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Federal Reserve Bank of M inneapolis 1986 A nnual R eport T H E UN PLEA SAN T A R IT H M E T IC OF BUDGET AND TR A D E D EFIC ITS Federal Reserve Bank of Minneapolis 1986 Annual Report T H E UN PLEA SAN T A R IT H M E T IC OF BUDGET AND TRA D E D EFIC ITS Contents President’s Message 1 The Unpleasant Arithmetic of Budget and Trade Deficits 3 Statement of Condition 18 Earnings and Expenses 19 Directors 20 Officers 21 President’s Message “ T h e U n p leasan t A rithm etic of B udget an d T ra d e D eficits,” th e title of ou r 1986 Annual Report, was selected to a ttra c t atten tio n . T his choice was intentional, for th e relation betw een the foreign trad e an d federal b udget deficits is seldom acknow ledged an d poorly understood. As a consequence, it is ap p ro p riate, an d p erh ap s essential, th a t fu rth er analysis be devoted to this issue. In this essay we argue th a t the b u d g et deficit, w hile reg ard ed in some q u arters as ra th e r benign, is in fact a prin cip al cause of the trad e gap an d the sectoral problem s in o u r dom estic econom y th a t have accom panied it. W e dem onstrate, m oreover, th a t satisfactory correc tion of the trad e im balance requires sustained reductions in the budget deficit. O th e r proposed solutions to th e trad e p ro b lem — protectionist legislation an d accom m odative m o n etary policy—are eith er doom ed to failure or likely to prove exceedingly costly. Indeed, alth o u g h the trad e deficit is a serious problem , it m ay in fact be the best w ay we have of dealing w ith persistent im balances in ou r fiscal affairs. Gary H. Stern President 1 Federal Reserve Bank of Minneapolis 1986 Annual Report T H E UN PLEA SAN T A R IT H M E T IC OF BUDGET AND TRA D E D EFIC ITS T h e U n ite d States foreign trad e deficit continues to rank n ear th e top of d isturbing econom ic issues. A n u m b e r of explanations for the trad e im balance have been proffered, including u n fair trad e practices ab ro ad , the d o llar’s high in tern atio n al value, financial problem s of some large developing countries, an d sluggish grow th elsewhere in the industrial w orld. D ep en d in g on the ex p lan atio n selected, altern ativ e rem edies have been proposed. M u ch of the discussion to date, though, has failed to consider the m ix of m acroeconom ic policies—th a t is, fiscal an d m onetary policies— in co n trib u tin g to the recent trad e im balance. W ith a few exceptions, little is understood of the relationship betw een federal governm ent b u d g et deficits an d trad e deficits. C onse quently, solutions to o u r trad e deficit ten d to em phasize policy m e a sures th a t are eith er im p o ten t or very costly. T ypical recom m endations include protectionist policies to reduce im ports w ithout reg ard to how o u r trad in g p artn ers m ight respond, or accom m odative m o n etary policy to reduce the d o llar’s in tern atio n al value w ith o u t considering its dom estic value. These recom m endations ignore the consequences of reducing the trad e deficit w ithout a corresponding reduction in the bud g et deficit. T h e u n p leasan t arith m etic of budget an d trad e deficits shows th a t, w ith aggregate savings fixed, large b u d g et deficits inevitably will be accom panied by foreign trad e deficits or a slowing in dom estic in vestm ent. F u rth er, im provem ent in the trad e balance, if achieved w ith o ut com parab le reductions in the b u d g et deficit, m ay not necessarily be beneficial. If, for exam ple, im provem ent comes th ro u g h im port restrictions, it will simply result in grow ing weakness in p riv ate invest m ent. A nd while accom m odative m o n etary policy m ay drive dow n the in tern atio n al value of the dollar, it is not clear th a t this developm ent, in an d of itself, will lead to a significant im provem ent in the trad e balance. In fact, if the econom y is at full em ploym ent so th a t aggregate savings are fixed, accom m odative m onetary policy could worsen the trad e balance. 3 The Unpleasant Arithmetic of Budget and Trade Deficits In this essay we first review econom ic perform ance over the past several years w ith reference b o th to the effects of large b udget deficits an d to the grow ing trad e problem . T h e initial question is w h eth er those concerned th a t outsized b u d g et deficits w ould “ crow d o u t” dom estic investm ent were sim ply “ crying wolf.” W e find th a t they w ere not, b u t th a t th eir concern was m isplaced. Instead of red u c ing dom estic investm ent, these deficits ap p eared to reduce net exports. W e dem onstrate this o th er type of crow ding o u t by in tro d u cin g a basic G N P acco u n tin g identity. This identity, along w ith some stan d ard econom ic assum ptions, has a significant im plication for reducing the trad e deficit: reduction in the b u d g et deficit is essential to satisfactory resolution of the trad e gap. W e then contrast this conclusion w ith two