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The Inflation Genie

Deficits, pricey oil, and a weak dollar--will the Fed keep interest rates low?

11:00 PM, Jan 12, 2004 • By IRWIN M. STELZER
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THE DOLLAR IS DOWN. Oil is up. America is running huge trade and budget deficits. The Japanese are intervening massively in the currency markets to prevent the yen from rising, and the Chinese show no signs of abandoning the renminbi's peg to the dollar. So the euro is bearing the brunt of the dollar's decline, making euroland goods less competitive and snuffing out any signs of a European recovery.

That should give the G-7 finance ministers something to talk about when they convene next month in Boca Raton, Florida. But very little on which they can agree. For one thing, there is a fundamental difference in the policy outlook of the United States and that of its fellow-members of the industrialized nations', rich man's club

American policy is aimed unambiguously at growth. The president has cut taxes and increased outlays both on the military and on domestic programs. He is now presiding over the largest expansion of the welfare state since Lyndon Johnson's Great Society and, by the way, pursuing the guns-and-butter program that Johnson favored, which left as his legacy a long period of stagflation. Also on the growth wagon is the Federal Reserve Board. Its chairman, Alan Greenspan has signaled that he plans to hold the line on interest rates in the face of a growing economy. He is counting on worldwide slack in the labor market and in industrial capacity to prevent a new round of inflation.

Larry Lindsey, a former Fed Governor and one-time chief economic adviser to the Bush administration, sums it up best in his recent private note to clients. "Economic growth," he writes, "is deeply embedded in the fabric of America's political economy. It is not only a good in the material sense; it also underpins social mobility, which has been the American ethic since well before America became an independent nation."

Europe, on the other hand, retains as its top priority the control of inflation. Although the euro area's major economies remain on the brink of recession, and are struggling to prevent the unemployment rate from progressing further up the double-digit scale, the European Central Bank is refusing to cut interest rates to ease the upward pressure on the euro. And the European Commission is to go to court to challenge the refusal of the E.U. finance ministers to fine France and Germany for running budget deficits in excess of the 3 percent-of- GDP limit specified in the Growth and Stability Pact. Just how cutting outlays and raising taxes can contribute to economic prosperity in recession-hit countries is nowhere specified. So Keynes continues to gyrate in his grave--or, perhaps not, given the willingness of a conservative American government to adopt him as its own.

SO THERE IS NOT VERY LIKELY to be a meeting of the minds as to what is to be done. British Chancellor Gordon Brown, the acknowledged intellectual powerhouse of the group, is not in a very good position to accuse the Americans of profligacy, since he is running deficits that are beginning to rival those of President Bush. The Europeans, stubbornly resisting the structural reforms needed to cure their sclerosis, are in no position to preach to anyone. And, having fixed exchange rates among themselves by adopting the increasingly unpopular euro, they can't logically complain that the Chinese have also fixed exchange rates (in their case by pegging their currency to the dollar).

Should the Europeans get testy, the Americans are prepared to argue that the realignment of exchange rates is just what is needed to correct the U.S. trade deficit, which is due to the refusal of other countries to stimulate domestic demand. Besides, the dollar's fall is gradual and, more important, the greenback is now more or less in line with the average level at which it has traded since 1970.

The U.S. delegation will also say that America's budget deficit, incurred to turn recession into growth, should be of no concern to other G-7 members, and indeed has helped them by refueling the American economic locomotive. But they will complain that America is funding its deficit by sucking in a disproportionate share of the world's savings. By one estimate--that of researchers at Bianco Capital--foreigners have been financing 80 percent of the U.S. government's borrowing.

America's G-7 partners are also worried by a recent International Monetary Fund report. The IMF reckons that if deficits increase as predicted by the Congressional Budget Office, the "unprecedented level of external debt" would pose "significant risks" for the world economy by pushing up interest rates and slowing economic growth.