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The US economy: performance and prospects.

THE US ECONOMY: PERFORMANCE AND PROSPECTS This is the second article from members of the CLARE Group to appear in the Review. Future articles will normally appear about twice a year. The Review is pleased to give hospitality to the deliberations of the CLARE Group but is not necessarily in agreement with the views expressed. Members of the CLARE Group are M.J. Artis, A.J.C. Britton, W.A. Brown, C.H. Feinstein, C.A.E. Goodhart, D.A. Hay, J.A. Kay, R.C.O. Matthews, M.H. Miller, P.M. Oppenheimer, M.V. Posner, W.B. Reddaway, J.R. Sargent, M.F-G. Scott, Z.A. Silberston, J.H.B. Tew, J.S. Vickers, S. Wadhwani.

1. Introduction Problems arising in the US economy and financial system are frequently of global significance, and the inauguration of a new President provides a convenient occasion for taking stock of the US economy's recent performance and prospects. In this article we include some longer-term background as well as an assessment of the current situation. The article is a sequel to one which we wrote nearly four years ago and which focused mainly on the remarkable recovery from recession achieved by the US economy in the period 1982-4.(1)

The speed of that recovery led to a widespread apprehension that succeeding years would be disappointing, with growth not only much reduced, but also lower than in other countries.

At the same time the US `twin deficits'--on the federal budget and on the external current account--have remained a cause of (somewhat exaggerated) concern, both in their own right and because of the need to preserve global confidence in the dollar. Moreover, the persistent underlying fears in financial markets of an inflationary resurgence have been reinforced by the ongoing momentum of economic growth, which in 1988 also helped to generate a significant strengthening of primary commodity prices (oil being a major exception).

The result of all this has been a welter of different forecasts of what was likely to happen, and of prescriptions for action (both national and international) which would make the outcome more pleasant, both for the US itself and for other countries: the achievement of these actions clearly involved the reconciliation of the conflicting priorities of the various countries and US institutions involved. The matters at stake are of great importance, and we seek in the course of this article to give an orderly presentation of some of the main issues.

One consideration may usefully be mentioned at the outset, in order to lend a better sense of proportion. The present US upswing has now been in progress for over six years. After such a prolonged expansion with large gains in employment, a temporary fall in the growth rate (even to zero), should not necessarily be regarded as a source of great concern--though it might have the longer-run disadvantage of weakening fixed investment, at a time when stronger productivity gains and improved international competitiveness are important objectives for US industry. A good deal would depend, however, on the exact manner in which this fall in the growth rate came about. At one extreme, action taken to narrow the federal budget deficit might be considered insufficient and this might lead to widespread loss of confidence in the dollar and thence to a sharp rise in interest rates: the damage to investment plans could be severe, and wild fluctuations in the dollar exchange rate might have a disruptive effect on production and trade. If, on the other hand, a slowdown in demand growth were brought about by well-organised fiscal tightening, and this were combined with a modest fall in the real exchange rate, this could open the way to a stronger subsequent investment performance, even though a significant balance of payments deficit might persist for some years on a declining scale.

More probably, the position would be intermediate, with continuing worries both about a federal deficit still considered by various bodies to be too large, and about an illogically prolonged balance of payments deficit which was declining too slowly and was causing erratic and undesirable movements in the exchange rate for the dollar. Without there being any `crisis', the growth rate might sag a bit through chance forces.

2. The US expansion in longer-term perspective It is helpful to view the latest phase of US economic expansion in a longer-term perspective, and especially in relation to the decade and a half that has passed since the economic watershed of the early 1970s. That watershed marked a deterioration in economic performance--slower growth, higher unemployment, faster inflation--for all industrial countries, but the deterioration turned out in several respects to be less severe for the US than for western Europe and Japan. To some extent this contrast reflected the exceptionally rapid growth achieved by Japan and by many west European countries in the 1950s and 1960s. But it has stemmed also from two major features of the US scene since the early 1970s. One is the series of monetary and fiscal measures pursued by the US authorities. The other is the functioning of the US labour market.

After the initial move to high oil prices in 1973--4 and the global recession which followed, US policy measures largely influenced the pattern of cyclical fluctuations both in the US itself and abroad. The nature of the policy measures differed sharply in successive cycles. The recovery of 1975--8 was brought about mainly through an easing of monetary policy by the Federal Reserve, and was accompanied by a serious weakening of the dollar and accelerating inflation. The recovery of 1982--4 was achieved through fiscal stimulus in conjunction with a cautious monetary policy. It was accompanies by a steep appreciation of the dollar and a declining rate of inflation.

