What Now?
Jude Wanniski
October 23, 1987


These are thoughts following President Reagan's press conference.

We have to keep in mind the central problem, the U.S. trade deficit. It is not the trade deficit itself that is a fundamental problem, but the fear that it will force policy change that will damage the U.S. and world economy. There are only three ways to reduce the deficit, one good way and two bad ways. The good way is to have West Germany and Japan cut marginal tax rates, which would put the world on a higher GNP path and reduce net capital inflows to the U.S. The two bad ways require a U.S. recession, which also reduces net capital inflows but puts the world on a lower GNP path. (Remember, a capital inflow equates with a trade deficit, a capital outflow equates with a trade surplus.) A recession would occur through monetary or fiscal policies that would repel capital. A dollar devaluation accompanied by rising gold and commodity prices signals higher inflation, interest rates and a weaker economy. Or, higher tax rates and protectionist trade legislation contracts the economy and repels capital.

When the September trade deficit figures were announced October 14, markets wobbled. There had been no progress on reducing the trade deficit through tax reform in Europe and Asia. The pressure then fell on the dollar, and when Jim Baker signaled a willingness to let the dollar devalue, the markets cascaded. It should be noted that Baker's motives were born of frustration in trying to get the West Germans to expand via monetary ease. Baker patched up the exchange-rate agreement in Frankfurt on Black Monday, and the dollar strengthened as gold declined. But pressure then shifted to fiscal policy, with JBIII back from Europe and Howard Baker Jr. urging the President to compromise with the Congress on the budget to calm the markets. In the process they seem to have persuaded the President that the budget deficit was somehow the cause of the crash, which RR wound up calling "a long overdue correction."

On Thursday afternoon the 22nd, hours before RR's press conference, Jack Kemp called the President to warn against the political trap the Democrats had set by trying to get him to go against his 1984 campaign pledge not to raise taxes, which Mondale at the time predicted RR would not keep. RR told Kemp he had to do something to calm the markets. Kemp argued the markets were soaring on the 21st with reports from OMB Director Jim Miller that RR was emphatically rejecting a tax hike. He told RR of rumors that morning of a deal by the Bakers with House Speaker Jim Wright to raise taxes and as they spoke he told RR the Dow was down 75. He urged the President to hang tough, that the Fed's actions and JBIII's patching of the Louvre agreement was all to the good, and a tax hike of any kind was sought by the Democrats only to get him to apologize for the last six years. The phone call seems to have made a difference in the way the President handled the press conference. While he left the impression he could be talked into some excise taxes, RR succesfully dodged any commitment to raise taxes, at least buying time.

Time is precious, because in November the trade numbers will come out for October, and once again there will be pressures to do something, another push for devaluation, another test of the Louvre, more pressure on RR to cave in on taxes, with the trade bill advancing in the wings. If he had JBIII's help, the President could conceivably fend off these pressures month after month, dodging and weaving. But for genuine relief, Bonn and Tokyo have to exert themselves on tax reform as they have not in the past. At least they may be more attentive, given the late unpleasantness.