Full text of The 1978 Midyear Review of the Economy : Hearings Before the Joint Economic Committee, Congress of the United States, Ninety-Fifth Congress, Second Session : The 1978 Midyear Review of the Economy : Hearings Before the Joint Economic Committee, Congress of the United States, Ninety-Fifth Congress, Second Session, Part 2, July 12, 13, and 18, 1978

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THE 1978 MIDYEAR REVIEW OF THE ECONOMY

HEARINGS
BEFORE THE

JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
NINETY-FIFTH CONGRESS
SECOND SESSION

PART 2
JULY 12, 13, AND 18, 1978

Printed for the use of the Joint Economic Committee

U.S. GOVERNMENT PRINTING OFFICE
35-940

WASHINGTON : 1978

For sale by the Superintendent of Documents, U.S. Government Printing Office
Washington, D.C. 20402


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JOINT ECONOMIC COMMITTEE
(Created pursuant to sec. 5(a) of Public Law 304, 79th Coug.)
RICHARD BOLLING, Missouri, Chairman
LLOYD BENTSEN, Texas, Vice Chairman
HOUSE OF REPRESENTATIVE,S
HENRY S. REUSS, Wisconsin
WILLIAM S. MOORHEAD, Pennsylvania
LEE H. HAMILTON, Indiana
GILLIS W. LONG, Louisiana
PARREN J. MITCHELL, Maryland
CLARENCE J. BROWN, Ohio
GARRY BROWN, Michigan
~IARGARE'l' M. HECKLER, Massachusetts
JOHN H. ROUSSELOT, California


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JOHN R. STARK,

SENATE
JOHN SPARKMAN, Alabama
WILLIAM PROXMIRE, Wisconsin
ABRAHAM RIBICOFF, Connecticut
EDWARD M. KENNEDY, Massachusetts
GEORGE McGOVERN, South Dakota
JACOB K. JAVIT.S, New York
WILLIAM V. ROTH, JR., Delaware
JAMES A. MCCLURE, Idaho
ORRIN G. HATCH, Utah

Executive Director
(II)

CONTENTS
WITNESSES AND STATEMENTS
WEDNESDAY, JULY

12, 1978

International Outlook
Mitchell, Hon. Parren J., member of the Joint Economic Committee:
Opening statement_______________________________________________
Cooper, Hon. Richard N., Under Secretary of State for Economic Affairs,
accompanied by Stanley Black, special assistant_____________________
Bernstein, Edward M., consultant, Washington, D.C___________________
Norris, John F., vice president for international economics, Chase Econometric Associates, Inc., Bala-Cynwyd, Pa___________________________
Ranson, R. David, senior economist and partner, H. C. Wainwright & Co.,
Boston, Mass___________________________________________________
THURSDAY, JULY

Page

269
271
285
294
-314

13, 1978

International Trade
Long, Hon. Gillis W., member of the Joint Economic Committee: Opening
statement______________________________________________________
Cline, William R., senior fellow, the Brookings Institution____________
Stern, Robert M., professor of economics, University of :!'.1ichigan______
Richardson, J. David, associate professor of economics, University of Wisconsin__________________________________________________________
TUESDAY, JULY

375
394
400
429

18, 1978

International Adjustment I
Bolling, Hon. Richard, chairman of the Joint Economic Committee:
Opening statement_______________________________________________
Dornbusch, Rudiger, professor of economics, Massachusetts Institute of
Technology_____________________________________________________
Kreinin, Mordechai E., professor of economics, Michigan State University_
Solomon, Robert, senior fellow, the Brookings Institution______________

473
474
488
49'8

SUBMISSIONS FOR THE RECORD
WEDNESDAY, JULY 12, 1978
Bernstein, Edward M.:
Prepared statement ___________________________________________ _
Response to additional written questions posed by Representative
Bolling with an enclosure ____________________________________ _
Cooper, Hon. Richard N.:

_

Ap~::~;e!~niti,~N~f~t _e~:~~~~ ~'~~~~~t--~f- _~~~~~i~~t~~- -~~~~~~
Letter of response, dated August 28, 1978, to Representative Bolling's
letter, dated August 7, 1978, requesting any thoughts or comments
on the results of the Bonn economic summit ___________________ _
Norris, John F.:
Prepared statement ___________________________________________ _
Ranson, R. David:
Prepared statement _________________________________________ _


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(III)

290

360
'2,75
358
299
318

IV
THURSDAY, JULY

13, 1978

Cline, William R. :

Prepared statement ___________________________________________ _
Response to additional written questions posed by Representative
Bolling ____________________________________________________ _
Long, Hon. Gillis W.:
Paper entitled "World Trade and the International Economy:
Trends, Prospects, and Policies" ______________________________ _
Richardson, J. David:
Prepared statement ___________________________________________ _
Response
to additional written questions
posed by Representative_
Bolling _______________________
. ____________________________
Stern, Robert M.:
Paper entitled "The Implications of Alternative Trade Strategies for
the United States" _________________________________________ _
TUESDAY, JULY 18, 1978
Rudiger:
Dornbusch,
Prepared
statement ___________________________________________ _
Kreinin, Mordechai E. :
Prepared statement ___________________________________________ _
Response
additional
written questions posed by Representative
Brown oftoOhio
_____________________________________________
_


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398

469
377

435
471

402

479
492
522

THE 1978 MIDYEAR REVIEW OF THE ECONOMY
WEDNESDAY, JULY 12, 1978

INTERNATIONAL OUTLOOK

CONGRESS OF THE u NITED STATES,
JOINT ECONOMIC COMMITTEE,

Washington, D .0.
The committee met, pursuant to recess, at 9 :30 a.m., in room 5110,
Dirksen Senate Office Building, Hon. Parren J. Mitchell (member of
the commitee) presiding.
Present: Representative Mitchell and Senator Javits.
Also present: John R. Stark, executive director; Louis C. Krauthoff II, assistant director; Richard F. Kaufman, assistant directorgeneral counsel; Lloyd C. Atkinson, Kent H. Hughes, L. Douglas Lee,
and M. Catherine MiMer, professional staff members; Mark Borchelt,
administrative assistant; and Charles H. Bradford, Stephen J. Entin,
and Mark R. Policinski, minority professional staff members.
OPENING STATEMENT OF REPRESENTATIVE MITCHELL
Representative MITCHELL. The hearing will oome to order.
I want to welcome you all to another session of the Joint Economic
Committee's midyear hearings on the American economy. Today, the
committee will hold the first of four hearings on the state of the international economy and what international problems imply for the
United States.
We will start with a broad overview that will include an assessment
of the prospects for economic growth and price sta:bility around the
world. We will also explore the prospects for a more stable dollar, a
decrease in the U.S. trade deficit, and the possible outcome of the upcoming economic summit to be held in Bonn, West Germany, on July 15
and 16. Subsequent hearings will explore the challenges that confront
U.S. trade policy, and the problem of international adjustment in the
context of floating exchange rates, multinational corporations, and
the general increase in economic interdependence.
Since World War II, the international economy has undergone a
series of sharp changes. The Bretton Woods system of fixed exchange
rates based on gold and the U.S. dollar has given way to a. wide array
of currency arrangements. Some foreign currencies are tied to the
dollar or other major currencies. Others are subject to periodic depreciation. Still others are allowed to float upward or downward largely
independent of government intervention. The United States has been


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270
freed of some of the added burdens of a reserve currency, but the dollar
and dollar stability remain central to the international monetary
system.
The successful cartelization of the international oil market and the
quintupling of oil prices stunned the ·western World. Although existing economic institutions have proved resilient in adapting to the
financial problems posed by a massive OPEC current account surplus,
there is every sign that the major industrial economies have not yet
fully adapted to sharply higher energy prices. Considerable progress
has been made in the United States and elsewhere in terms of conservation and conversion of existing assets. But the legacy of slowed
investment, indifferent growth, and inflation is still widespread.
The nonmember oil developing countries have also become an increasingly important part of the world economic system. Not only are
they a major market for the manufactured exports of the United
States and other industrial countries, but in several cases, developing
countries have themselves become major exporters of manufactured
goods. The increase in economic power and the growing diversity of
developing countries have made their political and economic positions
both more pressing and more complex.
During the postwar era, the world became more and more an economic unit. Even the Soviet bloc has become more closely alined with
the economic fortunes of the rest of the world as it has looked to the
vVest for technology, sophisticated manufactures, and agricultural
goods. The United States has been no exception to this trend. Where
the international sector was often simply ignored in the past, imports
and exports combined now account for about 14 percent of America's
gross national product. Both account for a much higher percentage of
the Nation's industrial and agricultural production.
Major changes in international economic institutions have accompanied the changes in the world economy. Multinational corporations
have expanded the volume and speed of international capital transactions. The existence of active Eurodollar and Asian-dollar markets
has made control of world money supplies more difficult.
In a very new international environment, America is now struggling with a series of economic problems. The record trade deficit of
1977 will almost surely be challenged by the trade deficit for 1978. To
some extent the tools for controlling the deficit are in our own hands.
Reducing domestic inflation will help spur U.S. exports, and an effective energy program will help regulate the size of U.S. oil imports.
But a decrease of the deficit also depends on faster growth abroad
and the reduction of barriers to U.S. exports.
The size of the U.S. trade deficit coupled with an increase in the
rate of inflation have contributed to considerable instability of the dolIar in foreign exchange markets. Given the substantial trade and current account surplus of Japan and Germany, some appreciation
against the dollar was appropriate. But the speed and severity of the
change may have created the kind of uncertainty that slows investment
and reduces the volume of world trade.
To help us find an intellectual path through this thicket of issues,
we are :fortunate to have with us Under Secretarv of State Richard
Cooper. Mr. Cooper will be followed by three disti~guished experts on
the international economy, Mr. John Norris of Chase Econometrics;


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271
Mr. E. M. Bernstein, a Washington-based economic consultant; and
Mr. David Ranson of H. C. Wainwright & Co.
Mr. Cooper, we are very pleased to have you with us again this
morning. Please proceed with your statement.

STATEMENT OF HON. RICHARD N. COOPER, UNDER SECRETARY
OF STATE FOR ECONOMIC AFFAIRS, ACCOMPANIED BY STANLEY
BLACK, SPECIAL ASSISTANT
Mr. COOPER. Thank you. It is a great pleasure for me to appear
before the committee today to discrn,s our international economic
policies.
I have with me today, Mr. Stanley Black, who is my special assistant, and who is a specialist in this area. He may help in responding to some of your questions.
This is a particularly timely occasion to be holding these hearings.
Later this week, President Carter will be in Europe attending a summit meeting with the heads of state or government of our major
allies and trading partners. I would, therefore, like to focus my prepared remarks on the policy framework the President will be advocating and the objectives he hopes to achieve. I shall discuss the current
international economic setting, our domestic economic policy objectives, and our consequent approach to the summit. I will conclude with
some thoughts about the relation of our current efforts to our longer
term interests.
THE CURRENT SETTING

As you know, the world economy has still not fully recovered from
the deep recession of the past few years. This week's summit meeting
occurs against a backdrop of slow growth at a rate of 3½ percent
this year, in the OECD area. Inflation has been reduced in all the
major countries from the magnitudes of 3 years ago, but unemployment in the OECD area outside the United States is at a postwar high
of some 10½ million persons and is growing, particularly in the smaller
industrialized countries.
Large payments imbalances persist, pressures to restrict trade are
widespread, private investment is low, and we have seen periods of
exchange rate instability. The situation, of course, varies significantly
from country to country. In addition, slow growth in the industrializea
nations is limiting the development prospects for many Third-World
nations with whom our own welfare is increasingly connected.
Improvements are possible over the next year. National growth
rates are converging in the OECD area, with favorable implications
for balance-of-payments patterns. The external financial situations
of a few countries which only recently were in perilous condition have
improved significantly. In several countries, inflation rates are continuing their slow decline, and we are making headway in further
liberalizing trade.
To maintain this momentum, however, will require additional actions. The mere continuation of current economic policies will not be
sufficient to put the world economy back on track so as to reduce aggregate unemployment and to facilitate necessary adjustment to high
energy prices and changing trade patterns.


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U.S. DOMESTIC ECONOMIC OBJECTIVES

President Carter has clearly articulated our major domestic economic objectives.
We must reduce our inflation, or run the risk of continued uncertainty in our investment climate, erosion of the economic security of
our citizens, reduced growth, and instability in the exchange markets.
We have made outstanding progress in creating 7.4 million new jobs
for Americans durinng the past 2 years, and good progress in reducing
the number of Americans without jobs from 7 million to 5¾ million.
But we must do better in the months ahead, particularly with programs targeted on those specific groups, such as young people and
minorities, which have experienced problems finding employment.
We urgently need energy legislation to limit oil imports and to
encourage conservation and the development of alternative energy
sources. The :failure to implement an energy program has reduced confidence abroad in our ability to manage our domestic policy effectively
and to fulfill our international responsibilities. It has also contributed
to recent monetary disturbances.
We must act now to reduce our trade deficit even though our policies
might take months or years to bear fruit. Energy legislation will help
to restrain our oil imports, which is a significant part of the deficit.
In addition, we must strengthen the performance of our export sector.
And we must maintain markets open to fair competition from
abroad. Trade is essential if we are to combat inflation while at the
same time achieving high productivity and growth.
OUR APPROACH TO THE SUMMIT

I wanted to outline briefly these domestic objectives in order to show
that our international economic policies are designed to reinforce them.
The simple fact is that today it is not possible for any nation, even the
United States, to achieve all its domestic objectives in the absence
of generally compatible policies by other countries. Our dependence
on foreign markets and on foreign supplies, and the general interconnectedness of markets and hence of economic conditions, is too
great for that.
At the summit the President will work toward cooperation with
other summit participants to insure global economic recovery. He will
be making the case that by acting together rather than in isolation,
countries can increase the effectiveness of their individual actions, all
of which are subject to political and economic constraint. The specific
issues will fall into several related categories.
First, the President will underscore the need for sound macroeconomic policies. His focus will be on the following:
The need for actions by countries which are growing slowly and
have strong balance-of-payments positions to grow faster. In terms
of our own interests, this would help us expand our exports and
contribute to stability of exchange markets.
.
The need for certain nations, including- the United States, to take
effective measures to reduce inflation. We can expect to come under
some pressure to demonstrate that we can ma~age t1:ie problem. .
The need for countries to create an economic environment wluch
encourages governments to give greater freedom to market forces in


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bringing about adjustment to new economic circumstances. At stake
for us is the reduction of rigidities and inefficiencies in our own economy, as well as the maintenance of an international economy characterized more by competition than by Government subsidy and control.
The macroeconomic strategy to which the President will be referring
has come to be known as concerted action. It has two interlocking
aspects, appropriate demand management policies in different countries, and policies to encourage resources to respond to market forces
to insure appropriate growth of supply.
I append to this statement an illustrative simulation of the probable
effects of one pattern of coordinated demand management policies
in different countries. The results suggest that growth outside the
United States could be substantially higher without raising inflation
rates very much.
Further, a notable aspect is that in most cases the pattern of international payments imbalances would be improved somewhat. On the
supply side, I refer to the IECD guidelines for adjustment policies,
which were agreed to by OECD Ministers at their meeting on June
14-15 in Paris.
Second, the President will make clear our support for the newly
revised international monetary system, with its reliance on flexible
exchange rates and the international surveillance of exchange rate
policy. This system does not work perfectly, but it allows a necessary
flexibility in a world in which countries' policies ,are too often out
of step with each other. Stability of exchange rates is dependent on
reasonable balance in the fundamental factors affecting payments
positions, such as economic growth rates, inflation rates, and energy
policies. In the meantime, a strengthened system of financing balanceof-payments deficits for many countries requires a strengthened International Monetary Fund. The Witteveen facility or supplementary
financing facility of the IMF is now seriously delayed through lack
of Senate approval. All countries will be eligible to use this facility.
Third, the President will aim to gain approval for the essential
elements of a package of agreements now emerging from the multilateral trade negotiations in Geneva. We would like to see all the negotiations completed by the end of the year. Major U.S. interests are
clearly at stake :p.ere: Expanded markets, jobs, and the many other
benefits which derive from an open international economy. U.S. negotiators, under the leadership of Bob Strauss, have led the way in the
reduction of tariff barriers, and the strengthening of the rules governing international trade. Progress on two issues is of particular importance to us : Establishment of a more open and stable system for
trade in agriculture and more international discipline over the use
of subsidies. We expect to be presenting the trade agreements to Congress early next year.
Fourth. there will be extensive discussion of national energy policies
and possibilities for international energy cooperb.tion. I underscore
the weak position the President will be in. All of the countries present
need to strengthen their energy policies in various ways. But we alone
among the other summit participants have not yet agreed among- ourselves on policies to allow our energy prices to rise to world levels. In
addition to focusing on our domestic situation, the energy discussion


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274
will center on ways to increase investment in the energy sector, to improve national conservation efforts, and to expand energy cooperation
with the non-OPEC developing nations.
Fifth, the President will be engaged in discussions on economic
relations with the developing countries. It has become increasingly
clear that economic growth in the Third World is an important element in the global economic situation. Our own trade and investment
ties with these nations are strong and growing. The summit participants will exchange views on the need to expand and make more
effective our respective foreign assistance programs; to support the
continuation of private capital flows to the Third World; to keep
open our markets to the Third World; and to find ways to encourage
developing countries to accept obligations in the international economy such as the need for many or them to reduce over time their
high trade barriers.
Once again, however, the President's ability to exercise leadership
in this area is weakened by our own inhibitions. As you know, our
own foreign assistance programs are small relative to our income,
and our contributions to the multilateral development banks are running well behind our pledges. In addition, despite our efforts to increase our foreign assistance levels and make our aid more effective,
our foreign aid request for fiscal year 1979 is seriously threatened in
Congress by deep cuts in appropriations and proposed legislative
restrictions.
Despite the economic situation both we and the developing countries
have faced, and the difficulties we have had delivering on specific
commitments, I believe this administration has made significant progress in our relationship with the Third World. The President intends
to keep up this momentum.
THE LONGER TERM

In our current policies I believe you can see the outline of a
strengthened international economy for the future.
Sound macroeconomic management is essential to lay the base for
a sustained long-term growth, which is a precondition of a prosperous
international economy, and a stable monetary system.
In the trade negotiations we are reaching a consensus with other
nations on the rules and procedures to govern international commerce
for years to come.
In our efforts to fashion an effective national energy policy and pool
our efforts with other countries, we are trying to manage both our
international payments position and a difficult transition to the time
when oil and gas will not be our principal source of energy.
And in our policies toward the developing countries we are searching for ways to cooperate in areas where both we and they stand
much to gain.
CONCLUSION

We cannot eliminate all our economic problems quickly; they are too
deepseated, and our policy options are circumscribed by a varietv of
political, social, and technical constraints. Yet every year in which we
fail to make progress has major costs to our society; in rigidities added


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275
to our economy, in supply bottlenecks built up, in the higher costs of
adjustment, and most importantly in the ultimate lowering of material
well-being for our citizens and the permanent scars on many of our
youth who cannot find work. We are redoubling our efforts to make
progress, and in this effort both the administration and Congress will
have to work very closely together. I appreciate the chance to make this
brief statement of our international economic policies, and I look forward to your questions.
[The appendix attached to Mr. Cooper's statement follows:]
.APPENDIX. IMPACT OF COORDINATED DEMAND MANAGEMENT POLICIES

The following table indicates the results of a simulation of a coordinated expansion strategy with the Project LINK model which includes linked econometric
models of twelve industrialized. OECD countries. The results are meant to be only
broadly illustrative of the expected effects of coordinated policies, since such
models inevitably suffer from a number of limitations. The simulation compares
the effects of the following fiscal stimuli with a control solution based on policies
as of May 19, 1978 (including in the control solution a proposed U.S. tax cut of
$19.4 billion in January 1979) : (a) sustained fiscal stimuli to raise GNP by 1 percent over the control solution in 1978, 1979, and 1980 in France and the Netherlands, and in 1978 and 1979 only in Belgium, Germany, Japan, and the U.K.;
(b) sustained fiscal stimuli to raise GNP by 0.5 percent over the control solution
in 1978, 1979, and 1980 in Finland, and in 1978 and 1979 only in Italy ; ( c) no further stimulative actions in .Australia, .Austria, Canada, Sweden, or the United
States. These fiscal stimuli could in many cases take the form of tax cuts. Monetary policy is assumed unchanged in each country, according to the monetary
assumptions in each model.
EFFECTS OF COORDINATED FISCAL STIMULUS ON GROWTH AND TRADE BALANCES OF OECD COUNTRIES,

1978-79

Australia _____________________________________________________________ _
Austria _______________________________________________________________ _
Belgium-Luxembourg __________________________________________________ _
Canada _______________________________________________________________ _
Finland _______________________________________________________________ •
France _______________________________________________________________ _
Germany, Federal Republic ______________________________________________ _
Italy_ • __________________ -- ___________________________________________ _
Japan ________________________________________________________________ _
Netherlands ___________________________________________________________ _
Sweden ______________________________________________________________ _
United Kingdom _______________________________________________________ _
United States ____ ••• _________________________________________________ _

Incremental
growth of real
GNP, average
of 1978 and
1979 (percent)

I ncrementa1
change in trade
balance, 1978
plus 1979
(billion dollars,

0.1
.8
I. 9

0.6
.2
-3.0

.2

I. I
I. 2
I. 5
I. 4
I. 0
1.6
-. I
I. I

.1

.&

.1

-1. B
-4.6

-1. Z
.1
.5
-2. 2
5. 2

Representative MITCHELL. Thank you very much for a very provocative and cogent statement.
Let me say before I start the questioning that with reference to the
foreign aid bill and the proposed deep cuts that are floating around
in the House and Senate, this is one Member in the House who is in
deep opposition to those cuts.
I think it is foolhardy, as we are attempting to estabilsh our position in relationship to particularly Third World nations, as we are
attempting to achieve rapprochement with various nations-I think
it is foolish to go in for meat-ax cuts. It may be politically popular,
but certainly in. the long run-and in the short run-it is a bad
policy to follow.


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276
I want you to know that one Member of the House is in opposition
to those cuts.
Mr. CooPER. We appreciate your support.
Representative MITCHELL. Spread throughout your statement you
talked about the necessity :for this Nation to act on the very pressing
problem of inflation. The President will go to the economic summit,
and it seems to me that the summit will revolve around the ability of
the United States to control inflation, to reduce oil imports, and the
willingness of Germany and Japan o stimulate their economies.
I guess it certainly boils down to the principles of free trade. However, with no energy bill having come out of the Congress as yet,
and with accelerating domestic inflation, I must ask you quite bluntly,
have we not sent the President to the bargaining table with essentially empty hands?
He is going there certainly to deal with American inflation with
reference to the international economy. But we have done nothing on
the two key issues that you talk about in your statement. Congress
has not.
So essentially have we not crippled the President by our inactivity,
crippled him at the summit?
Mr. CooPER. In answering that question, I think I would say at the
outset that I do not believe the President is crippled as he goes to the
summit.
I do agree with the drive of your question, that his position would
be far stronger if by this time, which is now-what 18 months after
he first proposed his energy program, the central features were
through the Congress.
We would be in a far happier situation if that were the case.
:However, as you know, there has been substantial agreement on :four
Jl)arts of the five-part package as it has moved through Congress.
I think the President can report that at the summit, and we hope
very much he will be redoubling his efforts to encourage Congress to
to give him the fifth part of the bill in the near future.
I don't feel he is crippled, although his position is certainly weaker
than it would otherwise be.
I might point out in this context that our actual energy consumption in this country has taken a turn to the better compared with historical trends. It is true that during the last 18 months U.S. energy
imports have grown rapidly, although they leveled out this year
'.because of Alaskan oil.
But it is also true, if one penetrates below the figures, that the
American public has responded to the energy shortage, and to higher
.energy prices than obtained before 1973. If I can just cite one set
-0f figures: GNP in the United States has grown by nearly 15 percent
in real terms since 1972, but energy has grown-energy consumption
has grown-by only 5½ percent during that intervening period,
which is just a third more, the ratio between those numbers.
That contrasts with an historical experience existent since the
early 1970's with energy growing slightly faster than GNP. So one
can· see in our economy, and as a result of both higher prices and
the policy actions that are taking place so far, one can see a response
by the American public.


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277.
It is just that as we project these figures out to the future, we still
see an important imbalance in the world energy situation. And we
feel that the energy program now before the Congress is essential
to keep the world energy situation in balance through the 1980's and
beyond.
On the question of inflation, it is, of course, a matter of tremendous
concern to the President, and to the other industrialized countries,
what the rate of inflation in the United States is. We have been
troubled by the movement upward in rates of inflation earlier this
year. In fact, much of that we attribute to factors that are essentially
temporary. They are in the agricultural area. We do not see the rates
of inflation that we observed during the first 4 months of this year
continuing throughout the year and mto 1979.
Nonetheless, the price increases that we have seen this year dramatize the exposure we still have to inflation. As you know, as our own
economy recovers further, our present priorities have understandably shifted toward giving much greater attention to inflationary
pressures, and the administration's deceleration program is intended to give some kind of guidance to the economy as a whole in
order to get rates of inflation down.
Representative MITCHELL. Let me just say as an aside, I am concerned about inflation. But I argue all the time against this No. 1
goal while we leave structural unemployment as high as it. That is a
matter for another hearing and another committee.
But I take sharp difference with setting forth one major goal, the
fight against inflation, while .,ve have so many people, minorities particularly, unemployed.
Let me get back to the economic summit. I suppose that since after
orld War II, generally we tried to do political bargaining over
international matters through tax treaties and trade treaties, and
suddenly there aJ?pears to be an annual economic summit that provides an internat10nal forum for the discussion of what was formerly
viewed as domestic economic policy.
There are some who have questioned the worthwhileness of these
economic summits. Take a situation such as we confront at this
summit, where the President is going without an energy policy which
is certainly not locked up in place, and with other problems that need
to be resolved.
There are those who would question the wisdom of an annual economic summit, primarily because it is so difficult for America or any
other nation to get all the bricks into place.
I would like to ask you for your opinion or an assessment as to
whether or not an annual economic summit approach is better than,
equal to, or worse than the former approach which we used in the
past on treaties, tax treaties, trade treaties?
Mr. CooPER. Yes. In effect you are saying-Representative MITCHELL. May I just throw one more into that?
With the understanding that it is good always to have an international forum to have discussions. But in terms of significant, concrete results, this approach compared to the past approach; which
would you prefer?
Mr. CooPER. I don't see these as competing forums. On the contrary,
I think they are complementary. We will continue to need tax treaties

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and trade agreements, and indeed, the multilateral trade agreements
that are now going on are of the type that you referred to as having
a continuity over the last 30 years.
In this case it will be laid before the Congress when it is completed.
I think that those kinds of agreements which are formal undertakings
by governments with formal commitments with procedures laid down
for adjudicating disputes, those kinds of international agreements
will continue to be necessary and desirable.
With summits-which as you point out seem to have become institutionalized-it has not become formally institutionalized, b11t this
will be the fourth one, and I notice already there is some commentary
on the next summit-Representative MITCHELL. It is institutionalized.
Mr. CooPER. It seems to me that the rationale for the summit is a
quite different one. We do not have at the summit formal undertakings
of the type that go into treaties or executive agreements. Rather, the
value of the summit is to bring together what are the main-not only
the major industrialized countries, but the major democracies.
These are government leaders who have similar problems in the
nature of the economies, and the character of the political system.
To exchange views on those common problems to see if they can reach
some generalized· agreement as to the course they would like the
world economy to take, since these economies make up the bulk of it in
term of economic share, to take in the future, and to have 2 days of
@1iiscussion among them on the various economic issues, seems to be
tremendously important in informing them on the problems of other
countries, the limits of expectations that can be put on other countries
and having them reach some kind of understanding on shared objectives.
It falls far short of the formal undertakings, but, nevertheless,
it shares objectives on problems they all face.
What we have found, especially in the last 10 years, is that it is
increasingly difficult for individual economies to act in isolationand this goes even to the United States, although the problems are
less acute for the United States than they are for other countries-the interconnection is just too great.
Also, I think it is useful for the heads of these countries to get
some sense of one another as individuals. It makes communications
between summits a lot easier. It. makes it a lot easier to pick up the
phone, or dash off a note, and establish a personal rapport which, in
today's world of fast, immediate communications, I think should not
be underestimated.
So I see the summit-or summits, to generalize-as an invitation to
do these things. I see them as complementary to trade agreements and
tax treaties and things of that type.
In addition, it is often the case that formal negotiations on formal
agreements can get bogged down for one reason or another, and the
summit can provide the occasion to sort of break bottlenecks and give
impetus to negotiations that have bogged down.
Representative MITCHELL. I think since I have been in the Congress, I have been concerned about the balance-of-trade deficit. It
probably got very large the first year I was here, and I don't think it
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Some people have come up with some methods by which to contain
this problem. Chairman Miller of the Federal Res_erve Board has
argued that the imports will continue to be a much higher percentage
-0f the U.S. GNP than they have been during the post-World War
II era. He has further suggested that to pay for an enlarged import
bill, we should set a goal for exports of 10 percent of GNP. The current figure is around 6 percent.
Is that goal feasible, given all of our internal problems? Is that a
feasible target, 10 percent of our imports, 10 percent of GNP to exports ? If it is feasible, how do we got about achieving it?
Mr. CooPER. On the feasibility of the target, it is very difficult
to pronounce on that without putting a time dimension on that.
There is little doubt in my mind, given tendencies in the world
ticonomy generally, that the day will come in which we do show 10
percent of our GNP-Representative MITCHELL. Three years, 5 years?
Mr. CooPER. But I would put it out a little beyond that.
I think to try to move from 6 percent of GNP to 10 percent, that
works out numerically to an increment of about $80 billion, in any
short period of time, would not represent a feasible goal, and it
would :put serious strain on our own policies, and a strain on the rest
of the world's economies, to have a swing in a short period of time in
U.S. exports of that magnitude, $80 billion.
So I think the feasibility of it depends on the time dimension one
has in mind.
There is a function to be served by setting targets, even if the
target is not qnite feasible, and that is in a concrete way to draw
attention to a problem.
Perhaps Chairman Miller's main emphasis was that, and in that
respect, I share his concern. There is no doubt that we must increase
onr exports, perhaps not by that much that rapidly, but we must increase our exports in the near future in order to correct our trade
situation.
The economic recovery, fast economic recovery, which the concerted
action program I outlined in my statement, would have an important
cetfect, not its main purpose, but an important effect is a substantial
stimulus to U.S. exports.
Our exports are seriously bifurcated between agricultural products
on the one hand and capital goods on the other. That means that our
-export performance is very sensitive to world crop conditions. When
the world crops are good, our exports suffer, and vice versa. And on
the other hand, our exports are very sensitive to plant and equipment
expenditures elsewhere in the world, and hence to rates of growth elsewhere in the world.
"\V"ith a consequent pickup in rates of growth, one would expect to see
a consequential pickup in American exports. So the kind of strategy
I outlined has built into it an implicit concern for American export
performance. But beyond that, I think it remains true that we should
do more to create export consciousness in this country.
As you may know, the President has commissioned a task force
within the Government to make recommendations on improving our
export conditions. That group has been working, and if I understand


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correctly, the task force report will be going to the President this week
with various recommendations to improve our export position.
T~e final point I may make on this is that, as you observed in your
openmg remarks, there has been a consequential change in exchange
rates during the last 12 months, particularly vis-a-vis some of our
important competitors in international markets, notably .Japan and
Germany.
One would expect, and one can see, in markets around the world, an
effect from this, the competitiveness of American products is now
measurably greater today than 12 months ago in various markets
around the world.
Again, the lag in response to changes of this type is consequential.
It is typically reckoned that it takes for manufactured goods something
like 18 months for the effects of a relative price change to come into
play.
But, nonetheless, one would expect to see over the next 2 years, an
effect on U.S. trade, on U.S. exports and imports, from the changes in
currencies that have taken place in the last 12 months.
Representative MITCHELL. That is a very long answer. Would you
agree with my summary of the answer that if Mr. Miller's proposition
is indeed enacted, it will be primarily symbolic in value, and nonfeasible in the short term~
Mr. CooPER. Yes; I would certainlv subscribe to the view that to
increase our exports to 10 percent of GNP in any short term, such as
3 years, is not a feasible or desirable objective.
Representative MITCHELL. Recently the President announced a decision to sell a very small portion of U.S. gold stock. Apparently this
was another quasi-symbolic gesture, a signal that we are determined to
stabilize the value of the dollar.
Do you feel that either the announcement of the program, or the
initial sale of this modest amount of gold has had any impact at all
on the value of the dollad
Mr. CooPER. Yes. The announcement of the sale did have some reaction in the foreign exchange markets when it took place.
I think that those gold sales have to be set in a historical context.
It was not a new departure, but a continuation of a policy that was
begun several years ago, in 1974, of making periodic auctions of U.S.
gold into the market, partly in recognition o:f the fact that there is
substantial gold consumption in the United States.
This is a way of satisfying it rather than through imports, but
partly to make the point also that we envisage a time of a diminishing
role o:f gold in the international monetary system.
That gold we felt would not play-and should not play-the kind
o:f role in future international monetary arrangements that it once
played. To that extent, therefore, sales into the private market o:f
the U.S. monetary gold stock was appropriate.
There was a gap :for a period o:f time in those sales, and the recent
gold sales are really a resumption o:f that pattern.
I think to come directly to the resumption o:f those sales, it was well
received, and there was some monetary effect in the exchange markets.
I would not want to exagerate that.
Representative MITCHELL. It certainly did not do much in terms of
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Mr. CooPER. No effect at all on that.
Representative MITCHELL. Mr. Cooper, what in your opinion is the
likelihood of the industrialized nations taking actions to combat their
own internal inflation problems, actions such as export controls and
unilateral import liberalization~ What is the likelihood of that?
I ask it only because during the period 1973-74, as inflation really
got out of hand, some economists would argue that the industrialized
nations really attempted to export their inflation problems. I would
like to get your reaction, one, to the likelihood of that happening
again; and two, has the international economic structure changed
significantly enough to prevent this exporting of inflation?
Mr. CooPER. You are asking for a forecast of future events, and I
guess I cannot say that these things will not happen.
Let me just say that I think the experience that the United States
had with export controls, motivated by inflationary concerns-and I
refer specifically to the soybean embargo in 1973, that type of thingit was a very chastening experience for us.
I would hope that we and other countries would learn from that~
In the first place, it came home dramatically that there was exportation of a problem, because we created a shortage elsewhere in the
world, and that put prices up very dramatically in countries that depended on our products.
Second, it established a reputation, to continue to focus on the example, as an unreliable source of supply. In our particular case, the Japanese were very much aggrieved. They are heavy users of soybeans, and
since that time they have invested heavily in soybeans in Brazil, and
now they have shifted to Brazil as a major supplier of soybeans.
From a point of view other than the short range, it was very undesirable. I certainly hope we can learn from that, that in today's
world this is not an appropriate action for combating inflation.
You asked also about unilateral reductions of barriers to trade.
That I see more prospect and more promise in. There has been occasion, a number of major countries in particular since the early 1970's,.
have from time to time reduced their barriers to trade unilaterally in
order to reduce inflationary pressure domestically. Japan in 1972 had
a major reduction in trade barriers. We are in somewhat of a paradoxical position at the moment, in the middle of trade negotiations countries are reluctant to lower their trade barriers unilaterally because·
they feel they are giving a way bargaining chips.
But, nonetheless, where there are consequential trade barriers, lowering them can be a help in fighting inflation. Certainly we have made
the point to the Japanese that one of the positive features of reducingtheir barriers to our agricultural products, for example, is that it will
help to combat inflation. The same goes for the United States where
we have barriers, and for other countries.
Representative MITCHELL. Let me say at this point that there are
numerous other questions, and you have to leave at 10 :30. Obviously,
we want to accommodate you.
I have just one other question before you leave. Many economists
argue that central to American economic recovery is the necessity :for
Germany and Japan to stimulate their own economies. I think it is
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:rather well known that these countries have been somewhat reluctant
for fear 0£ fanning the fires 0£ inflation within their own country.
What prospect do you see for _this to happen, _for b~th Ger~~1:-Y and
Japan to stimulate their economies, the assumption bemg that i£ mdeed
this happens it helps America achieve a better recovery, and a better
rate 0£ economic growth; and, indeed, it would contribute to the wellbeing o£the international economy.
·what prospect is there £or that happening 1
Mr. CooPER. I think we have to recognize at the outset that while
what I said earlier is true, that there is a strong international interest,
nonetheless, on matters 0£ this type, they are still primarily, over,vhelmingly, matters 0£ domestic economic policy, as they are in this
country.
Part 0£ our effort in the summit last year, in the continuing discussions we had with these countries, is to make clear the interdependence
0£ markets. As you probably know, the Japanese Prime Minister,
earlier in the year, set a target for economic growth in Japan 0£ 7
percent. That seems to us a desirable target for economic growth
during the current Japanese fiscal year.
The question now is, i£ there is enough pressure now in the ,Japanese
economy to achieve that 7-percent growth. They are examining that.
They have prepared a supplementary budget, should it be needed. The
judgment on whether it should be needed must be a .Japanese judgment.
So we express interest in the Japanese economy. As far as Germany
is concerned, while there is no formal target for growth, the Germans
have, over the course of the last 18 months, taken a number of actions
to increase growth in their economy; and at present there is a lot
of debate going on in Germany on the desirability of a tax cut of
consequential size, in order to provide more impetus to growth.
While no firm decisions have been taken, I would not be surprised
to see the German Government decide on a tax cut in the near future
in order to give greater impetus to their economy.
Representative MITCHELL. A tax cut debate in Germany is not nearly
as needed as one in our country.
I am delighted Senator J avits has joined us.
Senator JAVITS. Mr. Cooper, how much time do you have1 10
minutesi
Mr. CooPER. Yes.
Senator J AVITS. I gathered you had to leave.
You know that I am interested in Senate Resolution 440, so it
makes it easier to ask questions.
I have just run through your statement, and would like to report
to our committee that the Foreign Relations Committee has reported
Senate Resolution 440. That resolution emphasizes what you have
said in your statement, "He will be making the case that by acting
together rather than in isolation, countries can increase the effectiveness of their individual actions."
The resolution definitely calls for collegial action on the p!trt of
thP summit countries, and emphasizes their interdependence and the
fact that action should be taken multilaterally.
You would agree with that 1
Mr. CooPER. Yes,entirely.


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Senator J AVITS. I am hoping we can get that point across to the
majority leader today or tomorrow. I would greatly appreciate it
if you could handle what the State Department needs to do to advise
the majority leader that Senate Resolution 440 is helpful to the
President, and therefore the President should have it before he goes
.to the summit.
Would you try to do that?
Second, I like very much what you say again, "The need for actions
:by countries which are growing slowly and have strong balance-ofpayments positions to grow faster."
Is the President prepared to make any proposals at the summit,
,or do we know of any proposals that ought to be made? For example,
will Prime Minister Callaghan, who has considered this same question, request some kind of growth fund or other effort to accelerate
:the development of countries? Will they work with us on patterns
which will assure assistance to help solve the international economic
problems of the world?
Mr. CooPER. There will certainly be what I would call a general
. discussion, as opposed to a particular proposal, not only among the
participants at the summit, but between them and the other countries,
the developing world and the nonindustralized countries.
In those other countries, it is recognized that it is of great sig,nificance and importance to the major industrialized countries. What
will be done will be sort of a discussion. I am not aware of any concrete proposals that will be put forth. That is, we have not been
,officially notified of any concrete proposal that will be put forth at the
summit, although we have seen in the press-but we have had no
advance notice along these lines.
Senator JAVITS. I am sure you know that I have put forth a proposition for a growth development fund, or investment fund, to work
with those who will work with us along the principle which we
espoused in the Marshall plan of the late 1940's, a fund which would
come to $25 billion-$5 billion a year for 5 years-in order to obtain
·this result. I am very interested to know what you say about the
:macroeconomic strategies as you see it.
Let me just question you briefly on that.
"It has two interlocking aspects, appropriate demand management
·policies in different countries"; this is one aspect. I assume by that
·you mean this problem of energy conservation and the inflat10nary
impact of too many dollars chasing too few goods and so on.
Am I correct?
Mr. COOPER. And beyond that, one of the troubling features in
·today's world is that outside the United States, in industrialized nations, unemployment is at an alltime high, and private investment has
no pusb to it at all.
I mean to encompass in that actions which would stimulate demand
where that can be done without risking impetus to inflation.
Senator J AVITS. Good, we see eye to eye on that. As for the next one,
"policies to encourage resources to respond to market forces to insure
appropriate growth of supply," do you mean the creation of additional
markets to those we now enjoy for the industrialized products of the
industrialized world, which would include developing countries which
·are coming along to industrialization?


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Mr. CooPER. That is a very general formulation of what I said. But
what I was referring to principally there was-has a negative side toit; that is, the tendency that we note in many other countries to substitute government direction for market forces in the management of
supply at the sectoral level. Government directives of various kinds.
and so on. We are concerned about a process by which our private
enterprises, free enterprise and mixed enterprise, are becoming morerigidified, which will store up trouble for the future, because you get
locked into the patterns of supply which were appropriate at one
period, but which are totally inappropriate at a future time.
So this passage really refers to an attempt which we are making, .
mainly through the OSCD, and it will be taken up somewhat at the
summit to exercise restraint in government interference at the sectoral
level in ways that rigidify the economies. We are looking forward
toward positive adjustment policies, policies to facilitate change,.
rather than negative policies which freeze any given pattern of production in an unemployment mode.
Senator JAVITS. The reason I interpreted that statement as I did'
resulted from what follows, which is again something you and I see·
eye to eye on. You said, "The results suggest that growth outside theUnited States could be substantiaHy higher without raising inflation
rates very much. Further, a notable aspect is that in most cases thepattern of international payments imbalances would be improved'
somewhat." Which is why I interpreted your statement as I did.
I gather this is the policy which our country will pursue.
Mr. COOPER. Yes; those particular sentences refer to an appendix.
appended to my statement, which is purely illustrative. This is not a
policy plan, but it is just, what if the countries listed under item (a),
had introduced some additional stimulus in January of 1978?
·
What would that have done to their growth rates in 1978 and 1979,.
compared with projections of what they otherwise would have been,.
and what would that in turn have done to their trade balances i
As you can see in the second column, matching up against existing
trade balances, in all cases there is an improvement. There is an improvement in the United States, which is at a deficit but a, deterioration
in Germany, which is at a surplus. More appears, there is a slight reduction for Japan, which is in surplus, so that by and large the
changes are going in the right direction, and moving back toward·
payment balances, or toward diminution of imbalances-by acting·
together, you get these interacting effects which are helpful.
Senator JAVITS. Taking my cue from your statement, regarding the·
economic discussions with the developing countries and the weak position of the President-because we are dragging our feet on the energy
bill and the administration's bill for foreign aid.
I am hoping for a growth fund which will be an investment fund
similar to the Marshall plan and will be repayable with interest, as,
indeed, a great deal of Marshall plan assistance was.
I have one other question before I finish.
·with regard to energy, does the administration clearly realize that,.
while the Senate-over my own negative vote-has deprived the President of the opportunity to at least have in his hands the export card,
he does have in his hand the quantity limitation on imports? Is the·


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:-administration cognizant of that, and is he taking this limitation with
'.him to Geneva?
Mr. CooPER. Yes; obviously, we tread on weak ground, given the
vote in the Senate recently. As I said before you came in, to Con:gressman Mitchell, the President does feel somewhat inhibited in
going to the summit in this area, but he does not feel crippled, or
totally empty of items.
We would prefer not at the summit to get into details of how exactly
things might be done, but he does not feel totally crippled at the
present time.
Senator JAVITS. May I make one more point? It is one thing to come
:abstractly and say, I will put on an import fee. However, it is another
ithing to have whatever is agreed on as part of a package in which we
,give and receive. This is what I am driving at: I think the Senate vote
would have been very different if it had been considered as part of a
,deal in which we gave and we received. Looking solely at the interests
,of my State on that question, I could easily have opposed the President
because New York would suffer from an import fee; however, I voted
the other way.
The broader relationship of the economic situation of my State,
·which is intimately linked with the economic situation of our country,
:made it decisive for me and Senator Moynihan to vote the way we did.
Mr. CooPER. I take much comfort from what you say.
Senator J AVITS. Thank you for being so accomrrrodating.
Representative MrrcHELL. Thank you for being with us. We appre,ciate it.
Our next witnesses are Mr. E. M. Bernstein, of the consulting firm
in Washington; Mr. John Norris, of Chase Econometrics; and Mr.
])avid Ranson, of the H. C. Wainwright Co.
Gentlemen, welcome. Thank you for being here. I don't know what
kind of time constraints you are under. Unless there is any particular
_problem, we will start with the witness on my left, Mr. Bernstein.
Is there any objection to that? Fine. We have a copy of your prepared statement which was just delivered to us and the entire state:ment will be included in the record. Perhaps in the interest of time, you
·would just summarize.
STATEMENT OF EDWARD M. BERNSTEIN, CONSULTANT,
WASHINGTON, D.C.

Mr. BERNSTEIN. Thank you.
I will summarize my prepared statement. There is no need to read it.
The deterioration of the international payments position of the
·united States during the past 2 years has held down output and
,employment; caused a sharp depreciation of the dollar; and aggravated inflation. If we look at the current account of the United States
in table 1 of my prepared statement, which summarizes the main items
from 1975 to 1978, you will see that the balance on our current account,
by the new definit10n, deteriorated from a surplus of $18.4 billion in
1975 to a deficit of $15.2 billion in 1977.
In the first quarter of 1978, the current account deficit, including
:retained earnings as part of our receipts, was running at an annual


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rate of $21 billion. If you take the peak of the payments position in the
fourth quarter of 1975, and compare that with the first quarter of 1978,
there is a deterioration of over $50 billion a year in the current account
position of the United States.
Nearly all of that-in fact, all of it-is in the trade deficit. It shifted
from a surplus of $9 billion in 1975 to a deficit of $31 billion in 1977.
In the first quarter of 1978, the trade deficit was running at an annual
rate of $45 billion.
To see what effect this has had on our output, you s,tart with this
simple formula: Take the gross national product, and subtract from
that net exports of goods and services. Yon see net exports of goods and
services under the title, "Balance goods and services" in table 1 of my
prepared statement.
Wben you have done that, the rest represents domestic demand. I:f
in tJhe United States, the GNP had increased as much as domestic
demand, then the GNP in 1977, for the year, would have been 2 percent higher in current dollars, and 1.2 percent higher in constant dollars, than it actuallv was.
If you compare 'the peak quarter to the last quarter, the difference
is 3.6 percent in current dollars, and 1.8 percent in constant dollars.
This is an indication of how significant the deterioration in our international payments posit,ion has been for the growth of our economy.
The behavior of our exchange rates does not always follow a rational
pattern. For example, in the first quarter of 1977, when we were moving to a new level of trade deficit, from $4 billion to $7 billion a year
a quarter, the dollar suddenly became very strong.
It became very strong, because in Europe people were afraid of the
political situation. It was said that Italy was on the verge of communism and tihat the French would be a:fter their election. And besides,
no country was able to recover from the recession except the United
States. And the London Economist said there is no substitute :for having assets in the United States.
The consequence was that just as the trade deficit was jumping, almost doubling, to an intolPrably higher level, the dollar appreciated
against the Swiss franc, tihe D-mark, and other currencies, but not
against the yen.
Since March 1977, the dollar has depreciated considerably. l\fost of
the depreciation occurred in the 6 months between the end of December 1977 and the end o:f March 1978.
In these two quarters, the average depreciation against tihe currencies of the Group of Ten, and Switzerland-these are the big 10 industrial countries-weighted by their exports, was 9.2 percent.
Of course, the decline against individual currencies was verv much
bigger, especi'ally against the yen, the Swiss franc, and the D-mark.
In :fact, the onlv reason it averaged onlv 9.2 percent was tihat the
dollar appreciated" relative to the Canadian· dollar.
All of this has an effect on inflation in the United States. If the
effect of inflation were merely through the hip-her prices of the imports
from these big industrial countries, it would not be of great consequence for the price index.
For one thing, the retail prices in the United States would not rise
as much as the appreciation of the yen and the D-mark. That is be-


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cause the price in dollars rises only in proportion to the yen and Dmark content o:f the goods sold.
That means that the raw materials, which are dollar goods, the
shipping, which is a dollar cost, the retailing in the United States,
these costs do not rise any more than our own inflation. That part o:f
the price does not rise with the depreciation o:f the dollar relative to
the D-mark and the yen.
But as our own manufacturers are hard pressed by import competition, they may take this as an opportune time to raise their prices to·
get back what they say is a reasonable profit margin. The prices o:f
raw materials and :foodstuffs are also affected by the depreciation of
the dollar. So we have a very considerable rise in prices directly, before any repercussions in the United States, as a consequence o:f the
depreciation o:f the dollar.
Finally, we have to recognize that in the United States, informally,
and in some cases :formally, there is a link between the behavior o:f
wages, and the behavior o:f the Consumer Price Index. So i:f in :fact we
now raise wages to offset the deterioration in the real income o:f workers as a consequence o:f depreciation o:f the dollars, then the impact on
our inflation is enormous.
I:f we could somehow improve our trade position, it would have a salutary effect on our economy in almost every respect. O:f course, everybody is troubled about our deficits. The Europeans and the Japanese
say it is all due to our excessive consumption o:f oil. ,v-e say it is due tothe :fact that they do not want to expand their economies. They say
that their surplus is the reward, a well-earned reward, :for a conservative inflation policy, and :for productive efficiency. They advise us to
:follow similar policies.
O:f course, all o:f these things do enter into the deterioration o:f the
U.S. trade balance. I do not want to underestimate the significance of
the big imports :from the oil countries, but I think we must not underestimate the signficance o:f the very large increase in our trade deficit
with the large industrial countries.
Table 2 o:f my prepared statement shows the trade o:f the United
States by countries and areas, :for the first quarter o:f 1976, the first
quarter 0£ 1977, and the first quarter 0£ 1978. In the first quarter of
1976, we had a very strong trade position. It shifted to a trade deficit
in the first quarter o:f 1977, and the deficit became almost intolerable
in the first quarter o:f 1978. You will notice in the last column the
change in billions o:f dollars in our trade position with various areas.
Between the first quarters o:f 1976 and 1977, you will notice that our
trade deficit rose. The whole o:f the increase was with the oil countries
and with the raw material producing countries. The trade balance
o:f the United States with Western Europe, with Canada and Japan,
was virtually the same at the beginning as at the end o:f the period.
Now look at the period to the first quarter o:f 1978. You will notice
that our trade deficit with OPEC declined by $1.1 billion. Our tradebalance with the other raw material producing countries improved
very slightly. On the other hand our trade balance deteriorated by
$2.3 billion with Western Europe, by a billion dollars with Canada,.
and by $2 billion with Japan.
As a matter o:f :fact, in the first quarter o:f 1978, our current account
deficit with Japan was about $3.4 billion and it was rapidly approach-


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ing our $3.5 billion current acr.,0unt deficit with OPEC. 'So the argument that our payments difficulties are all due to oil imports is not
correct.
I don't agree with our Government experts on why our trade balance with the industrial countries has deteriorated so much, so quickly.
But I do think they are right in emphasizing the proposition that in
the past year our real difficulties have arisen from our trade with
'\Vestern Europe and Japan.
As you know, the favorite argument is that this is due to the differential rate of expansion in the United States, and in WPstern
Europe and Japan. Between the United States, and ,Japan, the difference is not overwhelming; between the United States and Germany,
it is considerable.
We have had no increase in our exports to Western Europe and
,Tapan. You will notice that in :fact they are down by about 1 percent.
~hat is a comparison of exports in 1977 with exports in 1978, both in
first quarter. I think that could be said to a considerable extent to be
clue to the fact that their economies have lagged in the recovery. They
have high levels of unemployment by their own previous standards.
They have very low levels of investment by their own previous
standa,rds.
On the other hand, I don't see how you can explain an increase o:f
nbout 42 or 43 percent in our imports :from Western Europe and
Japan in the last :four quarters by saying that it is due to the fact that
output in the United States grew by 10 percent plus in current dollars.
The truth of the matter is that if you compare the increase of our imports of goods from Western Europe and Japan with the increase in the
goods output of the United States, the increase was six times as µTeat
in buying goods from them as in producing goods for ourselves. This
is in percentage terms.
I think you have to explain this big increase in our imports on a price
basis. Furthermore, the growth of ou'.r economy, and the growth o:f their
economy, ought to have only marginal effects on the increase of exports
to third countries, say in Latin America, in Asia, and Africa as comvared to ours.
Rut they have done twice as well as we, if not better, in these other
regions, some o:f them closely tied to the United States in currency
arrangements. This competition is between the United States on the
one hand, and Western Europe and Japan on the other, in markets
where neither should have ,any advantage except throuQ"h prices.
My own conclusion then is that the main explanation of our large
trade deficit is that we have lost price competitiveness. I don't have
very much hope that the Western European countries and J a nan
will do very much to speed the rate o:f growth, certainly not while they
have the big trade surplus with us.
Their trade surplus with us is. in effect. a substitute :for doing more
to increase domestic demand. Their output can increase with Jess inerease in domestic demand because there is a big increase in foreign
deman<l "\V'e, on the othPr hand. have had to take measures like the
tax ~duct~on ?I 1977, which, by the way, about matched the $18 billion
det1w:1or11hon m our trade balance, and another tax reduction pronosed
nt the beginning of the vear which wonld ha,ve matched the $22 billion
-deterioration in our trade balance in 1977. As long as we have big trade


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deficits, it will always seem that we cannot take adequate steps to reduce the budget deficit.
So here we have a group of countries that are, in fact, the ultimate
beneficiaries of our expansionary policies through their increased exports to the United States. I think the best way to get them to do
more in the way of domestic measures is to take away that generous
help they have been getting through the trade deficit of the United
States.
I do hope that more can be done on the behavior of exchange rates. I
will not go into the question of whether or not the behavior of
exchange rates has been rational. It has not been rational at all times.
It was rational from the first quarter of 1977 to the end of 1977. The
fall of the dollar may have been a bit too much in the first quarter
of 1978.
It is strange that the trade deficit of the United States got worse
in the fourth quarter of last year, and in the first quarter of this
year, at the very time when the dollar depreciated most against the
currencies of the countries with whom we compete, not only in this
country, but in all other markets.
I think in part this was due to the leads and lags in trade. That
is to say, in Germany and Japan, they were increasing their exports
to the United States, say, Volkswagens and Datsuns, not because
they were trying to avoid the effect of the depreciation of the dollar
on their J'leceipts in D-marks and yen. They wanted to get these goods
through U.S. customs and be valued at a higher exchange rate for
the dollar, so that if their prices do not rise as much as some people
expect, it would not look like dumping. The same thing was true of
imports. They reduced their imports from us compared with a year
earlier.
If the recent increase in the deficit is due to the leads and lags in
trade, then I would expect a considerable improvement later this
year. Some of the increased imports went into inventories. They will
be sold more slowly in the futnrc. That is why I think our imports of
manufactured goods will increase very little, if at all. On the other
side, I don't expect we will have a big increase in our exports to the
industrial countries. The truth of the matter is that these countries.
are far more reluctant to take imports from us than we are to take
imports from them.
You will find in my prepared statement a quotation from an interview with a Japanese-I think the Minister of Agriculture-published
in "Washington by the U.S.-Japan Trade Council He was asked about
the restrictions on imports of oranges from the United States. He
said, "Citrus fruitgrowers are terribly upset at the prospect that thev
will have to cut their own mikan trees while the Japanese market
will be flooded with foreign oranges."
It almost sounds like the president of the Iron and Steel Institute
explaining why we have to keep out Japanese steel, or the complaint
made by the television producers that they were being swamped with
color television sets from Japan.
I d_on't think _we will get a lar~e i~crease in exports. My hope is that
the big change m the trade deficit will come from virtually no o-rowth
in our imports, and perhaps even a decline for a few months. 0


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I want to wind up with the following observation: We are being
told everywhere that the United States is the prime mover in the world
economy, and that our policies, our trade and so forth, will set the
standards for the world.
I am perfectly willing for the United States to have as liberal a
trade policy as any country, provided the behavior of fluctuating
exchange rates is conducive toward restoring a proper pattern of
international payments.
But we must consider what we are going to do, if, £or example, the
growth of the United States slows and our trade balance does not get
better.
I don't think that the United States is going to be willing to absorb
this large trade deficit when output is growing at less than 3 percent,
though it was willing to absorb it when output was growing at above
5 percent.
To be frank, I don't believe that the argument £or free trade policies,
at least on the tariff side, has a sound economic foundation under present conditions. I am talking as a clasical free trade economist now.
In a world in which exchange rates can rise and fall by 15 or 20
percent, in the course of several months, then one thing is certain :
Either the dollar was overvalued at the beginning of the period or
undervalued at the end, and the yen and the D-mark were undervalued
at the beginning or overvalued at the end.
There is no basis for arguing that free trade gives the lfiaximum
gain from international trade when exchange rates fluctuate so much
in such a short time. When the dollar is undervalued we are giving a
bounty on exports and putting a penalty on imports. When the dollar
is overvalued, you are putting a tax on exports, and giving a bounty
on imports.
I don't think we can argue that free trade maximizes benefits under
those circumstances. In fact, I think a uniform tariff of about 10 percent would be much better. It would not do much harm to advantageous
trade, and it would help in avoiding some of the disruptions caused
by uneconomic trade.
Mind you, in my opinion, the Europeans and the Japanese owe us a
lot of unilateral reduction in trade barriers, not only on our agricultural products, which we keep hearing about, but even on our manufacturing goods.
The prepared statement of Mr. Bernstein follows:]
PREPARED STATEMENT OF EDWARD

M.

BERNSTEIN

The deterioration of the international payments position of the United States
-during the past two years has held down output and employment, caused a sharp
depreciation of the dollar, and aggravated the inflation. Between 1975 and 1977
the balance on current account shifted from a surplus of $;18.4 billion to a deficit of
$15.2 billion, and in the first quarter of 1978 the deficit was at an annual rate of
l27.8 billion. From the high in the fourth quarter of 1975 to the low in the first
"quarter of 1978, the balance on current account fell by nearly $50 billion a year.
These figures are based on the new presentation of the balance of payments in
which reinvested earnings of incorporated affiliates of U.'S. and foreign enterprises
are included in receipts and payments of investment income and in the outflow
~nd inflow of U.S. and foreign capital for direct investment.
The deterioration of the balance on current account was entirely due to the
shift in the trade balance from a surplus of $9.0 billion in 1975 to a deficit of $31.1
billion in 1977. In the first quarter of 1978, the trade deficit rose further to $11.2


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'billion-that is, at an annual rate of $44.8 billion. From the high in the second
• quarter of 1975 to the low in the first quarter of 1978, the trade balance fell at
an annual rate of over $52 billion. Receipts from other current transactions increased far more than payments. Nevertheless, the large and rapid change in the
balance on current account inevitably had widespread consequences for the U.S.
• economy and the international monetary system.
The enormous deficit on goods and services held down the growth of output and
• employment. If output had increased as much as domestic demand between 1975
and 1977, the GNP last year Would have been 2.0 per cent higher in current dollars
and 1.2 per cent higher in constant (1972) dollars than it actually was. Measured
from the peak in the second quarter of 1975 to the nadir in the first quarter of
1978, the fall in net exports of goods and services reduced the increase of the GNP
by 3.6 per cent in current dollars and by 1.8 per cent in constant (1972) dollars.
The surplus on goods and services in 1975 ($23.1 billion) was much too high to be
acceptable to the rest of the world. On the other hand, the deficit in 1977 ($10.5
billion) and even more in the first quarter of 1978 (at an annual rate of $22.8 billion) is a severe burden for the United •States and a major source of disorder in
· the international monetary system.
When the Bretton Woods system was abandoned in March 1973, it was hoped
that with floating exchange rates, balance of payments adjustment would be
. achieved automatically by small and gradual changes in exchange rates. In fact,
fluctuations in the dollar exchange rates for the currencies in the Group of Ten
and Switzerland have been very large and at times they have been accompanied
by massive shifts of funds from one financial center to another that have not been
different from the exchange crises under the system of fixed parities. Most
recently, in the six months from the end of September 1977 to the end of March
1978, the dollar depreciated by an average of 9.2 per cent against the currencies of
· the Group of Ten and Swizerland, weighted by their export trade in 1977. The
very sharp fall in the foreign exchange value of the dollar in the fourth quarter of
1977 and the first quarter of 1978 did not prevent the trade deficit from becoming
, much worse, atlhough its corrective effect may be merely delayed.
TABLE 1.-SUMMARY OF U.S. INTERNATIONAL TRANSACTIONS ON CURRENT ACCOUNT, 1975-78
[In millions of dollars, seasonally adjusted)

Balance
go~ds,
services

Unilateral
transfer

Balance
on
current
account

197,088 -98, 041
9,047 25,359 -12, 546 23,208 -22,008
23,060
114,694 -124, 047 -9, 343 29,244 -13, 311 27,336 -24, 555
9,361
120,585 -151, 644 -31, 059 32,100 -14, 393 30, 529 -27,690 -10, 514

-4, 615
-5, 022
-4, 708

-is: 221

Exports

1975 _________
1976 _________
1977 _________
1975:
l_ _________
2__________
3__________
4__________
1976:
l_ _________
2__________
3__________
4__________
, 1977:
.l_ _________
2__________
3__________
4__________
, 1978: J. _____

InvestInvestment
men! Other
Other
Trade income
income services services
balance recei pis payments receipts payments

Imports

18; 445
4 339

27,018
25,851
26, 562
27,657

-25, 561
-22, 566
-24, 483
-25, 431

l, 457
3,285
2,079
2,226

6, 112
6,003
6,360
6,884

-3, 237
-3, 143
-3, 212
-2, 973

5,605
5,563
5,822
6,219

-5, 577
-5, 316
-5, 371
-5, 727

4,360
6,392
5,678
6,629

-1, 193
-1, 112
-1, 070
-1, 241

3, 167
5,280
4,608
5,388

27,001
28,380
29,602
29, 711

-28, 352
-29, 963
-32, 418
-33, 314

-1, 351
-1, 583
-2, 816
-3, 603

7,027
7,369
7,428
7,420

-3, 405
-3, 332
-3, 293
-3, 281

6,347
6,700
7, 130
7, 160

-5,887
-5, 973
-6, 222
-6, 473

2, 731
3, 181
2,227
1,223

-1, 028
-1 040
-1, 908
-1, 047

1,703
2,141
319
176

29,477
30,638
31,013
29,457
30,664

-36, 495 -7, 018
-37, 259 -6, 621
-38, 263 -7, 250
-39, 627 -10, 170
-41, 865 -11, 201

7,796
8,088
8,220
7,997
9,432

-3, 197
-3, 601
-3, 610
-4, 185
-4, 665

7,478
7,559
7,902
7,592
8,041

-6, 681
-6, 852
-6, 852
-7, 105
-7, 306

-1, 623
-1, 427
-1, 591
-5, 870
-5, 700

-1, 126
-1, 243
-1, 277
-1,064
-1, 254

-2, 749
-2, 670
-2, 868
-6, 934
-6, 954

Pri_ces and exchange rates tend to adjust to each other. Usually this occurs
through changes in exchange rates in response to differential rates of inflation.
Thus, if prices and costs are rising by 7 percent a year in the United States and
by 2 percent in Germany, the dollar should depreciate on this account by about
5 percent a year relative to the D-mark. If other factors, however, result in a
· larger· depreciation of the dollar, U.S. prices will tend to rise further in response
· to the lower foreign exchange value of the dollar. Most directly, this will occur
'in the prices of goods imported from the countries whose currencies appreciated.
:.~ven then, the rise in the dollar prices of their exports to the United States will


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not be proportionate with the appreciation of their currencies. It will be held
down ·by the dollar content of these goods, including raw materials, shipping
costs, and marketing costs in'the United States.
In 1977, slightly less than half of U.S. imports were from the Group ot Ten
and Switzerland, and the import-weighted depreciation of the dollar in terms
of th~_ir currencies was 6.3 percent in the six months to March 1978. If this were
the sole price effect of the depreciation of the dollar, it would have added very
little t9 the recent rate of inflation. Unfortunately, the price effects are wider.
Price_s of U.S. manufactured goods held down by import competitio'n may be
raised when the dollar depreciates. In addition, a depreciation of the dollar relative to the currencies of the other industrial countries will raise the dollar
prices· of foodstuffs and raw materials, those which the United States exports
as well as those it imports. Finally, if wages are increased in response to the·
rise of consumer prices, the ultimatie effect of the depreciation would be to accelera_te the inflation without correcting the balance of payments.
The.members of the International Monetary Fund must face the fact that the·
adjustment process has not worked as intended. One reaso·n is that too much
reliance has been placed on the automatic corrective effect of floating exchange
rates. Neither the United States nor the surplus countries have followed policies
diretced to restoring a better pattern of payments. Everyone blames the United
States for failing to reduce its oil imports, and that is a substantial source of the·
trade deficit. The United States says that the large increase in the trade deficit
with the non-oil countries is primarily due to the failure of Japan, Germany
and otp.er surplus countries to expa'nd their economies at a more rapid rate.
As for their own surplus. these countries justify it as the well-earned reward·
for th~ir success in holding down costs and increasing productive efficiencyand they urge the United States to match them in this respect.
There is some merit in all of these arguments. although they do not explain
why the trade balance depreciated so much concomitantly with such a large
depreciation of the dollar. It may help to look at the changes in the regional
pattei:n, of the trade balance over the past two years. From the first quarter of
1976 (~ the first quarter of Hl77. the trade deficit increased from $1.4 billion to
$7 billion. The balance with Western Europe, Canada and Japan was unchanged,
with a surplus of about $600 million in both period,;. On the other hand, the
deficit with OPEC increased from $3.2 billion to $6 billion and the trade balance
with other countries-nearly all @"Oducers of basic commodities-shifted from
a surplus of $1.3 billion to a deficit of $1.6 billion. It is apparent that the increase
in the deficit over the year from the first quarter of 1976 to the first quarter of
1977 was entirely due to the very large increase of imports from OPEC (55.4 percent) and from the other countries producing basic commodities (34.1 percent).
TABLE 2.-U.S. TRADE BY COUNTRIES AND AREAS, 1ST QUARTER OF 1976, 1977, AND 1978
[In billions of dollars!
1976-1

1977-1

Export Import Balance

Export Import Balance

TotaL _____ 27.00
Western Europe ___
Canada. _________
Jaoan ____________
OPEC ____________
Others•----------

7.07
6. 44
2. ~o
2. 57
8. 63

Change to-

1978-1
Export Import Balance

1977-1

1978-1

28. 35 -1. 35

29. 48

36. 50 -7.02

30.66

41. 87

-11. 20 -5.67

-4.18

5. 53
1. 54
6.11
. 34
3. 56 -1.26
5. 79 -3.23
7.37
1. 26

8. 49
7.02
2. 71
3.03
8. 24

6. 42
2. 06
7. 21 -.19
3. 98 -1.27
9.00 -5.97
9. 88 -1.65

8. 54
6.96
2. 5~
3. 06
9. 58

8. 76
8.14
5. 84
7.97
11.20

-.22
. 53
-1.18 -.53
-3.31 -.01
-4.88 -2. 75
-1.62 -2.91

-2.28
-.98
-2.04
1.10
.03

Includes the seasonal adjustment discrepancy.

The ,;;ituation was quite different in •the past year. 'I'he trade deficit increased
further by $4.2 billion to $11.2 billion in the first quarter of 1978. The deficit
with OPEC was reduced by $1.1 billion as 'imports fell hy 11.9 percent. The
deficit with other countries, mainly the producer!': of basic commodities, was
virtually unchanged as U.S. e:x,ports increased slightly more than U.S. imports.
By contrast, the trade balance with Western Europe deteriorated by $2.3:
billion-from a surplus of $2.1 billion to a deficit of $200 million. The deficit
with Canada increased by $980 million while the deficit with Japan increased,


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.'$2 billion to $3.3 billion. U.S. imports from these industrial countries increased
by 28.5 percent and exports to them fell by 1 percent over this four-quarter
period.
The trade deficit with OPEC has fallen steadily from the peak in the second
quarter of 1977 as a result of the reduction of imports. Nevertheless, the deficit
is a cause of great instability in the exchange rates for the dollar. In 1977, the
U.S. current account deficit with OPEC was $16.9 billion. In addition, these
countries had an inflow of $1.2 billion of U.S. capital, all from direct investment
and bank credits. The total current account surplus of the oil exporting countries
·was about $34 billion. Thus, half of the increase of OPEC's net foreign assets
last year was derived from current transactions with the United States. As
members of OPIDO did not want to concentrate the assets they acquired last
year to this extent in dollar holdings in the United States, they transferred about
.$10.8 billion of their receipts from this country to other areas. This contributed
to the decline of the dollar in the exchange market in 1977.
The United States must reduce its oil imports. It is equally important, however, to reduce the trade deficit with the other large surplus countries. The view
that the trade surpluses of some of these industrial countries are due to the
lag in their recovery is exaggerated, in my opinion. 'That may be one reason
for the fall of 1.1 percent in U.S. exports to Western Europe and Japan between
the first quarter of 1977 and the first quarter of 1978. It cannot explain why
U.S. imports increased by 36.4 percent from Western Europe and by 46.7 percent from Japan in a period when U.S. output of goods increased by only 7.2
percent. Nor does it explain why the exports of Western Europe and Japan
to third markets increased so much more than U.S. exports to the same areas.
That must have been mainly due to their competitive advantage which had
not yet been corrected by the appreciation of their currencies relative to the
-dollar.
If it should be true that the very large deterioration in the U.S. trade balance
with Western Europe and Japan is due to high income elasticities and low price
-elasticities of demand for import goods, then the world economy is in serious
trouble. The United States will not halt the growth of output and employment
in order to reduce its trade deficit, nor will •the imrplus countries agree to undertake a much more rapid expansion of home demand if they believe that it will
exacerbate their inflation problem. And if it should prove to be true that the
depreciation of the dollar has little positive effect on the trade balance, then
the United States would have surrendered real income in the form of worse
terms of trade and would have added to the rise of domestic prices without
achieving a significant improvement in its international payments position.
In my opinion, the price elasticities for imports and exports are i,ufficiently
high to make floating exchange rates an effective instrument for balance of
payments adjustment. It would help, of course, if changes in exchange rates
were supplemented by measures to restrain the growth of domestic demand in
the deficit countries without intensifying unemployment and to stimulate dome~tic demand in the surplus countries without aggravating inflation. Unfortunately, the experience of the past year does not provide encouragement for
the view that floating exchange rates will of themselves in all circumstances
re,mlt in a marked change in the trade balance. It may be, however, that the
sudden increase of •the U.S. trade deficit in the latter part of 1977 and early
1978 was the result of a temporary increase of imports and decreases of exports
in anticipation of the depreciation of the dollar.
If so, the trade balance should improve substantially in the next few months,
not merely to offset the leads and lags of trade, but in response to the large
change in the dollar exchange rates for the yen and the Western European
-currencies. That is what I hope and think will happen.
Nevertheless, we must consider the possibility that the trade deficit will not
·improve much in the near future. The fact is that the exporters of some countries
rrgard the United States as the one place in which they can sell that part of
their output that cannot be 3Jbsorbed by the home market. In some instances,
this has been facil'itated by an exchange rate policy designed to maintain an
nndPrvalned currency. It may b'e that even with the depreciation of the dollar,
the United States will continue to be swamped by imports. This country has
been very tolerent of the enormous trade deficit. It is unlikely to continue to
.accept such a large trade deficit with the industrial countries when the growth
of output slows and the unemployment rate is no longer declining. In self. defense, it may decide to impose restrictions on the imports from some countries.


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There will be complaint that the United States is abandoning the liberal policy
under which world trade flourished in the postwar period. The fact is that other
countries have been restricting imports from the United States and justifying it
as necessary to protect their producers. The United States-Japan Trade Counc,il
recently published an interview with a high official of the Japanese Government
explaining the restriction on imports of oranges from the United States. "Citrus:
fruit growers," he said, "are terribly upset at the prospect that they will have to,
cut their own milkan trees while the Japanese market will be flooded with for-eign oranges." This sounds very much like the complaint of U.S. steel producers.
and television set manufacturers about Japan's exports to the United States.
The economic basis for a liberal trade policy cannot be the same with floating
exchange rates as with fixed parties properly related to a country's prices and·
costs. ,vhen the exchange rates for the currencies of the largest trading countries
rise or fall by 15 to 20 per cent in the course of a few months. then it would seem
that one of the currencies must have been undervalued and the other overvalued·
either at the beginning or the end of the period. ,vhen a currency is overvalued,
it results in an implicit tax on exports and an implicit bounty on imports; and
when it is undervalued it results in an implicit bounty on exports and an implicit tax on imports. Under such circumstances, international trade is not the·
result of comparative advantage. On the contrary, at some stage it must be uneconomic and disruptive. If exchange rates are to flutuate as much and as radidly
as they did in th!! past few months, far in excess of changes in relative prices
and costs, then a uniform tariff on 1mports of, say, 10 percent might in fact he
beneficial. It would not allow the gaias from international trade to be maximized.
but it would help to minimize the losses from the disruption and distortion of
production caused by uneconomic trade.

Representative MITCHELL. Thank you. I would like to suggest that we
hear all of the witnesses and then question. Mr. Norris, indeed we have
a copy of your prepared statement which will be included in its entirety for the record.
STATEMENT OF JOHN F. NORRIS, VICE PRESIDENT FOR INTERNATIONAL ECONOMICS, CHASE ECONOMETRIC ASSOCIATES, INC.,
BALA-CYNWYD, PA.

Mr. NORRIS. Thank you, Congressman Mitchell. I am pleased to be
here today to testify before the .Toint Economic Committee.
We are living in a highly interdependent world economy, and I believe hearings of this nature are very useful in giving Members of Congress a better understanding of the role of the U.S. economy in the
world marketplace.
Too often in the sixties and early seventies legislation was passed
here in the United States in which little or no analvsis was clone with
respect to its impact on the domestic economy. I thi.nk there have been
great improvements in policy planning on domestic issues in recent
years, and I believe we need to gain a better understanding of the impact of policy actions here in the United States on the world economy.
A lengthy prepared statement has been prepared and presented :for
the printed record, but time constraints prevent covering all of the
details in that. Hence, I would like to summarize my prepared statement with the following comments.
As Dick Cooper has pointed out, the world economy has not performed particularly well during the past several years, either from
~he point of view of real growth, unemployment, or inflation. Equally
important, the balance of payments adjustment process appears to
have broken down, as exchange rate changes have actually widened
rather tJhan narrowed the imbalance in trade between the United
States, Japan, and Germany.


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"While the U.S. economy rebounded handsomely :from the depths of
the 1974-75 recession, most major industrialized countries have con~
tinued to grow at a subpar rate that has fostered high levels of unemployment and social tensions. The lackluster growth outside the
United States is evidenced by real GNP for the seven European countries in the Chase Econometrics international model system increasing
by a compounded average of merely 1.4 percent since 1974, substantially below the 4.9 percent average in the 1965-73 period. The Japanese economy has fared better than the European economy, growing
by an average of 4.6 percent since 1974, but a minimum of one-fourth
of this increase is attributed to the surge in exports. The Canadian
economy grew much faster than the U.S. economy in the late 1960's
and early 1970's, lbut real GNP has risen by only 3.1 percent per annum
during the past 3 years.
This slow growth is the major factor for the continuing high levels
of unemployment in Japan, Canada, and the EEC which averaged 1.1,
0.9, and 5.8 million, respectively, during the first quarter of 1978, in
each c_ase well above the levels prevailing during the depth of the world
recess10n.
I might add that unemployment in Japan would be substantially
higher if the Japanese did away with the lifetime employment concept
which has kept between 1.5 and 2 million workers on payrolls in a nonproductive fashion. Similarly, European labor markets have been
buoyed up by the practice of sending guest workers back to their home
countries.
In contrast, U.S. unemployment foll :from a peak of 8.4 million to
a current level of 5.8 million. More importantly, employment gains
in the United States have been nothing short of phenomenal, rising
:from 84.4 million in the spring of 1975 to 94.8 million in the spring
of 1978. Job creation in the United States during the past several years
has been far greater than in the major industrialized countries outside
the United States where employment gains have been negative or
virtually nil.
Progress has been made in reducing inflation in the major trading
partners of the United States, although there is still a long way to go
before returning to the low inflation rate of the 1960's. Inflation on
a general worldwide basis hit a peak of 14 percent in 1974, before
:falling to 11 percent in 1975 and 9 percent in 1976 and 1977. The improvement in European inflation was less substantial, with the consumer price index for the seven major industrialized countries increasing at a peak rate of 14 percent in 1975 followed by 11- and 12percent increases in 1976 and 1977.
On the balance-of-payments :front, most major industrialized countries outside the Unite,d States have experienced improvements :from
the oil-induced deficits in late 1973 and 1974. However, enormous difl
ferences still exist in the trade accounts of the major industrialized
countries, with Japan and '\Vest Germany maintain'ing excessive surpluses and countries such as the United States incurring enormous
deficits. In addition, with the exception of Japan and '\Vest Germany,
the countries that have experienced improvements in their trade accounts have done so through reduced import demand rather t~an
higher exports. Lower import demand plus the spread of protection-


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296
ist measures have combined to cause a dramatic slow-down in growth
o:f world trade.
I:f we were to place the blame :for the dismal performance o:f the
world economy in recent years on one single :factor, it is the inability
o:f world fixed investment spending to become a significant :force in
the world recovery. Plant and equipment spending in the United
States is still 2 percent below 1973 peak levels, but this disappointing
statistic pales in comparison to Japan's plant and equipment spending
being also below peak levels. Similarly, investment spending in West
Germany is also lower, while Italy and the United Kingdom have exprrienced 11- and 5-percent declines :from previous peak levels. It
should be noted that these declines would be even more dramatic i:f we
exclude investment in labor saving devices. While many economists
decry the business environment here in the United States, the situation ·abroad is much more acute; corporate profits in most industrialized nations have been pared to the bone as a result o:f double-digit
inflation rates, confiscatory tax rates, burdensome wage costs that are
unable to be passed on in the form of higher prices, and unrealistic
exchange rates.
Unfortunately we do not foresee a major change in the underlying
condition o:f the world economy over the next several years. Faster
growth in the U.S. economy was once thought to be a sufficient condition for a healthy world economy. However, the experience of the past
2 years is unique in postwar history since the continued upturn in
the U.S. economy occurred in the absence of even average growth in
the rest of the world, particularly Western Europe. One important
factor behind this unusual nhenomenon is the record U.S. trade deficit
that benefited mainly OPEC and Japan and to a lesser extent Western Europe, while causing nearly unprecedented instability in foreign exchange markets and a decline in world business confidence.
!he U.S. economy jg currently approaching a cyclical peak, and
ne1thn a soft landing nor an outright recession augurs well for those
countries that shipped their excess supplies to the U.S. market.
In the absence of a buoyant U.S. economy, governments of other
major industrialized countries could he expected to take up the slack
in stimulating the world economy. Increased stimulus will be one
major topic on the agenda at the ·Bonn summit later this week, but
any move to reflate will be constrained by the :fear of reigniting
inflation, the tenuous state of trade accounts in most countries and
hig-h government deficits that limit the room to maneuver. As of todav,
all indications suggest that no maior breakthrough will be forthcoming in the debate over who should bear the burden of providing the
impetus for a return to faster growth in the world economy. The "locomotive theory" which the United States participated in, has been abandoned, only to be replaced by the "convoy approach" in which each
country will implement policies that add a certain percentage to previously determined growth rates.
However, the meager incremental increases now anticipated, a maximum 0.5 percent to 1 percent of GNP. will not change the course of
the world economy durin~ the remainder of this year, although they
should exert a positive influence in 1979.
Nonetheless, our :forecast for the world Pconomv suggests that the
rest of the world will provide more stimulus to U.S. export demand


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over the next 2 years, but a sustained period of above average growth
is not expected to occur. ·world GNP outside the United States is
projected to rise by 3.7 percent in 1978, the same as in the United
States, but at least this is an improvement compared to 1977 when
growth in the United States exceeded the rest of the world by 1.8
percent. The European economy is expected to experience its fifth
consecutive year of recessionary conditions in 1978 when real GNP
is expected to rise by a meager 2. 7 percent, only slightly better than
the 2.1 percent upturn in 1977. The fiscal stimulus anticipated to be
announced at the Bonn summit should cause European GNP to grow
at a faster, but below equilibrium rate of 3.6 percent in 1979, followed
by 3.5 percent increases in 1980 and 1981. The Japanese economy will
experience the highest growth among the major industrialized countries in the 1978-81 period, when real GNP is forecasted to rise by
5.4 percent. In contract to the past three years when exports led the
recovery, we expect the moderate 5.4 percent growth to be due mainly to continuing e"xpansionary fiscal policies and a slight improvement in the outlook for private domestic demand; however, the resulting growth in import demand and a delay in breaking down trade
barriers will not be sufficient to satisfy foreign critics, nor to return the
trade account to equilibrium. The key fixed investment sector has been
criticaJly wounded by the rapid ascent of the yen and the spread of
protectionist measures, and it is not until 1984 that private plant and
equipment spending exceeds 1973 peak levels.
The major constraint on growth in the world economy will be the
prrsistence of unacceptably high inflation. Most countries outside the
United States experienced improvements in inflation between the two
halvrs of 1977, but this was because of temporary factors such as the
decline in the dollar that helped to lower import prices. The deceleration in inflation is also attributed to a fall in world industrial raw
material prices associated with the slump in world output, the decline
in food prices caused by abundant harvests on a worldwide basis, and
reduced profit margins. With the exception of the recent backtracking
of the dollar, each of these factors has already been reversed or will
be reversed in the months ahead, which will compound the problem
of the sharply higher unit labor costs experienced in most industrializecl countries during the past 2 years. In fact, a number of countries.
including the United States, have experienced a return to doublecligit inflation levels, and no significant deceleration is anticipated for
the latter half of this year. As an indication of the distance to be
traveled be-fore the major industrialized countries return to acceptable
levels of inflation, we note that world and European inflation averaged
4 percent during the 1960's, a sustained period of above average real
growth. This year, world and European inflation will average 7.7
percent and 9 percent respectively, improvements only when compared
to the l0.7 percent and 12.3 percent averages -for the 1974 to 1977 period.
During the next 3 years, world and European inflation are forecast
to average 8.2 percent and 10.2 percent.
The persistence of high levels of unemplovment and slow growth
::ire two important factors for our forecast of no major improvement
in vrnrld trade patterns over the next several years. Special interest
gTonps are expected to thwart the concerted effort being made at the
GA TT talks to effect a significant liberalization of world trade. Also,
35-940-78-3


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298
the high levels of world unemployment will engender increased protectionist sentiment, a factor which could lead to a stalemate at the
GATT talks. This anticipated slowdown in world trade will be damaging for countries heavily dependent on export growth, which in turn
will contribute to lackluster growth in fixed investment spending.
Thus we are gloomily confident that world trade will not provide
the much needed stimulus to the world economy over the next several
years. Growth in world trade was slashed from 11 percent in 1976 to
6 percent in 1977 and a :further slowdown to 3 percent is anticipated
for this year, followed by only a moderate pickup to 3.8 percent in
1979 and an average of 4.3 percent in 1980 and 1981.
The imbalance in trade between Japan, Germany, and the United
States is likely to continue for the next several years, the only consolation being that the surpluses of Germany and ,Ta pan are not likely to
widen and the current account deficit of the United States is expected
to diminish by a modest amount. Other nations such as France, Italy.
and the United Kingdom are anticipated to experience a worsening
trend in their external accounts over the next several years, due mainly
to their overvalued exchange rates and consumption-led recoveries.
In summary, we are not very optimistic on the outlook for the world
economy, nor for the outlook for the U.S. trade account. I do not
agree with those who are advocating a significant import fee, either
on imported oil or on goods in general. If we do have a significant
drop in our imports in volume terms, we are certain to repeat the world
recession of 1974 when our imports plummeted, dragging down the
rest of the economies of the major industrinJized world.
I feel that we must continue with our liberalized trade policies, but
it is vital that the U.S. Congress implement trade legislation designed
to stimulate exports rather than reduce imports. Higher export growth
is the only way that we wi11 reduce our deficit without experiencing a
severe recession in the United States and the rest of the world.
I agree that the floating exchange rate system has not worked
effectively over the past several years, but there is no other feasible
alternative. The trade surpluses of Japan and Germany have risen
concomitant with an apprecintion of the ,Tapanese yen and the deutsch
mark, causing many to conclude that exchange rate changes have a
perverse effect on a country's trade account. Exchange rate changes do
work, but to be effective thev must be followed up with appropriate
monetary and fiscal policies. Without a concomitant increase in domestic demand a higher value for a currencv will not lead to a reduction in
a country's trade surplus. Similarly when a currency depreciates. a
country will not enjoy the expected benefits unless domestic demand
is reduced.
I would also like to comment on Richard Cooner's statement in the
sense that he has called for higher growth with foreign economies, or
has demonstrated that higher growth in the major trading partners
of the United States will not lead to higher inflation.
This defies the experience of the past several years, in which each
attempt to effect higher growth in ,Janan and ,:vestern Europe has
occurred concomitantly with higher inflation. This is because profit
margins have been pared to the bone, and any attempt to increase
domestic demand tightens supply/demand conditions, allowing producers to increase their profit margins.


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So these are the probable problems confronting the major leaders of
the world attending the Bonn summit. The world economy is growing
at an unacceptably slow pace and unemployment is very high. Yet
there are fears over higher inflation and growth in world trade is falling instead of rising. These problems are acute for export-orient~d
countries, a number of which have high or overvalued currencies making it very difficult to stimulate investment. High government deficits
are a serious problem in the industrialized world, particularly in
Germany, France, and most of the European countries. In the case of
Italy, the country is nearly bankrupt.
So we are not optimistic on the outlook for the world economy. Certainly some forceful leadership on the part of President Carter would
go a long way in returning stability in world financial markets, and
hopefully, that will be one of the outcomes of the Bonn summit.
This concludes my formal remarks. I am available to answer any
questions on my remarks or prepared statement.
Thank you.
[The prepared statement of Mr. Norris follows:]
PREPARED STATEMENT OF JOHN

F.

