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SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers
March 11-12, 1984
PPS-84-1
CENTER FOR
RESEARCH IN
GOVERNMENT
POLICY
& BUSINESS
Graduate School of Management
University of Rochester
SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers
March 11-12, 198*
PPS-84-1
Shadow Open Market Committee Members - March 1984
SOMC Policy Statement, March 12, 1984
Position Papers prepared for the March 1984 meeting:
Deficits, Interest Rates and Monetary Policy, Karl Brunner, University of
Rochester
Base Velocity - The Trend Continues, Allan H. Meltzer, Carnegie-Mellon
University
Trade Restrictions Imposed in 1983, Jan Tumlir, University of California at
Los Angeles
Monetary Policy Options and the Outlook — 1984, Jerry L. Jordan,
University of New Mexico
Economic Projections, Burton Zwick, Prudential Insurance Company of
America
Recent Behavior of the M, - Adjusted Monetary Base Multiplier and Forecasts for Early 1984, James M. Johannes and Robert H. Rasche,
Michigan State University
Budget Deficits and the Disarray of Fiscal Policy, Mickey D. Levy, Fidelity
Bank
Shadow Open Market Committee
The Committee met from 2:00 p.m. to 7:30 p.m. on Sunday, March 11,
1984.
Members of SOMC:
PROFESSOR KARL BRUNNER, Director of the Center for Research in Government Policy and Business, Graduate School of Management, University of
Rochester, Rochester, New York.
PROFESSOR ALLAN H. MELTZER, Graduate School of Industrial
Administration, Carnegie-Mellon University, Pittsburgh, Pennsylvania.
PROFESSOR JERRY L. JORDAN, Anderson Schools of Management, University
of New Mexico, Albuquerque, New Mexico.
DR.
MICKEY D. LEVY, Chief
Pennsylvania.
Economist,
Fidelity
Bank,
Philadelphia,
PROFESSOR ROBERT H. RASCHE, Department of Economics, Michigan State
University, East Lansing, Michigan.
DR. ANNA J. SCHWARTZ, National Bureau of Economic Research, New York,
New York.
DR. BERYL SPRINKEL, Executive Vice President and Economist, Harris Trust
and Savings Bank, Chicago, Illinois.*
DR. JAN TUMLIR, Visiting Professor, University of California, Los Angeles.**
DR. BURTON ZWICK, Vice President, Economic Research, Prudential Insurance
Company of America, Newark, New Jersey.
*On Leave from the SOMC; currently Under Secretary of the Treasury for
Monetary Affairs.
**On leave from GATT, Geneva, Switzerland.
Policy Statement
Shadow Open Market Committee
March 12, 1984
Press attention concentrates on the Federal budget deficit and propagates
the mistaken belief that a smaller budget deficit is the key to lasting prosperity,
stable growth and low inflation. Spokesmen for the Federal Reserve and some
members of the Administration encourage this view. By concentrating on the
budget deficit, they draw attention from Administration and Federal Reserve
failures to implement policies that enhance price stability, efficiency and
growth.
Most concerns about the deficit are misdirected. There is no careful study
showing a direct connection between actual or expected budget deficits and
market interest rates.
No standard economic theory, Keynesian or nonKeynesian, predicts any direct effect of the deficit on market interest rates.
The size and composition of government spending, as well as the method of
financing it, affect the allocation of real resources, the rate of real growth over
time, and interest rates. Furthermore, despite repeated claims by some public
officials, neither theory nor empirical evidence supports the view that the
current deficit has been a principal cause of the appreciation of the dollar in
recent years. Typically, large budget deficits are the companions of weak, not
strong, currencies. Government fiscal policies affect economic decisions in four
ways. The financing of federal spending that agitates the financial markets is
perhaps the least important influence.
Effects on incentives have been
emphasized by supply side advocates. In addition to these much discussed
effects, fiscal policies change and alter the allocation of resources between
consumption and investment and redistribute income.
Public officials, including economists in public office, present inaccurate
and misleading measures of the deficit. Their statements concentrate on these
inaccurate measures, and ignore more relevant measures. They wrongly suggest
that the economy would benefit from higher taxes that lower the deficit.
Furthermore, their statements ignore more important effects of fiscal policy on
the composition of total spending and on money growth.
5
6
Money Growth and Inflation
Current monetary actions are short-sighted and irresponsible. They
increase inflation but have minor effects on the financing of the budget deficit.
Actual budget outlays must be financed by taxing, borrowing and issuing base
money. The principal effect of the budget on inflation, in the current U.S.
economy, can be avoided. An independent central bank is intended to limit
political pressure to finance government spending by issuing money.
Unfortunately, the Federal Reserve has failed repeatedly to conduct a
responsible, non-inflationary monetary policy, and it is failing again. Frequent
statements affirming the Federal Reserve's commitment to reduce inflation will
once again prove to be meaningless unless the Federal Reserve controls money
growth. Recently the Federal Reserve relinquished control of money growth. It
is repeating the major mistake of the seventies ~ holding the interest rate on
bank reserves (Federal funds) in a narrow range. Under current, Federal Reserve
operating procedures, actual monetary growth is a function of changes in market
credit demand. Such an approach is inherently procyclical.
Under the policy of interest rate control, the Federal Reserve issues money
and finances more of the deficit than planned whenever aggregate demand is
above the Federal Reserve's forecast. All changes in aggregate demand are
allowed to change money grwoth. The result is an erratic, unplanned rate of
money growth that is consistent with the Federal Reserve's announced targets
only by chance.
Erratic money growth, in turn, influences future spending with a lag. Chart
1 shows that, for the past three years, quarterly accelerations and decelerations
of the monetary base have been followed within one quarter by accelerations and
decelerations in nominal spending, or GNP. Each of the eight turns in money
growth was followed within a quarter by a similar turn in GNP growth. There is
no reason to expect GNP growth to follow base growth within a quarter, but, as
Chart 1 shows, the pattern continues.
There is; no easy way to correct the problems that present monetary
procedures and lack of policy impose on the economy. Continuation of the
recent rate of growth would take inflation back to the average levels of the
seventies. This in turn would inevitably elicit calls for a shift to an antiinflationary policy. If there were a sudden lurch to lower money growth late in
the year, another recession will follow. The prospects of another period of
stagflation are increasing.
CHART I
/I
18
Monetary VariablUly
•nd GNP Fluctuations
U>
/
Crawl* of Maa*l«y • • »
In O m c M Quattct
Gio«lk*(CNP
Out QWMICI I j t e f
8
For many years, we have advocated steady, gradual, pre-announced
reductions in money growth. Ten years of experience has convinced us that this
policy cannot be made to work under current practices. The Federal Reserve is
not held accountable for its repeated failures to carry out the disinflationary
policies it announces. Further, delay in lowering money growth accepts the
return to higher inflation implicit in current and recent money growth.
Last September, the SOMC warned that more than 6 to 7 percent inflation
in 198* was highly probable if high money growth continued. We urged the
Federal Reserve to keep the rate of growth of the monetary base ~ currency and
total reserves — at 6 percent in the year ending fourth quarter 198*. Instead,
the annual growth rate has exceeded 9 percent, far above our recommendation
and much higher than is consistent with the Federal Reserve's frequent statements about the importance of reducing inflation. The difference between the
SOMC recommended monetary growth and the recent 9 percent annual growth
rate of the base is a trivial $6 billion reduction in the Federal government's net
borrowing requirement in calendar 198*. The cost of this minor one-year
reduction in net borrowing would be a sharp increase in inflation that sets the
stage for another round of stop-go, and another recession.
The alternative is to return monetary base growth to 6 percent this year.
This is the path consistent with the Federal Reserve's target and our September
recommendation. We urge, but do not expect, the Federal Reserve to implement
this policy promptly to avoid the resurgence of inflation and another prolonged
recession.
Measuring Fiscal Policy
Reported or projected deficits of $200 billion give a misleading impression
of the current fiscal problem. Such projections do not accurately measure the
real burden of current fiscal policy on the public. Once the estimates are
corrected, the main source of the fiscal problem becomes clearer. Corrections
and adjustments are shown in the accompanying table.
Column (1) reproduces estimates by the Congressional Budget Office (CBO)
of the 1983 deficit and their projections for 198* to 1986. These estimates
include the effects of the last recession and the incomplete recovery. It is
widely recognized that cyclical increases in the deficit diminish as the economy
Current and Projected Deficits
1983-1986 (in billions)
Unified
budget
deficit
Structural
deficit
Inflation
tax*
State and
local
surplus
Current
payment
due on
unfunded
liability
(6)
Corrected
deficit
(4)
Adjusted
public
sector
borrowing
requirement
(5)
Year
(1)
(2)
(3)
1983
1984
198S
1986
$-195
-190
-195
-217
$-85
-114
-136
-167
$54
67
74
82
$51.0
51.0
51.0
51.0
$+20
+12
-11
-34
$-224
-238
-252
-267
$-204
-226
-263
-301
(7)
- denotes deficit; + denotes surplus.
Sources:
Cols. (1) (2) and (3) Congressional Budget Office. CBO, The Economic Outlook, A Report to the Senate and
House Committees on the Budget, Tables III.l & III.2 p. 63-64. CBO estimates Table B.l Col. 2 & Col. 3 p. 110.
Col. (4) 1983, Council of Economic Advisers; 1984-6 our projection
Col. (5) = Col. (2) less (col.) 3 and (col.) 4
Col. (6) 1983, Unfunded liability from Grace commission; 1984 to 1986, assumes growth at CBO's estimated
growth of social security payments (5.8%); Current payment is 8% of oustanding liability column (6).
Col. (7) sum of cols. (5) and (6).
* In principle the capital loss in outstanding gov't debt.
10
recovers.
The so-called "structural deficit" remains after these cyclical
influences are removed. Estimates of the structural deficit depend on the
computation one chooses, but that is true of all projected deficits. Column (2)
uses estimates produced by CBO.
During periods of inflation the purchasing power of wealth invested in
government bonds shrinks with the rate of inflation. The government collects an
inflation tax from bondholders.
Part of the interest payment made to
bondholders compensates them for their anticipated loss of wealth. If this part
of the government's interest bill is counted as spending, it should also be counted
as a tax and not included in the deficit. Column (3) is the CBO's estimate of the
inflation tax on outstanding debt that should be subtracted from the deficit.
Most countries report the consolidated public sector borrowing
requirement. This is the amount that the total government sector must finance.
Column (5) reports this sum after adjusting for the inflation tax, in column (3),
and the combined state and local government surplus, shown in column (4).
Column (5) shows that most of the reported deficit for the next 3 years reflects
government accounting procedures and the business cycle. Even if the state and
local government surplus is not subtracted, our measure of the Federal deficit
remains below 2 percent of projected total spending.
Unfortunately, these are not the only adjustments required to arrive at a
meaningful estimate of the fiscal deficit. The most important neglected item is
the unfunded liability in the social security, military and civil service retirement
systems. The Grace Commission estimated that, in 1983, the unfunded liability
is $2.8 trillion. We have used this estimate and the growth rate of future social
security payments to compute the amount that would have to be raised annually
to honor current commitments to persons currently in the labor force or retired
and eligible for pensions. These estimates are shown in column (6).
The adjustments to the reported deficit highlight the failure of Congress
and the Administration to provide revenues to match the payments promised to
current and future retired persons. These payments dominate the corrected
deficit in column (7). They show that the failure of the Congress and the Administration to control spending is the heart of the fiscal problem.
11
Real Effects of Fiscal Policy
In the absence of barriers to capital flows, global saving flows toward
countries with the highest expected after-tax rate of return. Countries with high
rates of saving invest where opportunities are highest. In recent years, private
Japanese saving has flowed to the United States.
Trade discrimination against Japan — quotas limiting imports of cars and
steel, duties on motorcycles and other barriers to Japanese imports ~ reduces
the return on investment in Japan and encourages an outflow of Japanese saving.
The offset to the inflow of saving into the United States is the current account
deficit. Attempts to close the current account (or merchandise trade deficit) by
restricting imports of specific commodities raise prices, lower efficiency and
increase the burden of financing current government spending.
Growing
restrictions on trade are one of the real costs of our current fiscal policy.
