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lEC'D IN RECORDS SECJtpf
JUN

2 198?

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DEFICITS, DEBTS AND DOLLARS

H. Robert Hel1er
Member, Board of Governors of the Federal Reserve System
Annual Goldman Sachs Exchange Rate Conference
St. Regis Hotel, New York City
May 28, 1987

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DEFICITS, DEBTS AND DOLLARS

The title of this conference, Deficits, Debts and
Dollars is not only most timely but also unusually
compact.

I trust that the term " deficits'1' refers to

both the federal government deficit and the trade
deficit; that "debt" includes not only our mounting
domestic but also our international debt; and that the
"dollar" refers both to the domestic purchasing power
of the currency and its international exchange value.
Moreover, all these issues are linked and are mutually
interdependent.

Consequently, it is difficult to find an appropriate
starting place for my remarks.

Conceptionally, it

is the budget and trade deficits that are driving the
buildup of the government debt and the external debt.

However, the relationship between the deficits, debt,
and the dollar is more complex.

My fellow economists

have not yet agreed whether it is the flow variables
measured in the national income and balance of payments
accounts that determine the value of the dollar or
whether the dollar's value is determined in domestic

and international asset markets.

Standing in front of a group that includes so many
foreign exchange traders, I cannot resist the temptation to ask whether it is the flow of customer orders
or the position sheet in front of you that determines
the next quote that you will give when the phone rings.

What makes the relationship between deficits, debt and
the dollar even more complex is that there is not only
a direct linkage between the federal government deficit
and the government debt buildup, but also between the
government deficit and the trade deficit and consequently also between the government debt and the
external debt of the nation.

Put differently, the
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income statement and the balance sheet of the government and the nation are all four inexorably
intertwined.

In turn, the value of the dollar is

determined by this complex interplay of variables.

Speaking as an economist, I am tempted to argue that
the value of the dollar, like everything else, is
determined in a general equilibrium framework.

Speaking as a former forecaster and banker, I know that
the relative importance of the vdifferent variables
changes.

Sometimes one and sometimes another variable

seems to drive events in the foreign exchange market.
If I may make a broad generalization, I believe that
the variable which is currently most out of long-term
equilibrium probably gets the largest amount of attention by the market.

Incidentally, economists also

tend to subscribe implicitly to that generalization.
In their regression estimates they tend to give an
inordinate weight to outlying variables and to deviations from the norm.

They do so by having the square

of the deviations from the average enter into the
regression equations.

Besides the obvious computa-

tional convenience of eliminating all the minus signs,
I have never heard of a convincing reason for this
standard practice.

But if the observation that extra-

ordinary deviations from the norm get the most attention is true, there may be some justification for
this procedure.

Today I would like to explore the relative merits of
the alternative policies that we and our trading
partners might pursue to rectify our current imbalances.

I will pay particular attention to policies

to stimulate foreign economic growth, fiscal policies
to reduce our federal budget deficit, monetary policy,
and exchange rate policy.
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We all learned in our basic economics!-course that? the
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sources and uses of national income and product must
balance in an accounting sense.

The government deficit

and its financing requirement must therefore be reflected either in a surplus of domestic saving over investment or be financed by an inflow of foreign capital.
This capital inflow in turn will be accompanied by a
trade, or more precisely, a current account deficit.
That all under the assumption that domestTic saving and
investment largely match each other.

The evidence available confirms the basic proposition
that the federal government deficit has been largely
reflected in our current account deficit.

During the

1960s government deficits of a few billion dollars were
accompanied by very small current account surpluses.
It was only during the Viet Nam buildup of the early
'70s that the federal deficits mounted to
$25 billion and turned the current account balance
negative.

As the government deficit was reduced to

$5 billion in 1974, the current account returned again
to a small surplus position.

But in the mid 1970s, the

federal deficits began to grow rapidly.

And with a

moderate lag the current account deficits began to
mount as well.

Last year, a $203 billion federal

deficit was reflected in $141 billion current account
deficit.

If one considers that^ the state and local

governments ran a surplus of $63 billion, the

ac -

counting comes out just as expected.

But before concluding that the federal government
deficit is the sole determinant of our external imbalance let me raise at least the question whether it
might also be the other way around.

Could we argue

that the large trade deficit and the accompanying
capital inflow is the cause of our government deficit?
To argue this way would imply that we are not the sole
masters of our destiny;

but it is undoubtedly true

that if the rest of the world were to import more from
us we would experience a multiple expansion of our own
GNP.

In turn, the government would share in that

expansion through higher tax receipts and this would
result in a lower federal deficit as well.

It is here

that slow economic growth in Europe, Japan, and the
developing countries makes a resolution of our trade
deficit and of our government deficit more intractable.

This difference of view may lie at the heart of our
differences with our trading partners.

While we argue

that a swifter economic expansion by the surplus
countries of Germany and Japan would return the world
ecpnomy to balance, they argue that all would be well
if only we were to eliminate our budget deficit.
views are correct in a purely arithmetic way.

Both

Which

one is the preferable policy to be implemented depends

on the state of the world economy.

If the world economy is operating at or near capacity,
and if global inflationary pressures are present, a
reduction in aggregate demand would be called for.
Under those circumstances reducing the US budget
deficit would be the most appropriate way to proceed.

But in a situation of excess capacity in industrial and
agricultural markets, it may well be argued that an
expansion of economic activity in the surplus countries
of Europe and Japan would be more beneficial.