The Reagan fiscal stimulus of the early 1980s combined higher defence spending with a reduction in individual and corporate income taxes. The impact on the US economy of this and other factors was seen in the rapid pace of recovery in 1982--4. Real GNP grew at an annual rate of 6 per cent over eight quarters, compared with a `typical' figure of 5.3 per cent in the preceding five recoveries. Moreover, while GNP thus rose in the US by about 11 per cent from 1982--4, the corresponding figure for OECD Europe was 3.5 per cent. The speed of the US recovery relative to other countries, plus the loss of competitive power caused by the high dollar exchange rate, brough a sharp deterioration in the trade balance. Export volumes rose only slightly slower than in previous `typical' recoveries, but imports rose four times as fast. The current external account, after recording modest surpluses in 1979--81, showed deficits of $9 billion in 1982, $43 billion in 1983 and $102 billion in 1984.

Viewing the figures in terms of the national savings/investment balance(2), the jump in the budget deficit meant that federal government absorption of savings rose to about 5 per cent of GNP in 1982--4 (compared with a peak of 4 per cent reached briefly in the 1974--5 recession). The fact that the figure of 5 per cent was maintained for several years despite strong recovery of GNP from the recession level of 1982 underlined the `structural' nature of the federal deficit. At the same time the combined financial surpluses--excess of savings over investment--of the private and state and local government sectors remained approximately unchanged at 2--2.5 per cent of GNP. Private (especially business) saving increased somewhat from the very low level recorded at the bottom of the recession, but there was a bigger rise in private investment, partly spurred by the investment tax credits allowed to corporations under president Reagan's tax measures. Thus the widening of the federal budget deficit was essentially accommodated by a net capital inflow from overseas, whose real-resource counterpart was an increased deficit on current external payments.

The upsurge in imports and the emergence of the current-account deficit were accentuated by the steep appreciation of the dollar. This began with the sharp tightening of monetary policy, and corresponding rise in dollar interest rates, in autumn 1979. Before the budget deficit emerged in 1982, the dollar's effective (that is, weighted average) exchange rate had fully reversed its 1975--8 depreciation of about 10 per cent; and in the succeeding three years, up to the first quarter of 1985, it rose by a further 40 per cent in real terms (the US inflation rate remaining somewhat above that of its largest competitors, Japan and Germany).

Without the appreciation of the dollar, there would have been an even stronger and considerably more inflationary rise in domestic output--which might in the end have led to a comparable balance of payments deficit. As it was, the appreciation helped to bring down the annual rate of consumer-price inflation from 12--13 per cent in 1979--80 to under 4 per cent after 1982.

The other important element assisting in the struggle against inflation was the moderate pace of wage and salary increases. This has been a central feature of US labour market behaviour, whose role in the US upswing after 1982 was very important. Wage moderation did not, however, begin in the 1980s. It has been evident since the early 1970s, as can be seen from the discussion on pages 69--71 of the `Economic Report of the President', 1988. Whether measured on an hourly or a weekly basis, real wage earnings have been on a downward trend since 1973. From the point of view of (non-farm) employers, average hourly labour costs continued to move up in real terms because of higher employer-provided benefits such as pensions and health insurance. But the increase tapered off markedly after 1977 and in the following decade amounted to no more than 3 per cent.

One would expect expansion of GNP in a period of stable real labour costs per worker to be associated with (a) slight gains (if any) in labour productivity and (b) substantial growth of jobs. The aggregate evidence from the US is consistent with this expectation, although there are certain problems over the data.

As regards productivity, the growth of real GNP per employed person, which averaged more than 2.5 per cent a year in the period 1958--66, has not reached 1 per cent per annum for any sizeable period thereafter. President Reagan expected his tax measures to lead to large increases in productivity, but in the event the rise was only 0.2 per cent per annum in 1973--81 to 0.8 per cent per annum in 1981--7--a very poor rate for a period in which GNP was increasing rapidly.(3)

Total civilian employment has risen substantially in the 1970s and 1980s. From a total of 85 million in 1973 it reached 114 million in 1988, an increase of over one third in fifteen years. Job gains were interrupted in the recession years 1974--5 and 1981--2, but in each case resumed strongly thereafter. Unemployment rates overall showed only a modest net increase over the period, from 4.8 per cent in 1973 to 5.5 per cent in 1988. Again, cyclical fluctuations mirrored the movement of demand and output with a 12--18 month lag: unemployment peaked at 8.3 per cent of the labour force in 1975 and again at 9.5 per cent in 1982--3. During the same fifteen-year period employment in western Europe showed little net change, while unemployment rose to almost 11 per cent in the mid-1980s, and has declined only fractionally since. Europe's real wages and output per person employed, on the other hand, continued to grow by some 2.5 per cent a year.

