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£:'.•
For release on delivery
9:30 A.M., E.D.T.
September 24, 1986

RESEARCH LIBRARY

Federal fkt^erve Bank
of St. Louis

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




before the
Subcommittee on Trade
Committee on Ways and Means
House of Representatives

September 24, 1986

/s«C-

Mr. Chairman and Members of the Subcommittee:
You have raised with me a number of important
questions concerning the state of the world economy, and
particularly the U.S. trade position and our increasing
international indebtedness.

There are, indeed, serious

problems in these areas that, left untended, would pose great
dangers both for us and our trading partners.

At the same

time, our responses, and those of other countries, need to be
r

well considered as well as forcible -- well considered in

c

terms of their consistency with sustainable world growth, a

^

greater degree of international financial stability and a
trading order able to support that growth.
The burden of my comments today is that much of the
groundwork has been, or is being laid, for such an approach.
I realize the results so far are uneven.
here and abroad.
exhausted.

Frustrations abound,

Margins for error have been pretty well

But I also sense a wider appreciation of those

risks, a larger degree of consensus on the directions we must




-2take in economic policy here and abroad,- and greater willingness to explore and perhaps deal with some of the longerterm "systemic" issues.
The most striking reflection of the strains in the
world economy is the enormous imbalance in our trade accounts
and the counterpart surpluses of some countries abroad.

When

I appeared before this Subcommittee in April 1984, our trade
and current account deficits were already big and getting
bigger —

running around $110 billion.

Two years later, in

the second quarter of 1986, those deficits approached $150
billion.
I emphasized in that earlier appearance that those
external deficits were related to more fundamental factors

—

relative rates of economic growth, the size of our budget
deficit, exchange rates, and the international debt crisis.
Those factors remained adverse for some time longer.
As a result, there are still no clear signs that the trade
deficit is declining, and we have continued to see marked




-3instability in exchange rates and strong protectionist
pressures.
hopeful.

But I also believe that prospects are now more
Some basic corrective forces have been put in

place, and others are receiving more attention.

As a result,

we have the clear opportunity for a more favorable conjuncture
of policies and results.
Certainly, industrialized countries generally
and many developing countries as well —

—

have made considerable

progress toward restoring a greater sense of price stability,
one prerequisite for sustaining economic growth and greater
interest rate and financial stability.

Current exchange rate

relationships place our industry in a far better competitive
position among the industrial countries than for some years;
I see no need for further adjustments on anything like the
scale or speed of the past 18 months.

You and your colleagues

now appear to be dealing with the budget deficit more forcibly

—

an approach that, if carried through, will reduce our dependence
on foreign capital and provide protection against a resurgence




-4of inflation.

Moreover, there have been some signs in some

major foreign countries recently* most notably Germany, of a
resurgence of domestic demand after a considerable period of
sluggishness.

There appears to be growing recognition of the

crucial importance of sustaining that demand.
The Trade Accounts —

Problems and Prospects

In 1980, the United States had a small trade deficit
and the current account —

benefitting from earnings from

our net overseas investment —

was in virtual balance.

Since then, the value of imports, other than oil, has almost
doubled.

Total imports are running at some $360 billion,

despite large declines in the oil import bill.
In contrast, the total value of U.S. merchandise
exports has been little changed on balance during the 1980s,
running currently at around $220 billion, or only about 60
percent of our imports.

An actual decline of more than a

third in exports of agricultural products has been only
partially offset by a rise in the dollar value of exports




-5of manufactured goods, which must make up the bulk of our
export sales.

In volume terms-, total exports have actually

declined a bit —

by about 3 percent —

since 1980,

That swing in our trade accounts is one reason —
most important reason —

the

that domestic manufacturing activity

has been sluggish during much of the current period of
economic expansion.

It is also a factor restraining the

willingness of manufacturers to invest for future expansion.
At the same time, the surplus we have traditionally
run on services and other current account items has virtually
disappeared, reflecting primarily the growing amounts of
interest paid on our increasingly heavy overseas indebtedness,
Borrowing abroad is, of course, a necessary counterpart of
a current account deficit.

