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SHADOW OPEN MARKET COMMITTEE P o l i c y s t a t e m e n t and P o s i t i o n Papers March 2 4 - 2 5 , 1985 PPS-85-1 \ f % £ • V ^m ^ ^ _ 4T ^ ^ *^hr CENTER FOR RESEARCH IN GOVERNMENT POLICY & BUSINESS Gradijate School of Management University of Rochester SHADOW OPEN MARKET COMMITTEE Policy Statement and Position Papers March 24-25, 1985 PPS-85-1 Shadow Open Market Committee Members - March 1985 SOMC Policy Statement, March 25, 1985 Position papers prepared for the March 1985 meeting: Confusion of Language and the Politics Brunner, University of Rochester of Uncertainty, Karl Guidelines for Deficit Policy, Mickey D. Levy, Fidelity Bank Economic Outlook, Jerry L. Jordan, First Interstate Bancorp Forecasts of the Ml - Adjusted Monetary Base Multiplier for 1985, Robert H. Rasche, Michigan State University International Trade Policy: Switzerland The Two Main Tasks, Jan Tumlir, GATT, Shadow Open Market Committee The Committee 1985. met from 2:00 p.m. to 7:30 p.m. on Sunday, March 2, 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. DR. JERRY L. JORDAN, Senior Vice President and Interstate Bancorp, Los Angeles, California. DR. MICKEY D. LEVY, Chief Economist, Pennsylvania. Economist, Fidelity Bank, PROFESSOR WILLIAM POOLE, Department of Economics, Providence, Rhode Island. First Philadelphia, Brown University, 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 Trust and Savings Bank, Chicago, Illinois.* Economist, Harris DR. JAN TUMLIR, Research Director, GATT, Geneva, Switzerland. *0n leave from the SOMC, currently Under Secretary of the Treasury for Monetary Affairs. POLICY STATEMENT Shadow Open Market Committee Meeting March 25, 1985 Economic economic recovery policies. continues The despite the absence of Federal Reserve concentrates on coherent short-term policy decisions and lurches from excessive money growth to slow money growth and back to excessive money growth, with no long-term to achieve non-inflationary money growth. program It is disappointing that the Administrtion projects essentially no change in the inflation rate in the rest of the decade. The Congress concentrates on short-term budgetary adjustments and avoids developing a long-term fiscal program to maintain growth counterproductive Administration achieve These its that and increase the economic Federal Reserve stability. and favor currency market intervention, intended effect and destabilizes the It members of is the since it does not exchange actions increase uncertainty and reduce efficiency. market. They make private planning more difficult. During the last five years, the United States has made progress in improving economic fundamentals — lower inflation, interest rates, increased output and productivity growth. should not be squandered. important lower These gains To maintain and extend these gains, present fiscal and monetary policy uncertainties must be resolved. Fiscal Policy The shifts and central fiscal issues are the degree to which the government resources toward current consumpiton and away from investment the way the budget is financed. 1 A rising share of government spending toward typically means that the government is shifting current consumption and away from investment. lower investment and eventually lower output. resources The result If higher spending is financed by increasing money growth, is government inflation rises. If spending is financed by higher income taxes, the government's spending for consumption crowds out private spending and saving. Investment and future output are reduced. Excessive attention to the size of the deficit away from these central issues. about the relationship of the budget deficit to the foreign government trade between There is no valid for believing that a reduction in the budget deficit followed by a fall in the dollar exchange rate. in statements There is no simple connection current exchange rate and the budget deficit. reason attention Misleading and incorrect deficit misinform the public. the draws will be In fact, a reduction spending for consumption that shifts resources toward investment and lowers the risk of future inflation may be followed further appreciation of the dollar against other currrencies. by This should not be an excuse for failing to act on the deficit. The effects of budget policy depend on the details of the package. Current All use reductions of price in spending do not have the controls expenditures under medicare efficiency. on It.is not a part of, medical same effect. services or a substitute for, to reduce that is a short-term stop-gap fiscal policy to reduce spending. fiscal reduces a long-term Reduction in defense appropriations often are followed by reductions in manpower that reduce efficiency by reducing equipment. the labor available Reductions in to operate planned available spending for maintenance of highways other social capital postpone spending to a later date. or 2 and Discussion of fiscal policy puts too much emphasis on the size of projected budget deficits and too little emphasis on the efficient use of resources. proposed We urge Congress to support the Administration's spending cuts and indeed enact additional cuts. We propose five principles of budget policy to contribute to growth and stability and reduce uncertainty. 1. Congress should reduce the ratio government spending to total output, initially, at least 2 percent below current levels and thereafter maintain the ratio as part of a long-term fiscal plan. 2. Spending reductions should take precedence over tax increases. These reductions should not be at the expense of public goods such as defense in order to maintain transfer outlays. Both must be reduced. 3. Spending reductions should be made in ways that increase efficiency in the use of resources. 4. Short-run action to reduce the deficit should be consistent with long-term structural reform of spending programs. Postponements masked as reductions should be avoided. 5. Any revenue increases agreed upon as part of a budget compromise should fall on consumption spending. Full indexation of the income tax should be retained. To make a fundamental change in the government's fiscal policy, it is essential to put a cap on total federal spending. Monetary Policy The Federal Reserve cannot change the government's fiscal The policy. responsibility of the monetary authorities is to maintain stable monetary conditions consistent with a return to full price stability. Unfortunately, confusion and uncertainty surround monetary policy. The Federal Reserve announces targets for monetary aggregates and, at the same time, urges more intervention in the exchange market. seem unaware that, They if they achieve their monetary targets, the only 3 effect of exchange rate intervention is to shift the risk of rate changes ultimately, from to private speculators to the the taxpayers. Federal exchange Reserve and Further, the Federal Reserve uses control procedures that increase the variability of money growth. long as current procedures are used, interest rates, exchange As rates and output will vary excessively. At our last meeting, we praised the Federal Reserve for keeping average money growth near the mid-point of the target range. We urged them to reduce the uncertainty created by erratic money growth and to announce a program to end inflation by the end of the decade. The Federal Reserve, instead, announced a very modest reduction of 1/2 percent in average money growth for 1985 and increased the shortterm variability of money growth. inflation, they have postponed or abandoned any inflation. This present adopt a long-term to is Although they talk about reducing a mistake. effort to reduce There is no better time than policy to reduce the trend the rate of inflation. A year ago the FOMC set a target for 1984 money growth centered on 6 percent. The Shadow Committee preferred a lower target for 1984 but emphasized the paramount importance of instituting a long-run of achieving non-inflationary money growth. policy Actual Ml growth in 1984 was 5.2 percent, below the center of the Fed's target. In order framework for to eliminate "base drift" and establish a steady progress towards lower money growth, coherent the SOMC urges the Federal Reserve to increase Ml in 1985 by 5 percent from the mid-point of the original target range for 1985. This policy would result in an increase of 5.75 percent over the four quarters of 1985, or a 5.5 percent average increase for 1984 and 1985 taken 4 together. In the event that money growth in 1985 exceeds this think highly likely, target, as we the target for 1986 would still be based on the target level for year-end 1985, rather than the actual level of fourth quarter 1985. Chairman of Volcker acknowledged to Congress that the present method announcing neglected the generated by monetary targets is unsatisfactory. two most unsatisfactory the aspects — use of multiple targets and a His the statement uncertainty shifting base for announced monetary growth. Eliminating policy plan. base A drift is one component of a second long-run key component is to announce a monetary multi-year projection for expected money growth. The rate of money growth should not shift about haphazardly but should decline regularly. long-term strategy reduces uncertainty, A credible particularly in an era of large budget deficits. Reducing uncertainty lowers interest rates and raises real output. Many announce countries announce montary targets a single target, than the Federal Reserve. procedures are or projections. and some achieve the target more The reason is that the archaic and inefficient. Federal The Fed is Most reliably Reserve's unjustifiably complacent about the intra-year volatility that results. The stability third and step end in developing a monetary inflation is to require the policy Federal choose a single monetary target and improved control again achieve Reserve procedures. to We urge the Congress to require the Federal Reserve to announce a multi-year strategy for reducing inflation. to 5 Exchange Rates The recent central interventions banks have been by the Federal counterproductive, Reserve and destabilizing foreign exchange markets. The Federal Reserve cannot simultaneously control the growth of money and manage the exchange rate. Proposals for massive intervention or coordinated intervention are misguided. short-term response to slower money growth is a rise market rates and a rise in the exchange rate. rate The expected in short-term The longer-term effect will be lower market interest rates on short- and long-term assets and no effect on the real exchange rate — the exchange rate adjusted for differences in anticipated rates of inflation at home and abroad. The only way that the Federal Reserve, or other lasting effect on the exchange rate is by expected rate without of changing inflation fail. inflation. central banks, can have a changing their Efforts to change the exchange the rate of money growth and the expected This is the finding of every country's careful rate rate of study of exchange rate policy. There dollar are many factors affecting the exchange rates between and other unmistakable. States currencies, First, the but two principal expected rate of inflation forces and Germany Second, the expected after-tax return to capital has increased in the United States both in terms are inthe United has fallen relative to other countries, particularly and Japan, during the past four years. the relative to other countries. absolute This is a real change that cannot be offset by Federal Reserve actions. Proponents of exchange rate intervention mislead the public. dollar has risen because holders anticipate a 6 higher return The from holding dollar assets than from holding foreign assets. The principal change been in U.S. a shift investment international capital movements in recent by U.S. citizens and financial years institutions abroad to investment in the United States. has from Americans are repatriating their foreign assets to take advantage of the improvement in investment opportunities at home. Foreigners are investing more in the United States for the same reason. As a result, the net capital flow to the United States is high relative to previous current periods. account deficit is the counterpart of the capital inflow The and will remain as long as the capital inflow continues. Many deficit. States people view this process as a means of financing the This view is misleading. The flow of capital to the United is the result of many private decisions to invest in denominated assets. budget dollar- Unlike the 1960s and 1970s, when foreign central banks supported a weak dollar, U.S. government debt held by foreign central banks has fallen. We urge the Administration to reject the policy of exchange market intervention. Federal The Administration and Congress should demand that the Reserve ignore exchange market fluctuations and institute stable policy of controlling money growth to end inflation. 