Charles R. Taylor is an international economist for the Prudential-Bache Securities firm in D.C. Taylor believes there exists a high probability that a crisis will occur in the foreign exchange market in the first six months of 1988. In fact, he believes that the days prior to Jan. 15 are especially critical, since that's when the merchandise trade numbers for November will be released.
Those days are crucial for two reasons. First, if the trade number is high -- $15 billion to $16 billion -- it could precipitate a dollar crisis. Second, Taylor believes the rumored agreement reached before Christmas by the Group of Seven nations to support the dollar to the tune of $15 billion to $30 billion could be in jeopardy.
Taylor reasons that these nations may have used up their $15 billion to $30 billion foreign exchange reserve capacity earmarked for the dollar support before Jan. 15. Consequently, a lack of support in advance of the data could put the dollar into a decline, and should the trade data be bad there could be a limit to the amount of reserve currency that these nations are willing to commit to keep the dollar afloat.
The crisis that Taylor fears would "take the form of a sharp retreat by international investors from U.S.-denominated securities. The crisis would have two effects that may or may not be simultaneous, but will be closely linked. The first effect would be a sharp decline of the dollar, while the second would be considerable pressure on U.S. rates to rise, caused by the exodus of foreign investors from dollar-denominated securities.
"The capacity for such a crisis to occur exists," he said. "The crisis can occur on a scale that may be too big for the foreign central banks to take effective action against." The reason it could occur is that there is between $750 billion and $1 trillion in liquid assets held by foreigners in the United States. Should that money begin to leave, it would be extremely hard to support the dollar.
What should be done? Several other international economists believe international investors want to see some evidence that our excessive consumption of imports is slowing, and that, unfortunately, means an economic slowdown or a recession for the United States. Foreigners will be looking for poor U.S. trade figures, an increase in unemployment, etc., anything that would assure them that our demand for imports is being curtailed while exports remain strong.
As to the best course of action before any crisis occurs, these economists suggest that the Federal Reserve tighten the money supply and raise short-term interest rates, and now. They feel that if this plan was carried out, it would produce a short recession and help control our insatiable appetite for foreign goods. Such action would be well received abroad, would lead to lower long-term rates here, and would have a tremendous positive effect in the medium term.
But should the Fed try to wait out the situation or expand the money supply in an effort to keep the economic expansion going, then it would run the risk of triggering the crisis. Deciding on policy at that stage of the game would not only be difficult, but implementing that policy would be hard, since long-term rates would be moving rapidly higher. The Fed, in an effort to keep up with the rising long rates, would have to raise short rates faster than long rates were accelerating. In effect, the Fed would be following the market.
Quite obviously some hard decisions are going to have to be made by official Washington, and before a crisis breaks over us. Since we are in a period of high risk, now is the time for action, not inaction. But this will prove most difficult to bring about in an election year.