Congress is now considering tax increases to lower the deficit. If they
were to choose consumption taxes, it would reflect the belief that a higher
saving rate would encourage capital formation while higher taxes would reduce
the deficit. This does nothing to alter current government policies that shift
resources from investment to consumption.
Concern about fiscal policy should not focus on the narrow issue of the
deficit. The more important issue is the way resources are used. Current
spending encourages consumption at the expense of investment, capital
formation and future income. Raising taxes will not greatly change this longterm outcome. To increase investment and productivity, Congress and the
Administration must reduce the growth of future public spending for health care,
pensions and defense. This would release resources for investment and capital
formation and raise future income.
DEFICITS, INTEREST RATES AND MONETARY POLICY
Karl BRUNNER
University of Rochester
!•
The Deficit Syndrome
The deficit of the Federal budget dominates the attention of the public
arena. The process began with President Carter's ill-fated budget announcement
in February 1980. The response of the bond market revealed at the time that an
increasing segment of the public recognized the futility of repeated official
promises to balance the budget. Attention to the rising deficit approached since
1982 a feverish pitch. Wall street "economists", Senators, Congressmen, pundits,
and the media in general attribute to the budget deficit an array of dismal
effects. We heard in 1982 that the deficit would obstruct any incipient recovery
of the economy from the recession. An upswing matching approximately the
average rate of real growth observed over the first four quarters of postwar
cycle recoveries effectively falsified this prediction. So it is replaced by a new
prediction. The deficit is supposed to halt the recovery in the near future and
possibly push the economy into a new recession. The deficit creates moreover
inflation. A direct link appears to be asserted connecting inflation with the
deficit. Lastly, the deficit seems to be the cause of double digit nominal interest
rates.
Such interest rates produce apparently an "over-valued dollar"
encouraging imports and lowering our exports. This pattern reduces, so we hear,
our welfare, as it lowers domestic employment and output below the otherwise
achievable level. And the close interdependence of national capital markets
transmits the effects of the "high interest policy" pursued by the US government
represented by a "loose" fiscal and "tight" monetary policy to all major nations.
This vision thus offers European officials an excellent opportunity to blame US
policy for their economic troubles.
The public arena seems to find this story plausible. But many beliefs are
"plausible", and economic analysis nevertheless offers no support for these
fashionable and contentious inventions. Policymaking guided by this political
14
vision of our economic problem will at best shift the nature of the problem with
little improvement in our future economic prospects. A clarification of the
nature of the issues associated with the budget deficit seems thus at this stage
particularly urgent and important. We may immediately dispose of the most
egregious error without long arguments. We can assert with some categorical
definiteness that deficits per se do not create inflation. Most particularly, our
inflationary experience of the last 18 years was not caused by the deficit.
Similarly, neither economic analysis nor empirical evidence support the
contention that high interest rates raise the foreign exchange rate. Such
assertions are on a level with the statements propounded by the Flat Earth
Society.
II.
Economic Reality and "the Budget Deficit"
Economic analysis offers little support for the peculiar attention concentrated on deficits and its rationale. Economic analysis does not deny that
fiscal policy exerts in various ways substantial real effects on output and the
formation of human or non-human capital. We learn however from economic
analysis to look beyond the budget deficit at the whole fiscal policy pursued by
the government. The President's rhetoric, not necessarily his actions, points
more nearly in the right direction than the concerns voiced by Congress, "Wall
Street" and the media. The President addresses the expansion of the budget as
the primary problem and the mode of its financing as a secondary problem.
Congress, intent on escaping from hard choices associated with any meaningful
control over the budget's magnitude, directs attention to the deficit. This
emphasis provides a better opportunity to avoid spending controls and centers
political action on taxes as the required instrument to "solve the problem". The
problem solved by Congress hardly includes the prospects of effective budget
controls. Such controls would seriously inhibit the political power of Congress.
The ultimate fiscal means affecting the economy are the magnitude and
characteristics of spending on goods and services, the pattern of the effective
tax schedule including both positive and negative taxes (i.e. transfers), the true
value of the government's liabilities and possibly also the government's assets. A
systematic investigation of the government's effect on asset markets and
resource allocations will attend to all those dimensions beyond the officially
measured deficit. An analysis directed to the long-term implication of fiscal
15
policy should moreover remove purely cyclic components among expenditures and
revenues. The cyclic components probably contributed to raise the measured
deficit. The inflation tax imposed on outstanding government liabilities is, on
the other hand, usually omitted in the standard accounting measures. This tax
reflects the implicit revenue accruing to the government as a result of the
inflation-induced real depreciation of nominal liabilities. The rate of inflation is
the tax rate and the stock of real valued debt the tax base. Such an adjustment
in the deficit is unavoidable whenever we wish to obtain an economically
significant measure linking the deficit with the change in the net stock of debt.
The listing of the government's liabilities is not exhausted however by its
official debt. Pensions, the social security system and various guarantee
schemes impose commitments for future outlays on the government. The present
value of these commitments is a political and economic fact just as real as the
official debt. It is noteworthy in this context that the apprehension on the
political and media market, or Wall Street, seems not to include the economic
reality of "unfunded liabilities".
Probing beyond the official measure of deficits alerts us to the real significance of fiscal policy. Decisions bearing on spending and tax schedules modify
the allocation of our resources and the normal level of output. Different fiscal
choices affect the division of output between investment and consumption. The
incentives or disincentives associated with spending patterns and tax schedules
affect savings, investment in productive capital (both human and non-human) and
socially non-productive investment in the political process. The latter increases
with the magnitude of spending and the complexity of tax schedules. These
effects occurr independently of the deficit and powerfully condition our
economy. The attention concentrated on the deficit alone thus obscures to a
large extent major problems associated with the budget policies.
This conclusion is reinforced by an explicit consideration of the deficit and
its consequences on the stock of outstanding real debt. The professional
discussion still copes in this context with a somewhat unresolved issue. The
"Ricardo theorem", recently revived by Robert Barro with an extensive analysis,
denies that the mode of financing the budget exerts any significant real effects.
The argument is essentially based on an intertemporal budget constraint of
households and government. This framework includes additionally a crucial
16
assumption to the effect that economic agents fully anticipate with certainty
that government borrowing will be repaid from future tax revenues based on
lump sum taxes. Current borrowing is thus equivalent to future tax liabilities
and the present value of these tax liabilities is equal to the current value of
borrowing. The (infinite) intertemporal budget constraint then implies under the
circumstances that the division of current budget finance between borrowing and
tax revenues does not affect the public's real consumption pattern. Reliance on
borrowing calls forth, in view of the anticipated tax liability, a matching
increase in the public's saving. Current deficits thus involve according to the
Ricardo-Barro analysis a redistribution of tax revenues over time. By fully
discounting these time shifts the public's behavior essentially offsets the
government's fiscal action. Real consumption and real interest rates are
consequently unaffected by the government choice of financing current
expenditures.
But large borrowing over a long and indefinite future raising persistently
the stock of real debt can indeed occur. We do not observe this, so far, in the
history of the USA. But the political process of western democracies appears to
move fiscal policies in this direction. The real interest payments as a proportion
of real income tend to rise over time as a result. This fact forces ultimately a
change in regime. The government raises either the inflation tax which
effectively lowers the growth in the stock of real debt or alternatively the
market's ultimate rejection of a growing avalanche of interest payments financed
with the aid of new debt forces a radical change in fiscal regime. But the
mechanism inducing the change in financial regime cannot be subsumed under the
Ricardo-Barro analysis.
It remains essentially an extraneous element
incompatible with the basic assumptions. An indefinite horizon of permanent
deficits need be interpreted as a violation of the intertemporal budget
constraint.
An alternative analysis denies for a variety of reasons associated partly
with the recognition of self-interested age cohorts with finite life spans the
equivalence of current borrowing and future tax liabilities. Once this link is
broken, due to a major discounting of future tax liabilities in the context of our
diffuse uncertainties, the mode of financing a given budget assumes some
significance. The accumulation of real debt does, under the circumstances,
17
affect the real rate of interest and thus also the allocation of output and the
formation of capital over the larger horizon. It also explains more effectively
the ultimate market response to indefinite debt financing raising the stock of
real debt. This response would appear over the long-run in response to a gradual
accumulation of the real debt relative to real income and the resulting increase
in real rate of interest. This will eventually necessitate a change in fiscal or
monetary regime. But a change in regime most favored by Congress, namely a
substantial rise in taxes, is a poor "solution" of the deficit problem. All our taxes
affect marginal returns of assets or marginal prices. They unavoidably impose
distortions on the use of our resources. Replacing debt finance with additional
taxes replaces one real effect with another real effect. There is no reason to
believe that the new taxes will affect our economy more beneficially than
persistent debt financing. Some tax increases would also raise the gross real rate
of interest, obstruct savings and investments or discourage the supply of labor or
the intensity level of effort. A variety of tax increases would eventually lower
the comparative level of normal output. Proponents of massive tax increases
intent on eliminating tax rate indexation need thus to demonstrate first that
their proposals will retard our future welfare less than the current fiscal policy.
They would find it particularly difficult to demonstrate that the welfare gain
caused by massive tax increases even approaches the welfare gain to be expected
from controlling real expenditures and the magnitude of the budget.
The somewhat unresolved state of economic analysis bearing on the mode
of financing the budget still provides some useful implication bearing on the
public critique of deficits. The Ricardo-Barro position tells us that deficits are
equivalent to taxes. The real effects are thus completely determined by the
budget and do not depend on the mode of financing. The alternative position
recognizes distinct real consequences on interest rates, savings and investments
resulting from deficit finance and taxes. Neither position offers a good rationale
for raising taxes as a substitute for debt finance.
III.
Deficits, Debt and Interest Rates
The arguments advanced in the public critique of deficits involve a direct
link between current savings, current deficits and the emerging interest rate.
18
The real interest rate in particular is seen to be determined by a "collision" of
supply flows of funds expressed by savings and net foreign capital imports with
demand flows made up by the government deficit and the private sector's real
investments. This view is clearly presented in the Economic Report prepared by
the Council of Economic Advisers. Dr. Emminger, former President of the
Deutsche Bundesbank, used this argument in a recent piece published in the Neue
Zurcher Zeitung. The media and "Wall Street" dominantly interpret our financial
affairs in terms of this argument. It appears to explain plausibly how a larger
borrowing requirement by the government sector competes with the private
demand for a scarce flow of investible funds supplied by households and
foreigners. This competition must be resolved by the rationing function of
interest rates. Larger deficits thus raise immediately the level of interest rates.
This vision implies moreover that interest rates, once adjusted to a deficit, will
not be influenced by any further repercussions even by a large and persistent
deficit. But interest rates are supposed, under the circumstances, to reflect
sensitively and immediately the relative magnitude of the current deficit.
The plausible appeal of this view in the public arena is unfortunately not
justified by economic analysis. We possess here a common professional core
unaffected by Keynesian and monetarist disputes about macro-analysis. Our
problem reaches actually beyond the bond market. It involves basically the
nature of the pricing process of durable objects with comparatively low
transaction costs. The prices of such objects formed at any given moment on the
market are not determined by a flow of new production encountering a flow of
new demands. A price determined in this manner would hardly persist beyond the
shortest moment. The low transaction costs enable holders of already existing
objects to change any time their existing possession. A price determined by
demand and supply flows generates, under the circumstances, responses among
the prior holders of objects. These responses together with the inherited stock of
objects determine at any moment the prevailing price. This applies in particular
whenever the existing stock is large relative to the new production flow. Prices
in markets for durable objects with comparatively low transaction costs are thus
controlled, not by flows of new production and a corresponding pro-rata
allocation of savings, but the interaction between the accumulated stock and the
public's willingness to hold this stock. Stock demand and stock supply and not a
19
(new) flow demand and (new) flow supply, determine the current price. The
prices of GM shares or of any other shares are consequently not determined by
the interaction between new issues and a partial allocation of current savings.
Share prices are determined at any moment by portfolio holders willingness to
hold the outstanding stock. The same situation describes the bond market, the
foreign exchange market and many commodity markets.
The public's stock demand depends on current and expected future market
conditions. Stock demands are in general quite sensitive to expectational states.
