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SHADOW OPEN MARKET COMMITTEE
Policy Statement and
Position Papers
March 13-14, 1988
PPS 88-01
THE BRADLEY
POLICY
RESEARCH
CENTER
Public Policy Working Paper Series
ROCHESTER
Contents
SOMC Members
1
Policy S t a t e m e n t
Shadow Open Market Committee
1.1 Monetary Indicators
1.2 The National Commission on Economic Policy
1.3 Trade and Protection
1.4 Policy for 1988
1
1
3
5
6
2 Economic Outlook
Jerry L. Jordan
2.1 SUMMARY
2.2 U.S. Economy
2.3 International
2.4 Industries
2.5 THE U.S. ECONOMY
2.5.1 Changes Since Last September
2.5.2 Policy Assumptions
2.5.3 Escaping a 1988 Recession
2.5.4 Inflation — Direction Still Up
2.5.5 Interest Rates — Flat or Lower, Then Up
7
7
8
8
9
9
10
10
11
12
3
14
The Economy and Fiscal Policy
Jerry L. Jordan
3.1 The Economy in 1988-89
3.2 Stock Market Crash and Monetary Policy
3.3 The Dollar and Foreign-Exchange Markets
3.4 Balance of the Federal Budget
3.5 Balanced Budget Amendment
7
14
16
17
18
19
3.6
3.7
3.8
4
5
6
Proposed Approach for Setting Economic Assumptions for
the Budget
Implications for Monetary Policy
Summary and Conclusions
21
24
24
Federal Budget Update — More of the Same
Mickey D. Levy
4.1 Recent Budget Action
4.2 The Budget Outlook
4.3 Outlook for the Budget Process
26
M o n e t a r y Aggregates a n d Economic Activity
Robert H. Rasche
5.1 III. Demand Functions for the Monetary Base
5.2 Forecasting
5.3 Time Aggregation and Alternative Measures of Economic
Activity
5.4 Appendix: Aggregation Over Time
32
26
27
30
33
37
39
40
U . S . I n t e r n a t i o n a l C a p i t a l Flows in the 1980s
42
William Poole
6.1 Overview of the Capital Account
43
6.2 Relative Economic Conditions in the United States and Abroad 44
6.3 More on U.S. Domestic Investment
46
6.4 Policy Issues
47
SHADOW OPEN MARKET COMMITTEE
The Committee met from 2:00 p.m. to 7:00 p.m. on Sunday, March 13,
1988.
Members of the SOMC:
PROFESSOR KARL BRUNNER, Director of the Bradley Policy Research
Center, William E. Simon Graduate School of Business Administration,
University of Rochester, Rochester, New York.
PROFESSOR ALLAN H. MELTZER, Graduate School of Industrial Administration, Carnegie-Mellon University, Pittsburgh, Pennsylvania.
MR. H. ERICH HEINEMANN, Chief Economist, Ladenburg, Thalmann
k, Co., Inc., New York, New York.
DR. JERRY L. JORDAN, Senior Vice President and Economist, First
Interstate Bancorp, Los Angeles, California.
DR. MICKEY D. LEVY, Chief Economist, First Fidelity Bancorporation,
Philadelphia, Pennsylvania.
PROFESSOR WILLIAM POOLE, Department of Economics, Brown University, Providence, Rhode Island.
PROFESSOR ROBERT H. RASCHE, Department of Economics, Michigan State University, East Lansing, Michigan.
DR. ANNA J. SCHWARTZ, National Bureau of Economic Research, New
York, New York.
Chapter 1
Policy Statement
Shadow Open Market Committee
March 14, 1988
At its meeting yesterday, the Shadow Open Market Committee adopted
a multi-part program designed to improve the performance of the economy.
The Committee called on the Federal Reserve to focus attention on the
growrth rate of the monetary base, which is the most reliable indicator of
the thrust of monetary policy. The SOMC rejected recent proposals by the
Fed for new monetary policy indicators. During 1988, the Federal Reserve
should increase the monetary base by 6 percent. In addition, the Federal
Reserve should ignore fluctuations in foreign exchange rates. The SOMC
called on the newly-formed National Commission on Economic Policy to
develop a medium-term strategy for fiscal policy. President Reagan should
veto any protectionist trade legislation.
1.1.
Monetary Indicators
According to recent press reports, the Federal Reserve has changed its
indicators of monetary policy. Under the new procedure, policy makers
will pay less attention to monetary growth. They will pay more attention
to commodity prices, exchange rates and the term structure of interest
rates. Assuming these accounts are correct, the emphasis given to these
measures will prove to be a mistake. So will the lowered emphasis accorded
money growth.
A major problem for monetary policy is to distinguish between real
and nominal changes. Real changes not only reflect shifts in productivity,
1
saving and investment, but also in taxes and the share of government in
the economy. Nominal changes ultimately affect only prices. A principal
task for the monetary authorities is to distinguish between these two types
of changes. The proposed measures do not do that.
Suppose there were another increase in oil prices. The U.S. would be
less dependent on imported oil than Japan, so the rise in oil prices would
cause the dollar to appreciate relative to the yen. Output would fall but
price indexes would rise. This would represent a one-time change. The
term structure of interest rates would respond; short-term interest rates
would increase relative to long-term rates. Commodity prices would rise,
particularly if oil prices are included in the price index.
A similar pattern could occur if monetary growth were restricted in an
expanding economy. In this case, the rise in short- relative to long-term
rates and the appreciation of the dollar would signal a shift to a disinflationary policy. The rise in commodity prices would reflect the momentum
of inflation and rising output.
We believe that exchange rates are a particularly inappropriate indicator
of monetary policy. No one has a reliable basis for deciding where exchange
rates should settle. No one knows when, whether or how much the dollar
must go up or down relative to other currencies to balance the U.S. capital
and current accounts. Moreover, it is mainly changes in real exchange rates
that have important, lasting effects on trade and capital movements. Such
changes cannot be achieved by monetary policy.
The SOMC believes that the proper approach for the Federal Reserve
is to let the dollar respond to market forces. Policy makers should neither
adjust monetary policy to the exchange rate nor try to adjust exchange
rates by monetary policy.
The Federal Reserve may be in transition — seeking reliable indicators
to replace ad hoe policy determination. However, the Federal Reserve's
"new" indicators reflect the expectations of market participants about future monetary policy. Therefore, these indicators cannot simultaneously
serve as indicators for the Federal Reserve. Market participants are in effect informing the Fed what they believe it has done in the past and what
they expect it will do in the future.
Sustained changes in money growth relative to the growth of output
continue to be a reliable indicator of future inflation. Central banks that are
most successful in controlling inflation — Germany, Japan and Switzerland
2
— use the growth of money relative to output as a principal, often the
principal, indicator of the inflationary force of monetary policy. The Federal
Reserve will make a major mistake, and reopen the possibility of repeating
its past mistakes, if it disregards money growth.
Short-term changes in money relative to output have large random components. Skepticism about the importance of money growth in this country is widespread. In part, the skepticism is the result of using measures of
money growth whose composition has changed in recent years. The Shadow
Committee has long advocated the use of the monetary base — a measure
of the size of the Federal Reserve System's balance sheet which the public
uses in the form of bank reserves and currency — as a reliable indicator of
money growth.
Chart 1 shows that the growth rate of base velocity (defined as the ratio of personal income to monetary base) has remained close to monthly
projections during the 1980s. The relationship between base growth and
nominal income in the 1980s is comparable, indeed virtually identical, to
that observed in the 1950s, 1960s and 1970s. The only difference between
the 1980s and the previous quarter-century is a one-time shift in the difference between the average growth rate of the monetary base and the average
growth rate of nominal income.
This change occurred abruptly more than six years ago. It can no
longer be used to obfuscate, ignore, or downplay the implications of longerrun monetary growth for economic activity. The data in chart 1 should not
be misinterpreted. The data in the chart are NOT a foundation for shortterm adjustments in the growth of the monetary base. The important and
correct conclusion from the chart is that there will be very little deviation
from the average growth rate of base velocity over longer time periods.
Setting a target for monetary base growth continues to be a useful strategy
for a monetary policy that seeks to achieve stable prices.
1.2.
The National Commission on Economic Policy
The appointment of a National Commission on Economic Policy presents
an opportunity to re-orient the discussion of fiscal policy and its future
performance. The Commission can take a narrow or a broad interpretation
of its mandate.
A narrow interpretation would focus only on the federal deficit. In this
3
case, the objective would be simply to find a means of reducing the difference between Treasury receipts and expenditures. By contrast, a broad
interpretation would look at the proper roles of spending and tax policies
in the economy.
Under such a broadly-defined approach, which we advocate, the Commission would seek to improve the procedures by which Congress and the
Administration determine fiscal policy. Focusing only on the deficit would
continue the mistaken emphasis that now dominates public discussion. This
emphasis obscures the most important issues facing government — how
much should be spent by the public sector and how the spending should be
allocated.
We urge the Commission to focus on broad questions: For example, how
should we determine the share of GNP to spend, on average, for defense of
our interests and commitments around the world? How do we decide what
to spend on income redistribution, health, education and other non-defense
programs? How should these expenditures be financed? What effect do
these decisions about taxing and spending have on long-term growth of
standards of living?
The critical issue about fiscal policy is not — repeat not — the size of
the budget deficit. Far more important are decisions about the allocation
of society's resources resulting from decisions about spending and financing. We recommend that the Commission direct its attention to mechanisms that encourage Congress and the Administration to resolve these
basic issues. Many countries have adopted, and successfully implemented,
medium-term strategies for fiscal policy. The urgent need for the U.S. is to
adopt a strategy of this kind.
To reduce the budget deficit, we recommend that the growth of nominal
government spending be set equal to the rate of inflation. If nominal GNP
grows at 7 percent and government spending grows at the current rate of
inflation for the next five years, the budget will be close to balance — and
may even have a small surplus — by the end of the next presidential term
in 1992.
We emphasize that our proposal is not a panacea. It requires choices,
hard choices of the kind that only elected officials can make. The budget
deficit is not a crisis about to happen. It is a problem requiring a mediumterm strategy for spending and financing.
4
1.3.
Trade and Protection
Legislation to restrict imports is again moving through Congress. Although
some of the worst anti-consumer sections have been removed from the current version, the trade bill retains its protectionist approach. Protection
against imports lowers welfare and living standards by raising prices and
misallocating resources.
A small group in the protected industry benefits for a time at the expense of consumers and society as a whole. U.S. consumers buy imports,
and foreigners buy U.S. goods and services, when they get better quality
or lower prices. Protection dulls the incentive to compete.
Further, protection of intermediate products like steel and micro chips
lowers living standards and harms the competitive position of U.S. producers by raising their costs of production. Instead of importing steel and
micro chips to lower the cost of producing autos, tractors, machine tools
and electronic equipment, we give a competitive advantage to foreign producers of finished goods.
Protectionists portray the U.S. as a crippled giant unable to compete in
world markets. The facts do not support this view. U.S. exports, whether
measured in current dollars or in dollars adjusted for price changes, have
been increasing rapidly for two years. The real trade deficit — the balance
in constant prices — reached its low point in third quarter 1986 and has
since declined by $25-billion. Chart 2 shows these changes.
Charts 3 and 4 show what has happened in Japan and Germany. The
Japanese trade balance, in constant Japanese prices, has been cut in half.
Imports have risen enough to more than offset the effect of falling import
prices; imports in current prices have been rising for a year.
In Germany, imports have been rising since 1985. By 1987, the rise in
imports was strong enough to offset the lower prices that Germans pay for
dollar-denominated imports. The German trade surplus has been eliminated in constant German prices.
The charts show that trade balances are adjusting. Adjustment will
continue if U.S. prices and costs of production remain competitive with
prices and costs in other countries. The main reasons for the change in
competitive positions are the devaluation of the dollar, rising productivity in domestic manufacturing and a low rate of increase in U.S. costs of
production relative to productivity and costs in major foreign countries.
5
Average - 1983-1986
1986
1987
Consumer Spending
4.2%
4.1%
0.6%
Output (Real GNP)
3.5%
2.2%
3.8%
Table 1.1: Growth Rates in Percent
The composition of U.S. spending shows evidence of the changing roles
of exports and consumer spending. During the years of a rising trade
deficit, U.S. consumption rose by more than U.S. output. Imports made
up the difference. Adjustment of the trade balance requires slower growth
of spending relative to the growth of output. In 1987, consumer spending
rose much less than output, and exports rose by more than 15 percent.
The table on page 6 shows these data. All data are in constant 1982
dollars and are computed from fourth quarter to fourth quarter:
Protectionists treat the world economy as a fixed pie. Each country
is limited to the gain it makes at the expense of others. Trade expands
the size of the pie. Protectionist legislation shrinks the pie. The President
should veto any protectionist trade legislation Congress makes.
1.4.
Policy for 1988
In 1988, monetary policy should initiate a policy of gradual disinflation.
The policy should continue until price stability is achieved. At our September 1987 meeting, we praised the Federal Reserve for reducing the growth
rate of the monetary base from the very high rates of 1986. We recommended a growth rate of 6 percent for 1988. This rate of money growth is
consistent with administration and Federal Reserve forecasts of real growth
and inflation. We repeat the recommendation today.
The Federal Reserve should ignore the dollar exchange rate. Monetary
policy should not be based on a view of the proper level of the dollar in the
foreign exchange markets. It is not the nominal exchange rate that affects
U.S. trade and the balance of payments. It is the real exchange rate that
has those effects. Monetary policy can have only a short-term effect on the
real exchange rate.
6
Chart 1
Percent Change Adjusted Base Velocity
Post Sample Projections 86,1 8 7 , 1 0
005 H
50
55
60
Time
— Actual Changes
•
Projected Changes
65
Chart 2
U.S.rEXPORTS,
NOMINAL
Sc R E A L
EXPORTS Or GOODS. SERVICES
460
450
440 H
430
420
410 -j
400 -|
390 -|
360 -I
370
360 H
350
63Q4
6402
6404
6&£2
6S04
6602
6604
6702
6704
SRCE: COMMERCE DEPT.."COMMERCE NEWS"
+
REAUC1962 PRICES)
NOMINAL
O
U.S.ilMPORTS,
NOMINAL
Sc R E A L
IMPORTS Or COOOS. SERVICES
63Q4
6402
6404
6502
6504
6602
6604
6702
SRCE. COMMERCE OEPT.."COMMERCE NEWS"
NOMINAL
-*•
REAL<1962 PRICES)
O
U.S.:TRADE
BALANCE,
NOMINAL
Sc R E A L
BALANCE Or COOOS. SERVICES
-20
-30
-]
- 4 0 -J
-50
H
-60
H
-70
H
- 6 0 -J
- 9 0 -J
- 1 0 0 -J
- 1 10
-120
-|
-130
-j
-140
-j
-150
-160
-170
\
I
63Q4
6402
O
6404
6502
6S04
6602
SRCE: COMMERCE OEPT ."COMMERCE NEwS"
4>
REAL(1962 PRICES)
NOMINAL
6604
6702
6704
Chart 3
JAPANrEXPORTS,NOMINAL
Sc
REAL
EXPORTS OF COOOS,SERVICES.FACTOR INCOME
8302
8304
05O4
8402
8502
SOURCE:B©fs> ECON.STAT. MONTWLY.NOV. 8 7
NOMINAL
•
R E A L O 9 8 0 PRICES)
jAPAN:IMPORTS,NOMINAL
8702
B602
&c R E A L
IMPORTS OF COOOS.SERVICES.FACTOR INCOME
48 -p
47 -4
46' A
45 A
44
43
42
41
—{
-4
-j
-j
40
39
38
37
36
H
-4
-i.