NORRIS

WORLD INFLATION OUTLOOK

One of the key coni:;traint:-; on growth in thf' world economy during- 19i7 was the
unacceptable high rate of inflation in the major indnstrial;zed countries. The
attempt to prevent either a further rise in inflation or bring about reduction in
existing high levels was an important determinant for the limited degree of fiscal
stimulus provided by most governments, and in tile casP of France, Italy and the
United Kingdom, restrictive fiscal and monetary policies were followed. However, a significant deceleration in world inflation occurred between the two halves
of 1977 that continued into the early months of 1978. As shown in Table A, the
most pronounced increases occurred in the United Kingdom where inflation was
more than halved from 19.0 to 9.5 percent, while Italy's inflation dropped from
19.1 percent to 11.1 percent. Significant declines also took place in Gemany, Belgium and the Netherlands and France. On an aggregate basis, the weighted average of consumer prices in the seven major European countries covered in our
system rose by an average of 13.3 percent in the first half of 1977 and 8.3 percent
in the second half of the year. Japan's retail price inflation also dropped considerably from 10.2 percent to 2.7· percent over the same period, while Canada's
improvement was less pronounced than in the rest of the major industrialized
countries with a decline from 9.5 percent to 8.8 percent.
TABLE A.-INFLATION COMPARISONS!

United States ______________________________________ _
Japan _____________________________________________ _
Canada ___________________________________________ _
United Kingdom ___________________________________ _
Germany __________________________________________ _
France____________________________________________ _
Italy ______________________________________________ _
Netherlands _______________________________________ _

g~~f
Mexico
~um____________________________________________
__~=========================================_
Brazi '---- _________________________________________ _
World
_________________ -- -- -- -- -- -- -- -- -- -- -- -- --_
Eu
rope'-____________________________________________
t Percent change, seasonally adjusted annual rate basis.
• 12 countries excluding Brazil.


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!st half
1977

2d half
1977

!st quarter
1978

2d quarter
1978

8. 6
10. 2
9. 5
19. 0
5. 9
10. 3
19.1
5. 8
7. 6
26. 3
29.1
48. 0
11.1
13. 4

4.8
2. 7
8. 8
9. 5
I. 5
8.3
11.1
4. 7
5. 4
28.3
17. 8
38.2
6. 3
8. 3

7. 9
0.1
8. 3
7.1
2. 2
7.4
11. 9

9. 5
7. 2
9. 7
9.0
4. 6
12. 5
14. 2
3.4
2. 6
18. 7
19. 2
32. 0
9.6
10. 0

1.7

4. 3
17. 7
20.3
34. l
6. 9
7. 5

300
The key question is whether these improvements are sustainable; if they are,
then the governments of the major trading partners of the United States would
be justified in increasing the amount of fiscal stimulus planned for their economies. In order to answer this question, it will be helpful to analyze the factors
that caused the lowering of inflation in the major foreign countries. We first
note that the sharp depreciation of the dollar against the Japanese yen and
European currencies led to a slower increase or absolute decline in import
prices; particularly in those countries highly dependent on imported raw materials from countries with dollar-based currencies. These figures are shown in
Table B. The permanency of this factor depends partly on the degree of wage
restraint; if wage gains were adjusted downward to the extent the decline in
inflation in the Japanese and European economies, then the improvement would
be of a longer lasting nature. Japanese labor unions appear to have exercised
a modicum of wage restraint following the slowdown in inflation in 1977 since
they accepted 6-7 percent increases in nominal wages during the 1978 spring
labor offensive. This is not the case in the European economies where the
rigidity of downward adjustments in wage gains resulted in only marginally
lower wage gains last year. In fact the continuing upward trend in European
wages coupled with the slower growth in output and the stickiness in labor
markets caused a sharp turnaround in European unit labor costs between 1976
and 1977, as shown in Table C. Thus once the U.S. dollar begins to appreciate,
or at least return to levels reached in May, the underlying cost pressures will
cause an acceleration in European inflation since the lower imported inflation
will not longer exert ·downward pressure on European prices.
TABLE B.-PRICE OF IMPORTS
(Percent change at annual rates!
1st half 1977

2d half 1977

!st half 1978

United States., ____________________________________ ---- __ ---------United Kingdom _________________________________________________ _
Germany ________________________________________________________ _
Franee _______________________________ -- -- -- __________ -- __ -- _____ _
Belgium ________________________________________________________ _

11. 8
11. 6
4. 5

___________
-- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --_
Italy
Netherlands
_____________________________________________________
Japan ___________________________________________________________ _
Canada __________________________ -- __ -- -- __ -- __ -- __ -- -- __ -- -- -- __
Spain __________________________________ ---- _____________________ _

19. 6
7.6
-1.3
21. 0
22. 9
19. 5
48. 4

I. 9
I. 4
-4.7
0
-7.9
2.3
-3.6

10. 3
6. 2
-I.I
10. 4
I. 3
18. 7

Mexico __________________________________________________________ _

Brazil ______________________ -- ---- -- __ -- -- -- -- ______ -- -- -- ---- - •--

9.8

3.3

-5.9

13. 0
47. 9
0
31. 4

.5

-24.0
16. 9
19.3
11.4

34.4

TABLE C.-UNIT LABOR COST COMPARISONS
(Percent change from previous periods)

United States __________________________________________________________________ _
United Kingdom _______________________________________________________________ _
Germany ______________________________________________________________________ _
Franee ________________________________________________________________________ _
Italy __________________________________________________________________________ _
Belgium •• _. _______ •• __ •• ·--·---·--·· __________ ··-- •• __ •• __ ·-·----- ____ •• _____ _
Netherlands
.. ·-·---··--···-···-···-·····-···----·---·------·-···------··-----·-_
Japan
_________________________________________________________________________
Canada •• __________________________________ ·- _________________________________ _

1976

1977

2.3

6. 8
9.8

13. 0

-3.7
3. 9
7. 7
2.4
-3.3
-.3
9.8

3. 3
12. 2
26. 7
9.1
4. 6
4.6

5.8

The second factor that contributed to lower inflation in Japan and Europe in
the second half of 1977 was the downturn in world industrial raw material and
food prices. The decline in industrial raw material prices was closely correlated
with the slump in the Japanese and European economies in the middle of 1977
and the slowdown in the U.S. economy which led to reduced demand for industrial raw materials at a time of over-supply. The decline in •agricultural prices
between the late spring and autumn of 1977 was directly related to the abundant
harvests in the major producing countries.


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Thi:,;d, Japanese and European inflation was held down by producers accepting
lower profit margins as higher wage costs were unable to be passed along to
the retail level due to depressed levels of output and final demand.
TABLE D.-WORLD AND EUROPEAN CONSUMER PRICES

Europe

World

1978:

L---------------------------------------------

32___
______________________
_
- ---- -- -- -- -- -- -- -- -- -- -- ---- -- -- -- -- -- -- --

4___ - -- -- -- -- -- -- -- -- ------ -- -- -- -- -- -- -- -- -- -1979:

L _____ -- ------ -- ---- ------ -- -- -- -- ---- -- -- -- --

2___ --- -- -- -- -- -- -- -- -- -- ---- -- -- -- -- -- -- -- -- --

3______ -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --

4___ - -- -- -- -- -- -- -- -- ---- -- ---- -- -- ---- -- -- -- -1980 · 1__ -- ---------------------------------- -----1978________ · -- ---- ---------------------------- ---1979___ -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -Ufil ______________________
_
1980
--- -- ---------------------------------- -- ----

1963=100

Percent over
previous
period 1

1963=100

238. 7
244.2
249.1
254.2

6.9
9.6
8.2
8.5

266.0
272.4
279.1
286. 7

259.8
265.3
270. 7
276. 0
281. 6
246.6
267. 9
289. 9
312. 6

9.0
8.8
8.3
8.2
8.3
7. 7
8. 7
8.2
7.8

294.6
302.3
309.8
317. 7
326.1
276. 0
306.1
337.6
369.6

Percent over
previous
period 1

7.5

10.0
10.2

11.5
11.4
10.8
10.4
10.6
11.0
9.0
10. 9
10. 3
9.5

• Seasonally adjusted at annual rates.

All three of these factors will be reversed in the months ahead or have already
been reversed, which has contributed to higher inflation in most foreign economies. Import prices in the Western European economies have begun to turn
upward due to the rally in the dollar in April and May, although some backtracking has occurred in the past several weeks. Even if the dollar fails to
rebound, it is unlikely that the late 1977 and early 1978 rate of depreciation of
the dollar will be repeated. The major exception is the Japanese yen, which has
continued its rapid ascent against the dollar, and a further decline in Japanese
import prices is inevitable. Industrial raw material prices have also rebounded
by a modest amount during the past several months following the improvement
in demand conditions in Japan and Europe and the rebound in the United States.
In addition, there has been a pronounced turnaround in world retail food prices
in recent months, partly reflecting the increased foreign grain utilization and a
reduction in grain stocks in non-U.S. agricultural producing countries. A number
of countries have also devalued their "green currencies," the exchange rates for
agricultural trade within the EEC, and this has raised the level of retail food
prices in recent months. In the case of the United States and Canada, retail food
prices have risen dramatically in recent months due to below equilibrium l1evels
of beef supplies, unusual weather patterns on the ·west Coast that reduced the
supply of fruits and vegetables, and higher grain prices arising primarily from
the U.S. government's attempt to restore agricultural incomes. Profit margins in
most foreign countries will probably be raised slightly concomitantly with the
improved demand conditions.
In summary, we do not think the improvements in inflation experienced in the
major industrialized countries during the second half of 1977 are sustainable.
In fact, there has been a distinct acceleration in world inflation during the first
six months of this year. 'l'his is evidenced by the Chase Econometrics eleven
country index of consumer prices which accelerated from a 5.4-percent increase
in the fourth quarter of 1977 to 6.9 percent in the first quarter of this year and
an estimated 9.6 percent in the second quarter. European inflation, as measured
by the Chase Econometrics seven-country index, followed a similar trend, rising
from 6.6 percent in the fourth quarter to 7.5 percent and 10 percent during the
first two quarters of this year. In addition Jo the factors mentioned above,
European inflation has been adversely affected hy hikes in public sector charges
in an attempt to generate additional revenues and reduce subsidies in an attempt
to lower unacceptably large government deficits.
Our outlook for world and European inflation is not very optimistic, and we
do not think that the significant deceleration experienced during the second half
of i-977 will be repeated during the second half of this year. The Chase Econ-


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302
ometrics world. index is projected to taper off slightly to an average increase of
8.4 percent in the second half of this year, due largely to a slowdown in inflation
in the United States, Japan and Canada. The slowdown in inflation in the United
States and Japan primarily reflects the abatement of the recent sharp rise in
retail food prices, which is corroborated by the decline in U.S. farm prices during
the month of June. In contrast, European inflation is forecasted to continue on
an upward trend in the latter half of this year, reaching an average of 10.9 percent. This reflects the absence of further decline in import prices now that the
dollar appears to have stabilized, a slight improvement in supply /demand conditions, a quickening pace of wage gains and increases in public sector charges.
However, the continued rise in European inflation is not uniform since it is
concentrated in the United Kingdom, Italy and Spain, and to a lesser extent in
Belgium and the Netherlands. French inflation, on the other hand, is expected to
taper off slightly from current high levels, while Germany's inflation will continue at the 3-3.5-r,ercent level. less than one-third the increase in the United
Kingdom and one-fifth the increase in Italy. The wide difference in inflation
rates between Germany, France, the United Kingdom, and Italy points out the
difficulty the European governments will have in widening the present EEC snake
by bringing in weaker currencies such as the French franc, the lira, and the
pound sterling.
In spite of the acceleration on a quarter-to-quarter basis, the world and European indices will be up by 7.7 percent and 9.0 percent in 1978, the lowest increase
since prior to the Arab oil embargo. However, world inflation will continue at an
unacceptably high rate of 8.5-9.0 percpnt throughout 1979 followed by a slight
deceleration to 8 percent in the 1980-81 period. This unwelcome trend will be
influenced by moderate increasPs in OPEC prices beginning in early 1979 in
addition to continuing upward pressure on world food and industrial raw material prices. European inflation is also forecastPd to remain at the relatively high
yate of 10.5-11 percPnt in 1979, followed by 10.3 percent and 9.5 percent increases
111 the 1980-81 period.
WORLD TRADE CONSIDERATIONS

A separate section in this report is devoted to the outlook for the U.S. current
account balance, ancl in the following we present only recent and projected trends
for the trade sector of major forPign industrialized economies. Similar to the
corn>traints placed on governments by the high rate of inflation in early 1977, the
relnctirnce to opt for higher growth was related to the desire to reduce sizable
trade deficits that existed in a number of key European countries. This was
most evident in the United Kingclom and Italy and to a lesser extent France
where governments took restrictive measures to reduce their trade. deficits which
met with significant succpss. As shown in Tahle E, the U.K. trade balance reverted from a deficit of $8.5 billion (FOB-CIF) in the first half of 1977 to $4.3
billion in the second half of the year. while the Italian trade deficit was lowered
from $4.1 to $0.3 hillion. A less significant improvement occurred in the French
trade account as the deficit WHS reduced from $6.3 to $4.4 hillion. Some of the
sma Her countries covered by Chase Econometrics, such as Mexico and Brazil,
were also successful in achieving improvements in their trade accounts.
TABLE E.-TRADE BALANCE (BILLIONS OF U.S. DOLLARS)

United States ______________________________________ _
Japan _____________________________________________ _
Canada ___________________________________________ _
United Kingdom ___________________________________ _
Germany. _________________________________________ _
France .. __________________________________________ _
~!lherlands _______________________________________ _
Beleium _____________________ -------------- _______ _
Soain .. ___________________________________________ _
Mexico. __________________ -- -- -- -- -- -- -- -- -- -- -- -- -Brazil. ____________________________________________ _
1

1st half
1977

2d half
1977

ls! quarter
1978

2d quarter
1978

-28. 7
8.6
.7
-8.5
17. 5
-6.3
-4.1
-4.2
-3.2
-7.4

-34.3
10. 3
I. 8
-4.3
15. 5
-4.4
-.3
-1.4
-2.4
-7.8
-1.5
-1.9

-44.8
21. 0
3.6
-5.6
18. 2
-4.4
-.3
-2.4
-2.6
-6.0
-1.0
-1.1

-~8.6
15. 4
.5
-7.4
17. 3
-4.2

-.5
-.1

Current prices. All are FOB-CIF except United States. Seasonally adjusted at annual rates.


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-1.1

-2.7
-1.4
-6.1
-1.2
-2.0

303
However, the improvements mentioned above were not without negative side
effects since they were achieved primarily through lower imports caused by
restrictive fiscal and monetary policies rather than increased exports. The
significant slowdown or decline in import demand in the United Kingdom, Italy
and France had a depressing effect on output and employment in other Eluropean
economies and the combined multiplier effects of lower growth in exports and
industrial output played an important role in the lackluster performance of
the European economy in 1977 which helps to explain the poor performance in
U.S. exports to Europe in 1977. The lack of a pickup in import demand in Europe,
a flat trend in Japanese imports and the spread of protectionist measures were
responsible for a sharp slowdown in world trade from an 11 percent increase in
1976 to 6.0 percent in 1977.
We do not think the favorable trends in the trade accounts for the United Kingdom, France and Italy will continue as industrial production in each of these
countries has rebounded in recent months and inventories are being replenished,
allJeit at a moderate pace. This should lead to a faster growth in import demand,
although the growth will stem mainly from increased demand for industrial raw
materials rather than manufactured goods. Nor do we expect an improvement
in export growth in these countries. since the underlying trend in inflation is
substantially higher than in the rest of Europe and their currencies are currently
overvalued by a substantial margin.
The more disturbing aspect of trade developments in 1977 was the inability
of exchange rate charges to have the desired effect of reducing the excessive
trade surplus of Germany and Japan. The German trade account balance fell
slightly from $17.5 billion in the first half of 1977 to $15.5 billion in the second
half of this year, but this was followed by an estimated $17.8 billion in the
first half of this year. This trade data may suggest that the elasticity pessimists
are winning out in the debate on the efficiency of the impact of the higher value
for the DM on Germany's foreign trade. However, a closer look at constant
price foreign trade data gives a somewhat different picture. Germany's export
volume rose 5.2 percent in 1977, slightly below the 6.0 percent rise in world trade,
implying that Germany's share of world trade decreased slightly last year.
Equally important, German import demand increased 5.2 percent compared to the
meager 2.6 percent upturn in domestic demand, which indicates that foreign
producers made significant inroads into the German market. Our latest analysis
of Germany's trade statistics show that export volume for the first six months
of this year was unchanged from the latter half of 1977, surely an indication
that the higher value for the DM is beginning to take effect. However, the depressed level of business activity during early 1978 caused a flattening out
of import volume.
Yet a further explanation is needed for the persistence of the sizable trade
surplus when measured in nominal U.S. dollars. First, approximately one-half
of German exports are capital goods that have a low price elasticity. Thus the
appreciation of the DM probably has had only a marginal impact on capital
goods exports during the past twelve months, and export volume only held steady
instead of declining during the first half of this year. This does not imply
that the DM can continue to rise indefinitely, since there is some point at which
the non-price factors will become secondary to price considerations. Second, the
time lag between changes in price competitiveness and exports is substantial
and may be as long as two years in the case of capital goods. Third, most German exports are priced in Deutschemarks, while most imports are priced in
foreign currencies. This causes a higher trade surplus in U.S. dollars when the
D:.\I appreciates against the U.S. currency. Fourth, the 11-percent trade-weighted
appreciation of the DM since early 1977 may appear excessive; yet when the
higher inflatioIJ in most European countries is taken into account, Germany has
maintained or improved its price competitiveness despite the higher value for the
D::\I. This is not true in the case of the rise in the DM versus the U.S. dollar
which has exceeded all measures of relative price competitiveness. However, a
strong case for a significant appreciation of the DM relative to the dollar can
he made from the bilateral trade between Germany and the United States that
ishows Germany':;: export volume shot up by 13.8 percent in 1977, while U.S. export volume fell by 6.2 percent.
In summary, there is little doubt that Germany's foreign trade when measured
in constant prices has been affected by the higher value for the DM, although
the impact on export volume has been less than expected. The continuing high
level of export volume plus the improvement in the terms of tra,de largely explain the further rise in Germany's trade surplus during the past twelve months.


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304
PRICE COl'PETITIUENESS - CERIWff
DOLLAR BASED E<PCRT PRICES

13"---------~-------- ---,

110

1.-

.A

100

1577.3

1 g?◄

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uns

GERr!~ PRICE OF EXPORTS 'T"O U.S.
GERMAN PRICE OF EXPORTS TO UORLD
GERMAN PRICE OF EXPORTS 'TO EUFaOPE

No significant change in the pattern of foreign trade is anticipated over the
next 12-18 months. Germany's exports are expected to rise at a moderate pace
during the latter three quarters of this year due mainly to the return to slightly
faster growth in Germany's major trading partners, particularly France, the
United Kingdom and Italy. However, export volume is projected to rise by only
3.4 percent on a yearly average basis, compared to the government's projection
of 6--7 percent. Import demand will also continue on a steady upward trend, rising
by 5.1 percent on a yearly average basis due to moderate growth in domestic
demand. This results in no substantial change in the trade balance in current
prices which is projected to reach $17.1 billion in 1978 on a yearly basis, or $0.6
billion higher than in 1977. Yet the $17.1 billion surplus entails a decline on a
quarter-to-quarter basis from the high $18.2 billion surplus achieved in the first
quarter.
The inability of exchange rate changes to have the desired effect of reducing
Germany's excessive trade surplus is even more pronounced in the case of
Japan. The Japanese yen appreciated from an average of 293.5 yen in 1976.4 to
237.6 yen in 1978.1 followed by a further rise to 221.0 yen in the second quarter and
to a current level of 202.0 yen. Yet ,Japan's trade balance rose from $2.6 billion (FOB-CIF) in 1976.4 to $12.9 billion in 1977.4 and a record $21.0 billion in
1978.1. Tentative statistics for the recent quarter show a slight decline to $15.4
billion.


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305
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C

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306
A number of factors help to explain 'the recent trends in Japan's trade ac•Count. First, in spite of the 31 percent appreciation of the yen, Japanese goods
are still highly competitive in world markets. As •shown in the accompanying
graph, the ratio of Japan's export prices to export prices in the major industrialized countries has risen substantially since early 1977, •but it is s1till well
below the average for 1973-74 when Japan's current account balance was in
•equilibrium. Japan's export prices relative to European export prices actually
declined from late 1976 through early 1978, although they increased during the
second quarter and a further advance is anticipated for the remainder of this
year. It should be noted that the comparison of export prices is the least favorable for Japan since other countries have held down their export prices at a
time when domestic inflation was much higher. Thus if we compare Japan's
export prices to consumer prices in the United l:ltates or ·western Europe, Japan's
price competitiveness would be even greater.
The partial adjustment of Japane,se export prices to the higher value of the
yen is partly explained by the sharp 17 percent drop in import prices 'between
December 1976 and April 1978. Since raw materials account for approximately
half of production costs in major industries, particularly those reiying on exports. the fall in import prices has more than offset the rise in unit labor costs,
and this expl'ains the 1.5 percent decline in wholesale prices over the same period .
.Another factor explaining the partial adjustment of export prices to the higher
Yalue for the yen is the Japanese custom of maximizing market share as opposed
to the traditiona'l U.S. corporate goal of maximizing profits. Thus Japanese
producers have accepted lower profit margins rather than relenquish their
market share.
The second major factor explaining Japan's continuing large trade surplus
i,, related to supply conditions. Japan still has a significant amount of excess
capacity in key industries such as autos, iron nnd steel, electronics and chemi·Cals, foHowing the investment boom in the early 1970's. In addition, most companies in Japan still hold to the lifetime employment concept that has resulted
in excess levels of employment. Thus industrial production has continued at
levels that far exceed domestic demand, causing producers to export their excess
capacity.
The obvious answer to the excess supply situation in Japan is a sh·arp turn,around in domestic demand. The Japanese government attempted to stimulate
the economy during the past two quarters throug-h expansionary fiscal and monetary policies. However, the increased government spending has been insufficient
to offset the deflationary effect of the .higher value for the yen. Thus, although
,domestic demand has risen at a moderate pace during the past two years, the
growth has not been high enough to deplete inventories rto levels that would cause
a marked upturn in import demand. The low levels of capacity utilization will
probably prevent an investment boom from occurring, a necessary condition for
a return to above average g-rowth in output and employment. Furthermore, a
•consumption ·boom can lbe safely ruled out since real disposalble income will rise
by only 4 percent this year and l•abor markets are expected to remain depressed.
However, this does not imply that Japan's trade surplus wiil continue to grow.
In fact, as noted above the trade surplus is estimated to have declined from
$21.0 billion in the first quarter to an estimated $15.4 billion in the second quarter. Nominal e:,qtorts continued to increase, but this is because of the higher
·value for the yen; export volume declined at an estimated annnal rarte of 18
percent during the second quarter. Moreover, in contrast to the 'low price
elasticity of German f'xports, Japan's exports are much more price elastic since
a significant portion is composed of consumer durables. Slower growth in the
U.S. economy durin,g the latter half of this year plus orderly marketing agreemPnts with the United States and Western Europe will 1also put 'a dnmper on
growth in .Tapanese exports. On the import side, the price comp,etitivenes,; of'
·foreiim goods in the Japanese m:irket has increaserl subi,;'rantially during the
pnst ve:ir and one half due to the rise in the yen and lower import nuties. Thns
increased price competitiveness coupled with a slight pickup in plant and eaui,pmPnt soending and cornmmrition ex'J)f'nditures and continued high rates of incrf'a se in government suendim? should lead to increased import demand during
the second half of this year. This should cause a lower trade surplus on a quarter-to-quarter hasis for the remainder of this year, but on a :vearly basis Japan's
·trade surplus will increase by $6--7 bi'llion compared to 1977.
On a broader basis, the slowdown in world tralte that occurred in 1977 is
-expected to persist over the next seyeral years. A successful conclusion of the
·GA.TT talks is a necessary condition for a return to high growth in world trade.


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307
Yet the GATT talks have repeatedly stalled due partly to the inability of U.S.
representatives to obtain easier access for U.S. agricultural goods to the Japanese
and European markets. Some progress on reducing tariff and non-tariff barriers
on agricultural exports to the EEC and Japan is likely to occur, however no
major breakthrough is anticipated. In addition, the lowering of traiffs that will
-eventually emerge from the GATT talks will take place over a long period of time,
and the safeguards built into the anticipated trade agreement will still make it
possible for weak industries such as iron and steel and textiles to limit the free
flow of goods across borders. Another sensitive area is the practice of governments providing subsidies to faltering or nationalized industries, which is another
form of a non-tariff barrier. This occurs most commonly in France, the United
Kingdom and Japan and we are doubtful that Germany and the United States
will be able to convince other countries to curb this practice.
In the absence of a major breakthrough in trade liberalization, faster growth
iri world trade will have to come from a return to high growth and a reduction in
unemployment in the major industrialized economies. However, as we describe
in the next section, the prospects are dim for a return to higher growth and lower
unemployment at Ieast for the rest of this decade and into the early 1980's. Thus
we are gloomily confident that world trade will not provide the much-needed
stimulus to the world economy over the next several years. Total export volume
in the twelve major industrialized countries in the Chase Internii-tional Model
system is expected to rise by only 3 percent in 1978, followed by slightly higher
increases of 3.8 percent, 4.1 percent and 4.5 percent in the 1979-81 period.
WORLD ECONOMIC OUTLOOK

One of the key determinants of the deterioration in the U.S. trade account in
1977 was the substantially higher rate of real growth in the United States compared to the rest of the world. As shown in Table F, U.S. real GNP increased
hy 4.9 percent in 1977 on a yearly average basis, more than double the 2.1 percent
for the seven major European economies-United Kingdom, Germany, France,
Italy, Belgium, the Netherlands and Spain-covered in our work. Real GNP in
Europe plus Japan, Canada, Mexico and Brazil increased at a slightly higher
rate, 3.0 percent, but this was still substantially below the U.S. experience. Japan
was the only country to have a higher growth rate than the United States, but at
least one-third of the 6.1 percent rise in real GNP is attributed to the 11 percent
gain in export of goods and services. Imports of goods and services were up by
only 2 percent, implying that Japan made virtually no contribution to the world
recovery last year, and its high export growth exacerbated recessionary condi•
tions in the rest of the world. In contrast, Germany's imports of goods and services were up by 4.5 percent, substantially ~igher than the 2.8 percent rise in
real GXP.
Thus if the U.S. trade and current account balance is to improve this year and
beyond, the rest of the major industrialized countries will have to grow at a
much faster pace than they did in 1977 in order to reverse the gap between growth
in the United States and the rest of the world. There are tentative signs that economic activity in Western Europe and .Japan improved in the first quarter, but
the evidence is far from conclusive that economic activity in these areas of the
world is on the verge of a sustained upturn.
TABLE F.-GROSS NATIONAL PRODUCT-CONSTANT 1972 PRICE
[Percent change from previous year]

United Kingdom ___________________ _
Germany __________________________ _
Franee ____________________________ _
Belgium __________________________ _
Italy _____________________________ _
Netherlands _______________________ _
Spain
---------------------------_
Mexico_____________________________
Brazil_ ___________________________ _
Japan ____________________________ _
Canada ___________________________ _
United States _____________________ _
West Europe ______________________ _
World less United States ____________ _
World ___________________ - - ----- ---


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1976

1977

1978

1979

1980

1981

3. 3
4. 9
5. 2
5. 5
5. 7
4. 3
1.8
2.0
8. 8
6. 0
4. 9
6. 0
4. 6
5. 1

0. 3
2. 7
2. 9

2.1
2. 5
3. 8
2. 4
2. 9
2. 5
3. 8
5. 9
4. 9
6. 1
3. 5
3. 7
2. 7
3. 7
3. 7

2.4
3. 8
4. 2
2. 7
3.3
3. 0
2. 8
7.1
7. 8
5.6
3. 8
2. 8
3. 6
4. 4
3. 7

3. 2
3. 9
3. 8
3. 4
2.6
3. 8
2.6
6.0
7. 8
4. 7
4.1
3. 1
3. 5
4. 1
3. 7

3.0
3. 6
3. 8
3.4
3.4
3. 2

5. 5

1.7

1. 7
2. 6
1.8
2. 8
4. 8
5. 2
3. 4
4. 9
2.1
3. 1
3. 9

3. 4

6. 9
5. 7
5. 1
4. 4

3. 5
3. 5
4.2
3. 9

308
TABLE G.-WORLD AND EUROPEAN INDUSTRIAL PRODUCTION
Europe

World
1963 =100
1978.1. ••••••••••• •••••
1978.2 ••••.••...•••.•••
1978.3 .....•....•••.•••
1978.4 •.....•..••••.•••
1979.1. ••..••...•••.•••
1979.2 .•....•.....•..••
1979.3 .••.......•••••••
1979.4 •••.......•••••••
1980.1. •••...•....••..•
1978..•.•..•.•........•
1979......••..•.....•..
1980..... ······- ·-. ·--1981_ __ . ·- ···--· -··. -·-

204. l
208.2
210. 2
211. 6
212. 9
215. 6
217. 8
219. 9
222. 2
208. 5
216. 5
225.4
235. 9

Percent over
previous
period

4. 7
8.4
3.9
2.8
2. 5
5. l
4. l

4. 0
4.3
4. 3
3. 8
4. l
4. 7

1963=100 I
228. l
231. 4
233. 7
236. l
238.6
241. 7
244. 4
247.4
250. l
232. 3
243.0
253. 7
265.8

Pei cent over
previous
period•

7. 3
5.8
4.2
4.1
4.4
5. l

4. 7
4.9
4. 5
4. l

4.6
4. 4
4. 8

1963=100
182. 6
185. 2
187. l
188.8
190. 4
192.2
194. l
195. 8
197. 8
185. 9
193. l
200.6
208.4

Percent over
previous
perilld 1

5.4
5.9
4.3

3.7
3.3
4.0
3.9

3.7
4.0
2. 7
3.9
3.9
3.9

• Excluding the United States.
• Seasonally adjusted at annual rates.
WESTERN EUROPE

We first consider the European economy, where the available data in industrial output show a turnaround in the first two quarters of the year compared
to the fourth quarter. For example, the Chase Econometrics seven-country index
of European industrial output increased by 5.4 percent in the first quarter compared to the 2.1 percent average decline in the latter three quarters of 1977.
A further 5.9 percent rise is estimated to have occurred in the second quarter.
This turnaround is partly explained by the rebuilding of invellltories that were
depleted in the middle two quarters of 1977. In addition, the slowing of inflation
and leveling off of unemployment has led to an improvement in consumer senti•
ment in most countries. More expansionary fiscal policies and the generally
easier credit conditions also played a role in the improvement in European
economic activity in early 1978. The major laggard is investment spending,
which has yet to evidence any vigor in any of the European countries. The disappointing aspect of the uptum in European output during the first half of this
year is that it was centered on the United Kingdom, France, and Italy. The
Germany economy was depressed in the first quarter due to abnormally cold
weather and labor disputes, but available information for the second quarter
shows that the economy has barely made up the ground lost in the first quarter.
Since Europe has yet to experience a sustained recovery without Germany either
leading the way or expanding simultaneously with the other European countries,
we are forced to treat with caution the positive results of this year.
Our current outlook for the European economy for the remainder of this year
and next has become slightly less optimistic in recent months, although we
still think that a repeat of the slump experienced in the summer of 1977 will be
averted this year. The Chase Ecol!lometrics index of European industrial output
is now expected to rise by 4.3 percent in the third quarter followed by a 3. 7 percent
gain in the fourth quarter; the 4 percent average growth in the second half of
this year is 1 percent lower than anticipated six weeks ago.
The downward revision in growth in European output during the latter half
of this year stems partly from even less impressive growth in the U.S. economy
than previously indicated. This is a result of the bulge in inflation in the second
quarter that is expected to lead to more sluggish growth in consumer spending in
the latter half of this year. The second major factor for our more pessimistic
outlook for the U.S. economy in the July-December period is the reduction and
postponement of the Oarter fiscal package. We had originally anticipated a $25
billion tax cut would be put into effect on October 1, but this has been scaled
down to $20 billion and deferred until January 1. Thus, we are still holding to
our forecast that the U.S. economy will not be a major source of growth for thf>
European economy later this year and next, a contrast to the 1977 experience
when almost all European countries experienced rapid growth in exports to the
United States.
In addition to slower growth to the United States, there are several factors
that explain the slightly lower growth forecasted for the European economy in
the second half of the year. First, the U.K. government, fearful of a run on


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309
the £ and faced with a lower-than-anticipated current account surplus and
excessive growth in the money supply, introduced a mini-budget on June 8 in
which monetary policy was tightened another notch and national insurance
costs to employers were raised by 2.5 percentage points effective October 1. The
net effect of the new monetary and fiscal policy measures is rto reduce investment spending in the short run, while raising inflation, lowering overall real
growth, and reducing U.K. international price competitivPness, all of which
will combine to cause a less buoyant recovery than we previously anticipated.
Second, the French government has embarked upon an ambitious program
to make the French economy healthier and more competitive over the long run.
Unlike most short-sighted decisions made by other European leaders in recent
years, Prime Minister Barre has taken the difficult route of phasing out price
controls from all industrial products between June and October, while pulling
back from subsidization of inefficient nationalized or quasi-nationalized industries. These measures are bound to restore the financial health of French firms
over the long term, which should lead to higher investment spending. However,
they are certain to lead to higher infla:tion and unemployment and lower consumption in the short run, and for this reason we have lowered our outlook for
French growth in the latter half of this year and all of 1979.
In summary, policy actions recently taken in France and the United Kin<"rl0,n
are the major contributing factors for the downward revision in our outlook
for the European economy over the next 6---12 months. Lower growth in 011tpnt
and import demand in France and the United Kingdom will have a multiplier
effect on intra-European trade, that will lead to slower growth in European
output. The German government could make up for the anticipated slower
growth by introducing more expansionary policies. However, the Bonn government is adamantly refusing to countenance any new spending programs, and
the emphasis of any new fiscal program will be on tax reform, but this has little
chance of being implemented before early next year.
Yet we are still holding to our previous forecast of no renewed downturn
in European output during the second half of this ye'tr. We first note that in
!<pite of the policy measures taken in the United Kingdom, private consumption
expen,ditures will still grow at a reasonably moderate pace in the second half
of this year as a result of the substantial nominal wage gains and personal tax
cuts that have already taken place. This is a stark contrast to the first two
quarters of 1977 when real incomes were sQueezed and consumption expenditures
11lummeted. Fiscal policy in the United Kingdom has reverted from contractionary to expansionary, and local authorities and government agPncies are
likPly to overRpend this year inst('ad of underspending as ithey did in 1977.
Similarly, consumption expenditures will continue on an upward trend in
France, and investment s,pending should be given ·a positive 'boost by the election
results and the improved profit picture. In addition. domeRtic dPmand in Germany
appears to be on the rebound as evidence by the strong upturn in domestic orders
in April, which should provide the basis for positive growth in industrial output
in the months ahead. We also expect that the Italian economy will make a positive
contribution to overall growth in ,the European economy in the second half of this
year, partly as a result of more bullish consumer spending and investment incentives. This will be in contrast to the mid-1977 experience when industrial output
plummPted, and import demand declined sharply. This leading to lower exports
and industrial output in other European countries. Finally. we are doubtful that
inventories wHl he liquidated in the later half of 1978 as they were in 1977. Inventory accum11!11tion has been a positive source of growth in recent months, but
producers .have 1been cautious in rebuilding stocks so that inventory /sales ratios
are currently estimated to be only normal rather ,than excessive as they were in
early 1977.
Nonetheless, we do not think the European economy is on the verge of a sustained period of above-equilibrium growth. Our forecasts for European industrial
output in 1978 indicate slightly higher growth rates compared to 1977, but this
does not represent any significant impairment in the underlying condition of the
European economy. We have made the assumption that the European leaders
meeting in Bonn this week will agree ,to implement policies that will add a certain percentage--between 0.5 and 1.0 percent-to their previously determined
growth •targets. However, the increased fiscal stimulus will not be implemented
until later this year and by next January at the earliest in the case of Germany,
implying that the ,pattern of growth in the European economy during the latter
half of the year will be unaffected by the agreeemnt made at the Bonn summit.
Yet the increased fisca,l stimulus should provide some impetus to slightly faster
growth in 19i9 when European industrial output is expected to rise by 3.5 percent


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310
compared to 2.7 percent in 1978. Growth in industrial output is expected to average about 4 percent in 1980 and 1981. On a broader basis, aggregate real GNP
for the seven European countries is expected to be up by 2.7 percent this year
compared to 2.1 percent in 1977, followed a 3.6 percent rise in 1979 and 3.5 percent
increases in 1980 and 1981.
There are four major factors that explain the below-equilibrium growth rates
forecasted for the European economy in the 1978-81 period. First, European
inflation has come down from the high levels experienced in the 1974---77 period,
but it is still SUJbstantially above the levels experienced in the 1960's and early
1970's and double-digit rates on average are likely to per1Sist into the early 1980's.
Although wages are tied to pru,t changes in retail prices in most European countries, progressive tax structures result in lower increases in real disposable
income and hence lower growth in consumption. Moreover, the higher levels of
inflation will result in persistently high savings ratios in Europe. A second manner in which high inflation inhibits growth is through lower investment spending. Although the U.K. and German government has made some headway granting tax relief for profits arising out of increased inventory valuation, corporate
profits in most European countries with the exception of France will be overstated due to the lack of tax breaks on inventory valuation adjustments. The
significantly higher levels of inflation will also increa:se the cost of capital resulting in higher threshold rates of return on new investment.
Second, with the exception of Germany, the trade accounts in most other European countries are expected to remain in deficit over the next several years. We
are even doubtful that the U.K. trade account will reflect the intended benefits
of North Sea oil due primarily to the decline in interrelated price competition of
U.K. goods and the government's proclivity to stimulate consumption without
extending a helping hand to investment. The sizable trade deficits will cauise the
governments of these countries to be much more cautious in stimulating demand
in spite of higher levels of unemployment for fear of incurring even larger trade
deficits.
Third, we expect no increase or at best a modest rise in the investment ratio
in every major European country over the next several years. A return to higher
rates of growth in investment spending is a necessary condition to achieve higher
productivity gains and lower inflation and unemployment. Yet the prospects for
a period of sustained growth in investment spending are expected to remain bleak
at least until the early 1980's. Double-digit inflation, caused in part by excessive
wage gains, and high interest rates largely explain the sharp increases in capital
costs and the resultant raising of the threshold rates of return of investment in
the European countries. Moreover, we expect a significant proportion of investment spending to be earmarked for purchases of labor saving devices in order to
offset excessive wage gains.
Fourth, the combination of high inflation, excessive wage gains, and a lowering of the investment ratio will result in no significant decline in the high levels
of unemployment in Europe over the next several years.
JAPAN

The Economic Planning Agency of the Japanese government reported that
real GNE rose by, a hefty 10 percent annual rate in the January-March period,
the highest growth since the early 1970's. The 10 percent rise in real GNE
provides support to the government's claim that it will be able to achieve its
7 percent growth target for fiscal 1978, and in the process cause a significant
rise in import demand. Yet, we do not agree with this interpretation of theperformance of the economy during the first quarter. Slightly more than onethird of the 10 percent increase in real GNE sterned from the current account
balance rising from 6.5 trillion yen (1970 prices) in the fourth quarter to 7.3
trillion yen in the fivst quarter; exports of goods and services rose at an annual
rate of 30.0 percent, while imports rose by 9.6 percent. The foreign trade figures
suggest that Japan's import demand is finally picking up, but a closer look
reveals that merchandise imports were basically flat, implying a sharp increase
in imports of service;;, a welcome event, but one that will do little to stimulate
production and employment in Japan's major trading partners. Nor are we
convinced that the reported 8.4 percent growth in real consumption expenditures
represents the beginning of a consumer spending boom. In fact, we expect real
consumption expenditures were overestimated 2.3 percent since real disposable
income was up by only 5.6 percent in the first quarter and labor markets showed
no improvement. The high growth in consumer spending for the first quarter
is consistent with previous NIA preliminary estimates made in 1976 and 1977.

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For example, original estimates for consumption in the first quarter of 1976 and
1977 showed respective increases of 14.8 percent and 5.2 percent, but these were,
subsequently revised downward to 6.0 percent and 3.0 percent due to substantial
revisions in the estimates for the consumption price deflator. The outlook for
consumer spending is not very promising. Quarter-to-quarter growth rates of
about 4 percent are pnjected for the remainder of this year, due to only
moderate growth in real disposable income and a continuation of the depressed
labor market conditions.
One disappointing feature of the first quarter NIA data was the meager
3.6 percent gain in private plant and equipment spending, thus continuing the
lackluster performance in this critical area since the start of the recovery.
More recent statistics show that new orders for machinery in the private sector
plummeted by a monthly rate of 23.4 percent in April, due mainly to the
renewed appreciation of the yen. The exchange rate developments during the past
several weeks are likely to result in a further decline in business confidence
which, coupled with depressed profit levels will result in no significant rebound
in plant and equipment spending for the remainder of this year.
We are also disappointed over the government's failure to provide the muchneeded fiscal stimulus to the economy during the first quarter that would lead
to above-equilibrium growth in private domestic demand later this year. Total
government spending on the current and capital account was up at an annual
rate of 6.8 percent in the January-March period, somewhat higher than the
3.7 percent rise in the fourth quarter, but insufficient to provide the stimulus
necessary to achieve the 7 percent growth target.
In sumary, we do not think the government has provided the stimulus necessary
to keep the economy growing at the 10 percent rate achieyed in the first quarter.
Private consumption expenditures will be given a positive boost by the sharp
deceleration in retail price inflation, however, moderate wage gains of 6-7
percent and depressed labor markets will prevent consumption from expanding
by more than 4-5 percent for the remainder of this year. Similarly, we expect
private plant and equipment spending to continue on an upward trend, but at a
rate that is insufficient to cause a substantially higher growth in overall output
and employment. Given the current planned levels of government spending, we
feel that the only way Japan will be able to achieve its 7 percent growth target
is through continued high growth in exports. Yet exchange markets appear to
be taking care of this problem with the yen rapidly approaching the 200 yen
barrier. Although the excessive trade surplus registered during the past few
months has led many commentators to conclude that Japan's exports are priceinelastic, we note that the high nominal value for exports is due to the substantial
appreciation of the yen. Export volume declined at an estimated annual rate of 18
percent in the second quarter and this i,s expected to be followed by only meager
growth in the second half of the year. Thus, in spite of the 10 percent growth
in the first quarter, we have not altered our forecast for a 6 percent upturn
in real GNE in 1978 on a calendar basis and 5.6 percent on a fif,cal year basis.
Nor does the intermediate term outlook for the Japanese economy provide much
hope for a return to the 10 percent growth rate of the 1960's and early 1970's that
is necessary to cause a surge in import demand. This does not imply that the Japanese economy does not have the capacity to grow by 8--10 percent per annum, but
the impetus to the high rate of growth would have to come from even higher levels
of government spending than are now planned, particularly in view of the poor
prospects for export-led growth. Simulations of our large scale model of the
Japanese economy indicate that government spending would have to increase by
35-40 percent over the next two years in order to cause the trade balance to revert
back to an equilibrium. Considering the much needed improvements in Japan's
infrastructure, this large increase in government spending would do much to
increase the Japanese standard of living. Yet the Japanese government has indicated it will not follow policies as expansionary as we think is necessary to restore
equilibrium in its trade account due to the already high levels of deficit financing
that have gone beyond what the government believes are fiscally prudent.
Without the necessary help from government spending, the private sector would
have to provide the impetus to a return to 10 percent growth. Yet plant and equipment spending is no longer the dynamic force in the Japanese economy that it was
in the super-growth era. In fact, the ratio of private plant and equipment spending
was only 14.4 percent in the first quarter, below the 16 percent at the trough of
the recession and substantially lower than the peak 21 percent rPached in 1973.
Low levels of capacity utilization, insufficient profits caused partly by the high
value of the yen and reduced profit margins, and the poor outlook for world


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trade will probably prevent real plant and equipment spending from rising by
more than 4 percent per annum over the next three years.
The slow growth in plant and equipment spending is an important factor for no
significant improvement in labor markets over the next several years, which will
put a damper on consumer sentiment. !Depressed labor markets plus an expected
poor performance of corporate profits will prevent business from granting labor
generous wage gains that would be necessary to cause growth in real disposable
income and consumption from returning to the 8 percent that existed in the 1960's
and early 1970's.
OUTLINE FOR THE U.S. CURRENT ACCOUNT BALANCE

Before proceeding to a discussion of the outlook for the U.S. trade i:ector, it
will be helpful to analy,ze the dismal performance experienced in 1977 which was
the primary source of the instability of the dollar and an important factor behind
the acceleration of inflation here in the United States during the past six months.
Much of the commentary a bout the $18.7 billion deterioration in the U.S. current
account balance between 1976 and 1977 has concentrated on increased dependence
on imported oil, an issue that Helmut Schmidt is placing at the forefront of the
upcoming Bonn summit. We have no major disagreement on this point, since oil
imports rose by $10.4 billion to $45.0 billion in 1977. Yet the rise in oil imports is
only part of the $18.7 billion deterioration in the U.S. current account balance. An
equally serious problem has been the substantial deterioration in the net foreign
balance of manufactured goods that recorded a deficit of $2.2 billion in 1977 compared to a surplus of $7.3 billion in 1976. The deterioration in the net manufactures balance has been shunted by the foreign leaders of the major industrialized
nations attending the Bonn summit, and understandably so since it was the dramatic rise in manufactured exports from ,Japan and Western Europe that played
a major role in the deterioration as will be shown below. However, we consider the
deficit in manufactured goods to be critically more important to the health of the
U.S. economy since it has a more important bearing on employment and inflation
than does the oil deficit.
As pointed out in a previous section of this report, the growth rate in the
rnited States was 4.9 pereent in 1977 compared to an avemge of 3.1 percent in
Japan, Oanada and Western Europe which largely explains the sharp rise in U.S.
imports and lackluster growth in exports. However, thrs does not fully explain
the poor performance of net manufactured goods, and certainly one should ha,e
expected that the strong appreciation of the European currencies and the Japanese yen since late 1976 ,should have had at least some partial impact on the U.S.
trade account hy late 1977 or early 1978.
All the evidence gathered to date suggests that U.S. foreign trade did not
respond to the improved price competitiveness of U.S. goodR in 1977. In fact. as
shown in Table H. just the opposite occurred. U.S. export volume to almost every
ma;ior trading partner included in the CEAI International Model System declined
in 1977, while U.S. imports from these same countries rose substantially. MoreOYer, in a number of the important trade links, exports from the United States
rleclined while total imports rose. thus implying a lower U.S. trade share in key
foreign markets. For example, U.S. export volume to .Japan fell by 6.3 percent in
1977. yet ,Japan's volume of merchandise imports rose 4.2 percent. Similarly, U.S.
exports to Germany wi>re- down by 6.2 percent, while Germany's imports were up
by 5.5 percent.
1

TABLE H.-BILATERAL TRADE DATA
[Percent change]
Exoort volume,
United States to
foreign countries

1976

1977

Exoort volume,
foreign count-ies
to United States

1976

1977

United States-France ________________
-8. 8
17. 0
14. 4
16. 3
United States-Germany ______________
14. I
-6.2
13. 8
5. 5
United States-Italy __________________
-18.0
-.3
19. 4
5. 6
United States-Netherlands ___________
29.
0
5. 8
-1.9
-1.7
United Slates-United Kingdom ________
10. 9
4. 0
I. 3
14. I
United States-Japan _________________
-6.3
3. 8
28. 2
17. 0
United States-Canada ________________
6. 8
II. 3
11.7
10. 9
United States-Belgium _______________
23. 8
4. 2
29. I
-6.6
United States-Meeico ________________
-2.9
30. 2
-3. 7
17. 4
United States-Spain_________________
-6. 6
-7. 2
9. 8
6. 0
United States. ____________________ ------------------------------- ___________________


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Total import volume
by importing country
(1963 prices)

1976

1977

20. 8
16. 5
14. 2
12. 8
5. 9
8.1
7. 2
14. 5
-10.9
3. 9

0. 5
5. I
-. I
2. 8
.7
4. 2
.7
6.0
-6.4
-. I
10.2

18. 4

313
There are several possible explanations for the lower U.S. trade share in the
major industrialized countries. First, the time lag between changes in price competitiveness and exports is substantial and may be as long as two years in the
case of capital goods. Thus the vastly improved price competitiveness of U.S.
goods during 1977 and 1978 may not have a significant effect on U.S. exports of
capital goods until 1979 or 1980. Second, a significant portion of U.S. exports are
concentrated in food and industrial raw materials that are traded in world
markets and have a fairly low price elasticity. Third, most countries had ample
supplies of inventories of raw materials in 1977.
Yet in spite of these factors, U.S. producers should have been able to take
advantage of the moderate rise in imports in the major trading partners of the
United States, even considering the long time lag needed to adjust to changes
in price competitiveness. More aggressive selling could have helped to achieve at
least a moderate rise in U.S. exports to Europe and Japan, yet as previous experience has shown, most U.S. producers have a cavalier attitude toward foreign
sales, and they lack the government incentives that producers enjoy in other
countries. For example, the Oarter administration has proposed the phasing out
of DISO's, one of the few export incentives available to U.S. producers, while
the fate of the EXIM bank is in doubt because of political considerations rather
than the need for export financing. Fortunately, more enUghtened members of
the U.S. Congress have recognized the importance of expanding U.S. exports. The
recently concluded House and Senate hearings showed some indication that a
more responsive foreign trade policy may be in the offing, although passage of a
bill is not likely to occur until late 1978.
We also believe that the constant barrage of criticism by the Carter administration that the Japanese and German governments were not doing enough to
stimulate their economies has backfired. Public opinion in Germany and Japan
has rallied in support of their government policies, thus contributing to an antiAmerican sentiment that has had a negative impact on U.S. exports to Japan,
Germany and other European countries.
Another important factor that may help to explain the lackluster performance
of the export sector in 1977 that is continuing this year is rapidly diminishing
gap between actual and potential GNP here in the United States. This is at
variance with the popular indexes that show capacity utilization rates to be about
85 percent. However, these indexes overstate the amount of total capacity available, particularly in those industries with heavy requirements for pollution abatement. The Chase Econometrics estimates for the GNP gap indicate that the economy is operating much closer to full capacity than is thought to be the case. If
this analysis is correct, then producers will probably shift even more resources
to domestic markets, and hence they are not likely to be able to take advantage of
the improved international price competitiveness of U.S. goods.
In summary, the problems with the U.S. foreign balance go beyond leads and
lags, the J-shaped curve effect of a devaluation, and the short-term increases in
Japanese exports. U.S. producers now enjoy their ibest competitive advantage
since 1978, but we !lave yet to detect any significant pickup in U.S. shipments
abroad, nor a throttling down of the appetite of U.S. consumers for foreign goods.
While there is little doubt that a sharp depreciation in the U.S. dollar will have
some positive impact on U.S. trade in 1978 and 1979, major structural changes
in the consumption-oriented policies of the United States and the export-oriented
policies of Japan ·and Western Europe will have to take place before the U.S.
trade account even approaches equilibrium. Thus we continue to be relatively
pessimistic on the outlook for the U.S. net foreign balance over the next several
years.
In the near term, the current account balance should improve as a result of the
unwinding of leads and lags following the rally of the U.S. dollar in April and
May. Economic activity in E:Urope and Japan is improving, albeit at a moderate
pace, while U.S. crude oil imports are showing signs of declining as a result of
slower growth in the economy, increased North Slope production, and domestic
conservation programs and legislation. Further support for the U.S. trade account
will stem from higher agricultural prices as well as a pickup in world demand
for feedgrains. Net exports of goods and services are expected to rally from
-$23 billion in the first quarter to -$10 billion by 1978.4, but this still implies a
yearly average figure of -$16 billion, down from -$11 billion in 1977, +$8 billion
in 1976, and +$20 billion in 1975. On an intermediate term basis, the ne.t foreign
balance should improve to -$10 billion in 1979 and -$9 billion in 1980, but this
will still be a dismal performance compared to the pre-1977 experience.
35-940-78--4

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Representative MrrcHELL. Thank you. There will be some questions. I feel so depressed.
Mr. Ranson, you are next. Your full prepared statement will be
incorporated in the record.

STATEMENT OF R. DAVID RANSON, SENIOR ECONOMIST AND PARTNER, H. C. WAINWRlGHT & CO., BOSTON, MASS.
Mr. RANSON. Thank you :for inviting me. I am delighted to come.
Let me come to the bottom line of my remarks first. I will talk
off the cuff.
As I see it, the outlook :for the world economy, and the U.S. economy in particular, in the foreseeable future, without changing policies, is deepening stagflation.
What I have to say will contradict a great deal of what other witnesses have to say, because my premises, and therefore my conclusions, are different.
I believe the mainstream of economic throught is pretty well inadequate to handle the problem of stagflation. We hear this said in media
many times these days. There is a lot of weeping and moaning, but
there are not many positive and constructive attempts being made to
provide an economic framework which would explain stagflation. Not
only explain it, but provide an understanding of it, and provide
remedies for it.
That is the task of research in which my firm has been engaged, under
the leadership of Arthur Laffer. Our economic framework is classical
economics. It is not any different from the old line of economics, but
it is a departure from what has taken place in economic thought
during the so-called post-Keynesian period.
Let me go through three premises to show how very different this
view of the world is from the mainstream wisdom which pretty much
dominates discussion of these issues.
First of all, what drives the economy i Where is the source of the
economy i Why do we have an economy in the first place i It is not
demand :from the point of view of this framework. We cannot have
demand by itself. You have to have supply. In fact, supply and demand are not two different things opposed, but two sides of the same
coin.
People supply goods and services because they want to exchange
what they supply in the marketplace £or what they can demand.
Supply and demand are really the same thing, viewed from two
angles. Demand does not drive the economy. What drives the economy is incentive to produce, and thereby to consume. Productive incentives explain economic activity to a great deal empirically as well
as logically.
That is the first premise. It is very different from the premise underlying implicitly-1 rarely explicitly, most of the conventional discussion today.
Second, and again this is not a new insight, the United States is
not a closed economy all unto itself. The economy of the United States
does not end at the foot of the Kennedy runway. The United States is
just a part of an integrated world economy. The full implications of
this are often not fully realized.


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It is often said that our exposure to the outside world is limited,
because trade accounts for only 6 or 8 percent of our GNP. But not
only is trade integrated with the world economy, so is the other 92,
94 percent. The reason is that our nontrading sector has to compete in
the marketplace with our trading sector, and our trading sector has to
compete with the world. So at only one place removed, our entire
economy competes with foreign countries.
The third premise is the notion that the marketplace, markets in
general, are intelligent, rational, and respond to events in a reasonable
way. The reason why we have a complete screwball of a world economy
is not that the private producers and consumers are behaving irrationally. This premise suggests that they are forced into crazy economy
behavior by economic policies which are not realistic. Of course, economic policies based on fallacies will tend to give you strange results.
That is, in broad outline, a diagnosis of what is going on in the
economy.
Let me give you some of the bricks and mortar of it. Let me pick out
one specific respect in which this way of looking at the economy differs
from the conventional wisdom.
Virtually all of the conventional wisdom assumes by and large that
you can fool all of the people at least some of the time. In particular,
by cheapening the currency, you can fool the population into buying,
and therefore, into producing more goods and services.
This directly contradicts the premise I just outlined. If the premise
is true, then the adjustment process as described in conventional
thought is not going to work logically, let alone empirically. Devaluation will not improve the trade balance.
Monetary policy, expansive monetary policies at home, will not stimulate production either. That is not only logical but if you look at the
empirical evidence, it is incredible how overwhelming the evidence
over a long period of time supports this rather extreme sounding
conclusion.
I have in my prepared statement a number of charts which supply
some evidence, especially on the problem of devaluation, specifically
figures 3, 4, and 5. We find empirically over both short periods and
long periods that devaluation is followed promptly by an offsetting
change in prices.
Devaluation does not change anything real. It only changes the
prices by which we measure the exchange of goods and services with
respect to each other. In fi~re 3 I show on a quarterly basis over a
5-year period, that when either appreciation or depreciation occurs
the prices of copper in different currencies accommodate immediately.
Representative MITCHELL. I hate to do this to you, but there is a vote
over on the House side. We will take a recess for 10 minutes.
I will make that vote and try to come right back.
[A brief recess was taken.]
Representative MITCHELL. Gentlemen, we will resume.
Mr. Ranson, again I apologize. 1Ve had the final vote on the parks
bill.
Mr. RANSON. I was just referring to three of the charts in my prepared statement which are in support of my contention. Extreme as it
sounds, devaluation, or if you like, depreciation, and in reverse appreci-


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316
ation and revaluation, very promptly have the effect of causing prices
to move in an offsetting way.
Thus, the real situation after the devaluation is the same as it was
before the devaluation. If you cannot change the real situation, by
which I mean production of goods and services, and incentives, then
you cannot change the trade balance.
I refer to Arthur Laffer, who was my thesis adviser at Chicago, and
with whom I have been working for many years. Three or 4- years
ago he put together a test by making a complete list of all the devaluations-I helped on this exercise-which occurred in the industrialized
nations since the Second World War. We found that in approximately
50 percent of the cases, the trade balance improved after the devaluation, and that in 50 percent of the cases, the trade balance worsened.
Since that test, in the last 5 years, I have done another test, looking
at the major industrialized nations, and found there is a correlation
between the trade balance and devaluation that goes in the wrong direction from the viewpoint of mainstream wisdom. That is, countries such
as Britain and Italy, that have had the worst balance-of-payments
problems, have been the ones that have the weakest currencies. Others
such as Switzerland, Holland, and Germany, which had stronger,
currencies, had the most substantial and stubborn surpluses.
If devaluations do not affect the trade balance, what do they do i
What they do is to cause inflation. In fact, the logic is quite strong here.
A 1-percent devaluation, if this is correct-and we do not present this
model as the whole answer but as only part of it-will create 1-percent
inflation in the home country relative to the rest of the world. I refer
specifically to figure 4, showing the overall inflation in the United
States since the 1900's, relative to foreign countries. The chart indicates
a 1-to-1 correspondence between the devaluations that took place, and
the relative inflation rates.
What have we had in the last 9 months~ It is my contention that the
most significant event is one that most people have neglected, or at
least viewed as a small factor in the whole situation. I believe that the
most decisive factor in the whole situation is the 14 percent depreciation in the U.S. dollar relative to our major trading partners since last
September.
If this model is correct, as I believe it is, then that 14 percent depreciation should create 14 percent inflation relative to foreign countries.
That is over and above the inflation rate countries have had and are
having.
From this model's point of view, the double-digit inflation in the
last several months is not a surprise at all. It is a completely predictable
consequence of the policies that by default the Treasury Department
has followed in the last year; namely, to let the dollar slide down..
But that is not the end of the story. Proceeding on from inflation,
you get effects through the tax structure which produce a real consequence to what is initially only a monetary cause. As everyone knows,
and this is very familiar now, inflation pushes people into higher tax
brackets, and especially the business sector. This can be quantified too,
as indicated in figure 2.
As I mentioned earlier, one of the premises of this approach is that
incentives are what drive the economy. If you push people into higher
tax brackets, you hit the root source of the driving force behind the
economy; namely, incentive.

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So you should expect inflation to lea<l to slower growth. Again, there
~s some confirmation of that. If you actually plot the rate of inflation
m the la_st 10 years or so agaim;t the rate of growth, you fin<l a negative
correlat10n as shown in figures 8 an<l !J. T11e faster the inflation, the
lower the growth, and vice versa.
This is just the opposite of the conventional wisdom. Conventional
wisdom says that lugh inflation occurs when you grow too fast, and
high growth when your inflation is fast. You also have low growth
when your inflation is low. .Empirically, just the opposite is true.
So the outlook for the U.~. economy would be more inflation and
lower growth. In a word, stagtlation. This is a model that predicts
stagflation from the policies we have had in the past, the policies we
still have today.
The same thing occurs in other countries. Other countries have
tremendous increases in taxes over the last 10 or 15 years. A lot of that
is due to inflation, but a lot is due to tax policies also. The few countries who have reduced taxes in the last 15 years have had higher
growth.
There is a strong correlation between tax policy and growth. There
are some policies implicit, therefore, in this model. If this model is
correct-and everything hinges on that; and as I say, I do believe it is
correct, but not the whole story-the first thing is to peg the value of
the dollar to foreign currencies, especially to those .European currencies whose governments want to have a stable currency.
That is a good policy as they well realize in Europe. I think it will
take us a while to realize it here.
A second recommendation would be to cut taxes decisively, preferably across the board, but most importantly in those areas of the economy presently stuck in the highest ranges. These are; namely, lowincome labor which is taxed at high rates due to the disincentives of
our welfare programs; capital gains, where the taxation goes on top
of the other taxes on investment income; and business profits.
Third, controls will only make the damage worse. The damage of
inflation is already done.
As figure 7 illustrates, we have seen only half of the inflation that is
coming due to the depreciation of the dollar. You can calculate that
from the one-to-one correspondence that I mentioned earlier. Price and
wage controls can only paper over the cracks.
.
.
.
As a long-range policy, the only real approach to mflation 1s to
make the currency sound.
Tying to foreign currencies is not the ultimate answer, because foreign currencies may not be sound either. Tying to gold was a~ways
the solution until the 20th century, but gold is only one commod~ty. It
is a rather unpredictable commodity. It makes more sense to tie the
dollar to the marketbasket of goods and services. This is a radical
policy not much discussed these days.
.
A second long-range policy, in the absence of a sound dollar pohcy,
would be to index the tax structure against inflation.
.
Fourth, the trade balance can take care of itself if the economy 1s
healthy. Crazy trade balance fluctuations are a natural result of craz.y
economic policies. To try to impose controls on trade balance flow~ 1s
only to try to impose controls on the flow of resources between countries.
That ft.ow of resources is fundamentally healthy. It leads to an economy
which is intelligent, as I believe ours is, to more gro"·th and not less.
[The prepared statement of Mr. Ranson follows:]

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PREPARED STATEMENT OF R. DAVID RANSON*
THE DOLLAR AND THE ECONOMY

SUMMARY

In my view, the most important economic event of the past twelve months has been the
officially-sanctioned 14% depreciation in the average value of the dollar. A decline of this magnitude has
the following implications, several of which are already painfully evident:
•

double-digit inflation in the U.S.; we may have seen in the CPI and WPI little more than half of the
inflatiog which is predicted to occur;

•

an increase in marginal tax rates on the incomes of business and households;

•

sharply lower growth;

•

lower (or even negative) inflation and accelerating growth in strong-currency countries such as
Japan and Switzerland.

Since the international monetary system was unhinged with the abandonment of the 1944 Bretton
Woods agreement, the dollar has periodically come under pressure. Adoption by U.S. policymakers of a
hands-off approach has facilitated a 14% fall in the dollar's value between la~t September and early July.
Contrary to official dogma, a soft currency does not improve the trade balance. However, its
consequences for inflation and thereby for tax brackets are far greater than ic; yet realized in
Washington. These consequences imply a decline in economic incentives, a slowing of national output,
and an increase in the "wedge". Obsolete economic policy responses have confined the U.S. economy in
1978 to a vicious circle resulting in higher inflation, unemployment and budget deficits, and lower
growth and stock prices.
Ifihis analysis is correct, the first quarter "pause" in the economy is due to more than the coalstrike and
severe winter. Thus, I expect it to last longer than policy makers do.
The longer term outlook has improved recently, with more responsible policies toward the dollar, and
moves afoot in the Congress to reduce tax rates without increasing the progressivity of the tax system. If
these developments were to continue, productive incentives and confidence would recover, and
economic activity would respond. Until that occurs the economy is likely to remain in a state of
stagflation.

•Special assistant to the Secretary of the Treasury during the Ford administration. Before
joining H. C. Wainwright & Co. at the beginning of 1977, Dr. Ranson taught _economics
at the University of Chlca~o Graduate School of Business. This testimony draws upon
two reports Issued by H. C. Wainwright & Co. In the past 6 months: "The Falling
Dollar" by R. David Ranson_ and "The Prospect of a Recession" by R. David Ranson and
Charles E. Babin. The author Is Indebted to Charles E. Babin, Charles W. Kadlec, and
Donna M. Jarvis for support and assistance.


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319
CHE FALLING DOLLAR

The plight of the dollar is once again front-page news. No wonder! Of eleven major world currencies
only two have underperformed the U.S. dollar since the end of 1976 (Table I).
Table 1

Cumulative Appreciation and Depreciation
From the End of 1976 to the Middle of 1978
(each relative to a weighted average of the other ten currencies)
appreciating currencies

Japanese yen
Swiss franc
German mark
Belgian franc
Dutch guilder
British pound
French franc
depreciating currencies

Italian lira
U.S. dollar
Swedish krona
Canadian dollar

cumulative apprecation(+)
+35.5%
+23.4
+ 7.2
+ 3.8
+ 3.7
+ 2.6
+ 2.5

cumulative depreciation(-)
- 5.4%

- 8.9
-19.3
-20.S

Source: Federal Reserve Board, exchange rates weighted according to 1972 global trade.•
Moreover, as Figure One shows, most of the U.S. dollar's fall has occurred since the third quarter of
1977.
The U.S. dollar fell by nine percent since the beginning of 1977 in spite of the fact that several
governments intervened in the foreign-exchange market on a large scale to support the dollar. In the
absence of these stabilizing actions, the dollar's fall would no doubt have been greater than it was.
This commentary will outline the implications of these currency movements with special emphasis on the
United Stat.es. I believe·that prevailing opinion among U.S. economists and policymakers is incorrect,
and harmful when translated into practical policy. Contrary to official pronouncements, I believe that
the fall in the U.S. and Canadian dollars is responsible for increased inflation and lower economic
growth in North America than would have been the case if exchange rates had been fixed. In perspective,
the experience of the past eighteen months appears to be part of a world trend toward increasing
instability in the world monetary system. It also spells a further decline in U.S. chances of regaining its
past leadership role. 2


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320
Figure One

Foreign Exchange Value
of the U.S. Dollar

l.05

1.05

1.00

1.00

. 95

. 95

. 90

I

. 90

~

. 85

,

. 8.5

I
I

•80

.80

. 75

. 75

. 70

70 71 72 73 74 ?5 76 77 78

. 70

------- In terms of ten major countries, weighted by 1972 global trade (Federal Reserve Board)
- - - In te_rms of eight major countries, weighted by 1974 gross domestic product


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321
FAILURE OF DEMAND-BASED POLICIES
The U.S. economy during the 1970's has been characterized by stagflation - high inflation during
periods of economic slowdown. Traditional analysis has lacked the ability to explain this debilitating
phenomenon. Inflation, which was thought to be generated by too much demand for goods and services
relative to supply, was allegedly incompatible with unemployment, which was thought to be generated
by too little demand relative to supply. In the light of so obvious a disagreement with reality, it is
disappointing that every prescription for the economy yet proposed by the Carter Administration to
combat stagflation has been based on the old, hopeless nostrums.
Evidence is mounting that conventional prescriptions are incapable of curing the economic malaise. For
example, according to Keynesian theory, government spending sets off a cascading effect throughout the
economy, and provides a powerful stimulus to total demand. But it is difficult to argue that the economy
has done poo"rly because we have not spent enough. Government transfer payments as a percent of GNP
have nearly doubled to 12-13% in the last decade. 3 Broadly-defined deficit spending has increased at an
unprecedented rate: legislated long-term financial commitments exceed the national wealth twice over. 4
These are liabilities which could exceed the tax system's ability to pay.
Second, according to Monetarists, rapid expansion of the money supply leads, after a lag, to an
acceleration in real GNP also by stimulating total demand. Overly slow monetary expansion allegedly
reduces real growth. But it is no easier to build a case that inadequate money supply has been responsible
for the chronic unemployment of the last few years. Monetary expansion rates have accelerated from
2½% during the period 1947-67 to 6% during the period 1967-77.
Third, according to some international experts, a depreciation of the dollar makes U.S. goods cheaper.
By improving U.S. competitiveness in world markets, it stimulates total demand for U.S. products. An
increase in the value of the dollar allegedly has contractionary effects. But it is just as difficult to explain
the economy's fragile state as the result of an overvalued currency and a corresponding lack of
competitiveness. The dollar has been declining in value during the past decade.
Table 2 summarizes the postwar experience with respect to these three traditional sources of economic
stimulus.

Table 2
Growth and Inflation and
Traditional Indicators of Economic Stimulus

period
1947-52
1952-57
1957-62
1962-67
1967-72
1972-77

average annual rate of increase In:
real
GNP
real transfer
GNP
deflator
payments•
5.0%
3.1%
-1.4%
2.6
2.3
8.2
3.3
1.6
7.7
4.7
2.3
6.9
3.1
4.8
8.3
2.7
7.2
8.4

money supply
(Ml)
2.3%
1.8
1.8
4.0
6.1
5.9

value of the
dolla,t
8.3%

0.7
0.5
0.1
-1.8
-0.9

*Total transfer payments of federal, State and local governments corrected for inflation.
t Average foreign~xchange value of the dollar, based on eight major currencies, weighted by
national outpuL


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322
As shown, the decade of lowest growth coincided with the decade of highest inflation. This same decade
also experienced the most rapid growth of real transfer payments, the fastest expansion of the money
supply, and the greatest decline in the value of the dollar. I do not believe these correlations are
fortuitous, however inconsistent they may be with prevailing economic wisdom.

A disease can be effectively treated only if it is correctly diagnosed. If President Carter is to realize his
target of 5% real growth and moderate inflation during the balance of his tenure, he can hardly do
without an economic framework which stands the test of explaining stagflation.

AN ALTERNATIVE FRAMEWORK
I believe that the following premises and conclusions offer a framework which stands the test of
explaining stagflation:
•

The economy is not driven by "demand" per se, but by a delicate balance of incentives to work,
produce and invest.

•

Government programs which tax producers and reward non-producers diminish economic
incentives. Thus, irrespective of their theoretical impact on demand, they hurt the economy and
retard its growth.

•

Persistent unemployment is not due to a shortfall of aggregate demand relative to supply. It results
from weakened incentives to employ labor and to exert work effort. Tax- and debt-financed
transfer programs foster unemployment by widening the "wedge" between labor cost and
take-home pay.

•

The United States is not a world unto itself, but part of a substantially integrated world market for
goods, capital and money.

•

The relative prices of goods and services, and the competitive positions of nations, are set by real
forces of supply and demand in the world as a whole. Transport costs and trade barriers aside,
prices tend toward parity in all countries.

•

Currencies are yardsticks against which prices are quoted. When exchange rates remain fixed,
inflation rates in all countries tend to converge. When one currency shifts relative to another, prices
measured in that currency shift proportionately relative to prices measured in the other currency. 5

•

A tax structure which penalizes some economic activities at sufficiently high increniental rates (the
"prohibitive range" of the "Laffer curve") reduces government revenue.• Such disincentives also
create bottlenecks in the chain of production and distribution, and thereby contract the overall
economy.

•

Inflation is not due to an excess of aggregate demand over supply. It results from too much money
chasing too few goods, or from a decline of confidence in the dollar. Such a decline can arise from:
(a) an unhinging of the dollar from reliable standards such as gold;
(b) an irresponsible expansion of the monetary reserve assets which underly the banking system;
(c) a refusal by the government to defend the dollar in the foreign exchange market by
extinguishing unwanted dollars.


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323
•

Inflation pushes bottleneck areas of the economy (especially incorporated business capital) deeper
into the prohibitive range by raising their tax brackets de facto. lt'thereby curtails the growth of
output, profits, wages and employment.

In sum, currency depreciation is pari passu inflationary and, with a highly skewed tax structure, also
leads to economic stagnation.
These premises provide a framework that contradicts the conventional wisdom. They explicitly predict·
stagflation as the result of government policies that separate effort from reward and which fail to secure
the value of the currency. Far from an enigma, stagflation is thus a predictable consequence of wrongly
focused economic policy.
The framework also provides natural explanations for several economic phenomena that have puzzled
economists, policy makers and financial observers. While these explanations are not new or original,
they do follow directly from the same set of premises. These phenomena include the following:
(A) Stocks, traditionally a hedge against inflation, have in recent years tended to decline during
inflationary periods. The inverse correlation between stock prices and inflation rates is statistically
significant. 7
(B) Federal revenues as a percent of GNP have risen since the mid-1960's only 2 percentage points (to

20%), although marginal tax rates on given levels of real income have risen anywhere from 4 to 17
percentage points.
(C) In the face of vast government expenditure programs, people in depressed urban neighborhoods
face almost insurmountable barriers against self-improvement by economic means.•

(D) Currency devaluations, both in North America and Europe, have usually failed to improve the
devaluing country's balance of trade. 9
(E) Net capital investment is running below historical rates in the face of large increases in business
liquidity. 10
(F) The Phillips curve has disappeared - inflation and real growth have been inversely correlated
during recent years. 11 This relationship too is statistically significant.
(G) In spite of the scoffing of some economists, inflation is extremely unpopular politically.


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324

EFFECTS OF INFLATION ON TAX BRACKETS

The fact that inflation pushes personal income into higher tax brackets is well known. To quantify this,
consider a series of hypothetical families of four whose incomes have remained constant in real terms
since 1965, when the present tax.rates for ordinary income came into effect. 12 Using IRS tax tables, each
family's marginal bracket can be calculated for each year.
Income
family

I
II
III
JV
V

(1977 dollars)
$ 12,500

25,000
50,000
100,000
200,000

Figure Two displays the upward drift in these families' marginal tax brackets that resulted from the
doubling of the price level that has taken place since 1965. The temporary bulge in 1968-70 is due to the
tax surcharge during those years. As shown, the greatest effect on incentives was felt by the family which
in 1977 earned $50,000. This family's bracket increased 17 percentage points to 51% during the 1965-78
period. Families with incomes higher than $200,000 have been less affected due to the 70% maximum
rate. Thus, an $800,000 family today is in the same marginal tax bracket as a $200,000 family. Under
today's legislated tax structure, a $25,000 family will reach the 51 % bracket by the time the price level has
doubled again. (If current inflation rates persist, this will occur in nine years.)
The effect of inflation on marginal tax rates incurred by business, and therefore on business incentives to
produce and invest, is harder to quantify. But it is easy to quantify three channels by which inflation
forces businesses to pay higher taxes on the same real profits:
I)

UNDERCOSTING OF GOODS SOLD. Historical cost accounting provides several different
methods for accounting for inventories: LIFO (last in-first out), FIFO (first in-first out), average
cost, and higher of cost or market. 13 Some firms even find it convenient to use different methods in
different divisions. All of these methods to one degree or another understate the cost of goods sold
from an economic point of view, where the relevent valuation method is replacement cost. 14
The higher the rate of inflation, the more out-of-date historical costs become, the more the cost of
goods sold is understated, and the more reported profits are overstated. Since the corporate income
tax applies to the reported profits, and not to profits computed on a replacement cost basis, higher
inflation leads to higher taxes.


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325
Fl1ure Two

Marginal Federal Tax Brackets on
Personal Ordinary Income, Family of Four
To:
Btacket

100-~---.-----------~----..---,~-~---.-100
00
80

00
Real Income ($1977) equals:

8Q

$200,000
'70 ------ ---------- --------------------------- --------------

70

60

60

.50 ---------------------------------------- SS0,000:..:::-=----- 50
40

=--=------:::.----- ---- -- -- ·----- -- ------- 40

30

30

20 ------- --- -

-------------- 20
2,SOO

10

10

o-----------+--------o


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326
For practical purposes it is often assumed that LIFO is a reasonable approximation to replacement
cost. For the total nonfinancial corporate sector of the economy, Table 3 lists the difference
between cost of goods sold as reported, and as converted to a uniform LIFO basis. The final column
in the table estimates the extra corporate profits taxes (assuming a 48% marginal rate) payable as a
result of the discrepancy between reported am;! LIFO costs of goods sold. As shown, the worst
episode occurred in 1973-74 when inventory prices skyrocketed; in those years undercosting
resulted in an extra $28 billion of corporate taxes - more than half the actual taxes levied!
Table 3

Impact of Inflation on Undercosting of Goods Sold
(billions of dollars)
Inflation rate
For inventoried
Year

goods(a)

1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976

0.3%
0.1
0.2
3.7
1.4
1.5

2.7
5.2
1.7

4.6
6.4
16.4
16.5
3.8
4.9

Inventory
Valuation
Adjustment(b)
$-0.1
0.2
0.5
1.9
2.1
1.7
3.4
5.5
5.1
5.0
6.6
18.6
40.4

12.0
14.1

Extra taxes due

To undercosting
(@ 48% rate)
S-0.1
0.1
0.3
0.9
1.0
0.8
1.7

2.7
2.4
2.4
3.2
8.9
19.4
5.8
6.8

(a) Computed from fourth quarter of preceding year through fourth quarter of current year;
(b) Equals discrepancy between cost-of-goods-sold as reported and after adjustment to LIFO.
Source of raw data: U.S. Department of Commerce, Bureau of Economic Analysis, National Income

and Product Accounts.

2)

UNDERDEPRECIA TION OF FIXED ASSETS. As with inventories, fixed assets such as plant
and equipment are valued on the books at historical (acquisition) cost for tax purposes. This results
in an understatement of depreciation expense.


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327
Table 4 lists aggregate depreciation for the nonfinancial corporate sector as reported, and as
converted to a "current value" basis by the Department of Commerce. The final column estimates
the extra corporate profits taxes payable due to underdepreciation of fixed assets. From this
viewpoint, too, 1974 was a very bad year with $10 billion of extra tax liabilities. Unlike the case of
undercosting, however, the over-reporting of profits due to underdepreciation takes many years to
die away after the inflation which triggered it has ceased. Thanks to this fact, combined with
continuing inflation since 1974, extra taxes levied due to underdepreciation were even higher in
I 975 and 1976.
'fable 4
Impact of Inflation on Underdepreciation of Fixed Assets
All Corporations
(billions of dollars)
Extra taxes

1962
1963
1964
1965
1966
1967
1968
1969
l970
1971
1972
1973
1974
1975
1976

Inflation rate
For new plant
And Equipment(a)
0.6%
0.9
1.0
1.2
3.0
3.3
4.2
4.8
5.4
5.5
3.8
3.8
11.1

14.7
4.8

Depreciation
At historical
Adjusted to
Cost(b)
Current Value
$ 24.4
$ 28.9
30.0
25.9
27.5
31.3
29.4
33.1
32.0
36.2
34.8
39.8
37.7
43.7
41.0
48.6
44.6
54.2
48.1
59.7
51.7
64.3
56.3
70.6
61.5
83.1
66.8
99.6
73.2
108.0

Difference
$ 4.5

4.1
3.8
3.8
4.2
5.0.
6.0
7.6
9.6
11.6
12.6
14.3
21.6
32.7
34.8

due to under
depreciation
(@48% rate)
$ 2.2
2.0
1.8
1.8
2.0
2.4
2.9
3.6
4.6
5.5
6.0
6.9
10.4
15.7
16.7

(a) Average change in prices since preceding year.
(b) With adjustments to bring different companies to common accounting assumptions (including
double-declining balance formula).
Source of raw data: Bureau of Economic Analysis, Fixed Nonresidential Business and Residential Capital in
the United States, 1925-75, updated.
3)

CAPITAL GAINS TAXES. Historical cost accounting is again used for tax purposes where a
private individual or a business firm sells an asset such as a security or a piece of real estate. For a
given real return, the higher the inflation rate during the period he held the asset, the larger will be
the capital gain he must report to the tax authorities." In the case of corporate stock, this extra tax
raises the effective cost of equity capital to business throughout the economy.


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328
CONSEQUENCES OF A DECLINING DOLLAR

Other influences remaining equal, a declining dollar implies:
•

a rise in the U.S. price level as compared with stronger-currency countries;

•

American individuals and corporations pushed into higher tax brackets, thus weakening incentives
for employment and production;

•

higher risks and costs of doing business overseas;

•

lower levels of production, and profits;

•

higher unemployment;

•

lower stock prices.

These effects are listed in logical, not temporal, sequence. Stock prices and interest rates appear to adjust
promptly, while the effect on official price indexes takes a few months to show up. Unemployment is
perhaps the slowest variable to respond.
There are two mechanisms which make this sequence of events a greater threat to the economy than it
would otherwise be, by setting off a depreciation/ inflation/ depreciation spiral. First, increased inflation
and unemployment may trigger inappropriate policy responses in Washington. For example,
wage-price controls cannot alleviate the true rate of inflation in an efficient market, and may actually
exacerbate it by inhibiting the use of resources. Likewise, increased government spending only weakens
employment incentives further. Such policy responses can "feed back" to the foreign-exchange market
and, in the absence of a policy to support the dollar, renew the depreciation/inflation cycle.
Second, once a currency has begun to decline, confidence in it diminishes, and moneyholders attempt
instead to use substitutes and to cut down on their balances of the weak currency. For example,
multinational enterprises and banks move out of dollars and into Swiss francs and German'marks, etc. 16
The mechanism is like that in Gresham's law according to which people hoard "good" money and get rid
of "bad" money by spending it. Anticipations of a further fall in the currency are encouraged, generating
expectations of higher inflation, higher interest rates, higher expected future tax brackets and reduced
incentives for growth and capital accumulation. As economic health declines, the currency becomes even
less attractive relative to others, and its value diminishes further. There is no theoretical end to this
dynamic process in the absence of firm intervention by the monetary authorities. It has been the process
responsible for hyper-inflation at other times and in other places.


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329
SOURCE AND IMPLICATIONS OF EXCHANGE-RATE MOVEMENTS

The logic behind these conclusions can best be explained by juxtaposing the view of the world economy
commonly held in North America with an alternative and contrary view.
According to one popular theory, exchange rate movements reflect a combination of domestic price
pressures and speculative tendencies. If a country "overstimulates" its economy, inflation will accelerate
domestically, and the country's goods will become "uncompetitive" in world markets. The country will
experience an increased trade deficit, and speculators will bet on a decline in the value of its currency.
However defiantly the central bank defends the currency, devaluation is supposedly bound to come
sooner or later unless the stimulative policies are reversed. When devaluation does occur, "equilibrium"
will allegedly be restored, the prices of the country's goods in world markets will again be competitive,
and the trade deficit will be eliminated. Some of the economists who advocate this theory believe that
governments can best avoid the adverse effects of "disequilibrium" in world markets by allowing their
currencies to float.
This has, indeed, been the policy of the U.S. Government. The Administration hopes also that the fall in
the dollar will alleviate some of the mounting political pressure from a number of domestic industries for
protectionist policies.
I believe that the different view (known as "Global Monetarisnl')is more logical and more capable of
explaining actual events: 17
I.

The prices of one nation's goods in terms of another's are fixed not by exchange rates but primarily
by domestic and international competition (the "Law of One Price").

2.

Traded goods must compete also with nontraded goods. As a result, all areas of the economy are
highly exposed to price and quantity changes originating overseas as well as at home.

3.

A country's inflation is not the cause of exchange rate movements, but it may be the effect. Inflation
is a worldwide phenomenon, and is associated with over-rapid growth of the world's money supply.

4.

Differential rates of inflation between countries occur to the extent that exchange rate shifts take
place between the corresponding currencies. Such shifts may be triggered by active government
policy. Or; in a floating rate regime, they may be changed by default ("malign neglect") through
private market perceptions of future monetary policies.

5.

Major currencies are close substitutes for one another even when they are not convertible. To
control the effective quantity of money available to its citizens and businesses, a country would
have to control the global quantity of money.

6.

There may not be any unique "equilibrium" or"natural" exchange rate between two currencies. An
infinite number of different exchange rates may be possible. However, for any given exchange rate
trajectory, a specific path of comparative price levels and inflation rates is implied ("purchasing
power parity").' 8


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330

It is implicit in these propositions that fluctuations in currency exchange rates do not alter the price of
one good in terms of another, but merely the yardsticks by which countries measure nominal prices. For

example, grade for grade, the spot delivered price of copper in Paris (measured in any specified currency)
is the same whether the copper is of Belgian, American or British origin. To conclude otherwise is to
presume that national markets are segregated, or that arbitrage profit opportunities (like buying cheap
from one country and selling dear to another) go unexploited. Figure Three illustrates the so-called
"Law of One Price" by comparing short-term fluctuations in the price of copper on different countries'
commodity exchanges.
Furthermore, in the absence of a change in the "real" prices of importable goods relative to ex portables,
real trade flows remain unaffected. A fall in the currency will not improve the balance of trade. Nor will it
provide relief to political pressure for protectionist policies.
Should the value of the dollar decline, by say ten percent, prices of U.S. goods would still remain
constant, relative to foreign goods. U.S. dollar prices, however, would have to increase ten percent more
than foreign currency prices in order to maintain "real" prices (and therefore the terms of trade)
unchanged. Official price indexes move slowly, suggesting that nominal price levels are inflexible, but
this is largely a result of using "list" or contract prices instead of spot transaction prices in compiling the
indexes. Moreover, official statisticians use interpolations, seasonal adjustment and other techniques
which impart artificial smoothness to the data. As a result, it would take time for inflation created by a
currency depreciation to show up fully in official price statistics, even if nominal prices were truly
flexible.
In sum, the "global monetarist" view implies that:
(I) devaluation will not improve the real trade balance (or alleviate protectionist pressure);
(2) a devaluing country will suffer inflation relative to the rest-of-the-world average in an amount
approximately equal to the percentage devaluation.
Earlier work has documented the fact that trade balances, on average, do not improve when currencies
are allowed to depreciate. 19 We have also published evidence that currency depreciations and inflation
go hand in hand. 2 Figure Four summarizes this evidence by comparing changes in the foreign value of
the dollar with inflation in the U.S. relative to seven foreign countries. Considering the major differences
in coverage and composition of countries' price indexes, the statistical fit is excellent. In spite of the
inevitable "noise" in the price indexes, more than 70% of the differences in inflation rates are accounted
for by exchange-rate shifts. Moreover, the correspondence between relative inflation and currency
depreciation, although not perfectly contemporaneous, is almost one-for-one.

°

An even more dramatic illustration is provided by a bilateral comparison of Canada and the United
States. Figure Five shows the almost perfect correspondence between wholesale prices in the two
countries when the Canadian index is converted to U.S. dollars. There is a one-for-one impact of shifts
in the exchang~ rate on comparative price levels. Moreover, this one-for-one impact has been in effect as
far back as the I 860's.
Combining these relationships with inflation's impact on tax brackets and output, 21 implies the chain of
consequences listed above for the declining dollar.