Durability of objects and low transaction costs offer expectations substantial
room to operate. Keynes recognized this phenomenon quite clearly. Keynes
emphasized in particular that a larger variance of expectational patterns raises
the transaction volume associated with given price changes, whereas a very small
variance of expectational states may produce large price changes at a vanishing
transaction volume.
This analysis of a "stock-dominated market" contrasts sharply with the
vision of a "flow-dominated market" encountered in the public arena. Some
important differences should be noted at this stage. Our intuition immediately
alerts us to crucial distinctions in relevant proportions or orders of magnitudes.
The proportion of the deficit looms in the context of the flow analysis with an
impressive magnitude. This fact was carefully noted in the Economic Report.
The direct link between deficits and interest rates thus suggests a massive effect
on nominal and real rates of interest. The stock analysis conveys a very
different sense. Deficits modify interest rates only indirectly. They gradually
increase the stock of real debt and interest rates respond to this increase in the
stock. But this increase in the stock relative to the inherited stock is modest
compared to the savings-deficit proportion. We should expect therefore a
smaller impact on interest rates by deficits than is typically suggested by a flow
approach.
Closely associated with these aspects bearing on orders of magnitude is an
important difference between transitory and permanent deficits. A temporary
deficit, recognized as such by market participants, produces a negligible effect
on
long-term interest rates according to the stock analysis. The flow analysis
implies on the other hand a substantial rise of interest rates for the duration of
the deficit. A permanent deficit produces according to the flow analysis a
20
permanent, once-and-for-all increase of interest rates to a higher level. The
stock analysis produces in contrast also a different implication on this point. A
permanent large deficit implies a persistent increase in the stock of real debt per
unit of real income, provided inflation remains sufficiently low. This persistent
increase produces not just a once-and-for-all rise of interest rates but initiates a
persistent upward drift over time in the real rate of interest. A stock analysis
thus suggests that the shorter-run aspects of a deficit policy pose no serious
economic threats. The longer-run implications of a permanent large deficit
persistently raising real debt per unit of real income loom on the other hand
more seriously than indicated by a flow analysis. The appendix to the position
paper argues in more detail that an indefinite increase in the proportion of real
debt to real income with the corresponding increase in the proportion of real
interest payments to real income will eventually be broken either by an escape
into inflationary policies or a change in fiscal regime produced by a political
crisis.
But what is the evidence about the comparative status of the flow and
stock analysis? We do know from ample observation that most transactions on
"auction markets", i.e. markets for durable goods with low transaction costs, are
associated with shifts in existing portfolios. This fact cannot be reconciled with
a flow analysis. The CBO also published a survey of all the empirical work
conducted in the profession over the past years. The results of the survey are
quite unambiguous. None of the studies found a statistically significant or
reliable systematic connection between current deficits and interest rates.
There exists thus simply no empirical basis for the assertions associated with the
flow analysis. Some studies addressing the role of the stock of debt found on the
other hand a significant effect on the level of interest rates.
IV.
The Anatomy of Interest Rates
The general argument developed so far need be supplemented for a useful
judgment by an examination of relevant orders of magnitude. We partition the
nominal rate of interest for our purpose into a sum of three components: the
basic real rate on default-risk free government securities, a risk premium
reflecting the market's uncertainty about the future course of monetary policy
and thus the profile of inflation, and lastly, the inflation premium expressing the
21
market's expectation of the inflation rate. The sum of the first two components
constitutes the gross real rate of interest. The argument developed in the
previous sections and the appendix indicates that a persistent deficit may be
expected to affect nominal interest rates via all three components. But the
popular view based on the flow analysis thoroughly fails to comprehend the
nature and magnitude of these effects.
The basic real rate on long term government bonds seems to have averaged,
according to Eugene Fama, about 2.5 percent for most of the postwar period
until the early 1970's. This level may be applied as a benchmark to a base period
1960-1964 used as a comparison with the current state. We need first an
estimate of the effect on the basic real rate attributable to permanent deficits.
This permanent deficit is specified as the cumulative stock effect expected by
the market over a five year horizon. Suppose the market expects under the
circumstances the stock of real debt to double over this period. The response of
the real rate of interest to the increase in the stock of real debt, discounted by
the market's expectation to the current interest level, depends on the elasticity
of the real rate with respect to the real debt. The asset market analysis jointly
developed over the past decade with Allan H. Meltzer implies an elasticity of
about .6. A 100 percent rise in real debt would raise under the circumstances the
basic real rate from 2.5 percent to about k percent.
The second component, i.e. the risk premium, was probably quite negligible
in the 1960's. But it emerged in recent years as a significant component of the
gross real rate of interest. The announcement of a move toward tighter
monetary control in October 1979 was actually followed by a large and pervasive
uncertainty concerning the future course of monetary policy. Federal Reserve
officials repeatedly supplied conflicting signals and statements. The variance of
monetary growth increased and the motion of the money stock approached a
random walk. The market responded to this deep uncertainty about the future
prospects of inflation with a lower level of bond prices. A risk premium became
thus embedded in the gross real rate of interest. Mascaro-Meltzer estimated, in
the Journal of Monetary Economics, 1983, this risk premium at around 2 percent
to 2.5 percent. Eduard Bomhoff estimated the premium independently at about
the same level. The gross real rate thus adds up to about 6 percent-6K2 percent.
The remainder of about 5& percent-6 percent constitutes the inflation premium.
22
The following table compares in broadest outline the current state with the
state prevailing 20 years ago. The table is not presented with any sense of
precision or detailed reliability. But it does convey a general sense about the
anatomy of interest rates. We should most particularly consider that our
elasticity estimate for real rates is most probably an upper bound defining the
range of our uncertain knowledge. We learn thus that the current effect of large
anticipated increase in the stock of real debt explains at most Wz percentage
points of the eight percentage point difference between 1983 and the early
1960's. The current deficit thus fails completely to explain both current nominal
and real rates. The permanent deficit explains via the stock effect a portion of
the higher gross real rate. But even a permanent deficit of the order of
magnitude specified cannot explain in terms of the real debt effect, only the
drift from 4 percent to 12 percent in the nominal rate of interest.
1960-64
1983
nominal rate
4%
12%
basic real rate
2K2%
4%
risk
premium
y2%
2%-2&%
inflation
premium
1%
5K2%-6%
One particular event occurring in the last year which also contributed to
raise the basic real rate need also be mentioned here. The investment tax credit
included in the tax legislation of 1981 raised the net real rate of return on new
real capital. The market distributed this effect over all assets lowering
consequently bond and share prices at the time. This means that the estimate of
the real debt effect or the inflation premium is too large.
A deficit expected by the market to persist into an indefinite future
modifies the nominal rate also via the risk premium and the inflation premium.
A permanent deficit raises over time the likelihood of irregular but substantial
monetary accommodation. It contributes then to maintain, or even raise, the
level of inflationary expectations and consequently also the level of the inflation
premium. The likelihood of this feedback from permanent deficits increases
moreover in case the stock of real debt per output unit drifts higher over time.
The same pattern combined with the established tradition of discretionary
policymaking also deepens the pervasive uncertainty about the future profile of
inflation and affects both level and volatility of the risk premium. Once we
consider the relation between deficits and interest rates in a broader context we
23
do find a decisive influence on level and variance of nominal interest rates
exerted by a permanent deficit recognized as such by the market. But the
mechanisms establishing the link are radically different than those suggested by
the popular flow analysis discussed in a prevoius section. This flow analysis
attributes most of the higher nominal rate to a higher basic real rate, our
analysis in contrast attributes the eight percentage point increase over 1960-64
dominantly to the inflation premium (about k%-5 percentage points), secondly to
the risk premium (about 2 percentage points) and lastly to the basic real rate and
the pure real debt effect.
The analysis of the anatomy of nominal interest rates presented here also
determines the requirements for a low interest rate policy. A determined noninflationary monetary policy would lower the inflation premium by a substantial
amount. But this monetary policy would not persist in the context of a
permanent deficit policy. A permanent policy of large deficits measured in
terms of the associated growth in real debt imposes a gradual upwards drift on
the basic real rate, fosters a high and volatile risk premium and prevents the
attrition of the inflation premium in response to expectations of eventual
monetary accommodation spurred by the rising real debt ratio to real income. A
non-inflationary monetary policy appears thus as a necessary but not as a
sufficient condition for comparatively low nominal interest rates. We need also
to change in addition our fiscal regime holding the deficit to at most a very small
margin of national income.
24
APPENDIX
Some Simple Analytics of Deficits and Real Debt
The relation between the real deficit and the mode of financing may be
formulated as follows:
(1) a.d + g.b = def = g +tr + r.d - ta
where a is the relative change in the nominal stock of debt, B the relative
change in the monetary base, d denotes the proportion of nominal debt to
national income at current price-level, b is the corresponding proportion for the
base. We have moreover g = government expenditures on goods and services per
unit of national income, tr = transfer payments per unit of national income, r =
average nominal interest rate applicable to d, ta = nominal taxes per unit of
national income.
Two more relations are required to complete the scheme. Equation (2)
describes the steady state conditions for a constant volume of real debt per unit
of real income with IT denoting the inflation rate and n normal real growth of
output. It also expresses the condition for a constant proportion of real interest
payments to real income. Equation (3) states a steady state condition for the
rate of inflation with v measuring the trend growth of base velocity. This
equation will in general be violated over shorter horizons.
(2) a = n + tr
(3) ft = 3 + v - n
Equations (2) and (3) yield together equation (4)
(4) o = g + v
The interaction between (1) and (4) determines our theme. We replace IT
occurring as a component of r (=rr + ir) on the right side in (1) with the aid of
equation (3) and obtain
(5) a.d + B (b - d) = def = g + tr + (rr + v - n)d - ta
Equation (5) defines line 1 in the diagram. The slope is given by (6), the vertical
and horizontal intercepts by (7)
25
DIAGRAM I
26
(6\ ^o _ d-b
{6)
n
d0" ~
(7) vertical: ^
°
;
horizontal: g j
We observe under U.S. conditions that d~.3 and b~.06. The slope approximates
thus .8, the vertical intercept (with the full steady state adjustment for inflation)
about .2 while the horizontal intercept is approximately -.25.
Equation (4) defines line 2. The vertical intercept is v(~.02) and the slope
is unity and thus exceeds the slope of line 1. With def > vd the vertical
intercept of line 1 exceeds the vertical intercept of line 2 and the intersection of
the two lines occurs in the positive orthant. With def sufficiently less than v the
intersection lies in the negative orthant. Line 3 ultimately describes the relation
between IT and 0. Its vertical intercept is (v - n). The diagram thus depicts the
steady state growth rate a and 0 together with the inflation rate associated with
a given deficit ratio def, financial ratios d and b, and velocity and nominal
growth v and n.
The diagram reveals that a larger deficit ratio raises a, 0 and IT. We also
note that a constant price level with a constant real debt per output unit requires
a deficit ratio def/d slightly above v. Combinations of a and 0 on the segment
between the vertical and the intersection point A on line 1 imply a rising real
debt ratio d and the segment beyond A falling real debt ratios. An inspection of
the graph shows that a persistent large deficit, expressed by a large positive
vertical intercept of line 1, confronts policymakers over time with a serious
dilemma. A non-inflationary (or modestly inflationary) monetary policy implies
under the circumstances a persistent rise in the real debt ratio expressed by a
choice (a, 0) left of A. Such a process may continue for quite a number of years.
But the rising real debt and interest payment ratio ultimately impose some
adjustments on the policymakers. Inflation, i.e. a greater reliance on 0, offers
an escape in this respect. The following table shows the steady state rate of
inflation associated with three different levels of the (persistent) deficit ratio
based on the assumption that v = .02 and b = .06 satisfying the condition of a
constant real debt ratio. The results also satisfy the condition that the real rate
of interest is equal to the normal rate n of real growth. The formula for the tr is
then
27
(8) 7T = -T—• + v, with def = g + tr - ta
With def independent of d the steady state TT is also independent of d.
def"
.01
.06
.1
ir
18.7%
102%
169%
The results may astonish at a first glance. But we should remember that the
crucial assumption expressed by eq. (3), viz. that inflation and also nominal
interest rates are fully adjusted to the inflationary finance 0. Without this
feedback line 1 would have a negative slope and TT would not blow up with the
speed indicated in response to higher levels of def. The feedback also implies a
comparatively low critical level of the deficit ratio assuring a constant price
level together with a constant real debt ratio.
