By: Louis B. Mendelsohn
President, Market Technologies

EFFORTS BY THE G-7 TRADING partners to assist the U.S. in reducing its merchandise trade deficit by allowing the dollar to drift downward thereby making U.S. products more price-competitive–involve so delicate a balancing act that they risk precipitating recession or possibly stagnation this year.

The current strategy appears to be based on the premise that a gradual decline supported by central bank intervention, rather than a precipitous devaluation of the dollar, is preferable. But despite recent action by the G-7 partners to support the dollar at its current level, a substantial further decline, combined with aggressive fiscal stimulation by both West Germany and Japan, would in fact be necessary to lower the U.S. merchandise trade deficit to an acceptable and sustainable level.

A major risk of continuing this strategy is that expectations of further decline in the dollar could spark a massive flight of foreign investment capital from the U.S. Holding dollar-denominated investments, particularly Treasury securities (with increasingly large negative rates of return), would no longer be justified on a risk-reward basis. Interest rates would rise as the Treasury’s funding needs crowd out other borrowers from the marketplace, despite indications by the Federal Reserve Board that it would like to avoid higher rates, which might choke off current economic expansion, particularly in an election year.

In my opinion, a more targeted, incisive alternative to the current shotgun strategy of manipulating the dollar should be implemented as soon as possible.

One option would be for the G-7 partners to agree to accept a plan for selective surcharges on U.S. imports, coupled with limited controversial relief for exports. The surcharges could be determined on a case-by-case basis, depending on the U.S. deficit with each of its trading partners and the rate of progress in deficit reduction achieved with each. The program could even be targeted at specific goods or industries, depending on their relative impact on the U.S. trade balance.

Effort should be made to include the NIC’s (South Korea, Taiwan, Hong Kong and Singapore), which together account for 20 percent of the U.S. trade deficit, more than that with West Germany and second only to the deficit with Japan.

Such a coordinated plan would preempt the trade protectionist bill pending in the U.S. Congress, effectively killing its chances for enactment, thereby avoiding the deleterious effects that have previously accompanied unilateral trade protectionist legislation, including retaliation, a decrease in world trade and broad economic contraction.

In addition to reducing the trade deficit by making selected foreign goods more expensive in the U.S. and U.S. goods less expensive in foreign countries, the program would have the added benefit of generating surcharge revenue in the U.S. Also, by stimulating domestic production, corporate tax revenues from affected domestic industries would increase, further decreasing the U.S. budget deficit.

Exchange rates would fluctuate within a more narrow range, with less daily volatility and need for central bank intervention. The risk to foreign holders of U.S. assets (real estate, equities, debt instruments, interests in U.S. plants and equipment, etc.) would be considerably lessened by this stability. Therefore, interest rates could be maintained at or near current levels.

Jawboning by domestic producers who take advantage of the program to raise prices without regard to marginal production costs could be engaged in as part of the surcharge program’s continuous fine-tuning. Adjustments could be made as economic statistics on the trade balance, G.N.P., money supply, price indexes, industrial production, etc., for the U.S. and its trading partners become available.

Furthermore, due to its precision and flexibility, this approach can be fine-tuned and modified quickly to respond to changing economic conditions or policy objectives, without causing unintended economic dislocations or imbalances such as would result from a further decline in the dollar. This is analogous to the difference between shooting at a target with a telescopic rifle versus using a shotgun. When dealing in the macroeconomic domain, with its attendant risks, precise focus is desirable.

Of course, no short-term solution will succeed unless substantial progress is made in the U.S., to reduce government consumption spending, to implement fiscal policy more favorable to capital formation and savings and to increase productivity. While progress on these fronts will continue to be elusive, initiating a coordinated surcharge program to combat severe trade imbalances at this time, rather than risking the enactment of restrictive trade legislation in the U.S. as well as the economic dislocations and imbalances that would result from a free-falling dollar, is at least a step in the right direction.

Louis Mendelsohn is a financial analyst, consultant and investment software developer in Wesley Chapel, Florida.