WALL STREET has sent our political leaders a powerful message: Time is running out. Mounting fear of rising inflation and interest rates triggered the Great Panic of October 1987. Investors, both at home and overseas, are afraid that, because our political leaders have been unable to deal directly with this nation's trade and fiscal imbalances, inflation will be the fall-back remedy -- the government will simply run the printing presses and pay off its debts in future years with cheap dollars.
Historically, inflation has been the debtor's escape valve. As recently as the 1970s inflation was a means of indirectly raising tax rates and reducing the real value of outstanding debt. But that experience left a very bad taste in the mouths of both U.S. and foreign investors. Since that time the economic landscape has become considerably more complex.
In today's markets, higher inflation, far from easing other economic troubles, would aggravate the problems of rising debt, rising interest rates and slower growth. The loss of stock market wealth will cut consumer spending in 1988 by $15 to $20 billion. That will slow GNP growth by about one-half of a percentage point and relieve pressure on interest rates, but that relief will be only temporary. The only sure way out of this bind is the same fiscal stringency that we have forced on the poorer debtor countries of the world.
The financial markets' inflation fears are certainly not without basis. The nation has been on a consumption binge, living far beyond its means. This spending spree has pushed the economy closer and closer to its productive capacity. When the nation's plants, mines and utilities are operating close to full tilt, producers start bidding up prices and wages. Right now industrial capacity utilization is near the levels at which we experienced a significant acceleration of inflation in the 1970s.
Recent declines in unemployment, below 6 percent in the nation as a whole, add to the inflation pressures. Labor markets in some parts of the country -- particularly New England, the Mid-Atlantic states, and California -- are getting quite tight. Add to this tightness the fact that living standards of American workers are falling. Adjusted for inflation, the average real wage has declined 6 percent in the last 10 years. In the first 8 months of 1987, prices outpaced wage increases by 2 percentage points. Previously, workers might accept those losses in fear of losing their jobs; but, as labor markets tighten, there will be inevitable pressures to catch up.
Higher prices for imported goods are also bound to drive up the inflation rate in future years. The fall in the dollar's value, as nervous investors seek to sell their dollars and get out of U.S. markets, has had the positive benefit of improving the price competitiveness of American industry; a cheaper dollar on foreign exchange markets makes U.S. products less expensive for foreign buyers so, presumably, they will buy more. But that improvement, helpful as it may be to economic growth, has come at the cost of higher prices for imported goods, now a major share of American consumption.
Already in 1987, consumer prices have been rising at a 5 percent annual rate compared to an average of 2 percent in the prior two years. At present, the acceleration of inflation is evident only in imported good prices, but increased fears that it will spread into domestic wages and prices is evident in the significant tightening of monetary policy -- interest rates have risen about 1 1/2 percentage points in the last 12 months.
When interest rates go up, the yields on stocks look less attractive to investors and stock prices head downward. In the wake of last Monday's market meltdown, Federal Reserve Chairman Alan Greenspan promised to loosen up on the monetary reins. But without an expansion of domestic productive capacity -- and the policy changes that could produce it -- more money chasing around can only mean higher inflation. Which gets us back to where we started.
So, investors may be right that higher inflation is coming. But the really bad news is that a dose of inflation won't solve the deficit problem. If anything, it may make it worse.
For one thing, the income tax system is now largely indexed to the general price level. As the result of the 1981 tax law, inflation no longer pushes taxpayers into higher tax brackets -- the "tax creep" effect that used to swell the Treasury's revenues and cut the fiscal deficit. On the other side of the government ledger, expenditures are also largely set in real terms with automatic adjustments for inflation. Thus, both taxes and expenditures rise in roughly equal proportion to a change in the price level and the deficit remains unchanged.
Second, it is no longer so easy to fool bondholders. At the first hint that the government meant to tolerate higher inflation rates they would sell their bonds, causing interest rates to soar. Today's investors are acutely aware of the losses sustained by bondholders in the inflation of the 1970s; and now they have a much wider range of investment options. Inflation would let the government pay off its longterm debt in cheaper dollars, but at the cost of higher interest rates on new debt issues.