altern ativ e rem edies to the trad e problem , nam ely protectionism an d m o n etary accom m odation, an d argue th a t bo th are seriously flawed. Crowding O ut or Crying Wolf? For th e past five years, persistently large federal budget deficits to m any observers have been am ong th e most tro u b lin g aspects of the econom y. A ccording to conventional analysis, these massive b udget deficits w ould result in in ordinately high real interest rates as the go v ern m en t’s d em an d for funds collided w ith p riv ate financing req u ire m ents. In the process, high real interest rates w ould crow d out private financing. Follow ing this line of reasoning, residential construction, business investm ent in p la n t an d equ ip m en t, an d perhaps consum er spending on d u rab le goods w ould be h a rd hit by the stance of fiscal policy, especially if m o n etary policy was nonaccom m odative. M o re over, it was an ticip ated th a t w ith these large sectors rem aining slug gish, the overall expansion w ould be subdued. A lthough the federal governm ent deficit increased to over S200 billion by 1986, these dire predictions did not com e true. R eal interest rates did rise, b u t consum er spending on durables increased steadily an d substantially th ro u g h the expansion, an d housing activity was strong. A m arked pickup in business p la n t an d eq u ip m en t spending occu rred as well, at least d u rin g the first th ree years of the expansion. T h e econom y’s overall grow th, too, surpassed expectations. It ex p an d ed u n in terru p ted ly from 1983 th ro u g h 1986 at a 4 percent a n n u a l rate, w ith grow th in the first two years of the expansion av er aging a robust 5.6 p ercent p er annum . O v er the whole period, total em ploym ent clim bed ab o u t 12 m illion workers. M ark et interest rates d ro p p ed perceptibly an d inflation was subdued, averaging ju st over 3 percent. 4 Federal Reserve Bank of Minneapolis 1986 Annual Report These relatively favorable statistics do not m ean th a t large b udget deficits h ad no adverse consequences for econom ic p erfo rm ance, althoug h identification of the effects of the b udget deficits was sufficiently difficult th a t those who have expressed concern ap p e a r to have been crying wolf. But a com ponent of econom ic activity th a t clearly has not fared well as the expansion has proceeded is the foreign trad e balance: the difference betw een U.S. exports an d im ports. O v er the four-year period end in g w ith 1986, goods an d services p ro d u ced a b ro ad an d im ported into th e U n ited States rose by an estim ated S I76 billion. D u rin g this same period, exports gained only S45 billion, so the trad e balance d eterio rated by S I31 billion. W ithin this deterio ratio n in the trad e balance, two sectors in p a rtic u la r stand out. W hile the U.S. ag ricu ltu ral trad e b alan ce is still in surplus, it has dim inished significantly in recent years, falling from over S I8 billion in 1983 to ju st over $2 billion in 1986. T hus, agricu l tu re has co n trib u ted ab o u t S I6 billion to a w orsened trad e situation over the past four years (see c h art 1). Serious deterio ratio n occurred as well in m anufacturing, especially in low -technology. (Low -tech m a n u factu rin g includes nonChart 1 U.S. Balance o f Trade o f Manufactured and Agricultural Goods, 1980-1986 (E xports less Imports) B illions o f S Source: B ureau of T h e Census, U .S. D epartm ent of C om m erce 5 The Unpleasant Arithmetic of Budget and Trade Deficits electrical m achinery, some fab ricated m etal products, household ap p li ances, autos, ships, an d railro ad equipm ent. H igh-tech includes p ro d u ction of electronic com ponents, com puters, aircraft, an d defense equ ip m en t.) N ot unexpectedly, low -tech is an area w here the U n ited States has ru n a trad e deficit for years. T h e deficit recently has w id ened m aterially. In high-tech m a n u factu rin g a trad e surplus persists, alth o u g h it has narrow ed perceptibly over the past few years. T h e decline in m a n u factu rin g trad e is reflected in both em ploy m en t an d o u tp u t statistics. E m ploym ent in m an u factu rin g declined by m ore th a n 300,000 w orkers betw een the m iddle of 1984 an d the end of 1986, an d expansion in industrial p ro d u ctio n in the U n ited States slowed to an a n n u al average rate of 1.5 p ercent in 1985 an d 1986, dow n d ram atically from the pace of the first two years of the expansion. Root Causes E norm ous trad e deficits have accom panied the large federal budget deficits (see c h art 2). T his fact does not necessarily m ean th a t budget deficits are responsible for the trad e problem . Indeed, several oth er d eterm in in g factors are com m only cited for the pronounced d eterio ra tion in o u r trad e balance in the 1980s. O n e such factor is the m arked ap p reciatio n of the d o llar relative to m any o th er currencies, as it m ade U .S. goods relatively expensive dom estically an d aro u n d