The Pandemic Depression
The Global Economy Will Never Be the Same
The principal problem with which the world’s economies must deal during the coming decade is the unsustainable imbalance of international trade. The United States cannot continue to have annual trade deficits of more than $100 billion, financed by an ever-increasing inflow of foreign capital. The U.S. trade deficit will therefore soon have to shrink and, as it does, the other countries of the world will experience a corresponding reduction in their trade surpluses. Indeed, within the next decade the United States will undoubtedly exchange its trade deficit for a trade surplus. The challenge is to achieve this rebalancing of world demand in a way that avoids both a decline in real economic activity and an increase in the rate of inflation.
A rebalancing of world trade is already beginning, due to a sharp decline in the value of the dollar. This decline, under way since early 1985, reflects fundamental economic forces rather than the influence of official jawboning or currency market intervention. The dollar’s value can be expected to continue to fall until it is low enough to achieve the required trade surplus.
The trade deficit of the United States is now so large, and its effect on the American economy so pervasive, that it is easy to lose sight of the fact that in almost every year between the end of World War II and 1981 the United States realized a significant trade surplus. In 1981 U.S. exports of goods and services exceeded imports by more than $14 billion, and the United States had a current-account surplus with which to finance net investments in other countries. But now U.S. trade in goods and services is running a deficit at the rate of about $125 billion a year. The trade deficit in goods alone (i.e., the merchandise trade deficit) has reached an annual rate of more than $160 billion, or more than four percent of U.S. gross national product. The previous capital outflow has been reversed and a foreign capital inflow is financing the U.S. current-account deficit at an annual rate of about $140 billion.
The recentness of the shift from trade surplus to trade deficit deserves emphasis because it indicates that the cause of the trade deficit lies not in the character of the American work force or of American management, as some have recently suggested. Such fundamental aspects of a nation’s industry cannot change in as short a time as five years. For the same reason it is wrong to attribute the massive trade deficit to a fundamental deterioration of U.S. productivity, of American product quality, or of other basic aspects of potential competitiveness.
The primary reason for the deteriorating trade imbalance is the 70-percent rise of the dollar that occurred between 1980 and the spring of 1985. This unprecedented increase in the exchange value of the dollar dramatically increased the price of American products relative to foreign products, causing the volume of U.S. exports to decline while merchandise imports increased by nearly 50 percent.
There were, of course, other factors that affected the U.S. trade deficit. The international debt crisis that began in 1982 caused a decline in U.S. exports to Latin America. The dramatic improvement in agricultural productivity that followed the introduction of an incentive system in China caused a decline in American agricultural exports to that country. Balanced against these changes were other special factors such as a decline in the price of oil which, by raising real incomes abroad and improving foreign trade balances, increased the demand for exports from the United States. But even taken all together, these special factors were not nearly as important as the sharp appreciation of the dollar.
The dollar’s dramatic rise began when the United States shifted from the accelerating double-digit inflation of the late 1970s to a sound monetary policy. The resulting temporary rise in real interest rates and the prospects for a sustained lower rate of inflation made dollar-denominated bonds more attractive to investors throughout the world. It was the increased demand for dollars to invest in those bonds that initially raised the exchange value of the dollar.
But it was the anticipation of massive and protracted U.S. budget deficits that sustained the rise in long-term real U.S. interest rates relative to foreign rates, and that therefore caused the dollar to continue its rise after 1982. The budget deficit rose from 2.5 percent of GNP in 1980 to more than 6 percent of GNP in 1983, absorbing virtually all of the net saving generated by American households, businesses, and state and local governments. As a result of this sharp rise in government borrowing, the real rate of interest on long-term bonds rose sharply; the market interest rate on such bonds was as high in 1983 as it had been in 1980 even though the rate of inflation had fallen by 8 percentage points, from more than 12 percent in 1980 to less than 4 percent in 1983. This dramatic increase in the U.S. real long-term interest rate attracted funds from around the world to invest in dollar securities and thereby raised the exchange value of the dollar.
