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SHADOW OPEN MARKET
COMMITTEE
Policy Statement and
Position Papers
March 18-19,1990
PPS-90-01
THE BRADLEY
POLICY
RESEARCH
CENTER
Public Policy Working Paper Series
U N I V E R S I T Y
OF
ROCHESTER
Shadow Open Market Committee
Table of Contents
Page
Table of Contents
i
SOMC Members
ii
SOMC Policy Statement Summary
1
Policy Statement
3
The U.S. Economy in 1990/91
Jerry L. Jordan
11
A Fiscal Policy Update
Mickey D. Levy
27
Dismal Landscape
H. Erich Heinemann
35
Foreign Exchange Market Intervention
Anna J. Schwartz
.
41
The German Democratic Republic: Economic Goals,
Constraints and Monetary Reform
WilliamPoole
i
45
March 18-19,1990
SHADOW OPEN MARKET COMMITTEE
The Shadow Open Market Committee met on Sunday, March 18,1990 from 2:00 p.m. to
6:00 p.m. in Washington, D.C.
Members of the SQMC;
Professor Allan H. Meltzer, Graduate School of Industrial Administration, Carnegie
Mellon University, Pittsburgh, Pennsylvania 15213 (412/268-2283); and Visiting Scholar,
American Enterprise Institute, Washington, D.C.
Mr. H. Erich Heinemann, Chief Economist, Ladenburg, Thalmann & Co., Inc., New
York, New York 10022 (212/940-0250).
Dr. Jerry L. Jordan, Senior Vice President and Economist, First Interstate Bancorp,
Los Angeles, California 90017 (213/614-2920).
Dr. Mickey D. Levy, Chief Economist, First Fidelity Bancorporation, Philadelphia,
Pennsylvania 19109(215/985-8671).
Professor William Poole, Center for the Study of Financial Markets and Institutions,
Brown University, Box B, Providence, Rhode Island 02912 (401/863-2697).
•Professor Robert H. Rasche, Department of Economics, Michigan State University,
East Lansing, Michigan 48824-1038 (517/355-7755).
Dr. Anna J. Schwartz, National Bureau of Economic Research, Inc., 269 Mercer
Street, 8th Floor, New York, New York 10003 (212/995-3451).
•On leave at the Bank of Japan until April 1,1990.
ii
Shadow Open Market Committee
SOMC POLICY STATEMENT SUMMARY
Washington, March 19 - The Shadow Open Market Committee today questioned the legal
basis for large scale intervention and speculation in foreign currencies by the Federal
Reserve. The SOMC, a group of academic and business economists who regularly
comment on public policy, said Congress should hold hearings "to determine whether an
explicit grant of authority to conduct these operations" is in the national interest
At the same time, the Committee commended the Federal Reserve for its efforts to
achieve zero inflation. "A policy of reducing inflation is the only reliable way to achieve a
sustained reduction in market interest rates,"the SOMC statement said. The SOMC
recommended that the Federal Reserve keep the growth rate of the monetary base "close to
an annual rate of 4 percent"tohelp achieve this goal.
On the question of Federal Reserve intervention in world financial markets, the
Committee charged "there is no economic rationale" for the U.S. government's $45-billion
foreign currency portfolio — mainly D-marks and yen. "Taxpayers are taking risks of loss
and getting no benefits," the SOMC said in its policy statement
The statement also criticized the Federal Reserve's practice of "warehousing"
foreign currencies for the Treasury's Exchange Stabilization Fund. The Committee pointed
out that such transactions amount to a direct loan from the Federal Reserve to the Treasury,
outside the Congressional appropriation process. These direct loans totaled $7-billion on
October 31,1989, the most recent date for whichfiguresare available.
"We recommend that Congress decide whether off-budget loans to the Treasury's
General Fund and its Exchange Stabilization Fund by the Federal Reserve are permissible.
The SOMC, which meets in March and September, was founded in 1973 by
Professor Allan H. Meltzer of Carnegie Mellon and the late Professor Karl Brunner of the
University of Rochester.
The SOMC statement discussed the economic consequences of German
reunification. The Committee made three points: (1) Assuming "proper monetary policy,"
combination of the two German currencies will not increase inflation. (2) The recent rise in
German interest rates reflects "the prospect of new investment opportunities and increased
consumption in Eastern Europe," which will benefit the world economy. (3) Changes in
Eastern Europe "do not portend a weakening in the Federal Reserve's control of U.S.
monetary policy."
The Shadow Committee backed a plan currently under study at the U.S. Treasury
to integrate corporate and personal taxes. "Full integration would lower the tax on capital
investment and encourage capital formation. It would reduce the appeal of leverage by
1
March 18-19,1990
lowering the relative cost of equity capital. It would reduce the importance of financing
decisions. These are socially beneficial changes that we fully support"
However, the statement warned that proposals — for example, by Senator Daniel
Moynihan — to alter Social Security payroll taxes "to achieve desired federal budget
outcomes would be short-sighted and ill-advised. Political rhetoric and the debate about
budget accounting rules should not obscure the need to provide sufficient capital to support
future generations of retirees."
2
Shadow Open Market Committee
SHADOW OPEN MARKET COMMITTEE
Policy Statement
March 19,1990
Monetary policy remains consistent with moderate recovery and declining inflation.
Annual growth of the monetary base - bank reserves and currency - have remained close
to the rate recommended at our last meeting. Growth of other monetary aggregates has
been moderate also and consistent with the Federal Reserve's announced aim of reducing
inflation.
The recent large increase in the base appears to be mainly a onetime increase in
demand by foreigners for U.S. currency. For 1990, we recommend that the Federal
Reserve keep the growth rate of the monetary base close to an annual rate of 4 percent
measured from 1st quarter 1990. Due regard should be taken to accommodate continued
foreign demand for currency.
In recent testimony to Congress, Federal Reserve Chairman Greenspan repeated the
emphasis the Federal Reserve now gives to maximum sustainable growth and zero
inflation. Chairman Greenspan's statement recognizes that "by ensuring stable prices,
monetary policy can play its most important role in promoting economic progress."
Several Federal Reserve bank presidents and the recent annual report of the Council of
Economic Advisers express similar views. We support these statements. We commend
the Federal Reserve for its stand.
The views expressed by the Council and the Federal Reserve contrast with much
public comment that treats lower inflation and sustainable growth as alternatives that cannot
be achieved together. Advocates of this view favor faster money growth to lower interest
rates and increase spending and output. This is a mistake. Interest rates are lowest in
countries with lowest inflation. Maintaining a policy of reducing inflation is the only
reliable way to achieve a sustainedreductionin market interest rates.
Foreign Exchange Market Intervention
Our September 1989 policy statement misstated the loss on foreign exchange intervention
for the year ending July 1989. We regret the error in reporting the losses incurred by the
Treasury's Exchange Stabilization Fund and by the Federal Reserve. For the nine month
period ending October 31,1989, the Federal Reservereportedan unrealized profit of $362million on foreign exchange holdings. There were no realized gains or losses in this
period. During the same period, the Exchange Stabilization Fund reported realized profits
of $197-million and unrealized profits of $81-million.
3
March 18-19,1990
More important than the periodic gains or losses are: (1) the amount of U.S.
government intervention and speculation in foreign currencies; (2) the legal basis for
intervention and the warehousing of foreign currencies; and (3) the economic rationale for
the intervention.
ftrteryeptKffl
The combined holdings of foreign currencies by the Federal Reserve and Treasury are
estimated by the International Monetary Fund at $45-billion for January 1990. The last
figure reported by the Federal Reserve, for October 1989, was $41.6-billion — $29-billion
at the Federal Reserve and $12.6-billion at the Treasury. Much of this large accumulation
is recent From March to October 1989, combined holdings of foreign currency increased
more than $21-billion. There is no economic rationale for the magnitude of current
holdings.
Federal Reserve and Treasury holdings of foreign currencies consist mainly of
German D-marks and Japanese yen. If the dollar appreciates against these currencies,
taxpayers will experience losses in proportion to the appreciation of the dollar. There is no
economic rationale for exposing taxpayers to thisriskof loss.
The economic benefits of exchange market intervention have been studied
repeatedly. These studies generally distinguish between sterilized and non-sterilized
intervention. In sterilized intervention, purchases or sales of foreign exchange are offset by
sales or purchases of domestic securities. Virtually all studies conclude that sterilized
intervention has no lasting effect and probably no effect at all on exchange rates. Most
Federal Reserve intervention has been sterilized, so taxpayers are taking risks of loss and
getting no benefit There is no economic rationale for imposing these costs and risks on
taxpayers.
We question the legal basis of these operations as have others in the past The
General Counsel of the Federal Reserve, in an opinion with which the Attorney General
concurred, found in 1962 that the Federal Reserve was authorized to conduct these
operations. However, Congress has not provided a firm legal foundation for these
opinions.
We recommend that Congress hold hearings to determine whether an explicit grant
of authority to conduct these operations is deemed to be in the national interest. If
intervention is to continue, Congress should limit the amount of permissible intervention
and limit the amount of foreign currencies held by the Federal Reserve and the Treasury.
Congress should also assignresponsibilityfor intervention either to the Federal Reserve or
to the Exchange Stabilization Fund.
4
Shadow Open Market Committee
Federal Reserve Loans to the Treasury
From time to time, the Federal Reserve undertakes so-called warehousing of foreign
currencies for the Treasuryfs Exchange Stabilization Fund. Warehousing amounts to a
direct loan from the Federal Reserve to the Treasury, bypassing Congressional
appropriations. In January 1977, the Federal Open Market Committee limited such loans to
$1.5-billion. The FOMC increased this limit to $10-billion in September 1989. On
October 31,1989, the amount held as "warehoused funds" was $7-billion.
Initially, the Federal Open Market Committee relied on the Thomas Amendment as
the legal justification for these loans. However, the Thomas Amendment expired in 1981.
Since 1978, the Federal Reserve has also made direct loans to the Treasury's General
Fund. The Treasury has used these funds, not appropriated by Congress, to acquire
foreign currencies.
We recommend that Congress decide whether off-budget loans to both the
Treasury's General Fund and its Exchange Stabilization Fund by the Federal Reserve are
permissible and, if so, whether these loans should be subject to the Congressional
appropriation process.
The G-7 Meeting in April
On April 7, Treasury Secretary Brady is scheduled to meet with G-7 finance ministers to
discuss currencyfluctuationsand foreign exchange market intervention. Despite frequent
claims to the contrary, the dollar has not appreciated in recent months. The appropriate
measure of appreciation is the trade-weighted index, showing the price of the dollar relative
to our trading partners. According to the Federal Reserve Board's index, the dollar reached
a recent peak in June 1989 and is now 10 percent lower. Further, part of any appreciation
or depreciation reflects differences in expected or actual rates of inflation. These changes in
nominal exchange rates do not affect the competitive position of the U.S. or its trading
partners.
Secretary Brady should avoid any commitment to devalue the dollar by purchasing
foreign currencies. Sterilized intervention has no effect on exchange rates. Unsterilized
devaluation raises the prices of goods and services at home. Neither sterilized nor
unsterilized intervention serves the interests of U.S. producers or consumers.
German Economic Unification
In February, Chancellor Kohl proposed a unified monetary system for greater Germany.
His proposal was, in part, a response to the migration of East German workers to West
Germany. Discussion about a unified Germany is underway.
5
March 18-19,1990
The prospect of integration has raised concerns about inflation and interest rates —
not only in Germany but in other economies as well. These concerns are based on a
misunderstanding. Proper monetary policy can avoid any sustained inflationary effect
Much of the recent rise in German interest rates reflects the prospect of new investment
opportunities and higher consumption in Eastern Europe. These developments represent
potential gains for Germany, Europe, the U.S. and the rest of the world. An increase in
real interest rates cannot be suppressed by Federal Reserve actions. like all changes in real
interest rates, it is a signal for redirection of resources. It does not portend a weakening of
the Federal Reserve's control of U.S. monetary policy.
Much attention has been directed to the choice of exchange rate between East and
West German marks and the effects of the choice on inflation. The problems of economic
unification are much greater than the problems of monetary integration or the choice of an
exchange rate, and most of the problems are independent of the choice of an exchange rate.
Once the barriers to migration from East to West Germany were removed, market forces
began to integrate the two economies. Migration is driven by real economic forces and will
not be much affected by the choice of exchange rate. It is important, here as elsewhere, to
separate monetary and real effects.
Inflation
There are two principal issues about inflation. First, the choice of the exchange rate for
East marks has no necessary implication for German inflation. The West German
Bundesbank does not have to provide a net increase in the money stock to pay for the
retirement (exchange) of East German marks. The Bundesbank can offset the effect on the
West German money stock and prevent an increase in the price level.