the world. A n o th er factor is robust grow th in o u r dom estic dem an d com pared w ith sluggish expansion a b ro a d —p articu larly in m uch of W estern E urope an d J a p a n —as o u r dom estic m ark et pulled in products from aro u n d th e w orld. Finally, a th ird frequently cited factor is cu rtailed d em an d by those developing countries w ith in tern atio n al d eb t p ro b lems, p articu larly those th a t form erly represented large m arkets for us. A lthough a useful description of some of w h at has h appened in the w orld econom y in the 1980s, these explanations of o u r trad e p ro b lem — relying as they do on eith er the relative value of the dollar, slow grow th elsewhere in the industrialized w orld, or special financial problem s of some developing co u n tries—do not get at root causes. For it is the m ix of fiscal an d m o n etary policies pursued by countries aro u n d the w orld th a t ultim ately affects interest rates, exchange rates, an d dom estic grow th; these variables are not in dependent of policy fun dam entals. T h a t is, it is fiscal policy— governm ent spending an d tax policies— an d m onetary policy th a t are relatively exogenous to the econom ic process an d th a t determ ine, at least in p art, econom ic perform ance. 6 Federal Reserve Bank of Minneapolis 1986 Annual Report Chart 2 Dual Deficits Quarterly, 1965-1986 Billions o f $ 100 Trade Balance Source: B ureau of E conom ic Analysis, U.S. D ep artm en t of C om m erce In the U n ited States, a highly expansionary fiscal policy was enacted w ith the tax reduction legislation of 1981. T his policy succeed ed in stim ulating dom estic d em an d an d co n trib u ted , not unexpectedly, to high real interest rates as large b udget deficits becam e com m on place. T he stance of fiscal policy was p articu larly telling since over m uch of the period dom estic m o n etary policy was oriented to w ard sub duing inflation. In contrast, o th er m ajo r industrial countries ad o p ted fiscal policies th a t were less stim ulative so th a t, given o u r relatively nonaccom m odative m onetary policy, ou r real interest rates were high rela tive to those prevailing abroad. A nd th ro u g h this channel, the policy stance co n trib u ted to the sharp ap p reciatio n of the dollar. M oreover, the adoption by some developing countries of austerity m easures to im prove th eir trad e balances an d enhance th eir abilities to service their foreign debts resulted in little or no grow th in d em an d for goods p ro duced in the industrialized countries. In this regard, it is revealing th a t the deterioratio n in the U .S. trad e balance occurred across a bro ad spectrum of trad in g p artn ers (see ch art 3). Since the early 1980s, the U .S. tra d e gap w ith virtually all m ajo r areas of the w orld has w idened; perhaps p articu larly striking is the swing from surplus to deficit in 7 The Unpleasant Arithmetic of Budget and Trade Deficits trad e w ith bo th E urope an d L atin A m erica, in p a rt a consequence of th e problem s th a t have beset the global econom y in recent years. W h at we have described to this p oint is a set of econom ic policies w hich co n trib u ted to the m ark ed w orsening in U .S. trad e perform ance over the 1982-86 period. A p p aren tly those concerned ab o u t th e adverse repercussions of large federal budget deficits were not ju st crying wolf. Serious sectoral problem s did in fact m aterialize, alth o u g h they were foreign-trade-sensitive, ra th e r th a n interest-ratesensitive. T his m ay have been because the incom e effect associated w ith stim ulative fiscal policy offset the dom estic effects of high real interest rates on the interest-rate-sensitive sectors. At the same time, Chart 3 U.S. Merchandise Balance o f Trade With Selected Areas in 1980-1985 (E xports less Imports) Key Canada East Asian Newly Industrialized Countries* Japan w m m —m Brazil and Mexico Europe Billions o f S 20 10 0 -10 -20 -30 -40 -50 _6° 80 81 82 83 84 *Includes H ong K ong, South K orea, Singapore an d T aiw an Source: In tern atio n al T rad e A dm inistration, U.S. D ep artm en t of C om m erce 85 Federal Reserve Bank of Minneapolis 1986 Annual Report the incom e effect an d the high d ollar reinforced each o th er w ith reg ard to o u r im ports, w hile the high d o llar low ered w orld d em an d for ou r exports. Unpleasant Deficit Arithm etic T h e relationship betw een the federal b u d g et deficit, the tra d e deficit, an d conventional crow ding out of dom estic investm ent by governm ent spending can be effectively illustrated w ith the following acco u n tin g identity, w hich is derived from the condition in econom ics th a t o u tp u t m ust equal to tal expenditures: G overnm ent Deficit = Savings Surplus + T rad e Deficit + (M - X ) or, for an aly tical purposes, (G - T) = (S - I) w here G is governm ent spending, T is taxes, S is savings, I is invest m ent, M is im ports, an d X is exports. W hile these variables can be defined in several ways, for this