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331
Flcun Three

Rates of Change
of the Price of Copper
+15?.

wholesale quotation
U.S. cents per pound
(Source: IMF)

London
Antwerp (Congolese)

~ U.S. eastern seaboard

~

-+,5·l,
!

:l;

0

ml
c::J

§
,'>!
JI.

Is~ I~1
\

~

11[

ll1

{~
,,,<

-~

f '

'I

JI
>

m

.N

I
}I

I

1969

,

,
i

-S?.

~

1971
JI[
N

1\970

~ ~

'i

''

l
'

i

1
'
I

1972
][

~~

'
'

~-10?.
Comment: The closeness of correspondence is all the more remarkable

in light of the gaps and uncer-

-157.


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tainties present in the monthly
figures. This evidence certainly corroborates the purchasing-power
parity hypothesis. Note that given
the great fluctuations of price change
over time, this commodity has a
much greater weight in measured
inflation rates than would be
expected from its dollar volume
alone.

332
Figure Four

Relative Inflation vs. Exchange-Rate Changes
United States vis a vis Six Foreign Countries

1901-1976
Percent

30-~~~-----~--

10

•

" "

I\

0
-10

German
hyperinflation

World
War I(

-20
-30

-40

I

I

-50

I
1910

1920 19'JO 1940 1950 1960 1970

_ _ _ change _in U.S. exchange rate ($ per average foreign currency unit)
_______ U.S. inflation minus average foreign inflation
Source of data: Moon H. Lee, "Excess Inflation and Currency Depreciation",
doctoral dissertation, Graduate School of Business, University of Chicago,
1974. Updated by H.C. Wainwright & Co.


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333
Figurri,ve

Wholesale Price Inflation in the United States and Canada
both measured in U.S. dollars

percent per annum

50
40
30
t

20

I

ti

I

10
0
-10

\

,,

-20

I

-30

-40
1860 1870 1880 1890 1900 1910 19'ZO 1930 1940 1000 1960 1970
- - United States
------- Canada

Note: Canada adopted its decimal dollar currency in 1858.

39-940 0 - 79 - 6


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334
THE CHAIN OF EVENTS BEHIND TODA Y'S ECONOMY
This economic framework sets up a chain of reasoning that casts light on the immediate economic
situation in the United States. The chain begins with a government-endorsed decline of confidence in the
U.S. dollar. Each event in the chain thereafter leads naturally to the next event:
(I) a fall in the value of the dollar against major currencies, amounting to 14% between September and
the beginning of July on an output-weighted basis;
(2) a surge in the inflation rate, frequently reaching double-digit levels in wholesale prices since
September;
(3) higher marginal rates of taxation, therefore, on individual incomes and economic profits;
(4) a resultant weakening of incentives to work, prodnce and invest, especially for those areas of the
economy which are already being taxed at the highest rates;
(5) lower growth rates of output, employment and capital investment;
(6) higher unemployment;
(7) acceleration in the growth of the transfer payment "wedge".
The chain of events is displayed in Figure Six. As the diagram shows, the chain does not end with lower
output and higher unemployment. Increased taxation of activity that is already taxed in the prohibitive
range implies a loss in government revenues, and therefore a larger deficit. Since deficits must eventually
be financed by additional government revenue, the expected policy response sooner or later is a still
higher rate of taxation. Higher unemployment also triggers a demand for more government aid to the
weakest sectors of the economy, and increased transfer payments. These additional expenditures will
enlarge the deficit further and imply higher future taxes.
These contractionary effects on output can also "feed back" to the health of the dollar. Slower U.S.
growth diminishes the importance of the dollar in the world, and weakens the demand for.dollars. It also
facilitates further inflation, because the same supply of money is chasing after fewer goods.
Through all of these channels (and perhaps others) a vicious circle is set in motion. Inflation and its
impact on tax brackets leads through conventional policy responses to still higher tax rates, and so on.
And diminished output leads to continued inflation. In other words, the "feedback effects" of a
tax-induced decline in the economy intensify the causes that triggered it.
Although this logic is sobering, there is a silver lining. Circularity is the most virulent aspect of the
problem; yet it provides a clue to overcoming the economic malaise. Once the direction of the economy's
momentum is switched (for example, by currency stabilii.ation or a well-designed tax cut), the "feedback
effects" sta1t to work positively. Carefully focused improvements in government policy, such as the tax
cuts of the 1920s and I960s, can set a "snowball" in motion. The analysis thus portrays a narrow line
between expansion and decline, as evidenced most recently by the V-shaped recession of 1974-75. The
key to getting rid of stagflation is to adopt policies that push the economy across this line from decline to
expansion.


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335
Figure Six

The Vicious Circle
of Depreciation and Recession
Actual or perceived
official unwillingness
to maintain the
dollar's value

Lack of
confidence in

the currency

(

H.C. Wainwright & Co.
May 1978

I
Currency
depreciation

t:i--

I

Rise in the
price of gold

Inflation

I

Sarne rn~oney

asmg

Higher
future taxes

r goods

--------+---------,
Bottlenecks
pushed deeper
into prohibitive
range

Higher tax

rates

I
\.


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Bigger
budget deficit

Slower
growth

Higher
unemployment

Increased
government
spending

I
../

336
THE OUTLOOK FOR INFLATION

Policy discussions in Washington center around broad price indexes such as the WPI and CPI, rather
than the more volatile prices of raw materials and of commodities traded on centralized exchanges. The
WP! and CPI are constructed or interpolated from list or contract prices. This means that they are
usually a few months behind the course of actual events.
Thus, the impact has only just begun to show up in offical wholesale price statistics. As mentioned
earlier, although spot transaction prices seem to be affected immediately, official indexes are smoothed
and take a considerable time to adjust completely. After a shift in the exchange rate, historical data
indicate that only about one tenth of the full price level change shows up in wholesale prices within one
month. The greater part of the price level change has shown up by the time a year has elapsed, but a
significant portion takes more than a year to show up. In the absence of contrary economic forces, large
wholesale price level rises should, therefore, be expected to continue in the United States for some
months to come unless the dollar should reverse its decline.
Figure Seven sets these data in perspective. The dashed line at the top traces the cumulative depreciation
of the dollar relative to an average of eight major foreign currencies (weighted by output 22). The lower
bold lines trace the increases in the WP! and CPI over the same period. If history is a reliable guide, the
two bold lines will eventually catch up to the dashed line. And this analysis may well be conservative,
since it assumes an underlying inflation rate in the rest of the world of zero. So we may have seen in the
indexes little more than half of the inflation that is predicted to occur.
INFLATION OVERSEAS

Currency changes are like a seesaw. If some currencies, such as the U.S. and Canadian dollars, depreciate
relative to a world average, others must appreciate. The same reasoning that predicts high inflation rates
in North America implies low inflation rates in these other countries.
Between September and April, the largest currency gains have been for the Swiss franc (25% relative to
the dollar), the Japanese yen (20%), and the Dutch euilder (13%), and the German mark (11%).
Accordingly, these countries have been experiencing very low or even negative inflation rates as Table 5
documents:
Table S
Currency Changes and Relative Inflation
since September 1977:

country
Switzerland
Japan
Germany

Holland


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latest
month

Apr.
Apr.
Apr.
Jan.

% appreciation
relative to dollar

24.7%
20.3

13.8
8.6

% change In
wholesale prices
-4.4%
-0.S
+0.6
+0.1

% change in prices
relative to U.S. prices

-10.3%
- 6.2
-S.O
-2.6

337
Figure Seven

U.S. Inflation: How Far It Has To Go
Cumulative
Percent Change Since
September 1977

16~-.......-.......-~-.---~-.---~--,..--~16
14

14
% Depreciation
in U.S.1 Dollars

12

12

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Sept

Im

Oct

Nov

Dec

Jan
1978

Feb

Mar

Apr

May

June

July

% depreciation of the aollar relative to an average of eight major currencies

WPI ____ wholesale price index (all commodities), seasonally adjusted
CPI---- consumer price index (all urban dwellers), seasonally adjusted


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0

Aug

338
For the Canadian economy, the implications of the 1977 currency changes are even more serious than for
the United States, because the Canadian dollar has itself depreciated 4½% visa vis the depreciating U.S.
dollar. This development alone has been sufficient to bring inflation in Canada back to double-digit
levels. In my own view, vigorous enforcement of the Anti-Inflation Board's incomes policy would serve
only to disguise these price pressures or drive them underground.

THE OUTLOOK FOR GROWTH
As mentioned earlier, we have in recent years seen a negative correlation between the amount of inflation
and the growth rate of the economy. This relationsllip, reported in a short paper by Arthur B. Laffer
about eighteen months ago, 23 is updated in Figure Eii;ht. On the average, a l %increase in U.S. inflation
has been associated (either immediately or with a short lag) with a l to l ½% decrease in real growth.
Figure Nine shows the similar relationship between inflation and growth in Can~da. The Canadian
relationship too is statistically significant.
The most recent U.S. episode in which a surge in inflation was accompanied by a slowing of growth was
1973-4. From the first quarter of 1973 through the first quarter of 1975 prices rose some 21%, ora rate of
10% per annum. Simultaneously, real GNP foll 5%, or a rate of -2½% per annum. The most severe
recession of the postwar era occurred. Perhaps exceptional factors were at work in 1974. However, the
experience is consistent with the logic outlined above: inflation averaged about 5 percentage points
above "normal" (4-5%) during this two-year period, while growth averaged about 7 percentage points
below normal. A detailed look at Figure Eight suggests that three extra percentage points of inflation
occurrine over a period of a year may be sufficient (other factors remaining the same) to bring growth
from a "normal" 4% to zero during that period. Logicilly, however, a recession is more likely if inflation
is rapid than whe1e an equal increase in the price level occurs gradually.

In this context, the 14% fall in the dollar's value (in as short a period res nine months) is a serious event.
Allowing for the fact that a large part of it would be expected to show up as a deceleration of inflation
overseas, the above calculation still implies that a substantial shortfall in real growth is predictable in
1978.
The actual behavior of output in recent months has been obscured to some degree by the coal strike and
the severe winter. Nevertheless, it is possible to detect a slowing in the underlying rate of growth since the
third quarter of 1977. Indeed, real GNP failed to grow at all in the first quarter of 1978.


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339
-Figure Eight

Rate of Inflation vs. Real GNP Growth
annualized percentage changes, seasonally adjusted
INFLATION
%per annum

UNITED STATES

GROWTH
%per annum

H.C. Wain•1right & Co.
May 1978

10

Rate of
Inflation

5
Q-1----------------

10
Rate of
Growth

5
0

-5

-10

------- Inflation
---Growth


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340
Figure Nine

Rate of Inflation vs. Real GNP Growth
annualized percentage changes, seasonally adjusted
CANADA

INFLATION

GROWTH

% per annum

% per annum

20~_,..._..,.....,.........,..._,......,._...._,..,._..........___,.......~-.........................-.........

,',
_t

15

I

I
/

10

,~\

5

I

r, I
I

\

\

Rate of
Inflation

\
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,~

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-5
68 69 ?O 71 72 73 11 75 76 7l


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Inflation
Growth

341
A better measure of the output of the market economy would exclude the salaries of government
employees (which arc officially counted as "output"). It would also exclude items which are extrapolated
rather than measured, such as the imputed rents on owner-occupied homes, and depreciation on
housing, plant and equipment. And it would exclude the output of U.S. enterprises overseas, but include
the output of foreign enterprises operating within our borders. The resultant, known as net domestic
business product (NDBP), appears to be a useful substitute for GNP in this regard. It is noteworthy that
real NDBP declined in the first quarter - a more disappointing result than that for the total GNP (see
·Table 6). Second quarter data are unavailable at this writing, but after a "snapback" in April, economic
indicators for May and June have been disappointing so far:

Table 6
Indicators of U.S. Real Growth
(seasonally adjusted annual rates)
real gross national product
real net domestic business product

Ill-1977
5.1%
5.5

IV-1977
3.8%
4.4

1-1978

-0.0%
-1.0

GNP and NDBP include inventory accumulation, which in part reflects the fact that firms save money by
keeping output smooth in the face of fluctuating demand. The rate of slippage in real NDBP less inventory
accumulation was 3.4%.

The logic and the evidence point to a slowing in the U.S. economy in late 1977 and the first halfof 1978. If
the dollar should decline further, and without favorable policy developments in Washington, the
combination of inflation and recession appears probable.
The currency seesaw implies symmetrically opposite results for foreign countries whose currencies have
appreciated. The decline in inflation documented above is bullish for economies like Japan and
Switzerland, where effective tax brackets rise with price level trends as in the United States. Signs are
already evident of a pickup in these economies since last summer. Real GNP in Japan grew at al0%rate in
the first quarter.
The impact of inflation on real output in Canada is moderated by the fact that the personal income tax
system has been "indexed" to the cost of living. But indexing is incomplete, and does not in any case
extend to capital gains or the corporate profits tax. In sum, inflation leads to a diminution of
employment and production incentives in Ca11ada just as it does in the United States. The impact of
recent currency value changes on Canadian output will likely be more severe than in the United States.
Sweden, whose currency has fallen more than 4% relative to the U.S. dollar since September, is also in a
state of stagflation. The Swedish government expects only I% real growth this year, while consumer
prices rose at a 25% annual rate in the first quarter of I 978.


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342
OUTLOOK FOR THE TRADE BALANCE

Figure Ten illustrates how successfully trade balance fluctuatiqns can be explained without resort to
theories of an undervalued or overvalued dollar. When the United States grows rapidly, more resources
must be allocated to capital formation and less to consumption, or high growth could not be sustained.
This can be accomplished by importing more goods and services from overseas. Our growth thus benefits
the rest of the world by providing a market to foreign producers. At othertimes, the mechanism operates
in reverse. Other countries grow more rapidly than the U.S., helping to maintain.their flow of final goods
and services by increasing their imports from the United States.
TI1is view of the blance of trade as a kind of"shock-absorber" is fully consistent with historical evidence.
Countries whose growth is accelerating tend to move toward deficit in their trade accounts, and
countries whose growth is decelerating tend to move toward surplus. The relationship is highly
significant statistically, and explains 80 to 90% of trade balance fluctuations during the postwar period. 24
Based on the foregoing analysis of the prospects for growth in the United States, a significant fall in our
trade deficit (especially relative to accelerating economics such as Japan) appears likely in the absence of
policy changes.
EVENTS SINCE MID-APRIL

Characteristically, the stock market looks beyond immediate economic circumstances into the future as
far as events and contingencies can be foreseen. The fall in stock prices last fall and through the first
quarter of 1978 seem entirely logical in the light of the declining dollar and its consequences. Indeed
stock market declines have been closely correlated with the falling dollar on a contemporaneous basis.
The mid-April rally in stock prices (a jump of 3.9% in the S&P 500 index in the space of a single week)
does not necessarily mean that the threat of recession has passed -especially since the gain has not been
sustained. Historically, the market has bottomed out several months before the trough in real GNP. And
the. absolute level of stock prices remains extremely low. It could simply be that the stock market, as
usual, saw past the valley in front of it through to whatever lies beyond.


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343
Figure Ten

U.S. Current Account Balance
(not seasonally adjusted)
annual rate
$ billion

8

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60 62 64 66 68 70 72
---Actual
------- As predicled one quarter ahead from the difference between
U.S. and foreign real growth


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Source: Marc A. Miles, Rutgers University

76

-4

344
Although supporting evidence is inconclusive, possible reasons for the market rally (and for the
subsequenct decline) can be identified. Each of these hypotheses fits closely into the economic
framework laid out above, and adds further background for evaluating the prospect of a recession.

I. Changing Government Policy Toward the Dollar
Only six months after Treasury Secretary Blumenthal's world tour talking down the dollar, recent
Administration actions demonstrate a change in attitude.
The Treasury's announced intention to sell some $300 million worth of gold in a series of six
monthly auctions is of far greater significance than official wurces will admit. Though Washington
apparently still will not countenance "direct" support operations in the foreign exchange market,
from an economic point of view intervention in the gold market will serve just as well. The basic task
is to soak up unwanted dollars, and it is of lesser consequence whether the government does this by
selling foreign exchange ("direct" support), selling debt securities (reverse open-market operations
by the Fed), or selling gold. Nor does it make much difference, in an integrated world money
market, whether the dollars are extinguished domestically or overseas.
Any and all purchases of dollars by the federal government should logically raise the value of the
dollar, diminish inflationary pressure in the United Stales, and reduce the price of gold. Indeed, the
mere announcement or anticipation of such purchases should trigger these changes immediately.
Even a relatively snrnll program of dollar purchases can have large effects if it is seen as a definite
change in policy. This is one interpretation of the events of mid-April, which included a 1.6% rise in
the dollar and a$ IO fall in the price of gold overa period of a single week. Since May, the dollar and
the stock market have fallen back, and the price of gold has recovered.
II, Rising Chance of Making the Tax .Structure Rational
As mentioned earlier, the tax structure plays a major part in the contractionary chain of events
resulting from inflation:
(a) the general level of tax rates (the magnitude of the "wedge") in both the present and the
expected future;
(b) the extent to which sizeable segments of the economy (e.g., the working poor, high-income
families, and business capital) face marginal tax rates in the "prohibitive range"; and,
(c) the extent to which inflation automatically increases tax rates and pushes the economy deeper
into the prohibitive range.


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345
All of these factors play a major role in the economy's present malaise. Federal tax changes whic
would alleviate the problem are, respectively;
(a) a deceleration in federal spending (not yet foreseeable);
(b) a lessening in progressivity for upper income groups and/or a reduction in taxes on capital
gains and corporate profits;
(c) an indexing of the individual tax structure and/or a move to permit businesses to deduct
depreciation and cost-of-goods-sold expenses on a replacement cost basis.
During April, there seems to have been a steady improvement in the chances of a number of
proposals (including the Kemp-Roth and Stockman bills) which address these issues. At the same
time, there has been a deterioration in the prospects for President Carter's plan, which seeks de
facto to increase progressivity for upper income groups. 25 The most dramatic change in mid-April
was a breakthrough within the Ways and Means Committee in support of an amendment
sponsored by Reps. Steiger, Jenkins, Jones, and Frenzel. 26 This amendment, which now stands a
good chance of passage, would roll back the maximum federal rate on capital gains from nearly
50% to 25%.
POLICY CONCLUSIONS

If the economic framework outlined in these pages (and documented in the references cited) is anywhere
near correct, some far-reaching conclusions follow:

I. Policy makers should abandon their adherence to demand--oriented economic thought. It takes
supply as well as demand to drive the economy, and neither will be forthcoming without adequate
incentives.
2.

The sharp division between domestic and foreign economic policies is illusory, and the existence of
two separate policy making apparatuses may foster detrimental conflicts. The United States is for
economic purposes fully integrated with the rest of the world.

3.

U.S. policy should seek to keep the dollar as stable as possible with respect to time-tested standards
of value, Exchange rate fixity would be a step in the right direction. Returning to the gold standard
would be better. However, exclusive reliance upon a single commodity may be risky. The best
policy would be to fix the price of the dollar in terms of a market basket of goods. Such a policy
could all but eliminate inflation, and would restore the dollar to its former position as lynchpin of
the international monetary system.

4.

In the absence of a sound dollar policy, the tax structure should be indexed against inflation. Tax
rates should be cut sharply, especially on activities of the upper reaches of the "Laffer Curve" such
as business capital and low-skilled labor. Such reforms would greatly stimulate the U.S. economy,
and thereby the world economy generally. And they would raise more, rather than less, tax revenue
to finance spending commitments.

5.

Policies to improve the trade balance by protecting domestic industry from foreign competition
serve primarily to "beggar our neighbors" and ourselves. They should be replaced by a policy of
laissez-faire toward the balance of trade. If the economy is healthy, the balance of payments will
take care of itself. Imbalances can and do perform a useful function by allocating capital efficiently
among countries growing at different rates.


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346
FOOTNOTES
Different weighting methods or more comprehensive indexes may give somewhat different figures. For
example, the U.S. dollar fell 15½% using 1977 gross domestic products as weights.
Arthur B. Laffer, "The International Monetary Outlook", H.C. Wainwright & C:o. Economic and
Investment Observations, Novermber 22, 1977.
R. David Ranson and Charles E. Babin, "Investment in Plant and Equipment: Part I: Diagnosis and
Outlook", H.C. Wainwright & Co. Economic Study, October 17, 1977.
R. David Ranson, "Toward a Broader Picture of the Budget Deficit", Policy Review, Winter 1978, reprinted
by H.C. Wainwright & Co., March 22, 1978.
R. David Ranson, "The Falling Dollar", H.C. Wainwright & Co. Economic and Investment Observations,
January,6, 1978.
Jude Wanniski, "Taxes, Revenues and the LA/fer Curve", The Public Interest, Winter 1978, reprinted by H.C.
Wainwright & Co., January 25, 1978.
R. David Ranson,• A Micro Approach to the Macro Economy: Some Investment Implications", Seminar on
the Analysis of Security Prices, University of Chicago, November 1977.
Arthur B. Laffer, "Prohibitive Tax Rates and the Inner-City: A Rational Explanation of the Poverty Trap",
H.C. Wainwright & Co. Economic Study, June 27, 1978.
R. David Ranson, "The Relationship between Trade Balances and Exchange Rate Changes", H.C.
Wainwright & Co. Economic Study, February 16, 1977.
•• Charles W. Kadlec and Charles E. Babin, "Investment in Plant and Equipment, Part II: The Role of
Liquidity", H.C. Wainwright & Co. Economic Study, April 28, 1978.
11

Arthur B. Laffer, "A New Perspective on Inflation and Unemployment", H.C. Wainwright&Co. Economic
and Investment Observations, January 17, 1977.

12

Since that date, earned income has received more favorable treatment, but this is not included in the data
shown here.

"

For a clear and concise description of how these techniques work, the reader is referred to Sidney Davidson
and Roman Weil, Fundamentals of Accounting, Hinsdale, Ill.: Dryden Press, 1975

••

In general, economists prescribe that any asset should be valued at the opportunity cost of sacrificing it that is, the amount of money it would take to restore the loss.

is James F. Nasuti and Charles A. Nickerson, "Capital Gains Should Be Indexed", Wall Street Journal,
editorial page, August 12, 1977.


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347
•• Arthur B. Laffer, "Substitution of Monies in Demand: The Case of Mexico", H.C. Wainwright & Co.
Economic Study, May 27, 1977.
17

Marc A. Miles, "Discussion" in International Exchange Rates and the MacroeconomicsofOpcn Economies.
Papers and Proceedings of the American Economic Association, New York: December 1977. American
Economic Review, May 1978, pps.415-16.

"

Arthur B. Laffer, "The Practical Implications of Global Monetarism", H.C. Wainwright & Co. Economic
and Investment Observations, May 23, 1977.

"

Arthur B. Laffer and R. David Ranson, "Some Practical Applications of the Efficient Market-Concept",
H.C. Wainwright & Co. Economic Study, July 6, 1977.

20

Ibid., p.21.

21

Arthur B. Laffer, "A New Perspective on Inflation and Unemployment", H.C. Wainwright & Co. Economic
and Investment Observations, January 17, 1977.

"

In an integrated world economic system the effects of exchange rate shifts are felt not only between countries,
but within countries. The relevant weight for a given country therefore logically should be based on the
amount of domestic as well as international trade in which that country engages.

23

Arthur B. Laffer, "A New Perspec1ive on Inflation and Unemployment", H.C. Wainwright & Co. Economic
and Investment Observations, January 17, 1977.

"

Arthur B. Laffer and R. David Ranson, "Canada, The United States, and the Rest of the Developed World: A
Study in the Integration of Markets", in Policy Formation in an Open Economy, University of Waterloo,
Ontario, 1972. Volume I, pp.27-55.

"

Arthur B. Laffer, "President Carter's Tax Plan", H.C. Wainwright & Co. Economic and Investment
Observations, January 30, 1978.

"

William A, Steiger R-Wisc., Ed Jenkins D-Ga., James R. Jones D-Okla. and Bill Frenzel R-Minn. See
"Stupendous Steiger", Wall Street Journal Review and Outlook, April 26, 1978, p.22.


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348
Representative MITCHELL. Thank you.
Gentlemen, I must say that this has been generally depressing
testimony in terms of the substance. Certainly we have heard some
very, very what appears to be radical remedies to help out in this
situation.
Let me start out with the first radical suggestion and that is in quotes,
the first radical remedy you suggested. You talked about a uniform
tariff across the board at about 10 percent.
Mr. Norris, I think, in his testimony indicated that that would not
be a good position for him. I wonder how you justify a recommendation like that when past history will reveal that when any nation has
done that kind of thing, that the action has been reciprocated by other
nations. We reach a point when there is just conflict.
Mr. BERNSTEIN. First, I think I better qualify myself as a liberal
on international economic policy. I was the chief technical adviser of
the U.S. delegation at Bretton Woods. I was the principal author
of the report for President Truman entitled "Trade and Tariff
Policy in the National Interest."
There is nothing in my background which makes me anything other
than a classical free trader.
The question that I put to you is the following: The reason for free
trade is that it will raise real incomes. The United 8tates exports its
goods in which it has the greatest comparative advantage, the greatest
relative efficiency. It imports goods in which it has relatively less
efficiency. Now, all this is true in a free trade world if exchange rates
reflect relative prices and costs. Under such circumstances, I am for
100-percent free trade.
But we have a floating exchange rate system in which the exchange
rates of the dollar for the European currencies and the yen have moved
on about five or six occasions, up and down by 15 or 20 percent in the
course of a few months. The last big movement was from September
of 1977 to March 1978.
As prices and costs in the United States don't rise by 20 percent or 15
percent in a 6-month period compared to, say, those in Germany
and Japan, the movement in the exchange rates is not corrective of the
differential rate of inflation.
If that is so, then the dollar must have been overvalued at the beginning of the period, or it may have been undervalued at the end of the
period.
Let me explain it this way. The rate of inflation of prices and costs
over a 6-month period is, let's say, 5 percent in the United States and
1 percent in Germany. A 4-percent depreciation of the dollar relative
to the D-mark from September 1977 to March 1978 would have offset
the greater rise in our prices and costs.
Now, as we had a bigger depreciation of the dollar, we know one
of two things must be true. The dollar may have been overvalued at the
beginning of the period or-Representative MITCHELL. May I interrupt you for a moment?
I followed your testimony very closely when you addressed this
problem area before. Maybe I didn't put my question pointedly enough.
My question, I hope, very specifically, is: If your recommendation,
your proposition about a uniform tariff, 10 percent across the board,


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should somehow or other obtain, what is to prevent other nations from
imposing that same kind of tariff, just locking us into an untenable
situation~
Mr. BERNSTEIN. First, I wanted to make sure that you UilderstoodRepresentative MITCHELL. I think I did from your earlier testimony.
Mr. BERNSTEIN. Right. Well, as a matter of fact, I don't think there
would be any harm in a 10-percent tariff by the others, too, because the
same is true in reverse trade with them.
I am arguing the following: It may be that you won't get the
greatest gains in trade if there were a uniform 10-percent tariff in all
the great trading countries.
I agree with that. You won't get the maximum. You won't get the
maximum, either, with a zero tariff, if exchange rates move up and
down by 20 percent.
You won't get the maximum because when the dollar is overvalued
the United States will be importing goods that we could actually produce more efficiently, and we will be prevented from exporting goods
which we can export very efficiently.
As we already have an implicit bounty on imports when a currency is
overvalued, the tariff would neutralize this in whole or in part. In my
opinion, a 10-percent tariff would reduce by half the distorting effects
on trade when the dollar exchange rates for major currencies move
up or down by 20 percent. It won't maximize the gains from trade
but it will prevent the harm done when the dollar is at the peak and
at the bottom.
This is a great deal for a country like the United States, which is
now running a trade deficit of $45 billion a year on a balance of payments basis.
Representative MrrcHELL. Mr. Norris and Mr. Ranson, do you care
to comment on this i
Mr. RANSON. Yes. My comment would be extremely brief. Two
wrongs don't make a right.
The reason we have crazy trade balance behavior is not in our failure
to impose tariffs on our imports. What we have is an overtaxed economy, both here and overseas, and to impose more taxes on top of that
is going to make the problem worse.
Representative MITCHELL. Mr. Norris, I think you have already
addressed this issue in your testimony.
Do you want to elaborate?
Mr. NORRIS. I agree with Mr. Ranson. I do not think that import
fees are the solution to our problems. They are only a palliative, and
they certainly will not rectify the structural imbalances that exist,
some of which Mr. Ranson has mentioned.
Representative MITCHELL. I will put one more question, and then I
will turn to you, Senator.
I think all three of you gentlemen indicated, to varying degrees, that
you foresee a rather. long series of U.S. trade and current account
deficits.
.I thinkessentially that, was the tlistimony of all three of you.
Mr..BERNSTEIN. I would like to qualify it for mysel:(.
Representative MITCHELL. poes that mean, then, that you foresee
a relatively long per.iod of dollar.instability in America?
35--940-78-7


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Mr. B:ERNSTEIN. Congressman Mitchell, I think it would be correct
for me to say the following:
First, sqme trade deficit for the United States in the kind of world
we are living in today is not inconsistent with a good pattern of intern.ational payments primarily because we have large net income, net
receipts, from investments and services.
Representative MITCHELL. Let me amend it, then, Ly saying a large,
an enormous deficit.
Mr . BERNSTEIN. The present deficit?
Representative MITCHELL. Yes.
Mr. BERNSTEIN. Congressman Mitchell, I think the present deficit
will come down. I have already explained why I think the last quarter
of 1977 and the first quarter of 1978 represented a hurry-up exporting
to the United States by Germany and Japan to get through Customs
before the Customs valuations are based on a greater depreciation of
the dollar.
So, there will be a correction. I also believe that the problem really
isn't that Germany and Japan aren't growing so much, except that
some of their exporters do regard the U.S. market as an excellent place
for taking up the slack in home demand and don't expect to get anything like the average profits they would get at home.
But I have another reaRon for thinking thnt we aren't P,"Oing to
have this big trade deficit indefinitely. I am ]ookin,Q' for a subst1antial
improvement by the end of the year, but I also won]d make the point
that if we don't have a substi1.ntial improvemPnt, I think we are going
to have a great demand, public demand, in the United St1ates to do
somethin,g about it.
The dollar can't keep falling indefinitely because the other counfrips
like .Tapan, for example, keep insisting that they have to have a trade
surplus.
It is their economy which iR structm~ally out of balance', not ours.
RepresPntative MITCHELL. Then you are reasonably optimistic that
there might be a change-Mr. BERNSTEIN. A consider::ible improvement this year.
ReprPsentative MITCHELL. Mr. NorriR.
Mr. Nonnrs. I don't see the scope for improvement that perhaps
yon are sw~gPstin~.
As I mentioned in mv prep::tred statPiment, WP rlo not thinl, that
r-rowth in the rPst of the wor]d will pick up relative to the United
States over the next seveiial years.
,
RepreSPrntative MITCHELL. Back to mv original onPstion. Yon foresee a protracted period of American dollar instability then; is that
correct?
·
Mr. Nmmrs. Under unchanged conditions, yes.
I would say that I do expPct the trade deficit to improve, which
woulil imply less dollar instability than we have seen over the last
6 to 9 months.
I woul<'l like to make an adclition::il comment. Evf»n if there wrre
the foreign dPmi1nd for our g90ds. I am not snrn that we have the
capacitv to supnlv that df>lmand. The studiPs of Mik:f>I Evans, presidPnt o-f Chase E<'-Oll.ometrics. have shown that the U.S. economy is
operating much closer to potential or full citpaJCity than is generally
thought to be the case, which partly exptains the return to donble-


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digit ;inflation levels here in the United States. Hence, if there were
increased foreign demand, producers simply would not have the resources to ship,abroad, even if they had the incentive to ship ,abroad,
which they don't.
Hence, slow growth in the rest of the world is one factor for our
relatively pessim:istic outlook for U.S. exports, but this is exacerbated
by the fact that the economy is operating much closer t-0 full capacity.
Now, any short term measures such as import fees or contmctionary policies that are designed to reduce imports are what they are described as, merely short term,
What we need are incentives to raise our productivity levels much
closer to Japan and Western Europe.
· Unless we have higher productivity gains, our goods will suffer
from a further loss in the international price competitiveness, thus
continuing the long-term depreciation of the dollar.
Representative MITCHELL. Mr. Ranson, I would assume your answers
to be, based on your three-part premise, that you would predict continued American dollar instability?
Mr. RANSON. I think it entirely depends on what policies we follow.
Our present policy is what the
all Street Journal has .correctly
termed "malign neglect." We could stop the instability of the dollar
overnight by following a sound dollar•policy, such as I have described.
Representative MrrcHELL. Senator J a vits.
Senator JAVITS. There is one question I would like to deal with. because we have posed a great debate in this country on these three
juxtapositions.
Mr. Norris, you said we are approaching the point where we don't
have the' capacity to supply the demand, even if. we had it, from
abroad.
You pointed out, and I agree with you, that when you join the lack
of productivity increase in the United States. with the uneconomic
price which we are paying for oil, you have almost insurmountable
barriers.
Now, as I see the three positions, and juxtapose them. the question
is, How much is there in the American market per se, and how much is
there in the foreign market~
The third question is, ,¥hat can be done to stimulate either the
domestic market or the foreign market~ Where should we make our
choice?
As I see the heavy incentive which a major tax cut procedure would
take, the theory is that we will materially increase domestic investment
and domestic opportunities simply by making money available.
It is a question of the volume of money which is available. Is that
essentially the issue, Mr. Ranson?
Mr. RANSON. I don't believe we necessarily have to make a choice. n
is part of my pr_emises tha~ the whole world is the only closed economy,
and that the Umted States 1s an open economy. What we do to stimulate
our own economy can't help but stimulate the rest of the world ttt the
same time. mat they do to stimulate their economies can't help but
stimulate us, too.
Unfortunately, what mainstream wisdom says is stimulative often
has the opposite effect. I think a tax cut in the United States would
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Senator JAvITs. But the main point you make is that we would stimulate our own growt~ right i
Mr. RANSON. I hil.ve no particular reason to emphasize the United
States more than the rest of the world, really.
Senator JAvtts. And you think it would translate itself so quickly to
the world that we could re9;p th0 :benefits of it in terms of exports, as
well as in terms of increased domestic demand~
Mr. RANSON. I think the effoots would be quick, yes.
Senator J AVITs. As quick a,broad as at home 1
Mr. RANSON. Yes. I don't think it would be quicker in one place more
than the other, not in any predictable way.
Senator JAvITs. I understand, Mr. Bernstein, who is a very old
friend, that what you really want to do is allow the forces of domestic
growth an opportunity to regain their strength, as it were, by immunizing them, at least for a little time, from the adverse impact which we
seem to have in our insatiable thirst for imports.
Mr. BERNSTEIN. Senator, I think the problem is a little more complicated than our insatiable thirst for imports. Incidentally, I would
Eke to see a greater flexibility in exchange rates, and if that had
been our subject, I would have explained how I would go about it.
I do agree that a major element in the achievement of greater
stability of the exchange rate for the dollar is to have less inflation
in the United States and, of course, an increase in productivity, given
the same prices and wages, would help to hold down inflation, of
course.
But it isn't so much, Senator, that we have an insatiable taste for
imports.
We have an insatiable taste for l?OOds. These goods could be,either
domestic or foreign. It is my opinion that in fact some of our competitors abroad confronted with a home market that is not growing
as much as they are accustomed to, find the American market a very
attractive place in which to sell their output.
I think in order to do this they do take smaller profit margins on
their sales here than, of course, we do, but even lower than they would
normally expoot.
In the case of at least some of the countries, the governments help
them along in this by keeping an undervalued currency.
If you stop to think that the dollar exchange rate for the yen was
lower, that is to say, the yen was worth less in dollars in September
1977 than it had been in March 1973, you get some notion of how
much intervention by the Japanese monetary authorities was involved.
So Senator, it isn't that we have an insatiable appetite for imports.
It is that in fact we have a big demand for goods at home, and they
are selling in this market, in some cases with Government help, at
prices which are not competitive with ours even at higher exchange
rates for their currencies.
If we had :fluctuating exchange rates, Senator, in which the move:rnent of the dollar rates of exchan~e against the currencies of the
Group of Ten in Switzerland, say, ,Japan and Germany, matched the
differential rate of inflation, I would be for 100 percent free tra,de.
It is my opinion that we are all exag~erating, especially the U.S.
Government and my friend on the left here, the relative importance
of differential growth of income-income\ not productivity, because


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J)toductivity enters into price-as distinguished from competitiveness
through price.
.
. .
.
I think we are not gomg to get the Japanese to mcreaae their rate
of growth as long as they can have a trade surplus with the United
States of this massive size.
Why should they t They don't have to undertake the budget deficits.
We undertake them. They don't have to ease monetary policy. We do it.
What is more, most of the goods they sell to us, like automobil~s,
are from a sector which is not more efficient than ours. Our automobile
industry has had the second or third biggest rate of increase in productivity of any major industry in the United States in the past 10
years.
If you want the Japanese economy to grow faster on the basis of
domestic demand. then I think one way to stimulate them is to say,
"We are not underwriting employment and production in Japan by
continuing this sized trade deficit with you."
Senator JAVITS. I appreciate that. Ofoourse, there is much sympathy
for that view in the United States, ~nd hence what are called the
orderly marketing agreements. I ml!St say that we have to look down
the road a little bit, and it sooms to·me tliat we are all suffering from,
and Mr. Norris pointed that out, is too small and overall demand for
all the industrial goods which we are within reason oapable of turning out, and right now we are taking in each other's washing a.nd we
are not endeavoring to expand materially the consuming ~pa.city of
people who are way, way down the scale on the grounds that that is
.
very good business, and excellent m_arkets.
Mr. Ranson wants to do that simply by encouraging more money
in the pockets of those who are able to invest and expand and show
initiative, those who are way under par.
Of course, that hasn't been the history. The history has boon that
we materially increase the standard of living of the 85 percent of
Americans who are not in the poverty level, and it does not have major
economic, which includes social, consideration of those conditions in
the world, and opening up new markets and making a more equal position in the world and closing the gap somewhat over what it has been.
I gather your prescription, Mr. Norris, would be, major capital investment in the United States, stimulate that, to increase productivity,
and capacity, coupled with major intelligent investment to expand
materially markets, mainly abroad.
You have a billion people going to bed every night hungry. Do I
understand you correctly 1
Mr. NORRIS. Yes, absolutely. I do believe that there is much that can
be done here in the United States, both :from the point of view of
stimulating supply, particularly stimulating our productive eapacity .
. I travel to Europe quite frequently, and each time I go I am receivmg £ewer deutsche marks, French francs, or Swiss francs in exchange
for my dollars. Yet when I go out to a shop or have breakfast or dinner,Tfind that the prices in local currency have also risen substantially.
I am astonished at retail prices in foreign countries. Approximately
2 years ago, I was in Oslo, and had a so-caUed continental breakfast,
which included coffee and toast, and I paid it in Norwegian kroner, but
when I translated it back to dollars, it cost me approximately $7.


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I am not'suggesting that we exp?rt continental bte~Jdasts to Eur?pe.
but ~ertainly <?Ur goods-the pn~s of our goo~s, our_autorp?b1l~,
clothing, machmes, our raw materials, are amazmgly competitive m
European Markets, and the same for·Japanese markets.
"Ve do need greater incentives to export.
.
·There is a problem, as I mentioned, that of supply capacity: Even i:f
the foreign demand were, there, at least in the manufactured goods
area, I am not. sure we would be able to take advantage of it. The obvious area for potential growtih without incurring inflationary pressures
would be the agricultural sector.
It would also make a lot of sense to reduce subsidies to the U.S. farm
sector. 3;nd reorient our policies to export our excess supply. I thinkit
is rather myopic policy to tell farmers not to plant wheat or corn,
when, as you say, there are a billion people going to bed every night
hungry.
I don't know the appropirate prescription for increasing agricultural exports. It is an area where we have high productivity, and it is
an area we should take advantage of.
The question you ·ask about present policy and what should be done
and where should the stiniuhis be .made, I think that was referring
not. only to the United States but to w·estern Europe and Japan.
It is a question that ican be answered either from American or a
foreign point of view.
From an American point of· view, obviously, we want to get the
Japanese and Germans to ~row as fast as they can without incurring
serious problems on the inflation front.
· Some would sav that the Germans could allow their inflation rate
to !!O from 3 to 5 or 6 percent without causing serious problems.
That is from a foreign point of·view. However, if you are a German, you would look at the postwar history and sav that your country
went througfu. nn enormotis inflationary spiral, and thus even the sug-•
gestion of tole-rating higher inflation from a level that Americans
consider low, that is, 3 percent, is not politically acceptable.
In addition, if I were a German, I would point to the fact that the
total• deficits of the Federal, local and State governments will approach approximately $60 billion deutsche marks, which is 4½ to 5
percent of GNP in Germanv.
So, if I were in ti.he position of Helmut Schmidt, I would tend to
resrist efforts to go for a big stimulus.
However. by the same token, Germans are part of a world economy.
Thev need foreign markets to se11 their excess supplies, and if the Germn.ns are statesmen they would accept a higher stimulus.
The problem is that the Germans want other countries to stimulate
as well, and I think that petting back to tJhe United States here. I
wonkl strongly sngP:est to President Carter to !l"O to Bonn with the
un<lerf'tandinP: that he will push :for a moderate fiscal pnckage if, and
onlv if, the Germans and Japanese offer something in return.
If we are the onlv ones who stimulate this winter, this will lead to
a further rise in U.S. demand, a, further rise in imports, and a further
substantial depreciation of the dollar.
.
On the other hand, if ,Ta pan introduces more fiscal stimulus, and
I want to point out that there isn't anv country in the world-among
the major industrialized countries-that has stimulated its economy


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as much as. J'.3.pan in ·terms o:f higher spending during the ·past 2
years.
.
.
The problem is that there is absolutely no chance of ~n investment
boom, and the rapid rise of the yen has offset the fiscal stimulus.
But.if .the Germans and ,Japanese would agree to some stimulus, I
think 'that they would import niore, and the United States would export more .. 'I,'hus, the whole world would be better gif than i£ we only
stiniulate·our: economy this-winter: without any concomitant stimulus
in the foreign countries.
·
Senator .JAVITS. I would, add only one note to that, and· I believe in
order to stimulate we are going to have to have inducement,. something that people in business -ean look .down the· road .and see where
YOlJ are going to estabii-sh broader markets.
.
They know that these ·ma:r.kets, and· I think Mr. Bernstein, is right
about this,. 9::re untena_ble politically. It can't go on; .and ,that is true,
Mr. BEnNsTEIN. May I make ·an observation on what -this gentle-,
man has just said j
.
·
It. is-an,:oqservation, too, on the policy of the United States. We
have found it ~ y.ery attractive, easy explanation of our trade deficit
to say that it.is due to the--fact-that other countries aren't stimulating
their.economy as mrn;h as we are.
·
If it were-true that this is the major explanation, and ~hat prices
don't entel" into· this thing to any- great extent, then we are really in
trouble, because I cannot s~e why the United Btates would have to
undertake• a continued, depreciation of the dollar because of the unwilliJJ.ghess, of the other count:r.ies to stimulate their economy, at the
same time holding down the growth of our output and en:i,ployment
and intensifying our inflation. ·
Why wotd<l the. United States· do thaH How could the United
States give in to such a policy and give in to it, as this.gentleman suggests, so that a deficit of this magnitude is going to continue for ~everal
years.
I would say it isn't going-to continue, because either it will correct
itself through the instrumentality I mentioned, that' is; exchange rate
changes, or I think you will find an _inevitable .demand in the United
States that we do something about keeping out some o:f these excessive
·
imports.
Mr. NORRIS. Since Mr. Bernstein pointed his comments at my re-s
marks, I would like to answer them.
Stimulus is not the only answer to our problem. In fact, in ·the
last section of my prepared statement, I have pointed out that the
U.S. share of world markets-of the markets of major industrialized
countries-actually declined in 1977 by a significant amount.
Total import volume of the major industrialized countries increased
by at least a modest' amount in' 1977, but our exports to those same
countries decreased by a substantial amount.
In terms of price competitiveness-I don't have the graphs, with
me-our studies have shown we are much more price competitive than
the Germans, French, Italians, British, or the .Japanese.
The problem is that the European currencies have .appreciated
against the dollar when in fact:some of them, at least the Italian lira,
pound sterling, French franc should have depreciated against the
dollar.


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I think if we are goina to have this negatil"e reaction to foreign
~oods here in the United §tates, it is going to cause serious problems,
m the world economy. I might add that this negative reaction anticipated by Mr. Bernstein will not come from consumers. The consumers
are the ones who are bnying the Japanese cars, Japanese cameras, and
German cars ancl appliances.
You are not going to get a negative reaction from the mass of U.S.
consumers. They are the ones who are attracted to the efficiency of
Japanese products, to their reliability, and to the aftersale service.
The reaction is going to come from the political arena, from the labor
unions, and aft'ected industries.
Now, that is not the mass of America. I think Americana are being
~enalized by the rapid ll,ppreciation of the yen and the D!r{ because
they are not benefiting from the higher productivity gains in those
countries, and I think 1t is an extremely pernicious policy on the part
of the U.S. producers to say, "Aha, the Japanese have rMsed their car
prices. Let's.raise our car prices, also."
· This is exactly what has happened here in the United States, which
is commonly described as sympathetic price increases.
So, stimulus alone is not the answer. We are competitive in world
markets, but we need a much broader program, stimulating export
growth. The f~reign markets ai:e there1 but we haven't tl!'pped them.
The emphasis should be on mcreasmg our exports, mstead of the
debilitatjng program of reducing imports.
If we decrease our imports by 10 percent, we will have a worldwide
recession in 1979 or 1980. That is unequivocal, and I make this statement in hope that some of the more enlightened Members of Congress
will prevent ~uch shortsighted action from being taken.
Senator JAVITS. Congressman Mitchell, I have to leave.
. Representative MITCHELL. I do have one area that I want to address
briefly. Mr. Bernstein has indicated that the floating exchange rates
may be effective in helping us with our balance of payments.
Mr. Ranson on the other hand has indicated he does n()t believe that
this is a benefit. That is sort of contradistinctive.
I would like to hear from Mr. Norris on this. We have gotten two
points of view on the effectiveness o:f the floating exchange rate..
I don't think you addressed that, and I would like to hear from. you
oi1 that.
.Mr. NoRRis. I was hoping I would have that opportunity. Mr. Ran•
son's analysis has shown that 50 percent o:f the time devaluation improves a current account bala.nee. That should be evidence that there
has been success in the past, even though in 50 percent of the cases
current account balances worsened.
,· 1 would say that the situation where the trade accounts worsened, in
most o:f those eases governments had irresponsible monetary and fiscal
policies that worked against the depreciation of the currency.
It is a classic Keynesian concept that the trade bale.nae will not
deteriorate unless you have offsetting .fiscal stimulus und,er the case of
an appreciating currency. With a depreciating currency, you will not
benefit unless you have offsetting deflationary policies.
Hence, I think devaluations do work, but they have to be backed up
by appropriate monetary and fiscal policies.


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·we have experienced a significant devaluation 0£ the dollar here in
the _States. Keynesia;n. ~h~ry wo~~d say deflate, curb domestic de!lland
by 1mplemenbng restrictive pohc1es. But we can't do that here m the
States.
We are the world's largest economy and to do so would cause a
worldwide recession.
I feel we can tolerate a large deficit. However, we cannot tolerate
larger ones than we have had, and I think we should shoot for a lower
trade deficit.
I say that we can tolerate a large deficit because there are no other
money or capital markets that even come close to the size 0£ the U.S.
money and capital markets.
So, we do have the capacity to tolerate a reasonably large deficit.
We sl10uid opt for an improvement, but through exports rather than
reduced imports.
Ifi my prepared statement, I have prepared charts on price competitiveness, and in the case 0£ Japan, prices have increased in dollar
terms relative to the United States and relative to an average for the
rest of the world.
The problem is that in the period between 1973 and mid-1977, Japanese export prices relative to the rest 0£ the world in dollar terms
declined substantially. In this period Japanese export prices were 20
percent lower than the average £or the rest 0£ the world because the
yen was a grossly undervalued currency.
So, you are seeing now a oorrection from that imbalance, and I think
the yen will have to appreciate against the dollar by at least another
10 percent before prices reach an equilibrium level.
Now, you might say, "Why has the Japanese trade account improved at the same time the yen has appreciated~"
One reason is that Japanese goods are still competitive. Another
reason is that each time the yen has gone up, their import prices have
declined by anywhere from one-half to three-quarters of the percentage increase in the yen.
So, the yen has gone up by 35 or 40 percent, and there is a concomitant decline in import prices by half to three-fourths 0£ that magnitude.
Since approximately half 0£ Japanese producers' costs are accounted
for by imported raw materials, the lower level of import prices has led
to a decline in wholesale prices relative to what would have occurred if
there were no appreciation of the yen. Lower import prices have offset
higher unit labor costs to a large extent.
The second factor which accounts £or the large and growing trade
surplus in Japan is the fact that Japan still has an enormous amount of
excess capacity, particularly in autos, television, iron, and steel. Partly
because of its concept of lifetime employment, production levels have
been kept up artificially high, and this has put pressures on producers
to export their excess supplies.
I do think the higher value for the yen is already affecting Japanese
exports. We have second-quarter tra'de data for Japan that indicate
export volume fell at an annual rate of 15 to 20 percent.
The trade balance has increased in dollar terms because its export
prices in dollars relative to its import prices have increased.
So, members of the Carter administration continue to focus on the
nominal dollar-based trade account in Japan, when in fact the real


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balance has declined, which is attributM to the higher value £_or the ye~
and to a lesser.extent the orderly marketing agreements that have been
arranged.
I think that.there is no question in my mind that if you had American
consumers being confronted with a $6,000 Toyota relative·t? a $4,000
Ford, there would be a greater preference for U.S. automoj>1Jes.
.
The problem is that U.S. producers have increase.d the pr1ce.S of their
small cars along with the price of Japanese cars. r think this is extremely shortsighted poJicy ·on the part of U.S. auto producers; and it
results from decisions made perhaps as far back as the 19~0's, when
U.S. producers decided to give up the small car market tp foreign
producers.
_
Now that foreign producers have gained a very large percentage of
the U.S. market, U.S. producers are claiming they are not equipped to
_produce small cars efficiently, and they won't accept the lo_wer profit
margins.
·
_ I think this is part of the problem that Mr. Ranson has pointed out,
that there are sympathetic price increases, and this has led to an overall
higher rate of inflation here in the United States.
Representative MITPHELL. Thank you very much.
Gentlemen, tha.nk you. It has been a long morning, and a part of the
afternoon. but we thank you very much for your testimony. The com7
mittee will stand in recess until tomorrow.
[Whereupon, at 12 :45 p.m .. the committee recessed, to reconvene at
10 a.m., Thursday, July 13, 1978.]
[The following information was subsequently supplied £or the
record:]
CONGRESS OF THE UNITED STATES,
JOINT ECONOMIC COMMITTEE,
Washington D.C., August 7, 1978
Hon. RICHARD N. CooPER,
Under,Yecretary o.t State for EconomJe Affairs,
Department of State, Washington,. D.C.

DEAR SECRETARY C'OOPER: On behalf of the Members of the Joint Economic
Committee, I would like to thank you for testif:ving on the International Outlook
and the prospe<'ts for the Bonn Economic Summit.
I am Rorry that my schedule did not enable me to attend the hearing- on Jnly
12. I did enjoy your testimony, albeit in written form, and appreciated your
.mmal thoug-htful approach to international probll'ms.
Your testimony came jnst before the Bonn Eronomic Summit. To make onr
hearing- record more complete. r would welcome any thoughts or comments you
might have on the results of the Summit itself.
, Thank you again for contributing so much to our Midyear Review of the
International Economy.
Sincerely,
RICHARD BoLLING, Chairman.
UNDER SECRETARY OF STATE FOR ECONOMIC AFFATl!S.
Washington, D.O., August 28, 1978.

Hon. RICHARD BOLLING,
Chairman, Joint Economic Committee.
Oonr,res,Y of the United States.

DEAR MR. CnAmMAN: Thank you for your letter of August 7 and your generous
comments about my testimony before the Joint Economic Committee on Julv 12.
I wel<>ome the opportunity to add some comments on the results of the Bonn
Summit.


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First, the agreement by Summit participa:nts to combat international terrorism
in the form of aircraft hijacking is a significant achievement which l did not
foresee in my July 12 testimony. Several participants commented that this agreeinerit alone made the Summit worthwhile. Representatives of the Summit countries. are now af work on the implementation of this -agreement.
. The strategy of "concerted action" to which I referred in my testimony was
well reflected in the Summit Declaration. The Declaration characterizes the total
effect of the economic strategy agreed in Bonn as "greater than the sum of its
parts." The participants thus recognized that the problems of growth, inflation,
payments imbalances, trade, energy and relations with developing countries can
be addressed.in.a concerted fashion, through mutually reinforcing actions, much
more effectively than they can be addressed alone.
The participants also emphasized that each ·country would have to contribute
in a distinct way. Since the U.S. has been growing at a relatively healthy rate,
President Carter stressed our determination to reduce inflation and our dependence on imported oil. Chancellor Schmidt and Prime Minister Fukuda, whose
countries have low inflation rates and large current account surpluses, stressed
the willingness of Germany and Japan to take appropriate measures to expand
domestic demand. It was heartening to us that the other Summit participants,
and especially Germany and Japan, were able to be as specific on measures to increase domestic demand as they were. I would emphasize that these commitments
stress government policy instruments rather than performance targets, the
achievement of which is often affected by forces beyond the control of individual
governments. These specific commitments would not have been possible ·without
the President's firm statement on inflation and energy.
·
The discussion of energy was not confined to expected U.S. actions. All participants emphasized cooperative efforts to develop energy sources, "including renewable sources, in both the industrialized democracies and the d~veloping countries. The importance of coal and the continued development of nuclear energy in
the context of our non-proliferation goals were also recognized. The role of private investment in the energy field was stressed.
The Bonn meeting clearly brought us closer to agreement in the Multilateral
Trade Negotiations. We would have liked to be even further along than we are
now. Nevertheless, the "Framework of Understanding" issued on July 13 in
Geneva hy the U.S. and other delegations reflects the advanced state of work on
tariff reductions and on several international codes to reduce non-tariff barriers
to trade. The participants committed themselves to conclude successfully the detailed negotiations, including those key areas such as agriculture, subsidies and
safeguards where major decisions are needed, by December 15. The participants
also endorsed the renewal of the OECD T·rade Pledge and the OECD guidelines
on adjustment policies. These latter guidelines represent a significant step forward from the London Summit Declaration. They discourage defensive policies
which prevent structural change and encourage the acceptance and facilitation
of such changes over time. Adherence to these guidelines will promote long-term
growth and diminish pressures for short-term protectionist responses to change.
International monetary issues were an important part of the Summit agenda.
The participants recognized that exchange rate stability can only be achieved
by attacking the fundamental problems which cause instability. At the same
time they pledged to intervene to the extent necessary to counter disorderly conditions in the exchange markets. We are very concerned by the sharp decline of
the dollar. since the Summit and are examining what additional actions might be
appropriate. Discussion at Bonn of proposals for the European Monetary System
was limited because a specific and detailed program has not yet been developed.
We told our European allies that we welcome measures which will contribute to
greater European unity but that we must reserve judgment on any specific scheme
for closer monetary cooperation until we can consider the specific elements.
The Declaration explicity recognizes the growing interdependence of developed
and developing countries. This fundamental truth was also implicitly recognized
in the discussion of the various functional areas. The impact of alternate policies
on non-participating countries, including developing countries, was in all cases
considered. Furthermore, the participants committed themselves to increasing the
flow of financial assistance and other resources for development. The need for
intensified and improved bilateral and multilateral assistance in the energy field
is specifically stressed. The Declaration also calls on the developing countries,


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360
particiularly the more advanced among them, to prepare for the responsibilities
which will accompany their enhanced role in the world economy.
The Bonn Summit was a positive step, but only one step, in what all participants recognize to be a long and difficult process. As the Bonn Declaration puts it,
"these are long-term problems which will only yield to sustained efforts". This
process, of which periodic Summits are only a part, will fail unless it is supported by the public and legislatures of each country. Cooperation between the
Administi,ation and Congress in energy, foreign assistance and other key areas
is critical if the U.S. is to assume its share of the leadership in finding solutions
to global economic problems.
Sincerely,
RICHARD N. CooPEB.
RESPONSE OF EDWARD M. BERNSTEIN TO ADDITIONAL WRITTEN QUESTIONS POSED
BY REPRESENTATIVE BOLLING
CONGRESS OF THE UNITED STATES,
JOIJ.ll'T ECONOMIC CoMYITTEE,
Washington, D.O., August 7, 1978.

Mr. EDWARD M. BERNSTEIN,
Oonnecticut A.,i,enue, N.W.,
Washington, D.O.

DEAR MR. BERNSTEIN: On behalf of the Members of the Joint Economic Committee I would like to thank you for testifying on the International Outlook as
part of the Midyear Review of the Jllconomy.
I am very sorry that my schedule did not enable me to attend the hearing on
July 12. I had very much looked forward to your testimony and enjoyed savoring
it through written form.
In order to complete the record, I would appreciate a written response to the
following questions :
(1) Yon suggested a possible 10 percent across-the-board tariff as a means of
avoiding the distortions of an overvalued dollar brought about by sharp fluctuations in the international value of the dollar. Would you couple the tariff with
some form of internationally agreed upon export subsidy? What would you propose for the occasions when the dollar was undervalued?
(2) You raise the possibility that the U.S. may take unilateral action to restrict
imports if dollar depreciation does not succeed in reducing the trade deficit. What
form would you expect U.S. action to take? If such restrictions were unavoidable.
what form would be the least damaging to the world economy?
(3) In the course of your testimony, you alluded to your own thoughts on how
to make the current regime of flexible exchange rates more flexible still. I would
be very interested in learning the outlines of your plan. Would it entail some form
of IMF surveillance? And if so, is there not some danger of slipping back into a
Bretton Woods' world where pressure is only exerted on the deficit countries?
Thank you again for contributing so much to our Midyear Review of the International Economy.
Sincerely,
RICHARD BOLLING, Ohairman.
El\fB (LTD.),

RESEARCH ECONOMISTS,
Hon. RICHARD BOLLING,

Washington, D.O., August 14, 1978.

Chairman, Joint Economic Oommittee,
Congress of the United States,
Washington, D.O.

DEAR CoNGRESSM.~N: I was glad to be able to give my views to the Joint Economic Committee as I believe that we must act more positively on our trade
problem and the exchange rate. I expect to discuss your questions fully in a paper
I am writing which will be completed before the end of this month. In the meantime, I offer these brief answers.
1. With the sharp fluctuations in exchange rates, the dollar is alternately
·0Yervalued and undervalued. When the dollar is overvalued, it has the same


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effect as a bounty on imports and a tax on exports. When the dollar is undervalued, it has the effect of a tax on imports and a bounty on exports.
My proposal for a 10 percent across-tlle-j)oard tariff is inte,nded to deal only
with the import effects. Its PUrPOse would be to keep out uneconomic importsthose that come in only because of the overvaluation of the dollar and which
could be produced with relatively greater efficiency in the United States if
(;Xchange rates reflected relative costs. It would thus enable domestic producers
of manufactured goods to supply the home market in those induetries in which
they would be competitive under appropriate exchange rates. '.rhe 10 percent
tariff would not apply to foodstuffs and raw materials which are imported from
countries whose currencies are more or less tied to the dollar.
The 10 percent across-the-board tariff would also apply when the dollar is
undervalued or properly valued on the basis of relative costs. Under such conditions, it would keep out imports of manufactured goods in which other countries
have a comparative advantage. The effect, therefore, would be to reduce U.S. real
incomes to the extent that import goods are replaced by less efficiently produced
domestic goods. The loss in real income from excluding economic imports when
the doUar is not overvalued, however, would be considerably less than the loss in
real income that is now incurred from the displacement of domestic production by
uneconomic imports when the dollar is overvalued.
My suggestion does not involve subsidies for C.S. exports when the dollar is
overvalued. There is a strong international consensus against export subsidies.
but not to the same extent against tariffs. It would not be in the interest of the
United States to offer export subsidies, even when they could be justified by an
overvalued dollar. There is no substitute for having appropriate exctu1,nge rates
that reflect relative costs and fluctuate only in response to changes in underlying
economic conditions. The 10 percent across-the-board tariff would not correet
the distortions caused by overvalued and undervalued currencies. It is intended
merely to minimize the disruption they cause.
2. In my opinion, the continuation of the U.S. trade deficit on the present scale
is prejudicial to the economic interests of the United States and destructive of
the international monetary system. Output in the United States is about 1 percent less in real terms ihan it would be wit11 a trade deficit better suited to the
structure of the U.S. economy. To maintain output and employment, the Administration proposed tax reductions at the beginning of 1977 and 1978 about equal
to the increase in the trade deficit in the preceding years--~18.4 billion in 1976
and $21.7 billion in 1977. It is apparent that the public is unwilling to depend any
longer on a budget deficit to offset the reduction of output and employment
caused by the trade deficit.
The. international monetary system is not functioning in the way that had been
expected when the system of floating rates was adopted. The advocates of floatil!,g
rates believed that changes in exchange rates would automatically adjust the
halance of payments. In fact, the adjustment process is more complex than that,
even with floating exchange rates. Nevertheless, the deterioration of the U.S.
trade balance by over $40 hillion in two years could not have occurred nnlesR
the correctiYe effect of floating rates was deliberately offset by action of some
SUrPlmi countrieR. In the case of .Tapan. this action took the form of Rupportiug
the dollar-not merely to avoid disorderly exchange movements, but to prevent
the appreciation of the yen necessary for reducing its enormous current account:
SUrPlns.
There is more to the increase in the U.S. trade deficit to $31.1 billion in Hl77
and $19.2 billion in the first half of 1978 than foreign intervention to maintaim
an undervalued currency as a means of securing an unfair advantage in intprnational trade. Foreign producers confronted with weak home demand fonn((
the large U.S. market a very favorable place in which to increase their exports
to maintain production. For this purpose, they cut their profit margins on exports far below what they would normally be and below what U.S. producPr:a;
eould match. The U.S. trade deficit was undoubtedly much affected by the
slower growth of output in Europe and Japan, but only to a modest extent
because their demand for imports from this country lagged. Mainly their slower
growth affected our trade deficit by inducing an extraordinary increase of exports
from those countries to the United States.
The United States cannot wait for the surplus countries of Europe ap.d ,Tap:m
to expand their economies as a means of reducing our current account defir•it.
As long as their own output and employment is maintained by an enormous trade


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362
surplus, they have little reason to undertake. expansionary fiscal and monetar:v
policies which they regard as inflationary and for which there is little domestic
support. If the trade balance is not quickly reduced to a tolerable level in the
next few months, I believe the United States should impose restrictions on
imports. The least harmful restriction would be a surcharge on imports applicable only to the surplus countries. There may be some practical_ difficulty in
'applying discriminatory tariffs, although it may be legally possible. The other
method would be to apply quantitative restrictions, preferably based on trade
shares before the enormous increase in imports from the surplus countries. An
import surcharge for the purpose of restricting excessive imports is not the
same as an across-the-board tariff to keep out uneconomic imports resulting from
alternate overvaluation and undervaluation of the dollar.
3. Under present conditions, there is no substitute for floating exchange rates.
They can have the desired effect as a means of adjusting imbalances in intern~tibnal payments, however, only if the fluctuations are in response to changes
in underlying economic conditions. Unfortunately, even when changes in exchange rates are initially caused by a deterioration in the trade balance, an
accelerated inflation in one country relative to others, or a decline in relative
interest rates. they may become excessive if they give rise to capital movemeuts
in anticipation of the depreciation of some currencies and the appreciation of
others.
It is true that in the long run the only way to achieve relative stability in
(\XChange rates is through domestic policies that slow the inflation of prices and
costs. At best that is a gradual process. In the meantime, the monetary authorities
!Should do what they can to moderate excessive fluctuations in exchange rates.
They can succeed in this, however; only when the exchange market is ready
to accept their guidance. That does not seem to be the case now. Until there has
been marked improvement in the trade balance, intervention by the monetary
authorities may absorb tremendous amounts of foreign exchange without having
murl). effect on dollar exchange rates.
When the trade deficit has been substantially reduced, the United States 8honld
adopt a policy of moderating excessive fluctuations in the dollar without trying
to keep exchange rates in a predetermined range. Such a policy would involve
no intervention if the fall in the dollar exchange rates for the major currencies
were gradual. If the decline became rapid, it would be allowed to go on for a time
before the monetary authorities intervened. If the rapid decline continued, the
monetary authorities would intervene, not to halt the decline but to slow it.
Thus, the exchange market would be able to signal its views on exchange rates,
but not to impose SUC'h a rapid decline as to create expectations of a further
depreciation of the dollar. When the decline ends and the dollar rises. the monetary authorities would follow a similar policy, slowing but not halting the rise
in the rate. Intervention in the exchange market should be undertaken only
in collaboration with the countries concerned and after consultation with the
International Monetary Fund.
I enclose a paper t wrote in May. My views on maintaining orderly exchange
arrangements are stated more fully in the last section.
EDWARD M. BERNSTEIN.
Enclosure.
THE TRADE DEFICIT, CAPITAL MOVEMENTS, AND THE FLOATING DOLLAR
SUMMARY AND CONCLUSIONS

Floating exchange rates did not prevent the United States from having a very
large deficit on current account nor has the depreciation of the dollar as yet succeeded in restoring the payments position. In 1977, the current account deficit
was $20.5 billion. From the end of September 1977 to the end of March 1978, the
dollar depreciated by an average of 9.2 percent against the currencies of the Group
of Ten and Switzerland. Nevertheless, the deficit on current account increased to
-about $9.0 billion in the first quarter of 1978. Since then, the dollar has appreciated by an average of 3.2 percent against these major currencies; but that is
due to a backflow of funds rather than an improvement in the current account.
Fluctuations in the current account are almost entirely due to changes in the
trade balance. Between 1975 and 1977, the trade balance shifted from a surplus of


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363
$9.0 billion,tera deficit of $31.5 billion. The main reason was the enormous increase
of imports of petr.oleum and products ( 66.5 perce.nt), foods, feeds and, beverages
and industrial supplies and materials (50.6 percent), and other imports (53.6
percent), mainly manufactured goods. Between 1975 ll,nd 1977, exports increased
by only 12.5 percent, and nearly all of that was due to ),ligher prices. In part,
the large increase in the trade deficit was due to the greater recovery of output
in the United States than in other industrial countries. Mainly, however, it was
because U ..s. producers were unable to compete with German and Japanese
producers in the domestic market or tn world markets.
'
The large increase in the deficit on current account made it difficult to induce
an offsetting net inflow of capital in 1977 without large changes in exchange
rates. The U.S. deficit with OPEC was $16.9 billion last year, while the net inflow
of capital from them was $6.1 billion. Thus, OPEC members transferred about
$10.8 billion of their current account surplus from the United States to other
areas. Net capital flows to Canada and from Japan about matched the current
account balance with them. The net U.S. capital outflow to all other countries,
however, was far greater than the current account balance and the excess was lent
by them to other areas, mainly by foreign branches of U.S. banks. Most of the
inflow of capital to finance the U.S. current account deficit came from Western
Europe ($29.2 billion). As the depreciation of the dollar discouraged private
capital inflow, the funds came mainly from official institutions.
One reason for the large :fluctuations in dollar exchange rates is that too much
reliance is placed on changes in exchange rates as a m·eans of adjusting the balance of payments, without the help of fiscal and monetary measures. Under such
conditions, speculation will cause the dollar to depreciate rapidly, as it did in
late 1977 and early 1978. The United States and Germany have agreed to cooperate to counter disorderly conditions in the exchange market which have
recently been marked by excessively rapid changes in exchange rates. The United
States will sell SDRs and is prepared to draw on its reserve position in the IMF,
if necessary, to·intervene in the exchange market. The use of SDRs and drawings
on the IMF to acquire D-marks involves a sharing of exchange risks by the United
States and Germany.
APPROPRIATE BALANCE OF PAYMENTS

For every country there is a balance of payments which is appropriate for its
economy and to which the structure of its production has been adapted. The appropriate balance for a country must fit into a pattern of international payments
acceptable to other countries and suited to the structure of their economies. To
achieve such a balance of payments, the exchange rate for each country's currency
would have to be related to its prices and costs in a manner that will induce a
level of exports and imports of goods and services that will result in the appropriate surplus or deficit on current account. With such exchange rates, countries
would export .the goods and services in the production of which they have a
comparative advantage and import the goods and services in which they have a
comparative disadvantage. Moreover, an appropriate balance of payments requires the surplus or deficit on current account to be matched by a net outflow or
inflow of capital without extraordinary financing by the monetary authorities.
To achieve this, relative rates of interest and profits in the major financial centers must be adjusted to induce such capital flows.
The system of fixed parities broke down because the large industrial countries
were unable to follow the policies necessary for maintaining an acceptable pattern of international payments. On the other hand, it was argued that floating
exchange rates would bring about automatic balance of payments adjustment
regardless of the causes of the surplus or deficit on current account. Thus, a rise of
prices and costs in one country relative to those in others would cause an increase of imports of goods and services relative to exports, an excess supply of
its currency in the exchange market, and a depreciation of its currency. The
change in exchange rates would offset the relative rise in prices and costs, maintain the country's competitive position, and restore the balance on goods and
services. Similarly, an adverse change in reciprocal demand, including out-ofpbase cyclical developments, would be neutralized by a change in exchange rates
that would induce an increase of exports of goods and services equal to the increase of imports.


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FOREIGN EXCHANGE VALUE OF THE DOLLAR, CURRENCIES OF TH.E GROUP OF 10, 1973-78
Foreign currency units per dollar, end of period
1973
Mar.
Belgium ____ ,._, ___________ f40. 081
Germany __________________ 2.838
Netherlands_ ______________ 2. 944
France ____________________ 4. 541
Sweden ___________________ 4. 500
United Kingdom ____________ 0. 404
Canada ___________________ 0.990
Japan _____________________ 265. 8
Italy ______________________ 582. 5
Switzerland •. ______________ 3. 237

1974

June

Sept.

Dec.

Mar.

36. 05
2.425
2.620
4.105
4.110
0. 387
0. 998
265. 3
584. I
2. 960

36.99
2.420
2. 535
4. 250
4. 215
0. 414
0. 999
265. 7
564.1
3. 022

41. 32
2. 703
2. 824
4. 708
4. 588
0.430
0. 996
280.0
607. 9
3. 244

38. 95
2. 523
2.685
4. 764

4.392

0. 418
o.9n
276.0
622. 3
3.000

1975

1976

1977

June

Sept.

Dec.

Mar.

June

Sept.

Dec.

Mar.

June

Sept.

Dec.

Mar.

June

38.01
2.555
2.652
4.823
4.380
0.418
0. 972
284.1
647.6
2. 998

39.23
2.653
2. 704
4. 741

36.12
2. 410
2.507
4.445
4. 081
0.426
0. 991
300.9
649. 4
2.540

34.66
2. 345
2. 395
4.216
3. 942
0. 415
I. 003
293. 8
632.0
2. 528

35. 06
2.355
2.440
4.040
3. 940
0. 455
1.031
296.4
630. 4
2.503

40.00
2.662
2. 736
4.536
4. 508
0.490
I. 025
302. 7
687. 3
2. 748

39. 53
2. 622
2.689
4. 486
4.386
0. 494
1.016
305.2
683.6
2.620

39.05
2. 538
2.687
4.669
4.401
0. 522
0. 984
299. 7
840.3
2. 534

39. 70
2. 574
2. 736
4. 740
4. 451
0. 561
0.969
297. 4
840. 5
2.473

37. 61
2.437
2.569
4. 927
4.283
0.596
0.973
287. 5
859.6
2.454

35. 98
2.363
2.457
4. 970
4.127
0. 587
I. 009
292.8
875.0
2. 451

36. 61
2.389
2.492
4.969
4.334
0.581
l.057
277.5
887. 3
2. 543

36.04
2.338
2.473
4.919
4.399
0.581
1.060
267.7

Dec.

Mar.

June

4.460

0.429
0. 986
298.5
660. 5
2. 946

1978

Sept.

Dec.

35. 74
2. 307
2.457
4. 963
4.833
0. 573
1.073
265.5
884.8 882.3
2.461 2.339

32. 94
2.105
2.280
4. 705
4.-670
0. 525
0.094
240.0
87L6
2.010

Mar.

May23

31.48
2.023

33.23
2.130
2.277
4.667
4.682
0.552

2.1$4
4. 581

4. 589
0. 539
1.132
222.4
852.5
I. 869

1.115
228.3
872.1

1. 970

Percent change from previous .period
1973

Belgium ________________ ...
fermany __________________
l'letherlands _______________
France ____________________
Sweden._--~------·--- -- -United Kingdom ____________
Canada __________ --------·Japan ___________________ -·
l!Jly ______________________
Switzerland ________________


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1975

19H

June

Sept.

Dec.

Mar.

-10. 1
-14. 6
-11. 0
-9.6
-9.7
-4.0
-0.6
-0.2
0. 3
-8.6

2. 4
-0.2
-3.2
3. 5
2.6
7.0
0. 7
0.2
-3.4
2.1

12. 0
11.7
II. 4
10. 8
8. 8
3. 9
-1.0
5.4
7.8
7.3

-5.7
-6.7
-4.9
1. 2
-4.3
-3.0
-2.3

-1.4

2.4
-7.5

June

Sept.

-2.4
I. 3

3.2
3.8
2.0

-1.2

1.2
-0.3
0.1
0.0
2.9
4.1
-0. l

-1.7

UI
2.5
I. 4
5.1
2.0

-1.7

Dec.

Mar.

-7.9 -4.0

-9.2
-7.3
-6.3
-8.5
-0.7
0.5
0.11
-1.7
-13.8

-2.7
-4.5
-i.2
-3.4
-2.5
l. 2
-2.4
-2.7
-0.5

June

Sept.

1976
Dec.

Mar.

June

Sept.

1.7 13. 5 -1.2 -1.2
1.7 -5.3
0.4 13.0 -1.5 -3.2
I. 4 -5.3
I. 9 12.1 -1.7 -0.1
I. 8 -6. l
-4.2 12. 3 -1.l
4.1
I. 5
3.9
-0.1 14.4 -2.7
0. 3
I. 2 -3.8
9.6
7. 7
0. 9
5.6
7.5
6.2
2. 7 -0.5 -0.9 -3.2 -1.6
0.5
0.9
0.8 -1.8 -0.8 -3.3
2.1
9.0 -0.5 22. 9
-0.3
0.0
2.3
-1.0
9.8 -4.6 -3.3 -2.4 -0.8

1977

Sept.

11178

Dec.

-4.3
1.7 -1.6 -0.8 -7.8
-3.0
1.1 -2.1 -L3 -8.8
-4.3
I. 4 -0.8 -0.6 -7.2
0.9
0.0 -1.0 -0.3 -4.0
-3.7
1.7
4.8
9.9 -.3.4
-1.5 -1.0
0. .() -1.5 -8.4
3.7
4.7
.0.3
2.-0
l.3
1.9 -5.2 -3.5 -0.8 -9.6
1.8
1.4 ~ll.3 -0.3 -1.2
-0.2
3..8 -3.2 -5.0 -14.0

Mar.

May 23

-4.4

-5.6

-3.9
-5. l

-2.6

-1.7
2.7
3.5
-7.3
-2.2
-1.0

5.3
5.3

1.9

2.0
2.4
-,1.5

u

2.3
5.4

~

~

365
Changes tn capU11l flows also act on exchange rates and for some countries,
inclml,in'g the United,.States, capital, mov.ell)ellts comprise. a .1arge .. part of the
supply of and demand for· foreign exchange. Some advocates of floating exchange rates have assumed that changes in capital flows would not cause large
changes in exchange rates nor impede the restoration of an appropriate balance
of payments in response to changes in exchange rates. Long-term capital movements, such as direct investments and security transactions, were assumed to
be relatively stable as they are made on the basis of economic conditions that
are expected to prevail for an extended time. As for short-term capital movements, particularly banking transactions, they were assumed to respond quickly
to changes in relative interest rates. Indeed, there was a view that the effect
of changes in the balance on current account on exchange rates would be limited
to what was necessary for restoring an appropriate balance of payments by a
stabilizing inflow of short-term funds, provided differences in interest rates
made this profitable.
Thus, the argument advanced in favor of floating exchange rates was not
only that this system would facilitate prompt adjustment of the balance of payments,,.lmt·that it would achieve this with relatively small and.gradual changes
in exchange rates. It was recognized, of course, that if countries did not take
corrective measures to halt the rise in relative prices and costs, to eliminate
excessive domestic demand, and to maintain adequate differentials in interest
rates, the exchange rates for their currencies would continue to decline. Even
so, it was assumed that the decline would be orderly, mainly determined by the
differential rates of inflation, and that it would in any case prevent a large and
persistent deterioration in the current account. It is implicit in these assumptions
that price elasticities of demand and supply for export/import goods are very
high, at least for the manufactured goods in which the large industrial countries compete with each other in their own and in world markets.
The exp&~Jwe .of the United States sµice 1973 has not conformed to this
idealized version of how floating exchange rates work. The year-to-year changes
in the balance on current account have been enormous. In 1977, the current account
deficit amounted to $20.5 billion and in the first quarter of 1978 it may have
been $9,0 billion or more. The foreign exchange value of the dollar has fluctuated sharply in terms of some of the currencies of the large industrial countries. From 1973 to 1975, there were six periods in which the dollar rates of
excbange for the currencies in the European joint float rose or fell by 10 percent
or more in the course of th·reEfor four months .. In the following, two years, .changes
in the dollaJ' exchange rates for most of the major curr.encies reflected changes
in~underlying economic conditions. From the end of September 1977 to the end
of March 1078, .however, the dollar rates of exchange rose by 14.1 percent for
the D-mark, by 10.4 percent for the yen, and by 25.2 percent for the Swiss franc.
For all of the currencies of the Group of Ten and Switzerland, weighted by their
total exports in 1077, the average depreciation of the dollar over the six-month
period was 9.2 percent. Since the end of March the dollar has recovered a part
of the earlier decline. In the eight weeks to May 23rd, the dollar appreciated by
an average of 3.2 percent relative to the currencies of the Group of Ten and
Switzerland,

35-940-78--8


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366
VALUE OF THE DOLIAR IN THREE CURRENCIES
End of month, March 1973 to May 1978*
-Units per

dollar

DEFICIT ON CURRENT ACCOUNT

In the past five years, the U.S. balance on current account has fluctuated widely
between a surplus of $11.6 billion and a deficit of $20.fi billion. In 1973, the
first year of floating exchang erates, the deficit fell by $9.6 billion to less than
$400 million. In 1974, with the increase in the price of oil, the g.eficit increased
by $4.7 billion to $5.0 billion. In 1975, the current account balance rose by $16.6
billion to a surplus of $11.6 billion. In 1976, the balance fell again by 13.0 billion
to a deficit of $1.4 billion. And in 1977, the current account deteriorated further
by $19.0 billion to a deficit of $20.5 billion. These large year-to-year changes reflect the inherent instability in the world pattern of payments.
Fluctuations in the balance on current account are almost entirely due to
changes in the trade balance. The net receipts from services increased from
a little over $300 million in 1972 to $15.8 billion in 1977, with a slight decline
in only one year ( 1975). This was mainly due to three items-receipts from
investment income, including fees and royalties, transfers under U.S. military
agency sales contracts, and receipts from miscellaneous private services. Unilateral transfers rose moderately from $3.9 billion in 1972 to $4.8 billion in 1977,
with only one very large increase (1974) which was dne to a reclassification
of previous loans to India as grants. Excluding merchandise trade, receipts from
all other current transactions have increased steadily relative to such payments
over the past five years.
The merchandise trade balance, however, has fluctuated sharply_ from year
to year. The largest changes were the shift from a surplus of $9.0 billion in
1975 to a deficit of $9.3 billion in 1976 and an increase in the deficit to $31.5
billion in 1977. The deterioration in the trade deficit by $40.5 billion over these
two years had a severely restraining effect on the U.S. economy. Between 1975
and 1977, domestic expenditure on goods increased by $189.1 billion of which
28.6 percent was supplied by increased imports. Over these two years, domestic
production of goods increased by $148.5 billion of which only 9.0 percent was
absorbed by the incre11se of exports. In 1975, the trade surplus was equal to
1.4- percent of the goods output. In 1977, the trade deficit was equal to 3.8 percent of the goods output.


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367
GOODS, SERVICES, AND UNILATERAL TRANSFERS, 1971-78
[In millions of dollars]
Exports
Merehan•
dise
1971. •.•.••.....••
1972 •. ···•········
1973 ............. .
1974 .•..........••
1975 .• ·•··········
1976 .•.....•... ·•.
1977 ..... ··•······
1978-11 ..••••..•..
1Seasonally

Services

22,295
43,319
23, 283
49, 381
30,287
71,410
39, 997
98, 306
40, 512
101,088
48, 572
114,694
56,086
120, 47'2
30,578 ······•····

Balance on

Imports
Merchan•
dise

Services

Unilateral
transfers

--33,.780541
-45, 579 -20, 375
-55, 797 -22, 955
_-37,: 881887
-70, 499. -27, 678
- 103, 673 -32, 470
-4, 612
-98, 043 -33, 393
-5, 023
-124, 014 -35, 655
-4, 795
-151, 968 -40, 259
-41, 778 ·•··········•·•······•

Trade

Goods,
services

Current
account

-4, 041
-340
-2, 260
~9, 942
-6, 088
-6, 416
-367
3,620
911
-5, Ol8
2, 160
-5, 367
11, 552
16, 164
9,045
-1, 426
3, 579
-9, 320
-20, 464
-31, 496 -15, 669
-11, 200 •······•·•·••·••··•··•

adjusted, 1st quarter.

The main factor in the deterioration of the trade balance was the increase
of imports. In 1976, imports increased by $26.0 billion (26.5 percent) to $124.0
billion; in 1977, they increased further by $28.0 billion (22.5 percent) to $152.0
billion. Of the increase of total imports in these two years,' $18.0 billion (83.3
percent) was petrolellill and products, $16.1 billion (29.0 percent) was foods,
feeds and beverages, and· industrial supplies and materials, and $19.8 billion
(36.7 percent) was other imports, nearly all finished manufactured goods. Total
imports increased by 55.0 percent over these two years. The increase was 66.5
percent for petroleum and products, 50.6 percent for foods, feeds 'and beverages
and industrial supplies and materials, and 53.6 percent for other imports.
The very large increase of imports of petroleum and products was the result
of a fall 'in domestic production and an increase in consumption. The increase of
imports of foods and raw materrials was mainly in response to the increase of
output and income, although the large rise in the prices of some ,foods and the
moderate rise in the prices of industrial supplies and materials add considerably to the imports of these commodities for which demand in teirms of price is
relatively inelastic. The large increase of other imports is most disturbing. The
income elasticity of demand for consumer goods is about unity, as indicated by
the rielative stability of the personal saving rate. The income ( output) ·elasticity
of demand for capital goods is much greater, as indicated by the larger increase
of investment in producers' durable equipment than of the gross national product
in a cyclical expansion. Between 1975 and 1977, impor,ts of finished manufactured goods increased by 53.6 percent, while expenditure on consumer durable
and nondurable goods increased by 21.8 percent and investment in producers'
durable equipment increased by 28.3 percent. This would seem to indicate that
factors other than the expansion of output must have contr'ibuted significantly
to the increase of imports in the past two years.
'l'he lag in U.S. ·exports aggravated the deterioration in the trade balance.
In 1976 exports increased by $7.6 biUion (7.1 percent) to $114.7 billion; and in
1977 they increased by $5.8 billion (5.0 percent) to $120:5 billion. Exports of food,
feeds and' beverages increased by only $500 million (2.8 percent) over the two
years. That was because of a fall of about ~.O percent in the prices of these
products. The volume of such exports, in fact, increased moderately. Exports
of industrial supplies and materials increased by $4.0 billion (13.0 percent),
with about two-fifths of the increase due to higher prices. Other exports, nearly
all finished manufactured goods, increased by $8.8 billion (15.5 percent). Nearly
all of this increase reflected higher prices, so that there was virtually no increase
in the volume of exports of manufactured goods. The total volume of U.S. exports increased by 3.4 percent in 1976 and fell by 0.5 percent in 1977.
To some extent, the failure of U.S. exports to increase more, particularly finished manufactured goods, was due to the slow recovery in Europe and Japan
and the relatively small growth of imports in some other regions, including
Canada and Latin America. Mainly, -however, the lag in exports must have been
due t-0 the inability of the United States to compete effectively in world markets. ·while U.S. exports increased by 12.5 percent in dollars over the two years,
those of Germany increased by 30.9 percent in dollars and by 23.4 percent in
D·marks, while those of Japan increased by 45.3 percent in dollars and by 30.7
percent in yen. This disparity in the export performance of the three 1'argest


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368
trading countries could not be significantly due to the difference in their cyclical
situ~ti(!n. Exc\u.tun;, the U!lited s,tates, Germany'.s ~xpof!~ to all other countries.
increased'•by ·29.8 percent m dollars and by 22.5 pePCent·m D,marks over thesetwo years. J·apan's exports to all countries other than the United States increa,sed by 37.2 percent [n dollars and by 24.1 percent in yen. In all major world'
markets, Germany and particularly Japan increased their exports far more than
the United States. This must have been due to a decline in the competitiveness
of the U.S. exporters.
It would appear that the system of floating rates did not prevent the emergence of a large U.S. current account deficit and it did not bring an improvement
in the current account in spite of the depreciation of the dollar. This may be too
harsh a judgment. The current account was in surplus until the second quarter of
1976 and the deficit in the second half of that year was relatively small-$2.5
billion. In the first quarter of 1977, however, t11e deficit rose to $4.5 billion and
remained at close to this level until the third quarter. This was due to the increase in the trade deficit to a quarterly average of $7.2 billion. Nevertheless,
the dollar did not weaken signficantly in this period. From the end of December
1976 to the end of September 1977, the average depreciatjon of the dollar :relative
the currencies of the Group of Ten and Switzerland WM 1.4 percent. Except
against the yen, which appreciated by 10 percent. the market did not adjust the
dollar rates of exchange to reflect the deterioration in tbe current account in
the first three quarters of 1977.
The current account became very much worse in tb.e fourth quarter of 1077
and the first quarter of 1978. The trade deficit increased to $9.9 billion and the
current account deficit increased to $8.0 billion in the fourth quarter. In the first
quarter of this year, the trade deficit increased further to $11.2 billion anrl the
current account deficit increased to about $0.0 billion-twice as much as it had
been in the first three quarters of 1977. This was also the period when the dollar
depreciated sharply-by an average of 9.1 percent relative to all of the currencies
in the Group of Ten 1tnd Switzerland. and two to three timNI as nnwh rela.,tive
to the D-mark, the yen, and the Swiss franc. Clearly, the depreciation of the
dollar did not have a favorable Pfl'ect on the trade balancP.
Between the third quarter of 1977 and the first quarter of 1978, U.S. import'!
increased by $3.5 billion (9.2 percent) to $41.8 billion. This occurred in spite of
the large fall in imports of petroleum and products-by $1.6 billion (15.2 percwit)
to $9.1 billion in the first quarter of 1978. Other imports, however, increased by
19.4 percent, with the largest increase (30.3 percent) in imports of motor vehicles
and mtrt!I from Jj,lu:r;ope an~ Japan. Tl)is enormous increase in Imports of manufactured goods was d'e!'!igned to get them through U.S. customs before the dollar
depreciated further. On the other hand. U.S. exports declined by 1.3 percent
over these two quarters. While exports had been lagging before, foreigners hall
an extra inducement to wait for a further depreciation of the dollar before increasing their imports from the United States.
Now that the decline of the dollar in the exchange market has been halted.
the leads and lags in trade may begin to unwind. Imports may decline quickly,
as much of the recent increase, particularly of manufactured goods. has probably gone into stock. Exports may be slower in expanding, although they should
also be helped by the depreciation of the dollar. This is in addition to the effect
on the U.S. trade balance of a higher rate of expansion in the large industrial
countries. The improvement in the trade balance has apparently not yet begun.
On a Census basis, exports increased by 6.6 percent in April to $11.63 billion, and
imports increased by fi.8 percent to $14.50 billion. The trade rleficit on a Census
basis increased to $2.86 billion from $2.79 billion in March. Adjusted to a b!llan<'e
of payments basis, however, the trade deficit was unchanged at about $8.4 billion.
The rise of the dollar in April and May was due to the inflow of funds to
cover short positions. The dollar can recover more of the recent decline relative
to the European currencies, however, only if thP deficit on current account i:<
rerluced to a level that can be covered by thP net inflow of capital without extraor<'liuary financing by the monPtary authorities. Under prPsent conditions, whilP
the oil-exporting countries still have a large current account surplus, a U.S.
dPficit of about $10 billion a year might be appropriatP. If reinvested earninirs of
direct investment enterpri,ses were included in r-ipts and payments of invPstment income and also in capital outflow and inflow. as they will he hereafter,
the appropriate current account deficit would be about $5.0 billion.