Second, any increase in the general price level would be a onetime effect, not a
sustained increase in the rate of price change. If after unification the money stock increased
more than the GNP of the united Germany, prices would rise. The rise would be a onetime
change that would not continue unless the Bundesbank increased money more rapidly than
output
Relative Prices
The principal problems are not monetary. There are larger subsidies for food and housing
in East than in West Germany and very different social welfare benefits in the two parts of
Germany. Unemployment compensation in West Germany is higher than the wages
received by many workers in East Germany. This acts as an incentive to migration from
6
Shadow Open Market Committee
East to West The West German policy of providing shelter for migrants also encourages
migrationfromEast to West
These, and many other, social policies on both sides of the former border distort the
prices of goods and labor. The distortions make rational calculation and allocation difficult
or impossible. Differences of this kind cannot be removed by choosing an exchange rate.
Economic decisions to migrate depend mainly on current and future income and purchasing
power in different locations. Differences in taxes and subsidies are important in these
calculations. The nominal exchange rate is not
Unless the real distortions are reduced, by adjusting social policies, migration will
continue. To integrate successfully and at lowest cost, market forces must be permitted
larger scope in resource allocation. Decisions about taxes and subsidies are the critical
decisions for successful German economic unification. These decisions can make the
adjustment less disruptive and costly to both German economies.
The Role of the UtST m Eastern Europe
The collapse of communism in East Germany and Eastern Europe is a potential gain for the
world economy. With proper policies, the productive potential of an educated population
can be directed toward more productive tasks. The early optimism can be lost, however, if
the acceptance of market discipline is delayed.
Bureaucracies in much of Eastern Europe have strong vested interests in the present
system of state control and direction. Maintaining state ownership of resources, failure to
adopt a legal system based on private ownership and binding contracts, and unwillingness
to provide the political, legal and accounting framework for a market economy will retard
development in Eastern Europe. Western countries, including the United States, can be
most helpful in providing technical assistance for developing this framework.
Government-to-government financial aid for development is often counterproductive. The experiences of Latin America and Africa illustrate some of the failures. A
main reason for these failures is that development aid often sustains subsidies to
unproductive enterprises and discourages private ownership. In Eastern Europe, state
enterprises must be sold to private owners and large bureaucracies must be removed, not
retained. Reliance on market processes, not government aid, is the most effective way to
speed development
Taxes
The Administration's budget proposes reductions in the capital gains tax, new taxadvantaged family savings plans (FSAs)and an expansion of individual retirement
7
March 18-19,1990
accounts <IRAs). Senator Moynihan has proposed a reduction in Social Security Taxes.
House Ways and Means Committee chairman Rostenkowski has suggested a wide-ranging
package of tax increases (including income taxes) as part of a broad deficit-elimination
proposal. In addition, the Treasury is considering integration of corporate and individual
taxes.
We advocate full integration of the corporate tax and the individual income tax. Full
integration would eliminate double taxation of dividends. Interest payments and dividend
payments would be taxed equivalently. Corporations would have little incentive to issue
debt andretireequity to reduce corporate taxes.
Full integration would lower the tax on capital investment and encourage capital
formation. It would reduce the appeal of leverage by lowering the relative cost of equity
capital. It would reduce the importance of financing decisions. These are socially
beneficial changes that we fully support.
The Administration's proposal to exclude from taxation a portion of capital gains
would increase saving and improve economic efficiency. The proposed FSAs would
exempt from income taxes interest income from non-deductible contributions. The FSAs
would be separate from IRAs and 401Ks. IRAs would be expanded and penalties on early
withdrawals would be waived for first-time home purchasers. IRAs and the newlyproposed FSAs are relatively costly ways to increase total saving since some of the
contributions to these accounts are not net additions to aggregate saving.
Senator Moynihan's proposal to roll back payroll taxes has refocused the fiscal
debate on Social Security surpluses and the share of taxes paid by different income groups.
Reducing payroll taxes would increase unfunded Social Security liabilities and require
either higher payroll taxes or lower Social Security benefits in the future. Thus, lowering
payroll taxes is a drain on the future capital stock andredistributeswealth from future to
current generations.
The Social Security tax has always beenregressivebecause there is a cap on wages
against which Social Security taxes are assessed. However, the Social Security benefit
structure provides substantially higher benefits for retirees with low earnings histories.
Accordingly, Social Security's combined tax and benefit structure is highly progressive,
with currentretireeswith low income historiesreceivingthe highest benefitsrelativeto their
lifetime taxes. By contrast, futureretireesface significantly lower expected rates of return
on their lifetime payroll taxes. Reducing Social Security payroll taxes without reducing
benefits would accentuate these intergenerational inequities.
Altering payroll taxes to achieve desired federal budget outcomes would be shortsighted and ill-advised. Political rhetoric and the debate about budget accounting rules
8
Shadow Open Market Committee
should not obscure the need to provide sufficient capital to support future generations of
retirees.
Chairman Rostenkowskfs deficit-elimination plan includes a freeze on non-meanstested entitlement programs and Social Security, as well as higher income taxes. Any rise
in income taxes would be counterproductive. Spending for Social Security and other nonmeans-tested entitlement programs has risen significantly as a share of total federal outlays
and national output We support limiting outlay increases in these programs.
Previous large budget imbalances have been reduced significantly. Spending and
deficits have been reduced sharply as a percent of GNP. The primary deficit (the deficit
less net interest outlays) has been eliminated. The ratio of public debt to GNP has
stabilized. The fiscal policy debate should focus on the objectives and economic effects of
federal spending and tax policies and their impact on allocation of national resources.
9
Shadow Open Market Committee
THE U.S. ECONOMY IN 1990/91
Jerry L. JORDAN
First Interstate Bancorp
Summary
The slow national economic growth of late 1989 and early 1990 will set the stage for a
more sustainable pace of expansion well into the new decade. Output and employ-ment
growth will increase later this year and in 1991, but will stay well below the robust
expansion of 1987/88. Inflation reached a cyclical peak in the first half of 1989 and can be
expected to decline for at least the next two years.
This outlook for modest growth and falling inflation for the near future will be
accompanied by reduced volatility of interest and exchange rates compared with the
previous two decades. Oil prices are expected to average somewhat below $20 per barrel
through 1991, and food prices will retreat from the recent cold-weather induced highs.
Consumer spending will grow at a subdued rate, and major sectors such as residential
construction and automobile production will operate at much lower levels than in the mid1980s.
Growth of capital spending by businesses in 1990 will be well below the rates of
the past few years — a reflection of the contraction of corporate cash flows. However,
capital spending in 1991 is forecast to be fairly robust. Exporting and import-competing
industries will continue to outperform other sectors of the economy.
Defense spending by government will fall by about 4 percent a year in real terms for
much of the 1990s. Consequently, regions and industries of the economy that were
stimulated by the defense buildup of the 1980s will be adversely affected this decade.
Spending by government and private industry for environmental purposes will trend higher
for many years to come.
The torrid rate of real estate price increases during the late 1980s is now over for
most of the country. For 1990/91, appreciation of house prices is not likely to exceed the
rate of inflation expect in a few areas such as the Pacific Northwest Sale of assets the
government acquired from failed thrifts and banks will continue to depress real estate
markets in some southwestern and northeastern states.
Although the unemployment rate is forecast to rise somewhat this year, the Federal
Reserve is not expected to shift to a sharply more stimulative monetary policy. Sustained
monetary restraint means that such indicators as personal income and retail sales will grow
more slowly on average than in the recent past. The resulting short fall of tax receipts at
both the state and the federal levels will constrain spending by governments.
11
March 18-19,1990
US. Outlook for 1990191
Since our meeting last September, a number of changes have taken place — some of which
will produce only temporary effects, while others will have long-term impacts.
(1)
Unusually cold weather in various parts of the United States at the end of
1989 pushed food and energy prices up steeply. Although unsettling to
consumers, the resulting price spike in the first part of 1990 will be
temporary.
(2)
Long-term interest rates have climbed sharply in the first part of 1990.
U.S. interest rates are now high relative to expected inflation and economic
growth and are, therefore, likely to move lower.
(3)
The pace of change in Eastern Europe should bolster growth opportunities
for the United States, although immediate export potential will be modest.
Changes in the Soviet Union will permit significant reductions in defense
spending, although such changes will also lower growth prospects of some
industries and regions.
(4)
Fiscal policy has taken some unexpected turns. Defense spending
projections have been scaled further downward, and the overall deficit
picture began to look somewhat brighter toward the end of 1989.
However, Senator Moynihan (D-NY) has proposed rolling back the 1990
social security payroll tax increase to prevent the current surplus from being
used to fund other government programs.
Our view of the U.S. economy remains relatively unchanged. We expect no
recession, although growth in the first part of 1990 will be slow — below 2 percent We
still expect interest rates to move lower in the second quarter of 1990.
Policy Assumptions
The Bush administration has submitted a budget for fiscal 1991 that formally complies with
the Gramm-Rudman deficit target of $64 billion. The actual deficit for fiscal 1991 is
expected to be much higher.
Defense spending is slowing, and real declines averaging 3-4 percent per
year seem likely during the next four to five years. Any "peace dividend," however, has
already been claimed in demands for higher spending on child care, education, drug
control, infrastructure, foreign aid, and the environment. Consequently, an increase of
Federal spending significantly larger than 3 percent shown in the administration's 1990
budget seems likely.
12
Shadow Open Market Committee
The Federal Reserve continues its balancing act between fighting future inflation
and maintaining current economic growth. Since last spring, it has gradually reduced its
target for the Federal funds rate from a peak of nearly 10 percent to 8.25 percent. Its
strategy during recent months has been to make a small cut in the funds rate (25 basis
points) and then wait to assess the impact
We believe that three more quarter-point reductions in the funds rate will
occur by mid-year as the soft economy puts downward pressure on market interest rates.
The growth of the monetary base (currency and bank reserves) is likely to pick up to
over 5 percent this year and in 1991 from the very low rate of about 3 percent in 1989.
This is an expectation, not a recommendation.
The Federal Reserve remains highly committed to reducing inflation over the next
five years. Even though a zero inflation target may not be achieved, monetary policy is
likely to restrain the growth of total spending in the economy. Several members of the
Federal Reserve see the economy's real growth potential as only about 2.5 percent a year
and may attempt to keep actual growth close to that perceived non-inflationary limit
Economic Growth
We look for a relatively modest gain of 2.2 percent in real GNP this year (fourth
quarter to fourth quarter). The non-farm economy is expected to expand this year at about
the same pace as in 1989 on balance, but second-half growth is expected to be about double
that of the first half. The higher growth at about long-run potential is forecast to continue
in 1991, with real GNP up 2.7 percent next year.
The two major forces affecting growth in 1990 will be a more accommodative
monetary policy and a continued sizable demand for American exports. A pickup in
monetary growth should bolster spending in general, with at least modest increases in
consumer expenditures, housing, and capital outlays. Both consumer and capital-goods
producers should realize moderate export gains in 1990, as growth in Europe, the Far East,
and Mexico will be relatively strong.
Consumer spending will rise in line with incomes in 1990 — about 2 percent in
real terms. A total of 14.4 million cars and light trucks are expected to be sold,
about equal to the 14.5 million total of 1989.
We believe that 1989 marked the low point for the housing cycle nationally. The
rise in 1990, however, is likely to be modest with an increase to 1.43 million housing
starts from L37 million in 1989.
13
March 18-19,1990
For 1991, we forecast that 1.54 million housing units will be started. This level
contrasts with 1.81 million units built in 1986, before demographics of the aging "babyboom" population began to limit the number of new units.
Business capital spending should pick up by the second half of 1990 with
some improvement in profits and the ongoing efforts of companies to improve labor
productivity, inventory control, and other operating efficiencies. Energy companies plan to
conduct a significant amount of oil and natural gas drilling this year. Investment in
infrastructure should also be sizable. Finally, the commercial aircraft business continues to
boom, with strong orders for new planes as well as rehabilitation of older equipment.
In the area of non-residential building, the oversupply of offices, hotels, and
other commercial space in many locations will limit new construction in the current year.
Defense spending will be down, affecting both primary contractors and their many
subcontractors.
Job growth is likely to slow in 1990 as companies attempt to improve profit
margins and adjust to a moderate pace in overall sales and shipments. We expect the
overall unemployment rate (including the military) torisefrom 5. percent in February
to about 5.6 percent in the third quarter. The jobless rate would then drift slowly back to
about 5.1 percent by the end of 1991.
Manufacturing sector employment fell through most of 1989 with a loss of
300,000 jobs between the peak in March 1989 and January 1990. The weakest segments
have been autos, computers, and their supplier industries. With the exception of aircraft,
most other manufacturing industries were essentially flat in terms of new orders,
production, and employment as 1990 began. Many furloughed auto workers have already
been recalled, but a number of auto plants will see temporary or permanent closure this
year. Hiring in other manufacturing industries is likely to be slow in 1990, although
conditions should gradually improve as the year progresses.
Meanwhile, employment growth has continued almost unabated in the broad service
sector. A squeeze in profit margins for retailers and service businesses is, however,
expected to slow the pace of employment gains in 1990.