The changes in U.S. domestic monetary and budget policy that raised U.S. interest rates relative to interest rates abroad were not the only reasons for the rise in the real value of the dollar. The 1981 change in tax rules and the fall in inflation produced a higher real after-tax return on corporate investments in plant and equipment, which permitted corporate borrowers to pay higher real interest rates. The deterioration of the Latin American debt situation discouraged additional lending to the developing countries. And stronger economic growth in the United States compared to Europe raised the relative level of dollar interest rates, further increasing the attractiveness of investing in American securities.
But the principal reason for the substantial and sustained rise of the dollar was undoubtedly the rise in U.S. real interest rates that resulted from the massive increase in projected budget deficits in a monetary environment that aimed at preventing a return to high inflation.
By early 1985, the dollar had reached a level that could not be sustained. With the dollar at 3.3 West German marks and 250 yen, a sharp decline in the dollar at some point in the future had become inevitable. Although dollar bonds paid a yield of about four percentage points more than German bonds, that extra interest was not enough to compensate the holders of dollar bonds for the decline of the dollar that would eventually have to occur. Ultimately, with a four-percentage-point interest differential, holders of dollar bonds would be as well off as holders of German bonds only if the dollar declined at a rate of four percent a year or less. But so slow a decline of the dollar would cause a massive rise in the U.S. trade deficit and an explosive growth of U.S. debts to the rest of the world. U.S. annual borrowing needs from the rest of the world would snowball so rapidly that they simply could not be financed.
The only way to slow the growth of the country’s trade deficit and future borrowing needs was for the dollar to drop at a faster rate than four percent a year. As 1985 began, it became clear to an increasing number of investors worldwide that a very gradual and orderly reduction of the dollar was no longer possible. Although some foreign investors who held dollar bonds continued to hope that they would be able to sell before that inevitable decline began, eventually the fear of losses outweighed that unfounded optimism. Investors began to sell dollars and the dollar began to decline in value.
The attractiveness of the dollar was reduced further as interest rates fell in response to the slowing of the U.S. expansion and the easing of monetary policy. By the spring of 1985, there was also a growing understanding that the politics of the budget deficit had changed and that Congress would soon legislate significant reductions in future budget deficits. When this actually happened, with the enactment of the congressional budget resolution in the summer of 1985 and of the Gramm-Rudman-Hollings legislation in the fall, realistic projections of annual budget deficits in the near future were reduced from $300 billion and six percent of GNP to less than four percent of GNP. As a result, the U.S. real interest rate and the interest differential in favor of U.S. bonds narrowed significantly, encouraging the continued decline of the dollar.
After the dollar had been falling for six months, the finance ministers and central bankers of the Group of Five major industrial countries (the United States, West Germany, Japan, Britain and France) held a highly publicized meeting at the Plaza Hotel in New York to put their weight behind the continued fall of the dollar. With the dollar already on a steady downward course, U.S. government officials could no longer continue to claim that the strong dollar was an indication of the world’s approval of U.S. economic policies. Treasury Secretary James Baker therefore reversed his earlier position and acknowledged that the still overvalued dollar was a serious problem for American industry. In an even greater departure from previous U.S. policy, Secretary Baker also agreed with the other G-5 finance ministers that the United States would join in coordinated exchange market intervention aimed at reducing the dollar further in the future.
Although much has been said and written about that G-5 meeting, I believe that its significance in reducing the dollar has been greatly exaggerated. There is no doubt that it did initiate a temporary turning point in Japanese monetary policy; the Japanese government increased domestic interest rates with the aim of raising the value of the yen in an attempt to forestall support for anti-Japanese protectionist legislation that was then heating up in the U.S. Congress. But for West Germany and the other G-5 countries, the Plaza meeting was essentially a non-event, and even the change in Japanese monetary policy was soon abandoned.
