America needs a program to end its dual deficits.
Commentators from Wall Street or the financial media have been predicting that this external borrowing process would end unhappily--in a severe recession or even a depression. Many even blame the stock market crash of 1987 on the fact that we were borrowing money overseas.
I think it important, therefore, to analyze the reasons why America has emerged as a big external borrower--and why the process has so far gone so well. Some of the factors that caused us to become a big borrower were transient and cyclical in nature and are now fading away, while others are more structural in nature and could endure well into the 1990s.
America has emerged a s an external borrower on a large scale becuase there is now for the first time since World War I a truly global capital market. From the late nineteenth century into the early decades of this century, it was commonplace for financial institutions around the world to invest a significant portion of their assets in other countries. Then, this process of global financial integration was broken for half a century by two world wars, the great depression, and a series of capital controls enacted after the two world wars. Only here in the 1980s have we reconnected to the world that we lost before 1914.
Why has this happened? First, we've had a worldwide movement towards financial deregulation, which has liberalized not just domestic financial institutions but also, in the last decade, international capital flows. A recently as 10 years ago, it was illegal for most Japanese investors to own U.S. Treasury bonds. But in 1980, Japan phased out many of its capital controls, as did Germany in the '60s. The U.K. had abolished exchange controls in 1979, and we did the same in 1974 by phasing out the interest equalization tax.
To understand the American financial markets in the next 10 years, it helps to understand that the real parallels for the stock market crash of 1987 were not 1962 or 1929, which was the common comparison 12 months ago, but the bear markets of the late nineteenth century. All of them revolved around sudden changes in capital flows to the U.S. from London. They centered either on a financial crisis in Britain that shut off money flows or an event in this country that called into question the value of the American dollar and the safety of foreign assets in this country.
When we introduced in the 1890s an experiment in currency depreciation by going to a bimetallic silver and gold standard, foreign investors became frightened. In 1893, there was a capital flight from New York, and the New York/London interest rate differential went from 100 basis points to about 1,000. In 1896, President Grover Cleveland lost control of his party to a populous movement under the leadership of William Jennings Bryan, who was committed to severing our ties to the British financial community.
We think of Bryan's famous speech in Chicago that won the nomination as the "cross of gold" speech. But if you read it, you'll see that much of it was an attack on the Bank of England for giving us high interest rates. In fact, various striking similarities exist between the Bryan speech of 1896 and James Baker's press conference that occurred the weekend before the October 19 stock market crash--when Baker attacked the Germans for pushing up their interest rates and threatening to cause a hike in our interest rates.
The second reason this country has emerged for the first time since the turn of the century as a large external borrower is that other countries have developed economic policies that are complementary to ours. That is, we have attracted external savings because of large budget deficits and because of robust credit demand on the private sector, while other countries, with far more restrictive policies, have had savings excesses.
Now, by any traditional standard, our policy has been highly irresponsible. It's rund own our capital stock. It may expose us to severe problems in the 1990s. But in many ways it was a happy accident. And historians may write that we were lucky that we had an economic policy in America that was expansionary--given the powerful deflationary forces coming out of Europe and out of Japan as commodity prices fell.
These other countries had excess savings in the 1980s because of differences in their population structure. Of the big eight industrial nations, only the U.S. and Canada have expanding populations. Our birth rate is much higher, and we also have more immigration. We will receive in the 1980s 10 million immigrants, compared to three or four million in the 1970s.
Why is population structure so important to capital flows? Because a population profile tells you about a country's need for external savings. In any industrial country, the great bulk of the savings belongs to people over the age of 55. In the case of the U.S., Federal Reserve data shows that 80 percent of all the financial assets in this country--stocks, bonds, cash--belong to people over the age of 55 who are getting ready for retirement.
Younger people, by contrast, carry most of the debt, because they are starting families, building houses, and educating children. therefore, in a global financial marketplace, you have movements of capital from aging societies, like Europe or Japan, to younger societies, which have greater need for capital. The population charts for Europe show very low birth rates. The population of Germany is currently falling by about 3,000 per week. This mean Germany's population could fall from 62 million today to about 40 million by the year 2050. In Japan, the population is not falling, but population growth is very slow, and Japan will have a much older society in 10 or 15 years.
As a result, Germany, Japan, and other industrial countires are trying to build up excess savings to get ready for this retirement bulge. In the 1980s, the savings found a home in the U.S. In a perfect world, more of the money would have gone to Mexico, Brazil, India, Nigeria.
The final reason why the U.S. has been able to cope with this big external borrowing is that it has access to special help in periods when the private marketplace breaks down. During 1987 and briefly in 1988, America found it difficult to attract foreign capital for the same reason as it did from time to time in the 1890s. The world financial marketplace has concerns about our economic policy, about the value of our currency, and therefore about the safety of buying U.S. financial assets.