Profit margins fell to recession levels last year but should gradually improve in
1990. Many companies faced rising labor costs (especially for health insurance and other
benefits) as well as higher average interest expense. At the same time, product demand
was not strong enough to pass on those cost increases. Lower average interest rates, a
slowdown in new hiring, and a pickup in general economic activity in the second half of
1990 should begin to help the profit picture later this year.
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Shadow Open Market Committee
Inflation
Prices rose last year at the highest rate since 1981. Consumer prices increased 4.6 percent
on a year-end to year-end basis in 1989, slightly faster than the 4.4 percent inflation rate of
each of the prior two years.
The bitter cold at the end of 1989 increased demand for energy substantially while
cutting the supply of various winter crops. The result has been sizable energy and food
price increases in the first part of 1990, which will send consumer prices up at an annual
rate of about 6 percent in the first quarter of the year. Subsequent actual declines in food
and energy prices should dampen inflation in the spring and summer to an annual rate of
less than 4 percent.
The impact of tighter monetary policy during the past two years should be an
easing of basic inflationary pressure this year and next. Consequently, we continue
to expect that consumer prices will be up about 4.2 percent this year and 4.0 percent in
1991.
Total employee costs rose 5.0 percent last year, and a similar rise appears likely
in 1990. We are forecasting an increase of 4.7 percent in 1991. Health-care costs show no
sign of slowing, although a reduction in social security taxes would moderate the rise in
labor costs.
Interest Rates
We believe interest rates will decline further towards a trough around mid-1990. The
pace of economic growth will be the most important force affecting the trend of short-term
rates. Weakness in the economy will push market rates lower and will also encourage
the Federal Reserve to be more expansive and reduce its target for the Federal funds rate.
We look for the funds rate to fall to a low of about 7.5 percent by mid-year from 8.25
percent in early March. The prime rate is likely to fall from 10 percent recently to at
least 9.5 percent, and possibly 9 percent, by summer.
A pickup in economic growth would then push short-term interest rates gradually
higher in the second half of 1990 and through 1991. The Fed funds rate would average
about 7.75 percent in the fourth quarter of this year and 8.45 percent in thefinalquarter of
1991. The bank prime rate would be 9.5 percent at year-end and 10.0 percent during most
of 1991.
Long-term interest rates rose in early 1990 —froman average of 7.9 percent in both
November and December 1989, 30-year government bond yields increased to about 8.5
percent in early March. With real economic growth in the United States of only about 2
percent and inflation of close to 4 percent; a long-term bond yield of 8.5 percent would
15
March 18-19,1990
seem unsustainable. Consequently, we believe that 30-year bond rates will move back
down to 8 percent by the middle of this year. The long-bond yield is likely to stay
close to 8 percent during the remainder of 1990 and in 1991.
While many savings and loan institutions have cut back lending and sold assets to
meet new capital requirements, no major increase has occurred in the spread of 30-year
fixed-rate mortgages over 30-year government bonds. An easing in 30-year bond yields
should be accompanied by some reduction in mortgage rates from the 10.25 percent level in
early March. We are forecasting that mortgage rates will ease to a low of about 9.8
percent by the middle of the year and stay below 10 percent through the balance of 1990.
Mortgage rates would then inch back to about 10 percent by the middle of 1991.
16
MAJOR ECONOMIC INDICATORS
QUARTERLY
1686
_J
II
GROSS NATIONAL PRODUCT
(Billions of $, annual rate)
% Change, annual rate
5113.1
REALGNP
(Billions of 1982$. a. r.)
% Change, annual rate
4th QUARTER
1900
III
Actual
5201.7
S281.0
QL.
>
•
l»
Forecast
5491.9
5580.4
IV
_J
1991
H»
Forecast
5864.5
5961.9
{J
% Change
1989 '89/88
Actual
5337.0 6.4
% Change
% Change
'90/89
1991 '91/90
Forecast
5680.0
6.4
6057.9 6.7
4168.1
2.4
4259.7
2.2
4376.8
2.7
4201.9
IV
1.8
4293.5
2.2
4406.1
2.6
1990
S337.0
5411.6
5680.0
5772.9
4.3
17
6.1
6.6
7.3
6.7
6.6
6.6
6.6
4168.1
4179.5
4198.2
4226.3
4259.7
4288.1
4315.7
4346.7
4376.8
3.0
0.5
1.1
1.8
2.7
3.2
2.7
2.6
2.9
2.8
4161.5
4205.9
4201.9
4223.8
4238.7
4262.8
4293.5
4321.1
4348.1
4376.7
4406.1
2.0
4.3
-0.4
2.1
1.4
2.3
2.9
2.6
2.5
2.7
2.7
24.5
19.1
21.9
32.6
15.5
17.0
20.0
22.8
25.0
26.5
29.0
31.5
32.6 N/A
22.8
N/A
31.5 N/A
GNP DEFLATOR
(1982-100)
% Change, annual rate
124.5
125.9
126.9
128.0
129.5
130.8
132.0
133.3
134.6
135.9
137.2
138.4
128.0 3.8
133.3
4.2
138.4 3.8
4.0
4.6
3.2
3.5
4J
4^2
3.6
4.0
3.9
3.8
3.8
CONSUMER PRICE INOEX
(1982-84-100)
% Change, annual rate
121.9
123.8
128.7
125.8 4.6
131.1
4.2
136.4 4.0
,7.9
7.1
6.2
4106.8
4132.5
4162.9
37
&8
REAL FINAL DOMESTIC SALES*
(Billions of 1982 $. a.r.)
% Change, annual rate
4140.6
1.3
REAL CHANGE IN INVENTORIES
(Billions of 1982 $,a.r.)
6057.9
3.7
124.6
125.8
127.5
129.9
131.1
132.5
133.8
135.1
136.4
5.4
6.4
2.6
3.9
5.6
3.8
3J
4.0
4.1
4.0
4.0
3.9
AUTO SALES
(Millions, annual rate)
9.8
10.3
10.8
8.7
9.9
9.7
10.0
10.1
10.3
10.4
10.5
10.3
9.9**
-6.9
9.9"
0.2
1 0 . 4 - 4.4
HOUSING STARTS
(Millions, annual rate)
1.52
1.35
1.34
1.33
1.35
1.37
1.49
1.52
1.54
1.54
1.54
1.55
1.37**
-7.7
1.43-
4.3
1.54-
INDUSTRIAL PRODUCTION
(1977-100)
% Change, annual rate
140.7
141.8
142.2
142.3
142.4
142.8
143.6
144.9
146.0
147.0
148.1
149.2
142.3 1.7
144.9
1.8
149.2 2.9
3.0
2.8
3.1
2.9
NONFARM EMPLOYMENT
(Millions)
107.7
111.3
111.8
112.3
112.8
109.4 2.4
110.8
1.3
112.8 1.8
5.4
5.3
5.2
5.1
5.3 N/A
5.4
N/A
5.1 N/A
320.0
325.0
333.0
295.5e -13.1
309.0
4.6
333.0
7.7
7.6
7.8
152.0e -13.4
163.0
7.2
178.0 9.2
298.6
5.3
314.1 5.2
UNEMPLOYMENT
RATE, ALL WORKERS (Percent)
CORPORATE PRETAX
OPERATING PROFITS
(Billions of $, annual rate)
% Change over year ago
3.2
1.1
0.3
0.2
1.2
2.3
3.6
108.3
108.9
109.4
109.8
110.0
110.3
110.9
5.1
5.2
5.2
5.3
5.3
6.5
5.6
5.4
316.3
307.8
295.2
295.5e
294.0
297.0
302.0
309.0
7.1
2.3
'
-0.6
«5.4
-10.8
PROFITS AFTER TAXES
(Billions of $, annual rate)
% Change over year ago
173.6
181.1
152.4
MONETARY BASE
(Billions of S. a x ) '
% Change, annual rate
277.7
4.7
8.6
-3.5
-13.1
152.0e
315.0
-7V1
<L5
2.3
4.6
150.0
153.0
158.0
163.0
165.0
168.0
173.0
178.0
-5.0
3£^
7.2
10.0
9.6
9.5
7.8
9.2
-12.0
-13.4
-13.6
278.7
280.8
283.6
287.3
291.2
295.0
298.6
302.6
306.3
1.5
3.0
4.1
5.3
5.5
5.3
5.0
5.5
5.0
NOTE: All quarterly series are seasonally adjusted; % change, annual rate calculated from prior quarter;
calculations based on unrounded data; a.r. • annual rate; e-estlmate. 'Excluding Commodity Credit Corp. purchases
7.5
310.2
5.2
314.1
283.6
3.3
5.1
'Annual total; N/A - Not applicable
SHADOW OPEN MARKET COMMITTEE
Jerry L. Jordan
Chief Economist & Senior Vice President
First Interstate Bancorp
March 18-19, 1990
1
REAL GNP, Q U O 04
CONTRIBUTIONS TO 4TH QTR PERFORMANCE
(Distribution of 0.9% real growth)
(Percent change)
•0.5
0
0.5
'Excluding Commodity Credit Corp. transactions
MERCHANDISE-TRADE DEFICIT
DEFENSE SPENDING WANES
(Defense outlays as percent of GNP, fiscal years)
Billions of dollars, seasonally adjusted)
Vietnam
12-Month
Average
FMAMJJASOND
1987
JFMAMJJASOND
1989
Shadow Open Market Committee
79
9f
0
9f
1
March 18-19, 1990
PERSONAL SAVING AS A % OF DISPOSABLE INCOME
REAL RETAIL SALES
(Quarterly, percent change over year ago retail sales/personal consumption deflator lor goods)
(quarterly)
12
I I I I I I I I I I I 11 11 I I H
.78
79
80
81
82 83
84
II II I I I II I
85
86 87
T
4461
64
67
70
73
76
79
82
85
HOUSING STARTS & PERMITS
AUTO SALES
(Millions of units, annual rate)
(Millions of units, annual rate)
1.8
Starts
1.7
1.6
1.5
1.4
1.3
1.2
Permits lagged
1.1
1
A
S 0
1988
N D
J F M A M J J A S O N D I J F
1989
1990
1 month
I
I
A
I
S 0
1988
Shadow Open Market Committee
I
I
N D
I
J
I
I
I
I
I
I
F M A M J J A
1989
I
I
S
I
0
I
N D
J F
1990
March 18-19, 1990
3
INDEX OF LEADING ECONOMIC INDICATORS
INDUSTRIAL PRODUCTION
(Percent change from prior month, annual rate)
(Percent change from prior month)
6-Month
1.0 -r
6-Month
7-Month
Average
Average
6-Month
Average
0.5 |
•—HB -i_|i|_i_tll
'"jahi
0.0
•llflfll™!
pa.
.WU Rpr
•I—•
4-H
t
•0.5
6-Month
•1.0 +
•1.5
J A S O N
D
J F M A M J J A S O N D
1988
J
1990
J
A
S O
1988
N
D
J
F
M
A
M
J
J A
1989
DURABLE GOODS ORDERS
O
N
D
N
1990
PURCHASING MANAGERS1 INDEX
(Percent change, 3-month moving average)
S
(Percent)
4 j
3
2
6-Month
I
Average
I
1I
I
6-Month
M^
I—I
7-Month
Average
Average
JL,wl
-1 +
J
A
S O
1988
N
D
J
F
M
A
M
J
J A
1989
S
O
N
D
J
1990
A
S O N D
1988
Shadow Open Market Committee
J
F
M
A
M
J
J A
1989
S
O
N
D
J F
1990
March 18-19, 1990
4
UNEMPLOYMENT RATE
NONFARM EMPLOYMENT GROWTH
(All Workers, Percent)
6.0
(Change from prior month, in thousands)
2-Month
Average
T
5.5 +
5.0 +
4.5
I
J
I 1 I I I I I I I I I I I I I I I I I
A S 0 N 0 | J F M A M J J A S 0 N DIJ F
1988
1989
1990
J
A S O N D I J F M A M J J A S O N D
1989
1988
CORPORATE CASH FLOW
MANUFACTURING EMPLOYMENT
(Quarterly, percent change over prior year)
(Change from prior month, in thousands)
120 T
6-Month
Average
80
J F
1990
6-Month
Average
40
TT
40 +
dfi—i-
6SW
•4—i
t
-80 +
6-Month
Average
-120
t
Month
-160
J
A S O N D J F M A M J J A S O N D
1989
1988
J F
1990
55 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89
Shadow Open Market Committee
March 18-19, 1990
0661 '61-81 yojew
116
106
68
I I I II
I I.I I I
\
/8
98
98
I I I I I I I I I I
eeujLuujoo ).a>ijei/\| uedo /wopeijs
W
E8
06-UBp
68-d3S
68-Aew
68-UBf
88*<k$
88-AB^
I I I I I I I I I I I I I I I I I I I I I I I
UBf
0
\J
(o6e JBeA je/vo e6uBqo jueojed 'Ajj^jeno)
(81BJ iBtiuuB 'qiuotu JOjjd JSAO e6usip iU80J9<j)
S30IHd(lNVA3NOW
116
81006
68
88
IS
98
S8
I 1 1 1 I 1 I 1 II 1 I 1 1 1 1 1 1 I 1 1 1 II
HiM0d0A3N3ddn0
W
88
81006
68
88
(O6B JBeA mo e6uBip lueojad 'AjjeiiBno)
L2
98
S8
W
C8
28
18
(eiHJ (enuuB 'jsycnb joud nto e6u*ip lueDJSd)
HiMOB93A«3S3aiViOi
dN0aNV3SV8AaVi3N0W
6
CONSUMER PRICE INDEX
CRUDE OIL PRICES
(Monthly change, annual rate)
15
(West Texas Intermediate, dollars per barrel)
24
T
T
10 +
J
A
S
O N
1988
D
|
J
F
M
A
M
J J A
1989
S
O
N
D
Q
1
J
1990
Q2
Q3
Q4
Q
1
1989
1990
EXCHANGE RATE-YEN/$
EXCHANGE RATE -DM/$
(Weekly averages*)
(Weekly averages')
j
150 j
145 +
140
J
135 +
130
125
n iintitn itntnmti m nninntti in in iinn MI tn in
Q1
Q2
1989
Q3
Q4
* Last point is spot rate
LA/
1990
j
March 12 Spot Rate
YerV$
152.75
10 i M i i M i i i t i i i t i i i i i i i i i t i i i i i i t i i i i t i i i i i i m n m n i m i i i n m
2
Q1
Q1
Ar
<^v
Q2
1989
Shadow Open Market Committee
Q3
Q4
4
Last point is spot rate
Ot
1990
March 18-19, 1990
7
3-MONTH T-BILL & 30-YEAR GOVERNMENT
BOND-EQUIVALENT YIELDS
YIELD CURVE, 3 MONTHS TO 30 YEARS
(Percent)
(Weekly averages', percent)
10
10
T
T
March 23,1989
03
04
'Last point is spot rate
1 3
5
7
10
FED FUNDS & 3-MONTH T-BILL QUOTED RATES
INTEREST RATE FORECASTS
(Percent, quarterly averages, bond equivalent yields)
(Weekly averages', percent)
ID •
March 8 Spot Rates
14 12 •
\^
10 •
8-
30-Year Government Bond
'/S
^- —
\,^""^
\
6^~"~
90-Day T-Bill
4- 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
02
Q1
1989
03
Q4
'Last point is spot rate.
