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Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System
before the
Subcommittee on International Economic Policy
Committee on Foreign Relations
U.S. Senate
June 15, 1984

I am pleased to have this opportunity to discuss the outlook for
world trade and U.S. exports in light of the international debt situation
and dollar interest rates and exchange rates.
The growth of international trade that we have witnessed over the
past several decades has provided a vital boost to standards of living
throughout the world. During the 1960s and the 1970s, the volume of world
trade expanded at an average annual rate of about 7 percent. That expansion
allowed countries with raw material resources and fertile agricultural lands
to raise their incomes significantly by marketing their minerals and crops
outside their borders. Apart from the exploitation of natural resources,
the expansion of trade has also allowed countries to raise their living
standards by devoting their labor and physical capital to larger scale
production of manufactures and provision of services. The pressures of
international competition associated with the expansion of world trade have
encouraged the efficient use of resources, helped to restrain the forces of
inflation^ and fostered a continuing stream of new products and technologies
that have pervasively affected the lives of us all.
The growth of world trade slowed markedly -« in both volume and
value -- during the first two years of this decade and turned negative in
1982. To a large extent that performance reflected the recession and
sluggish growth of economic activity in industrial countries. It was also
affected by the slowdown of international lending to developing countries.
In 1983, the volume of world trade began to recover, and some
forecasters are predicting growth on the order of 5 or 6 percent in 1984.
The expansion of U.S. trade contributed importantly to the recovery of world




-2-

trade last year, but, as most of you are intimately aware,, that expansion
occurred disproportionately on the side of our imports rather than our
exports.
U.S. exports did increase moderately in value and volume terms
during the four quarters of 1983. They continued to increase during the
early months of this year, though the expansion has been outpaced by that of
imports. Thus, today we face a number of serious economic policy concerns
with international symptoms: our large and growing international trade
deficits, the international debt situation, and the high value of the
dol lar.
In approaching these issues, I believe it is right to emphasize,
first, that the past year and more has been one of vigorous economic
advance in the United States. That in turn has been a powerful force
assisting growth in other industrialized countries and easing the difficult
adjustment problems of much of the developing world. At the same time,
that progress has been accompanied by some obvious and serious Imbalances
in the international economy and financial system. Those international
strains are a reflection, in considerable part, of problems in intern^
policy here and abroad.
One aspect of those problems that has received a great deal of
attention, internationally as well as domestically, is the high level of
interest rates in the United States. Those interest rates have risen over
recent months under the pressure of rising private credit demands, as the
economy has grown, superimposed on the need to finance an already huge
federal deficit. High interest rates have helped attract a growing inflow




-3-

of capital from abroad, and that inflow has, for the time being, helped to
reconcile rising investment with the need to finance the deficit.
But that capital inflow is not without heavy cost to us and to
others in the short and long run. The essential counterpart of a net
capital inflow is a massive trade and current account deficit partly
related to an appreciating dollar, Increases in our interest rates
directly add to the strain on the external payments of heavily indebted
developing countries* And, over time, the capital flows and trade
imbalance will not be sustainable, posing the risk of further financial
disturbances in the absence of needed policy adjustments.
If we are to restore better balance in our international trade
accounts and relieve the pressures on our internationally exposed
industries, and if we are to mitigate the burdens that high interest rates
place on borrowing countries without undermining other objectives -including stability and growth at home — we cannot, in my judgment, escape
the need for decisive action to reduce our federal budget deficit. The
more slowly we proceed in correcting our internal imbalance*, the greater
are the risks not only to our international trade position, but also to the
health of our domestic economy and our financial markets.
Congress is in the process of taking a first step toward dealing
with the problem over time, and I welcome that effort. Reducing a
substantial budget deficit, in the United States as elsewhere, is not easy.
Popular support for painful adjustment is particularly difficult to win
when the consequences of inaction are prospective rather than immediate.
That, to many, has appeared to be the case over the past year and a half as