In this most recent period, private capital flows to America stopped and there was a jump for a few weeks or months in our short-term and long-term interest rates. But this did not get out of control, because in contrast to America 100 years ago, we had access to official assistance. America is so important to the rest of the world economically and militarily that it received a great deal of help from foreign central banks in financing our external deficit. Officials at three central banks have told me that in 1987 our entire current account deficit of $150 billion was financed by the efforts of German, Japanese, British, and other central banks in supporting the dollar.
The support of Japan
It's especially important to look at the role that Japan has played in this process. The key to understanding the soft landing we've had here in the last two or three years has been the emergence of Japan as a large creditor power willing to assume political and economic responsibilities that go with its new financial status.
Three or four years ago, I could have sketched a pessimistic Cassandra-like scenario that stated the world was about to repeat the history of the 1920s, when America emerged as the great creditor power in place of the Bristish. Our institutions were not mature enough then to preside over the world economy, so we passed two highly protectionist trade bills. We created a bottleneck in the world economy by lending lots of money and then blocking off the exports from Latin America, Europe, and Asia that were needed to service our loans in those countries.
In the 1980s, some suggested that Japan was about to make the same mistake. It was parochial. It was insular. It had no history of global responsibility. And, therefore, it would fumble this great transition in financial power from America to Tokyo. But the fact is that Japan has risen very handsomely to its new role. Not merely because the Japanese want to help us, but because it is in their own self interest to do so.
One saw, I suspect, the power of Japan at work in the central bank intervention of 1987. Japan's foreign exchange reserves have grown from about $35 billion to about $90 billion over the last two years. The Bank of Japan keeps over 90 percent of its reserves in U.S. dollars, a level matched only by Canada.
One also saw the power of Japan in how the Ministry of Finance handled Wall Street's fear that Japanese insurance companies might dump bonds at the end of their 1988 fiscal year in order to take losses. Japan's Ministry of Finance ordered the insurance companies not to do so. Then it leaned hard on the Bank of Japan to maintain an expansionary monetary policy that would take pressure off our short-term interest rates. In most countries, this kind of monetary policy would have led to an inflationary boom, and in Japan, it did lead to significant asset inflation both in the stock market and in the property market. Indeed, during the Reagan years, while the U.S. share of world stock market capitalization fell from 55 percent to about 28 percent, Japan's share rose from 17 percent to about 46 percent.
Our dependence on Japan for help in the last two years is not totally unprecedented. In the 1960s, we had a special agreement with the Germans to help us cope with the problem of a falling dollar as a result of our defense spending in Europe. Under this "offset program," the Germans agreed to do four things as a quid pro quo for U.S. defense spending in Europe.
First, the Bundesbank ceased converting dollars into gold, as the Bank of France was doing after France quit NATO. Second, the German government agreed to buy a large tranche of U.S. Treasury bonds. Third, the Germans agreed to increase their direct subsidies for our bases there. And, finally, they agreed to give a very large quota to U.S. defense equipment suppliers, at the expense of companies in France, Britain, and Italy.
But the Japanese offset program is going to have to evolve in the next four or five years into a much more coherent plan that relies on more than monetary policy. Because if we subsidize our defense effort primarily through central bank activity, we create the danger of too much monetary growth and the financial imbalances that would follow. Moreover, we're now talking about a scale of support equal to 2 and 3 percent of our GNP, not the $2 to $4 billion of the late 1960s that led Senator Mansfield to want to bring our troops home if we didn't get help from the Germans.
Now, what happens from here? After this help from Japan, after these structural changes have given us more time to solve our trade problem and to solve our budget problem, we cannot postpone forever the need for a correction in our domestic and external deficits, because by 1991 or 1992 we will have a trillion-dollar external debt. And we must at some point have a trade surplus to service the debt and bring its growth back into line with the growth rate of nominal GNP.
Ironically enough, Ronald Reagan and George Bush will basically take us on a 100-year round trip. Our external debt as a share of GNP will probably peak in Bush's final year or the first year of the following term at about 20 percent of GNP, which is exactly what is was in 1893 at the height of British financial power over the U.S. in the nineteenth century.
The road to economic survival
There will, I think, be four major components to the American adjustment process during the Bush administration's first term, and probably spilling over to the term of the next president.
* The first adjustment is macroeconomic. We have to bring our growth rate down to a noninflationary level.