7 a CONFUSION OF LANGUAGE AND THE POLITICS OF UNCERTAINTY Karl Brunner University of Rochester I. Confusion of Language Interest rates fell throughout the second half of last year. dropped They by the middle of January 1985 below the level from which they started to rise early in 1984. The Federal Funds rate fell about 3 00 basis points and the discount rate was lowered in repeated steps last year. policy So turned apparently public "Wall Street" and the media decided "increasingly endless easy". Once again repetition of an old story. that we late monetary observe the The experts of the arena persist in interpreting the stance of policy in terms of the prevailing movements of interest rates. Declining interest rates reveal "tight an expressions movements signal "easy policy" and rising rates a policy". are moreover not just meant to summarize of interest rates. These the observed These movements are understood as a indicating that monetary policy conveys a stimulative ("easy") or retarding ("tight") effect on economic activity. This story has a long history. Depression done During the first year of the Great in 1930 the Fed assured itself and the public that it had everything possible to stimulate the economy. after all, were falling. Interest rates, There was nothing more to be done. Events had moved beyond the control of the Fed. Early policy. in the year 1960 the Fed announced a shift Free reserves rose and the Federal Funds rate fell. apparent stimulus failed to affect the economy. mild recession. toward Naturally, voices y were heard easier But the It still slid into a claiming that the economy had moved beyond the influence of the Fed. money stock declined In particular, the throughout this period in spite of an "easy policy". More examples experiences. could be collected from old or more recent But the point requires no further elaboration and we had better examine its basic fallacy. We note first that the Fed exerts in the short-run a very limited influence on market rates of interest., These interest actions effect operate are dominated by market forces. on market rates to a large extent via The the Fed•s signal these actions convey to the market about the future course policy. cannot rates of But contrary to widely held beliefs among politicians the Fed persistently lower interest rates with an expansionary policy against prevailing market forces. The longer-run consequences of such a policy have been clearly demonstrated for many years. inflation correspondingly high and It follows that over ongoing inflation. indeed substantially interest as interest rates shape rates with large monetary adjusted the longer interest rates. expansion It of low monetary expansion. to the run the Fed can can high produce and low interest in the early part of the 1960s, with a credible policy They produce rates, non-inflationary Mr. Volcker understood this fact very clearly and made this point repeatedly during the first years of his stewardship. The horizon first over a shorter manipulated against point made above thus emphasizes that interest rates cannot be effectively market forces and the market's dominant evaluation. horizons the behavior is And over longer Fed's influence on the broad contours of interest just the reverse of 10 the belief expressed by rate many politicians. Interest rates provide thus very poor information about the thrust of monetary policy. A wide range of experience drawn from many different times and countries informs us that economic activity responds to the variations in monetary growth. In particular, monetary accelerations or unexpected monetary expansions stimulate activity for a few quarters. Monetary decelerations or unanticipated monetary contractions on the other hand activity for a short period. interest panied We note thus with some that the phase of rising interest rates last year was accom- by a strong monetary acceleration. deceleration This retard was behavior The subsequent accompanied by a large decline of monetary interest rates. is not consistent with an explanation attributing changes in interest rates to a "restrictive policy" in the first and an "easy policy" in the second half. expands half This linguistic regulation increas- would otherwise mean that policy is "tight" whenever the Fed ingly the the money stock and the supply of credit. mean that policy is "easy" whenever the Fed lowers It would also monetary growth and credit supply. The noting. change in monetary growth experienced last year is Monetary growth dropped from the first to the second Period M-l 8.1% 10.3% 7/11/84 - 1/ 9/85 3.0% period Monetary Base 1/11/84 - 7/11/84 worth 4.6% by more than half. We also note that the deceleration of the monetary base was the major cause of the monetary retardation. sensible 1984 to describe this shift from the first to the second half as a move toward "easier policy". It seems hardly 11 of The monetary retardation and the associated slower supply of bank credit reflected to a large extent the Fed's behavior. The same pattern prevailed in 1930 and 1960. The fall in interest rates tary was accompanied throughout 1930 by lowered growth of the monebase actually I960 and the money stock. a The apparently "easy policy" policy fostering continued economic contraction. "Wall Street" and the media just concentrated on was And free in reserves and the federal funds rate. They failed to notice the actual behavior of the Fed expressed by the persistent decline of the monetary Contrary stock to did an opinion voiced at the time in the not become (actual) policy. media, uncontrollably disconnected from base. the money Fedss the It effectively reflected this policy imitating the recession. The annual instructive reports of the Fed for 1949 and 1950 also offer examples. The report for 1949 advises us that essentially pursued an "easy policy", dominated monetary report by sales. growth for and Massive open market purchases in 1950 credit supply were represented that year as an expression of a ago Allan H. Federal rhetoric Reserve the in "tighter" annual policy. The More than 20 prepared for Congress that and actions were negatively correlated. raising the Meltzer and I emphasized in a detailed Policymaking Fed but open market operations were history of the Fed exhibits thus a singular phenomenon. years some study on the Fed's The problem still persists today, but mostly located in the media and "Wall Street". II. The Creation of Uncertainty as a Matter of Policy Monetary policy has been riding a roller coaster over the past six years. In 1979 until the fall of that year monetary growth spurted at 10.2%. It dropped to 2.2% from the fall 1979 to the spring of 1980. 12 This slow phase was followed until the spring of 1981 by another go- phase with a growth rate of 10.1%. A slowdown to 5.4% emerged from the spring of 1981 to the late summer of 1982. There appeared at this time a go-go episode until the fall of 1983 with a monetary growth of almost 13%. This rapid acceleration ultimately subsided to a lower growth of 5.6% over most of the winter 83/84 well into 1984. This behavior of monetary growth reveals the basic problem of the Fed's strategy and tactics. It did manage in the average over the past five years summarized above conveys the erratic and uncertain sense of our monetary policy. This uncertainty to lower inflation. But the record was reenforced by contradictory statements intermittently supplied by various Fed officials. Monetary policy thus appeared more and more as a "random walk through history". tainty The prevaiing uncer- contributed to the high level of the real rate of interest and most particularly to the remarkable variance of nominal interest rates observed over the past five years. It is noteworthy that the variance of both monetary growth and interest rates increased over this period. Table I shows the large increase in the standard deviation of monetary growth over the levels observed in the 1950s, the 1960s and the 1970s. Standard Deviations of the First Difference of the Logarithm of the Percentage Change in Velocity and Ml (Quarterly Data, Seasonally Adjusted) Period VBase 1952.3-1960.1 1960.2-1970.1 1970.2-1979.3 1979.4-1984.4 1952.3-1984.4 VM1 MB 1.333' 0.759 0.931 1.286 1.196 0.734 0.904 1.475 0.462 0.502 0.287 0.576 0.534 0.608 0.504 1.157 1.072 1.050 0.771 0.849 Table I 13 Ml There seemed to be no anchor to our monetary affairs which would provide a stable and predictable performance. It is important unavoidably from to the recognize that Fed's tactical this uncertainty procedures and institutional choices expressed most particularly by the nature of reserve ments. Policy implementation involves a shifting game varying combinations by the federal funds rate, of the economy, tude of require- guided the Fed's in perception its views about recent monetary growth and the magni- borrowed reserves. conception follows The emergence of this borrowed revived in recent years old views and reserve procedures guiding Fed policymaking during the 1920s. The Fed sets under this conception a target market for borrowed reserves and proceeds subsequently operations designed to adjust the actual volume reserves to its target level. with of open borrowed It follows under the circumstances that whenever borrowed reserves exceed their target level the monetary base tends to opposite changes be accelerated. case. We The monetary base is decelerated need to recognize at this stage that in the short-run in borrowed reserves are dominated by an evolution of shocks affecting credit markets and banks' positions. The "borrowed reserves tactic" thus converts these random shocks modifying reserves random borrowed into erratic and unpredictable movements of monetary growth. A similar argument extends to the case of federal funds targeting. A reliable assessment of the future course of monetary policy is further impaired by the shifting combination of guide posts noted above which are used by the Fed. A policy of uncertainty is not innocuous. of output and investment. higher real rates It affects the evolution The pronounced uncertainty contributed to of interest. 