+Reynolds 1989 Fed Testimony

8/3/2019 +Reynolds 1989 Fed Testimony

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International Economic Policy:Choices, Problems and Opportunities for the Bush Administration

Testimony Before TheSystem Committee on International Economic Analysis

Board of Governors

Federal Reserve SystemApril 14, 1989

Alan ReynoldsVice President & Chief Economist

Polyconomics Inc.Morristown, N.J.


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The Bush Administration faces several uniquely challenging tasks in

international economic policy -- coordinating monetary and exchange rate

policies with other G-7 nations, helping Latin America and African economies

stop inflation and revive economic expansion, and adapting constructively to

integration in Europe and perestroika in the Soviet Union. There have been

many suggestions that certain policies or objectives be assigned "top

priority," yet the acutal top priority must be avoiding recession or

inflation. Although a recession might reduce the trade deficit, it would

surely increase the budget deficit. And although a weaker dollar might

conceivably reduce the trade deficit, it would surely increase inflation.

Policies that threaten recession or inflation are to be avoided, regardless

of their promised effects on budget or trade deficits.

Neither the national debt or foreign debt of the United States are

particularly large. Yet it is important to improve longer-term confidence

that these debts will be financed in a non-inflationary way. The effort of G-

7 central banks to stablize exchange rate expectations can be helpful in this

respect, particularly if it leads toward openly announced, credible long-term

commitments. By itself, though, an exchange rate indicator for monetary

policy cannot determine which country should do what. The recent appreciation

of the dollar, for example, might indicate that U.S. monetary policy is too

tight, or that foreign monetary policy is too loose. To resolve such

questions, serious consideration should be given to more explicit use of

sensitive prices of internationally traded commodities as an early indicator

of incipient inflation or deflation, as Governor Wayne Angell, former

Treasury Secretary James Baker and the Toronto Summit proposed. "The price of

gold should be included...because of the historic and widespread perception

of gold as an indicator of a flight from currency," as Chairman Greenspan

Reynolds, Alan, "Wake Up to the New Monetary Order" Institutional Investor(September 1988); Branson, William H. & Boughton James M., "Commodity Pricesas a Leading Indicator of Inflation" NBER Working Paper No. 2750 (1989).


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observed. When world commodity prices appear inflationary, countries with

declining currencies should tighten money; when the world situation looks

deflationary, countries with rising currencies should ease. To the extent

that exchange rate risk and global inflation risk can thus be minimized,

investors will become relatively indifferent between, say, U.S. or Japanese

bonds. Long-term interest rates should then converge toward a similar, low

level, allowing less onerous refinancing of troublesome dollar-denominated

debts, at home and abroad.

The Budget

So long as the U.S. is operating at high employment, a slowdown in the

growth of government purchases and government-financed consumption would help

free-up real resources, such as energy and labor, to expand private

production. An increase in taxation, on the other hand, does not free-up

resources for private production, but instead permanently transfers private

resources toward government services (which are quite difficult to export).

The United Kingdom and Australia moved from budget deficit to surplus

in the past few years, yet nonetheless have sizable current account deficits,

high inflation and extremely high interest rates. Clearly, there is no

automatic link between budget and trade deficits, or between budget deficits

and inflation. The "policy mix" idea -- the theory that higher taxes are a

substitute for prudent monetary policy -- is a proven recipe for stagflation.

Easy money simply stimulates nominal GNP (demand), while higher tax rates

suffocate real GNP (supply).

Many economists who did not anticipate the U.S. current account deficit

nonetheless confidently "project" that it will continue indefinitely. The

usual policy conclusion is that the dollar should be repeatedly devalued.

Greenspan, Alan, "Testimony" House Subcommitee on Domestic Monetary Policy,December 18, 1987.

