On the supply side - contrast between the US economic boom and the volatile international currency markets

National Review, May 30, 1994 by Lawrence A. Kudlow

MAIN STREET loves it, but international currency markets and Wall Street do not. What is it? An economic boom that will last throughout this year and may well spill over into 1995. It is not sustainable, and it will generate considerably higher inflation and a nasty economic downturn when the cycle runs its course, probably in 1996. But in the meantime, 1994 will turn out to be a much stronger growth year than nearly all the experts predicted.

To begin with, most Americans owning or working in businesses believe the recent news on strong job creation is grounds for optimism. April produced 265,000 new non-farm payroll jobs, after a stunning 464,000 new hires in March. About a million new hires in March. About a million new jobs were generated during the first four months of 1994.

What's more, Main Street realizes that, for whatever reasons, the U.S. economy has entered a boom phase. After growing less than 2 per cent annually from the end of 1988 to the end of 1992, the economy over the past four quarters has accelerated markedly: 3.6 per cent for real GDP growth, and 5.5 per cent for private real GDP growth.

Not only a boom, but a industrial boom. While the East and West Coasts are still lagging, the middle of the country, including the natural-resource- and commodity-producing Rockies, is experiencing its best times since the late 1970s. Business investment spending has surged 17 per cent over the past year, while machine-tool orders are up 21.6 per cent. Industrial production has increased 5.1 per cent since last April, including a 10.8 per cent rise in the production of business equipment. As a leading indicator, unfilled-order backlogs of capital goods (excluding the volatile defense and aircraft sectors) have jumped at a 21.6 per cent annual rate over the past three months, suggesting that the boom will continue at least through year's end.

Much of the Main Street boom can be traced to the cheap dollar, which already this year has dropped 10 per cent against the Japanese yen and 5 per cent against the German mark. In fact, over the past three years the dollar has lost 50 per cent of its value against the yen. This currency protectionism has virtually shut Japanese and German manufacturers out of U.S. markets.

U.S. automakers are especially happy campers. With the overpriced yen, Japanese competitors are losing sales and market share, and domestic auto production has increased 18.7 per cent over the past year, and at a 48 per cent annual rate in the first quarter. Meanwhile the yearly selling rate has skyrocketed to 21.3 per cent, while inventories are relatively low. Tried to buy a jeep or minivan lately? There are only 59 selling days of "light truck" inventories on dealer lots, compared to 75 days a year ago.

But it is precisely the exchange-rate imbalance that has caused so much turmoil in world currency markets, centered on the sinking Clinton dollar, which is reminiscent of the Carter dollar 15 years ago. In his first 15 months, Treasury Secretary Lloyd Bentsen cooperated with confrontational trade negotiators Mickey Kantor and Ron Brown by hinting to the rest of the world that the U.S. would accept a lower dollar to offset a growing trade imbalance.

Of course, Mr. Bentsen's Republican predecessors, James Baker and Nick Brady, also supported a lower dollar. Indeed, it was Mr. Baker's public bickering with Germany in the summer of 1987 that led directly to the global stock-market crash that October.

World investors, businesses, and entrepreneurs vastly prefer stability to volatility where money is concerned, but since President Nixon ended the Bretton Woods system in 1971-73, currency volatility has been the rule. Except for a brief interlude (1981-85) under President Reagan, the dollar has come under sporadic attacks for the better part of over twenty years.

Now the trade deficit has grown worse, and a new dollar crisis appears on the horizon. Mr. Bentsen has changed his stripes and publicly called for intervention to stabilize the greenback's value, but as of this writing the Fed has not backed up the new policy with decisive action--i.e., raising the discount rate from 3 per cent to 4 per cent. An indecisive 0.5-percentagepoint rise would likely do more harm than good.

The current situation cannot be blamed solely on the U.S., however. Japan has been deflating its economy for three years, keeping real-estate interest rates way too high, monetary base growth much too low, and pulling the yen price of gold down by a staggering 37 per cent. Over the past year wholesale prices in Japan have declined 3 per cent, generating the worst recession since the mid 1970s.

That said, the U.S. and Japan must sit calmly at a negotiating table to realign exchange rates and monetary and trade policies before the world experiences another scary stock-market collapse. Not only because the dollaryen relationship is so far out of line, forming the nexus of the G-7 problem, but also because a further sinking of the dollar could sharply undermine economic recovery all around the world. The dollar is still the world's reserve currency, and emerging freemarket countries everywhere have essentially adopted the dollar as their principal means of exchange and investment store of value.