14 It also explains the remarkable volatility policy of over prepared interest rates which accompanied our the past six years. This result was shown by Bomhoff, Mascaro-Meltzer and others. uncertainty produces operating some more pervasive problem. But a studies policy consequences. of Agents a serious They must set prices and plan their activities facing an uncertain course of monetary affairs. link coaster in in the economy confront under the circumstances information ences roller This context influ- a price setting behavior which effectively establishes a causal between monetary shocks and real variables. Prices do not respond in general to all the passing variations in market conditions. Many prices adjust to more permanent changes in the underlying state. A policy of uncertainty obscures however the recognition of the actual conditions. unavoidably price setting behavior Agents find it in are thus particular to distinguish between transitory and permanent aspects of monetary affairs. partly guiding erroneous to some extent. impossible our Perceptions misinterpreted Comparatively more permanent as transitory events barely conditions justifying are major adjustments of prices. They affect under the circumstances output and employment. tions A politics of uncertainty thus produces misinterpreta- of current and expected monetary conditions which foster short- run variations in output and employment. These shorter run patterns do not exhaust the consequences of uncertainty prospects evaluation created by the monetary authorities. of prices are difficult to assess in such a longer-run regime. The of costs and returns of projects with a long payoff period suffers therefore even greater risks. The resulting increase in risk lowers the incentive to invest in such projects. The the 15 Recent discussions revealed additional consequences of the uncer- tainty associated with some monetary regimes. istics of the regime, expressed for instance by the imposes, run* conditions It appears characterizing the The general character- stochastic different uncertainty trend and variability of output over the that the properties of the stochastic the regime contribute to determine the process levels governing output. of built in uncertainty thus longer process properties Different it of regimes with produce different patterns for the evolution of output. A preliminary and still crude examination of this important issue may be useful. A recent study by Kormendi and Meguire in the Journal of Political Economy listed data from 47 countries describing standard deviation and mean of monetary and real income growth based on values some over twenty years. These data were explored with the aid simple regressions presented in table II. that ciated is a larger average monetary growth is with a higher standard deviation. highly significant. suggests tional It confirms systematically the asso- The regression coefficient The constant term is non-significant which that the standard deviation of monetary growth SM is propor- to average monetary growth MM. This implies a constant coefficient of determination equal to the regressive coefficient. also of Regression 1 attends to a question frequently discussed in recent years. view annual We note that 73% of the cross-country variation in SM is associated with variations in MM. The association between the standard deviation SY of real growth and its average MY is in contrast quite weak. coefficient is barely significant at standard levels. The regression The low corre- lation also suggests absence of any systematic connection. 16 income Only 4.5% of the variation standard deviation in SY is reducible to the variation of real growth appears, relative in MY. The to the mean real growth, as a constant plus a random term. Correlation Between Mean and Variance of Money Growth and GNP MM SM MY SY = = = = Mean Growth Rate Ml for 47 Countries Standard Deviation Growth Rate Ml Mean GNP Growth Rate for 47 Countries Standard Deviation Growth Rate GNP Regressions 1. + SM - 0.008 (.822) 0.665 MM (11.13) (.)=T-Value Adjusted R-Square=0.73 F=123.84 DW=2.07 Standard Deviation Residuals .03711 2. SY = 0.021 + (3.68) 0.201 MY (1.78) (.)=T-Value Adjusted R-Square=0.045 F=3.18 DW=2.04 Standard Deviation Residuals .011278 3. SY - 0.024 + (9.15) 0.07 SM (3.22) (.)=T-Value Adjusted R-Square=0.17 F=10.36 DW=2.10 Standard Deviation Residuals .010521 Table II The It last regression is of particular interest for our purposes. regresses the standard deviation SY of real growth on the standard deviation SM of monetary growth. coefficient are quite significant. terms Both constant term and It is noteworthy that the constant in regressions 2 and 3 are not correlation coefficient in regression significantly the last regression is different. however The modest. Only 17% of the total variation in SY is associated with corresponding 17 cross country variations in SM or ultimately in MM. This implies that real shocks and real conditions dominate the pattern of real growth. Even an average monetary growth of 100% p.a. would raise SY only by about 20% from .024 to approximately .029. Some further interpretation is needed at this stage. shocks" reflected in the constant and random term of The "real regression 3 include the real effects of the realizations generated by the stochastic process shorter controlling run aspects. monetary growth discussed above under the The regression coefficient associated with SM reflects on the other hand regime characteristics. The total tary effect" on SY consists thus of two components, one operating via the regression coefficient and the other via portions of the "mone- random term. An issue requires our perceived are the depend emerging in monetary analysis attention. in recent It has been argued that years the larger aggregate shocks relative to allocative shocks the real effects of monetary shocks. This analysis and crucially on the existence of a substantial also the smaller result information lag for aggregate information relative to allocative or local information. This information lag hardly exists in the USA but may operate with substantial force in most of the 47 countries used in the sample. But an alternative available. larger We monetary proportion. interpretation underlying our short run analysis obtain the same conclusions with the assumption shocks are perceived to contain a higher is that permanent This assumption forms essentially a hypothesis about the stochastic characteristics of prevailing monetary regimes. Either one of the two interpretations implies that the relation between SY and SM is non-linear involving a decreasing sensitivity of SY with respect to 18 SM as SM increases. linear Such a non-linear relation would imply that a approximation seriously underestimates the regression coefficients in the lower levels of monetary growth. The regression in table III including the square of SM examines this issue. The Non Linear Regression of SY on SM SDY = .013 + .257 SDM - .524 SDM Squared (2.7) (3.2) (-2.4) R-Squared = .251 F » 8.7 Standard Deviation Residual=.00998 Table III coefficient of SM2 . is negative second supports the moreover substantially . .. significantly negative and derivative of SY with respect to contention advanced above. raised thus SM. implies a This result The coefficient of from .07 in table II to SM is .257. An average monetary growth of .1 (i.e. 10% p.a.) would raise SY in the average to about .031 which is more that double the level of .013 associated with a zero level of SM. We note finally that the constant term The is still significant but smaller than in the linear "explanatory regression. power" has also been raised from 17% to 26% of the total variation in SY. III. Excuses The results occurrence The argument which accelerations than two reveal of real consequences associated with a politics of tainty. innocuous. support prior and ongoing studies which Fed typically justifies its policies however denies such consequences. or decelerations It asserts that over less than three the uncer- with an monetary quarters are Variations in monetary growth need be maintained over more quarters before a monetary shock operates 19 on the output market. The potential real effect of a shorter run monetary shock can always be offset under the circumstances by a suitable reversal. Such shorter-run variability may indeed generate no serious uncertainty and corresponding inference problem for agents whenever they occur in the context of policy. The case of Switzerland offers some interesting experience in this a well understood and generally respect. But uncertainty believed pre-committing unavoidably mounts with short run variability of monetary growth in the absence of any constraining and credible institutions pre-committing the behavior of the Central Bank. Agents setting prices and planning activities confront in this case a burdensome problem of interpreting monetary evolutions. inferences affect the economy and so does the Misconceived recognition of the inherent risk. The immunization of established discretionary policymaking against its critics objections control. does not rely on a single argument. A wide variety has been addressed to a policy of pre-committing monetary The idea that "nobody knows what money is" was discussed in a previous position paper and is really embarrassingly silly. noteworthy irrelevance that it circulates mostly among It non-economists. is The of this idea is easily recognized by the falsehood of its central implication. would of randomly transactions. If people would not know what money is then they select objects to settle obligations This clearly has not happened. monetary control is technically not feasible. arising from Others maintain that But the examination of this issue pursued by James Johannes and Robert Rasche over the past six years demonstrates that control of monetary growth over one year within a 2% band centered on the target level is quite feasible. This 20 conclusion of one is confirmed by studies prepared by the staff at the Board Governors of the Federal Reserve System. The control level over year indicated is quite sufficient for all practical purposes of policymaking. The potential nation's worthy money errors associated with the measurement stock raises a more respectable issue. data with larger measurement error is not voiced (e.g. trade deficit, current account deficit, price indices as inflation Concern the It is note- however that a similar concern about publicly used probably of was increased particularly measure, voiced whether the measurement or especially become more volatile. The etc.). error has implications of this event coincide with the consequences of another problem I wish to address with my final comments. A chorus of voices stresses potential effects of deregulation financial innovation. the relation and These effects are expected to "loosen" somehow between monetary policy and monetary growth, and the latter's relation with aggregate nominal demand or national income. A paper recently published in the Review of the Federal Reserve Bank of Boston exemplifies the typical thrust of this literature. Two more ambitiously designed papers were published over the past years in the Brookings Papers on Economic Activity. The general content and nature of the argument offers however no additional material. The general sense of the "deregulation cum innovation" critique can be discerned from the following quote: As a result of recent banking deregulation and continuing innovations in communication and data processing technology, the relationship between the growth of money stock and the course of economic activity may become less dependable in the future. Therefore, forecasters may discover that the growth of the money stock is a less reliable indicator of GNP growth. Furthermore, policymakers may find that smooth 21 targets for the growth of monetary aggregates, which change slowly over the years, are less reliable guides for monetary policy unless perhaps the funding strategies of depository institutions can be anticipated well in advance. A detailed pervasive what no examination of the papers mentioned above sense of inconclusiveness and vagueness. conveys a It is not clear the nature of the problem precisely involves. There is moreover logical policy link between negative conclusions bearing and the discussion of financial innovations. remains an exercise in impressionisms. on The There seems to monetary discussion be little perception that financial innovations proceeded over the centuries and shaped monetary evolution over a long time. more than loan associations