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r odara! Reserve Bank
of St. Ufljl* release

on delivery
111 00 Goirtral Europe Summer Time
5:00 a.m. Eastern Daylight Time
June 11, 1988

External Adjustment in the Major Industrialized Countries

Remarks by
Manuel H. Johnson
Vice Chairman, Board of Governors of the Federal Reserve System

Commencement Address
Troy State University in Europe
Kaiserslautern, West Germany
June 11, 1988

It is an honor to join you in celebrating the graduation of the
Class of 1988 of Troy State University in Europe.

As an alumnus of Troy

State in Alabama, who carries fond memories and appreciation of my
educational experience at this center of learning,
ranks of Troy Slate alumni.

I welcome you into the

You too can look ahead with pride and

Your experiences here at this institution have prepared you

well for the challenges that face you.
There is something unique about your experience here at TSU.


are receiving a degree from an American institution on foreign soil,
while many of you,
Armed Forces.

I understand, have been stationed here in the U.S.


thus, have not only been exposed to various academic

but you have also benefitted from living in another

economic, political,

and cultural environment.

Your experiences living and studying abroad will serve you well.


live in a world that is highly integrated and economically and
politically complex.

A citizenry that is acquainted with the

international dimension of these relationships will be productive
participants in international ventures and will lend support to efforts
to address issuies of common concern in a spirit of understanding and
I congratulate you all for participating in that effort,

and I look

forward to your contributions in the years ahead.
This leads me to the subject of my talk today:
international trade imbalances.

the adjustment of

This problem involves adjustment and

cooperation that challenges economic policymakers throughout the
industrial world.

In recent years,

the United States has recorded large current

account deficits -- defined as the difference between what U.S.
of goods and services sell to other nations and what U.S.
producers buy from other nations plus our net earnings
our international investment position.


consumers and

(or payments) on

This deficit totalled $160

billion in 1987 -- roughly 3-1/2 percent of nominal U.S. GNP.
terms this external deficit is unprecedented,

In dollar

and as a share of our

nation's output it is high relative to our experiences since World War

At the same time, many of our trading partners have recorded large

current account surpluses.
Continuation of such large external imbalances among industrial
countries is likely not sustainable.

As a result, a corrective process

is underway to reduce these imbalances to more manageable proportions.
This process involves changes in relative prices,

including exchange rate

and relative income among major trading nations.

The multilateral nature of the U.S. external imbalance deserves

Current account balances of all nations combined,


add up to zero.


One country cannot have a current account

deficit without at least one other country having a current account

There are other large industrial countries that have large

external surpluses,

large by historical standards and relative to their

In 1987, Japan had an external surplus of roughly $87 billion,

or 3-1/2 percent of

its GNP.

surplus of roughly $45 billion,

Likewise, Germany recorded an external
or 4 percent of its GNP.

And a number of

so-called Newly Industrialized Economies -- among them Taiwan

and South Korea -- also have relatively large external surpluses.
These large external imbalances are the result of a process that
began much earlier in this decade.

A simple explanation for the

emergence of the large U.S. current account deficit in the early 1980s is
that it was the consequence of the appreciation of the U.S. dollar vis-avis other major currencies from 1980-1985.
The U.S. dollar appreciated from 1980 to its peak in 1985 by almost
60 percent against the currencies of the major foreign industrial

The rising dollar during this period led to a decline in

exports from the United States as U.S. producers were priced out of
foreign markets.

At the same time, the sharp appreciation of the dollar

made foreign goods very attractive to U.S. consumers and producers,
thereby leading to an increase in U.S. demand for imports.
A contributing factor to this strong appreciation, particularly in
the lattor phase, was high U.S. real interest rates relative to foreign
rates, and the perception of profitable investment opportunities, which
sharply increased the demand for dollars relative to other currencies.
The relatively high real interest rates of the early 1980s reflected
a combination of historically high budget deficits, dramatic changes in
personal and business marginal tax rates, and tax incentives for
increased investment in the U.S.

Together these policies increased the

supply of capital to the United States.

At the same time,

disinflationary monetary policies were being pursued worldwide in an
attempt to reduce inflation and the inflationary psychology bred during
the mid- and late-1970s.

Growing investment opportunities in the United

States were a contrast to the relative dearth of profit opportunities
elsewhere in the world.

In addition, the dollar was attractive as a

"safe haven" because of the perception of political instability in some
other parts of the world.
There is a linkage between a country's external balance and
internal balance.

The external balance in any country can be directly




linked to savings and investment decisions (or expenditure and production
decisions) made by its residents,
its government.

including budgetary policies pursued by

The difference between domestic investment and domestic

sources of financing,

including government savings or dissavings, must be

met by foreign sources of savings.

If a country wishes to invest more

than it saves (or spend more than it produces), this excess must be
financed by a net inflow of foreign capital.