"One view, frequently expressed by economists residing in Cambridge,Massachusetts, is that a sustainable external balance would not be achievedwithout a substantial further decline in the dollar....These modelextrapolations may be overly pessimistic inasmuch as they fail to capturepotentially significant longer-run adjustments on the supply side." Hooper,Peter, "Exchange Rates and U.S. External Adjustment in the Short Run and the


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By accounting convention, the current account deficit equals investment

minus private savings and government deficits. Many economists have

emphasized "net" figures for investment and savings, often expressed in

nominal terms and divided by gross national product. Regardless of the

legitimacy of such statistical creativity, it is gross investment outlays

that have to be financed from domestic or foreign wealth, not simply the net

portion. Measured in 1982 dollars, gross private investment increased by 42%

from 1980 to 1988, from $509 billion to $721 billion. Since it is highly

unlikely that real savings could have increased that rapidly, particularly if

marginal tax rates had been higher, the 1984-88 surge in investment was

partly financed by reduced U.S. investment abroad (notably, fewer loans to

LDCs) and by increased foreign investment in the United States.

Since the current account deficit is mainly a real phenomenon -- an

increase of real investment that exceeded the increase in real savings -- it

follows that depreciating the dollar could only help by reducing real

investment or (less likely) increasing real savings. Another big drop in the

dollar could indeed cut real capital investment, and thus narrow the gap

between investment and savings. It would do so because taxes on real profits

and capital gains increase with inflation, reducing the incentive to invest.

Moreover, the Federal Reserve would be likely to respond to the inflation by

temporarily raising interest rates, thus causing households and firms to

postpone purchases of durable goods and structures.

A familiar academic point is that a one-time depreciation of the dollar

merely results in a one-time increase in the level of prices, not an ongoing

increase in the rate of inflation. Yet a one-time increase in the price level

certainly looks just like inflation to the public and the politicians, so the

Fed feels compelled to react to past depreciation of the dollar by a

subsequent freeze on bank reserves. The resulting lucrative real return on

cash makes it impossible for producers of, say, houses and cars, to recover

Long Run" Brookings Institutions, October 1988. See also, Cheng, Hang-Sheng,"Must the Dollar Fall?" Federal Reserve Bank of San Franciso Weekly Letter(October 7, 1988).


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past costs that had been inflated by the previous devaluation. This results

in squeezed profit margins, and cutbacks in investment and employment. In

this way, a lower dollar may indeed reduce the trade deficit, but it does so

by provoking contraction. Such a painful policy is invariably followed by

monetary ease, which again stimulates demand for imports, which again leads

to calls for another devaluation of the dollar. There are no lasting benefits

from such dollar instability to either inflation or trade. A habit of

devaluing a national currency from time to time also undermines the

reputation of the monetary authorities. Bonds then have an extra risk premium

added for possible future devaluations, regardless how tight immediate policy

may be.

Commodities priced in dollars can normally be expected to increase with

a lower dollar -- including the price of oil -- since such commodities become

cheaper to foreign countries who therefore purchase more. The increased cost

of imported commodities, as well as reduced competitive pressure from

imports, can be expected to increase prices of U.S. exports. Once dollar

prices of imported commodities and exported finished goods have been inflated

by the lower dollar, the net effect on the volume or value of imports and

exports is ambiguous. Since there is little spare capacity to quickly expand

the volume of exports, devaluing the dollar for that purpose mainly boosts

prices. On the import side, there is no certainty that reduced quantities of

imports will ever outweigh the increased price, particularly for essential

imports such as oil or nickel. Since a drop in the dollar strengthens foreign

demand for oil and other commodities that the U.S. imports, bidding-up their

prices, that effect alone can make dollar depreciation counterproductive.

"Exchange rates account for close to half of the variation in oil prices..."Trehan, Bharat, "Oil Supply Shocks and The U.S. Economy" Federal Reserve Bank

of San Franciso Weekly Letter, February 27, 1987.

Granger causality tests indicate no significant link between U.S. exchangerates and import volumes, but only on import prices. Any effect of exchangerates on export volumes is also insifignificant at the 5% confidence level.Rosenweig Jeffrey A. & Koch, Paul D., "The U.S. Dollar and the `Dealyed J-Curve'" Federal Reserve Bank of Atlanta Economic Review July/Aug 1988, Table2, p. 14.


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On the other hand, efforts to deliberately slow the U.S. economy,

through monetary stringency or surtaxes, could likewise prove dangerous,

particularly for foreign countries dependent on net exports for employment.

