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Exhausting the Alternatives

Author: Roger M. Kubarych
November 17, 2004
Council on Foreign Relations

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Winston Churchill said it best: "The Americans will always do the right thing... after they've exhausted all the alternatives." That is true for the Bush administration’s international economic policy.

They started out four years ago inheriting a large budget surplus, a strong dollar, and a huge $400 billion current-account deficit. When the high tech bubble collapsed, they were prepared to take aggressive action to stimulate the economy through tax cuts and government spending increases. But they kept the strong dollar policy of the Clinton years. Back then, former Treasury Secretary Rubin was an icon in the financial markets. Repudiating his policy strategy would have brutally criticized. Stock markets were shaky enough. It was easier to continue Rubin’s approach.

When the inevitable recession hit the US, it was relatively short and mild. But the dollar continued to go up, setting the stage for an unprecedented explosion of the trade deficit once recovery began. The current-account deficit is now approaching a once unimaginable 6% of GDP. It is bound to increase further, since growth in US domestic demand continues to outpace demand growth in Europe, Japan, Korea, and many other major trading partners. Yet, the US Treasury has continued to repeat ad nauseam the slogan that “a strong dollar is in the interests of the United States.” It was seven or eight years ago. But not now.

How have Bush administration officials reacted to the trade imbalance? Mainly they have dismissed it as a problem. They said it confirmed that the US economy was in better shape than other economies, and that foreign investors were happy to acquire dollar assets. This doctrine of “benign neglect” began to sound hollow, however, as foreign private investors largely stopped investing in US stocks and bonds. Instead it was left to central banks and governments in Asia to finance most of the US external deficit (and most of the US government’s budget deficit, too). They did that not in quest of attractive yields on US assets, but to keep their currencies from shooting up against the dollar and making their exports unprofitable.

But what could the Bush administration actually do once they came around to the view that the trade deficit is a problem? For one thing, it could tighten fiscal policy. That is what European finance officials recommend. That would lower US growth, raise unemployment, slow consumption, but also hold down US imports. That outcome would not be in anyone’s interest, neither the US public nor foreign countries. So the US government is not going to follow that unhelpful advice.

Second, the Bush administration could impose trade restrictions. Other Republican presidents have done that: Nixon in 1971, by putting limits on soybean exports to Japan and introducing an import surcharge; Reagan in 1981, by forcing Japan to adopt “voluntary” export quotas on Japanese autos. The current Republican president hinted at this option when he slapped tariffs on steel imports two years ago. They were withdrawn after US steel users complained. But the trade restriction option was put on the table and it is still there.

Finally the Bush administration could shift to a policy of dollar depreciation. Bush’s economic advisers know that a big drop in the value of the dollar against Asian currencies will not solve the trade deficit problem overnight. For example, the 1985 Plaza agreement, in which the G-7 finance ministers set the stage for a 30% decline in the average value of the dollar, didn’t produce results for five years.

But the political pressures for adopting a weak dollar strategy are mounting. He nearly lost the election in traditionally Republican Ohio, one of the Great Lake states hit hardest by foreign competition resulting from the strong dollar.

A shift in Bush administration policy toward the dollar would be praised in the US Congress and widely (though not unanimously) applauded on Wall Street. Moreover, about every senior official of the Federal Reserve has stated that a lower dollar is a necessary, though not sufficient, requirement for stopping the rise of the US trade deficit and eventually bringing it down. Foreign central banks and governments in Asia have resisted this logic.

The re-elected Bush administration has signaled that it will not turn a blind eye to the trade deficit or the dollar indefinitely. To be sure, heavy turbulence will rattle the foreign exchange markets for a while. But America has exhausted all other alternatives, and as Churchill shrewdly foretold, is now about to do the right thing.

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