our economy has performed remarkably well. From the fourth quarter of 1982
through the first quarter of this year9 our gross national product has
expanded at an average annual rate of 6-3/4 percent in real terms, while
the unemployment rate has declined from its 10-3/4 percent peak at the end
of 1982 to 7-1/2 percent in Hay* Moreover, the recovery has brought
healthy rates of investment in producers* durable equipment, in
nonresidential structures, and in housing.
Of course, these gains started from a low level, and for a time
it could be argued that an expansionary thrust from the budget deficit
could be helpful. But, as the forward momentum of the economy continues
and private spending and borrowing increase, the consequences of the
continuing structural budget deficit are apparent.
That is perhaps most apparent in the deterioration of our trade
position* One counterpart to the continuing federal budget deficit at a
time of growing economic activity has been the growing net inflow of
capital from abroad and its counterpart, the widening deficit in our
current account transactions with other countries. In essence, that
growing deficit has permitted us to consume, to invest, and to buy "more
government" than provided by the increase in national output -- the GNP.
In fact, all domestic demands have expanded since the fourth quarter of
1982 at an annual rate of 8-3/4 percent, about 2 percentage points faster
than our gross national product* Looking at the financial side of the
equation, the net inflow of capital that we have attracted from abroad is
supplementing internal savings by about one-quarter -- or by more than 2
percent of the GNP -— enabling us to finance our large federal deficit




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while private spending on consumption and investment goods has also been
growing rapidly.
Whatever the net benefits and difficulties of this process to
date -- and both have been present — the issue for the future is how to
promote a sustainable pattern that meets our interests in stable and
sustained growth at home in a context of growing world trade and financial
stability.

In analyzing these prospects, it is useful to review

developments with respect to our external position since the fourth quarter
of 1980, when the dollar began its extraordinary appreciation. From that
period through the first quarter of this year, our trade balance has
deteriorated by roughly $75 billion, despite a sizable reduction of about
$25 billion in our imports of oil. The adverse swing in the non-oil trade
balance has thus amounted to about $100 billion. To put that figure in
perspective, the additional $100 billion annual sales that our tradable
goods industries might have retained or captured in the absence of shifts
in our non-oil trade flows is two-thirds the size of the entire annual
output of our residential building sector, which measures around $150
billion in the GNP accounts.
Plainly, the deterioration in our trade position has had profound
effects spread through many firms and farms in all parts of the United
States. Those engaged in foreign trade or competing with imports have not
shared proportionately in the strong expansion of the U.S. economy, and
some important industries are still operating well below 1980 levels.
Exports of all major categories of goods have declined since the fourth
quarter of 1980. Measured in real terms or at constant base-period prices,




re-

exports of agricultural goods declined by 4 percent on balances, while
exports of nonagricultural goods declined about 15 percent. Among the
leading categories of nonagricultural goods, exports of both machinery and
industrial supplies declined nearly 20 percent• The longer our exports
remain depressed, the more difficult it becomes to maintain marketing
networks, and the more costly and difficult it becomes to recover foreign
sales.
The strong expansion of aggregate demand in the United States
relative to aggregate demand in foreign industrial economies has
contributed importantly to the widening of our trade deficit.

In that

sense, some of the deterioration in our trade position is cyclical and
reflects not the loss of markets at home or abroad$ but rather the absence
of proportionate gains*

In addition, exports have dropped sharply to

developing countries that are burdened with large external debts and are in
the process of readjusting their economies and their balance of payments
positions* This is particularly true with respect to our neighbors in
Latin America; our exports to that area have dropped by $15 billion since
the fourth quarter of 1980. Together, the change in our cyclical position
relative to foreign industrial countries and the decline in our exports to
debt-burdened developing countries appear to explain one-third to one-half
of the adverse swing in our non-oil trade balance.
The dramatic appreciation of the dollar has also had an important
effect. Since the fourth quarter of 1980 the value of the dollar has
appreciated about 45 percent on average against the currencies of foreign
industrial countries. Over the same period, U.S. price performance has




-7-

been somewhat better than the average in foreign industrial economies, but
even allowing for the differential in inflation, the dollar has appreciated
substantially.