While the working of the US labour market in the period generated more jobs rather than higher real earnings, research work has not produced a clear-cut picture of the structural connections between changes in the pattern of employment and the near-stability overall of labour costs.

3. Developments since 1985 By the end of 1984 the cyclical upswing appeared to be running out of steam and into an impasse. The initial impact of the Reagan fiscal stimulus had worn off and the budget deficit for general government (including state and local governments) had settled at a steady level of around 3 per cent of GNP. GNP growth, after its steep recovery in 1972--4, had slowed down to under 3 per cent a year and was threatening to decline further.

At the same time the current external deficit was running at over $100 billion a year, pushing the US rapidly towards net debtor status on its external balance sheet. Moreover, although the absurd rise in the dollar exchange rate came to an end early in 1985, and was replaced by a modestly falling tendency, nevertheless lagged effects of the previous rise on US trade performance were still to come. On top of that, the continuing overvaluation of the dollar was felt to be pushing the trade balance yet further into the red and also threatening to bankrupt substantial parts of the US tradeables sector, ranging from electronics (other than defence contractors) to horticulture. The modest pay settlements noted above were conspicuous in branches subject to strong foreign competition. US Congressmen and Senators found themselves under mounting pressure from constituents to pass protectionist legislation.

In the event, all the bogies--recession, trade wars and a collapse of confidence in the dollar, as well as renewed inflation--were avoided, at least up to the end of 1988. Real GNP continued to expand at a 3 per cent annual rate, accelerating in 1988 (despite the impact of the drought) to nearly 4 per cent. Unemployment declined from 7.4 per cent of the labour force in 1984 to 5.5 per cent in 1988. Consumer price inflation dipped as low as 1.1 per cent in 1986--the year of the big drop in oil prices; thereafter it rose, but even in the second half of 1988 it still remained below 5 per cent per annum.

How was this favourable outcome achieved? This historical record is summarised, from which it will be seen that in arithmetical terms personal consumption provided the major factor raising real demand. A rise in personal consumption is always in part a consequence of the whole gain in GNP, however induced: but on this occasion the rise was bigger than one would expect simply on the basis of GNP growth--the first table in box 1 shows that the household savings ratio fell markedly in 1985 and stayed low.(4)

Private investment expenditures also served to raise real demand in all years, though their growth did not reach the high rate recorded for 1984. In 1988 the rise was in the business component (offsetting a small fall in house-building), and this was important for enlarging capacity at a time when utilisation rates were rising.

On the external side, the picture is a mixed one, but with improvement in the later years. Exports of goods and services actually fell in 1985, and showed only a modest gain in 1986. For the latest two years however they showed substantial increases, which in 1988 exceeded the rise shown for personal consumption, although that is a much bigger item. This reflected the better competitive power of US exports, plus the growth of demand abroad.

The import picture is bad, in the sense that imports of goods and services grew more steeply than GNP in all four years. The rise in the last two years however, was smaller (in $ terms) than that recorded for exports, so that foreign trade as a whole made a net contribution to the expansion of real demand, which was quite substantial in 1988: the deficit in that year (about $100 billion at 1982 prices) was still undesirably large, but the reduction from the previous year contributed significantly to the expansion process.

The rise in the GNP over the last two years has included a substantial increase in manufacturing production, which had suffered severely from international competition during the high dollar period. The index of industrial production went up by nearly 9 per cent between 1986 and 1988, and the rate of capacity utilisation in manufacturing in the second half of 1988 was about 84 per cent (and still rising), against 79.7 per cent in 1986.

Continued expansion in 1985--8 was helped by both structural factors and government policies. Besides US labour-market flexibility already noted, structural factors included the collapse of oil prices in 1986. The moderating effect of this upon price inflation was apparent at once; the stimulus to industrial investment and growth took longer to appear and has therefore tended to be underrated. In the policy domain the US authorities conducted an active and flexible monetary policy, supported by international co-operation between monetary authorities. On the fiscal side, congressional legislation in the shape of the Gramm-Rudman-Hollings Act gave promise, in its amended (1987) version, of a gradually disappearing federal budget deficit in the period to 1993.(5) And among other countries, the Japanese government emerged in a leading role in 1987--8 with an expansionary fiscal package which accelerated the growth of Japan's GNP from the domestic side.