This boomerang effect is particularly true in a world in which funds can so easily be withdrawn from U. S. markets and sent abroad. The reaction to inflation in the United States would be -- and in some measure already has been -- a flight from the dollar and downward pressures on the exchange rate. The only alternative, again already felt to some degree, is to raise interest rates here in the United States to induce investors to remain in our markets. As we are beginning to discover, debtor countries, like the United States, are often held hostage to the concerns of their creditors -- in this case inflation.
Although inflation cannot provide a way out of the deficit dilemma, it now seems almost inevitable that the failure to reduce the budget deficit will drive both interest rates and inflation up in future years. Thus far, the United States has been able to avoid either of these consequences only because of the willingness of foreigners to finance our spending.
The unfortunate truth is that the United States needs the trade deficit, as we cannot support our current level of spending out of domestic production alone. In 1986 two-thirds of all private saving had to be used simply to finance the budget deficit, leaving less than 4 percent of the nation's output for net capital formation. We are currently borrowing abroad about $150 billion annually to meet the excess of domestic spending over our income. If the trade deficit should disappear tomorrow the result would be an explosive rise in U.S. interest rates, as government, business and individual borrowers fought for the scarce supply of domestic saving -- and/or a sharp rise in inflation as demand for goods and services exceeded the domestic supply.
While economists failed to anticipate the magnitude of this overseas borrowing and thus the extent to which a domestic financial crunch could be postponed, the current situation cannot continue indefinitely. Already, in response to inflation concerns, as well as the pressures of other countries, our government agreed to join in an effort to hold up temporarily the dollar's value -- last February's Louvre accord. Thus far, this commitment has been largely reflected in the purchases of dollars by foreign central banks, but the current magnitude of these purchases cannot be sustained.
In the first half of 1987 half of all the net inflow of capital into the United States was provided by foreign governments. Today, the resources of these governments -- and the risks that they are willing to take with their taxpayer funds -- are paltry when measured against the potential outflow of private funds from U.S. financial markets. The uneasiness of one major U.S. creditor has already shown up in the boost in German interest rates, the apparent trigger for the recent panic.
Under current circumstances, private investors can be induced to reenter U.S. market only if they are offered a higher return -- a higher interest rate on U.S. investments. It is also becoming evident that a significant improvement in the U.S. trade balance with other countries can only be achieved by a further decline in the price of American products -- a still lower exchange rate. As investors become more certain that the dollar must fall in future years, they will require ever higher interest rates to offset the expected future capital loss. Thus, the commitment to defend the dollar's value will have to take the form of even higher interest rates and with them higher borrowing costs for government, slower growth and, as a result, still bigger budget deficits.
How did we get into this mess -- and how can we get out of it?
It would be convenient to believe our politicians, who, as in war, blame foreigners for our problems; but the truth is that we shot ourselves in the foot. In 1981, when the poorest countries of the world were faced with a debt crisis, our President advised them to tighten their belts and live within their means. Surprisingly, they managed to do so -- albeit, at extremely high costs in terms of unemployment and reduced living standards. Most countries of Latin America now have a trade surplus. At present, the United States should take a little of its own advice. We can avoid paying similar costs only if we act before the debt has accumulated further and before the unavoidable import price inflation becomes embedded in domestic wage and price increases.
If we could reduce the budget deficit by $30 to $40 billion annually, we could offset the contractionary effect of a shrinking deficit on the economy with lower interest rates without having to worry so much about foreign capital drying up. That action would provide financial markets with the relief they need. It would also free up resources to expand our export industries.
Other industrial countries could then follow the U.S. lead and reduce their own interest rates. If they did so, that would foster world economic growth by stimulating capital investment in the industrial countries and reducing the debt burden of the developing countries. Faster growth abroad would also help expand the market for U.S. exports.
If other countries chose not to lower their interest rates, funds would flow out of U.S. markets and the dollar would decline in value: but our goods would be more competitive. They would lose and we would regain much of the share of world markets that we lost in the first half of the decade.
We would prefer that other industrial countries follow our lead toward lower interest rates. We could, however, live with either choice; both are better than what we have now -- a future of rising inflation, interest rates, and debt. No wonder Wall Street is worried.
Barry Bosworth is an economist at the Brookings Institution. He was formerly director of the Council on Wage and Price Stability in the Carter administration.