The G-5 meeting and the subsequent exchange market intervention had no sustained effect on the dollar’s overall rate of decline. In the first few days after the G-5 meeting the dollar declined by about four percent against the other major industrial currencies. But then the dollar resumed its previous gradual rate of decline. More specifically, the dollar fell against a weighted average of other industrial currencies at the same rate in the year after the G-5 meeting as it had fallen in the six months before the meeting. There is simply no evidence in the dollar’s behavior since early 1985 to suggest that the G-5 meeting and the process of coordinated intervention had any effect on the rate of decline of the dollar’s value. It was not currency intervention or coordinated jawboning that depressed the dollar but the basic fundamentals of the decline in international interest differentials, in projected U.S. budget deficits, and in the price of oil.
Although the yen-dollar exchange rate did change more quickly in the period after the G-5 meeting than it had before, there is no reason to attribute this yen-dollar shift to the G-5 meeting as such, or to the exchange market intervention that followed, since those actions did not appear to affect any of the other currencies. Of more fundamental importance was the already mentioned temporary shift by the Bank of Japan to a tighter monetary policy that raised interest rates in Japan, and the unanticipated fall in the price of oil in early 1986 that was far more important for Japan than for other countries.
Between February 1985 and December 1986 the dollar declined by more than 40 percent in real inflation-adjusted terms against a weighted average of all the major industrial currencies. The corresponding real decline against a broader group of currencies, including the currencies of virtually all the developing nations, would be between 30 percent and 35 percent. The driving force in lowering the dollar was not the pronouncements of government authorities, or government intervention in currency markets, but the actions of private portfolio investors as they responded to changes in their perception of the risks and rewards of investing in alternative currencies.
Even with the substantial fall of the dollar that had occurred by the end of 1986, the level of the dollar at that time still implied a substantial, persistent U.S. trade deficit and therefore a continually rising capital inflow to the United States. Portfolio investors around the world will not be willing to go on providing this credit, accepting the increased risk of investing in dollar-denominated securities for what is now a relatively modest or nonexistent real interest rate advantage. The dollar must therefore continue to decline and the cumulative fall below its current level must be substantial. The key to this conclusion is the fact that the United States has already shifted from being a net creditor in the world capital market to a net debtor—or, more accurately, to having a substantial negative international investment position in which foreign loans to U.S. borrowers, plus foreign equity investments in the United States, exceed the sum of the U.S. loans and investments abroad. Although the level of the dollar, which as of this writing is approximately 1.85 West German marks and 155 Japanese yen, would bring a significant reduction of the trade deficit during the next two or three years, the combination of the trade deficit plus the interest and dividends that must be paid on the U.S. net "debt" to the rest of the world would decline only temporarily. The United States would soon need increasing capital inflows to finance its growing debt service requirements.
More specifically, as the International Monetary Fund has noted, the present value of the dollar implies that U.S. net obligations to the rest of the world would increase from $200 billion now to about $800 billion by the beginning of the next decade. The annual cost of interest and dividends on these obligations would be some $60 billion. Even if the merchandise trade deficit were cut in half from its current level to about $80 billion, the United States would then have an annual current-account deficit of $140 billion, i.e., $80 billion of trade deficit plus $60 billion of net interest and dividends to foreigners. This means that the U.S. debt to the rest of the world would have to increase by an additional $140 billion in that year. And, in each successive year the amount would have to be even larger because of the ever-growing debt service costs.
Such an exploding level of debt is unsustainable. As overseas investors accumulate a larger and larger volume of dollar securities, they are exposed to increasing risks of fluctuation in the value of the dollar and in dollar interest rates. That increased exposure makes additional investments in dollar securities less attractive. Moreover, the real interest differential that originally attracted funds to the United States has now disappeared. The real net-of-inflation interest rates that will ultimately be realized on U.S. bonds is probably less today than the corresponding real rates on West German bonds.
