During the past few years, the American economy has demonstrated impressive resiliency and America’s economic performance has improved substantially. Inflation has dropped from 13 percent to four percent. The rise in unemployment that was an inevitable consequence of the accelerating inflation of the late 1970s has retreated to just a fraction over seven percent. And real GNP has increased more than 12 percent in the two years since the recovery began.

Much of this progress has been mirrored in other industrial countries. Inflation is down throughout Western Europe and real GNP is rising. Unfortunately, though, unemployment rates remain extremely high.

The experience of the past few years has underlined the interdependence of the world economy. Sharp changes in international trade, in capital flows and in exchange rates have affected all major economies. The rise in real interest rates everywhere reflects the close links among capital markets.

I believe that the U.S. budget deficit has been the dominant influence on the world economy during the past two years and that the coming resolution of America’s fiscal imbalance will have profound effects during the years ahead. It is America’s budget deficit that has been the primary cause of the high real interest rates and therefore of the rising dollar. By increasing American imports and depressing our exports, the over-strong dollar has proven to be a direct stimulus to the economies of Europe, Japan and Latin America.

But, at the same time, the American budget deficit has raised real interest rates in the world capital market and induced European governments to pursue contractionary monetary and fiscal policies aimed at offsetting the inflationary pressure caused by the fall in their own currency values. The poor performance of European investment and employment is due in no small part to the budget deficits in the United States.

I am optimistic about the prospects for legislation that will reduce future budget deficits. That deficit reduction may not prove to be as much as I would like, but in my view it will be very substantial and it will have important effects on not only the American economy but also on the economies of Europe and on our relations with Japan.


The most dramatic effect of our budget deficit is the U.S. trade imbalance that has been so much in the news and in the policy debate in Washington. The U.S. merchandise trade deficit has quadrupled in the past three years, rising from $28 billion in 1982 to more than $107 billion last year. This year, it is likely to rise to about $140 billion, or over three-and-a-half percent of the U.S. gross national product.

Our vast trade deficit means that several important American industries have not been sharing in our economic recovery. The businesses that are suffering range from agriculture and timber to basic industries like steel and chemicals and to high-technology firms. Indeed, as the latest GNP figures indicate, the result of the trade deficit has been not only to create an unbalanced or lopsided recovery but perhaps even to reduce the overall strength of the economy.

Despite their very serious adverse consequences, both the trade deficit and the strong dollar have also brought some temporary advantages to the American economy. The 1984 trade deficit was financed by a new inflow of nearly $100 billion in capital from abroad. That inflow nearly doubled the funds available for net investment in the United States and kept real interest rates from moving substantially higher. In addition, the rising dollar lowered the prices of imports and competing American products by enough to cut our overall inflation rate by at least one percentage point last year.

There is a real danger, however, that the capital inflow and the rising dollar are giving Americans a false sense of well-being. The dollar must eventually decline by enough to offset most of the nearly 70-percent increase that has occurred since 1980. When it falls, there will be upward pressure on prices in the United States that could return us to the stagflation conditions of the 1970s. And with a smaller capital inflow from abroad, investment in the United States could be substantially lower and real interest rates significantly higher unless the reduced capital inflow is offset by a fall in government borrowing.

The trade deficit and the capital inflow have now made the United States a debtor nation. In the future, we as a nation will have to give up some of each year’s production to service our public and private debts to the rest of the world. To pay for our current profligacy, our children will not be able to keep all that they produce.

But the greatest danger in our current trade deficit is that it may foster the adoption of protectionist policies that would hurt both the United States and the world economy. The 20-percent tax on imports that has recently been proposed in Congress would immediately hurt American consumers and contribute to rising inflation in the United States. Moreover—and this is not well understood—a decreased demand for imports in the United States would reduce Americans’ demand for foreign currency and that, in turn, would cause the dollar to rise further. As a result, American firms and farmers would find that they have an even harder time selling their products abroad. While those American firms that compete with imports would be able to raise their prices and profits, their gains would be more than offset by the losses experienced by American consumers and exporters.

