View PDF

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

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


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102