discussion we let G an d T refer only to the federal governm ent (G is inclusive of interest on the debt), so th a t S is gross priv ate savings including th a t of state an d local governm ents. (See table for recent U .S. history of this identity.) T h e identity says th a t a given b u d g et deficit (the difference betw een federal expenditures an d tax receipts) m ust be eq u al to the sum of the savings surplus (the difference betw een dom estic savings an d investm ent) an d the trad e deficit (the difference betw een im ports an d exports). O r equivalently it says th a t the federal governm ent has two sources of credit: a governm ent deficit can be funded by dom estic savings or by foreign lenders. (T he trad e deficit, M - X , represents the net am o u n t of funds we m ust borrow from abroad.) T h e identity also implies th a t given fiscal policy, a n arro w in g of the savings surplus (e.g., because investm ent increases) m ust be accom panied by d eterio ratio n in trade. W hile some m ight object to focusing on a given fiscal policy because a bu d g et deficit could result from changes in oth er com po nents of the identity, it is this deficit, an d this deficit alone, th a t is largely u n d er the control of policym akers. T h e im plications of this simple expression are striking w hen coupled w ith assum ptions ab o u t the econom y. T h e conventional view of crow ding out, for exam ple, assumes th a t th e trad e balance is both relatively small an d slow to change; hence, it largely ignores the trad e deficit an d focuses on the relation betw een the governm ent deficit an d the savings surplus. G iven this assum ption, an increase in the b u d g et 9 The Unpleasant Arithmetic of Budget and Trade Deficits Table National Income Accounting Identity by Component (in B illions o f D ollars) Budget* Deficit (G-T) Savings Surplus (S-I) Trade* Deficit (M -X) 1965-69** 2.4 9.6 -7.1 1970-74** 13.7 23.9 -10.2 1975-79** 42.9 57.8 -14.9 1980 1981 1982 1983 1984 61.3 63.8 145.9 176.0 170.0 93.4 97.7 172.2 169.9 111.3 -32.1 -33.9 -26.3 6.1 58.7 1985 1986 198.0 204.9 119.1 99.7 78.9 105.2 •Positive num bers indicate deficits; negative num bers indicate surpluses. **A nnual average. Source: B ureau of E conom ic Analysis, U.S. D ep artm en t of C om m erce. deficit m ust be m atch ed by an increase in the savings surplus. F u rth er, assum ing th a t the econom y is o p eratin g at full em ploym ent so th a t real incom e an d savings are fixed (and assum ing savings are not responsive to changes in interest rates), a b u d g et deficit increase will result in h igher real interest rates an d depress priv ate investm ent. W hile the conventional crow ding out story is indeed plausible, it is not w h at h ap p en ed as th e c u rren t econom ic expansion progressed. Instead, m uch of the adju stm en t to large b u d g et deficits cam e in the w idening of the trad e deficit. H igh real interest rates drove up the value of the d ollar in tern atio n ally an d th ro u g h this channel co n tri b u te d to th e deterio ratio n in trade. A t the same tim e, dom estic invest m en t was ap p aren tly little inhibited by high real rates, especially in th e early years of the expansion (see c h a rt 4). T h e identity helps to dem onstrate the relationship betw een the federal b u d g et an d trad e deficits. A ssum ing th a t the econom y is at full em ploym ent so th a t aggregate savings (S) in o u r econom y are fixed, an increase in th e b udget deficit m ust eith er depress dom estic investm ent (I) or result in deterio ratio n in the trad e deficit (M - X). T his aspect of the u n p leasan t arith m etic of b udget an d trad e deficits is often over looked. It has very significant im plications for policies aim ed only at 10 Federal Reserve Bank of Minneapolis 1986 Annual Report im proving o u r trad e position. T h e identity tells us th a t if the trad e gap narrow s while the b u d g et deficit does not, or if it dim inishes m ore th a n the budget deficit, th en the savings surplus m ust increase. If aggregate savings are fixed, how ever, investm ent m ust fall in these circum stances. T hus, im provem ent in o u r trad e position w ould not lead to stren g th en ing in private sector econom ic activity, as it w ould be offset by a tte n d a n t w eakening in investm ent. T his description of the im plications of the identity does not explain how the adju stm en t m ight actually occur. T h ere are any n u m b e r of scenarios th a t m ight play out, b u t prices, interest rates an d exchange rates in p articu la r, are likely to be cen tral to all of them . F or illustrative purposes, consider the co m bination of a fall in the dollar, a reduction in the trad e deficit, an d no progress on the b u d g et deficit. In th a t circum stance, we know th a t the savings surplus m ust w iden and, on o u r assum ption of being at full em ploym ent, the ad ju stm en t will not come th ro u g h increased savings. H ence, investm ent m ust fall, in response perh ap s to higher