-4
35 A
34 -|
33 -4
32 A
31 H
30 A
29 H
28 A
27 -4
26 -4-
I
6304
8302
O
8402
8404
8502
8504
SOURCE:BofJ ECON.STAT. MONTHLY.NOV. 8 7
+
REALC1980 PRICES)
NOMINAL
JAPAN:TRADE
BALANCE, NOMINAL
6602
86Q4
8702
&c R E A L
B A L A N C E ON GOODS.SERVICES.FACTOR INCOME
8302
8304
O
8402
8404
8502
8S04
SOURCE:Bo'J ECON.STAT. MONTHLY.NOV. 8 7
* £ A t p 9 8 0 PRICES)
NOMINAL
8602
8604
8702
Chart 4
GERMANY:EXPORTS,
NOMINAL
&c R E A L
EXPORTS Or GOODS. SERVICES
100
170
100
150 H
130 H
120
80O1
0*O3
SRCE.' OBB MTMLY REV.(PRICES).BOP(TRADE)
NOMINAL
•
REAL(100O PRICES)
6303
GERMANY:IMPORTS,
NOMINAL
00O3
07O1
Sc R E A L
IMPORTS Or GOODS. SERVICES
100
0303
8401
0*O3
SRCE
NOMINAL
0503
07CM
OBB M T H L V REV.(PRICES).BOP(TRADE)
+
REAL(190O PRICES)
GERMANY:TRADE
BALANCE,
NOMINAL
Sc R E A L
BALANCE ON GOODS. SERVICES
03O3
0AO1
O
0403
SRCE
NOMINAL
05O1
0503
06O1
DBB MTMLY REV.(PRICES).BOP(TRADE)
*
REALO900 PR»CES)
0603
07O1
07O3
Chapter 2
Economic Outlook
Jerry L. Jordan
First Interstate Bancorp
2.1.
SUMMARY
The risk of recession in 1988 has diminished significantly since the end
of last year. Since the SOMC meeting last September, two developments
posed a possible risk to continued economic expansion in 1988:
First, the stock market crash of October 19 was thought by some observers to have severely damaged consumer and business confidence, with
repercussions on spending and investment. Consumer spending did drop
in the final quarter of 1987, but was more than offset by increases in other
components of national income, so that GNP increased at an annual rate
of 4.5 percent.
Second, the Federal Reserve sharply curtailed the growth of bank reserves in its efforts to defend the dollar in 1987. Had monetary growth
remained very low or negative in 1988, a recession most likely would have
occurred. Since the beginning of 1988, however, reserves have begun to
expand at a more rapid pace. The monetary base is expected to rise at
about a 9 percent rate in the first quarter.
2.2.
U.S. Economy
Consequently, our forecast remains that the economy will not experience
a recession in 1988. The Federal Reserve is assumed to supply more rapid
7
growth of reserves during the current year.
A reduction of excess inventories will hold down economic growth in the
first part of 1988, with faster growth in the second half.
Real GNP is expected to increase 2.9 percent in 1988, compared with
last year's gain of 3.9 percent. Consumer prices are projected to rise 5.0
percent this year, up from 4.4 percent in 1987.
The Federal Reserve is likely to tighten significantly in late 1988 or early
1989 in response to higher inflation. In reaction, a recession would begin
in 1989.
Interest rates are expected to hold relatively steady into the second
quarter of 1988. Increases of one-half to three-quarters percentage points
are expected in the second half of this year.
Sharper interest rate increases are projected in the first part of 1989 in
response to a shift toward monetary restraint.
2.3.
International
The U.S. trade deficit is forecast to decline by about $23 billion in 1988, although the reduction in the total current-account deficit, including services,
will be considerably less. Some further decline of the dollar is expected in
the second half of 1988.
2.4.
Industries
Growth is shifting from the consumer to the manufacturing/producer sectors. Industries serving the export and business equipment markets should
do well in 1988, while certain parts of the retail and service sectors may
experience earnings pressure.
Auto sales are forecast at 10 million units this year, down from 10.3
million in 1987. Housing starts are projected at 1.54 million units, compared
with 1.62 million last year.
8
2.5.
2.5.1.
THE U.S. ECONOMY
Changes Since Last September
Since we last met, three major events have occurred that could potentially
affect the course of the economy.
(1) The stock market crash of October 19, 1987 provoked widespread
concerns of a collapse in consumer spending and cancellation of investment
plans by business. The primary risks to the economy from the market's
decline stemmed from the effect on wealth and the impact on general confidence. It had been our view that, just as consumers had not adjusted
sharply upward their spending to the stock market peaks of August, they
would not cut outlays drastically in response to the market's downturn. In
terms of the impact on wealth, with some recovery after October, the overall stock market ended 1987 at a level close to that at the beginning of the
year. Consumer confidence has also improved from its lows of October. As
a result, retailers experienced at least a moderately good Christmas season,
and few firms made major changes in capital spending budgets for 1988.
(2) After the stock market crash, Congress and the President reached
a compromise on the federal budget for fiscal years 1988 and 1989. A
sizable component of the deficit reduction, however, represents more of an
accounting artifice than an attack on the underlying fiscal problem. Total
federal spending is still likely to be up by about 6 percent in fiscal 1988
compared to the prior year. More actual deficit reduction without tax
increases would have been achieved by allowing the automatic spending
cuts of Gramm-Rudman-Hollings to have been implemented. On balance,
although the deficits for the next two years are likely to be less than we
previously expected, the fiscal problem is far from solved.
(3) A major risk, which increased after we issued our Forecast, came
from monetary policy. Efforts to subdue inflationary expectations in 1987
and to support the dollar through intervention in foreign-exchange markets and higher interest-rate targets sharply curtailed the growth of bank
reserves and the money supply. In October, reserves were injected liberally in response to the stock market plunge, but that easing was reversed in
November and December. At year-end, we were concerned that the Federal
Reserve would remain too tight for too long.
9
2.5.2.
Policy Assumptions
It is our present assumption that the Federal Reserve will allow a sufficient
expansion of the money supply to support economic growth in 1988. A
faster growth of reserves could be accomplished through a pickup in the
demand for reserves at recent interest-rate levels or through selection of a
lower interest-rate target. Strengthening of the dollar's value on foreignexchange markets would permit a lower interest-rate target. Alternatively,
even if the dollar again came under downward pressure, overriding concerns
about the domestic economy might cause the Federal Reserve to reduce its
target range for the federal funds rate. Evidence in January showed a strong
pickup in reserve and money growth, apparently mainly from an increase in
the demand for bank reserves. We assume monetary-base growth this year
of 7.4 percent (fourth quarter to fourth quarter), which should be adequate
to support economic growth in 1988. Our forecast that the increase in
inflation will prompt a significant tightening in monetary policy by the end
of this year or early in 1989 remains unchanged.
No significant initiatives with respect to the fiscal budget are expected in
the face of a presidential election. The Reagan Administration will attempt
to hold Congress to the terms of the budget compromise agreed to last year.
We expect the deficit for fiscal 1988 to be about $160 billion, higher than
the $150 billion of fiscal 1987. For fiscal 1989, slower economic growth
could push the deficit up to about $180 billion, in contrast to the $136
billion targeted by the Administration.
2.5.3.
Escaping a 1988 Recession
Economic expansion continued for a fifth year in 1987, with real GNP up a
strong 3.9 percent (fourth-quarter-to-fourth-quarter). Assuming sufficient
support by the Federal Reserve, we are maintaining our forecast of moderate
growth, with real GNP up about 3 percent in 1988. In reaction to the
inventory buildup at the end of 1987 and slower monetary growth last
year, the economy will grow at a slower pace in the first half of this year
than the second.
Major changes in the sources of strength and weakness in the U.S. economy will continue in 1988. For the second year in a row, U.S. production, as
measured by real GNP, will grow faster than spending by U.S. consumers,
business firms, and government agencies.
10
Consumer spending and construction were the lead forces in the earlier
stages of the expansion, but they are now weakening. Little real growth
is projected for federal defense and non-defense spending in the current
year, while the increase in state and local government outlays is likely to
be moderate.
Our current view is that auto sales will total about 10 million units
this year, down from 10.3 million in 1987. Housing starts are expected to
decline to about 1.54 million units, compared with 1.62 million in 1987.
High vacancy rates and loss of tax advantages will again place most of the
reduction in the multi-family sector.
The primary engines of growth in 1988 will be exports, investment in
equipment by business, and the ability of domestic producers to win a larger
share of the U.S. market. Export business is booming for a wide range of
American companies, and many may step up capital outlays to modernize
or expand facilities. The higher cost of imports is also driving U.S. buyers
to domestic suppliers.
The U.S. economy should support the creation of another 2.7 million
jobs in 1988, following last year's addition of 2.9 million. This increase
would bring the total number of jobs created since the expansion began in
1982 to 17.3 million. The unemployment rate is also expected to bottom
out at about 5.5 percent during the second half of 1988. We continue to
forecast a recession beginning in 1989 as a result of a significant tightening in monetary policy. Such a downturn would probably be of mild to
moderate intensity, lasting for about a year.
2.5.4.
Inflation — Direction Still U p
Inflation, in terms of the fourth-quarter-to-fourth-quarter increase in consumer prices, moved back up to 4.4 percent in 1987 after the plunge in
energy prices depressed the rate to only 1.3 percent in 1986. Although
last year's tightening in monetary policy may have slowed the increase in
inflation, we still expect to see an uptrend over the course of 1988. Our
current forecast is for consumer prices at the end of this year to be about
5.0 percent above the year-end level of 1987. This is down from the 5.5
percent inflation rate we had projected in October.
The rise in inflation will reflect principally the interaction of three economic forces: continued increases in government debt and its monetization;
11
rapid money growth in 1985 and 1986; and the decline of the dollar on foreign exchange markets. So long as excess capacity existed in production
facilities in the United States and abroad, while labor conditions placed
little pressure on wages, inflation remained relatively low. It should be
noted, however, that even under these conditions inflation during the past
few years has held at about 4 percent, except for 1986 with the sharp break
in energy costs.
U.S. industries entered 1988 operating at about 82 percent of capacity,
a level close to that which typically results in more rapid price increases.
Although foreign producers have absorbed significant amounts of the dollar's depreciation through lower profit margins, import prices are likely to
rise about 10 percent in 1988. Full employment in the United States, defined as that level of unemployment at which more significant pressure on
wages begins, is now probably about 5.3 percent. Our forecast is for the
unemployment rate to approach this level as it falls to 5.5 percent. An ending of the recent trend of employee "give-backs" with the upswing in the
manufacturing sector will also contribute to upward wage pressure. With
respect to oil prices, our assumption of October remains that the price of
the West Texas Intermediate benchmark will average between $16.50 and
$18.50 per barrel in the 1988-89 period. For at least 1988, the lower end
of that range now seems the more likely.
It currently appears that the Federal Reserve's "threshold" for tolerating inflation is somewhere between 5 percent and 6 percent. As monthly
consumer-price increases begin to move in that range late in 1988, the conditions can be expected to be present for Federal Reserve tightening.
2.5.5.
Interest Rates — Flat or Lower, Then U p
The federal funds rate is likely to hold in the 6.5 to 6.75 percent range in
the first half of 1988, as opposed to over 7 percent last fall. Indications of
slower economic growth in the first part of the year have caused a reduction
in all short-term interest rates from their levels of the latter part of 1987.
Short-term interest rates are likely to remain relatively flat through
the second quarter of 1988. Unless massive selling of dollars on foreignexchange markets were to resume, moderate economic growth and inflation
will place little pressure on interest rates.
In the second half of 1988, higher economic growth, more inflation, and
12
rising credit demands are expected to push market interest rates moderately
upward. In the pre-election period, the Federal Reserve will probably want
to maintain a "low profile" by resisting either upward or downward pressure
on interest rates. Attempts to hold interest rates below market levels will
produce more rapid growth of the monetary aggregates.
Our expectation is that short-term interest rates will rise about threefourths of a percentage point between the first and fourth quarters of 1988.
Then, a shift in Federal Reserve policy late this year will push up shortterm interest rates between 150 and 175 basis points before the peak is
reached in the spring of 1989. Short-term interest rates then would fall
sharply in the second half of next year.
The yield curve steepened significantly in 1987, representing uncertainty
over the future rate of inflation and interest rates in view of questions
about the federal budget deficit, the value of the dollar, and the ability of
the United States to attract foreign capital. If foreign investors became
convinced that the dollar had bottomed out, the inflow of foreign funds
could drive long-term rates down significantly. With uncertainty remaining,
the yield on 30-year government bonds is expected to average about 8.6
percent in the first quarter of 1988. Some increase in inflation as the year
proceeds is expected to cause a rise of about one-half of a percentage point
to 9.15 percent by year-end. These long-term rates would then climb to
about 9.75 percent in the spring of 1989, along with the upswing in shortterm rates.
Interest rates on 30-year, fixed-rate mortgages are also expected to rise
moderately from their low point of the first quarter of 1988. Our current
forecast is for an average of 10.7 percent in the fourth quarter of 1988,
compared with an estimated 10.1 percent in the first quarter. We expect
mortgage rates to peak at about 11.5 percent in the spring of 1989 before
a decline resumes in the second half of the year.
13
QUARTERLY
MAJOR ECONOMIC INDICATORS
1988
II
III
IV
4744.4
4840.6
4942.4
III
IV
4377.7
1997
II
Actual
4445.1
4524.0
4604.0
6.6
6.3
7.3
7.3
5.3
7.1
8.4
9.7
6.8
3919.3
3953.1
3989.2
3999.2
LCTOGSNATOT^ PRODUCT
(BHHone of t . annual rata)
% Change, annual rate
4lh QUARTER
|
l_
4663.5
l__
Forecast
5021.4
1 969
II
III
IV
5092.7
5124.6
5167.5
5.8
2.5
3.4
3999.2
3966.8
3949.9
1997
Actual
4604.0
% Change
•>7rji6_
1966
% Change
Change
• a r e ? 1969 ' a s / a t
Forecast
7.3 3167.3
4.6
7.4
4942.4
3877.9
3.9
3989.2
2.9 3 9 4 8 9
-1.0
3957.6
1.5
4046.0
2.2 3991.9
-1.3
REAL O P
(Biniont of tgs? $. a.r.)
% Change, annual rafe
3772.2
3793.3
3833.9
3977.9
3892.4
4.4
2.5
4.3
4.5
1.5
2.8
3.7
3.5
1.0
0.0
-3.0
•2.0
REALFIMALOOMESTC SALES
(Billions of 19S2 S. a_r.)
% Change, annual rafe
3859.7
3998.9
3949.9
3957.6
3982.4
4006.1
4028.1
4046.0
4043.4
4043.6
4022.6
3991.9
-3.9
3.1
6.4
0.9
2.5
2.4
2.2
1.8
-0.3
0.0
-2.1
-3.0
47.6
39.0
24.6
56.7
10.0
6.0
9.0
16.0
20.0
12.0
-7.0
-2.0
56.7
N/A
16.0
N/A
-2.0
N/A
116.1
117.1
117.9
118.7
119.8
121.1
122.4
123.9
125.6
127.3
129.1
130.9
118.7
3.3
123.9
4.4
130.9
3.6
4.2
4.5
5.0
5.5
5.8
5.7
5.5
353.0
357.5
362.4
367.7
373.4
379.1
384.6
345.3
4.4
362.4
5.0
384.6
6.1
REAL CHANGE KM
NVENTORES
(Billions of 1982 $. a.r.)
