Sooner or later, the high-flying U.S. dollar has to come down to earth -- perhaps with a crash and a new burst of inflation -- to move the nation's trade with the rest of the world back toward balance.
This has to happen because there is some limit to how much money foreigners will be willing to lend to the United States to finance its still-growing trade deficits, a group of prominent economists attending a Federal Reserve conference here agreed.
Paul Krugman of the Massachusetts Institute of Technology estimated that the buildup in U.S. debt owed to foreigners is so rapid that, if the dollar's value does not fall from present levels, the debt would equal about 20 percent of the gross national product by 1990.
In terms of today's $4 trillion GNP, that would mean an $800 billion foreign debt. With, say, a 10 percent rate of return, $80 billion would have to be paid to service that debt for a single year. Similar estimates were offered by C. Fred Bergsten, director of the Institute of International Economics in Washington.
The U.S. trade situation has deteriorated to the point that imports this year are likely to be nearly twice as great as exports. The magnitude of the U.S. deficit in all its international transactions is so large that the value of the dollar -- weighted according to the volume of trade with other major countries -- would have to drop by 35 to 40 percent to bring those transactions back into balance, according to some estimates presented to the conference.
The dollar would have to fall that far partly because debt would continue to build up in the meantime. The only way to service the debt is to run a trade surplus. And selling those extra goods and services abroad will require a still cheaper dollar.
No one at the conference -- which was sponsored by the Federal Reserve Bank of Kansas City -- could suggest any even relatively painless way out of this dilemma. Richard N. Cooper of Harvard University, a former undersecretary of State, argued that a crash landing for the dollar actually would be better than a slow depreciation, both because of the debt buildup and because a quick fall could mean a smaller enduring inflationary problem.
"It is desirable to get the dollar exchange rate down as quickly as possible, not as gradually as possible," Cooper declared. That way, the United States would lose less of the inflation gains that have accompanied the 40 percent rise in the dollar since 1980.
As the dollar rose, imports became relatively cheaper for U.S. consumers and businesses. The cheaper imports also helped hold down the prices of U.S.-produced goods competing against imports. A drop in the dollar could reverse that process.
The difference would be between an abrupt, one-time jump in the price level and a more enduring acceleration of inflation as wages responded to a slower but more persistent rise in the price level following a gradual fall in the value of the dollar.
"It would be better to take it all at once," Cooper said.
Such advice runs counter to the desire of Federal Reserve officials that any fall in the dollar should be gradual to limit the immediate inflationary impact.
In congressional testimony last month, Fed Chairman Paul A. Volcker tried to convince financial market participants that the Fed's more generous money growth target for the remainder of this year does not constitute a major easing of policy that would mean sharply lower interest rates.
Fed officials acknowledge that Volcker took this step precisely to keep the dollar from falling too far too fast -- particularly in the absence of action to reduce budget deficits that were credible to those same financial market participants.
At the conference, Fed Governor Henry Wallich warned that a drop in the dollar that came before a budget fix could lead to both higher interest rates and generally higher inflation, particularly if the drop came along with an easing of monetary policy.
Like Cooper, Robert Solomon of the Brookings Institution, another speaker, was somewhat more sanguine about the inflation outlook.
"Whatever the initial price effect, the important matter for the longer run is whether it gets translated into higher inflation," Solomon said. "That depends on how wages react to the jump in prices. . . . It is not beyond hope that the inevitable upward price pressures that will accompany a dollar depreciation will be a one-time phenomenon rather than a continuing higher rate of inflation."
At the conference, there was considerable disagreement among the economists about what caused the dollar's value to rise so far above what reasonably could be regarded as a sustainable level. However, most felt it was due to the combination of factors.
Leading the list were the large federal budget deficits. The budget red ink and an anti-inflation monetary policy adopted by the Federal Reserve produced a sharp rise in real interest rates -- that is, interest rates compared with current or expected inflation relative to rates in West Germany, Japan and a number of other nations. The high real interest rates, in turn, attracted a large inflow of foreign capital to the United States. foreigners' purchases of dollars to invest here drove up the dollar's value compared with their own currencies.
