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for release, ©n delivery
1-6:00 A;M. , B.S.T.
February 2ML 1985

Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System

before the
Senate Foreign Relations Committee
United States Senate

February 27, 1985

I am pleased to discuss with you this morning the
role of the United States in the global economy.

That role,

of course, has many dimensions, and I can only touch upon a
few of them this morning —

specifically on the relationships

between our expansion and growth in the world generally,
certain aspects of trade and exchange rate policy, and the
problem of developing country debt.
As you know, we have enjoyed a strong recovery for
more than two years, with the real Gross National Product
rising by some 12-1/2 percent from the fourth quarter of
1982 to the fourth quarter of 1984,
GNP is a measure of production*

Throughout this

period, domestic demand has increased faster than the GNP,
In essence, a significant fraction of demand currently
generated here -- more than 2-1/2 percent —

is now flowing

abroad, providing stimulus to production overseas.


another way, U.S. purchases of goods and services have increased
by about 15 percent over the past two years, as compared to
the 12-1/2 percent increase in production.
With strong stimulus absent in the rest of the world,
the growth of demand in the United States represented 70
percent of the total growth of demand in the OECD area from
1982 to 1984, even though we accounted for only 40 percent of
OECD GNP in 1982.

Moreover, countries outside the OECD area,

including importantly many countries in Latin America, have
similarly benefitted from the vigor of U.S. recovery.

The difference in economic performance over this
period has been starkly evident in employment figures.


the United States, jobs increased by 7 million since the end
of 1982,

In contrast, there has been virtually no increase

in employment in the rest of the OECD area as a whole, and in
many of those countries unemployment rates have continued to
fluctuate around their post-World War II highs.
At the same time, the growth and relative dynamism of
the American economy have helped attract a flow of funds from
abroad, strengthening the dollar even as our external trade
and current accounts have moved into deep deficit.


growing net capital inflow -- now supplementing net domestic
savings of individuals, businesses and state and local
governments by nearly a third -- has been a critically
important factor in enabling us to finance both rising
investment and the enormous Federal deficit.

The strength of

the dollar and the ready availability of goods from abroad
have also been potent factors restraining price increases for
manufactured goods in the United States.
From one perspective, those results are gratifying
for us, and our trading partners have benefitted as well.
there are, of course, serious flaws —


flaws that unless dealt

with constructively, will undermine all the progress.


and distortions are evident, for instance, in pressures on our
farmers, miners, and producers of heavy capital equipment.
have been exceptionally high levels of unemployment in many


-3other industrialized countries, andf looking ahead, too few
signs of significant improvement in that respect.


the financial position of the heavily indebted developing
countries remains vulnerable.

Those difficulties feed back

on prospects for our exports and our financial system.
Interest rates remain high relative both to historical
experience and to recent rates of inflation.
Those strains have specific causes and potential remedies,
But it is also true they are all aggravated by underlying
imbalances in our trade and budgetary accounts.

U.S. trade

and overall current account deficits reached levels of almost
$110 billion and $100 billion, respectively, during 1984.
Such deficits seemed almost unimaginable a few years ago, yet
the present prospect is that those external deficits could rise
still further.

And it is not a coincidence that those external

deficits are accompanied by internal budget deficits of
unprecedented size during a period of prosperity, deficits
that, according to both Administration and Congressional
Budget Office estimates, will tend to grow further in the
absence of corrective action even assuming healthy U.S.
economic growth.
Economic analysis and common sense coincide in telling
us that the budgetary and trade deficits of the magnitude we
are running are not sustainable indefinitely in a framework of
growth and prosperity.

They imply a dependence on foreign

borrowing by the United States that, left unchecked, will
sooner or later undermine the confidence in our economy

-4essential to a strong currency and to prospects for lower
interest rates.

But the hard fact is that we have come to

rely on that foreign borrowing to finance the combination of
a budget deficit and the private investment demands generated
by a growing economy.

The largest and richest economy in the

world has perforce been required for the time being to draw
on savings that might otherwise have been invested abroad.
Indeed, the inflow of savings from abroad is equal to something
on the order of 15 percent of net savings (or about 8 percent
of gross savings) in all other OECD countries combined.

And, the

related exchange rate pressures, trade imbalances and financial
strains generate political as well as economic pressures
toward economic nationalism and protectionism.
It seems to me essential that those pressures be

There are powerful reasons why such an approach is

not in our economic interest whatever the response abroad.
For instance, we have encouraged developing countries
to adopt policies that will enable them to service their debts,
to enhance over time their productive capacity, and to grow.
Success is dependent upon their ability to increase exports


and as their exports grow they will also import, from the
United States and other industrialized countries.

But that

success will be denied if the United States and other industrial
countries protect their own markets from fair competition by
developing countries.
Even if we could somehow shield developing countries
from broad protectionist measures —

and it is not clear that

-5in practice we could do so —

there are other high economic

costs from widespread protectionism.

Quotas, new tariffs, or

import surcharges all act directly to raise prices, and the
problem would not be temporary if the effect would be to
refuel inflationary expectations —

just at a time when so

much progress has been made in changing that psychology.
Other things equal, protectionist measures that actually had
the effect of appreciably reducing some imports would presumably
be reflected in still further upward pressures on the dollar,
hurting exporters and industries not protected.
Beyond those specifics there are potentially much
more damaging risks of a breakdown in a world trading order
built up so laboriously after the chaos of the 1930s.
Consider, for example, the proposals now being
discussed for a temporary import surcharge.

Those proposals

are sometimes coupled with other measures to reduce our budget

Such proposals are offered as a relatively painless

means of raising government revenue v/hile simultaneously
addresing the trade deficit.
One attraction is that an import surcharge effectively
taxes foreign exporters as well as domestic residents.


it is also clear that any benefits, either for trade or for the
budget, would be temporary.