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0

369
CAPITAL FLOWS AND EXCHANGE RATES

A ebahge in the balance on current acrount will be offset by a change in the
net caJ)ital inflow- or outflow, although that may not occur without and aejustment of exchange. rates. At times, ehanges in dollar exchange rates have been
greatly exaggerated by pel'V'el'l!le changes in capital flGWS. While unbalan'Clng
capital flows may be initiated by expectations of accelerated inflation or by too
easy fll!ll!al and monetary policies, they are usually <!II.used 'bY a deterioration in
tbe current accollilt. .As noted, the balance on current account has fluetnated
widely in the past ftve yea.rs. In 1978, the United States had a current account
surplus of $2.9 billion with metnbers of OPEC. The balance shilted t:o a deficit of
$4. 7 billion in 1974: whteh has increased since then to $16.9 billion tn 1977. The
U.S. balance on current account with all other countries has been much more
volatile, and has ranged from a surplus of $16.7 billion in 19,5 to a deficit of
$8.& billion in 1977.
SELECTED U.S. TRJ\NSACTIONS WITH OPEC MEMBERS•
(In millions of llollarsj
1972

MerehAndiSI 8)(\1(1/ts, ektepl'milltary ..•••••••

-423

'Export~ .•••..••...•...•••••••.••••••••••••••••

2,6fl
imports .••••••.•••.••••••••••••.•••••••.•••.••• -2,9 4

1976

1977

-8, 941 -15,851

-22, 763

6,219
11,558
3,414
-5,097 -17, 234 -1Nff -27, 41$

12,877
-35,640

1973

1974

~1,683 -11,015

1S75

Services, except investment income••••.•••••

340

665

1,020

1,988

2,888

4,153

Transfers, U.S. tnilitary sale$ •........•.••...••..•
'fees 111d royattie~ .. -...........•••.••••.•••••.••
'Other private service1 ..••..•....•...••.•••••••••
'U.S. Govemmenhi\isceltaneo11s services ..•.•••.•••
'Direct 'deferffll exj,enlfituies ...••.•..••••.••••.•••
'Private payme!li' for semcts .•...•.•.•••.•••.•.••
l\J.S C:ovemment payments for miscellaneous
service•.••••••••••.••••.•...•...•.•.••.••.•.•

217
134
139
5
-105
-16

489
l52
146
7
-75
-20

862
195
253
7
-234
-20

l, 61>7
204
372
8

2,~
535
21
-«I
-26

4,021

-34

-34

-34

-40

-60

-60

Investment income, net .•••••••••••••.•••.•

2,750

3,901

5,374

1,868

3,095

1,764

5,671
330
105
-5
-451
-276

2,650

4,050

3,~i~
116
-6
-755
-1,094

'\J.S. direct investments •..•••.•••••••...•..•••..•
2,660
3,789
·Other U.S. private reteipts. .••.....•..•..•...•..•
85
166
U.S. Government reeelpts. •••••.•..••...•...•••.•
76
87
'foreign direct investments •....•.•.••...••..••..•••.•......••..•....•
-Other private paymenls .................•...•.•..
-52
-103
-19
-38
'U.S. Government paytnents ..•.•.••...•.•...•••..•

-m
-22

m
118

-8
-574
-650

405
117
-6
-655
-816

ri

17
-789
-37

l\J.S. Government grants .•......••..•••..•••.•••.•

-44

-33

-35

-27

-20

-15

U.S. assets abroad, net. .••...••••••..•••.•

-905

841

6,347

-3, 158

-2, 501

-1,242

V.S. Government assets, except reserves ....••...•.

-214
-203

-211
7,556

-1, 955

-44

-261
-967

-467
-536

32

-548
-643

35

23
-1,331

-74
-663
18
252
-775

Claims reported by nonbank concerns •.•..•.•••..•
Claims reported by banks, n.i.e....•........••..•.

-lll

-385

-391
1, 80~
-158
-425

Foreign assets in United States ••••.•••••..•

796

1,179

11,884

8,095

11,260

7,320

U.S. Treasury securities .•••.•...••..••.••••.....•
Other U.S. securities_ ...•.......•••.••••...•...••
other U.S. Government liabilities ...••••••..•••.•••
Direct investments in Uniten States ....••..••...••
liabilities reported by non bank concerns ...•..•.••.
Liabilities reported by banks, n.i.e ••••..•...••..•.

184
-26

50

5,473
1, 191
518
111
493

2,426
3,199
1,118
-36
756
631

3,206
3,005
2,851
23
537
1,638

3,457
2,938

175

1,129

10,783

-8, 941 -15, 851
-5, 112 -9, 888
7,111
9,455

-22, 763
-16,861
6,758

f~~::~n ~~sut:l\f~ .a.~r~.a.d_-_-::::::::::::::::::: :: :
5

8

90

-18
-8
574

Other transactions and transfers of funds between
foreign areas, net ..•••••....••....•.......•..• -2, 514
Memoranda:
-423
Trade balance ......•......••••••.•••..••.••
Balance oh current account .•.•••.•.....•.••••
2,623
Foreign official assets ..••.•••.••..••..•••.••.
593

-2

433

2

145
551

5

4,098

-4, 870 -13, 575
-1, 683 -11,015
-4, 656
2,f~~
10,840

758

12
-271
426

1 There are minor omissions in the service accounts and in the capital flows which are included in "other transactions
and transfers of funds between foreign areas."

,The wide fluctuations in the balance on current account have made it difficult
to induce offsetting changes in net capital flows without considerable changes in
exchange rates. The difficulty is aggravated when the capital flows from the surplus countries are much more or much less than the U.S. current account deficit


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370
with them. In rn74 the United States had a current account deficit of '$4.7 billion
with memhers of:OPEe.:The·net c;apHal infk>w, {rom- them, however, was $18.Z
billion, of-whicb·$7.6 billion, was,pjiyment fQr U.S. direct investments nationalize.d
by members o:fi OP:E0. As a conseqwinc;e, thet,-e ,countri(ls transferred about. $11.0
billion from-other countries to JLnance the J)Xcess of. their net capital flow to theUnited States over their current account surplus. On the other band, th~ current
account of the United States with all other, countries -was almost-in balance in
1974. Virtnally·all of the-funds transferred from them by OPEC bad to be recycled
in increased capital outflow from the United States to enable these countries to
finance. their,deficit with'. OPEC: _In. 1975 and ·1976, ·the net capital inflow from
members of OPEC was•,&1:igbtly 1eSfl thRn the 1].S. current account deficit with
them.
The situation changed abruptly in 1977. The U.S, deficit on cm;rent accoqnt with
members of OPEC increased by $7.0 billion to $16.9 billion. The net capital inflow
to the United ,states from them decreased by $2.7 billion. The transfer of funds by
members of OPEC from the United States to other areas increased by $9.7 billion
to about $10.8 billion. The United States also had a current account deficit of $8.0
billion with Japan, but all except $1.2 billion of this was covered by a net capital
inflow from that country, mainly official funds. -With Canada, the United ,states
bad a current account surplus of 1$2.9 billion, which was more than covered by net
capital outflow from the United States, including the drawing down of Canadaian
reserves, With all other areas eKcluding Western Europe, the United State.s bad
a small current account deficit Jmt a large capital outflow, mainly from U.'S. banks,
about half of which was to their Caribbean branches. These funds were lent to
other countries and that was done by transferring $8.3 billion of their capital
receipts from the United ·States to other areas.
Actually, all of the net capital inflow in 1977 necessary to balance the shortfall
in the net capital inflow from OPEC and other areas came from Western Europe.
Very little of that inflow was private funds ($4.8 billion). By far the greater part
of the foreign capital inflow from Western Europe was official funds ($24.4 billion) and a very large part of the official and private funds came from the United
Kingdom ( $14.~ billion). The need to attract this enormous inflow of funds from
Western Europe would under ordinary circumstances have resulted in a depreciation of the dollar in the exchange market. As the dollar depreciated without
any improvement in the balance on current account, foreigners were discouraged
from acquiring dollar assets, so that the inflow of funds came from foreign mone•
tary authorities concerned to avoid a further appreciation of their currencies relative to the dollar. This was supplemented by U.S. intervention which was also
classified as an inflow of foreign official funds because the currencies for intervention were acquired from foreign monetary authorities.
SUMMARY Of U.S. INTERNATIONAL TRANSACTIONS, BY-AREAS,-1977
[In millions of dollars!
All
areas

OPEC

Current accounL ••••••••••• _______________ -20, 464

-16, 861

2,053

2,857

-8, 019

-494

Merchandise trade_ •• ___________________________ -31, 496 -22, 763
Services, except investment income ________________
3,892
4, 153
Investment income ______________________________ 11,935
1, 764
Unilateral transfers _________ ·- __ •• _______________ -4, 795
-15

6,229
-3, n,
-708
-334

-1, 689
1,513
3,173
-140

-8, 058
50
32
-43

-5, 215
I, ,09
7,674
-4, 263

Capital flows __ • __ -·-·-- ___ •••• ___ ••••• ___

Western
Europe

Canada

Japan

Other
areas t

23, 202

6,078

21, 465

-3, 382

6,850

-7, 809

U.S. assets abroad ________________ ··-·-·-----·-- -26, 059
Foreign assets in the United States:

-1, 242

-7, 689

-2, 679

760

-15, 209

6, 758
562

24,397
4, 757

-1, 063
360

(7, 327)
} 6,090 7,400
(6, 163)

10, 783 -23, 518

525

Official__ __ •• ______________ -·_. ________ ---·Other_ •••• ___ --··- •••••• -··----··- __ ---·_ ••

37,419
11,842

Statistical discrepancy and inter-area transfers •- ______ •••• ____ •••• ____________ -··

-2, 738

1, 169

8,303

t Include, international institutions and transactions unollocated by area •
• 2 The total for all areas is the statistical discrepancy, The amounts for eoch area reoresent the sum of its statistical
discrepancy and transfers from other areas to the United States (minus) or to other areas from the United States (plus),,


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Because of the role of th·e dollar in international capital transactions, those of
other countries al; well as the United States, there are large amounts of assets
denominated in dolfars that nonresidents of the United States hold in this country
and abroad. A't the end of February 1978, U.S. liabilities to foreigners reported by
U.S. banks, including holdings of U.S. Treasury securities, amounted to· $197 billion. Of this, $133 billion was to officiat institutions, $41 billion to commercial
banks, $16 billion to other foreigners, and $8 billion to nonmonetary international
organizations. Official funds do not flow out of the United States when there is
speculation against the .dollar-,that is when they are more likely to come. in, at
least from the industrial countries. The holdings of commercial banks are almost
all cover for liabilities, and increased in' 1977. The holdings of other foreigners are
also mainly :celated to business affairs and also increased last year. Moreover, foreign purchases of U.S. corporate stocks and bonds increased in 1977. There is no
evidence that the outflow of capital from the United States came from the sale of
foreign-owned assets.
·
According to the Bank for International Settlements, at the end of 1977 the
banks of eight reporting European countries had liabilities in foregin currencies
to nonresidents· of $383.4 billion of which $272.9 billion were denominated in U.S.
dollars. Not all of these.Eurodollar deposits are regarded by their holders as dollar assets. To. a considerable extent they are European currencies temporarily
converted int9. dollars because of slightly better net interest rates, but sold forward for European currencies. This is also true of much of the Eurodo.UaF loans
which are converted into other currencies needed by the borrowers with offsetting
forward purchases of dollars..The greater part of the Eurodollars are :;ilready
covered by forward exchange transactions and salies of Eurodollars were not a
significant factor in the fall of the dollar in the exchange market. In fact,
Eurodollar deposits of nonresidents with the banks of these eight countries
inrreased by $26 billion in the fourth quarter of 1977.
The issue of bonds in Europe denominated in dollars increased sharply after
the United States imposed the interest equalization tax (1963) and aftJer the
limitations on the transfer of funds for U.S. foreign direct investment, voluntary
in 1965 and mandatory in 1968. The total dolla'r-denominated Eurobonds issued
between 1964 and 1977 amounted .to. about $52.5 billion. From 1965 to 1977, U.S.
corporations issued over $10.0 billion of Eurobonds of which about 80 percent
were denominated in U.S. dollars. Some foreigners with dollar-denominated bonds
sold them when the dollar became weak in the exchange market. The first effect
was that their price, quoted in dollars, fell. This happened in the fourth quarter
of 1977 and the first quarter of 1978. Over this period, the yield on a New Zealand·
dollar issue maturing in 1986 rose from 7.86 percent in September 1977 to 8.41 percent in March 1978. The yield on a New Zealand D-mark issue of the same maturity fell from 6.46 percent to 6. percent over the same period. The fall in thedollar price and the rise in the D-mark price reflected the change in the preference
for bonds denominated in these currencies and had the effect of making them
equally attractive at the new prices in national currencies and at prevailing
exchange rate,;.
The changes in the prices of Eurobonds denominated in dollars and D-marks
were more a consequence than a cause of the change in exchange rates. If foreigners who switched out of dollar-denominated bonds sold them to other foreigners, then the dollars purchased by the buyers would offset the dollars sold by
the sellers of the bonds, with no overall change in the supply of and demand for·
dollars in the exchange market. If Americans bought the dollar-denominated
bonds from foreigners there would be an outflow of capital from the United States
and that would increase the supply of dollars in the exchange market. If foreigners wanted to sell dollar-denominated bonds because of a fear of depreciation
of the dollar, that would apply to bonds issued in the United States as well as
those issued abroad. In fact, foreigners were net buyers of $1.'5 billion of U.S.
corporate bonds in 1977, although their net purchases declined quarter by quarter
from $505 million in the first quarter to $225 million in the fourth quarter.
The emphasis on foreign holdings of dollar-denominated assets as a significant
factor in the fluctuation of dollar rates of exchange is misplaced. When foreigners,
and even more U.S. residents, change the currency composition of their assets and
liabilities, they do it mainly by speeding up payments in foreign currencies and:
slowing down payments in dollars. They also change their net position in different
currencies by buying forward exchange, without any movement of funds by them,
although the banks that supply the deficiency in the forward market will sell spot
dollars to cover their forward contracts. There are considerable transfers of foreign funds when the dollar is expected to depreciate, but they appear in the capital


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flow data as a diminution in the foreign capital inflow. The end result is that net
private holdings of dollar assets, by foreigners and U.S. residents, are short of
normal requirements. When the depreciation of the dollar is halted, the short positions are corrected and that is the initial cause of a recovery in the exchange rate
after a large decline.
MAINTAINING ORDEllLY :EXCHANGE CONDITIONS

The large fluctuations in dollar exchange rates may indicate that the price
elasticities for export/import goods are much lower than has been assumed. 1'bey
are probably due more to the excessive emphasis on the automatic adjustment of
the balance of payments through changes in exchange rates. The depreciation of a
currency will ultimately restore an appropriate balance on current account, but
the depreciation could be very large if measures are not taken to slow the rise ih
prices and costs. That ts because the exchange market foresees that the decline in
the exchange rate will have to be larger without complementa,rr··fiscttl and monetary policies than with them. Once speculation begins in anticipation of a depreciation of the exchange rate, it is difficult to stop. An increase in interest rates
which could have a considerable effect in atttractihg an inflow of capital when the
exchange market is orderly can have little efrect once the exchange rate depreciates rapidly. Under such conditions, ohly the intervention of the tttbnetary
authorities can be efl'ective in preventing a greatly excessive depreciation of the
-currency.
The management of the exchange r11te is an integral part of monetary policy.
An undervnlued currency acts like a too-easy monetary policy-it stimulates
output, but cohtributes to the rige in prices and costs. An overvalued currency
nets like a too-tight monetary policy-it re!!trains the rise in prices and costs,
hnt holds down output. The monetary authorities cannot escape the responsibility
for avoiding excessive fluctuations in exchange rates by saying that the way to
do it is by maintaining sound fiscal nnd monetary policies. The exchange rate
problem is a pragmatic one. It is useful to let the exchange market provide
the monetary authorltie!I with an indication of what the exchange rate should
he. But when exchange rates change too much too rapidly, the market is no
longer concerned with wh11t the exchange rate should be, but with what it
will be in the very near future. As Mr. Gerald K. l3ouey, Governor ot the
Rank of Canada, told the House of Commons Standing Committee on Finance,
Trade and Economic Affairs: "A rather curious situation can develop in which
the authorities continue to look to the market to determine the rate while
the market insists on probing further and further to find out how far the rate
will be allowed to move before the authorities step in."
At such a time, the exchange market needs guidance. It has been suggested
that the monetary authorities should decide on a range within which exchange
rates would be allowed to move freely and that they should intervene when
necessary to keep the rates from going beyond the limits ot the range. Such a
J)Olicy would be equivalent to restoring fixed parities With wide margins. Once
the exchange rate reached the upper or lower limit of the range, futther flexibility could be in only one direction unless the range were changed, as it no
doubt would be. If the changes in the range were large and discontinuous, they
would resemble changes in parity and might induce speculators to test the
bottom of the new range. If the changes were small and frequent, they would
not achieve the purpose of having a degree of exchange stability for a time
-within the range.
The monetary authorities need greater flexibility than that. Instead of trying to keep exchange rates within a predetermined range, their objectives should
lJe to avoid large and rapid changes which are clearly disruptive. With such a
policy. there would he no intervention if the fall in the dollar exchange rates
for the major trading currencies were gradual. If the decline became rapid,
it would be allowed to go on for a time before the monetary authoritieR interTened. If the rapid decline continued, and particularly if it accelerated, the
monetary authorities would intervene, not to halt the decline but to slow it.
Thus, the exchange market would be able to signal its views on exchange rates,
hut not to impose such a rapid decline as to create expectations of a further
depreciation of the dollar. When the decline ends and the dollar begins to
recover, the monetary authorities would follow a similar policy, slowing but
not halting the rise in the rate.
Int'ervention to support the exchange rates or to moderate changes in the
~xchange rates for currencies should be undertaken only by agreement of the


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countries concerned and after consultation with the International Monetary
Fund. The United States would intervene in the market on its own account
in only a very few key currencies, such as the D-mark. It could consent to intervention by other countries to avoid large changes in the dollar exchange rates
for their currencies, but only if it were clear that such intervention would not
prevent necessary adjustment in the U.S. balance of payments. As the behavior
of the'. dollar exchange rates.· for other major trading . currencies is of great
importitn,ce·to <>titer' couhtries as ,well as those immediately concerned, members
should consult with the International Monetary Fund before intervening in
the exchange market.
Most of the intervention to support the dollar was undertaken by other countries rather than the United States, at least until early his year. As the United
States holds very little foreign exchange reserves, it had to acquire currencies
it needs for intervention from other central banks. When foreign monetary
authorities intervene to support the dollar, their operations increase the money
supply and create reserves for their banks. That also happens when th'e United
States intervenes using currencies acquired from the swaps. Recently, the Swiss
and Germans suggested that the United States should take a more active role
in suwort~g the dollar and that it should issue foreign currency bonds to raise
the flmds 'i'equ'fred 1for · intervention. · The extraordinary borrowing of foreign
currencies would show that the United States was concerned about the depreciation of the dollar. The use of funds borrowed in the bond market would enable
the United States to intervene without drawing funds from their central banks,
thus avoiding an increase in the money supply and in bank reserves.
The United States decided not to use this means of raising currencies for
interventi.oi;i. The purpose•of intervention should;not be to maintain an exchange
rate for the dollar higher than it would be with an orderly exchange market.
The U.S. policy should be to buy in the exchange market as much foreign currencies during the recovery of the dollar as it sold during the fall of the dollar,
with no net intervention over a period of a few months. There is no reason for
issuing foreign currency bonds to finance such a temporary need. The United
States may continue to have a current account deficit for some time, but if the
payments position is appropriate the deficit will be matched by a net inflow of
funds without extraordinary foreign borrowing by the Government. In fact,
such borrowing would have the effect of preventing the exchange rate adjustment necessary for an appropriate balance on current account.
The United States is concerned about avoiding excessive fluctuations in the
dollar exchange rates for other major currencies. On March 13, 1978, the U.S.
Secretary of the Treasury and the· German Minister of Finance issued a joint
statement agreeing to cooperate on such a policy. The statement said: "The
U.S. Treasury has arranged for the sale of SDR 600 million (approximately
$740 million) to purchase Deutsche Marks. In addition, the United States has
a reserve position in the IMF (automatically available in amounts up to
approximately $5 billion) which it will draw if and as necesary to acquire
1tdditiQ:Q.al.,.foreign exchange." As part of this cooperative effort, the Fe?8ral
Resen:e.'.·.and .the Bundesbank agreed to double the swap line from $2 billion
to $4 billion.
The use of SDRs and of drawings on the IMF has a significance not attached
to the use of swap lines. The use of such resources represents a sharing of the
exchange risks from intervention. When the United States draws D-mark_s from
the IMF it incurs an obligation to the IMF for an amount of SDRs eqmvalent
to the v~lue of the D-marks at the time of the drawing. Germany, in turn,
acquires a claim on the IMF for an amount of SDRs equivalent to the value of
the D-marks at the time they were drawn. If the United States, for example,
had drawn D-marks from the IMF on Spetember 30, 1977, its obligation on
March 31 1978 would have belen 6.3 per cent more in dollars than when the Dmarks w~re drawn. That is because the foreign exchange value of the dollar
fell by this amount relative to the weighted average of the currencies that
comprise a unit of SDRs. On the other hand, the claim of Germany on the Il\lF
would have been 6.8 per cent less in D-marks at the end of March 1978 than
when the drawing was made. That is because the foreign exchange value of
the 'D-m'llrk ro'se by this amount relative to the weighted average of the currencies that comprise a unit of SDRs. This would have been an almost equal
sharing of the exchange risk betwen the United States and Germany. Ach~a~ly,
the risks of loss from intervention which is solely for the purpose of av?Hhng
excessive fluctuations in exchange rates are very small; they are insigmficant
compared with the economic costs of excessive fluctuations in exchange rates.


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THE 1978 MIDYEAR REVIEW OF THE ECONOMY
THURSDAY, JULY 13, 1978

INTERNATIONAL TRADE
CoNGRESS OF THE UNITEO STATES,
J orNT EcoNoMro COMMITTEE,

W(l,8hington, D.O.
The committee met, pursuant to recess, at 10 :04 a.m., in room 2168,
Rayburn House Office Building, Hon. Gillis W. Long. (member of
the cornmittoo) presiding.
·
Present: Representatives L~ng and Brown 0£ Ohio; and Senator
Roth.
Also present: Lloyd C. Atkinson, Thomas F. Turnburg, Kent H.
Hughes, M. Catherine Miller, William)). Morgan, and Robert .A.sh
"\Vallace, professional staff members; Mark Borchelt, administrative
assistant; and Charles H. Bradford, Stephen J. Entin, and Mark R.
Policinski, minority professional staff members.
OPENING STATEMENT OF REPRESENTATIVE LoNG

Representative LoNG. This hearing will come to order.
Gentlemen, speaking on thehalf of the Joint Economic Committee,
we.appreciate your taking the time not only to be with us _today, but
also to prepare the statements that you have submitted, and to give
us t.he benefit of your views.
I have a short opening statement that I would· like to make and, if it
is acceptable to you, we will then proct>ed to a panel-type discussion, as
we have done with most of theee hearings, having found that they are
more productive.
"\Ve will give each of you an opportunity to present his prepared
statement, and when we go into the question period, if any of you has
a comment with respect to the partioular question that is being discussed, even though it might have been addressed to one of the other
members of the panel, don't hesitate to speak up, make yourself heard,
and your point of view known. That will add a great deal to the continuity of the proceedings.
In past years if America ]ooked at ecoµomic statistics at all, it seems
we focused on growth, employment, and inflation. Suddenly the trade
deficit and the value of the dollar have jumped off the financial page,
and have crowded their way into the everyday headlines. Never in this
century has foreign trade weighed more heavily on the£oonomic mind
of the country.
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National interest in foreign trade has grown at a time of tumultuous
change in the international economy. Fixed exchange rates have given
way to a wide variety of currency system. The OPEC cartel has succeeded in sharply raising the price of oil and generating a large financial: surplus. Competj.tion for wor.ld markets,has be,cQme more seive.re.
There. are a number of dev~loping coup.tries that have become major
exporters of manufactured goods.
Throughout this period, the United States has remained a finn
advocate of freer trade. Ambassador Strauss, our special trade representative, has been a major foroo in moving the current Toyko round
of trade negotiations, we all hope, in the direction of a successful
conclusion.
There has already been some pl'e$s speculation that, with the exception of agriculture, a basic agreement on trade matters will be announced at the upcoming Bonn economic summit. Today, we hope to
anticipate the summit just a little by taking a look at the economic
implications of a possible trade agreement.
Despite the progress made at the multilateral trade negptiations
that have been held around the world, there are, of course, a number
of potential problems that could seriously disrupt the future course
of international trade.
In the United States, the broad political coalition that supported
free trade for so long has 'begun to break apart. A large part of organized labor began to question the benefits of expanded trade in the
late 1960's, and formally broke with other free trade groups in 1971,
a break represented by introduction of the Burke-Hartke bill.
Then, following the OPEC-mandated inc:re,ase in the price of oil,
most of the industrial world was forced to suffer the worst of economicworlds; that is, recession coupled with rapid inihition.
In an attempt to fight the recession and still earn sufficient income
to meet the cost of higher oil prices, many countries have sought to
boost their exports. At the same time, a variety of measures were
adopted to reduce import pressures; this is not, of course, an exclusively American phenomenon. The signs of what many call the
new protectionism, if that is a good term for it, can be found all
around .the world, and there may be more trade-r~lated difficulties in
the future.
The rapid growth of the number of developing countries has put
their manufactured exports in competition with those of the industrial West. Even more competition for the industrial markets can be
expected when Iran, Saudi Arabia, and other OPEC powers complete their industrialization drives. The result may be increased pressures in the developed countries to adopt quotas or other trade-restricting measures.
As I mentioned earlier, to discuss these problems and all of the
issues that are related to them, we are fortunate to have with us this
morning an exceptionally distinguished panel of economists, Mr. William Cline of the Brookings Institution, and Mr. Robert Stern of the
University of Michigan, who are going to focus their attention on the
likely outcome of the international trade negotiations in Geneva and
what they might mean for the United States and for the rest of the
world. Mr. David Richardson, of the University of Wisconsin, who


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will explore the implications of foreign trade for the United States
.and the developing world.
Before we start, 1 would like to insert into the record a reoon.t ~ r
by Mr. Balassa on world trade and the international economy IW.tl,
without objootion,'that will be ru.ade a part of the record at this point.
[The paper referred to follows:]
WORLD TRADE .AND THE lNTERN.ATION.AL ECONOMY:

TRENns, PROSPECTS, .AND POLICIES

(By Bela Balassa)

*

I. TB.ADE IIBEBALIZATION IN THE POSTWAR PERIOD

The progress of trade UberaUzation

The postwar period saw steady progress intrade liberalization until the oil
crisis and the world recession of 1974-75. Apart from removing quantitative import restrictions imposed during the depression of the nineteen-thirties and the
Second World War, efforts were concentrated on lowering tariffs. Reductions in
tariffs originally aimed at reversing the increases effectuated during the depression, but they were subsequently lowered much below pre-1930 levels.•
Tarilf reductions were undertaken in the framework of GATT on the basis
of the dual principles of nondiscrimination and reciprocity. Nondisctimination
means that, customs unions and free trade areas apart, reductions in tariff barriers are extended to all member countries under the application of. the mostfa vored-nation (MFN) clause. In turn, reciprocity means that, in negotiating
tariff concessions, an attempt is made to balance the interests of the participating
countries.
During the nineteen-fifties, trade liberalization proceeded on the basis of
item-by-item negotiations, With the participating countries making offers to each
other to lower tariffs in exchange for tari:ft reductions on items of export interest
to them. After initial successes, this procedure became increasingly cumbersome
and was superseded by across-the-board taritt reductions, first in the Dillon
round and subsequently in the Kennedy round of negotiations, with -exceptions
made for so-called sensitive items.
Although most developing countries did not actively participate in trade
negotiations in the framework of GA.TT, they enjoyed the benefits of tariff reductions being automatically extended to them under the application of the MFN
clause. Indeed, it appears that the benefits of multilateral trade liberalization
for the developing countries far exceeded the benefits they have derived from
the application of the General Preference Scheme which, despite its name, has
1·emained limited in scope.• And while the elimination of tariffs on intra-area
trade in the framework Of the European Economic Community and the European
Free Trade Association favored imports from the partner countries over imports from outsiders, including the developing countries, tariffs on these imports
were reduced on the average by one-half during the nineteen-sixties. At the
same time, the developing countries benefited from increased demand for their
exports that accompanied the acceleration of economic growth in Western
Europe following the success of integration efforts.•
• The author Is Professor of Political Economy at thP Johns Hopkins tJniv!'rslty and
Consultant to the World Bank. The opinions expressed in the paper are those of the author
and shonlrl not be lnterpret<><l to refleM: the vlPws of the' World Bank. The oaper was
presented at the Seminar on "The Role of World ~rade In the Present Economic Situation,"
sponsored by the Instttuto Ballcario San Paolo di Torino, and held in Milan on
March 31, 1978. The author ls indebted to participants at the Seminar for helpful discussions and to Geza Feketekutv, Nicholas Pless, and Jan Tumllr for valuable comments.
1 While the ratio of tariffs to dutiable Imports does not appropriatPJy m1>asure the
PxtPnt of prot~ction, it ma;v be used to indicate general trends. Jn the United Stat..s, this
ratio averaged 38 percent In 1922-21>; it was 53 percent In 1930--33 under the Rawley.
Smoot law; and it decreased to 25 percent by 1957 (Sidney Ratner, The TarlfJ m Amerioan
History, New York, Van Nostrand, 1971!, pp, 52-57). 'l'be ratio of U.S. tar"'s to dutiable
imports declined further following the Dillon-round ( 1960--61 l and tile Kennedy-l'Ound
1106.~67) negotiations and reached 8 percent in 1974 (8tat'8tioo1 Abstract of the United
States. 1975, R· 22).
• Ct. J. M, Flnirer. "T1trlff Provisions for Oirsho,.,. Al!lilembl:v a:n<l"the Eipnrtfrot Dev.,.Top!ng
Countries-," Eoonomic Jt111mal, June 1975, and "E«ects ot·the Kennedy Round, Tarllf Con,
cessions on the Exports of Developing Countries," lbla., Mareh 1976.
• f'f. Bela Balassa, European Economic Integration, North :llolland, Amsterdam, 1975.
ch. 2.


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Trade liberalization pertained largely to raw materials and to manufactured
goods· while food imports remained subject to barriers. As tariffs on most
raw materials were reduced to low levels by the mid-fifties, in this paper emphasis
be gi-ven to trade in manufactured goods.' This choice is also warranted by reaso:p of the fact that trade in manufactured products had to bear
the b'runt of the "new protectionism" since 1973 and that prospective changqs
in the international division of labor between develop~ countries a_ffect primarily these commodities.

will

International trade and.economic growth
It has been noted that the elimination of barriers to intro-area trade contributed to the acceleration ·of economic growth in Western Europe. More generallr, the expansion of international trade has favorable effects on economic
growtp.. Apart from improvements in resource allocation according to comparative advantage, these effects find their origin in the exploitation of large-scale
economies through the construction of larger plants ( the traditional form of
economies of scale), reductions in product variety in individual plants (horizontal specialization), and greater specialization in the production of parts,
components, and accessories (vertical specialization), as well as in technological
changes that is stimulated by foreign competition. Rapid economic growth. in
turn, contributes to increased imports, thereby extending the gains to other
countries.
Raguar Nurkse suggested that the effects of trade on economic growth are
indicated not by "the average ratio of world trade to world production [but by]
the incremental relationship between trade and production ...." • He noted that
such a relationship was obs·erved during the nineteenth century, when the expansign of international trade at a rate much exceeding that of domestic production importantly contributed to economic growth in tlie industrial coun. trie$. Economic growth wa,s, in turn, transmitted to other countries of the
world as the industrial countries' imports of primary products rose at a substantially higher rate than their ·national income.
·
Nurkse claimed, however, that "the world·s industrial centers in the midtwentieth century are not 'exporting' their own rate of growth to the primaryproducing countries through a corresponding ex,pa:nsion of demand for primary
products"• and that the developing countries face difficulties in exporting manufactured good to the industrial countries. According to Nurkse, ''.Industrialization for export markets may encounter ... difficulties on the supply side. In the
scale of comparative advantage there may be a wide gap, or at any rate a certain discontinuity, betwieen the traditional primary products and the new manufactured goods which a country would seek to export ... Equally serious are the
obstacles which industrialization for export is liable to encounter on the side
of external demand" 7 due to protection in the industrial countries.
These pessimistic views, shared by writers such as Gunnar Myrdal• and Raul
Prebisch,9 were not borne out by the facts. To begin with, the "incremental
relationship" between exports and production in the industrial countries obtained
also during the postwar period as their exports rose much more rapidly than
their gross national product. Between 1953, the first "normal" postwar yPar, and
1960, when the effPcts of tariff reductions, in the EEC and EFTA began to he
felt, the export volume of the,industrial countries increased. at an average annual
rate of 7.0 percent while their combined GNP rose 3.6 p!'rcent a year. 10
The industrial countries' imports of primary products from the developing
countries, too, increased m-0re rapidly than their eombimed GNP. These imports
rose at an average annual ;rate of 5.1 percent between 1953 and 1960, ex<'eeding
the GNP gro_wth of the industr\al countries by about one-half, with even larger
• Manufactured goods will be defined as SITC commodity classes 5 to 8 less nonferrous
metals (68).
5 Ra~nar NurkRe, "PRtterns of Trade and DevPlopmpnt." In Equilibri1tm and Growth in
the World Economy, Cambrl'dge, Mass., Harvard University Press, 1961, p. 283.
8 "Patterris•of Trade and Development," op. cit., p. 289.
• Ibid, p. 310.
.
·
8 OnnnPr Mvrillll, FJconomie Theor11 and Underr1e1•elor,ed RegionR, London, 1957.
• Raul Preblsch. "Commercial Policy In the Underdeveloped Countries," Ameerican Economic Re1Jiew Pr,pers and Proceedings, Ma:v 19!'i9. np. 251-7:l.
10 Tlnlted NatlonR, Yearnook of International Trade Sf'lfistics. 1962 and Bela Balas~a,
Trade Prospects fo.- neveloping. Countries, Home<vood, Illinois, R. D. Irwin. 1964, pp. 7.
10.-All data have been expressed In terms of constant prices.
·


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increases shown in regard to manufactured goods. 11 At the same time, the export
·performance of a number of developiing countries was adversely affected by their
own policie13 : the bias against exports in countries pursuing import substitution
policies led to a loss in their world shares in primary exports 12 and forestalled
the emergence of manufactured exports.
DeveZopments until the oil crisis

The observed trends in trade and growth continued rund even accelerated after
1960 when trade liberalization in the framework of the Dillon and the Kennedy
rounds, integration in Western Europe, and the adoption of export-oriented policies iin several developiµg countries gave added impetus to world trade. The
eX!perts of the developed countries ·rose at an average annual .rate of 8.8 percent
between 1960 and 1973," the last year before the quadrupling of oil prices and the
world recession, exceeding the growth of their combined GNP, estimated at
4.8 percent a year, by a considerable margin.
Economic growth in the developed nations led to a rapid rise of their import!'
from the developing countries, with increases averaging 7.2 percent a year between 1960 and 1973. The imports of manufactured goods rose especially rapidly,
far exceeding earlier projections. Thus, while the United Nations foresaw an
increase of only 60 percent during the sixties, these exports increased fivefold
between 1960 and 1970 and theii; rate of growth averaged 18.3 percent between
1960 and 1973.14
Within the developing country group, the largest export increases were experienced in countries that adopted export-oriented policies and liberalized their
imports. Thus, Korea, Singapore, and Taiwan, which first adopted such policies,
increased their share in the combined exports of manufactured goods by develop'ing countries from 2.7 percent in 1960 to·32.7 percent in 1973. By contrast', the
share of India, a country that continued wi'th protectionist policies 'throughout
the period, fell from 24.6 percent in 1960 to 6.6 percent in 1973.w
The rise iii their foreign exchange earnings .allowed the developing countries
to increase their imports from the developed na1tions at a rapid rate. These
imports rose 6.2 percent a year between 1960 and 1973, with manufactured imports growing at an annull}l average rate of 6.5 percent. As a result, the mannfactupng t.rade surplu,i of the developed nations wi•tl~ the developing countries
increased from $14 billion in 1960 to $43 billion in 1973, when the developing
countries provided markets for 37.7 percent of the manufactured exports of the
developed nations, excluding trade between the United Sta'tes and Canada as
well as within and between EEC and EFTA.10
II. OIL CRISIS, RECESSION, AND PROTECTIONIST PRESSURES

The post-1973 situation

It has been shown that the rapid expansion of foreign, trade contributed to
economic gro\\•th in the developed countries during the postwar period. Growth
in the developed countries, in· turn, was transmitted to the developing countries
through trade. At the same time, imports by the developing countries provided
an important matket· for the manufactured exports of the developed countries.
These developments occurred in an atmosphere marked by progressive trade
liberalization on the pa11t of the developed nations and by the adoption of exportoriented policies, accompanied by reduced protection, in several developing
Trr,de Prospects for Deuelovinr, Countries, np. 9-10. .
12 I. B. Kravis. "Trade as a Handmaiden of Growth : Similarities between the Nineteenth
and the TwPnt!Pth CentnrlPs" Economic Journal, DPcember 1970: np. 850-72; R. C. Porter,
"Some Implications of Primarv-Prorluct Trends." Journnl of Political Economy, May/June
1970, pp. 586-97: and Bela Balassa, The Structure of Protection in Developing Oownti-ies,
Baltimore. Md .. Johns Hopkins Press. 1971. ch. 2 and 4.
.
13 United Nations. Monthl11 Bulletin of Statistics. October 1977-Developed countries
are defined to Include thP industrial countries of North America, Western Europe, and
Japan, as well as Australia, New Zealand, Isdael, and South Africa. All other market
economies are classified as developing-,
.
.
u "Trai!e and Development : Trends, Needs and Policies, Part I" In United Nations,
World Economic Surve11, 1963, New York, 1965, p. 31, and United Nations, Monthl11 Bulletin
of Rtritlstics. June 1!177.
.
·
15 Bela Balassa, "Export Incentives and Export Performance in Developing Countries : A
Comparative Analysis" World Bank Sta:/J Working Paper No. 248 January 1973, Appendix
Table 2.
,
is United Nations, l(onthl11 Bulletin of Statistics, June 1977 and February 1978.
11


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cou.11tties. The atmo~hete wall marred only by quantitative imPort restrictions
pettaining ehieizy to Japanese exports, and by the adoption of the International
Cotton '11e1tiles atJ.d, stt'bsequently, M:ultifi'ber Arrangement. Neverthele8$, the
Mul!tiflbet' Arrangement provided for an annual growth o,f 6 percent in the exports of textiles and clothing and, as a result ot increases in their- quota allocation and the upgrading of their exl)Ort products, the developJng, countries'
exports of textiles and clothing rose substantially faster. 17
The situation changed as the quadrupling of oil prices aggravated 'the recession that followed the 1972-73 world economic boon. tn adding to inflationary
pressures, the oil price increase led to stronger an'ti-inflatiouary measures on
the part of the developed countries 'than would have been otherwise the case.
'!.'he recession was further aggravated by policy reaction on the part of the developed countries to the increase in 'their combined 'balance-of-trade deficit vis-av.is OPIDO from $17.2 !billion in 1973 ito $66.6 billion in 1974.18 And, while the
United States h•as maintained a steady rate of expansion since mid-1975 without regard to its •balanee-of-ipayments consequences, in the other developed countries 'the desire to lower inflation rates and/or to reduce balance-of-payments
deficits has not permitted economic expansion to proceed at a rate approaching
capacity growth following the recession. As a result, unemployment has continued to increase in Western Europe and Japan, whHe it has not yet declined
'to pre-1973 levels fol'lowing the deep recession in the United States.
High unemployment and unused capacity in a number of industries of the
developed countries have contributed to the emergence of protectionist pressures, which were intensified by reason of the continued existence of trade
deficits in most developed countries. The protectionist measures proposed and
actually applied, if not the extent of their application, have a certain resemblance to those observed during the depression of the nineteen~thirties. 1• They
may be subsumed under the heading "new protectionism" and include various
forms of nontariff restrictions on trade, government aids under the aegis of
the "rationalization of industry," as well as attempts made at the establishment
of worldwide market-sharing arrangements.

N ont«ri8 restrictions
As noted above, the Multifiber Arrangement, the principal case outside agriculture where nontariff measures were applied prior to the oil crisis, provided
for a 6 percent annual rate of growth in the textiles and clothing exportl!I of'
the individual countries. The new agreement, pertaining to the 1978-82 period,
is more restrictive. While notionally setting a 6 percent annual rate of growth
for the exPorting coun•tries, taken together, it leaves considerable scope for the
importing countries to set lower limits through bilateral negotiations.
In fact, the European Common Market that forced the adoption of the re•
vh,ed rules at the behest of France and the United Kingdom, has required that
the largest developing country eXporters reduce their 1978 exports of textiles
and clothing to the EEC below the 1976 level (the relevant figtlres are -9 percent for Hong Kong, -7 percent for Korea, and -25 percent for Taiwan). Ati,d
while better overall terms are provided to very poor countries, the total imPorts
of eight sensitive products, accounting for 62 percent of EEO iml)Orts of textile$
and clotliing from developing countries, wlll decline below the 1976 level in
1978 and will increase slowly afterwards, with growth rates in the 1978-82
period ranging from 0.3 percent a year for cotton yam to· 4.1 percent a year
for sweaters (The Economist, December 24, 1977). Import growth rate!! were
also set at less than 6 percent a year for another iml)Ortant group of clothing
products, so that the rate of growth of the imports of textiles and clothing into
the EEO will rema1n much below 6 percent.
The United States reached agreements with Hong Kong, Korea, and Taiwan
to freeze their 1978 exportl!I of textiles and clothing tn the U.S. at the 1977 level
and to increase the exports of a number of sensitive items, accounting for
about 70 percent of exl)Orts in •the case of Korea, at a rate Rubstantially less
than 6 percent afterwards. Taking further account of bilateral agreements
11 D. R Keesing. "World Trai!P and Outpnt of Manufactures: Structural Trencls and
DPvPloping Countries' Exports" Washington, D.C,. World Bank. February 1978 (mlmeo).
1s UN<"MonH!Zy Bttfff/tm·-0/'StotiBUcB. August 1976. ',
•
19 On this point, see Jan Tu~lir, "The New Protectlonlsm,Cartels, and the International
Order." paper prPsented at th~ Conference on' Oha!len!}ea to a Lifuwal ·1snteffl,atl1>11ai Eco•
nomic Order, sponsored by the American Enterprise Institute and held on' December 1-2,
1977 in Washington, D.C.


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negotiated with other countries, it is apparent that -the 6 percent annual rate
,of growth of the imports of textiles and clothing under the Multifiber Arrangement will not be attained in the United States either.
In regard to steel, the European Common Market established guideline prices
for five product groups and a mandatory minimum price for reinforcing bars
in 1976. As of January 1978, basic or reference prices were set for all products
:based on the lower foreign (i.e., Ja,panese) production costs adjusted for transport co;,ts. Imports below -the reference price come under anti-dumping rules,
with a levy imposed in the amount of the price difference. This scheme is assumed
to be temporary, to be replaced by bilateral agreements negotiated with steel
exporting countries. The Commission reportedly hopes ·to get some 20 countries
to accept the same share in the EEC market in 1978 as they had in 1976, implying
an average cut in steel imports by 8 percent from the 1977 level ( The Economist,
January 28, 1978). The cuts would be larger for the new developing exporters
that increased their steel exports to a considerable extent between 1976 and 1977.
In establishing reference prices for steel, the EEC Commission drew on the
Solomon-plan in the United States that came into effect in February 1978.
Under the plan, the reference or trigger prices have been set on the basis of
a~sumed Japanese production cos,ts and the cost of shipping to U.S. markets.
Correspondingly. the reference prices rise, and the chance of effective import
•competition declines, as one moves from \Vest to East (The Wail Street Journal
February 23, 1978).
The adoption of import restrictions in regard to textiles and steel is a manifestation of protection}st tendencies that have emerged in recent years. In the
Fnited States, the practical application of the provisions of the 1974 Trade Act
·also points in this direction. Under the Act, the U.S. Treasury has to reach a
•decision within one year after petitions are filed requesting the imposition of
<'Ountervailing duties on exports that are allegedly subsidized by foreign countries, and <'Ountervailing action has heen extended to duty free imports, including
those entering under the generalized preference scheme. In turn, dumping has
been redefined as selling at less than full production cost, including a margin for
profit, rather than at less than the domestic sales price as beforehand.
The Trade Act has also weakened the conditions for escape-clause action by
·requiring only that imports are "a substantial cause of serious injury, or the
threat thereof" while previously such action could be taken only if imports were
"the major cause" of serious injury and the increase in imports causing or threat,ening the injury was the result of previous trade concessions. Furthermore, "orderly marketing agreements," representing negotiated restrictions on exports to
the United States, have been introduced in the arsenal of protectionist mea,sures.
Finally. the two houses of Congress can overrule the President if he rejects recommendations made by the International Trade Commission on anti-dumping and
·escape clause action.
While the Trade Act of 1974 has also liberalized the conditions for granting
adjustment assistance to a•ssist domestic industries adversely affected by imports,
it is the possibilities provided for the use of protective measures that have come
to be increasingly utilized. To begin with, there h1ts been a substantial increase
1n positive findings in countervailing duty cases; there were thirty-four positive
findings in the years 1974-77 as compared to thirteen in the preceding 11 years.
And, at least in one case, the criteria for imposing countervailing duties have
been modified to the fletriment of foreign exporters."° The Treasury plans even
stricter enforcement in the future, although in many developing countries subsidy
measures only compensate for the effects of domestic protection.
The number of anti-dumping cases has also increased since 1974 and the recent
interpretation of production costs in the exporting countries is likely to give
impetus to further increases in the future. Thus, the Treasury has established a
formula for steel based on the "constructed value" of Japanese production costs
plus an arbitrary markup of 10 percent for general expenses and another 8 percent for profits, both of which are much above the industry average (Busine.~s
Week, November i4, 1977).
At the same time, the International Trade Commission has become active in
its investigation of complaints that imports are harming domestic industrieseven if this may involve encroaching on the territory of other governmental or20 The Treasur:v has countervniled the Imports of bromide and bromide products from
Isra!'l t1,nt lsenefit from re;rional aids, although only 1l percPnt of total product'.o!l is
PX!)orted to the C, S.

35-9,l0-78--9


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ganizations... It issued 42 decisions in 1976 as compared to 15 in 1975, with the
amount of imports affected rising from $248 million in 1975 to $1.9 billion in
1976, and surpassing $5 billion in 1977 (The Wall Street Journal, November 25,
1977). Finally, although President Carter overruled ITC recommendations in
several cases, some important decisions have favored protectionist interests.
Apart from steel and textiles, particular instances are orderly marketing agreements with Japan on color television sets and with Korea and Taiwan on footwear, both in 19'77. In the first case, imports were limited to 1.75 million sets a
year until 1980, representing a 4-0 percent reduction from the 1976 level. In the
second case, import limitations apply until 1981 and, despite annual increases in
quotas, the 1976 level would not be reached by the end of the four-year period of
the agreement. The application of protectionist measures in these well-publicized
cases has, in turn, contributed to demands for protection in industries such as
citizen-band radios, electric ovens, railroad equipment, bicycle tires and tubes,
copper, and zinc, among which tariffs have already been increased on citizen-band
radios.
The taking of protectionist measures by the Carter Administration has been
rationalized on the grounds that these help to forestall more drastic action by
Congress. At the same time, according to The Wall Street Journal (December 29,
1977), "the sentiment in Congress for protectionism is rising again." This reflects
increased protectionist pressures emanating largely from labor, with labor and
industry joining forces whenever they perceive a common iilterest.22
It should be emphasized that, whatever the outcome, pn,l:ectionist demands
create uncertainty for exporters. Thus, demands for countervailing or anti-dump,ing action may induce foreign producers to limit exports to the U.S. for fear of a
financial loss in the form of the payment of additional duties for which they have
to put up a bond. 23 More generally, even if they ultimately prove unsuccessful,
protectionist demands are reportedly initiated in the expectatr"'n that foreign
producers will cut back their expansion plans for the U.S. market. 24
Protectionist pressures have also increased in Western Europe, in particular
in Britain and ]!'ranee. In Britain, the Cambridge Group has provided theoretical
justification for the protectionist attitude taken by the Labor Government 20
while in France protectionism has political backing from the right as well as
from the left. Notwithstanding the generally liberal attitudes in Germany and
Italy,•• the position taken by these two countries has apparently greatly influenced the Common Market Commission, as evidence-2 by the imposition of strict
limits on the importation of textiles and clothing as well as by increased reliance
on countervailing and anti-dumping legislation.27
"'It bas been reported, for example, that ITC found tbe Japanese steel producers guilty

of "predatory pricing" which bas been defined in a similar way as 'umping violations that
are ruled on by the Treasury (WaBhington Post, January 15, 197b). It has also been re-

ported that the White House objected to the ITC negotiating consent orders between domestic and foreign color TV makers on its own initiative (The Wal! Street Journal,
November 25, 1977). Note further that the Message from the Chairman. introducing the
1976 report of the ITC, speaks of "an innovative approach to our substantive and administrative duties and . . . considerahle progress in meeting the objectives which the Commission had set as a result of its increased role in international trade."
22 In this connection, a statement made following the December 1977 AFL-CIO Convention may deserve quotatlon-"Althougb organized labor lost Its last big fight for Import
protection only three years ago, [when the Burke-Hartke bill went down In defeat], AFLCIO officials say that much has changed since then. The steel, elect~<lnics, shoe, textile and
apparel Industries have been badly hurt by imports, unemploymen, has soared, and ;,ultlnational operations have suffered a black eye for overseas bribery. The 'new reality' says a
union economist is that the public no longer perceives protectionism as a ba·' thing"
(Bueinees Week, December 26, 1977). In this connection note that the House has already
organized a 150-member steel caucus and a 229-member fiber caucus to defend the interests
of the steel and textile industries (The Wall Street Journal, December 29, 1977). and that
a subcommittee of the House Ways and Means Committee has voted to override President Carter's decision to reject the recommendations of the ITC for increasing duties
on. metal fasteners.
""A case in point is the imposition of antldumping duties, amounting to $46 million In
March 1978 on Japanese-made television sets imported in 1972 and 1973.
24 An example of apparent harassment of foreign exporters is the simultaneous Initiation
of countervailing, anti-dumping, and escape clause action against Imports of bicycle tires
and tubes from Korea.
""Cf. e.g. Le lflonde, April 4, 1978 and The Wall Street Journal, April 24 1978.
20 On the latter, see the favorable reactions in the Italian press to the author's speech on
the "new protectionism" on March 31, 1978.
21 The Economiet (December 24, 1977) reports on the Increasing number of anti-dumping
cases In the EEC and the increase in the "Commission's anti-dumping ~tall: from three to 10
to cope with the burgeoning work load."


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At the same time, while the application of protectionist measures in the United
Sta:tes is circumscribed by legislation, in Western Europe as well as in Japan,
protectionism often takes the form of discretionary measures by national governments. Such "occult" measures, which do not find their origin in legislation,
present a particular danger for foreign countries, and especially to· developing
countries, both because legal recourse is lacking and because they create additional uncertainty.
Limiting attention to protectionist measures actually taken by the industrial
countries, one may cite an estimate by the GATT Secretariat, according to which
the application of these measures over the last two years has led to restrictions
on 3 to 5 percent of world trade flows, amounting to $30-50 billion a year (The
New York Times, September 23, 1977). Reference may further be made to a list
prepared by the Taiwanese government on restrictions affecting manufactured
exports. The list includes one item for 1975, nine items for 1976, and 33 items for
1977, of which seven are still under investigation.
Government aids to industry

Prior to the oil crisis, government aids were used in the major European countries as well as in the United States principally in favor of the shipbuilding industry. Furthermore, regiona:l aids provided in Western Europe benefited certain
industries that are concentrated in depressed regions.
Government aids, often granted under the heading "rationalization", have come
into greater use since the 1974-75 recession. They take a variety of forms, including direct subsidies as well as preferential tax and credit treatment. These aids
provide indirect protection to domestic industry by reducing its production or
sales costs.
The German governmenit provides 75 to 90 percent of the difference between
the full-time wage and the wage earned by workers who had to be put on a parttime basis because of unfavorable business conditions. This scheme subsidizes
weak industries indirectly as they are likely to have proportionately more parttime workers. In turn, other European countries have directly or indirectly subsidized employment. These measures together with the introduction of regulations making it difficult to fire workers, have contributed to labor hoarding.
A case in point is the British Temporary Employment Subsidy Scheme that
compensates firms for keeping workers on the job who would otherwise be no
longer needed. In 1977, about one-half of benefits under this scheme accrued to
textiles, clothing, and footwear industries that reportedly received a subsidy
equivalent to about 5-10 percent of their total production cost. At the same time,
as The Economist (January 14, 1978) notes, little effort has been made to put
pressure on subsidized companies to rationalize their operations. It would appear,
then, that the subsidy provides an additional protection to the three industries
without contributing to adjustment.
While employment schemes are not industry-specific, they tend to benefit
labor-intensive industries which have higher than average unemployment rates.
In several countries, government aids have also been provided to specific industries. This is the case in particular in France where the automobile, data-processing, pulp and paper, steel, and watch industries have received various forms of
government aids. Whatever their avowed purpose, these aids will shore up, and
hence protect, weak induS'tries that find it difficult to face foreign competition.
The takeover of insolvent firms by the government, and the financing of their
deficits as well as the deficits of other state-owned firms from pub'lic funds, have
had similar effect in Italy.
Government aids applied by the individual Common Market countries discriminate against imports from member as well as from non-member countries.
In turn, in several instances, actions have been proposed, or have actually been
taken, on the Common Market level. To begin with, the EEC steel industry has
a legalized cartel, Eurofer, which ensures compliance with minimum prices and
also set quotas for market sharing among producers. Furthermore, the Common
Market has provided financial aid to the steel industry under the Treaty establishing the Coal and Steel Community; the regional fund will reportedly be
doubled between 1974 and 1981, in large part to provide assistance to the steel
industry ; ,and the EEC Commission is said to be working on a sectoral policy for
steel (The Economist, October 15 and December 31, 1977).
The Common Market countries have also taken, or contemplate taking, joint
action on shipbuilding and synthetic fibers. For one thing, the EEC Commis-


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sion has demanded that Japan cuts back its exports of ships (The Economist,
becemher 31, 1977) and proposals have been made for establishing a credit scheme
aimed at financing domestic shipbuilding. For another thing, it has been proposed to establish a production cartel for synthetic fibers, and "a common
market plan to ease the financial pain of redundancies" (The Economist, October 15, 1977) is reportedly in preparation.
Apart from shipbuilding where subsidies have long been used, under the
Solomon-plan the United States will use a variety of measures, including loan
guarantees, acct>lerated depreciation provisions, and subsidies to resea,rch, to
aid the domestic steel industry. Also, a variety of export promotion measures are
reportedly under consideration.••
In .Japan, a bill containing special measures for aiding certain industries in
difficulties was introduced in February 1978. The bill aims at providing assistance
to the aluminum, shipbuilding, steel, and synthetic fiber industries, formalizing
:and extending aids that have been provided in the past. Its application may
:also be extended to other industries, some of which have been beneficiaries of
:government assistance in the past. 20
International cartels and market sharing

·while government aids under the guise of the rationalization of domestic industries have led to moves aimed at cartelization in the steel, shipbuilding, and
synthetic fiber industries in the European Common Market, suggestions have
further been made for cartelization on the world level. In this connection, reference may be made to statements by Raymond Barre, the French Prime Minister,
"to define collective rules for an orderly growth of international trade . . . " 30
in the framework of "a genuine organization international trade" and "organized
liberalism".31 It has been proposed that the definition of "collectively defined
and applied rules which will generate conditions for growth security and dependability in trade . . . should be one of the main objectives of the international negotiations to be held in the coming months; they must not simply
repeat the negotiations of the last 20 years." 32
Negotiations on the organization of international trade would cover a variety
of industries, including steel and shipbuilding that have experienced worldwide
oYercapacity; some sophisticated industries, such as aircraft and computers,
where the United States is in a particularly strong position and infant industry
arguments are ilwoked in favor of European producers;""' as well as industries
such as textiles, shoes and electronics, where competition on the part of developing countries and Japan is feared."'
"\Yhile the lfrl'nch government proposals may have aimed at taking the wind
out of the sails of the domestic opposition and have not again been voiced since
the parliamentary elections held in March 1978, moves toward the establishment
"According to the New York Times, (April 2, 1978), these include "fast writeotl's when
companies develop new facilities to serve export markets, tax credits for those th·• t establish foreign sales offices, a new tax program on exports tailored principally for mediumSized companies, a system of information-exchange to promote greater exports, a Government loan program for companies that introduce a new product line for exports and a
beef eel-up operation (in money and personnel) for the existing Commerce State' exportdeYelopment actiYities."
'" It has been reported, for example, that "when the fast-growing computer firms in Japan
began to han tl,fficulties with their cash flow situation, the Japanese government organized
a leasing company to buy computers and handle the leasing, thus providing a fast injection
of cash and reducing the ongoing capital burden." (H. B. Malmgren, "International Order
for Public Subsidies," Thames Essay No. 11, London, Trade Policy Research Centre, 1977,
p. 24.)
30 Statement made at the National Press Club In Washington on September 16, 1977 and
quoter! in the press release of tbe French Embassy.
31 Foreign Trade Minister And!'~ Rossi in Le Monde July 27 1977 and Raymond Barre in
the ,Journal <le Geneve, September 15, 1977.
'
32 Journal <le GeniJve, September 15, 11}77-As noted above. the negotiations of the last 20
years have led to a considerable expansion of trade and economic growth through trade
33 According to Raymond Barre, "when a country develops a sector that is indispensable
to t"e structura} equi_Jibrlum of its economy but unable to meet normal competition until it
reaches a sufficient size, that country may rightfully take such steps as are necessary to
protect this activity from being destroyed while it Is vulnerable" (Journal
Geneve 'septernber 15, 1977).
' ·
"'As Raymond Barre expressed it, "France cannot allow international competition to
develop under conditions that would throw its economic structures into confusion, bring
about t''e sudden coliapse ot whole sections of its industry or agriculture, put thousands of
workers out of work. un(l Jeopardize Its independence by eliminating essential activities"
(U.4.urore, March 25, 1977).
·


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385
of world-wide cartels have been made in the shipbuilding and steel industries.
In the shipbuilding industry, market sharing arrangements have been proposed
in the framework of the OECD that would entail a division of new orders between the European countries, Japan, and the developing countries, together with
increases in the prices charged by Japanese producers (Business Week, December 5, 1977). In the steel industry, earlier reports that a steel working-group
established in the framework of the Organization for Economic Cooperation and
Development (OECD) is "planning to unveil a model for an international system
to monitor prices, trade, and structural changes in steel industries in the member
countries [that] could provide the basis for 'sectoral' talks on steel ..." (Business Week, November 28, 1977), have ,been given credence by meetings of United
States, Common Market, and Japanese officials allegedly aiming to establish a
"world steel agreement" ( The Economist, April 29, 1978).
III. THE "NEW PROTECTIONISM": AN EVALUATION

The effects of the measures applied

'l.'he preceding section examined the emergence of the "new protectionism" in
the developed countries since the oil crisis and the 1974-75 recession. It has been
noted that the "new protectionism" is characterized by the employment of nontariff restrictions on trade, the granting of government aids to domestic industries, with further attempts made at organizing world trade. This contrasts with
the "old protectionism" that involves placing reliance primarily on tariffs. At the
same time, various considerations indicate the superiority of tariffs over the
measures employed, or proposed to be used, under the aegis of the "new protectionism."
To begin with, tariffs are instruments of the market economy. Consumers make
their choice between domestic and imported goods and among alternative foreign
suppliers on the basis of price, quality, delivery dates, and other product characteristics, and domestic as well as foreign producers compete in the market without government interference or quantitative limitations. Also, tariffs do not
inhibit shifts in trade patterns in response to changes in comparative advantage
that are reflected iby changes in relative costs.
In turn, nontariff measures interfere with the operation of the market mechanism by restricting consumer choice and limiting competition between domestic
and foreign producers. The use of nontariff measures also involves administrative discretion that introduces arbitrariness in the decision-making process, when
the decisions actually taken are affected by the relative power position of various
groups. With consumer groups generally having less influence on decision making
than pressure groups representing various segments of labor and business, then
the new protectionism involves a bias towards restrictive measures.
At the same time, limiting imports in quantitative terms increases the market
power of domestic producers, thus enabling them to raise prices. when restrictions
applied to raw materials and intermediate products may spread forward as users
seek to offset the higher prices of their inputs ... Also, incenth-es for improvements
in productivity are reduced as a result and there is a tendency to freeze production patterns, thereby obstructing changes in international specialization according to shifts in comparative advantage.
Quantitative limitations on trnde interfere with the market mechanism in the
exporting countries, too. With allowed exports falling short of the amount producers would like to sell at the going price, they may collude or the government
may apportion among them the amount that can be exported. This, in turn, may
entail discriminatory pricing, with higher prices charged in export than in domestic markets. Foreign firms may also attempt to evade the restrictions through
additional processing ( e.g. steel), changing the basic material used ( e.g. textiles),
or shifting the place of production of countries which enjoy a preferential (e.g.,
television sets).
35 These conclusions also apply to thi, use of reference prices as an Instrument to limit
lmnorts. as ev!ilPnceo by the !5.5 percent lncrPase In trigger prices on stePl as of July 1,
197R anrl the demands for the imposition of trig-,;"er prices on wire products in the United
States. It has been suggested that steel-using industries will also request increased protection, since "distortions arising In steel aft'ect the international competitive position of all
steel users-from producers of nuts and bolts to manufacturers of sophisticated machinery" (New York Times, l\fay 11, 1978).


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Apportioning quotas among exporting countries also involves interference-with
the market mechanism. Maintaining historical market shares in the allocation
process discriminates against new exporters while changing market shares is
subject to discretionary decision-making. At the same time, the decisions taken
will be influenced by the bargaining power of the importing country and the actual and potential exporters, respectively, generally favoring larger countries
over smaller ones.
In cases where both parties can inflict damage, the possibility of retaliation will
arise. An example is Australia threatening to impose embargo on uranium in
retaliation to European restrictions on steel imports. A retaliatory motive is also
apparent in the imposition of antidumping duties by the Common Market on
kraftliner-paper imported from the United States in early 1978 as the U.S. had
used similar measures against European steel products.
There is further the danger of a cumulative process. Thus, while George Meany,
the Secretary General of the AFL-CIO called for "fair trade-do unto others as
they do to us, barrier for barrier, closed door for closed door" (Business Week,
December 26, 1977), measures taken by the United States for alleged offenses by
others are bound to elicit foreign reactions. Apart from retaliations, this may
take the form of imitative action as in the case of the imposition of trigger prices
in the framework of the so-called Davignon Plan for the Common Market steel
industry.
International trade is also affected by government aids to domestic industry,
which have come into increased use in recent years. Apart from distorting competition among firms located in different countries, these aids represent a further
increase in the role of the state in economic life and extend the scope of bargaining. Thus, the government may wish to obtain a quid pro quo for its aid in the
form of stipulated levels of employment, the regional allocation of production etc.
At the same time, within particular industries, inducements are provided for
collusive action to divide up the "spoils" and to increase bargaining power vis-avis the government.
Moreover, government aids become the subject of policy competition in the international arena. This first occurred in the case of shipbuilding as, Japan excepted, substantial subsidies have been provided to the industry in all producing
countries. Policy competition has further been extended to new technologically
advanced industries, such as computers and integrated circuits and, more recently, to some "old" industries, such as steel and t~xtiles.
Note may further be taken of implicit subsidies provided in the form of preferential export credits where, despite the efforts made, the coordination of policies
has not been accomplished. In fact, export promotion measures are coming into
increasing use, as evidenced by a statement made by K. H. Beyen, State Secretary for Economic Affairs in the Netherlands: "Rather reluctantly, we have been
forced to give a certain amount of assistance to our exporting industry when it
is threatened with distortion of competition by measures taken in other countries." (Barron's, April 24, 1978).
The dangers of policy competition were first recognized by Richard Cooper
in the mid-sixties, when this existed nnly in an embryonic form. 36 More recently,
Assar Lind,beck pointed to the dangers of the trend towards greater government
intercention and policy competition. In Lindbeck's view, "It could be reasonably argued that future conferences on international trade should perhaps concentrate on reducing various selective subsidies rather than cutting tariffs. That
would have the additional advantage of perhaps stopping, or even reversing, the
enormous concentration of economic powers to central planning administration
and politicians, which is perhaps the major consequences for our societies of
selective interventions.""'
The international organization of trade has been proposed, in part, in order
to limit policy competition. It also represents a natural outgrowth of collusive
action on the national level, inasmuch as national cartels would have limited
power in an international economy characterized by strong trade ties among
the countries concerned. Orderly marketing arrangements and other forms of
quantitative restrictions entailing the division of markets among exporting countries, too, gave an impetus to the international organization of trade.
""R. N. Cooper. The Economics of Interdependence: Economic Policy in the Atlantic
Community, New York. McGraw Hill, 1962.

•1 Assar Lindbeck, "Economic Dependence and Interdependence tn the Industrialtzed
World," tn From Marshall Plan to Global Interdependence, (ed. L. Gordon), OECD, Paris,
1978, p. 82.


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These developments are apparent in the European Common Market, where measures taken on the national level to provide financial aid to particular industries
and to limit imports have given rise to efforts at cartelization and trade restrictions on the Common Market level. Proposals for cartelization have come from
the EEC Comwlssion in the guise of the rationalization of industry as well as
from industrie-. that expect to benefit from cartelization. Apart from the shipbuilding, steel, and synthetic fibers industries, such proposals have been put
forward in regard to automobiles, chemicals, and shoes (Business Week, March
27, 1978).
The Common Market experience points to the tendency of cartelization to
spread among industries. This may occur along the chain of input-output
relationships as the cartelization of an input-producing industry affects the
costs of the input-using industry, or, in the form of imitative behavior. At
the same time, experience shows that cartelization tends to reduce the scope for
improvements in productivity that may have been its raison d'etre in the first
place. This is because, under market-sharing arrangements, producers would
derive little benefit from improving productivity as they are enjoined from expanding their sales, whereas higher-cost firms can continue their operations
without having to fear competition from lower-cost rivals. 38
An oft-cited example is the limitations imposed on the sales of small and
medium-scale steel producers in Italy's Brescia region, who produce reinforcing rods and various other steel products in the framework of the EEC steel
cartel. In an effort to maintain market shares, larger firms in the EEC countries that had higher production costs objected to sales by the Bresciani producers at low prices. The process of bargaining, in turn, has been affected by
political considerations, in part because several of the high-cost firms are
state-owned and in part because the governments of the individual countries
wish to defend the interests of their national industries.
Similar problems are bound to arise in the framework of the recently established cartel of the eleven largest EEC producers of synthetic fibers, which
would freeze existing market shares. With small European producers and the
European subsidiaries of American companies not being a party to the agreement, and non-European producers having different objectives, the potential for
conflict is considerable.""
The difficulties multiply if the organization of trade or production is attempted
on the world level, where the decisions concern not only the division of markets
among the producer,s of a single country or of the European Common Market but
among producers of the major developed and developing countries. Bargaining
and international politics will now increasingly take the place of market forces,
with a tendency to freeze existing patterns, thereby discriminating against new
producers, obstructing changes in comparative advantage, and foregoing the benefits that may be obtained from shifts to lower-cost sour~es.
The employment argument

,The deficiencies of national and international cartels are well-illustrated by the
experience of the depression of the thirties.'° However, just as in the thirties, the
argument has been put forward that there is need for cartelization for the sake
of employment that is threatened by foreign competition.
In recent years, employment arguments have been directed largely to the
development countries that are said to be encroaching on the markets of the developed nations and to have contributed to unemployment in the latter. This contention leaves out of account the increa,se in employment th,at is generated in the
developed nations' through their exports of manufactured goods to the developing
countries. In fact, since the oil crisis, these exports have increased more than the
imports leading to a substantial improvement in the trade balances of the developed nations with the non-oil producing developing countries in manufactured
goods. The relevant figures for 1973 and 1976 are $3.0 and $5.3 billion in the
•• For an excellent discussion, see Jan Tumlir, "The New Protectionism, Cartels, and the
International Economic Order," op. cit.
89 According to press reports, while "one commission official closely involved in the arrangement said he hoped that the United States companies would abide by the rules," the
manager of one of the subsidiaries stated, that he "will operate on the basis of a free market" (New York Times, May 17, 1978).
40 Cf. e.g. C. D. Edwards, "International Cartels as Obstacles to International Trade,"
American Economic Review, March, 1944, pp. 330-39 and B. F. Hoselitz, "Intemational
Cartel Policy," Journal oJ Politic.al Economy, February 1947, pp. 1-28.


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United States, $11.3 and $16.5 billion for the European Common Market, and $7.7
and $13.2 billion for Japan."It may be conjectured, then, that during the period of the 1974-75 recession
and its immediate aftermath, employment in the developed nations actually
benefited from trade in manufactured goods with the non-oil producing countries.
This result reflects the fact that the developing countries spend practically all
their foreign exchange earnings and that they have borrowed additional amounts
on foreign financial markets. Such borrowing, and the continued economic growth
of the developing countries, are in turn predicated on their success in exporting.
Note further that the developing countries have assumed increasing importance
as markets for the manufactured exports of the developed nations. In 1976, the
share in these exports, excluding trade between USA and Canada, as well as
within and between EEC and EFTA, was 27.9 percent for the non-oil producing
developing countries and 45.7 percent if exports to the oil-producing developing
countries are added."'
It appears, then, that the developed nations have benefited from the continued
economic growth of the developing countries during and after the 1974-75 re:.:ession. As these conclusions refer to ex.port and import-lC'Ompeting Industries combined, one further needs to consider, however, the employment effects of trade on
import-competing industries. Available data indicate that fears on the loss of
employment in these industries, too, have been exaggerated.
Thus, the findings of various studies indicate that the decline in employment
due to import competition is generally small compared to that due to technological change. According to the results of studies sponsored by the International
Labor Office, the total elimination of barriers to imports from developing countries would lead to a 1.5 percent decline in manufacturing employment spread
over 5--10 years in the developed countries.'" By contrast, technological change
associated with increases in productivity entails an annual displacement of labor
of 3 to 4 percent.
These findings have been confirmed by studies of British industries that are particularly sensitive to import competition. Thus, "detailed analyses of the Lancashire cotton textile industry and Dundee jute joint to the domirnrnt role of technical change--in the form of competition from synthetics in both cases and, for
cotton textiles, from labor-saving investment-as a cause of labor displacement."" On the basis of more recent data, the conclusion is reached that "it is
difficult to suggest that any labor-intensive sector except men's shirts and suits
suffered between 1970 and 1975 from exceptionally damaging import growth"
and that in the textile yarn, fabrics, clothing, and shoe industries, taken together,
"productivity growth emerges as twice as important as trade factors in job replacement," when "the job less annually from ldc import competition (less exports to Ides) is little more than 1.5 to 2 percent in the worst case, clothing,
0.8 percent annually for cotton textile fabrics, 0.4 percent for footwear, and negligible for textile yarn." 46
Also, during the 1963-71 period in the United States, "The loss in job potential
in import-competing industries due to foreign trade has averaged about 44,000
jobs per year-about 0.2 percent of total manufacturing employment and an even
more minute fraction of the total U.S. labor force. The loss of job potential due
to increased labor productivity was about six to nine times as great as the loss
due to foreign trade in import-competing industrieR.""" At the same time, one-half
of the estimated job loss was related to imports from developing countries.
Employment losses associated with increased imports from developing countries are likely to have been larger in recent years. However, it should be recognized that, with these countries spending practically all their foreign exchange
earnings, restrictions on imports from the developed countries only shift unemployment from import-competing to export industries in the developed nations.
41 GATT. International Trade, 1976-77. Geneva. 1977.
"T1nited Na~jons, Mo_nthly Bulletin of Statistic.~. February, 1978.
48 C. Hsieh.
Measurmg the Effects of Trade Expansion on Employment: A Review of
Some Research." International Labor Review, .Tannary 197fi.
•• Cited in Vincent Cable. "British Protectionism and Ldc Imports" O DI Review 1977
( 2). P. 88. The relevant references are Caroline Miles. Lancashire Temtiles.: A Case 'stwlu
of Industrial Oh~!'yes, Cambridge Unlve_rsity Press. 1968 and S. McDowell, P. Draper. and
A. McGninness. Protection. Technolog1cal Change and Trade Adjustment : The Case of
Jute in Britain." ODI Review, 1976 (1), pp. 43-57.
"Cable. op. cit., pp. 38-41.
•• Charles R. Frank, Jr. Foreign Trade and Domestic Aid, Washington D.C, The Brookings Institution, 1977, p. 36.
'
'


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Now, as the former rely more on unskilled and the latter on skilled labor, the
upgrading of the labor force of the developing countries is obstructed as a result,
leading to losses in real incomes. As Jan Tumlir eloquently expressed it, "Unemployment is fungible; the jobs which protection could save at the import-competing end of the industrial spectrum would be balanced out by the jobs foregone at
the exporting end. The latter are higher productivity jobs requiring better education, high skills.... Protection thus restricts an economy's capacity to provide
adequate employment for the higher skilled and better educated.
" ..,
IV. CONCLUSIONS AND POLICY RECOMMENDATIONS

'l.'he risks of protectionism
It has been shown .that considerable progress was made in trade liberalization

during the postwar period until the oil crisis and the recession of 1974-75. The
developed countries eliminated quantitative import restrictions imposed during
the Second World War and substantially reduced tariffs on raw materials and
on manufactured goods. Furthermore, an increasing number of developing countries adopted export-oriented policies, accompanied by reduced protection.
Trade liberalization led to the rapid growth of world trade. The expansion
of world trade, in turn, contributed to economic growth in developed and developing countries alike. For one thing, export expansion favorably affected the
growth performance of the developed nations. For another thing, economic
growth in the developed nations was transmitted to the developing countries
through trade and provided opportunities to these countries to successfully carry
out export-oriented policies.
The experience of the first three postwar decades contrasts with that of the
depression in the nineteen-thirties, when the imposition of nontariff barriers, the
"rationalization" of production, and the establishment of international cartels
contributed to the decline in world trade. 48 The nontariff barriers employed during the depression included increased reliance on countervailing and anti-dumping duties, as well as formal and informal ( or "voluntary") quotas.•• Governments also provided aid to their industries in the guise of rationalization and a
number of international cartels were formed.'°
It has been estimated that 42 percent of world trade between 1929 and 1937
was cartelized or was subject to cartel-like arrangements." The League of Nations reports that "international cartels have actually been established in all
branches of industry and at practically all stages of proouction, from industrial
raw materials to different types of producers' and consumers' finished goods;
minerals and metals and their products ; wood, wood-pulp and different kinds
of paper; textiles; chemical and pharmaceutical products ; glass, earthenware
and porcelain; electrical goods, etc. Among the products covered by international cartels, manufactures are preponderant."••
Nontariff measures and government aids have again come into increased use
since 1974 and efforts have also been made to establish international cartels
and cartel-like arrangements. The employment of these measures has, in turn,
contributed to a slowdown in world trade. In particular, while world trade rose
by 11 percent in 1976, the increase was only 4 percent in 1977 when protectionist
actions increased.
The comparisons with the nineteen-thirties should not be interpreted to mean
that the measures applied in recent years would be comparable in magnitude.
Also, there is still hope that the Tokyo-round of tariff negotiations will succeed.
But, tariffs pale in importance compared to the measures of the "new protectionism." Moreover, the experience of the nineteen-thirties indicates the economic
costs involved in the application of these measures and the danger that they will
multiply through retaliation and imitation.

,1

.Jan 'l'umlir, "Can th~ International Economic Order be Saved" The World Economy,
October 1977, p. 18.
,. Between 1926--29 and 1931-3'5 world trade in manufactured goods fell by 28 percent
(League of Nations, Industrialization and Foreign Trade, Geneva, 145, p. 157)-As beforehand data are expressed in constant prices.
•• P. W. Bidwell, The Invisible Tariff, New York, Council on Foreign Relations, 1939, chs.
IV and V.
o0 Cf. e.g-. G. W. Stocking and M. W. Watkins, Cartels in Action, New York, Twentieth
Century Fund, 1946.
51 Frederick Hanssman and Daniel Ahearn. "International Cartels and World Trade. an
Explanatory Estimate," Thought, Fordham University Quarterly, September, 1944, p. 429.
52 League of Nations, International Cartels, Lake Succe8s, N.Y., 1947, p. 3.


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Po'Ucie8 for long-term growth

Just as in the nineteen-thirties, protectionist measures have been invoked on
the grounds that imports are responsible for the loss of jobs. This argument is
obviously incorrect as far as trade among the developed countries is concerned
as the expansion of this trade does not lead, on balance, to a decrease in employment opportunities in the developed world.
Nor is the argument valid as far as trade with the developing countries is
concerned. Between 1973 and 1976, the exports of manufactured goods from the
developed nations to the developing countries increased substantially more than
their imports of manufactured goods from these countries. It would appear, then,
that manufactured trade with the developing countries is likely to have been
favorable, rather than unfavorable, for employment in the developed nationsAlso, available evidence indicates that in import-competing industries the loss
of jobs due to increased imports has been relatively small compared to the effects
of technological change.
The high rate of unemployment in the developed nations, then, cannot be
attributed to international trade. Rather, unemployment has been the result of
the policies applied by these countries, which have unfavorably affected domestic
production and investment in particular in Western Europe and Japan. 63 Nor
can one expect that protection would reduce unemployment; it will only shift
unemployment from lower-skilled labor used in import-competing industries to
higher-skilled labor used in export industries.
Apart from employment considerations, the desire on the part of the individual
countries to improve their balance-of-payments position has created pressures
for the application of protectionist measures. We find a "fallacy of competition"
here as protectionist actions taken by any one country can improve its position
only temporarily as the OPEC surplus must be matched by the collective deficit
of the non-oil countries .
.At the same time, the taking of protectionist actions by a number of countries
simultaneously cannot fail to be detrimental to all. National incomes will be
lower as a result since resources are not used to best advantage and potential
economies of scale obtainable in export industries are not exploited. Furthermore,
protection reduces the pressure for productivity improvements in import-competing industries whereas possible improvements in export industries are foregone.
The application of protective measures is also likely to adversely affect investment activity in the developed nations. While protection may not lead to increased
investment in high-cost import-competing activities which have a precarious
existence, it may discourage investment in low-cost export activites which suffer
discrimination under protection. The direct subsidization of high-cost activities
from government funds will have similar effects by syphoning off funds that
could have otherwise been used for investment in low-cost activities.
While protection tends to lower the rate of economic growth through its
adverse effects on national income and investment activity, measures aimed
at accelerating economic growth would lessen pressures for protection. Such
measures, involving increased inducement to investment and lessening the
rigidities introduced through government measures and labor legislation, would
have to be carried out with special vigor in the surplus countries, particularly
Germany and Japan, both to offset the deflationary effects of the appreciation
of their currencies and to reduce asymmetries in the balance-of-payments of the
developed countries."' at the same time, it should be recognized that the deficit
visa-vis OPEC is not immutable as there are possibilities for reducing the imports of energy. This would require, in particular, the adoption of appropriate
policies in the United States to lower the consumption, and to increase the production, of energy.
Problems of adjustment

It has been concluded that, in leading to higher incomes and employment,
growth-oriented policies would reduce protectionist pressures in the developed
countries. In turn, the avoidance of protectionism would contribute to economic
63 Cf. Bela Balassa, "The Locomotive Theory: An Eclectic View," paper prepared for the
Seminar on the 'Locomotive Theory' held at the American Enterprise Institute for Puhl!e
Policy Research on Apr!l 18, 1978.
"'For a deta!led discussion, cf. "The Locomotive Theory : An Eclectic View" op. cit.


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growth that requires a continuing transformation of the industrial structure,
entailing shifts from lower to higher productivity activities."" This conclusion also
applies to the developing countries whose economic growth depends to a considerable extent on the availability of trade opportunities in the developed
countries as well as on their own policies for making use of these opportunities.
More generally, trade permits economic growth to proceed in the world economy
through shifts in product composition. This entails the developed countries increasingly specializing in research and technology intensive products; the semiindustrial developing countries upgrading their exports which are now based
largely on unskilled labor ; and the less developed countries proceeding to export
unskilled-labor intensive manufactures. 06
Structural transformation cannot proceed smoothly and creates problems of
adjustment in industries that decline in absolute or in relative terms. Adjustment problems, in turn, have often given rise to efforts to reduce the speed of
adjustment. This has been the case, in particular, when adjustment in developed
countries was presumed to have been triggered by increased imports.
The objective of reducing the speed of adjustment has been pursued by the
measures of the "new protectionism" as well as by adjustment assistance as it
has been applied in practice in most developed countries. Thus, in reporting
the results of a comparative study, Goran Ohlin concludes that "adjustment
assistance seems in practice often designed to bolster the defences against
imports rather than to clear the ground for them [and] public policy has sought
to delay the transfer of resources."••
In this connection, several questions need to be raised, including the appropriate purpose of adjustment policies, the choice between import restrictions
and adjustment assistance, as well as the choice of the particular measures to
be employed. These questions will be taken up briefly in the context of the
industrial transformation of the developed countries.
As to the first question, adjustment policies that artificially bolster employment and raise profitability in high-cost industries by reducing the cost of IalJor
and other inputs or by increasing the price received by producers, run counter
to the process of industrial transformation that is necessary for continued growth.
Rather, policies should aim at promoting the movement of resources from lower
to higher productivity activities.
Nor should one single out imports as being the cause of reduced employment
and profitability as, more often than not, this has been the result of technological
change. Also, it is incorrect to argue that losses suffered by domestic nationals
due to increased imports require different treatment than losses due to technological change on the grounds that the beneficiaries are foreign nationals in the
first case and domestic nationals in the second. In fact, with higher imports
leading to increased exports in the process of adjustments, the beneficiaries
will be domestic nationals in the second case, too.
In view of these considerations, it is preferable to use adjustment assistance
rather than import restrictions to ease the problems of adjustment to changing
conditions in domestic industry. The question remains, however, what kind of
adjustment measures, and government aids in general, should be utilized for this
purpose.
It has been suggested that the measures applied should promote the movement
of resources from lower-productivity to higher-productivity industries. This is
in the interest of the developed countries as it contributes to improved resource
allocation and rapid economic growth. It is also in the interest of the developing
countries because of the gains they can obtain through international specialization. The community of interests is further enhanced by reason of the fact that
in contributing to the foreign exchange earnings of the developing countries,
the application of the proposed mesures would permit them to avoid high-cost
import substitution policies that would have adverse effects for all.
The described objectives would be served if, rather than subsidizing production
and employment in high-cost industries, the developed countries were to encourage
56 On this point see R. Blackhurst, N. Marian, and J. Tuml!r, "Trade L!beral!zation, Protectionism and Interdependence," GA.TT Studies in International Trade No. 5, Geneva,
November 1977.
66 C.f. Bela Balassa, "A 'Stages' Approach to Comparative Advantage," World Bank Stalf
Workmg Paper No. 256, Washington, D.C., May 1977.
"'OECD Development Research Centre, Adjustment for Trade: Studies on Industrial
.4.diustment Problems and Policies, Paris, 1975, pp, 9, 11.