The combination of increased exposure to exchange rate risk and the vanishing real interest advantage of dollar securities will make foreign investors unwilling to finance the projected capital flow to the United States. As they seek to shift their new investments from dollar bonds to securities denominated in their own or other currencies, the value of the dollar will be driven down further. Eventually the dollar must fall far enough to cut the subsequent current-account deficit (the sum of the ordinary trade deficit and the net interest on our foreign obligations) to the level that foreign investors are willing to finance. As long as foreign investors are not willing to buy enough bonds to finance the existing current-account deficit at the prevailing exchange rates, the dollar will fall and the subsequent current-account deficit will shrink. Moreover, as financial investors become aware that the dollar’s current level is unsustainably high, their fear of a currency decline will accelerate the portfolio shifts that cause the dollar to decline.
It is important to emphasize that it is the individual portfolio decisions of investors around the world that will depress the dollar and therefore the U.S. trade deficit. It is true, of course, that as long as the United States has a trade deficit, the resulting current-account deficit must be financed by a capital inflow from abroad. It is also true that foreign portfolio investors cannot now find an alternative place to invest the present massive current-account surpluses of the United States’ major trading partners. But in the process of trying to shift their funds to non-dollar securities, the portfolio investors have driven down the dollar and will continue to do so, thus shrinking the subsequent trade deficit of the United States and therefore the surplus balance that its trading partners have to invest overseas. Thus each portfolio manager, responding to his own assessment of the risks and rewards of investing in dollar securities and other securities, will move the value of the dollar down, and therefore bring the U.S. trade balance closer to a sustainable level.
At some point the United States will begin to meet the cost of servicing its overseas debt by exporting more than it imports. Even reducing the capital inflow to $60 billion a year by 1990 or 1991 would require that U.S. trade be in balance because that entire $60-billion capital inflow would be needed just to finance the interest and dividends on accumulated international obligations. To reduce the capital inflow below $60 billion a year would require a U.S. trade surplus.
I expect that by the early 1990s the United States will again be running a merchandise trade surplus. The longer it takes for the United States to achieve a trade surplus—that is, the longer that the U.S. international debt continues to grow because of a combination of a trade deficit and the cost of servicing existing U.S. overseas debt—the larger the ultimate trade surplus must be. Just when the United States will return to a trade surplus is uncertain. But there can be little doubt that the United States must eventually have a trade surplus in order to finance at least part of the net interest and dividends that Americans will owe to investors abroad.
The speed and extent of future progress in reversing the U.S. budget deficit will affect the pace and character of the shift in the American trade balance, but not the inevitability of an eventual decline and reversal of the American trade deficit. A more rapid reduction of future U.S. budget deficits would speed the decline of U.S. real interest rates and of the dollar. The trade deficit would therefore shrink more rapidly. The ultimate size of U.S. overseas obligations would be smaller and the magnitude of the eventual U.S. trade surplus needed to service that international debt would also be smaller. A smaller budget deficit would also make it easier for the United States to compete in the world market for capital-intensive goods and services.
But even if the budget deficit were to remain at three or four percent of GNP, the dollar and the U.S. trade deficit would eventually decline, as foreign portfolio investors became satiated with dollar securities. The combination of persistently high government borrowing and a reduced inflow of foreign capital would raise real U.S. interest rates and thereby slow the dollar’s decline. But eventually the unwillingness of foreign investors to keep increasing the shares of their portfolios that are invested in dollar securities will cause the decline of the dollar and the reversal of the U.S. trade deficit.
That this forecast of an inevitable U.S. trade surplus runs counter to the common impression—that the world does not want to purchase U.S. products and that even Americans want to buy only foreign products—only shows that the common assertions in this area are misinformed. In 1986 the United States exported $150 billion of manufactured products to the rest of the world. Moreover, more than 70 percent of the American demand for manufactured goods is being satisfied by products produced in the United States. There is little reason to doubt that U.S. exports and the country’s ability to satisfy domestic markets will both increase as the declining dollar reduces the relative price of American goods.
By the 1990s, the world trade imbalance will have come full circle. The domestic policies in the United States that created a massive trade deficit for the United States in the mid-1980s are setting the stage for a major U.S. trade surplus in the 1990s.
