Washington has embarked on three major policy changes that are highly desirable and badly needed for the long run: reducing the structural budget deficit, reforming the tax system and reducing the exchange rate of the dollar. But as welcome as these changes are for the longer run, they pose problems for the immediate future.
Only the lower dollar promises to stimulate U.S. demand and economic expansion in the near term, and it adds nothing to demand in the world as a whole. A lower dollar helps expansion here by reducing our trade deficit only to the degree that it weakens expansions in foreign economies by reducing their trade surpluses. The other two policy changes--budget deficit reduction and tax reform--will weaken U.S. demand by late this year and weaken total world demand in the process. That weakness must be offset by stronger demand from other sources or it will slow expansion and possibly tip the United States and world economies into recession.
What is the potential list of other sources of demand? There is always the possibility of a spontaneous burst of optimism from business and consumers. Such bursts, both positive and negative, do occur and make economic forecasting the hazardous business that it is. But a fortuitous positive burst is not something to count on. Rather, the impending weakness arising from changes in U.S. fiscal policy needs to be offset by lower interest rates worldwide and more expansionary budgets abroad.
Reversal of Previous Policies
This prescription implies a reversal of the policies of the past several years. In the first half of the 1980s, the economies of Europe and Japan tightened their own fiscal policies while enjoying the rising export demand that came from the strongly expansionary fiscal policy pursued in the United States and the soaring dollar exchange rate that came with it.
This strategy, which produced a roughly neutral fiscal push for the industrial world as a whole, provided enough demand in Europe to maintain expansions but not at a fast enough rate to keep unemployment from rising.
Now that trip is over. With U.S. fiscal policy turning the other way and the dollar down sharply, European economies will have to expand domestic demand just to maintain their growth rates of recent years. To grow faster so as to reduce unemployment, they will have to stimulate domestic demand even more. That is the clear message behind the U.S. attempt at the Tokyo summit to achieve better policy coordination.
Yet despite the clear need for this kind of policy change as viewed from this side of the Atlantic, Europe's policy-makers appear reluctant to use the traditional tools of fiscal and monetary policy to provide the boost that will be needed by their own and the world's economies. In light of the fact that average unemployment in Europe has risen every year for a decade, this reluctance is puzzling. In part it stems from questionable theories that view unemployment as structural or unresponsive to demand for other reasons. But mostly it stems from a continuing fear of inflation.
Inflation had become a serious problem in the 1970s, and the policy emphasis in most European countries shifted to restraint and a tolerance of high unemployment as a necessary cost of bringing inflation under control. But now the extended period of rising unemployment has brought inflation down to a much lower plateau in most countries and to near zero in some. Restrictive policies had a big effect in reducing inflation initially. The continuation of those policies has yielded less and less further improvement. What motion remains in the wage-price treadmill appears to be remarkably unresponsive to continued high unemployment.
Reducing unemployment may always carry some risk of more inflation. But the present is certainly a time when that risk is modest and the costs of not taking it are great, especially for the European economies. The inflation "habit" has been broken. With an enormous pool of unemployed, pressures from tight markets are minimal or non-existent.
Problems With Unilateral Action
With European currencies now appreciating and oil prices sinking, the downward pressure from foreign prices will help moderate the overall price level. Thus, as appropriate as the emphasis on fighting inflation was in the past, it is now time to redirect demand management in Europe toward more expansion and lower unemployment.