The reader should be cautioned at this point that an important feedback has
been omitted thus far. The ratio b depends on a (or 0). This means that the
slope of line 1 in diagram I steepens as 0 increases. The corrected intersection
points on line 2 are thus even further removed from the origin. This result can
be established in the following way. Recognition of the feedback modifies
equation (6)
.
d-b-0bD
1
• ,
»> U - —r > "
This can be rewritten as
(10) | |
= 1 - | [l + e(b,B)J.
The elasticity e (b, 0) is negative and approximately equal to the interest
elasticity of the base velocity multiplied with minus one. The marketed
expression is thus at least .5. Larger steady state values of 0 lower b. It follows
that the slope of line 1 increases as we move along the line and converges toward
unity. This implies that a steady state solution only exists for deficit ratios
which do not exceed a critical upper boundary.
28
The steady state rate of monetary expansion can also be determined with
the aid of diagram II. This diagram is obtained from equation (8). It is rewritten
as eq. (11)
(11) |3b(g) = deT
dif, gb(|3)
DIAGRAM II
The right side of eq. (11) is represented by line 1 and the left side by line 2. The
slope of line 2 is b [ l + e (b,g)]
< b and declines with rising g as b falls.
The
slope is thus positive and declining as we move along the line. The intersection
between the two lines determines the rate W required to produce for given def a
constant real debt ratio. Given slope of line 2 this rate rises rapidly in response
to larger permanent deficits.
BASE VELOCITY - THE TREND CONTINUES
Allan H. MELTZER
Carnegie-Mellon University
Attached to this brief statement is an updated version of the chart showing
deviations (DV) of base velocity from trend. The deviations are measured from
the trend estimated for the postwar period, approximately 2.5 percent a year.
As before, DV depends on expected inflation and on innovations in base
growth. Expected inflation (pe) is the systematic component of a first order
moving average of inflation rates and the innovations are the residuals from a
second order moving average of base growth (DBMAZ). Errors from the linear
regression
DV= OQ + djpe + a2DBMAZ
are corrected for first-order serial correlation. Typically, the correction coefficient is 0.95 or above, so the deviations in trend are persistent.
Recent persistence is shown in the chart by the decline in 1982. Base
velocity is now about IA below its former trend, but it is rising at the old trend
rate. This is shown by the serially corrected residuals on the right of the chart.
They have remained close to zero for the past three quarters while the actual
deviation (DV) remains about -I A as shown on the left.
The low values of the residuals imply that if base growth remained
constant, velocity would rise at its past trend rate. The level of base velocity
appears to have been reduced.
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PAGE
TRADE RESTRICITONS IMPOSED IN 1983
Jan TUMLIR
Visiting Professor
University of California at Los Angeles
Last time I presented some rough overall estimates of protection. Today I
want to report on developments in 1983. Let me emphasize that my list is
selective and illustrative only, compiled from official notifications to the GATT
(which are themselves woefully incomplete) and from newspaper clippings
collected by my office. I hope that all the major ones are listed but am reporting
also some minor ones for their intrinsic interest.
Argentina: prior authorization of all payments for imports is now required.
Brazil: quantitative restrictions were imposed or tightened on all imports
of manufactures.
Hungary: a general restriction imposed on imports from outside the Eastern
trading area, for balance of payments reasons.
Israel: general import surcharge was raised and a prior deposit by importers
is not required.
Nigeria: quantitative restrictions were imposed on all imports, for balance
of payments reasons.
Portugal: a general import surcharge was imposed together with quantitative restrictions on imports of ail consumer goods.
All these are countries in obvious payments difficulties.
That trade
restrictions are unsuitable for correcting payments imbalances needs no
discussion here. Numerous import control measures have also been taken by
Mexico on which, however, I do not have information, Mexico not being a
member of the GATT. Then we come to the large trading countries.
Australia tightened restrictions on automobiles and steel strip.
Canada tightened restrictions on imports of footwear of all kinds.
More interesting is the complaint that Canada has reduced,
apparently quite sharply, the number of customs officers authorized to
clear clothing imports. Only twenty-six officers have been given the
32
'special training' which is now required for clearing clothing imports; of
these, six are in Montreal, five in Toronto and Vancouver, where all Asian
imports enter, has only three.
Canada also instituted official discussions with Japan of periodic
•forecasts' by Japanese automobile industry of its exports to Canada.
Pressures were reported from or on Canadian Parliament for
domestic content legislation on automobiles.
U.S.-made cars would
presumably be exempt, these exchanges being regulated by the U.S.Canadian Automotive Agreement.
The European Community: A major precedent was created in February
1983 when the European Commission obtained from the Japanese
government an agreement to restrain ten items in Japan's export to Europe.
This is the first Community-wide Japanese restraint; until last year, Japan
has accepted bilateral restraints only vis a vis national governments. The
items concerned are: cars, trucks, motorcycles, fork-lift trucks, color TV
sets and tubes, numerically controlled machine tools, music recording and
reproduction equipment, quartz watches and video-casette recorders.
These items alone account for some 40 percent of Japan's exports to
Europe. Exports of steel, ships and textiles and clothing were already
under an even tighter restriction.
A commission report published in September shows the number of
anti-dumping investigations to have increased by 20 percent in 1982. Most
of them were settled by the Commission's acceptance of price undertakings
by the exporters concerned. A new method was devised for calculating
normal value of imported iron and steel products. Proceedings will be
instituted against exporters invoicing at less than normal value.
Two front-page headlines from The Financial Times of January 26,
1984: "France acts to slow down meat imports"; "Paris denounces US move
to stem European wine imports".
An agreement under which Thailand had restrained its exports of
manioc/tapioca to the E.C. was extended to 1986. This agreement was
concluded in 1982, concurrently with a large loan by the European
Community to Thailand. Subsequently, the E.C. Commissioner of External
Affairs, Haferkampf, who had negotiated the restraint and the loan, was
awarded the highest Thai distinction, the Order of the White Elephant.
The United States reported five cases of "safeguard action", or temporary
emergency protection permitted under GATT Article XIX. In two cases,
preserved mushrooms and porcelain-steel cooking wares, existing
restrictions were extended in time while new measures were taken on
heavy motorcycles (of which there is only one producer in the U.S.), lag
screws and bolts, and speciality steels (by far the most important item of
the five).
Outside GATT rules, the voluntary export restraint on automobiles
obtained from Japan for three years in 1981 was recently extended for
another year at a higher level of 1.85 million units.
In early 1982, the U.S. embarked on a 'reconquest' of some of its
agricultural markets in the Middle East and the Caribbean by offering
wider subsidy-margins than the E.C, in acute budget difficulties, could
afford. Urgent negotiations were instituted..
33
Some additional comments are needed for full understanding of the trade
restraints undertaken on the export side. The European-Japanese agreement was
renegotiated and given greater precision in November. In particular, the amount
of video-casette recorders imported from Japan was made contingent on
Japanese production of them in Europe in joint ventures with European firms.
When Japanese color TV sets were under restraint in the U.S. in the 1970s,
similar conditions were negotiated. Japan formally undertook not only to
produce in the U.S. but to produce by methods no less labor intensive than those
used in Japan. Finally, Japan's agreement to restrain automobile exports to the
U.S. has already led to a spate of joint ventures between American and Japanese
car makers. I shall return to the most important of them, the GM-Toyota
project. Here we can conclude that this method of protection, in which the
government of the importing country holds out tempting inducements to the
export industry, eventually but almost inevitably leads to negotiations about the
location of production and technology transfers through joint ventures.
Second, note that protection relying on restraint from the export side is in
several respects more costly than the simple old-fashioned protection by tariff.
The tariff at least ensured that the protecting country (as distinct from the
consumer) obtained its imports at the lowest possible cost. Where it possessed
some monopsony power, it could even, for a time, reduce the prices of its
imports by raising the tariff. And its public always knew what the margin of
protection was. Now exporters are bribed into self-restraint in that they are
allowed to collect the export (scarcity) rent, that is, export at the price
prevailing in the protected market which is considerably above their own costprice. The Thai manioc/tapioca case is a particularly graphic example of bribing.
A more interesting illustration (because it also reveals the quality of the thought
that goes into these matters) is provided by the European complaints about the
effects of the American-Japanese automobile restraint. It is said to have so
increased the profit margins of Japanese firms on American sales that Japanese
producers can cut prices in third markets where they compete with European
cars. A slightly different though related issue — closer to extortion than to
bribing — is involved in the background of the U.S. safeguard action on heavy
motorcycles. The Japan Economic Journal of September 20, 1983, revealed that
in February last year Harley-Davidson had approached the Japanese motorcycle
34
firms and the Ministry of International Trade and Industry for financial aid,
offering to withdraw its application for emergency protection in return for a $50
million debt guarantee. The safeguard measures by the U.S. government were
taken in April. A new approach by the American motorcycle firm to its Japanese
competitors was reported to have been made in the week preceding the Journal
article.
Third, all that the export industry has to do in order to collect the scarcity
rent on its restrained exports is to organize itself into a cartel. The new form of
protection thus poses, intrinsically and inevitably, a problem for antitrust law.
Private cartels are notoriously unstable formations. To survive for any length of
time, they need government's help in enforcing discipline. The European steel
cartel was disintegrating in 1982 when a conflict arose between the European
Commission and the U.S. government about subsidization of European steel in the
United States. The European export restraint by which the conflict was settled
provided an effective means for the Commission to assert control over the
failing cartel. As I read the Japanese situation, the automobile restraint has
similarly en'abled MITI to act on its old conviction that the Japanese automobile
industry ought to be much more concentrated than it is. The three large firms
get a lion's share of the controlled export volume while the smaller and younger,
but fiercely competitive, companies go hungry. Thus we export cartels while
paying lip service to the proposition that competition benefits and protects
domestic consumers. The Japanese government must fear for its constitutional
integrity and legitimacy as it is coerced into cartelizing one important industry
after another, and is vainly trying to make the U.S. government understand that
such a result cannot be in the interest of the American people either.
Whatever integrity there was in our antitrust law is vanishing rapidly.
What we have there are two large bureaucracies — the commercial policy
establishment and the antitrust enforcement — making work for each other,
taking in each other's washing. The FTC already gave a provisional approval of
the GM-Toyota joint venture. I am sceptical about the usefulness of antitrust in
normal circumstances but there can be no doubt that behind the Japanese export
restraint, the joint venture of these two firms, both No. 1 in their respective
countries and Toyota No. 4 in the U.S., would substantially lessen competition in
the American market. Toyota would have a strong incentive, for example, to
price the new car so as to minimize its own Corolla's loss of market share.
35
Protection, Deficits, Exchange Rates and Efficiency
Allan has called my attention to the estimates of the cost made recently by
Michael C. Munger, ("The Costs of Protectionism: Estimates of the Hidden Tax
of Trade Restraint", Washington University Center for the Study of American
Business, Working Paper No. 80, July 1983). As I suggested last time, any undertaking of this kind is fraught with difficulties. Munger's paper, however, is a
thoroughly professional piece of work and its bottom-line (minimum) estimate of
$255 per inhabitant is within the order of magnitude of several similar estimates
made in recent years. Reporting his findings in Cato Institute Policy Report
(February 1984), Munger touches on several broader issues of current policy
debate. This seems an appropriate occasion for the following comments.
The relation between fiscal and foreign sector deficits is easy to explain.
We are in a period of a relative capital shortage. The global savings ratio has
declined in consequence of (a) unprecedented rates of government dissaving in
both industrial and developing countries and (b) the swing of the OPEC group of
countries from a large current account surplus to a deficit. In this situation,
countries compete for a reduced global supply of savings by the quality of the
investment opportunities they can generate. To take two extreme examples,
Japanese institutional arrangements are such that the country still maintains a
savings ratio of some 30 percent of GNP while the U.S. aggregate saving ratio is
currently only 15-16 percent. In Japan, however, experiencing intense trade
discrimination abroad, investment opportunities are now insufficient to absorb
national savings while in the U.S. they are growing so rapidly that domestic
savings are insufficient to finance them without inflation. So the U.S. borrows
abroad, and the only way the borrowed capital can be brought home is through a
current account deficit.
