Executive Summary: The annual economic summit meeting of Western heads of state, May 2-4, could be historic. Coming off his landslide re-election win, President Reagan has standing among his peers and is in a mood to offer supply-side economic advice. Paul Volcker helps by urging European tax cuts. A summit's eve tax-reform proposal by Reagan would be the talk of Bonn. Unless Europe copies tax cuts, its capital outflows would produce deeper U.S. trade deficits – as predicted by Robert Mundell in 1974. Significantly, West Germany joins France in urging monetary reform on the summit agenda. President Reagan and Treasury Secretary Baker oblige by keeping "Open minds." A "Paper snake" won't work, though. Central banks need an objective reality for day-to-day adjustment. How about a gold SDR with "wide bands?" Watch for a wave of industrial world, Third World tax reforms radiating from Bonn. A monetary conference too, perhaps. As they say, a historic juncture.
The Bonn Summit
The economic summit meeting in Bonn early next month could turn out to be the first such meeting that historians will remember. It is the fifth summit for President Reagan and the first of his second term, coming off his landslide triumph over Walter Mondale. For the first time, he is in a position to confidently offer his counterparts some economic advice. And they may be ready to listen to this American Miracle Man, coming to realize there is more to him than simply the luck of the Irish.
Yes, he maneuvered through the worst recession in half a century. He presided over an end to the worst U.S. inflation in two centuries, a dramatic economic expansion that did not reignite inflation, a Wall Street boom, and falling interest rates plus 7 million new jobs. Yes, he won an unprecedented 49 states in an almost effortless re-election campaign, seeming to grow younger on the job. But the clincher for this political magician was pulling Star Wars out of his hat, suddenly changing the terms of the global debate over strategic doctrine as smoothly as he altered the terms of economic debate. Smart people around the world are beginning to admit to themselves that they may have been wrong about this one-time movie actor. A little more, and smart people may be suspecting we have a Great One on our hands, of the kind school children are taught to admire centuries from now. As they say, the Bonn summit could be a juncture in history.
To qualify for this distinction, Bonn must result in wholesale changes in the way Europe — then the rest of the world — thinks and acts when it comes to economic policy. In short, it's time for the supply-side revolution to go international.
President Reagan is already warming to the idea of selling the other summit participants on the idea of tax cuts to get their economies moving. The double-digit unemployment rates throughout Europe would not respond to monetary "reflation" or to increased deficit spending, even if there were the inclination to try these vehicles again. Fed Chairman Paul Volcker's public advocacy of European tax cuts — as a way to expand their economies and increase demand for their currencies — has enormously strengthened the President's hand. As Irving Kristol put it in his Wall Street Journal column of April 1, entitled "The Old World Needs a New Ideology":
Our strong economic recovery cannot be expected to last indefinitely if the economies of Western Europe do not pick up momentum. Even Paul Volcker (of all people!) is now urging the British and German governments to enact a substantial cut in tax rates — and to accept the larger deficits that go with it — in order to get their economies moving again. Perhaps voodoo economics will be more acceptable coming from him than from Ronald Reagan.
It seems so simple. Why is there so much resistance? The easy answer is that it represents change, rather an abrupt change from what we had been telling the Europeans just a few months ago. It's hard to exaggerate the problems caused in Europe by Martin Feldstein when he was chairman of the Council of Economic Advisors. It was Feldstein who sowed the argument across Europe that the U.S. budget deficit was the source of their miseries — driving up U.S. interest rates that drain capital from Europe, strengthen the dollar and balloon the U.S. trade deficit. It should not be surprising that this message would be embraced by the bureaucrats of Europe's economic ministries. How easy for them to blame the United States when the President's chief economist invited them to do so. Administration officials who have recently been to Europe, selling growth, report that the Feldstein arguments are as popular as ever in the bureaucracies.
The Bonn summit offers the opportunity for President Reagan to go over the heads of the bureaucrats, not only to the heads of state, but to the people of Europe themselves. Where the bureaucrats now plan to focus the summit agenda on deficits and trade protectionism, the President can easily turn it to growth. The key will be the tax reform proposal he is scheduled to unveil May 1, on the eve of his trip to Europe. If he does so, it's easy to see the dramatic impact it would have on the meeting, especially if, as we suspect, the new Treasury plan will call for a 30 percent top personal income-tax rate. It would not only be the talk of the town, it would have all Europe buzzing.