Protectionism is never a one-sided affair. If the United States pursues protectionist policies, our trading partners will inevitably retaliate and will feel morally justified in protecting and subsidizing their own industries. American businesses and labor will suffer as we lose export markets and are denied the opportunity to do those things that we in the United States can do best. And the world as a whole will risk a trade war that could result in a collapse of our world trading system and a worldwide economic downturn.

Countries that are hurting each other in such a trade war are not likely to be effective political allies. Protectionist policies are therefore likely to have serious consequences for our foreign relations as well as for our economic well-being.


To remedy our trade deficit, the real value of the dollar must decline by enough to reverse its nearly 70-percent rise in the past five years. Although the U.S. trade deficit also reflects the strength of the American recovery in the past two years and the ability of the debtor nations to become less reliant on foreign loans, we would certainly not want to reverse either of those developments. Although a stronger recovery in Europe and Japan would help to shrink our trade deficit, the potential magnitude of the gain from that source is rather small. So the dollar must be substantially reduced—a decline of at least 35 percent from the current level—if we are to return to at least an approximate balance of our external account.

The sharp increase in the dollar since 1980 has occurred because dollar securities have become much more attractive in comparison to investments in other currencies. The principal reason for this increased attractiveness had been the sharp rise in the real interest rate on medium- and long-term dollar investments relative to the returns available elsewhere. For example, interest rates on corporate bonds are nearly six percentage points higher in the United States than they are in Germany. Although everyone expects that the dollar will eventually decline, investors are willing to hold dollar bonds because the extra yield on American bonds would be enough in just a half-dozen years to offset a one-third fall in the dollar’s value relative to the German mark.

Some people have pointed to the rise in the dollar during the last half of 1984 while U.S. interest rates were declining as evidence that the interest rate has not been so important in determining the dollar’s value. I think that misinterprets the evidence. It is the expected real interest rates on medium- and long-term securities that matter and not the nominal market yields. And those real expected rates did not come down with the market interest rates. It must be remembered that last summer the American economy had just completed six months of real growth at a rate of 8.5 percent and the common worry then was that the economy would soon be overheating. Moreover, many monetarists were predicting that past money growth would generate double-digit inflation by the end of 1984. In fact, the inflation stayed below four percent and the rate of economic growth dropped to less than three percent. In short, inflation expectations have declined rapidly since last summer and may well have generated higher expected real interest rates by January and less uncertainty about inflation than had prevailed six months earlier.

Some commentators have tried to explain the sustained rise in the value of the dollar by pointing to the dynamism and profitability of the American economy. I believe that these factors have had relatively little direct effect on the value of the dollar. The vast bulk of foreign funds coming into the United States have come as bank deposits or as purchases of fixed-income securities and have not been investments in corporate stock or direct investments in American business. Thus the profitability and dynamism of the American economy have attracted foreign funds primarily by contributing to the rise in U.S. real interest rates.

Although the rise in the real interest rate on dollar securities has been the key reason for their increased attractiveness, it has not been the only reason. The attractiveness of dollar securities has also been enhanced in the past several years by the pursuit of a monetary policy that has reduced the risk of inflation in the United States. In addition, the reduction in borrowing by the debtor nations has reduced the supply of dollars in world financial markets and thereby increased the dollar’s value. Moreover, the political stability of the United States encourages individuals and institutions around the world to place their investments in dollar securities. Although it is important to reduce the dollar’s value, it would obviously be wrong to do so by increasing the risk of inflation in the United States, by inducing the developing countries to go more deeply into debt, or by weakening the political stability of the United States.

So the only appropriate policy for reducing the over-strong value of the dollar is to reduce the level of real interest rates in the United States. The sharp rise in those interest rates since the beginning of the decade has been due primarily to the dramatic increase in the level of current and future structural budget deficits. Although the higher real interest rates also reflect an improved climate for business investment, the only desirable way to reduce our real interest rates is by cutting the projected budget deficits. If Congress enacts legislation that cuts the projected budget deficits significantly, we will see a substantial further decline in real interest rates and in the value of the dollar before the end of the year. By 1986 there would be a clear improvement in our trade balance.