GNPOEFLATOR
(1982-100)
% Change, annual rafe
CONSUMER PRCE
NDEX
(1967*100)
% Change, annual rata
4.2
3.5
2.9
2.7
3.8
335.0
339.0
342.3
345.3
348.8
5.3
4.9
3.9
3.6
4.1
4.9
5.2
3.6
6.0
6.3
6.2
6.0
AUTOSALES
(Million*, annual rata)
9.5
10.0
11.5
10.0
9.8
10.0
10.3
10.0
9.6
9.3
8.7
8.5
10.3"
-10.2
10.0*
-2.5
0.0
#
-10.0
MOUSNO STARTS
(Millions, annual rate)
1.90
1.01
1.62
1.52
1.53
1.56
1.56
1.50
1.39
1.35
1.37
1.50
1.62*
-10.4
1.54*
-4.9
1.40*
•6.9
129.9
129.2
130.9
133.0
1-33.8
134.7
136.2
137.7
138.0
137.3
135.4
133.6
3.1
4.3
9.7
6.4
2.3
2.7
4.6
4.7
0.7
•1.4
-5.9
•4.6
101.1
101.7
102.3
103.3
103.9
104.6
103.3
106.0
106.5
106.8
106.8
9.5
9.1
5.9
5.8
5.6
5.7
3.6
5.5
5.7
6.0
243.7
247.9
250.7
255.7
261.3
265.1
269.6
274.6
277.9
11.8
7.0
4.7
8.2
9.0
6.0
7.0
7.5
5.0
IMDUSTRIAL
PnOOUCTCN
(1977-100)
% Change, annual rare
NONFARM
EMPLOYMENT
(Millions)
UNEMPLOYMENT
RATE. ALL WORKERS (Percent)
MONETARY BASE
(Buttons of f. a.r.)
% Change, annual rafe
NOTE: All quartedy eerlee are ssasonafy
% change, annual rate calculated from prior Quarter;
calculatlona based on unrounded data; a.r. - annual rale
133.0
5.6
137.7
3.6
133.8
•2.9
106.6
103.3
2.9
106.0
2.6
106.6
0.6
6.5
6.9
5.8
N/A
5.5
N/A
6.9
N/A
279.3
282.7
287.6
255.7
7.9
274.6
7.4
287.6
4.7
2.0
5.0
7.0
'Annual total; N/A - Not applicable.
Chapter 3
The Economy and Fiscal Policy
Jerry L. Jordan1
First Interstate Bancorp
Mr. Chairman and members of the Committee, I am pleased to have
this opportunity to appear before you today and present my views on the
outlook for the U.S. economy and the implications for the fiscal 1989 budget. My comments will focus on the following issues: (1) the economic
outlook for the next two years; (2) the effects of the stock market crash;
(3) the concerns regarding the dollar on foreign-exchange markets; (4) the
proposed balanced budget amendment; and (5) a proposal for normalizing
the economic assumptions so that budget priorities can be set independently of the financing requirements. The Full Employment and Balanced
Growth Act of 1978, known as the "Humphrey-Hawkins" legislation, set
forth useful long-term goals that are still achievable.
3.1.
The Economy in 1988-89
The probability of a recession occurring in 1988 is Very small. However, we
believe that the likelihood of a recession occurring in 1989 is considerably
greater. Even then, the likelihood of a short and mild recession beginning
in the middle of 1989 is crucially dependent on two assumptions. One assumption is that monetary policy remains overly expansive during 1988,
causing total spending growth in the economy to accelerate, with the result
1
Thb paper was presented to the U.S. House of Representatives, Committee on the
Budget, March 2, 1988
14
that inflation rises into the 5 percent to 6 percent range later this year.
The second assumption is that, once inflation reaches this range, a more
restrictive anti-inflationary monetary policy will be adopted and that this
monetary restraint will sharply slow total spending growth by mid-1989,
causing a decline in domestic output and a temporary decline of employment.
A recession even in 1989 may still be avoidable or mitigated if monetary
growth can be constrained to a slow, steady, and predictable pace during
this calendar year. If so, then it will not become necessary to adopt more
restrictive measures next year to reduce inflationary excesses.
The drop in equity market prices last October did not automatically
trigger the onset of recession. While consumer spending did decline in the
final months of last year, it is recovering now in early 1988 and there is
sufficient strength in business fixed investment and in export demand to
provide for some growth in domestic output.
A slower growth of real consumer spending in the 1988-89 period is a
desirable development in view of the necessity of raising the national saving
rate in order to solve the "twin deficits problem." Earlier in the current expansion, consumer spending rose to a historic peak share of GNP, while the
federal budget and international-trade accounts went into massive deficits.
The resulting net debtor status of the United States has become a great
concern to international investors. Reducing the government's dissaving
and increasing the private-sector's saving rate both would contribute to
reversing the trends of the early 1980s. As the consumer spending share of
GNP falls back toward its longer-term historic average, the private saving
rate, and therefore private sector investment, will increase and the trade
deficit will fall.
Our forecast for all of 1988 (on a fourth-quarter to fourth-quarter basis)
is for GNP growth of almost 3 percent, accompanied by a 5 percent increase
in the consumer price index and modestly higher interest rates by year-end.
In 1989, we expect interest rates to rise more rapidly during the first half
of the year as a part of a more restrictive monetary policy to combat rising
inflationary pressures, and we also expect GNP growth to turn negative by
the second half of next year.
15
ECONOMIC FORECASTS
lafljfi
First
Interstate
Economics
OMB
1989.
C30
First
Interstate
Economics
OMB
CBO
7.3%
6.9%
4th QTR. to 4th QTR
PERCENT CHANGE
Nominal GNP
7.4%
6.4%
5.7%
4.6%
Real GNP
2.9
2.4
1.8
-1.0
3.5
2.6
GNP Deflator
4.4
3.0
3.9
5.6
3.7
4.2
Consumer Price Index (CPI-W)
5.0
4.3
4.9
6.1
3.9
4.8
91-Day Treasury Bill Rate
6.1%
5.3%
6.2%
7.7%
5.2%
6.7%
10-Year Treasury Note Yield
8.7
8.0
9.3
9.3
7.4
9.5
Unemployment Rate,
Including military
5.6
5.8
6.1
6.3
5.6
6.0
It should be emphasized that such forecasts of national economic activity should not play a major role in setting federal budget priorities. We
believe that planned federal outlays should not depend on the performance
of the economy or on any associated deficits. I will turn to a specific proposal in this regard in a few minutes.
3.2.
Stock Market Crash and Monetary Policy
At the time of the stock market crash last October, the Federal Reserve appropriately eased monetary policy significantly to cushion the impact on the
financial system and the real economy. These actions by the central bank
lasted about two weeks until the crisis atmosphere abated. Subsequently, as
the dollar began to decline more rapidly on foreign-exchange markets, the
Federal Reserve intervened as part of an international currency-stabilization
program. Also, the Fed appeared to resist the tendency of short-term market interest rates to fall as a result of the preference for liquidity and quality
on the part of private investors. The combination of these foreign and domestic actions produced a contraction in bank reserves and a very sharp
reduction in the growth of money and bank credit in the final two months
of last year.
However, since the beginning of 1988, the dollar has begun to recover on
foreign-exchange markets, creating the opportunity for the Federal Reserve
to unwind the effects of previous intervention and also to inject reserves
in the domestic money market, with further declines of short-term interest
rates.
We believe the acceleration of reserve and money growth during the
past two months will be sustained for most of this year. If so, the period of greatest concern about the stock-market crash and recession has
now passed. Both short- and long-term interest rates are now about two
percentage points lower than just prior to the stock-market crash. Consequently, the most interest-sensitive sectors of the economy, such as housing
construction and automobiles, are likely to be somewhat stronger than
would have been the case had interest rates remained at the levels reached
late last summer.
16
3.3.
The Dollar and Foreign-Exchange Markets
For the near term, we believe that the dollar is more likely to rise rather
than continue to fall on foreign-exchange markets. Late in 1987, the dollar
was dropping rapidly because of growing foreign-investor concerns that U.S.
policies would remain excessively expansionary in an eflfort to inflate out of
our fiscal dilemma. As the year ended, a combination of upward revisions of
forecasts and perceptions about foreign economies and downward revisions
in forecasts about U.S. inflation and real growth produced a more positive
short-run outlook for the dollar. Because we expect these conditions to
prevail for the next few months, the dollar could rise into the range of 135
to 140 yen and 1.70 to 1.75 deutsche marks.
During the second half of 1988, our forecast of higher real growth plus
somewhat higher inflation should cause the dollar to begin to depreciate
again in spite of the somewhat higher interest rates that we also forecast
later this year. Although the U.S. trade deficit will drop by some $20 to $25
billion in 1988, it will still be very large in absolute terms. Nevertheless,
we do not believe that the dollar must fall substantially further in order
to begin making concrete progress in reducing the trade deficit, nor do we
believe that the existence of a trade deficit means the dollar must continuously decline. However, U.S. fiscal policies have produced an environment
that has been associated with higher monetary growth and higher inflation
in the U.S. than in most of the other major industralized countries, which
has contributed to the sustained decline in the dollar. Since we believe
that the United States will continue to have higher inflation than most of
the other large industralized economies through 1989, the dollar is likely to
gradually decline further from current levels.
As long as the U.S. sustains a significant deficit in the federal budget —
and also, as the world's international reserve-currency country, enjoys the
privilege of financing its external debt by issuing securities denominated
in its own currency — the U.S. may be tempted to tolerate a higher rate
of inflation than historically has been the case. Our foreign creditors are
very well aware of this temptation since the alternative is to make the hard
choices necessary to reduce the deficits. Consequently, they are monitoring
developments in this country for signs of fiscal and monetary discipline.
The sustained current-account deficits and recent net-debtor status of the
United States have created a dependency on foreign saving flows that can-
17
not be ignored in considering fiscal and monetary alternatives.
3.4.
Balance of the Federal Budget
The objective of moving towards balance in the federal budget is highly
desirable, and the Gramm-Rudman-Hollings (GRH) target date of 1993 is
achievable and worth maintaining. Congress should not be influenced by
the view that a smaller deficit necessarily implies less fiscal stimulus to the
economy. Not all actions to curtail deficits are restrictive.
In the jargon of economists, there is considerable disagreement about
both the sign and size of fiscal-impact "multipliers." Changes in government spending do not have the same effect on the economy as do changes
in taxation and different types of spending and different types of taxation
have different effects on private economic activity.
My own view is that a program of dependable progress towards smaller
deficits would reduce some of both the uncertainty and the inflation premiums embodied in current levels of market interest rates. Institutional
investors in the U.S, and abroad fear that, as long as the deficits persist,
the U.S. will be tempted to monetize the debts and repay the obligations
with cheaper dollars. The resulting uncertainty and inflation premiums
have helped cause interest expense on the national debt to be the fastest
growing major component of the federal budget in recent years. Sustained
progress toward lower deficits, together with a downward trend of inflation,
would produce a budgetary dividend of falling interest expense as a share
of the budget and as a share of national income.
While GRH emphasizes deficit reduction targets, the more basic issue is
government spending itself. Last year, the economy produced $4.5 trillion of
goods and services. Nearly one-third of available resources were channeled
through government sectors last year. By contrast, in the early 1960s,
government spending at all levels was only 27 percent of the nation's total
spending.
Although efforts to reduce the deficit as stressed by GRH are useful,
it is much more important that the initial spending decision itself be well
thought out and justified. A wasteful government expenditure would make
the country worse off even if the budget were balanced. Similarly, a couple
of billion dollars spent to prevent the spread of a serious communicable
disease might easily have broad public support and therefore ought to go
18
forward regardless of the size of the deficit.
There is a danger that focusing on annual deficts may cause fiscal actions
to take on a greater pro-cyclic bias, rather than move countercyclical^. For
example, if it appears that the next year will be weaker than previously
thought, focusing on deficits implies that less spending or higher taxes
would be called for in order to hit a deficit target. Conversely, if the next
year appears to be stronger than previously thought, more spending or
lower taxes would seem to be justified.
Furthermore, focusing on the deficit leads to statements that suggest
that it is deficits, rather than government spending, that caused our reliance on foreign financing or "crowded out" private investment. This is
mistaken, for lowering the deficit by raising current taxes could also entail
foreign borrowing (to meet current tax obligations) or lower private saving
and capital formation. In real terms, it is government's claim on current
production that "crowds out" private claims.
Given a decison to make an expenditure, government imposes taxes,
implicitly or explicitly, directly or indirectly. Taxes may be collected against
current output or against future output, but we need to recall that the
incidence and burden of a tax are not one and the same. The extent
of inter-generational tax shifting is neither easily determined nor directly
under government's control.
In spite of my reservations about targeting annual deficits, the goal
of GRH — phased reductions in the deficit each year through 1993 —
is important and reachable. The economy will be better off if Congress
accepts this fiscal discipline, while awaiting the recommendations of the
National Commission on Economic Policy for fundamental reforms of the
budget process.
3.5.
Balanced Budget Amendment
I cannot give a blanket endorsement of a constitutional amendment requiring balance in the federal budget without knowing something about the
implementing legislation to achieve it. As desirable as it may be to achieve
and maintain balance between federal expenditures and receipts, the actions taken to move toward balance will have effects on private-sector economic activity. In addition, since the performance of the economy has a
pronounced effect on both receipts and outlays, actual balance cannot be
19
expected in any given year. In view of the recent legacy of deficits and the
wide range of forecasts about the likely performance of the economy over
the next few years, spending targets should be set with the objective of
limiting the relative size of the federal government over time.
Early in his administration, former President Carter set forth a goal
of reducing to 21 percent the share of GNP accounted for by federal government spending.2 The actual average during the Carter presidency was
government spending equal to 21.2 percent of GNP. A few years later, President Reagan set forth a goal of achieving a balanced budget with federal
spending equal to 19 percent of GNP.8 However, the actual average has
been 23.4 percent during the Reagan presidency.
The 1978 Humphrey-Hawkins legislation set an ultimate goal of reducing total federal spending to 20 percent of GNP, with an interim goal of
21 percent.4 Since this ultimate goal falls between the Carter and Reagan
goals, it seems that a bipartisan consensus has emerged. However, over the
past 10 years government spending has averaged 22.8 percent of GNP. Over
the past 20 and 25 year time periods, government spending has averaged
21.6 percent and 21.0 percent of GNP, respectively.
Whether the socially and politically acceptable ratio of federal spending
to GNP is 20 percent, 21 percent or 22 percent, it is imperative to decide
on and live with a fixed federal government share of the nation's income
and output. Once having set a national objective in terms of total federal
spending as a percent of national income, agreement also must be reached
regarding the priorities within this budget total.
Since any possibility of implementing a balanced budget amendment
to the Constitution is several years into the future, I would like to take
a few minutes to summarize a proposal for changing the role of economic
assumptions in the budgetary process, and focus attention on the national
priorities within the budget, rather than on the deficit.
2
Economic Report of the President, January, 1978; p. 9.
A Program for Economic Recovery, February, 1981; pp. 11-12.
4
The Full Employment and Balanced Growth Act of 1978, Section 1022a.
3
20
3.6.