Q1
83
84
85
86
87
89
Mill
90f
91 f
1990
Shadow Open Market Committee
March 18-19, 1990
+-H
Shadow Open Market Committee
A FISCAL POLICY UPDATE
Mickey D.LEVY
First Fidelity Bancorporation
In recent years, federal spending and deficits have declined significantly as a percent of
GNP, the earlier sharp rise in the federal debt-to-GNP ratio has been halted, and the huge
primary deficit (budget deficit excluding net interest outlays) has been eliminated. More
progress on reducing the budget imbalance is projected, but frustration and political
maneuvering has sidetracked the debate to such issues as social security and on-budget
versus off-budget accounting. In addition, both the Administration and Congress are
bracing for the reality that the Gramm-Rudman-Hollings (Balanced Budget Act, or GRH)
deficit target of $64 billion in fiscal year 1991 will be impossible to achieve. Such
concerns are unlikely to yield rational fiscal decisions. More attention must be paid to the
important issues of the allocative impact of fiscal policies, and what the structure of
spending and tax programs imply for the mix and level of short and long-run economic
output.
Recent Budget Trends
A string of budget legislation and sustained economic expansion have significantly reduced
the budget imbalancefromits earlier peaks:
°
Federal spending growth slowed to a 5.8 percent annual ratefromFY1983
to FY1989 (2.6 percent in real terms), compared to 12.2 percent from 19741983 (4.1 percent in real terms). Consequently spending as a percent of
GNP has declined from a peak of 24.3 percent in 1983 to 22.2 percent in
1989, retracing approximately half of its earlier rise.
°
Net interest outlays has risen from 2.7 percent of GNP in 1983 to 3.3
percent in 1989; consequently, federal spending excluding net interest
outlays have dropped sharply, from 21.6 percent to 18.9 percent Most of
the reduction in outlays have occurred in defense and non-defense
discretionary programs, while outlays for social security and other nonmeans tested entitlement programs haverisenas a share of federal outlays.
°
The federal budget deficit has receded from 6.3 percent of GNP in 1983 to
2.9 percent in 1989. The deficit has fallen from a peak level of $221 billion
in 1986 to $152 billion in 1989. Further declines are projected.
°
The primary deficit (the budget excluding net interest outlays) has been
eliminated. A primary surplus of $2.4 billion in 1979 deteriorated to a
27
March 18-19,1990
°
primary deficit of $118 billion in 1983 and $85.2 billion in 1986. Largely
as a consequence of sharply slower growth of non-interest outlays, the
1989 budget excluding net interest outlays was in surplus by $16.8 billion.
Larger primary surpluses are projected.
The soaring rise in the public debt-to-GNP ratio has been halted. It zoomed
from 24.3 percent in 1974 to 41.5 percent in 1986, but has stabilized
around 42.6 percent in the 1987-1989 period. It is projected to recede
gradually.
Further progress on reducing the budget imbalance will be limited temporarily in
1990-1991 as a consequence of the substantial increase in on-budget outlays tofinancethe
Resolution Trust Corporation's (RTCs) restructuring of the savings and loan industry.
While the Administration's budget projections do not include the RTCs need for additional
working capital in the 1991 budget, the CBO estimates that the RTC will borrow $24
billion in 1990 and $31 billion in 1991 from the Federal Financing Bank (FFB), and these
additional costs of S&L case resolutions will count as budget outlays and add to the deficit,
pushing it well above Administration projections.
The deficit will continue to recede in dollar terms and as a percent of GNP,
although the increased outlays for the RTC will inhibit progress in 1990-1991. The speed
at which the deficit declines depends crucially on economic and interest rate outcomes and
whether President Bush's budget proposals are enacted. The Administration's Budget
projects a current services deficit of $84.7 billion in 1991 and proposes sufficient spending
cuts and revenue increases to barely meet the GRH target with a deficit of $63.1 billion. It
proposes a deficit of $25.1 billion in 1992 and surpluses beginning in 1993, driven
primarily by slower spending growth (4.3 percent annual average from 1991 to 1994).
The CBO's projections are significantly more pessimistic: its baseline budget issued in
January projects a 1991 deficit of $138.0 billion, while its reestimate of the
Administration's budget, which includes the President's proposals but also the substantial
increases in oudays for the RTC, projects a $131 billion deficit The CBO baseline budget
projects very little deficit reduction through 1994.
The Administration assumes 2.4 percent real GNP growth in 1990 and a healthy
bounceback above 3.0 growth beginning in 1991, while the CBO assumes 1.7 percent
growth in 1990 and a more modest rise to 2.5 percent beginning in 1991. The different
growth projections reflect the Administration's optimism about productivity gains. The
Administration projects modest declines in inflation, while the CBO assumes virtually no
improvement. The Administration also projects significantly lower interest rates than the
CBO in nominal and real terms.
28
Shadow Open Market Committee
During 1990-1992, real GNP growth is likely to be closer to the CBO's more
modest forecast, while inflation is likely to fall below both the Administration's and CBO's
forecasts. Criticizing interest rate projections may be unfair, since they involve substantial
uncertainties, but the Administration's projection of sharply declining real rates is
seemingly inconsistent with its projected strong bounceback of real GNP growth that is
driven primarily by stronger productivity gains. Projections with either more moderate real
growth or higher real interest rates, consistent with historical standards, would generate
higher deficit projections. Recently, the Administration has admitted that weak economic
performance will drive 1991 deficits above levels projected in the Budget.
Failure to enact the Administration's budget proposals will also slow progress on
deficit reduction. The Administration proposes substantial deficit cuts — $36.5 billion in
1991, $46.9 billion in 1992, and $75.6 billion in 1994. In general, few cuts are proposed
in non-defense discretionary programs, and the several recommended cuts are old
proposals that already have been rejected. Large cuts are recommended in Medicare
payments to doctors and hospitals and in COLAs for civil service and military retirement,
and unspecified cuts have been designated for farm price supports and federal employee
health benefits. No cuts are proposed for social security. The President proposes a 2
percent annual decline in real defense outlays. Given rapidly changing world events, actual
cuts in defense outlays may exceed this proposal for the 5-year period, but the larger cuts
probably would occur in the later years.
The Administration proposes several significant tax policy changes designed to
encourage saving and investment The proposed exclusion of a portion of capital gains
subject to taxation would raise investment, but the extent of the response is uncertain. Its
enactment is unlikely this year, due to strong opposition primarily on distributional grounds
and, according to congressional estimates, its negative impact on tax receipts over a 5-year
projection period. The proposed Family Savings Account (FS A) is appropriately designed
to encourage savings. Its near-term revenue losses are limited by "back-loading" the tax
benefit to participating contributors, which increases its political attractiveness. The
proposal to eliminate penalties on early withdrawals from IRA accounts for certain new
home buyers is politically attractive. However, it would allocate more savings to housing
rather than equity, which is inconsistent with long-run economic growth.
Another tax policy alternative under consideration by the Administration but not
included in the Budget is a partial or full integration of the individual and corporate income
taxes. This could involve several provisions, including allowing corporations to deduct a
portion of dividends (as is allowed in most industrialized nations). Reducing the double
taxation of dividends has many advantageous economic characteristics, including reducing
29
March 18-19,1990
the current bias against equity financing relative to debt financing, but in the past it has not
had a natural base of political support The recent problems with junk bonds may create the
political environment in which Congress would find this tax policy attractive.
It is unlikely that much of the Administration's spending cut proposals will be
adopted, and the chances are low for immediate enactment of a capital gains tax cut or a
partial income tax integration. Recently, Chairman Dan Rostenkowski of the House Ways
and Means Committee has proposed a broad plan to reduce the deficit, which includes a
freeze on most federal spending programs, including social security, but also higher
personal income taxes. If the proposal to cut spending in social security and other nonmeans-tested entitlement programs becomes part of the mainstream fiscal policy debate, the
political logjam that has been a major stumbling block to meaningful deficit cutting would
be broken.
Despite this possibility, it is virtually certain that the budget outcome in 1991 will
grossly violate GRH's $64 billion deficit target Several outcomes are possible. If real
GNP falls below 1 percent in two consecutive quarters, Congress may vote to suspend
GRH's sequestration process. Whether first quarter 1990 GNP triggers that process
remains uncertain. Second, since the GRH law requires only that OMBfs budget
projections, not actual budget outcomes, achieve the deficit targets, the Administration may
choose to adopt a blatantly unrealistic budget projection. However, the political costs of
doing so may be very high. Third, the GRH law may be amended, with the deficit targets
once again stretched out
Fourth, the Administration may threaten sequestration to extract a significant budget
compromise from Congress. Across-the-board cuts were implemented last fall, but they
were very small ($5.7 billion total); potentially large cuts would be required to meet GRH's
1991 target ($75 billion without legislation). Although large across-the-board cuts are not
expected, the shift in national security needs and defense spending may alter the perceived
winners and losers of sequestration. Until recently, the threat of sequestration was exerted
somewhat evenly across the political spectrum, as conservatives did not want to cut defense
spending and, in general, liberals did not want to cut non-defense spending. The threat of
large cuts to non-defense programs may now substantially exceed the threat of cuts in
defense, and the Administration may try to use this political shift to its advantage.
The Social Security Debate:
Political Maneuvering, Not Rational
Debate
Senator Moynihan's proposal to roll back scheduled payroll tax increases has initiated
debate about social security, broader tax policy issues, and on-budget versus off-budget
accounting. Much of the debate about payroll taxes and social security is driven by current
30
Shadow Open Market Committee
budget concerns, while the debate about on-budget versus off-budget accounting is simply
political maneuvering. The resulting confusion may prove counter-productive.
Social security was taken off-budget by the Balanced Budget Act of 1985; its
balances are included in the GRH deficit calculations, but its outlays are excluded from
sequestration. Both the Administration and CBO regularly display separately and
combined social security balances and the unified budget in the summary budget figures.
Recently, as a consequence of higher payroll taxes enacted as part of the Social Security
Amendments of 1977 and 1983, social security has been accumulating surpluses, and those
surpluses have been offsetting deficits in the unified budget Moreover, a sizable and
rising portion of projected surpluses in the 1990s are intergovernmental transfers of
interest. These social security surpluses are not "hiding" larger deficits in the unified
budget, except to those who have just observed the distinction for the first time. The
surpluses in the social security trust funds are obligated to future social security payments.
Nevertheless, social security balances are a convenient bookkeeping entry within the
federal budget and, in fact, reserves are "lent" to the general fund and spent for general
purposes. Despite the unique nature of social security, the total federal budget including
social security is the most important measure from the perspective of credit markets and the
national savings.