policy. Shaw argued twenty years ago that the explosive growth of savings during the 1950s erodes the potency of and monetary The subsequent evolution discredited such fears or hopes. The consequences of deregulation and financial innovation can be usefully sively) under Gurly and organized for our purposes in one or the other (not exclu- of two groups. In order to condition the relevant process consideration (i.e. the link between policy and nominal gross national product) they must modify the behavior of the monetary multiplier or velocity. These two magnitudes fully define the relation between monetary policy and nominal gross national product. encounter Here we a difficult obstacle however for any serious investigation. A general assertion that deregulation cum innovation modifies behavior of multiplier and velocity somehow yields no assessable implications. This remains an empty but politically suggestive exercise. of modifications in behavior are moreover quite compatible continued effective application of monetary control policy. A variety 22 with a Consider include first the monetary multiplier. since 1979 The the statistical analysis and by Johannes-Rasche. The Shadow statement forecasts multiplier prepared statistical reveals a remarkable stability of the process governing plier. Changes of the analysis the multi- in monetary regime from the 1979-82 episode to the subsequent interest targeting phase of deregulation and innovation did not modify stochastic years. the tracking record of the analysis. Similarly, the properties of forecast errors hardly changed over the six There is simply no evidence of "loosening" or lessened relia- bility in this portion of the overall relation linking monetary policy with nominal gross national product. Monetary verbal noise years. velocity has describes the second portion of the link indeed been addressed to it over We indeed observed, the past Much three as indicated in the graph, the most pro- nounced decline in velocity ever recorded in the postwar period. this reflects probably the large decline in the inflation rate occurred over this period. of increase But which We also observe in table IV that the rate in velocity (for both V and V^) over the first eight quarters of the cyclic recovery proceeded at the lowest level recorded over the postwar period in spite of the rigorous upswing. increase of the standard deviation of AV. (i.e. of the first ence the The differ- in M-l velocity) since 1979 noted in table I appears to support idea of a "loosened connection". The standard deviation of V o (i.e. in the first difference of base velocity) also listed in table I denies however this conclusion. The link between monetary policy and national income did not deteriorate in the past six years relative the 1950s. whether to More importantly, the arguments advanced never make clear deregulation and innovation raise or lower 23 the level, the trend, noted tion or the variance of the velocity innovation. The observations above yield so far little information about a reliable to the three possible components of arguments tutes velocity imputa- behavior. emphasizing a wider menu of interest bearing money appear to suggest a rise observations are in level or trend, their underlying notions. substi- or both. difficult to reconcile with such Some But our implications and Perhaps more important is the circumstance that modification of trend or level does not impair the quality of the link. in Changes in level pose at most a transition problem and changes trend can be incorporated into the non-inflationary benchmark for monetary growth. Changes in the variance of velocity innovations do indeed the quality of the link. the nature of the problem may be modify presented with the aid of the following relation m + t-i p + + \ v t-i + 6 <L>Avt-i + e t - v t where y = level of nominal GNP, n. , " money stock in (t-1), y = the current desired rate of increase in n, v = white noise in money supply process, process v -j-_i ~ P a s t value of velocity, 6(L)AV,_ 1 = an autoregressive in AV and e =a white noise component change. All Suppose first first log Monetary the level data (i.e. y, in current m and v) are in that velocity is approximated by a random difference AV coincides thus with e and growth p velocity log form. walk. ( L ) Av t-i The = 0s can be set at a level ~ expected to realize a target level y where p = y - ^-^^^ ~ vt-i* The variance of the error (y-y) is then given by - 2 E(y-y) = variance v + variance e + 3 covariance of e and v . This variance is also the minimum achievable under the 24 circumstances. There exists no strategy for setting u which will lower this variance. Arguments developed in detail on other occasions determine a constant u as an optimal solution. It remains optimal even substantially But consider now the case when velocity is increased. not a random walk. tunities to authorities This scheme. to assures the variance Serial correlation of Av offers potential forecast autoregressive if current velocity changes with the oppor- aid of an Knowledge of this scheme allows the monetary set y in response to the optimal prediction of again a minimum variance around the target level A v. irre- spective of the deterioration of "the link" expressed by a rise in the variance of component). velocity A to estimate it. based than a show (i.e. its random The reliability of this estimate is constant v. It is just as likely to raise the moreover nominal GNP the variance. of an activist period by period adjustment of that noise There is consequently no assurrance that setting on such estimates yields a smaller variance of Advocates to innovation But we do not know the autoregressive scheme and we highly questionable. y its constant setting of u would not be optimal under circumstances. need or the forecast error of velocity based on would an have estimated serial correlation scheme possesses a smaller variance than the change AV. They would persistence of also have to show some good grounds to this pattern over time. The crucial however independent of activist or non-activist setting growth. In either case the advantage of a monetary not expect conclusion of 25 is monetary control policy is destroyed by a deterioration of "the link" expressed by a variance of the random component in velocity. some higher Growth Rates of Velocity After a Recession Over the First Eight Quarters (Per Quartsr in Percentage) Y(r) Y(n) Ml VM B VB = * * = = Growth Growth Growth Growth Growth Growth Rate Rate Rate Rate Rate Rate Real GNP Nominal GNP Ml Velocity Ml Base Money Velocity Base Money Recession Year Y(r) Y(n) Ml VM 1954.2(7) 1 ©3 o X ® 82 0.62 JL> O M 1958.1(6) le4 / 1.95 0.64 1960.4(8) 1.20 1970.4(8) 1.20 2.15 1975.1(8) 1.09 2*28 1980.2(6) 0.72 2.54 1982.4(8) XcJ J 2.18 0.24 1.58 0.56 U VB JL e -3 i? Wo DJ> Percentage Growth Per Quarter B X © UU 0.59 0.92 1.54 0.61 JL ft O ib 0.53 1 1.01 1.64 0.64 JL e / O 0.78 1.40 1.14 1.76 0.42 1.90 0.28 B»« (.)=# of Quarters Used Table IV 26 VELOCITY (1947.2-1984.U quarteriy data, aeaaortaty adjusted VELOCITY to il I I I I I I 1 , 1 I I. L. t . J ) I 1 1 1 1 , 1 - ^ L t I I I M W ) « 3 f i S I 1 9 n f l S 1 9 6 8 S a B f l n » I I «W I I I I i l l «7 OO YEAR VHJCOTY*NOM?NAL GNPSA/M1SA SOURCE FEDERAL RESERVE BULLETIN 1 «3 GUIDELINES FOR DEFICIT POLICY Mickey D. LEVY Fidelity Bank, N.A. According to the Budget, basis the Fiscal Year 1986, on a current services FY1985 deficit now will be $223.6 billion and the FY1986 deficit approximately $230.3 billion. This is sharply higher than the estimates Budget the Administration's Mid-Session in (August 1984), half of the FY1985 which forecast deficits of $172.4 billion FY1985 and $174.2 billion in FY1986. FY1985 Review in The higher estimated deficit in reflects in part the slowdown in economic growth in the second of 1984 and in part the impact accounting of HUD loans. outlays to of the shift to on-budget Given the heightened sensitivity of federal changes in interest rates, deficit projections would even higher if actual and projected interest rates had from mid-1984 levels. ' not be declined Nevertheless, the projected rise in outlays (7.7% average annually from FY1985 to FY1988), the climb in deficits to the $250 billion area, and the associated sharp rise in the federal debt-to-GNP ratio proposed FY1987, that are striking. In response, the Administration has spending cuts of $50.8 billion in FY1986, and $105.3 billion in FY1988. $82.7 billion in The Administration forecasts these cuts would reduce the deficit in FY1988 to $144.4 billion or 2.9 percent of GNP. 'Aided by faster-than-forecast economic growth and a shortfall in spending, the year-to-date deficit (October 1984 to February 1985) is consistent with a FY1985 deficit below $200 billion. However, interest rates have risen recently, economic growth should moderate from its current pace, and the shortfall in spending outlays will probably narrow, and the FY1985 deficit should end out close to the Administration's estimate. 29 The Administration's percent real GNP long-run budget growth through 1988 forecast is and somewhat based slower on 4 growth thereafter (see Table 1). Economic Assumptions Underlying Administration's Budget Forecast 1985 Source: Budget, 1987 1988 1989 4.0 8.5 4.0 8s3 4.0 7.9 3,8 7.4 4.1 4.3 4.2 3.9 3.6 7.0 6.9 6.6 O e 3 feel 8•X 11.0 CPI ( chg. Year-over-Year) % Unemployment Rate ( , annual % average) Interest Rates ( , annual % average) 90-day Treasury Bill 10-year Treasury Note 1986 4.0 8.5 GNP ( chg. 4th Qtr-4th Qtr) % Real $ Nominal $ 7.9 10.3 7.2 9.3 o ®y 7.3 5.1 5.7 FY1986. According to Administration estimates, a permanent one percent slowerthan-expected annual rate of real growth would reduce receipts dramatically, billion in FY1986, Perhaps more beginning in January 1986 and increase the deficit by $4.1 $16.9 billion in 1987, and $33.4 billion in 1988. troublesome to the budget outlook are the Administration's interest rate assumptions, particularly for 1987 and beyond. The Administration assumes the 3-month Treasury bill rate will average 7.2 percent in 1987, 5.9 percent in 1988, and 5.1 percent in 1989. Budget In Outlook: contrast, CBO budget Fiscal projections (The Years 1986-1990, Economic February 1985) assume the 3- month Treasury bill rate to average 8.2 percent each year after The and Administration's assumptions of healthy economic growth, 198 6. little change in expected inflation, and continuously declining real interest 30 rates, may be inconsistent. ' Higher-than-expected interest would have a dramatic impact on interest outlays and would rates exacerbate the difficulty of stabilizing the federal-debt-to-GNP ratio. Based on the Administration's proposed deficit forecasts, one percentage point higher-than-projected interest rates would raise net interest outlays and deficits by $8.2 billion in FY1986, $11.7 billion in FY1987, and $14.8 billion in FY1988. Guidelines for Deficit Policy Deficit First cutting efforts should be guided by several principles. and foremost, budget proposals should be conceived and debated within a context of a fiscal (deficit) policy whose primary goal is to create run growth. Given failures of fiscal policy in managing aggregate past an environment conducive to long-run economic demand, short- stabilization While there policy on growing the short-run pattern of economic spending sector of fiscal substantial uncertainty about the impact consensus government private is goals should not be the focus activity, of activity The reallocation of to the public sector fiscal there about the long-run adverse consequences of and debt. policy. is a rising resources generated by from higher 'Under these circumstances, a decline in nominal interest rates, given what appears to be little change in inflationary expectations (the Administration projects the percentage change in the CPI to recede from 4.3 percent in 1986 to 3.9 percent in 1988 and 3.6 percent in 1989), implies a sizeable decline in real interest rates. There does not seem to be sufficient changes in the capital stock, nor is there any proposed change in tax policy, that would substantiate a decline in real rates. If, however, real rates were to fall as the Administration's budget projections assume, one could expect a decline in the exchange value of the U.S. dollar, which would drive up inflationary expectations (and nominal interest rates). 