Economic Policy: The Old Tools Won't Work

In an increasingly global economy, U.S. fiscal and monetary policies don't perform the way they used to.

Marc Levinson

Since the advent of the New Deal more than half a century ago, the federal government has actively helped shape the course of the economy. Its ability, at least in the short run, to pump up the economy in hard times and slow it down when inflation began to boil up has been unquestioned. As recently as 1981, when a sharp cutback in money supply growth pushed the country into recession, or 1983, when the stimulative effects of a tax cut brought the economy back to health, the old elixirs worked as they had in the past.

But in 1986, things were different. Heady growth in the money supply, repeated cuts in the Federal Reserve Board's discount rate and record federal budget deficits all failed to juice the lackluster economy. The old linkages between the government's actions and the economy's responses have changed in ways economists do not fully understand. As a result, the government's economic tools have been partially blunted. Contends Lawrence Chimerine, chairman of Chase Econometrics, the ability of policy changes to improve the economy is much smaller than ever."

The reason: the growing internationalization of the U.S. economy. Flexible exchange rates and the resulting mushrooming of international capital markets have made traditional economic policies act in unexpected ways. "No one has a reliable theory of exchange rates," says Paul Krugman, a professor of international economics at the Massachusetts Institute of Technology. "It makes it very difficult to be sure of the effects of macroeconomic policy."

These international connections make it increasingly difficult to aim economic weapons at purely domestic targets. Even thinking of "domestic" in terms of economic problems is misleading. The problem is global over-capacity and global underconsumption,'' contends Steve Quick, an economist with the Joint Economic Committee of Congress. "But we have no tools. We have no global fiscal policy. We have no global monetary policy.'' Adds Harold Rose, chief economist of Britain's Barclays Bank: "It's very hard to see how we can get out of these problems by macroeconomic policy alone."

Certainly, the assumption that the government can "fine tune" the economy has been in disrepute since the early 1970s, when policymakers were helpless as they faced high unemployment and high inflation at the same time. But faith in the government's ability to deal with one of these problems at a time has remained strong. Now, however, the government's very ability to achieve some domestic goal--3% growth in output, 4% unemployment--appears increasingly limited. The jury is still out on whether these limitations are a temporary phenomenon or a permanent fact of life.

Take monetary policy, the Federal Reserve Board's method of influencing the economy's performance by manipulating the money supply. Financial ' deregulation, of course, has blurred the meaning of the money supply figures. But international capital flows have also made it much more difficult for the central bank to plot the nation's monetary course.

The amount .of capital sloshing from country to country in search of the highest return is far greater now ever before. In 1985 alone, some $127 billion in foreign-owned assets were moved to the United States, while another $32 billion of U. S.-owned assets were brought home. The total amount of foreign-owned assets in the U.S., most of which are in relatively liquid form, now tops $1.2 trillion--twice the level of only five years ago. "Any effort by the Fed to predict the consequences of its polities is much harder than it used to be, because of the internationalization of the economy," says Brookings Institution economist Ralph Bryant, former director of the Fed's International Finance Division.

Suppose, for example, that the Fed wants to boost the economy's growth rate. When international capital flows were small, the central bank could stimulate borrowing by pumping up the money supply or cutting the discount rate. But now, lower real interest rates will spur investors to move their capital out of dollar-denominated investments. Economists can't even begin to estimate the likely extent of those capital flows. If little capital moves abroad, the lower interest rates will powerfully stimulate the U.S. economy. If, on the other hand, lower rates trigger a massive flight from the dollar, higher import prices will inject a strong dose of inflation into the economy, which would discourage the very business spending the Fed wanted to stimulate. Would faster money growth cut the U.S. trade deficit? Nobody knows.

The direction of the overall change remains undisputed: Increasing the rate of money supply growth will stimulate the economy, and reducing it will retard growth. But the magnitude of the change is now almost unpredictable. "If the Fed wants to weigh the effects of expansion versus inflation, that depends a great deal on whether monetary policy works on interest rates or on the exchange rate," says M.I.T.'s Krugman. "We just don't know. That's a significant inhibition on the Fed right now. We've lost certainty."

If the primary effect is on exchange rates, the major result of money supply changes is on demand forexports and imports around the world, argues John Williamson of the Institute for International Economics. "It doesn't make much sense to think of monetary policy being used for purely domestic purposes," Williamson says.

This exchange rate effect, alongside the traditional interest rate effect, may be why the Fed's policy initiatives now seem to take far longer to move the economy than the six months or so that has long been the rule of thumb among economists. "Those channels are not well understood," points out former Fed Governor Lyle Gramley, now senior vice president of the Mortgage Bankers Association. "We're working with somewhat longer lags than the old policies we worked with."

This growing uncertainty about the relationship between the money supply and the economy bewilders even economists who believe that international capital flows are not at fault, such as the American Enterprise Institute's Herbert Stein. The top White House economist in the Nixon Administration is not willing to pronounce monetary policy less effective than it once was, but he admits that the lags between Fed action and the economy's response have become erratic. "It's like sitting there with a stock of explosives that haven't gone off, so you don't know whether to throw in more," he says.

