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January 27,1 984

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Export Crowding Ou t
The U S economic recovery continues
at a brisk pace, with real G NP rising in 1983
by over 6 percent. Although the overall
strength of the economy at this stage is
fairly typical of earlier post-World War II
expansions, the composition of output is
substantially different. Namely, the export
sector is far weaker in this recovery than
in previous upswings. The U.S. current
account deficit on international payments
(goods, services and transfers) reached
nearly $40 bil-lion in 1983 -the largest on
record. This year's deficit will probably be
larger, with forecasts ranging from $40 to
$80 billion. This Letter identifies reasons
for the deterioration in the U.S. export and
import sectors, and explores the link
between the resulting current account
deficit and the massive credit demands
posed by current and projected federal
government budget deficits.
Cyclical weakness
Some weakness in the international trade
sector usually develops during a business
cycle upturn. The chart shows the trough of
the downturn (marked on the timeline as
"0"), three quarters preceding the trough
and eight quarters following the trough, for
the average current account balance from
six previous business cycles and the current account balance in the present cycle.
The diagram shows that a cyclical deterioration in the current account has been a
normal development during economic
recoveries in the post-war period. An
upswing causes domestic income to grow
faster than incomes abroad, spurring a
greater demand for imports; the trade and
current account balances consequently
decline. It is primarily the pattern of
demand in the U.S. and abroad, therefore,
that causes the cyclical weakness in the
"external" sector. The downturn in net
exports usually runs its course after a period of several quarters and then stabilizes.

Current account deficits in the present
recovery exceed the typical cycl ical
deterioration during a business upswing.
While it is true that the.U.S, recovery is
leading that of the other major western
industrial countries (excepting Canada) to
an extent greater than usual, this alone
does not explain the unprecedented
deficits. The drop in the current account
balance as a percent of G N P is almost
twice as large as the average post-war
decline, and it surpassesthe decline in any
individual previous cyclical upturn. In addition, the absolute
size of the present
current account deficit (in both dollar
amount and as a percent of GNP) surpasses that of any previous post-war
period, during a business cycle upswing or
otherwise. Forecasts suggestthat deficits
through 1984 could stabilize at an unprecedented 1.5 percent of GN P or more, rather
than at the rough balance which has been
typical in the second year of most economic recoveries.

Strong dollar, weak exports
Thus, a large part of the current account
deficit is related to non-cycl ical factors, the
most significant of which is the high real
(price adjusted) value of the dollar in
exchange markets. The dollar is currently
more than 30 percenthigher on a trade
weighted basis, in both nominal and real
terms, than it was in 1980. Dollar appreciation has raised dramatically the prices of
u.s. goods in comparison to those of our
foreign competitors. As a result, U.s.
exporters have found it increasingly difficult
to sell abroad, and U.s. producers at home
have found it more difficult to compete with
foreign imports. The current account balance therefore has deteriorated because
our imports of goods and services have
grown considerably faster than our exports
(more than twice as fast between 1980
and 1982).

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()pinions expressed in thi.t;:.news!ptl Pf do not
neccssarilv rf,:f1ect the vic\vs of thi.' rnanagernf::'l1 t
o( II'H' Federal Re'serve Bank of .San Frar1c'i:;co,
or of the Board o( CovC'fnors of lht' Federal
Reserve Svstern.
Since supply-sider hopes for a large jump in
private domestic savings to augment credit
supplies haveyetto be realized, rising
federal government budget deficits are to
some extent being financed by foreign
creditors via the U,S. current account
deficit. They do so directly when they
purchase U.S, government securities, and
indirectly by lending to private U.s, entities.
In a closed economy, without an external
sector, increased government spending
competes with privatespending and to some
extent" crowds out" domestic consumption
and, especially, domestic investment. In an
open economy such as that of the U.s., government spending will also crowd out
resources destined for the export and
import-competing sectors.