Since early 1985 US monetary policy and international co-operative action have moved through a number of relatively brief phases--bried, that is, in comparison with the monetary squeeze that had by then been kept in place for over five years, albeit with some alleviation after August 1982 to help ease the third-world debt crisis. In the subsequent period four phases may be distinguished. Monetary policy was on a moderate expansionary tack for about two years beginning at the end of 1984. Short-term interest rates declined from over 8 per cent to a low of 5.2 per cent in the autumn of 1986. This was followed by a phase of gradual re-tightening in the first three quarters of 1987, carrying money-market rates to nearly 8 per cent in early October. The stock market crash in October 1987 interrupted the new squeeze, as the Federal Reserve moved promptly to supply liquidity and head off any possible crisis of confidence. However, as the resilience of the expansion became more apparent month by month during 1988, monetary conditions were once more increasingly tightened.

International co-operation played a significant supporting role in each of these phases. At first the principal intermediate objective was to lower the dollar exchange rate. By the autumn of 1985 the mounting pressure of protectionism in the Congress had made this an urgent requirement. The Plaza Agreement of the group of five in September 1985 provided both for co-ordinated exchange market intervention and for co-operation in monetary policy. The Bank of Japan shortly afterwards raised short-term interest rates temporarily, specifically to help stem the flow of Japanese funds into dollars, even though the general direction of Japan's monetary strategy called at that time for lower interest rates.

During 1986 a declining dollar proved to be consistent with a continuing inflow of funds to the US, sufficient to match the current account deficit. In 1987, however, the situation was different. Early in the year, monetary authorities in the major countries seemed to have reached the judgement that the dollar had fallen far enough to deliver a significant boost to US competitiveness (though this might still prove to be inadequate, even after the inevitable lags); it was also thought by some that further sizeable falls in the dollar exchange rate might trigger a new burst of inflation in the US, besides threatening a serious erosion of international confidence.

In February 1987 the Louvre Agreement sought to stabilise the dollar exchange withing a broad band, despite the unsatisfactory position on the US budget deficit. Since the net inflow of private capital to the US fell drastically at about the same time, the agreement led to substantial accumulation of dollars by the major central banks, which largely financed the US external deficit in 1987. Confidence in the dollar returned in 1988 (despite little progress on meeting the Gramm-Rudman targets), and some of the previous year's accumulations of dollars by central banks were reversed, while credit policies (notably in Germany, Japan and the UK) turned to restraint, in parallel with Federal Reserve moves.

Since 1982 confidence in the US economy has been affected by a series of threats to the stability of the US banking and financial systems. These have included Third World debts, the US farm debt problems (accentuated by the overvaluation of the dollar), and losses on bank loans to oil producers and on real estate--chiefly office building--in oil producing regions. As a result, some major banks (for example, Continental Illinois and First Republic of Dallas) have collapsed. In addition, increasing numbers of savings and loan associations have become insolvent, largely because of bad loans--including loans on commercial real estate, which have been permitted for these institutions only since deregulation in 1983--made in a period of high real interest rates. The potential damage to the economy from all these problems has, however, been substantially mitigated by the actions of various supervisory authorities to protect the vast majority of depositors from losses: these actions are leading to a growing burden on the federal government, because the financial resources of the institutions directly responsible have become inadequate. Concern has also been expressed about the growth of relatively high-risk corporate debt associated with take overs and capital restructuring (`leveraged buyouts'), and the increased exposure of banks to such risks. As usual with financial structures, the reason for concern is not the exposure of those directly involved in these transactions, but the likelihood that widespread failures would cause significant injury to innocent third parties.

4. The `twin deficits' and their effects In assessing the so-called twin deficits and their effects it is useful to start by examining--and largely dispelling--some of the mythology which has developed about them. Thus many people seek to portray the deficits as reflecting wildly improvident action by the US or its government, of a kind almost unknown outside the traditional banana republics; whilst others (including President Reagan) seem to imply that the balance of payments deficit is essentially due to other countries not following the US into the full employment zone.

Some simple international comparisons help to put matters in perspective.

Government budget deficit Taking the more relevant concept of the general government deficit (rather than the federal deficit) as a percentage of the gross national product, OECD statistics show that the US has for the last four years been very close to the average. One might of course argue that as the US has had a higher than average level of activity it could easily have had a smaller than average budget deficit; but talk of wildly improvident budgetary behaviour does not stand up, unless special factors can be adduced to show that the US should, for example, come top of the class.

