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.”
In “America in the World Economy,” in 1988, the head of the Institute for International Economics, C. Fred Bergsten, seemed to consider even foreign investments in the U.S. stock market or in building new auto factories in the United States as a mere loan. “If foreign investors and central banks finally stop lending such quantities to the United States,” he wrote, “the dollar will plunge and interest rates will soar.”
Faced with the unexplained embarrassment of a falling dollar after the Fed eased, the fiscalist establishment simply reversed Mr. Feldstein’s previously handy argument that budget deficits made the dollar soar. And while Mr. Marris warned in 1984 that a rising dollar would set off a world recession, Mr. Thurow and Ms. Tyson now warned us a falling dollar would have the same effect.
Unfortunately for them, the dollar began rising steadily after January 1988, as the Fed tightened. And later, when the U.S. current account deficit rose from 0.8 percent of GDP in 1992 to 4.2 percent in 2000, Mr. Feldstein’s illusory “twin deficits” relation between budgets and trade was quietly set aside because the budget was inconveniently in surplus.
The real reason U.S. imports grew faster than exports during the long economic expansions after the recessions of 1981-82 and 1990-91 is that the U.S. economy was growing faster than those of its biggest export markets. That is still the reason. For the year ending in the third quarter, economic growth was 1.8 percent in the euro area, 2.6 percent in Japan and 4 percent in the United States.
Any proposal to “fix” the current account deficit by imposing brutal European or Japanese tax policies on the United States simply aims to weaken the U.S. economy and thus reduce demand in general, including demand for imports. It “works” only in the same sense recessions have always cut our need for imported industrial materials, components and equipment, and our ability to pay for them.
Today, as in the ‘80s, the United States is again said to be at grave risk if foreigners suddenly decide to sell their U.S. stocks and bonds. This is often said to threaten the dollar, but that too confuses fiscal policy with monetary policy.
The $1.9 trillion in daily trades on the foreign exchange market, mainly involving dollars, is settled with cash, not Treasury bills. You cannot offer to trade dollars for euros unless you either have the dollars in a checkable fund or are willing and able to sell something quickly to get the cash. Selling U.S. Treasury bills or bonds is one way to get dollars, but selling labor (wages) or goods (exports) are much bigger ways of acquiring dollar cash.
To sell stocks, bonds or commodities for dollar cash would lower that asset’s price (i.e., raise interest rates) only if the seller is willing to sell cheap. But neither buying nor selling Treasury bills can add to the world’s supply of dollar cash. If the world wants more euros, only the central bank of Europe can do something about it. If the world wants fewer dollars, only the Fed can do something about that.
Regardless whether our own Treasury or some foreign central bank offers more U.S. Treasury bills for sale, prospective buyers must pay for them with dollar cash. Buyers end up with fewer dollars in their checking accounts, buyers with more. The world supply of dollar cash is unaffected unless our own Fed buys those Treasury bills, paying for them with new bank reserves and thus allowing banks to create new money by making loans or buying securities.
Another reason not to worry about foreigners becoming unwilling to finance the U.S. trade deficit (by investing extra dollars earned from exporting) is that this so-called problem is identical to what the same worriers describe as the solution. If the current account deficit could not be financed, then it could not exist. Hard landing zealots begin by fretting about the gap between imports and export, and end by fretting the gap might disappear. They also claim trade deficits are bad because they will make the dollar fall, but the falling dollar is good because it will shrink the trade deficit.
If a falling dollar reduces the trade deficit and a shrinking trade deficit lifts the dollar, then it follows a falling dollar must make the dollar rise. All this makes as little sense as the related pretense that “restoring confidence” in a currency depends on higher taxes.
Correction: My last column said, “Like other New York Times employees, [Daniel] Altman has a 401(k) retirement savings plan.” I have since learned Mr. Altman quit the New York Times payroll in August 2003 and appears as a freelance writer in the paper.
Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.