31 government spending tends to reduce private investment, how it is financed. Also, the sharply rising regardless of federal debt-to-GNP ratio eventually will constrain the availability of credit for private investment, although the timing of this impact is uncertain. A long-term growth-oriented fiscal policy requires stabilizing the federal what debt-to-GNP ratio. level Empirical research does not indicate at or when the debt ratio should be stabilized in achieve an investment/economic growth goal. order to However, substantial cuts are necessary merely to stabilize the federal debt-to-GNP ratio. Administration's proposed spending cuts would stabilize the The federal debt-to-GNP ratio at slightly above 40 percent, but only if those cuts were accompanied by the Administration's anticipated declines in real and nominal budget interest rates. In stark contrast, the projection, which assumes 3.4 percent real GNP 1987, 4.2 Treasury percent annual rise in the CPI after 1986, bill rate of 8.2 percent after 1986, CBO baseline growth after and a 3-month forecasts the federal debt-to-GNP ratio to climb to 49.7 percent by 1990. Second, take to preserve production incentives, the lead in any deficit-cutting effort. spending cuts should From 1983 through the end of the decade, all of the rise in the cyclically-adjusted deficit as a percent of benchmark GNP is attributable to the rise in cyclically-adjusted outlays. Cyclically-adjusted revenues in 1989 are projected Many to be nearly the same percent of benchmark GNP as in 1983. spending projected require tested programs are well intended, but in some case sharp increases in outlays are due to structural flaws that corrective action. This is particularly true of entitlement programs, which have grown dramatically general, have been spared from recent budget cutting efforts. their 32 non-means and, in Third, should as be a practical matter, all government spending considered candidates for budget cuts. programs In particular, social security and other non-means tested entitlement programs, defense, cannot be excluded from the outlay-trimming exercise. programs constitute composition subjective However, that of 62.5 percent government of spending total budget has evolved from preferences, and is not derived from simple economic The series of analysis. arithmetic takes us a long way toward the conclusion "everything should be on the table." Allowing non-means entitlement These outlays. a and outlays to remain sacrosanct severely constrains tested efforts to stabilize the debt-to-GNP ratio. Also, these transfer programs are a source of economic inefficiency to the extent that they reduce labor supply and/or savings. of The defense program must be analyzed in terms national security as well as budget goals; nevertheless, it is doubtful that a judiciously chosen, modest slowing of scheduled growth in defense Ultimately, cuts, on outlays would severely hamper national security. resolving the thorny issue of the composition of spending for example, as between defense and non-defense programs, rests the ability of elected officials to compromise. Therefore, common-sense suggests that all budget programs should come under close scrutiny in an efficient and fair effort to slow the growth of spending and debt. Fourth, short-term deficit-cutting efforts should be with long-run program reform. package Enacting a "quick fix" deficit-cutting is not necessarily good public policy if it does not generate long-run savings or if it fails some of consistent the structural to address, flaws 33 of or precludes addressing, government spending programs. Temporary reductions in the armed forces would not generate permanent long-run that savings those freeze in defense outlays if military discharged must be rehired in the on social security COLAs may preclude readiness future. much A requires one-year needed program reform. And, attempts to limit Medicare outlays by strictly limiting doctors' compensation would generate some short-run saving but costs and perpetuate inefficiencies in increase long-run industry. (Providers would Medicare participants. less efficient and respond by restricting would the health services to Meanwhile participants may respond by seeking more costly types of medical care, i.e., substituting in-patient care for a routine ailment that normally would require an out-patient visit. Instead, phasing in changes in financial incentives for hospitals and Medicare recipients would be an important step toward Medicare reform, even though it may not generate any short-term cost-saving.) The fifth principle concerns the fact that since the deficit required to political stabilize the federal debt-to-GNP ratio compromise may Therefore, any should assessed be disincentives income on consumption so that to save and invest, These are very large, in reflect are and (2) the indexing is now in place, rules there should not be the fact that a that suppresses productive output would be to the effort to stabilize the debt-to-GNP ratio. considered difficult (1) they no of further personal delayed or deficit-cutting counterproductive The real difficulty with this guideline for taxation is practical in nature: are tax revenues. increases should abide by two rules: taxation, which eliminated. package tax result in some increases cuts "open game" in deficit-cutting efforts, once taxes it would be politically to limit tax increases only to higher taxes on 34 consumption. So while the rule to avoid higher taxes on investment or saving stands as an important guideline, the key point is that slowing the rise in federal debt should be accomplished largely by slowing spending growth. FY1986 Budget Proposals The Reagan Administration's proposed substantial spending would reduce outlay growth to 1.5 percent in FY1986, and 4.5 cuts percent annually from FY1985 to FY1988. If enacted, they would be the largest in recent history. eventually must However, the cuts would be small relative to what be done to correct the current unstable situation. Nevertheless, the size of the proposed cuts represents a major step in the right direction. Importantly, the FY1986 Budget did not recommend tax increases, and Congress's current primary deficit-cutting focus is on spending cuts rather than tax increases. The most striking characteristic of the proposed cuts is that they are imposed largely on programs whose outlays portion of the total spending cuts budget (see Table 2). are proposed for social security (OASDI), $199.8 billion in constitute a small Specifically, no whose cash outlays of FY1986 and $641 billion during the three years FY1986 to FY1988 constitute nearly one-fifth of total current services outlays. to Cuts of $5.4 billion in FY1986 and $25.5 billion in FY1988 are proposed for all non-means tested entitlement FY1986 programs (social security; Medicare; railroad, military, federal employee, and other retirements and disability; and unemployment compensation) , whose $345.5 billion outlays in FY1986 and $1,112.1 billion in FY1986 to FY1988 constitute over one-third of all current services spending. Proposed to cuts in defense outlays also are small relative 35 total defense outlays. cuts would be A disproportionately large portion of the proposed imposed on the broad range of non-defense, non- entitlement programs, with the largest chunks coming out of farm price supports, general revenue sharing, civilian agency pay raises, and strategic petroleum reserves. TABLE 2 Composition of Administration's Proposed Outlay Cuts for the Combined Three Year Period FY1986 to FY1988 Current Service Outlays f$ bill I. Defense Saving as a portion of Portion Total Current of Proposed Proposed Service Total Saving Saving Outlays f%) (S bil) £%J (%) 993.5 29.8 28.2 11.8 2.8 II. Entitlements? A. Non-Means Tested Social Security All Other a . B. Means-Tested 1112.1 (641.0) (471.1) 216.0 33.4 (19.2) (14.1) 6.5 25.6 (0.0) (25.6) 11.0 10.7 (0.0) (10.7) 4.6 2.3 (0.0) (5.4) 5.0 III. Other Non-defense, Non-entitlement outlays 660.8 19.8 134.3 56.2 20.3 IV. Offsetting Receipts -213.7 -6.4 9.6 4.0 4.5 565.4 17.0 30.2 12.6 5.3 3,333.9 100.0 238.8 100.0 7.2 V. Debt Service Total NOTES: a 'Includes railroad, military and federal employee retirement, other retirement and disability, Medicare, and unemployment insurance. 'Includes Medicaid, AFCD, foodstamps, child nutrition, guaranteed student loans, SSI, earned income tax credit, and veterans pensions. c 'Includes programs identified in Budget FY1986 as other mandatory outlays, dedicated funding and business operations, outlays for forward-funded and related programs, outlays for slow-spending and fastspending discretionary programs, and discretionary loan outlays. 36 Considered above, would in terms of the fiscal policy guidelines mentioned the Administration's proposals in general are admirable: they modify spending programs and in many ways eliminate sources of inefficiency (for example, the farm subsidies) and address the rising costs of certain retirement), pension programs (for example, civil they would generate substantial immediate service savings, and they avoid tax increases. As expected, the deficit-cutting package is controversial. eliminating By some cutting some programs and not others, programs altogether (for example, general and revenue sharing) , the proposal effectively redefines the role of government in certain types of economic activity. are is largely subjective; cutting spending in some programs "fair" Whether these proposed cuts and not others is not necessarily unfair. Similarly, the "fairness" of an across-the-board freeze on all government spending programs depends on whether the current size and distribution of government spending considered "fair". On the other hand, the skewed distribution of the cuts does point to the enormous potential proposed cuts that could be achieved if all government programs, means is in spending including the non- tested entitlements, were part of a comprehensive spending cut package. The following recommendations are samples of the type of program reforms that deserve consideration. Social freeze in employees benefits. Security. The Administration proposed a one retirement benefits for former military year and COLA civilian and the industrial pension component of railroad retirement This provision should be extended to social security benefits. Social security participation should be extended to all new state and local government employees, the only major group of workers still 37 excluded from the program. program would Extending coverage for this redistributive reduce a source of inequity between participants and non-participants. Currently, recipients half of social security benefits are taxed whose total income, including social security and for income from tax exempt bonds, exceeds $25,000 for individuals and $32,000 for married couples filing jointly. retirement benefits that Instead, social security and railroad exceed household lifetime contributions should be taxed, similar to tax treatment of private pensions. For equity reasons, households with total incomes below $12,000 would be excluded. This tax treatment would not affect the lower income elderly and would tax other recipients roughly in proportion to their and marginal tax rates. It also would reduce some income of the intragenerational inequities caused by spouse benefits, and narrow the wide differential between after-tax rates of return on household contributions received by current and