Proposed Approach for Setting Economic Assumptions for the Budget
Economists have long found it useful to employ a concept known as permanent income, sometimes referred to as standard income, in analyzing
consumer spending and saving behavior. The basic idea is that income
from one period to the next can often be highly variable, but individuals adapt spending patterns according to the average income they expect
to realize over time. I suggest that much of the perennial problem of setting economic assumptions is counterproductive to the setting'of budgetary
priorities and deflects attention away from the important issues of the composition of the budget. Therefore, I think it would be highly desirable for
both houses of the Congress and the Administration to agree on a concept
of standard national income for the purpose of setting budget ceilings for
the five-year planning horizon.
For this purpose, the standardized GNP assumption used in the budgetsetting process would be derived from the average actual growth of real
output over a lengthy prior period — such as 20 or 25 years — plus the rate
of inflation agreed upon by Congress and the Administration as a desirable
long-run objective. For this purpose, the 3 percent interim target rate of
inflation mandated by the Full Employment and Balanced Growth Act of
19785 would be desirable. The target 3 percent inflation goal plus the 3
percent actual average real GNP growth over the past 25 years would yield
a growth rate of 6 percent for standard national income. Based on this
standard national income assumption, Congress and the Administration
should then achieve a bipartisan consensus regarding the portion of the
nation's resources that will flow through the government sector.
In fiscal 1987, federal spending, including interest on the national debt
less offsetting receipts, was 22.8 percent of GNP. Outlays for defense, nondefense discretionary, and entitlements and other mandatory spend-ing
amounted to 20.9 percent of actual GNP in fiscal 1987 — a l | percentage point larger share of GNP than total tax revenue.
If the Humphrey-Hawkins interim goal of reducing total federal outlays
to 21 percent was set for three years and the 20 percent goal was to be
reached in five years, the deficit could be cut to under 1 percent of GNP
5
The Full Employment and Balanced Growth of 1978, Section 1022a.
21
by 1993. However, if interest expense and offsetting receipts remain at
approximately the current share of standard national income, the total of
defense, non-defense discretionary, and payments to individuals will have
to be reduced by about 1.5 percentage points as a share of GNP from the
level that otherwise would be reached in the target year.
Starting with the defense budget, at the end of the Carter presidency,
defense spending was equal to 5 percent of GNP and the average during
the Carter presidency was 4.9 percent of GNP. During the 1980 campaign
and early in his Administration, President Reagan set a goal of increasing
defense spending as a percent of GNP from 5 percent to 7 percent, arguing
that the nation could and should devote two percentage points more of
national income to defense. That goal was never reached. Defense spending
reached a peak of 6.5 percent of GNP in 1986, and is projected to decline
in 1988 and 1989. The average for the Reagan presidency will be close to
6.1 percent for the eight years of the current Administration. For the past
10, 20 and 25 year periods, defense spending has averaged 5.8 percent, 6.3
percent, 6.7 percent of GNP, respectively.
The national goal regarding the share of the nation's resources to devote
to defense spending is, of course, a political decision and must be arrived
at through a political process. However, it seems quite clear that the 5
percent level at the end of the Carter presidency is at the low end of what
is acceptable in this country and the 7 percent goal set by the Reagan
Administration, but never achieved, is higher than the politically acceptable
rate. It would appear that somewhere between the 5 percent to 6.5 percent
actual range of the past decade reflects the consensus of the American public
at present. This is an issue that presidential candidates and candidates for
Congress can address in order to find out what the voters of this country
are willing to support.
Turning to non-defense discretionary spending, its actual share of GNP
in fiscal 1987 was 3.7 percent and estimates by the Congressional Budget
Office suggest that the share will be the same in fiscal 1988. Non-defense
discretionary spending is now at its lowest share of GNP in the last 25 years,
and CBO projections of the "current-services* budget indicate a slight decline in this share of GNP over the next five years. Again, a consensus
should be achieved regarding the proportion of the standard national incomt that is to be devoted to non-defense discretionary outlays, prior to
discussions about the composition of such spending.
22
Turning to the large ttpayments-to-individuals" share of the federal budget, the actual experience has been for this spending to average 10.8 percent, 9.6 percent and 8.7 percent of GNP over the past 10, 20 and 25 year
intervals. In fiscal 1987, such spending amounted to 10.8 percent of GNP
and the CBO currently estimates that, in fiscal 1988, entitlements and other
mandatory spending will amount to approximately 10.6 percent of forecast
GNP.
Over-correction for inflation during the past fifteen years contributed to
a significant increase in real benefits to recipients, even though the intent
of indexation was to prevent an erosion of real benefits due to higher costs
of living. Some of the sources of this over-indexation, such as the inclusion of home prices and mortgage rates in the consumer price index, have
been corrected, but some still are present. Limiting COLAs for indexed
programs to the 3 percent Humphrey-Hawkins interim inflation goal, or
the actual CPI minus 2 percentage points, which ever is smaller, would
help considerably in the effort to reduce the deficit over a period of several
years. Because of the difficulties of measuring productivity and the quality
of services, which account for one-half of the consumer price index, there is
an upward bias in the CPI as a measure of cost of living. Consequently, full
CPI indexation raises real payments. Tightening up on eligibility rules and
subjecting more recipients to means testing would also significantly reduce
this source of the national budget problem, while channeling resources more
effectively to the intended receivers.
Achieving a goal of federal spending equal to 20 percent of standard
national income within the next five years is possible, while still allowing
for some increases in major spending categories. Excluding net interest
and offsetting receipts, it would imply holding the sum of the three major
categories of federal spending — defense, non-defense discretionary outlays
and entitlements and other mandatory payments — to an average growth
of about 3 percent per year. If any one category of spending were allowed
to grow by more than 3 percent per year, slower growth or cuts would have
to occur in other categories.
The decision to increase or decrease either the total federal budget as a
percent of standard national income^ or to change the composition among
the broad categories, is a political decision that should be derived without
complications caused by disagreements about economic assumptions. Also,
decisions regarding the total amount of federal spending as a share of stan-
23
dard national income and the relative shares of major components should
precede decisions regarding how much of such spending will be financed
by explicit current taxation and how much will be financed through the
issuance of interest-bearing obligations of the government.
3.7.
Implications for Monetary Policy
Over the long run, monetary policy actions are a form of fiscal instrument.
Open market purchases of government securities by the Federal Reserve
reduce the net interest expense on the national debt, but at a cost of reduced purchasing power of the U.S. dollar. Inflation should be viewed
as an unlegislated tax, and as an especially regressive and divisive tax.
Deficit financing of current government outlays tends to create pressures
in domestic and international financial markets that usually result in more
rapid monetary growth and inflation. There is nothing automatic about
the relationship, but the temptation to monetize more debt and tolerate
higher inflation increases when deficits are larger.
Rather than focus on current interest-rate or exchange-rate levels, Congressional guidance to the Federal Reserve should include instructions to
conduct monetary policies in such a way as to cause the trend of actual
GNP growth to approximate that implied by standard national ineomt goals
over the budget horizon. The five-year budget planning horizon makes little
sense if the economic assumptions are not consistent with the central bank's
intentions with regard to the growth of total spending in the economy over
that period.
3.8.
Summary and Conclusions
A recently released survey of members of the National Association of Business Economists reported that 83 percent expect the U.S. to be in recession
before the end of 1989. Whether or not that turns out to be an accurate
forecast, current decisions about the fiscal 1989 budget should be based
on a non-cyclical estimate of the normal or "core* rate of national income
growth. If a majority of economists were forecasting a roaring boom in
1989, it would not make sense to assume there would be more room for
federal expenditure since the deficit would be smaller.
24
A concept of standard national income growth is implied by the objectives for inflation and output growth specified by the Full Employment and
Balanced Growth Act of 1978. Such a concept should be employed as the
basis of economic assumptions for establishing the federal budget, even if
actual economic conditions are different.
The Humphrey-Hawkins legislation also provided very useful national
goals regarding federal government spending as a share of national income,
and a concrete plan to move toward achieving that goal over the next five
years would have a highly favorable effect on financial markets. A plan to
hold the growth of federal outlays below the growth of nominal GNP, so
that total government spending falls towards the 20 percent share specified
by the Humphrey-Hawkins legislation, would reduce the deficit to less than
one percent of GNP.
Thank you for inviting me to appear today and giving me the time to
present my views. I wish you success in your deliberations.
25
Attachment 1
FEDERAL OUTLAYS AS A PERCENT OF GNP
(Fiscal Years, Average)
(1)
(2)
Entitlements
And Other
Mandatory
Fiscal
Year
Defense
1987
6.4%
Last 10 Years Avg.
5.8
Last 20 Years Avg.
6.3
10.8
9.6
Last 25 Years Avg.
6.7
8.7
Spending
10.8%
(3)
Nondefense
Discretionary
Spending
(4)
Sum
(Columns
1 to 3)
(5)
(6)
Net
Interest
Offsetting
Receipts
(7)
Total
(Columns
4 to 6)
3.7%
20.9%
3.1%
-1.2%
22.8%
4.9
21.5
2.6
-1.2
22.8
5.0
20.9
2.0
-1.2
21.6
4.9
20.3
1.9
-1.2
21.0
First Interstate Economics
March 2,1988
Attachment 2
Defense &
Nondefense
Discretionary
GNP
& Entitlements** S h a r e
(Billions)
(Percent)
Fiscal
Year
Standard
National
Income*
(Billions)
Actual 1987
$4409
$920
1988
4673
959
20.5
96
2.1
1055
22.6
1989
4954
988
19.9
108
2.2
1096
22.1
1Q90
5251
1017
19.4
123
2.3
1140
21.7
1991
5566
1048
18.8
133
2.4
1181
21.2
1992
5900
1079
18.3
135
2.3
1214
20.6
1993
6254
1112
17.8
137
2.2
1249
20.0
Percent change, 1988-93
average compound annual rate
6.0%
3.0%
20.9%
Net Interest
& Offsetting
GNP
Receipts*** Share
(Billions)
(Percent)
$85
7.4%
1.9%
Total
Federal
Spending
(Billions)
$1005
GNP
Share
(Percent)
22.8%
3.4%
First Interstate Economics
March 2, 1988
^Actual GNP for 1987, based on 6% growth thereafter.
**Actual 1987, CBO assumption for 1988, based on 3% growth thereafter.
*** Actual 1987, CBO assumptions for 1988-93.
THE ECONOMY AND FISCAL POLICY
CHARTS SUPPLEMENTING STATEMENT OF
Jerry L Jordan
Senior Vice President & Chief Economist
First Interstate Bancorp
U.S. HOUSE OF REPRESENTATIVES
Committee on the Budget
March 2, 1988
CONSUMER PRICES, WAGES, AND IMPORT COSTS
(Percent changes, 4th quarter to 4th quarter)
REAL GNP
(Percent change, 4th quarter to 4th quarter)
InfMJft Pfl089,
Except Fuel
8?
83
84
85
86
87
88f
89!
Continued economic expansion is expected in 1988, with real GNP
growth of nearly 3 percent. An increase in inflation and subsequent
tightening of monetary policy could produce a recession in 1989.
Inflation, measured in terms of consumer prices, Is expected to move up
to 5 percent in 1988. Past monetary expansion, In part prompted by
fiscal policy, will be the major cause of this increase. The dollar's decline
will drive up import prices further, and wages are likely to lag behind price
increases.
CHANGES IN EMPLOYMENT
(Minions, 4th quarter to 4th quarter)
SECTORAL CONTRIBUTIONS TO GNP
(Percent share of two-year real GNP growth, fourth quarter data)
120
82
83
84
85
86
87
88f
89!
Nonf arm employment Increased by 2.9 million in 1987 and another 2.7 Major changes are occurring in the sources of strength and weakness in
million jobs are expected to be added in 1988. The unemployment rate the U.S. economy. While the consumer, housing, and government
is expected to fall to 5.5 percent in the second half of this year.
sectors were the lead growth areas in 1985-86, business capital
spending and exports have now moved to the fore.
First Interstate Economics
INTEREST RATES
TOTAL BANK RESERVES
(Percent quarterly averages)
(Monthly, percent change from prior month, annual rate)
20 T
151
10"t
90-DayT-M
5"t
0 I It t|I II| II I|I iII IIt| ItI I III| 11I 1
J F M A M 1 J A S O N D J F M A M J
J
I9S6
1987
A S O N D J
IMS
The growth of bank reserves slowed significantly in 1987, but a more
rapid expansion has developed in 1988. The trend of monetary
policy win be more important than last fairs stock market crash in
determining the course of the economy this year.
82
83
84
85
88
87
88f
891
Interest rates are forecasted to remain relatively stable in the near
term. Some increase in the second half of 1988 Is expected in
response to a pickup in economic growth and higher inflation.
Sharper increases are then likely in the first part of 1989.
U.S. CURRENT-ACCOUNT DEFICIT
EXCHANGE RATE - YEN/*
(BUoflB of OORM)
(Weekly averages)
180 T
20 +
-40 +
-60 +
160 +
-80 +
-100 +
-120 +
140 4
-140 +
-160 +
120 Jf**
A S
19*6
O
N
D
J
P
IIIII
M A
M
ii
J
J A
1987
an m u m i n • i i i . m M I H I ••
S O N D J
I 1 **
After a steep fall onforeign-exchangemarkets in the latter part of
1987, the dollar has recently moved up against such currencies as
the Japanese yen. Some further appreciation may occur in the near
term, although the dollar is likely to move lower again later in 1988.
First Interstate Economics
-180
82
83
84
85
86
87t
86f
89!
The U.S. current-account deficit Is expected to diminish in 1988
from its peak of last year. Our foreign-trade deficit will decline by
about $20-25 billion. A smaller reduction will occur in the overall
current-account deficit because of a shift from surplus to deficit in
the services balance.
3
10-YEAR TREASURY BOND ft EXPECTED INFLATION *
NET NATIONAL DEBT* AS A % OF GNP
(Percent)
•3
85
67
«»
71
73
7S
77
79
81
* FMfMw dsbt IMS hoMnps bf 0OV9fnfntnl sccounts and tht F wtecal Hosfwvt
83
85
87
The net national debt of the United States reached 38 percent of
GNP in fiscal 1987. This was double the ratio which existed in fiscal
1974.
TOTAL GOVERNMENT SPENDING AS A % OF GNP
(Ffecalyrafs)
Spending by all levels of government combined (federal, state, and
local) amounted to nearly one-third of GNP in fiscal 1987. In the early
1960s, about 27 percent of total national income was channeled
through the government sector.
http://fraser.stlouisfed.org/ First Interstate
Federal Reserve Bank of St. Louis
Economics
4,00 lltWIHWfff WIWWtWWJWIWWIWWIWIWHf WWf MIHWIIMWIIIBtUIHHm M l WW f i l m
80:1
81:1
82:1
83:1
84:1
85:1
86:1
87:1
88:1
* 0»wl Bumhwn Pol
The actual level of interest rates reflects both the expected rate of
inflation and ariskpremium for uncertainty. More responsible fiscal
policies could reduce both of these components and thus lower
interest rates.
FEDERAL OUTLAYS AND REVENUES AS A % OF GNP
(Fiscal years)
Holding the growth of defense, entitlements and nondefense
discretionary spending to an average of 3 percent per year, total spending could be reduced to 20 percent of GNP by fiscal 1993. Based on
current CBO assumptions regarding the revenue/GNP share, the deficit
would thus be reduced to less than one percent of national income.
4
NONDFFENSE DISCRETIONARY AS A % OF GNP
DEFENSE AS A % OF GNP
(Focal years)
(RscsJ years)
12T
10 +
8+
6+
63
65
67
69
71
73
75
77
79
91
83
85
63
87
In the past several years, defense spending has climbed from a low of
4.8 percent of GNP in 1979 to a peak of 6.5 percent in 1986.