interest rates. In the context of this exam ple, a rise in interest rates w ould not be at all surprising if funds from ab ro ad h ad to be attra c te d or retain ed in the face of a d o llar falling, in Chart 4 Real Gross Private Domestic Investment and Real Interest Rate * Q u a rte rly , 1 9 6 5 - 1 9 8 6 P ercen t Billions of 82 S 700 iu 8 600 6 Investm ent ► 500 4 2 400 0 -2 -4 •* Real R ate -6 -8 in 66 68 70 72 74 76 78 80 82 84 86 •R e a l rate is difference betw een 4 q u a rte r m oving average in 3 m o n th T-Bill and 4 q u a rte r percent change in G N P deflator Source: B ureau o f Econom ic Analysis, U .S. D ep artm en t of C om m erce a n d the Federal R eserve Bank o f New York 11 The Unpleasant Arithmetic of Budget and Trade Deficits p a rt as a consequence of grow ing reluctance of foreign investors to acq u ire d o llar-d en o m in ated assets. T h e identity depicted above thus dem onstrates th a t im prove m en t in o u r trad e position is not sufficient, in an d of itself, to assure a h ealth ie r p riv ate econom y. W eakened dom estic investm ent spending could co u n terb alan ce dim in u tio n of the trad e gap. Promise of the Plaza As we have seen, the stance of fiscal policy is a t the h eart of o u r trad e im balance an d the associated sectoral problem s. C orrection of the trad e p roblem thus requires addressing m acroeconom ic policies a p p ro priately. W e believe th a t the so-called P laza A greem ent (fall 1985) was such an attem p t. In the abstract, in tern atio n al co o rdination of m acroeconom ic policies should be beneficial. As a consequence of highly in teg rated global financial an d p ro d u ct m arkets, one co u n try ’s policy choice affects the econom ic perform ance of m any others. O n e co u n try ’s borrow ing m ay affect w orld interest rate levels, an d its d em an d m ay influence w orld prices. As a result of this interdependence, econom ic perform ance an d w elfare can be im proved if co o rdinated policies are im plem ented ra th e r th a n if, alternatively, each country determ ines policy on the assum ption th a t policies of o th er countries are fixed. T h ere is value to in tern atio n al policy cooperation irrespective of the state of trad e flows or, for th a t m atter, of the business cycle. S eptem ber 1985 m arked the beginning of an overt effort to co o rd in ate policies am ong several m ajo r industrial countries, w ith the objective of achieving a m ore balan ced p a tte rn of w orld grow th an d trade. T h e effort was the Plaza A greem ent am ong the G-5 countries, w hich called for econom ic policy coordination, p articu larly am ong W est G erm any, J a p a n , an d the U n ited States. As p a rt of the Plaza strategy, it was envisioned th a t fiscal policies—th a t is, governm ent spending an d tax policies—w ould be m odified here and ab ro ad in o rd er to adjust aggregate d em an d an d realign exchange rates. C o o r d in a ted intervention in the foreign exchange m arkets by m ajor central banks was a second aspect of the strategy. As events unfolded, it ap p eared th a t some of the objectives of the P laza A greem ent were achieved. T o be sure, the decline of the d o llar began in M arch 1985, p rio r to the agreem ent. H ow ever, there was co o rd in ated intervention in the foreign exchange m arkets by m ajo r cen tral banks in the w ake of the P laza A greem ent w hich was accom panied, for a time, by sym pathetic reductions in interest rates. T h e d o llar declined appreciably. 12 Federal Reserve Bank of Minneapolis 1986 Annual Report Misgivings D espite this ap p a re n t success, th ere should be serious misgivings ab o u t the way in w hich the P laza A greem ent has been im plem ented. As a key p a rt of th a t agreem ent, it was in ten d ed th a t U.S. fiscal policy w ould be altered to reduce, in a m eaningful an d sustained way, the federal b ud g et deficit. A lthough th ere has been some m ovem ent to a low er deficit, the b u rd en of adju stm en t to achieve P laza A greem ent objectives so far has fallen to m onetary policy. C onsequently, U .S. m o n etary policy was decidedly m ore accom m odative in m uch of 1985 an d 1986 th a n it h ad been earlier in the econom ic expansion. G row th in M l, the n arro w m onetary aggregate, was exceedingly rap id in those years, an d b an k reserves increased sub stantially (see ch art 5). T his accom m odative policy co n trib u ted to the decline in the dollar b u t sim ultaneously served to bolster d em an d for goods an d services in this country. T h u s the decline in th e d o llar has not as yet generated any dem onstrable im provem ent in the trad e balance, an d it is possible th a t it never will. Chart 5 Growth in Money Supply ( M l ) and Total Reserves Quarterly, Annual Rate, 1965-1986 P ercent C hange from 4 Q u arters Previous 25 Source: Board of G overnors of the F ederal R eserve System 13 The Unpleasant Arithmetic of Budget and Trade Deficits A gain, the G N P acco u n tin g identity can help to elucidate the