Yet many short-sighted economists have been
strengthening the case for protection by calculating how many more jobs there
would be if the U.S. did not have an external deficit. That is a meaningless
calculation because, if the U.S. did not have a trade deficit, it would already
have a rising inflation accompanied or followed by higher unemployment.
We should be similarly careful in pronouncing on how much the exchange
rate of the dollar, necessary to bring the borrowed capital into the country, is
hurting U.S. exporters and firms competing with imports. There is hardly a firm
in the U.S. that would produce for exports only. While their domestic sales are
36
improving, the continuing sluggishness and increased competition for export
orders in the rest of the world economy is depressing U.S. exports along with —
but would do so even without ~ the high exchange rate of the dollar. We cannot
say how much each of these forces contributes to the observed performance —
admittedly poor — of our exports.
At the same time, the exchange rate keeps a lid on domestic prices.
Except for a relatively small segment at the high-technology end of the
spectrum, all U.S. industry is import-competing. In the 1960s and early 1970s,
American economists tended to calculate the impact of an exchange rate change
on the domestic price level as the product of the exchange rate change and the
proportion of traded goods in the GNP. (Willy Fellner wrote about it in summing
up his experience on the Council of Economic Advisers.) We learned eventually
that the two changes are more likely to be of the same order of magnitude but
recently, the old mistake seems creeping back again. We must keep explaining
that exchange rate depreciation is not an independent contribution to inflation
but an integral part of the mechanism by which inflation develops from the
original monetary impulse.
All this said, we must acknowledge that a large current account deficit
does generate strong political forces for protection. It is thus important to see
clearly what the consequences of protection in this situation are.
Observe, first, that selective protection, which is what all countries
practice, is, from the economic viewpoint, random. There are 'political economy'
theories about which industries are most likely to obtain protection and they all
boil down to the following proposition: only industries in closely disputed
electoral districts get protection, those in safe ones never do.
Return, then, to the case of the expanding economy attracting capital from
abroad as it cannot finance all the investment opportunities it generates from
internal savings. The corresponding current account deficit generates pressures
for protection to which the government yields. In a free trade situation, the
industries bearing the brunt of the import competition intensified by the
country's need for foreign capital would be those possessing the least
comparative advantage, thus offering the least attractive investment
opportunities. Their absolute or relative shrinkage, in other words, would be
irreversible. When the investment cycle has run its course (or when the country
37
got its public finances under control again), the current account would revert to
balance or surplus but at a higher level of trade.
When selective protection is granted, the industries with originally
attractive investment opportunities will go on with their investment projects.
But investment prospects have also improved in the industries receiving
protection. The demand for external capital is still there and may have even
grown. Since the imports through which it would have been most economical to
transfer the capital from abroad are now restrained, other imports will grow.
Under the intensified competition from abroad, investment prospects in
industries with a more promising economic future but lacking the political
influence will gradually deteriorate. Scarce resources will be tied up in the
protected industries. How the corresponding foregone expansion will be divided
between the high-technology industries whose original expansion potential
started the investment boom, and the import-competing industries which might
have been pushed by normal import competition into viable, higher-productivity
forms of adjustment, cannot be theoretically deduced.
MONETARY POLICY OPTIONS AND THE OUTLOOK -- 1984
Jerry L. JORDAN
University of New Mexico
Assumptions
1.
2.
3.
Monetary growth will be somewhat less than in 1983; Ml and monetary base
growth expected to be 8-9 percent;
Velocity growth expected to show some typical pro-cyclical increase, so
nominal income growth expected to be faster than in 1983;
4.
While 1983 nominal income growth was about 60 percent output and 40
percent prices, the split this year most likely will be reversed — 60 percent
prices and 40 percent output;
Nominal interest rates will rise on balance in 1984, but not as much as
inflation; falling (ex post) real rates will be associated with a weaker U.S.
dollar and rising imported goods prices; however, both the falling dollar and
falling realized real rates will be the result of rising inflation;
5.
Any actions by Congress and the Administration to reduce future deficits
will have no discernible effect on 1984 economic activity.
Economic Projections
A year ago, t h e SOMC outlook was for real growth of about 6 percent and
inflation of about 5 percent in 1983. We were only slightly low on output, and
somewhat too high on prices.
We had indicated that "two or more quarters of
real growth over 7 percent" was likely, so a vigorous recovery was anticipated a t
a time when others thought it would be anemic.
At the September 1983 meeting of the SOMC, the following table was
discussed:
Q4/82-Q4/83
Q4/83-Q4/84
GNP
Output
Prices
Ml
VI.
Monetary
Base
VB
11.4%
9.2%
6.1%
3.7%
5.3%
5.5%
10.2%
6.0%
1.2%
3.2%
9.3%
6.5%
2.1%
2.7%
40
The assumptions underlying the table included a slowing of Ml growth to the
mid-point of the target range and a return to a long-run trend velocity growth.
Also, at the September 1983 meeting, the following projections were made,
assuming that the level of monetary base velocity returned to historic trend
while the growth of the base slowed:
Q4/83-Q4/84
GNP
Output
Prices
Monetary
Base
VB
10.8%
4.3%
6.5%
6.0%
4.8%
Nothing has happened since last September to change that basic outlook,
given the assumptions.
However, in Ql/84 it now appears that monetary base
growth will be in the range of 8 percent to 10 percent, following a 9.5 percent
increase for all of 1983. Consequently, a most likely (although definitely not
preferred) assumption about monetary growth in 1984 is that it will be in the 8
percent ot 9 percent range.
Therefore, the following projections are highly
probable:
Q4/83-Q4/84
GNP
Output
Prices
Ml
Vj^
Monetary
Base
VB
11-12%
4-5%
6-7%
8-9%
3-4%
8-9%
3-4%
The risk is that nominal GNP growth will be even faster, possibly exceeding the
historic record growth of 13.
% in 1978.
Also, the probability is increasing
that inflation in 1985 will exceed that of 1984. If monetary growth slows sharply
in late 1984 and in 1985 in a shift of emphasis toward reducing inflation, nominal
income growth would be reduced (after a short lag) while inflation continued to
rise, leaving little or no room for real growth.
The inevitable conclusion of monetary analysis is that a more stimulative
monetary policy in 1984 to maintain real growth and further reduce unemployment raises the probability of a recession in 1985.
caused by getting drunk!
In the end, hangovers are
41
Federal Reserve Objectives and Projections for 1984
It now appears likely that for the second year in a row nominal income
growth will exceed the upper end of the FOMC projection range. A year ago, you
may recall, in the February Humphrey-Hawkins testimony, the FOMC projected a
very slow recovery (similar to Martin Feldstein's). Then in July 1983, the revised
projections for 1983 showed a range in which the lower end was above the
February upper end. Early in 1983, the FOMC reported an Ml target range of 4
percent to 8 percent, the same as they now have for 1984. Unfortunately, the
actual Ml growth rate was 12.8 percent for the first two quarters of last year,
according to the newly revised data.
It might seem that after all the huffing and puffing about Ml being misleading, some members of the FOMC might wonder if the much more rapid
nominal and real income growth last year (compared to FOMC projections) was
related to the much faster Ml growth (compared with targets). In any case, 1983
may be the first year in several in which the Fed did what they said they would.
They said they would not try to keep Ml growth within the announced target
range and they succeeded in not keeping it within the target range.
At mid-year, just as Ml growth was beginning to slow, the FOMC rebased
and raised the target range; then money growth seemed to be falling short of the
targets for the remainder of the year. When it was all over, we had 10 percent
Ml growth for the year — the fastest ever recorded -- and a vigorous recovery.
Oddly enough, we also had a number of economists who should know better
worrying that the Fed would put us back into recession. Admittedly, the 7.3
percent growth of MI in the second half of 1983 was slower than the explosive
growth of the first half, but since when is 7+ percent money growth too slow?
The FOMC has indicated the following for 1984:
Nominal GNP
Real GNP
GNP deflator
Ml
Range
8-10.5%
3.5-5%
4-6%
4-8%
Central Tendency
9-10%
4-4.75%
4.5-5%
42
On the surface, that set of projections looks consistent, and is about the
same as the consensus of business economist forecasts. But, of course, there are
problems with it. One is that last year's experience gives us no basis for
confidence in the Fed's ability to stay within its target ranges for money or to
forecast nominal or real income growth. Another is that since Ml growth will
come in at over 8 percent for the first quarter of 1984, getting back down to the
mid-point of the range for the year would mean a significant deceleration at
some point. That would play havoc with the real GNP projections. Furthermore,
the FOMC's inflation projections appear much too low following a two year
growth of Ml of 9.3 percent and monetary base growth of 8.5 percent.
Historic pro-cyclical patterns of velocity growth would suggest nominal
income growth that is at least at the upper end of the FOMC projection, if
money growth is in the upper half of the target range. However, if money
growth is in the lower end of the target range, nominal income growth might fall
in the FOMC range, but real output growth would be slower than the FOMC
indicates. With real growth of 6 percent or more in the first quarter, growth of
only 3.5 percent for the year (the lower end of the Fed range) would mean three
quarters of under 3 percent average real growth.
Since the trend growth rates of both Ml and the monetary base have been
about 8 percent for the past seven years, that serves as a good first guess about
what it will be in 1984. The growth of Ml in 1982 (recession) was 8.5 percent and
in the first year of recovery it rose further to 10 percent. Now, in the second
year of recovery, it is just as likely to rise further as to slow. Since reported
inflation was low in 1983 and FOMC projected inflation for 1984 is still low, the
Fed is not likely to worry too much if money growth is exceeding targets again.
The "Bunker Hill mentality" regarding inflation results in repeated overshooting.
That is because waiting until the "whites of the eyes" of rising prices is observed
before acting ignores the existence of rather long and uncertain lags between
money growth and inflation.
What the FOMC actually does in 1984 will be influenced by financial
market developments. If interest rates continue to rise, reflecting upward
revisions of inflation expectations, and a weak dollar and rising gold prices
suggest diminishing confidence in the outlook for U.S. inflation, the FOMC can
be expected to (belatedly) take action to convince financial market participants
43
that they have not caved into political pressures to re-inflate. As long as our
central bank is guided by a "premium on judgment", rather than objective rules,
forecasting economic developments requires second guessing the FOMC's
"reaction function" to market conditions.
ECONOMIC PROJECTIONS
Burton ZWICK*
Prudential Insurance Company of America
Overview
The economy grew very rapidly in 1983, inflation remained generally well
behaved and interest rates rose from the lows they reached in the first half of
the year. Since 1983 included another round of tax cuts designed to increase
output from the supply side, some have interpreted 1983's strong growth-low
inflation performance as evidence of fundamentally improved supply conditions
in the economy. By this interpretation, strong output growth can continue with
less pressure on inflation and interest rates than is suggested by the traditional
relationship between output growth and inflation.
An alternative explanation views the strong recovery in more traditional
terms, as the combined result of rapid demand stimulus and a "natural rate"
tendency of the economy to move toward full employment (postponed
consumption of durable goods, reduction in real wage rates, high productivity
growth, etc.). In particular, very rapid money growth from 1982:2 through 1983:2
translated with a short lag into rapid output growth from 1982:4 through 1983:4.
Inflation remained well behaved partly because monetary stimulus always affects
output more quickly than prices and partly because of the extremely high
prevailing level of unemployment. By this interpretation, the unprecedented
first year increases in utilization rates already suggest some acceleration of
inflation, while continued rapid income growth brought on by continued monetary
stimulus will lead to further increases in inflation and higher interest rates.
Each attempt to extend the period of rapid growth can be achieved only at the
expense of more rapid inflation and higher interest rates.
I gratefully acknowledge extensive discussions with 3ason Benderly and
Michael Hamburger.