At the moment, Europeans are not quite sure President Reagan is serious about tax reform. But this is because there has been no push from the President since the original Treasury bill was unveiled in December. In the weeks ahead, though, it should become clear that the President intends to go all out for it and that he expects legislation passed this year. The first emphatic push from the President should come in his Saturday radio address of April 13 — perhaps with a promise to the nation's taxpayers that this April 15 will be the last with high rates and complexities that they will have to struggle through.
At the summit, where the bureaucrats want to talk about the U.S. trade deficit, President Reagan should oblige. In line with his (and Volcker's) new argument that tax cuts lead to stronger currencies, the President could warn (or perhaps merely alert) the Thatchers, Kohls and Mitterrands that his new tax reform may further strengthen the U.S. dollar and deepen the U.S. trade deficit. The only way this could be avoided, he could say, would be for the Europeans to emulate the U.S. with flat-tax reforms of their own.
These arguments may be new to the President and Fed Chairman, but they are hardly new to the supply-siders. On December 11, 1974, in an op-ed article I wrote for The Wall Street Journal entitled 'It's Time to Cut Taxes," I quoted Professor Robert Mundell of Columbia on the effects a U.S. tax cut would have on the world:
The international effects of a tax cut are particularly important, he [Mundell] asserts. With announcement of a major tax cut, the capital market would instantly perceive that it is more profitable to do business in the United States than the rest of the world. Capital that is now flowing out would remain; foreign capital going elsewhere would come in. The increased real economic growth would mean the U.S. would run a sizeable trade deficit as the U.S. would keep more of what it produces and buy more goods from abroad. Offsetting this in the short run would be an inventory effect caused by tighter monetary conditions; the expectation of slower inflation could cause a reduction in optimal inventory levels.
There would be balance-of-payments equilibrium, he says, because the capital flows would cover any residual trade deficit until market opportunities were arbitraged worldwide. The U.S. tax cut would help to pull the whole industrial world out of its slump, he maintains.
If the United States were to now enact another major tax cut, via the reform measure, there would be a further surge of capital from Europe to the U.S. and an even greater U.S. trade deficit. It's the same thing that would happen if one of two adjoining states with the same high tax rates suddenly cut rates significantly. Both capital and labor would flow to the low tax-rate state until equilibrium.
What kind of change in the system does he want? "We have had a good experience with our European Monetary System" he said. "It's a fixed exchange rate system, but with the possibility of changing rates. For the past two years we haven't had a change, however, which suggests that it is a stable system, because of its political impact on the monetary policies of the European Community." This, he said, shows that "monetary weakness is fundamentally a political problem."
He is not calling for a return to the Bretton Woods system, which, as he sees it, had two fundamental principles: first, stable exchange rates based on a gold standard, and, second, close cooperation to defend those rates. "The first," he said, "is difficult or impossible to reconstruct. But the second is not."
Bangemann is wrong about the relative difficulty of constructing an exchange-rate system with or without gold — a "paper snake" as opposed to a gold standard. But it is significant that Germany has joined France in pressing monetary reform onto the summit agenda. The U.S. officially opposes abandonment of nationalistic floating exchange rates for the international responsibilities of a fixed-rate system. But in recent weeks, both the President and Treasury Secretary James Baker III have told journalists they are keeping open minds. This in itself is a novelty for the Europeans, who have been told repeatedly by a succession of Treasury Secretaries that all minds are closed. In fact, the Reagan-Baker expression of open-mindedness is an open invitation to the Europeans to brainstorm.
The remarkable exchange-rate volatility this year has been useful in getting the key players thinking about a mechanism to stabilize the system. When the dollar exceeded 3.4 Deutschemark a month ago, there was a solid consensus in Washington and on Wall Street that the dollar was "overvalued," but also a consensus fear that if "something were done" to correct the valuation, the dollar might somehow plunge out of control. This kind of concern invited talk of a mechanism.