Is the US exceptionally well or badly placed for `handling' a deficit of this kind? On the one hand there are the special problems of budgetary management under the US political system, and also the low level of US saving which affects the ease of covering the deficit by borrowing. But on a simple objective test, OECD statistics show the US and Japan as having the lowest ratio of government revenue to GNP of all the OECD countries: their figure of 31.3 per cent in 1987 compares with 39.8 per cent for `OECD countries excluding US'. Consequently, by international standards, tax rates would still be low if the US deficit were removed by raising taxation: there is no fundamental economic problem, only a problem of political will.

The balance of payments deficit on current account In the nature of the case, the OECD countries in total show a rough balance in their current payments (oil crises and statistical errors excepted). For 1985-8 the US deficit was on average equivalent to about 3 per cent of GNP, and was accompanied by a surplus for the rest of the OECD countries of rather over 1 per cent. There were admittedly five countries, out of 23 in the OECD table, which showed a higher ratio than the US, and the deficit currently being experienced by the UK seems likely also to yield a higher ratio for 1988. Nevertheless, a continued US deficit of this size should be a matter of concern to the US authorities, quite apart from its effect on the rest of the world.

In addition, although the arithmetic effect of such a deficit is to enlarge US domestic absorption of goods and services relative to production by only 3 per cent, nevertheless the fact that the US is so largely self-contained makes `a 3 per cent deficit' a large item in relation to the flow of exported goods and services: it is roughly a `30 per cent deficit' by that standard, and a formidable marketing effort at home and abroad is needed to increase sales sufficiently to eliminate the deficit without adverse effects on economic activity in the US.(6)

Similarly a rise in external demand caused by an exceptional upsurge in activity abroad does less to reduce the deficit than one might think from the 3 per cent ratio. A 5 per cent abnormal increase in activity abroad might raise demand for US exports by 5 per cent or even a bit more, but this has to be set against a deficit equal to 30 per cent of exports.

Connection between the two deficits Many advocates of the case for reducing the budget deficit seem almost to imply that there is a dollar-for-dollar casual correspondence between the two. Economic theory certainly suggests that action to reduce the budget deficit will normally tend to produce some reduction of the balance of payments deficit. Many other factors are involved however, and it is only on very special assumptions that a dollar-for-dollar result will emerge in the historical statistics.

This point is usefully illustrated on an international basis for the years 1985-88 by table 3, based on OECD statistics. The US figures for this period conform very roughly to the idea for a one-for-one correspondence, both on level and on movement--especially as the reduced budget deficit in 1987 reflects the temporary `timing' gain from the introduction of the tax reform measures. But no such simple correspondence applies to the other two countries.

The UK has a fair agreement between the average levels, in the sense that both are fairly small, but--much more importantly--the movements are in opposite directions and are large--and this is absolutely contrary to the dollar-for-dollar causal hypothesis. Italy shows a budget deficit enormously greater than the balance of payments deficit--a reflection of the fact that the private sector's saving far exceeds its investment; and there is little or no agreement on movements.

The conclusion is not of course that action to reduce the US budget deficit would contribute little or nothing to the much more important objective of reducing the balance of payments deficit: such action is sensible in itself, and it would certainly help with the balance of payments problem, raising the overall level of savings in the US, and hence lowering the ratio of internal demand to national output. But these international statistics support the economic argument that measures to reduce the budget deficit do not, in themselves, imply a dollar-for-dollar reduction in the balance of payments deficit: other measures (to ensure an adequate competitive power for US producers and avoid prolonged recession) are also needed. And, at least in principle, it would be possible to solve the balance of payments problem by combining measures to improve competitive power with changes other than deficit reduction to lower the demand/output ratio--for example, increases in the very low levels of personal or business saving, or cuts in private investment.

Other arguments for reducing the budget deficit The fact that a reduction in the budget deficit would help with the balance of payments problem (and raise the level of US saving) is, in our view, far the strongest argument in its favour. Most of the other arguments which have been advanced are mildly supportive, but it is easy to exaggerate their importance.

Thus there is an advantage (though not a compelling one) in encouraging a general belief in `sound budgeting', as a means of securing responsible political decisions--with exceptions being acceptable only in slump conditions, not at a time of near-full employment. This idea is open to many interpretations. From a macroeconomic point of view it is the surplus or the deficit of general government which is important, but for securing `responsible' behaviour the federal government should not logically be allowed to argue that its deficit is offset by the surpluses of the states. Moreover some people go further, and say that the surplus on the social security fund also should not be counted (as it is under Gramm-Rudman) towards reducing the federal deficit, because this `cash surplus' reflects the fact that there are as yet relatively few qualified pensioners. Our own view is that an approach to social security finance which separates it from the budget goes too far: a broad `pay as you go' basis for financing social security outlays is adopted in the budgets of nearly all countries, and the level of government saving implied by following a fully-funded insurance principle might create serious economic difficulties if it were not accompanied by at least a partially offsetting deficit on the general budget.

