The turmoil in the world's currency markets is a reflection of a basic truth: The current easy-money policy in the United States is no substitute for tax reductions in West Germany and Japan as a way of keeping the world economy out of a looming recession.
Today's policy mix in the G-3 (United States, Japan and West Germany) is a recipe for a world slump. The United States needs to discourage consumption at home to reduce the demand for imports as well as for domestic goods. But foreign demand for U.S. goods must increase to keep American factories from laying off more workers.
Key foreign economies are sluggish. So the United States is maintaining an easy-money policy to keep consumption strong and offset the contractionary effects of a gradually declining budget deficit. But easy money undercuts the positive effect on imports and exports that would otherwise flow from a weaker dollar.
Chairman Paul A. Volcker and the Federal Reserve Board now face an agonizing dilemma. Reducing the trade deficit calls for tighter money to reduce domestic demand for goods, but tighter money coupled with weak worldwide growth could precipitate a recession in the United States. The steadfast refusal of West Germany and Japan to stimulate their economies--they prefer, in fact, deflationary policies--could throw the world economy into recession.
Meanwhile, the danger of a trade war compounds the threat of recession. The Reagan Administration has resisted protectionist pressure in Congress by stalling for time until dollar depreciation could reduce the trade deficit. But the dollar's decline has failed to produce the hoped-for dramatic turnaround in trade because monetary policy has been too tight abroad and too easy at home--a combination that keeps demand for goods high in the United States and low abroad.
Congress, failing to understand the broad economic causes of the trade deficit, is frustrated because it has been promised that this deficit would fall along with the dollar, and it attributes the continued large deficit to unfair trade practices abroad.
Lawmakers will be sorely tempted by the twin trade and budget deficits to limit imports in the mistaken hope that such action would reduce both deficits. Any such protectionism would provoke retaliation from our trading partners, which might easily escalate into a trade war.
West German Finance Minister Gerhard Stoltenberg and Japanese Finance Minister Kiichi Miyazawa may want to reflect on the policy choice that confronts them in 1987. They can enact stimulative tax reductions in their own economies and win political kudos at home while helping to ensure continued world economic recovery. Or they can sit by and watch Congress place a tax on their exports.
There is some evidence that Miyazawa is considering the far more desirable tax-cut-at-home alternative. The Japanese Diet is moving toward the enactment of tax reform that includes some tax reductions. Unfortunately, the effect of those cuts will be reduced by measures to make up the revenue losses later on. The West German government has scheduled some very modest tax reductions well into the future, which will likely be too little and too late to help deflect the world economy from its current path toward recession.
It would be a serious mistake to believe that the policy dilemma confronting the world economy could be solved by an agreement to stabilize currencies. The exchange markets are a sideshow; they measure only the tensions among the world's major economies. When the temperature gauge registers an overheated engine, the problem is not solved by gluing the gauge back to normal.
Trade tensions are best reduced by a growing world economy that provides expanding markets for exporters of all nations. Unless lower tax rates in the major industrial countries replace U.S. monetary policy as the major economic stimulant, world inflation and a smaller flow of goods and services among nations will replace economic growth.