Ducking a dollar crisis: why Bush advisor Lindsey's strong dollar policy is headed for a fall.
Bergsten, C. Fred
In his reply to my call for a change in U.S. policy toward the dollar, both of which appeared in the July/August issue of The International Economy, White House economic advisor Lawrence Lindsey once again ignores the impact of the exchange rate on the real U.S. economy. Lindsey's initial article, in the March/April 2001 issue, omitted any reference to the huge deficit in the U.S. current account and its adverse effects on jobs, profits, and trade policy. It also failed to recognize that continued "strong dollar" rhetoric is likely to keep propping up the currency, or even push it higher, setting up an inevitable sharp fall that could drive up inflation and interest rates sufficiently to send the economy into recession. Lindsey has now ducked these issues for a second time, suggesting either blissful ignorance or--much more likely --a willful decision to avoid discussing them because the administration has no policy response.
Since our original exchange was written, representatives of a very large share of the American economy--including some of the administration's usually strongest allies--have joined the attack on current policy in this area. The Business Round Table, the National Association of Manufacturers, the American Farm Bureau, the AFL-CIO, and Goldman Sachs have all now called for an orderly downward correction of the dollar. Such a correction would of course be promoted by a change in the "strong dollar" rhetoric that contributes to maintaining the currency's substantial overvaluation in trade terms.
Since Lindsey has missed the key points twice, let me reiterate them briefly. First, the current account deficit has now approached $500 billion, or 5 percent of GDP, which requires the United States to import over $3 billion of foreign capital every working day to balance our international books (including to cover our own capital outflows). These numbers are far higher than when the U.S. deficit hit its previous record ... in the middle 1980's, after which the dollar fell by more than 50 percent against the yen and the European currencies in less than two years--not the 9 percent cited by Lindsey in an obvious effort to downplay the problem. Any such dollar collapse would push inflation up sharply, push interest rates up even more and tank the stock market--probably driving the economy into recession if it occurred any time soon. Former Federal Reserve Chairman Paul Volcker testified to the Senate Banking Committee on July 25 that the current deficit is "a symptom of imbalances in the national economy ... cannot be sustained."
Second the dollar has risen substantially since 1995. It has increased by 30-45 percent against baskets of currencies of all major U.S. trading partners and the other industrial countries, respectively, and by over 70 percent against the European currencies and about 50 percent against the yen. The resulting rise in U.S. prices has severely undermined the international competitive position of even the most successful U.S. companies, through no fault of their own. The effects include very large and probably permanent job losses, especially in the high-paying manufacturing sector, and sizable reductions in profits and hence investment.
It is not "whining" for workers and companies to complain when their livelihoods are being badly damaged by policies and price signals that virtually all analysts, including the International Monetary Fund in a series of public statements, agree deviate sharply from sustainable equilibrium levels. Secretary of the Treasury Paul O' Neill rightly registered similar complaints when he was CEO of International Paper--whose current CEO is leading the corporate attack on present policy--during the last big dollar overvaluation in the middle 1980's. As noted in my original article, the benefits that accrued from the external deficits and dollar overvaluation when the economy was booming in the late 1990's--downward pressure on prices and interest rates--are of modest value today when growth is tepid, unemployment is rising, inflation has largely disappeared and interest rates have already dropped sharply.
Third, dollar overvaluation and large external deficits have traditionally been the most accurate leading indicators of trade protectionism in the United States. The current situation will thus make it harder, perhaps impossible, for the administration to win public and Congressional support for new Trade Promotion Authority--without which there will be neither a Free Trade Area of the Americas nor a new multilateral round in the World Trade Organization (whether or not one is nominally "launched" later this year). The administration's stance on the dollar undercuts its own trade policy and several of its key foreign policy objectives.
Rather than address these problems, Lindsey stooped to misstatements and the creation of straw men in responding to my initial article. He ludicrously suggested that I am "opposed to foreign capital inflows" and "would just say `no' to more foreign direct investment" when I had criticized him solely for welcoming such flows at any level that the rest of the world may wish to send us for a while. The United States will obviously continue to import large amounts of foreign capital for a long time and they are good for our economy. Lindsey seems unwilling to recognize that there are prudent limits on how much foreign capital (and hence external debt) we should allow ourselves to be hooked on, however; Volcker pointed out to the Senators that it is simply unreasonable to expect that the United States can indefinitely continue to attract the current daily requirement of $3 billion and that we should therefore promptly start cutting back our dependence.