As with Bangemann, the West German, most such talk centered on the idea of a "paper snake." If the Europeans could manage for two years to keep their currencies roughly aligned, all fluctuating within the bands of the European currency unit, the ecu, then why couldn't it work with the dollar as well?
For some reason, these paper-snake advocates fail to realize that the European central banks are snaking against the U.S. dollar. At any moment, the central banks have to be able to decide which of them is obliged to add monetary reserves and which must subtract, in order to remain within the snake. They do so according to the relative position of each currency to the U.S. dollar. The dollar represents objective reality, the guiding "North Star" for the ecu. Because the dollar itself floats, the ecu is as unstable as the dollar.
But what happens if the dollar joins the ecu snake? How do the central banks decide from day to day what to do? Where is objective reality? When Paul Volcker was asked last month by a member of the House Budget Committee why the Fed and the Bundesbank couldn't stabilize the rate between the dollar and DM, he asked how we would know if the Bundesbank should tighten or if the Fed should ease. Because the Fed chairman freely admits to favoring a fixed-exchange-rate system, his answer to the question tells us he knows there must be a separate guide in a fixed system. The only possibilities are interest rates, money supply or commodities.
In other words, the central bankers agree on a universal range for M-1 (along with a definition of what constitutes M-1), or a specific interest rate, or the price of a commodity or commodity basket. In this framework, it doesn't take a genius to figure out that it would be impossible to target an interest rate or an arbitrary money-supply measure in several different currencies. Only a commodity target is feasible, thereby letting interest rates and money supplies fluctuate from country to country. And once serious people get to this reality, they get to a gold standard of some kind. Volcker, perhaps.
In 1983, two weeks before the summit meeting in Williamsburg, Va., Mundell suggested the participants consider a "gold-SDR" mechanism, with the SDR (Special Drawing Rights of the International Monetary Fund) "used as an intermediate asset separating gold and national currencies."
A new international monetary regime should be based on a unit of account that has a stable purchasing power. The SDR is now a weighted average of currencies that are inflating, so it is not itself a stable reserve asset suitable for a world unit of account or unit of contract. A gold-stable SDR, which was the original intention of the 1967 agreement establishing it, would, however, help to create a monetary basis for a stable international money into which currencies can be made convertible at a given parity.
In other words, if the SDR's purchasing power was fixed to gold, it could provide the objective reality to guide central bankers in their daily stabilizing of exchange-rates. And as with the ecu snake, stabilization could begin with fairly wide bands, permitting central-bank discretion within those bands. The idea is hardly exotic or impractical. As Mundell points out, this was the plan on the IMF's drawing board in 1967 when the SDR was created. "Paper gold." How much gold would be needed in such a system, a Treasury official asked me last month. Really only an ounce, theoretically, although between the IMF, the U.S. and European central banks, there are almost 800 million ounces in monetary reserves. About $250 billion.
Mundell has always been well ahead of his time, but perhaps in addressing himself to the Williamsburg summit he was only two years premature. As he put his concluding remarks then:
The recovery and movement of self-sustaining growth would be fostered, rather than impeded, by stabilizing the exchange rates and the value of international gold reserves, which means stabilizing the price of gold. This is partly because it would lower long-term interest rates quickly. It is the only feasible way to get interest rates down while the recovery proceeds without anticipation of an appreciating dollar. A further drop in long-term interest rates would be achieved if maximum tax rates were lowered (not only in the U.S. but everywhere) and there were an additional reduction in income-tax rates....! would support those who argue for a maximum 30 percent marginal tax on incomes.
Will next month's meeting in Bonn be remembered by historians a hundred years from now? If in the next year we see a wave of tax reforms or simply tax cuts spreading through the industrial world and into the developing world, it would be likely that they radiated from Bonn. And if in the next year we observe the major central banks of the West, including the Fed, conferring on coordinated snakes, paper and otherwise, it's also likely the impetus came at this summit. Such developments would have such profound lasting meaning for the world economy that school children a century from now indeed will be expected to memorize the dates, May 2-4, 1985, and the name of the American President who made it happen.