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the expansion of efficient activities and ensure the transfer of resources to these
activitit>s. Appropriate measures include reducing government-induced rigidities
in labor markets, retraining workers, and promoting research and development.
Establishing an international code of good conduct

It has been concluded that adjustment assistance will be preferable to import
restrictions for easing the adjustment of domestic industries. Nevertheless,
adjustment assistance may not carry the entire burden, especially if sudden
changes in trade flows occur, necessitating the use of safeguard measures to
limit the growth of imports. At the same time, the application of these measures
should be made subject to internationally-agreed rules.
Article XIX of GATT provides an international code for the application of
safeguard measures. This article has rarely been applied, however, in part
because a country invoking it risks retaliation and in part because import
restraints are to be imposed in a nondiseriminator)' fashion. Rather, countries
have invoked safeguard measures by unilateral action or on a bilateral basis.
Article XIX would need to be reinterpreted, so that it becomes a credible
instrument which can replace presently applied national safeguard measures.
One should also avoid making it overly restrictive. Finally, safeguards should
:remain temporary, which is not the case under Article XIX.
These objectives would be served by retaining the "injury clause" in Article
:XIX while leaving it to appropriately constituted institutions in the individual
countries to judge whether injury has been sustained or threatened and to determine the measures to be employed. Decisions hJ· national bodies should, however,
be ,mbject to multilateral surveillance in the sense that exporting countries
would have the right to retaliate if an international committee established for
this purpose finds that safeguard action was not warranted or the measures
usPd were excessive.
Also, while ,it would be desirable to maintain the nondiscriminatory applicati'on of safeguard measures, at the minimum no Pxporter should be required
to reduce i'ts share in the domestic market of the country concerned. At the same
time, imports from new developing country producE'rs should not be subjected
to limitations. Finally, the temporary nature of the safeguard measures would
be expressE'd 'by their lirnitE'd duration in time; the progressive liberalization of
import restrictions during the time period of their application; and t11e exclusion
of the reimposition of the safeguard measures.••
Export subsidies, too, are subject to international rulf's under Article VI and
XVI of GATT. However, there would hP need to establish stricter obligations
for developed countries and to introduce exce!itions for developing countries.
At the same time, these exceptions would he circumscribed so as to ensurP that
the subsidies ,applied by developing countries compensate for, hnt do not create
new, distortions wi'th progressively stricter rules applying whPn developing
countries showed superior competitiveness in some products. And, finally, in
regard to export subsidies other than those for which deyeloping countriPs are
granted exceptional trea'tment, It wonld be dr:-iirahlP to make claimR for in,inr:r
subject to internationally agreed rules, with international snrveiBance of the
manner in which they are udministered.
It would further be desira'ble if, in addition to saf Pguard mea:-mrPs and export
subsidies, the international code of good conduct covered adjustment assistance
and government aids in general. This is because government aids affect foreign
producers in domestic and foreign markets and 'they have increasingly become
subject to international policy compPtition.
As regards adjustment assistance, governments may agrep to forego taking
measures that hinder the movement of ref'lonrC'es from low-prodnC'tivi'ty to highproductivity industries. In turn, positive mlc'asures aimed at encouraging the
movement of resources should have general incidence affe('ting all industries
in the same wey, so that the choice among alt<.>rnative activities i,; left to the
market mechanism.
There may be cases, however. when the market does not fully anticipate
future npeds and the applic,ition of mi>as11re-- affecting specific indrn,'tries could
not he foregone. Also, assistance to dPpressed re,gions can he considered admissihle to the extent that such assist:rncp corrects for existing distortions or serves
•• On the last point, the paper follows suggestions made in an unpu!Jl!shed memorandum
by Isaiah Frank.


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social goals. Finally, whatever its rationale, there exist in most countries rules
of government procurement favoring domestic industry.
An international code of good conduct should vrovi<le, first of all, for transparency in the matter of government aids. This would take the form of making
explicit the measures actually applied by incorporating them ,in public regulations, whenever this is not presently the case. Secondly, the budgetary cost of
aids provided to specific industries and regions shonld be estimated as this is
done in the Report on Subsidies in Germany and in Economic Impact Statements in the United States. Thirdly, it would be desirable to undertake commitments to "freeze" the status quo as regards government aids in the same way
as tariffs are bound in GAT'.r. Finally, some general rules should be defined
on the use of government aids by individual countries.
Gre_!lter transparency, estimating the budgetary cost involved, freezing the
status quo, and establishing general rules on their application would provide
a basis for negotiating reductions in government aids. Such negotiations may"
be in\tially undertaken by the developed countries, and patterned on actions
taken in the framework of the European Common Market. They would necessitate establishing machinery, possibly in the framework of the OECD, to procide international surveillance of the application of government aids as well as
a forum for continuing discussions and negotiations.
The ·Tokyo Round negotiations provide an opportunity for establishing 11.n
international code of good conduct on safeguards, export subsidies, and government aids. This may take the form of an interpretation of GATT regulations,
so as to avoid the difficulties involved in changing the existing provisions of the
General Agreement.
Parallel with these efforts, it would be desirable to reach agreement on acrossthe-board reductions in tariffs and on lessening disparities in tariffs on individual products. Further, it would be desirable to liberalize trade in agriculture
commodities, in particular in products of export interest to the dleveloping
countries.
Policies by developing countries
Developing countries have a considerable interest in establishing acceptable
and credible international rules on the application of measures affecting their
exports. The exports of these countries have been repeatedly curbed by the
impo§l!tion of restrictions by the developed countries; they have little bargaining p_qwer to forestall the application of new restrictions on particular commodities ; and the threat of the imposition of restrictions creates considerable uncertainti- for them. Developing countries need a stable environment in which the
shifts in the international division of labor necessary for their rapid economic
growth can take place.
At the same time, developing countries would be well-advised to avoid demanding unilateral conc.essions that would jeoparcIJ~e the establishment of
international rules, since they stand to lose :Qilore through the continuation and
the extension of the "new protectionism" that what they may gain from any
concessions. Nevertheless, while individual developing countries have little
bargaining power, they could influence the outcome by adopting a joint position. The same observation applies to tariff reductions in the Tokyo Round,
where qeveloping countries could press for reductions on items of export interest to them.
In this connection, it should be emphasized that developing countries have much
more to gain from multilateral tariff reductions than from maintaining preferential margins, on which UNCTAD efforts have concentrated in recent years. This
is because tariff reductions do not involve quantitative limitations on trade
and are not reversible while imports under preferences are subject to quantitative limitations and can be revoked on short notice.
Semi-industrial developing countries would also be well-advised to reduce
existing protection. To begin with, the existence of high protection in some
of these countries is used as an argument for protection in the developed nations.· Furthermore, offers made to reduce trade barriers would strengthen the
bargaining. p6sition of the developing countries in the Tokyo Round of negotiations. Finally, lowering protective barriers would ,lessen the need for (explicit) export subsidies that are thr'eatened by countervailing action. This
would mean putting greater reliance on the exf!hange rate since one may com-


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pensate for reductions in import tariffs and export subsidies by a devaluation."'
Semi-industrial developing countries would also be well-advised to enter into
bilateral agreements with developed nations on li'beralizing tmde as it has recently been done in U.S.-Mexico relationships. This would be of especial importance as far ,as trade with Western Europe is concerned. In this connection, it
should be recognized that several of the semi-industrial countries have sufficiently
large markets so that they can offer meaningful concessions.
At the same time, the chances for avoiding the imposition of restrictions would
be increased if semi-industrial developing countries upgraded and diversified
their exports. In particular, it would be desirable to expand the exports of commodities where firms in developed countries can respond by changing their product composition, which is not possible in industries consisting largely of oneproduct firms, such as textHes, clothing, and shoes. The possibilities of expanding
exports without encountering restrictions would be further increased by diversifying export markets, in particular by seeking export outlets in the rapidly growing
OPEC countries.
Finally, it would 1be desirable that semi-industrial developing countries gradually abandon the exiports of simple, unskilled-labor intensive manufacturers for
the 1benefit of countries at lower levels of development. The latter countries, in
turn, would have to follow appropriate policies ,that would not discriminate
against exports.

Representative LoNG. l\fr. Cline, if you will start, we would be
pleased.
STATEMENT OF WILLIAM R. CLINE, SENIOR FELLOW, THE BROOKINGS INSTITUTION
. Mr. CLINE. Thank you very much, Mr. Long. It's a great pleasure
for me to testify before this committee on the subject of international
trade. I shall focus my comments upon the outlook for trade policy
here and abroad, and in particular on the potential economic e:ffects
of the Tokyo round of multilateral trade negotiations currently in
progress in Geneva.
Before turning to the Tokyo round, a subject on which we have recently published a book at the Brookings Institution, I would like to
make a few remarks on the current tides of protectionism. The forces
of protectionism have gathered strength both here and abroad in the
past few years, in large part as the result of high domestic unemployment. At home, we have imposed voluntary quotas on shoes from Korea
and Taiwan, and on color television sets from Japan. We have instituted a trigger-price mechanism that in practice restricts steel imports, and there are calls for much more restrictive measures.
Abroad there are increasing restrictions in Europe on imports into
sensitive sectors such as steel, shipbuilding, electronics, textiles, and
shoes, and there is a move toward "organized trade" or cartels. Nevertheless, there ate reasons for believing that the United States will not
go the route of higher protection. A major reason, in my view, is that
the public is becoming more and more concerned about inflation, and
Members of Congress as well as the· administration will be more and
more reluctant to accept the protectionist demands of specific interest
groups at the price of pushing this country back toward double-digit
inflation.
60 For a ·detailed discUJ!slon, see Bela Balassa, "Export Incentives and Export Performance
In DevelO'I)lng Countries: A Comparative Analysis," WeZtwirtscha/tlichea A.rchiv,. March
1978.
. .
.


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Let me turn, however, to the principal subject of my prepared statement : the Tokyo Round of trade negotiations.
The study recently published by the Brookings Institution develops
a model of the economic effects of alternative "tariff-cutting formulas"
which might be agreed upon in the Tokyo Round of negotiations.
In order to estimate the effect of tariff cuts on imports, the calculations apply empirically estimated "import elasticities," which tell the
percentage change in import demand for a given percentage change in
the price of imports. These elasticities are applied to the base level of
imports and the percentage change in consumer price caused by a
particular tariff cut. Increased exports are calculated by summing up
all the other countries' increased imports from the supplier in question. w·elfare effects--the consumer savings from importing rather
than buying more costly home goods, and the production efficiency
gained by shifting resources to more efficient sectors-are computed on
the basis of the import increase and the height of the tariff.
These so-called static welfare gains are expanded to an approximate
estimate of total welfare g-ains, including effects of economies of scale
and induced investment. These calculations are made on the basis of
European economic integration from the experience of other studies.
Employment effects are calculated by applying "job coefficients,"
both direct and indirect, to account for intermediate goods requirements, to the changes in imports-job loss--and changes in exportsjob gain. The principal results of the estimates on tariff liberalization
are the following:
First, the so-called Swiss formula for cutting tariffs-in other words,
the compromise formula which has emerged from the negotiationswould cut tariffs by about 40 percent on average and would increase
annual imports of industrial countries by more than $7 billion; using
1974 import values as the base. This outcome for tariff cuts would represent a fairly liberal compromise between the original U.S. approach-a 60-percent tariff cut-and the much more restrictive formula
originally suggested by the EEC.
Second, the economic benefits resulting from the tariff cuts would
probably be close to $7 billion annually. These benefits include savings
to consumers, gains from moving resources out of inefficient sectors,
stimulus to investment, and increased economies of scale. This estimate
may be conservative, because it does not include macroeconomic output
gains made possible when the anti-inflationary impact of liberalization
permits more expansive macroeconomic policies; nor does it include
effects such as the stimulus of outside competition to increased technical change.
The economic benefits of liberalization would continue year after
year and grow along with. the trade base, so that their once-for-all
value would reach approximately $130 billion. Of this total, the United
States would stand to gain about $40 billion. Therefore, the economic
stakes in the Tokyo round are large, both for the United States and
for the world.
Third, these economic benefits would not come. at the cost of serious
dislocation of workers either here or abroad. In the United States,
tariff cuts according to the Swiss formula would cause a loss of about
90,000 jobs because of increased imports, or about one-tenth of 1 per-.


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cent 0£ the U.S. labor force, but in return, about 120,000 new export
jobs would be created.
Even in individual "sensitive" industries, labor displacement would'
be limited. For example, in the unlikely event that both tariffs and
quotas were liberalized in textiles, job losses would reach only abont
2 percent of employment even in that sensitive sector. MoreovP1\ aff
tariff cuts would be phased in over periods of !i years or longer, giving"
ample time for labor to relocate. In terms of benefits relative to costs,
our calculations show that the <'Conomic benefits of U.S. tariff liJ)('ralization ·would be 80 times as large as labor adiustment costs. '\Ye find
similar results for Canada, ,Ta pan, and the EEC.
Fourth, trade balances would not be jeopardized by liberalization.
The United States and ,Japan would experience minor trade halancP
increases, and the EEC and Canada, similar decreases: and by ancT
large the effects of the negotiations are evenly balanced, in terms of
trade results of the tariff cuts.
The Brookings study also examines nontariff barriers. The study
converts European and ,Japanese agricultural nontariff barriers into,
tariff equivalents, and then applies thr same basic model as used for
tariffs to compute the trade effects and economic benPfits that would
result from liberalization.
These estimates show that a 60-percent cut in the tnriff equivalent
of agricultural nontariff barriers would cause an estimated incrN1se
of U.S. exports of approximately $500 million and a $300 million increase £or Canada, and on the other hand, a trade balance deterioration
of ~1.9 billion for Enrope and of $280 million for .Tanan.
The principal point here is that these figures are all lower than thecorresponding effects for tariff liberalization, primarily in manufactures, and this result suggests that the importance of agricultural
nontariff barriers in the negotiations hns been overstated.
It is true that for Europe and for ,Japan themselves the wp]fare
effects would be very large in agricultural nontarifl' barriers because
this protection is high, and it is also true that for Europe and ,Ta pan,
the job effects would be somewhat larger than in the tariff sector because agriculture tends to be labor intensive.
EvPn in these sectors, however, the employment effects would be
relatively limited.
Onr study also makes estimatPs of the impact 0£ liberalizing trade
in Government procurement. ,ve estimate that a 60-percent cut in
the direct and indirect or explicit and implicit Government procurement. discrimination would cause an estimated increase 0£ imports into
the United States of $600 million and an increase of imports into the
EEC of about $550 million.
These effects are significant, but again they are small relative to the
basic effects in the central tariff negoti ations.
We do not have quantitative estimates for the other nontariff barriers, including discrimination by product standards, uss of GovPrnment subsidies and countervailing duties, quantitative i-estrictions
including voluntary export quotas, and safeguards.
It is clear, however, that these and other nontariff barriers constitute a major impediment to trade as well as an ongoing source 0£
political-economic antngonism among the industrial countries.


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397
The "codes of conduct" being negotiated in these areas should mah
a significant contribution to liberalizing trade. They are also likely to
act as the catalyst to formation of an infrastructure that ·will permit
ongoing trade consultations among the industrial countries once the
Tokyo round is over.
In summary, the Tokyo round represents an opportunity for another
major forward step in the historical process of tradP liberalization
which has already contributed so much to international prosperity and
grov,th in the postwar period. The economic benefits of liberalization
will be substantial and its costs extremely limited. The crucial question
is whether the United States and the other industrial countries will
move forward to take advantage of this opportunity :for mutual economic benefit, or whether instead they will withdraw into a new phase
of protection in response to the demands of special interest groups
at home and in counterproductive attempts to deal in isolation with
problems of international economic interpendence that require cooperative solutions among nations.
I would like to add a :few words, departing from my prepared
statement, with respect to trade relations with tlw developing
countries.
I would simply like to signal one important issue, that is tlrn issue
of countervailing duties. The Presidential authority to waive the application of countervailing duties expires in January of this coming
year, and there are a number of developing countries that use export
subsidies in order to give incentives to their exports primarily to
offset the disincentives that their economic structures impose against
exports.
In particular, countries that have ovenalued exchange rates and
controls on imports create a large incentive for the producer to sell
to the domestic market and ignore the export market. These countries
need some form of compensating stimulus to exports, and they typically use export subsidies for this purpose.
It seems to me that we are poised for a trade ,var of sorts with some
important developing countries, especially Brazil, if we do not have
some change between now and January.
If there is a negotiation whereby the United States accepts the
principle that counterveiling duties are only imposed when there is
injury in the product as may come out of the Tokyo round, then much
of this problem will be addressed, because basically many of these
imJ?orts_ b_eing subsidized from developing countries are not causing
ser10us mJury.
At the same time it seems to me that there is a need for additional
legislative authority for the executive branch to enter into bilateral
negotiations and agreements with some developing countries that
would permit those countries to phase in a period of 5 or more vears a
number of radical changes in their structure of incentives to rxports
and their di~in~enti:es to_ expo1:t5 in orde!' that tJ1ey ocon]d elimi_n~te
some of the d1stort10ns m then· economies that makP the snbs1d1es
n~essary in the first place.
Thank you very much.
[The prepared statement of Mr. Cline follows :J
35-94-0-78-10


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PREPARED STATEMENT OF WILLIAM

R.

CLINE

*

INTERNATIONAL TRADE

It is a great pleasure for me to testify before this Committee on the subject
of international trade. I shall focus my comments upon the outlook for trade
policy here and abroad and in particular on the potential ~onomic effects of
the "Tokyo round" of multilateral trade negotiations currently in progress in
Geneva.
Before turning to the Tokyo round, a subject on which we have recently published a study at the Brookings Institution,' I would like to make a few remarks
on the current tides of protectionism. The forces of protectionism have gathered
strength both here and abroad in the past few years, in large part as the result
of high domestic unemployment. At home, we have imposed voluntary quotas on
shoes from Korea and Taiwan and on color television sets from Japan. We
have instituted a trigger-price mechanism that in practice restricts steel imports,
and there are calls for much more restrictive measures. Abroad there are increasing restrictions in Europe on imports into sensitive sectors such as steel, ship
building, electronics, textiles, and shoes, and there is a move toward "organized
trade" or cartels. Nevertheless, there are reasons for believing that the United
States will not go the route of higher protection. A major reason, in my view,
is that the public is becoming more and more concerned about inflation, and
members of Congress as well as the administration will be more and more reluctant to accept the protectionist demands of specific interest groups at the price
of pushing this country back toward double digit inflation.
Let me turn, however, to the principal subject of my testimony : the Tokyo
round of trade negotiations.
The study recently published by the Brookings Institution develops a model
of the economic effects of alternative "tariff cutting formulas" which might be
agreed upon in the Tokyo round of negotiations. In order to estimate the effect
of tariff cuts on imports, the calculations apply empirically estimated "import
elasticities" (percent change in imports per unit percent change in import
price) to the base level of imports and the percentage change in consumer price
caused by a particular tariff cut. Increased exports are calculated by summling
up over other countries their increased imports from the supplier in question.
Welfare effects~the consumer savings from importing rather than buying
more costly home goods, and the production efficiency gained by shifting resources to more efficient sectors-are computed on the basis of the import increase
and the height of the tariff. These static welfare gains are expanded to an
approximate estimate of total welfare gains (including effects of economies of
scale and induced investment) on the basis of the experience of European integration as estimated in other studies. Employment effects are calculated by
applying "job coefficients" (both direct and "indirect" to account for intermediate
goods requirements) to the changes in import (job loss) and exports (job gain).
The principal results of the estimates on tariff liberalization are the following:
Firet, the so called "Swiss-formula" for cutting tariffs, the compromise formula which hal!l emerged from the negotiations, would cut tariffs by about 40
percent and would increase annual imports of industrial countries by more than
$7 billion, using 1974 import values as the base. This outcome for tariff cuts
would represent a fairly liberal compromise 'between the original U.S. approach
(a 60 percent tariff cut) and the much more restrictive formula originally
suggested by the EEC.
Second, the economic benefits resulting from the tariff cuts would probably be
close to $7 billion annually. These benefits include savings to consumers, moving
resources out· of inefficient sectors, stimulus to investment, and increased economies of scale. The estimate may be conservative, because it does not include
macroeconomic output gains made possible when the anti-Jnflationary impact
of Hberalization permits more expansive macroeconomic policies: nor does it
include effects such as the stimulus of outside competition to technical change.
The economic benefits of liberali:zation would continue year after year and
grow along with the trade 'base, so that their once-for-all value would .reach
*The views expressed in this staten;ient are the sole respons1b1llty of the author 'and do
not purport to represent those of the Brookings Institution, its officers, trustees,· or other
stall' members.
1 Willlam R. Cline. Noboru Kawanabe, T. 0. M. Kronsjo, and Thomas Wllliams. "Trade
Negotiations in the Tokyo Round: A Quantitative Assessment" (Washington, D.C. : The
Brookings Institution, 1978).


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approximately $130 billion. Of this total the United States would stand to gain
about $40 billion. Therefore the economic stakes in the Tokyo round are large,
both for the United States and for the world.
'l'hird, these economic benefits would not come at the cost of serious dislocation of workers either here or aboard. In the United States, tariff cuts according
to the Swiss formula would cause a loss of about 90,000 jobs because of increased
imports ( or only about one-tenth of one percent of the U. S labor force), but it
return about 120,000 new export jobs would be created. Even in individual "sensitive" industries labor displacement would be limited. In the unlikely event that
both tariffs and quotas were liberalized in textiles, for example, job losses would
reach only about two percent of employment in the sector. :Moreover, all tariff
cuts would be phased in over periods of five years or longer, giving ample
time for labor to relocate. In terms of benefits relative to costs, our calculations show that the economic benefits of U.S. tariff liberalization would be 80
times as large as labor adjustment costs. We find similar results for Canada,
Japan, and the EEC.
l<'ourth, trade balances would not be jeopardized by liberalization. The United
States and Japan would experience minor trade balance increases. and the EEC
and Canada, similar decreases, but in broad terms the trade resulcs of the tariff
cuts would be evenly balanced among all parties.
The Brookings study also examines non-tariff barriers. The stnJy converts
European and Japanese agricultural non-tariff barriers into tariff equivalents,
and then applies the same basic model as used for tariffs to compute the trade
effects and economic benefits that would result from <liberalization.
These estimates show that a sixty percent cut in the tariff equivalent of agricultural non-tariff barriers would cause a negative trade balance effect of $1.9
billion for Europe and $280 million for Japan, and positive trade balance effects
of approximately $500 million and $300 million for the U.S. and Canada respectfully. These figures are all lower than corresponding effects under tariff liberalization (primarily in manufactures), suggesting that the importance of agricultural
non-tariff barriers in the negotiations has been overstat:ed. However, in terms of
extra welfare to consumers as well as possible job losses to increase imports, the
agricultural non-tariff barriers ,are quite important in Europe and Japan. This
result stems from the facts that agricll'.ltural protection is extremely high and
that agriculture is labor intensive. E;ven in the case of agricultural non-tariff
barriers, however, liberalization would cause re}atively small job losses: approximately one percent to three percent of total labor in Japan, and one-third of one
percent of the labor force in the EEC.
With regard to other non-tariff barriers, a sixty percent cut in the degree of
protection provided by discrimination in government procurement would cause
estimated import increases of $600 million in the United States and $545 million
in the EEC, in 1974 values (or one-sixth and one-twelfth respectively of the estimated import increases from a sixty percent cut in tariffs and in agricultural
non-tariff barriers). Quantitative estimates are not avuilable for effects of
liberalizing other major non-tariff barriers: discrimination against imports by
"product standards;" government subsidies and countervailing duties; quantitative restrictions (including "voluntary export quotas") and safeguards. It is
clear, however, that these and other non-tariff barriers constitute a major impediment to trade as well as 11n ongoing source of political-economic antagonism
among the industrial conntriPs.
The "codes of conduct" being negotiated in these areas should make ,a significant
contribution to liberalizing trade. They are also likely to act as the catalyst for
an infrastructure tllat will permit ongoing trade consultations among the
industrial countries once the Tokyo round is over.
In summary, the Tokyo round represents 'an opportunity for another major
forward step in the historical process of trade liberalization which has a'1ready
contributed so much to international prosperity and growth in the postwar period.
The economic benefits of liberalization will be substantial and its costs extremely
limited. The crucial question is whether the United States and the other industrial countries will move forward to take advantage of this opportunity for
mutual economic benefit, or whether instead they will withdraw into a new phase
of protectionism in response to the demands of special interest groups at home
and in counterproductive attempts to deal in isolation with problems of international economic interdependence that require cooperative solutions among nations.

Representative LoNG. Thank you, Mr. Cline. You have interjected
into this an important political consideration.:__a domestic political
consideration-inflation. We will come back to that.

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I would like to explore that with you a little further after we have,
heard from our other two panelists.
Mr. Stern, would you proceed, please, in your own way.

STATEMENT OF ROBERT M. STERN, PROFESSOR OF ECONOMICS,
UNIVERSITY OF MICHIGAN
Mr. STERN. Thank you very much, Congressman Long.
There are many important issues o:f international trade policy that
are presently o:f great concern to the United States, the other major
industrialized countries, and the developing countries. One such issue
is trade liberalization, which is being addressed in the Tokyo round
o:f multilateral trade negotiations that are now approaching their
climax in Geneva.
In this regard, I have been involved, together with my colleagues
at the University o:f Michigan, in analyzing the potential impacts of
alternative strategies :for reducing tariff and nontariff barriers to
trade.
For this purpose, we have constructed a model of world production
and trade, which is designed to assess in quantitative terms how production and employment would be affected in each of 29 sectors in
the United States and 17 other major industrialized countries and how
prices and the exchange rate would be affected in the individual countries. The model and some results are summarized in nontechnical
terms in a paper that I have submitted separately -for inclusion in the
record.
'When we consider tariff reductions alone, the main conclusion that
emerges from our research is that even i:f very sizable tariff reductions
are negotiated in the Tokyo round, there will be comparatively small
impacts on the United States and the other industrialized countries.
For example, assuming that all products except agricultural products, textiles, and petroleum products are subjected to an across-theboard 50-percent reduction by the United States and other industrialized countries, we estimate based upon the data for 1970 that there
would be a net de,eline in U.S. employment o:f around 12,600 workers.
Considering that in 1970 total U.S. employment was 76.5 million, the
employment effects o:f tariff reductions would be negligible.
Our results suggest further that consumer prices would :fall slightly and there would be minimal effect on the dollar exchange rat~,
The results do not vary appreciably :for other possible tariff reductions. The effects on the other industrialized countries are estimated
to be similarly small. To elaborate a bit further, it should be notf•d
that the emplo:vment effect just cited for the TTnited States represents
the net effect of expansion of output and employment in U.S. export
and related industries and contraction in importing-competing and
related industries. "While the workers in the latter industries might
well experience some unemployment in the short run, it con]d be eased
b:v fairly small percentage rates o:f growth even in tlw most seriously
affP,,ted industries.
We have also experimented, using our model. with chanQ"es in nontariff barriers. Unfortunately, because of difficulties in determining
the price equivalents of nontariff barriers, we have not been able to
carry out much analysis in detail. But one experiment with liberalizing


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,quotas on textiles and wearing apparel is interesting because it suggests that, by reducing the import price of textiles which are an input
into the production of wearing apparel, this might cause the wearing
apparel industry to expand. "\Vhile this result would probably have to
be qualified because we do not include the developing countries in the
present version of our model, it nonetheless demonstrates the important effect that trade liberalization might have in reducing input costs
in particular U.S. industries.
The research that I have just described is by no means the last
word on the subject, in view especially of some technical limitations of
our model and problems of data availability. Our results are nevert lieless consistent with those obtained in studies carried out at the
University of Wisconsin and the Brookings Institution, which are
represented here today.
At this point, the committee might well wonder why, if the effects
-of trade liberalization are comparatively so small, there is so much
-concern with the outcome of the Tokyo round.
Representative LONG. Mr. Stern, if you would yield, that was the
-question that was running through my mind at the moment you said it.
Mr. STERN. The reasons why the effects appear small are that the
ratio of trade to production is fairly small in many U.S. industries
and that tariffs are already at comparatively low levels as the consequence of the Kennedy round and earlier rounds of multilateral
tariff reductions nuder GATT. The small size of welfare gains from
tariff removal perhaps typifies the marginal nature of many economic
distortions that exist in the United States and in other advanced
economies.
The point then is that even though the gains are small, it may
nevertheless be worthwhile to attain them for the benefit of society
as a whole. By the same token, it should be emphasized that nontariff
barriers, which have to date remained largely outside the negotiating
framework, may impose substantial costs on the United States and
-other countries that maintain them. There has been considerable discussion of the possibility of reducing nontari:ff barriers in the Tokyo
round negotiations. But to date the accomplishments here seem
problematical.
There are two important implications that follow from the foregoing remarks. First, it ,rnuld appear that the negative effects of
import competition per se on particular U.S. industries may often be
<>xaggerated. Thus, for example, slackness in the U.S. economy as a
whole or ineffectual management may be the primary or root causes
of the difficulties that haYe been experienced in certain industries. If
this is a correct interpretation, it suggests that the appropriate remedies are domestic rather than international.
The second implication is that the imposition and extension of nontariff barriers are detrimental to intermtional trade generally and to
developing countries in particular. While import quotas, voluntary
export restraints, and orderly marketing arrangements may provide
some protection to U.S. firms and workers, they are nevertheless very
costly to the Nation as a whole an<l directly frustrating to the further
industrialization of many developing countries. Here again the basic
rPmedies must be sought in terms of changes in domestic policies in
the United States and the other industrialized countries.
Thank yon.


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[The paper referred to in Mr. Stern's statement follows:]
THE IMPLICATIONS OF ALTERNATIVE TRADE STRATEGIES FOR THE UNITED STATES

*

(By Alan V. Deardorff, Robert M. Stern, and Mark N. Greene)
I. INTRODUCTION

Trade policy consists of the use of various policy tools-:such as tariffs,
quotas, negotiated voluntary export restraints, etc.-to influence the volu_me
of international trade in var1ous industries. Since, in the advanced countries,
such policies have usually been directed at restricting the volume of im~o:ts,
we will accordingly confine our attention for the most part to such pohcies.
Given that the effects of tariffs and other trade policies depend both on the
level of their use by different countries and on the industries to which they 3:re
applied, our analysis will concentrate primarily on alternative trade strategies
that differ either across countries or across industries.
Before beginning the more detailed analysis, it may be useful to discuss
briefly the principal advantages and disadvantages of trade policies. Consider,
then, the reduction of a tariff in a particular industry and country. The immediate effect is to lower the price paid by domestic importers of the good
and thus to lead to an increase in the quantity of imports. These price and
quantity changes are felt most quickly and strongly in the domestic industry
that produces the previously protected good. But the effects are also spread
over the entire economies of both the tariff-reducing country and its trading
partners.
Certainly the most visible effects of a tariff reduction are the costs borne by
those who derive their livelihood from production of the good at home. As
the tariff and consequent price reduction cause demanders to switch from
domestically-produced goods to imports, domestic producers find demand for
their products curtailed. Both the owners of these firms and the workers that
they employ then suffer loss of income as profits fall and workers are laid off.
For those adversely affected, these income losses may be substantial, and, since
they are visibly related to the tariff reduction, these costs are the most readily
understood and appreciated by national policy makers and the general public.
The benefits of a tariff reduction are more diffuse. First, the fall in import
prices lowers the cost of living for all consumers. The effect here cannot be
large, for any one consumer, since it is limited by the portion of the consumer's
budget spent in the affected industry, but it nonetheless constitutes a net gain
for all of the many consumers whose source of income has not been directly
reduced.
Second, if the product on which the tariff was reduced is used as an intermediate input into production in other industries, then the cost savings from
cheaper imports will benefit both producers and consumers there as well. Again
this benefit is spread over the entire economy. It may thus be very difficult to
relate the benefit to the tariff reduction per se, but the benefit is nonetheless
real and may be substantial.
Third and finally, one must today consider the effect that a tariff reduction
will have on the country's exchange rate and what this, in turn, implies for
domestic welfare. The rise in imports causes excess demand for the foreign currencies needed to purchase them, and this causes the exchange rate of the domestic
currency to depreciate. While the currency depreciation may appear to be a
cost, in fact it has the effect of stimulating demand for all domestic products.
Whether they produce for export or for domestic use in competition with imports, all domestic producers gain a competitive edge over foreign competitors
when the value of their currency falls.
~o far ~e have considered the effects of the tariff reduction only in the
tariff-reducmg country. That there are also benefits abroad is more obvious
and requires little discussion. The important thing is to remember these benefits when we contemplate multilateral tariff reductions. For then, the effects
on a country of tariff reductions elsewheve may be just as important as the
effects of its own reductions.
•Prepared for the Panel on Trade and Planning, United Nations .Association of the
United States of .America, University of Michigan, .Aug. 1, 1977.


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As we have seen, there is an important difference between t:11.e eosts and
benefits of a single tariff reduction in that the costs are concentrated within
the affetced industry, while the benefits are diffused throughout the entire
economy and abroad. There is, in addition, a second difference that should be
noted, which concerns the evolution over time of these costs and benefits.
The costs of a tariff reduction are likely to be greatest initially and to disappear gradually over time. Workers who are laid off will eventually find jobs in
other industries, though perhaps only after retraining and relocation. And owners
of capital experience a once-and-for-all capital loss but can reinvest what is left
for a competitive return. We do not mean to minimize the importance of these·
losses, which can be substantial for the individuals involved, but merely to point
out how they are distributed over time.
The time distribution of the benefits from ,a tariff cut is quite different. Con•
sumers gain immediately as they pay a lower cost for the goods that they were·
already importing. But the full extent of their gain is realized only over time·
as they are able to substitute between domestic and imported goods and as the
economy's resources are reallocated from import-competing to other uses. Likewise, the benefits of reduced prices on imported intermediate inputs take time to
be passed on to the consumer. Thus, while the costs arising from tariff reduction
are likely to fall over time, the benefits are likely to rise.
With costs and benefits that differ so markedly in their visibility and dynamic
incidence, it is no wonder that reasonable men have disagreed on the desirability
of cutting tariffs. Economists have by and large been able to argue that the
benefits outweigh the costs. The argument is basically that, taken as a whole,
a country can only gain by acquiring goods from the least cost source. Thus,
when policies are used to limit imports, their only effect is to tie up resources
in the protected industry that would be better utilized elsewhere. Given the
abstract nature of this argument, it is quite remarkable that many practical
policy makers have apparently accepted it ·and that we now find ourselves involved in still another round of multilateral trade negotiations.
The p,ecision, then, has already been reached to negotiate even further reductions in tariffs and, if possible, to reduce other trade barriers as well. 'l'he
question is therefore not whether it will be done, but how and to what extent.
For tariffs alone, there are many choices to be made. How far on average should.
tariffs be reduced? How should the average tariff reduction be distributed among
countries? And how should it be distributed among industries? Should high
tariffs be reduced the most, on the grounds that the benefits from doing so,
would be greatest, or should low tariffs be reduced the most on the grounds that
the costs of doing so would be least? In theory, the world has the most to gain
from complete removal of all trade barriers. But, in fact, only partial removal
is likely to be possible, and partial removal can be accomplished in an infinite
variety of ways.
To make an informed choice among alternative strategies, one needs, first,
to have more quantitative information about their costs and benefits as they
affect the separate sectors of the economy, and,. second, to have a means of
weighing these costs and benefits so as to reach a decision. Our paper is an
attempt to contribute toward the first of these ingredients for a decision.
To do so, we make use of a computable general-equilibrium model of production and trade in and among the world's 18 major industrialized countries. The·
model can be solved for the effects of changes in quantitative restrictions on
trade. The solution includes estimates of output, employment, and price changesin each of the countries, with production disaggregated into 29 industries. In
addition, the model includes estimates of changes in exchange rates and consumer price indices. Thus, it yields information about all of the separate effects
of tariff reduction that we described earlier.
We do not attempt to translate our results on output, employment, prices, and
exchange rates into comparable dollar measures of costs and benefits. To do so
would require more information than we have available about the welfare impli·
cations of most of these economic variables. The difficulties are most obvious
with respect to employment, for the costs of unemployment must include not only
the foregone output but also the financial and psychological hardship of the
unemployed workers. Other problems are encountered if we try to measure the·
welfare implications of output, price, and exchange-rate changes. Thus we are
unable to produce dollar estimates of the welfare effects of tariff reductions. Any
conclusions regarding the overall desirability of alternative trade strategies must
therefore be interpreted with caution-a caution which would be appropriate in,


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4C4
any case given the uneven di;;tribution of costs and benefits across sectors of the
economy that we discussed earlier.
It should he noted that, for some problems, the approach used here would not
be optimal. Since our model is static, it does not provide information about the
dynamic response to trade liberalization. Also, for this and other reasons, the
model cannot be tested against actual experience with tariff reductions so as to
asse:;;s its accuracy. These are admitted drawbacks, but it must be realized how
complex the problem at hand actually is. In our description above of the effects
of only a single tariff reduction, we came nowhere close to describing all of the
complicated interactions that must be taken into account. Add to these the need
to consider many tariff changes simultaneously and our desire for information
about many separate industries, and the problem becomes far too large to he
handled in a testable, dynamic, Pconmnetric model.
On the other hand, our model does incorporate R grent denl of empirical information, giving us some confidence in its accuracy. Supply ano demand fnnctions
are both based on published econometric studies of behavior. and other parameters
of the model are derivPd from carefully gathered data on r1roduction. trade. and
employment. All of this, tol!'ether with our very detailed modelling of intercountzy
and interindustry interactions, convinces us that our results may well be more
reliable, and are certainly more useful, than could have been obtained from a
simpler and more highly aggregated model.
With this introduction, we now turn to the body of the paper. In Section II, we
provide a brief and nontechnical description of the model and how it was used.
In Sections III-V, we report and comment on a variety of results that we obtained
for alternative tariff-change formulas. In Section VI, we consider the issu!' of
quantitative restrictions on trade. Finally, in Section VII, we comment on the
role of less developed countries in the system of world trade and how their exclusion from our model may have affected our results. Section VIII provides a summary of our results.
II. DESCRIPTION OF THE MODEL AND ITS USE

A more complete description of onr model is given in Deardo~ff et al. (l976).
For the pre,sent purpose, a brief ovPrvil'w should therefore sufficP.
The model indudes world market;:; for each of 22 tradable industries, with
separate fnnctiom, for the supply of exports into these markets and for the
demand for imports out of these markets in !'ach of 18 countries. In addi.tion,
the model includes separate "home" markets for each country ano industry in
these as well as an additional 7 nontradable indm,tries. This division of the
tradable industries into home ano world markets reflects an assumption that
home-produced and imported products are regarded b:v both producers and consumers as imperfect substitutes. All supply and demand functions are constructed
to incorporate some substitution het\veen home and imported goods, as well as a
romplete network of interindnstn· interactions taken from the U.S. input-output
table.
The l'qnations for equilibrium in all of thl'Sf' world and domestie markets can
he soked simnltaneonsly for !'quilibrinm worlo and domestic prices. By adding
equations for the exchange markets of each country, we can solve for the Pquilihrium exchange rates as wPll.
Tariff,; enter the model in t"·o ways. First, they cause the domestic prire 01'
imrorts to exceed the world price by the percent of the tariff. And second. all
tariff revenue is assumeo to he rNlistributed to consumers. This Fecond assumption is used to neutralize the effect that tariff changes would otherwise have on
tlw amount of aggregate expenditure that reaches producers.
Labor markets nre not assumed to clPar in the model. ·wages im;tead are taken
as ronstant ano changes in demands for labor are assumed to change levels 01'
spctoral unemployment. Thus, the model iR a,ble to generate the initial impact of
tariff changes on labor-market disequilibrium.
Finally. we have not attempted to model the process of macroeconomic income
determination. Rather than have our resnlts be dominated by uncertain predictions of the response of marro policy mak!'rs to tariff changes. we have chosen
to maintain aggregate expenditure at levels that will keep world economic activity approximately constant. Thus. our results reflect exclusivPly microeconomic
considerations.
Ro far we have described the model as it appeared in Deardorff et al. (1976).
For the present paper, we have modified that model to include ouantitative trade
restrictions and changes in those restrictions. The presence of import quotas. for


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405
example, is modeled as breaking the relationship between domestic prices of
imports and world prices that would normally arise from tari.fl's. Instead, we
have domestic prices that adjust automatically to prevent imports from changing. For tb.ose industries in which quotas affect only a fraction of trade, that
fraction is used to construct an average of the two hypothetical prices that would
prevail with no quota at all and with a quota on the entire industry. The result
is to make trade in quota-protected industries less responsive to changes in
tariffs and other variables than it would have been had quotas not been considered.
The model covers the following 18 major industrialized countries, which are
listed together with the abbreviations that will be used to refer to them in subsequent sections. The choice of countries was dictated by the availability from
GATT (1974) of detailed trade and tariff information at the line-item level.
We shall comment below in Section VII on the implications of having excluded
the less developed countries from the model.
IT-Italy
ALA-Australia
JPN-Japan
ATA-Austria
NL-Netherlands
BLX-Belgium-Luxembourg
NZ-New Zealand
CND--Canada
NOR-Norway
DEN-Denmark
SWD--Sweden
FIN-Finland
SWZ---Switzerland
FR-France
UK-United Kingdom
GFR-West Germany
US-United States
IRE-Ireland
World industry was categorized into 29 classifications, of which 22 are tradable.
They are identified by numbers adapted from the International Standard Industrial Classification (!SIC) and are described below:
NontradabZea

group:
!SIC2 ____________
_
4 ____________ _

5 ____________ _
6 ____________ _
. -----------_
7 ____________
8
9____________ _

DeBcription

Mining and quarrying.
Electricity, gas, and water.
Construction.
Who_lesale and retail trade, restaurants and hotels.
Transport, storage and communication.
Finance, insurance, real estate, etc.
Community, social aind personal services.
TradabZeB

group:
ISIC1____________
_
310__________ _ Agriculture, hunting, forestry and fishing.
321 __________ _ Food, beverages and tobacco.
322 __________ _ Textiles.
328__________ _ Wearing apparel, excluding footwear.
324__________ _ Leather and leather and fur products.
Footwear.
831 __________ _
332._ _________ _ Wood products, excluding furniture.
341 __________ _ ]'urniture and fixtures, excluding metal.
342__________ _ Paper and paper products.
and publishing.
35A _________ _ Printing
Industrial chemicals ( 351) : other chemical products (352).
35B ---------- Petroleum refineries (353) ; miscellaneous products of petroleum and coal ( 354) .
355 __________ _
Rubber products.
36A _________ _ Pottery,
china and earthenware (361); other nO!llmetallic
mineral products (369).
362 __________ _
371 __________ _ Glass and glass products.
372 __________ _ Iron and steel basic industries.
381_ _________ _ Nonferrous metal basic industries.
382 __________ _ Metal products. excluding machinery, etc.
383 __________ _ Machinery, excluding electrical.
384 __________ _ Electrical machinery, apparatus, etc.
equipment.
38A _________ _ Transport
Plastic products. n.e.c. (356) ; professional, photographic
goods, etc. (385) ; other manufacturing industries (390).


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406
To give some idea of how the 18 countries interact with one another in the
22 tradable industries, we present a summary of the basic trade rund trade policy
data in Table 1. For each tradable industry, the first column gives U.S. net exports
(exports minus imports) for 1970 with the total U.S. trade balance at the bottom.'
Then, we report average nominal post-Kennedy Round (1972) tariff levels by
industry for the U.S. and for the world as a whole (the 18 countries, including
the U.S.). Average tariffs have been obtained by using 1970 levels of imports as
weights. In this case, the bottom entries in the table are the import-weighted
averages of the columns above, rather than their sums. Finally, in the last two
column we report an index that we have constructed to indicate the importance
of quantitative restrictions on trade. This index is intended to represeint the pereentage of trade within each industry and country that is subject to quantitative
restrictions. Further details on its construction are given in the appendix below.
Again, as with tariffs in the preceding columns, import-weighted averages were
used to get the figures for the world and for all industries together.
Since our focus in this paper will be on the U.S., it is worth noting from Table 1
how the U.S. compares in its level of protection with the other industrialized
-countries. It appears that U.S. tariffs are, on average, lower than in the rest of
the world. In fact, while it is not apparent from Table 1, there are only 2 of the
18 countries whose average tariffs are lower tham. those of the U.S. (Norway and
Switzerland). And among 22 separate industries, there are only 6 in which the
U.S. tariff exceeds the average for the world. As for quantitative restrictions, the
U.S. is again slightly below average.
TABLE 1.-THE PATTERN OF U.S. TRADE AND PROTECTION COMPARED TO AN AVERAGE OF THE WORLD'S
INDUSTRIALIZED COUNTRIES

U.S.
net exports,
1970 (millions)

ISIC industry

!____________________________________
310_________________________________
321.________________________________

m-

m ================================

1!L~

~= ========================= --=

i=::mt::ii:::::::=/
m-::::: ::::: ::

$1,924.7
-791. 2
-191.1

=~It i
1~1

~lill

J!

Avera3e post-Kennedy
Roun tariff (percent)
United States

World

United States

World

3. 14
7.40
20.44
26. 32
6. 72
10.08
1. 95
7.14
.43
. 76
6. 34
2.89
4. 31
11. 26
12. 95
6. 32
2.29
8. 79
4.97
7.23
3. 51
8.47

10.66
16. 78
12. 41
18. 74
4.02
11.62
2. 94
9. 36
5. 81
5. 46
10.12
3. 14
7. 70
6.29
10. 77
5. 72
2.56
9.02
7. 13
9.63
7. 81
8.86

1. 4
45. 4
100.0
100. 0
0
0
0
0
0
60.6
0
56.2
0
0
0
0
0
0
0
0
1. 8
•5

21. 38
28.08
100.0
100.0
1.04
16.12
0
0
.53
9.07
4.52
41. 39
3. 72
7.25
0
.23
4. 75
2. 74
2.68
5.03
12. 20
3.40

