The President Faces a Five-Part Economic Policy Dilemma
Heinemann, H. Erich, American Banker
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.
"I don't think it is logical," Mr. de la Madrid was quoted as saying, "for countries like Mexico -- and the same can be said for other Latin American countries -- to become net exporters of capital. In realistic terms, it is impossible to aspire to a net reduction in the Latin American countries' foreign debt."
According to estimates prepared by the International Monetary Fund, the flow of new credit to the developing countries has dried up. Last year, for example, total lesser developed country debt rose a scant 4.6 ($36.7 billion) to a total of about $830 billion. At the same time, the developing countries made payments of $123.1 billion in interest and principal, which implies a net capital drain of $86.4 billion. Projections by the IMF staff indicate that this outflow will increase in both 1985 and 1986.
'Solution' to Debt Crisis
Obviously, the "solution" to the debt crisis (if there is one) will require many facets. The debtor nations must control inflation, stabilize their exchange rates, expand their economies, end the flight of capital, and promote domestic investment. Where appropriate, they should consider exchanging a portion of their foreign debts for equity participations in their state-owned enterprises.
For their part, the creditor nations in the north -- in addition to maintaining stable, noninflationary growth so that the lesser developed countries have open markets in which to sell their products -- must also be willing to extend additional net credit to support economic expansion in the south.
The fourth element of the President's dilemma is the spreading virus of protectionism. This has been spawned in the United States by the distortions that have resulted from the absence of a coherent fiscal policy in Washington.
Over the past five years, the administration has pushed real government spending as a percent of gross national product to a postwar record while simultaneously cutting explicit tax rates. In the circumstances, it is hardly surprising that the Treasury is running a massive deficit, real interest rates are at historically high levels, the dollar is overvalued, there is a huge deficit in U.S. international trade, and the nation's industrial heartland has been ravaged.
The distress among American manufacturers is real enough, but there are huge risks if the United States closes its borders to foreign goods. That could easily start a trade war, which in turn would lead to a sharp contraction in the volume of world trade. Two generations ago, the Smoot-Hawley Tariff played just such a role in triggering the "beggar-thy-neighbor" policies of the Great Depression.
As with the debt crisis, there are no simple answers to the problem of protectionism and the threat of renewed stagflation that it implies. Obviously, the first step would be to cut Treasury deficit, which would lover American interest rates, bring the international value of the dollar down to a more realistic level, and set the stage for more stable monetary policy and sustained economic growth. Renewed growth in domestic manufacturing employment would be the best antidote, bar none, to the poison of protectionism.
Precarious Condition of Banks, Thrifts
The final element in the President's dilemma, and in some ways the most serious, is the precarious condition of financial institutions in the U.S. According to a detailed analysis of the financial condition of the thrift industry by a team of economists at the Federal Home Loan Bank Board, under normal generally accepted accounting principles, 1,290 institutions representing 45% of the industry's assets were "insolvent" or "nearly insolvent" in 1984.
Even under the more lenient "regulatory accounting principles" that the Bank Board now uses, 877 thrifts were insolvent or nearly insolvent. These institutions have assets of more than $300 billion, or 31% of the assets of all associations insured by the Federal Savings and Loan Insurance Corp. At the same time, record numbers of thrifts have failed.
Among commercial banks, too, failures and near-failures have been running at historically high rates -- and some of them, of course, have involved very large organizations. For all practical purposes, the federal government had to nationalized the Continental Illinois National Bank and Trust Co. in Chicago to prevent its collapse.
Many factors have contributed to the losses and failures among banks and thrifts -- distortions caused by federal regulation of deposit interest rates, unstable monetary policy, wide gyrations in the economy, inflation, and interest rates, not to mention managerial incompetence and fraud.
The common denominator underlying each element of the President's dilemma is the need to maintain stable, noninflationary growth in the United States. Whatever else, renewed inflation and recession would make the administration's present problems pale by comparison.
It is true that inflation seems far away. Wholesale prices declined slightly in August. But keep in mind that if the Federal Reserve were to maintain a 20% growth rate in the money supply (it won't), it would only be a matter of time until the rate of increase in prices turned sharply higher.
The main industrial nations -- the U.S., Germany, and Japan -- represent islands of relative monetary and price stability in a world that still has a strong bias toward inflation. According to the IMF, world inflation is currently running at a rate of about 15.5%, scarcely changed over the last five years. Not surprisingly, the rate of growth in the world money supply is about the same.
There are no easy answers to the President's dilemma. One thing is clear, however. An inflationary monetary policy at the Federal Reserve is not one of them.…
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Article title: The President Faces a Five-Part Economic Policy Dilemma. Contributors: Heinemann, H. Erich - Author. Magazine title: American Banker. Volume: 150. Publication date: September 16, 1985. Page number: 4+. © 2009 SourceMedia, Inc. COPYRIGHT 1985 Gale Group.
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