One immediate effect would be to reduce output more rapidly than employment,

causing falling productivity, rising unit labor costs and falling profit

margins. Another effect would be cancellation of contracts and orders for

plant and equipment, needed to expand capacity for export and for import-

substitution. The resulting reduction of potential supply and productivity

are harmful to the longer-run inflation outlook, even though prices might be

temporarily depressed by going-out-of-business sales.

There are also practical difficulties with the using dollar devaluation

as a trade weapon. Toyota has not been able to raise prices enough to

compensate for the stronger yen, because of competition from Korea, Mexico,

Brazil, Canada, and U.S. plants making Japanese cars. The weaker dollar

reduced the cost of commodities to Japan, making price restraint feasible for

finished goods. Japanese and European producers of autos, electronics and

chemicals also responded by moving more production inside the United States,

but that means more imported machinery and materials which increase the U.S.

trade deficit in the short run. Indeed, the U.S. has virtually imported

entire factories. As that new capacity comes on stream, it will both displace

imports and increases the U.S. ability to export.

Another reason that such capital surpluses and trade deficits are self-

correcting is that the relative improvement in U.S investment opportunities

must eventually face diminishing returns. As plant and equipment becomes more

abundant in the U.S., and relatively scarcer in capital-exporting countries,

the relative return on additional investment will begin to look more

attractive elsewhere.

So long as capital is free to move between countries, the old idea that

current accounts "should" be balanced is literally impossible -- it implies

zero capital flows. Chronic current account surpluses are a symptom of

relatively poor after-tax real returns on capital. The best solution to so-


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called "imbalances" of trade and investment flows is to improve investment

opportunities elsewhere -- particularly in Continental Europe, Latin America

and Africa.

Third World Debt

Third World debt is a claim against future real income, which is

equivalent to future real output. It is not possible to improve any debtor's

prospects by making him poorer, so austerity is not the solution. Besides,

the usual schemes imposed on developing countries impose austerity on private

producers, not on governments. The key question is not whether developing

countries are to be aided with debt relief, grants or loans, but rather what

conditions will be attached to such aid. It is no coincidence that the

weakest economies in the world have the highest tax rates, the most

prohibitive tariffs, the most capricious regulations, and those most

irresponsible monetary policies. Diplomatic euphemisms, such as encouraging

"market-oriented" reforms, will simply not suffice. To some field workers

handing out policy advice, "reform" apparently means more of the same --

punitive tax rates and tariffs, and perpetual currency devaluations.

Countries that have instead experienced dramatic recoveries -- such as

Bolivia, Mauritius, Chile, Singapore, Jamaica and the Philippines -- have

invariably begun with the easiest changes, not those leading to riots.

Specifically, every successful turnaround of a contracting LDC involved

reduced marginal tax rates, and most successful countries also cut tariffs.

Moreover, no hyperinflation, past or present, has ever been stopped without

more-or-less pegging the exchange rate to a credible currency. Whatever the

merits of floating exchange rates, they do not work in small economies with a

reputation for lax monetary mismanagement. Even though all of the major

industrial nations have reduced their own marginal tax rates and agreed to

stabilize exchange rates, this is not the advice they typically give to

developing countries. It should be.

Reynolds, Alan, "A Baedeker to Better Living" The Wall Street Journal(February 23, 1989).


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In short, the main challenge to the new Adminstration, and to the

Federal Reserve, is to continue to lead the world toward expanding

opportunities for investment, employment and trade. That requires secure

property rights, including money that is expected to hold its value over

time, predictable regulations, reasonble taxation and free trade. The more

countries that follow such policies, including Marxist economies, the less

burden on the United States and Japan to serve as locomotives for the

cabooses. This is no time to make a fetish of mere instruments and symptoms,

such as budget or trade gaps, at the expense of the broader picture. Japan

has managed to have a 15-year expansion with reasonably rapid growth, low

unemployment and no inflation. When Japan runs short of capacity, they add

more. The United States economy, which is a mere infant in the race for

sustained economic expansion, must settle for no less.

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+Reynolds 1989 Fed Testimony