future retirees. Three would benefit persons actuarially (AIME) social security changes should be no generate security 1990, other reduced saving: retire between ages 62 benefits, and (a) growth 65 the (this provision should inflation would be that social beginning (b) average indexed monthly be calculated by indexing for wage liberalizing short-term structure should be modified so that who should average additional implemented in receive earnings rather complemented than by IRA and Keogh provisions, by raising maximum limits and reducing penalties for withdrawal), and (c) the current spouse benefit provision whereby should spouses be replaced by an earnings sharing would divide evenly covered household 38 arrangement earnings and benefits would be based on his or her own earnings base. recommended that These three changes would be part of a broader social security reform must be implemented gradually and would not generate any short- term savings. Medicare. paid Medicare Supplementary Medical Insurance (SMI) premiums by beneficiaries currently cover 25 percent of average benefits for an elderly enrollee (they are estimated to be $17.30 per month 1986) and their increases after 1985 are limited to increases in CPI. These of income, in the premiums should be increased and graduated as a function so that by 1990 the average premium would equal 35 percent of average costs, with higher income elderly paying premiums up to 50 percent and lower income elderly having their premiums remain tied to increases in the CPI. Medicare hospital Part feature ability to pay. A should be redesigned to include a catastrophic and an adjusted cost-sharing arrangement Currently, based on participants pay for the first day of a hospital stay, incur zero costs for days 2 through 59, and then co-pay 25 percent of costs after 59 days. "stop-loss" patients. through limit A catastrophic plan would place a on out-of-pocket costs incurred by long-term Short-stay patients would pay more than they do a modest (15 percent) co-payment schedule, which care currently, would be graduated with income, for in-patient care for days 2 through 15. An additional reform for Medicare involves transforming the current prospective payment system to hospitals and HMOs more toward a medical insurance voucher system by: (1) relaxing some of the burdensome eligibility requirements for HMO and hospital participation in Medicare, (2) allowing hospitals and HMOs to rebate cost savings to Medicare participants (rather than being only able 39 to offer more services), and (3) allowing individuals to take actuarial equivalent values premiums that best of suits their needs. cost-effective and choosing the private health plan These reforms would encourage more innovative and medical delivery systems and also provide financial incentive to participants to be more cost-conscious in their choice of medical provider. Military with Retirement. approximately Currently, military employees may half-pay after 20 years of service retire (the initial benefit is 2 1/2 percent of final base pay per year of service). this financial incentive, it is not surprising retirement age for non-disability, years old. schedules Military are pensions that the With average active-duty service members is 43 should be modified so that benefit a function of years of service and age of retirement, with younger retirees receiving reduced pensions. Unemployment portion of threshold married are Insurance and Workers unemployment income exceeds Compensation. insurance is taxed only $12,000 for individuals Currently, a if and a taxpayer's $18,000 couples filing jointly, while workers compensation tax exempt. for benefits All unemployment insurance and workers compensation benefits should be taxed as ordinary income. These the proposals would generate substantial additional savings non-means tested entitlement programs — FY1986 to FY1988. over $60 billion in during Combined, these modifications would encourage work effort and saving, and to discourage excessive and unnecessary uses of medical services by the elderly. The recommended phased-in changes in social security and Medicare are not geared to generate short-run cost savings but instead form the basis for necessary long-run reform. 40 Prospects for Responsible Fiscal Policy The Administration FY1986, and has recommended sizeable spending For example, postponing the COLA for social security has emerged as one possible cost-cutting current for Congress has taken initial steps to broaden the scope of sources for potential spending cuts. although cuts its eventual political acceptance maneuvering is highly measure, questionable. around the budget issue While in Congress seems to be following the same path as previous unsuccessful efforts, a note of optimism can be found in the perceived immediacy of the need to cut deficits. Nevertheless, the magnitude of the budget imbalance is staggering, and sharply rising interest costs constrain efforts to stabilize the debt-to-GNP ratio. A note of caution is appropriate: a spending cut proposal would even close in total size to be a major first step toward the Administration's fiscal responsibility, if it is not large enough to eliminate the primary stabilize long the federal debt-to-GNP ratio. time to importantly, was package generated 1970s. lay the by the foundation for Remember, such recent growth of the non-means tested The unwinding process may be equally as long. 41 and it has taken large legislation enacted in the late deficit a deficits entitlements 1960s and early ECONOMIC OUTLOOK Jerry L. JORDAN First Interstate Bancorp It appears that the FOMC has assumed that Ml velocity will rise 2 to 2 1/2 percent in 1985, given their intention to increase the money stock by 5 1/2 percent by year end. However, they have emphasized that money would grow faster if velocity appears to be growing slower, or money would grow slower if velocity is growing faster. be That could taken to imply that there is a current year target for nominal GNP that is more important than the Ml target. Table I shows the various "official" numbers for this year: TABLE I 1985 Projections (Fourth Quarter to Fourth Quarter) FOMC Administration GNP 8.5% Output: 4.0 Prices: 4.3 Unemployment:* 6.9 Congressional Budget Office 7.7% 3.4 4.2 7.0 Range 7 - 8 1/2% 3 1 / 4 - 4 1/4 3 - 3 3/4 6 1/2 - 7 1/4 Central Tendency 7 1/2 - 8% 3 1/2 - 4 3 1/2 - 4 6 3/4 - 7 *Year end All of these projections compare with actual results for 1984 as follows: 1984 GNP: Output: Prices: Unemployment: 9.7% 5.9 3.6 7.1 Since actual Ml growth for 1984 was 5.2 percent, the Fed's central target for 1985 is slightly faster, which is hard to understand. As long of as there is supposed to be a 43 long-run policy objective reducing monetary growth to a non-inflationary rate, there is justification for little targeting monetary growth that is faster than the previous year. It is worth noting that the Administrations inflation is higher than the CBO and the Fed. assumption That is undoubtedly due to the desire on the part of the Administration to show a smaller deficit (as a percent of GNP) that is associated with faster nominal GNP growth. For the second year in a row, the Fed has a lower inflation projection than just about anyone else inside or outside government. Current thinking by the Fed is more optimistic than last summer. The comparison of projections for 1985 is shown on Table II. TABLE II 1985 Projections (Fourth Quarter to Fourth Quarter) July '84 Projections Central Range Tendency 6 3 / 4 - 9 1/2 8-9 2-4 3-31/4 3 1 / 2 - 6 1/2 5 1 / 4 - 5 1/2 GNP Output; Prices; Looking February '85 Forecast Central Range Tendency 7-81/2 7 1/2 - 8 3 1/4 - 4 1/4 3 1/2 - 4 3 - 4 3/4 31/2-4 back over the past year-and-one-half, the Fed's optimism about inflation has been borne out, while the SOMC did not anticipate the favorable effects on inflation of a strong dollar energy prices. and declining While the lower inflation has been very welcome, it has been accounted for by transitional factors that cannot be expected to continue. In both 1974 and 1979-80, the monetary approach to inflation used by the SOMC underestimated the acceleration of major 44 price indices. The transitory relative effects of the "oil shocks" were causing price shifts, and a transitory increase inflation rate. in the past suggested. trend the reported For similar reasons, the reported rates of inflation two years have been less than a monetary approach Declining energy and imported goods prices cause the rate of inflation to temporarily emphasis in significant is rate fall below the monetary rate. The correct on the long-run trend rate of inflation implied of monetary growth, recognizing that by there the will be deviations due to measurement errors and non-monetary factors. While the FOMC's record on inflation was very good in 1984, they underestimated real growth. when and Their biggest miss was in 1983 they projected output growth of 3.5 to 4.5 percent, versus actual of 6.3 percent. is 1983 Now, the for 1985 the FOMC projection for output slightly lower than the CBO and Administration, but in line with most business economist forecast. The SOMC was more optimistic (and more accurate) on output in 1983, and also projected a strong 4 to 5 percent real growth 1984. the growth for The 10.1 percent real GNP growth recorded in Ql/84 ensured that annual figures would be quite high even though the third quarter came in at only 1.6 percent. Monetary similar growth in 1985 is destined to be very high for to the high output growth recorded in growth will be 11 to 12 percent a.r., quarters is going 1984. In reasons Ql/85, Ml which means the remaining three can average only 3 to 4 percent if money growth for the year to fall near the middle of the 4 to 7 percent range. The longer the rapid money growth persists, the sharper the deceleration necessary range. to illustration, "average out" anywhere in the target For if Ml growth in the first half averaged 11 percent, the 45 second half would have to be zero in order to get 5.5 percent for the year. Obviously, (to us) , such sharp fluctuations are undesirable. There about may be a basic disagreement between the SOMC and the growth. significance Some of large intra-year the of fluctuations FOMC money Fed staffers have argued that they are unimportant long as the average is maintained. as Our position should be that there are two important adverse effects of the intra-year go-stop pattern. One is for that sharp accelerations and decelerations lasting six months or more do have a significant effect on output growth, as seems to have been the case in 1984. creates Second, the volatile uncertainty about the underlying trend, money and market growth interest rates must compensate for this heightened uncertainty. Language suggests but is higher from that in the February 1985 Report of the Fed the erratic quarterly pattern is not only deliberate. The FOMC is said to believe that to Congress acceptable, "a somewhat rate of money growth than implied by straight line projections the fourth quarter 1984 base to the targets for the fourth quarter of 1985 may be appropriate early in the year, but growth of Ml would be expected to slow, and velocity growth to rise, as the current adjustments are completed."