However, it is currently expected to drop again below 6 percent by
1989.
65
67
69
71
73
75
77
79
81
83
85
87
T h e share of G N P comprised b y nondefense discretionary spending
has declined significantly since the p e a k of 5.9 percent in 1 9 8 0 . Last
year, such spending fell to 3.7 percent of G N P , a share expected to
also hold in 1 9 8 8 .
NET INTEREST AS A % OF GNP
ENTITLEMENTS & OTHER MANDATORY
AS A % OF GNP
(rscatyoBis)
(risen yoors)
12
T
10 +
8
I
6+
4+
63
65
67
69
71
73
75
77
79
81
83
85
Entitlements a n d other mandatory spending have climbed to nearly
11 percent of G N P In the last few years. This is twice the share of
national income claimed by this sector in the first half of the 1960s.
First Interstate Economics
87
Interest expense h a s b e e n o n e of the fastest growing components
of the federal budget in recent years a n d currently amounts to over 3
percent of G N P .
Chapter 4
Federal Budget Update — More of the Same
Mickey D. Levy
First Fidelity Bancorporation
In the Fiscal Year 1987, real outlays declined and the nominal budget
deficit slid to $150 billion from $221 billion in FY1986. But a significant
portion of the improvement was achieved through one-time events and,
despite deficit-cutting legislation in late 1987, budget deficits in FY1988 and
FY1989 should rise. Despite this renewed deterioration, little fiscal action
should be expected in this presidential election year. President Reagan's
last budget proposed only minor changes for FY1989 (Budget of the United
States Government, FY1989), and Congress will have little incentive to
consider seriously substantive budget action in 1988. Moreover, revisions
to the Balanced Budget Act of 1985 (Gramm-Rudman-Hollings) make the
new deficit constraint easier to circumvent. Thus, most likely, the burden
of resolving the budget dilemma effectively will be shifted onto the next
Administration and Congress. Barring an unexpected change in political
priorities, continued pressures to cut deficits without reducing spending
raise the probability of misguided tax increases in 1989.
4.1.
Recent Budget Action
Last year's fiscal actions were supposed to resolve the federal budget dilemma. The Bipartisan Budget Agreement—precipitated by the Congress
and Administration's incorrect perception that the stock market crash was
caused by high budget deficits—led to enactment of the Omnibus Budget
26
Reconciliation Act of 1987 (P.L. 100-203) and the continuing resolution
of appropriations (P.L. 100-202). These measures generated $34 billion
in savings in FY1988 ($15 billion from lower spending, $11 billion from
higher taxes, and $8 billion from asset sales and loan repayments), $36
billion in FY1989 ($19 billion from spending cuts and $17 billion from
higher taxes), and $40 billion in FY1990. As required by the Bipartisan
Budget Agreement, the reconciliation bill additionally included caps on
appropriations for FY1989 that limit growth in budget authority to 2\
percent for defense and 2 percent for non-defense programs.
Earlier, enactment of the Balanced Budget and Emergency Deficit Control Reaffirmation Act of 1987 (P.L. 100-119) revised the original Balanced
Budget Act of 1985 (GRH) by easing the deficit targets, stretching out
their implementation through 1993, and changing the sequestration process. The new GRH II targets for FY1988 and FY1989 are $144 billion
and $136 billion, up significantly from the original $108 billion and $72 billion. GRH II allows that sequestration may be avoided if deficit reduction
measures of $36 billion or more are achieved before scheduled sequestration, and limits the amount of across-the-board cuts in any fiscal year to
$36 billion. Also, GRH II provides that the OMB's budget forecast alone
determines whether or not sequestration is necessary and the magnitude of
the cuts. Previously, the arithmetic average of OMB's and CBO's deficit
forecast determined the amount of required sequestration. Still intact in
GRH II is the provision that if real GNP growth is less than 1 percent for
any two consecutive quarters, or if either OMB or CBO projects real GNP
to decline for any two consecutive quarters, Congress may vote to temporarily suspend GRH's sequestration process. Proceeds from asset sales
or prepayments are no longer counted toward deficit reductions.
4-2,
The Budget Outlook
The President's FY1089 Budget proposes a deficit of $129.5 billion in
FY1989, below the new GRH target (see Table 1), with very new proposals.
The budget includes a 3.6 percent increase in outlays (a 0.2 percent decline
in real terms) and a 6.1 percent increase in receipts.
The Administration's budget projects an 0.8 percent annual growth
in real spending from FY1988 to FY1991, a continuation of the trend of
sharply slower spending growth that began in FY1986. Real spending rose
27
2.1 percent in FY1986 and declined 0.7 percent in FY1987, after rising 3.2
percent annually from 1970 to 1980 and 3.9 percent annually from 1980 to
1985. Inflation-adjusted receipts are proposed to grow substantially faster,
at a 3.6 percent annual rate, from FY1988 to FY1991. Abo, the composition of proposed federal spending is in sharp contrast to the early 1980s:
from FY1988 to FY1991, nearly all of the proposed increases in real outlays
occur in payments to individuals (largely retirement and medical program
outlays). Real defense spending increases by less than 0.3 percent annually,
while real outlays for net interest, grants to state and local governments
and other spending programs are projected to decline.
In sharp contrast to the Administration's optimistic budget outlook, the
Congressional Budget Office baseline forecast calls for a sharp increase in
the FY1989 deficit to $176 billion (CBO, The Economic and Budget OutIdok: Fiscal Years 1989-1998, February 1988). The $40 billion gap between
the CBO projected baseline deficit and the GRH II FY1989 deficit target
widens in FY1990 and FY1991. Although the CBO baseline projection does
not include the President's budget proposals, it suggests that without significantly more deficit-cutting than is requested in the President's budget,
GRH's deficit targets will be grossly violated. Under the new maximum
sequestration of $36 billion, there would be cuts of approximately 9 percent
in defense and 13 percent in non-defense programs.
The wide difference between the Administration and CBO's budget forecasts is due primarily to the underlying economic projections (see Table 2).
The Administration forecasts significantly stronger economic growth, lower
inflation, and lower nominal and real interest rates than the CBO. It forecasts real GNP to grow 2.4 percent from 1987:IV to 1988:IV, and 3.5 percent
in 1989. Its 1988 economic growth forecast represents a significant downward revision from the 3.5 percent it forecast in the Mid-Session Review
of the FY 1988 Budget, issued in August 1987. Nevertheless, this economic
growth forecast is substantially more optimistic than the CBO's baseline
forecast, which projects real GNP growth of 1.8 percent from 1987:IV to
1988:IV, and 2.6 percent in 1989. The gap between their real GNP growth
projections widens in the later projection years.
The Administration and CBO have similar implicit GNP deflator forecasts in 1988, but the CBO projects higher inflation in 1989 and beyond.
Consequently, after 1988, the CBO's nominal GNP growth path is not significantly less than the Administration's. The sizeable forecast difference
28
in 1988, however, generates approximately $12 billion lower receipts in the
CBO's baseline forecast in FY1989 and beyond.
The difference in interest rate paths is the largest source of discrepancy
between the Administration's and CBO's budget projections. With its
higher rate assumptions, the CBO's baseline forecast projects net interest
outlays to rise to $196 billion by FY1991, compared to the Administration's
$160 billion. The Administration projects continuous declines in interest
rates on 3-month Treasury bills and 10-year Treasury bonds. With little
change in inflation expectations from 1988 to 1990, this implies significant
declines from present levels in inflation-adjusted interest rates. In contrast,
the CBO projects increases from current levels in both short and long-term
Treasury rates, and significantly higher inflation-adjusted rates than the
Administration. Implicit in the CBO's interest rate forecast is the expectation of a 10 percent decline in the exchange value of the U.S. dollar from
early 1988 through year-end 1989, and a continued depreciation throughout
the projection period.
The actual path of outlays and receipts is very sensitive to economic and
interest rate outcomes. Using general rules-of-thumb, the Administration
estimates that a one percentage point lower annual real GNP growth rate
beginning in fiscal year 1989 would add to the deficit $7.7 billion in FY1989,
$21.8 billion in FY1990, and $39 billion in FY1991, with approximately
three-quarters of the deterioration due to lower receipts. The CBO's estimated sensitivity is somewhat larger. The Administration also estimates
that a sustained one percentage point higher interest rate beginning in fiscal year 1989, with no inflation change, would add $5.2 billion in FY1989,
$10.5 billion in FY1990, and $14.4 billion in FY1991.
In light of the large errors in economic forecasting in the 1980s, any criticism of either the Administration's or CBO's forecast cannot be made with
certainty. However, the Administration's projection of continuous rapid
economic growth, with no recession, and declining interest rates, seems
suspect. The probability of no recession throughout the projection period
is slim. Even if the projected average economic growth rate is achieved,
but a recession occurs, levels of GNP and the federal deficit would temporarily fall far short of the Administration's projections. Moreover, the
projected 3.2 percent annual real GNP growth from 1989 to 1991 is substantially higher than the average annual rate of long-run economic growth.
Implicit in this projection is nearly 2 percent annual improvement in pro-
29
ductivity. This rate is substantially higher than average productivity gains
since the early 1970s, but in line with the long-run rate of productivity
growth. While this projection cannot be rejected, demographic trends and
expected slower labor force growth, with an already low unemployment
rate, imply that the projected economic growth path hinges critically on
these productivity gains.
The Administration's interest rate projections hinge upon no change in
inflation from 1988 to 1990 and declining real interest rates. Its inflation
projection may be too optimistic. Also, declining real interest rates may be
inconsistent with the projected rapid economic growth, in the absence of
any tax policy change. If, in fact, real rates were to fall as the President's
budget assumes, in the absence of international real rate adjustments, one
could expect a decline in the U.S. dollar. This would raise inflationary
expectations, which would generate a steeper yield curve and probably
drive up nominal interest rates.
These concerns suggest that the Administration's budget projections are
too optimistic. Given all that may go wrong, the CBO's baseline projection
seems to be a better central tendency for what may actually occur.
4.3.
Outlook for the Budget Process
Even if the budget outlook deteriorates from the President's FY1989 Budget projections, and the FY1989 deficit appears to be above $146 billion
(the new GRH $136 billion target plus $10 billion leeway), neither significant budget legislation nor sequestration under GRH should be expected
this year. Neither political party would find it advantageous to pursue
large spending cuts or tax increases this presidential election year, and the
President is not expected to initiate budget legislation beyond the minor
proposals included in the FY1989 budget. If the deficit outlook deteriorates, how can sequestration be avoided? Quite simply, under the revised
GRH, OMB may submit a deficit forecast that meets the GRH target,
based on any economic projection it chooses.
This action would comply with the legal provisions of the new GRH, but
effectively shift the burden of the unresolved budget dilemma onto the next
Administration and Congress. This does not heighten my level of comfort
with either the process or the likely budget outcome. The earlier anticipated
flaws of GRH are surfacing. GRH's deficit targets are arbitrary, without
30
any economic rationale. The budget constraints generate an overemphasis
on the deficit. This diverts attention away from the level of outlays, and
reduces the emphasis on meaningful debate on tax and spending programs,
their economic effects, and the national priorities they imply. Moreover,
GRH's across-the-board sequestration process is porous. As such, it has
deviated from its original intent of reducing the deficit through spreading
evenly the burden among all spending programs. It excludes from consideration several large programs, most notably social security, that must
be addressed if the deficit issue is to be resolved. A positive note, however, is that GRH, despite all its flaws, probably has deterred additonal
federal spending. Outlays as a percent of GNP will fall to an estimated
22.4 percent of GNP in FY1987 from 24 percent in FY1985.
Recent budget events show that GRH is only as binding as the Administration and Congress wish. As the gap between realistic deficit projections
and the new GRH deficit targets widens in 1989, to outcomes seem likely:
the budget constraint will be modified again, and a tax hike will become
the centerpiece of a new budget compromise. Unfortunately, politicians
may find raising taxes the easiest way to reduce deficit projections, and the
next Administration is not likely to have the same resolve against higher
taxes than does the Reagan Administration. Higher taxes would serve to
validate a higher spending share of GNP. And unless additional new taxes
are assessed solely on consumption, they may be inconsistent with long-run
goals of savings, investment and economic growth.
31
TABLE 1
Selected Budget Projections
1987
1988
Fiscal Years
1989
1990
Receipts
President's Budget
CBO Baseline
854.1
854.0
909.2
897.0
964.7
953.0
1044.1
1036.0
1124.4
1112.0
Outlays
President's Budget
CBO Baseline
1004.6
1005.0
1055.9
1055.0
1094.2
1129.0
1148.3
1203.0
1203.7
1269.0
Deficit Projections
President's Budget
CBO Baseline
150.4
150.0
146.7
157.0
129.5
176.0
104.2
167.0
79.3
158.0
Memo: New GRH Targets
Original GRH Targets
144.0
144.0
144.0
108.0
136.0
72.0
100.0
36.0
64.0
0.0
3.4
3.4
3.1
3.4
2.6
3.5
1.9
3.1
1.4
2.8
43.0
43.0
43.0
43.6
42.8
44.5
41.9
44.7
40.5
44.6
President's Budget Receipt Growth
11.1
Nominal
8.7
Real
6.5
2.5
6.1
2.2
8.2
4.4
7.7
4.2
President's Budget Spending Growth
1.4
Nominal
-0.7
Real
5.1
1.2
3.6
-0.2
4.9
1.2
4.8
1.4
Deficit-to-GNP Ratio
President's Budget
CBO Baseline
Public Debt-to-GNP Ratio
President's Budget
CBO Baseline
1991
TABLE 2
Administration and CBO Projections
1987
1988
1989
1990
1991
Real GNP
Administration
CBO
3.8
3.8
2.4
1.8
3.5
2.6
3.5
3.4
Nominal GNP
Administration
CBO
7.2
7.2
6.4
5.7
7.3
6.9
7.1
6.5
CPI-W
Administration
CBO
4.6
4.6
4.3
4.9
3.9
4.8
3.5
3.0
Nominal GNP
Administration
CBO
5.9
5.9
6.5
5.8
7.0
6.8
7.2
6.8
6.7
6.8
Real GNP
Administration
CBO
2.9
2.9
2.9
2.3
3.1
2.6
3.5
2.6
3.4
2.6
GNP Deflator
Administration
CBO
3.0
3.0
3.5
3.4
3.8
4.1
3.6
4.1
3.2
4.1
CPI-W
Administration
CBO
3.6
3.6
4.3
4.5
4.1
4.9
3.6
4.6
3.2
4.4
3-Month T-Bill
Administration
CBO
5.8
5.8
5.3
6.2
5.2
6.7
5.0
6.6
4.5
6.4
10-Year Government Bond
Administration
CBO
8.4
8.4
8.0
9.3
7.4
9.5
6.8
9.0
6.0
8.4
Inflation-Adjusted
(CPI) Rates
3-Month T-Bill
Administration
CBO
2.2
2.2
1.0
1.7
1.1
1.8
1.4
2.0
1.3
2.0
10-Year Government Bond
Administration
CBO
4.8
4.8
3.7
4.8
3.3
4.6
3.2
4.4
2.8
4.0
Percent change, fourth quarter
over fourth quarter;
Percent change, calendar years:
Interest Rates, percent,
Calendar Year Averages:
Memo:
Chapter 5
Monetary Aggregates and Economic
Activity
Robert H. Rasche
Michigan State University
Attached you will find a preliminary copy of a section of a paper that I
am preparing for a Federal Reserve Board conference next May. This particular section addresses the behavior of demand functions for two measures
of the monetary base (Board of Governors and St. Louis Federal Reserve
Bank), in the context of the M l demand equations that I discussed at the
Carnegie-Rochester Conference in November, 1986 and have reported at
the past two Shadow meetings.
