Don’t Make a Fetish of a Level Dollar : Slippage There Is Preferable to Raising Interest Rates

“Fear came upon me, and trembling . . . the hair of my flesh stood up.” That is how the Bible describes Wall Street. There is no adequate explanation of the great crash on Monday or of the subsequent recovery. But there is fear, and fear--whether of a further crash or of missing the chance to profit in a recovery--can do great damage to the economy.

But fear can have creative effects as well, and, as fear swept from Wall Street to Washington, our government, which often seems incapable of doing anything very well, showed that it can respond to a crisis. First, the Federal Reserve System did just the right thing and announced that it would provide whatever liquidity the markets needed to halt their fall--exactly the reverse of the horrendous mistake made in the Great Depression. Second, the President, after an uncomfortable delay, did the right thing and said that he was finally ready to bargain with Congress over the budget.

No one knows for sure what these actions will do to the marketplace. Remarkably, some who have been adamant about the need to reduce the budget deficit are suddenly worried that tax increases and spending cuts will be too contractionary given the newly increased danger of a recession. But, because of the pain inherent in deficit reduction, I cannot believe that we need fear the politicians doing too much.

If the President is serious about his proposal to negotiate--and his press conference last night suggested that he is--the results could be highly beneficial for him and the country. If a successful compromise is achieved, I suspect that he will end up with a stronger military, somewhat less domestic spending and a tax increase less harmful to economic incentives than if he had continued to remain remote from the process. If bargaining fails, we may be no worse off than before, but get out of the way just in case the market crashes yet again.

Certainly any compromise will contain some smoke and mirrors, and no one should expect quite the deficit reduction that is promised. But with the market looking over their shoulders, the bargainers have a strong incentive to be honest.

Let us be optimistic and assume that some significant, rational deficit reduction occurs and that the Federal Reserve’s actions successfully calm financial markets in the short run. Does that mean that we will achieve an economic nirvana? Unfortunately not.

The Federal Reserve still faces a difficult problem. It must provide sufficient liquidity to guard against a financial collapse, but not so much as to raise fears of inflation. That is a narrow path to walk, and, given the state of economic knowledge, it has to walk it largely in the dark. Moreover, the path will narrow through time and eventually disappear in inflation or recession. The business cycle still lives. The trick is to put off the day of reckoning as long as possible.

Even if the economy keeps to the path for a long while, the trade and budget deficit will not disappear overnight, and the United States will therefore remain highly dependent on an inflow of foreign capital to finance the two deficits. That raises the question of whether the interest rates along that path--the one consistent with a continued non-inflationary recovery--will be sufficiently high to attract enough foreign investment to prevent a decline of the dollar.

It can be if West Germany and Japan also keep interest rates low, but, despite good noises emanating from their governments in recent days (they are scared, too), they clearly fear inflation and budget deficits more than we do. That is of course their sovereign right, and the United States should not rely heavily on their helping us to keep interest rates down and the dollar up over the several years that it will take to work our way out of our twin deficit problem.

If progress is made on the two deficits, the United States will appear to be a better credit risk to foreigners, and there may be no good reason to worry about the dollar. But if other countries persist in highly restrictive policies and we have little choice but to either raise interest rates or to let the dollar fall, I say let it fall.

There is some danger in this. The risk of inflation goes up because import prices rise and spread to other products. But I suspect that the dollar’s fall would be moderate; if it is not, we can then respond with some increase in interest rates. All else being equal, dollar stability is desirable, but it is not worth a very high price. If it means adopting policies that we deem totally inappropriate to the needs of the U.S. economy, it is not worth it.