Dollars and deficits

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Some of the most painful errors in economic policy resulted from the belief monetary problems were not monetary but fiscal -- caused by budget deficits.

Blinded by such fiscal fundamentalism, President Hoover persuaded Congress to triple income tax rates in 1932, President Lyndon Johnson proposed a surtax as a counterproductive alternative to Federal Reserve tightening in 1968-69. A series of Japanese governments imagined wasteful public works schemes and new taxes on consumers and investors would somehow undo the Bank of Japan's prolonged deflation.

Over the past two decades, the U.S. dollar has often gone up and sometimes down. Although these ups and downs were transparently unrelated to budget deficits or surpluses, apostles of the quaint Keynesian faith have nonetheless misspent two decades alternating between predictions that budget deficits must push the dollar up or down.

In December 1983, Stephen Marris of the Institute for International Economics wrote, "Crisis ahead for the dollar" for Fortune magazine. "When capital begins to flow out," Mr. Marris predicted, "U.S. interest rates will rise. And as the dollar goes down, inflation will accelerate."

This became known as the "hard landing scenario," but only the scenario itself suffered a hard landing. Rather than falling, the dollar soared. Inflation fell below 2 percent by 1986, down from 13 percent in 1979-80. Interest rates on 10-year bonds fell to 7.7 percent in 1986 from 13.9 percent in 1981.

The original hard landing story underwent its first metamorphosis within a year. Rather than pushing the dollar down, budget deficits were suddenly said to have the opposite effect -- pushing the dollar up. Stephen Marris wrote, "Why the dollar won't come down" in the November 1984 Challenge. Unless "continuing large budget deficits" were severely curtailed, he warned, "there is a serious risk that the present recovery in both the United States and the rest of the world will come to an untimely end."

In the May 1986 American Economic Review, Republican economist Martin Feldstein decreed that, "The massive current and projected budget deficits were the primary cause of the sharp 60 percent rise in the real trade-weighted value of the dollar between 1980 and the end of 1984. The dollar's rise was in turn the major reason that the U.S. current account shifted from a surplus in 1981 to an unprecedented deficit that currently exceeds 3 percent of GNP."

Even in 1986, however, events were starting to move against this inverted revision of the fiscal theory of exchange rates. Mr. Marris had been right to complain in 1984 that the rising dollar and falling commodity prices were causing unnecessary global economic pain. I offered a similar complaint in a July 1984 Wall Street Journal article, but blamed it on the Fed. The Fed finally slashed the fed funds rate from 11.6 percent in August 1984 to 5.9 percent by September 1986. The dollar came down too, of course, and the U.S. economy kept growing at 4 percent from 1983 to 1989.

In 1987, with the dollar reversing its previous rise, the 1986 dogma that deficits pushed the dollar up was evidently in need of an extreme makeover. This third flip-flop can be traced to the summer 1987 issue of Foreign Policy, in which Lester Thurow of the Massachusetts Institute of Technology and Laura D'Andrea Tyson of University of California-Berkeley fretted about "The economic black hole."

"The more Washington is forced to rely on a continuing fall of the dollar to restore the trade balance," they wrote, "the more expensive imports will become with respect to exports.... A further drop in the dollar also threatens to touch off a worldwide recession and add instability to world financial markets. ... As import prices continue to increase, the inflation rate will continue to accelerate."