Twin deficits and the G-7.

Twin Deficits and the G-7

ONLY POLITICS can explain how the idea that budgetdeficits cause trade deficits has survived. The notion was that only a smaller budget deficit could make the dollar fall, and that the resulting cheaper dollar would somehow make Americans rich by allowing them to sell cheap and buy dear. Yet the dollar has fallen quite a lot since February 1985, without any decline in the budget deficit. The obvious political allure of the "twin deficits' theory nonetheless keeps it alive. If voters could be persuaded that trade deficits are a consequence of budget deficits, perhaps they might even be persuaded that a big tax increase or tariff would make the economy stronger--by solving both budget and trade deficits at once.

Some of those who used to claimthe budget deficit was what made the dollar rise, notably Federal Reserve Chairman Paul Volcker, are now properly concerned that the dollar may fall too far. Harvard's Martin Feldstein, who has also long urged a smaller budget deficit to sink the dollar, likewise warned in the Washington Post that too sharp a drop in the dollar might "trigger an economic downturn' (by fostering inflation and higher interest rates). Yet if budget deficits really made the dollar rise, then the dollar could not possibly go into free fall unless the budget was in grave danger of swinging into surplus. To get the dollar up, on this line of reasoning, Messrs. Volcker and Feldstein would be compelled to propose a larger budget deficit. Fed Chairmen and Harvard economists are not required to be that consistent.

The world's finance ministers and central bankersrecently met in Paris, agreeing that the dollar had fallen quite enough. Not one of them suggested a larger U.S. budget deficit to strengthen the dollar. Instead they noticed that the relative value of German money in terms of U.S. money has a lot to do with monetary policy. Countries with falling prices, like Germany and Japan, can (and did) cut interest rates. If necessary, the Federal Reserve could tighten money. This does not even require "intervention,' which means having central bankers buy and sell one another's currencies. And it certainly does not require the bugbear of "coordinating fiscal policies,' since economists can't decide whether budget deficits make a currency stronger or weaker.

Karen Pennar of Business Week suggests the Parismeeting was "little more than talk' because the U.S. is not "ready to bring on a recession for the sake of exchange-rate stability.' The purpose of monetary cooperation is not to bring on a recession in the U.S., but to stop incipient recessions in Japan and Continental Europe. A persistent drop in the dollar is likely to be deflationary in Europe and Japan, or inflationary in the United States. Neither of those alternatives is good for either the U.S. or the world. Interest rates in the U.S. have also been higher than in Japan and Europe to compensate foreign investors for the risk that the dollar may fall, so the U.S. stands to benefit as well. If the Paris accord was just talk, why have speculators suddenly become so wary of betting against the dollar?