Other factors cited included a faster recovery from recession here than in most other industrial nations, a desire on the part of foreign investors to put their money in a "safe haven" and the impact of the 1981 corporate income tax cuts on after-tax rates of return on business investments.
Cooper began his analysis by asking -- as many American consumers happy with the availability of less costly imported goods might -- whether the dollar's rise is even a problem.
"U.S. employment has risen, U.S. inflation rates have dropped, economic recovery continues, albeit at a moderate pace," Cooper said. "If the course of economic events is going well, why should the government alter the course of economic policy? If there are not problems, there is no need for solutions.
"There are two difficulties with this insouciance," he said. "The first is that the strong dollar is hurting badly those sectors of the economy that are most exposed to foreign competition, whether at home or abroad." The damage being done to some parts of the manufacturing sector and to the mining and farm sectors has generated the strongest drive to legislate direct protection from import competition since 1929-30, Cooper warned.
The second difficulty is the debt buildup, which is occurring "at an annual rate that exceeds the total external debts of such large debtors as Brazil and Mexico," he continued.
"The buildup of external debt imposes a burden on future generations. If the counterpart of the debt were being productively invested in the United States, that would be no problem; future Americans and foreign lenders would both be better off.
"But . . . exceptional external borrowing has not been accompanied by exceptional domestic investment; on the contrary, that has followed a fairly typical cyclical path. Even if the external debt iself is not repaid, it will have to be serviced out of future income that has not been augmented. Sooner or later, a worsening of the U.S. terms of trade the relative value of the dollar will be required to generate the necessary improvement in net exports.
"So future generations will not be able to enjoy all of their contemporary production," he concluded.
Cooper and many other speakers and attendees said the principal policy response needed to correct this long-term difficulty ought to be a substantial reduction of the federal budget deficit. Cooper cautioned, however, that a sharp shift in fiscal policy could cause a recession unless offset by an easier monetary policy. Without such a concomitant change by the Federal Reserve, a deficit reduction package might not even push the dollar down because its adoption could serve to increase foreign confidence in U.S. management of its economy.
The dollar's value has fallen 6 or 7 percent from its levels of early this year. Nevertheless, its value is still as high -- or perhaps 5 percent higher, depending on how one calculates the trade-weighting -- as its 1984 average.
That means the trade deficit is likely to continue to worsen, because there is a substantial lag between changes in relative exchange rates and shifts in trade balances. In the short run, a drop in the dollar actually makes the trade numbers look worse, because U.S. exports are worth less in terms of foreign currencies while U.S. imports earn more dollars for their producers.
Bergsten and Krugman also raised another serious question: If the United States must bring its external transactions back toward balance, some other nations' trade surpluses must shrink. If so, whose?
Ideally, Japan's trade surplus, the world's largest, should drop, Bergsten said. But that would account for probably no more than $50 billion of the $150 billion to $200 billion adjustment that the United States must make. That means that the surpluses of other industrial nations, and many of the world's developing nations, also will have to diminish.
Of course, if that happens, those nations could well begin to take new protectionist actions to try to preserve their trade advantages.
Most of the conference participants felt that the massive imbalances in the U.S. transactions with the rest of the world could not be allievated much by changes in the current system of floating exchange rates, perhaps through an agreement among a few major countries to keep their exchange rates within a flexible, but limited, range of one another.
Ronald McKinnon of Stanford University suggested that a better alignment of exchange rates could be achieved if the principal industrial countries agree to coordinate their monetary policies. Such coordination could allow the nations to keep their exchange rates within "officially announced target zones," McKinnon said.
Fed Governor Wallich, however, said the U.S. central bank is in the unfortunate position of having to try to achieve several objectives with only one tool, monetary policy, and, except on rare occasions, cannot set that policy just according to foreign-exchange-rate concerns.
In the end, probably the most striking aspect of the discussion of the value of the dollar was the sheer magnitude of the international imbalances faced by the United States. If the dollar does not fall, the nation's international deficit will continue to worsen because of rising debt service costs, making the eventual correction still greater. If the dollar does fall enough to correct that problem, its plunge could set off a new round of inflation and trigger new debt repayment problems among Third World countries.
The choices are not appetizing.