The record stock market crash a week ago Monday, a jarring experience for financial market participants, was, more than anything, a reflection of the frustration of global investors over a confused U.S. economic policy. If this policy is not promptly altered to address the ongoing problem of the U.S. budget deficit, the frustration felt by those in the financial markets soon will spread to the population at large as interest rates rise and as recession sets in.
The plain fact is that under the Louvre accord, where the dollar is pegged to its present level in order to maintain currency stability, the U.S. trade gap cannot narrow appreciably unless the budget deficit is reduced significantly. True, the dollar has depreciated against many of the currencies of its major trading partners to a level that is about 10 percent above its average during the late 1970s, when the U.S. trade shortfall was much smaller. But it has not fallen enough to curb the American appetite for imports and to restore balance in the trade account.
The reason is that since 1980 domestic demand has grown much faster in the United States than abroad, as a result of the unprecedented divergence between U.S. fiscal policies and those of this country's major trading partners in the first half of the 1980s. The extraordinary fiscal stimulus introduced in the United States during this period, in contrast with fiscal restraint overseas, produced a 23 percent surge in the real volume of spending in the United States, almost twice as great as the average increase of 13 percent abroad. This disparity in domestic spending levels led to a substantial rise in import demand in the United States, which has not been matched by a similar pickup in expenditures of foreign buyers of American products.
Consequently, pegging the dollar at its current value, given the disparity in spending levels, means that U.S. interest rates must remain substantially above those of Germany and Japan as the United States attempts to attract foreign capital to finance its outsized trade deficit. Any upward movement in rates in either of these countries, such as the moderate increase in German short-term interest rates earlier this month, must be matched by similar increases in U.S. rates. Indeed, the pegging of the dollar had effectively turned U.S. monetary policy over to the Germans, whose commitment to low inflation and concern over fast money growth almost guarantee further increases in interest rates.
Moreover, the longer the trade deficit remains large, the more dependent the U.S. becomes on foreign capital inflows. This, in turn, implies that the gap between rates in the United States and those in Germany and Japan must widen further if the dollar is to be stabilized. Pegging the dollar without a simultaneous tightening of fiscal policy, therefore, implies high and rising interest rates.
Reinforcing this tendency for such rate hikes is increased volatility in financial markets, which raises the risk premium in interest rates that investors must be awarded. In general, when one price is pegged, other prices must bear the full burden of the adjustment to changing market conditions that normally is shared by all prices. In our case, the pegging of the foreign exchange value of the dollar has produced a substantial increase in the volatility of interest rates and, of course, in stock prices. More volatility is likely in the coming weeks if the dollar remains pegged and if no actions are taken to reduce the U.S. budget deficit.
Thus, given the disparity in domestic demand between the United States and countries abroad, the current value of the dollar is unable to narrow the trade gap. U.S. economic policy, therefore, must be fundamentally altered if we are to avoid rising interest rates, dangerously high levels of volatility in financial markets and recession.
This could be accomplished by the United States' adopting a more restrictive fiscal policy, which would curb consumer demand, or by foreign countries' implementing more stimulative measures, thus increasing local spending. But in this case, it is the United States that must take the first step.
It is of the highest order of importance that the president and Congress make an irrevocable commitment to do whatever necessary -- whether this is higher taxes, reduced government spending or both -- to shrink the budget deficit. This commitment could then be presented to the Germans in exchange for something that they have been unwilling to give without a quid pro quo -- that is, a more growth-oriented economic policy. As the disparity in domestic demand is reduced, U.S. interest rates would fall in the process, and the dollar would stabilize without having to be pegged by the authorities.
But time is running out. Another surge in interest rates, perhaps caused by a hike in rates abroad or by investor anxiety over the massive and seemingly unrelenting trade deficit, could trigger another crash in the stock market. Then we will all be in the soup.
The writer is managing director and chief economist at Morgan Stanley & Co. Inc. Another surge in interest rates, and we all could end up in the soup.