Possibly more important in principle is the argument that unless the budget deficit is reduced the federal government will be unable to raise the loans to cover it, unless it pays a `premium' interest rate to cover the risk of default; but in practice the position in the US seems to be so far removed from this failure of confidence that the argument can largely be ignored. Although the risk of default is negligible, however, some loans might again be suitably denominated in foreign currency, to cover the lenders against the risk of dollar depreciation--as happened in the past with Roosa bonds and Carter bonds.

Finally, it is argued that the interest payable on loans raised to cover the deficits will make the budget problem in future years progressively more difficult--just as the increasing number of pensioners will also be exacerbating it. These points are formally correct, and they certainly mean that one cannot uphold for long the rigid views at present propounded by various interested parties, for example, insistence on `no new taxes' and/or the sacrosanct character of many types of federal expenditure: this is true even though the real GNP is rising. But as mentioned above, the level of US taxes is exceptionally low, and the concern about the federal deficit reflected in the Gramm-Rudman Act shows that there exist powerful political forces working against `irresponsible' deficits.

There are extremely awkward political forces to be overcome in arriving at really good budgetary decisions: but the problem is fundamentally a political one, and there is no reason to expect that a workable `solution' (or series of temporary solutions) will not be found. The position is similar to a crisis in labour relations, where it is impossible to say just what solution(s) will avert the threat of an unending stoppage of production--but where one confidently expects that this catastrophe will not happen.

Balance of payments on current account The problems created by the persistent balance of payments deficit are both more serious and less easy to solve (assuming reasonable political behaviour).

A solution requires both that the competitive position of US producers shall be adequately improved and that macroeconomic measures be enforced to lower the ratio of effective internal demand to national production. Moreover, for the solution to be adjudged satisfactory, there must be no serious or prolonged rise in unemployment. On these matters we wish only to add the following rather dogmatic statements to the ones about the budget made above: (a) The most obvious way of improving the

competitive power of US producers is through a lowering

of the effective exchange rate for the dollar. This

is not, however, an operation which lends itself to

simple administrative decisions, and the views

and interests of other countries are also involved.

Moreover there is some danger (though less in

the US than elsewhere) that the lower exchange

rate will provoke rises in domestic money prices

and costs, which will undo the benefits.

Equally serious is the long lag which is involved

before the benefits of the US depreciation show

up in the foreign trade statistics, and the

consequent uncertainty as to whether the right rate for

the dollar has been established. Consequently

only a purblind optimist would believe that

`leaving it to the market' will ensure a reasonable

solution--and in any case `the market' is

inevitably influenced by monetary policy. (b) The expansion of exports (or contraction of

imports) which is required is large in relation to

the value of trade and will not happen

`automatically': trade contacts have to be developed and

production of saleable goods expanded, and this

is an expensive and risky business. The fact that

the deficit is so large, despite the fall in the dollar,

is in part due to high US activity, and in part to the

lasting effects of what happened in the years

when the absurd over-valuation of the dollar led

US producers to abandon as hopelessly

unprofitable many forms of competition with foreign

rivals--for example, by closing marketing

networks, or narrowing the range of goods made, or

failing to develop new products or new models.

With a more reasonable exchange rate some

recovery of market share has started, but it is a

slow process, and if it is eventually to be

adequate the general indices of apparent

competitive power will probably have to be more

favourable to US producers than in past years.(7) (c) Consequently the process of eliminating the

balance of payments deficit (or even cutting it by

half) without provoking a serious recession is

almost bound to be a long one, even if the rest

of the world experiences good growth.

Exporters--or competitors with imports--have to

develop confidence in their continuing ability to

compete before they will expand their facilities

adequately. (d) The above three points apply even if one

assumes that reasonably acceptable action is

adopted, by one means or another, on the

budget. To the extent that this assumption is not met,

either the balance of payments deficit will remain

undesirably large, or its reduction will be secured

by such unpleasant methods as a severe

recession, induced by tough monetary policy.

What, then, are the awful consequences which flow from the continuation of a balance of payments deficit of over $100 billion per annum? There has been one for four years now, and nothing alarming has happened: both the US and the rest of the world have enjoyed rather good growth, and inflation has remained low in the main countries.