No doubt that appreciation of the dollar has helped to

maintain the progress made against inflation during a period of vigorous
recovery. But, if it proves inconsistent with a more sustainable trade
position, we cannot count on the current strength of the dollar to persist
indefinitely.
The dramatic appreciation of the dollar reflects a number of
forces, and the outlook for the dollar is difficult to predict. Apart from
the relatively high level of interest rates in the United States, the
performance of our economy and a sense of confidence in our political
stability have helped encourage capital inflows, particularly when tensions
have increased abroad. The degree to which these forces will continue in
the months and years ahead cannot, of course, be assessed with certainty,
but the point is often made that, in a purchasing power sense, the dollar
is now "overvalued."

Such calculations are necessarily imprecise. They

differ depending upon the particular type of price index that is used —consumer prices, producer prices, export prices, etc, — and upon the time
period that is chosen as the base period for the calculations.
There can be no doubt, however, that the dollar has risen in
recent years substantially more than in proportion to movements in relative
price levels here and abroad. Thus, the value of the dollar is
substantially higher today than would be warranted solely on the basis of
changes in the relative levels of U«S. and foreign price indexes.
But exchange rates are clearly Influenced — in the short and
even in the longer run -- by factors other than relative rates of general




-8-

price inflation. This often is the case when there has been a substantial
change in the relative levels of interest rates, as has been the case
between the United States and its trading partners in recent years. In
principle, large capital inflows could persist for some time ahead even
though the United States is now becoming a net debtor internationally. But
there is a serious question as to whether the situation is in our best
interest or that of other countries. High interest rates pose severe
problems for important sectors of the domestic economy and certainly for
the indebted countries. Moreover the sustainability of our trade deficits
and net capital inflows over a prolonged period are questionable, to say
the least*
A precipitous large decline in the dollar, whatever its immediate
cause, would not be in our interest. If related to a reduced willingness
to invest in5 or lend to, the United States, the burden of financing the
budget deficit, in competition with private needs for credit, would be
increased. Domestic prices and costs would be affected. And, the
prospects for achieving lower interest rates would be further clouded.
All of that emphasizes the key importance of maintaining
confidence in our economic policies and outlook. There are implications
for monetary policy because that confidence must be rooted in a sense of
conviction that inflation will remain under control. And there are clear
consequences for fiscal policy as well because of understandable concerns
that excessive fiscal stimulus may regenerate inflationary forces or
stronger financial market pressures, or both.




-9-

There is a straightforward and constructive way to deal with
concerns of the kind -- a way fully consistent with purely domestic needs.
I am thinking, of course, of credible action to put the structural budget
deficit on a course that is headed toward balance within a reasonable time
period. Apart from the direct benefits of taking pressures off financial
markets and reversing recent increases in interest rates, we would become
less dependent on inflows of capital from abroad to balance our savings
with our investment needs. Over time, the dollar should move into an
equilibrium consistent with a stronger, and sustainable, trade position.
And, the risk of disturbingly large declines in the dollar should be
ameliorated because U.S. policies would earn the continued respect and
confidence of the financial community.
While I will not try to suggest an appropriate "equilibrium"
value of the dollar over time, I do believe that balance will be struck at
a higher level, and the risks of sharp and abrupt changes reduced, to the
extent that we can build upon the progress against inflation.

I also

believe it is not in our interest to see abnormal, and ultimately
temporary, strength in the dollar when such strength is really a reflection
of imbalances in our domestic policies and markets.
Sometimes it is suggested that intervention in exchange markets
can be useful to smooth these fluctuations, or as some would suggest now,
to depress the dollar in the interests of our trade position.
In my judgment, exchange market intervention can play a useful
role in dealing with disturbed market conditions or, occasionally, in
signaling the desires or policy intent of the financial authorities in