12. 36

15.45

~~~~:
179. 6
i
-------------4,423.6
6.26
8.23

38A. ______________
======
__ __ ==
__ ====
__ __ ========
__ ______
A(I____________________________

Index of post-Kennedy Round
quantitative
restrictions
(percent)

Note: The trade and tariff data were compiled from GATT (1974). The tariffs are post-Kennedy Round (1972), ad valorem
equivalents and are import weighted, using 1970 trade. Details on construction of the index of quantitative restrictions
.are given in Appendix Table A-5.

1 Detailed Information on Imports at the line-Item level was available for 1970 and 1971
in GATT (1974). W.e used the 1970 data to correspond with our data on employment by
industry for this year, which was the latest available at the time we assembled all the data
for computational purposes.


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407
Among industries, the most heavily protected are clearly food, beverages, and
tobacco (ISIC 310), textiles (ISIC 321), and wearing apparel, excluding footwear (!SIC 322). Textiles and wearing apparel (321,322) are specially notable
in being subject to quantitative restrictions.2 This means that the tariffs which
are also present in these industries are essentially meaningless, since they
merely tax the profits of those who control the limited allocation of imports
but do not affect prices.
III. THE EFFECTS OF EQUIVALENT MULTILATERAL TARIFF CHANGES

We turn now to the analysis of results generated by our model. We begin by
considering several formulas for tariff change in which all countries are treated
identically. That is, a single formula for determining a tariff change is constructed based upon the level of the existing tariff. The formula is then applied
to all countries at the same time. Thus, there is no attempt to discriminate
among countries, except to the extent that their existing tariffs may make them
unusually vulnerable to a particular tariff formula.
'.rhe simplest formulas (1-3) of this sort consist of changing all existing tariffs
by the same percentage, independently of their initial size. More complicated
formulas ( 4-6) make the percentage tariff cut dependent on the initial tariff.
'l'he individual formulas are as follows:•
Formula 1.-A 10-percent increase in all tariff rates.
Formula 2.-A 50-percent reduction in all tariff rates.
Formula 3.-A 100-percent reduction in all tariff rates.
Formula 4.-A "harmonization" formula consisting of three iterations of a
tariff cut equal to the initial tariff.
Formula 5.-A "nonlinear" formula in which all tariffs below 5 percent are
removed entirely, tariffs above 40 percent are cut to 20 percent, and all other
tariffs are cut in half.
Formula 6.-A "linear with intercept" formula in which all tariffs are set
equal to 3 percent plus 40 percent of their initial value (but with no tariff allowed
to rise).
With the exception of formulas 1 and 3, which are included in order to determine the effect of changing the overall level of tariff reduction, all of these
formulas are very similar in terms of their overall effects. In addition they all
approximately represent actual tariff formulas that have been proposed by different participants in the current round of trade negotiations. They differ primarily
in terms of their differential treatment of high, medium. and low initial tariffs.
Formulas 4 and 6 both cut high tariffs the most and low tariffs the least, with
the difference being most pronounced for formula 4. Formula 5, on the other
hand. requires large cuts of both very high and very low tariffs, and has its
smallest effect on tariffs in the middle range ( 5 to 40 percent). In addition, the
tariff reductions implied by formula 5 are all at least as large as for formula 2,
so that the average tariff reduction under formula 5 is likely to be somewhat
greater than under the others.
In principle, each of these tariff formulas is intended to apply to all industries as well as to all countries. In fact, there are certain industries that are
likely to be excluded from tariff cuts in the current negotiations. We therefore
assume in all of our calculations in this paper that-regardless of the formula
applied-tariffs in these industries are unchanged. These industries are: agriculture, etc. (!SIC 1) ; food, beverages, and tobacco (ISIC 310); textiles (ISIC
321); wearing apparel (!SIC 322); and petroleum products (!SIC 35B). In section V, we will take a further look at two of these industries, textiles and wearing apparel, to determine the effect of their being excluded.
The results of these six tariff formulas are summarized in Tables 2, 3, and 4.
Table 2 reports effects on employment, first in man years, then in percentages.
Table 3 reports price effects for both the U.S. and the world (all 18 countries) .
.And Table 4 reports exchange-rate effects.
• As noted in Table A5 below, we set the coverage of quantitative restrictions for these
industries at 100 percent In the absence of more detailed information.
• Our choice of formulas has been Influenced In part by the work of Cline et al. (1975,

:J.976).


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4C8
TABLE 2.-SUMMARY OF EMPLOYMENT EFFECTS OF ALTERNATIVE TARIFF·CHANGE FORMULAS
10 percent
up

50 percent 100 percent
down
down

Absolute change in man•years:
All United States................

(3)

(2)

(1)

Harmoni·
zation
(4)

Nonlinear
(5)

Linear with
intercept
(6)

2,509

-12, 550

-25, 099

-3, 226

-21, 158

JPN

UK

UK

UK

UK

BLX

Maximum country ..•.•..........

8,438

28,339

56,677

8,373

42, 709

5,166

UK

JPN

JPN

ALA

us

JPN

Minimum country •••........••.•

-5,668

-42, 190

-84, 380

-26,680

-21, 158

-27, 781

ISIC 9

ISIC 5

ISIC 5

ISIC 5

ISIC 382

ISIC 5

2,603

7,239

14,478

3,948

3,328

5, 179

ISIC 5

ISIC 9

ISIC 9

ISIC 9

ISIC 9

ISIC9

-1, 448

-13, 017

-26, 033

-4, 390

-12, 283

-3, 307

0.003

-0. 016

-0.033

-0.004

-0.028

-0.001

IRE

BLX

BLX

BLX

BLX

BLX

Maximum country ..•...•.......•

0.106

0.465

0. 930

0.151

0. 390

0.138

BLX

IRE

IRE

NZ

CND

ALA

Minimum country •.............•
Maximum U.S. industry (ISIC) ....

-0.093
358
0. 317
382
-0.070

--0. 531
382
0. 348
35B
-1. 587

-1.062
382
0.696
35B
-3.173

-0. 582
384
0. 212
35B
-0. 977

-0. 212
323
0.405
355
-0. 384

-0.481
35A
0.256
35B
-1. 035

Maximum U.S. industry ..•.•....•
Minimum U.S. industry ••........
Percentage changes:
All United States ...••.•.•...•.•.

Minimum U.S. industry (ISIC) •..

-1, 044

TABLE 3.-SUMMARY OF PERCENTAGE PRICE EFFECTS OF ALTERNATIVE TARIFF·CHANGE FORMULAS
Formula
10 percent
up

(1)
Export prices:
United States.......
World ..............
Import prices:
United States .......
World .••••........
Consumer prices:
United States .......
World ..............


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50 percent
down
(2)

100 percent
down Harmonization
(3)

(4)

Nonlinear

Linear wth
intercept

(5)

(6)

0.052
.008

0.259
-.044

-0. 519
-.088

-0.107
-.015

-0.068
-.030

-0.110
-.013

. 278
. 256

-1.388
-1.281

-2. 777
-2. 562

-. 737
-.573

-.262
-.494

-.860
-.578

.009
.034

-.044
-.168

-.088
-.337

-.015
-.082

-.030
-.049

-.013
-.084

409
TABLE 4.-PERCENTAGE EXCHANGE-RATE EFFECTS OF ALTERNATIVE TARIFF-CHANGE FORMULAS
Formula
10 percent
up
Country

ALA __________________ _
ATA __________________ _
BLX __________________ _
CND __________________ _
DEN __________________ _
Fl N__________________ _

- ----- ------ -- -- --_
FR_ -__________________
GFR
IRE ___________________ _
IT_ __ -- -- -- -- -- -- -- -- --

JPN.-----------------NL___________________ _
---- -- -- -- -- -- -- --_
l. -__________________
N
NOR
SWD __________________ _
SNZ __________________ _
UK ___________________ _

us __________________ -·

(I)

o. 317

. !JI
-. OJI

. ry35
.0\7

. 023
. 057
-.0!1
.OlJ
. 0 )5
-. Qj8

-.026
.127
-.OH

-.03}

-.06)
. 0)3
-.OIJ

50 percent
down

100 percent
down Harmonization

Nonlinear

(2)

(3)

(4)

(5)

-1.535

-3. 171
-1.0)5

-1. 71)

-0. 186
. 018
.143
.142
-.061
. OJI
-.013
.032
-.0)6
-.019
. 161
.02.J
-.013
.Oil
. 015
-.171
. 006
-.2)7

-.5>3
. 457
-.173
-.235
-.OU
-.331
.118
-.,JIB
-.032

.233
.131
-.635
.OH
. 193
.3'\7

-.015
. 013

. 915
-.315
-.471

-.023
-.557
. 237
-.OJj
-. 05\
. 576
. 262
-1. 272

.OH

. 337
. 6)1
-.Oll
. 0)5

-.451
. 185
-.157
-.OBl

-.020
-.lH
. 015

-.013
. 019

. 2ll

. 051
-.557
. 012
.113

. 242
. 054
.13)

Linear with
intercept
(6)

-1. 575
-.508
. 191
-.195
-.075
-.014
-.155
. 012
-.034
. 029
. 141
. 061
-.568
.018
.132
.304
. 058
. 173

The first thing to notice in all of these results is that they are not very large.
·with only a few exceptions, none of the changes is more than a fraction of a percent, and even the exceptions never muc-h exceed 3 percent. Thus, whatever the
costs and benefits may be from tariff reduc-tion, neither is likely to he very large.
'\Ye had intended, before looking at these results, to report also the amount of
time that would I.Je required for the economy to reabsorb workers who had been
laid off due to the tariff changes. However, as we look at the bottom part of
Table 2, it is clear that even a mere 1 percent annual rate of growth of each
industry would be sufficient to reabsorb most of the unemployed workers back
into their original industries within a year. And, with a 3 percent rate of growth,
this would be true in even the most seriously affected industries.
Variation among the six formulas is also comparatively minor except of course
that all rt>~ults are reversed in sign when tariffs go up, as in formula 1, instead
of down. Otherwise, the results tend to be of the same general order of magnitude,
regardless of the formula used.
The minor variations that do appear among the formulas seem to follow a
11attern. From the point of view of the U.S., formulas 4 and 6 generate the
.smallest employment reductions. Similarly, the U.S. dollar appreciates the most
with formulas 4 and 6. On the other hand. the benefit in the form of reduced
~onwmer prices is smallest for the U.S. with these same formulas.
The reason for these results is of course that formulas 4 and 6 cut low tariffs
the least and, as we have already noted, U.S. tariffs are already comparatively
low. In contrast, New Zealand and Australia, both of whose tariffs are quite high,
become the greatest. losers of employment only when formulas 4 and 6 are applied.
'\Ve have reporL•d here only a summary of the res•Jlts for the six formulas. For
the employment rt>sults, since space does not permit reporting the detailed
results for all industries, we have included the maximum and minimum countries
.and U.S. industries affected in order to show the range of the results. Those who
wish to see more detailed results on employment and other variables may consult
Appendix B, where more complete results of the effects of formula 2 are reported.
Formula 2-the 50 percent tariff cut-is also used as the basis for comparison in
Jhe next two sections.


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410
IV. 'THE EFFECTS OF VARYING THE EXTENT OF U.S. PARTICIPATION IN TRADE
LIBERALIZATION

In the previous section, we noted that the U.S. can benefit somewhat from
the multilateral application of a tariff formula that impinges most severely on
high tariff countries. The reason was that the average tariff reduction in the
U.S. would then be smaller than in other countries. This seems to lend support
to the idea that any country will benefit most if it can exclude itself from a
general round of tariff reductions by other countries. To examine this proposition
in more detail, we used our model to calculate the effects of three more tariff
formulas in which the extent of U.S. participation in trade liberalization was
varied. As we shaU see, whether or not the U.S. can be said to gain or lose from
unilaterally excluding itself from a round of tariff reductions elsewhere depends
upon the weights one gives to the costs and benefits discussed in the introduction.
The additional formulas which we consider here are the following:
Formula 7.-10 percent increase in all U.S. tariffs; 50 percent reduction in all
tariffs of all other countries.
Formula 8.-No change in U.S. tariffs; 50 percent reduction in atl tariffs of
all other countries.
Formula 9.-100 percent reduction in all U.S. tariffs; 50 percent reduction in
all tariffs of all other countries.
As before, we exclude industries 1, 310, 321, 322, and 35B from tariff changes
in all countries.
The results for each of these formulas are summarized in Table 5, together
with results for formula 2 with which they are readily compared. As we move
to the right in the table, we have U.S. tariffs being made lower and lower, until
they are completely eliminated in the far-right column.
TABLE 5.-THE SENSITIVITY OF U.S. VARIABLES TO UNILATERAL VARIATIONS IN U.S. TARIFFS
U.S. across-the-board tariff change-(Form. 7)

(Form. 8)

0

-50 percent

-100 percent

0.002

-0.001

-0. 016
382
o. 348
35B
-1. 5887
-0.044

-0. 031
382
0.698

+10 percent

Percent change in U.S. total employmenL·-·-····-····
Maximum U.S. industry (ISIC).. ·-··-·········-··-····
Percent employment change __ --·- •• ·-·--·········-···
Minimum U.S. industry (ISIC).--•-······-··---····-··
Percent employment change_·-·---· •• ______ ·---·· •.••
Percent change in U.S. consumer price ____ ·-···········
Maximum U.S. industry (ISIC)_ ••.••••• - •••••••••••.••
Percent home price change_···················-·----Minimum U.S. industry (ISIC)._ •• ·-············--····
Percent price change .....• -· ..•••• ·--····· •••••• ···Percent change in U.S. exchange rate .•• •·•·····-····--

35A

35A

o. 328

0.329

-2. 373
o. 010
384
0.032

-2. 242
0
384
0.019

o. 044
0.655

-0. 005
0. 554

35B

372

35B

323

(Form. 2)

6

-0.023
324
-0.085
0.048

(Form. 9)

35B

-0. 931
-0.089

6
-0. 046
324
-0.166
-0.458

As might be expected, overall employment in the U.S. falls more the more the
U.S. tariffs are reduced and actually rises if U.S. tariffs are increased. However,
even with complete removal of U.S. tariffs, the fall in total employment is a tiny
three hundredths of one per cent.
If we look at the industry detail of employment effects, however, we find a surprise. The most adversely affected industry (ISIC 35B) actually suffers a smaller
loss of employment when U.S. tariffs are reduced than when they are not. Similarly the industries that expand the most do so by a greater percentage when
U.S. tariffs are reduced than when they are raised. Now obviously it is not pos·
sible for all industries to expand with greater U.S. tariff reductions and still
have the aggregate effect be negative. To see what was happening, we looked at
the detailed industry results that space presents us from reporting here. We
found that the pattern reported in Table 5 for industry 35B is also observed in 16
of the 22 tradable industries. On the other hand, all but one of the nontradable
industries were hurt by larger U.S. tariff reductions. The reason is apparently
that U.S. tariff reductions cause U.S. consumers to substitute away from non·
tradables toward tradables as the latter become less expensive.
Turning now to the benefits from tariff reductions, we find that consumer
prices fall more the greater are the U.S. tariff reductions. This is not surprising
since tariff reductions cause import prices to fall. Note, however, in the next two
lines of the table that the prices of home·produced goods also fall more as tariffs


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are reduced. Thus, the benefits to consumers from reduced prices are not confined
to the goods they happen to import.
Together, these results again suggest the problem noted earlier of weighing the
costs and benefits of tariff reduction. Broadly speaking, those who derive their
livelihoods from tradable industries tend to gain income while those dependent
on nontradable industries tend to lose income. At the same time, both groups
share the benefit of reduced consumer prices. Now it can be argued that the 1atter
effect is enough to tilt the scale in favor of a net benefit for society :;ts a whole,
and that the U.S. should therefore take the lead in reducing its own tariffs as
far as possible. But the question remains whether the losers in this process
should be adequately compensated. If so, the process of compensation is likely
to be difficult, since our analysis suggests that the bulk of the losers will not be
located in the import-competing industries, but in those vast industries which
deal in nontradables.
V. ANALYSIS OF SELECTED INDUSTRIES

So far, we have reported results for specific industries only when they were
identified by the solution of the model as experiencing extreme responses to the
tariff changes being considered. In this section, we report the results for several
industries in more detail.
Table 6 contains the percentage output changes that we calculated for each of
the 9 tariff formulas considered so far. for the selected industries. Since the main
differences within the tables are between the first two columns and the last four,
we will comment on these two groups of industries in turn.
Textiles and Apparel
Textiles (ISIC 321) and Wearing Apparel (ISIC 322) were selected because

they were excluded from the tariff reductions in our calculations. Nonetheless,
we see from Table 6 that the tariff reductions elsewhere caused these industries
to contract. This result would probably come as a surprise to workers and manufacturers in those industries, who surely feel the "protection" afforded them by
tariffs to be desirable.
In fact, what is happening is that by exempting an industry from multilateral
tariff reductions, that industry is denied the benefits of the consumer substitution toward tradable goods that we mentioned earlier. Instead this substitution
acts against it, just as if it were a nontraded good. While not included in Table 6,
the other excluded industries display the same pattern, as can be seen for formula 2 in the appendix. In the case of the textile industries, this effect is even
stronger due to the presence of quantitative restrictions on trade. While these do
not exclude imports entirely, they do make trade so unresponsive to price changes
that the industries behave more like nontradables than tradables.
TABLE 6.-PERCENTAGE OUTPUT CHANGES IN SELECTED U.S. INDUSTRIES FOR ALTERNATIVE
CHANGE FORMULAS
Industry

Multilateral changes:
10 percent up ___________________
50 percent down ________________
100 percent down _______________
Harmonization __________________
Nonlinear ______________________
Linear intercept__ _______________
Unilateral
changes
by United States:
10 percent
up ___________________
No change _____________________
100 percent down _______________

321
Textiles

322
Apparel

324
Footwear

371 Iron
and Steel

383
Electrical

384
Transpor

0. 013
-.065
-.129
-.065
-.017
-.077

0.023
-.113
-.226
-.039
-.131
-.029

-0.044
. 219
.439
. 021
.022
-.093

0.003
-.015
-.030
-.037

0. 027
.136
.271

-.059

.111

.072
.068
.075

-0. 052
.262
• 523
.161
-.021
.176

-.178
-.159
.030

-.035
-.048
-.178

. 069
.094
• 345

-.124
-.106
.077

. 081
.090
.181

. 166
. 182
• 341

There is a difference between the results for industries 321 and 322 in Table
6 that should be noted, even though we cannot fully account for it. When
unilateral variations in U.S. tariffs are considered in formulas 7, 8, and 9, we
see that wearing apparel is hurt, but textiles are helped the greater is the U.S.
tariff reduction. Since both industries are excluded from these reductions,
we would have expected both to be hurt, as though they were nontradable.


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412
Our only explanation for this result is that textiles are primarily an intermediate
product and that they may be benefitting from expansion of the industries in
which they are used. However, since the principal textile-using industry is wearing apparel, this explanation is less than satisfactory.
Footwear, Iron and Steel, Electrical, and Transport
Footwear (ISIC 324) was selected for study because of the recent pressure

on the U.S. government to increase its level of protection. Electrical machinery,
apparatus, etc. (ISIC 383), which of course includes televisions, was selected for
the same reason. Iron and steel basic industries (ISIC 371) and transport equipment (ISIC 384), on the other hand, were selected because of their importance
as producer goods and as consumer goods, respectively.
But in spite of these differences and the fact that all of these four industries
are noticeably wary of competition from abroad, all but one respond similarly to
most of the tariff-reduction formulas by increasing their outputs. The exception
is iron and steel (ISIC 371) which contracts under all but one of the tariffreduction formulas. The explanation for these results is easily found in the
data of '!.'able 1. There we see that iron and steel is the only one of these four
industries in which the initial U.S. tariff is greater than the world average. Thus,
it appears that a primary determinant of an industry's vulnerability to multilateral tariff reductions is whether its own tariff is greater or smaller than the
world average.
Variation of Industry Tariffs

We have noted that tariff reductions tend to cause consumer substitution
towards the affected industries and away from both nontraded industries and
those traded industries which were exempted from the tariff reduction. As a
check on this result, we have experimented with variations in the tariffs on
the second group of selected industries considered above. For each of those four
industries, we first tried setting their taril'f changes equal to zero iu all countrie:,:.
then tried complete removal of their tariffs in all countries, and finally tried
exempting only the U.~. industry from tariff reduction. In each case all other
tariffs were reduced hy 50 percent as in formula 2.
'The results are reported in Tahle 7, including percentage output changes both
for the selected industl'ies as a whole and for their home and export sectors. In
three of the four industries (all except footwear) the pattern inferred earlier
is reaffirmed; each expands more, the more tariffs are reduced multilaterally
in the industry. 'l'he Hectoral results indicate. however. that it is the export
sector which expands while the home sector, in most cases, contracts. This distin,:,tion is important. ot' course. since the costs of shifting from home to export
production are not likely to be borne equally by all firms within an industry.
TABLE 7.-PERCENTAGE OUTPUT CHANGES IN SELECTED U.S. INDUSTRIES WITH ALTERNATIVE CHANGES IN
TARIFF OF SELECTED INDUSTRY

Tariff change in selected industry
0 in all countries:
Total ___ . __ . __ .. _. _.. ______ . _. ___ . ______ . _. ___ .
Home .. __ . _____ . ____ - -- . - -. - . - . - . -- - . -- -- -- -- Export ____ • __ .. _____ . __________ ._._._._._. ____ _
-50 percent in all countries:
Total __ .. _._._. __________ . _______ . ____ ._ .... _._
Home._ .. _. ___ . ______ . - _- . - _- _- _-- . - -- . - . - . --- Export_ .. _._ ... ______ .. ____ . ________ ._._._._._.
-100 percent in all countries:
Total. ... _...... ------------------ -- -- ----- -- -Home ____ .. _._. _______ ._ - . _. - ___ - . -.... - . - . - -- .
Ex~ort_ ........ ______ - - ... - . -- -- -- .... -- --- -- -0 in United States, 50 percent other:
Total. .. _.. _._. ___ . ______ . _______ ..... ________ .
Home._. __ ._._._. ________________ • _______ . __ . __
Export__._._._ .... ________ ._. __ . ______________ _

324
footwear

371 iron
and steel

383
electrical

384
transport

0.888
. 8£6
-2.28

-0. 056
-.006
-1.50

0.016
. 034
-.482

0.039
.045
-.201

.219
. 204
7.06

-.015
-.084
2.00

.136
-.025
4. 55

3. 90

-.450
-.487
16. 41

.026
-.162
5. 51

. 256
-.083
9. 58

. 493
.000
8.00

. 964
. 960
2. 87

-0.14
-0. 084
2.00

.187
. 065
3. 57

.328
.141
3.18

. 262
.023

An exception to the pattern was found for the footwear industry (ISIC 32")
which loses (in the U.S.) from multilateral tariff reductions on footwear importts. The reaRon for this result seems to he the unusually small size of the
export sector in the U.S. footwear industry. This prevents it from participating
in the world"·ide expansion of demand for footwear that tariff reductions imply.


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Finally, the last lines of the table report the effects of unilaterally excluding
the U.S. from tariff reductions in the selected industries. Here, as one could
expect, most of the industries benefit from having tariffs on their products reduced elsewhere but not at home.
VI. THE ROLE OF NONTARIFF BARRIERS

It should be evident that we have confined our attention thus far only to the
effects of tariff reductions. There are numerous nontariff barriers (NTB's) that
impede trade in various industries that must also be taken into consideration.
These include quantitative restrictions on imports, voluntary export restraints
( "orderly marketing" arrangements), goyernment procurement practices, customs regulations, health and safety requirements, and numerous other barriers
that are too detailed to be documented here.
While these yarious NTB's are obviously important, they are unfortunately
yery difficult to analyze. The problem is one of translating them into their tariff
equiYalents, or otherwise estimating the extent to which they may restrict imports. For want of anything better, we have used the data on NTB's compiled
by Murray and Walter (1977), based upon the coverage of trade that was subjected to NTB's in indiYidual countries in 1973. These data by no means measure
the restrictiveness of NTB's, but they nevertheless provide some indication of
the degree to which imports in particular industry categories and countries are
affected by NTB's.
The detailed results are given in Table A5. As Murray and Walter (1977, p. 18)
note:
Apart from the textiles sector, . . . , U.S. quantitative restrictions at
present cover imported meat, specialty steel, petroleum products, printed
books and periodicals, aircraft, ships and boats, dairy products, oil seeds and
fruits, margarine and other edible fats, sugar, chocolate and other food
products containing cocoa, certain preparations of flour and starch !'ontaining cocoa, sweetened forages and certain other food preparations. Imports of
wild bird feathers are controlled, as are narcotics and firearms.
We would have to add to the foregoing list the recently imposed voluntary restraints on imports into the U.S. of shoes and teleYision sets. These restraints are
not reflected in the data in Table A5.'
It may be of interest to compare the NTB coyerage data for the U.S. with the
other major industrialized countries. Thus, as Murray and Walter (1977, p. 19)
have noted, it appears that France, Italy, Japan, Norway, the Benelux countries,
and .Switzerland maintain fairly extensive NTB's on industrial products, in particular footwear, ceramic tableware, cutlery, and tools. For agricultural products,
besides the European Community's rather restrictive Yariable levy scheme,
Austria, Canada, France, .Japan, Norway, and Switzerland impose NTB's on many
items.
We have already ,seen how the presence of nontariff barriers can affect the
outcome of tariff reductions. That is, hy limiting the response of imports to price
changes, they cause the protected industry to behave more as though it were
nontraded than traded. It remains to consider what effects changes in the nontariff barriers themselves may have.
To determine this, we ran two more experiments with our model, increasing
the quotas on the textile and wearing apparel industries (ISIC 321 and 322). The
increases were assumed first for the U.S. alone, then for all countries. The results
are summarized in Table 8.
The effects on the textile industry are similar to what we have found before
for tariff reductions. The U.S. textile industry contracts if the quota increase is
done unilaterally by the U.S., but expands when all countries raise quotas. The
expansion in the latter case is however confined to the export sector.
• llfurraJ· an/I Walter (1977. pp. 11-13) have summarized the evidence on the costs of
NTB's to the U.S. On an aggregate level. It has heen estimated. based on 1971 data. that
the annual efficiency losses to the U.S. from NTB's was about $3.6 billion. or about 0.44
percen~ of nationa! Income. In terms of tra,le co,·erage. for 1972. ahout $100 billion of
domestic consumption was estlma terl to he subject to NTB's on imports (including petroleum. which may have lntlaterl the estimate). Estimates of costs of NTB's have also been
marle for snedfic industries and sectors. For examnle. these ran ahont 20-25 percent of
total lT.S. domestic expenditure on raw sugar in l!l70. and about 10 percent of total expenditure on cott?n and noncotton textiles In 1!!72. Estimates for more recent years are also
clterl f~~ textiles. f!Ieat. an<l steel. ~bile all of the available estimates are no doubt subject
to cr!hnsm on yar10us methorloloi,-1cal grounds, there Is nevertheless good reason to believe
that many NTB shave been and will continue to be rather costly to U.S. consumers.

39-940 0 - 7() - 11


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414
TABLE 8.-THE EFFECTS OF A 10-PERCENT INCREASE IN TEXTILE AND APPAREL QUOTAS IN
UNITED STATES ONLY AND IN ALL COUNTRIES
Quota increase inUnited States
only
Percent chan~e in U.S. total employment__ ________________________________________ _
Percent in U.S. textile employment ----------------------------------------------Absolute
in U.S. textile employment (man-years):
Homechange
_____________________________________________________________________
_
Export ____________________________________________________________________ _
Percent change in U.S. apparel employment_ ______________________________________ _
Absolute
in U.S. apparel employment (man-years):
Homechange
_____________________________________________________________________
_
Export
_______________
-- --_________________________________________________
-- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --_
Percent
in U.S.
consumer prices
Percent
change
in U.S. prices of textiles:
Home
_____________________________________________________________________
_
Im port ____________________________________________________________________ _
Percent
change
in U.S. prices of apparel:
Home
_____________________________________________________________________
_
Import____________________________________________________________________ _
Percent change in U.S. exchange rate _____________________________________________ _

0. 0007
-0.021

All countries
I
0. 01
0.304

-867
635
1. 40

-830
4. 214
1. 44

16. 055
261
-0.011

16. 080
758
-0.012

-8. 785

-0.012

-0.012
-8. 785

-0.020
-2.569
-0.080

-0.020
-2.569
-0.095

The results of the apparel industry, however, are surprising. Here there is expansion in both cases and in both the home and export sectors. The reason turns
out to be the heavy dependence of that industry on textiles as an input and the
extreme reduction in import prices that the quota increase there permits. While
this result is surely not representative of what would happen to most industries
if their nontarifl' barriers were relaxed, it does point up the importance of allowing for interindustry interactions as we do in our model.
We have seen that the effects of changing quotas can be very similar to the
effects of changing tariffs. However, this does not mean that the effects of maintaining constant levels of tariffs and quotas are the same when other things are
changing. There is an important difference. When quantities demanded or supplied change, a tariff permits some adjustment to that change through imports.
A quota does not. When a quota is present, such adjustment must be accomplished
entirely through prices. Tariffs are therefore a much more flexible instrument
than quotas.
VII. THE ROLE OF LESS DEVELOPED COUNTRIES IN U.S. TRADE

Data limitations have prevented us from incorporating the less developed
countries (LDC's) into our model. In this section, we will attempt to assess the
importance of this omission.
Two factors should be considered in evaluating the importance of omitting
countries from our model. The first is simply the amount of trade accounted for
by the omitted countries and the second is the price responsiveness of that trade.
For it is only the changes in rest-of-world trade that occur when tariffs are
reduced that matter for our results. '.rhese changes would necessarily be small
if the volume of trade itself were minimal, but they could also be small for a
large volume of omitted trade if that trade were relatively unresponsive to price
variations. We shall consider each of these points in turn.
To give some idea of the volume of omitted trade and its possible importance
for the United States, w,e report U.S. exports and imports by region, for 1975, in
Table 9. The source of these data was not the same as was used elsewhere in the
paper, and the industry and country classifications are accordingly not exactly
comparable. Still the column labeled Industrial Areas closely approximates U.S.
trade with the 18 countries included in our model. It is clear from this column
that we have accounted in our model for well over half of U.S. trade in all industries except for imports of primary products, textiles, and clothing, and exports
of iron and steel. Nonetheless, the quantity of trade with LDC's is fairly sizable
in all but a few industries.
Even in quantitative terms, however, this result can be misleading, since it
reflects only U.S. trade. Since the U.S. competes on world markets with all other
countries, a better measure of the omitted trade would have been that of all 18
countries together. This was not available on a disaggregated basis, but we can


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415
report the results for total trade. Of the total exports of the industrial areas, 70
percent was to the 18 countries included in our model. The analogous figure for
imports was AA nercent. Comparing to the last row of Table 9, it is clear that U.S.
trade with LOO's is disproportionately large. Thus, the data in Table 9 for the
U.S. alone tend to overstate the importance of the trade that was omitted from
our model.
We turn now to -the issue of the price sensitivity of the omitted trade. In our
model, prices are determined so as to leave the balance between world supply
and demand unchanged in each industry. Were we to add to the model additional
trade with countries that are currently excluded, the estimates of equilibrium
price chanj!es would be altered only to the extent the additional net trade is
responsive to changes in world prices.
TABLE 9.-PERCENTAGE OF U.S. TRADE WITH SELECTED REGIONS OF THE WORLD (1975)

Industry
Primary
products:
Imports
_____________________________________________________ _
Exports _____________________________________________________ _
Nonferrous metals:
Imports_____________________________________________________
____________________ -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --_
Exports
Iron Imports
and steel:
_____________________________________________________ _
Exoorts ____________ ------ -- -- ---- -- ---- -- -- -- -- -- -- -- -- -- -- -Chemicals:
Imports _____________________________________________________ _
Exports _____________________________________________________ _
Engineerin,
products:
Imports _____________________________________________________
_
Exports_ _____ -- ______ ------ -- -- -- -- -- -- -- -------- ---- -- - -- -Road motor vehicles:
Imports
______________________ -- -- -- -- -- -- -- -- -- ------ -- -- ----_
Exports _____________________________________________________
Textiles
and
clothing:
Imports _____________________________________________________
_
Exports _____________________________________________________ _
OtherImports
manufacturers:
_____________________________________________________ _
Exports _____________________________________________________ _
Total:
Imports ______________________________________________ -- _____ _
Exports _____________________________________________________ _
t

Industrial
areas 1

Eastern
trading area

Developing
areas

30.6
62.9

I. 0
6. 1

68.4
31.0

67. 8
75.6

4. 7
3.8

27.1
21. 4

93.0
37.4

.6
1.2

6.4
61. 4

86.8
56.0

1.1
1.0

11.9
42. 9

80.6
57.0

.4
2.4

19.0
40.6

98.9
70. 7

.1
.4

.9
28.9

32.0
65. 5

1. 9
.5

66. 4
33. 5

73. 7
72.3

I. 0
.9

25.4
26. 7

58.6
61. 3

.9
3.0

40. 5
35. 7

Includes the 18 countries used in this study plus South Africa.

Source: General Agreement on Tariffs and Trade, International Trade 1975-76, Geneva, 1976.

Now consider the nature of the omitted trade as indicated by Table 9. First, a
portion, admittedly small, of that trade is with the centrally planned economies
of the eastern trading area. Since this trade is negotiated by state traders in
whose own economies market prices play only a minor role, it seems unlikely that
such trade is very price elastic. Indeed the same argument may be applied to the
much larger volume of trade with the LDC's. These countries are notorious for
their government intervention in export and import markets, either directly via
export and import licenses or indirectly through exchange controls and other
means. Thus, there may be limited scope for competitive supply and demand responses within these economies to be :felt on world markets, particularly in the
short-run period encompassed by our model.
Finally, if we look at the particular industries for which the quantitative
importance of LDC trade is greatest in Table 9, we see that there are reasons
for these industries to be even les,s price responsive than normal, at least in the
short run. In primary products, for example, short run supply depends mo•re on
current weather 'COnditions and on the pattern of historical resource exploitation
than on current prices. In textiles and clothing, on the other hand, supply is
presumably much more price elastic. But here, as we have seen, the demand for
imports on the part of the developed countries is severely constrained by quantitative restrictions.
For all of these reasons, then, we are inclined to regard the omitted trade with
DDO's as comparatively unimportant for our results.


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416
YIII. CO;"!CLUSION

In the earlier sections of the paper, we analyzed the effects of a wide variet~· of
tariff-cutting formulas. Of these, only four (numbers 2, 4, 5, and 6 of Section III)
rerireHent vhurnihle outC'omes of the eurrent round of trade negotiations. All other
formulas were included in order to highlight the effects of varying the extent of
trade liberalization in particular countries, particular industries, and for the
world as a whole. '.l'wo exveriments were also performed in Section YI with
changes in quotas, though we found no notable differences between quota changes
and tariff changes. Finally, while all of our results are somewhat inaccurate due
to the omission of less developed countries from the model, ,ve were able to argue
from data on trade with the LDC's that these inaccdracies are unlikely to he
very large, at least for most industries.
Several conclusions of a general nature emerge from our analysis. First, we
have seen that multilateral tariff reductions reduce prices in all countries. The
greatest reductions are in the prices of imports themselves, hut the effect extends
as well to the prices of exports and to consumer prices generally (see Table 3).
In addition, the price declines in any particular country tend to be greater, the
larger are the tariff reductions in that country. 'l'his was noted in '!'able 3 in
comparing the effects on U.S. consumer prices of formulas 4 and 6 versus the
others and is also evident in Table 5.
Second, we have seen that the employment and output effects of tariff reductions are distributed quite unequally across sectors of the economies involved.
There is some tendency for particular industries to be harmed by tariff reductions
if their own tariffs are initially high compared both to other countries and to
other industries. However, in general, the own tariff of an industry in a given
country is less important than whether the tariffs elsewhere in that industry are
reduced. Thus we have seen that multilateral tariff reductions tend to cause
expansion in most industries that share in the reduction. '.l'his expansion is at the
expense of nontradable industries as well as of any tradable industries which are
exempted from the redudions.
Third, the expansion of (nonexempted) tradable industries is accomplished
hy means of a considerable alternation of production within these industries.
\Vith some exemptions, the export sectors of these industries expand substantially while the sectors producing for the home market contract. This shifting
of production within the industry may impose additional costs of adjustment,
particularly if labor cannot easily move between the home and export sectors.
Finally, we have computed the effects on exchange rates that arise under the
alternative strategies. As one would expect, a country's currency rises less or
falls more in value the greater are its own tariff reductions compared to the
rest of the world. The welfare implications of exchange rate changes are unclear,
however, since a devaluation on the one hand stimulates most sectors of the
economy, but on the other hand raises prices and is viewed politically as a sign
of failure.
Together, these conclusions indicate that any trade strategy that might be
chosen will result in benefits to some parts of the population and costs to others.
No trade strategy is possible that will, by itself, make everyone better off.
Instead one must try to balance the interests of producers (including Tabor) in
tradahle industries against those of producers in nontradable industries and in
industries that are to be excluded from world-wide trade liberalization. The
first group is likely to gain from tariff reductions both by receiving higher
incomes and by paying lower prices. The second group is likely to lose by
~uffering loss of income in excess of the price reduction.
l<'or the United States this trade-off is apparent in the comparison of the
more realistic of the tariff-reduction formulas we have studied (formulas 2 4
;;, and 6 of Section III). Because U.S. tariffs are low compared to the rest of
the world, formulas 4 and 6, which reduce high tariffs the most and low tariffs
the least, lead to comparatively small tariff' reductions in the U.S. This in turn
means that the benefits to consumers are minimized (i.e. the fall in consumer
prices is small) but that producers in nontradable and exempted industries
lose less than they would with the other formulas. Furthermore the effect on
producers in tradable industries is unclear. The small U.S. tariff' reductions
under formulas 4 and 6 limit the extent of substitution by U.S. consumers
towards these industries, but, on the other hand, the larger tariff reductions


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417
abroad stimulate these industries. All in all, then, it would seem that tariff
reduction formulas such as 4 and 6 might be the most deeirable from the U.S.
point of view.
:l!'inally, we should note again that, whatever formula is applied, none of the
effects is. likely to b~ very large. Even 100 percent tariff remm·al was seen to
ha,·e very small percentage effects on output, employment, and prices in most
countries and industries. Tims, it may not be of crucial importance that we
succeed in calculating exactly all of the costs and benefits of alternative trade
strategies, for the difference bet,veen the optimal strategy and other nonoptimal
strategies is probably not very large. The importance of our analysis here, then,
is not that it enables us to pick out the optimal trade strategy. Rather, it is
useful in directing our attention to particular sectors of the economy that will
be hurt the most by whatever strategy is ch0sen.
REFERENCES

Cline, W. R. et al., "Prospective Trade Effects of Tariff Reductions in the Multilaterial Trade Negotiations," in process, November 1975.
- - - , "Choice Among Alternative Tariff Cutting Formulas in the Multilateral
Trade Negotiations," in process, January 1976.
Deardorff, A. V., R. M. Stern, and C. F. Baum. "A multi-Country Simulation of
the Employment and Exchange-Rate effects of Post-Kennedy Round Tariff
Reductions," presented at the Eighth Pacific Trade and Development Conference, Pattaya, Thailand, July 1976, forthcoming in Conference proceedings.
GATT, "The Basic Documentation for the Tariff Study," Geneva, 1974.
i\Iurray, T. and I. ·waiter, ''Special and Differential Liberalization of Quantitative
Restrictions on Imports from Developing Countries," presented to the Agency
for International Development and Foreign Sen·ice Institute, February 22,
1977.
APPENDIX

A: DATA

The five tables of this appendix contain the complete data, by industry and
country, on production, net trade, employment, tariffs, and quantitative trade
restrictions that were used in this paper. The figures may serve to put particular
results of our model into perspective.
Table Al shows the value of domestic production in each ISIC industry category together with row and column sums. Figures -are in millions of U.S. dollars
and were derived from the United Nations, "The Growth of World Industry"
(1974) and OIDOD publications on national accounts.
Table A2 presents net export Rtatistics for each industry-country cell. Figures
are in millions of U.S. dollars and ,vere computed from GATT magnetic tapes
pertaining to "The Basic Documentation for the Tariff Study" (1974).
Table A3 gives employment statistics for each industry-country cell. Figures
are thousands of man-years, and wer•e taken from the United Nations source
noted above.
Table A4 presents post-Kennedy Round (1972) nominal tariffs expressed in
percentage form. The underlying data came from the GATT study cited abo,·e, and
the aggregation process used is detailed in Deardorff et al. (1976).
Table A5 presents an index of the degree to which 1973 imports were subject
to quantitatiYe restrictions ( quotas, etc.). A value of unity indicates 100% restriction ; zero denotes no restriction. The construction of this index is described
fully in a note immediately following the table.
Both Ta·bles A4 and A5 -are accompanied ·by country and industry averages
that were computed using 1970 imports as weighting factors.


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NOTE TO TABLE A5

The calculations in this table were based upon the detailed data underlying
Table 1 in Murray and Walter (1977, pp. 21-22). The procedure was to record
the value of 1973 imports for a given country and commodity category that was
subject to some type of NTB, as identified in underlying documents prepared by
the U.S. Department of State and UNCTAD. The NTB's included: discretionary
license; global quota; health and sanitary regulations; bilateral quota; state
trading ; variable levy ; and prohibition.
The NTB data were compiled at the 4-digit BTN level. The import data, based
upon the SITC, were concorded with the BTN classification insofar as possible.
The results were then concorded and aggregated to correspond with the ISIC
categories that we have used throughout the study. The numerator of the fractions
reported above thus measures the amount of imports for the given ISIC sector
that were covered by some type of NTB. The denominator of the fractions measures the total imports for that sector.
In the absence of detailed information for textiles and wearing apparel (!SIC
321 and 322), we set these fractions at unity on the assumption that imports for
all the industrialized countries were subject to NTB's. Murray and Walter did
not report NTB coverage for Australia, New Zealand, and Finland. For Australia
and New Zealand, we generally assumed NTB's equal to the median NTB for all
countries imposing them in the given sector. For Finland, we used the median
NTB's for Denmark, Norway, and Sweden.
APPENDIX B: SOLUTION FOB FORMULA 2

The tables of thls appendix report selected results, for all industry-country
cells, of a 50% tariff reduction in all countries (Formula 2).
Tables Bl and B2 show respectively the absolute and percentage changes in
employment resulting from the tariff cuts. For Table Bl the units are man-years.
Table B3 presents the absolute change in net trade, with the figures corresponding to those in Table A2.
Tables B4 and B5 show the percentage changes in home and import prices respectively. The first seven columns of the import price matrix are zero, since
these are nontradable commodities.


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429
Representative Lo NG. Well, thank you very much, Mr. Stern.
The similarity of the position is taken by you and Mr. Cline, in
many of these instances, is particularly interesting.
.
The political implications that I referred to earlier-perhaps we are
seeing only the tip of the iceberg, but the political problems appear to
me to be much more severe than is generally recognized. Perhaps what
we need to do is to have a massive educational program, and I
would like to discuss that after we have an opportunity to hear Mr.
Richardson.

STATEMENT OF J. DAVID RICHARDSON, ASSOCIATE PROFESSOR
OF ECONOMICS, UNIVERSITY OF WISCONSIN
Mr. RICHARDSON. Thank you, Congressman Long. I will try to be
brief. I have a prepared statement that is somewhat longer, and I
would like, with your permission, to have that inserted into the
record.

Representative LoNG. It will be made a part of the printed record.
Mr. RICHARDSON. It is no news to this committee and yourself that
almost a half century's increasingly liberal U.S. international trade
policy, ever since the Reciprocal Trade Agreements Act of 1934, is
under attack today.
The question I would like to pose and answer for you today is
whether that attack is justified.
My answer will have a somewhat different tone from Bob Stern's
and Bill Cline's. I would like to give basically the answer, yes, that
attack is justified on liberal trade policy both in principle and in
practice.
But having said that, let me add that to my mind the bottom line is
not abandonment of a liberal trade policy, but rather a cautious and
innovative reshaping of it to take account of three potential offsets
to the national gains that we do receive from liberal international
trade. These three offsets loom larger now than they have ever since
the thirties when that first Reciprocal Trade Agreements Act was
passed.
I would like to refer to these three things as three ways in which
more liberal international trade policy is not as attractive today as it
was in the recent past to the United States, and having said that, let
me take just a moment to dispel the notion that I am going to waffle on
what is called the principle of free trade. My reading of economic
theory, and economic history, and economic politics convinces me that
what is called the principle of free trade is not a "principle" at all.
That is, it is nothing- that we should swear undying allegiance to, come
hell or high water. Trade policy is instead rather like situation ethics,
unfortunately for pure freetraders, but also unfortunately for pure
protectionists.
There are circumstances in which certain trade restrictions are justified-even on the grounds of economic theory. We have an economic
theory of the "second-best" that elaborates the grounds on which
trade restrictions are, indeed, justified, but which we rarely put into
practice when we give testimony.

39-Q40 0 - 79 - 12


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430
There are also circumstances under which the status quo trade policy should be preserved against attempts both to make it more liberal
and against attempts to make it more protectionist. All these circumstances have to do, crucially, with the three ways in which liberal
trade policy istess attractive today than it used to be.
Let me describe now the first way in which I think this is true.
The first way is that any multilateral changes in trade policy may
well today dislocate more resources-labor, machines, and plant-and
it may dislocate them for a longer period of time, than used to happen.
That is to say, trade-related unemployment and excess capacity will be
more enduring than used to be true.
,
The result of this is that both people and capital are made involuntarily unproductive. The national product declines by the value of
goods that could have been produced but are not produced by these
men, women, and machines. And the overall national welfare declines
further to the extent that there are very real subjective and psychological costs of unemployment of people, which can seriously reduce
future productivity of those displaced.
In the longer run, we as economists believe that wages and prices
which are inflexible momentarily, and which cause involuntary dislocation, are generally much more flexible. Wages and price inflexibilities moderate in the longer run because almost all prices cease to be
rigid when we have contract renewals and lease renewals and things
like that.
Yet, even in theory, temporary displacement caused by trade liberalization can in some circumstances undermine its desirability. This
i& true, despite the indefinite recurrence of the familiar benefits that
Bill Cline outlined, because future gains, even those that go on forever,
are subjectively discounted compared to present losses, and the present
losses from dislocation occur immediate] y.
Now the importance of this particular offset, this dislocational offset
to the gains from more liberal trade policy, is often dismissed by U.S.
economists. They doubt that in practice it could ever convincingly overrule their presumption that freer trade is almost always desirable. My
colleague Bob Baldwin quotes somebody who said, "Free trade, like
honesty, is more or less always the best policy."
The grounds for that aphorism and for doubts about how large the
dislocation is, are rarerly more than gut feeling.
It is only recently in some of the resea1'Ch that Bob Baldwin and
myself have done, and some of the research that Bill Cline has <lone,
and some of the research that Bob Stern has clone, what we have firmer
foundations for the usual practice of saying, "Well, you might be right
in theory, Dave, but you are wrong in practice."
To give you an example, let me cite the '\Visconsin results where we
actually try to quantify the loss from the involuntarily unproductive
men and machines that this offset imposes.
We find the overall benefits from engaging in multilateral halving
of all existing tariffs, reducing them 50 percent, would be an extra, $1
billion-much smaller than Bill Cline's figurer-in real consumption.
'\Vhat that is is a measure of what U.S. buyers, whether industries or
individuals, would be willing to pay in order to trade at more liberal
world prices.


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431
Or you could view it as the brioo that someone would have to pay
buyers to ma;ke_ them contend ,vith the status quo. Either way that is
what the $1 billion represents.
That $1 billion turns out to be yery large compared to our estimates
of the lost 011tp11t from people an<l machines made involuntarily unemployed. It turns out to be 200 times as large as the output lost because of capital dislocation; it turns out to be 25 times larger than the
output lost due to labor dislocation.
And even if you were to take the labor dislocation from import
competitive industries, all by itself, forgetting all about export gains
from this exercise-even that is only one-third of $1 billion in lost
output.
So, despite our feeling that in principle there are circumstances in
which dislocation alone could undermine a more liberal trade policy,
we don't find for the linited States that this is the case, given our
calculations.
However, it is something to keep in mind because things change.
The bottom line for the time being from this exercise is that liberal
international trade policy appears to be nationally beneficial despite
the very high rates of overall unemployment in this country, and the
increasing wage and price inflexibility in the U.S. economy.
Yet it could be even more beneficial if these problems were solved
nationally.
Now I have ooen referring to national gains from more liberal trade
policy, but that word introduces the second of my points, the second
way in which more liberal trade policy is not as attractive today as it
used to be. National gains aren't all that is relevant. Any change in
the trade policy as you well know creates gainers and losers. Hence,
it alters the U.S. income distribution among individuals, between the
rich and the poor, and ootween industries. Because in more recent
years, what is called equity in income distribution has become a much
more important policy goal than it used to he in past decades, the
impact of trade policy on income distribution is examined today with
a heightened vigilance, a vigilance that never used to be there.
Representative LONG. Going back to my point about looking at the
political implications of this: One of the things that causes a great
deal of concern around here are the regional economic dislocations that
are occurring. This was not one of the points you mentioned of course,
because you were looking at it from a purely economic perspective.
I well recognize that you were not covering that. But when you
look at the economic implications of the regional changes, they never•
theless contain severe political implications as well.
Mr. RICHARDSON. That is true; I could have mentioned distributional effects among regions. I think that we are able to show that
New England and the Upper Mid west are going to suffer more
from more liberal trade policy than the rest of the country wouldthe industrial Midwest is what I want to say. That is the real poltical issue, indeed. These are things we have often ignored as economists,
but should not, to my mind. The possibility has to be accepted that
the moderately increased satisfaction of certain regions, certain individuals, even if they are in a majority, could be insignificant when
compared to dramatic unhappiness if visited upon a minority.


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432
Significant enough distributional consequences of trade liberalization could even, in turn, weaken the economy through social malaise
and unrest. I don't think that is true in this economy, but it certainly is true in many economies world,vide, and the result is indirect
impacts on incentives and confidence and uncertainty which all stem
from the more liberal trade policy and the pressure it puts on certain
individuals and regions.
Now, I find it insensitive to dismiss the self-interest of regions or
individuals on the grounds that it's self-serving or selfish. People
sometimes accuse one another of being that way, because of the absence
of a sufficient compensation mechanism.
In its absence, not everyone in this society can win from more liberal
trade policy, and how do you balance gainers versus losers in that
situation?
Economists don't have any good answer, or definite way of doing it.
One source becomes immediately apparent for the notorious disagreement among equally intelligent people on whether trade liberalization is socially desirable or socially disastrous. Some weigh severe
losses for the few more heavily than others in trying to assess national
distributional welfare.
Some feel that New England textile workers and Youngstown steelworkers are already victims of an ungenerous society, and they will
recommend foregoing large trade liberalization gains to avoid victimizing those workers further.
Others feel that those same workers have largely Yictimized themselves by not being willing to move and adjust when all the signals
prompted them to.
We have done a little research at vVisconsin on tlwse matters, too,
and we find that breaking down labor groups by wage rates per hour
worked, we don't come to any solid conclusion as to whether more
dislocation from. more liberal trade is progressive or n·gressin'. '\Vhat
we find is that it is progressirn in the sense that more liberal trade
helps the poorest paid workers, who are the agricultural workers in
this country. But almost all the other poorly paid ,rnrkers are injured
by a more liberal trade policy. That is to say, they an' dislocated more
than proportionately to their sharp in the labor forcr.
"\Ve find that the highest paid workers. tlw most skillr(l groups, for
the most part are less severely dislocated than yon would liaYe thought
from their share in the overall labor forcr.
"\Ve also find thnt, as yon might we11 imagine, certain irnlustries bear
the brunt of this dislocation much more than other indnstries. and
~ can ~ite some of thosp for you in the question period if it is
rnterestmg.
_ The third reason why liberal trade may not Le as attradiYP to(lay as
1t used to Le is thait lilwral trade policy as we interpret it in the United
States has been rejPcted hy tlw great majority of de,·eloping countries
worldwide. I think that if the rnited Stafrs is to maintain its eonsidPrable gains from trade with the dew loping "·odd-more than a third
of our exports are to the develoriing ,nn·l,1. and almost half of our
imports are from the dPnloping ,Yorlll-tlwn we may haw to pay a
price to do so.


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433
The price we may have to pay is moving toward much less liberal,
much more politicized trade, as given perhaps by the new international
economic order, which is proposed with notable solidarity by the developing countries in concert.
·
The issue at stake in the new international economic order is again
a <listributional issue, only in this case the issue is regional among
nations rather than a regional one within the nation.
It is comfort, I think, hut very cold comfort, for developing countries to suspect that, although trade strengthens their economy, it
stre11;~hens the economy of developed nations far more; that is their
susp1c10n.
They are confronted constantly with an exasperating anomaly; it's
that liberal international trade-as we interpret it here-may well
make the rich richer relative to the poor and thus increase international income inequality.
Exasperation in the developing countries is compounded by the
belief that the gains from international trade are distributed among
nations roughly in proportion to market power under a liberal trade
system, the power of buyers and sellers in the market. To the strong
go most, and to the weak go rnme, but only what can be extracted from
a residual veto; namely, "'Ve will not trade."
To commentators in the developing countries, distribution based on
market power is worse than arbitrary; it is positively inimical to their
development because it condemns them to a vicious circle of relative
poverty-relative to us-from which they can emerge only by chance.
Their relative poverty requires spending on what are viewed as the
necessities of the day, on penalty of collapse, and little is left over for
them to accumulate capital and technology at a faster rate than we do
in the United States, which would enable them to close the international gap in living standards and to end their relative poverty.
Now, our natural reaction in this country has so :far been very reluctant support for the new international economic order, at best. I
think we tend to feel in this countrv that international trade does alleviate absolute poverty in deYelopi;1g countries, and to alleviate their
relativ~ poverty more than a certain degree "·ould be to concede too
much to jealousy and covetousness, however well disguised it is as
equity.
But I think perhaps we should keep reminding ourselves in our consideration of the new international economic order that we have seen
these issues before. tlw. vPry ones the developing countries raise, but
in quite another context. The arguments on both sides of the demand
for a new international economic order bear striking resemblance to
those which divided rnanagement from labor within this country in
the early years of labor union formation and confederation.
,ve today, the deYeloped countries, play a r?le analog~us to the owners and managers of yesteryear; the developmg countnes play a role
analogous to the laborers and the~r unions.
. .
.
The debate in both instances 1s onr how to d1v1de the spoils from
mutually beneficial exchange, hmv to split them up; it is also ov.er hmY
widely to allow those with market power to buy and sell, or lure and
tire, if yon likr. frerly. "·ith01_1t ·any n~lrs o~· procrdnr:s.to 111:◊tect the
economicallv weak, rnles "·lnch are mvanably adnumstratively negotiated and bnreaucratically rnforcccl.


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I think the developing countries look hopefully to the future when
their proposed rules and procedures for a new international economic
order will be as accepted and appreciated as those governing labor
relations within developed countries today.
I£ you will permit me a few more minutes, I would like to speak
a little bit on how the three offsets to more liberal trade come together
on the very issue of imports of manufacturers from developing
countries.
All three offsets are important when we look at manufactures imports from developing countries. Organized labor in the United States
for very good reason seeks protection against what they call low-wage
imports. It is true in theory and in practice that their impact on U.S.
labor is either fewer jobs or lower wages, or more likely both.
Yet, it is hard to say whether such dislocational/distributional objections as U.S. labor voices are significant enough to outweigh the
gains to what we might call the whole of U.S. society.
Furthermore, it may be true that dislocation or distributional
losses from those kinds of imports are not inevitable.
We do have assistance aspects of trade adjustment assistance, especially under the more liberal Trade Act of 1974, that compensate
for at least some of the distributional losses to those displaced by
developing-country goods.
And adjustment aspects of trade adjustment assistance, while they
are minimal under existing legislation, could in principle reduce the
overall economy's loss from enduring involuntary unemployment of
both people and physical capital. I think that certain proposals under
current consideration to strengthen the adjustment aspect of U.S.
trade policy should be welcomed on these grounds.
What I have in mind for example is what I have called human investment tax credits, for industry hiring workers who have been
certified to have been displaced by imports, certified as a recipient of
trade adjustment assistance.
Another idea is community assistance programs to aid both prospering communities and faltering communities to move trade-displaced
workers from one place to another.
Both of those ideas and proposals have the virtue of not extending
government intervention and regulation beyond where it is now,
because both investment tax credits and community assistance programs are familiar policies to us in other contexts. There are also
some gains from the adjustment standpoint to portability of fringe
benefits. Even portability of seniority within a firm across different
plants and different regions of the country has an unexpected dividend in providing places for trade-displaced workers to go within
the same firm, and in assuring them o.f certain continuity in their
benefits and salaries.
I think the payoff is extremely high to any policies which ameliorate
the internal consequences of manufactures imports from developing
countries. The payoff is very high because those policies will buy
votes both in this country and votes abroad. They reduce domestic
adjustment burdens, and they facilitate developing countries in seeking to attain a goal of 25 percent of world industrial production by
the year 2000.


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Unlike many traditional trade policies, adjustment policies do not
aggravate one set of problems at the expense of another. They don't
aggravate internal problems at the expense of international problems,
as the GSP system does-it aids the international distribution at the
expense of domestic dislocation.
Imaginative adjustment policies can reduce internal problems without frustrating developing countries in thPir goal of a more equitable
international income distribution. Yet, I must say it is no small job
to design workable and politically acceptable adjustment policies. At
that point, I, as an economist, yield the floor to you as the real pro
in devising workable and politically acceptable adjustment policies.
Thank you very much for this opportunity.
[The prepared statement of Mr. Richardson follows:]
PREPARED STATEMENT OF

J.

DAVID RICHARDSON

Crucial Issues for Current International Trade Policy
In our judgment, two issues are of paramount importance for trade policy today. The first is how trade policy should be shaped or augmented in light of its
heightened impact on dislocation and income distribution within countries. The
second is whether and how trade policy should be applied to narrowing the increased inequality of income distribution among countries.
Both issues have a long history. But both have become more crucial in the
profound global economic flux of the 1970's.
·widespread stagnation has raised global unemployment rates toward preWorld War II highs. More importantly for trade policy, stagnation has lengthened
the duration of both the average job-seeker's unemployment, and the operation of
capital at sub-optional rates of capacity utilization. As a result, any men and
machines that are displaced by trade liberalization are involuntarily unproductive for longer periods of time than during the 1950's and 1960's. Both their personal burdens and the overall social cost of their unproductivity are offsets to the
gains from freer trade-offsets that loom larger now than at any time since the
Great Depression.
World-wide inflation, on the other hand, has significantly altered the internal
income distribution in many countries. Owners of natural resources, land, and
sophisticated human capital have fared well; semiskilled and unskilled workers
have fared poorly. Unlike inflationary boomlets during the 1950's and 1960's, the
much more dramatic outburst of the 1970's seem to have been regressive in its
internal distributional impact. Pressures to "catch up" and to maintain former
standards of living have heightened the vigilance with which all policies are examined for adYerse incidence. Trade policies are increasingly suspect, given the
nearly world-wide growth in the open-ness of economies (measured by the share
of tradeables in overall production).
As a result of recent import pressures in an economic environment of high and
enduring unemployment and inflation. protectionism is currently stronger than at
any time since the early 1930's. Voluntary export quotas, orderly marketing agreements, target (reference) import pricing systems. and increased resort to escapeclause relief all reflect a new interventionist sentiment. Support for a liberal international economc order has been eroded dramatically in the U.S. and elsewhere by the internal dislocational and distributional consequences of trade.
Furthermore, most poorer developing nations now almost unanimously oppose
the liberal international economic order of the past 30 years. Their opposition
is based largely on the international inequality of income that 1the old order
has failed t-o eliminate. Their solidarity is nurtured by the successful predatory
price of OPEC ( Organization of Petroleum Exporting Countries). Oil prices
sextupled between 1970 and 1974, and the :terms of trade deteriorated dramatirally for oil-importing nations. OPEC's model of politicizing a part of international trade, and of pursuing transfers of wealth from other countries, rather
than wealth creation. has prompted other developing countries to do likewise.
'l'heir commitment to succeed. along with OPEC's explicit support (in the fashion
of a prosperous Robin Hood), has led to the formulation of plans for a "new
international economic order." The most important of these plans-thorough-


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going integrated commodity agreements, preferential trade policies, and international pacts on technology transfer and "common resources" all shift the
international income distribution in favor of poorer developing countries through
political intervention in market processes.
In richer, developed countries OPEC has heightened still further the internal
jealousy/equity impulses that rivet attention on dislocation and income inequaHty, by making them suddenly poorer and by forcing significant structural
adjustments among sectors of the economy. :Many of the proposals for a "new
international economic order" would do likewise.
What follows are some reflections on liberal foreign trade, and on whether
dislocational and distributional issues alter the case for it. The reflections are
usually straightforward, but unfortunately neglected. Their neglect seems to be
responsible for the sterile irrelevance of most classroom international economics, for the propagandistic artifice of some congressional testimony, for the
inflammatory rhetoric that engulfs discussions of international income inequality,
and for 1the obtuseness of much journalistic reporting on all.
THE GENERAL CASE FOR LIBERAL FOREIGN TRADE

International trade strengthens an economy for many reasons. Having some
is better than having none, although more and more is not necessarily better
and better. The pattern of trade, and not merely its existence, may also be
strengthening. The U.S. has comparative advantage in goods that are believed
to have special economic :md strategic production value: goods which feature
stable expol't earnings and a monopolistic position in the world market; hightechnology, growth-promoting manufactures; 1 armaments.
The U.S. also has a comparatively well-diversified set of stable suppliers and
customers, few of which can match the market power of the U.S. economy. This
enhances U.S. independence and bargaining power, and mitigates uncertainty. In
sum, both the industrial and geographical pattern of U.S. trade is favorable. On
the other hand, the pattern of international trade· can also increase a nation's
economic and political vulnerability. And it can create pressures on selected labor
groups and capital-owners alike that are productively debilitating. Developing
countries especially feel victimized by these negative aspects. Liberal international trade may be materially beneficial to them, but its "benefits" are reduced
by volatile and highly competitive exports, by lack of bargaining power in import
markets, by uncertainty, and by the peculiar kind of dependence that liberal
exchange always imposes on the economically weak.
Overall, however, one of the most robust of all economic theorems is that some
international trade is better than none at all. Throughgoing national self-sufficiency may he a virtue in some ways, hut any country which attempts it pays a
huge economic price.
Robust as this theorem is, it is often superficially proved, then cavalierly
applied in problems to which it has no real relevance.
The superficial proof goes like this: "Obviously, certain countries produce some
things more cheaply than we do, such as textiles, and we produce some things
more cheaply than they, such as aircraft. Therefore hoth exports and imports
are beneficial. Exports provide jobs and income to U.S. labor and resource-owners; imports reduce the U.S. cost of living because they are price lower than
their U.S. equivalents."
,vhile these observations are true, they do not "prove" that trade is beneficial
to the U.S.-any more than fears that exports raise U.S. prices and imports displace U.S. workers "prove" the case false. In fact, all the descriptive observations are usually simultaneously true. Somewhat crudely, exports can generate
1 Despite well-publicized import penetration by now standardized. once high-technology
goods (e.g .. consumer and business electronic equipment). there is no conYincing empirical
evidence that the U.S. Is losing its comparative advantage in the most technologically advanced goorls. U.S. exports of technology-intensh-e manufactures grew at an average annual
rate of 2!Ul percent over the years 1!l7:l-1975. faster than eithn Germany's or Japan's.
Furthnmore. the U.S. comparath·e advantage has been relativelv unaltere,J even though
the U.S. ahsolute technology advantage has dearly ,letnlorated. That is. even though the
U.S. is losin1:" much of Its across-the-board technologkal leadership of the l!l1\0's anrl J!l60's
compared to other notions it is still much more comrwtith-e in innovative. high-technology
goorls than in established. stail<larrlizNl goods. In fact. It is probable that the U.S. will
retain comnarat!Ye arlvantage anrl exports in high-technology goods nen If sometime In the
future it slins to a position of ahsolute terhnologicnl inferiority. compared to flerman:v and
.Tapan. On these points. see the "International Economic Report of the President" Washington: U.S. Government Printing Office, ;\larch 1976, pp. 117-120.
·


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employment and upward pressure on prices; imports can "take away" employment but hold down prices. It is necessary to go beyond these superficial statements to prove that some international trade is preferable to none, and to demonstrate how trade's existence strengthens an economy.
Impossible as it sounds, trade enables every country to get more and give up
less. It can increase every country's overall consumption of real goods and services without any increase in its use of resources, or it can free up resources for
voluntary leisure, while still allowing a country as a whole to consume the same
goods and services as it did without trade.
International trade performs this ·'magic" because it is completely analogous
to superior technology. It allows inputs to be transformed into outputs more
productively than would be possible without trade 2--only exports are the inputs
into creating physically different outputs called imports. ,Just as superior technology allows a country to get more for less, or :;;omething for nothing, so does
trade. Nations thus choose to trade internationally out of self-interest, not altruism. The added economic strength obtained thereby is not due to the weakening
of other countries either. All can gain simultaneously, just as they ca11 from
superior technology.
These insights alone, however, shed little light on the practical concerns of
trade policy. They deal with comparisons of some trade to none. Two questions
thus go unanswered: "Is free trade better than restricted trade?" and "Is freer
trade better than the status quo?" Neither question can be answered glibly, although both free-traders and protectionists sometimes try to do so in the heat of
controversy. Trade policy is like situation ethics, unfortul).ately for the purists at
either extreme. Appropriate answers to these questions under one set of circumstances are not necessarily appropriate under another. There is no universal,
timeless answer to either practical trade-policy question.
The list of circumstances under which restricted trade can conceivably make
an economy stronger (and freer trade can make it weaker) is quite long. It includes exploiting national monopolistic power in export sales, or monopsonisitic
power in import purchases. It includes using trade policy to combat foreign monopoly, felt perhaps through predatory dumping, when superior anti-monopoly
policy is unavailable or administratively more costly. It includes protecting
economic sectors that possess positive production externalities ( e.g., national
defense, or high-technology industries with significant spillovers into the rest
of the economy), when more direct, first-best production subsidies are infeasible
or suflicietly costly to implement. And most importantly in current world conditions, it includes defending the staus quo when trade liberalization would lead
to a sufficiently large and enduring rise in national unemployment and excess
capacity-one that could not be alleviated quickly ( or at all) by conventional
government policies.•
INTERNAL DISLOCATION AND DISTRIBUTION OF INCOME

The last entry in the list is a direct consequence of downward inflexibility of
prices. Economists often refer to such inflexibility as a "distortion." But it seems
more appropriate to treat it as a fact of life-and not even necessarily a regrettable one, since one person's inflexibility may be another person's predictability.
Most prices, including wages, rents, and interest, are contractually determined
between buyers and sellers. and cannot legally be altered in the short run. The
familiar result of such rigidity is short-run unemployment and excess capacity
when any demand decline. Layoffs take place, assembly lines are idled, and whole
plants are shut down. Both people and capital are made involuntarily unproductive. National product declines by the value of the goods that could have been
produced, but were not. And overall national welfare declines further to the
extent the very real subjective and psychic costs of unemployment reduce furture productivity of those displaced. Problems of unemployment and exces,s capacity are further exacerbated by other inflexibilities-unwillingness of labor to
move from job to job or place to place; unwillingness of management to move
• These points are persuasively and enj?agingly illustrated in James C. Ingram's "Fable
of Tra<1e and Technology," International Economic Problems, New York: John Wiley, 1978,
pp, 40-41.
3 Gh·en the "structural" character of much unemployment and excess capacity today, for
example. It ls clear even that the familiar tools of fiscal and monetary policy are sufficiently
effectil-e to rule out all opposition to trade liberalization.


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from industry to industry; difficulties and costliness of restraining, retooling, and
refurbishing.
In the longer run, of course, these inflexibilities moderate, and almost all prices
cease to be rigid as contracts expire and are renegotiated. Yet even temporary displacement caused by trade liberalization can in some circumstances undermine
its desirability, despite the indefinite recurrence of its familiar benefits, because
future gains are always subjectively discounted compared to present losses.
There is also some tendency in the current world setting for even long-run flexibility of prices to be less than it once was, thus lengthening the duration of
any temporary displacement, and making any movement from the staus quo less
desirable than it once was.
The list of ways in which freer trade might potentially be unfavorable is sometimes dismissed by U.S. economists, who doubt that it could ever convincingly
over-rule their presumption that, in practice, freer trade is almost always desirable. But the grounds for their doubts and presumptions are rarely more than gut
feeling. Only recently, in some of the research that my colleagues and I have been
carrying out at the University of Wisconsin, have firmer foundations been provided for the usual practice. We find, for example, that the overall U.S. benefits
from engaging in multilateral halving of all existing tariffs would be an extra
billion dollars in real consumption-which is 200 times as large as the output lost
because of increased excess capital capacity, 25 times as large as the output lost
because·of net dislocation of labor (export-related employment gains less importrelated employment losses), and even 3 times as large as the output lost because
of increased unemployment in import sensitive industries alone.'
Whether firmly founded or not, economists' skepticism about the practical application of the list of exceptions to the liberal-trade principle often reinforces the
arguments of those who favor freer trade out of self-interest (for example, U.S.
wheat farmers, aerospace companies, and retailers). And the list is frequently
abused by those who favor restricted trade, and who want to wrap their selfinterest in the flag of national welfare.
The abuses of the list suggest one more important entry to it. Except in ideal
worlds, there are always gainers and losers from trade liberalization. To design
and carry out practical me<;hanisms whereby every loser was duly compensated
(and more) would require a frightening diversion of resources from wealthproducing to wealth-transferring activity. Yet in the absence of such mechanisms,
there may be instances in which trade liberalization should be rejected because it
undermines a society's sense of equity. In other words, the absence of compensation makes any reference to national economic welfare tenuous and a matter of
opinion. Suppose that trade liberalization increased consumption possibilities for
99 out of every 100 individuals by two percent. For the 100th, however, it led to
temporary dislocation that reduced consumption possibilities to zero ( or to the
basket that unemployment consumption will buy). In the aggregate, as a lump, the
society's average standard of living would rise even in the very short term.6 But a
small minority of society would be made desperately worse off, and a large majority somewhat better off. The possibility must be accepted that the moderately
increased satisfaction of the many could be insignificant compared to the dramatic
unhappiness visited upon the few. Significant enough distributional consequences
of trade liberalization could in turn weaken an economy through social malaise
and unrest, and then through their indirect impacts on incentives, confidence, and
certainty.•
• Robert E. Baldwin, John H. Mutt!. and J. David Richardson, "Welfare Effects ou the
United States of a Significant Multilateral Tariff' Reduction." April 1978.
5 If the average standard of living were 100 to start with, the new standard of living
under liberalized trade would start at 100.98 (=(.99Xl02)+(.10X0)) in the very short
run.

• The distributional consequences of trade liberalization are not always so dramatic, of
course. People do not have to become unemployed. nor need machines be idled. for "losers"
to exist. "Income displacement" will frequently take place In that wages and profits are
Indefinitely and frequent!)· reduced In an lnnustry from what they would have been otherwise. bec~}JSe of tra~e liberalization. James McCarthy's survey study of New England shoe
workers. Trade AdJustment Assistance: A Case Study of the Shoe Industrv of Massachusetts" (Federal Re.serve Bank of Boston ..Tune 197!l) : for example. implies that even shoe•
workers who remarned employed from 1970 to 1973 "lost" seven percent In real terms berause of import pressure, rompared to wageearners In other Industries on averai:e Such
"Income displacement" rats,•• the sam~ Issues of equity and compensation that dlslo cation
rloes.


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This discussion also makes it clear why it is insensitive to dismiss the selfinterest of either free-traders or protectionists as "self-serving" or selfish." It is
simply impossible often to define any alternative "public interest" to which to
recommend adherence. Besides, one person's selfishness is another person's concern for home and family. The problems of trade policy are not conflicts between
pure motives and cupidity, nor between intelligence and stupidity• They are
problems of resolving legitimate, well-taken differences. My opposition is justified
from my point of view; your support is justified from yours. Understanding this
is only the beginning of a resolution.
National politicians (and sometimes even economists), of course, resolve such
differences to their own satisfaction in practice. But there can he no objective
guidelines for doing so. One source becomes immediately apparent for the notorious disagreement among equally intelligent people on whether international
trade liberalization is socially desirable or disastrous. Some weight severe losses
for the few more heavily in national welfare than others. They feel that poor
New England textile workers and Youngstown steelworkers are already victims
of an ungenerous society, and will recommend foregoing large gains to avoid
victimizing them further. Others feel that these same workers have largely victimized themselves, by not being willing to move and adjust when all the signals
prompted them to. (Trade liberalization is rarely a surprise.) 7 There is no such
thing as a "correct" position on these matters of opinion, interpretation, and
subjective judgment.•
INTERNATIONAL DISTRIBUTION OF INCOME

Distributional conflicts and contradictory perspectives aggravate relations
among nations as well as within them.
None of the insights provided in the general case for liberal international trade
sheds any light on the way in which the gains from trade (or, for that matter,
from advanced technology) are distributed among nations. It is comfort indeed,
but cold comfort, for developing nations to suspect that although trade strengthens their economy, it strengthens the economies of developed nations far more.
They are confronted constantly with the exasperating anomaly that liberal international trade may well make the rich richer relative to the poor, and thus increase international income inequality.
Exasperation is compounded by the belief that the gains from international
trade are distributed among nations roughly in proportion to their market power•
To the strong go most; to the weak go only what their residual veto ( "we will
not trade") can extract. Distribution based on market power is worse than
arbitrary from the perspective of developing countries; it is inimical. It condemns
them to a vicious circle of relative poverty, from which they can emerge only by
chance. Their relative poverty requires national spending on the necessities of
the day, on penalty of collapse. Little is left over for the accumulation of capital
and technology at a faster rate than developed countries, which would enable
them to close the international gap in living standards and end their relative
poverty.
In this context, OPEC's 5-year-old success story is a two-edged sword. It
confirms the belief of developing countries that the gains from trade are distributed arbitrarily and inimically according to market power (no oil importer
ceased to trade with OPEC, so their gains from OPEC trade must not have dried
up completely). And it holds out to them a model of "development without tears"
based on collective political agitation to bring about the wealth transfers from
rich nations that would enable poor nations to break out of the vicious circle, and
begin the processes of wealth creation and rationalization of their production
structure. Yet while validating their view of the world, OPEC impoverishes them
7 In other research being carried on at the University of Wisconsin, we have discovered
that the dislocation caused by multilateral trade llherallzation Is disproportionately concentraterl on low-wage lahor groups, except for agricultural workers (the lowest-pal!! of
all). High-wai:;e labor groups experience less dislocation than others, and the effects of trade
liberalization on middle-wage groups are mixed.
8 _For historical examples of the internal political dynamics of policy formation on lnternat10nal trade. see (for just two examplPs) : Robert Fl. Baldwin, "T1'e Political Economy of
Postwar U.S. Trade Policy," New York University. Graduate School of Business Administration. Center for the Study of Financial Institutions. "The Bulletin." 1976-4; and Raymond A. Bauer. Ithlel de Sola Pool. and Lewis Anthony Dexter. "American Business and
Public Policy: The Politics of Foreign Trade," Chicago: .A.ldlne-Atherton, 1972.


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still further, heightening their demands that international income inequality be
alleviated.
Pleas and proposals for a "new international economic order" fall on comparatively deaf ears in the U.S. and other developed c1,untries. In their view,
international trade does alleviate the abso:ute poverty of the world's developing
countries. To alleviate their relative poverty more than a certain amount would
be to concede to'O much to jealousy, however well disguised as equity. Most importantly, it would require them to sacrifice, unlike engaging in trade, where
all nations can gain. They have poor enough at home; they view their prosperity
primarily as a bequest of capital and technology from diligent and prudent past
generations, not from arbitrary manipulation of the international terms of trade;
and they see international income inequality as a red herrin!?'. diverting attention
from the fundamental proposition that trade strengthens all.
The arguments on both sides of demands for a "new international economic
order" bear a striking resemblance to those which divided management from
labor during the early years of labor union formation and confederation.• Developed countries play a role analogous to managers and owners; developing countries play a role analogous to laborers and their unions. The debate in both instances is over how to divide the gains (spoils) from mutually beneficial exchange.
It is also over how widely to allow those with market power to buy and sell
(hire and fire) freely, without rules and procedures to protect the weak, rules
which must be administratively negotiated and bureaucratically enforced. Developing countries look hopefully to the day when their proposed rules and procedures for a new international economic order will be as accepted and appreciated
as those governing labor relations within developed countries today.
U.S. IMPORTS OF MANUFACTURERS FROM THE DEVELOPING WORLD: AN ILLUSTRATION

Nowhere are the trade-policy issues of dislocation and income distribution
joined more heatedly than in the matter of U.S. market access for the manufactured products of developing countries. Organized labor in the U.S. understandably seeks protection against such "low-wage" imports because their impact on
U.S. labor is either fewer jobs than otherwise, lower wages than otherwise, or
1
probably both.
Yet such dislocational and distributional losses to parts of U.S. society may not
be significant enough to outweigh the gains to the whole of U.S. society. Nor are
they inevitable. The "assistance aspects" of trade adjustment assistance, especially under the more liberal Trade Act of 1974, compensate for at least some of
the distributional losses to labor from such displacement. And "adjustment
aspects" of trade adjustment assistance, while minimal under existing legislation,
could reduce the overall economy's loss from enduring involuntary unemployment of people arid physical capital due to increased imports. Certain proposals
under current consideration to strengthen the "adjustment aspects" of U.S.
trade policy should be welcomed on these grounds. "Human investment tax
credits" for industries hiring workers certified to have been displaced by imports
are one such proposal. Community assistance programs to aid both prospering
and faltering communities in easing the voluntary movement of trade-displaced
workers from one place to another is a second such proposal. Both have the
virtue of not extending government economic regulation and intervention beyond
where it now is: investment tax credits and community assistance programs are
both familiar policy tools in other contexts. l<'amiliar efforts to guarantee portability of fringe benefits and seniority rights across all the plants of a multi-plant
firm will also have an unexpected dividend in frequently making adjustment to
international trade displacement easier. Encourag-ement to widespread bidding
for open positions within a firm has the same salutary effects on adjustment.
Simply maintaining the temporary nature of trade adjustment aRsistance and
escape-clause relief also has favorable ad.iustment consequences. hy settin!?' up
unmistakable signals to change. These cmrnequences. lwwever. huy adj1rntment at
the expense of assistance. an example of the often-ignored tra,leoff hetween the
two aspects of "adjustment assistance" (the surest means to bring about adjustment is to provide no assistan<'e; and assistance thnt compensate,: for every hnrden leaves no incentive for adjustment).
9 ThP analoi?v hns heen Pxnandeif hv .Tni?dlsh N. Bhni:wnti In his eilitorlnl introiluctlon to
"The New Intnnntionnl F,ronomk Oriler: The .North-South Debat!'." Camhrlili?<'. l\Inssarhusetts: l\Iassachusetts Institute of TechnologJ•, 1977.


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The payoff is extremely high to policies which ameliorate the internal dislocational and distributional impacts of manufactured imports from developing
countries. Such policies win votes at home and abroad. They reduce domestic
adjustment burdens, and they facilitate attainment of a chief goal of the "new
international economic order": to increase developing countries' share of world
industrial production from its current 8--10 percent to roughly 25 percent by the
year 2000. 10 Unlike many traditional trade policies (for example, GATT-spon·
sored multilateral liberalization, Generalized Systems of Preferences, offshore
assembly provisions of U.S. tariff legislation), imaginative adjustment policies
do not aggravate one problem at the expense of another. They are capable of reducing internal dislocation and distributional shocks from international trade
without frustrating developing countries in their goal of a more equitable international income distribution. Yet it is no small job to design workable and politically acceptable adjustment policies. Nor is it easy to envision how to encourage
the private sector of the economy to respond more willingly to market signals.
'l'hese tasks, however, become significantly easier in the absence of global stagflation. Thus to return to a theme at the beginning of this testimony, trade policy
is certain to be an important indirect beneficiary of solutions to the macroeconomic problems which confront the world. This makes it all the more important
that these macroeconomic problems be addressed, perhaps before any radical departure from current trade policy is entertained.

Representative LoNG. Thank you, Mr. Richardson. I think that that
basically goes back to what I was speaking of at the very beginning,
that is the political implications, and the political necessity for working out an acceptable method for making these adjustments.
I was particularly interested, Mr. Cline, as I indicated to you previously, in what I gathered to be your feeling that the inflationary
aspects of the more restrictive policies would result in enough political
weight that it might offset the political weight on the other side.
That is not my feeling at all. Perhaps all of us become very parochial because we have the responsibility of represent-ing either one
State or a half million people within a particular area, and we tend to
emphasize and become more associated with particular problems; consequently, that reflects itself in our actions, as it should.
But in my general conversations with Members of Congress, I have
the impression that Members believe that the direct effect upon their
constituencies of economic dislocation far outweighs the indirect effect
of inflation. I am not at all sure that the political impact from inflation is going to be as strongly felt as the impact from economic
dislocation.
Do you have any feelings on that?
Mr. CLINE. 'Well, I think we do have some historic experience with
trade liberalization in response to inflation. If one considers the period
from 1972 to 1974, when we had the highest international and domestic inflation probably on record, we removed a number of very burdensome nontariff barriers. In particular, we removed the structure of
qoutas on steel in this country; we removed quotas on sugar; we
removed quotas on oil before the oil price increase in the period when
it was relevant; and we were essentially taking very large measures in
which we were voting for keeping down inflation rather than for
maintaining protection.
10 Increased industry ls sought by developing countries to bring them closer to patterns
of trade anrt production wbich mnn~· economists lwlieYe to hnYe positiye external benefits:
stabilizing the terms of trade, encouraging the realization of economies of scale. enhancing
the opportunlt~· for technological a1Jynncenwnt. In arh11tion, deYPloplng countries see increase« exports of manufactures as creating countervailing economic dependence of the
<leyeJoped on the deYeloping world.


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I think we have a recent example of the kind of force I am talking
about in the case of meat quotas. Very recently the President liberalized the meat quotas. The reason given in the press was to help out
in terms of dealing with rapidly increasing meat prices, and I think
there i$ a strong force there that has to be reckoned with.
I think that this country at this time is running a high risk of getting back into very high inflation rates, that our system i1;, not structured to deal with. We don't have indexing. One of the reasons people
are worried about capital gains taxes is we don't have an indexing
system for capital gains. 1V-e tax illusory profits caused by inflation.
It is these systemic problems caused by very high rates of inflation
that leads me to believe that there will be a greater willingness to
resist the individual protectionist moves by specific interest groups because of an awareness of the impact that these will have on American
inflation.
Representative LONG. Mr. Stern, do you have a view on this?
Mr. STERN. Yes, my own feeling is that perhaps Mr. Cline's views
are more idealistic than practical. I share your views on this rather
than his. It is unfortunate, as Dave Richardson pointed out in his
statement, that the direct dislocation effects that come about often
are felt by specific and well-identified groups and regions.
Representative LoNG. They become very real politically?
Mr. STERN. Yes, that is quite corrPct. '\V"hereas the benefits to consumers are spread over the society as a whole.
So from that stanclpoint, the 'biggest problem is to try to convince
those that are makin!!' political decisions as well as thPir constituencies
of the importance of the consumer benefits that are realized from trade
liberalization. The advantage of this would be to moderate or soften
the protectionist movement that would come about as policies are
brought to bear upon those that are more seriously affected.
Representative LoNG. According to the press reports that we have
had-and all of you may feel free t-0 comment on this-the current
trade negotiations have stumbled over the European and Japanese
reluctance to reduce their barriers to U.S. agricultnrnl products. Yet,
Mr. Cline, if we look at your figures, a 60-percent reduction in European and Japanese restrictions on agricultural imports would only
boost the U.S. exports by something like $500,000 a year.
If this is true, why would it appear that so much emphasis has been
put on agriculture; and, if agriculture is not our way out of our
trade deficit woods, what is?
Mr. CLINE. I think the reason that agriculture has been so important is partly the fact that there has been an over-estimated perception of how significant this liberalization would be to our exports.
I think, more Importantly, it is precisely for the same kiml of
political reasons, Congressman Long, that you were mentionecl in
regard to perception of trade policy overall. I think, for example.
that if we could get from the Japanese and from the Europeans sonw
concessions in the agricultural area, that might be small in terms of
dollar volumes but could be fairly conspicuous in terms of political
gesture. It would go a long way toward making a package acceptable-.
It is my impression that that is one of the kinds of things that we
arc after. We are after politically conspicuous concessions from them,


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but that which are not, perhaps going to solve massive figures in terms
of increased exports.
My own feeling on this subject is that we have systematically overstated the importance of agricultural nontariff barriers. In a sense
there has been an interesting evolution because about a year ago my
perception is that An1bassador Strauss got the negotiations moving by
making a concession of sorts to hold agricultural and industrial talks
separately, basically a procedural matter. That then got the Europe,ans
willing to really start talking in se,rious terms.
I think it was one of the important factors in getting them to agree
to a much higher tariff cut than they had originally submitted.
Now we have reached a sit,uation where once again agriculture seems
to.be a major sticking point. All I hope is that we do not jeopardize
the benefits from the negotiations by insisting on measures in agricultural nontariff barriers which are just not feasible for them to take
and that would not be all that overpoweringly significant even in terms
of our own export effects.
In terms of what the solution to our trade balance deficit is, I don't
think that anyone can expect that our trade balance is going to turn
around massively 'because of liberalization to be achieved in the Tokyo
round, including agricultural nontariff barrier liberaliza.tion.
The increase in the Japanese trade balance surplus, for example,
did not coincide with increased ,Japanese protection. On the contrary,
if anything, Japanese protection was going down in this period. As I
indicated, trade balance e,ffects are neutral, as in some sense in order
to get all parties to agree to liberalize.
I think the solution to our trade balance deficit lies in other areas,
particularly the cyclical dephasing between our economy and the
other economies. This is No. 1.
No. 2, the lag between the adjustment in exchange ra.tes and the
erosion of our competitive position which has ,been pla~ing us for the
last year but now should 'begin helping us, given the fact that the dollar
has depreciated considerably in the last months, and there should be
some improvement in our competitive position, which may have an
effect as much as a year or 18 months or perhaps 2 years later on our
trade balance.
Obviously the other area is dealing with our energy imports.
Representative LoNG. How does this square with your feelings on
this matter, Mr. Richardson?
Mr. RICHARDSON. Congreffiman Long, I can confirm that in onr study
we found almost insignificant trade balance effects from multilateral
trade negotiations-just so long as they are mnltilateral.
But your mention of agriculture is worthwhile citing agnin. because
were we to have multilateral trade liberalization, the result for agricultlural prices would be, if anything, higher, certainly now lower
prices. That is important to mention because it gives the lie to drawing
and rigid link between trade liberalization and inflation.
There is no predictable link between multilateral trade liberalization
and the price level in this country. Export prices become higher when
we liberalize, because other people put more pressure of demand on
export goods subject to that kind of pressure, especiallv agricultural
goods.


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Import liberalization certainly lowers prices, but on the export
side they are raised. I think it is unwise of us to try to sell trade liberalization for what it does to the inflation rate, if we are talking about
multilateral trade negotiations.
Representative LONG. Consequently, you feel that the inflation argument, with respect to the effect upon the direction taken by the Congress
is really of no effect at all?
Mr. RICHARDSON. I think it is a very poor argument. Mind you, I
think it is a worthwhile argument to talk about the import side
benefits alone from that.
Representative LONG. I understand.
Mr. RICHARDSON. Especially so because those can be sold to the
voters. I have been surprised in several talks I have given to nonstudents at how sensitive people are to prices of highly selected imports
that they do encounter in retail stores to<lay.
It surprised me that they know that shoes are largely imported,
that many textiles are imported. They certainly know that many
automobiles are imported, and I have had some surprising comments
from steelworkers who talk about how hard it is to make a buck these
days and how they wish somehow that the prices of goods like that
could be lowered.
Then they do draw the logical link between that and import policy.
They say that there are some gains to be had from liberalization. So
I think it can be sold to the voter on the import side, but not in general.
Representative LONG. Mr. Stern, do you have any comment?
Mr. STERN. The only comment that I would like to make with re/lard
to the question that you asked about agricultural issues is that I think
that the potential gains from trade liberalization in agdcultural
products are probably quite large, especially if one were to take into
account the differences in production costs especially of temperate
zone foodstuffs in the United States and Canada as compared to
"\V'estern Europe.
Perhaps one of the reasons why the Brookings study got somewhat
low results with respect to the estimates of liberalization may be
that they didn't build into their analysis the underlying supply conditions that would be affected if liberalization were carried out.
But having said that, I wond nevertheless agree with Bill Cline
that it would be unfortunate if the tariff reductions were to be held
up pending some agreement on al:"ricult,ure. Agriculture is something
that was not covered during the Kennedy round negotiations. There
was the same kind of concern then that there is nmY. The point is that
so long as the Common Market is um,·iJling to make basic clmnges in
the common agricultural nolicies. I don't think that there is going to
be very much to be gained by holding up the negotiations until some
agreement can be reached there.
It might be preferable to separate the issues' until some agreement could be attained on agriculture, but as I said, I do think
that. there are re1al1y large potential gains that could be had here.
RepresentatiYe LoNG. Gentlemen. in most of the years since "\V'orld
"\V'ar II the political bargainin~ that has been going on over international economic matters has been largely limited to trade and tiax
treatie'i. The advent of the annual f'Conomic summit has created an


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international :forum now for the discussion of what· was formerly
viewed as a purely domestic policy.
How do each of you view this development? Do you view it as
desirable, necessary, promising, good, or bad? 1V-e might ·start with
you, Mr. Richardson.
Mr. RICHARDSON. I think that the chief benefit from summitry on
economic matters is that information is provided to pol'icymakers on
what other policymakers are doing. That enables people who form
tax policy, monetary policy, and so forth, to form it much more intelligently than they could do in the dark.
By contrast, I do not think there is much of a future in cooperative
international policymaking because these are intrinsically domestic
matters and I don't see the decline in nationalism that would be necessary to really think of policy planning on an international basis.
But I strongly support the summitry because of the information it
provides.
Representative LoNG. Mr. Stern.
Mr. STERN. One of the difficulties with economic summitry is that
it sometimes raises expectaitions with regard to 1accomplishments that
may be very difficult to achieve in practice.
I think :for these kinds of meetings to be most effective it requires
a great amount of technical preparation among the financial and other
experts in the individual countries to the point where, once the views
are exchanged among the political leaders, they rest upon solid foundation. If agreements can be made based upon the technical preparations that have been accomplished, I would think that the benefits
could be achieved much more readily.
Representative LONG. Do you have any comment here, Mr. Cline 1
Mr. CLINE. Just very briefly, it seems to me that there are economic
benefits to be achieved. Clearly when we have problems of cyclical
maladjustment between the various economies, we have an interdependent situation, and reducing the trade balance surpluses of some
member countries clearly depends on resolving those differences
through measures such as more harmonized growth rates.
I do think, however, there are political dangers to the process in
that it raises the stakes from a technical level to that of a national
confrontation, where one country is viewed internationally as not
cooperating- with other countries. So summitry is a double-edged sword.
It is a risky kind of strategy.
I think we have to judge after a certain period of time whether
the economic benefi.ts we are getting out of the summit process warrant some of the political confrontations that come out of it.
Representative LoNG. Speaking again in the agricultural policy area,
it seems to me that it was in the Kennedy round that the EEC
kept saying that they had just been formed and if we would wait
a few more years until the next round, that they would be much
more forthcoming with respect to the ability to discuss this aspect of
it, and the next round is now with us and they really haven't been
very forthcoming at all. This is just as a side comment.
Going back to this question of the trade deficit, what is your
view, gentlemen, of the extent to which our trade deficit is due to
the slower than usual growth in Europe, in Japan, and in some of
the developing industrialized countries?
35-940-78---13


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Going a step further, by apI_>lying the U.S. wowth rate to the
Canadian and European economies, the Congress10nal Budget Office
came up with some figures that estima,ted that U.S. exports could
have been many billions of dollars higher.
Are the lower than usual growth rates in Europe and elsewhere,
the ones that we were discussing, merely cyclical in nature or are
they really reflective of a structural change to permanently lower
rates of growth?
Mr. Richardson.
Mr. RICHARDSON. I would not want to call them merely cyclical
ju nature, but cyclicality is a great part of the very large trade
deficit that we have had. Most people who do quantitative work on
these matters find that the responsivenes of both exports and imports to cyclical conditions is very high. That for the United States
is due in great part to the large proportion of capital goods and intermediate products in both our exports and our imports, which tend to be
even more cyclical than the average business cycle itself.
So you find that there is even more ups and downs in exports
and imports than there is in general economic activity. However, there
are other things going on that are equally important, although I
cannot quantitatively break it down.
Bill Cline's reference to the lagged response of trade to exchange
rate changes is an important one that I would second.
Then, third, I might mention that for the next few years and for
the last few years it is to be expected that the United States has
some trade deficit that is not to be shunned. It arises largely because
of the demands throughout the world for American financial assets,
on the part of OPEC, official holders of those financial assets, and
private holders worldwide.
We still command the most liquid capital markets anywhere, and
there is some expectation that we will be an absorber of liquid funds
from the rest of the world. Under floating exchange rates the only
way we can absorb these is by running a trade deficit.
It is nothing we should shun, because it enables us to have a higher
national consumption level for any given level of GNP, all in exchange for providing financial intermediation services to the rest of
the world.
Representative LoNG. Do either of vou other gentlemen have any
comment with respect to this 1
•
Mr. STERN. Yes, I, too, believe that a great part of the explanation of
trade deficit lies in the differences in cyclical phasing between the
United States and the other major industrialized countries.
Bv the same token, it is important to understand why it is that
particularly in ,Japan and "\Vest Germany policies have been followed
now for several years which have kept their rates of economic 2Towth
~uch lower th3:n they were historically. I think the explanati~n here
1s really very simple, on<' that we are all familiar with: namely, that
~he "\~est Germans and the Japanese are prcoC'cnpied with controlling
mflat10n.
So long as that continues to be the case, then we are <min(}" to see
rates of growth ':7hich will be lower than they were a0nd perhaps
lower than they 1mght need be. So I have always felt that it was cor-


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rect on the part of the United States to try to induce the Germans and
Japanese to increase their rates of expenditure and thus their rates
of growths.
A related point is that this growth issue has often been discussed
at previous economic summits.
I think there is a very real problem that was created by this where
national governments sometimes agreed to change their rates of economic growth without really having the capabilities of doing so in
the short run. I am referring here particularly to the Japanese where
some statements were made that a certain rate of growth would be
achieved which would then, in turn, reduce the trade surplus. It turned
out that all of the evidence that was available in Japan based upon
the various econometric studies that existed simply pointed out that
what the Japanese Government had promised could not be attained in
the time period involved.
So that points up a very real danger of putting political pressures
on other countries and getting them to agree and then they can't produce.
Representative LONG. That is an interesting point, Mr. Stern. But if
you look at the upcoming summit you find that we want the Germans
to increase their productivity and to increase their growth faster than
they have been willing to do; the Germans, of course, properly fear
inflation; in turn, however, the Germans want France and the United
Kingdom to reduce trade barriers; then, on the other hand, everyone
else really wants the United States to establish an effective national
oil policy, and, at the same time, to slow down inflation.
So the goals are fairly straightforward. Doesn't the stating of these
goals, while it does lead in some instances to unfulfilled expectations,
serve a purpose by letting everybody know what everybody else is
looking for?
. Mr .. STERN. Yes; I think it does definitely serve that purpose, although the purpose is also sened at lower levels in the OECD and
other meetings that are held periodically. Other important countries
are very much aware as we are of their policies at these meetings
where information is exchanged and targets are discussed and so
forth.
So the summitry is then just a way of dramatizing the thing at a.
much higher level.
Representative LONG. Mr. Cline.
Mr. CLINE. Mr. Long, in connection with the question of whether a.
lower p-owth rate is permanent or temporary, I would like to refer tothe problem that Professor Stern mentioned, that of inflation. It seems:
to me.we n?t only suffer from low growth polici~s wh~le attempting tO'
fight mflat10n, but we also have other effects of mflat10n that restrain
growth.
In particular, inflation causes uncertainty about investments and
tmds to restrain the level of capital investment, and capital investmPnt has bePn very low here and abroad.
I ~o think there i~ a rela_tionship to tra~e policy, and here I am
a £raid I would take issue with Professor Richardson. I would agree
that theory permits the kinds of conclusions he had in his general exposition as well as in his comments on inflation, but in both cases it


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seems to me that practical considerations point in the direction of
opposite conclusions that may be valid theoretically.
The fact of the matter is that the empirical studies on the supply
elasticities of products and of exports find those supply elasticities to•
be very high. Mr. Richardson's rejection of the anti-inflation argument
rests on the assumption that the elasticities of supply are low, and that
when foreigners demand more of our goods, we don't have enough to.
sell so that increased exports just raise our prices.
Now we can think in terms of agriculture which is specifically cited.
At a time when we are retiring land from production it is a little difficult to make the case that increased foreign demand would suddenly
push prices extremely high.
In terms of the overall macroeconomic status of the economy, both
here and abroad, at a time when unemployment is high and there is
excess capacity in plant, it is a little hard to argue that increased
exports would cause large price increases.
80 I do think it is important to link the trade situation with theinflation problem and to see what relief we can get from inflation
through trade liberalization.
Representative LONG. I tend to share the view that the relationship
is worth a thorough investigation. I am not sure exactly what sideI fall on with respect to this discussion, but I do think it is worth
examining.
Another point, Mr. Richardson-and I am going back to the political
aspect of this whole problem, in addition to the economic situation;
you cited three reasons why more liberal trade policies may not be as
advantageous as they were in the years past.
Might not there also be a fourth? That is, the perception and in some
instances the reality, of becoming a hostage to the political and economic interests of other nations.
Can we afford, for example, as a matter of domestic security-national security-to do without a basic metals industry for using steel
as a classic example? Are we not endangering national security by
failing to protect a basic metals industry?
Mr. RICHARDSON. I, as do a great many economists, say that trade
policy is the wrong tool to use if you had your druthers, to assure a
national defense and a national·security basis. There are other policies
that are even better than trade policy, and we have a way of showing
that; namely, production subsidies, or governmental production of
certain goods.
We know that there are political objections in practice, however, and
hence those may not be politically feasible policies. 1:Vhen you tell us
that, then we are prepared to say that national security and national
defense are reasons for maintaining trade barriers to assure at least
some level of basic metals industries, armaments production, food
product~on-things like that-as a second-best way of accomplishing
those thmgs.
However, the hostage argument is an incomplete argument if yon
want to use it to favor protectionism. It cuts both wayiii. Liberal trade
does make us to some extent a hostage to foreign producers, but it
turns us into a kidnapper of foreign industries, too.
Representative LONG. That's right; of course.


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Mr. RICHARDSON. We can make them hostages. To that extent you
have to balance these hostage-making effects. We could end up to
be a winner from more liberal trade because we can make more of
them hostages than they can make us. We could be a loser.
In any case, the national security argument, the national defense
argument, are acceptable as a second-best way of getting what you
want through trade policy.
Representative LONG. I must say I am inclined to agree with you,
but what you consider the first-best way is probably not politically
acceptable.
Mr. RICHARDSON. That is right for explicit production subsidies.
But take steel as an example. If it is the Congress desire to maintain,
say, a certain minimal steel production, or other basic metals production in this country, then there are other things to be done that could
assure that other than imposing or sanctioning reference prices and
other trade barriers any more than we have. There are other programs in relation to the steel industry, such as for modernization
and technical assistance. These are other things that can be done that
are perfectly feasible and they do not penalize users of steel in this
country in the way that quotas and tariffs do.
Representative LONG. To follow up on that, if you look at what
happened in Great Britain-and I am treating with something I am
not completely familiar with-if you look at what happened in Great
Britain recently when they started the subsidization of the industries that were experiencing very, very severe import pressures, this
began to bring very serious objections from the other trading partners, saying that this was an unfair trading practice in itself. How
do you see that?
Mr. RICHARDSON. It is no more unfair than is leveling a quota an
unfair trading practice. Hence, you will get the same objections regardless of how you attempt to bail out your own steel industry.
Representative LoNo. What if you carry that to the next step, the
corporate tax incentive?
Mr. RICHARDSON. What is wrong with the corporate tax incentive?
Representative LoNG. No, that is not the question. How is it viewed
as an unfair trade practice?
Mr. RICHARDSON. It is an unfair trade practice. You can carry it to
that extreme. Any policy that you levy to assist a given sector of the
economy has impacts on international trade that in some cases can
injure a foreign country.
I have no objection to carrying things to that extreme, although
it becomes bureaucratically cumbersome to have countervailing duties against, say, everything, every single policy that you could come
up with.
But in principle you can carry it to that extreme.
Representative LONG. Mr. Stern, do you have any comment i
Mr. STERN. With respect to the issue of national security I am not
clear these days about exactly how national security should be defined, particularly in a time where nuclear warfare, if it were carried
out, would be disastrous for all parties involved.
Representative LoNG. But also when a country as powerful as ours
is dependent upon other resources--such as oil, foreign sources of oilfor 40 percent of its needs.


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Mr. STERN. I would then want to think of national security more in
terms of having access to supplies, particularly of oil and other kinds
of important materials, that are absolutely basic to the production
process in the United States.
