THE SHARP PLUNGE in world stock markets requires a degree of cooperation among the United States, Europe and Japan not seen since the energy crisis. America must tackle its budget deficit, but collective action is also needed to correct international imbalances. Without both, a global slowdown is a major risk.
Underlying the market sell-off was the feeling among investors that despite good news on U.S. inflation, employment and corporate profits, prosperity cannot be built indefinitely on growing domestic and foreign debt. Many investors, observing the lack of progress in slowing America's accumulation of both types of debt, foresaw a sharp drop in the dollar, higher inflation, tighter monetary policy and ultimately recession.
The sharp fall in American and then world stock markets has three major ramifications. Many people here and abroad now have less wealth and less confidence in the economic outlook; they are likely to cut back on expenditures. Corporations will have difficulty in raising equity. Lower consumption combined with less equity will slow new investment. Comparisons with 1929 are inevitable -- but a similar outcome can be averted.Robert Hormats is vice chairman of Goldman Sachs International Corp. and former assistant secretary of state for economic affairs.
The 1929 crash occurred in a world in which trade barriers were already very high. After the crash, nations further protected their internal markets from one another, tightened credit and raised taxes. They now must pursue a wiser course -- one aimed at avoiding a sharp economic downturn and reducing underlying imbalances that cause market apprehensions and instability. Only a collective set of measures by the major western economies can do that. Priority one for this country -- both for its own good and to enhance its now-diminished ability to convince others to do the right thing -- is to establish a credible, multiyear course for reducing the federal deficit. Raising taxes to slice billions from the deficit has become the primary test in the minds of many of whether the government can "get its house in order." But what was a wise course a few years, or weeks, ago when the economy was strong is not as unambiguously desirable today. The budget summit must decide what magnitude of spending reduction and tax increase (if any) would satisfy the market that Washington was acting boldly enough -- without being so bold as to cause a large contraction in economic activity.
Because a key objective of the "package" is to stabilize financial markets, it must have credibility in those markets. For that reason, the administration and Congress should consult heads of leading investment banks, commercial banks, pension funds, insurance companies and mutual funds. Because the budget deficit draws substantial resources from the private economy, a credible package must assure substantial deficit cuts in fiscal year 1988 and for several years thereafter. The dominant portion -- all, if possible -- of FY '88 cuts should come from lower spending.
If higher taxes are to be imposed, they should be user or sales taxes rather than taxes which might impair savings or investment. To reduce the large U.S. trade deficit -- one cause of the market's fall -- Americans must produce more than they consume and export the difference. That means shifting resources from consumption to savings and to investment in manufacturing. Taxes that penalize capital would retard those shifts.
A smaller budget deficit would improve prospects for the reduction of interest rates needed to offset contractions caused by the drop in stock prices and encourage business investment. Lower rates are already leading to a decline in the dollar, welcome because it will increase U.S. export competitiveness.
The dollar's decline is consistent with recent agreements to introduce more "flexibility" into last February's Louvre accords that sought to stabilize major currencies. It should not be a major concern to the market so long as it is kept under control. Foreign central banks have become uncomfortable with massive intervention to sustain the current dollar level. It's more than time for our major trading partners to face the facts: They cannot have it both ways. They cannot expect to have both high trade surpluses and currency stability.
Reducing future stock or currency volatility requires lowering the U.S. trade deficit. Moreover, given concerns about an economic slowdown -- to which the otherwise desirable reduction in the budget deficit may add -- the Federal Reserve should not raise interest rates to hold the dollar at overvalued levels. The central banks of other nations must be prepared to reduce their interest rates at least as much as we do.
Once a credible budget agreement is reached, ministers and central bank governors of the seven major industrialized nations should meet immediately. They must work in concert to assure that the interest rates of America's major trading partners are far enough below those of the United States to achieve the lower dollar needed to improve prospects for reducing our trade deficit. Then they should try to stabilize currencies around the new levels. A further common balancing act is required to provide enough liquidity to prevent a recession -- while avoiding creation of excessive liquidity that could trigger new inflation.
Low interest rates -- in some cases combined with fiscal stimulus -- will also be required in Europe and Asia to help avoid a sharp weakening of their economies as imports from this country increase and exports to this country decline. Countries such as Germany and Japan naturally resist external pressure to modify their fiscal, monetary and trade policies. So do we. But our allies must now recognize that the current situation is not tenable. The U.S. trade deficit must decline. This country's consumers can no longer provide the fuel for world economic growth by borrowing abroad to finance their purchases of imported goods.
A reintensification of efforts to reduce global trade barriers is particularly important. Global trade negotiations now underway provide an alternative to the beggar-thy-neighbor policies of 1929. A U.S. trade bill aimed at supporting these negotiations and opening markets, a rededication by other countries to cutting subsidies and other restrictions, and ratification of the Canada-U.S. trade agreement by both nations, would demonstrate to the world that we were not repeating the mistakes of 1929.
Western governments failed to prevent a depression six decades ago. Now they must do better.
Robert Hormats is vice chairman of Goldman Sachs International Corp. and former assistant secretary of state for economic affairs.