Our current and absolutely unprecedented trade deficit has been a particularly severe source of friction with Japan. This growing conflict is important not only because Japan is America’s largest overseas trading partner but even more so because Japan is now the second largest industrial democracy in the world and the linchpin of democracy in the Far East. It would be a disaster if the current trade conflict were permitted to undermine the friendly political and economic relations between the United States and Japan.

Although Japan does have a $40-billion trade surplus with the United States and a $30-billion trade surplus with the world as a whole, sophisticated observers realize that it is wrong to blame our overall trade deficit on Japan or indeed to focus on any bilateral trade deficit in our multilateral trading world. Moreover, our bilateral trade position has actually declined less with Japan since 1980 than with either the European Economic Community or Latin America.

The fundamental reason for Japan’s trade surplus with the rest of the world is Japan’s extremely high savings rate. Gross savings in Japan are over 30 percent of GNP, 50 percent higher than the average of the other OECD (Organization for Economic Cooperation and Development) countries. Because the combination of Japanese investment and the budget deficit of the Japanese government is not enough to absorb all of those savings at home, the Japanese invest abroad as well. That overseas investment must, of course, be matched by a corresponding trade surplus.

Looked at in a slightly different way, the high Japanese savings rate results in extremely low interest rates on Japanese bonds. Long-term corporate bonds in Japan now yield less than seven percent. It is not surprising that Japanese investors want to invest overseas. The process of selling yen and buying foreign currencies to finance that overseas investment depresses the yen and gives rise to Japan’s trade surplus.

The Japanese could reduce their trade surplus if they pursued policies that increased investment in Japan. Improved tax incentives for investment would induce Japanese firms to invest more at home instead of seeking foreign investment opportunities. More important, investment in Japan could be increased if the Japanese government reduced the constraints that currently limit American and other non-Japanese firms that would like to invest in Japan.

Although the Japanese recently acceded to U.S. pressures to allow increased borrowing in Japan by non-Japanese firms, this actually tends to depress the yen and strengthen the Japanese competitive position. It is far more important for Japan to encourage more direct investment in Japan by foreign firms.

It is frequently suggested that the Japanese favorable trade balance would be reduced if Japan increased its extremely low level of defense spending. This would be true only to the extent that the higher defense spending increased Japan’s budget deficit, and thereby absorbed more of the private savings that are now going abroad. An increase in defense spending that is financed by higher taxes or reductions in non-defense outlays would have no effect on Japan’s trade surplus. Indeed, even if Japan increased its defense outlays by purchasing more foreign-made defense equipment, that would only change the composition of Japan’s trade surplus and not its total magnitude unless Japan increased its budget deficit in the process.

Because of Japan’s current demographic situation, the national habits of thrift, and the institutional inducement to save, I believe that the Japanese will continue for many years to save more than they invest in Japan. The result will continue to be a capital outflow to the rest of the world and therefore a trade surplus. In a world in which capital is scarce, we should learn to regard this as an advantage rather than a problem.

We have heard that many Japanese say that Japan’s trade surplus is caused by the high value of the U.S. dollar. I think that this is false. It is important not to confuse the cause of the current U.S. trade deficit with the world as a whole with the cause of Japan’s structural trade surplus. Japan had a growing trade surplus before the second oil shock in 1979, even though the dollar was then very depressed. And Japan can be projected to have a trade surplus in the future even if the dollar declines substantially from its current level.

Japan has a structural trade surplus because Japanese institutions want to invest in foreign securities. They do that because domestic investment opportunities in Japan are not attractive enough to absorb all of Japan’s very high rate of savings. Past experience suggests that lower real interest rates in the United States will not change radically the Japanese desire to invest in foreign securities. Even when U.S. interest rates decline from their current level, they will not decline to the level of Japanese interest rates because of Japan’s extremely high savings rate.

