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FOR RELEASE ON DELIVERY Expected at 10:00 AM (E .S .T.) March 23, 1984 Statement by Henry C. Walllch Member, Board of Governors of the Federal Reserve System before the Committee on Finance United States Senate The U.S. Trade D e fic it: Causes, Consequences and Policy Options SUMMARY POINTS 1. The strong d o lla r and our large trade and current account d e fic its are related 1n a fundamental sense to the large federal budget d e fic it . 2. Import re strictin g actions, whether broadly or narrowly applied, are contrary to the national Interest of the United States, except where foreign competition Is judged to be unfair as defined by our trade acts. 3. The only appropriate policy prescription fo r beginning to deal with the trade and current account d e fic its and avoid an excessively strong d o lla r, in my view, is to reduce the structural d e fic it In our federal budget. Other proposals fo r reducing the external d e fic its without reducing the budget d e fic it would, i f successful, only s h ift the Impact of our nation's budget problems by putting upward pressure on real Interest rates. The U.S. Trade D e fic it: Causes, Consequences and Policy Options The U.S. merchandise trade and current account d e fic its widened considerably during 1983. For 1983 as a whole, the trade d e fic it exceeded $60 b illio n , and by the fourth quarter i t had reached a $75 b illio n annual rate. The current account was in d e fic it by more than $40 b illio n for the year as a whole, and reached a $60 b illio n annual rate in the fourth quarter. Many are predicting that the current account d e fic it w ill be around $80 b illio n for 1984 as a whole, and the trade d e fic it around $100 b illio n . Causes of the External D e ficits It is customary to analyze changes in the external d e fic its by focusing on proximate causes, such as changes in exchange rates and the growth of economic a c tiv ity at home and abroad. In that tra d itio n , the widening of the external d e fic its can be related, f i r s t and foremost, to the very substantial appreciation of the d o lla r and the conditions that have given ris e to the appreciation. On a weighted-average basis against the currencies of the other major industrial countries, the d o lla r has appreciated by more than 45 percent since the fourth quarter of 1980, when our current account balance was showing a small surplus. Some of the appreciation has reflected our re la tiv e ly good in fla tio n performance, but even in real terms — adjusted for changes in consumer price levels — the weighted-average value of the d o lla r is now nearly 40 percent higher than i t was at the end of 1980, and roughly 25 percent higher than it s average for the entire floating rate period since 1973. Against the European currencies the appreciation in real terms has come to 30 percent against the Swiss franc, 45 percent against the German mark, and higher amounts against the weaker currencies. Against the Japanese yen the d o lla r has risen 20 percent in real terms; against the Canadian d o lla r i t has depreciated s lig h tly . - 2- The cy clic a l behavior of the U.S. and foreign economies has been a second factor contributing both to the time p ro file and to the widening of the U.S. trade d e fic it . The U.S. recession held down imports and thus delayed the rise in the trade d e fic it until a fte r the middle of 1982, and the re la tiv e ly rapid expansion of the U.S. economy in 1983 was a dominant element in la st year's trade developments, accounting for more than half of the $30 b illio n increase in our trade d e fic it from the fourth quarter of 1982 to the fourth quarter of 1983. As a third factor, the external financing problems of some countries, especially of our neighbors 1n Latin America, have resulted in lower exports to these countries. A fourth factor has been the fa ilu re in the past of some of our industries to adjust adequately to the pressures of International competition. While the strong d o lla r and our large external d e fic its re fle c t, in part, our improved macroeconomic performance and the greater return on financial Investment in th is country, in a more fundamental sense they are related to the budget d e f ic it . When the U.S. government runs a d e f ic it , other sectors must, on balance, finance 1t. Part of the financing has been provided by foreigners in the form of the net capital inflow that is the counterpart of the current account d e f ic it . The remainder of the financing has been provided by private domestic residents and state and local governments, which has diverted resources from productive domestic capital formation. Naturally, the net capital inflow and the surplus of private domestic saving over private domestic investment have not arisen automatically, but have had to be induced. As a re su lt, real interest rates have been higher then they would otherwise have been. In addition, the higher real interest rates have been associated with upward pressure on the -3d o lla r: such upward pressure has prevailed over whatever downward pressure may have emanated from the external d e f ic it , which usually is a negative element in the market's evaluation of a currency. Thus the d o lla r has risen. In th is way, high real Interest rates, the strong d o lla r, and large external d e fic its are a ll linked to large federal budget d e fic its . Consequences of the D e ficits and the Strong Dollar Some of the damaging consequences of the d e fic its and the strong d o lla r are reflected 1n the decline in our exports. In value terms, exports declined by % about $25 b illio n from the fourth quarter of 1980 to the fourth quarter of 1983, with two-thirds of the drop accounted