Whether social security balances are counted on-budget or fully split off from the
budget has little economic impact (A more constructive fiscal debate would involve the
budgeting treatment of direct federal loans and federally guaranteed private loans.) What is
important is the distributive and allocative effects within and across generations of social
security's tax and spending structures. The current debate is not addressing these issues.
Demographic fluctuations increase the complexity of designing a tax and benefit structure to
meet social security's objectives fairly and efficiently. Clearly, either rolling back
scheduled payroll tax increases or spending a portion of the mounting social security
surpluses raises the government's unfunded liabilities and imposes higher taxes on future
generations, or requires that future social security benefits be lowered Moreover, reduced
payroll taxes not offset by spending cuts or tax increases would temporarily raise the
consumption share of national output, while offsetting tax increases would have other
adverse economic consequences. Altering current payroll taxes to achieve a desired federal
budget outcome is short-sighted budget policy and may exacerbate structural problems in
the social security system.
Confusion about payroll taxes and social security has also created a flawed basis for
assessing the distribution of the tax burden, which misguides the fiscal debate. Recent
findings of increased regressivity of the tax burden stem entirely from the rising total tax
31
March 18-19,1990
share of payroll taxes. But since payroll taxes are part of the social insurance program,
their distributional characteristics must be considered in conjunction with the distribution of
social security benefits. For current retirees, social security's benefit and tax structure is
highly progressive, with benefits relative to lifetime payroll tax contributions inversely
related to a retiree's income. Moreover, because payroll taxes were so low prior to the
early 1970s, current retirees enjoy very high rates of return on their lifetime payroll tax
contributions, while current workers (particularly younger ones) will receive very low rates
of return. Rolling back payroll taxes now will only accentuate this intergenerational
redistribution of wealth, which would be unfair in terms of accepted standards of equity
and also drain the future capital stock.
Refocussing the Fiscal Debate
The single-minded obsession of economic policymakers with the budget deficit must be
tempered. The budget imbalance has already been reduced substantially, and further
improvement is projected. Moreover, fiscal policy is vastly more complex than just the size
of the deficit Policymakers must consider more carefully the relative benefits and costs of
different proposals to reduce the deficit in terms of the broader objectives of fiscal policy,
including the desired rate and mix of national output in the short and long-run, as well as
the objectives and economic impact of the spending and taxing structures underlying the
deficit. The allocation of national resources between the public and private sectors and
between consumption and investment must not be overshadowed by short-sighted attempts
to achieve the artificial GRH deficit targets.
Policymakers should reexamine the objectives of specific spending programs and
whether their current structures efficiently achieve those objectives. Social security, with
its flawed design and persistently rising real outlays is a good example. It is ironic that the
current fiscal debate attempts to use social security to "impose discipline" on the unified
budget, when in fact the opposite discipline would be more constructive. Unfortunately,
GRH excludes from sequestration social security and over half of all budget outlay
programs, and only reinforces certain misplaced fiscal values.
Economic responses to taxing and spending structures must not be ignored.
Attempts to reduce the deficit by raising taxes may not raise national saving if private
saving is discouraged, and will not improve U.S. competitiveness if it discourages
investment, raises private costs of production, or otherwise dampens productivity.
These important issues must not be neglected by policymakers as they jockey for
political advantage.
32
Shadow Open Market Committee
Table 1
SELECTED BUDGET PROJECTIONS
(Fiscal Years)
actual
1989
1990
1991
1992
1993
1994
Receipts
President's Budget
President's Baseline
CBO Baseline
CBO Est. of Pres. Budget
990.7
990.7
990.7
990.7
1073.5
1072.8
1067.0
1068.0
1170.2
1156.3
1137.0
1146.0
1246.4
1234.9
1204.0
1208.0
1327.6
1323.5
1277.0
1276.0
1408.6
1401.9
1355.0
1356.0
Outlays
President's Budget
President's Baseline
CBO Baseline
CBO Est. of Pres. Budget
1142.6
1142.6
1142.6
1142.6
1197.2
1194.8
1205.0
1226.0
1233.3
1241.0
1275.0
1277.0
1271.4
1290.4
1339.0
1292.0
1321.8
1343.6
1418.0
1355.0
1398.0
1394.0
1484.0
1404.0
Deficits
President's Budget
President's Baseline
CBO Baseline
CBO Est. of Pres. Budget
152.0
152.0
152.0
152.0
123.8
122.0
138.0
158.0
63.1
84.7
138.0
131.0
25.1
55.5
135.0
84.0
5.7*
20.1
141.0
79.0
Amended GRH Targets (1987)
136,0
100.0
64.0
28.0
0.0
Receipts, Z Change
President's Budget
CBO Baseline
9.0
9.0
8.4
7.7
9.0
6.6
6.5
5.9
6.5
6.1
6.1
6.1
Outlays, Z Change
President's Budget
CBO Baseline
7.4
7.4
4.8
5.5
3.0
5.8
3.1
5.0
4.0
5.9
5.8
4.7
As a Percentage of GNP:
Revenues
President's Budget
CBO Baseline
19.2
19.6
19.6
19.6
19.9
19.5
19.7
19.4
19.6
19.3
19.5
19.3
Outlays
President's Budget
CBO Baseline
22.2
22.1
21.8
22.0
20.9
21.7
20.1
21.5
19.5
21.2
19.4
20.8
Deficit
President's Budget
CBO Baseline
2.9
2.6
-2.3
-1.1
2.5
2.4
-.4
2.2
Publicly-held debt
President's Budget
CBO Baseline
42.5
42.5
41.9
42.6
40.0
42.4
37.7
42.0
* Surplus
33
10.7*
7.9
130.0
47.0
0.1*
0.1*
2.1
1.8
34.9
41.5
31.9
40.8
March 18-19,1990
Table 2
CBO, ADMINISTRATION, AND BLUE CHIP ECONOMIC PROJECTIONS
(Calendar Years 1989-1995)
EstimatedI
1989
Nominal GNP
(Billions of dollars)
CBO
Administration
Forecast
1990
1991
1992
Projec:ted
1994
1993
1995
5,236
5,236
5,534
5,583
5,893
6,002
6,279
6,439
6,688
6,881
7,121
7,324
7,579
7,771
Real GNP (Percentage
change, year-over-year)
CBO
Administration
Blue Chip
2.9
3.0
2.9
1.7
2.4
1.6
2.4
3.2
2.4
2.5
3.2
3.1
2.5
3.1
3.0
2.4
3.0
2.6
2.4
3.0
•2.5
Consumer Price Index
(Percentage change,
year-over-year)
CBO
Administration
Blue Chip
4.8
4.8
4.8
4.0
3.9
4.3
4.3
4.0
4.2
4.3
3.9
4.3
4.3
3.6
4.3
4.3
3.3
4.3
4.3
3.0
4.2
Implicit GNP Deflator
(Percentage change,
year-over-year)
CBO
Administration
Blue Chip
4.2
4.2
4.2
4.0
4.1
4.0
4.0
4.2
4.0
4.0
3.9
4.1
4.0
3.6
4.1
4.0
3.3
4.2
4.0
3.0
4.1
Three-Month Treasury
Bill Rate (Percent)
CBO
Administration
Blue Chip
8.1
8.1
8.1
6.9
6.7
7.3
7.2
5.4
7.3
6.9
5.3
6.9
6.5
5.0
7.0
6.1
4.7
6.9
5.8
4.4
6.8
Ten-Year Government
Mote Rate (Percent)
CBO
Adminls trat ion
Blue Chip
8.5
8.5
8.5
7.8
7.7
7.9
7.7
6.8
7.9
7.6
6.3
7.9
7.4
5.7
7.9
7.3
5.4
7.9
Inflation-Adjus t ed
Three-Month Treasury
Bill Rate
CBO
Adminls tration
Blue Chip
3.5
3.7
3.5
2.8
2.6
3.0
2.8
1.4
3.0
2.6
1.5
2.6
2.2
1.5
2.7
1.8
1.5
2.6
1.5
1.5
2.6
Soread Between Ten-Tear
Government Note and
Three-Month Treasury
Bill Rate
CBO
Adminls tratlon
Slue Chip
0.4
0.4
0.4
0.9
1.0
0.6
0.5
1.4
0.6
0.7
1.0
1.0
1.0
1.0
0.3
1.3
1.0
1.0
1.5
1.0
ii
.
7.5
6.0
7.8
SOURCES: Congressional Budget Office; Office of Management and Budget; Eggert Economic
Enterprises, Inc., Blue Chip Economics Indicators.
34
Shadow Open Market Committee
DISMAL LANDSCAPE
H. Erich Heinemann
Ladenburg, Thalmann & Co., Inc.
March 19,1990
At the ides of March, the economic landscape presents a dismal prospect Federal Reserve
actions have led to a substantial deceleration of monetary growth. As a result, aggregate
business activity stalled and may soon begin to decline. From August 1989 through
January 1990, total business sales — measured in constant 1982 dollars — dropped at an
annual rate of 6.2 percent
Profits of both financial and non-financial corporations have collapsed. According
to the Commerce Department, pretax profits of thefinancialsector (excluding the Federal
Reserve banks) were at an annual rate of $1-billion in the fourth quarter of 1989. That was
down 90.7 percent from the final three months of 1988. The Bureau of Labor Statistics1
index of profits per unit of real output earned by non-financial corporations declined at an
annual rate of 39 percent in the fourth quarter. It was 23.9 percent below the comparable
period a year earlier.
Consumer spending is stagnant. Real retail sales in February 1990 were slightly
lower than in November 1988. Merchants who chose to ignore the fundamental weakness
in the consumer sector are now in the bankruptcy courts. Industrial production has hardly
changed in the past year. Real construction activity — bothresidentialand nonresidential —
has been flat since 1986. Corporate cash flow, which finances business investment in
plant and equipment, has started to decline. It will drop more as profits slide to lower
levels. Capital spending will follow suit
Exports are mired in a deep rut Preliminary figures suggest that the merchandise
trade deficit increased substantially in January. The monthly trade deficit has averaged
$9.4-billion since May 1988. If our calculations are correct, the tradereporttomorrow will
show a deficit close to that average — sharply higher than the $7.2-billion recorded in
December. Over the last 21 months, the three-month moving average of the trade deficit
has been in a narrow range between $8.8-billion to $10.2-billion.
Recession in 1990
Weremainconvinced that a recession is on the docket for 1990. Recent data suggest that
the decline, when and if it develops, will be more severe than we forecast last year (see
Prospects, March 13,1989). Macroeconomic forces that would generate recovery are not
in sight. True, the Fed stopped draining reserves out of U.S. banks last July. Since then,
the money managers have replaced a modest amount of the funds they previously
35
March 18-19,1990
withdrew. Nonetheless, total reserves of depository institutions - the raw material for the
money supply - were lower in February 1990 than in April 1988.
On the bright side, tight money has improved the outlook for inflation. To be sure,
core inflation - year-over-year changes in the CPI less food and fuel - has remained
between 4 and 4.5 percent However, the sharp reduction in monetary growth has had,
and will continue to have, a cumulative, highly beneficial effect on price behavior. The
collapse in corporate profits is dramatic evidence of the fact that producers have been
unable to raise prices to offset rising costs.
Rep. Stephen Neal (D-NC) has introduced a resolution in the House of
Representatives that would direct the Federal Reserve to achieve zero inflation. Fed
policymakers support the resolution. Moreover, they are acting as though Congress had
passed the bill and the President had signed it. In reality, there's little or no chance that Mr.
NeaTs initiative will become law. In our view, the Fed has created unnecessary risks by
pretending that zero inflation was already the law of the land.
Battered Budget
The federal budget is likely to suffer substantially as economic growth falls short of the
optimistic scenario outlined by the Bush Administration. On the basis of the national
income accounts, the federal deficit — including the surplus in Social Security — was at an
annual rate of about $156.4-billion in the fourth quarter of 1989. Exclusive of Social
Security, the deficit was $222.6-billion. On both measures, the deficit was far, far away
from the fictional targets in the Gramm-Rudman-Hollings Balanced Budget legislation.
Tax receipts will weaken as the rate of growth in income slows. Expenditures will
rise as contracyclical income maintenance programs automatically kick into action. The GR-H program will likely be suspended. Rep. Daniel Rostenkowski (D-IL), the powerful
chairman of the House Ways and Means Committee, last week proposed a "cold turkey"
plan for balancing the budget that included repeal of G-R-H. Who knows, maybe
Congress will actually make some difficult fiscal policy decisions.
Many conservative analysts take comfort from the fact that both federal spending
and the federal deficit have declined substantially as a percent of GNP. Indeed, the socalled primary budget — which excludes net interest payments - is in substantial surplus.
However, portfolio managers should not get carried away with such an approach.
These are normal cyclical developments. Federal outlays always decline as a share
of GNP during a period of economic expansion, as does the federal deficit Similarly, the
primary budget almost always goes into surplus prior to a peak in the business cycle. The
one exception to this rule was in the 1950s. While the current business cycle represents the
36
Shadow Open Market Committee
longest peacetime expansion since World War n, the improvement in the federal budget has
been well below par, especially as a share of GNP.