The likely decline in America’s overall trade deficit in the years ahead will make it easier for the United States as a nation to accept the view that Japan’s structural capital outflow and the associated trade surplus are benign. But even with this understanding, it is important to recognize that there is a very serious Japanese trade problem that has deep political implications for Japanese relations with the United States and with Europe. Virtually every American firm that does business or tries to do business in Japan complains that the combination of tariffs and non-tariff barriers prevents the sale of foreign products and services in Japan even when they are clearly better in price and quality than their Japanese competition. American business is frustrated and furious about the way in which the Japanese government protects and nurtures Japanese industry. These same views are echoed by many leading European firms.

The current congressional action calling for a tariff to block Japanese products from the American market is not really a reaction to our trade deficit with Japan as such or to the volume of Japanese sales in America. Congress is reacting more out of anger and frustration than on a basis of economic logic. The Japanese should understand that the true basis of this frustration is the sense that Japan as a government and as a people is being unfair in its pursuit of policies that preclude foreign products from Japanese markets. If the international trading system is to continue to flourish and bring benefits to consumers throughout the world, the Japanese must make an opening of their markets to foreign products a matter of the highest national priority.


The current prospect for a reduction in future U.S. budget deficits also has profound implications for the economies of Western Europe. At past summit meetings and elsewhere, European leaders have complained loudly that large U.S. budget deficits cause high real interest rates and a massive capital flow to the United States. Although these same leaders are also prepared to admit that the U.S. trade deficit has increased demand for their exports, they are unanimous in their call for lower U.S. budget deficits.

I believe that these calls for lower U.S. deficits are more than the seizing of a convenient scapegoat for the relatively weak economic performance in Europe. In fact, European economic conditions have made the rising dollar and the net capital flow to the United States substantial impediments to an improved economic performance in Europe. Although the rising dollar has increased European exports, it has led to a lopsided recovery that, on the whole, is probably weaker than it would otherwise have been.

Let me explain why. Just as the stronger dollar has brought reduced inflation to the United States during the past several years, the consequent fall in the values of the French franc, the German mark and the British pound put upward pressure on prices in those countries. To prevent that pressure from initiating a new round of domestic inflation, the government in each of those countries was forced to pursue tighter monetary and fiscal policies than it would otherwise have chosen. These tighter monetary and fiscal policies have prevented a stronger recovery in Europe and have contributed to the continually rising rate of unemployment that now plagues all of the major European nations.

Let me be very clear. All of Europe’s current abnormally high unemployment certainly cannot be attributed to the U.S. fiscal situation. There is no doubt that European real wages in the 1970s outstripped the natural increase in productivity and forced employers to reduce employment in order to raise productivity to the imposed rising real wage levels. The contrast between the American and European experience in the 1970s is striking. Between 1970 and 1980, real earnings per hour actually declined in the United States, but employment rose more than 25 percent. In Europe, during the same decade, real wages continued to rise at a substantial rate. The rigidity of the European labor markets exacerbated the problems caused by the resulting excess real wage levels. As a result, there was no increase in total employment in the European Community, and the rate of unemployment rose from less than three percent in 1970 to nearly 11 percent last year.

Although it was excessive real wages and basic labor market rigidities that raised the European unemployment rates in the 1970s, the rising U.S. dollar since 1980 has led to even higher European unemployment because it induced European governments to pursue contractionary policies designed to offset the inflationary effects of their falling currencies. Because the rigidities in the European labor markets reduce the sensitivity of inflation to increases in unemployment, it takes a substantial rise in unemployment in Europe to offset the inflationary pressure that results from a rising dollar. It is not surprising that European political leaders have been frustrated and annoyed by an American budget policy that they see has contributed to America’s strong economic expansion while impeding their own.

The dramatic rise in the net capital flow to the United States has also made it more difficult to reduce European unemployment. The currently excessive real wage rates in Europe can only be corrected if the rate of increase in European real wages is reduced relative to the rise in productivity. Although the high level of European unemployment has recently caused some decline in real wages, this is clearly a slow and painful process. The gap between productivity and wages would be closed more rapidly and with less pain if productivity were rising faster. One way to achieve this would be a higher rate of investment in plant and equipment. European leaders rightly see the net capital flow to the United States as denying Europe some of the capital that could raise productivity and lower unemployment. They are frustrated that the U.S. budget deficits are depressing European productivity and raising European unemployment through a change in net capital flows that at the same time mitigates the adverse effects of America’s budget deficits on U.S. investment and productivity.

