You cannot change a country’s tax rates, government spending and interest rates without also changing the exchange value of that country’s currency. Educated people in smaller or poorer countries understand that, but many in our own nation do not, in part because we are spoiled by the special role the U.S. dollar plays in the global economy. However, people over 50 who paid attention in the 1980s do remember. Some may wonder if we are entering an analogous period with similar dangers.
The short answer is that in many ways, we are. In many ways, 2017, the opening year of the Trump administration, eerily resembles 1981, the first year of Ronald Reagan’s first term. That was a decade of painful economic adjustments, particularly in farming, mining, steel and automobiles.
On the other hand, there are important differences. So while some broad variables are akin, differing specifics mean that outcomes won’t be identical. But powerful forces will play themselves out.
First the similarities: These center on the links between domestic macroeconomic policies — think taxes, spending and interest rates — and the exchange value of the dollar.
In his campaign, Reagan argued that inflation needed to be controlled, that we needed to spend more on the military, that taxes had to be lowered and budget deficits reduced. This message resonated with many voters.
What many did not note was that the process of reducing inflation was well underway, beginning with Jimmy Carter’s October 1979 appointment of Paul Volcker as chair of the Federal Reserve Board. Volcker knew that to get rid of entrenched inflation, the Fed had to crimp down on money growth, which inevitably would push up interest rates. It did so with a vengeance.
Reagan was able to get Congress to spend more on defense and to cut taxes. But the GOP did not control Congress and so one price of those political wins was that there was little cutting of other spending. The deficit burgeoned and the national debt, which under Carter had reached a 40-year low relative to GDP, began to rise again.
The combination of a tighter money supply and increased government borrowing pushed interest rates even higher. This attracted savings from around the globe and not just domestically. But to take advantage of high U.S. rates, one has to have U.S. dollars. So demand for dollars by foreigners who wanted to invest in our country drove up the price of the dollar relative to other countries’ money.
If it takes more yen or pre-euro francs or marks to buy a dollar, it takes more of these currencies to buy anything priced in dollars, whether a bushel of Minnesota soybeans or a heart valve. At a higher price, you sell a smaller quantity. A “strong,” or high-priced, dollar has the same effect as a tax on U.S. exports — paid by the country that’s bringing them in.
Looking at the other side, if a dollar buys more francs or marks or yen, then the dollar cost of anything priced in those currencies, such as Japanese steel or electronics or German cars, falls. A strong dollar the same effect as subsidizing imports to the U.S.
As the exchange value of the U.S. dollar increased by a weighted average of some 47 percent against other currencies in the four years after Reagan took the oath of office, any U.S. sector that depended on exporting, particularly agriculture, was poleaxed. Ditto for any sector, such as U.S. automobiles and steel, that had to compete with imports.
Cheap imports helped the Federal Reserve squelch inflation and were a bonanza for consumers. But they hammered farming and manufacturing. They pushed up unemployment.
An additional problem was that U.S. heavy manufacturing, but especially autos and steel, had deep structural problems, including excess and obsolete facilities, low productivity growth due in part to outdated union work rules, and sclerotic management. (Journalist John Hoerr’s “And the Wolf Finally Came: The Decline and Fall of the American Steel Industry,” remains a masterful account of these problems three decades after it was written.)
Agriculture had deep structural problems, too. It had boomed after the decline in value of the U.S. dollar when the Bretton Woods-managed exchange rate system fell apart in 1972. In the context of a growing economywide inflation mentality, land prices had zoomed. This was unsustainable.
All three sectors — farming, steel and autos — had high debt levels predicated on inflation-adjusted interest rates being very low. So they were hit hard when the Volcker-led Fed pushed rates to double digits. Even if the exchange value of the U.S. dollar had remained stable, these sectors faced painful adjustments.
The dollar did not remain stable and the successive punches of higher borrowing costs, weak export demand and cheap import competition knocked all three American industries into a financial stupor. Accounts of the decline of “the Rust Belt” and of the “crisis in agriculture” were in the news for years. Employment in steel and autos fell by more than 300,000 each, as did jobs in associated sectors like iron mining. A high fraction of farms went through bankruptcy, ag machinery manufacturing slumped, and so on.
All this meant that, at an annual average rate of 7.3 percent, unemployment for the 1980s was the harshest of any decade between 1940 and 2010, a full point above that for the 1970s. (For 2010 through 2016, the average is 7.2 percent.) Needed restructuring did take place, but historic industries never again had the same place in the U.S. economy.
So readers with a sense of economic history are correct in wondering if we face similar dynamics today.
Yes, the Fed is starting a phase of raising interest rates. Yes, a new administration is asking for tax cuts and defense spending increases. Yes, the political dynamics are such that while many in the GOP call for deficit reduction, there is little appetite for cuts in the largest categories.
There are interactions between fiscal and monetary policy. The Fed will tighten somewhat in any case, after a decade of unprecedented low rates. But, if the fiscal stimulus of lower taxes and higher spending in a situation of full employment creates inflationary pressures, the Fed will feel even more the need to tighten on the monetary side. The more U.S. rates rise while Europe and China are mired in their own problems, the more attractive the U.S. dollar will be to foreigners. And as the dollar rises in value, U.S. imports will become cheaper and made-in-USA exports will become more expensive. This sounds like 1981-1985 all over again.
The cruel irony for Donald Trump is that the core of his campaign was to slash imports and raise exports. Yet the effects of tax cuts and increased spending, whether on the military or infrastructure, are highly likely bring about the opposite trade outcome.
But there are key differences between now and then. The 1980s followed a decade of the worst peacetime inflation in U.S. history. Now, we are coming off 10 years of historically low consumer inflation. Overall, the stock market had been lethargic in the 1970s. It now is at the peak of a bubble. Baby boomers coming of age caused large growth of the labor force in the 1970s, but they have been retiring over the last 10 years and the pace of that will increase. Europe was becoming more competitive in the 1980s and now its future is clouded. China played little role in the global economy back then and an enormous one today. The national debt was at a low point relative to the economy when Reagan took his oath and now is high and rising as Trump takes the reins. Reagan never had his own party controlling both houses of Congress but Trump begins with that power.
What will happen? Other than predicting that the next several years will be harsh for farmers and that the U.S. trade deficit is not going to shrink, much is still up in the air. But the lesson of the 1980s is that modern economies are complex domestically and intertwined globally. Apparently simple policy initiatives like cutting taxes, spending more on infrastructure, and returning interest rates to “normal” levels are much more complicated than most people understand. It is going to be a fascinating time, but not an easy one.