Everything else equal,


higher is the government budget deficit - - o r government dissaving -- the
greater will be the need to borrow from abroad.

The borrowing is

manifested in various financial transactions and may be associated with
interest rate and exchange rate movements.

Any country with an external deficit must, therefore, borrow from
external sources in order to finance that deficit.

It is the same as

when a household spends more than it earns; the household must borrow to
make up the deficit.

Countries that are lending are generating domestic

savings in excess of domestic investment and a surplus of exports over

Japan and Germany are currently large net lenders to the rest

of the world, and the United States, given its large current account
deficit, is a large borrower.
The process of reducing the external balance in tLo United States
is already underway in both nominal and real terms.

Net exports of goods

and services in real terms (that is adjusted for price changes) began to
improve toward the end of 1986 and have continued to improve since.
been less,

although improvement in the nominal trade figures to date has
the trade data for the first three months of this year

indicate that the U.S.
last year.

trade balance improved considerably from its level

We anticipate a continuation of this trend of lower U.S.

trade deficits in the year ahead.




One reason forecasters are predicting a continued reduction in the

external deficit is the fairly continuous and dramatic depreciation

of the dollar since early 1985 to a level close to where it started in

Although the trade accounts have shown less adjustment than some

would have anticipated from such a sharp depreciation,

there are

technical reasons for expecting a delayed adjustment.

Trade volumes

react with a fairly substantial lag to changes in prices.

Dollar prices

of imports typically respond with a lag to changes in exchange rates.
And the dollar's continuous depreciation has meant that a series of socalled J-curve effects would have tended to obscure the improvement in
the underlying current account position for a period of time.

These J-

curve effects occur because import volumes adjust more slowly than import

Thus, when the dollar depreciates,


the cost of imports rises

and the trade balance weakens.

Adjustment of external imbalances should occur without imposing
undue strains on other countries involved in the multilateral trading


it would be undesirable to have Japan's surplus increase

for example,

the developing countries,

or some of the smaller

European countries at the same time as it succeeds in lowering its

surplus with the United States.

What is necessary is a reduction of

Japan's total global surplus.
A consequence for Japan of a smaller total external surplus is that
the external sector's contribution to Japan's total GNP growth is

Alternative sources of aggregate demand,

necessary to sustain a reasonable growth rate.

therefore, will be


like other surplus

is reducing the contribution to its overall growth from

international or external sources and increasing the contribution to
growth from domestic or internal sources.

For this to continue,





balance of domestic and internationally oriented policies must be

in Japan and elsewhere.

In 1987, Germany's bilateral surplus with the United States declined
slightly but its surplus with its European trading partners increased.
This sort, of adjustment has economic and political consequences within
the European Community and within the European Monetary System.


places strains on the currencies in the deficit countries within the
European Monetary System.

And through these pressures in exchange

markets it places strains on trading relationships and can affect levels
of production and employment in the deficit countries of the European

To reduce its total external surplus, Germany,

like Japan,

must increase the contribution to growth from internal or domestic
sources relative to the contribution from international or external
In summary,

a large part of the global adjustment process is the

achievement of a better balance between saving and investment behavior.
The United States must provide a better environment for domestic saving.
An increase in U.S. domestic saving relative to domestic investment would
reduce the U.S. dependence on foreign capital and allow U.S.
rates to be lower than they might otherwise have to be.




including among others, Japan and Germany, must become less

dependent on their export sectors for growth.

They must encourage the

further development of their domestic markets and thereby increase
domestic investment relative to domestic savings.
But this may not be accomplished easily and smoothly if left to
international financial markets alone.

There is a sensitive policv

balance that must be struck between domestic and international policv




objectives in leading economies in the industrial world.

And this fine

balance requires continuous and informed dialogue between policymakers.
National leaders have an important role to play in this process.
Economic performance in the major industrial countries should be
monitored closely.

There should be candid and frequent consultations.

And as in the past there will undoubtedly be concerted and coordinated
measures to reduce external imbalances and related,

and potentially

costly, pressures in financial markets.
Such a process has been pursued in such international forums as the
Group of Five or the Group of Seven.

Through these forums, economic

policymakers are in close collegial contact discussing their objectives
and the ramifications of pursuing policies to achieve those objectives.
It is a challenging process that at times requires coordinated efforts,
with one eye on domestic objectives and the other on international

These efforts,


in turn, have consequences for domestic

and financial market developments.

And this brings me to where I started.
world community.

We are a highly integrated

There is a continuing need for international

understanding and cooperation.

This understanding and cooperation can

and will help in achieving mutually beneficial objectives.
The educational program at Troy State University, here in Europe,
has offered you the opportunity to study in another economic and
political environment.

This will enrich your understanding and

appreciation of international economic developments in a broader