* Thus, the Fed has defended "front-loading," and is counting on the lagged slow growth of money at a later time. output the relationship between money and GNP rising (velocity) to permit effects of such fluctuations of money, the Fed might be able to uncertainties such a policy creates *Page 4. If there were no 46 for the private on allay market participants. impasse, However, especially in view of the fiscal policy it is likely that market participants will guard against the possibility that the initial rapid money growth will persist and inflation will accelerate. In view probability monetary far is the 11 to 12 percent money growth in Ql/85 rising that '85 could see a repeat of '83 as targeting is concerned. above second of already been and did not try to offset. signaled by Vice as Two years ago, money growth was so target by mid-year the FOMC reset the base period quarter far the Chairman Preston the possibility Such a to has Martin when acknowledged the possibility that Ml might be allowed to grow 8 to he 10 percent in 1985, with the justification that velocity growth might be low. The Outlook The 1985 growth of nominal income and real output in the first half of will exceed the respective growth rates recorded in the second half of 1984. Most likely, money growth will be at the top end of the Fed's target range for all of 1985, so nominal GNP can be expected to grow faster than the Fed's projection. of this subdued year, as Especially in the second half inflation can not be reliably expected to the FOMC has indicated. The trend growth of Ml and monetary base have remained at historically reported rate of inflation will eventually rise trend. 47 remain high to levels, the so as the the underlying TABLE III .Ml MB Prices GNP Q4/76-Q4/80 Q4/80-Q4/84 Q4/76-Q4/84 7.8 7.4 7.6 8.7 7.3 8.0 Os2 6.7 8.3 9.9 Q4/83-Q4/84 ™? © £s 7.3 3.6 9.7 Output 3.0 3.0 «5 e v* 5. 9 *H^ O 6. 4 Q1/84-Q1/85* asp 7.4 *estimated The growth of MB in 1984 was the same as the four-year average for Q4/80-Q4/84. the trend, recorded The Ml growth reported for '84 looks like a break with but the so Once the rapid Ql/85 Ml figure year-over-year increase in Ml is half way back longer-term trend. Since did 1981. to is the By year end, it will probably be all the way back. inflation can be expected to average about 1 percent slower than money and base growth, a sustained 6+ percent inflation rate is consistent with the underlying monetary trends. The economic projections (but not preferences) for 1985 are: TABLE IV Q4/84-Q4/85 A GNP 8 1/2 to 9 1/2 Output 3 1/2 to 4 1/2 Prices 4 1/2 to 5 1/2 Ml 6 to 7% VI 2 to 3% MB 6 to 7% VB 2 to 3% half-year breakdown of these projections would show real growth more rapid in the first half and slower in the second half, but less of a change in 1984. The inflation rate is expected to be rising more rapidly late in the year, possibly reaching into the 6+ percent range. 48 Money growth of no more than 7 percent for the year requires a slowing from the first quarter's rapid pace to only about 5.7 percent for the final three quarters. Recommendation The continued slowing into of '85. the base and money from *83 to This year the monetary base permitted to rise by more than 6 percent. is adequate «84 should should A range of 5 to 6 for continued real growth with sustained low not be be percent inflation. An objective of reducing the growth of the base and money to the 2 to 3 percent range before the end of the decade should be adopted by the FOMC. 49 FORECASTS OF THE M - ADJUSTED MONETARY BASE MULTIPLIER FOR 1985 Robert H. Rasche Michigan State University We are presently in the middle of the annual round of revisions of the monetary revisions of but and reserve aggregates. The announcement of the data for the monetary aggregates in the H.6 of the release February 14, 1985 indicated a change in the levels of M , and . M_, showed little change in the growth rates from the unrevised data, prior to changes in the seasonal adjustment Table 5 from the H.6 release). Appendix revised basis were released in mid-March. factors (see attached The historical data on the The Federal Reserve Bank of St. Louis has not yet revised either the Adjusted Monetary Base or the seasonal factors for the base. Thus we have a mixture of revised and unrevised data available on which to base our current forecasts. At to our have analysis last meeting, not of it was suggested that it would be only the forecasts for the coming the year, but source of the projected changes from year. In an attempt to present this information, Tables 1 and 2 below. I helpful also the previous have prepared The technique used to construct the forecasts in Table 1 is to use the revised not seasonally adjusted data for monetary an aggregates, the revised seasonal factors for the unrevised seasonal the monetary base. The data for January and February are the actual data we for the monetary aggregates, and for those months as presently estimated. factors the The forecasts suggest will observe a decline in the multiplier on a seasonally basis adjusted that adjusted through the middle of the year from the present value estimated for February, but that this decline will be reversed during the third 51 quarter of 1985, and that in the fourth quarter the multiplier will be essentially unchanged from the February level. In Table 2 we compare the not seasonally adjusted forecasts for the remainder of the year with the actual value of the multiplier the corresponding month of 1984. year-over-year forecast percentage percentage Column 3 of Table 2 indicates change change (for January (for March and through February) December). in the or The remaining columns of Table 2 indicate the allocation of the percentage difference between component actual ratios and the 1985 and 1984 of the multiplier. increases These among columns in the t. and t_ the various indicate ratios that for 1985 to 1984 work systematically to reduce the value of the relative forecast numbers 1985 multiplier below 1984 levels. Conversely, a lower actual and forecast value of the adjusted reserve ratio works to increase the value of the 1985 multiplier relative to the corresponding month in 1984. The contribution of changes in the currency ratio varies considerably from month to month, the and in several months is quite small. Changes in all other ratios show little influence on the year-over-year changes in the multiplier. Finally, we linear have been experimenting with forecasts from approximation to the multiplier model. This model a log uses the same component ratio ARIMA models as in Tables 1 and 2, but instead of using the together exact non-linear formula to put the into a forecast of the multiplier, approximation is employed. Monetary of the a linear multiplier with forecasts Taylor series In this case, the log of the M . - Adjusted . Base Multiplier is expressed as the sum of the multiplied component respect to each of the component by the appropriate components, plus an error 52 elasticities term. ratios The elasticities ratios for are evaluated at the geometric means the sample period. of the various The sample period residuals of this expansion are modeled by an ARIMA process. The component models, plus the residual model form a log-linear system which can be solved for forecast that of the multiplier. The advantage of this linearization a is if we assume that the innovations of all of the ARIMA models are jointly normally distributed, we are able to construct standard errors for the multiplier from the covariance Since matrix the linear approximation of the innovations of the the M 2 and M_ multipliers are functions of the ratios, this multipliers the forecast from several linearization technique at the same time, forecasts can can if desired, be be ARIMA same applied given Table in Table 3. constructed. Forecasts component to these from the linearization is highly accurate. 53 the interval A comparison of the linearized forecasts 3 with the exact non-linear forecasts in Table 2 models. confidence ellipsoids for linearized model together with estimates of a 95% confidence are model reveals in that APPENDIX TABLE 5 Comparison of Revised and Old Ml Growth Rates (percent changes at annual rates) Difference Revised (Ml) (1) Old Ml (2) Difference (1-2) duei to Benchmark Seasonals (3) (4) (5) xoy 0.2 0.2 JL © / Monthly 1983—Oct Nov Dec 8.1 5.0 4.1 3 eJ 1984'—Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec 7.7 10.7 6=3 7,0 4.2 7.3 10.6 -0.9 6.2 3.2 X©8 -1.2 -1.3 -3.1 -0.7 X2 a O *"D o O 0.1 0.4 0.6 0.1 0.0 cju « B -0.7 "0.1 -0.6 0.2 0.0 2.8 0.8 0.5 2.8 6.6 5.2 0.4 D <an? -3.0 'xa\J a J leO 3.8 w 8.6 0.2 2.6 0.7 0.7 3.4 10.4 11.1 9.2 9.7 6.3 6.2 6.5 4.5 3.4 4.8 7.2 6.2 4.5 2.0 1 9 8 4 — Q I V «83 to QII '84 6.4 4.4 1.6 KJ O aL -1.1 o ©/ 1.8 5.0 -6.7 -7.4 -0.2 -0.1 JL 3 <& 3.7 cj e 3 -0.7 0.2 0.6 0.1 -0.8 -0.5 0.3 -0.8 JL e ««# 0.3 0.0 1.4 0.3 0.3 0.2 0.0 0.2 6.7 -0.3 0.2 -0.5 QII '84 to QIV '84 3.9 3.3 0.6 0.1 0.5 (QIV tc> QIV) 10.4 10.0 5.2 5.0 0.4 0.2 0.3 0.2 0.1 0.0 1 9 8 5 — Jan p „ c £e « f Quarterly 1983—QIV 1984—QI QII QUI QIV -1.0 1.2 -1.3 0.1 0.0 1.2 Semi-Annual Annual 1983 1984 p—preliminary 54 TABLE 1 M, - Adjusted Monetary Base Multiplier Forecasts x 1985 Seaonally Adjusted Month January February March 2.5705 2.5955 2.5831 April May June 2.5916 2.5883 2.5725 July August September 2.5849 2.5937 2.5886 October November December 2.5874 2.5936 2.5891 January February 2.5868 2.5920 Seasonal factors for monetary aggregates published in February, 1985. Seasonal factors for adjusted monetary base published in March, 1984. 55 TABLE 2 M l ~ Adjusted Monetary Base Multiplier Forecasts February, 1985 Base, Not Seasonally Adjusted Month 1985 1984 % change k ratio t 1 ratio % change due to changes in the: g ratio z ratio rl rati t_ ratio A, a D O ! J 2.6175 2.5835 2.5871 -1.10 - .25 - .22 -.48 -.20 -.11 -.74 -.59 -.59 -.72 -.57 -.46 .02 .00 .03 .00 .00 .00 .82 1.03 .89 Apr May June 2 .6269 2.5694 2.5848 2.6203 2.5688 2.5838 .25 .02 .03 -.02 -.24 -.20 —. 56 -.64 -.69 -.35 -.27 .01 -.01 .00 .00 .00 .00 1.15 1.20 1.18 July Aug Sept 2.5837 2.5724 2.5823 2.5688 2.5539 2.5588 .58 .72 .91 .04 -.58 -.50 -.48 -.19 -.21 -.22 -.02 -.01 .01 .00 .01 .02 1.31 1.16 1.29 Oct Nov Dec 2.5920 2.5900 2.6019 2.5589 1.29 1.21 .86 -.30 — .26 -.28 -.12 -.14 -.17 -.04 .00 .00 .02 o %J &> 1.17 1.19 .01 le &1 Jan Feb Mar 2.5889 2.5770 dC s «3 3 © =# 2.5796 Year over year percent change. in * 26 • b / .53 .36 .05 a «J X TABLE 3 M . - Adjusted Monetary Base Multiplier Forecasts . 1985 February, 1985 Base Not Seaonally Adjusted Linear Approximation Models Month Forecast 95 % confidence interv January February March 2.5889* 2.5769* 2.5807 2.5517 2.6100 April May June 2»6263 2.5693 2.5840 2.5820 2.5146 2.5191 2.6714 2.6251 2.6507 July August September 2.5830 2.5724 2.5822 2.5095 2.4916 2.4936 2.6587 2.6559 2.6738 October November December 2.5915 2.5905 2.6021 2.4960 2.4888 2.4936 2.6907 2.6964 2.7153 *Actual 57 INTERNATIONAL TRADE POLICY: THE TWO MAIN TASKS Jan TUMLIR GATT, Switzerland International unknown many since trade policy exhibits the end of the 1940s. directions a degree instability The repercussions are felt but in most of them they represent deterioration, a growing burden on the world economy. which of only a in gradual The one area in the general growth of protection could produce dramatic results soon is international financial relations. crisis is acceptable far to from both The international over and I would argue that a sides must include an solution international debt of it agreement stabilizing the conditions of trade. Restoring credit worthiness is not primarily a question of increasing the export earnings the indebted countries can realize from existing production capacities. the Such an increase goes, of course, in right direction, but it is only a minor contribution magnitude of the problem. given the A number of indebted developing countries, including the two main ones, Brazil and Mexico, achieved large current account the surpluses last year which led to a widespead perception debt crisis was easing and coming under control however, unlikely again. It in government reappear in three digits two decades in the and rising, taking power. and the Crisis first 59 with civilian headlines business, perhaps even on the front, pages newspapers. is, that the 1984 current account achievements of most debtors can be repeated in 1985, certainly not those of Brazil, inflation that of will our A solution improvement that is of the debt problem must involve a substantial in the overall performance of the indebted economies beyond the possibilities of financial policy and alone. Rescheduling the principal, manipulating the interest, riding herd on the hundreds of nervous banks involved are all necessary measures far from sufficient. cannot but The reason is simple. We know that all the debt be repaid or even serviced but nobody is in a position to today what proportion of it can be salvaged. say That depends entirely on more general economic policies in both creditor and debtor countries. The political squeeze Latin a problem, economies are obvious. microeconomic performance on macroeconomic policy, "sufficient" external surplus for debt American efficiency, constraints operating on their trying to from the level of service present Yet in the international discussion of the overall the indebted economies, have been given but of policy reforms needed to improve the minimal attention so far. Not just more investment is needed to improve economic performance but a more efficient allocation of it. The average rate of return on investment debtor cannot be raised substantially improved pattern in the of investment economies incentives. without a Rising real rate of return on investment would ease the interim financing problems by increasing repatriation most of indebted investment the voluntary inflow of capital, inducing even the private assets held abroad by nationals countries. incentives But how is the level and to be improved in economies where some of pattern the the of public sector accounts for more than a half of aggregate gross investment and the allocative role of the market has been correspondingly weakened? 