The financial writers of The Wall Street Journal and The New York Times -- who once told us that budget deficits made the dollar go up -- lost no time in deciding that budget deficits now make the dollar go down. Every setback in the dollar, stocks or bonds, is being attributed to Mr. Bush's stubborn refusal to impose new taxes. The circle is squared with the argument that central banks bought dollars before the election, to help Bush get elected (despite his read-my-lips no-tax pledge), but now the central banks are selling dollars to force Bush to raise taxes!
All this is perfect nonsense. Foreign central banks sold more dollars than they bought before the election, and since the dollar has been weakening after the election, the G-7 has been intervening to keep it in the target range. (Of course, the interventions are sterilized in any case by the Fed's open-market desk, which sells dollars to keep its domestic Fed funds target on track above 8 1/4%.) The dollar has weakened and the stock market is down and edgy because there are real fears of a reversion to the demand-side mix of a cheaper dollar and higher taxes. The fears are justifiable to a degree because the President-elect's team has not yet decided on a dollar strategy, and the whole world knows it.
Today's WSJ story, "Senior Bush Adviser Backs Dollar Policy," assumed to be Jim Baker, reveals a lackadaisical stance ("I can't get excited about" the dollar's decline) that simply encourages speculation that the incoming team can be browbeaten into more dollar devaluation, and if it caves on the dollar, a tax deal with Congress would not be far behind. It makes no difference to the Keynesian reporters who dominate the financial press that a sharply declining U.S. stock market turned up at noon on November 21 at the exact time that both Mr. Bush and Richard Darman were reasserting a strong pledge to concentrate on the spending side of the budget. As with President Reagan, however, market increases are never attributed to low tax rates — only declines.
Bush has, in fact, been marvelous since his election on everything but the dollar, where the incoming team nervously fears that a commitment to dollar stability may require higher interest rates — fears which Alan Greenspan has fostered. As a result of the indecision, the odds of weak policies have apparently increased a bit since the U.S. election. The opposite has happened abroad. Japan pushed through another 10% cut in income tax rates with unexpected ease, pulling the yen up with the Japanese stock and bond markets (investors have to buy yen to buy Japanese securities). Germany also eased its coming tax on interest income, likewise helping the mark. Canada's critical vote yesterday for the Progressive Conservative Party of free trade and lower tax rates pushed Canadian stocks and its dollar up.
The British have been shrill in insisting on higher U.S. taxes, although Mrs. Thatcher apparently gave GB a little elbow room on her visit this week. Yet the U.K. has a budget surplus (after cutting tax rates in half), while its own current account deficit is nearly as large as that of the U.S., and inflation, interest rates and unemployment are all much higher in the U.K. than in the U.S. Mrs. Thatcher argues that the U.K.'s "higher savings rate" permits this kind of anomaly. The Bush team, unhappily, is beginning to talk about finding ways to push up the savings rate, a blind alley if there ever was one.
The most salubrious action regarding the dollar instead came this week with the naming of Richard Darman as budget director. Of all the OMB directors since the office was created, Darman is the only one who understands the impact monetary and exchange-rate policy has on interest rates, debt service and the budget deficits. We're betting that Darman will produce a dollar policy soon that can fairly quickly end the market suspicions of cheap money. Unlike Greenspan, Darman knows that defense of the dollar will bring interest rates down, not force them up.
The experience of the G-7 and EMS proves that monetary, not fiscal policies dominate monetary disturbances. The recent drop in the dollar was not accompanied by speculation in U.S. gold, and was accompanied by a nearly inverted yield curve. This means the dollar drop is not expected to add to U.S. inflation (or the dollar is expected to recover). If the dollar remained about where it is without adding to U.S. inflation, countries that had virtually no inflation before would soon be under deflationary pressure. Japan and Europe would have to cut prices in yen or marks in order to compete in terms of dollars. If those central banks nonetheless kept nominal short-term interest rates unchanged, then real interest rates on cash would rise with falling prices.
What's going on then? As we have been arguing throughout, the dollar has not weakened because of anything fundamental in the U.S. Private speculators have shifted dollars to other currencies out of increased fear that something fundamental might occur soon. The situation is unstable in that over time it would require more U.S. inflation, which the Fed will not abide, or Japanese/German deflation, which their central banks will have to resist. Trying to peg the dollar and pound to such a deflationary policy could compound the danger. Absent a solid dollar strategy at the moment, the G-7 central banks can offset speculation in their currencies by easing. Or, if they don't like that idea either, they might prefer that everyone focused on U.S. tax policy, which is after all the scapegoat they have chosen.