Rosty's
Cold Turkey
Mr. RostenkowskTs plan to balance the federal budget is a straightforward package
of $255-billion in spending cuts from 1991 through 1995 and $195-billion of
miscellaneous tax increases. The Bush Administration, which may have played a
backstage role in drafting the plan, immediately accepted it as a basis of negotiation in the
ongoing budget debate. Mr. Bush said that he would continue to oppose new taxes.
However, definition of which taxes fall within the President's proscription and which do
not is increasingly a semantic game, rather than a matter of serious discussion.
Unfortunately, chances are slim that Congress will pass, or that the President
would accept, the plan. While Mr. Rostenkowski did not address, perhaps even consider,
many thorny issues in tax policy today, his package has the great advantage of eliminating
the deficit in only three years — as he put it, of going "cold turkey"fromred ink to black.
Clearly, a federal surplus would help reduce personal consumption and government
purchases, thusfreeinglabor and plant capacity for the production of investment goods and
exports. Long-run, that is just what the doctor ordered.
At the same time, there are other tax issues which portfolio managers should
monitor carefully. Most important, is the extraordinary increase in effective corporate tax
rates that occurred during the Reagan Administration. Combined federal, state and local
corporate income taxes now exceed 48 percent of pretax corporate income, the highest
since the Korean war.
From the viewpoint of a tax accountant, the data tend to overstate effective tax rates.
They include actual tax accruals, but they exclude corporate capital gainsfromincome. To
an economist, however, capital gains do not represent income in any meaningful sense.
Rather, a capital gain is simply the result of transferring an asset from one period to
another. This is why capital gains are excludedfromGNP.
Soak the Rich
As we see it, the increase in corporate tax rates in the 1980s has played an important role in
the sharp decline in net investment in the U.S. Until the 1980s, the focus of debate over
tax policy was over whether and how to reduce taxes on income from capital. Congress
financed expansion of government services by increasing taxes on labor income. The
combined Social Security tax rate has gone up about three percentage points per decade
during the postwar period.
37
March 18-19,1990
According to C Eugene Steuerle, a senior fellow at the Urban Institute in
Washington and a former senior tax strategist in the Reagan Administration, this is likely to
change in the 1990s. "I expect that considerable attention may soon be paid to the ways in
which workers are taxed under both the Social Security and the income tax." Since no one
knows who actually pays corporate taxes (consumers, workers or stockholders), Congress
may well be tempted to enact further hikes in effective corporate rates.
By contrast, we support the proposal by our colleagues on the Shadow Open
Market Committee to integrate corporate and individual income taxes. Taxes should be
paid once, by stockholders, not twice or three times as under the present system. Not only
would full integration eliminate double taxation of dividends, but interest and dividends
would be taxed equally. Corporations would have little incentive to sell debt and retire
equity. Full integration would also lower taxes on investment income and encourage
capital formation. Short of repealing the corporate income tax and replacing it with a
broad-based consumption tax, integration of corporate and personal taxes would be the
most important single step Congress could take to improve the competitive position of
America in the world economy.
False Signals
Meanwhile, portfolio managers have to guard against false economic signals generated by
mild winter weather. A variety of factors distorted the report that employment took a big
jump in February. Because of warm weather, construction, manufacturing, transportation
and retailing were all affected substantially.
Weather-related shutdowns have been rare this winter. However, this does not
suggest an improvement in the underlying trend. Rather, the economy has simply
borrowed from the future. Employment always goes down during the winter months.
Because of the mild winter, the drop was less than normal. Seasonally adjusted, that was
equivalent to a gain.
Employers laid off fewer workers than usual in January and February. Thus, they
will have fewer to rehire when the weather improves in March and April. Seasonally
adjusted, a subnormal hiring rate this month and next will translate into a decline in
employment
Contrasting Views
To understand the economy at present, you need to step backfroma mass of contradictory
data. For example, the Bureau of Labor Statistics publishes competing measures of the
labor market. In one version, the BLS counts the number of nonfarm payroll jobs. In the
38
Shadow Open Market Committee
other, the agency surveys a panel of roughly 60,000 households to determine the number
of people who have jobs. The household survey is the basis for the widely reported
figures on the unemployment rate.
Currently, the payroll series is the stronger. On this yardstick, seasonally adjusted
nonfarm employment increased by 700,000 in the past two months and by 1.7-million
since last June. According to the household survey, by contrast, nonfarm employment
went up only 280,000 since December, and by 550,000 since mid-year 1989. The BLS
did not actually count all the payroll jobs it reported. Rather, the agency simply assumed
that new businesses create about 80,000 jobs a month. No one knows whether that
assumption was correct
Of course, BLS statisticians adjust the employment data to take account of normal
seasonal variations. The actual job count declined by 1.5-million from December to
February, or roughly 1.5 percent If the weather had been normal this year (more snow
and a lot colder), employment would have dropped more than 2 percentage points.
Therefore, on a seasonally adjusted basis, the job market improved — notwithstanding
longer lines at unemployment offices.
That's not all. The payroll series showed that employment in "service producing
industries" accounted for 98.6 percent of the reported jump of 2.6-million jobs during the
year ended February 1990. However, the household survey reported that employment in
"service occupations" declined by 258,000 over the past year. The unemployment rate for
service workers was 6.8 percent in February, upfrom6.3 percent last year.
In a country as diverse as the U.S., no one knows for sure which of these
contrasting measures provided a better picture. However, the recent pattern was not
unusual. Reported gains in payroll employment normally exceed changes in total
employment at the end of a period of economic expansion. The big increases in payroll
jobs in the last few months may represent a warning the economy is about to go into
recession.
Even with a jump in auto employment last month, most manufacturers laid off
workers. According to the BLS, 76 of 141 industries reduced their employment in
February. Manufacturing industries cut jobs on balance during 10 of the last 11 months.
The BLS indicated that weakness in manufacturing jobs was "particularly apparent... in
six industries, including textiles, apparel, rubber and plastics."
39
March 18-19,1990
Take Heed
Mr. Greenspan should take heed of the weakness in corporate profits. On nine occasions
since World War n, profits declined as much as they have in the past year. In seven of
those nine episodes, the economy had either entered, or was about to enter a recession.
The White House has scouting parties out looking for Mr. Greenspan's scalp. In such an
environment, the Fed can ill afford to allow the slowdown in the economy to get out of
control.
40
Shadow Open Market Committee
FOREIGN EXCHANGE MARKET INTERVENTION
Anna J. SCHWARTZ
National Bureau of Economic Research
Congressional oversight of foreign currency purchases by the Federal Reserve and the
Exchange Stabilization Fund is long overdue. Congress should scrutinize the validity of
the legal grounds on the basis of which the Federal Reserve intervenes in the foreign
exchange market and provides warehousing facilities for the Treasury's foreign currencies.
What is the Federal Reserve's Legal Authority to Intervene?
Nothing in the Federal Reserve Act of 1913 and as amended authorizes foreign currency
operations by the Federal Reserve System. Section 14(e), which empowers the Federal
Reserve to maintain accounts with foreign correspondents, served as the legal justification
in January 1962 for approval by the Federal Open Market Committee of a program of
System foreign currency operations.
An opinion of the FOMCs General Counsel, concurred in by the General Counsel
of the Treasury and the Attorney General of the United States, found that the Federal
Reserve Banks under existing law were authorized to conduct such operations.
Two governors dissented. Governor Mitchell's dissent in part was based on the
need for prior "legislative clarification of the System's statutory authority to acquire, hold,
and sell foreign currency assets" (Annual Report, 1962, p. 56). Governor Robertson also
questioned the legality of the proposed operations. In addition, he noted the "express intent
of Congress to confer upon the Treasury's Exchange Stabilization Fund a limited authority
for operations to stabilize the exchange value of the dollar." He saw no need for two
separate agencies to be engaged in buying and selling foreign exchange.
Despite their dissent, at the FOMC meeting on February 13, 1962, the two
governors voted affirmatively for the implementation of the decision of the majority in
January to initiate "an experimental program of System foreign currency operations." The
experiment has been in effect for 28 years, with dubious consequences noted below.
Congress should hold hearings to determine if Fed intervention is in the national
interest Should it so determine, Congress should specify in legislation the circumstances
and amounts of permissible intervention, and appropriate the funds for intervention
operations.
41
March 18-19,1990
What is the Legal Authority for Warehousing?
Congress, in the Gold Reserve Act of 1934, gave the Treasury $2 billion to establish the
Exchange Stabilizazaton Fund to deal in gold, foreign exchange, securities, and other credit
instruments for the purpose of stabilizing the exchange value of the dollar. The original
capital was reduced by $L8 billion, which became the U.S. subscription to the IMF in
1946-47.
In March 1961, with the Federal Reserve Bank of New York as its agent, the
Treasury for the first time since the late 1930s entered into foreign exchange transactions
for monetary purposes.
The first warehousing for the ESF occurred in November 1963, when the FOMC
authorized spot purchases of $100 million of Italian lire, and other European currencies,
and their simultaneous forward sale to the Treasury to cover outstanding Treasury debt in
these currencies. The operation was also described as an experiment, to be reconsidered by
the FOMC as occasion warranted.
In January 1977, the FOMC agreed to a suggestion by the Treasury that the Federal
Reserve undertake warehousing of foreign currencies on occasions when the resources of
the ESF were inadequate. The amount was set at $1^ billion, with a proviso that the
FOMC at its organizational meeting each March would review the arrangement. In
December 1978, the FOMC extended warehousing to the Treasury's General fund as well
as the ESF. The Fed thus offered to lend its resources to the Treasury, bypassing
Congressional appropriations. In March 1980 the FOMC decided that it was prepared to
warehouse for the Treasury or for the ESF up to $5 billion of foreign currencies, with the
understanding that it would be subject to annual review. That understanding was observed
for some years, but no annual review has occurred since 1986.
The total of warehoused funds for the ESF as of October 31,1989, the latest report
date, was $7 billion, in excess of the ceiling established by the FOMC in 1980. Some
members of the FOMC have expressed concern at the extent of warehousing, and urged the
Treasury to seek Congressional approval of the amount currently on the books of the
Federal Reserve.
Congress should determine whether warehousing for the ESF is permissible and, if
so, whether it should be fully funded by the Treasury with the Fed acting only as the
Treasury's agent, or with funds specifically appropriated by Congress.
42
Shadow Open Market Committee
Recent Developments in Intervention
The Federal Reserve and the Treasury increased their foreign currency holdings in the
period from March 1989 until October 1989, the latest date on which the two authorities
reported, continuing the intervention operations in the foreign exchange market that we
noted in our last report
Of the combined total of $41.6 billion in foreign currencies owned by the
authorities in October, the Federal Reserve held $29 billion, an increase of $18.5 billion
since March. The Treasury's Exchange Stabilization Fund held $12.6 billion, an increase
of $2.8 billion over its March holdings.
Purchases of foreign currencies by the authorities since October 1989, according to
International Financial Statistics, raised the combined total to $45.2 billion in January
1990.
The two most important foreign currencies the U.S. authorities have purchased are
yen and D-marks. Despite these purchases, the dollar strengthened against the yen and was
roughly unchanged against the D-mark. The monetary authorities are engaged in a
speculation that yen and D-marks will appreciate in relation to the dollar. This gamble
contradicts the monetary policy objective that Federal Reserve officials have repeatedly
stated they seek, namely, achieving a zero inflation rate over afive-yearperiod.
It is not possible to say at this time whether the gamble has achieved gains on
foreign currency assets. The Federal Reserve and the Treasury report realized and
unrealized profits (losses). Profits are realized only when purchases have been sold at a
price higher than the currencies were bought. The Federal Reserve sold no foreign
currencies in the three quarters ending October 31,1989.
The unrealized portion of profits - the change in the cumulative valuation profit —
is clearly subject to the choice of end-of-period exchange rate valuation. An unrealized gain
reflects not only exchange rate change but also a change in the composition of the foreign
currency portfolio.
In the three quarters ending October 31,1989, the Federal Reserve reported one
quarter in which the change in unrealized gains was negative, two quarters in which the
change in unrealized gains was positive for a total of $361.7 million.
Federal Reserve publications report Treasury realized and unrealized profits for
quarterly dates covering months 2-4, 5-7, 8-10, and 11-1. For the first three of these
quarters through October 1989, the Treasury had realized profits of $196.9 million and
change in unrealized profits of $80.9 million. The ESF reports for calendar quarters. Its
latest report for nine months from October 1, 1988, to June 30, 1989, records a loss on
43
March 18-19,1990
foreign exchange of $510 million with no detail on the realized and unrealized components.
Who speaks for taxpayers when intervention risks losses?
Foreign currency purchases have changed the composition of the portfolio of the
Federal Reserve banks. The Federal Reserve sterilizes its official intervention, reducing its
open market operations in domestic assets to offset its acquisition of foreign currencies.