Here there are various policies that are already being carried out
1:1rnt are much superior to international trade policies, as Dave Richardson pointed out. Perhaps the most obvious one here is stockpiling
in order to build up the availability of inventories in case there were
another embargo or if there were any kind of natural disaster that
would limit the supply and availability of various kinds of raw
materials.
Representative LoNG. They are filling all the salt dunes in Louisiana
with oil.
Mr. STERN. Yes.
Representative LONG. You know, it seems like we always make a full
circle. We took it out of the ground. Now we are putting it back in
again.
l\fr. Cline.
Mr. CLINE. I would agree with what has been said before. Certainly
the industries where we are hearing complaints about imports, such as
shoes and textiles, are not exactly national security industries. I suppose we need uniforms. But basically these problems are not security
problems.
In steel, I think certainly with the degree of import penetration we
have had, we are not talking about the entire elimination of an industry. Steel is not comparable to a case such as black and white television
sets where we simply do not have significant domestic production anymore.
So I don't think we have a security problem in those trade areas. I
think you indicated, sir, the key area, and that is energy. On energy, it
seems to me that we are not doing enough, because we are maintaining
r,_ large price differential favoring consumers here in comparison with
the world price. Perhaps in the tradeoff between distributional questions and the question of incentive to produce domestic oil, we might
want to ask again whether we must come down so heavily in favor of
the distributional issue in prohibiting the passthrough of higher prices
to the oil producers.
But I think it is primarily the energy area where we have a national
security issue.
Representative LONG. Evidently the administration, gentlemen, is
committed to a fairly firm policy of finding jobs for young people and
members of minority groups. I wonder if sometimes our international
posture runs counter to our need to alleviate unemployment. What
would you economists call it? The structurally unemployed. I guess
that is the hest term.
For instance, might not a successful completion of the multilateral
trade negotiations lead to a further reduction in the number of these
low-skilled people, the entry-level-type jobs that usually are open, at
least the most open, to both young people and to the minority groups?
What would the effect on that be as we go into it, looking at our
international posture and the effect upon those particular groups?


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Among the young black males, the data indicate as much as 40
percent unemployment. .
.
How does the international posture that we take affect this very
real problem that we have at home of the structurally unemployed?
Who would like to comment on that?
Mr. RICHARDSON. I would really rather not comment because I don't
have a good answer. I can't think o:f any way in which the effects
would be significant. That is because, as I understand the groups you
are concerned about, they are urban and young workers who are not
in areas o:f the country which, to my knowledge, produce disproportionately large amounts o:f tradable products.
Since they don't produce tradable products disproportionately, as
a rule they don't stand to gain directly :from multilateral trade negotiations-or to lose for that matter.
Representative LONG. Mr. Cline.
l\Ir. CLINE. I think the basic point is that we expect, if anything,
more jobs to be created by liberalization for exports than would be
lost to imports. I think there can be some structural adjustment
problems.
The textile and apparel sectors appear to have a large number of
workers who are black, and :from rural areas. Often the worker is the
wi:fe, and the family might be unable to move in search o:f a new job
if the wi:fe loses her employment.
And so I believe there can be instances of structural problems. But
I think the point here is that the benefits to the economy overall are
so large relative to these adjustment costs that we can afford to have
very comprehensive schemes o:f adjustment assistance, including training programs to take care o:f this problem.
Again, the figure we come up with is that the benefits, which include
some dynamic benefits, economies o:f scale, and increased investment
that are often omitted :from the more standard calculations of benefits, these benefits are somethfog like 80 times the size o:f the costs to
workers :from adjustment. That figure is based on past experience of
the number o:f weeks that trade-impacted workers are unemployed,
and multiplying by the average industrial wage.
So I think the point is that we should be aware of the possibility of
some of these structural adjustment problems, but we should be prepared to address them in the knowledge that the benefit to the overall
economy is so much larger that we should not abstain :from trade liberalization because o:f these possible adjustment problems.
Representative LONG. Which brings me to another question which
I meant to ask a while ago, skipping you :for a moment, if I may, Mr.
Stern. I would like you to comment upon the apparent disparity of the
views, with respect to the possible effects o:f the :free trade policy, between the study made by Brookings and the work done at the University of ·wisconsin. Perhaps you would like to comment first, Mr. Cline,
because Mr. Richardson spoke last on this particular point.
Mr. CLINE. Well, I think perhaps the important point to make here
is that we are not in disagreement on the bottom line.
Representative LoNG. But you are in substantial disagreement with
respect to the figures themselves as I understand it.


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Mr. CLINE. I think the figures themselves have the following differences:
One, it is my impression that the Wisconsin study is using 1971 dollars, which look lower than the 1974 dollars simply because of inflation. These kinds of simple data base differences can occur.
Two, in terms of the benefit estimates, our estimates do attemptalthough there is no universally accepted method of doing this in the
economics profession-to bring in some dynamic effects that everybody agrees exist, but no one has a terribly well-accepted method of
quantifying: The benefits from increased economies of scale and of
.stimulus to investment.
My impression is that the Wisconsin study measure of benefits is
focusing on the traditional welfare benefits which are so-called static
benefits, and that they have not cpmntified the dynamic benefits.
In addition, we have looked at the present discounted value of these
~conomic benefits. If one chooses to look at it this way, one obtains a
large once-and-for-all figure for the total benefit. This figure is of
course, much larger than the benefit for only 1 year.
All this being said, I would point out that the Wisconsin study does
come to the same basic policy conclusions. Robert Baldwin, the coauthor, and I participated in a seminar held by the Labor Department more than a year ago and the general thrust of both studies was
very much the same kind of conclusion: That there are only minor job
dislocations, and that, even as Professor Richardson was citing, the
benefits are extremely large relative to job dislocations.
Representative LoNG. Do you have any comment, Professor Richardson?
Mr. RICHARDSON. I think it is fair to support Bill Cline in what he
says. He has elaborated the differences well. The key one is the attempt
of the Brookings study to take the dynamic effects into account.
One minor one that he failed to mention was that we engage in
different tariff-cutting exercises. Ours is a 50 percent linear cut, his
is the Swiss formula cut. That would be minor, and otherwise he has
mailed down the differences well, and I agree with him.
The bottom line is the same, although when I speak about it, I tend
-.to be more attentive to the possibility of offsets being large.
Representative LONG. As I said earlier, it was frankly surprising
to me that the differences are no greater, in the end result. From our
point of view, it would have appeared that economic dislocation is a
larger problem. Maybe it is the squeaking wheel getting the grease
that makes it so apparent to us.
But I think you are going to find among the political figures of
the country a little bit different perception as to what the effect of it
might be, than the one expressed here and one more in keeping with
my own, unless I am seriously mistaken.
It is not that I am necessarily happy about this. I don't mean to
indicate that I am, because I am not. It is really very encouraging
news to me.
Mr. RICHARDSON. May I respond briefly?
Representative LoNG. Sure.
Mr. RICHARDSON. I think you get quite a bit of heat because you
are besieged by constituents who, if displaced by trade, view it as


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something permanent. It is yery hard £or you to explain to them that
chances are good within a year that they will pe in a new job situation, and although they won't be happy initially, 5 years from now
chances are good that they will be as happy as they ever were.
Our calculations in both Bill Cline's work and our own are based
on the temporary nature of the unemployment produced by trade liberalization. I£ it were to be permanent, it would be a very different
bottom line.
Representative LoNG. It is awfully difficult to tell a horse collar
manufacturer that he is going to be making automobiles in 3 years.
[Laughter.]
Mr. RICHARDSON. There are other things.
Representative LONG. Senator Roth.
Senator RoTH. Gentlemen, I am sorry that I have not been here
since 10 o'clock, but unfortunately, as always is the case, we have
two hearings at the same time.
Mr. Cline, I read with great interest the Brookings study on trade.
On the Subcommittee on Trade, in fact as ranking member on the
Finance Committee, I would like to ask three or four questions in that
area whicl}. may-if it does, I apologize-cover ground that already
has been covered.
But as you are well aware, the implementing legislation as far as
monetary barriers will probably be coming; before the Congress sometime in January next year, assuming; that an agreement is reached.
Apparently, I gather, that the 1978 trade statistics will come in
roughly at the same time, which probably will show another horrendous trade deficit. For example, it is estimated that the Japanese deficit
will increase from something like $9 to $12 billion.
In any event this is not going to be a very favorable climate in whirh
to talk about trade liberalization. I wonder what you think we might
seek from the Japanese or from anybody else so far as that is concerned, in the sh<;>rt run, to try to improve these figures.
Is there anything that can be done?
Mr. CLINE. Senator Roth, I believe that the trade negotiations are
not really the solution to our trade deficit problem. While I think it
is true that the Japanese can make additional concessions and that
there might be some possibility for agricultural concessions, although,
that is terribly difficult politically, the answers to our problems on
trade deficit lie in other areas. They lie in the areas of our exchange
rate and our competitiveness, the growth rates in Europe and Japan
compared with our growth rate; and in dealing with our energy
problem.
I agree that it is unfortunate that the time at which the U.S. Congress will be considering- these negotiations happens to be the time
when we have a large trade deficit.
Senator RoTH. Let me pinpoint it a little more.
I am not talking about the long-range solutions.
Mr. CLINE. Right.
Senator RoTH. I would like to get to those in a minute, but let
me just quote what Lloyd Bentsen, the Senator from Texas, said publicly when we had this meeting a week or so ago, when Ushiba was here
and all the chief negotiators were here.


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He said very bluntly that if there is a great increase in the trade
imbalance between Japan and ourselves, come January tha~ there are
going to be efforts made to close off our markets. He said, "I will
be there to lead it."
So what I am saying, what is strictly within the boundaries of
the current negotiations or without the negotiations in Geneva, is
there anything that can be done? I think that Senator Bentsen very
accurately reflects the mood of Congress.
Mr. CLINE. My impression, sir, is that the problem here is tha.t it
takes time for the exchange rate movement to have an effect on trade.
We have seen a very massive change in the exchange rates of the yen
and the dollar and it may take 1 or 2 years for that change to make
itself felt on the Japanese trade balance surplus.
And I guess what I am talking about is that it will require a great
deal of statesmanship on our part to realize that we are making-Senator RoTH. Well, I hear you, but there are many people that
think that the Japanese in particular should take some specific steps
to improve the situation.
I am a great admirer of the Japanese, it is an amazing story of
economic success. At the same time we are, of course, told from time
to time when it comes to agricultural products that they cannot buy
them because of the political situation.
Now that is not a question of statesmanship. I think the fact is
that the problem many people here are having is access to their
markets and other markets. The Europeans don't want to talk about
that.
I think the problem is the American Congress is always told to
be statesmen in this area and the long-range situation will work
~tself out.
What I am saying is that come January when these agreementsas you may or may not know, I support, one of the first to support
these negotiations-but the fact is that if there is a serious deterioration in this impasse, I think it is going to raise serious questions as
to whether the agreements will be ratified.
What I am suggesting is that as far as the Japanese are concerned,
it seems to me that they have to take a pretty tough look at their own
practices and, as I have told them, it is no harder for them to go to
their farmers-and I understand their political situation-but it is
difficult for our Members of Congress, who are facing reelection,
and also the Senators, to go back and talk to their constituents who
see the steelmills closing down, or whatever it may be.
So I for one think the Japanese and the others have to look at
the short-range as well as the long-range corrections that can be
made.
It has also concerned me that in the Tokyo round we have in no
way dealt with border taxes, so-called rebate of indirect taxes. I was
over in Europe recently and discussed this with some of those in
the EEC.
What kind of an advantage do you regard this to our European
competitors? Is there any way of measuring it?
Some people have tried to suggest that one way out of the dilemma
is to agree that we will discuss it after the close of these negotiations,
but that doesn't seem to me to leave us much bargaining leverage.


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If you say that it is of no concern, then why is it the Europeans
won't even discuss it? Or why won't they agree that our taxes be
treated similarly? I wonder what comments each of you gentlemen
would care to make on that.
Mr. STERN. Well, if I can make a brief comment, I think that border
taxes do not confer any distinct advantages on European exporters,
mainly because they are part of a method of taxation which tries to
tax products at the source of consumption and exempts them if they
are exported. So from that standpoint, unless the border tax is changed
specifically with the end in mind of stimulating exports or reducing
imports, it is not going to confer any unusual benefits to Europeans.
As far as the American corporate income tax is concerned, I don't
think that it confers any particular disadvantages on American producers. From all of the studies that have been made, it doesn't seem to
be the case that the corporate income tax is passed on in the form of
higher prices.
So my own view is that it is really a nonissue, and I think I would
side in this respect with the European position. There are other more
important questions that should be addressed like agriculture and various other things. Border taxes are not really very important.
Senator RCYrH. Does anyone disagree with that?
Mr. RICHARDSON. I won't disagree, Senator Roth, but I might add a
couple of other things. Were you to change the border tax treatment,
you would have exchange rate effects that would offset those changes
to some extent and, hence, they would not have nearly the effect on
trade that you were expecting.
Second, I think the European objection to changing the status quo
is that the status quo is sanctioned by the GATT right now. From a
political standpoint the Europeans are not interested in leaving border
tax adjustments to the side even if they were useless for stimulating
trade, because they would like politically to get some kind of conces.-.
sions from us in return for their removing them.
Senator RoTH. Basically they have refused to even discuss them
and I would just point out-and I am no economist- but like on so
many of these issues, there are differing points of view. In the davs of
President Johnson's administration a determined effort was made at
that time to modify. They took a position directly opposite.
In any event, I think maybe the latter point you make has some
merit. They may want something to offset. It is interesting to me they
would not even discuss it.
If what you are saying is that essentially it is awash, it seems
strange to me that they have been so adamant in this area. I must
confess that in this round our instruction was that this was to be a
matter of negotiation.
Th~re _had been some suggestions that instead of having these major
negotiations every 10 or 15 years, maybe we ought to move to some
sort of more permanent means of having ongoing discussions and negotiations, especially with respect to nontariff barriers.
J:Iow much progress is going to be made in the current round remams to be seen, but even if one were optimistic, I would guesstimate
that we are just going to touch the top of the iceberg.
Do rou think _there_ oug1it to be some continuing type of negotiating
authority, especially m the area of NTB or economic affairs?


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Mr. CLINE. I think it makes a lot of sense to establish that kind of
an authority, partly because we have brought tariffs down in the Kennedy round and, if we are successful, in this round, to much lower
levels. Therefqre, we have pretty much exhausted the pote:ntial of the
traditional type of trade negotiations, where representatives get together, maJr.e tariff offers, reach a final conclusion and then go horn~.
That type of negotiation is really not so relevant for our future in this
area. It seems to me what will be more relevant is an evolutionary
process of trying to apply in practice the necessarily vague codes on
nontariff barriers which are likely to come out of the negotiations, and
trying to improve those codes as we see e::mctly what our experience is.
In order to have the flexibility to do that, it seems to me that it
does make a lot of sense to move to a mode of negotiation which has
some provision for ongoing consultation and revision in the codes.
Senator RoTH. Anyone else~
Mr. STERN. The only point that I would add to what Bill Cline said
is i:f it were followed through, I think it would change the nature of'
the trade legislation that we have typically followed under the periodic
renewal of the negotiating authority that the administration has had.
So i:f some permanent type arrangements were set up, I think that
that would, in turn, require that the Congress change the nature of the
authority so that it would not have to be renewed periodically every
few years.
Senator RoTH. Well, I don't think Congress would delegate that
authority, nor do I think it should, if I ma.y say so. I think it is an
area where we have speeial responsibility, but I think th{',re is some
merit if we are really going to move ahead in a meaningful way on the
nontariff barrier area.
Congressman Long, I will close with this. I was in Germany recently
and as you probably know. the vast majority of trade policy is implemented in the Economic Ministrv under Count Lanzdorff.
We have MITT in Japan. Here we;have a special trade representative
conducting negotiations, which is more or less a temporarv office. "'\Ve·
have the Treasury responsible for protection as well as ITC. We have·
promotion in Commerce, statistics done by ITC and Commerce, probably a couple dozen agencies are involved in this.
I have propoSf'xl that we combine manv of these :functions in ,a new·
Department o:f International Trade. I don't know whether any of you
are :familiar with this legislation.
if you are or would care to comment generally, I would appreciate
your comments.
Mr. CLINE. One of the things I ,always wonder about in terms of"
structural organizations is how one gets away from two things. The
first is the continuing basic power of some of the traditionally strongeconomic agencies, suc:h as the Treasury Department.
The same kind o:f question comes up, :for ex,ample, in foreign aid.
We have had the Humphrey bill which would restructure fore,ign aid,
and some people would propose to have a totally separate department
for foreign aid.
The same consideration arises. On the major economic issues, it is
very difficult to get away from the ongoing power that resides in thekey agencies. That is the first point.


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The second point is that personalities invariably affect the relative
bargaining strength of the different agencies. For this reason, i:elative
strength shifts from 1 year to the next. So my reaction is to wonder
whether one really can change the locus of economic policymaking
power on international trade.
Now we have tried coordinating committees before, in the Council
on International Economic Policy that has now been abolished.
I am just not convinced that creating a separate department would
change things that much. One wonders whether the new department
could have the kind of clout that would really be needed to make the
final decisions.
·
Senator RoTH. Well, just a comment. One, of course general monetary
policy and economic policy we would not attempt to take away from
the State Department or Treasury Department. But one of my concerns is that this country-I think both in the Government as well as
in business itself-has not been export oriented. There has been no real
effort to promote the export of American-manufactured products
a.broad.
American industry, generally speaking, if they have some surplus
that they cannot sell in the American market, may seek a market outside. But in contrast, the Japanese and the Europeans develop products
for the American market.
I think we are going to see in the years ahead a large market
developing.
Representative BROWN of Ohio. Is that wishful thinking or-Senator RoTH. Not for us necessarily, but I think you see in Southeast Asia around the rim of Asia new markets developing there.
Representative BROWN of Ohio. The markets are there, but are you
suggesting we will get in them i
Senator ROTR. The point is that I think the future growth and development will be in much of the underdeveloped world and that we
ought to put ourselves in the posture where we can better export
American-made products to those markets, more so than we have in the
past.
I don't care where you go. I am sure you will agree with this, that
you see the Japanese as well as ,MITI very much involved. They are
looking down the road 10 or 15 years as to what Japan is going to sell.
We don't have any of that here. I think we could change; both
American business and American Government have to change their
attitude about sales abroad. We have to become more aggressive in
seeking the sale of American-made products abroad. That is one thing,
I think that kind of legislation might help.
Representative BROWN of Ohio. Can I comment on your comment?
Senator RoTH. Sure.
Representative BROWN of Ohio. Only this: Those markets on the
periphery of the Pacific in Asia and South America have been expanding for the last several years and the Japanese are in them and we
are not.
Senator ROTH. That is exactly what I am saying.
Representative BROWN of Ohio. Yes; but I don't see any reason~
in our current policies, to hope that we are going to get in them any
more aggressively than we have because, first, ·we have to be com-


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petitive and we are not at this point in that competitive frame of
reference. Unless we make some changes in our own society, we are
not going to be in those markets.
W"ould you agree or disagree 1
Mr. STERN. I would agree. But I am not sure that restructuring
in itself would cause any significant change whereby American manufactures would compete more effectively. The markets are there, they
.ttre changing and expanding all the time.
The Germans, Japanese, and others simply do a much better job
than many of the American companies are doing. So it is a question

t>t~

Representative BROWN of Ohio. The key question is why 1 I think
that is what Senator Roth is getting at. They have an aggressive
national and entrepreneurial policy for that expansion and we apparently do not. We say we do, but really we don't.
Mr. STERN. I think the Japanese and Germans and other companies
involved essentially specialize in production for export. It has been
a longstanding tmdition, especially in the Japanese economy, to produce for the export market and to tailor your products and your
marketing to the markets in question.
American companies have, by contrast, mostly concerned themselves with selling at home and it has taken them a great deal of time,
it seems to me, to develop methods and techniques that will allow them
to compete effectively overseas.
Representative BROWN of Ohio. To pursue his point, how do we
build on that great base of home market which we have-the wealthiest
economy in the world-how do we use that to our advantage to expand
our foreign trade 1 It seems to me that the Japanese and Germans
·
have gone somewhat in the other direction.
They have always started out enhancing their domestic wealth
with their foreign trade, and as •a result now they are doing well
relatively in terms of their living standards, real wages and so forthbetter than we.
How do we enhance our ability to build on that domestic base and
go from there~
Mr. STERN. Well, that is a difficult question to answer.
Representative BROWN of Ohio. That is what the whole hearing is
about, isn't it 1
Mr. STERN. Well, it has been about other things, too. The reason
it is difficult to answer is that the kinds of issues you are raising are
ones that are built into the profit incentives that different companies
face. Maybe what we are saying is that American producers are not
responding as effectively to these incentives as producers overseas.
Representative BROWN of Ohio. Part of our problem may be domestic. Is that what you aresayingi
Mr. STERN. Part of our proolem may be that.
Representative BROWN of Ohio. Our own taxing system, our own
incentives, our-Mr. STERN. I would say there are really more incentives at the
company level in many cases rather than things that are being carried
out in terms of Government policies.


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Representative BROWN of Ohio. It _certainly isn't because we are
isolationist as a philosophy. We have not been that since the beginning
of World War II. The Japanese jolted us into World War II.
So we are not isolationists as a matter of national proclivity, it
would seem to me, what with the great foreign a:id systems we have put
together. It must be something about our domestic approaches that
are different from the Japanese and Germans that don't provide the
incentive or perhaps, more precisely, provide disincentives for us to
get into those fields.
For instance, the German savings rate is three times ours. Does that
have any impact on our foreign trade?
Mr. STERN. If you use the savings rate as it affects the production
rate in Germany in terms of increasing their competitiveness, that
would certainly add to it.
But I don't think that American companies, to the extent that these
opportunities exist, are always necessarily taking the greatest advantage of them.
Representative BROWN of Ohio. I guess my question was down to
a psychological question in a way. Are we right to be paranoid about
all of the trade disadvantages that we suspect are built into our international competitors' systems, subsidization of their industry, restrictions against our products, so forth and so on?
vVe tend to be paranoid about that because we are a big economy
and we think that they are doing something to keep us out. Is that
true?
Or is it something we should be looking to; should we look more to
ourselves and the problems with our system that have seen us grow
increasingly noncompetitive?
Do you understand my question?
Mr. STERN. Yes.
Representative BROWN of Ohio. All right.
Mr. STERN. Maybe I should quit talking.
Representative BROWN of Ohio. Anybody can play. I would be glad
to get Mr. Richardson's ideas and Mr. Cline's.
Mr. RICHARDSON. I am somewhat puzzled with the vehemence with
which you state your case.
Representative BROWN of Ohio. That is just the way I talk.
[Laughter.] It isn't a case. I am asking the questions.
Mr. RICHARDSON. My impression has been that American exporters
never turned down a good opportunity and that we are no more reluctant to export than other countries are, and that the cases you cite
are not always cases where the Government has a strong role in exporting. Japan certainly, but not Germany.
Representative BROWN of Ohio. I want to translate that this way:
'\Ve never turn down a good opportunity. If somebody wants to buy
from us, we will sell. But I am under the impression that the great
businesses in this country went out and hustled. I come from an
area where National Cash Register, for instance, was founded on
salesmanship. We went out and hustled, really sold our products and
made a better mousetrap and then we wou1d beat the path to the
world's door and shove the mousetrap down their throats.


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Mr. RICHARDSON. As an economist I believe that o~r compani~s,
NCR among them, have beaten a path to other people s doors qmte
dramatically in the 20th century; have we not 1
.
Representative BROWN of Ohio. Yet with these problems, and mvestors in NCR today would agree, has there not been some subtle
change in the status of NCR in the world in the last few years 1
Do you understand what I am saying~
Mr. RICHARDSON. Uh-huh.
Representative BROWN of Ohio. I think NCR has not e~actly kept
up competitively. My question is, is that because of decay !n management of NCR or is it something that has happened withm our system in this country in the last few years that has given us not quite
the same aggressive ability that we once had 1
.Mr. RICHARDSON. I have no answer. I don't see us being any less
aggressive than we have been before. I don't see the policy that-Representative BROWN of Ohio. Let me cite you a statement made
by a significant personality in the Departmen~ of Energy the other
dav before the Science and Technology Committee as to whether or
not we. would be adversely affected if we did not go ahead and develop
a fast breeder reactor.
His comment was, if we don't do that, we can always buy one from
the French. This seems to me sort of an acceptance of second place
in that technology just as we accepted, through actions of the Congress, second place in aircraft development when we decided-to opt
against the SST and let the French and British go ahead and
develop it.
Mr. CLINE. I think there are a number of factors that are behind our
export performance in the last few years. I think we may be overstating the role or lack of effort on the part of American firms. We
have a number of other changes, in particular the fact tha,t the
<lollar was becoming somewhat overvalued in the period 1975-77.
Now we are going to have a turnaround of that and we should be
seeing the effects in our export performance over the next year or
two.
We have nationwide developments on productivitv rrrowth which
are. ~omewhat disturbing. These get built into our underlying competitiveness. They are probably more the result of macroeconomic
considerations such as the levei of our employment, and the rate of
inflation, than they are attributable to any particular competitive
effort.
We do have institutions with which we try to spur comnetitive
effort. We have the Export-Import Bank which has been active and
is probably going to be increasingly active. We have DtSC. which is
anothPr spur and, if anything, many would argue that it is an undue
incentive to exports.
,
Some people cite the change in the tax status of Americans livin~
abroad as a disadvantage to American exports: it makes it more difficult for American firms to put personnel abroad, makes it more
costly for them.
.
In addition, we ·have the whole macroeconomic situation. When
the TT$. Pconomy is buoyant and the rest of the world is more
stagnant, then it· is easier· to meet demand at home. It is simple to


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sell the goods to the domestic market, which is taking up the most
of the supply without the need to resort, therefore, to export markets.
So I think we have a number of factors that all lead to an export
performance that is not what we would like to see, but I am not sure
that the solution is somehow to try to turn around the mentality of
the American exporter and try. to make him more competitive.
I do have the impression that the case of Japan requires some
special effort. One gets the impression that the very distribution
system in Japan hinders U;S. exports, even though the distribution
system is not necessarily a protective structure. A typical pattern
seems to be that American exporters rely on low volume and high
profits, in a form of monopoly strategy, and that they do not expect
to sell too much.
They sell to a luxury market probably. These kinds of institutional
factors, I think, are perhaps important especially in Japan. But they
donot really constitute protection.
'I do not think that one can make the case very convincingly, although many people assume that it is true, that Japanese protection
is much, much higher than ours. So in short, while I am sympathetic
to concern about how hard American firms are trying to export, I do
think there are many other factors working against their exports.
Representative BROWN of Ohio. Please don't misunderstand my
comment. It isn't just t'hat. One of the factors has to be that the Japanese; even when they go on strike, they stand out in front and
sing the company song before they punch in. That is a labor factor.
That raises the question about the Germans' savings rate, which
would seem to be a factor in encouraging investment in plant modernization and therefore national productivity: If they are saving more,
certainly that encourages productivity;
We save less and maybe we don't encourage it.
Our steel industry would seem to be an example of our inability to
make timely investments to keep up with the competitive nature of
some oversea productive capacity.
Let me ask you a couple ·of specific questions. What are the prosperts
for proposed European monetary integration, and what would be
the impact of this integration of the monetary system on us, plus or
mihusi
Mr. RICHARDSON. The prospects look brighter than they did a short
while ago :for European monetary integration. The French and the
Germans have at least made some agreements to commit themselves
to such in the near future.
I think that the effects of that on us would be :negative if it were to
come about. l don't think it will. I think they are likely to be as unsuc-cessful as they have been since the first snake-in-the-tunnel agreement.
But were they to form a European monetary bloc that would be as
-strong as the deutsche mark is strong, you would have a competing
asset, a competing set of capital markets that would rival the American
-capital market as a source for world financial investment.
Representative BnowN of Ohio. Is that good news or bad news for
us~
Mr. RrnHARDSON. That is bad news for us in that we are presently
·very mi1eh the monopolistic provider of banking services to the world
35-940-78-14


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for particular kinds of assets. It is a very advantageous position to be
in. It eases our balance of payments financing problems. It allows us
to run a trade deficit of a moderate proportion. To have a competitor
in that game is something we would rather not have.
We might find that we would have to start redeeming dollars presently being held by the private holders and official holders, and we can
only redeem them in goods.
Representative BROWN of Ohio. Are there other comments?
Mr. STERN. One of the possible benefits that might come about if the
Europeans were succesful would be to help stabilize rates of domestic
inflation within Western Europe and to the extent that that puts pressure on us to follow suit, I think that it would be a desirable result of
the integration exercise.
Having said that, I would agree with Dave Richardson that the
chances of success of European monetary integration are really not
aJl that great, mainly so long as you have some countries within the
EEC that have very different rates of change in productivity and
prices and wa~es. It is going to be very difficult to get a system like
that to work effectively.
That was true in the past. I think it is going to remain true.
So from that standpoint then I am not sure what the overall outcome
would be. I think it would be unfortunate if they tried to establish an
integration program which would operate by restricting the international flow of capital. That is always one of the big dangers that Americans have viewed about European monetary integmtion.
Mr. CLINE. I think there are some aspects which might be beneficial
to us. It seems to me that we have seen in the last few years a pattern
whereby some of the lesser European countries run into balance of payments constraints and thereby have to limit their growth. Then they
are not able to pursue full employment policies.
That then, in turn, reduces their demand for our exports.
Representative BROWN of Ohio. And the exports of others?
Mr. CLINE. And the exports of others. yes.
One of the implications of the kind of thing that the French and
Germans are talking ahout is that the vast kitty of reserves that the
Germans have would be available in some way to facilitate the adjustment to balance-of-payments constraints by other countries in that
unit, and to the extent that that activitv relaxed the balance-of-payments constraint to more dynamic growth policies in the lesser European countries, it seems to me it could make some contribution to
a picking up in the general level of economic activity, which, of
course, would help deal with the problem that we have had.
One of the sources of our trade deficits is that we have had a higher
rate of growth in recent years than Europe overall, and I am also not
quite as convinced that the holding of dollar reserves by other countries a,nd its replacement bv the holding of European monetary reserves
would be all that serious a blow to us.
I think we have some evidence that the view that reserve center currency status 18 b<>neficial is not necessarily shared hy Germany and
,Japan. In fact, thev .hav:e restrictions on .foreign holdings of their
assets. So it is not clear to me that there is an enormous windfall that
we are enjoying that could then become denied to us by the develop-


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ments that Professor Richardson is suggesting, although it is obviously
one of the factors to consider.
Representative BROWN of Ohio. How much in international monetary reserves is it appropriate to hold?
Mr. CLINE. I don't think there is any agreement as to a particular
accurate level or optimal level of reserves to hold.
By practice, my impression is that most countries hold approximately 3 months' worth of imports as their international reserves, but
there is virtually no agreement on what is an optimal level of reserves
to hold.
I think one would probably get agreement that Germany and Japan
at the moment are holding above what is a desirable level from an
international standpoint, although I am sure some would disagree
with that.
Representative BROWN of Ohio. Would you like to comment, Mr.
Stern?
Mr. STERN. It is difficult to answer because exchange rates are floating, to the extent that floating of the exchange rate and the holding
of reserves are really alternatives for one another.
So, as we continue to operate under the international monetary
system in which exchange rates move, it is difficult to answer just what
the appropriate level would be unless you specify some particular
objectives, either say with respect to moderating exchange rate movements in the short run or achieving some degree of price stability.
Representative BROWN of Ohio. Yes.
Mr. RICHARDSON. The only thing I would add is that the question
ior the United States differs from that for other countries because
our reserves are lower optimally than others, since we don't intervene
nearly as much as they do in foreign exchange markets.
Representative BROWN of Ohio. They have traditionally been lower?
Mr. RICHARDSON. Yes, and-Representative BROWN of Ohio. When we have a strong currency.
Mr. RICHARDSON [continuing]. They are still lower.
Representative BROWN of Ohio. You mean now?
Mr. RICHARDSON. Even now, because our intervention is dramatically less than foreign central banks.
Even as of January 4 when President Carter adopted- his so-called
active intervention policy, the total intervention was about $1 billion in the first 3-month period, and :foreign central banks intervened
15 times as much as we did in that same period of time.
Representative BROWN of Ohio. But our intervention has been less
and, presumably since the dollar has sunk in value, not as
impressive?
Mr. RICHARDSON. It is dollar £or dollar; you bid up the rate about
the same as you ever did.
Representative BROWN of Ohio. A dollar is a dollar is a dollar i
Mr. RICHARDSON. Well-Representative BROWN of Ohio. Except that yesterday's dollar is
stronger than today's i
Mr. RICHARDSON. Yes, that is quite right, but the impact of selling a
dollar on the foreign exchange market has the same impact yesterday
as today.


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Representative BROWN 0£ Ohio. Except that the dollar is worth less~Mr. RICHARDSON. Yes.
Representative BROWN of Ohio. Mr. Stern, you said that slackness
in the U.S. economy as a whole, or ineffectual management, may be
the primary or root cause of the difficulties that have been experienced
in certain industries.
If this is a correct interpretation, it suggests that the appropriate
remedies are domestic rather than international.
I want to ask you: If we want to improve our competitive posture,
don't we have to lower the cost to U.S. production by cutting taxes
on U.S. labor and capital in order to be more competitive?
Mr. STERN. I had in mind, when I made that statement, a whole host
of different kinds of policies, domestic in character, that might be appropriate to deal with the kind of situation that you mention.
For example, one of these policies might be with respect to the iron
and steel industry to perhaps develop some kinds of programs for
investment tax credit or similar sorts of policies that would in £act
make it more profitable for the industry to expand.
Representative BROWN of Ohio. Let me ask you: If £or one industry
over another, why not for all industries?
For instance, we could say that all industries can have a proper and
accurate depreciation rate based on replacement cost rather than original purchase cost. Therefore, wouldn't an industry that tmns more
sw~ftly have an advantage ove,r a.n industry which does not turn as
qmckly?
Mr. STERN. The remark in my statement was made with particular
industries in mind but I would agree most definitely with you that as
far as policy is concemed, it would be desirable to apply it across
industry in the sense tha.t if· we are concerned-as I think we should
be-with trying to increase rates of investment with the end in mind
of improving productivity and, therefore, competitiveness policies like
this would indeed be desirable across industries.
Representative BROWN of Ohio. So, you would have competitiveness
across industries, perhaps the plastics industry mtight replace some
steel capacity and we could use that; or aluminum could replace steel,
or steel replacing sometJhing else?
Mr. STERN. Yes.
Representative BROWN 0£ Ohio. I assume we would all agree that in
the next 10 years the developing nations or underdeveloped nations
will have advantages in the raw materials sector since they have the
raw materials that have not been brought out and it is likely that they
will need.to be brought out in the years ahead; but, in whichindustries
do you thing European countries wil1 have an advantage in production over the next decade and in which industries will the United
States have an advantage?
I don't ask this for my stockbroker, but rather from the standpoint
of whether there are industries that should, in spite of our conversation, Mr. Stern, need special attention.
Mr. RICHARDSON. The natural candidates for special attention are
the ones that would be impacted by developing country manufacturers,
asyousay.


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I can't think of any particular trend m European versus U.S.
competition-Representative BROWN of Ohio. Japanese versus the United States?
We have had a shift of several of our industries to Japanese production. Televiision and electronic items, for example.
Mr. RrCIL,'\.RI>SON.. That should continue. The general prediction that
I would make is that the new technology industries will still be shared
between the United States and. Germany and Japnn in roughly the
proportion that they have been. But as the technologies become more
and more standardized, the location .of production wdl flow more and
more .to European countries----not necessarily Germany and Japan,
however.
Changes in exchange rates and in unit la.bor costs have made those
countries not nearly as advantageous for developing standarized new
technologies as they used to be.
I think instead you may see movements toward other European
countries, Mediterranean-European countries, especially if Greece becomes a member of the European community and if Spain and Portugal come to ·be well on their way to that.
Representative BROWN of Ohio. \Vould you give me a broader
picture on. that?
· Mr. RICHARDSON. A broader picture, I thought I was giving you as
broad-Representative BROWN of Ohio. Weill, Greece will capture the baklava market, I suppose. What would the Greeks get into, laborintensive industries?
Mr. RICHARDSON. Yes. With some modicum of skills required, since
educational systems are more developed there than they are in many
developing countries.
You will see pressure I presume on many things such as we have
seen in the recent past, calculators, consumer electronics equipment,
standardized high technology.
Representative BROWN of Ohio. Where the teehnology levels off?
Mr. RICHARDSON; Exactly, where the technology levels off.
Representative· BROWN of Ohio: What about agricultural products?
Is that what we have left, then, in the United States~
Mr. RICHARDSON. No. We have new technology products. We have
heavy machinery-Representative BROWN of Ohio. Would you like to name a couple of
them?
Mr. RICHARDSON. Name a couple.
Representative BROWN of Ohio. Name a couple of the new technology areas in which we are apparently taking the lead. I have difficulty with that.
Mr. RICHARDSON. Armaments, undersea exploration of mineral beds.
Representative BROWN ofOhio. As I understand it, our effort in the
mineral bed development area is in cooperation with the Japanese.
I am not sure whose technology it is. It will obviously be both
countries' technology.
Mr. RICHARDSON. But as I understand it, we have virtually the only
independent technology for exploration of mineral beds. That is to


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say, we don't need to cooperate with anybody. Everybody else needs:
to cooperate witJ1 somebody; namely, us.
Representative BROWN of Ohio. All right.
Mr. RICHARDSON. We will still have advanta,ges that are quite clearin production of trtnspottation equipment, airers.~, locomotives; heavy
duty· construction machines; no way are we going to lose that as far
as I can see.
Those, plus agriculture and chemicals.
We have a very large positive balance there. We are developing new
chemicals and pha:rnn'ltCeutiools all the time. That is dramatic evidence.
Representative BROWN of Ohio. So, our success proba:bly lies in thetechnology areas is it has for some time?
Mr. RICHARDSON. And in agriculture and in large-scale operations,.
economy-of-scale intensive type capital equipment.
Representative BROWN of Ohio. The Japanese are putting up a
plant to build Honda motorcycles in my district and will move into·
the manufacture of Honda automobiles there.
The Germans just built a new plant in New Stanton, to build
Volkswagens in this country. What 1s the significance of that?
Isn't the answer to that that it is cheaper to build closer to themarket with American labor now than it was a few years ago when
it was cheaper to build with German and Japanese labor and then
ship it in?
Mr. RICHARDSON. Briefly, the answer is yes, and that is a matter·
of exchange rates and labor costs.
Representative BROWN of Ohio. What does it say about American
labor costs?
Mr. RICHARDSON. That they have declined relative to German and·
Japanese labor costs.
Representative BROWN of Ohio. So, labor-intensive items are likely
to--

Mr. RICHARDSON. Certain labor-intensive manufactures that requin~·
this modicum of skills, such as motorcycles, are likely to, I would
think, do rather well in this countrv, but in foreign-owned plants.
Representative BROWN of Ohio. That puts us in the same category
with the Spaniards and the Italians.
Mr. RICHARDSON. To some extent.
Representative BROWN of Ohio. Mr. Cline.
Mr. CLIN~. I think I woulil agree with the kinds of sectors that
Professor Richardson has indicated, technology and agriculture.
I think some of the foreign investment we have seen come in herein addition to reflecting changes in exchange ra,tes and Jabor costs
probably is also sensing the political vulnerability of continuing to
rely on ·exports to a market in which there are more and more compl11.intR about import penetration.
I think the ,Japanese firm has a certain incentive to invest in the
United States rather than producing in ,fapan now because there has
been so much talk about the possible nePd to simnly screPn out ,Japanese imports if the Japanese trade surplus doesn't come down.
Representative BROWN of Ohio. "Buv American. ride a Honda."
Mr. CLINE. Maybe it would be a good slogan for them. [Laughter.]


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Mr. STERN. You have to stress in that respect, it seems to me, the
increased employment opportunities that the Japanese investment
brings with it.
I think that that would be important in the district that you are
representing and elsewhere where these foreign multinationals are
investingin. the United States.
That seems to be one of the most beneficial aspects of these kinds
of activities.
Representative BROWN of Ohio. OK.
Mr. STERN. So, the goods don't have to be produced necessarily by
American-owned companies.
Reprsentative BROWN of Ohio. Well, does it follow, then, that
we should encourage investment by our rich friends in Germany and
Japan if our Nation needs further development i
Mr. STERN, It is not a question of giving them explicit encouragement apart from the encouragement that they have gained from the
fact that their currencies have appreciated very significantly with
respect to the dollar, and the differences in relative labor cost that
Dave Richardson stressed.
I don't think indeed they need more encouragement than that.
A further point would be that there is no reason to discourage
them in terms of the impacts that this would have both on employment and on the balance of payments, and the exchange rate.
Representative BROWN of Ohio. We should feel good about them
investing in our country because they are providing employment in
our country where our system is not quite absorbing the full need for.
How would you feel about them investing in nonlabor-intensive production such as agricultural land i
Mr. STERN. Well, that wouldn't necessarily concern me. The main
areas that I would have more concern about would be if, say, they
were to invest in things like armaments or related types of industries
that involve security considerations.
Apart from that, I don't think, necessarily, that there would be
any reason to be concerned about investments in agricultural land
or other similar sorts of things.
Representative BROWN of Ohio. If there is a pecking order in this
international investment, what should it he i
In other words, if it is nice for the Germans and the Japanese with
stronger currencies than we to invest in this country because it helpsour employment and we profit from this kind of thing and if we are
able to reinvent the motorcycle, then seize the market back, where·
should we be investing i
Where should the United 'States be investing its capital-what kind
of countries~ In the lesser developed countries i
Mr. CLINE. I think that's the logical place for our investment to•
flow. The large U.S. investment in Europe in the 1950's and late
1960's had much to do with the temporary phenomenon of the formation of the European Common Market and the desire to get behind
a common market tariff wall.
Historically, our investments have been heavily in Latin Americat
in particular--


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Representative BROWN of Ohio. So they could buy German and'
Japanese goods i .
Mr. CLINE. No. For example, the investment in Brazil in the automobile industry means they are purchasing automobiles that are
made in Brazil by U.S. subsidiaries.
It doesn't mean 'they are purchasing German and ,Japanese goods,
but I think the broad picture still remains true that the United States
is abundant in capital, and the developing countries have very little
capital so that extra capital going to developing countries is very
productive.
Representative BROWN of Ohio. We get a better return.
Mr. CLINE. It makes sense.
.Representative BROWN of Ohio. I£ we invest in the developing·
countries.
Mr. CLINE. That is right.
Representative BROWN of Ohio. Should we try to undertake anything that would give us a better return then, if we invested it in the
United States and shipprd the stuff nhroad ~
Mr. CLINE. Well, the question of whether investing in the United
States-instead of investing abroad-and shipping it abroad, whether
that makes much difference on employment-which is where this is
usually politically sensitive--'-it is my understanding that there is a
very mixed picture on that and orn~ cannot make a very strong case that
we are eliminating American jobs by investing abroad.
There are a number of £actors that are involved such as the fact that
once an American firm puts in a subsidiary abroad it sends exports tothe subsidiary in order to provide materials, parts, and equipment: and,
the studies done by a number of people, including a recent study by
Bergsten, Horst, and Moran at Brookings, raise serious doubts about
whether we are losing American jobs because of the activities of investment abroad.
So, in that sense, I don't think one would want to assert that it is preferable to try to keep American investment at home and to keep it from
going where the return is higher.
Representative BROWN of Ohio. Let me conclude with this question.
I have kept you after lunch, and I appreciate your patience.
The thought that I come to is that an investment ought to be made in
the most productive area of return, although that return is not always
a percentage on the dollar, it is sometimes to get the thing that you need
most.
Now, therefore, our dollars ought to be invested in areas~in technologies perhaps such as undersea development-where we will get a
return or that will give us something we need snch as raw materials that
we may be lacking but are fundamental to other production that tends
to defend our other production advantages. Or we could invest in areas
where the labor advantages of efficiency are greater, as isthe case now
with the Germans and the ,Japanese investing here because the transportation costs and labor costs and potential· for tariff protectionism
measures on our part argues :for the Germans and the Japanese to
manufacture here.
Now, does that summarize a sound investment policy for us and :for
foreign countries or :foreign nationals in the United States?
Mr. 9LINE. I think it does, if it is interpreted in the following way:
I£ one mterprets that the normal market signals should lead to the cor-


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rect investment decisions because if in fact it is more important for us
then we will be prepared to pay a higher price for the product in question and the return will be higher.
The one exception, I think, is natural resources in developing countries. It seems to me we have a situation where the political risks to
investment in the natural resources area in developing countries has
escalated so much that firms are no longer prepared to invest in
natural resources such as copper mines.
Representative BROWN of Ohio. Such as in Zaire.
Mr. CLINE. Yes; and in general, because of the greater degree of
risk.
So, many people are saying this is leading to a global inefficiency
because we are putting too much resources into mineral deposits
that have lower quality at home, and in other industrial countries,
rather than in some of the developing countries.
There may be a need for policy action in this area, for some new
forms of multilateral action or codes of agreed conduct on direct investment that would make it possible to reduce that political risk
and to once again make the rate of return and the natural efficiency
of the deposits be what direct the investment.
Other than that, it seems to me that basically the market signals
give the solution one is seeking.
Representative BROWN of Ohio.. Sort of enlightened colonialism to
assure the source. Colonialism is a bad word. I shouldn't have used it.
An enlightened international policy to assure the source of our supply
of raw materials.
Mr. CLINE. That is right.
Representative BROWN of Ohio. Any other comments?
Mr. STERN. No.
Mr. RICHARDSON.No.
Representative BROWN of Ohio. It is lunchtime. I have been asked
by the chairman if you would respond to written questions, please,
at your earliest convenience.
Our staff-always frustrated-likes to ask questions of you.
[Laughter.]
We appreciate your being here and the contribution that you have
made to this rather extended period of hearings on international
economics.
Thank you. The committee will stand in recess.
[Whereupon, at 12 :50 p.m., the committee recessed, to reconvene at
10 a.m., Tuesday, July 18, 1978.]
[The following written questions and answers were subsequently
supplied for the record:]
RESPONSE OF WILLIAM:

R.

CLINE TO ADDITIONAL WRITTEl'r QUESTIONS POSED
REPRESENTATIVE BOLLING

BT

Question 1. In your testimony, you expressed concern about the forthcoming
expiration of Presidential authority to waive application of the countervailing
duty statute to the imports of developing countries. In what form would you
favor extending the President's authority? Can you suggest any standards for
when and how rapidly a developing country should begin to phase out its export
incentives?
Answer. The economic case for export subsides by developing countrie11 rests
upon the concept that in their economies the disincentives to exporting are so
severe that compensating incentives are required in order to provide the correct economic signals to exporters. The disincentives to exports result from


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measures such as tariffs and quotas on imports, prior deposits of local currency
for import purchases, import licenses, and so forth. These restrictions on imports cause an unduly high incentive to produce for the protected domestic
market instead of for export. As a result, at the private market exchange rate,
the incentive to the firm to export is far lower than the real economic benefit
to the economy that can be obtained from each dollar of extra export earnings.
In these circumstances, permitting developing countries to subsidize their exports
represents granting them permission simply to get back to a neutral, fair price
for exporters; it does not constitute a license for them to engage in unfair trade.
Economists are divided on whether some degree of protection is good for devel-0pment; some maintain that the only good tariff is none at all, while "structuralists" support import protection for countries to develop their "infant industries."
Most economists would ,agree, however, that so long as protection exists, it
improves economic efficiency and growth to offset that protection by export
incentives such as subsidies.
As to how long developing countries should be given to phase out export subsidies, it is useful to recall that even Europe and Japan had many of these same
features of high protection and outright control on imports and foreign ex-change as recently as to the late 1950's. For that matter, the United States itself
adopted high protection of manufactures in its historical development, rather
than merely import manufactures from England and export raw materials, and
American tariffs remained extremely high from the Great Depression into the
early postwar period. As a matter of international equity, then, it hardly seems
fair to insist that the poor countries dismantle their protection immediately
when the rich countries only gave up their protection in recent decades (and
maintain it even now in some sectors).
I would like to set forth, then, the outlines of what I believe to be appropriate
legi~lative authority in this area.
(1) For all countries considered to be "developing" (as judged, for example.
by their eligibility for loans from the World Bank group), the President would
-retain the authority to waive countervailing duties for a period of ten years.
{Ideally the Least Developed Countries and the Most Seriously Affected Countries,
as df'fined by the United Nations, would ,be giv,en a gra'ce period of twenty years.
For legislative purposes, however, it may be more practical to state a period of
ten years for all countries, and to redraft the legislation as needed at the end
of this period.)
(2) In addition to complete waiver authority, legislation should grant the
President authority to apply countervailing duties in amounts required to offset
1mh' that portion of the total subsidy that exceeds the degree of subsidy which
is deemed by the Secretary of Treasury to be necessary in order for the country
1n question to offset its existing disincentives to exports. For administrative
purposes, an appropriate measure of the degree of subsidy permissible before
countervailing on the excess would he the average level of tariffs and tariff
equfralents of non-tariff barriers in the country in question. For example, a
,country with an average tariff level (including the tariff equivalent of nontariff barriers) of 30 percent would be allowed to grant up to 30 percent subsidies, but would be countervailed against on the excess of subsidies above the
.!0 percent level.
Because it could be difficult to determine for legal purposes the average level
of protection in the country. it would be important to retain full waiver authority (item 1 above) in addition to specifying the alternatives of partial countervailing (this item).
<3) The legislation could provide that the authority under items (1) and (2)
would not apply to products for which the International Trade Commission had
made a dPtermination of the existence of "serious injury" as defined in Section
201 of the Trade Act of 1974.
Q1ie-~tion 2. A number of authorities have suggested the use of tax and other
incentives to hoo~t U.S. Pxports. ·what incentives would best serve this purpose
in a world of floating ex<'lrnnge rates?
Answer. I would not recommend the adoption of tax or other special incentives
for U.S. exports. The major decline in the dollar over the past several months
should provide sufficient incentive for correction of the large trade balance deficit that arose in 1977 and 1978. Because it takes 18 months or longer for exchan.g-e rate changes to affect trade, what is required now is patience and steady
nerves until the results of the dollar depreciation materialize.


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High oil imports, high U.S. growth compared to that abroad, and slow U.S.
productivity growth are all factors contributing to the trade deficit. The best
incentives to exports would be tndirect-those resulting from improved action on
€nergy, faster growth abroad, reduced domestic inflation, a return to more normal
productivity growth.
Because special tax incentives, financing subsidies, and so forth would act to
reduce the price of American exports, they would do nothing more ( and probably
less) than the more direct way of reducing our export prices-depreciation of
the dollar. Therefore such special incentives in all likelihood would provide no
faster remedy than the dollar depreciations that have already occurred.
I hope that these replies will be of use to the Committee in its Midyear Review
of the Economy. Once again I would like to thank you and the Committee for the
invitation to participate in the Review.

RESPONSE OF

J.

DAVID RICHARDSON TO ADDITIONAL WRITTEN QUESTIONS POSED
BY REPRESENTATIVE BOLLING

Question 1. In your testimony, you noted that many developing countries do not
feel that the gains from trade are fairly distributed. As a re1mlt, you predicted
an increasing politicization of trade relations with the third world. What is your
independent evaluation of the merits of their case? Do you expect the emergence
of several manufacturing ,powers among the developing bloc to split their ranks
or otherwise change the tenor of their demands?
Answer. I think that the case of the developing countries is well-taken from
the perspective of their own economic self-interest, and poorly taken from the
perspective of our own. But I also believe that developing countries overstate
their potential gains from politicizing trade relations. First, they seem to give
insufficient value to the economic losses from open and disguised hostility
to the North's liberal economic order-losses they bear primarily in the form
of reduced access to Northern technology, management expertise, and financial
capital as Northern providers of these resources are "scared off." Second, perhaps because they have had so little experience with market organization of
economic activity, they undervalue their own losses from the global dulling of
economic ambition and productive incentives that politicization would bring.
Third, I believe that they understate the extra administrative resource costs
that are imposed on all societies when political bureaucracies replace or overrule corporate bureaucracies. Fourth, I believe that they would be surprised and
disappointed to find themselves as much as ever on the "short end". of the modified power relationships, involuntary action, and dependence that the new international economic order would create.
As to whether the emergence of several manufacturing powers among the developing bloc will split their ranks, I think not significantly. It seems to me
that the analogy to the American labor movement is again useful: the issues of
disagreement between the most-developed and least-developed developing countries are comparable to the issues of disagreement between trade unions of
more-skilled and less-skilled workers. The one "splits the ranks" of the developing countries about as much (or as little) as the other "splits the ranks" of
the labor movement Moreover, I think that conflicts among developing countries
may be alleviated in the near future by cooperative horse-trading among
themselves, aided by considerable attention to the problems of the least-developed developing countries by international organizations such as the International Monetary Fund, World Bank, and United Nations. (Even the European
Community has recently altered its Generalr2led System of Preferences to be most
preferential toward the least-developed developing countries.)
Question 2. A number of trade specialists have argued that many of our competitors accepted a lower profit in the United States in order to sell their excess
production. In their v,iew, the practice was partially responsible for our record
trade deficit. Would you agree with their opinions? If so, why was the practice
unaffected by our anti-dumping statutes?
Answer. I don't disagree with one interpretation of their opinions as you
have stated them. But neither do I find this a convincingly large quantitative
influence on our trade balance under any interpretation. I am will1ng to grant
the frequently-cited heresay that foreign producers accept a lower rate of profit


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in. the U.S. market than elsewhere. That is exactly what I would expect from
American markets coming closer on average to the economist's competitive norrµ
than any in the world. But I doubt very much if foreign producers regularly or
continually accept a lower rate of profit than tbe1r U.S. competitors, and I have
seen no claims (much less evidence) to suggest this second interpretation of
'.'lower profit." Even if it were true currently I believe it would be a temporary
and. abnormal consequence of today's considerable .(positive) difference between capacity utilization rates in this country and elsewhere. And even if it
were true, and widespread among all our import suppliers, how large an ereect
could it have? I wouldn't think that different profit margins could possibly make
more than a one or two percent difference in rela-tive prices under pegged exchange rates. And under varia·ble exchange rates, even most of that small difference would be offset in time by a correspondingly lower value of the dollar
in foreign exchange markets.
,vhether allegation or fact, if foreign producers do accept lower rates of profit
in the U.S. market than their American counterparts or than they do elsewhere,
that practice does not constitute dumping, as U.S. law presently defines it. That
is why the practice was or would be indeed "unaffected by our anti-dumping
statutes," as you say in your question. I might add incidentally that I would
blanch at the thought of rewriting U.S. law to make such practices illegal. It
would be economically unnecessary because it would have as insignificant an
economic impact as the practices themselves. But the political fallout would be
alarming. Such a re-definition of dumping would be an inflamatory new non-tarift'
barrier to trade, unilaterally imposed, that would set us rather acrimoniously
at odds with our trading partners, largely because it would be inconsistent with
the mutually agreed definition of dumping in Article VI of the General Agreement on Tariffs and Trade.
Question 3. The Administration is presently considering adopting a plan of
tax and other incentives to boost the level of U.S. exports. In your judgment,
what incentives would best serve this purpose in a world of flexible exchange
rates?
Answer. I'm afraid I find unconvincing all the reasons usually put forward by
the Administration and others for boosting exports above their "natural" level.
I am also quite confident that in the months to come we will see remarkable
growth of exports and export orders as a result of depreciation of the dollar
over the past fourteen months. In light of this, I hope that your question will be
soon moot.
But that is not an answer. Let me start to give one by commending you on
recognizing the intricacy that flexible exchange rates create. If the Administration insists on increasing exports by special government inducements, and
succeeds in doing so, then a very likely result is a more valuable dollar than
otherwise in the foreign exchange market. That in turn leads in due time to
increased imports. And if the original purpose of the export inducements was
to improve the trade balance, its success can be disappointingly tiny. The export
inducements will generate very small perceived "benefits" for their "costs." I
might add to clarify that the dollar appreciation from export inducements is
smaller and less likely the more inflationary and expansionary are the means
of financing the program. But imports still rise somewhat, now because of higher
U.S. prices and income, and the inflationary impacts are definitely unwanted
side-costs of encouraging exports this way.
As to the means by which exports might be increased if the .Administration
insists, whether for trade-balance or for other purposes, let me encourage you to
look most favorably on directly targeted programs. It is less desirable to legislate
tax breaks and other incentives for all exports than to legfalate them for "new"
or "incremental" exports, say those above a traditional base. The fairly recent
revision of the Domestic International Sales Corporation program reflected this.
It is also less desirable to legislate incentives for exports with unique (uncompetitive) positions in the world market than for those which face sti:tr foreign competition. Most of the former exports will take place anyway even without incentives; the latter may not. To be specific for the United St;ltes, non-agricultural
exports are predominantly the former, and agricultural exports predominantly
the latter. Export incentives targeted on agricultural goods would not only
generate large "bang for the buck," but might also alleviate some of the current
domestic problems in U.S. agriculture.
Rut my heart is not in ~nch recommendations. It would he far better to leave
exports a lone.


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THE 1978 MIDYEAR REVIEW OF THE ECONOMY
TUESDAY, JULY 18, 1978

INTERNATIONAL ADJUSTMENT I

CONGRESS OF THE UNITED STATES,
JOINT ECONOMIC COMMITTEE,
lVa,shington, D.O.
The committee met, pursuant to recess, at 10 a.m., in room 2168,
Rayburn House Office Building, Hon. Richard Bolling ( chairman of
the committee) presiding.
Present: Representatives Bolling, Reuss, Mitchell, and Brown of
Ohio.
Also present: John R. Stark, executive director; Richard F. Kaufman, assistant director-general counsel; Lloyd C. Atkinson, Thomas F.
Dernburg, Kent H. Hughes, and Paul B. Manchester, professional
staff members; Mark Borchelt, administrative assistant; and Stephen
J. Entin and Robert H. Aten, minority professional staff members.
Special Study on Economic Change staff present: Robert Ash Wallace, research director; A. A. "Chip" Sayers, research assistant; and
Richard D. Bartell, staff economist.
OPENING STATEMENT OF REPRESENTATIVE BOLLING, CHAIRMAN
Representative BOLLING. The committee will be in order.
This is the first of two hearings that will be devoted to the problem
of balance-of-payments adjustments in our international monetary
system.
The focus of our attention at this hearing will be the problems of
world economic recovery and balance-of-payments adjustments under
the present quasi-managed floating exchange rate system. The empha~is at tomorrow's hearing will be longer range international economic
issues.
A widespread adoption of floating exchange rates in 1973 spelled
the end of the Bretton Woods system of fixed par values. Its demise was
perhaps inevitable in view of, one, the speed and magnitude with which
balance-of-payments disequilibrium began to emerge at constant exchange rates as a result of rapid changes in underlying economic and
financial conditions, especially after the mid-1960's; two, the extreme
reluctance of countries to adjust exchange rates even in the :face of
indisputable fundamental disequilibria; and, three, the magnitude of
the international movements of capital in response to perceived exchange rate disequilibria.


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474
Thus Bretton Woods, which had become the symbol of economic
liberalism and international financial cooperation, could no longer
be retained in its original form. Indeed, it increasingly becam.e evident from the mid-1960's on that maintenance of the par value system
was itself a threat to international financial cooperation. A change in
exchange rate procedures was essential to the continuation of the principles that fostered the original Bretton ·woods arrangement.
There are a :few of our floating rate experiences which reveal that
floating has been adhered more in the breach than in the observance.
In the past year or so this has been very extensive. It is no wonder that
the current system has been dubbed a "dirty floating system" by observers over the world, or at certain periods of time "filthy floating"
would be a more apt description.
We have before us today a very distinguished panel of economists
whose task it will be to assess the operation of our current quasimanaged floating exchange rate system. Is it true that a system of
fixed exchange rates would be inappropriate in today's world economic environment? Is it best to allow exchange rates to float cleanly,
or should exchange rates be somehow managed?
In short, what kind of exchange rate rules should be devised in order
to assure that financial cooperation will dominate international relations in the future? How do we insure that individual countries will
not manipulate exchange rates in pursuance of blatant beggar-thyneighbor policies in the face of balance-of-payments disequilibria?
How should the burden of adjustment be divided between surpllls
and deficit countries, and should the burden of adjustment fall on the
exchange rate, or on the domestic economies?
One group of economists, the so-called global monetarists. argue rate
exchanges are ineffective as an instrument of balance-of-payments
policy. Worse still, exchange rate changes are positively detrimental
to world economic welfare. Should the global monetarists be taken
seriously? Is there anything to their thesis?
In short, is the system of floating exchange rates really superior to
a svstem of fixed rates?
I am hopeful that this distinguished panel will provide us with the
answers we so badly need.
Our witnesses today are Mr. Rmliger Dornbnsch, professor of economics at MIT; Mr. Mordechai Kreinin, professor of economics at
Michigan State University; and Mr. Robert Solomon, senior fellow
at the Brookings Institution.
Gentlemen, welcome to this hearing of the ,Joint Economic Committee. Let nR proceed in alphabetical order. Mr. Dornbusch, will you
please begin as you wish.

STATEMENT OF RUDIGER DORNBUSCH, PROFESSOR OF ECONOMICS,
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
Mr. DORNBUSCH. Mr. Chairman, I appreciate the opportunity to
share with this committee my views on the U.S. balance-of-payments
and the role of the U.S. dollar.
The world economy is in considerable unrest, and that unrest is
attributed to three facts: One, the growing U.S. overall balance-of-


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475
payments deficit, partly the current account and partly the capital accolll}.t; tw(), the depreciation of the dollar, which has been considerab.le
relative to the mark and to the yen; and true, the failure of the United
States to pursue an effective energy program.
What I would like to do in my remarks here, and what I have substantiated more extensively in my statement is to review briefly why
we should be concerned about the current account. What are the main
reasons that we can think of for the deterioration in the U.S. accounts,
and what policies are there to remedy the current account deficit
should we want to do so.
Lastly, what part do exchange rates play in that adjustment?
I would like to note at the outset that I believe considerations of
oil and of the U.S. stage in the world business cycle have been overemphasized in that context and that insufficient attention has been paid
to the possibility that U.S. competitiveness is declining over time partly
with respect to LDC's and partly with respect to Europe and Japan
that have grown in productivity much more than we have. I will
return to that subsequently.
First, the current account. Why are we interested in it?
There are two reasons. One, the current account measures net exports
as part of aggregate demand. That is important because if we sell more
abroad, that creates demand for U.S. goods and production. orsening
of the current account from that point of view brings marked economic
deflation.
The second reason we are interested in the current account is that
if we have a deficit, we are borrowing from the rest of the world. We
are building up liabilities.
Connected with that is a further reason for our interest in the current account : It signals movements in exchange rates. ,iVhen we have
a growing deficit, then that will lead, typically, to exchange rate depreciation, and exchange rate depreciation, in turn, will affect relative
prices. I will return also to that question.
That sets the framework for asking why are we interested at all
in the current account? The next question is what has been happening
to the U.S. current aecon11t? l will turn to ~hart 1 in my propared
statement, the chart shows the U.S. balance on goods and services as a
fraction of GNP over the last 20 years. If you look at the chart in the
right way, you will see that the trend of deterioration in the balance
occurred through the 1960's, and that commonly is attributed to U.S.
expansion and to a decline in U.S. competitiveness. What we are concerned about now is what has been happening since 1973 and particularly what accounts for the very large deficit in 1977-78.
Well, there are three reasons for the deficit. One is that we have
expanded fast relative to the rest of the world. The second reason is
competitiveness. The United States may or may not have lost competitiveness relative to trading partners. The third reason is oil-that
·we have a very large oil deficit.
Let me review what can be said about these three explanations for the
deficit.
First, if :vou will turn to table 2 in my prepared statement, this is a
table that lays out growth rates in the United States and abroad,
and what is shown there is that in 1977, with the exception of the


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476
United States, all industrialized countries have growth rates far below
what they had on average in the 1960-73 period. That point is important to recognize, because ~ople might argue that the United
States in pushing the rest of the world to faster growth is asking them
to perform some very unnatural act.
That, of course, is nonsense when we look at what they have been
doing over a 15-year period in the 1960's and 1970's. They are growing
much, much less than they did then, and a return to faster growth from
that perspective is not unreasonable.
But we must ask, too, what does the United States expect for the
current account from faster growth abroad, and I think there we
have to be very careful. If we get a 1 percent of extra growth in the
rest of the world, will that turn our current account around by many,
many billions, or very little~
I think the reasonable estimate is that a 1-percent increase in the
growth of the rest of the world might change our current account by
$1 or $2 billion, $2 billion on the high side. So we really can't expect
that the decisions at the Bonn meeting now will make a difference to
our current account. The extra 1 percent, or whatever was promised
there, will not make a major dent in the U.S. current account.
If the United States grows fast relative to the rest of the world over
a long period of time, then we are accumlating this $1 to $2 billion
every year, and, of course, we can build up over time a very substantial
imbalance. A large part of the current account deficit in 1977 is, in
fact, the cumulative past growth in the United States relative to the
rest of the world. Of course, I view the U.S. growth as just right and
growth abroad as much too low.
· The last point to make is how can we drasticallv improve the current
account~ A U.S. recession is reallv the only way'to do it. For the rest,
we have to worry whether over time we are out of line with the rest
of the world in· their growth patterns. This is an important point,
because there are signs that the rest of the world, and particularly
Germany and Japan, are considering lower trend growth rates. Japan
is closer to lower growth. This leads us to believe that we have to be
worried that should we continue to grow as we have, we might get
seriously out of balance. That is the type of medium-term consideration
that I think we should increasingly pay attention to.
,vell, let me turn to the second question. competitiveness.
In table 3 of my prepared statement, I have various indicators of
U.S. competitiveness, and we can look at three types of things. ,ve can
look ·at the exchange mtes and say that there has been a depreciation
of 50 percent. The United States must really have gained a lot. More
reasonably we look at what has happened to the average price of foreign currency, adjuste,<l for U.S. trade patterns. v\Te call it the effective
exchange rate, a.nd the table shows a 15-percent depreciation.
So on that argument we have Q"ained since 1973 about 15 percent, but
that doesn't account for the differences in price movements. wages
and productivity. If you want to ask what is the real edge that the
United States has gained on the rest of the world. we have to look at
the next three columns, thait show various indicators that adjust exchange rate movements -for differences in the behavior of costs and
prices and -for productivity here and abroad.
On all these accounts, we see that the United States has gained in
competitiveness, but the indicators, of course, differ. They show gains

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in productivity, and gains in competitiveness since 1970 ranging between 7 and 25 percent.
. ·
·when we see these numbers, we have to ask: Well, what do we do
with them~ What do they really tell us about U.S. competitiveness i
If, in fact, we had the large gain incompetitiveness, why is the deficit
growing? That is really the question we have to ask.
The first problem with these indicators is that they are index num-'
bers that may be very seriously misleading. A country that is innovative at a fast rate will find that wages are rising, because we have become more productive, and that means prices will be rising. The country that is really innovative and competitive will, in fact, experience
faster inflation than the rest of the world.
That is the view we have to consider, and it is radically different
from macroeconomic thought, that our prices go up and that w~'can't
sell abroad.
If you look at table 4 in my prepared statement, it shows for the
1958 to 1970 period inflation rates and growth rates of exports for
Japan, Germany, the United States, and the United Kingdom. The
amazing fact, of co-µrse, is that Japan had the highest rate of inflation
in that period and it also had the fastest rate of export growth.
So that tells us that there is really no presumption that high inflation countries are not countries that are fast growing in competitiveness in world trade. In fact, the evidence from the 1950's and 1960's
really leads us to look the other way around.
The second reason why these measured gains in competitiveness may
be misleading is that in the short run they may be absorbed substantially by reductions in profit margins. That is the case in Japan and in
Germany, and we would expect that once these profit margins are
redressed, there would be more of a gain for the U.S, economy in terms
of increased net exports.
There is the argument that the gain in real exchange rates that we
have had takes time to be reflected in trade. I think that is not an argument that we can accept, because the major gains in real exchange rates
occurred in 1970-73, and wear~ now in 1978. Most of those adjustments
should have taken place. The only remaining adjustments I see are
those that are related to relocation internationally, and we do see increased foreign direct investment in the United States. So there is some
evidence there that at least relative to Europe we have again competitiveness.
The most important point I want to make about competitiveness
concerns the changing role of LDC's in the world. In table 5 of my prepared statement I show that the United States hi:is run a trade de,ficit
,vith nonoil LDC's. and that is really a very novel and unusual fact.
"\Ve think of LDC's as deficit countries that are growing and borrowing, bnt the United States is now running a deficit of $8 billion with
these conntries.
Striking is also the growing role of LDC's as exporters of manufactured goods. We see in the table that since 1972 the LDC's h:we increased their share in U.S. imports to 21 percent, and apparently the
numbers for 1977, when they come out, will be even higher.
Over the last 10 years there has been a substantial change in world
trade. LDC's have become exporters of manufactured goods, and the
United States will be the first to bear the burden of that,'because econo85-940-78-15


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mies 0£ scale make the U.S. market the first £or any foreign exporter to
consider. The size 0£ the U.S. market and the relatively easy access
means that the United States will be the proving ground for their new
ability to trade and produce manufactured goods.
I have a little to say about oil. I caution that there won't be any fast
effects from a U.S. energy program on the current account. The effects
won't be fast because the domestic production 0£ alternative sources
will be slow, and a substantially increased price in the home market for
energy would mean that we would substitute toward energy-efficient
products and equipment which are currently produced abroad. So
there will be a substantial increase in imports.
That doesn't mean we should not pursue such a program, because in
the mC'dium term. the United StatN, in response to higher prices will
become a producer 0£ energy-efficient resources and products, and
should become an exporter. I think our technological know-how means
that once we adjust prices we will become a source for net export of
energy-efficient resources.
I want to come next to the question 0£ what adjustments in the current account are possible.
One possibility 0£ adjustment is recession, and I think everyone
realizes that is disagreeable. There is also a sharp depreciation 0£ the
dollar as an alternative, and I don't think that is a good idea. It will
make the already shaky world economy more precarious. So the argument must be for coordinated expansion. Foreigners should expand
their economies. First, they should expand their economies and take
over growth leadership from the United States because our GNP gap
is narrowing while they have plenty of slack.
Second, foreign profitability is very low. Investment has been stagnant. The United States is an exporter of investment. and the Unit?.d
States, therefore, has a direct interest in foreign profitability induced
by a foreign expansion.
·
Next, balance is important. The concern with macroeconomics in the
last 10 years has really thrown into chaos our economies. The balance
between investment and consumption has been upset to the detriment
of investment. The private and public sector balance has been upset,
and perhaps most importantly, the balance between domestic demand
and exports has been very much upset.
In my prepared statement, I show a table, table 7, that reflects the
sources of growth in various countries, and you will find that net exports have contributed in most countries other than the United States
to increased demand and not their domestic demand. So that is reallv
a reflection 0£ beggar-thy-neighbor policy.
•
. Perhaps the most important argument about a coordinated expansion concerns the exchange rate movements in the process of expansion. I£ one country expands alone, that country will have a depreciating exchange rate.
In my prepared statement, table 8, I show the domestic prices and
import prices in Germany, Switzerland, and Japan. For anyone interesfod in controlling inflation the table shows that these countries have
fa1ling import prices.
If vou look at the first quarter of 1978, import prices are falling at
the rate 0£ 8 to 10 percent in those countries. You can afford quite a
bit of domestic inflation and still come out to zero. My argument is


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479
that the deflation, or the reduction in inflation, in Europe and Japan is
substantially borrowed from the rest of the world through an uncoordinated expansion, and it is time to ~ve it back and give the rest of the
world the benefit of some price stabilization.
We have come to the issue of surveillance. It is becoming important
in view of the very substantial dollar accumulation in the rest of the
world and the increase in U.S. liabilities under the outstanding agreements. I don't really see that except as the IMF has traditionally
practicea surveillance for small countries there is any scope. I certainly
do not see any scope to practice surveillance on surplus countries. The
problem is that we don't have unambiguous indicators. I have commented earlier, in this context, on the ambiguity of real exchange rate
measures. But without indicators that could be used, the political process favors countries that can claim prudence and anti-inflation policies.
The effect this will have is that small countries that expressly ask for it
will make exchange rate arrangements with the Fund, but large countries, say, countries like Japan, will be, in effect, not forced to have
their exchange rate considered by the Fund.
The problem of surveillance is this: In a high employment economy, one does not have an interest in beggar-thy-neighbor policy. In
an unemployment economy, beggar-thy-neighbor policy is a problem.
What must be the answer is an agreement on world demand and along
with that, n, pattern of exchange rates.
From the U.S. point of view we don't have any interest in surveillance, because surveillance would mean stabilization of the dollar
and that would prevent further depreciation of the U.S. exchange
rates, which are required to compensate for our loss of competitiveness.
The alternative, of course, is for us to have unemployment.
Thank you very much.
[The prepared statement of Mr. Dornbusch follows :]
PREPARED STATEMENT OF RUDIGER DoRNBUSCH

International Adjustment and SurveiZZance

The large external imbalance of the United States, the ongoing depreciation
of the dollar and the continuing high level of oil imports are viewed abroad as a
central problem in the world return to stability of trade and payments. Some of
the relevant facts are shown in Table 1. Here we show that the dollar price of the
Deutsch-Mark, one of the key exchange rates, has changed by only 5 percent in
the 1975-77 period but since then has undergone an increase of more than ten
percent. The same pattern is true for the Japanese Yen where an 11-percent
appreciation in 1975-77 was followed up since last fall by a further appreciation
of almost 15 percent.
TABLE 1

$/DM

1975 ___ -- -- -- -- -- -- -- -- -- -- -- -- -- -- -1976 ___ -- -- -- -- -- -- -- -- -- -- -- -- -- -- -1977----- ---------- -- ------ -- -- -- -- -1978/1 __ ----- -- -- -- -------- -- ---- ----

$/Y Trade balance

Goods and
services

Official
settlements

(I)

(2)

(3)

(4)

(5)

100. 0
97. 6
105. 8
118. 3

100. 0
100. l
110. 9
125. 0

9.0
-9.3
-31.2
-11.2

22. 6
10.1
-8.7
NA

10. 5
35.3
15. 9

4. 7

Note: Columns (I) and (2) are indexes of the dollar price of the DM and the yen. Columns (3), (4), and (5) show in billions
of dollars the U.S. trade balance, the balance on goods and services, and the overall balance of payments measured by the
increase in net foreign official reserve assets.
Source: International Financial Statistics, Federal Reserve Bulletin and Economic Indicators.


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With respect to the U.S. external balance we note the turn-around from a
$9 billion trade surplus in 1975 •to a 1977 deficit of more than $30 billion. That
trend is sustained by an $11 billion trade deficit in 1978/1. The overall U.S.
balance of payments deficit measured by 'net changes in foreign official reserve
assets is reported in the li;tst column. It shows a growing deficit that by 1977
had reached a very substantial $35 billion. This measure of the U.S. balance of
payments is a rough indicator of exchange market in,tervention and can 'thus
be interpreted as a sign of rising and very substantial efforts to slow down
or stop the decline in the external value of the dollar. Striking as these, facts
may ,be we still have to ask whether they should be of concern, what rt:heir
origins are and what can or should be done about them. I will turn now to
these considerations.
THE U.S. CURRENT ACCOUNT

The balance on goods and services is of concern for two reasons. First, from
a macroeconomic perspective, it is a component of aggregate demand. It measures
net exports of goods and services to the rest of the world. A deterioration in
the current account thus implies a reduction in demand for U.S. goods and
services. It is of course important to recognize that the statement is incomplete
without asking why net exports should have declined-increased imports as a
consequence of say domestic spending, a loss of exports or adverse movements
in international prices. This perspective on the current account is riow well
appreciated in part at least as a consequence of the oil price increase and the
resultant inflationary impact on the U.S. economy.
The current account not only measures our net exports of goods and services
but also the increase in our net claims on the rest of the world than we purchase
and that accordingly we acquire claims, in whatever form, on the outside world.
'l'his aspect of rt:he current account is again well understood in part as a consequence of the OPEC build-up of wealth which their surpluses and our deficits
have made possible. One important implication that is associated with net
external borrowing implied by current account imbalance is pressure on exchange
rates. An increased deficit is typically viewed as a signal for exchange rate
dPpreciation.
To gain some perspective on the recent deterioration in the current account
we show in Chart I the U.S. balance on goods and services as a fraction of
nominal GNP. (Deflating the balance by nominal GNP provides a rough adjustment for the changes in the size of the economy and in the level of prices.)
The Chart brings out the fact that the current account has been gradually
deterioraiting throughout the sixties, falling from a surplus of more than 1 percent as a fraction of GNP to less than half a percent by the early seventies.
The current deterioration in the balance is commonly attributed to three
factors: (1) Relatively fast growth in the United States compared to the
rest of the world, (2) Oil imports, and (3) A change in U.S. competitiveness.


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CHART

1

llJ\L).NCE ON GOODS & SERVICES AS A
FAACTION OF GNP

481
Growth, cycZe and the current account
There is no doubt that the relative U.S. position in the recovery from the
world recession has le:tlt the United States particularly exposed. The domestic
expansion in demand has spilled into increased imports without a substantial
compensation in terms of foreign sales induced by growth abroad. This fact
is readily appreciated from table 2 where we show growth rates for real output
in some of the major industrialized countries. The table shows that with the
exception of the U.S. growth in 1977 has been very substantially below the
1960-73 trend. I111ll'l'd, for all other countries show11 growth in 1977 real out.put
was less than half the growth rate achieved on average in the 1960-73 period.
Moreover, these growth rates also contrast with those achieved in 1976. With
the exception of Japan all countries in 1976, in the initial recovery from the
recession, were near to their trend growth rates. The implication of these changing patterns for the U.S. trade balance is brought out by a comparison of the
1!}76 and 1977 numbers. When world real growth is in line with the United
States or even higher, such as was the case in 1976, the United States shows a
current account surplus. By contrast in 1977 with growth abroad very sluggish
but sustained at home the external balance shows a large deficit.
TABLE 2.-GROWTH RATES OF REAL OUTPUT

United States _______ • __ •• __ •••• __ ••• ____ •••••••••••••••• _______ •• _
Germany __ .-----·· ____ •••••••••••••••• - - --· - -- -- •· •• -- - - - • - - • - •• Japan •••.• __ •••• ________ •• ____ •• ___________ • __________ ._ •• _. ___ ._
France ___ • _____ • __________ • ____________ • ______________ •• ___ • ____ _
United Kingdom __ •• ____ • ________________ • _____________ • _________ _
Canada._._. ____________________ •• ________ • _____________________ _

Annual
average,
1960-73

1976

1977

4.1
4. 5
10. 3
5. 4
3. 1
5. 6

6. 0
5. 7
6. 0
5. 2
3. 1
4.9

4. 9
2. 4
5. 1

3. 0
0

2. 6

Source: Federal Reserve Bank of St. Louis.

There can be no argument with the propoflition that a large part of the
1977 and 1978 deficits are due to the particular constellation of growth patterns here and abroad. There are, however, two important issues to be re~olved.
One is the quantitative importance of the divergent growth patterns. Tlw other
issue, related to the question of adjusment, is whether there is a permanent
change in growth patterns that fundamentally changes the U.S. growth potential ·consistent with reasonable exteTnal balance.
The quantitative importance of the divergent growth patterns for the U.S.
current account are very hard to nail down with any precision. If fiscal measures raised real spending iu non-U.S. industrial countries by. an average of
one-half percent the effect would work out to perhaps as much as a 1 percent
increase in the rest of the world real GNP. How much of a current account
improvement could the United States expect from such a move? Real <>xports
no doubt would increase with difference .across commodity categories that
average out to 1 percent or 1½ percent on the high side. There is some offset,
however, from increased real raw material prices including the possihi!ity of
a rise in real oil prices. Taking this into account the resulting current account
improvement may be as small as $1 or $2 billion.
The composition of U.S. exports suggests that we should pay attention to
the details of the foreign expansion program. A policy mix abroad that would
favor investment and capital expansion would clearly raise the U.S. possibilities
as an exporter of machinery. By contrast, if the policies are primarily in the
area of construction and public works, with a local concentration of benefits,
there is a corresponding reduction in U.S. opportunities. On balance the con.
cern over investment, and hence a shaping of policies in that direction. is
likely to be offset by a concern to capture locally most of the policy benefits.
What lesson can be drawn from the preceding discussion? In interpreting
the current account deterioration and in contemplating the potential benefits
of foreign expansion three points stand out. First. a small and transitory
change in foreign growth will not cause a multi-billion-dollar change in our
current account. Second, the current account is very substantially affected
by our own level of economic activity. This is, indeed, the single most important
influence. Third, a sustained change in foreign growth rates relative to those
in the United States will cumulate into a substantial change in our current
account. I take this to be the main reason for. the deterioration in our current
account since 1978-75. On average, over the last few years our growth has been
high relative to that abroad.
·
·

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The point also forces us to ask whether there is a permanent change in the
prospects for output and growth abroad and thus, on our present growth
trend, the potential of increasing imbalance, There is good reason to believe
that such a change in trend growth rates has indeed occurred. In the medium
term the decline in investment implies lowered productivity growth and thus
a lowering of trend growth in potential output. Beyond that major changes in
the social attitude toward growth in Japan and Germany and in the potential
for growth through domestic industrialisation in LDO's are likely to lead to
a lower trend growth abroad and hence to a reduced growth rate of our exports. In this context it is also important to recognize that the growing aversion
to public sector deficits will lead increasingly to policies that sustain the growth
of potential output through exports rather than public sector demand.
O ompetitiveness

A second factor in assessing the current account is the change in U.S. competitiveness. It is generally recognized that throughout the sixties the U.S.
dollar gradually became overvalued. That overvaluation, in conjunction with
the overexpansion in the late sixties, lead to increasing current account problems. The question now is to what extent that overvaluation has been remedied
by the dollar depreciation that has taken place since. Table 3 shows some of
the pertinent facts about the effective exchange rate and various measures
of the real exchange rate:
TABLE 3.-u.s. COMPETITIVENESS (1970=100)

1973 ______________________________________________ _
1975
• _-- -- ____ -- -- -- -- -- __ -- ___ --- -- ____ ---- ---_
1977 ____
______________________________________________

Effective
rate

Export unit
values

Value added
deflator

Labor
costs

84. 0
83.6
87.1

87.0
91. 5
93. 7

77. 5
75.8
76.1

78. 1
71. 5
75. 2

Source: lhternational Monetary Fund,

"'rhe effective exchange rate measures the dollar price of a basket of currencies,
'the composition of which is determined by the importance of foreign countries
in world trade. The decline in the effective exchange rate since 1970 is of the
order of 15 percent and indicates a substantial depreciation of the dollar in
terms of foreign currencies. That depreciation, however, had largely occurred in
the 1970-73 period, although there has been some further depreciation earlier this
year. The important point to recognize, of course, is that the depreciation relative
to the average foreign currency, while substantial, is by far less than the depreciation relative to the DM and Yen that amount to 60 and 35 percent respectively.
The effective exchange rate by itself does not provide a measure of the gain in
competitiveness that the United States has gained. The depreciation of the
dollar, to some extent, merely reflects the differences of inflation rates between
the United States and the rest of the world. Various measures of "real, effective
exchange rates" are shown in the table. Here we look at the rates adjusted for
the behavior of export prices, the GNP deflator and labor costs for the United
States and competitor countries. By either of these measures the United States
has become more competitive since 1970 and has substantially maintained that
gain in competitiveness. Our export prices have risen less than the dollar prices
of our competitors. The same is true for our labor costs, adjusted for productivity and cyclical factors, and for our value added prices. While various real
exchange rate indicators may vary in the extent of the gain in competitiveness
that they suggest they do nevertheless all show a maintained and substantial gain.
They also show, however, that the gain was achieved in the early seventies
and has, at best, been maintained since then.
The gain in competitiveness that is shown in table 3 promises, of course, to
have a beneficial impact on the current account. The adjustment lags to changes
in relative prices are very substantial, perhaps of the order of two or three years.
Nevertheless we must assume that a substantial part of the adjustment has
already been taking place and is reflected in the favorable current account in
1973-76. The remaining adjustments will derive largely from the international
relocation of production through direct investment. In the short and intermediate term these relocations may have quite adverse effects on the current account
since foreign direct investment typically has a very high import content and
only in the operating stage comes to cutting down imports and replacing them
by domestic production.


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A second point in evaluating the implications of the measured gain in competitiveness concerns the interpretation of these indicators. The point is simply
that these index numbers, since they represent the average behavior of prices or
costs in the economy, may be very misleading. A country may gain in competitiveness despite a substantial increase in average wage levels if in the traded
goods sector the increase in wages is more than offset by productivity gains. The
point is best understood by reference to the fixed exchange rate period 1958-70
for which we show in table 4 the average rate of increase in GNP deflators
and export value for several countries :
TABLE 4.-AVERAGE ANNUAL INFLATION AND EXPORT GROWTH, 1958-70
[In percent[

Japan

Germany

United
States

United
Kingdom

4. 9
17.1

12. 0

4.0

2. 7
8.2

3.4
6.1

Inflation __________________________________________ _
Export Growth _____________________________________ _
Source: Federal Reserve Bank of St. Louis.

The table shows that a low inflation country like the United Kingdom has
relatively low export growth while a high inflation country like Japan enjoys a
very substantial export growth. There is no way around the fact that broad
competitiveness indicators may be entirely misleading if there are substantial
changes in relative prices or the composition of trade. As a rule an innovating,
expanding country should experience both a gain in competitiveness and an improvement in the terms of trade or rise in relative wages. With this consideration in mind it is of course quite possible that the measured gain in US competi•
tiveness quite substantially overstates the gain that actually has occurred.
The point is reinforced by inspection of chart 2 where we show for a selection
of countries the change in effective exchange rate since 1970 and the change in
competitiveness measured by value added prices. The figure shows the appreciating countries-Germany, Japan and Switzerland-as losers in competitiveness.
The depreciating countries-the United States, Italy or the United Kingdomby contrast gain in competitiveness. These changes in competitiveness notwith•
standing Germany and Japan have sustained, if not increased, their trade surplus while the depreciating countries have not had the expected gains in terms
of a trade balance improvement.
Competitiveness
Switzerland

130

•

Japan

•

120

•
Netherlands
•
110
Germany
•
France
Belgium
Sweden

U.K.

•

50 •60

I

70

80

I

llO

90 •

I

Canada

Italy

120 130

Eff.,ctive
140 150 160 Exchange Rate

90
80

•

u.s.

70

CHART 2

EFFECTIVE EXCHANGE RATES' AND COMPETITIVENESS : 1977


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One possible explanation for the limited trade effects of the changes in real
exchange rates is that they have been offset, in part at least, by reduced profit
margins. This argument has been advanced for the cases of .Japan and Germany.
It suggests that the changes in real exchange rates will still come to exert their
full effects when profit margins are restored or foreign firms cease operation. A
further fact that is of importance in evaluating U.S. competitiveness, and that of
industrialized countries at large, is the growing role of LDC's as producers and
exporters of manufactured goods. LDC's such as Brazil, Mexico or Taiwan ha,·e
growing experience in producing competitively manufactured goods that tradi•
tionally have ranged among industrialized countries' output and exports. The
phase of learning by doing and production for the domestic market is coming to
fruition as they show up in the world market and make increasing inroads on
industrialized countries' markets and in intra.LDC trade. Such a possibility is
perhaps best indicated by the important changes in bilateral trade patterns between the United States and LDC's.
TABLE

5.-u.s. TRADE

WITH LDC's

[Dollar amounts in billions)
Nonoil LDC
manufactured
exports to
Imports United States 1

U.S. trade with nonoil LDC's
Exports

1972 ...••......•.........•••••.•••.••••..................•......•
1974...•.••.•.••.......•• •·········••··•················· •....•••
1976.•....•....•••.•••.....•••••••.•••••.•...•••••••. ···••··· ..••

1977·····-········ ··········-···· ............................. .
1

$10. 8
25. 6

28.2

29. 7

$8. 5
22. 5
30. 3
37. 2

15. 3
19. 2
21.1
NA

Percent of total U.S. manufactured imports.

Source: Direction of Trade and International Trade 1976/77.

The table reflects not only the striking fact of a U.S. deficit with respect to
non.oil LDC's as a group but also shows their growing role as a supplier of
:inanufactured goods. While the trade figure for 1977 reflects no doubt in part a
slowing down of growth in the LDC's, I interpret them nevertheless to show
a change in trade patterns. The traditional or structural deficit of LDCs' char•
acteristic of the development process is narrowing and trade competition with
traditional U.S. exports is widening. If that interpretation is correct then it has
to be recognized, along with the slowing growth trend in industrial countries, as a
tendency with major implications for the medium term current account prospects.
Oil
The role of the oil price increase in the deterioration of the U.S. current
account has received much comment and needs little further explanation. Table 6
shows the behavior of total imports and oil import spending. Since 1973 oil
imports have risen from 12 percent of import spending to 30 percent. Failure to
conserve on oil and reduce imports of oil products are commonly blamed for the
deficit and it is. implied that a vigorous program would have substantial shortrun
trade balance effects.
TABLE 6.-OIL IMPORTS, 1973-77
[In billions of dollars!

Total imports •••••••••••••••••••••••••
Oil and products ••••••••••••••••••••••

1973

1974

1975

1976

1977

70. 5

103. 7
26.6

98. 0
27.0

124. 0
34.6

151. 7
44. 7

8.4

Source: Economic Report of the President and Federal Reserve Bulletin.

The energy program is popularly viewed as an important source for an im•
provement in the U.S. current account. There is, however, some doubt about the
extent of these beneficial efl'ects. These doubts arise both with respect to the
short term effectiveness of the pl'ogram, with respect to the longer term substitution effects that it is intended to induce; and with respect to the associated
macroeconomic policies designed to offset the adverse effect of the price increases.


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In interpreting the current account effects we must b€ar in mind that the current
account is equal to net exports or the difference between our income and our expenditure. We thus would have to be able to show that the energy program raises
aggregate income or output relative to our spending, or, to put it differently, that
the program exerts an expansionary macroeconomic effect on the home economy.
There would, of course, be incentives to substitute toward more energy-efficient
goods and production processes.
The development of domestic energy sources is not a shortterm source of major
macroeconomic expansion. The substitution toward energy efficient goods and
processes will no doubt oonefit partly domestic producers of these commodities.
In substantial measure, however, it may also mean an increase in imports since
the rest of the world has surely at present a comparative advantage in the design
of energy efficient goods. The net effect, therefor, may well be a conservation
of oil products on the import side but a largely offsetting increase in other imports or a reduction in exports where the implicit subsidy from low energy prices
is eliminated. This is all the more so if the deflationary effects of an energy
are offset through compensating fiscal action.
These considerations suggest some dampening of the beneficial current account
effects of an energy program. They, of course, in no way imply that we should not
adopt a more efficient policy in this vital area. In the medium and long term an
energy program domestically would create the right demand pattern that leads
to the innovation and production of energy efficient products-small cars, appliances, industrial equipment-of which the U.S. presently is of course an importel"
but which, with the U.S. technological potential, may well become export
products.
In summary I see three main influences that have worked to deteriorate the
U.S. current account. The first is the cumulative effect of a high U.S. rate of
expansion relative to the rest of the world. Here it is important to ask whether
the resulting imbalance will be reversed by Germany and Japan taldng a turn at
growth leadership. The second source of a deterioration in the current account
is the worsening in our current account from the oil price increase. The prospects
for an improvement here are long term and at present do not look too good. The
third factor is competitiveness. Here the interpretation is ambiguous. The conventional measures of competitiveness show a gain for the United States as does
the fact of increased foreign direct investment. At the same time it is true that
the United States is increasingly meeting the challenge of foreign countries, and
LDC's in particular, imitating U.S. technology and products and doing so competitively. There is no escape from such imitation and the only long-term adjustment is to invest in new products and techniques that will keep the export sector
vital. In this respect it is interesting to note that Germany, which of course fac2s
the same problem, is considering a public investment fund for the production of
new techniques and goods that will keep the economy competitive.
COORDINATION AND ADJUSTMENT

The preceding discussion has set a framework in which to. review U.S. interests
in an adjustment of the pattern of current account balances and in an international. coordination of macroeconomic policies. Before entering that 1iiscussion,
however, we should note that there is nothing intrinsically wrong or undesirable
about a current account deficit. There is certainly no economic principle by which
the United States or the typical developed country should year after year run a
current account surplus with offsetting deficits run by the LDC's. The very fact
of a persistent, though declining, OPEC sul"))lus forces the rest of the world to a
current account deficit, the world distribution of which is determined by privat"·
and public saving and investment choices.
Against this background we can evaluate the possibilities for an adjustment
in the U.S. current account. We first look at unilateral· actions of which there
are essentially three. We have already noted the first policy, a forceful energy
program. This is of course the policy suggested by Europe and Japan since
it is a policy that directly benefits them by softening the .real price of energy
and by creating demand for their energy efficient output. Even if. the current
account effects should be moderate there are overwhelming reasons to pursue
such a policy.
The alternative route to current account adjustment involves either a slow
down in U.S. expansion or a drastic change in real exchange rates. so as too


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shift world demand from foreign goods to our output. Neither of these policies
is desirable. They are disruptive of an already shaky recovery abroad, they
do little to deal with the fact that the world economy faces two problemsaggregate slack and external imbalances. The proper policy mix, as the United
States has long argued, should deal with both problems simultaneously.
There are four important arguments for an adjustment strategy that is coordinated and involves a substantial growth contribution of the surplus countries, in particular Germany and Japan. The first argument is that the United
States can no longer assume that growth leadership in part because the GNP
gap is narrowing while abroad it remains large and indeed is growing in some
countries. Moreover, continued U.S. growth leadership would further aggravate
the current account problems that are to be mitigated along with a world
recovery.
A second argument for a coordinated expansion with a strong domestic contribution by surplus countries considers the effect on profitability, and therefore investment. The adverse change in real exchange rates in the case of
Germany and Japan, and perhaps in United Kingdom manufacturing, and the
contraction of economic activity with which the Italian surplus was achieved
have seriously cut profitability and have led to a sharp decline in real investment. An expansion of economic activity will provide room for profit margins to
recover and for investment to revive. This is all the more so if, as is sensible,
the stimulus takes the form primarily of investment subsidies and incentives.
The United States stands to benefit from such a policy particularly because of
its role as an exporter of investment goods.
Both of the preceding arguments involve the idea of a balanced expansion
in the world economy. The idea of balance applies not only to the reduction
in GNP gaps across countries but also to the composition of output between
domestic demand and exports, between public and private spending and between
investment and consumption. A more balanced expansion than has taken place
to date will reduce the very substantial disequilibrium. The present imbalance
is reflected in the sources of real growth-domestic demand, export growth
and import reductions :
TABLE 7.-REAL GROWTH PATTERNS, 1976/IV-1977/IV
(Annual percentage rates(

Real growth
·United States ______________________________________ _
·Germany __________________________________________ _
Japan _____________________________________________ _
'United Kingdom ____ ------------------------------ __
'ltaly ______________ --------------------------------

5. 7
2.1
5.3

-.3

-1.4

Domestic
demand

Exports

Imports

6.3
1. 2
4.2
-.8
-3.0

-2.2
4.6
4.1
.6

7.0
1. 8
-5.2
-1.3
-3.6

3.1

Source: Bank for International Settlements,

Conceptually, at least, there is a fullemployment pattern of output composition and current accounts that is compatible with an open trading system rund
significant growth in capacity, employment and productivity. That pattern is,
of course, not very precisely defined. Clearly, though, a pattern of increasing net
•exports by a group of hard currency coUllltries and a trend of declining investment ratios and productivity growth is entirely the wrong direction in which
to head the adjustment process.
The fourth argument for a coordinated expansion with leadership by the hard-currency countries involves the exchange rate movements associated with divergent rates of expansion and the associated trade imhalance. A country that, in
isolation, expands relative to the rest of the world will find its current account
·<leteriorating sharply and its exchange rate depreciating. The depreciation of the
exchange rate will immediately lead to higher import prices and thus also to
'higher domestic prices for producers and consumers. Countries. by contrast, that
lag in the expansion find their exchange rates appreciating and derive from that
appreciation and the associated decline in import prices a dampening of inflation.
In theory we would expect the exchange rate depreciation of the expanding
•country to further advance its eX'I)ansion by increasing competitiveines!'l. That
tendency, in the short run, is however not very effective. More likely, the


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J-curve will imply growing deficits and increasing depreciation and inflation
before the beneficial real effects set in. Likewise in the lagging country we would
-expect.the appreciation to work primarily on the rate of inflation and on a shortrun widening of the trade surplus before the loss of competitiveness makes substantial inroads on real activity. This process has been called the "virtuous and
vicious circle" and it is recognized as one of the important aspects of exchange
rate movements.
This process has certainly been at work in the stabilization of inflation in the
<'ase of Germany, Switzerland, and Japan. Table 8 shows data for the GNP
deflators and import price inflation in these coUJntries. It is not surprising that
the very low rates of import price inflation, and the deflation in some cases, should
have allowed a very rapid stabilization of inflation in these very open economies.
That reduction in inflation, though, has been achieved at the expense of other
industrialized countries like the United States whose depreciation has added to
their inflation rates. The relatively fast U.S. expansion, or the lack of synchronization and coordination, has thus introduced a discrepancy in inflation rates that
worsens the trade-offs for the countries that are relatively close to full employment and eases them for those that have grown very slowly.
TABLE 8.-DOMESTIC AND IMPORT PRICE INFLATION
Germany

1975•••••••••••••••••••
1976.•• _••••.••••••••••
1977 --·· •••••••••••••••
1978/1 •••••••••••••••••

Switzerland

Japan

Domestic

Import

Domestic

Import

Domestic

Import

7. 1
3.2
3. 8
NA

-1.7

6. 7
2.3

-9.8

7.4
6.5
6. 2
NA

7.6
6.0
-4.2
-11.4

6. 7
I. 5
-8.0

.1

NA

.4
1.2