The part of this draft that you will probably find most interesting is
the section on forecasting and the graphs at the end. The specification in
terms of the monetary base measures is even more stable than it is for M l .
It is possible to forecast the events of the past two years extremely well,
based on estimates through 1985, and it is possible to forecast all of the
post-1981 experience based on estimates through 1981 and a modification
of the constant term (drift of velocity).
The projections from various M l equations that I have estimated indicate a number of large errors during late 1986 and from time to time in
1987. In late 1986 these errors appear to be systematic (as I reported at
our last meeting) but during 1987 they seem to be quite random.
Based on this information, it is my conclusion that some strange things
are going on with the monetary base multiplier over the past year-and-ahalf, which I haven't fully investigated at this point. Whatever this may
32
be, it has not affected the long standing relationship between the monetary
base and economic activity, consequently I believe that it is appropriate
to judge the impact of monetary policy in the recent past and in the near
future in terms of the effect it has had, or will have on the growth rate of
the base.
5.1.
III. Demand Functions for the Monetary Base
The previous sections indicate that it is possible to obtain extremely parsimonious specifications for demand functions for various measures of "transactions money," in the U.S. economy which are extremely robust over the
entire Post-Accord period, and which are consistent at various levels of time
aggregation.
The demand for the monetary base can be viewed as a derived demand
generated by the demand for "transactions money" and other assets which
are subject to legal reserve requirements. This is conveniently summarized
in terms of a "money multiplier" identity:
Mt=mt*
Bt
(5.1)
^vhere Mt is nominal transactions money, Bt is the monetary base, and mt
is the "money multiplier." In real percentage terms this is rewritten as:
[AlnMt - AlnPt] = Aln{mt) + [AlnBt - AlnPt]
(5.2)
When this equation is substituted into the demand equation for "transactions money" and the "money multiplier" term is subtracted from both
sides of the equation, a derived demand function for the money base results:
[AlnBt - AlnYt] = a - £ ftAflTB, + £ > , A / n ( y / P ) <
+ 0DINFUt + \D82t - Alnmt + et
(5.3)
The evidence compiled in Rasche and Johannes [1987] strongly suggests
that the various component ratios of the "money multiplier" are accurately
described in terms of very simple ARIMA models and that the correlation
of these variables with interest rates and income variables is very close to
33
zero. The weight of various econometric studies of "structural equations"
supports this conclusion. Therefore, it is unlikely that any strong correlation exists between the percentage change of the multiplier and any of
the other variables on the right-hand side of equation (5.3). Under these
conditions, it is unlikely that any substantial bias is introduced into the
estimation of equation (5.3) if the term fit = [-A/nm t + et] is treated as
a composite error term. There is the possibility that the serial correlation
properties of Alnmt could introduce serious serial correlation into the fit
composite error that does not appear to be present in the estimated et's.
Estimates of the low order autocorrelation coefficients for Alnmt are given
in Table III.l for both the Adjusted Monetary Base published by the Federal Reserve Bank of St. Louis and the Monetary Base published by the
Board of Governors during various sample periods. The conclusion from
these statistics is that regardless of concept and regardless of sample period, the log first difference of the seasonally adjusted monetary base on a
monthly basis is approximately a random walk. Therefore, the hypothesis
is that a derived demand function for the monetary base can be estimated
of the form:
[AlnBt - &lnYt} = a - f^fc&RTBt
«=o
+ f>tA/n(y/P),
t=o
+ ODINFUt + \D82t + M<
(5.4)
Since under the maintained hypotheses regarding the money multiplier the
estimates of the parameters in equation (5.4) are estimates of the same
parameters as those in the "transactions money" equations discussed previously, the same parameter restrictions that were found to be valid in the
various "transactions money" demand equations should be applicable to
the estimated parameters of equation (5.4).
The unrestricted estimates of the parameters of equation (5.4) are presented in Tables III.2 and III.3 for the Board of Governors Monetary Base
and the St. Louis Fed Adjusted Monetary Base, respectively, for sample periods corresponding to those estimated for "transactions money" for
monthly data. The only exception is that since the Board of Governors
Monetary Base is not available before January, 1959, the 1950s have been
dropped from the longer samples using this variable.1 A comparable sample
x
The Adjusted Monetary Base was revised in December, 1987 after work on this re-
34
is included in Table III.3 for the Adjusted Monetary Base.
Tables III.2 and III.3 contain several notable results. First, all conclusions are invariant to the choice of measurement of the monetary base.
Second, the estimates are robust to the choice of sample period. The estimates are the same in the pre-1975 sample period as in the post-1975
sample period, and are not altered by the extension of the sample from
the end of 1985 to the middle of 1987. Third, the "shift in the drift" as
measured by the coefficient of DB2 which is characteristic of all of the Ml
nexus is highly significant in these results also. Fourth, in contrast with the
estimates of Ml equations reported in Rasche [1987a], there is no eivdence
of heteroscadasticity in the residuals of the monetary base demand equations as the sample period is extended into the late 1970s and 1980s. Fifth,
estimated residuals exhibit only very low first order serial correlation to the
extent that they give any indication of serial correlation. This is consistent
with the estimates of this specification for the Ml equations and suggests
that impounding the "money multiplier" term in the composite error of the
monetary base specification causes little if any specification error problem.
Sixth, the parameter restrictions that were not rejected for the Ml demand
equations appear equally valid for these base demand equations, as measured by the F-tests reported at the bottom of Tables 111.2 and III.3. In
several of the samples for the Monetary Base, the F-tests are on the margin of rejection at the 5 percent level, but in all cases with the Adjusted
Monetary Base, the restrictions are not rejected at very high a values.
Only semilog specifications in the Treasury Bill rate are reported in
Tables III.2 and III.3. In a few cases estimates were constructed for double log specifications. The results of these estimations provided little basis
for choosing among the two functional forms. Other tests were performed
to consider whether the interest semi-elasticity of the base changed in the
post-1981 period. In every case the data rejected a shift in this coefficient. Therefore, as far as the monetary base is concerned, it appears
that the increase in the demand elasticity in the post-1981 period that was
found in the "transactions money" demand equations by Rasche[l987b] is
adequately captured by a constant interest semi-elasticity and the higher
average Treasury Bill rates in the post-1981 sample period. The estimated
impact of real income elasticities in these specifications is virtually identical
search was started (see Gilbert [1987]). Consequently, the data used in the regressions
reported here are the pre-revision estimates.
35
to those estimated in the "transactions money" equations.2
Finally, the estimated standard errors of the residuals of the base demand equations are considerably lower than the corresponding estimated
standard errors for the "transactions money" equations. This is in part because of the lower variability of the monetary base measures, as can be seen
from Table III.3 where the adjusted R*'s are of the same size as those in
the "transactions money" equations, while the estimated standard errors of
the residuals are considerably lower. In the case of the Monetary Base, the
estimated standard errors are lower than in the transactions money equations both because the sample variance of the money is lower, and because
the specification captures a larger percentange of that variation.
It is interesting to speculate why the estimated variance of the composite error term, /z, is lower than the estimated variance of the "transaction
money" demand error term, e. One rationalization of this result is that
the dominant source of shocks to the demand for "transactions money" are
shocks to the transaction deposit component of that aggregate. Let op
measure the standard deviation of such shocks and assume that this is the
only source of shock to the demand for transactions money. Since transactions deposits average around 70 percent of M l , under these assumptions
•7am = cz>. Shocks to transactions deposits in the absence of shocks to
the currency component of M l imply shocks to the currency-deposit ratio, fc, which is historically the most important source of variation in the
money multiplier. The elasticity of the money multiplier with respect to
the currency-deposit ratio is k * (1 + A;)""1 * (1 — m) which under the assumption of k approximately equal to .4 and m approximately equal to 2.6
is approximately .45. Thus the standard deviation of the money multiplier
with respect to shocks to transaction deposits am = .45(7p = .64em. The
variance of the composite error term a* = a^ + a] - 2pomo€. Under these
assumptions, this equation can be solved for an implied estimate of the correlation between shocks to transactions deposits and shocks to the money
multiplier which is consistent with the observation of lower standard errors
of the residuals of the monetary base specifications. These computations
suggest correlations on the order of .5 - .6.
3
This result is not consistent with the alternative hypothesis that the interest elasticity
of the 'money multiplier9 is positive. Under this alternative hypothesis, the estimated
interest semi-elasticities in the monetary base equations should be larger in absolute value
that those estimated from the 'transactions money* equations.
36
The restricted estimates of the derived demand for the monetary base
and the adjusted monetary base are given in Tables HL4 and III.5, respectively. The only substantial differences between the estimated parameters
here and those of the "transactions money" specifications discussed above
are the lower interest rate semi-elasticities and that the estimate of the pre1981 drift of the monetary base velocity is approximately one-half percent
(at annual rates) lower than that estimated for transactions money.
5.2.
Forecasting
There are two interesting forecasting experiments to perform given the results in Table III.4 and III.5. First, how well do the pre-1982 parameter
estimates forecast the 1980s, if allowance is made for the "shift in the drift"
that is estimated to occur around the beginning of 1982? This is important, since in recent discussions of monetary policy it is commonly asserted
that previously established relationships between monetary aggregates and
economic activity measures are completely broken down. Second, how well
do estimates from samples ending in 1985 predict the demand for the monetary base in 1986 and 1987? This is important since it is claimed that if
there was any life left in the assertion that monetary aggregates are appropriate guides for money policy after the experience of the early 1980s, the
experience of 1986-7 provides the final nail in the coffin [Friedman, 1988],
The errors in this experiment are also important for interpreting the implications for the course of the economy in 1988 of the monetary acceleration
in 1985-6 followed by the deceleration in 1987.
Two relevant experiments are available for each of the monetary base
measures. First, the parameter estimates for the sample periods ending
with 1981 can be used to project the percentage changes of base velocity
for the 70 months from January, 1982 through October, 1987. Second, the
estimates for the sample periods ending with 1985 can be used to project
the percentage changes of base velocity for the 22 months from January,
1986 through October, 1987. Since there are no lagged dependent variables in the estimated specification, nor is there any autoregression in the
error structure, on the surface there is no distinction between "static* and
"dynamic" forecasts here. However, there is a secondary problem in these
experiments in constructing values for the unexpected inflation variable,
DINFUt.
37
DINFUt is measured during the sample periods as the residual (innovation) of a MA(l) model, estimated over a sample period beginning in
January, 1953 and ending with the end of the sample period of the base
demand equation. Post-sample values for DINFUt are constructed as the
difference between the observed change in inflation rate and the static forecasts from the sample period MA(l) model for each month in the forecast
period. Thus, it is important to view the predictions of base demand as
static forecasts.
The post-sample projections of percentage change in the monetary base
and the observed percentage changes in the monetary base are plotted in
Figures III. 1-2 for the Monetary Base, and Figures III.3-4 for the Adjusted
Montary Base. These figures suggest that the estimated equations track
the post-sample behavior of base velocity remarkably well and completely
contradict the presumptions that there is no longer a stable relationship
between a narrowly defined monetary aggregate and economic activity and
that the relationship between the monetary base and economic activity
bears no relation to the pre-1980 experience. Graphs of observed and projected values can present a distorted picture, therefore, the projection errors
for these experiments are given in Figures IIL5 through III.8. The only evidence of anything unusual occurring in these errors, relative to the sample
period experience, is during one or two months around the end of 1986 and
the beginning of 1987 (the timing varies slightly with the different monetary
base concepts). This may be nothing more than an artifact of unrevised
data.
The statistical characteristics of these projection experiments are summarized in Table III.6. In every case the root-mean-squared-errors are
comparable to the standard error of the residuals during the sample period. In three of the four cases (the exception is the 1986-87 projection of
the Monetary Base) the proportion of the RMSE attributation to bias(J7m)
is very close to zero. In all cases the proportion of the RMSE attributable
to unequal variance is less than .25. In summary, the available evidence
strongly supports a stable demand function for the monetary base during
the 1980s comparable to the relationship that existed in the 1950s through
the 1970s.
38
5.3.
Time Aggregation and Alternative Measures of
Economic Activity
The comparable specification on a quarterly average basis to the monthly
specification discussed here is derived in the Appendix. Estimates on a
quarterly average basis for both monetary base concepts using personal
income and GNP are given in Tables IIL7 and m.8. In these equations
quarterly personal income is the geometric average of the corresponding
monthly data, quarterly average Treasury Bill rates are the arithmetic average of the corresponding monthly data, and GNP is the published quarterly data. These estimates are constructed from specifications that omit
the variables that represent the intra-quarter effects discussed in the Appendix. The unexpected inflation variable is the difference between actual
inflation for the quarter and the prediction from a MA(l) model estimated
on quarterly data.
The parameter estimates in these tables are consistent with the comparable estimates from the monthly data in Tables III.4 and III.5. In addition,
the ratio of the standard errors of the residuals in the monthly equations (at
annual rates) to the standard errors of the residuals in the corresponding
quarterly equations (at annual rates) is approximately equal to the squareroot of 3. The one unexpected characteristic of the quarterly specifications
is the low Durbin-Watson Statistics. The autocorrelation functions of the
residuals from all the estimated equations in Tables III.7 and II1.8 suggest
significant AR(l) processes. The source of this serial correlation is not clear,
particularly given the absence of serial correlation in the monthly specifications. The equations estimated with personal income were expanded to
include the intra-quarter variation terms that appear in the Appendix, but
the serial correlation remained with these terms added to the equations.8
The one change in the specification that appears to have a substantial effect
on the serial correlation of the residuals is the computation of the unexpected inflation term. When the average of the three one-month forecast
errors from a monthly MA(l) model of the change in monthly inflation
rates is used rather than the forecast error from a quarterly MA(l) model
of the change in the quarterly inflation rate, the serial correlation of the
3
The serial correlation of the residuals is not a result of the restrictions imposed on
the parameters in these equations. The Durbin-Watson values are virtually the same for
estimations with all of the parameters free.
39
residuals in the equations with personal income is greatly reduced, with
little effect on any of the estimated parameter values.
5.4.
Appendix: Aggregation Over Time
In Rasche [1987a] the issue of time aggregation of Ml demand equations
was investigated, but a number of casual approximations were assumed.
The purpose of this Appendix is to examine the exact quarterly average
and annual average demand equations that are implied by an assumed
monthly demand specification. The basic monthly demand specification
with all the rstrictions applied to the various parameters is:
[A/nM H - AlnY^] = a + 0 E ARTBt^j
- (n * 7)Aln{Y/P)t^
+ 7 E A/n(y/P),. l W - (n * ^DINFUt-j - aD82t^ + e w
for j = 0,1,
When this equation is averaged over j = 0,...,2 the
resulting expression is:
2
2
2
E AlnMt-j/3 - E Aln{Y/P)t^/3
= a + (2 * 0) E
ARTBt^/3
+ (3 * 0) E ABTBt-tlZ + (3 * /?) E ^RTBt-j/Z + 0 E
- (2 * 0){ARTBt - ARTBt-2)/3 + 0{ARTBt-9 - (7 * If) E *ln{YlP)t-ilZ
ARTBt-U)/3
+ (3 * 7) E A/n(y/P)^ y /3
+ (3 * 7) E A/n(y/P),. i /3 + 7 E A/n(y/P),_,./3
j=6
i=9
- Tf(A/n(y/P)t - Aln{Y/P)t-%)/3
+ 7(A/n(r/P),. 9 Aln[Y/P)t-n)/3
- (8 * <y) E DINFUt-,1* - a E # 8 2 w / 3 + £ Ci-y/S
y=o
/=o
40
jf=o
ARTB^/3
This expression gives the quarterly (geometric) average velocity as a function of distributed lags on quarterly (arithmetic) average interest rates
and quarterly (geometric) average real income, two intra-quarter variation
terms in both interest rates and real income, and the quarterly average of
unanticipated inflation. The latter term is not the average unanticipated
inflation for the quarter based on expectations during the previous quarter,
but rather the average of the three individual one-month expectation errors
during the quarter. Thus, it is not possible to approximate the average of
the monthly specification exactly in terms of quarterly average data.