The international forces undermining monetary policy now hamper the action of fiscal policy as well. Traditionally, more government spending and lower taxes boosted both consumption and investment, at least temporarily, leading to faster U.S. economic growth and lower unemployment. But in an internationalized economy, businesses and consumers may buy more from abroad. Meanwhile, faster economic growth will drive up interest rates and thus the value of the dollar. For most Americans, Lesson One in fiscal policy failure was the tax cut of 1981, whose stimulative impact was greatly undermined by the overvalued dollar it brought about.

These international repercussions were hardly considered when the 1981 tax cut was passed, and economists are still unable to forecast exchange rate shifts with any certainty. As a result, it is almost impossible to predict whether the $108 billion deficit reduction that Congress is required to make this year under the Gramm-Rudman-Hollings Act will slow the economy.

There is no doubt that a $108 billion budget slash will cut domestic demand. It will also lower deficits and reduce the government's borrowing from abroad, driving crown the dollar. But whether a more favorable exchange rate for exports will boost the economy more than lower government spending retards it is an open question. "We don't know the responsiveness of the economy to a changed deficit," contends economist Mickey D. Levy of Philadelphia's Fidelity Bank. "We don't know the lags." Concurs Rudolph Penner, director of the Congressional Budget Office, "If we had been analyzing that big a change twenty years ago, there wouldn't have been much debate that it would cause a recession."

In fact, economists now shy away from talking about "fiscal policy," because they believe a given amount of government spending can have vastly different effects on the economy, depending upon its purpose and method of financing. A budget financed by government borrowing will affect U.S. interest rates, and thus exchange rates, far more than the same budget financed by taxes, says University of Wisconsin economist Kenneth Rogoff.

The varying economic impacts of such policy choices can only be guessed at. The venerable Keynesian multiplier, which links changes in government spending to predictably larger changes in economic output, can, for all practical purposes, be tossed out the window. Using fiscal policy to reach some desired target in terms of, say, unemployment or Gross National Product is thus far more difficult than in the past.

The use of both fiscal and monetary policy has become even more treacherous as government officials have come to realize that they are not operating in an isolated economy. Indeed, the reactions of other governments can blunt or reverse Washington's initiatives, making economic policy a strategic game, according to a brand new line of economic research. The U.S. must figure out how other countries will respond to its moves, and determine the degree to which those responses will counteract the effects that American policymakers seek to achieve. "We can't make policy without taking into account what our competitor overseas is doing," contends University of Illinois economist Stephen J. Turnovsky.

Consider the reaction of the German government to the Fed's raising the money supply to push the U.S. economy faster. If a faster-growing U.S. economy buys more imports from Germany, boosting the German economy, the Bundesbank may be able to achieve its economic growth targets with less monetary stimulus than it had planned, holding down Germany's inflation rate. But higher German interest rates, in turn, could force the Fed to boost the U.S. money supply even further to rev up our economy, accepting far more inflation in return.

One way to deal with the diminished effectiveness of monetary and fiscal policies, says the Joint Economic Committee's Quick, is to examine the economic impact of policies long considered unrelated, such as foreign aid or regulation of international lending. Increasing the industrial nations' contributions to the International Monetary Fund, for example, could help stimulate growth in the developing countries, which in turn would step up their purchases of U. S. exports. This viewpoint is catching on in Washington, where Congress has finally come to understand that the debts of developing countries are a major drag on U.S. growth.

The Reagan Administration is attempting to get the major industrial nations to coordinate their economic policies to spur faster growth worldwide. But this effort could falter because of insufficient knowledge about the interrelationship between fiscal and monetary policy and exchange rates.

Even if the governments cooperate, economists disagree about the effects of specific coordinated policies. University of California economist Jeffrey Frankel points out that even as the U.S. is urging Germany to boost its money supply to drive its economy faster, economists debate whether faster German money growth would be a plus sign for the U.S. trade balance by causing more imports or would be a minus by driving down the deutschemark relative to the dollar. "People disagree about the sign," Frankel confesses.

he argument that internationalization has fundamentally changed the nature of the government's policy tools is by no means universally accepted. "I'm not sure it's any harder to target the real GNP growth rate or the unemployment rate than it ever was," maintains Harvard University economist Lawrence Summers. "We can reduce the unemployment rate to 6% if we want to."

University of Chicago international economist Michael Mussa, currently a member of the Council of Economic Advisers, rejects the suggestion that monetary policy now works primarily through exchange rates rather than interest rates. Although that may be true for some countries, Mussa points out, "for the U.S. that would be a serious error in thinking about monetary policy." Sooner or later, he contends, the tumultuous effects of financial deregulation will wear off and the relationship between money growth and GNP will become more stable, enabling the Fed's tools to regain their former potency.

Still, a world economy with complex and poorly understood interactions requires a much broader view of "economic policy" than the nation has had in the past. Glib recommendations to cut the deficit or lower the discount rate make little sense by themselves. The two must be considered jointly, along with such nontraditional tools as labor laws, banking regulations, foreign aid outlays and the reactions of the nation's trading partners.

The U.S. has long been less dependent on foreign trade than most other countries, and has had far more economic independence as a result. But from now on, Americans must adjust to a new economic reality. In a global economy, even the greatest of economic powers can no longer control its own destiny.