fo r by a 40 percent contraction of shipments to Latin America, mainly to Mexico, and the other th ird reflecting a 15 percent reduction 1n shipments to Western Europe. It is noteworthy that exports to both Japan and Canada expanded somewhat from 1980 to 1983. In volume terms, our merchandise exports were more than 15 percent lower in the fourth quarter of 1983 than 1n the fourth quarter of 1980. Exports of capital goods declined by more than 25 percent 1n volume terms, exports of nonagricultural industrial supplies by more than 20 percent, and exports of agricultural products by about 10 percent. The longer exports remain depressed, the more d if f ic u lt It becomes to maintain marketing networks, and the more costly and d if f ic u lt 1t becomes to recover foreign sales. If our current account d e fic it were to continue for long at the rate of around $80 b illio n that 1s lik e ly to be recorded 1n 1984, the United States would soon become an International debtor country. At the end of 1983, the United States had an estimated International net cred itor position of about $125 b illio n . This balance could be pushed to the minus side in l i t t l e more than one -4year. Our position as an International creditor has been a major support to our balance of payments so fa r. Thanks to the very productive character of some of our foreign assets, the United States had a surplus of investment income averaging more than $30 b illio n annually during the years 1979-81. This has meant that we have been able to tolerate a sizable trade d e fic it without thereby incurring a d e fic it in the current account, which combines services and trade. If our International position sh ifts to that of a debtor country, th is advantage w ill be eroded; indeed, i t is estimated that our surplus of investment income f e ll below $25 b illio n in 1983. Eventually, the United States might find it s e lf in the position of having to earn a surplus in the trade balance in order to cover a d e fic it on investment income. Other things equal, the larger the net debtor position we build up, the lower w ill be the value of the d o lla r necessary in the long run to generate the required trade balance. In addition, I might say that, for one of the richest countries in the world, i t seems hardly appropriate either to be borrowing currently on a massive scale from the rest of the world or to be a net debtor to i t . The external d e fic it also has a strong bearing on the future of the d o lla r. I have noted the severe appreciation the d o llar has experienced against a number of currencies, which has been one — but only one — of the reasons for the trade d e f ic it . As the United States continues to borrow abroad and moves toward net debtor status, causing the rest of the world to hold ever larger amounts of dollar-denominated assets, the good acceptance that our currency has had in the world may wear out. Nobody can predict the timing, but in the longer run i t seems probable that the dollar-depressing effect of the external d e fic it w ill begin to overwhelm the dollar-supporting effect of higher interest rates. -5I do not believe, therefore, that the current value of the d o lla r is sustainable, although i t is impossible to predict the sequence or timing of events that w ill bring i t down. If the d o llar does decline substantially while the budget d e fic it remains unchanged, the external d e fic it w ill, with a lag, also decline. That would reduce, in a sense, the magnitude of the problem that this Committee is addressing. It would also, however, intensify other problems created by the budget d e f ic it . With a return of the external sector toward balance, the foreign financing of the budget d e fic it would cease. It would have to be financed entirely at home, absorbing a s t i l l higher fraction of scarce available savings, thereby raising interest rates. The "crowding out" resulting from the budget d e f ic it , which now goes in part against the foreign-trade related sectors of the U.S. economy and in part only against other sectors of the economy, would then be directed fu lly against the other sectors. This needs to be emphasized in order to make clear that a reduction or ending in the external d e f ic it , without a reduction in the budget d e f ic it , would only s h ift the impact of our nation's budget problems without resolving them. The impacts of the external d e fic it and the strong d o lla r have been fe lt by our manufacturing industries, the agricultural sector, and some of our services industries. The effects are adverse not only for exports, but also for domestic import-competing sectors. quite well absorbed. On the whole, nevertheless, these impacts have been The American economy has expanded strongly. This has offset some of the pressure of mounting import competition deriving from a strong d o lla r. Moreover, some of the industries that have suffered from import competition are in that condition more because of factors sp e cific to th e ir industry than because of the high d o lla r. Industries that have fa iled to invest -6and reduce costs, have not kept up with modern technology, and in some cases have paid wages fa r above the national average for production workers, are bound to suffer even at a lower level of the d o lla r. Aside from such industry-specific problems, I do not see the United States being deindustralized. The combined domestic and foreign demand for U.S. industrial output has increased since 1980. In p a rticu la r, the industrial production index for manufacturing is currently almost 7-1/2 percent higher than it s level at the end of 1980, when the d o llar began to appreciate. Employment in the manufacturing sector, on the other hand, is currently 3-1/2 percent