You cannot change a country’s tax rates, government spending and interest rates without changing the exchange value of its currency. People elsewhere understand that. Many Americans, spoiled by the special role our dollar plays globally, don’t. However, some do remember the 1980s. They may wonder if we face similar challenges.
In many ways, we do. The opening year of the Trump administration eerily resembles 1981, Ronald Reagan’s first year. That opened a decade of painful economic adjustments, particularly in farming, mining, steel and automobiles.
But there are differences. The outcomes won’t be the same.
First the similarities: These are links between domestic policies — taxes, spending and interest rates — and the exchange value of the dollar.
Campaigning, Reagan argued that inflation had to be controlled, military spending increased, taxes lowered and budget deficits reduced. This resonated with voters.
Many did not note that lower inflation already was well underway, beginning with Carter’s 1979 appointment of Paul Volcker to head the Federal Reserve. Volcker knew that to whip inflation, the Fed had to crimp the money supply, which would boost interest rates. It did so with a vengeance.
Reagan got Congress to spend more on defense and to cut taxes. But the GOP did not control Congress and neither party really wanted to cut other spending. The deficit burgeoned and the national debt, which hit a 40-year low relative to GDP under Carter, rose again.
Tighter money and increased government borrowing pushed interest rates even higher. This attracted savings from around the globe. But to earn high U.S. rates, one needed U.S. dollars. So demand by foreigners drove up the price of the dollar relative to other currencies.
If it took more yen, francs or marks per dollar, it took more to buy anything priced in dollars, whether U.S. soybeans or heart valves. At a higher price, you sell fewer units. A “strong” dollar is like a tax on U.S. exports.
Conversely, if a dollar buys more francs or marks, then the dollar cost of Japanese steel or German cars, falls. A strong dollar subsidizes imports to the U.S.
As the value of the dollar increased by 47 percent against other currencies in Reagan’s first term, any U.S. sector, like agriculture, that depended on exports was poleaxed. Ditto for any, such as U.S. automobiles and steel, that competed with imports.
Cheap imports helped the Fed squelch inflation and were a bonanza for consumers. But they hammered farming and manufacturing. And they pushed up unemployment.
Additionally, U.S. manufacturing had deep structural problems, as did agriculture. Agriculture boomed after the Bretton Woods exchange rate system fell apart in 1972, lowering the dollar. And, with the mentality of general growing inflation, land prices had zoomed unsustainably.
All three — farming, steel and autos — had high debt levels predicated on inflation-adjusted interest rates staying low. So they suffered when the Fed pushed rates to double digits. Even if the exchange value of the dollar had not risen, these sectors faced pain.
The dollar did rise, and higher borrowing costs, weak export demand and cheap imports knocked all three industries into a financial stupor. Employment in steel and autos fell by more than 300,000 each, while jobs in associated sectors like iron mining fell proportionately. Many 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 in the 1980s was the highest of any decade between 1940 and 2010. Needed restructuring occurred, but historic industries never again had the same place in the U.S. economy.
So readers with memories are correct in wondering if we face similar dynamics today.
Yes, the Fed is raising rates. Yes, a new administration wants tax cuts and defense increases. And yes, while many Republicans call for deficit reduction, few want cuts in the largest categories.
There are interactions between fiscal and monetary policy. After a decade of unprecedented low rates, the Fed will tighten somewhat in any case. But if lower taxes and higher spending during full employment create inflationary pressures, the Fed will tighten even more. As U.S. interest rates rise while Europe and China are mired in their own problems, the dollar will become even more attractive abroad.. As its value rises, U.S. imports will become cheaper, and made-in-USA exports will become more expensive. This sounds like 1981-85 all over again.
The irony for Trump is that his campaign centered on slashing imports and raising exports. Yet the effects of tax cuts and increased spending will cause the opposite.
There are key differences:
▪ The 1980s followed the worst peacetime inflation in U.S. history. Now, we are coming off 10 years of historically low consumer inflation.
▪ Overall, the stock market swooned in the 1970s. It now is at a peak.
▪ Baby boomers burgeoned the labor force in the 1970s, but have been retiring since 2008.
▪ Europe was becoming more competitive in the 1980s. Now its future is clouded.
▪ China was small then. It is enormous today.
▪ The national debt was low when Reagan took his oath. Now it is high and rising.
▪ Reagan’s party never controlled both houses of Congress. Trump’s does.
What will happen? Other than predicting that the next years will be harsh for farmers and that the U.S. trade deficit won’t shrink, much is still up in the air.
The lesson of the 1980s is that modern economies are complex domestically and intertwined globally. Apparently simple initiatives like cutting taxes, spending more on infrastructure, and returning interest rates to “normal” levels are more complicated than people understand.
It is going to be a fascinating time, but not an easy one.
St. Paul economist and writer Edward Lotterman can be reached at firstname.lastname@example.org.