46
As discussed below, we believe that the strong 1983 output growth
reflected monetary stimulus more than any fundamental changes from the supply
side. We continue to believe that rapid growth, low inflation and low interest
rates cannot coexist in the U.S. economy for any extended period because of
persistent structural problems. The question is which of the unfavorable
outcomes ~ recession or accelerating inflation — will be chosen by policymakers.
We expect that, throughout most of 1984, policymakers will emphasize continued
growth even at the expense of higher inflation, which we expect to reach 6-8
percent by late 1984 or early 1985. However, in an effort to avoid even higher
inflation in 1985, policymakers will accept the need for slower growth. To
prevent inflation from moving outside the 6-8 percent range, the Federal
Reserve will tighten by the end of 1984 and induce a recession by the end of
1985.
Structural Problems in the Economy
In contrast to what would seem to be implied by a supply side resurgence,
the U.S. economy continues to experience a strong orientation toward
consumption and debt usage and away from saving and investment. The following
developments over the past year highlight this orientation:
*
The level of private saving on a cyclically adjusted basis was no
higher in 1983 than throughout the past decade. The personal saving
rate was 5.0 percent, somewhat above the very low rates in the past
few years but far below the average of the post World War II period.
Corporate saving was also unchanged on a cyclically adjusted basis,
with corporations becoming net absorbers of available funds in 1983
as typically occurs during cyclical upswings.
*
The three most credit dependent {and therefore interest rate
sensitive) sectors of the economy — consumer durables, housing and
business inventories — accounted for 75 percent of GNP growth
during the first year of the recovery versus 60-65 percent
historically. As a result, credit use has increased in line with past
recoveries, consumers and corporations have reliquified only
marginally, and overall liquidity for corporations is still quite low by
post World War II standards.
*
Business fixed investment typically rises with a lag as the economy
moves out of recession. This recovery, business investment is rising,
but only in line with what has occurred in past recoveries.
47
*
The federal budget deficit has now reached about 4 percent of GNP
on a full cycle basis. This compares with 2 percent in the late 1970s,
less than 1 percent in the 1960s, and virtually zero in the 1950s.
Since this deficit must be financed out of an unchanged volume of
private saving, the only way the U.S. has been able to finance
government spending and private expenditures over the past year is
through enormous capital inflows. Our major export has been U.S.
treasury securities. Of even greater concern, perhaps, is what these
deficits imply for the outstanding stock of debt. The outstanding
stock of debt is currently about $1.3 trillion; annual budget deficits in
the $200-250 billion range will increase the outstanding stock about
15 percent per year. This is well in excess of annual GNP growth, so
that the interest burden of the debt will escalate relative to GNP and
federal expenditures. Pressure to escape this dilemma through
monetization and inflation will intensify.
These patterns and structural problems suggest business as usual in the U.S.
economy and undermine the argument of a supply side resurgence. They suggest
why strong growth « if it occurs — is likely to be associated with accelerating
inflation and higher interest rates in 1984 and 1985, as discussed below.
Outlook for 1984
*
*
The following factors form the basis for our 1984 forecast:
The balance between consumption and investment in the U.S.
economy, including the large budget deficts, remains unfavorable, as
just discussed.
Monetary growth (both Ml and the monetary base) exceeded 9
percent in 1983, following 8-9 percent growth in 1982. In order to
promote continued growth, we expect the Fed to allow money growth
(both Ml and the monetary base) in the 7-Z percent range in 1984,
which will leave 3 year monetary growth -- 1982-84 — close to its
1977-79 rate.
*
The economy ended a very strong year with strong growth in the
fourth quarter as well. The reported 4.8 percent growth in the fourth
quarter is misleading because of a sizable negative contribution from
reduced farm production in response to the payment-in-kind program
and bad weather. We estimate that eliminating the effects of farm
production shows non-farm growth of 5.5 percent-6 percent for the
fourth quarter.
*
Though inflation is far below the double digit figures in 1980, there is
increasing evidence of a firming in the inflation numbers. The CPI,
excluding food and energy, is running about 5.5 percent over the past
six months, up from about 4 percent earlier in the year. Fixed-weight
price indices for GNP and its major components increased at a 4.5-5.0
percent rate in the second half of 1983 versus 3.5 percent in the first
half. Wage settlements are running about 6 percent, much lower in
48
*
declining industries but somewhat above 7 percent in the rest of the
economy. Unit labor costs are certain to rise as soon as productivity
growth slows in line with an inevitable slowing in ouput growth.
Near-term money growth, though lower than the double-digit growth
from mid-1982 to mid-1983, remains quite high. The monetary base
grew over 9 percent per annum over the past three months and the
past six months. Ml growth is slightly lower over the past six months
but exceeds 9 percent over the past 12 months. These numbers do not
suggest restraint but are consistent with continued growth over the
next several quarters.
Also suggestive of continued monetary
stimulus is the positive slope of the yield curve. Typically, when the
Fed tightens sufficiently to bring on recession, the yields curve
flattens or even inverts. At present, the yield curve is as upward
sloping as at the end of 1982.
Assuming 7 percent money growth and 3 percent velocity growth in 1984,
nominal GNP will grow 10 percent to 11 percent in 1984. Total GNP growth
should be fairly uniform throughout the year, but the distribution between output
and inflation will change over the year. In the first half of 1984, inflation will
still be 5& percent-6 percent. With inflation below 6 percent and unemployment
still above its natural rate, output will increase at a 5 percent annual rate.
However, this above trend output growth will cause unemployment to decline to
the 7 percent area and capacity utilization to rise to the 83 percent-85 percent
area by late 1984. Reflecting long run monetary growth and the very rapid
convergence toward full employment, the inflation rate will accelerate to the 6
percent-8 percent range by late 1984 or early 1985. Higher inflation and fuller
utilization will result in a decline in output growth — to the 3H percent area ~ in
the second half of the year. We believe the greatest risk to this forecast is not
the supply-side forecast allowing for another year of rapid growth with moderate
inflation but a weaker economy (with somewhat less inflation) if the Fed opts for
restraint to control inflation at the expense of continued expansion.
Looking Ahead to 1985
Assuming that the Federal Reserve continues to foster above trend growth
in 1984 in order to reduce unemployment, the economy will end 1984 with both
inflation and unemployment at 7 percent. At this time, the Fed will face the
same pair of unpleasant options that existed at the end of 1973 and 1979.
The Fed can opt for another year of expansion. Unfortunately, with
inflation at 7 percent, it will take an 8 percent-10 percent rate of monetary
49
growth to keep the economy expanding faster than trend. With unemployment at
7 percent, another year of above trend growth will bring unemployment below its
natural rate. Particularly with such a low rate of unemployment, 8 percent-10
percent money growth is likely to cause inflation to accelerate to an 8 percent10 percent rate by late 1985. Alternatively, the Fed could opt for restraint to
keep inflation from accelerating further. In this case, the economy will move
into recession before the end of 1985.
Whereas we expect the Fed to promote expansion in 1984, we expect the
Fed to bite the bullet and move toward restraint in late 1984 or early 1985. As
well as the removal of election considerations, the inflation-unemployment
tradeoff will appear different by the end of 1984.
At present, with
unemployment still around 8 percent and inflation below 6 percent, the major
priority is to reduce unemployment. By the end of 1984, with unemployment
closer to 7 percent and inflation moving toward 8 percent, the major priority will
shift toward controlling inflation. Federal Reserve actions will shift in response
to these changing priorities, just as the policy focus alternated between inflation
and unemployment throughout the 1970s.
ECONOMIC PROJECTIONS
(1972$, Seasonally Adjusted Annual Rates of Change Except Where Noted)
1982
Heal GNP
GNP Deflator
Nominal GNP
Real Final Sales
1983
1984
Q3A
Q4A
QIA
Q2A
Q3A
8!A
211
Q2E
Q3E
Q4E
-1.0
-1.3
3.7
2.7
3.8
2.5
4.5
2.6
5.5
8.2
0.6
9.7
3.3
7.6
3.6
6.1
5.5
4.6
6.0
3.6
6.5
3.5
7.0
13.3
11.5
11.9
10.9
10.3
10.8
6.8
5.1
4.8
4.2
9.2
4.8
5.8
3.7
3.3
2.7
-1.5
Ml
Annual: 4th Qtr. to 4th Qtr.
1982A
1983A
1984E
-1.7
4.4
2.6
0.2
9.0
7.9
Monetary Base
Velocity of Ml
Velocity of Monetary Base
-5.9
-5.0
Real GNP Conponents:
Consunption
0.9
Durables
-3.7
Nondurables
1.3
Services
2.1
15.2
Business Inv.
Structures
Equipment
-8.8
-7.2
-9.6
6.2
4.1
4.4
6.2
10.6
10.9
4.3
3.9
10.0
7.0
7.0
3.6
3.6
9.3
0.5
1.2
4.4
6.0
4.5
3.8
2.8
4.0
2.5
2.6
2.0
2.1
2.0
2.0
2.5
6.2
0.6
2.9
12.9
10.2
13.9
10.6
8.6
9.0
8.4
-9.0
-4.2
-11.1
13.0
-2.6
20.4
10.4
11.2
9.6
9.0
9.9
2.1
5.0
2.5
0.0
0.0
3.0
40.6
1.9
4.5
0.0
-5.9
19.4
7.1
4.6
7.0
4.5
6.8
4.5
6.7
8.6
7.5
-5.9
7.3
8.1
6.9
-23.4
16.5
-1.1
-1.1
-1.1
-0.5
-1.1
-0.7
11.1
-27.2
4.2
-33.8
-0.5
60.2
0.0
0.1
0.5
11.6
-0.6
20.5
-15.4
12.3
-5.4
11.4
6.3
3.9
1.0
5.0
-2.0
3.8
-2.0
10.0
-1.5
13.0
10.5
10.2
9.2
9.5
8.4
9.4
7.4
(9--10)
7.2
7.0
8.7
9.9
8.8
7.8
9.3
10.8
-8.1
69.0
10.7
10.6
18.4
73.9
11.6
21.8
77.4
11.7
10.6
78.9
-7.5
15.1
7.3
0.2
-15.7
5.2
61.1
4.0
20.0
2.9
7.6
3.2
1.4
10.0
32.6
-6.7
-5.5
-7.1
-1.5
-13.9
8.0
-13.1
Federal
Defense
Nondefense
State 4 Local
26.2
14.1
59.1
-0.2
Net Bcp (Bi.72$)
Invent (Bi.72$)
3.6
5.7
6.3
18.4
19.5
4.1
3.0
4.2
3.7
5.0
-14.9
19.8
18.6
11.1
22.0
29.1
10.6
37.1
53.1
57.7
78.6
36.0
28.2
-17.9
-2.7
5.1
6.5
7.5
92.6
-0.2
-52.5
-1.6
24.0
-1.3
23.0
-22.7
9.8
11.0
12.8
-3.4
71.1
-0.3
1.5
1.9
6.4
6.4
2.2
3.7
3.6
0.6
5.2
15.0
4.3
2.8
3.9
7.7
3.3
3.0
Ui
Residential
Addenda:
Unenp Rate (%)
Funds Rate (%)
30-Yr Gov't. (%)
Ind. Prod.
CapUtil Mfg. (%)
DPY72$
PretxProf w/IVACCA
Auto Sales*
Housing**
4.1
5.6
1.12
70.7
8.5
(11--12)
11.0
9.0
82.0
80.5
6.0
3.5
83.0
83.0
2.6
2.9
3.5
6.5
7.9
5.5
4.5
3.5
2.5
59.0
107.5
68.0
21.5
25.0
22.0
19.3
13.9
6.0
6.1
6.9
6.9
7.2
8.0
7.8
7.7
7.7
1.26
1.64
1.69
1.78
1.69
(1.7--1.9)
5.3
9.3
10.8
(10--11)
(12--13)
-14.8
•Millions of domestic units.
**Millions of starts.
Prudential Economic Research
February 27, 1984
9.9
0.0
9.0
(1.7--1.9)
O
RECENT BEHAVIOR OF THE Mj - ADJUSTED MONETARY
BASE MULTIPLIER AND FORECASTS
FOR EARLY 198*
James M. JOHANNES
and
Robert H. RASCHE
Michigan State University
Since the last meeting of this committee, we have been experimenting with
a different presentation of our forecasts of the M. - Adjusted Monetary Base
Multiplier. In the past we have always constructed forecasts directly from the
forecasts of the various component ratios, which come out of the ARIMA models
that we have estimated.