consequences of various policy choices. A less stim ulative fiscal policy will be accom panied by im provem ent in the trad e balance a n d /o r in dom estic investm ent, as a decline in real interest rates aids these sec tors. H ow ever, stim ulative m o n etary policy, u n d er the assum ption of full em ploym ent, should reduce the nom inal value of the d o llar b u t will also co n trib u te to inflation, a t least over tim e, leading to little if any im provem ent in the term s of trad e an d in the trad e balance. Indeed, if the dro p in interest rates leads to a substantial increase in investm ent, th e identity im plies th a t the term s of trad e m ust worsen so as to increase the trad e deficit. O f course, the econom y over the last two years was not at full em ploym ent. C onsequently, the stim ulative m o n etary policy m ay have h ad some positive effects on the tra d e balance. In the first instance, such a policy lowers real interest rates an d the foreign exchange value of the dollar. Low er interest rates in tu rn stim ulate dom estic invest m en t so th a t aggregate incom e is h igher th a n it otherw ise w ould be. T h e incom e effect by itself worsens th e trad e deficit as the rise in in com e induces consum ers to buy m ore im ports. H ow ever, this effect can be m ore th a n offset by the term s of trad e if the d o llar falls w ith o u t a corresponding rise in dom estic prices. M oreover, as incom e increases, the b u d g et deficit should n arro w as tax revenues climb. In short, in these circum stances accom m odative m o n etary policy can am eliorate the trad e an d budget deficits, at least to a degree. H ow ever, as we have seen, the ability of expansionary m onetary policy to accom plish these objectives is significantly circum scribed as the econom y approaches full em ploym ent. T h e p ractical experience of the past two years, as the d o llar has declined w ith accom m odative m o n etary policy, suggests th a t the effects of such a policy m ay be small indeed. Protect Us From Protectionism A ccording to o u r identity an d in light of cu rren t econom ic experience, it is unlikely th a t we will m ake progress on reducing the trad e deficit w ith o u t also reducing the federal deficit. Even if we can fix the trad e deficit some o th er way, how ever, the cure could be worse th a n the disease. T h e best exam ple of such a cure is so-called “ trad e legisla tio n ” — the euphem ism for protectionist policies. P rotectionist policies could readily have adverse effects on our dom estic econom y. T o the extent th a t they succeed in restricting the volum e of im ports, they will raise prices of im ported goods, an d thus 14 Federal Reserve Bank of Minneapolis 1986 Annual Report the A m erican consum er will pay for the policies. T h ere is evidence to suggest, m oreover, th a t low -incom e consum ers b ear a disp ro p o rtio n ate share of these costs. A ccording to a recent staff study by th e F ederal R eserve Bank of N ew York, the cost to U .S. consum ers of trad e p ro tec tion on clothing, sugar, an d autom obiles is not only high b u t also regressive, in th a t the cost of protection is m any times larg er for lowincom e consum ers th a n it is for those w ith high incomes. F u rth er, if com petition is restrained by protectionism , there m ay be room for dom estic producers to raise prices and, if this process gains m om entum , it could foster rap id inflation. As the G N P identity discussed earlier m akes clear, if the econom y is at full em ploym ent, protectionist m easures th a t successfully reduce the trad e deficit m ust eith er depress dom estic investm ent or reduce the governm ent deficit. T h e la tte r reaction w ould result as protectionism adds to inflation an d tax revenues clim b w ith nom inal income. T his effect is likely to be small, however. T h e b u rd en instead will m ore likely fall on investm ent as the private an d public sectors will have to com pete for m ore lim ited capital funds. P rotectionist policies, too, could m ake it difficult for dom estic industries to com pete effectively here an d ab ro ad , if im p o rt prices were to rise beyond levels faced by foreign firms. F or exam ple, if foreign steel were b arred from the U n ited States or if its price rose signifi cantly, U .S. m an u factu rers th a t use steel as an in p u t w ould face higher costs th a n th eir foreign com petitors. W e should not expect these m a n u facturers to do well if we h an d icap them in this way. W e m ay also w onder if o u r trad e balance w ould in fact im prove if o u r m an u fac turers were thus shackled. R etaliatio n is an o th er likely outcom e of protectionist m easures. W e are well aw are of the trad e barriers th a t exist in m any foreign countries today, yet th ere is no evidence th a t these unfair trad e p ra c tices ab ro ad have co n trib u ted in a m ajor an d system atic way to ou r trad e im balance. If we began to raise o u r trad e barriers, foreign govern m ents w ould p robably not