The slumping dollar signals an international vote of no confidence in President Clinton's economic policy. This outcome could have been predicted by anyone except the demand-side economists who spent the decade of the 1980s agitating for high tax rates and easy money--a policy mix whose results are now in.

Clintonomics has brought us higher interest rates and a weaker dollar. Like its predecessor, the Clinton Administration does not understand the economic relationships that determine its fate. Economists in the Treasury and the White House believe that low interest rates are the key to economic growth and that a weak dollar is the solution to the trade deficit. They overlook the fact that the dollar is the reserve currency in which a vast amount of wealth is held and inflation-sensitive commodities are priced. Any policy that weakens the dollar causes a flight by investors. That, in turn, causes U.S. interest rates to rise sharply.

An Administration committed to a low- interest-rate policy is bound to revive inflation fears. The Federal Reserve keeps interest rates down by supplying reserves to the banking system in order to prevent the demand for loans from bidding up interest rates. There is a limit, however, to how long this policy can succeed. As bank reserves are converted into demand deposits, the growth in the money supply pushes up inflation. This is especially the case when easy money is combined with an increase in tax rates and regulation, which restrain the growth in real output.

Once the bond market deduces that the Fed is priming the economy by flooding the banking system with reserves, the expectation of inflation is enough to carry interest rates up and the dollar down. Foreigners are hypersensitive to any currency loss on dollar investments. A Japanese investor who bought U.S. bonds in 1985 paid 240 yen per dollar. If those bonds were sold today, they would fetch less than 100 yen per dollar.

FATEFUL MOVE. When it became clear earlier this year that the U.S. economy had picked up sharply in the fourth quarter of 1993, following three years of rapid reserve growth, interest rates moved up. The Fed followed that rise with four hikes in the federal funds rate, totaling 125 basis points. This stabilized the dollar for about a month, but it came under renewed pressure in the latter part of June and soon broke through the 100 yen mark.

If downward pressure on the dollar persists, the Fed will have to protect the reserve currency by draining reserves from the banking system. Otherwise it would risk a sell-off in dollar-denominated assets as investors try to protect themselves from a depreciating store of value. Any further threats from the Clinton Administration to use a depreciating dollar as a trade weapon against Japan would signal a potentially fatal ignorance among Clinton's policymakers.

SKITTISH CAPITAL. The dollar also is under pressure because investors have realized that Clinton favors big government "solutions," while other parts of the world, especially Asia and Latin America, are curtailing the scope of government and growing rapidly as a result. Equity investors have developed a global perspective, and they prefer markets where government is downsizing and the prospects for economic growth are good. Clinton's policy causes investors to see the U.S. as a relatively poor prospect. Moreover the First Lady single-handedly wiped $50 billion off the value of pharmaceutical equities by demonizing the drug companies, and the Clintonian attack on the private health-care system reduces the value of medical research and new medical technology equities. Consequently, capital flows away from the dollar, keeping the currency under pressure.

The Fed could make dollars scarcer by draining reserves from the banking system. However, this move would not address all the various concerns of investors. To remain competitive in the global economy, the U.S. needs to reduce taxes on labor and capital. This would attract investment to the U.S. and strengthen the dollar. It also would help if Congress were to repeal hundreds of ill-considered laws that benefit special interests at the expense of the overall performance of the economy, and if thousands of counterproductive rules in the Code of Federal Regulations were removed.

The dollar's sharp drop could stabilize it for now, but the currency's woes are not over. The ruling ideology prevents the necessary tax and regulatory relief, and the Fed has to worry about a political backlash from the Democrats in Congress, whose solution to the problems they cause the economy is always lower interest rates.

This leaves the foreign-exchange market as the arbiter of U.S. economic policy. If the situation continues to deteriorate, one wonders if spurned policymakers will attempt to fight the market's judgment with exchange controls. Such calls already are being heard. Indeed, the hubristic believers in big government need only this one last act to complete their self-destruction.

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