These forecasts are not seasonally adjusted, so
comparisons over time horizons shorter than one year are difficult to interpret.
Our revised presentation allows us to compute forecasts on a seasonally adjusted
basis that are not contaminated by errors in forecasting seasonal factors. The
presentations employ the known seasonal factors that are published in the
Federal Reserve Bulletin for the various components of the monetary aggregates
and the seasonal factors constructed each year for the Adjusted Monetary Base
by the Federal Reserve Bank of St. Louis. The exact formulas that are employed
to construct a seasonally adjusted forecast of the multiplier from the not
seasonally adjusted forecasts of the component ratios are indicated in the note
attached to this report.
The history of our recent forecasting experiments is presented in table 1.
There, monthly forecasts on up to six months horizons are given starting with
data available through August 1983, and continuing through January 198*. It
should be noted that the forecasts based on information through January 1984,
correspond to the unrevised data as presented in the H.6 release of February 10,
1984, and not the revised data initially presented in Chairman Volcker's
testimony and subsequently in the H.6 release of February 16, 198*. The latter
data incorporate new benchmarks, new computations of the seasonal factors, and
a new definition of the M, aggregate.
In order to construct forecasts
52
corresponding to the new revisions, we would need the historical series for all of
the components of the monetary aggregates in order to reestimate our ARIMA
models for the various ratios. It is our understanding that the historical data will
not be available until approximately mid-March 1984 so at the moment we have
no choice but to present the forecasts on the old basis.
Our forecasting experience in the recent months has been comparable to
the results that we have tabulated at various times in the past. The mean error
for the one month ahead forecasts (5 observations) is .15 percent and the
corresponding root-mean-squared-error is .52 percent. When we advance to a
two month forecasting horizon (4 observations) the mean error is -.26 percent
and the root-mean-squared-error is .68 percent. On a three month horizon there
are only three observations, so the sample is so small that computation of any
error statistic is not very meaningful. On the surface it would appear that the
forecasting performance deteriorates when we advance this far, but this
conclusion can be heavily influenced by one month's observation.
The forecasts for the next six months suggest very little, if any, change in
the multiplier in the near future. The forecasted values decline slightly in March
and April, but then recover to the January level by Oune and 3uly of 1984. Of
course, it should be kept in mind that the models are naive with respect to the
change from lagged reserve requirements to contemporaneous reserve
requirements that has just taken place. It is possible that the uncertainty
associated with this change may cause an increase in the demand for excess
reserves by banks, at least temporarily. If such an increase should occur, then
the observed reserve ratio would be higher than that forecasted by our ARIMA
model, and the partial effect of this influence on the multiplier would be that the
actual value would turn out lower than the predicted value.
M,-Adjusted Monetary Base
Forecast for Months of:
(Seasonally Adjusted)
1983-84
Base
Sept.
Oct.
Aug.
2.6384
(-.38)
2.6346
(-.78)
2.6349
(-1.40)
2.6421
(-1.24)
2.6333
(-1.29)
2.6446
Sept.
2.6284**
2.6175
(-.13)
2.6181
(-.76)
2.6246
(-.57)
2.6227
(-.88)
2.6284
2.6241
2.6141**
2.6105
(-.47)
2.6165
(-.26)
2.6151
(-.60)
2.6207
2.6174
2.5996
2.5982**
2.5847
(-96)
2.5799
(.76)
2.5831
2.5775
2.5593
2.5733
2.6096**
2.6051
(-.21)
2.6093
2.6057
2.5887
2.6040
2.5977
2.5995**
2.6020
2.5976
2.5809
2.5970
2.5906
Oct.
Nov.
Nov.
D e c , 1983
Dec.
Jan.
Jan.,* 1984
* Prior to revised data announced In H.6 release of 2/16/84
**Actual multiplier
Note:
Numbers In parentheses are percentage forecast errors
Percent
Mean Error
RMSE
1 Month Forecasts (5)
.15
.52
2 Month Forecasts (4)
-.26
.68
Feb.
Mar.
Apr.
May
June
July
2.6028
5k
FROM:
SUBJECT:
Bob Rasche
Seasonally Adjusted Multiplier Forecasts
As you know, the multiplier forecasts that Jim Johannes and I have been
constructing are developed from not seasonally adjusted component ratio data,
and hence are forecasts of the not seasonally adjusted multiplier. The simpliest
way to construct a seasonally adjusted multiplier forecast is to use the seasonal
factors prepared by the Board of Governors and the St. Louis Fed in February of
each year, and which are used to seasonally adjust the data for the coming year.
This eliminates any forecast error from errors in forecasting the seasonals.
The Board of Governors seasonally adjusts the components of Ml spearately.
Their seasonal factors are published on p. 200 of the March, 1983 Federal
Reserve Bulletin. In contrast, the St. Louis Fed seasonally adjusts the whole
adjusted monetary base, not its components. They have sent me their seasonal
factors for 1983 (attached).
The seasonal factors are defined in all cases such that
X (NOT SEASONALLY ADJUSTED)
X (SEASONALLY ADJUSTED)
=
POD V
« . „ „ . , ^nr™
SEASONAL FACTOR FOR X.
Therefore we can write:
(1)
Ml(SA)
BASE (SA)
=
CUR(SA) + TC(SA) + DD(SA)
BASE(SA)
where CUR(SA)= currency (seasonally adjusted)
TC(SA) = travelers checks (seasonally adjusted)
DD(SA) = demand and other checkable deposits (seasonally adjusted)
We can use the above definition for seasonal factors (SF) to write this in terms of
the not seasonally adjusted data:
(2)
Ml(SA)
BASE(SA) "
CUR(NSA)
CUR(SF)
+
TC(NSA)
TC(SF)
BASE(NSA)
BASE(SF
+
DD(NSA)
DD(SF)
55
Now divide through the top and bottom of (2) by "••Kprt'sFi
m
w
,
r CUR(NSAX r DD(SF)
L
Ml(SA)
DD(NSA) J l CUR(SF) J +
BASE(SA) ~
r BASE(NSAn
1
DD(NSA) J
CUR(NSA)
a +
But
J C C N S A h rDD(SF) ,
DD(NSA)J [ TC(SF) J
rTjDiSFH,
l
BASE(SF"}J
+ l
,
,
=k
DD(NSA)
BASE(NSA)
DD(NSA)
l
:
=
,
(r
.
IW|
D(l
+
+
t
1 +
t
+ g +
2
2)
» ,
+ k
As forecast by the Johannes-Rasche models and
r TC(NSA), rDDCSF), _ r TC(NSA), .CURCNSA), , DD(SF), f CUR(SF) 1
1
DD(NSA) J l TC(SF) J " l CUR(NSA) J l DD(NSA) J l CUR(SF) J l TC(SF) J
t r Lr r DD(SF),
l
CUR(SF) J
TC,K
, +
Let
DD
r
l
^SF> i _ c
BASE(SF) J - V
DD(SF) ,
'CURCSF) J
r
=
V
r
l
r
l
CUR(SF),
TC(SF) J
CUR(SF) .
TC(SF) J
Then
Ml(SA)
BASE(SA)
l+(Sc.k)(USt.tc)
- [ { r + £ ) ( l + t 1 + t 2 + g + z ) + k] S b "
t
_ 3
BUDGET DEFICITS AND THE DISARRAY OF FISCAL POLICY
Mickey D. LEVY
Fidelity Bank
The Budget of the United States Government, FY 1985 verified what
already was well-known — that high budget deficits will persist and the
government's debt will mount rapidly, even if the economy expands continuously
toward potential GNP. As stated in the Budget, on a current services basis,
deficits will remain near the $200 billion level even after the
economy has returned to lower levels of unemployment rate, below 6
percent in 1989.
At that time economic recovery will have
completed its contribution to deficit reduction . . . so projected
deficits at this level of unemployment are not 'cyclical' or temporary.
They are permanent or structural and will persist unless determined
policy actions are taken to eliminate them. (2-14)
Very few budget forecasters quarrel with this assessment although some, like the
Congressional Budget Office, use less optimistic economic forecasts and arrive
at faster growth of outlays and/or lower revenues, and thus higher deficit
projections.
Perhaps what is more disturbing about the FY1985 budget is that the Administration proposes no substantial changes in the trend of the budget
aggregates. It proposes continuous increases in real dollar outlays and only a
small reduction in outlays as a percent of GNP from an all-time high for a
peacetime, expanding U.S. economy. It is a sad commentary that, even if
Congress agrees to everything the Administration asks for (and if the
Administration's economic outlook actually occurs), real spending will rise
substantially and deficits will remain about $175 in each of the next three fiscal
years. Furthermore, Congress does not seem willing to consider anything more
than minor, symbolic cuts in government spending. The unwillingness of the
Administration and Congress to seriously address the budget issue -- at least
until after the Elections — points glaringly to the disarray of fiscal policy.
The Administration's FY 1985 Budget Proposals
The Administration proposes FY 1985 outlays of $925 billion, revenues of
$745 billion, and a unified budget deficit of $180 billion, slightly less than the
58
deficit it estimates for FY 1984. These proposed budget aggregates include $19
billion of outlays savings from current services in FY 1985 ($72 billion during the
three years FY1985-FY1987) and $8 billion higher taxes in FY 1985 ($34 billion
for the three years). Absent the proposed changes, the budget deficit would be
$208 billion in FY 1985 and increase further in later years (see Table 1).
TABLE 1
THE ADMINISTRATION'S BUDGET PROPOSALS
(Billions $)
Outlays
Current Services
Saving-DOD
Saving-Non DOD
Budget
Receipts
Current Services
Receipt increases
Budget
Deficit
Current Services
Budget
1985
Fiscal Year
1986
1987
945
-13
-7
925
1019
-13
-15
992
1094
-6
-19
1068
737
8
745
803
12
815
874
14
888
-208
-108
-216
-177
-220
-180
Slightly Slower Spending Growth. Outlays are proposed to rise 8.4 percent
from FY 1985, or 3.3 percent in real (constant 1972) dollars. In FY 1986 and 1987,
real spending is proposed to increase 2.1 percent and 2.9 percent, respectively.
This represents a continuation of the recent trend toward slower growth in
spending, but it is not as sharp a turnaround as one would hope. In fact, the
Administration has scaled back from last year's budget proposals its request cuts
in non-defense spending, and its recommended increases in defense outlays more
than offset proposed reductions in non-defense spending. On the tax side,
proposed revenues are 11.2 percent higher than FY 1984 (7 percent in real
dollars). Absent from this year's budget is the large contingency tax proposed
last year, and included are some modest ($8 billion) increases in tax revenues
above current services.
59
Shift In Composition of Spending. The most notable characteristic of the
FY1985 Budget, beside the persistent budget imbalance, is the continuation of
the sharp shift in the composition of government spending, not the slowdown in
spending growth. The portion of outlays for debt service and defense spending
will each continue its sharp rise. Defense spending is retracing its share that
eroded in the 1970s, while the portion of outlays for debt service is rising to new
record highs for a peacetime economy. The portion spent for entitlements will
not change much, but there will be further reductions in spending for programs in
the domestic discretionary spending category (see Table 2).
TABLE 2
COMPOSITION OF BUDGET OUTLAYS
(Percent of total federal outlays)
Fiscal Year
1965
1970
1975
1980
1985 e s t .
Defense
Payments for
Individuals
Net
Interest
Other
Offsetting
Receipts
42.7
41.7
26.7
23.2
29.4
28.5
33.8
48.4
49.1
47.6
7.3
7.4
7.1
9.1
12.5
26.5
21.5
22.0
22.0
14.3
-5.0
-4.4
-4.2
-3.4
-3.8
The Administration proposes a 14.5 percent increase in defense spending
for FY 1985 (9.5 percent in real terms). While this is less than the increase asked
for in last year's budget, it would raise the portion of total federal outlays spent
on defense to 29.4 percent from 23.3 percent in FY 1980. Most of the proposed
increase in budget authority in defense is for weapons procurement and
operations and maintenance, although over one-quarter of the defense budget is
for military personnel.