Why has the dollar remained so high in
recent years? The answer lies largely with
U.s, monetary and fiscal policies and their
impact on credit markets, Beginning in
1 979, the Federal Reserve slowed money
growth to reduce inflation, For several
years, money increased more slowly than
prices, resulting in a progressive tightening
of real liquidity that pushed up our real
(inflation-adjusted) interest rates; this
increase in real interest rates in turn raised
the valueof the dollar on the foreign
exchanges, By mid-1 982, however,the
upward pull of monetary policy on interest
rates and the dollar began to wane. As
inflation fell sharply and money growth
accelerated, real liquidity began to
increase, At this point, however,growing
federal government budget deficits (a $1 38
billion increase in fiscal 1 983 over the 1981
level)added to private credit demands and
prevented the fall in our real interest rates
that would otherwise haveoccurred,

Outlook
Since federal deficits in 1984 will probably
grow despite the cycl ical expansion, large
government credit demands (in the absence
of a substantial increase in net savings from
the private sector) will likely keep real
interest rates and the dollar at high levels.
This will generate continued large foreign
capital inflows and current account deficits.
It appears, therefore, that the export- and
import-competing sectors will continue to
remain weak spots in an otherwise robust
economic recovery,

This explanation suggests that there is a
basic economic link between government
budget deficits and current account deficits. Consider the economy divided into
three sectors: the government sector, the
domestic private sector and the international sector, All together, the total
supply of credit must balance the total
demand for credit. When the government
sector runs a net deficit, it has a net
demand for credit that must be met by
some combination of credit supplied from
the domestic private sector (i.e" an excess
of private domestic saving over investment) and the international sector. The
latter source of credit results from a current
account deficit. Because the present
current account deficit represents the
excess of
purchases over sales of
goods to foreigners, it reflects an extension
offoreign creditto the U.s. and hence a net
capital inflow into the U.s. economy; that is,
foreign resources are being transferred to
the U.S. to complement domestic production in meeting the growing government
demand for goods and services,

The longer-term outlook for the international sector is less clear, however,assuming
that large budget deficits persist. One view
is that large current account deficits are not
sustainable for an extended period because
foreigners are not willing to increase their
U.S, claims indefinitely, This implies that
the real value of the dollar must eventually
decl ine to bring the current account balance
back to a more sustainable level. The upshot
of this argument is that a large part of persistent government budget deficits cannot
continually be financed from abroad, and
wi II eventually crowd out domestic spendi ng ina way analogous to the closed economy case. In this circumstance, U.S, interest
rates would remain both stubbornly high

u.s.

2

CurrentAccount
and the BusinessCycle
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Does this imply that the dollar's value can
be expected to fall back to its pre- 1 980 real
level with stable or somewhat lower real
interest rates in the U.5. compared to those
abroad? Not necessarily. Proponents of the
second argument point out that the dollar's
value is not only determined by relative
interest rates in financial markets. Over the
longer term, the real value ofthe dollar must
also be consistent with the supply and
demand for goods in the economy. In particu lar, a strong dollar may well be necessary to keep the current account in deficit
-to effect the transfer of real resources from
abroad to the U.5. that is needed to finance
our budget deficit. For this reason, a significant part of the dramatic rise in the value
of the dollar since mid-1 980 may be maintained, even in the face of moderate interest
rate declines, for the foreseeable future. In
essence, this view suggeststhat we may be
witnessing a permanent upward shift in the
value of the dollar-a shift caused by the
new stance of fiscal policy in the United
States.This shift can be thought of as reflecting the fact that fewer U.5. goods will be
available to foreigners in the future since
more will be absorbed domestically because of our fiscal deficits ..