60 Trade policy appears to be the logical starting point, as it was instrumentally involved already in the emergence of the debt It problem. should be recalled that the large-scale borrowing by the now over- indebted countries coincided with rising protection everywhere. The increasing uncertainty of trading conditions could not fail to further distort investment incentives in the borrowing countries. a safe conclusion conditions of investment that a credible long-term international opportunities to It is thus stabilization of the trade would allow attractive new emerge in the debtor economies. The presence of such opportunities would be an additional, possibly quite effective, political argument for privatization of the industrial enterprises now inefficiently operating in the public sector. Only trade the large creditor countries conditions should, of important course, act that discipline sufficiently the can for these unilaterally stabilize effects in to debtor countries also agree to in the conduct of their trade policy. to eliminate or phase out existing At here is that tariffs do not insulate They but accept quantitative replacing them perhaps by higher, but bound, point occur. this respect have an almost unlimited freedom to restrict imports. urged international it a is basic present, they They should be restrictions, tariffs. The important an economy from the international price system as quantitative restrictions do. Moreover, once tariffs are bound and the government's freedom of interfering with import transactions effectively constrained, most of the "purely" domestic policies distorting resource allocation (such as subsidies or enforcement of private cartel agreements) cease to be feasible, least lose much of their effectiveness. 61 Liberalization of or at imports thus can be said to compel internal liberalization, strengthening the allocative role of the market. The debt problem is, of course, only one argument for an international action to restore stability in the conditions of trade. The cost of protection to the protecting economies is another, long run even more important one; and there political costs of interfering with foreign for the United States with its global are many transactions, political in the indirect, especially responsibilities. Governments are becoming aware of these costs of allowing the present drift in trade policy to continue. Our diplomacy is now engaged in an effort to get a new round of trade negotiations underway. It is at the moment impossible to say whether the effort will be successful. It may be useful, however, to point out the two dangers it entails. The Administration has proposed, authorization, Canada, and interpreted to negotiate free trade area arrangements with Israel, the as countries of the Caribbean Basin. between probably a This is widely a stratagem to induce the European Community wide-ranging trade negotiation. trade and obtained statutory A genuine free-trade area, with all the partner countries relieved of good thing? as it eliminates the all obstacles, is political impinging on transactions between the partner countries, investment are and however, that uncertainty it growth by virtue of which the trade creating likely to dominate into a the trade diverting ones. The promotes effects danger is, the free-trade area arrangements negotiable under the present trade policy conditions, conceptions and practices will considerably short of genuine free trade. an agreement to eliminate There may be, for example, tariffs accompanied by administrative "management" of trade in "sensitive" 62 fall provisions sectors. for Should that occur the system of internationally agreed rules to govern national trade policies would be weakened futher and the chances of a productive multilateral trade negotiation would grow even more remote. The second danger inheres in the habitual approach of trade policy makers to international negotiating rounds. They are conceived of in terms of bargaining for concessions on the basis of reciprocity. technique This was developed specifically for tariff negotiations where it proved useful. It cannot, however, cope with the present difficulty which stems from advanced erosion of the very principles on which system of rules was based. Approaching these problems adversary, bargaining mode would be not only pointless but the in the in fact counterproductive. The destabilization which occurred mainly in the 1970s can traced to two specific breaches of the trade policy rules agreed after World War II. conditions of have if the international trade system, it had not been possible for governments negotiated, little international trading system. rules exports fortiori. a else to grant can be though incomplete, is done to stabilize the The practice is clearly contrary to the which prohibit quantitative restrictions on in general, and discriminatory quantitative imports and restrictions a The restraint is a bilateral agreement, however, and where there is no plaintiff, rule breaking cannot be prosecuted. only While bilateral export restraints remain available as a form of protection which, GATT and requires Protection levels could not have risen as much as protection in a discriminatory way. easily upon One is flagrant, concerns the main principle and brief explanation. they be 63 There is a way of permanently remedying this defect. viewpoint of trade revolution. It discrimination transformed policy makers, would consist of it would amount a legal act by commitment (the unconditional MFN to From the a virtual which the non- clause) would be from a diplomatic convention to a requirement of national law, effectively binding the governments of at least the major trading countries. The second major breach concerns issues of a highly technical nature, well beyond the attention and understanding of general public; administrative procedures for handling subsidy and dumping complaints. If sufficient political support is to be maintained nationally for an international trade system, there must be provisions against unfair competition. unfairness second. legal Subsidies and dumping are the two main forms here, the being real in the first case, widely suspected in the Firms required by law to compete against each other must have recourse when they find themselves competing with firms backed by public subsidies. As economists we may find it difficult to understand why a country should refuse to accept subsidized imports. Indeed, if the foreign subsidy could be expected to stay in place for a sufficient length time, it would be equivalent — country it has become investment-inhibiting is importing — to a change in comparative advantage to which it would efficient to adjust. as from the viewpoint of the of be When subsidization becomes widespread, however, in the last decade, it cannot but generate uncertainty in the importing countries. an additional, more practical argument. When we maintain There that subsidized imports are a benefit, we assume that only some governments are foolish enough to subsidize, the importing country's 64 government being fully rational, government? to impervious to the temptation. International protect Is there such a rules against subsidization were intended all governments against domestic political demands for subsidies. The traditional procedure in these cases was that firms exposed to such a competition instituted and if would complain, investigation a significant margin of subsidy ascertained, an offsetting merchandise. A logically duty would be imposed equivalent "price undertaking" from the exporters, price an or on would dumping the remedy might be to i.e., was imported demand that they raise export price and the true cost of production. a third remedial practice has become established, an agreement by the exporting legally country restrict exports of the challenged merchandise to a given amount quantitative restaint — the From the end of the 1970s, however, in which a their by the amount of the officially established margin between original be is an acceptable alternative settlement to — a of complaints against subsidized or dumped imports. This practice has fundamentally changed trade firms and industries fear perhaps nothing more than an for subsidies or dumping. lasts, The policy. the exporter Exporting investigation The investigation can drag on and while it is paralyzed as to reacting to market changes. particular market, established through substantial investment of both finance and effort, may be lost to competiton while the official decision on a subsidy or dumping complaint is pending. therefore their strongly predisposed to settle for a quantitative limit sales investigation. Exporters are when such an agreement terminates Export restraint settles the complaint 65 the on official quickly; but then, too, Remedy a fundamental principle of legal procedure is sacrificed., is imposed (punishment meted out) without any proof of wrong- doing . Indeed, there is a glaring logical inconsistency: a restraint is subsidy agreed to offset the harmful effects of a putative dumping the extent of which has not been established. the viewpoint or Looked at from of the complaining domestic firms, protection is now available practically for the asking. As as long as this easy road to protection remains open — that is, long as the authorities administering the two markets of the world, rollback" measures, agreement even if important the US and the EC, have legal power to unfair competition complaints in this way — and largest settle the hope of a "standstill on new and recently all trading nations agree imposed protectionist on desirability, its cannot lead to any practical results. The correction theoretically of this simple, though defect of the trading it will be difficult to system is achieve in political practice. Where subsidization is involved there is no other solution than completed. a legal requirement that all investigations must be That ultimately means that governments will have to stop, or at least radically limit, subsidization of exportables. As regards dumping, markets predatory it is should a be recognized that price differentiation normal and efficient pricing practice form of competition, and that it official intervention in the market. 66 rather across than a should not give rise to