Outlay savings of $5 billion are proposed for non-defense and non-interest
programs in FY 1985, representing less than a 1 percent reduction from those
program outlays scheduled under current law. The Administration proposes very
little change to social security, railroad retirement or unemployment insurance,
which constitute about two-thirds of all entitlements and other "mandatory"
spending programs. It does call for modest cuts in federal and military
retirement and disability programs, primarily by delaying cost-of-living
60
adjustments. It recommends savings in Medicare, but those savings would be
generated largely by increasing beneficiary premiums for Supplementary Medical
Insurance (in the unified budget, this raises offsetting receipts, which are
counted as negative outlays rather than revenue additions).
The FY 1985 budget calls for further cuts in major means-tested transfer
programs, such as AFDC, food stamps, and SSI, which are targetted toward
lower-income families. (These cuts are similar to those proposed in last year's
budget.) Additionally, the Administration recommends freezing at current prices
farm support payments, which would generate substantial saving, depending on
crop production and price levels.
Slight Increase in Revenues. The Administration's proposed tax changes
would have only a relatively small impact on total revenues — combined they
would raise $8 billion in FY 1985 (approximately 1.1 percent of total revenues)
and $35 billion over the three years FY 1985 to FY 1987 — but for the most part
they represent worthwhile reforms. The largest revenue gains, taxing a portion
of employer contributions for health insurance premiums, was recommended last
year.
Other recommended changes include increasing federal employees
contributions to retirement and covering railroad employees under unemployment
insurance; limiting use of tax exempt revenue bonds, leasing by tax exempt
entities; and generally limiting use of several blatant tax shelters, particularly
certain corporate accounting and tax abuse practices. Many of these proposals
were part of last year's budget, and some already have been approved by the
Ways and Means Committee.
Persistent Deficits and Mounting Debt
Sensitivity of Budget Projections to Economic Forecasts. The Administration forecasts that with passage of its budget proposals, which during the
three years FY1985-FY1987 reduce current services spending by $73 billion and
add $34 billion to tax revenues, deficits still will remain above $175 billion
through FY 1987. After that, the Administration projects deficits to fall, to $152
billion in FY 1988 and $123 billion in FY 1989. These out-year projections are
aided somewhat by the mounting impact of its proposed spending cuts and tax
increases, but even more by very optimistic economic projections of continued
strong economic growth with monotonically declining rates of inflation and
61
interest. The Administration clearly states the extreme sensitivity of its budget
forecasts to the path of economic activity, prices and, particularly, interest
rates. It provides one example that is particularly eye-opening: if, beginning in
1985, the Administration's forecast for nominal GNP occurs, but with one
percentage point slower real economic growth and one percentage point higher
inflation, with no further declines in interest rates after 1984, deficits would be
$12.6 billion higher than forecast in FY1986, $30.8 billion higher in FY1987, and
$85.7 billion higher in 1989.
Based on less optimisitc economic assumptions, the Congressional Budget
Office (An Analysis of the President's Budgetary Proposals for Fiscal Year 1985,
February 1984), foresees deficits rising from $184 billion in FY 1984 to $192
billion in FY 1985 and $211 billion in FY 1986, even with enactment of the
Administration's spending and taxing proposals. The largest difference between
the two forecasts is the higher spending path estimated by the CBO, primarily as
a consequence of its higher forecasts for nominal and real interest rates, and its
outlook for slower economic growth beginning in 1986, as described in Table 3.
In addition, the CBO forecasts faster growth of defense outlays based on the
Administration's request for defense budget authority. The impact of different
economic forecasts mounts as the projection period lengthens. The CBO
forecasts that the Administration's FY 1985 budget proposal will generate budget
deficits of $248 billion in FY 1989. While it is impossible to accurately forecast
economic events so far out, such projections illustrate quite clearly the
instability of current spending and taxing policies (see Chart 1).
The SOMC also sees higher deficits than the Administration forecasts,
particularly beyond 1986. The SOMC's outlook for real GNP growth in 1984 is
similar to the Administration's, but it expects faster growth in inflation and
nominal GNP, which would generate higher tax revenues. However, interest
rates are not forecast to decline, leading to more rapid growth in outlays and,
consequently, slightly higher deficits. Current interest rate levels clearly
indicate the lack of financial market credibility in the Administration's interest
rate forecasts.
The Rising Government Debt. The persistent flow of deficits is adding to
the total stock of government debt at an alarming rate. The federal government
outstanding public debt has risen from $533 billion in FY 1975 to $908 billion in
62
Table 3
ESTIMATES OF THE ADMINISTRATION'S BUDGET PROGRAM
(Billions S)
1984
Revenues
Administration
CBO
Outlays
Administration
CBO
Deficit
Administration
CBO
Fiscal Year
1985
1986
1989
670
665
745
741
815
807
1060
1039
854
851
925
933
992
1018
1084
1287
184
184
180
192
177
211
123
248
ECONOMIC ASSUMPTIONS UNDERLYING BUDGET FORECASTS
GNP, nominal (Bil $)
Administration
CBO
GNP, real
Year-Over-Year % Chg.
Administration
CBO
CPI,
Year-Over-Year % Chg.
Administration
CBO
Unemployment Rate, civilian
% Average
Administration
CBO
3-Month Treasury Bills,
% Average
Administration
CBO
Inflation-Adjusted Interest
Rate (T-Bill minus
GNP deflator)
Administration
CBO
Source:
1984
1985
Calendar Year
1986
1989
3642
3651
3974
3995
4319
4339
5445
5480
5.3
5.4
4.1
4.1
4.0
3.5
3.9
4.4
4.5
4.6
5.0
4.5
4.9
3.6
4.3
7.9
7.8
7.7
7.3
7.5
7.0
5.8
t .5
8.5
8.9
7.7
8.6
7.1
8.4
5.0
7.«
2.9
3.5
2.6
3.5
1.4
3.3
Congressional Budget Office, An Analysis of the President's Budgetary
Proposals for Fiscal Year 1985, pg. 10 and 16.
TREASURY RECEIPTS AND EXPENDITURES
AS A PERCENTAGE OF GNP
28
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/ /,
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25
P
E
R
C
E
N
T
22
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' /,
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/ /.
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/ /.
/ /,
/ /,
/ /,
- 1/' /,/.
//,
' //
///
'//
'//
'//
'//
'//
'//
'//
'//
' //
'//
•//
'//
'//
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'//
'//
'//
//
'/ /
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'/ /
• /
/
//
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// /y
//
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/? //
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1-28
25
/ si
I - 22
ON
19
h- 19
16
16
13
13
Rpcclpts
Exprmll t u r e s
FY19Rr; Rudp.rr
Pi nixiM.T 1 fv.i Iw.ite
FISCAL YKARS
64
FY 1980 to nearly $1.38 trillion by year-end 1983. Based on the CBO deficit
projections, the total outstanding debt will exceed $2 trillion by year-end
FY 1986, a nearly 50 percent rise in just three years. And this outlook is based on
continued strong economic growth that would provide a sharp erosion of the
cyclical component of the deficit.
It is difficult to think of any benefits of such a trend, and easy to identify
undesirable impacts:
*For Budget and Fiscal Policy. The government's net interest costs will
rise, in absolute terms, and as a percent of federal budget outlays and GNP.
Budget outlays and deficits will become increasingly sensitive to interest
rates. Thus, the avenues available to reduce spending and deficits shrink.
Without unanticipated sharp and sustained declines in interest rates, budget
outlays will rise, even as the economy moves toward its potential growth
path. As net interest costs rise as a portion of federal spending and GNP,
the deficit becomes less sensitive to macroeconomic fluctuations. This
calls into question the future role of built-in automatic stabilization in the
fiscal policy sense (particularly if inflation-adjusted rates remain high), and
may have implications for the future path of potential GNP and the
calculation of structural budget deficts.
•For Monetary Policy. With the rapidly mounting stock of government
debt, a non-inflationary monetary policy requires that the Federal Reserve
absorb a smaller portion of new debt than its post-Accord average and
substantially reduce the current ratio of federal debt held by the Federal
Reserve to total federal debt. Maintaining the current ratio of debt held
by the Federal Reserve to total debt would produce sharp increases in
reserves and money supply, generating higher inflation and inflationary
expectations. Simply put, with the deficits and mounting debt we now
face, the fine line between monetary accommodation of government debt
and inflation becomes razor-sharp, and the Federal Reserve has less room
to maneuver.
*Other. The forecasted rapid expansion of the stock of public debt would
far exceed the growth of economic activity, growth of the stock of capital
assets, or the growth of domestic saving. Regarding the impact of deficits
and stock of debt on prices of financial assets, the jury is still out on the
65
basis of rigorous theoretical and empirical research. However, during the
next several years the concept of Ricardian equivalence certainly will be
severely tested, and the ratio of the stock of government debt to the stock
of total capital assets will rise substantially, perhaps enough to induce
portfolio adjustments, which would lead to upward interest rate pressures.
Budget Prospects
Certainly, the goal of reducing deficits is important, but it should not be
pursued blindly without regard to how it is accomplished and the economic
effects of doing so. Slowing the growth of government spending should be
considered equally high on the priority list. Rising government outlays bias the
composition of economic activity and, under current circumstances of an already
high ratio of spending to GNP, may reduce future economic growth. It would be
a mistake to neglect the path of spending and reduce the budget imbalance by
raising taxes in a way that would discourage saving and investment. Moreover,
while Wall Street clearly favors lower deficits, one would be naive to believe
that it is indifferent as to how deficits are cut. For example, raising taxes may
lead to lower interest rates — but it would do so by slowing economic growth, a
counterproductive outcome.
Tax hikes should take the backseat to spending cuts. Most importantly, the
indexation of personal income taxes scheduled for 1985 must remain intact, and
tax increases should avoid increasing marginal rates or other means of discouraging productive economic activity. Nevertheless, within these guidelines,
there is substantial room to broaden the tax base, increase economic efficiency,
and improve the fairness of the tax system.
The Administration's few proposed spending cuts in the FY1985 Budget are
disappointing, but not unexpected in this election year. In general, the proposed
changes are minor relative to what must be done. In another sense, the lack of
substantial cuts reflects the difficulty of the task at hand.
Substantial
momentum generated from earlier enacted increases in budget authority for
defense nearly guarantees increases in defense spending. Interest expenditures
will rise substantially, and probably will be higher than the Administration forecasts. And non-defense outlays for means-tested entitlement programs already
have been cut sharply in recent years. Meanwhile, despite continued sharp
66
increases in payments to individuals, Congress and the Administration are still
congratulating themselves on the passage of the Social Security Amendments of
1983. It is a discouraging exercise to go through the categories of federal
spending programs and eliminate areas where spending cuts would be very
difficult politically to achieve.
Two areas that must be addressed are the non-means-tested entitlement
programs, where cash payments to individuals are not based on the beneficiary's
income, and Medicare. The first group, which includes social security, railroad
retirement, Veterans compensation, civil service retirement, and unemployment
compensation, constitute over 80 percent of all non-health payments to
individuals. Likewise, the very rapid growth of Medicare payments must be
slowed. Medicare outlays have more than doubled every five years since the
program began, and are proposed to be $70 billion in FY1985. There are many
ways that these programs can be modified to generate budget savings without
dealing unfairly with the truly needy or undercutting adequate medical insurance
for the aged (a list of options is provided in Congressional Budget Office,
Reducing the Deficit: Spending and Revenue Options, February 1984). Until
these components of the budget are faced squarely, budget cutting exercises will
be limited to band-aid type solutions applied to a large, menacing problem.
What are the prospects for action in 1984? At present, Congress seems
prepared to embrace the tax reform package passed by the Ways and Means
Committee, which includes some of the Administration's proposals and would
generate approximately $50 billion in additional revenues during the next three
years. Most of the recommended provisions in the tax package would improve
the current tax structure. As budget policy, the importance of this legislation
will be determined in part by whether it is accompanied by cuts in spending.
While nothing major should be expected, I am cautiously optimistic that a modest
spending cut package will emerge. That would represent a pleasant change from
typical election year economic policies.
@FedFRASER