Basically, of course, the difficulty is that what is acceptable for a limited period may become intolerable if continued indefinitely. Put simply, the process requires that the US obtains over $100 billion of net finance from the rest of the world every year--whether through net borrowing by the US government or US banks, or the sale to the rest of the world's investors of shares in US companies, or takeover purchases of US companies by foreign enterprises, or the repatriation of assets held abroad by US citizens, or in other forms. Some combination of different types of flow is likely to be needed.

So long as there is widespread confidence in the US and its financial institutions, there may be no real difficulty over this: in particular, (a) many financial institutions in other countries (for

example, insurance companies) like to invest

each year a proportion of their growing funds in

the US. (b) Central banks abroad hold most of their foreign

exchange in dollars, and their desired reserves

increase year by year. (c) Multinational companies hold growing amounts

of short-term financial assets, and usually keep a

large part in dollars.

There are of course some `normal' flows in the opposite direction, but the quantitatively most important one before 1982--bank loans to Third World countries--is now much reduced. Given a reasonable maintenance of confidence, there is no reason why the flows listed above (and others) should not provide the necessary finance for the US: they have indeed done just this since major deficits started in 1984--though there may have been some once-for-all readjustments of existing portfolios, (partly associated with relaxation of exchange and portfolio controls by foreign governtments), and in 1987 special support for the dollar came on a large scale from other central banks, as noted above.

If, however, `confidence in the dollar' began seriously to weaken, then for a time there could be a large outflow of funds from the US, which might cause disruption of the exchange market. This is why it is so important that there should be visible signs of action being taken against each of the deficits, and that the external one should be seen to be on a declining trend.

As a result of past deficits, the US has become `the world's largest debtor country'. In itself this should not be very disturbing to confidence because the foreign claims are small in relation to the vast real assets of the US; but net interest or dividends payable abroad are rising by perhaps $10 billion each year as a result, and this increases correspondingly the amount by which the trade balance has to improve if the deficit is (say) to be halved. The case for taking early action to reduce the deficit is strengthened by the possible consequences of further delay. And the whole idea of the rest of the world continually supplying capital to a wealthy country `to make up for its own low savings' seems so anomalous that many people feel that something drastic will be done, and all concerned are oppressed by uncertainty as to what that action will be.(8)

This disturbing uncertainty shows up particularly over the dollar exchange rate, which has shown great volatility: this has hampered the investment plans of many producers (not only in the US), because the profitability of much investment is greatly affected by the exchange rate. Interest rates in the US are also liable to big increases if confidence about the dollar weakens, and this tends to affect interest rates in other countries.

Finally, the inter-related questions of the US payments deficit, the dollar exchange rate and interest rates occupy most of the efforts of G7 officials or ministers, as well as other bodies seeking to achieve international co-operation. Much attention is devoted to measures to reduce the budget deficit because it is difficult to recommend other measures which would reduce the balance of payments deficit. The crucial importance of the latter is also reflected in concern about the best level of the exchange rate; but agreement on this is not easy to attain, so that efforts are diverted to the reduction of volatility.

5. The medium-term outlook Without offering any formal statistical forecast, our basic `best guess' as to where the US economy is going in the medium-term is that anyone looking back in 1993 will be more impressed by the broad similarities between the developments in 1989-92 and those in 1985-8 than by any differences between the two periods. Both for the US and for the OECD countries as a whole we expect the two periods to show much the same average growth rate, with much the same size of variations: this means, of course, that the average growth rate will be lower than in 1988. On the inflation front, we again expect the two periods to show much the same four-year average rates.

We also expect our observer to note the persistence--albeit on a reduced scale--of the international imbalances about which we now hear so much. The US will still have a balance of payments deficit, and Germany and Japan will still have surpluses. These imbalances will continue to cause `international concern', but this will serve primarily as a means of maintaining the political pressures to secure action to contain them, and preferably to reduce them further. Other international problems will doubtless have emerged to join the old ones (for example Third World debt) on the G7 agenda--perhaps including ones related to the UK. The world economy is not of such a character that one can ever expect to say `and so they lived happily ever after'; but the world has a great capacity for muddling through.(9)

Within this broad vision we expect that, during the next four years, the improved competitiveness of US producers--probably assisted by a downward drift in the effective dollar exchange rate--will be producing a modest but progressive improvement in US trade performance. Business investment should be fairly high, and these two factors will help to keep output advancing, despite the contractionary force produced by the budgetary decisions which will painfully emerge from the attempts of politicians to observe the Gramm-Rudman ceilings.