The monetary base therefore is unchangedfromwhat it would have been in the absence of
intervention. Sterilized intervention does not change the national money supply. Nonsterilized intervention is monetary policy based on open market operations in foreign rather
than domestic assets. It could just as well be conducted as domestic monetary policy.
In the seven months from March to October 1989, the monetary base grew by $4
billion. During that period domestic interest-bearing securities held in the System Open
Market account declined by $11.6 billion. Accordingly, net income of the Federal Reserve
Banks and the amount that they rebate to the Treasury has been reduced.
CORRECTION
The $500 million loss on its foreign exchange market intervention in 1988 reported by the
Federal Reserve was inaccurately described in our policy statement of September 18,1989.
The loss was a sum of a realized gain and an unrealized loss, not a realized loss only.
We withdraw our estimate of the loss sustained in its foreign exchange operations
by the Fed in the year ending July 1989. The estimate is not verifiable.
Contrary to the statement, the Exchange Stabilization Fund reports profit or loss in
the quarterly issues of the Treasury Bulletin.
44
Shadow Open Market Committee
THE GERMAN DEMOCRATIC REPUBLIC: ECONOMIC GOALS,
CONSTRAINTS AND MONETARY REFORM
William POOLE
Brown University
On 6 February, Chancellor Helmut Kohl of the Federal Republic of Germany (FRG)
proposed unification of the East and West German currencies. This proposal generated
immediate concern over the rate at which marks issued by the German Democratic Republic
(GDR) would be exchanged for Deutsche marks (DM) and the implications of the proposal
for inflation of goods prices quoted in DM. (Note that marks issued by the GDR are
sometimes called "ostmarks," or "OM.") Later, on 13 March, Chancellor Kohl announced
his intention to convert "small" personal holdings of OM by GDR residents to DM at a rate
of 1 DM for 1 OM. "Small" was left undefined and the conversion rate for the rest of OMdenominated assets was left for future decision.
To analyze these developments, we need to sort out a number of separate issues,
most of which are not monetary issues at all. Ill start with a list of essential points. To
avoid awkward terminology, I will use "GDR" to refer to the territory presently governed
by the GDR whether that territory continues to be governed separately or is governed as a
part of a single Germany.
(1)
The GDR has issued currency and other financial assets denominated in its
own currency. With monetary unification, there will be a wealth transfer
from the FRG to holders of OM-denominated assets. The net size of that
transfer will depend on the amount of the personal holdings of OM to be
converted at the one-for-one exchange rate, the amount of non-personal
holdings of OM, the exchange rate on the non-personal holdings, and on the
value of the assets the GDR turns over to the FRG in conjunction with the
currency unification. However, it is important to recognize that the
exchange rate used to convert OM assets to DM assets has no necessary
relation to the exchange rate used to convert goods prices from OM to DM
for goods presently priced in OM. To avoid confusion, it is best to confine
the term "exchange rate" to the rate or rates at which OM currency is
exchanged for DM currency. Exchange rate issues arise for all deposits and
other assets whose prices in terms of OM currency are fixed at 1.0. The
central point is to distinguish between the conversion of OM financial assets
to DMfinancialassets and the conversion of GDR goods and factor prices
45
March 18-19,1990
to DM, These are two entirely different issues. (More on this point in item
4 below.)
The exchange rate has no necessary implication for the effect of currency
unification on the size of the DM money stock. There is much unnecessary
confusion on this issue. The FRG can pay for some or all OM assets
converted to DM by issuing DM bonds either directly to holders of OM
assets or by selling bonds in the open market to absorb DM created in the
OM to DM exchange.
Pensions currently paid in OM have had a real value determined in part by
GDR subsidies for food and housing. The exchange rate for converting
OM currency to DM has no necessary implication on how pensions
presently paid by the GDR in OM will or should be converted to pensions
paid in DM.
As emphasized in item 2 above, currency unification has no necessary
implication for the DM prices of goods and factor services (especially
wages) currently stated in OM. Any attempt to convert prices of goods and
factor services from OM to DM through central direction can only cause
great difficulty. Prices in DM of GDR-produced goods and of factor
services in the GDR must be free to adjust if the GDR economy is to be
transformed to a market economy.
The cost to the FRG of merging the two Germanies will depend critically on
whether the FRG continues its policy of making its social welfare benefits
available to those who migrate from the GDR to the FRG. ("Merging," by
the way, is a nice, neutral word that avoids the overtones and undertones of
using "unification" versus "reunification" or vice versa.) If social welfare
benefits remain available to GDR residents who migrate to the FRG, then
there is no easy way to calculate the total cost to the FRG of converting
GDR pensions and other benefits to DM at various rates. For example, if
the conversion rate is low, so that benefits in the GDR are low, some people
will simply move to the FRG and collect high FRG benefits. The total cost
will then depend both on the DM value of benefits for GDR residents and
on the number of GDR residents who migrate to the FRG. The cost to the
FRG will also depend greatly on the disposition of property owned by the
GDR government It may make sense, for example, for the GDR to give
the housing stock to current residents, or sell the housing stock to residents
at low prices, and eliminate all housing subsidies at the same time.
46
Shadow Open Market Committee
(6)
The sharp increase in bond yields in the FRG in recent months, and
especially since late January, probably reflects a mixture of higher inflation
expectations and a higher expected real rate of interest It is not implausible
to believe that the higher nominal rate reflects higher inflation expectations
and a higher real rate in roughly equal measure.
In the body of this memo Til take up these points, although not precisely in the
order listed above.
The Politics of Wealth Transfers
As is so often the case with political issues, much of the discussion within the FRG and
GDR concerning their merger involves issues of wealth transfers. Residents of the GDR
quite naturally want to keep what they have, or think they have, and if at all possible to get
more. Residents of the FRG quite naturally want to limit the size of their wealth transfer to
GDR residents.
According to a recent article in The New York Times; personal savings accounts in
OM in the GDR are worth about $100 billion when converted to DM one-for-one and given
the recent DM/$ exchange rate.1 That works out to about $6,300 per capita for GDR
residents or 1/2 to 2/3 of average annual income in the GDR. However, $6,300 per capita
is a gross figure; we do not yet know what assets the GDR will be turning over to the FRG
as part of currency unification. A factor increasing the size of the transfer is that businesses
now have an incentive to minimize their OM holdings and individuals may have an
incentive to accumulate more. A recent article in The Wall Street Journal indicates that the
exchange will be limited to "small savers," which presumably means that there will be a
limit to the amount an individual can exchange at the one-for-one rate.2 Chancellor Kohl
has not been explicit enough about the currency exchange plan to know how the incentive
for OM transfers from businesses to individuals might be affected. We do not know what
the cap on exchanges at the one-for-one rate will be or what rate will be applied to holdings
beyond the cap. The FRG may attempt to limit exchanges to holdings as of a particular
date. Nor is it clear whether GDR residents who have migrated to the FRG retain title to
their OM savings accounts. As with all multiple exchange rate schemes, there is a powerful
incentive for individuals and enterprises to restructure balance sheets to maximize OM
assets subject to exchange at a high DM rate.
1
Ferdinand Protzman, "Bonn Sets Mark Rate on Savings," March 14,1990, p. D l .
"Kohl Backs Rate of 1 to 1 for Some Mark Conversions," The Wall Street Journal, 14 March 1990, p.
A15.
2
47
March 18-19,1990
Issues concerning conversion of OM assets to DM are one-shot in nature. A far
larger issue concerns pensions, health benefits, and the like presently received by GDR
residents. The present value of continuing these programs with unchanged real value is
very large. We should not consider these programs to be "commitments" or "obligations;"
there will have to be a negotiation over their future scale. It makes no sense to think about
converting benefits presently denominated in OM to DM at some exchange rate chosen for
converting existing financial assets. This issue of converting benefits, especially pension
benefits, is complicated by the large subsidies for food and housing in the GDR. These
subsides will have to be eliminated. I will argue below that elimination of these subsidies
is not really a policy issue because the GDR, whether merged with the FRG or not, does
not have a genuine choice now that borders are open.
Finally, decisions on how to convert on-going benefits should take account of the
fact that people can migratefromthe GDR to the FRG. As a matter of economics, it would
have been possible to wipe out therealvalue of OM financial assets by selecting a low DM
conversion rate, and there would not have been anything GDRresidentscould do about it;
their only recourse would have been through electoral processes. The issue with on-going
future benefits is quite different because GDRresidentscan move to the FRG. Til take up
the important migration issue later.
The FRG has an election scheduled for December, and it is possible that the merger
will take place quickly enough that GDRresidentswill vote in that election. The decision
may depend in part on the outcome of the GDR election on 18 March. (This date was no
doubt chosen to coincide with the SOMC meeting and to make this memo more difficult to
write!) Even if the merger occurs after December, there does not seem to be much doubt
that the event will occur within a few years. Political parties in the FRG are quite naturally
positioning themselves to bid for votes in the GDR; this maneuvering, of course, had
something to do with the timing of Chancellor Kohl's announcement of a one-for-one
exchange rate. Much press commentary has argued that GDR voters are more likely to vote
Social Democratic than Christian Democratic, and the conclusion of this analysis seems to
be that the present FRG government is being pulled to the left, toward generous social
welfare benefits for GDR residents. I am surprised that there is so little attention being
paid, at least in the U.S press, to pressures working in the opposite direction. When FRG
residents become fully aware of the large cost of converting OM assets to DM and of
making FRG social welfare benefits available to GDRresidents,it is surely inevitable that
policies involving these large wealth transfers will lose some votes in the FRG. I have no
idea how all this will work out, but am merely expressing mild surprise that the argument
so far seems all one way.
48
Shadow Open Market Committee
Constraints — Migration and Arbitrage
Perhaps the most difficult part of the wealth transfer issue concerns the fact that it is not
feasible for the FRG to deny benefits to GDR residents and at the same time make benefits
available to all FRG residents including migrants from the GDR. The border is open. The
only way to maintain lower benefit levels for present GDR residents is to base benefits not
on current place of residence but on place of residence as of, say, November 1989 when
the Wall opened, or as of some other date. Whether such a policy is politically and
administratively feasible I do not know, but it is clear that with an open border it is
impossible to sustain a policy of large differences in benefits based on current place of
residence.
Relative living standards in the GDR and FRG provide an indication of the
incentive for migration from the former to the latter. The table at the top of the next page
compares several consumption indicators for the two areas. Aggregate income statistics
suggest that per capita income in the FRG is perhaps twice that of the GDR. The
consumption indicators in the table do not allow for the quality differences. As an aside,
we can see that the GDR government was very interested in communicating with
households, as shown by the high fraction of households with TV sets, but not interested
in having households communicate with each other, as shown by the small number of
telephones.
Migration from the GDR to the FRG has been running at about 2,000 people per
day, both before and after the demise of the GDR's communist government At this rate,
the country will be entirely depopulated in 22 years. We can be sure, of course, that this
outcome will not come to pass, but the key to understanding the situation is to figure out
what will keep people in the GDR. Merger of the two Germanies will not automatically
solve the problem. The migration from the GDR to the FRG is a type of arbitrage. It
seems safe to assume a continuing absence of political and physical barriers to this
migration; a communist GDR could not keep its people in and it seems unlikely that the
FRG would now erect physical barriers to try to keep these people out However, because
the migration is causing significant strains in the FRG - housing is short and there are not
enough jobs at the moment for all the migrants — the FRG may well reduce or eliminate
various benefits for migrants from the GDR. Withregardto social welfare benefits, the
issue is the incentive to migrate; this issue has nothing to do with the rate at which GDR
benefits in OM are converted to DM per se but rather with the purchasing power of benefits
in the GDR relative to those in the FRG. Even if existing GDR benefits were to be
converted to DM at a rate of 1 OM = 1 DM, GDR benefits would be low compared with
FRG benefits. We should not focus on the conversion rate but rather on therelativelevels
49
March 18-19,1990
Consumption Indicators, 1988
German Democratic Republic and Federal Republic of Germany
GDR
FRG
Motor car
J2_
-22.
Freezer
_42_
JL
Television
_26_
M.
Color television
_52_
_9A
Percentage of Households owning:
7(1985^
Telephone
Monthlv rent (two bedroom apartment
75M
Average living space per person
(square meters)
.,
ZL
M.
411 DM
-26.
Source: The Institute of International Finance, Inc., based on official FRG and GDR
statistics.
of benefits in real terms and whether all residents of the FRG, including migrants whenever
they might arrive, are eligible for FRG benefits.
Eliminating FRG government subsidies for migration will not eliminate the
migration incentive for skilled people who have good employment opportunities in the
West An individual's standard of living in the GDR must approach the standard available
to that same individual in the FRG or that person will move. Of course, migration
decisions depend on more than a narrow comparison of income levels. People are often
willing to remain in their home towns with friends and familiar surroundings even though a
higher salary beckons elsewhere. Young people, though, are more footloose. The GDR
cannot retain population in the long run by appealing only to old people. Individuals who
might migrate must see living conditions, or expected future living conditions, in the GDR
approach those in the FRG; differences comparable to those across various regions of the
FRG might well remain, but these differences are small compared to the present gap in
conditions between the two Germanies. As policies are announced it will be important to
see how they affect expectations about the future.