-11. 1

Note: Domestic inflation is measured by the GNP deflator; inflation of import prices corresponds to the rate of import
price increase (not import unit values). The 1978/1 inflation rate is the annualized quarter to quarter growth rate of import
prices.
Source: International Financial Statistics and Federal Reserve Bank of St. Louis.

The proper recovery strategy for a world recession should be a policy mix that
leaves nominal and real exchange rates substantially unchanged and envisages
rates of demand expansion that stand in proportion to excess capacity, current
account surpluses and the degree of price stability.
In summary, the current position is one where the United States should no
longer assume growth leadership but rather be concerned about arresting the
acceleration of inflation and the decline in investment and productivity growth.
Germany and Japan, by contrast, should stop riding the J-curve and the safest
way to do so is by a serious commitment to real growth. Such a commitment is
important for the world economy siI:1ce their.accumulated loss in competitiveness
eannot fail to start cutting into their real growth and thus has to be offset. At
the sa:me time their growth leadership will allow the poorly adjusted surplus
countries-Italy, the United Kingdom and other countries that have been
IMF'ed-to take a more expansionary posture without endangering their external
position. There is little doubt that such an expansion will be inflationary for the
leading countries, but then their good inflation performance has in good measure
been borrowed and now should be returned. The expansion will also improve
the terms of trade of primary producers and their exPort revenue. This will
spread the expansion to poor countries. Given their high import propensities we
ean be certain that most of that expansion will be spent on industrialized countries' output and thus add to the expansion or reduce the required initial
stimulus.
SURVEILLANCE

The problem of exchange rate surveillance arises as an important issue for
two reasons. The first is the entry into force of the amended articles of agreement of the IMF that provide explicitly and quite formally for exchange rate
surveillance. The other reason is the growing concern over the depreciation of
the U.S. dollar and the growing extent of exchange market intervention. One
measure of the extent of exchange market intervention is the U.S. deficit, another
measure is provided by the change in foreign international reserve holdings.
These are shown for some countries in table 9.


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TABLE 9.-INTERNATIONAL RESERVES

[In billions of dollars]

Germany ____ ••••••••••••.•••••••.•••••••.•••••...••
lao'lf;d Kingdom ••••••• _•••...•.•.•.••••.••••••••.••

1975

1976

1977

1978/1

31. 0
12. 8

34.8
16. 6
4.2

39. 7
23. 3
21. 2

42.2
29. 0
21. 6

5. 5

Sou·ce: International Financial Statistics.

'!.'he data of course raise the question whether the exchange rate system is
overmanaged, whether exchange rates are sustained against fundamental
trends, whether current account adjustment is impeded and whether "unfair
competitive advantages" are gained.
'I.'he IMF presumptive indicators of inappropriate exchange rate practices
include protracted one-way intervention, unsustainable borrowing, controls or
restrictions on trade and payments, financial policies for the encouragement of
abnormal capital flows and finally a behavior of exchange rates that is out of
line with fundamentals. By one or the other of these criteria each of the countries in table 9 pursued an inappropriate exchange rate policy. Yet there would be
agreement that the British intervention served substantially to stabilize employment in the face of speculative inflows. The ,Japanese intervention in conjunction
with continuing trade protection and insufficient domestic expansion, however, is
largely viewed as an inappropriate exchange rate policy. The two examples
already suggest that there is little purpose in establishing narrow rules and that
exchange rate surveillance will remain an informal, infrequently practiced activity. The IMF will, as it always has, accompany stabilization schemes by conditionality that includes exchange rate terms. For surplus countries the IMF in
principle now has the procedures to question exchange rate policies but in prac•
tice one cannot but expect an asymmetry whereby the burden of exchange rate
adjnstment falls primarily on small deficit countries. The problems raised hy surveillance, as has been noted, are no different from that of "fundamental disequiJibrium" or the scare currecy clause in the IMF rules. 1 Of course these rules have
never come to be applied, at least to major countries, because surplus countries
can claim the virtues if prudent, non-inflationary policies.
The problem of Pxchange rate surveillanC'e is larg-ely the problem of a world
economy with insuffic>ient aggregate demand. In a high-emplovment world eC'onomy those countries that undervalue their (real) exchan,ge rates will experienC'O
excess demand and inflation or an excessive inflow of external factors of production such as Germany and Switzerland did in the sixties. Those that overvalue their exchange rates find stagnation in the industrial sector and an over~
expansion of public sector activity such as in the United Kingdom. There is· no
imp0rt,rnt foreign interest that is hurt. The current accounts implied hy real
exchange rate C'hoices reflect largely the choices between consumption and
investment and there is no reai::on to subject them to international surveillance.
This cea~es, of course, to be true in a world of nnderemnloyment where an expansion of net exportR and externa~ !ending becomes an alternative to a pnblic sec~
tor defldt. International coordination of the pace of economic activity is thf' essential route to reconcile divergent interests and the implied pattern of equilihrinm
exchange rates is one aspect of the coordination. In this perspective exehange
rate surveillance for major countries without a commitment to coordinafiori is
entirely illusory as an international undertalting.

FenrPsentative BOLLING. Thank you £or an interesting statement.
Mr. Kreinin, please proceed.

STATEMENT OF MORDECHAI E. KREININ, PROFESSOR OF ECONOM•
res, MICHIGAN STATE UNIVERSITY
Mr. KREINI'N". Mr. Chairman, it is a pleasure to appear before this
committee_ I would like to compliment the committee and its staff for
1 See A. Swoboda. "Interdependence, Co-Operation and Conflict In the Post-Bretton
Woods Era," Harvard University, 1978.


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suo-o-esting such divergent emphasis in the statements that there is virtu:lly no overlap, even though we are talking about the same general
subject.
I will confine myself to my statement, although I have a few comments on Professor Dornbusch's statement, most of which I am in
agreement with.
Since March 1973, the international currency system has been a hybrid of four exchange rate regimes: "Managed floats" of the major
currencies; a "joint float" of five European _currencies led by t_he German mark; LDC's currencies pegged to a smgle currency, mamly the
dollar; and LDC's currencies pegged to a basket of currencies, be it the
SDR or a tailor-made basket. As a consequence, the U.S. dollar has
also become a fluctuating currency.
U.S. intervention in the foreign exchange market has been minimal.
But since foreign central banks use the dollar as the intervention currency in their activities, intervention that exceeded $10 billion in 1977,
they indirPd ly influence the exchange value of the dollar.
In the late sixties and early seventies most academic econom~s:s and
many "men of affairs" advocated the abandonment of the adjustable
peg system in favor of floating exchange rates. Now that generalized
floats have been in force for several years the system is being criticized
as "unstable." In Europe the system appears to have fallen into some
measure of disrepute because of alleged excessive and disruptive exchange fluctuations. This is certainly evident in statements of the Bank
of International Settlement, concerned mainly with the large swings
in foreign exchange rates.
But in evaluating the system one must always ask: Good or bad relative to what?
"\Vould a regime of fixed exchange rates have been sustainable during the past 5 years? The Bret.ton Woods system was abandoned not as
a result of considered deliberations by central banks, although both
Europe and the United States grew increasingly dissatisfied with it.
Rather, it broke down under the onslaught of market forces that prevailed early in the decade. Since then the international economy was
subject to continuous gyrations of almost unprecedented magn.itude.
Some causes of these gyrations were:
One. the booming demand for raw materials in 1973, leading to substantial advances in prices.
Two, the quadrupling of oil prices by OPEC in 1973-74 contributing to both the inflation and the recession in the followini years.
Three, the need to divert massive resources to environmental cleanup and to the development of new energy sources.
Fourth, changes in the worldwide food sitnation, bronght on bv unfavorable weather conrlitions in the Soviet Union, Asia, and .Africa
m 1972-73, and the subsequent drastic improvPment in food supplv.
These and othe;r factors combined with policy measures to bring
about the stagflation of 1974. The worldwide recession in 1974-75 was
the deepest and most prolonged since the war. Policy measures designed
to_ promote r~covery varied in intensity from one country to another,
with the U mted States recovering faster than its trading partners.


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These developments reflect, in part, differences in the tolerance of inflation between countries. In other words, existing differences between
countries concerning the short-run unemployment-inflation tradeoff
are magnified during substantial economic swings.
There is no way for a fixed ex~ha~ge rate system to a~com~odate
large differences between countries m the tolerance of mflation. A
fixed exchange regime would have broken down several times during
this period. We would have been living in a continuous international
currency turmoil dwarfing the crises of the .1967-73 peiod.
It was this constellation of underlying economic difficulties that
caused large fluctuations in exchange rates.
True, they were magnified by speculative activity. But both theory
and experience suggest that speculation abounds under fixed exchange
rates as well, and may even be more pronounced.
In short, the floating exchange rate system weathered the crises
rather smoothly, relative to what would have been the case under an
alternative regime. Only floating rates can accommodate the divergent
preferences toward the short-run inflation-unemployment tradeoff that
exists among nations.
A contrary view that has gained some currency in recent years is that
associated with, or attributed to, Professors Mundell and Laffer. They
assert that not only do exchange fluctuations fail to equilibrate the
balance of payments, but they also contribute to worldwide inflation.
The argument runs roughly as follows: The law of one price guarantees that, given sufficient time for adjustment, and abstracting from
transport costs, all internationally traded goods will command the
same price everywhere. This applies to homogeneous and differentiated
products alike.
Thus, a currency devaluation cannot, over time, change a country's
prices relative to those of its competitors. Either its price would rise or
foreign prices would decline until prices were fully equalized internationally.
Here Mundell and Laffer introduce a second supposition; namely~
that the price ersponse to exchange rate adjustment is not symmetrical.
Export prices, denominated in local currency, rise in the devaluing
country, but import prices fail to decline in the revaluing one. This
asymmetry is often referred to as the "ratchet effect."
As a consequence, the equalization of international prices is accomplished strictly 'through price increases in the devaluing country.
Since in a regime of fluctuating exchange rates, some currencies depreciate ana others appreciate over one time period, while the reverse
tends to occur during some subsequent period, and because domestic
price changes occur only in the depreciating countries and not in the
appreciating ones, the net effect is a worldwide increase in the prices
of traded goods. The fact that the emergence of worldwide doubledigit inflation coincided with the introduction of generalized floating
is used as evidence in support of the thesis.
Both links in the Mnndell-Laffer argument can be questioned.
First, there is no a priori reason for the law of one price to hold in
the case of differentiated products. Even a brand name can account,
for a persistent price differential. And, in any case, it makes a con--


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siderable difference whether the period required for price equalization following a currency devaluation is long or short. If it is protracted, then the argument that devaluation does not improve a country's competitive position holds only in the long run. Improvement
could occur during the time in which the price equalization process
takes place. And that may be sufficient for exchange rate adjustments
to perform their traditional function.
Second, there is no a priori reason to expect a ratchet effect in the
case of exchange rate changes. Even if internal prices are inflexible
in a downward direction, import prices-expressed in terms of the
home currency of a revaluing country-can decline following an upward adjustment in the exchange rate. Indeed, empirical studies
have shown many instances of such price reductions. Apart from that,
in an inflationary world it is necessary only that the appreciating
country lower its rate of inflation, rather than reduce prices absolutely, for the ratchet to disappear.
Finally, it might be asked: What gives rise to exchange-rate fluctuations to begin with? According to the monetary approach to the
balance of payments it is divergent rates of inflation, which in turn
are caused by divergent growth rates in domestic money stocks. This
takes us back to mainline monetarism, where inflation is a result of
the growth in the money supply rather than a consequence of floating
exchange rates.
In sum, both empirical evidence and theoretical analysis do not
support the M-L thesis. The worldwide inflation of the past 5 years
had its roots in a variety of fundamental factors, not related to generalized floating. The relation between floating rates and inflation is
complex, and has been the subject of many an economic discourse.
On a simplified level, a floating rate can protect a country from inflation originating abroad, and can accommodate divergent inflation
rates in many countries. On the other hand, it enables a country to
inflate at home, freeing it from the balance-of-payments constraint,
and would probably magnify domestically produced inflation by
"bottling it up" within the country. But the rate of inflation is still
determined by domestic policies, although there is, of course, transmission of inflation from one country to another.
European nations may be dissatisfied with the present-day system,
first, because exchange fluctuations are too disruptive in small economies; and, second, because monetary integration is considered important for the European Community. Although the present European
~oat may m3;ke sense a~ essentially a German currency area, monetary
mtegrahon m the entire European Community appears premature
at this time. This applies to the proposal to enlarge the joint float
a_nd to bring the major European countries within a range of :fluctuations of 5 percent of each other. This would require substantial diminution of national sovereignty .
. While. the Unit~d Sta~es may wish to encoura,ge European monetary
mteg~ahon, the ~ntfalls mvolved should be clearly recognized. What is
most important 1s that the dollar should continue to float as freely as
~ossible. whether relative to individual European currencies or relative to blocs of currencies floating jointly.


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In sum the currency system that evolved over the past 5 years is
superior to any fixed exchange rate regime. It weathered well the
traumatic events in the international economy. The questions on the
international agenda should be how to improve the present system
rather than how to change it. Rules for central bank intervention in
foreign exchange markets, IMF surveillance of such intervention, and
greater international cooperation would all be useful. A movement
toward broad currency zones may make the system more stable, but it
is doubtful that such a movement is feasible at this time.
Thank you.
[The prepared statement of Mr. Kreinin follows:]
PREPARED STATEMENT OF MOBDECHAI

E.

KBEININ

Functioning of the International Currency System
(A.)

Present-Day currency arrangements

Since the introduction of generalized floating in March 1973, the international
currency system has been a hybrid of four exchange rate regimes:
/a) Most major currencies, including the Japanese yen, the French franc,
the British pound sterling, the Italian Lira and the Canadian dollar fluctuate
( or float) on the foreign exchange market in response to supply and demand
conditions. The float is not free however. Rather governments ( or central
banks) intervene on their respective foreign exchange markets to influence
the exchange rate. This system iR known as "mana11;ed" floats. In Hl77 total
intervention by the major central banks was approximately $100 billions, having risen from $73 billions in the previous year. For the most part intervention
is conducted by buying or selling U.S. dollars in exchange for the local currencieR. This is one reason why central banks maintain foreign currency reserves,
and the overwhelming proportion of these reserves are in dollars.
(h) The currencies of five European countries: West Germany, the Netherlands, Belgium-Luxembourg, Denmark, and Norway (with Austria maintaining an informal association) are pegged to each other and float jointly, with a
maximum of 2¾ percent between the strongest and weakest currencies in the
group. They are known as the "Joint European Float" or the "snake". The
composition of the "snake" has changed several times during the past five
years. For example, France moved in and out twice and Sweden-an original
member-withdrew in August 1977 and now floats independently. There were
also several changes in the par value of the member countries.
Although an original impetus to the formation of the joint float was a desire
for monetary integration in the European Community (EC). the composition of
the ,:nake does not coincide with that of the EC. The United Kingdom, Franre,
Italy, and Ireland, members of the EC, do not belong to the joint float, while
Norway (and until August 1977. Sweden) is a member of the "snake" but does
not belong to the Community. There has been no long term commitment on the
part of EC members to the joint float, and that statement applies even to France
who pays a great deal of lip service to the idea of monetary integration in the
EC.
Members of the snake are all countries with close economic ties to Germany,
and consequently the snake today can be viewed as a German currency area :
"The various smaller countries in the snake have found it convenient to tie
their currencies to a neighbour which is their principal trading partner and
which has managed in recent years to maintain the real value of its currency
more than any other major capitalist country. But the governments and monetarv authorities of these small countries have preserved their monetary freedom. The:v can certainly leave the snake when they want to." 1
( c) Man:v developing countries peg their currency to that of a major induRtrial
country-often, their main trading partner-and fluctuates with it. The dollar
is the most popular such currency, followed by the French franc and the pound
sterling. But such a link does not eliminate exchange fluctuations for the
1 w. M. Corden, "Inflation. Exchang-e Rates, and the World Economy," Chicago, the Uni•
v~rs!ty of Chicago Press, 1977, p. 141.


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peggers. If the Thai baht, for example, is pegged to the dollar, it necessarily
fluctuates (along with the dollar) in terms of the yen and all other major
currencies. As long as· the major currencies are floating, LDC's currencies
necessarily fluctuate in terms of some• of their main trading partners.. Such.
fluctuations are unavoidable. For a variety of alleged reasons (some valid .and
some not) LDC's appear to prefer fixed exchange rates,• and therefore dislike
the present system.
(d) A score of LDC's peg their currencies to a basket of currencies. The most
popular basket is the Special Drawing Rights (SDR) of the International Mone•
tary Fund (IMF)---eomputed as a weighted average of the 16 currencies? But
some peg to a tailor made basket, which contains the currencies of their main
trading partner. ,stabilization of import prices is one objective of basket pegging.
It should be emphasized that the SDR is a unit of account as well as a reserve
asset. But since it is "held" only by central banks and not by the general public
or by private institutions, it cannot be used as an intervention asset in pegging
operations. Oonsequently basket peggers tend to use the dollar as an intervention
currency. But since the dollar•SDR rate is computed and published daily by the
IMF, the dollar exchange rate of the pegged currency can be adjusted to reflect a
stable exchange rate vis-a-vis the •SDR.
(B) Position of the U.S. dollar

With all main currencies floating independently or jointly, the dollar. has
become a floating currency as well. The United States was thus freed to a certain
extent from the straight-jacket imposed on it by the Bretton Woods system, under
which other countries determined the exchange value of the dollar. But this freedom is far from complete. •Since the float of other currencies is heavily managed,
and because the U.S. dollar is the currency with which central bankers intervene
to control their respective floats, they indirectly affect the exchange value 9f the
dollar. Thus while the United States itself holds foreign currency intervention to
a minimum-a laudable practice that should be continued-intervention by foreign countries prevent the dollar from floating freely . It is still the best policy for
this country to continue keeping "hands-off" the market and permitting the dollar
to find its own level.
In addition to being the intervention currency, used by central bankers in a system of managed floats, the dollar is the main transaction currency for the private
sector. Dollar deposits in foreign banks have been estimated at around a quarter
of a trillion. Finally, for a variety of purposes the dollar is used as the international standard of value and unit of account.
During the past year much concern has been expressed over the 15 to 25 percent
depreciation of the dollar relative to the German mark, Japanese yen, and Swiss
franc. There exists a "traditional" and a "monetarist" explanation of this phenomenon. The traditional economist would focus on the '$31 billion UiS. trade
deficit that adds to the supply of dollars overseas, thereby depressing their price.
That is exacerbated by dollar sales on the Euro-dollar markets, instigated by
expectations of decline in the value of the dollar, and the desire of holders to avoid
losses: With so many dollars floating overseas, even mariginal sales can depress
their price. In turn the U.S. trade deficit is explained partly by large oil imports
and in part by the fact that U.S. growth is real GNP and U.S. inflation were dou~
ble their rates in Germany and Japan-a result of d.iverse preferences concerning
the short-run inflation-unemployment trade-off.'
In contrast, monetarists devote exclusive attention to the so-called "official set•
tlements" balance. Their explanation, embraced editionally by the Wall Street
Journal, centers on the expansion of money supply in the United States relative
to the increase in money demand, and the. resulting "spillover" of the excess
money to foreign currency markets. It is that "spillover" that depresses the
exchange value of the dollar.
• See M, E. Kre!n!n, "Living With· Floating Exchange Rates: A Survey of Developments
1973-77," Journal of World Trade Law, November/December 1977, pp .. 514-536.
.
3 The basket was first introduced on July 1, 197 4. and its composif!on reflected the tms
portance of countries ,fn the 5-year period 1968-72. The country composition as well a:s· the
weights, were changed on July l, 1978, with the revised basket being based on statlstieff for
1972-76. In. particular, the currencies of Iran and Saudi. Arabia were added to the basket,
while those of Denmark and South Africa were dropped. The weight of the U.K doU.ar
remained at 33· percent. The next revision in the composition of the basket Is scheduled for
July 1, 1983, to be based on statistics for 1977-81. See Finance and. Development,• June
1978, p. 5.
• For details see M. E. Krelnln, "How Buck Lost Its Bang", Congressional Record-Extension of Remarks, Apr. 25, 1978, p. E 2114.
35-940-78--16


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Regardless of the explanation, the dollar depreciation has made American
goods and services more competitive both here and abroad. And it has changed
the relative profitability between investing abroad and exporting from stateside
facilities in favor of the exporting. For foreign corporations, the balance has
been tipped in the opposite direction, encouraging foreign investments in the
United States. Both trends are welcomed as salutory ingredients of the balance
of payments adjustment mechanism. The unfavorable aspect of dollar depreciation is that it contributes to domestic inflation. Down the road there is the
added possibility that producers of truly international commodities may switch
their pricing unit from the dollar to, say, the SDR. This fear has been expressed
with respect to the OPEC's pricing of oil. But the current oil glut on the international market acts as a restraint to such action. Another reason for that
restr-aint is the fact that OPEC countries have piled up hug-e amounts of dollar
assets. Consequently they stand to lose from any action that would trigger a
further decline in the value of the dollar.
To the monetarists, balance of payments adjustment works through a different
mechanism. It will come about only when the Federal Reserve lowers the rate
of growth in the money stock to the rate of growth in money demand. The
depreciation of the dollar contributes to this process by raising domestic prices
in the U.S. and thereby increasing money demand.
But in all probability some monetarists would join "traditional" economists
in insisting that the United States avoid interventi{m in the foreign exchange
markets and permit the dollar to find its own level. That indeed is what the
Government has done so far. Pressure from Europe and .Japan on the United
States to prop up the dollar by market intervention should be resisted. It is not
in the U.S. interest to offset fundamental trends in the foreign currency markets.
Nor is it in the U.S. Government interest to assume the ex<:hange risk involved
in securing foreign currencies for the purpose of market intervention.
In a very real sense the dollar depreciation is merely a symptom of domestic
developments. Policy initiatives should address the problems of energy, inflation,
and unemployment, and permit the dollar exchange rate to be determined by
market forces.
(0) IMF practices and, charter

Only recently did the International Monetary Fund modify its charter to
a<:<'ommodate the diverse C'nrrenC'y regimes now in exi,:tenC'e. Floating ex<'hange
rates are now permitted under the modified charter. But since practically all
floats are "managed" to a greater or lesser extent, a major issue on the IMF
agenda concerns rules to govern central banks' intervention in the currency
markets. If and when such "do" and/or "don't" rules are promulgated, the
IMF would play a role in enforcing them through an agreed-upon form of
"surveillance".
Among other changes in IMF practices has been thP downgrading of the role
of gold and the upgrading of the role of SDR's in the system. Although only
10.5 billion SDR's have been created, the SDR is used as a unit of measurement,
sincejt is now valued as a weighted average of 16 important currencies.
Along with other organizations the IMF introduced the ·concept of an "effective
exchange rate". Because all major currencies are floating, it is not possible to
dPtertnine changes in the value of a curren<'y simply by observing changeR in
bila,teral rates.' Thus while the dollar depreciated considerably relative to three
currencies (D.M., F.F., and S.F.), it depreciated mrich less relative to other
European currencies, and appreciated considerably relative to the Canadian
dollar ( Canada being our main trading partner). The change in the value of
the dollar is a weighted average of these bilateral movements. And it is this
weighted average change that is <'aptured by the index of an "effe<'tive ex<'hange
rate". Bilateral trade flows with each trading partner ( exports, imports, or
the two combined) can serve as weiy,hts, as can the global trade value of each
trading partner.
Alternatively the IMF derives the weights for its Index fr0m A special mod<>l
desie:ned to measure the impact of exchange rate changes on the home country's
trade balance. Because the weighted average depends on the weights chosen,
several effective exchange rates indexes are in use, differing from e!lch other by
the we!P"hts emploved. It is however instrnf'tive thAt in 1977 the dollAr deori>ciation I;-l!ltivi> to all currencies was around 5 percent and not 20 percent, as it is
sometimes alleged.


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(D) Evaluation of the floating exchange rate system

In the late 1960's and early 1970's most academic economists and many "men
of affairs" favored the abandonment of the adjustable peg system in favor of
floating ex'change rates. Now that generalized floats have been in force for several years the system is being criticized as "unstable" by many observers. Currency fluctuations are viewed as "excessive" as well a~ "erratic". ~n _Europe.the
system appears to have fallen into some measure of disrepute. This is certamly
evident in recent statements of the Bank of International Settlement in Basel,
concerned mainly with the large swings in foreign exchange rates.
But in evaluating the system one must always. ask: good or bad relati've to
what? '!'he Biettori Woods system was abandoned not as a result of considered
-deliherations by central bankers, although both Europe and the United States
(the center country) grew increasingly dissatisfied with it-each for its own
reasons.• Rather it broke down under the onslaught of market forces that
prevailed early in the decade. Since then the international economy was subject
to continuous gyrations of almost unprecendented magnitude. Some causes of
these gyrations were :
(a) The booming demand for raw materials in 1973, leading to substantial
advances in prices.
(b) The quadrupling of oil prices by OPEC in 1973-74, contributing to both
the inflation and the recession in the following years.
(c) The need to divert massive resources to environmental clean-up _and to
the development of new energy sources, cutting into the standard of hvmg (as
commonly perceived) of vast segments of society.
(d) The changes in the world wide food situation, brought on by unfavorable
weather conditions in the Soviet Union, Asia and Africa in 1972-73, and the
subsequent drastic improvement in food supply.
These and other factors, combined with policy measures to bring about .tJla1i:!
stagflation of 1974. The world wide recession in 1974--75 was the deepe,st and
most prolonged since the war. Its effects are still being felt in many countries.
Policy measures designed to promote recovery varied in intensity and duration
from one country to another, with the United States recovering faster than its
trading partners. These differences reflect in part differences in the tolerance
of inflation between countries. In other words, existing differences between countries in their preferences concerning the short-run unemployment-inflation
tradeoff are magnified during substantial economic swings. There is no way for
a fixed exchange rate system to accommodate large differences between countries
in the tolerance of inflation. A fixed exchange regime would have broken down
several times during this period. We would have been living in a continuous
international currency turmoil dwarfing the crises of tbe 1967-73 period.
It was tbis constellation of underlying economic difficulties that caused large
fluctuations in exchange rates. True, they were magnified by speculative activity.
But both tbeory and experience suggest that speculation abounds under fixed
exchange rates as well, and may even be more pronounced.
In short, the floating exchange rate system weathered the crisis rather smoothly, relative to what would have been the case under an alternative regime. Only
floating rates can accommodatP the divergent preferences toward the short-run
inflation-unemployment trade off that exists among nations.
(E) The'M'undell-Laffer thesis

A contrary view that has gained some currency in recent years is that associated with Professors Robert A. Mundell and Arthur B. Laffer. They assert that
not only do exchange fluctuations fail to equilibrate the balance of payments but
they also contribute to worldwide inflation. The argument runs roughly u
follows: The law of one price guarantees that, given sufficient time for adjustment ( and a•bstracting from transport costs), all internationally traded goods
wilil command the same price everywhere; this applies to homogenous and differentiated products alike. Thus, a currency devaluation cannot, over time, change a
country's prices relative to tbose of its competitors; either its prices would rhie
or foreign prices would decline until prices were fully equalized internationally.
• The United States-primarily because it had no control over the dollar exchange rate;
11nd Europe-primarily because It was saturated with dollar reserves. because. Its contl·dence In thP ilollRr ilPcllned, and because It viewed the system as causing! mported inflation
trom the United States.


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Here, Mundel!l and Laffer introduce a second supposition-namely that the price
response to exchange rate adjustment is not symmetrical. Export prices ( denominated in local currency) rise in the devaluing country, but import prices fail to
decline in the revaluing one. This asymmetry is often referred to as the "ratchet
effect". As a consequence, the equalization of international prices is accomplished
strictly through price increases in the devaluing country. Since, in a regime of
fluctuating exchange rates, some currencies depreciate and othe.r appreciate over
one time period, while the reverse tends to occur during some subsequent period,
and because domestic price changes (i.e., increases) occur only ,in the deprecia·ting
countries and not in ,the appreciating ones, the net effect is a world-wide increase
in the prices of traded goods. Through substitution that increase spreads to nontraded goods as ,well. The fact that the emergence of worildswide double digit inflation coincided with the introduction of generalized floating is used as evidence
in support of the thesis.
Both links in the M-L argument can be questioned. First, there is no a priori
reason for the law of one price •to hold in the case of differentiated pi:-oducts. Even
a brand name can account for a persistent price different.ial. The elasticity of
substitution between different suppliers of a manufactured product having similar
characteristics is less than infinite, even in the long run. And in any case, it
makes a considerable difference whether the period required for price equalization following a currency devaluation is 'long or short. If it is very protracted,
then the argument that devaluation does not improve a country's competitive position holds only in the long run. Apart from the question of how long the long
run is, it is clear that improvement could occur, and persist, during the years in
which the price equalization process takes place. And that may ·be sufficient for
exchange rate adjustments to perform their traditional function of improving the
country's competitive position and its balance of payments. By the time the relevant period •was over, other exchange rate changes would undoubtedly occur.
Second, there is no a priori reason to expect a ratchet effect in the case of exchange rate changes. Even if internat prices were infle:idble in a downward direction, import prices ( expressed in terms of the home currency of a revaluing country) can decline following an upward adjustment in the exchange rate. Indeed,
empirical studies have shown many instances of such price reductions, on both a
quarterly and an annual basis, in the postwar period. Apart from that, in an
inflationary world it is necessary only that the appreciating country lower its rate
of inflation, rather than reduce prices aJbsolutely, for t'he ratchet to disappear.
Finally, it might be asked: what gives rise to exchange-rate fluctuations to
begin with? According to the monetary approach, it is divergent ra.tes of infla,tion,
which in turn are caused by divergent growth rates in domestic money stocks.
This takes us !back to- mainline monetarism, where inflation is a result of the
growth in the money supply rather than ,a consequence of floating exchange
rates.
In sum both empirical evidence• and theoretical analysis do not support the
1\1-L thesis. The worldwide inflation of the past five years had its roots in a
variety of fundamental factors, not related to generalized floating. The relation
between floating rates and inflation is complex, and has been the subject of many
an economic discourse. On a simplified level, a floating rate. can protect a
country from inflation originating abroad, and can accommodate divergent inflation rates in many countries. On the other hand it enables a country to inflate
at home, by freeing it from the balance of payments constraint, and at the
same time, it can magnify domestically-produced inflation by "bottling it up"
within the country. But the rate of inflation is still deterimned by domestic
policies.
(F)

The European countries

In the final analysis it is up to each country to decide on its exchange rate
regime. Viewed rationally, that regime should be selected which would minimize
the cost of adjustment to balance of payments disequilibria. For the United
States, with its huge and highly diversified economy, the cost .of adjustment
is less via exchange rate changes than via domestic policy measures. The dollar
should clearly continue to float. And this country should not get itself back into
the .. Bretton Woods straight-jacket, where it cannot change the exchange value
of the dollar.
6 SPe M. E. Krelnln "The Eft'ect of Exchange Rate Changes on the Prices and Volume of
Foreign Trade" International Monetary· Fund staff papers, July 1977, pp. 297-329, and
the literature cited therein.


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But the relative cost of adjustment is different for the European countries.
Certainly small countries may find that the cost of adjustment to external disequilibria is lower via domestic policies than via exchange rate changes. It
would then be rational for them to peg to each other, and perhaps to one
major country, and float jointly. That may explain the European snake.
But what of the larger members of the EC? If past experience is any guide,
they regard the cost of adjustment to external disequilibria to be less via exchange rate changes than via domPRtic policies. That judgmPnt corresponds
well to empirical analyses of the subject. They therefore opted out of the
joint float. Given their divergent preferences toward the short-run inflationunemployment trade-off, opting out was their only alternative. The only way a
Community wide "snake" can succeed is by removing or at least minimizing
intra-area balance of payments disequilibria, and thereby minimizing the need
for any adjustment policies. But that would require at the very least a highly
coordinated monetary policy, reasonably free factor mobility, and consequently
substantial diminution of national economic sovereignty. Only immense dissatisfaction with the present exchange rate regime may lead the EC countries to
agree on such a course of action.
Still, dissatisfaction abounds. And proposals surfaced recently for "relinking"
the EC currencies. A long standing proposal calls on the EC to issue a "parallel
currency", the Europa, which would circulate along with national currencies.
National currencies would be pegged to the Europa it,t a fixed rate and would
consequently be pegged to each other. With time-it is hoped-the Europa
would assume increasing importance relative to national currencies.
For the time being however, the Europeans are considering less far reachin~
alternatives. The following quote from the Wall Street Journal (June 13, 1978,
p. 13) summarizes the four proposals currently under active consideration:
"One of the options being shaped at the BIS is to keep the snake as it is
but to create a wider margin of about 4 percent to 5 percent, within which such
weaker Common Market currencies as the British pound and Italian lira might
float and with their governments under less strict requirements to enforce the
limit.
"The second option would also preserve the present snake but ask the other
countries to stabilize their currencies in terms of an "effective weighted average"
of currencies of their trading partners, or perhaps against a basket consisting
only of the dollar and German mark.
·
"The third would scrap the snake and have all Common Market currencies
limited to a 1 percent range above and below a group of community currencies,
while the fourth would create "a European IMF" to receive deposits of part of
Common Market member reserves and of some of their currencies, against which
they could draw when they need extra funds for intervention."
If European financial integration proves successful, the world could evolve
into a system of three currency areas: the dollar zone, the European zone, and
the yen zone. Stable exchange rates will exist within each zone, while currencies
of each zone would float jointly. against those in the other two zones. Considering
the vast size of each area, and the degree of economic interdependence of countries
within each zone, such a system may prove rather stable. However, none of the
four options are likely to work unless EC countries exhibit greater convergence
in matters of domestic economic policies and tolerance of inflation. All that the
EC bas accomplished to date in this sphere is the creation of an accounting
unit (The European Unit of Account), whose value is calculated as a weighted
average of the EC currencies. While the United States may wish to encourage
European monetary integration, the pitfalls involved in such steps should be
clearly recognized. What is most important is that the dollar should continue to
float, as freely as possible, whether relative to individual European currencies
or relative to blocs of currencies floating jointly.
(G) Summary

The currency system that evolved over the past five years is clearly superior
to any fixed exchange rate regime. It weathered well the recent traumatic events
in the international economy. True, floating rates require an adjustment on the
part of business enterprises to protect themselves against possible losses from
currency fluctuations. But such protection is usually available on the forwartl


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exchange markets. There is no evidence that the volume of world trade and
investments has declined because of floating exchange rates. Even LDC's tend
to exaggerate the problems and understate the benefits accruing to them from
this system.
It should be the policy of the United States to maintain a floating dollar, and
insure that the float be as "free" as possible. The questions on the international
agenda should be how to improve the present system rather than how to change
it. Rules for central bank intervention in foreign exchange markets, IMF
surveillance of such intervention, and greater international cooperation would
all be useful. A movement toward broad currency zones could make the system
more stahle, but it is doubtful that such a movement is feasible at this,time.

Representative BoLLING. Thank you :for an interesting statement.
l\fr. Solomon, please proceed.

STATEMENT OF ROBERT SOLOMON, SENIOR FELLOW, THE BROOKINGS INSTITUTION 1
1\fr. SOLOMON. Thank you, Mr. Chairman.
I am pleased to participate in this midyear review o:f the economy
before the Joint Economic Committee. You have asked that I :focus
on how world recovery may be :facilitated and on the appropriate
roles o:f surplus and deficit countries in the adjustment process.
1\fr. Chairman, I submit that the solution to the problems you have
posed is quite straightforward. The major reason for both the slow
growth o:f the world economy and the large deficit in the U.S. trade
balance may be found in the stagnation that has characterized the
economies o:f Europe and Japan since the latter part o:f 1976.
An acceleration in domestic demand in Europe and Japan is the
most important condition for achievement of healthier growth o:f the
world economy and at the same time :for better balance-of-payments
adjustment. The result would be not only an increase in real income
and a decline in unemployment in Europe and Japan, but also reduced
threats of protectionism, an improvement in the position of developing countries, and perhaps greater political stability in some o:f the
countries of southern Europe.
I might note, Mr. Chairman, that this statement was prepared before, but is being presented after, the Bonn summit mooting. Nothing
would please me more than that my statement would turn out to be a
repeat of the Bonn communique. I am not sure that it is.
STAGNATION IN EUROPE AND JAPAN

Let me first provide a little documentation :for the statement that
Europe and Japan have been stagnating. Taking the European industrial countries as a group, we find that industrial production in the
first quarter o:f this year was barely higher than at the prerecession
peak in 1974. There is virtually no increase in industrial production
over a 4-year period. During the year from the first quarter o:f 1977 to
the first quarter o:f 1978, industrial production actually fell slightly.
More recent data are available for individual countries. In Germany, industrial output in April and May o:f this year was only 1
percent higher than a year earlier. In Italy, Belgium, and the Nether1 The views expressed In this statement are the sole responsibility of the author and do
not purport to represent those of the Brookings Institution, its officers, trustees, or other
stall' members.


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lands production is lower than a year ago. France, after showing a
falloff in output during 1977, has experienced an increase in industrial
production in recent months.
A similar story may be told 0£ ,Japan. Industrial production barely
crept up from late 1976 to late 1977. But from October through May
it jncreased more than 6 percent.
The slow rates 0£ economic expansion during 1977 were reflected
in the volume 0£ imports by these countries. Thus from the fourth
quarter 0£ 1976 to the fourth quarter 0£ 1977, import volume in absolute terms £ell in France, Italy, United Kingdom, and the Netherlands.
In Japan, the physical volume 0£ imports increased only a little over 1
percent and in Germany 3.5 percent. Meanwhile, the United States,
where economic activity was moving ahead rapidly and oil imports
were going up, import volume increased 7.3 percent-1978-I to 1978-I.
It is not surprising, therefore, that the U.S. trade balance moved
sharply into deficit in 1977.
In the early months 0£ 1978 the volume 0£ imports into most major
European countries and Japan appears to have speeded up. This should
begin to show up in U.S. exports soon. But the fact remains that, aside
from France, most European countries, and notably Germany, have
not yet moved out 0£ the condition 0£ stagnation that I have described.
Let me say a word about the effect 0£ stagnation.
The stagnation has brought high levels 0£ unemployment in Europe.
Unemployment is actually higher now than it was at the trough of
the 1975 recession.
The stagnation has also brought pressures £or import barriers and
cartelization in Europe, as is well known.
And the stagnation has, as noted, kept imports low while producers
have had strong incentives to find markets abroad for what they could
not sell at home. This so-called export push has been especially evident
in Japan and Germany.
In these circumstances, most European countries and Japan have
experienced either a reduction in balance-of-payments deficits or an
increase in surpluses on current account. In the case of Germany,
Japan, and Switzerland, the combined surplus on current accountgoods, services, and private transfers-came to more than $23 ,billion
in 1977, an increase 0£ $8 billion over 1976. Most 0£ that was accounted
£or by Japan. The deficit 0£ France fell sharply, while Britain and
Italy shifted from deficit to surplus.
The major counterpart of this movement toward surplus of the current lll'<'ount positions 0£ the indnstrial <'mmtrirR of En rope and Japan
was, of course, a sharp increase in the U.S. deficit on current account.
In addition, as is well known, the increase in U.S. oil imports in 1977
.added to the American deficit.
These large changes in current account position had an effect on exchange rates. As we know, the Japanese yen began to move up early
in rn77 as ,Tapan'R surplus grew rapidly. In the fourth Qnarter of 1977
the Deutsche mark began to move up rapidly, pulling other European
currencies with it.
This appreciation 0£ these currencies in Europe and Japan, and the
corresponding depreciation of the dollar against them, occurred even
though interest rates in the United States were rising relative to inter-


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est rates abroad. Clearly, expectations 0£ further exchange rate movements outweighed the pull of higher interest rates in determining capital flows.
While the exchange rate relationship between the dollar and the
European currencies has been more or less stable since March, a fact
that has not been widely recognized, the yen has continued to move up
as the perceived balance-of-payments surplus in Japan got bigger and
bigger. Thus the stagnation in the other in_dustrial countries has r~sulted in exchange rate movements that will, when they have then·
effect on trade flows, aggravate the stagnation.
Meanwhile the exchange rate movements are having more immediate
price effects. The rate of inflation, especially in Germany, J,apan, and
Switzerland, has been dampened significantly by the combined impact
of slack demand and falling domestic currency prices of imports, as
Profe1ssor Dornbusch pointed out.
In the United States just the opposite has occurred. The combination of vigorous economic expansion and depreciation 0£ the exchange
rate has increased the underlying rate of inflation.
I come finally to policy implications. It follows from what I have
been saying that the European countries and J,apan need to stimulate
their economies by increasing domestic demand.
Johannes Witteveen, until recently managing director of the International Monetary Fund, has set forth a sensible policy prescription.
He calls for coordinated expansion by the industrial countries. The
United State:s would experience some slackening in its rate 0£ expansion, as is widely expected. But most other industrial countries would
accelerate their growth, and by more than 1 percent, in?identally.
Germany, for example, would speed up from an estimated 3.1 per.cent in 1978 to 4.5 percent in 1979-80. France would do the same. Italis
real GNP would accelerate from 2.6 percent exp,ansion in 1978 to
4 percent in 1979-80, and so on. The smaller industrial countries, ,apart
from the seven that met in Bonn, would double their rate of expansion
from a mere 2.2 percent in 1978 to 4.5 percent in 1979-80.
Now, Mr. Witteveen is not a wild man, Mr. Chairman, and it seems
to me when he makes an observation, we should pay 'attention to it.
Further, according to Mr. Witteveen, "There would now appear to
be quite a number of countries in which, because of the accumulation
of economic slack and the blunting of infl,ationary expectations, the
risk of exace,rbating inflation would be minimal if cautious and welldesigned policies of expansion are pursued."
On this basis, Mr. Chairman, it is possible to 'bring 'about a healthier
rate of expansion of the world economy and a reduction in balance-o:fpayments disequilibria without worsening the problem of inflation.
Thank you.
Representative BOLLING. Thank you, Mr. Solomon. I think this is an
interesting a group of papers on this subject as I have ever heard, and
I wish that we had been able to induce every Mem.ber of the House
to listen to them.
Congressman Reuss.
Representative REuss. Thank you, Mr. Chairman.
Let's talk about the summit meeting, the communique of which we
nave all seen. I would like to run down the panel and ask for your


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views. I would comment, first, however, that while Germany seems tel
have made some kind of a commitment toward more active growth
rates, the same doesn't seem to be true of Japan.
What they seem to have said is that "we will let down some of our
barriers on imports," which did not seem adequate. I think I will just
go down the panel and ask, if you care to give them, i£ you have had a
chance to look at this morning's paper-if you would care to give us
your views on the accomplishment of the summit. There is nothing
disastrous there. They didn't do anything wrong, but after all, these
countries have been promising more growth for some time.
Let's start with you.
Mr. DORNBUSCH. The striking e:ffect of the summit is, of course, the
hijacking agreement. The economic effects don't dominate. There was
a Japanese commitment, for example, to limit the volume of the
exports to last year's. We can think of Japan as having an increase of
10 percent in export prices, and that would reduce their export in
volume terms by perhaps 5 percent. I£ the world economy grows by
5 percent, that would raise their exports by 5 percent. That means they
have to do nothing to keep exports constant.
From the German statement, we don't know whether the stimulus or
outcome is 1 percent of GNP, and we don't know whether it is real or
nominal GNP. H it is nominal GNP, perhaps they are going to
contract.
'
I believe a lot of cosmetics have gone into this. Before, the outlook
was one of antagonism, and now it looks as i£ there is more substantial
concern and an agreement that something perhaps should be done;
But I don't think anything has substantially changed.
Each one said they would go home and submit to their legislatures
what they had, in fact, agreed to do before. There is, perhaps, more of
a commitment to keeping the dollar from depreciating than one might
want to see. The United States has not undertaken that, but one reads
that there was pressure to that effect.
I see a substantial buildup of U.S. commitments. I think the pressure
of Europe is on oil, but what is behind it substantially is dollar stabilization. I think we should be worried about that.
Representative REuss. For instance, the .Japanese did not promise
to take steps to build a sewer system for the city of Tokyo, which now
uses the honey wagon as a method of disposal. That would help the
world, would it not?
Mr. DORNBUSCH. They did not promise any substantial liberalization of imports. Japan remains a heavily protected country. Japan
still practices exchange control on tourism and remittances.
Perhaps the best way to look at the rest of the world attitude is to
ask why they care so much about U.S. oil imports. There are two explanations. If the United States used less, the stock wouldn't be so
rapidly depleted. Of course, in Germany and Japan the price of oil
has been falling with their appreciation. The real reason though is
that if the United States had not so large an oil bill, and if that
changed the current account substantially, then the dollar wouldn't be
depreciating and then the United States wouldn't be gaining competitiveness at the expense of Japan and Germany and France and
Italy. I think that is the spirit in which one has to see that. They


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have said that the United States should be restricting oil imports, not
that we should stop foreign small cars.
Representative REuss. Neither, one would note, was there any reference in the protestations of added growth such as in the case of Germany to that kind of added growth which is best suited to solving
the problem you brought out in your paper, that added growth that
is aohieved through capital goods and machine tools is likely to help
the United States, because we export some. Capital growth achieved by
building autobahns isn't likely to do the same.
Mr. DORNBUSCH. The optimism I have for the coordinated expansion is limited. It would take in the first instance the form of public
works. We must not forget that all these countries have a much larger
state enterprise system that controls the awards of contracts. It takes
a long time before reaching imports. Finally by the time people receive their income and decide to buy U.S. goods, can they get them?
I think expansion abroad is much more controlled than the U.8.
expansion.
Mr. SoLOMON. From the discussion that has been going on in Germany, my impression is that if the German authorities act in a stimulative matter, they are most likely to cut taxes fairly soon, and probably
partly on business and partly on consumers, and that would have an
effect in the desirable direction.
Representative REuss. Neither, so far as I could see, was anything,
said about principles of surveillance of intervention. We are still
back in the rather circular disorderly conditions market. You intervene if there are <lisordPrlv conditions. 0 1 · - Mr. KREININ. Surveill~nce is turning out to be a difficult issue, and
there really is no agreed procedure, either in the IMF or anywhere
else, as to what indicates important intervention and what rules of
surveilJance ought to be adopted. There are proposals in the professional literature, but there is nothing that has been agreed upon, and
many of the proposals for surveillance require some sort of notion of
what the longrun equilibrium exchange rate is, as though there were
some central authority, and as though we had an agreed-upon theory
that would tell precisely what the long-range equilibrium exchange
rate is, and then surveillance would prohibit policies to push the exchange rate away from that.
We really don't have a good mechanism for determining this longrun equilibrium exchange rate at this point, so I perceive of surveillance as a typically difficult and controversial topic before we even
get to political discussions and to a powerplay between the countries.
I want to add a few points to the question of the trade balance. I
agree with the other participants. My prepared statement reflects
concern about the U.S. trade deficit. It is just that the summary statement focuses on what has been requested by the committee staff.
I would like to raise a couple of points. First of all, in the past, every
time Japan undertook to do something, it was to increase the imports of raw materials-in other words, Japan would stockpile raw
materials, which is what it imports anyway. In the next 5 years they
will import and stockpile raw materials for the next 10 years while
in the following 5 years they wouldn't need any raw materials. In
other words, there is no real, fundamental change in the Japanese pos-


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ture with respect to control of foreign exchange, as Mr. Dornbusch
mentioned, which I think is true. Domestic taxes and imports of manufactured products are also included.
What we would like to see Japan do is import more manufactured products rather than continuously pile up raw materials. I think
that is crucial. I believe the Japanese growth rate is crucial to any
kind of agreement. And the United States ought to bring its full
leverage to bear, insisting on a higher growth rate in Japan and
Germany, because it is in their interest as well as ours.
Let me also add that there is some evidence that if Japan and the
United States grew at precisely the same rate, Japan would develop a
surplus and we would develop a deficit because of the differential
response of trade to growth of imports.
There are some studies to that effect, and they suggest this differential response, that if the United States and Japan both grew at 6 percent, the United States would develop a deficit and Japan would develon a surplus. That means that Japan ought to grow faster than
the United States to attain and maintain equilibrium.
One point with respect to the LDC's. I agree with Mr. Dornbusch.
One reason for the upsurge of protectionism in the United States has
been deep penetration of imports, not only from Euro-pe and Japanwhere they are concentrated in highlv visible, industries such as steel
and automobiles rather than spread across the board. It is this visibility that brings forth a sort of protectionist feeling, I am sure on the
Hill and elsewhere. But a]so the increase in imports from LDC's. I
think there is no question about that penetration, which, incidentally,
is ::1 favorable development.
LDC growth rates have increased. It is no longer true to say that
the rich are getting richer and the poor, poorer, because the LDC
growth rates are higher than the DC growth rates.
In several instances where I appeared on public panels with representatives of the U.S. labor movement, they suddenly started mentioning the general system of preferences, the GSP. On these occasions,
mv first readion was thn.t of surnrise. I thought I was the onlv one
who knew about the GSP. I didn't realize that it became sort of commol'\ knowledµ-e.
To me it refle<'ts the concern of U.S. labor with import penetratio111.
from underdeveloped countries.
Now, that does not concern me from the point of view of global U.S.
interests, because the United States does have an interest in promoting
economic development. However, for a ]ong time I have been concerned
with the lack of reciprocity between the industrial and the underdeveloped countries when it romes to trade negotiations. In other
words, what happened at GATT is that the LDO's, so to speak, sit on
the si4elines and collect the cn~mbs. They get the benefit of whateve,r is
negotiated among the DC's without themselves having to reciprocate.
One effect of this procedure is that LDC's don't get many concessions
on products that are being exported to them, and they complain about
it. Rut it has another effect.
~he LDC's subject themselves to extreme measures of protection in
their economies, which interfere with their efficiencv and their own
development progress. Those LDC's that have changed their import


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regime and switched to some measure o-f export promotion as against
fmport substitution to the hilt, have grown -faster.
So there happens to be a convergence o-f interests, on the part o-f the
-United States and Europe, on the one hand, and on the part o-f the
LDC's, on the other hand, to induce the LDC's to come to the negotiatfng- table and offer concessions.
In other words, to me the action paragraph o-f the statement Mr.
Dornbusch made, that penetration by the LDC's is a problem, is that
fhev should also offer concessions in GATT negotiations. That would
be 'in both the interests o-f the industrialized and the developing
countries.
Representative REuss. My 10 minutes have expired. Maybe I should
suhside and come back to this.
There are some other questions I want to ask Mr. Solomon, and then
Mr. Dornbusch has another point.
Representative BOLLING. Congressman Mitchell.
Representative MITCHELL. Thank you, Mr. Chairman.
.
.
Is the dollar overvalued or undervalued~ Quite -frankly, m this
rather esoteric area, I am not even sure what -factors enter into a determination as to whether the dollar is overvalued or undervalued. I raise
the question because it seems to me that whether it is or is not, whether
it is overvalued or undervalued, obviously whatever the condition is, it
is going to accelerate intervention in the exchange rates. I guess that is
a three-part question.
Is it or is it not overvalued or undervalued, and how do you go about
determining whether these two conditions obtain, and what -factors are
brought into that decision; and whether it is overvalued or undervalued, will this not accelerate intervention in the exchange rate?
Mr. SOLOMON. Congressman Mitchell, it seems to me, i-f I may, I suggest that you now ask that question-Representative MITOHELL. It is a good question.
Mr. SoLOMON. You can't expect a meaning-ful answer to it. No one
can tell you whether the price o-f the dollar is overvalued or undervalued, just as they can't tell you whether the price o-f tomatoes is
overvalued or undervalued. It depends on a whole variety o-f criteria.
Part o-f the trouble with the international monetary .system in the
past was that people had a notion that you could determme the appropriate value and exchange rate, and stick to it, and that system broke
ilown. We are now in a svstem where that question is, in my view,
simply not answerable, and there-fore it doesn't make sense -for countries to engage in sustained intervention in an attempt to maintain
what they---or what somebody-regard as an appropriate value for
thfl currency.
I think I take a little bit o-f com-fort from the communique, which
I have iust hurriedlv looked at. As I read it, it seems to me -consistent
with what I inst said. It says that exchange rates depend upon underTying conditions in the various countries.. Those conditions obviously
change over time. Therefore, there is no fixed value for exchange rates.
They do talk about combating disorderly conditions, as they have
done be-fore.
Mr. DORNBUSCH. Let me trv to answer somewhat differently. Of
eourse, it is not enough to say 'that the U.S. dollar at present is overvalued, but I think there is reason to believe that this, -in fact, is true.


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First, there has been substantial intervention, not of the disorderly
market kind, but dramatic dollar buying. The United States ran a $35
billion sale last year. Central banks were buying dollars to the tune
of $35 billion. They haven't been getting rid of it, nor have their
dollar holdings declined over the past 10 years.
There is a systematic pattern of U.S. intervention, which as of the
end of April had reached $1.8 billion. If the United States were to pay
off their liabilities now, it would make an $85 million loss. That is a
rough calculation. It may be $60 or $100 billion, but the numbers that
are shown on actual realized losses show profits consistently.
So the first argument is that there has been strong- intervention, and
dollar buying by the rest of the world. That is an rndication that the
dollar may be overvalued. The second is a movement in Europe toward
monetary integration, which is really a-movement, if you like, by Germany to allow the soft currency countries to come in and keep the mark
from appreciating. I think this is, in part, a means to compensate
for the dollar's present overvaluation.
Third, what would the world look like at a full employment pattern of trade and payments? I think the United States would have to
have a depreciation in the real exchange rate relative to the rest of
the world. The United States cannot achieve a depreciation relative
to LDC's.
The only way the United States can, in effect, achieve a real depreciation is relative to other industrialized countries, and that means a
movement of the nominal exchange rate relative to the mark a,rea and
the yen.
,
I have made that point before, and I think we have to get accustomed to it, that if the mark appreciates by 15 percent, it makes very
little difference to the U.S. real exchange rate. The la,rge exchange
rate movements we observe are attempts by the market to get the real
U.S. relative price structure right in the face of declining competitiveness.
We shouldn't be surprised by that depreciation, and we certainly
shouldn't enter agreements with Germany and Japan to peg the dolla,r
at its current level. Exchange rate movements have to take effect and
restore U.S. competiveness. That is the only way to redress our current account.
Mr. KREININ. First of all, on the extended intervention in 1977, tota1
global intervention has been estimated at $100 billion. The year before
1t was about $70 billion. I can't remember the exact figure.
So we are talking about substantial intervention to keep the dolla.r
from depreciating. There is no question that the broader European
snake.will do more.of that; 1977 center~ attention on the depreciation
of the dollar relative to three currencies, the mark, the Swiss franc
and the yen. It is relative to those that the dollar came down by 20 0 ;,
25 percent.
The effective exchange rate of the dollar-in other words the
weighte~ average chang~ in the dollar relative to all U.S. trading partners, weighted by the importance of ea,ch trading partner in U.S.
trade~ame down only by 4 percent.
Remember that Canada is onr major trading partner, and relative
to Canada the United States dollar appreciated by about 10 percent. So
the reason why the dollar depreciated so much against these three cur-


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rencies is because it is through that movement we attained a 4-pcrcent
overall depreciation.
A better way of looking at what happened to exchange rates last
year is to focus on the appreciation of three currencies rather than depreciation of the dollar. It would provide a much more representative
noti,on of what has been happening.
Now, I suspect very much that Mr. Dornbusch is correct in suggesting that the dollar is still somewhat overvalued. In other words, we
came down 4 or 5 percent last year, not 20 or 25 percent, in the value
of the dollar relative to all our trading partners, and the dollar will
probably depreciate some more.
Estimation of the equilibrium of exchange rate is difficult for any
country. We have several conflicting theories.
There is a point of view, which I make parenthetically, among economists which don't care to devote any attention to the trade balance;
only to the official settlement balance as it relates to money supply.
And that view has been embraced by the Wall Street Journal. In other
words, the current account or the trade balance is of concern to us,
hut there is a view that it can be dismissed.
So, there are conflicting theories of how to determine the equilibrium
exchange rates for any currency. For the U.S. dollair it is much more
difficult, because there are $250 billion floating out there, deposited in
foreign banks, any and deJCline in confidence triggered by rumors,
triggered by happenings, triggered by' anything, can induce a small
fraction of these holders to unload some of those billions and that is
going to deprecia.te the dollar. In other words, for the dollar it is much
more difficult than for any other currency to distinguish fundamental
underlying trends from the actual ex<lhange rate movements. Dollar
deposits in foreign banks, in such substantial amounts, militate against
TT.S. intervention. In other words, I think the dollar ought to float
clean.
It doesn't float clean primarily because foreign currencies intervene
in their own foreign exchange markets. If they intervene in dollars to
affect their own exchange rate, that indirectly affects the value of the
dollar. But the United States should not contribute to that, because
with so many dollars floating overseas, almost equal to the U.S. money
supply, measured as M-1, there is little we c:an do.
I believe we shouldn't. and I think we cannot manage the dollar float.
In other words, the dollar ought to float as clean as possih1e, both becaiuse we shouldn't and because we cannot intervene adequately. So
that is the answer to your question concerning intervention.
I believe the dollar is still SOIJilewha,t overvalued. It will depreciate
fm:ther, but when it comes down, yon have to look at the overa,ll depreciation of the dollar rather than the depreciation relative to three
currencies.
Representative MITCHELL. Thank you.
I might come back to that. I don't know how our time is running, and
I want to get into another area.
1'here is one thing that a1most all the Members of the Houf'e of Representatives agree on-and that is rare--and that is that oil imports
are the chief cause of our balance-of-trade deficit. I think there is
consensus on that.


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The problem is, how do you try to limit the oil in:iports? There are
options, of oourse. I think we can use quotas or tanffs. W:e could use
a crude oil equalization tax, and maybe the~ are ?ther opt10~. But as
I read it, the Members of Congress are gropmg with these options and
still haven't come up with ,any answer.
I would like to get expressions from the mei:nbers 0£ the p_an~l O?what, in your opinions, a;re the most appropnate ways to limit 011
imports'?
Mr. DORNBUSCH. I certainly find myself in disagreement with your
view that oil imports are the chief explanation for the deficit. I don't
think one can look to oil, and I think it is a mistake to try and solve
the current account with an oil policy. But I think there is, of cours~,
an overwhelming case for saving energy in the U.S. eco:r_iomy, and it
will in the intermediate term, 5 or 10 years, have beneficial effects on
the current account.
I think the rise in domestic prices-allowing domestic prices to
increase to the world level-is the best way. I wouldn't think that
quotas are desirable. I think the minimum of regulations and the
maximum 0£ a clear sign that the real price of energy is up £or good
is the best way.
When you ·do that, there will be some cutdown in demand, but most
of the adjustment takes time, as we change capital equipment and
consumer durable goods and housing to more energy-conserving modes.
That is a very long process, and I think the free market in that case is
really indicated.
Mr. KREININ. Congressman Mitchell, in listening to your first question, is oil imports the crucial factor in our deficits? You might reverse
it and ask if oil is the crucial £actor in the deficit, why is it that Japan,
which depends on imported energy 100 percent of its energy consumption, and Germany, which depends £or maybe 80 percent, are running
surpluses. If oil is the crucial £actor, that is.
I am not denying that oil is some of the £actor, but oil is not the
crucial £actor, because the evidence is against it.
.
Obviously, we can improve our position by cutting down on oil
imports. In other words, oil does play a role in the <leficit.. but I
wouldn't attribute the entire deficit to it, because, otherwise, you
cannot explain the performance of Japan and Germany.
Oil is one of the second things. In my prepared statement, I make
the following observation. Policy initiative in the United States should
addrrss tlw prohlrms of enrnrv. inflation 1111d nnemployment, and to
permit the dollar exchange rate to be determined by market forces,
In other words, there is no question that energy is a big problem on
its own merits and it ought to be tackled, because, in the long ran1Ie,
it is a !>rob~em _in the United Stri.tes, not because 0£ its balance-of-paymr·nts 1mnhcat10ns onlv.
When I say that oil is not the beginning and the end of the balance
of payments problem, I am not suggesting that energy is not a problem
in the ·united States. It is. But it is a problem on its own merits rather
than ?ecause of the balance of payments. That is the first part of your
quest10n.
"With respect to energy policy, my own view is not similar to that
of most economists. I would like to see energy prices rise to world


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levels in the United States, as Professor Dornbusch suggested, but I
don't think that is enough.
In other words, I would like to see a policy of taxes and subsidiesnot •import quotas. I think import quotas are the third or fourth
best policies. There are other measures to bring U.S. prices first to the
world market level.
That is No. 1.
No. 2, introduce additional taxes and subsidies schemes that would
further discourage consumption of energy even then.
In other words, we, in the United States have become accustomed
to it today, that 67 or 70 cents at the pump is sort of our God-given
right. In fact, the real price of gasoline has declined over the years
in the United States.
In foreign countries, it has gone up. In other words, the Europeans
are accustomed to paying $1.50 or $2 a gallon. We are not. I, myself,
believe that we do need an active policy of taxes and subsidies superimposed upon market prices.
In other words, I would like to see market-plus. What we have
now is market-minus.
The reason for my different views, different from most economists
on that-most economists probably would advocate letting the market
price prevail-is because I look at the energy problem as very, very
long run, spread over generations.
It requires probably a generation or two to switch the economy from
an oil-natural gas base to, say, coal base or some other base, and I ani
not sure that if left to the markets, we would have enough time for
smooth transition.
In other words, we all agree that markets do discount, but I do notI am not sure at all that we have experience with this over generations,
and it is for that reason that my own view is this; but there is no question that energy prices must rise in order to discourage consumption.
I just don't see any other way out.
But that is not because of the balance of payments implication. It
is because we do face a longrun energy problem which ought to be
·
taken on its own merits.
:Representative MITCHELL. Thank you, Mr. Chairman. Mr. Solomon,
you had a comment i '
Mr. SOLOMON. One word, if I may.
As :vou know, when you assemble three economists, you expect to hear
more than three different views on anv single subject.
Representative BOLLING. Would the intervention of the members~
[Laughter.]
.
Mr. SOLOMON. I would like to enter jnst a slight reservation to what
has been said by my colleagues. I don't disagree with them head on.
Neither of them. however, said anything about the current inflation
problem in the United States. The existence of inflation and the threat
of it is having a significant impact on macroeconomic policy of the
United States.
It is having- a significant impact on all sorts of other aspects of our
society, and it is obviously a matter of deep concern to many people in
this country, just the present rate of inflation.
If we go about solving our energy problem, and we all agree that
t.here is an energy problem in the long run, if we go about solving it in


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the short run by raising prices abruptly, this will have, in turn, feedback effects through wages and worsen the wage-price cycle that Mr.
Strauss and Barry Bosworth and others are trying to do something
about.
I thought that consideration ought to be put into the record along
side the other views.
Represent81tive MITCHELL. Thank you. I know my time is up, but I
would like to seize this opportunity to press my position, which recognizes the danger of inflation but takes serious issue with singling that
out as the key problem right now.
Every time I get an opportunity, I suggest that there are two dangers, not just inflation, but unemployment and more in particular
structural unemployment, because you cannot separate these out and
give one a higher priority over another.
Thank you, Mr. Chairman.
Representative BOLLING. Congressman Reuss.
Representative REuss. I am glad, Mr. Solomon, you made the point
you did just now, that raising domestic oil prices to the world price,
while it sounds simple, it is possible could be a most Draconian measure,
and I have been disappointed that the White House has not, in my
judgment, faced up to what really needs to be done.
You do have to raise the domestic price to the world price over a
period of years, but, meanwhile, nobody seems to take into account
the position of a large part of the American working public, which
was conditioned by public policy into buying a little home 40 miles
8:way from the working place.and commuting back and forth.
It seems to me you have to do something for them. You have to do
something for other people who need to use gasoline1 and I don't know
why the Department of Energy hasn't cooked up-1s it perfectly possible to do, and it was done in ·world War II-some kind of a phasedin program, where you take, for instance, as gas rationing program,
where everybody gets 15 gallons a week.
If you cushion that so that those who need more in order to get to
work and for other essential purposes get more at a lower price for a
while, 3 or 4 or 5 years, that would be helpful.
I think, then, and only then, would it become politically possible.
I gather that something like that is in your mind when you say we
should raise the prices to the world level, and that that will have an
iq.flationary impact.
Mr. SotoMON. Yes.
Representiative BOLLING. Anybody want to comment 1
Mr. KREININ. Yes.
Let me suggest two things.
First of all, the topic of this meeting was not ffilergy policy, and I
am sure that the reason why nobody here expounded their views on
energy was because we had a totally different focus. But in direct response to your points, I, myself, would not support an abrupt price
increase to world prices.
I would support a gradual, proonnounced increase over a period of
several years.
Representative REUSS. If I may interrupt yQIU, that is sffilsible, because that is a signal to somebody who is contemplating buying a
home 40 miles from his workplace, that it isn't a very good idea.
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Mr. KRErNIN. Yes. The adjustment in the economy would start immediately after the announcement is made and everybody can be c~rtain it is coming over a period of years. Most observers would hke
to see a gradual change, 1although we might differ about how gradual
it should be.
Second, when it comes to the gasoline tax, which is a big part of the
original administration program, :i,t was not proposed only as a tax.
Rather, it was coupled with a direct subsidy. It was a tax-subsidy
combination. In other words, you could impose a 100-percent tax on
gasoline, and return the money to people in the low- and middleincome brackets in the form of a direct subsidy.
The reason why the general public failed to understand the nature
of the proposal is booause econo1II1ists went on confusing it with technical statements, such as substitution effect and income effeot. But actually the idea is very simple.
If you take an average family that spends $500 a year on gasoline,
and if you double the price by a tax, you increase the relative cost of
gasoline; and at the same time you return the $500 to the family in
the form of an income subsidy. The income of this representative
family was not affected by th<> tax-subsidy action.
As long as the family is not going to spend the additional money
on gasoline, you have reduced gasoline consumption. without making
the family worse off.
Represenfative. REUSS. This, again, isn't a hearing on energy, but
the pwr devil.who has boon induced by American'social decisions to so
order his lifestyle that he has to use a lot of gasoline is worRe off. That
fact that he gets back peanuts on the income tax isn't going to save
him.
If you shy away from a quasi-rationing system, which I think one
should not shy away fro1II1-I think one needs one--if you shy away
from that, about the best way of getting the money back in the right
pockeits that I can think of in 1a Rimple way is to repeal the increase
in the workers' share of the social security tax that we mistakenly
enao.ted.Jast December.
There is a rough correspondence, a very rough correspondence
there.
As you say, this is not a hearing on energy.
Mr. KREININ. It is a different issue. But if vou ma.tch the tax for the
average person with a direct subsidy; if he spends $500 on gasoline in
a year and you doubled the price by tax to $1,000, and you retnrned
the, $500 to him, he is no worse off than he was before, and all the
adinstment that he would make is of his own choosing.
. You have only changed relative prices, but have not affected his
mcome.
Representative REuss. He would probably choose to buy additional
gas.
Mr. KREININ. Not to the full extPnt.
Mr. DORNBUSCH. I am happy Congressman Reuss mentioned social
SPcurity, because that, of course, is one way to offset the inflationary
effect.
I think the U.S. economy has plenty of measures of that varietv to
act where we can control inflation on 'the supply side. I do think that


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is a way of compensating for the inflationary impact of an energy
program.
It is true, too, that in the aggregate, the U.S. economy has been
poorer, because the increased oil price has to be borne, and I don't
think it is right to go out and compensate everyone that has an identifiable loss. Of course, we may want to ask for changes in the real
income distribution, but that is a separate question.
I do think the price increase is important to give a subsidy to ~he
production of energy conserving resources and products and eqmpment. If we have a slowlv phased-in nominal price increase, we don't
know whether that woulctn't be overtaken by inflation. Of course, if
Congress would make it a real increase, and would have regulations,
that might do it, but I don't think that is the right approach either.
We have agreed that a relatively free market-oriented solution is
preferable, and that it should come very soon, and if it has an inflationa~y impact, that is a good occasion to cut out other regulations and
taxes m the economy.
Representative REuss. Thank you, and other members of the panel.
Representative BOLLING. Thank you.
Congressman Brown.
Representative BROWN of Ohio. No questions at this time, Mr.
Chairman.
Representative BOLLING. Let's take Bonn again. It was not a disaster.
It was a verv nonspecific success. [Laughter.] That is much better than
a diisaster. You·gentlemen have studied a great deal in terms ofint:er~
national economics. Is that the best we can expect out of a developing
technique of summits annually?
Have we made progress over the one, two, three, or have we retrogressed?
What I am asking you in effect is an impossible question, and this is
another impossible question, but it has to be asked because we have to
try to think about it here.
·what are the ways in which. we can improve _the possibility of
coordinating whatever seems to agree is an absolute essential-the
efforts of a variety of economies of different kinds in the world?
What I am getting at is, is there a structural approach? Is there
a technical approach? Is there any approach that will make it more
likely that we will do what I think everybody agrees we have to do,
do a better job _of coordinating world economies?
May I_ start with you, Mr. Solomon, sir?
Mr. SoLOMON. Mr. Chairman, I think the first thing one has to do
is define what one means 'by coordination. I don'tthink what we are
talking about is having all countries necessarily move in the same
direction at the same speed at the same time.
That isn't what is implied by your question at all.
Representative BOLLING. No.
Mr. SoLOMON. I think what coordination ultimately comes down
to is, one, acknowledging that it is in the interests of all countries
that all countries should expand somehow along an optimum growth
path with a mjnimum of inflation. That is the objective that they can
agree upon. They can agree upon that without having meetings, of
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Then, the next question is, how do governments go about pursuing
policies to achieve that result i That is, an optimum growth of the
world econom;-v, each one taking into account what the others are
doing, the pohcymakers in each country taking into account the economic performance of their major tradrng partners.
That is how I would define coordination; namely, adjusting your
own economic policies, country by country.
Now, that cannot be done exclusively by Presidents and Prime
Ministers, particularly when in all frankness those Presidents and
Prime Ministers don't understand economic processes very well.
I could quote to you, and I shall not do it, a statement from Prime
Minister Fukuda, which may have been put out for political reasons,
and maybe he knows better. The statement was that the slow growth
of the world economy was the result of U.S. oil imports. That indicates to me that he needs a little more education in the field of economics. I say that with, I hope, respect to Prime Minister Fukuda;
he cannot be an expert in everything.
To get back to my main point, this process of coordination, as I
have just tried to define it for you, and I hope it is a helpful way· of
defining it, has to be pursued at all sorts of levels.
It can be discussed at the Presidential level, but it certainly needs
to be discussed also at the Minister of Finance level and the Under
Secretary level, ·and, perhaps, at lower and more technical levels
among governments, and within the framework of the international
economic instituti()ns to which the nations of the world belong, particularly the OECD and the IMF.
I think that is all I wish to say. My main purpose was to try to
help a little bit in defining w'hat we mean by thi!;l Pl'.OCess.
Representative BOLLING. ·what you are really saying is uh.at there is
no substitute for a rather slow, and for lack of a better word, I will say
a "grinding" process, in which we learn by going through each month
ancf each year, pursuiing our best goals at whatever level we are
working.
Mr. SOLOMON. I am afraid there is an awful lot of learning to he
done. Since Mr. Kreinin has given a little bit of free publicity to the
Wall Street Journal, perhaps I could mention, Mr. Chairman, that I
write a newspaper column fortnightly in the Journal of Commerce, in
which I try to spread a little bit of ooonomic wisdom as I see it. I have
tried in these columns over the past few months to comment on the
state of the world economy in an eft'ort to make a very tiny contribution
to an improvement to what we have just been calling economlic knowledge and economic education.
I think that has a long way to go, if one looks at the statements that
come out of our leaders. I have already mentioned Prime Minister
Fukuda, and I won:t pick on him anv more.
I could say something about some of the stat.Pments Chancellor
Schmidt has made, and with all due respect to our President, as I listened to him being interviewed by John ChancPllor the otili.er nig-ht,
perhaps tired after 2 days of meetings, but I felt his comprehension
of some-of the problems he had been concerned with c<>uld have been
more acute.
Representative BOLLING. That leads me inevitablv to what I consider
an even more acute problem in this country, which is not the executive,


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but right here in Congress-at ]east, so it seems to me as I grapple
from day to day with the handling of problems in our domain.
Mr. SoLOMON. I didn't dare raise that subject. [Laughter.]
Representative BoLLING. But, really, what that amounts to, and I
will be curious to see if anybody agrees with that particular approach,
but thatsavs that we need a vast amount of time for self-education if
we are to move into what is in effect a totally new kind of situation,
not just in the last 10 years, but from 1966 on.
We have a totally different economy and world economy to deal
with.
Now, that is a very simple minded statement, but I think it is terribly important that more and more people up here, at least, realize it.
Would you like to comment i
Mr. KREININ. Yes, I would like to say a few words.
You might ask yourself the following question, Mr. Chairman.
Why is 1t that suddenly without any preparation, the world's leaders, on the spur of the moment, agreed on an antihijacking agreement!
Representative BOLLING. Agreed on what~
Mr. KREININ. Antihijacking agreement.
Representative BOLLING. I think for reasons we all understand.
Mr. KRE1NIN. Because there is a commonality ofinterest. They came
together and found they had a common interest, and they agreed
immediately.
Representative BROWN of Ohio. It is easier than reaching agreement
on the economies i
Mr. KREININ. Yes. The areas in which we can reach an agreement
are areas in which we have common interest.
Mr. SOLOMON. Nobody is going to lose any votes by signing that
agreement.
,
Mr. KREININ. Finally, areas of mutual agreement in economics are
not all that easy to find. Even if we were all educated on both sides
of the Atlantic and there were absolutely no information problem,
there are problems of perception.
Every time I go across the Atlantic, I am surprised by some of the
things the Europeans are preoccupied with, a contrasted to what
Americans are occupied with, and I am talking about well-informed
people.
I am not talking about people who don't understand the issues.
Their preoccupations are different.
So what we have is three things.
No. 1, education; No. 2, interchange of views; No. 3, finding areas
of common and mutual interest.
These matters cannot be handled over a 2-day period by seven
Presidents, and what strikes me about the summits is that the staff
work is incomplete.
What I would suggest on that score is to assign a task force within
the OECD exclusively devoted to doing staff work in preparations for
those annual summit meetings, and try to identify areas where they
c,ould reach agreement because of commonality of interest.
Otherwise, I just don't think it will be very advantageous to have
those meetings.
Representative BoLLING. From the Hill, the staff work looks rather
remarkably good. I am not disagreeing with you, but I am giving you


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a different perception. I think you are right ·and I am right. I think
it is true of the staff work, given the moment in time in which we find
ourselves, is good, but I think undoubtedly, in line with what Mr.
Solomon said, we need more involvement at different levels.
Have you any comment~
Mr. DoRNRUSCH. I think the summits deserve more cynicism than
they have so far received. The main purpose they must serve is to make
interaction between the executive and. the domestic parliaments, easier
by the executive signing blank checks abroad and taking them back
home.
'f'hat may be an effective technique.
Representative BoLLING. It hasn't been very effective in this country.
[L~ughter.l
Mr. DoRNRUSCH. In the present case, of course, it is natural, because
none of the foreign commitme.nts is fresh or new. In fact, is there anythin q; that was really different i
If, on the other side, one asks what benefits can be achieved, the
executive is better prepared for economic issues, and that might not
haPnen otherwise.
We should not assign too much importance to this, and, certainly
have not much optimism that it changes international economic circumstances in any way.
Since the last summit things are g-oing worse.
Mr. SoLOMON. If I mav take the other side.
Since I criticized President Carter, let me quote him.
He said in answer to a question of John Chancellor last night, "None
of us knows what would have happened had we not had a summit a,
year ago."
One can say that to Mr. Dornbusch. One cannot really attribute the
worsening of economic conditions since the last summit to the fact
that a summit took place.
Renresentative BOLLING. I would like to say that we are really talking about two different things. I think they are clearly two different
things.
One is an attempt of the soft science to be hard economics, and a
totally known science to be effective politics, and I think we find that
a summit, sort of a blending of that with one element that I think is
terribly important, and that is that I think all of you would agree that
psychology has something to do with that conference.
Mr. DORNBUSCH. I think the last summit did some damage, because
every country came out with growth targets that they did not achieve.
Mr. SOLOMON. What harm did that do~
Mr. DORNBUSCH. In designing their own policies, they all understimulated their own economies. Only those who ran large deficits
and had the large depreciations did achieve their targets. I think there
is a real risk in going out and making promises and coming home and
getting less. The differences between last year and this year was that
chiefs of state recognized that this had happened, and this leads them
to be more careful. Japan, moreover, could say they couldn't make 7
percent because the dollar depreciation worsens their position.
Representative BOLLING. Congressman Brown.
Representative BROWN of Ohio. My first question is, why do we
always have to take economic advice from the Germans~


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I don't know your background.
Mr. KREININ. Mine is not German.
Mr. SOLOMON. Mr. Fukuda is not German, too.
Representative BROWN of Ohio. Have you already persuaded me not
to take his advice on anything~
I wasn't trying to think of his redeeming virtues, but I think he
speaks Japanese better than any of us, which has to be some
recommendation.
Representative BROWN of Ohio. In your prepared statement, Mr.
Kreinin, you talk about causes of some of the gyrations, and it seems
to me that a couple of those factors are not within our control, such as
the quadrupling of the oil price by OPEC, or the changes in worldwide food situations brought on by unfavorable weather. Then there
is the need to divert resources to environmental cleanup and to develop
new energy sources.
It seems to me we could slow or defer our environmental cleanup
policies, and thereby reduce unproductive investments. I wouldn't say
necessarily to reduce such investment permanently, but defer it.
Or, we could maintain our existing energy sources in this country by
appraising policy or making policies that will encourage use of American resources over foreign resources.
Would either of those steps be desirable, given our current situation i
Mr. KREININ. I said that these developments were combined with
policy measures to bring about the gyrations and certainly those policy
measures were within our control. To put it in broader context, the reason why I made the statements is to suggest why exchange rate fluctuations were large.
In other words, the Europeans are saying the exchange rate fluctuations are excessive.
To return to your immediate concern.
First, with respect to the environment: This is a matter of social
choice.
I don't think tliat the economist in his capacity as economist, has
all that much to say about it. It is a social choice.
Representative BROWN of Ohio. How fast we want to pay for it. I
guess, is an economic choice as well as a Rocial choice. The social choice
jg that we wnnt to do it, but we would like to do it at a somewhat different rate than we are now doing it.
Mr. KREININ. The economic input into that is what are the costs and
benefits?
Representative BROWN of Ohio. I would agree with you.
Let me suggest that we close all the factories in the country tomorrow and get clean air and stop all the automobiles tomorrow and get
cleaner air.
Now, that probably is not a good social choice, but it clearly is not
a good economic choice. Let's go from that situation and go to my question which was: What should be the rate?
Should it be faster in terms of environmental cleanup, or slowe,r,
given the current economic situation that we face not only in the
United States but in the world?
Mr. KREiININ. My personal feeling on that is that we are proceeding
at about the right pace.


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Representative BROWN of Ohio. Isn't it true that some of the other
manu:facturing countries and trading countries are proceeding somewhat more slowly than we are?
Mr. KRErnrn. Yes; it is certainly true from what I have heard that
Germany is proceeding further than we are, and that Germany is
prepared to expand the use of coal in dealing with the energy situation.
But this is a matter of view. I don't think I can give you an economic
answer on how fast or how slow we should go.
My view is that we are proceeding at about the right pace, because
the environmental decay has increasing social and economic costs, in
terms of disease and so :forth, that are only now coming to the surface;
Representative BROWN of Ohio. It sounds like you are giving me ~
social response to what was an economic question.
Mr. KREININ. The economic answer is that investments in the environment and in Germany have severe economic dislocations.
I have my pet theory that the tax revolt in the United States is due
partly to massive expenditures on environmental cleanup and the de~velopment of energy sources. Because those developments are holding
down or slowing down or leveling off the standard of living in the
United States.
We are devoting much resources to these areas. Since these investments are a part of GNP, GNP rises. But that increase is not reflected
in your standard of living. We have attained a situation where the
standard o:f living may be leveling off, and people resist income redistribution through the Government budget when that occurs.
That, I think, explains many initiatives in favor of the so-called
middle class; people who were traditionally happy with their .economic lot. I think we have to adjust, but there really is not much of a
choice on energy development.
We have to pay the price with respect to that and the environment.
Representative BROWN o:f Ohio. You add the second dimension, and
I want to ask you about that, the domestic energy development. You
think we should develop domestic energy~
Mr. KREININ. Yes.
Representative BROWN of Ohio. Should that be continuing the development of our traditional sources of energy, and also, "new
sources"?
Mr. KREININ. It depends on what sources. I am not knowledgeable on
the nuclear energy, because I am not an engineer. I constantly talk to
engineers, and I get different views.
Representative BROWN of Ohio. Engineers like economists tend to
be politicians and social thinkers, and it is difficult for them to keep
things in organized boxes.
Mr. KREININ. We were talking about the real technical dangers of
developing nuclear energy. Well, I wish we could skip the nuclear
st9.ge and move to solar.
I would like to see the Federal Government subsidize solar more
heavily. Certainly, coal has to be expanded. I, myself, am an agnostic
on the nuclear question.
I don't know whether my colleagues here have a view.
Mr. :SoLOMON. I don't have the confidence to express a view, Congressman Brown.


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Representative BROWN of Ohio. Let's not get hung up on nuclear
power as the main point of the question.
The question was, should we, :from an economic standpoint-if you
can separate your economic view from the social view--continue our
environmental cleanup at the same pace, pursue it somewhat more
gradually, or quicker 1
I guess that is the other choice. The same thing applies to energy
development.
Mr. SOLOMON. I am not normally an unresponsive person.
Representative BROWN of Ohio. Maybe the question is irrelevant.
Mr. SoLOMON. No, no; I don't think it is irrelevant at all. I am not
an expert on the environment. I have a :feeling as a citizen that we
ought to continue. As I look at the C. & 0. Canal and the Potomac
River, I would like to jump into once in a while, but I cannot.
Representative BROWN of Ohio. Let me ask you a question as an
economist, and never mind your proclivities to jump into the Potomac
River, or your religious :feeling with nuclear power.
Could you tell me from an economic standpoint if you think we
ought to go :faster or slower on environmental cleanup and domestic
energy development 1
If you want to opt out altogether, I will try another question.
Mr. DORNBUSCH. It is easy to detect why we are reluctant, because
we have to know what the purposes o:f society are. That is a technical
question.
I think there is a different economic a.nswer to it that is important.
Investment performance in the United States is extremely poor. It is
starting to interfere with output. It interferes with capacity growth
and employment, and I believe we have to do very dramatic things in
the U.S. economy about investment.
The environmental programs have, to some extent, cut into corporate
profitability, because they were imposed without much consideration
for the costs. We need more attention on how to do it better. The
extraordinarily difficult administrative nightmare that surrounds the
environmental controls are important. For that reason, I think we
ought to slow controls and cleanup, and reexamine it, and let investment get up a bit. I think that is a sufficiently overriding concern to
delay jumping into the Potomac. fLaughter.J
Representative BROWN of Ohio. Do you want to comment on energy'?
You have given me a response, "environmentally."
Mr. DORNBUSCH. I think there is room for domestic improvement. I
really don't know anything about nuclear plants. I have faith, however, in technological J?rogress. Over the last 150 years, it has been a
main factor in economic growth.
With the right price structure, I think we can expect responses on
the demand and supply side.
Technological progress has been extremely important historically.
You cannot ask what will be tomorrow's product, but over the past
150 years, it has been the main source of growth, and I think it is
something we should let happen and see what it will be.
Representative BROWN of Ohio. Would you agree with Mr. Solomon
on energy, Mr. Kreinin '?
Mr. KREININ. Yes.


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Representative BROWN of Ohio. Let me ask a prepared question.
Can we support the value of the dollar by currency intervention if
the Federal Reserve keeps expanding the money supply too rapidly~
Isn't the oversupply and falling value of the dollar interest naturally
largely reflecting the oversupply and the falling dollar _domestica~ly?
Mr. DoRNBUSCH. If you compare monetary growth rn the Umted
States and abroad, you will find the United States, certainly on M-2,
has a very low growth compared to Germany. There is not excessive
monetary growth in the United States at the current stage.
vVe know money is very tight and very expansive, depending whether
you take the view of M-1 or M-2. There is really no way, however,
you can go directly from monetary growth to the depreciation of the
dollar.
It is true that the average higher rate of inflation that we have in
the United States compared to, say, Germany, will imply that the
dollar will depreciate over time.
I have argued before that the depreciation rate should be even higher
to rPstore competitiveness to the U.S. trading sector.
We certainly shouldn't try at all to support the doHar. I think that
wonld be a terrible policy. There shou1d be depreciation, because our
inflation is sti11 highn than ahroail. arn1 T think there shon1d be even
more to gain competitiveness, and I don't believe the monetary growth
is an obstacle. I think there is substantial support across the economics
profession that you cannot stop inflation by stopping monetary growth.
Representative BROWN of Ohio. Mr. Kreinin, I would like an agreement on this growth.
\Ve seem to be on the brink of solving the problem by eliminating
some of the options.
\Von1d von agree with Mr. Dornbusch's analysis of monetary growth
in the TTnited States~
Mr. KREININ. Yes; I think there is surprising agreement among the
threP ofus.
vVhen I got the invitation to apnear here, I expected disagreement
betwPen Mr. Dornbusch and myself, until I read his book.
I think that there is a hip:h mPasure of ap-reement between us with
resnect to the ro1e of money, although I did mention that there is a
boilv of Pconomic thought ihat would disagree with ns.
Secondly, thPre is a very substantial me·asure of agreement on the
need for the dollar to float freely. In other words, I don't think we can
do anythin!!" by intervention, and I don't think we should do a.nything
by intervention.
Representative BROWN of Ohio. Mr. Solomon.
Mr. SoLOMON. I agree. One of those newspaper columns I wrote was
on this subject, and I showed there that one cannot attribute the change
in exchange rates to differences in monetary growth rates.
That is simply an incorrect view that many monetarists have adopted
because they just assume, given the religion by which they live, that if
the ex~hange rate moves, there have to be differences in monetary
expansions.
Representative BoLLING. I would like to see what you say about the
effect of U.S. deficits on the economy.
Mr. SowMoN. U.S. current account deficits 1


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Representative BoLLING. No. I am talking about deficits in the
budget. I will start with either of you.
Mr. SoLOMON. Since I am still panting here [laughterJ, it seems to me
it still has equally little or less to do with the international economy
than differences of rates of growth in the money supply.
To a significant degree, the U.S. budget deficit is the result of a
shortfall from our potential GNP, and I acknowledge immediately
that there is great uncertainty as to just what our potential G~P is.
Secondly, the U.S. ,budget deficit is an offset to the substantial current account deficit in our balance of payments, which is, as you just
heard, a drag on economic activity.
Thirdly, the Federal budget deficit is an offset to the very substantial
surpluses of the State and local governments in our country.
You put all that together, and the Federal deficit doesn't look all that
large. Meanwhile, Germany with its very, very strong currency and
insufficiently strong economy, has a budget deficit which Chancellor
Helmut Schmidt tells us with great pride, equals 4 or 5 percent of
Germany's GNP, considerably greater than the Federal budget deficit
in the United States.
So, I don't think that Federal budget deficits are relevant to the
subiect of this hearing.
Representative BOLLING. You are clearly not agnostic on that.
Mr. SOLOMON. I don't say deficits are appropriate on all occasions.
Representative BoLLING. I understand that. But I am interested in
the revival of an old religion, which has now become a new religion in
this country, that the whole cause of inflation in every respect is the
Federal deficit.
Mr. DORNBUSCH. The point I want to make has been raised.
First, with respect to the size of the deficits, we have to aggregate
Federal and State and local deficits. For macroeconomic purposes, you
11ave to aggregate them. It doesn't matter whether it is Cook County or
"\Vai:shington, D.C., that does the spending.
When we aggregate them, the Federal deficit is largely offset by
State and local surpluses. You next want to make allowances for price
level changes that have taken place since 1950. The consolidated deficit
in real terms has fallen over the last 3 years substantially. When you
adiust for the fact that the economy has grown, then the consolidated
deficit as a fraction of GNP is lower now than in any period of comparable economic slack, defining it in the usual way. We really don't have
a budgetary problem at present in the United States.
Now, it is true that the current account deficits tend to equal the
budget deficit plus the excess of investment of the private sector over
saving. w·e thus can see a relation between the budget and the current
account but we should be happy that the deficit was so large, because,
otherwise, the economic slack would be even bigger in the United
States.
"\Vhat we should worry about is, in fiscal policy, that we are trying
to throw an enormous amount toward the consumers at the expense of
investment. That is the concern, not the size of the deficit, but the nature
of the fiscal initiatives.
I think we should not give any cuts to consumers and instead use a
policy that would reduce inflation, such as social security rollbacks,


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and second, bring about a very significant increase in investment
opportunities.
Mr. KREININ. I think the budget policy should be formulated with
eyes on the domestic economy, and we should not pay too much attention to the external situation. You cannot neglect it altogether, but the
primary consideration in formulating policy is the domestic economy,
and I agree with Professor Dornbusch that it is the composition of
the fiscal initiatives, rather than the other way around.
Representative BROWN of Ohio. I want to get into this just to make
a comment.
One is inclined to be very careful, because I think by holding up yourhand, you may be falling into a "Lafferesque" position.
If we don't follow the suggestion, it seems to me we should do what
Professor Dornbusch suggests, that is, to start stimulating saving and
investment in order to improve the domestic economy.
Perhaps, after all, the-Lafferites may have a point, that one should'
not worry about the deficit. One ought to cut the taxes so as to stimulate the investment of those dollars rather than their seizure by theGovernment and their use to benefit consumers.
Now, what is wrong with my logic there~
Mr. DORNBUSCH. I think the logic is very good that we should do·
something about investment.
When we come to implementation, we would depart from measures
that would cut personal income taxes. I think we should considerinstead investment subsidies to policies of inflation control.
Representative BROWN of Ohio. In other words, you must target
investment or the tax cuts or whatever vehicle you use, to increase·
productivity.
Mr. DoRNBUSCH. Capital formation and productivity.
Representative BROWN of Ohio. I was skipping capital formation.
Your objective would be to improve productivity, to obtain with those
dolJars an increase int.he supply of goods; is that right~
Mr. DORNBUSCH. We are really not so worried about the shortness
of supply. We have two problems. One current aggregate demand orshould we expand total spending i
The second is the makeup of that increase in spending. That is what
worries us. We should shift away from the policy followed in the last
5 years. a proconsumption policy. To redress it we should choose between the fiscal initiatives of $10 or $15 billion, and that size might
be appropriate. policies that favor investment.
Representative BROWN of Ohio. How about a subsidy on savings
such as the Germans use 1 Would that encourage people to put their
money in the bank and savings and loans rather than go out and buy
widgets with it~
Mr. DORNBUSCH. I don't think we want to get people to stop consuming that way. I think if we ,ro for investment subsidies and better
treatment for investment, we will have done enough.
I wouldn't worry about the savings, because this comes at the
moment the stock market goes up and people find there is an alternative to current consumption.
People will stop buying refrigerators as a form of investment when
the real returns in the economy, on the stock market, are restored.


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Representative BROWN of Ohio. It seems to me what people are
buying now is an investment, meaning people who have discretionary
money. They don't buy refrigerators, but gold or Chinese paintings,
or antique furniture, which-Representative BOLLING. That is a very good group.
Represt>11tativl\ BROWN of Ohio. Or land.
Mr. DORNBUSCH. Policies that will subsidize the savings will not
affect the way in which people choose to hold their wealth. What
determines that is the rate of return on those assets. W'hat 'has happened is that the profitability of capital has not fared very well, and,
therefore, people have shifted out of capital. That is why people have
boon investing in housing and in Chinese paintings.
Representative BROWN of Ohio. It would seem to me the people who
invest in real est,ate trusts and Chinese paintings, as the chairman
pointed out, are those people who in the current inflationary period
have discretionary wealth, but the policy pursued by the Federal Government toward subsidizing savings might establish some other people
who have discretionary wealth.
For instance, those Congressmen who still drive 1969 automobiles
might decide not to huy a new car this year, and instead put that
money into the savings account, or in the bank. The same reasoning
goes for the purchasing of a refrigerator or perhaps a new color television or some other product.
In other words, you create some discretionary savings in that marginal area of discretionary consumption that perhaps even middle income people in the current inflationary period might be able to find.
Mr. DORNBUSCH. There is no evidence in the United States that the
distri'bution of wealth has shifted, and that inflation has acted in a way
to redistribute it by lowering savings on the part of lower income
people.
Representative BROWN of Ohio. I was trying to compare our savings
rate not to some previous savings rate, but to the savings rate in Germany, where they do subsidize savings.
Mr. SOLOMON. There is an implioation, Congressman Brown, that
investment in the United States is somehow being impeded by an
absence of savings, and I think probably all three of us would-I
cannot speak for all three of us, but I am guessing-disagree with
that in the present condition of our economy.
Representative BROWN of Ohio. There is no relationship between the
sa:v;igs rate and the rate of productivity in the United States?
Mr. SoLOMON. I will speak only for myself, but repeating what Mr.
Dornbusch said, certainly incentives for higher investment are desirable, and the savings would be forthcoming.
We still have enough slack in our economy, though it is not enormous, so that higher investment and higher income would also generate
higher re al savings.
If, at the same time you encourage savings, you also reduce consumption, and this might also disoourage investment.
Representative BROWN of Ohio. I had some additional questions that
I wanted to ask; hut I want to go. to the quorum call. I was absent
yesterday.
Representative BOLLING. I think this is a:bout the right time to stop.
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We thank you for your patience and for your contribution to our
education.
The committee stands recessed.
[Whereupon, at 12 :12 p.m., the committee recessed, to reconvene at
10 a.m., Wednesday, July 19, 1978.]
[The following written questions and answers were subsequently
supplied for the record:]
RESPONSE OF MORDECHAI E. KREININ TO ADDITIONAL WRITTEN QUESTIONS POSED
BY REPRESENTATIVE ]3ROWN OF OHIO
CONGRESS OF THE UNITED STATES,
JOINT ECONOMIC COMMITTEE,
Washington, D.C., July 20, 1978.

Mr. MORDECHAI E. KREININ,
Depa,rtment of Economics,
Michigan State University,
East Lansing, Mich.

DEAR DR. KREININ: Representative Clarence J. Brown has requested that the
enclosed questions be sent to you. They, along with your answers, will be included
in the record of the hearing on our Midyear Review of the Economy which was
held on July 18.
We would appreciate your reply as soon as possible in order to insert the answers in the final transcript.
Thank you for your attention to this matter.
Sincerely,
JOHN R. STARK,
Executive Director.

Enclosure.
The Law of One Price states that identical products sell for identical prices
at any one time, adjusted for transportation and tax differences between countries. Or, to put it another way,· wheat bound for Boston and wheat bound for
Bombay originally sell for the same price in Chicago.
You question Mundell and Laffer's use of this law because of price differentials
between products of different brands. But, all they are saying is that, after a
devaluation. the relative prices of goods return to their normal predevaluation
pattern-that identical goods which traded at identical prices before the devaluation, will sell at identical prices after the devaluation, that a product which sold
at a (say) 2 percent premium over its competition before the devaluation will
return to the same premium after the devaluation.
You seem to be implying that, if German wine had a 2 percent premium over
American wine before the df'utsche mark began to rise, it could develop a 4, 8. 16.
or 32 percent premium as the mark continues to rise, with no regard whatsoever
for the relative real costs of production of wine in Germany and the United
States. Please explain.
You then claim that Mundell and Laffer use a "ratcµet effect" to say that devaluation raises i,ntlation Jn tb,e deJ;a,luating:countp, wttlJ9yt lowering pricf's in
the revaluing country. Can you document this claim? Remember that Mundell
is the chif'f author of the theorem that the devaluing country experiences more
inflation, and the rest of the world less inflation, sharing the adjustment burden
in inverse proportion to the relative sizes of the domestic and rest-of-world
economies.
Romething resembling a ratched effect is discussed by Mundell in the case where
nations are competitively cheaping their currencies in an attempt to boost government spending, or to export unemployment to each other, and, particularly,
where the IMF requires countries to intervene in the exchange markets to print
more of their own money to prop up the value of someone else's currency. It is
not a general rule in the Mundell-Laffer model of devaluation, and it is an @otirely separate que!,tion from the one of who bears the adjm:itment burden or'a
devaluation. They do not have an asymmetry in their theory that puts the whole,
impact of a devaluation into inflation in the devaluing country.


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Finally, we have been given charts by H. C. Wainwright and Company showing
that wholesale price indexes, adjusted for exchange rates, move in tandem across
major nations with very little lag or error. Prices are set by real conditions of
supply and demand, not by exchange rates. If you wish to contest this point.
please furnish the Committee some charts showing long-term divergence of wholesale price indexes of various foreign countries from the U.S. index, with each
country's index adjusted for the dollar exchange rate.
MICHIGAN STATE UNIVERSITY,
DEPARTMENT OF ECONOMICS,
East Lansing, Mich., August 10, 1978.

JOHN R. STARK,
Ewecutive Directo-r, Joint Economic Committee,
Washington, D.O.

DEAR DR. STARK: Representative Clarence Brown raises a couple of important
points relating to my analysis of the Mundell-Laffer hypothesis.
FirRt, concerning the documentation of the thesis and the ratchet effe<>t embodied in it, I would draw your attention to the following articles: Arthur B.
Laffer, "Do Devaluations Really Help Trade"? ,van Street Journal, FelJruary 5,
1973, p, 10; and "The Bitter Fruits of Devaluation", Wall Street Journal, January 10, 1974, p. 14. Jude Wanniski, "The Case for Fixed Exchange Rates", ,van
Street Journal, June 14, 1974; and "The Mundell-Laffer Hypothesis-A New
View of the World Economy", Public Interest, No. 39, Spring 1975, pp. 31-52.
There exist other secondary references to the M-L thesis. And when I summarized it for the second edition of my textbook (M. E. Kreinin, "International Economics-A Policy Approach," Harcourt Brace J a vanovich, 1975), I
checked whether the summary represented their views, and indeed it did.
Because several years have elapsed since originally expounded, it is perhaps
more reasonable to refer to the hypothesis as one attributed to Mundell-Laffer.
With respect to the "Law of One Price," it is indeed correct that the Law
applies to homogeneous products such as wheat. It would probably also hold
iu tbe case of mater,ials whose prices are determined internationally. But the
butden of evidence is against the "Law" in the case of differentiated products;
namely in the case of most finished manufactureR. Furthermore there is considerable evidence that relative prices are affected by exchange rate changes.
And finally, there is evidence of price reductions in cases of revaluation.
I shall cite three studies relating to the points raised in the last paragraph:
(1) C. Pigott. R. Sweeney and T. Willett. "Some AspectR of the Behaviour find
Effects of Flexible Exchange Rates" (especially table 10), U.S. Treasury Discussion Papers (mimeographed), .June 1975. (2) Peter Isard, "How Irar Can
We Push the 'Law of One Price'?" the American Economic Review, December 1977. And (3) M. E. Kreinin, "The Effect of Exchange Rate Changes On
The Prices and Volume of Foreign Trade", International Monetary Fund Staff
Papers, July 1977.
Finally, I do not have charts. similar to those supplied by H. C. Wainwright
and Co. However, together with a colleague I have completed a comprehensive
if not exhaustive survey of the literature pertaining to that topic. It is sch1>duled to appear later this year in M. E. Kreinin and L. H. Officer, "The Monetary
Approach To The Balance of Payments: A Survey." Princeton Studies in International Finance No. 43.
Chapter 10 of that study surveys the empirical tests of the 'Law of One
Price' on the goods market, Bonds market, and Equity market. With one or t_wo
exceptions the 'Law of One Price' in the commodities market does_ not receive
empirical support. Nor does it receive support in the bonds and equity market;;,.
It would appear the 'Law of One Price' must be rejected at the present state of
the globe.
.
I trust this reply is responsive to the issues raised by Representative Brown,
and appreciate the opportunity to expand on the original discussion.

Thank you,
Sincerely,


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MORDECHAI E. KREININ,
Professor of liJconomics.

0


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