In that

way Europe and Japan could keep their export industry
working at the present level,they would maintain their
employment, and producers would earn a return on the .
investments that they undertook in the last few years.
In addition, consumers in Europe and Japan would enjoy
the benefits of higher living standards brought about
by more imports.

In such a scenario everybody would be

better off.

Alternatively, if we in the U.S. would initiate sharply
restrictive policies of austerity, the US external
imbalance would be eliminated through a reduction of
imports and not an expansion of exports.

Reducing our

imports would mean less exports; for Europe and Japan.
These countries would lose their export

markets and

unemployment would surge.

Foreign investors would

experience a reduction in the value of their investments and stock markets might decline.

In all, this

policy does not present a very attractive picture.

Of course, the US government deficit should and would
not continue at its present level if foreign countries
were to grow more rapidly.

If our exports are to

expand, resources must be made available for export.
That is, ideally a federal government budget deficit
reduction will go hand-in-hand with the improvement in
our trade performance.

Notice that I haven't'said

anything about monetary policy or the exchange rate so
far.

Both can remain neutral under this scenario.
«

But if our trading partners are unwilling to take the
necessary expansionary action?

I would argue that

under these circumstances we should take the lead by
taking aggressive action to reduce our federal deficit.
This shoulcji be accomplished preferably by spending
reduction rather than tax increases.

Under this

scenario the reduced fiscal stimulus can then be offset
by a more accommodative monetary policy if this should
prove to be necessary.

Reducing the federal deficit WQuld be beneficial in its
own right as it would bring domestic capital markets
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into better balance by easing the financing requirements of the federal government. Interest rates would
therefore have a tendency to fall.

Adhering to the Gramm-Rudman targets and fulfilling the
commitment made by the US government as part of the
Louvre Agreement in February of this year and reaffirmed in April at the Washington meetings of the G7
Ministers is an essential part of our economic policy.
The only question is whether we should go it alone or
act in a coordinated fashion with our trading partners.
I am arguing that the coordinated approach would be
more effective and appropriate in the current world
economic environment.

One way or another our federal deficit must be reduced
and eventually eliminated.

Otherwise we will never

come to grips with the domestic and external debt
problems.

There is also the option of dealing with the trade
deficit through a tighter US monetary policy.

At least

initially, dollar interest rates would be higher.

This

would tend to restrain investment and lead to a general
slowdown of the economy.

As a result, imports would

also tend to fall and thereby move the external accounts towards balance.

I do not believe that such exclusive reliance upon
monetary policy would be an effective way to reduce our
external imbalance.

Such a policy might place strains

on our own financial markets by driving up interest
rates.

Consequently, investment would be constrained

and economic growth might well slip precipitously.
Finally, the high interest rates experienced under this
scenario might also have adverse affects "on the heavily
indebted developing countries.

In my view, monetary

policy cannot do the job of rectifying our external
imbalance alone.

Let me add a word of caution at this juncture.

Some

people argue that we should maintain high interest
rates in this country to assure a continued capital
inflow.

Clearly, if we want to reduce and eventually

eliminate our trade - or better our current account
deficit - we will also have to rely on less net capital
inflows.

The simple arithmetic of balance of payments

accounting assures that one will go hand-in-hand with
the other.

Maintaining interest rates so high that

capital will continue to flow into the country may
prevent the trade adjustment that we all seek.

So far, I have said nothing about the exchange value of
the dollar.

The point is that further exchange rate

changes are neither a necessary nor a sufficient

condition to bring about a better balance in our
external accounts.

Just yesterday President Reagan

stated that "the dollar is at the place that it should
be."

Just like monetary policy should not shoulder the
burden alone, I believe that exchange rate policy
cannot do the job alone.

One factor that is often neglected in assessing the
relative merits of the various policy tools are the
terms of trade and balance sheet effects of an exchange
rate change.

A dollar depreciation implies that all US

assets are reduced in value in terms of the appreciating currencies - let us say, Japanese yen.

At

the end of last year the total value of US equities was
approximately $2.4 trillion.

At an exchange rate of

162 yen per dollar this translates into 389 trillion
yen.

If we still had the exchange rate prevailing in

the spring of 1985, it would have taken 624 trillion
yen or 60 percent more to buy the same US equities.
It is little wonder that the US has lost in relative
importance in the world economy in the eyes of foreign
observers.

One may argue that the value of US assets expressed in
terms of Japanese yen is largely irrelevant for US
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based investors.

Yet the argument is the same if we

change the base currency.

Today it would cost us

roughly $1.8 trillion to buy the entire value of the
Japanese stock market.

At the exchange rates pre-

vailing two years ago we would have had to spend only
$1 trillion.

These are rather large magnitudes in

view of the fact that our exports to Japan amount to
only about $25 billion per annum and that our imports
from that country are roughly $75 billion.

While we worry much about the trade imbalance, one
wonders whether the real battle is not being waged in
the asset markets of the world.

It is here that

national wealth is being traded and where valuation
adjustments through exchange rate changes can easily
outweigh the hard won gains in the trade balance.

I

believe that we should take all these factors into
account in designing our economic strategy.

Let me conclude by reiterating that the problems of
excessive fiscal and trade deficits and the surging
debt at hone and abroad are all intertwined.

Clearly,

the dollar alone cannot and should not be the sole
equilibrating variable.

Focusing economic policy on just one variable places
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too much burden on that instrument alone and runs the

risk of introducing additional instability somewhere
else in the economic system.

Only a judicious and

coordinated approach that takes account of the economic
environment and the adjustment costs associated with
alternative policy measures is apt to bring about
victory over the multiheaded hydra now threatening the
health of the world economy.

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