By Heinemann, H. Erich
American Banker , Vol. 150
PRESIDENT REAGAN is face-to-face with a serious dilemma in his economic policy. The dilemma is hardly recognized as such by the Potomac pundits who set the tone of the national political debate. Nonetheless, it is real and now, and its resolution -- which is far from certain at present -- should largely determine the course of the economy and whether the Republican Party will retain control of the Senate in 1986 and the White House in 1988.
There are five principal elements to the problem. Individually, each has been widely discussed, but only rarely are they linked together as representing a critical threat to continued expansion in the American, and hence also the global, economy.
The first element is Federal Reserve policy. Since early June, the Fed has been printing money at an annual growth rate of almost 18% (in contrast to its "target" of 3% to 8%), yet at the same time short-term interest rates are slightly higher today than they were three months ago.
The fact that interest rates have gone up even slightly in the face of such a massive injection of funds suggests that a powerful rebound in business activity is starting to build. Sooner rather than later, Fed Chairman Paul A. Volcker will either reverse his course or risk losing his credibility as the leader of the hard money bloc in Washington.
Assuming Mr. Volcker remains in office (that's far from certain), he wants to be remembered in the history books as an inflation fighter. So a swing back to tight money is probable. When that happens, rates will move substantially higher (J. Anthony Boeckh of Bank Credit Analyst says 300 basis points), and that is bound to put a damper on the economy.
The second element is Mr. Reagan's ever-changing program of tax "reform." The proposal seems to be based on the curious principle that close to $150 billion of tax cuts (which are enormously popular) can be precisely balanced by $150 billion of tax increases (which clearly are not popular at all). The obvious danger is that the President could end up with much more in the way of tax cuts than increases, which would lead to an even bigger river of red ink flowing out of the Treasury.
Even without new tax legislation, the budget outlook is far from sanguine. As the Congressional Budget Office pointed out last month, if the economy should falter any time in the next three years, the federal deficit will quickly spiral to $275 billion, and possibly higher.
Effect of Tax Plan
Meanwhile, were the President's tax plan to be passed as proposed, the major result would be a significant shift in the burden of taxation from individuals to corporations. Since the corporate tax is laregly invisible to the average taxpayer (even specialists in public finance cannot agree on who pays it), the major effect would be to hide from scrutiny an ever larger portion of the cost of federal services.
Ironically, this should make the task of reducing the size of the federal government -- the elusive goal of Mr. Reagan's first term -- still more difficult. Taxpayers are hardly likely to vote to restrict federal services if they are hoodwinked into believing that government can be purchased at an apparent discount -- through deficit spending or higher corporate taxes.
The third element is the international debt crisis, which is far closer to a flash point than most popular accounts would suggest. In recent weeks, first Peru and then South Africa have apparently been successful in thumbing their noses at the international banking community -- a lesson that has not been lost on other major Third World debtors.
In a telling interview with editors of The Wall Street Journal last week, Mexican President Miguel de la Madrid Hurtado suggested that if the industrial nations in the north really want to avoid widespread repudiation of debt by the lesser developed countries, then they must be willing to resume lending in the south. …