It is difficult to judge the actual magnitude of these adverse effects. But there is no doubt that current European perceptions create a climate of ill will in which European governments can believe that the pursuit of protectionist policies aimed at increasing employment in Europe is a morally legitimate response to the harm being done by American budget deficits.

A substantial reduction in future U.S. budget deficits will certainly not eliminate all of the sources of economic friction between the United States and Europe, or cause European governments to abandon all of their protectionist policies. But it should create a climate of greater cooperation within which the United States could hope to be more effective in persuading European governments to reduce their import barriers and production subsidies. In addition, the substantial decline in the dollar which will follow the decline in our projected budget deficits will reverse the inflationary effect of deteriorating European exchange rates and therefore encourage European governments to pursue more expansionary monetary and fiscal policies.

This point is very important. A protracted decline in the dollar will mean less inflation in Europe and therefore more real growth of output and employment at any rate of expansion of nominal GNP. The European governments and their central banks may simply accept these more favorable consequences of maintaining the existing growth rates of their monetary aggregates. Alternatively, they could take advantage of the reduced inflationary pressure to raise the rate of money growth temporarily, thereby reducing unemployment more and inflation less. Additional fiscal policies aimed at raising the rate of investment would not only help to maintain and expand aggregate demand but would also contribute to achieving the increases in labor productivity that can raise the demand for the labor that is currently unemployed because wage levels exceed their potential productivity.


This brings us back to the starting point: the prospects for reducing the U.S. budget deficit. I continue to talk frequently with my old colleagues in the Reagan Administration and with leading members of Congress in both parties. On the basis of those conversations, I am actually quite optimistic that we will see legislative action this year that will substantially reduce future budget deficits.

More and more members of Congress see the urgency of reducing the projected deficits. Moreover, they have come to recognize that 1985 is the best time to do the politically difficult things that need to be done. Of course, there are no sure things in politics. And the magnitude of the deficit reductions that I expect to be enacted this year is less than I would like to see. But I do believe that there is a better than even chance of really significant deficit reduction legislation during this year.

The thing that makes deficit reduction so hard to achieve, and that also makes the process so hard for foreigners to understand, is the independence of the executive and legislative branches of the American government. The opposition party now controls the House of Representatives and the President cannot control even his own party in either house of Congress. The result is not only a lack of discipline but also a great deal of posturing by all of the participants who are eager to avoid the adverse political consequences of the actions that they know should be taken.

The agreement reached in mid-April between the President and the Senate Republicans is therefore very significant. They agreed to a package of spending cuts that would reduce the budget deficit by about $50 billion in the next fiscal year, rising to $150 billion in 1988 and thereby reducing the Administration’s projected 1988 deficit to $100 billion, or just two percent of GNP. This would put the economy on a path that could lead to a balanced budget by the early part of the next decade. Although the actual legislation will probably fall short of achieving this ideal pace of deficit reduction, the final result should not be far from this target.

What is likely to come out of the legislative process? The President agreed to cut his requested increases in defense spending to a three-percent real rate of increase from the more than seven-percent rate that he had previously requested. This will reduce the 1988 deficit by nearly $50 billion. It would not be surprising if the House of Representatives imposed even further defense cuts.

The President and the Senate Republican leadership agreed to total cuts in non-defense spending that will increase to $80 billion by 1988, including $11 billion of reduced outlays for old-age retirement benefits to be achieved by an ingenious plan for reducing the automatic inflation adjustment of benefits. All of these spending cuts will not survive the entire legislative process but, in the end, non-defense spending in 1988 is likely to be cut by about $50 billion.

In addition to trimming the budget deficit, this will represent a remarkable achievement in reversing the growth of government spending in the United States. By the end of the decade, non-defense spending, on all programs other than the social insurance benefits for the aged, will be back to the same share of GNP that it was at the beginning of the 1960s—just slightly over six percent. And total non-defense spending, including all of the programs for the aged, will be back to only 12 percent of GNP, a level not seen since the early 1970s. Even when the spending of state and local governments is included, total non-defense spending in the United States will be only about 22 percent of GNP—about half of the level now seen in many European nations.