The aggregation suggests that even if a quarterly average specification
is approximated by ignoring the intra-quarter variation in interest rates
and real income and by using the quarterly inflation forecast error based
on information through the previous quarter, then the uniform distributed
lag coefficients of the monthly specification do not translate directly into
uniform distributed lags in the quarterly average data.
41
Perc ent Change Monetary
Be
velocit''
7
Post Sample Projections 82,1 8 , 1 0
.015-1
.01 H
.005-^
\ikhtkfj\ f\
-.005 H
-.01 H
-.015 -h
0
T~
—1
10
20
30
40
50
Time
Time
— Actual Changes
•
Projected Changes
-r~
60
70
Percent Change Monetary Base Velocity
Poet Sample Projections 86,1 6 7 , 1 0
.015-1
q
X
c
0
D
o
i.
V
Q.
r
c
0
2
-.01 H
Time
— Actual Chonges
*
Projected Changes
Percent Change Adjusted Base Velocity
Post Sample Projection© 82,1 8 7 , 1 0
.015n
C
q
.01 H
x
.005 H
c
0
r
o
c
0
V
-.005 H
c
0
1
-.01 H
-.015
10
20)
1
1
30
40
5u
Time
— Actual Chaivjj'S
•
Proj*c*ea 0r,ong«s
i
i
60
70
Percent Change Adjusted Base veiocit'Po-st Sample Projections 86,1 8"M<*'
.015
1
•o.J
f<
04-
J
id^
00^ -J
..
*
V-
rrA
•of
V
I
-.01
^
V/X
.005 H
-I
\
.015 - j 45
c
I
.o
60
55
T?me
— A.:*UOI Changes
•
Projected >»anges
65
70
Monetary Base Velocity Errors
Post Sample Projections 82*1 8 7 , 1 0
f
q
X
c
0
r
o
c
t>
o
D
Q.
X
c
0
2
Time
Monetary Base Velocity Errors
Post Sample Projection 8$,1 8 7 , 1 0
q
X
t>
c
0
SL
o
+•-
c
o
t>
Q.
2
•»-
c
o
5
Adjusted Monetary Base Errors
Po*t Sample Projections -32,1 6 7 , 1 0
.015 n
•OH
D
c
0
.005 H
c
i)
o
c
0
-.005 H
2
-.01
Adjusted Monetary Base Error;
Post Somple Projections S6.1 8 7 , 1 0
.015-,
q
X
-01 H
c
c
.005 H
c
0
u
i
i/ \ /
c
o
2
-.005
1
45
50
1—
55
60
Time
/y
v
v
1/
65-
70
Table III.l
Autocorrelations of Honey Hultipliert
A. Monetary Base
Sample
59,2
i
.04
.05
.04
2
3
4
5
6
7
8
9
10
11
12
- 85,,12
59,2
•• 74,,12
.27
.06
.02
.08
.07
.12
.11
.11
.04
-.11
.02
.03
-.10
-.03
-.01
-.08
-.02
-.02
.00
.04
-.01
.04
.13
.20
-.04
-.01
.09
-.01
.09
.03
.06
-.17
-.06
75,1
B. Adjusted Monetary Base
Saaple
1
2
3
4
5
6
7
8
9
10
11
12
59,2
-.01
-.02
.02
- 85, 12
59,2
-.08
-.10
.03
- 74,12
75,1
.06
.05
.00
-.12
-.01
-.01
.03
-.26
-.06
.02
-.02
-.09
-.07
-.08
.07
.05
.02
.01
.09
.05
.14
.06
.04
.02
.06
.10
-.06
-.07
.00
.13
Table III.2
Monetary Base -- Honthly
(Y » Personal Incoae)
Unrestricted Estiaates
59,2 •• 65,12
59,2 -• 74,12
Constant
-.0015 (.0003)
-.0013 (.0004)
RTB
.0003
-.0010
-.0005
-.0005
-.0004
-.0006
-.0007
-.0004
-.0003
(.0003)
1.0003)
(.0003)
(.0003)
(.0003)
(.0003)
(.0003)
(.0003)
(.0003)
-.0003
-.0002
-.0002
-.0008
-.0003
-.0005
-.0015
-.0010
-.0001
Y/P-,
Y/P.a
Y/P.s
Y/P. 4
Y/P-B
Y/P-*
Y/P.,
Y/P..
-.8731
.1170
.0791
.0985
.0683
.0827
.0635
.0346
.1056
(.0305)
(.0300)
(.0294)
(.0296)
(.0293)
(.0295)
(.0293)
(.0289)
(.0296)
-.8973
.1583
.0590
.0915
.0601
.0715
.0487
.0484
.1124
DINFU
-.8067 (.0636)
Saaplff
RTB-,
RTB.a
RTB-s
RTB-4
RTB.8
RTB-*
RTB-,
RTB..
Y/P
D82
.0022 (.0004)
75,1
-85,12
59,2 - 87,7
-.0015 (.0005)
-.0015 (.0003)
(.0006)
(.0006)
(.0006)
(.0006)
(.0006)
(.0006)
(.0006)
(.0006)
(.0006)
.0007
-.0013
-.0003
-.0004
-.0002
-.0004
-.0004
-.0000
-.0002
(.0004)
(.0004)
(.0004)
(.0004)
(.0004)
(.0004)
(.0004)
(.0004)
(.0004)
.0003
-.0010
-.0005
-.0005
-.0004
-.0006
-.0007
-.0004
-.0003
(.0003)
(.0003)
(.0003)
(.0003)
(.0003)
(.0003)
(.0003)
(.0003)
(.0003)
(.0386)
(.0370)
(.0368)
(.0366)
(.0364)
(.0371)
(.0364)
(.0356)
(.0361)
-.8602
.0015
.0839
.0986
.0721
.0879
.0339
-.0246
.1019
(.0562)
(.0574)
(.0550)
(.0556)
(.0548)
(.0560)
(.0567)
(.0548)
(.0570)
-.8772
.1163
.0B17
.1002
.0629
.0877
.0616
.0357
.1162
(.0306)
(.0296)
(.0292)
(.0292)
(.0291)
(.0293)
(.0292)
(.0289)
(.0293)
-.8384 (.0799)
—
-.6835 (.1196)
-.7791 (.0625)
.0030 (.0005)
.0028 (.0004)
Ra
se
d-w
.76
.74
.75
.0024
1.73
.0024
1.70
.0024
1.80
.0024
1.68
F
1.62(18,293)
1.13(17',171)
1.56(IE1,102)
1.91(161,312)
.76
Table III.3
Adjusted Monetary Base -- Monthly
(Y * Personal Incoae)
Unrestricted Estimates
Staple
53,1 - 85,12
53,2 - 74,12
75,1 - 85,12
59,1 - 85,12
53,1 -87,7
Constant -.001K,,0003) -.0010(,.0004) -.0015(.0006> -.0012(.0004) -.001K.0003)
RTB
RTB-»
RTB-a
RTB-a
RTB-*
RTB.a
RTB-*
RTB-,
RTB..
Y/P
.ooou,.0004)
-.0013(..0004)
-.0006(,,0004)
-,0007(..0004)
-.0006*..0004)
-.OOIOC.,0004)
-.0005(.,0004)
-.0007(.,0004)
-,0004(,,0004)
-.0013< .0008)
-.0004 (..0007)
-.0012 I.
,0008)
-.0012 <..0007)
-.00051,.0008)
-.0003(,.0008)
-.00181.,0009)
-.0007(..0008)
-.0005(,.0008)
.0012(.0006)
-.0019(.0006)
.0001(.0005)
-.0007(.0005)
-.0002L0005)
-.001K.0005)
.0001(.0005)
-.0006L0005)
-.0005(.0005)
.000K.0004)
-.001K.0004)
-.0006(.0004)
-,0007(.0004)
-.00061.0004)
-.001K.0004)
-.0005(.OO04)
-.0008(.0004)
-.00051.0004)
-.0001(.0004)
-..0012(.0004)
-.0006(.0004)
-.0008(.0004)
-.0007(.0004)
-.0010(.0004)
-.0006(.0004)
-.0007(.0004)
-.0004(.0004)
Y/P-i
Y/P-3
Y/P. 3
Y/P-4
Y/P.s
Y/P-4
Y/P-7
Y/P-.
-.8983(,,0382) -.9093(,,0454) -.9153(.0768) -.B725(.0279) -.9035(.0377)
.0970(,.0377) .1049( .0443) .091K.0783) .U70(.0371>
.0989(.0368)
,0375) .0393(,.0444) .0922(.O750) .06421.0366) .0716(.0366)
". 06B8 <.
. 1108 <.,0375) ,1349(,,0759) .0517(,0759) .067K.0367) .1083(.0365)
,0487(,,0373) .045B(,.0442) ,1012(.0747) .0754(.0365) .04B0(.0365)
,0547(,.0363) .0603(,.0427) .0096(.0764) .077H.0365) .0608(.0356)
,0797(,,0363) .0684(,.0424) .1044(.0760) .1084 <.0362) .0743(.0356)
.0263* .0360) .0506(,.0419) -.049K.0747) .0324(.0360) .0248(.0354)
,0673(,.0364) .045K,.0420) . 1732(.0776) .0949(.0369) .0786(.0356)
DINFU
-.B447(,.0779) -.B388( .0922) -.8190(,1631) -.8216(.0720) -.B1B3(.0757)
D82
Ra
. o o i e.0005)
(
--
.0025(.0007)
,0016(.0005)
.0021(.0005)
.62
.63
.61
.67
.63
d-«
.0033
2.15
.0033
1.96
.0033
2.40
.0030
2.27
.0033
2.14
F
1.29(18 ,366)
1.28(18,102)
1.04.(18,294)
1.29(18,385)
it
.98(17 ,244)
Table III.4
Monetary Base — Monthly
(Y • Personal Incoae)
Restricted Estimates
Saaple
59,2 - 87,7
59,2 - 85,12
59,2 - 74,12
Constant
-.0021 (.0003)
-.0021 (.0002)
-.0024 (.0003)
-.0021 (.0002)
RTB
-.0006 (.0001)
-.0007 (.0002)
-.0005 (.0001)
-.0006 (.0001)
Y/P
-.8310 (.0288)
-.8518 (.0354)
-.7878 (.0507)
-.8337 (.0291)
DB2
Ra
se
d-w
75,1
-85,12
.0021
.0021
.0024
.0021
.75
.0024
1.73
.76
.0024
1.67
.71
.0025
1.74
.74
.0025
1.66
Table III.5
Adjusted Monetary Base — Monthly
(Y • Personal incoee)
Restricted Estimates
Saeple
53,1 - 85,12 53,2 - 74,12 75,1 - 85,12 59*1 - 85,12 53,1 -87,7
Constant -.0021 (.0002) -.0021 (.0002) -,0022(.0004) -,0019(.0002) -.0021 (.0002)
RTB
-,0008(.0001) -,0012(.0002) -,0006(.000l) -,0007(.0001) -.0009(.0001)
Y/P
-.8524C.0358) -,8713(.0423) -.B115(.067B) -,8336(.0349) -,8529(.0389)
D82
Ra
se
d-M
.0021
.0022
.0019
.0021
.62
.63
.60
.67
.62
.0033
2.09
.0033
1.92
.0034
2.33
.0030
2.22
.0034
2.09
Table III.6
Projection Error Statistics
(Y« Personal Incote)
Root-Mean-Squared
Error
U*
Us
Uc
Monetary Base (86,1-87,10)
.0030
.43
.16
.41
Honetary Base (82,1-87,10)
.0027
.04
.10
.86
Adjusted Monetary Base (86,1-67,10)
.0034
.03
.25
.72
Adjusted Monetary Base (82,1 87,10)
.0031
.00
.16
.84
Table III.7
Honetary Base - Quarterly Data
Restricted Estiaates
Personal Incoie
GNP
59,2-81,4
59,2-85,4
59,2-61,4
59,2-85,4
Constant
-.0064(.0004)
-.00631.0004)
-.005B(.0006)
-.0056(.0006)
RTB
RTB-,
RTB.a
RTB-s
-.0012(.0002)
-.O018(.0004)
-.0018(.0004)
-.0006(.0001>
-.0013(.0002)
-.00191.0003)
-,0019(.OO03)
-,0007(.000i)
-.001H.0003)
-,0017(.O0O5)
-,0017(.0005)
-.00051.0001)
-.0015(.0002)
-.00231.0004)
-.0023(.0004>
-.0008(.0001)
lnY/P
lnY/P-»
lnY/P-a
lnY/P.3
-.61341.05B2)
.2629(.0249)
.2629(.0249)
.0876(.0081)
-.59B8(.0510)
.2566(.0216)
.2566(.0218>
.0855(.0073)
-.677K.0526)
.2902(.0225)
.2902(.0225)
.0967(.0075)
-.6757(.0471)
.2896(.0202)
.2896(.0202)
.0965(.0067)
DINFU
-.6134(.05B2)
--
-,5988(.0510)
-.0063(.0004)
-.677K.0526)
--
-,4757(.0471)
-.0056<.0006>
Saaplt
082
Ra
se
d-w
.71
.60
.0040
. 0039
1.04
.97
.66
.72
.0053
.0051
.79
.82
Table 111.8
Adjusted Honetary Base - Quarterly Data
Restricted Estiaates
Personal Incoee
6NP
53,1-81,4
53,1-85,4
53,1-81,4
53,1-85,4
Constant
-.0062(.0005)
-.0052(.0005)
-.0057(.0006)
-.0057(.0006)
RTB
RTB-,
RTB-a
RTB.a
-.0021(.0003)
-.0031(.0004)
-.003K.0004)
-.OOIO(.OOOI)
-.0019(.0002)
-.0029(.0003)
-.00291.0003)
-.OOIO(.OOOI)
-.0021(.0004)
•.0032(.0005)
-.0032U0005)
-.001K.0002)
-,0022(.0004)
-.0033(.0004)
-.0033(.0004)
-.001H.0002)
lnY/P
lnY/P-,
lnY/P-a
lnY/P-,
-.6324(.0600)
.2710(.0257)
.2710(.0257)
.0903(.0086)
-.6137(.0541)
.2630(.0232)
.2630(.0232)
.0877(.0077)
-.6743(.0512)
.2890(.O22O)
.2B90(.0220)
.0963(.0073)
-.6696(.0472)
.2870(.0202)
.2870(.0202)
.0957(.0067)
DINFU
-.6324(.0600)
--
-.61371.0541)
-.0052(.0005)
-.6743(.0512)
••
-.66961.0472)
-.0057(.0006)
Sample
D82
Ra
ie
d-w
.57
.0050
1.13
.66
.0049
1.17
.62
.0063
.BB
.66
.0060
.93
Chapter 6
U.S. International Capital Flows in the
1980s
William Poole1
Brown University
The United States current account deficit — and especially the trade
deficit — has received considerable attention in recent years. However,
much of the political debate seems oblivious to the fact that the current
and capital accounts in the balance of payments are necessarily mirror
images of each other. Moveover, when the capital account does enter the
debate there is an unfortunate tendency for people to argue that the trade
deficit has caused the capital inflow.