My emphasis on the declining dollar as the key factor that will improve the U.S. trade balance contrasts sharply with the comments of those in the Reagan Administration who have suggested that the trade problem could be solved without any further decline of the dollar if West Germany and Japan would only increase the pace of their economic activity. Such pronouncements may be intended to stabilize the foreign exchange market, to fight protectionism, or even to establish foreign scapegoats for future U.S. economic problems. But they have no plausible basis in economic analysis.
Even if not only West Germany and Japan but all of the countries of the world (other than the United States) were to increase their real rates of economic growth from a projected average of about 2.5 percent a year for the next two years to an implausibly high 4.5 percent a year, the resulting 4-percent extra rise in the rest of the world’s real GNP would, by itself, only raise demand for U.S. exports by about 6 percent, or $15 billion a year. A $15-billion increase in exports is less than one tenth of our current merchandise trade deficit.
The real reason why foreign governments should be thinking about the future expansion of demand in their own countries is not to help the United States but to pick up the slack that will result from the decline in their own net exports. If the decline in the dollar causes the U.S. merchandise trade deficit to be eliminated over the next five years, foreign producers will have lost $160 billion in markets at home and abroad. And if the dollar falls far enough to stop the flow of new capital to the United States, foreign producers will have lost nearly $250 billion a year in markets at home and abroad.
To maintain a growing level of real output and employment at home, foreign governments around the world will have to permit domestic demand to increase more rapidly than domestic production. As such, this is a pleasant assignment: permitting the standard of living of their population to rise more rapidly than the increase in production would otherwise allow. But the precise timing of the needed increase cannot be known with any assurance. The delays between a change in the exchange value of the dollar and the resulting changes in trade are long and uncertain. Similarly, the response of the domestic economies to changes in domestic monetary and fiscal policies is also uncertain. The major challenge to foreign governments will be to avoid both the excessive stimulus that could lead to a rekindling of inflation and the excessive caution that could permit their economies to drift into recession as export demand declines.
The reversal of current trade surpluses abroad will also shift the primary threat of increased protectionism from the United States to our trading partners. While it will then be tempting for them to protect their domestic demand by restricting imports, the resulting trade war would not only hurt consumers everywhere but would, by reducing exports from all countries, make the adjustment process more difficult.
Although the declining dollar will expand demand for U.S. industrial products and give a desirable boost to American manufacturing firms, the combination of the dollar’s decline and the massive net U.S. obligations to foreigners will reduce the overall rate of growth of the American standard of living. A lower dollar means that Americans trade U.S. products for foreign products on less favorable terms. American firms will receive fewer Japanese yen or West German marks for their products and American consumers will have to pay more dollars to purchase foreign products.
The net foreign obligations of more than $800 billion in the 1990s will mean annual interest and dividend payments to foreigners of some $60 billion a year. This implies that more than one percent of each year’s gross national product will be given to foreigners in payment for the excessive imports of the 1980s. Taken together, the deterioration in the U.S. terms of trade and the increase in overseas debt service could reduce the annual rate of increase of real income in the United States over the next five to ten years by between 0.5 percent and one percent a year. Since per capita income has grown at a rate of about two percent a year over the past few decades, this is equivalent to losing between one fourth and one half of our historical rate of real per capita income growth.
A failure of the U.S. budget deficit to shrink in parallel to the decline of the capital inflow from abroad would compound this problem. The combination of a reduced capital inflow and a persistent high level of government borrowing would mean less capital for investment in plant and equipment and in housing. The resulting decline in the growth of productivity and in the quality of the housing stock would reinforce the adverse effects on the American standard of living of the deteriorating U.S. terms of trade and the increased international debt service. The long-term importance of reducing the U.S. budget deficit thus remains undiminished.
The process of simultaneously unwinding the U.S. trade deficit and the budget deficit carries with it the risk that a mismatch of timing could push the American economy into recession. This risk is the unavoidable consequence of the imbalances that have developed during the past half decade. But a clearer view of the inevitable decline of the dollar and the future reversal of the U.S. trade deficit would help government officials and the Congress to avoid misguided policy shifts that exacerbate these risks.