The reductions in spending and the resulting savings in interest on the national debt would cut the 1988 deficit by about $110 billion, a reduction equal to about 40 percent of the deficit that would be likely with no legislative action. Such a deficit reduction would be a major achievement with favorable effects on real interest rates and on the value of the dollar.

It would, however, still leave an unacceptably large 1988 deficit of about $175 billion or 3.5 percent of GNP. In my view, further progress in shrinking the deficit will require increased tax revenue. Although President Reagan has made it exceedingly clear that he does not like the idea of raising taxes, I believe that in the end he will agree to a rise in tax revenue after he believes he has achieved as much spending reduction as Congress is willing to enact. Although the President would veto an increase in personal income tax rates, there are a number of other ways of raising tax revenue that I believe would be acceptable to him: a gasoline tax or other tax on energy; a modification of tax-bracket indexing in parallel to the change in the indexing of social security benefits; and a tax reform that modifies existing tax rules in a way that permits both a reduction in tax rates and an increase in tax revenue.


What would be the effects of the type of deficit-reduction measures that I have been describing?

The long- and medium-term effects would clearly be good: a smaller national debt to be financed; lower interest rates and a more competitive dollar; a more balanced expansion; and greater capital accumulation leading to greater productivity and growth.

The near-term effects are more uncertain. The direct effect of deficit reduction is contractionary: a reduction in demand and therefore in economic activity. Reduced government spending means less demand for the goods and services that the government purchases. And reduced transfer payments or increased taxes mean less demand for consumer goods. So the direct effect of deficit reduction is to shrink demand and economic activity.

Of course, this direct contractionary effect is eventually outweighed by the indirect expansionary effects of the lower deficit. A smaller deficit means lower real interest rates and therefore increased investment. And a smaller deficit means a lower dollar and therefore an increase in net exports.

But experience shows that there are substantial time delays between the fall in the interest rate and the subsequent rise in investment, and between the fall in the dollar and the subsequent rise in net exports. It takes about a year to 18 months to reach the full effects of the changes in the interest rate and the dollar.

There is, therefore, a risk of a mismatch of timing. The American economy could stop expanding or turn down in 1986 if the direct contractionary effects of deficit reduction shrink economic activity before the countervailing expansionary effects of the lower interest rate and more competitive dollar are felt. This risk of a mismatch of timing cannot be avoided. It is the price that we must pay for having waited so long to deal with our budget deficits.

But I believe that even if such a mismatch of timing does cause an economic downturn in 1986, that recession would be short-lived and shallow because the fundamental condition of the American economy is basically sound. There has not been an overbuilding of plant and equipment capacity. There has not been excessive inventory investment. And there is not a high rate of inflation that the Fed must crush by a sharp tightening of monetary policy. So a 1986 recession, if it occurs because of a timing mismatch, would be mild and short. And when it is over, the economy would be in a healthy position for future expansion.

The next six months will be a crucial time for American economic policy and therefore for the future of the world economy. If the U.S. Congress and the Reagan Administration can now agree on appropriate budget and tax policies, America’s economic future can be very bright indeed. But if these things are not done, America can lose the progress of the past three years and fall into a future of economic stagnation, high inflation and rising unemployment.

America’s political leaders now know what should be done; they will try to take the needed steps in the months ahead. Their success will be important not only for the United States but for the rest of the world as well.

You are reading a free article.

Subscribe to Foreign Affairs to get unlimited access.

  • Paywall-free reading of new articles and a century of archives
  • Unlock access to iOS/Android apps to save editions for offline reading
  • Six issues a year in print, online, and audio editions
Subscribe Now
  • Martin Feldstein is the George F. Baker Professor of Economics at Harvard University and the President and Chief Executive Officer of the National Bureau of Economic Research. From 1982 to 1984 he served as Chairman of the Council of Economic Advisers and President Reagan’s chief economic adviser. This article is adapted from remarks to The Trilateral Commission meeting in Tokyo, April 1985.
  • More By Martin Feldstein