A Game of Chicken

By George Russell

Around the world last week, the mood in international money markets could only be described as akin to panic. In Tokyo, frantic Japanese traders stayed at their desks even during a Jan. 15 national holiday to execute orders $ through branch offices and foreign subsidiaries, and through the week they dumped billions of U.S. dollars in favor of the local yen and the West German deutsche mark. In Frankfurt, harried West German moneymen followed suit despite reported efforts by the country's central bank to stem the landslide. In Manhattan, foreign-currency trading occasionally came to a halt as money merchants momentarily failed to find any buyers at all for the U.S. greenback. Marveled Christine Patton, chief foreign-currency trader for Manufacturers Hanover Trust: "There were times when I saw the dollar plunge by a quarter of a percentage point within a few seconds. That's very erratic, almost a free fall."

Indeed it was. By week's end much of the chaos and confusion had begun to clear up, at least for a time. But the net result remained: after five days of often turbulent trading, the U.S. dollar had taken one of the worst pummelings in recent history against the value of the yen and the mark. The dollar lost 3.5% of its value against the mark in a single day, fluctuating around a six- year low before closing the week at 1.85 marks to the dollar, down 3.7% from the previous week. The movement against the yen was only slightly less spectacular. The greenback's value plunged near last August's record low of 152.55 yen to the dollar before recovering slightly to close in Tokyo at 153.1, down 3.2% for the week.

The dollar's precipitous drop was a sign of what John Lipsky, a vice president at the Salomon Brothers investment house, described as a "gigantic geopolitical game of chicken" that had broken out between the U.S. and its major trading partners. It was also a sign of a lack of confidence among money traders both in the current domestic economic policies of the Reagan Administration and in those of its allies abroad. In the view of the moneymen, something new may be required if the U.S. is to deal with its mammoth trade deficit. That deficit is expected to total more than $170 billion when the final figures are added up for 1986. In the meantime, further disconcerting drops in the value of the dollar seemed likely.

Despite repeated claims that it was interested only in the orderly operation of the international financial market, the Reagan Administration had a hand in last week's dollar upheaval. A major part of the drop came after an Administration official was anonymously cited as saying that the U.S. wanted to see a further decline in the dollar's value. The Administration hurriedly disclaimed any such view, but in the weakest fashion, saying only that the statement was not "authorized." At one point, White House Spokesman Larry Speakes even issued a new assertion that "the dollar is in an orderly decline against other countries, and that's the way we want it to remain." Then Speakes hurriedly retracted once again.

The fact was that at the risk of adding to the uncertainty in world financial markets, the Reagan Administration seemed ready to watch the dollar fall even further as a way to help solve the U.S.'s trade woes. Says Rimmer De Vries, chief international economist at the Morgan Guaranty Trust: "No one in Washington is talking about stabilizing currencies anymore."

The latest currency upheaval may have had ominous implications for international cooperation but, paradoxically enough, it failed to quell investor confidence in the booming U.S. stock market. Last week the Dow Jones average of 30 industrial stocks continued its spectacular rise past the magic 2000 mark that it attained on Jan. 8. After showing gains every day since the New Year began and reaching record heights each day for the past two weeks, the Dow closed at 2076.63, up more than 3.5% last week.

The combination of U.S. stock-market success and currency-exchange strains showed how complex the international economic climate had become in the past 16 months. In September 1985 the so-called Plaza Accord on exchange rates was hammered out between Treasury Secretary James Baker, architect of the agreement, and the finance ministers of Japan, West Germany, France and Britain. It provided for a gradual and orderly decline in the value of the dollar, which had reached a peak in February 1985. Before last week, the dollar had dropped 28.7% against other major currencies.

The theory was that the weaker dollar would eventually cut into the U.S. trade deficit by making foreign imports more expensive and U.S. exports more competitive. Last week U.S. Treasury Department officials were claiming that something like that had indeed happened. The trade deficit, said one, "has leveled off and is showing signs of improvement."

The signs are virtually indecipherable, however. Increasingly, what other U.S. officials have been focusing on is the fact that while U.S. trade was in deficit, Japan's trade surplus last year was $82.7 billion and West Germany's $57 billion. Both were records. Japan's trade surplus with the U.S. alone last % year stood at $51.5 billion and West Germany's at about $16 billion. Trade figures released in Tokyo last week showed that despite the dollar's long decline against the yen, Japanese exports to the U.S. actually increased by 23.5% last year, to $80.5 billion.