It is even more misleading to speak of the capital account as "financing"
the current account deficit. In recent years most of the capital inflow has
been private. The motivation of individual investors is certainly not to
finance the current account deficit; they are simply financing their own
individual investments. In short, the issue of causation is complex and
should be discussed with care.
Another defect of much of the discussion of the U.S. balance of payments
is the implicit or explicit argument that what has happened is due entirely
to changes of economic conditions within the United States. Trade and
capital flows are simultaneously determined and they depend on relative
prices and relative returns across the various countries of the world.
Acknowledgement: Chart data from Data Resources, Inc.
42
6.1.
Overview of the Capital Account
Figure 1 provides an overall view of the U.S. capital account using data
from the first quarter of 1975 through the third quarter of last year (latest
data available). The large increase in the net capital inflow after 1983
shows up clearly, as does the rise in the official capital inflow in 1986-87.
In this figure, and all of my discussion below, the capital accoimt surplus is
defined as being equal to the reported current account deficit; I will not get
into the interesting, but frustrating, subject of errors and omissions. Thus,
all errors and omissions are assumed to be unidentified capital flows rather
than unidentified net exports.
In 1986 the net official capital inflow was 23.5 percent of the total capital
inflow, and 21.9 percent over the first three quarters of 1987. The official
inflow was motivated, of course, by the desire of foreign governments to
limit the speed and extent of the depreciation of the dollar after the Plaza
agreement of September 1985.
Although the net official capital inflow was large in 1986-87, the size
of the inflow was not very different than in 1977-78. The 1986 inflow was
$33.3 billion and the inflow over the first three quarters of 1987 was $46.6
billion at an annual rate. These figures may be compared with inflows of
$35.0 billion and $31.9 billion in 1977 and 1978, respectively. However, in
1977-78 private capital was flowing out of the United States; the official
inflow was larger than the total capital inflow, as can be seen in figure 1.
In contrast, in 1986-87 private inflows were more than three times as large
as offical inflows.
Figure 2 provides more detail on official capital. The net official capital
inflow is the same as shown in figure 1. The net flow is divided into its U.S.
and foreign components. The U.S. component is relatively small. Despite
the talk of a changed U.S. policy on intervention in the foreign exchange
market it is clear that the U.S. authorities did not commit very much
in the way of foreign exchange reserves to market in 1987. Interestingly,
figure 2 also shows some examples where the U.S. and foreign authorities
were working at cross purposes. In 1981, for example, U.S. official capital
was moving out of the country while foreign official capital was moving in.
Figure 3 tells an interesting story about direct investment flows. On a
net basis, from 1975 to 1980 direct flows were consistently out of the United
States, from 1981 through 1984 consistently into the United States, and
43
from 1985 to 1987 quite volatile quarter-by-quarter. Note that fluctuations
in the net flow have been driven to a considerable extent by fluctuations in
the U.S. direct capital outflow. From mid-1981 to early 1985, U.S. direct
capital outflow abroad was relatively small and in 1982 even involved a
capital inflow — the stock of U.S. direct capital abroad fell in that year.
The 1981-85 period spans the enactment of the Economic Tax Recovery
Act and the beginning of official proposals that culminated in the Tax
Reform Act of 1986. This period also corresponds almost exactly to the
period when the dollar was appreciating.
6,2.
Relative Economic Conditions in the United States
and Abroad
Why has such an enormous amount of private capital come to the United
States in the 1980s? The fundamental motivation of private investors is
that they seek the highest returns after allowing for risk. Returns on physical and financial capital are closely related by virtue of the willingness of
investors to channel new investment in one direction or the other. I want
to concentrate on returns on physical capital because the financial market
effects of the government budget deficit have been so widely discussed.
It is difficult to measure the relevant returns on new investment in physical capital because of inherent measurement problems for realized returns
and because the prospective returns in the heads of individual investors
and entrepreneurs are inherently unobservable. But we can measure some
things that are closely related to the unobservable returns.
Economies with high returns on capital typically grow rapidly. Thus,
economic growth is itself a proxy for the rate of return on capital. Figure 4
provides some evidence on long-term trends. The figure uses OECD data
through 1986, the latest year available in the OECD database. The growth
rate for Japan is much lower after 1973 than before. The growth rate for
OECD Europe has also declined, and has been very low since 1980. The
U.S. growth rate has been a little lower in the 1980s than earlier, but not
by much.
The behavior of investment itself also provides evidence on investment
returns. Figure 5 shows gross domestic investment as a percent of GDP
for Japan, Europe and the United States for 1960-86 (OECD data). The
44
figure also shows saving, which I will discuss in a moment, as a percent of
GDP for the same regions. The gross investment share of GDP has declined
markedly for Japan and Europe, but has held up well in the United States.
I conclude that evidence on economic growth rates and investment shares
of GDP supports the view that the United States was a relatively attractive
place to invest in the 1980s. This view is reinforced by what has happened
to economic growth and investment opportunities in many of the LDCs.
By the national accounts identity, the U.S. capital import is equal to
the difference between U.S. domestic investment and U.S. saving. That
difference shows up clearly in figure 5. At the same time, however, the
capital exports from Japan and Europe are equal to the differences between
their respective saving and investment shares. Investment shares in Japan
and Europe have been declining since 1970; after 1982 modest increases
in their saving shares went into foreign investment, mostly to the United
States. Taking as given U.S. investment incentives and inflation experience
in the 1980s, it seems likely that most of the capital exports from Japan
and Europe would have come to the United States even if the U.S. federal
budget deficit had been much lower than it was. That means, of course,
that the U.S. current account deficit would not have been much different
and the difference between U.S. domestic investment and private saving
would have been smaller by the amount that federal government saving
was larger (the budget deficit smaller).
To argue otherwise, we would have to assume that the capital flow out of
Japan and Europe would have gone to the LDCs or that domestic investment shares would have been considerably higher in Japan and Europe.
The LDC argument can be dismissed out of hand; the investment share
argument needs further discussion.
For Japan, economic growth and the investment share were extraordinarily high in the 1960s. Both have declined as the Japanese economy
has matured. Japan's growth is now in a familiar range but its saving
ratio is still very high when compared to other countries. Japanese saving is difficult to understand, but we should be cautious in asserting that
the Japanese save "too much." Two rate-of-return conditions are relevant.
First, Japanese saving invested in the United States is in the interest of the
United States if the return we pay to the Japanese is less than the return
we earn on the invested capital, and there is no evidence that this condition
is not met. Second, Japanese investment in the U.S. is in the interest of
45
Japan if the rate of return Japan receives in the United States is greater
than the rate of return available in Japan. Given the declines in Japan's
growth rate and investment share, and evidence that the rate of return in
the Japanese equity and fixed income markets is extremely low, it is highly
likely that both these rate-of-return conditions were met from 1981 to 1985,
and perhaps later.
For Europe, it seems clear that the declining investment share is a
supply-side problem; incentives to produce are too low because of high
marginal tax rates and labor market rigidities. Europe also provides substantial subsidies to weak and inefficient enterprises. U.S. policies have, if
anything, raised European growth in the 1980s by providing a large market
for European exports. Thus, the two rate-of-return conditions discussed
for Japan also apply to Europe.
Much has been made of the low saving rate in the United States, and
justifiably so. Many have argued that a lower federal budget deficit would
reduce the size of U.S. capital imports. However, that conclusion depends
on how the budget deficit is reduced. Even if the budget deficit were reduced
in a way that left private saving unaffected, there is still the matter of how
U.S. domestic investment would react. I will discuss this issue shortly.
6.3.
More on U.S. Domestic Investment
Figure 1 provides a long-term perspective on U.S. domestic investment in
nominal dollars as a share of nominal GDP. Now I want to examine U.S.
domestic investment in somewhat more detail.
Figure 6 shows U.S. quarterly domestic investment in 1982 dollars from
1980 through 1987. Non-residential fixed investment rose substantially in
1983-84, but reached a peak in 1985 and then fell somewhat. The tax
reform discussion, which began in earnest with the Treasury I tax proposal
in November 1984, killed the investment boom. Further evidence for this
view is that U.S. direct investment abroad rose substantially at the same
time (see figure 3).
Figure 7 provides information to discuss the important distinction between gross and net investment, but before getting into that topic, I want
to look at investment during the 1981-82 recession. Figure 7 shows that
gross investment as a share of GNP did not decline much until 1983 when
GNP rose sharply. During the 1981-82 recession gross investment fell, but
46
only by about the same percentage as did GNP. In contrast, from figure 7,
we can see that the gross investment share fell substantially during the
other two deep recessions after World War II — 1957-58 and 1973-75.
The behavior of investment during the 1981-82 recession provides further
evidence that the investment incentives resulting from ERTA in 1981 and
lower inflation were very substantial.
Those who argue that investment has been low in the 1980s focus on net
investment, while those who argue that investment has been high focus on
gross investment. Figure 7 shows that there has been an unusual divergence
between gross and net investment in the 1980s. The reason, of course,
is that the mix of investment has changed toward equipment and away
from structures. However, the accuracy of the estimate for the capital
consumption allowance in the national accounts is an important issue here.
My guess, and it is nothing more than that, is that the CCA is too high in
the 1980s. An investigation of this issue is on my future work agenda.
6,4.
Policy Issues
It is widely recognized that restriction of trade imports is likely to lead to
retaliation abroad that will also reduce U.S. exports. The consequence of
reductions of both imports and exports would be to leave the trade balance
much less affected than protectionist arguments lead many to expect. But
the effect of U.S. protectionism will depend as much on what happens to
capital flows as on what happends to the trade accounts. If capital continues
to pour into the United States the current account must continue to be in
deficit.
U.S. protection may have actually increased capital imports in some
areas. It seems likely that Japanese auto firms have established production
facilities in the United States in part because of the restrictions on U.S.
imports of Japanese cars. In general, though, trade protection will simply
change the composition of the current account while leaving the size of the
current account deficit unaffected.
Direct controls on capital imports are less likely than trade restrictions,
but if capital restrictions were put in place the outcome is very uncertain.
Countries ordinarily impose capital controls to keep capital from flowing
out; it is rare that they restrict capital flowing in. Given the earnings in U.S.
financial centers from services provided to the international capital market
47
it is unlikely that the United States would impose direct controls or taxes
on financial capital imports. There is some chance that certain restrictions
on direct ownership and control might be imposed but such restrictions are
unlikely to be sufficiently burdensome to have any noticeable effect on the
U.S. capital account.
What this means is that capital will continue to flow to the United
States as long as the prospective rate of return on U.S. investments is
attractive relative to the rate of return abroad. Although it seems unlikely
that Europe and Japan will begin to grow so rapidly within the next year
or two that they will cease exporting capital, it is clear that the relative
attractiveness of U.S. investment has been declining for several years now.
Depreciation of the dollar reflects the reduced attraction of the United
States for the world's capital. Much of last year's capital inflow must
have been speculative — investors moved funds here on the expectation
that dollar depreciation would give way to dollar stability or even some
appreciation. This capital flow will decline as the U.S. current account
responds to the lower dollar.
Assuming that the U.S. economy is close enough to full employment,
that higher net exports cannot come from substantial increases in total
real GNP, the key issue now is whether rising net exports will come at the
expense of domestic investment or at the expense of domestic consumption
(including government). If fiscal policy does not reduce government consumption, then rising net exports will reduce either private consumption
or domestic investment.
Without a change in fiscal policy, the rise in net exports is more likely
to depress domestic investment than private consumption. If the economy
remains at full employment, the interest rate is the only variable free to
move to change the composition of aggregate demand. Higher interest rates
will tend to reduce residential and non-residential investment and consumer
durables.
If the economy starts to press beyond full employment, then pressures
on existing capacity will keep investment strong for a time while rising
interest rates and inflation hold down residential investment and consumer
durables. However, rising inflation will bring a monetary policy response at
some point and the resulting recession will reduce both consumption and
investment.
By far, the most attractive fiscal policy option for the United States
48
is to increase the U.S. saving rate while not simultaneously depressing the
U.S. investment rate. Tax increases on business are certainly not the way to
go; with higher business taxes the federal budget deficit might fall, which
would increase national saving, other things equal, but business saving
and business investment would also fall. In fact, tax increases on business
might sufficiently reduce the rate of return on U.S.investment to cause a
substantial change in international capital flows. The result would be a
very uncomfortable period of a sharply declining dollar accompanied by
simultaneous inflationary and recessionary pressures.
The only sure-fire way to raise national saving is to reduce federal expenditures and to direct tax increases, if any, entirely toward consumers.
However, success in altering fiscal policy to reduce private and public consumption might well lead to increased rather than decreased capital imports
and increased U.S. investment. The reason is that evidence that the United
States could solve its fiscal problem without loading taxes on business would
make U.S. investment especially attractive in an international context.
We ought to welcome rather than fear such a result. No nation can
grow by making capital formation unattractive.
49
FIGURE 1
U.S. BALANCE OF PAYMENTS, CAPITAL INFLOW
Billions of Dollars per Quarter
50
50
Total Capital Inflow =
Current Account Deficit
40
40
30
30
20
-j 20
10
-I 10
0
0
•10 h
-10
Official Capital Inflow
-20
>VV>>>>VV>VV'
fl*
\<*
-20
FIGURE 2
U.S. BALANCE OF PAYMENTS, OFFICIAL CAPITAL
Billions of Dollars per Quarter
20
20
15
15
Foreign in U.S.
10
10
5
5
0
0
-5
U.S. Abroad
-5
-10 h
-10
-15
-15
^>vvv>>v>vvvy
FIGURE 3
U.S. BALANCE OF PAYMENTS, DIRECT INVESTMENT
Billions of Dollars per Quarter
15
10
Foreign in U.S.
5
0
-5
-10
-15
U.S. Abroad
^^v>vvv>v>vv-
FIGURE 4
GROWTH RATES, REAL GDP
Percent
FIGURE 5
SAVING AND GROSS DOMESTIC INVESTMENT
Percent of GDP
45
45
JAPAN-S
40
40
H 35
35
30
30
X • _ « . - .
EUROPE-S
25 h
' ^
'
H25
y*
\
EUROPE-I
\
20 h
N
***-
V
USA-I
/
•y-^-Vv
\>T
15
^—..
15
USA-S
j
10
s
1.
^ ° <& ^
J
<fifi #& JP
1
1
1
1
1
jgfl- N«{1 * N<»1* N<1* No,%° ^
i—
i
,»•
-I 20
i.
^
I -jo
FIGURE 6
U.S. GROSS PRIVATE DOMESTIC INVESTMENT
ions of 1982 Dollars
800
800
700
700
TOTAL
600
600
500
500
NONRES FIXED
400
400
TREASURY I TAX PROPOSAL
300
^ o * ^\*
-I
•
1
^&*
i
t
'
^&*
l
l
_l
^^
I
I
I
L
^^
J
J
L
I
,1
^6^ ^r^
I
I
I
300
FIGURE 7
S. NONRESIDENTIAL FIXED INVESTMENT, 1982 DOLLARS
ercent of Real GNP
14
14
12
12
10
10
1953-80 AVERAGE
8
8
16
NET
14
2h
12
1953-80 AVERAGE
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