More lasting favorable consequences

of the proposals would be derived not from the temporary surcharge
but from the accompanying budget measures.
I would question whether the imposition of a surcharge
makes those accompanying measures easier, or more difficult,

to enact*

In any event, so attractive a tax to the United

States would certainly be attractive to others as well.


countries have budget deficits larger than they would like,
and with high unemployment would not be averse to reducing

If the surcharge approach is, in effect, legitimized

by the United States, wouldn't others find almost irresistible
temptations to emulate our example?

Would not that eliminate

any net benefits and also have destructive implications for
world trade —

upon which our hard-pressed farmers, among

others, are so dependent?
At a more fundamental level, we cannot logically take
actions to reduce our trade deficit and at the same time
welcome the associated capital inflows from abroad.


trade deficit and our capital inflow are two sides of the
same coin.

Unless we reduce our budget deficit, success in

improving our trade balance, and thus reducing the capital
inflow, will only threaten stronger pressures on our domestic
financial markets, jeopardizing housing and investment*
In essence, a lasting solution to the problem of our
external imbalance rests on simultaneously restoring internal
financial equilibrium.

I know of no approach to that problem

that promises success other than straightforward measures to
reduce our budget deficit over time.

Approaches that obscure

that basic need will, in the end, be counterproductive.
I do not want in any way to suggest that, important
as action with respect to the budget deficit is, that approach

will somehow deal with all the problems of the global economy.
In particular, other industrial countries have clear
responsibility and opportunity to take actions themselves to
enhance their economic prospects.

The importance of policies

to deal with structural rigidities in their economies has
often been noted*

Moreover, in some important countries

where inflationary pressures have been successfully contained,
and where credible long-term anti-inflationary monetary
policies are firmly in place, there may be scope for action to
stimulate their growth by constructive measures to speed tax
reductions or otherwise.
Certainly, much remains to be done to restore
sustainable growth patterns in much of the developing world.
Over the past two years or more, a number of the more advanced
and largest developing countries, particularly in Latin
America, have made serious efforts to implement appropriate
adjustment programs in conjunction with IMF and private
financing arrangements.
spectacular progress —

Clear progress -- in some cases,
has been made in eliminating or

narrowing external imbalances.

Mexico and Venezuela in Latin

America, and Yugoslavia and Hungary in Eastern Europe, have
produced current account surpluses.

Brazil's current account

deficit was essentially eliminated last year.

Happily, most

of those countries have also managed to restore a measure of
domestic growth.

All of that progress was facilitated by

access to foreign markets, most importantly in the United

In some instances, the progress in adjustment has
encouraged and justified longer-term or multi-year restructuring
of outstanding debts on terms that reflect stronger creditworthiness and permit planning on a more assured basis for the

Such arrangements have been agreed in principle

between the commercial banks and Mexico, Venezuela and Ecuador,
and serious negotiations are underway with Brazil and Yugoslavia.
However, these signs of progress do not mean that the
"debt problem" is behind us —

or that, more broadly, the

borrowing countries are firmly on a path of sustained strong
growth in a context of political and economic stability.
Indeed, some of the more fundamental adjustments necessary to
that end are still absent, or only partially in place.
Inflation, for instance, remains disturbingly high in many of
the countries, and in some is still rising to new peaks.
Spontaneous new investment by either domestic firms or from
abroad has often been slow to develop, reflecting in considerable
part concern in some countries about the role for private
investment and the degree of controls and market distortions.
Moreover, on the more purely financial side, cooperation
among borrowing countries, commercial banks, multilateral
institutions, and creditor countries will continue to be
required despite the protracted and tedious nature of the

Rather than impatience, the need remains for energetic

and constructive approaches to the longer-term problems faced
by individual countries.

-9I will conclude with a few words about the dollar.
Few if any anticipated the degree of strength that the dollar
has displayed persistently for some time, nor can it fully be
explained by such factors as relative interest rates or
differences in inflation rates.

No doubt, relative confidence

in our economic prospects, in our political stability, and in
our business climate have played a part, as has a sharp
diminution in our bank lending abroad.

At the same time, the

widening gap in our trade position suggests that our basic
competitive position cannot support so high a dollar indefinitely,
The policy question is what measures can be taken to
encourage a reasonably competitive equilibrium over time.


suggest that the general approach I have alluded to today
would work in that direction.
Credible measures to reduce the U.S. budget deficit
would alleviate one source of inflationary concern and encourage
lower real interest rates than would otherwise be the case.
In that environment, some other important industrial countries
might find it easier to undertake more stimulative policies
at home.

If they managed at the same time to deal more

effectively with some structural rigidities, the perceived
contrast between the opportunities in the U.S. economy and the
relative sluggishness of European economies could constructively
be diminished*

If developing countries could reduce inflation

and restore more confidence in their own business climate,
their own citizens would then employ more of their savings

-10in their own countries,, and funds could again be attracted
in greater volume from the United States or elsewhere.
At times, forceful official intervention in exchange
markets could have a useful role to play.

But that role has

to be complementary and subsidiary to more basic measures to
have lasting impact.

That is why measures to deal with the

fundamental imbalances in our own financial requirements are
so important.
Over the near term, prospects for the economic
performance of the United States, and to a lesser extent the
rest of the world, appear to be favorable.

We want to build

sensibly on those strengths and to deal in a lasting way with
the imbalances.

Purely symptomatic treatment is not adequate -

and, in the form of protectionism, will be counterproductive.
The more basic approaches necessarily take time, and we have
let too much time pass already.

But fortunately we can still

proceed from a position of strength.
most of the opportunity before us.


I trust we will make the