Economists have traditionally blamed such anomalies on a theory called the "J-curve." That notion decrees that whenever a country's currency declines in value, the national trade balance worsens before it improves, in a line that loops down and up in the shape of the letter J. The reason: immediately upon depreciation, the price of imports rises, but a contraction of the demand for such imports takes time. In the interim, the trade-balance differential widens. Economists usually estimate that at least 18 months is required before any expected improvements in the trade balance will appear.

The U.S. experience since the Plaza Accord, however, indicates that the trade problem is much thornier than that. One of the most immediate effects of a dollar decline should be a decrease in foreign travel by Americans -- but there the U.S. suffered a $5.2 billion deficit last year. Apparently, the rising cost of staying in Paris or Rome has been offset by cheaper air fares, among other things. Moreover, even while the international purchasing power of the dollar has declined since the Plaza Accord, the price of imported goods in the U.S. has often failed to rise by an equivalent amount (see chart). The explanation: foreign exporters have been willing to cut their profit margins in order to retain their share of the U.S. market.

The pain those exporters are willing to withstand is clearly illustrated in Japan. In the six months ending last September, pretax profits at the giant Toshiba electronics firm were down by 80%, and at Fujitsu, the country's largest computer concern, by 79%. Such declines cannot be sustained indefinitely, but they have helped frustrate those who expected an earlier U.S. trade turnaround.

There are a few heartening signs that some foreign exporters at least may be reaching the limits of their ability to cut margins. Just two weeks ago Japan's Matsushita lost its contract with General Electric to supply color- television sets for U.S. distribution. Matsushita wanted to raise its prices, while GE felt that it could arrange for cheaper supplies. Among the options GE is considering: buying the sets from the Bloomington, Ind., plant of its RCA subsidiary. West German machinery exporters, notes University of Rochester ) Economist Karl Brunner, are also beginning to feel a pinch.

Another striking fact is that the dollar's decline has not affected its relationship with a number of foreign currencies that have increasing importance for the U.S. trade picture. The U.S. dollar has dropped only 10% against Taiwan's yuan and about 1% against the Canadian dollar since the greenback's 1985 peak. Over the same period, the value of a buck has stayed unchanged against the Hong Kong dollar and has actually risen by roughly 2.5% against the South Korean won. All of those countries, and more, enjoyed big trade surpluses with the U.S. last year: $37.1 billion in the case of the newly industrializing countries of Asia and $23.7 billion for Canada. In all, these so-called new suppliers, which include Latin America, account for an estimated 47% of all U.S. trade, meaning that even a continued decline in the dollar against other currencies will leave a substantial portion of the trade problem unaffected.

Even so, U.S. exports started to rise, touching $19.3 billion in October, an increase of 10.3% over the previous month. On the other hand, in November the monthly trade deficit also rose, to $19.2 billion, the highest figure ever. Currently, U.S. exports must increase at a rate roughly double that of imports to close the trade gap. That is not happening.

The Administration has long preferred another solution to the trade problem but has had little luck in achieving it. Not long after the Plaza Accord was signed, Treasury Secretary Baker began urging West Germany and Japan to stimulate their domestic economies as a means of encouraging U.S. exports and sopping up exports from Third World nations. Neither country has yet complied satisfactorily with Washington's wishes.

In September, Baker warned that the allies' failure to stimulate would make a precipitous decline in the dollar's value unavoidable. His remarks kicked off a brief currency tailspin. In October the U.S. Treasury Secretary met with Japanese Finance Minister Kiichi Miyazawa to discuss the stimulus issue, with few dramatic results. At the same time, they were said to agree that a floor of approximately 160 yen should be put under the dollar's gradual fall. Last month Baker held similar talks with West German Finance Minister Gerhard Stoltenberg. Despite such conversations, West German growth has continued at a conservative 2.5%, while Japan's is about 2%.

Last week's currency fire storm was a major reminder that there are ways ; other than quiet reasoning to influence West German and Japanese policy. Trouble is, the message did not seem to register. Both the West German and Japanese central banks were believed to have intervened heavily in money markets in support of the dollar during last week's plunge, even though West German central bankers deny any activity. Such action would indicate that both countries are willing to fight to protect their current economic policies. By some accounts, the Japanese central bank spent $20 billion in a bid to stop the dollar's drop, while Bank of Japan Governor Satoshi Sumita declared that "we are firmly determined to intervene whenever necessary." In Bonn a senior official sniffed that "if people in the U.S. are thinking in such simple ways as creating growth in West Germany by depressing the dollar, they will be quickly proved wrong."