and significantly above world levels. (The
interest rate differential represents a risk
premium needed to induce foreigners to
hold an increased share of their wealth
in U.S. assets.)
An alternate view holds that foreigners will
be willing to increase their U.S. investments
substantially over an extended period,
making large current account deficits sustainable. Political stability and the U.5.
policy allowing international capital to flow
in and out of our borders virtually unrestricted are two major reasons foreigners
may readily increase their investments in
this country. In addition, U.5. current
account deficits amount to less than 10 percent of the gross savings offoreign industrial
countries as a whole, and to a much smaller
fraction of their wealth. Moreover, given the
dollar's standing as an investment and international reserve currency, foreigners may
consider investments in dollars to be as safe,
if not safer, than investments in their own
currencies. As long as the Fed maintains an
anti-inflationary monetary policy, advocates of this alternative view believe that
there is no apparent reason why the U.S.
cannot continue to run very large current
account deficits as long as budget deficits
remain high.

In short, both views point to substantial
crowding out of the private sector if budget
deficits persist. They differ in the industries
that will suffer the most. The first view
suggeststhat interest-sensitive sectors such
as business fixed investment, housing and
consumer durables will bear the major
burden. The second view implies that U.S.
export and import-competing industries will
suffer most. In either case, deficits must be
financed and the private sector bears the
cost.

This second argument suggeststhat
foreigners will be willing to finance large
U.S. current account deficits for the foreseeable future, and without any significant
risk premium. If so, continuing foreign
capital inflows should eventually relieve
pressure on domestic financial markets,
bringing U.S. real interest rates down.

Michael Hutchison and Charles Pigott

Editorialcommentsmaybeaddressed
to theeditor (GregoryTong)or to theauthor.... free copiesof
this and other federal Reservepublicationscanbe obtainedby callingor writing the Public
Information Section,federal ReserveBankof Sanfrancisco,P.O.Box7702,Sanfrancisco94120.
Phone(41S) 974-2246.

3

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BANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT
( Dollar amounts in millions)
Amount
Outstanding

SelectedAssetsand liabilities
Large Commercial Banks
loans, Leasesand Investments1
Loans and Leases1 5
Commercial and Industrial

2

Realestate
loans to Individuals
Leases
2
U.S.TreasuryandAgencySecurities
2
OtherSecurities
TotalDeposits

Demand Deposits

TotalTransactionDeposits
DemandDepositsAdjusted3
4
Other TransactionBalances
s
TotalNon TransactionBalances
MoneyMarketDepositAccounts-Total
Time Depositsin Amountsof $100,00
or more
Other liabilities for BorrowedMoney
Weekly Averages
of Daily.Figures
Member Bank ReservePosition
ExcessReserves
(+ )/Deficiency(-)
Borrowings
Net freereserves(-I-)/Net borrowed(-)

1/4/83
155.317
175,984
45.832
58.877
26,630
105
12,506
8,161
190,988
49,232
62,006
31,578
12,774
128,982
39,596
38,169
22,978

Change from
year ago
Dollar
Percent

Change
from

12/28/83
670
1,145
622
- 108
- 116
0
1,470

-

-

3.065
2,263
172
692
1,873
1
1,316

NA
NA

NA
NA

3,616

3,785

NA
NA
NA
NA
NA

NA
NA
NA
NA
NA

393
2,936

- 15,176
1,095

Weekended

Weekended

1/4/84

12/28/83

333
57
276

367
224
142

-

2.0
1.3
0.3
1.2
7.6
1.0
11.8

NA
NA
8.3

NA
NA
NA
NA
NA
- 28.4
4.5

Comparable
year-agoperiod
297
21
276

Footnotes
1 Includeslossreserves,
unearnedincome,excludesinterbankloans
2 Excludestradingaccountsecurities
3 Excludes
depositsof u.s.governmentandcommercialbanksin U.s. andcashitemsin process
of collection
4 ATS,NOW,SuperNOW andsavingsaccountswith telephonetransfers
5 IncludesborrowingsfromFederalReserve
banks,treasurytaxandloannotes,federalfundspurchases
andsecuritiessold underagreements
to repurchase,
andotherborrowedmoney
6 Includesitemsnot shownseparately

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