We do not expect any large-scale panic flights out of the dollar, despite the hiccups which are to be expected in the assault on the twin deficits: there were no such flights in the period before 1985, when the rate for the dollar was far more irrational. We do not expect any repetition of the crazy rise in the dollar rate up to 1985, and this is a powerful reason for not expecting a sudden violet fall. Continuity in the exchange market will be preserved because there will be enough signs of responsible action by the US authorities (including the federal government), assisted by a sufficiently widespread view that international co-operation will help to restrain excessive volatility. Thus, our observer may well note that over the four years the dollar has continued its process of intermittent slippage against the yen and the DM; but he will realise that operators had no reliable way of predicting the timings or extent of either the slippage or the temporary reversals.

6. Lessons from the Reagan years In conclusion, it may be helpful to list briefly the principal economic lessons which emerge from the Reagan years. First, the large-scale US fiscal action up to 1984 (aided by some other factors, like deregulation) produced an unusually rapid recovery in the US, at a time when most other countries were stuck in recession. The large increase in US imports in those years helped to relieve that recession.

Secondly, this revival was produced in a way basically different from that envisaged by President Reagan, whose declared strategy included a reduction in the federal deficit, not a large increase. Other features of the recovery were also quite different from what the strategy had envisaged--notably on productivity, tax revenues and personal saving.

Third, the revival did not lead to high inflation--quite the reverse--despite being produced by a high budget deficit. A large balance of payments deficit helped to contain inflation by preventing an imbalance between the increases in real demand and in real supply on the US market; the balance of payments deficit was enhanced by a rise in the exchange rate for the dollar, which also had a direct impact on prices.

Fourth, the `twin deficits' did not prove catastrophic in the succeeding four years, even though political action to contain them was less strong than it should have been. It was important that attempts at such action were made--notably the passing of the Gramm-Rudman Act and efforts to implement it, and monetary action to get a more realistic dollar exchange rate (assisted by international co-operation). It is even more important that these attempts should continue and be intensified.

Finally, the small rise in money wages has been very helpful: it is to be hoped that increases in productivity will improve, and minimise the effect on inflation of the bigger increases in money wages which may well be coming. This is a subject on which much research has been done in the US, but few convincing answers have emerged.(10) NOTES (1)`The US economy: an overview', Midland Bank Review, 1985. (2)Summarised in table 3 of box 1. (3)For further details, see Economic Report of the President, 1988, p. 67. (4)It should be noted that the fall in personal savings (which is also apparent in table 3 of box 1) came in spite of the rise in disposable income produced by the cuts in tax-rates: President Reagan's `strategy' had envisaged a large rise in personal savings, which would help to finance any budget deficit that his policies might produce. (The UK has also seen a big fall in personal savings, despite cuts in tax-rates.) (5)It is hard to assess progress in implementing this Act. In 1987 the deficit was substantially reduced by the temporary timing effect on revenue produced by the Tax Reform Act of 1986. In 1988 this lower level deficit was roughly maintained, thanks largely to the higher level of activity; but the OECD projection (Economic Outlook, December 1988, p. 70) shows little progress in 1989 or 1990 unless further political action is undertaken. (6)It is of course possible that the US figures for the balance of payments deficit are too high: the sum total for the recorded payments balances on current account for all countries in the world has been substantially negative for some years and part of this world discrepency might well be attributed to the US. This point will not be mentioned again but must not be forgotten. (7)The change in structure (which might of course be reversed later) is seen from the fact that imports of goods and services at 1982 prices were fairly steady at around 11 per cent of GDP (or a bit less) from 1977 to 1982, but have been over 14 per cent in each year from 1986-8; moreover this percentage has continued to rise somewhat, despite the fall in the exchange rate. For an alternative view, see P. Krugman `Long-run effects of the strong dollar' in R.C. Martson (ed.), (1988) Mis-alignment of exchange rates: effects on trade and industry. (8)In the early years of the Reagan expansion, the US deficits on current account increased the demand for other countries' exports in ways which were very helpful for their growth. With the higher level of activity now prevailing, this benefit to the rest of the world is much reduced. (9)In this it may get substantial help from effective agreement(s) about international disarmament. These might lead to a substantial reduction in the deficit on the US federal budget, which would help to reduce the US payments deficit. (10)See for example the symposium on productivity growth in the Journal of Economic Perspectives, vol. 2, no. 4, 1988.
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Author:Oppenheimer, Peter; Reddaway, Brian
Publication:National Institute Economic Review
Date:Feb 1, 1989
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