below it s level at the end of 1980, partly reflecting re la tiv e ly rapid productivity growth in the manufacturing sector, which h is to ric a lly has contributed to a negative trend in the share of manufacturing employment 1n total private employment. Arguments Against Import Restrictions My purpose in citin g these s ta tis tic s is to counsel strongly against additional import restriction s at th is juncture as a means of dealing with the trade d e fic it . The type of import restricting actions authorized by Section 122 of the Trade Act, which would apply on a broad and uniform basis, are certainly contrary to the national interest of the United States. Thanks to the strong economic recovery last year, our tradeable-goods industries as a group have not been severely injured on balance. Their circumstances cannot ju s tify additional import re strictio n s , except where foreign competition is judged to be unfair as defined by our trade acts. -7The costs of import protection are well known. The decision to protect one industry invariably Imposes costs elsewhere in the economy. It is costly to other industries i f foreign countries re ta lia te against U.S. exports, of i f Import restrictio n s lead to higher d o lla r exchange rates than would otherwise p re va il, or i f the prices they must pay for inputs ris e . leads also to higher prices and less choice for consumers. Protection ty p ic a lly An example of the consequences of protection for consumers we now observe in the recent very high p ro fits of the automobile Industry, which is protected by "voluntary" export restraints in Japan. F in a lly , protected Industries ty p ic a lly delay making the adjustments that are necessary i f they are ever to stand on th e ir own feet. These costs should make us hesitant even to reciprocate against foreign protectionist actions. Retaliatory measures taken by us damage our own Interests, whatever they may do to foreigners. Reducing the trade d e fic it by protectionist methods without reducing the budget d e fic it would not resolve our problems. It w u ld certainly not ease the pressures on our export Industries which, thanks to tfte d isc ip lin e of International competition, are bound to be among our most e ffic ie n t. Other Policy Options The appropriate policy presciptlon for dealing with the trade d e fic it and the excessively strong d o lla r, 1n my view, is to reduce the structural d e fic it in our federal budget. Controls on trade or on capital inflows, or any other proposals fo r reducing the external d e fic its without reducing the budget d e f ic it , would only s h ift the impact of our nation's budget problems by pushing up real interest rates. -8You have asked, as w ell, for an analysis of whether the floating exchange rate system I ts e lf may have contributed to our problems. floating rate system has served us f a ir ly well. In my view, the Swings in exchange rates over the past decade, to be sure, have been extremely wide. But many of these swings can be related mainly to changes in the rela tive outlooks fo r interest rates, Inflation and real growth in d ifferent countries. A good part of the changes in re la tiv e economic outlooks in turn can be related to changes in monetary and fisc a l p o lic ie s . Given the stances of monetary and fis c a l p o licie s in the United States and abroad during the past four or fiv e years, i t is hard to believe that the Bretton Woods system of pegged exchange rates would have survived, and certain ly not without major upward adjustments 1n the exchange value of the d o lla r. Greater s ta b ility of exchange rates, which 1s greatly to be desired, must be founded in the f i r s t place on greater domestic s ta b ilit y 1n a ll countries, and on p o licie s supporting th is s t a b ilit y . F in a lly , you raised the question of whether the d o lla r 1s overvalued. view, the meaningful answer to th is question 1s yes. In my It 1s sometimes argued, to be sure, that whatever exchange rate prevails in the market at any moment balances demand and supply and therefore cannot be over or undervalued. however, begs the question. That, Interpreting the question as referring to the effect of the exchange rate on the economic magnitudes in which th is Committee is interested, such as the trade balance or the current account, 1t seems evident that the recent value of the d o lla r has been c le a rly Inconsistent with even very approximate balance 1n either the trade or the current account and that, therefore, in th is sense, the d o lla r is overvalued. Given th is interpretation of our situation , the right policy prescription for dealing with the trade d e fic it is to deal with the circumstance that is at the root of the high d o lla r. This brings me back to the need to reduce the structural d e fic it in our federal budget. Such action, of course, would not cure a ll the diverse problems encountered in the various sectors of our economy. But a substantial adjustment of the budget toward balance, other things equal, would lead to declines in real interest rates, a depreciation of the d o lla r in exchange markets, and (with some lag) a reduction in the external d e fic its . Recent statements by the President and members of Congress, such as the statement of the Chairman of th is Committee announcing these hearings, give hope that some progress may be made in that direction. I hope that my remarks have conveyed the message that the strong d o lla r and large external d e fic its are partly symptoms, themselves damaging, of large budget d e fic its . I hope as well that the Congress and the Administration w ill re sist temptations to try to suppress the symptoms without curing the disease.
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