The Federal Reserve and the Treasury Department estimate that our potential GNP growth rate is about 2.5 to 3 percent. The labor force growth is about 1.5 percent, and productivity growth is about 1.2 percent. So the thrust of monetary policy must be to get the growth rate of the GNP also between 2.5 and 3 percent. Next, we must divert 0.5 to 1 percent of that GNP growth each year to reducing the trade deficit. That leaves about 1.5 percent for growth in domestic spending on goods and services. Since our population is growing by about 1 percent per year, there is about 0.5 percent remaining for growth in real per capita income. So we're looking not at a recession but simply a long, long workout.
Another set of challenges within this macro context is to make the adjustment without depressing our private savings and investment. We must be able to increase our capital stock, our productivity, and our living standards at some point after the first Bush administration ends.
* While it's easy to specify the macro fundamentals, it's far more difficult to find the micro components consistent with those macro objectives. Basically, the choice becomes what is politically possible and then what is economically optimal.
There are four major components on the micro side of our adjustment process. First, the government must rely on more user fees or on targeted tax increases for those who benefit from particular programs. For example, last year's catastrophic health insurance bill is accompanied by a surtax on elderly Americans that will finance their health care.
Second, more attempts will be made to move spending programs into the private sector through what are called mandated benefits. This will happen by the early 1990s in a variety of social areas.
Third, there will be further cuts in the U.S. defense budget, which will fall from 6.2 percent of GNP last year to about 5.1 percent in 1994. While events in the Soviet Union are very encouraging in this respect, we certainly cannot base our defense policy on a political change there--and it's extremely hard to forecast beyond this year.
Finally, more consumption taxes. I suspect that once we've passed the first year of the administration and have moved to substantive discussion of the problem of the deficit, you will see excise taxes on alcohol, gasoline, tobacco, and a variety of other items in order to comply with Gramm Rudman.
In the 1980s, all the major industrial nations have introduced significant income tax reduction programs--not just in American, but in Britain, Australia, New Zealand, Japan, Canada, and most recently Germany. In each case, except that of American, lower income taxes were offset by big increases in consumption taxes.
* The third component of the adjustment program is a continuing policy of economic expansion in Europe and Japan. If we're going to spend less and export more, we need growth in the domestic demand in Europe and East Asia. And the outlook is good for the next 12 or 18 months, with Japan chugging along at 4.5 to 5 percent, non-Japanese East Asia at 6 or 7 percent, and Europe at about 2.5 percent.
As we get the capital spending locomotive going, the developing countries also are experiencing a significant recovery in trade. We're going to see healthy growth rates not just in Singapore, Taiwan, and Korea, but also in Indonesia, Malaysia, and Australia. And even in Latin America, if its political situation gets under control.
* The final component of our adjustment process will be a rethinking of the role of government as it affects industry and the trade outlook. Without really calling it as such, there has been a significant movement in this country towards both protectionism and a de facto industrial policy in high technology.
Under Ronald Reagan, the share of imports under quota grew from 12 to 24 percent in five years. And the Congressional trade bill signed last summer has the potential to increase this protectionism.
In regard to an American industrial policy in high tech, the new superconductor legislation passed last year may be joined by more legislation to establish a policy for high definition TV. While I'm not an expert on science and technology, I can say that our institutional structure is not yet ready for such programs. In contrast to Japan, Germary, and other countries, the U.S. does not have a high-caliber civil service to preside over any kind of new industrial policy.
Will we just muddle through?
To summarize, America's adjustment process will go reasonably well in 1989. It will be a year of less of the same. Growth was 4 percent last year; this year it will be 3. Investment growth was 12; this year it will be 6. Export growth was 20; this year it will be 7 or 8. The big issues are in 1990, not 1989.
And the outlook for 1990 will center on the policy changes made in the next 12 months. Do we get a fiscal package that takes the pressure off monetary policy? If we do not get that fiscal package, do we get inflationary overheating because the economy stays above 3 percent growth, and does this force the Fed to impose a credit squeeze?
The danger is not a depression or a recession. The danger is a volatile stalemate in which we chug along at a moderate growth rate, but we don't sustain a capital-spending cycle to reverse the damage done four and five years ago.
Instead, we get a year of good growth, followed by a financial crisis caused by bad trade numbers and bad inflation numbers. So we jack up interest rates. Then comes a stock market crash or a bond market crash. We start over again, but we don't have that sustained break-through we need in capital spending to raise our productivity and become a stronger economy again.
None of these bad things have to happen. Those are simply the dangers we face if we don't make the policy changes needed to correct the imbalances of the 1980s. From those changes will come the potential for a higher rate of investment and productivity in the 1990s.
This article is based on an address by Mr. Hale at FEI's Treasurers Conference.
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|Author:||Hale, David (American economist)|
|Date:||Sep 1, 1989|
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