Commentary | Economic Growth

The War’s Other Shoe | EPI Viewpoints

Opinion pieces and speeches by EPI staff and associates.


The War’s Other Shoe

By Josh Bivens and  Christian Weller

During the war in Iraq, airwaves hummed with pundits waging their own preemptive strike, trying to predict whether war would help or harm the U.S. economy. Answers to some of the most-asked questions are in. Would the war set off a rise in oil prices? Apparently not. Would the additional spending help boost growth enough to lower unemployment? Not yet.

The answer to a more complex question will take longer, and it could spell the most economic trouble for the United States and the world. How will U.S. unilateralism before and during the war play out now? That question carries the greatest potential fallout for the dollar and other currencies and the economies they are linked to. It is the war’s other shoe, and it hasn’t dropped yet.

The rancorous prewar debate and the hard feelings left in its wake are likely to carry costs that go far beyond the printer’s bill for turning French fries into freedom fries. Strained relations make economic policy coordination hard. Without such coordination, international financial markets may chart their own path around these obstacles, and the results might only make things worse.

Forecasters have unanimously revised downward their predictions of economic growth in the U.S. and the global economy. With anemic U.S. growth – less than 2.5% is projected for 2003 – employment and wages will keep falling. Sluggish growth overseas means that the U.S. will not be able to export its way back to prosperity and that the enormous U.S. trade deficit will remain the 600-pound gorilla looming over the economy.

The current trade deficit, $503 billion in 2002, is unsustainable over time. Importing so much more than we export requires the United States to find investors willing to lend us more and more to cover an international debt that expands by about $1.5-2 billion each day. Eventually, international investors who doubt the ability to repay a debt of this magnitude may start withdrawing their money. Such a sell-off in Sweden and Argentina produced financial crisis. In the United States, it could cause prolonged slow growth, which would shrink consumption and reduce imports, as people have less income to spend on any goods, domestic or foreign.

The best strategy for avoiding such a scenario is coordination among the large industrial nations to manage a controlled lowering of the dollar’s value, while at the same time promoting economic growth abroad. Otherwise, the chaos of international currency markets will determine when and how far the dollar will fall, not an encouraging prospect given the markets’ history in managing rational currency realignments.

Washington should take a page from the Reagan administration, which engaged in a coordinated effort among the major currencies to lower the dollar under the Plaza and Louvre Accords of 1985 and 1987. These international efforts involved direct interventions in foreign exchange markets by central banks and finance ministries, as well as public statements by politicians to indicate that the dollar was still considered overvalued. In the end, these accords were successful, reducing the value of the dollar and returning the U.S. trade imbalance to sustainable levels.

Responsibly lowering the dollar will increase U.S. exports and decrease imports and should be a priority for moving the U.S. economy out of harm’s way. To soften adverse effects on U.S. trading partners, active policies are needed to revive growth in Europe and Japan. The European Central Bank, for instance, might opt to lower its interest rates, effectively replacing export growth with domestic growth. Europe’s interest rates, well above those of the United States, give the bank ample maneuvering room. The Japanese government could, for its part, explicitly target sustained inflation. Such a move could combat the current adverse effect of falling prices, which are encouraging consumers and businesses to delay shopping or investing in the expectation of lower future prices.

In an ideal world, dollar devaluation and compensating growth policies should occur in tandem through coordinated economic policies among countries. But the players in this real world have just been through a bitter diplomatic row. In the fallout of the Bush adminstration’s unilateralism, issues like consumer boycotts of French or American goods are a sideshow. The real challenge is to mend fences quickly and get the essential players back to the table. Otherwise, the solutions needed for a global recovery, which none can implement alone, will continue to elude us and the bill for unilateralism will be high, indeed.

Josh Bivens and  Christian Weller  are economists at the Economic Policy Institute.


See related work on Economic Growth

See more work by Josh Bivens