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various countries, particularly when the approach is coordinated among
them. But its role is subsidiary: experience strongly suggests that
intervention alone is a limited tool that cannot, itself, greatly or for
long change market exchange rates unless accompanied by changes in more
basic policies. In present circumstances, as I have indicated, we have
come to rely on Inflows of capital to finance our domestic needs* So long
as the fiscal situation is unchanged and private credit demands are high,
an intervention approach that resulted directly or indirectly in curtailing
that flow would risk undesirable consequences for interest rates. Those
risks would be particularly great if the United States were seen to be
embarking on a deliberate policy of depreciation*
Others suggest we attack our external deficits directly, either
by erecting barriers to capital flows or by restricting imports. Again,
such measures do not go to the root of the difficulty,,
To the extent direct measures were successful in reducing the net
capital inflow, real interest rates in the United States would presumably
rise,, other things equal, as part of the process of replacing the lost
saving from abroad with an increase in private domestic saving or a
reduction in private domestic investment. The burden of our budget deficit
on interest-sensitive sectors of the U.S. economy would be intensified; the
problem would be shifted without resolving it. That would be true quite
apart from the other compelling considerations against direct controls,
which would be administratively difficult and contrary to our basic
interest in open markets.




-11-

Yielding to the pressures for intensified import restrictions
also could only complicate our problems. Beware, in particular, of
arguments suggesting that import restrictions designed to benefit one
industry or another will produce more jobs for the economy as a whole. To
an individual firm or industry, shutting off import competition offers
immediate advantages; more generally, it is argued that each billion
dollars of the trade deficit represents a billion dollars of domestic
output foregone, other things equal. Using the rule of thumb that each
billion dollar's worth of domestic output requires about 25,000 workers, it
is then calculated that one million jobs could be created by reducing the
trade deficit by $40 billion*
The pitfalls in such reasoning should be clear at a time when the
economy is already expanding strongly: a more rapid growth of output and
employment than we have experienced over the past year and a half, combined
with reduced capital inflows, would likely have been reflected in more
pressures on financial markets at the expense of other sectors of the
economy.
Hore generally, it should not be overlooked that the decision to
protect one industry invariably imposes costs elsewhere.

It is costly to

other industries if foreign countries retaliate against U.S. exports, if
import restrictions lead to higher dollar exchange rates than would
otherwise prevail, or if costs rise. Protection typically leads also to
higher prices and less choice for consumers and can be politically
difficult to terminate, as exemplified by the current export restraint
program on Japanese automobiles.




-12-

St:ill another essential reason for resisting protectionist
pressures is the adverse implications of protection for the export earnings
of the developing countries. We encourage those countries to take
effective measures to build their productive structures over time, and we
urge strong steps to adjust their economies in the short run to generate
the payments due on their debts*

But those processes cannot ultimately

succeed if the United States and other industrial countries protect their
own markets from the competitive exports of the developing countries.
Those developing countries have traditionally been an important
market for our exports, and they have the potential to be much larger.
That process of two-sided trade is fundamentally a healthy one « a process
that raises our own average productivity and real income over time at the
same time that it promotes growth in the developing countries. In a
context of growing economies, we should be able to adjust to international
competition so that we can ease the process of transition for impacted
workers and firms.
That, of course, is more easily said than done.

It is

particularly difficult-to anticipate adjustment and to accept the pressures
of international competition in an environment of large and fairly rapid
swings in exchange rates* Moving toward a healthier process of
international development and competition over time requires that we
discipline our fiscal and monetary policies to provide the conditions for
more stable exchange rates.




-13-

This brings me back to the central thrust of my remarks -- the
need here and elsewhere to achieve better balance in our basic policies and
a more sustainable pattern of external transactions*
Much has been achieved in these last few years to put the economy
on a sounder footing -- too much, at too great a cost, to see it all
jeopardized now*

Our recovery has been proceeding rapidly, with little

acceleration of inflation. But the combined credit demands of the Federal
Government and the private sector have generated disturbing pressures on
interest rates* on developing countries, and on exchange rates.
In concept, we can visualize an economic expansion characterized
by relatively high interest rates and by strong private consumption and a
large budget deficit*

That is what we are having. But it has costs --

costs reflected in huge trade deficits and net borrowing from abroad,
potential problems for housing and other interest-sensitive sectors, and
risks of exchange rate and financial instability.
What is at issue is the sustainability of growth here and abroad,
and our prospects for further progress toward price stability.

In the end,

I know of no way to deal with these risks, and to provide solid assurance
that we can build on the real progress of the past, other than to carry
through on the efforts to deal with the federal deficit.




**********