Lindsey also suggested that I disagree with the administration's support of sound Federal Reserve policy. In fact, my chief fear is just the opposite: that continued "malign neglect" of the dollar by the administration will ultimately prompt a dramatic reversal of capital flows that will push interest rates up sharply and thus swamp the Fed's laudable effort to rekindle growth in the American economy. The Fed itself has noted that the failure of the dollar to follow the normal pattern of declining in response to its interest rate cuts has truncated one of the usual channels through which such cuts stimulate renewed growth.
The most important policy difference between Lindsey and me is whether a change in the Administration's approach to the dollar at this time could in fact promote the needed adjustment in the huge U.S. deficits and reduce the risk of severe disruption later. He says that the Plaza Agreement in 1985 "worked" but was "unsuccessful," whatever that means, whereas the clear result was that the dollar returned to rough equilibrium in two years and, by 1990, had produced virtual elimination of the external deficit and the virulent protectionism of the middle 1980's. Moreover, Lindsey ignores the latest evidence: joint U.S.-Japan intervention stopped and reversed both the excessive strengthening of the yen in 1995 and its excessive weakening in 1998, and joint U.S.-EU intervention a year ago stopped the slide of the euro and prompted a 10 percent rebound. Careful studies by the Bank of Italy and leading academic economists, such as Jeffrey Frankel and Kathryn Dominguez, show that intervention is not only successful when conducted properly but has played a central role in triggering many of the needed turnarounds in relationships among the major currencies for over fifteen years. But the best evidence comes from the administration itself: Why is it so afraid to alter the "strong dollar" mantra if it believes there would be no impact from doing so?
The most likely answer is that the administration realizes that the situation is precarious but fears that any change in its rhetoric could trigger the freefall of the dollar that everybody wants to avoid--and that it would then be blamed for causing the crisis. The latter fear is understandable politically but hardly a persuasive rationale for policy. It is in fact much more likely that a freefall could be avoided by deliberate action to ease the dollar down now, when neither Europe nor Japan is likely to attract huge financial flows away from the United States, than by continuing to prop it at substantially overvalued levels. There is indeed a risk that the dollar might rise even higher under current policy, especially against the yen now that the Japanese authorities--with the apparent approval of Lindsey--are looking to additional yen weakening to rescue them from their latest recession.
Hence I continue to believe--along with the business community, the agricultural community, organized labor, and at least some on Wall Street--that the time has come for a change in administration policy. The goal should be to ease the dollar down by an average of about 20 percent over the next year or so, implying substantially larger adjustments against the euro and probably the yen, which would cut the external deficit and foreign borrowing requirement roughly in half. Lindsey and his colleagues should stop talking about a "strong dollar" and instead inform the markets that a "sound dollar" would suffice, or simply stop commenting on the issue. They should reinforce that step by joining the Europeans to support a further rise in the euro, including by direct intervention in the foreign exchange markets. Both steps would send a clear signal that U.S. attitudes had changed and the markets will take it from there. The alternative is to perpetuate a growing imbalance that both weakens our economy at present and poses severe risks of throwing it into far worse shape at some point in the fairly near future.
Johns B. Taylor is the Undersecretary of the Treasury for International Affairs. He served as Senior Economist on President Ford's Council of Economic Advisors in 1976, as a Member of President Bush's Council of Economic Advisors from 1989-91, as Economic Advisor to the Bob Dole presidential campaign in 1996, and as Economic Advisor to the George W. Bush presidential campaign in 2000. Before joining the new administration, Taylor was a Senior Fellow at the Hoover Institution and Professor of Economics at Stanford University, where he developed the Taylor Rule, a model for assisting Fed monetary policy moves.
C. Fred Bergsten is Director of the Institute for International Economics. He was Assistant Secretary of the Treasury for International Affairs from 1977 to 1981 and Assistant for International Economic Policy to the National Security Council from 1969 to 1971. This article continues the strong dollar vs. sound dollar debate between Bergsten and White House Economic Advisor Lawrence Lindsey (see TIE's March/April 2001 and July/August 2001 issues).