50
Shadow Open Market Committee
The incentive to migrate is an important constraint on what policies the GDR, the
FRG, or a merged entity can adopt The longer the migration incentive issue is unresolved,
the longer the migration will last and the larger it will be. There is no point in discussing
what is "fair" and what is not; the simple fact is that people will move, like it or not, as long
as the FRG maintains a policy that permits migrants to receive generous social welfare
benefits. In short, migration is forcing quick decisions on merger of the two countries; a
gradual step-by-step process spread over a period of years cannot work.
The principle of arbitrage is also the basis for understanding some of the price
reform issues facing the two Germanies. As shown in the table, at a conversion rate of 1
M = 1 DM, housing is much cheaper in the GDR than in the FRG. The same is true of
food. The GDR provides heavy subsidies for these goods. The subsidies will have to go,
and go fast Residents of both the FRG and Poland are crossing borders to buy food in the
GDR. Others are working in the FRG while living in the GDR to take advantage of low
rents. These arbitrage activities increase the total subsidy burden in the GDR and
simultaneously reduce the tax base to support them.
It is important to recognize that migration and trade issues are especially closed
linked for the FRG and GDR. There has been some talk of maintaining an "administrative
border" between the two areas even after merger.3 Part of the motivation for such a border
could be protectionist - to control sales of GDR output in EEC countries. There is no
question that integrating the GDR economy into the EEC will upset some established trade
relations, but protectionist policies would be very short-sighted. Those residents of the
GDR who are potentially productive need the promise of rapid gains in income or they will
move to the FRG to realize their potential. Rapid economic development in the GDR will
not depress the EEC as a whole, but resources will have to be reallocated from EEC
industries competing with GDR industries with a comparative advantage to other EEC
industries supplying capital and other goods in which the GDR has a comparative
disadvantage.
Monetary Issues
The official exchange rate of one-to-one clearly overvalues the OM. According to The New
York Times article cited earlier (note 1), the free market rate was about 20 OM to 1 DM
shortly after the Wall opened in November. More recently, the rate has been about 4 OM to
1 DM on speculation on the rate the FRG would select for the currency unification. Now
5
See Steven Prokesch, "Economic Border Urged Even After German Unity," The New York Times, March
14, 1990, p. A19.
51
March 18-19,1990
that the FRG has decided on a one-for-one exchange for some balances it will be important
to complete the currency unification promptly. "Promptly" literally means next week or the
week after. Speculation on the exchange rates to be used in the currency unification is
likely to cause volatile fluctuations in the free market rate between the two currencies.
Moreover, at this point, the GDR can finance anything it pleases, including food and
housing subsidies, bonuses to workers and government officials, etc., by printing OM.
The OM rate against the DM will be maintained at some level or other by speculation on the
ultimate exchange rate. It is an untenable situation for the Bundesbank and for the FRG as
a whole for the GDR to be able to increase the amount of the ultimate wealth transfer by
printing OM without constraint.
Discussion of a one-for-one exchange touched off inflation fears when Chancellor
Kohl first proposed currency unification in early February, and these fears surfaced anew
when Kohl announced that the one-for-one rate had been decided. Some have argued that
the DM money stock would rise substantially with such an exchange. I have already
pointed out that there is no necessary connection between the exchange rate and the size of
the increase in the DM money stock. What is true is that there will be an increase in the
demand for DM when that currency becomes generally used in the GDR. It will be difficult
to predict the size of the increase in the demand for DM and so difficult for the Bundesbank
to estimate the proper size of the DM money stock after monetary unification.
It is also true that the FRG may be led, one way or another, to pay for some of the
wealth transfer through inflation. Voters in the FRG may find the increases in real interest
rates flowing from the wealth transfer so large that they apply political pressure on the
Bundesbank to inflate in an effort to hold rates down. What this means, though, is that we
should not form our views on the likely rate of inflation by making a mechanical calculation
from the amount of OM to be converted to DM but instead analyze the size of the wealth
transfer and its likely effects on real interest rates. As I have pointed out earlier, the
conversion of financial assets is only a part of the total wealth transfer, and probably not
the largest part
52
Shadow Open Market Committee
As can be seen in Figure 1 on page 54, in recent months interest rates have
increased very substantially in the FRG, especially since 6 February when Chancellor Kohl
broached the idea of monetary unification.4 As the figure also shows, Frankfurt stock
prices (Commerzbank total share price index) have not fluctuated in a particularly
pronounced fashion or direction. Nor has the DM behaved especially unusually on the
foreign exchange markets. The DM appreciated from last summer to the beginning of this
year — the DM price of the U.S. dollar and the yen fell — but the appreciation is
unremarkable. In fact, over the most interesting period since early February when FRG
bond yields rose very sharply, the exchange rate has been about unchanged and share
prices have not shown any particular direction.
I have relied on my general feel for what is an "unusual" change in one of these
series, but to check my intuition I constructed Figure 2 (page 55) showing the monthly
bond yield since 1985. 5 The increase in FRG bond yields since last summer really is quite
substantial given the recent history of this series.
We have a puzzle, then, in that German bond yields have risen sharply while share
prices and exchange rate have not moved all that much. It is important, I think, to look for
unusual changes in economic series in a situation such as this one; we do not want to fall
into the trap of over-interpreting changes that are actually reasonably normal.
If the increase in the bond yield were caused primarily by an increase in inflation
expectations, then the DM should have depreciated substantially. Share prices might also
have weakened in these circumstances. But the DM appreciated from the summer to late
January, and remained about unchanged over February. The inflation expectations
interpretation of higher bond yields does not fit the data.
4
The data in Figures 1 and 2 are drawn from die data bank maintained by Data Resources, Inc., and I want
to thank DRI for providing me with access to the data. Commerzbank is die original source for the daily
data in Figure 1. The exchange rates reflect Frankfurt trading as of 11:00 a.m. Frankfurt time; the bond
yield is the 10-year constant maturity yield on German Government bonds; the share price index is the
Commerzbank total index (31 December 1953 * 100). The Bundesbank and the Federal Reserve arc the
original sources for the monthly data in Figure 2; the FRG series is the average yield on Federal bonds, 10year constant maturity, and the U.S. series is the average yield on Treasuries, 10-year constant maturity.
The February observation for die FRG series was not available as of this writing; I have estimated it by
adding to the January observation the increase from January to February in the monthly average of the daily
Commerzbank bond yield series.
5
For reasons I do not understand, the monthly FRG bond yield series in Figure 2 differs from the daily
series in Figure 1, and so the levels do not match properly; however, I assume that the two bond yield
series must have very similar fluctuations even if their levels differ.
53
FIGURE 1
FEDERAL REPUBLIC OF GERMANY
FINANCIAL MARKETS, DAILY, 3 JULY 1989 --16 MARCH 1990
Exchange rate
6 Feb --^
Share price index
2400
2200
1.8 UExch. rate: DM per dollar (left scale
1.6
••••
•_•••'
Share price index (right scale) :
2000
Percent
9
1.4 h
8
Exch. rate: DM per 100 yen (left scale)
1.2
H 7
10-year bond yield (right scale)
llltMllllllMMIlllllliniMlllinilUlllllllUllllMIMIIlllllllMlllllllllllllnnUllllHHIIIIlllllllllllllllllllllllMlllllllllllllllllllllllllllllll
Source: Data Resources, Inc.
inliiiiiiiiiliimiiiiliiii
6
FIGURE 2
FEDERAL REPUBLIC OF GERMANY AND UNITED STATES
10-YEAR BOND RATES, MONTHLY, JAN. 1985 TO FEB. 1990
Percent
12
11
10
9
8
6
I l I l l I I I l t 1 I I I t I I l I I I I l I I l l l I I I t t l I ,l I I l I l l I t l 1 I I I l I I I t I I l I l l I I
1985:1
1985:7
1986:1
Source: Data Resources, Inc.
1986:7
1987:1
1987:7
1988:1
1988:7
1989:1
1989:7
1990:1
March 18-19,1990
If the increase in the bond yield were caused primarily by an increase in the
expectedrealrate ofreturn,then the DM should have appreciated substantially, and perhaps
we might have expected share prices to rise. (The implications for share prices are actually
rather complicated.) The DM did appreciate somewhat from the summer to February, but
changed little during February when bond yields rose especially sharply.
A hypothesis consistent with these observations is that inflation expectations and
the expected real rate of interest have both gone up, contributing about equally to the
increase in the nominal bond yield. This hypothesis is consistent with the modest increase
in bond yields in the United States in recent months, which might reasonably be interpreted
asreflectingan increase in the expected real rate of interest for the world as a whole. Given
that international capital markets are highly integrated, changes in therealrate of interest in
Eastern Europe could not be confined to that area, or simply to Europe as a whole.
If this interpretation is correct, an interesting implication is that the financial markets
expect that there really will be significant investment opportunities in Eastern Europe. This
view is consistent with the numerous reports of negotiations on joint ventures between
Eastern Europe and western firms. There would be no reason for yields to rise in the
world's capital markets if investors thought very little capital would be flowing to Eastern
Europe.
Therealsignificance of monetary unification in Germany is that monetary and fiscal
conditions will be important determinants of flows of labor and capital into or out of the
GDR and other Eastern European countries as well. The GDR has a tremendous advantage
over the other countries in this respect The DM is one of the world's most trusted
currencies. When the GDR converts to the DM, capital can flow without fear of gross
monetary instability. Moreover, once the government of the GDR has lost the power to
print money, it will be forced to put its fiscal affairs in order. The GDR will have to cut its
subsidies to cut total expenditures and will have a powerful incentive to sell property to
gain revenues. These privatization steps need to be taken in any event, but experience
suggests that those with vested interests in subsidies and state ownership will resist
privatization, covering government expenditures by printing money if need be.
Goals and Policies
Dispassionate recognition of constraints can be important in setting sensible goals.
Assuming that Eastern European countries do indeed want to become as prosperous as
Western European countries, they will have to adjust their convictions on the benefits of
socialism to the constraints they face. To retain skilled people who have opportunities to
migrate, the countries of Eastern Europe simply must permit these people to realize
56
Shadow Open Market Committee
earnings approaching those in the West After-tax earnings comparable to those in the
West should be permitted but not subsidized in the private sector; those enjoying the
earnings must actually earn them and accept the private sector risks that go with high
salaries. To attract capital, these countries must establish conditions conducive to private
capital flows from the West Whatever views these countries may have on issues such as
income distribution and pricing of necessities, they must face the constraints imposed by
conditions in the prosperous economies of the West
One of the most interesting things to watch will be the skill of political leadership in
Eastern Europe in making capitalist rewards palatable. People in these countries were
pleased to be rid of totalitarian governments, but many still retain allegiance to socialist
goals concerning income distribution and state ownership of the means of production.
Economic growth will depend importantly on how Eastern European countries adapt to the
competitive world environment within which they are constrained to operate.
When talking of economic goals it is important to remember that people have
different goals that often conflict with one another. Of special importance in the present
context is the fact that existing bureaucracies have strong vested interests in state
ownership. Maintaining state ownership of most enterprises is simply incompatible with
rapid economic development
There is considerable discussion of the need for Western governments to make
large development grants to help Eastern European countries transform their economies to
market systems. The United States and Western Europe obviously have a very substantial
stake in the success of Eastern Europe. Moreover, there are genuine and deep charitable
instincts in the West; we want Eastern Europe and the U.S.S JR. to succeed for the sake of
the residents of these countries and not just for our own sake.
In my opinion, it is important for Western governments to go slow in providing
aid. Eastern European countries cannot be successful unless they adopt market systems
open to private investment from their own citizens and from the West The danger in
government-to-government aid is that such aid will support efforts by these countries to
pursue some "middle way" that does not in fact provide sufficient private ownership and
incentives. As I noted above, there are powerful vested interests in state ownership and
subsidies. Western governments should not, in my view, provide any unrestricted aid
whatsoever, but only aid for particular infrastructure projects such as highways and
airports. We should do nothing that provides any material resources that might be used to
sustain state subsidies and state ownership of productive facilities, except for
infrastructure. Even infrastructure aid should be conditional on the recipient country being
open to foreign investment on a competitive basis. We do not want to encourage or
57
March 18-19,1990
sanction exclusive arrangements with foreign firms that permit them to monopolize local
markets.
This discussion has emphasized constraints, but that is not the proper concluding
note. Theopportunities in Eastern Europe are tremendous. The populations are literate and
generally skilled. With proper economic organization ~ a market system — these
economies can produce far more than they are now producing. This is the "freedom
dividend;" it is far larger than the peace dividend available to the West With the end of the
Cold War Western economies might be able to spend 2-3 percent of GNP less on arms,
and so have that much more to improve standards of living. In Eastern Europe, production
increases of 10-20 percent or more are possible within a few years. There is ample bounty
to be shared by domestic populations and foreign investors alike.
58
@FedFRASER