stand by an d w atch. T hey are likely to retaliate by im posing tariffs or volum e restrictions on U.S. goods. So the outcom e of protectionism for the U .S. econom y as a w hole w ould be deleterious, alth o u g h specific p rotected industries m ight benefit. Even this list of p rotectionism ’s repercussions does not do justice to its flaws as public policy. C onsider a w orld econom y w here trad e legislation an d subsequent retaliation have becom e pervasive. U n d e r these circum stances, a logical outcom e w ould be a significant c o n tra c tion in trad e w orldw ide. Such a con tractio n w ould be expensive, in the 15 The Unpleasant Arithmetic of Budget and Trade Deficits sense th a t em ploym ent an d p ro d u ctio n w ould necessarily be cu rtailed a ro u n d th e world. This is, of course, the conventional description of a w orldw ide recession, an d it w ould be accom panied by h igher prices for m any p roducts th a n otherw ise w ould be the case. Conclusion T h e perform ance of the U .S. econom y over the past several years, ch aracterized by grow ing federal b u d g et deficits, tog eth er w ith d eterio ratio n in the trad e balance, can be b etter understood w ith the analy tical strictures of deficit arithm etic. This arith m etic shows th a t b u d g et deficits can indeed crow d o ut p riv ate sector activity, b u t p e r haps in ways th a t were m ore subtle th a n initially an ticip ated . T he G N P acco u n tin g identity also m akes clear th a t in the absence of increases in the volum e of dom estic savings, the only effective way to alter the arith m etic favorably is to reduce the go v ern m en t’s deficit. If such a policy is not im plem ented, im provem ent in the trad e balance will result in w eakening in investm ent spending. T o be sure, reduction of the b u d g et deficit is n eith er a riskless no r a new policy prescription. N onetheless, it rem ains a sound one. At this stage, such action w ould strengthen the priv ate sector of the econ om y an d w ould spur im provem ent in the trad e situation. Im proving the trad e balance, in an d of itself, though, should not be a policy goal. P rotectionist policies aim ed a t this objective will surely miss the m ark. Progress on the trad e issue is also questionable if we rely solely on accom m odative m onetary policy. T h e u n p leasan t arith m etic of budget an d tra d e deficits in fact suggests th a t such a policy could actually ex acerb ate the trad e problem . A t the same tim e, it could trigger a reacceleration of inflation. In sum m ary, if we can n o t correct o u r fiscal im balance, it m ay not be wise to try to redress o u r trad e im balance. — Gary H. Stern 16 Federal Reserve Bank of Minneapolis 1986 Annual Report Statement of Condition Earnings and Expenses Directors Officers 17 Statem ent of C ondition (In Thousands) December 31, _______ 1986 December 31, 1985 $168,000 78,225 20,068 206,210 $156,000 (38,542) 63,000 21,680 2,810 113,125 2,855,458 108,417 2,342,928 $2,968,583 $2,451,345 492,649 654,339 35,976 312,642 48,279 35,684 231,495 81,347 $4,396,632 $3,659,158 $2,838,142 $2,390,476 884,056 4,950 11,708 470,703 4,950 12,588 $900,714 $488,241 Deferred Availability O ther Liabilities 495,471 40,035 630,410 33,045 Total Liabilities $4,274,362 $3,542,172 $61,135 61,135 $58,493 58,493 $122,270 $116,986 $4,396,632 $3,659,158 A ssets Gold Certificate Account Interdistrict Settlement Fund Special Drawing Rights Certificate Account Coin Loans to Depository Institutions Securities: Federal Agency Obligations U.S. Government Securities Total Securities Cash Items in Process of Collection Bank Premises and Equipm ent— Less: Depreciation of $23,628 and $21,664 Foreign Currencies O ther Assets Total Assets 66,000 L iab ilities Federal Reserve Notes1 Deposits: Depository Institutions Foreign O ther Deposits Total Deposits Capital Accounts Capital Paid In Surplus Total Capital Accounts Total Liabilities and Capital Accounts 'A m o u n t is net of notes held by the Bank of $545 m illion in 1986 an d S608 m illion in 1985. 18 Earnings and Expenses (in Thousands) For the Year Ended December 31 1986 1985 C u rren t E a r n in g s Interest on U.S. Government Securities and Federal Agency Obligations Earnings on Foreign Currency Investments Interest on Loans to Depository Institutions Revenue from Priced Services All O ther Earnings Total Current Earnings $224,145 12,988 1,156 35,416 390 $274,095 1222,590 7,526 2,413 34,280 298 $267,107 C u rren t E x p e n s e s Salaries and O ther Personnel Expenses Retirement and O ther Benefits Travel Postage and Shipping Communications Materials and Supplies Building Expenses: Real Estate Taxes Depreciation—Bank Premises Utilities Rent and O ther Building Expenses Furniture and Operating Equipment: Rentals Depreciation and Miscellaneous Purchases Repairs and Maintenance Cost of Earnings Credits O ther Operating Expenses Net Shared Costs Received from O ther FR Banks Total $26,434 5,725 787 5,682 525 1,864 $25,621 6,016 1,055 5,585 672 1,866 2,500 1,050 