The stock market crash has exposed the fragility of international economic cooperation schemes, much touted as one of the "safety net" features that insulate the world from another big depression.
But with the benefit of hindsight, it becomes clear that the famous Louvre Accord -- designed to stabilize the dollar's exchange rate -- is a key cause of the crash of financial markets. The price being paid for it -- high interest rates -- was proving to be too much for the economy, and to have continued it would have guaranteed a recession quickly.
Treasury Secretary James A. Baker III, an astute politician above all else, was not about to let that happen. So, faced with a choice of defending the dollar with the likelihood of a recession before the November election or risking a later recession triggered either by higher interest rates or a run on the dollar, Baker chose the latter.
In the convoluted, indirect, semimysterious way that has become his hallmark, he let the world know that the administration's new priority is to pursue an easy money policy, and let interest rates fall. Just how long Federal Reserve Chairman Alan Greenspan and the other governors of the board will keep pumping money into the economy at Baker's behest remains to be seen.
To be sure, to pinpoint the Louvre Accord as the main villain of the piece is Monday-morning quarterbacking par excellence: Most observers, including this one, praised the Louvre Accord when it was announced last February in Paris. Equally, Baker got high marks from Wall Street and the business community.
"He was the golden boy, and deservedly so," says a Houston banker. "But even down here in Texas some of us are wondering whether Jim now isn't in over his head." To recover his reputation as a skilled negotiator, Baker will have to restore believability to the international cooperation process as well as persuade his boss, Ronald Reagan, to back off his opposition to a tax increase.
Increasingly, we have seen the major powers -- notably the United States, West Germany and Japan -- under stress to take care of their own parochial, national interests, even while paying lip service to international policy coordination.
Indeed, skeptics such as former Economic Council chairman Martin Feldstein and Stanley Fisher, the new top economist for the World Bank, want to junk the whole policy of coordination.
Feldstein, in congressional testimony Oct. 29, said:
"The United States should explicitly but amicably abandon the policy of international macroeconomic coordination.
"We should accept that Japan, Germany and other leading nations have the right to guide their own monetary and fiscal policies as they wish, and should recognize that their choice of policies does not have a significant effect on the American economy."
That probably would be a prescription for suicide. As Sylvia Ostry, the Canadian government's leading international economist, said in an interview, "We shouldn't abandon the process, but attempt to make it more credible and effective." For one thing, Ostry would place less emphasis on exchange rates as the key element in international bargaining.
West German central bank president Karl Otto Poehl said in New York last Monday: "In the end, stable exchange rates are not a goal in themselves. What we are really aiming at is a coordinated process of noninflationary growth."
Baker's carefully contrived coordination process began to fall apart at the Louvre Palace in February, when six major powers (later expanded to the Group of Seven) pledged to stabilize exchange rates around then-current levels. The crucial deficiency of the Louvre Accord was that it tried to stabilize the dollar at too high a level -- around 150-155 yen to the dollar, and around 1.80 to 1.90 West German marks. Those rates were not compatible, as the Louvre Accord signatories contended, with underlying economic conditions.
At the Louvre, the United States undertook to make substantial reductions in its huge budget deficit. And to replace some of the expansionary force resulting from the expected deflationary American policy, Japan and West Germany agreed to expand activity in their countries. The other four countries -- France, Britain, Canada and Italy -- would contribute what they could to the process.
But two of the Big Three failed miserably to live up to their promises: The United States -- with political responsibility split between Congress and the presidency -- was not able to deliver a major cut in the budget deficit (the lower, $148 billion deficit for this year is largely the product of a one-year bonanza from the tax reform legislation, not to be repeated next year). Sam Nakagama, a Wall Street veteran, sums it up this way: "Jim Baker lost the Louvre Accord when he couldn't deliver Reagan."
West Germany was the other major nonperformer after the Louvre: With a psychotic fear of inflation, the German government not only decided not to improve an earlier schedule of tax reductions, but allowed interest rates to creep up. (Japan put through a modest program of fiscal expansion, but in the view of its partners, could well do more.)
The net result was that no progress was made in reducing the trade deficit incurred by the United States and the continued extraordinary Japanese and German surpluses. As these huge imbalances persisted, it was natural that the yen and mark would be strong, and the dollar weak, despite central bank intervention. The only way that the American government could keep the dollar around the Louvre levels was to allow a sharp rise in interest rates.
The way the markets read it, higher interest rates to protect the Louvre targets for the dollar would ultimately lead to recession. Or, if the United States abandoned the tight monetary policy, the dollar could plunge, adding to serious inflationary pressures.
In a worst-case scenario, there could be a "free fall" of the dollar, inducing foreign investors to bring their money home, forcing the Federal Reserve Board to dam off the hemorrhage by resorting to punitively high interest rates.
In his initial warning that the Louvre Accord on exchange rate support was falling apart, a frustrated Baker pointed a finger at West Germany as the main culprit: With zero inflation and high unemployment, Baker said, Germany could take much of the heat off the United States by an expansionary policy. In that case, American interest rates could be lowered, and the dollar could be allowed to seek a modestly lower level -- without too much risk of inflation. That would begin to cure the trade deficit, and help the United States begin restructuring its economy in a way that might lead to trade surpluses.
But the Kohl government, bitterly opposed to major economic reforms in West Germany that might redistribute wealth, believes in a slow growth policy based on capital formation -- at the expense of consumer stimulation. The Germans are happy with 1 or 2 percent real growth and little or no inflation, even if one of the consequences is high unemployment in Germany and slower growth in Europe. The main problem, the Germans said -- not without some logic -- is the American budget deficit.
"Don't talk to us any more about being a 'locomotive' for global growth," said a German official. Moreover, it is plain to the Germans that the mirror image of conditions that will ease the American trade deficit will narrow the German export surplus. Like the Japanese, the Germans have a built-in bias for an overvalued dollar, which gives their manufacturers a huge trading advantage.
What, then, was Baker thinking about at the Louvre? He had few cards to play, knowing how immovable Reagan would be on raising taxes. Looking at the persistent trade deficit -- which was not coming down as he had predicted it would -- it made sense to let the dollar continue the slide initiated at the Group of Five meeting at the Plaza Hotel in September 1985. But Baker was hostage to two fears. The first was former Fed chairman Paul Volcker's insistence that a lower dollar would trigger inflation, and Baker went along with that.
In brief, Baker and Volcker worried less -- then -- about higher interest rates than a cheaper dollar. They proved to be wrong. Now, Baker has reversed his concerns: He worries more about high interest rates and what they can do to the economy (and Republican candidates) than about the dollar.
His second concern was the convincing argument advanced by the Germans and Japanese that any further rise in the mark and the yen would throw their economies into a serious recession. If that happened, Baker told his associates, a dollar decline -- intended to make American exports more competitive -- would be "counterproductive," in the sense that a Japanese/German economic slide would limit the ability of those countries to buy American goods.
Now, even the Japanese and Germans may begin to see that the bigger danger to their own economies may be a high interest rate pattern that staggers financial markets and throws the world into a depression. In the wake of the decline of stock prices, the Germans have made the first modest reductions in interest rates. They would have been even more useful some months ago.
The need now is for Kohl, Reagan and the policymakers to make further concessions to each other: If they are listening to the financial markets they must know that they have to respond, and that they don't have much time left.