That position was backed strongly elsewhere. In Paris, an aide to French Finance Minister Edouard Balladur declared that "allowing the dollar to fall precipitously is not the solution to either America's trade problem or the world's economic difficulties." Later in the week both Balladur and West Germany's Stoltenberg went a step further, insouciantly describing the dollar as "undervalued."

The Europeans argue that rather than arm twisting its friends to achieve economic stimulus, the U.S. should be cutting back on its own spending as a means of solving the trade imbalance. Above all, they point to the nation's staggering budget deficit, which the Administration projects at $173 billion for 1987, as the place to start. Says a West German central banker: "The U.S. is a deficit nation spending as if it were a surplus nation." That assertion would seem to contradict Stoltenberg's claim that the dollar is undervalued. Nonetheless, another Bonn official argues, "As long as there is not enough assurance in the currency markets that the U.S. is dealing with its deficits, the dollar will continue to decline."

Some American economics experts agree. The value of the dollar, argues John Makin, director of fiscal-policy studies at Washington's American Enterprise Institute, is "totally irrelevant. If the budget deficit isn't going to improve very much, the trade deficit isn't either." Sidney Jones, an economist at Washington's Brookings Institution, also warns of a danger if the dollar continues to serve as the main instrument for altering the trade balance: the risk that the U.S. inflation rate, about 2% last year, will flare up. Says Jones: "Once those import prices do go up, then you can get away with increasing domestic prices. That's probably a greater inflation risk than simply the increase in the price of imported goods."

Mounting frustration over the trade balance is liable to trigger a response on Capitol Hill. Last year the House passed a highly restrictive omnibus trade bill, but it stalled in the Republican-controlled Senate. This year both Democratic and Republican legislators say that they will try again. Explains Edward Madigan, deputy Republican whip in the House of Representatives: "Members feel we're being screwed over by the Japanese and the Germans. Something substantial and permanent needs to be done."

Sensing the militant new mood, the White House has already prepared a package of measures intended to improve American business competitiveness. The broad thrust of the Administration's approach will be unveiled in the President's Jan. 27 State of the Union address. Few of the measures, however, will bear directly on the central problems of the trade issue. They largely embrace such themes as stricter enforcement of antidumping laws and new definitions of monopoly that will take into account shares of international as well as domestic markets.

Even outside Washington, a number of influential experts feel the U.S. would do well to sharpen up its haggling skills. Says Morgan Guaranty's De Vries: "A very tough trade policy is needed." The U.S., he argues, should bargain for greater reciprocity in trade agreements with Japan, as well as a further opening up of that country's markets to goods from third countries.

The Administration has already begun to adopt a tougher posture. Washington has given the twelve-member European Community until Jan. 30, for example, to settle a trade dispute involving the loss of U.S. grain markets in Spain and Portugal. Failure to meet the deadline will mean automatic 200% U.S. tariffs on a number of European products, notably wine, liquor and cheese. The problem is that the Europeans have promised to retaliate in kind, meaning that a major or minor protectionist trade war might already be in the offing.

The unhappy fact is that nothing is going to change the U.S. trade-deficit picture soon. Therefore, trade frictions are liable to increase, pressures on U.S. allies to change their policies will intensify, and further currency flurries like last week's turbulent episode will remain a constant possibility. Last week's dollar plunge, says Bluford Putnam, a senior economist with the Morgan Stanley investment house, is evidence that money markets are trying to accomplish "what politicians could not do" in solving the trade issue. The same hair-raising experience shows that some other approach might be preferable.

CHART: TEXT NOT AVAILABLE

CREDIT: TIME Chart by Joe Lertola

CAPTION: VARIABLE WINDS, STABLE CARGO

DESCRIPTION: Color: Three charts of Japanese yen, West German mark, South Korean won, changes against U.S. dollar, 1985, 1986, 1987, with suggested retail prices of principal exports of each country.

With reporting by David Beckwith/Washington and Frederick Ungeheuer/New York, with other bureaus