843 700 2,294 1,041 857 692 1,014 4,296 1,915 5,577 1,877 1,889 1,761 3,601 1,579 6,177 1,572 1,638 $62,678 $62,027 (3,587) (2,804) $59,091 $59,223 $215,004 64,005 $207,884 41,001 3,191 2,381 3,554 267,241 2,572 2,131 3,391 236,602 $2,642 $4,189 Surplus, January 1 Transferred to Surplus—as above $58,493 2,642 $54,304 4,189 Surplus, December 31 $61,135 $58,493 Reimbursed Expenses2 Net Expenses C u rren t N e t E a r n in g s Net Additions3 Less: Assessment by Board of Governors: Board Expenditures Federal Reserve Currency Costs Dividends Paid Payments to U.S. Treasury Transferred to Surplus S u r p lu s A c c o u n t R e im b u rse m e n ts due from the U.S. T reasury an d o th er F ederal agencies; S I,973 was u n reim bursed in 1986 an d $245 in 1985. 3T his item consists m ainly of unrealized net gains related to revaluation of assets d en o m inated in foreign currencies to m arket rates. 19 Directors December 31, 1986 Federal Reserve Bank of Minneapolis Helena Branch JO H N B. DAVIS, JR . Chairm an and Federal Reserve Agent M ARCIA S. ANDERSON Chairm an M ICHAEL W. W R IG H T Deputy Chairm an W ARREN H. ROSS Vice Chairm an Class A E lected by M e m b e r B a n ks A p p o in ted by B oard o f Governors BU R TO N P. ALLEN, JR . President, First National Bank Milaca, Minnesota M ARCIA S. ANDERSON President, Bridger Canyon Stallion Station, Inc. Bozeman, M ontana TH O M A S M. STRO NG President, Citizens State Bank Ontonagon, Michigan W ARREN H. ROSS President, Ross 8-7 Ranch, Inc. Chinook, M ontana DUANE W. RING President, Norwest Bank La Crosse, N.A. La Crosse, Wisconsin A p p o in ted by B oard o f D irectors F R B o f M in n ea p o lis C lass B E lected by M em b er B a n ks H A RO LD F. ZIGM UND (Retired Chairman, Blandin Paper Co.) Minneapolis, Minnesota W ILLIAM L. M ATHERS President, Mathers Land Company Miles City, M ontana RICH A RD L. FALCONER District Manager-Finance, Northwestern Bell Minneapolis, Minnesota C lass C A p p o in ted by B oard o f Governors JO H N B. DAVIS, JR . (President Emeritus, Macalester College) Minneapolis, Minnesota M ICHAEL W. W R IG H T Chairman, Chief Executive Officer, and President Super Valu Stores, Inc. Minneapolis, Minnesota JO H N A. ROLLW AGEN Chairm an and Chief Executive Officer Cray Research, Inc. Minneapolis, Minnesota M em b er o f F ederal A dvisory Council DeW ALT H. ANKENY, JR . C hairm an and Chief Executive Officer First Bank System, Inc. Minneapolis, Minnesota 20 SEABROOK PATES President and General M anager M idland Implement Co., Inc. Billings, M ontana DALE W. ANDERSON President, Norwest Bank Great Falls, N.A. Great Falls, M ontana F. CHARLES M ERC O RD President and M anaging Officer First Federal Savings Bank of M ontana Kalispell, M ontana Officers December 31, 1986 Federal Reserve Bank of Minneapolis GARY H. STERN President TH O M A S E. GAINOR First Vice President K A TH LEEN J. BALKMAN Assistant Vice President RICH A RD W. PU T T IN Assistant Vice President JO H N H. BOYD Research Officer TH O M A S M. SUPEL Assistant Vice President R O B ER T C. BRANDT Assistant Vice President K E N N ETH C. TH EISEN Assistant Vice President JA M ES U. BROOKS Assistant Vice President TH O M A S H. T U R N E R Assistant Vice President MARILYN L. BROWN Assistant General Auditor CAROLYN A. V E R R E T Assistant Vice President JA M ES T. D EU STER H O FF Assistant Vice President JO SE P H R. VOGEL Chief Examiner PHIL C. GERBER Vice President RICH A RD K. EINAN Assistant Vice President and Community Affairs Officer W ARREN E. WEBER Research Officer BRUCE J. HEDBLOM Vice President JEA N C. G A RRICK Assistant Vice President RICH A RD L. K U XH A U SEN Vice President JA M ES H. HAM M ILL Assistant Vice President and Secretary M ELVIN L. BURSTEIN Senior Vice President and General Counsel LEONARD W. FERNELIUS Senior Vice President RONALD E. KAATZ Senior Vice President A R T H U R J. RO LN IC K Senior Vice President and Director of Research SHELDON L. AZINE Vice President and Deputy General Counsel JA M ES M. LYON Vice President SUSAN J. M ANCHESTER Vice President PRESTO N J. M ILLER Vice President and Deputy Director of Research CLARENCE W. NELSON Vice President and Economic Advisor CHARLES L. SH R O M O FF General Auditor CO LLEEN K. STRAND Vice President T H EO D O R E E. U M H O E FE R Vice President CARYL W. HAYWARD Assistant Vice President W ILLIAM B. H O LM Assistant Vice President W ILLIAM G. W U R STER Assistant Vice President Helena Branch R O B ER T F. McNELLIS Vice President and M anager DAVID P. NICKEL Assistant Vice President RONALD O. HOSTAD Assistant Vice President BRUCE H. JO H N SO N Assistant Vice President TH O M A S E. K LEIN SC H M IT Assistant Vice President K EITH D. K REYCIK Assistant Vice President R O D ER IC K A. LONG Assistant Vice President 21 F o r a d d itio n al copies contact: Public Affairs Federal Reserve Bank of Minneapolis Minneapolis, Minnesota 55480 F ederal Reserve Bank of M inneapolis 250 M a rq u e tte A venue M inneapolis, M innesota 55480
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