 1990s, that reflects the healthy growth of the American economy during most of the decade, pushing up demand for imported goods. U.S. exports still have soared nearly 80% since 1990. America remains highly competitive.

In fact, there is a vivid illustration of that U.S. competitiveness closer to home: the Mexican peso debacle of 1995.

The collapse of the peso prompted predictable warnings from NAFTA opponents about an onslaught of cheap Mexican imports. The past three years, however, have provided a somewhat different lesson. Mexico has been unable to wring inflation out of its economy; since the crisis, prices have jumped nearly 130% in Mexico, but less than 8% in the United States. As a result, though the peso is worth only about 12 cents today compared with almost 30 cents before the crisis, in after-inflation terms the Mexican currency is roughly back where it started. In terms of relative purchasing power, the peso has regained its post-devaluation loss in value.

At the same time, economic recovery has revived Mexico’s appetite for U.S goods. As a result, the U.S. merchandise trade deficit with Mexico, which NAFTA critics predicted would rise indefinitely, declined last year by 17% from its 1996 peak. U.S. exports to Mexico reached $71 billion last year, an increase of more than $20 billion, or 41%, from 1994, the year before the peso crisis. Mexico passed Japan last year to become the second-largest U.S. export market, after Canada.

If an inflationary spiral does develop in Asia, much if not all of the competitive edge gained from the recent currency devaluations will be eroded away. In that regard--as in so many other aspects of the Asian crisis--Indonesia may be the bellwether. Prices in that unhappy nation have risen 40% since last year and still are rising.

Even so, the next few months are sure to provide ample ammunition for trade pessimists. The U.S. trade deficit with Asia will rise. This is inevitable, given the continued growth of the U.S. economy, which will suck in imports, and the slowdown in Asia, which will depress demand for exports. Indeed, the U.S. deficit must increase if the Asian crisis is to be contained. Only in that way can the region’s debtors obtain the dollars they need to survive.

But a temporary rise in the trade deficit should not be read as a sign that America’s fundamental competitive position is slipping. The United States remains an extremely dynamic, flexible economy. Low inflation will help it stay in that enviable position--as long as the Fed continues to be America’s stability anchor.