But we have been dependent on

foreign borrowing in another sense as well? it has had the
practical effect of largely offsetting the huge demands on
our money and capital markets from the budget deficit.




-6Convenient as that borrowing has been however, that process
is not sustainable indefinitely.
We are now by far the world's largest debtor country,
and even under favorable circumstances that net indebtedness
will increase substantially further in the years ahead.

Of

course, our external debt, relative to our GNP, is still
rather modest.

Nonetheless the trend is disturbing.

Over time, interest on that debt will have to be
paid, implying the need for relatively more exports and
fewer imports.

Unless the foreign funds have, directly or

indirectly, been employed in building productive investment,
the implications for growth in American living standards are
adverse.

Unfortunately, given our budget deficit, savings

patterns, and the trend of plant and equipment spending, the
evidence suggests that most of the funds available from
abroad have indirectly supported consumption rather than
adding much to our productivity or productive capacity.




-7That is a long-term consideration.

In the more

immediate future, the relevant question is whether foreigners
will remain so willing to employ so large a fraction of
their own savings in our markets.

The question could become

more pointed if and as their own economies expand more
rapidly, as we would like to see.
In that respect, much turns on confidence —

confidence

that the U.S. will in fact sustain growth without reigniting
inflation; that the dollar will tend to stabilize in the
exchange markets; and that, over time, our trade balance
will decline, reducing our need for overseas financing.
There are, of course, strong domestic reasons why a
reduction in our trade deficit is essential.

For a time,

it could be argued that the rising level of imports and
accompanying capital flows brought short-term benefits to
most Americans.

We could enjoy relatively cheap and high

quality imports, intense competition helped stabilize the
domestic price level, and the ready availability of funds




-8from abroad meant that we could finance the federal deficit
at lower interest rates than would have otherwise been
possible.

But the process also squeezed our industrial

base, severely affecting a number of industries and workers.
The strains are now showing economically and
politically.

Indeed, prospects for continuation of the

economic expansion through 1987 and beyond are heavily
dependent on an improved trade balance.

The relevant

question is how to achieve that resultf consistent with our
growth and stability and that of the world at large.
Toward a Constructive Solution
No single measure, here or abroad, is likely by itself
to restore a better balance in our trade position without
damaging other important objectives, including prospects for
world growth.

That is particularly true of a scatter-gun

approach toward protectionism.
I well understand, at a time of stress in important
regions of the country and particularly in the light of evidence



-9of restrictive practices by others, the temptations to
move in that direction.
the risks.

But I hope we are fully aware of

The results now would be no better than in

the 1930s; then, one protectionist measure bred others, and
world trade and economic activity were depressed together.
We preach to Latin America and others the need to
find solutions to their problems in the context of an open
trading system, and in the efficiencies and productivity
that fosters.

But of course that won't work unless our market

and others' are open to them.

And the lesson of the benefits

of a liberal trading order is equally applicable to all of us.
Our effort, instead of retreat, must be directed
toward opening other markets, and toward assuring trade can
proceed on fair and reciprocal terms.

In the broadest

sense, that is of course what drove our negotiating efforts
at Punta del Este, as we and others worked to launch a new
round of GATT negotiations.

Strengthening the agreed set

of international trading rules is essential to provide a fair




-10and more comprehensive framework for the conduct of international business.

It is part of a constructive response to

protectionist pressures*
I realize that is the work of years.

More can and

should be done to deal, case by case, with particular problems
with particular trading partners in the nearer term.
are familiar with those efforts —
the frustrations.

You

with both the successes and

But I know of no other way of proceeding

without damaging our fundamental objectives.
In terms of achieving decided improvement in our trade
balance, other approaches will in any event be quantitatively
far more important.

One of those approaches is to maintain a

value for our currency vis-a-vis other industrial countries
that permits our companies to compete effectively.

Judgments

in this area are always difficult and results are the acid test.
However, in contrast to the situation 18 months ago, and assuming
growing markets are open to us, my sense is that we are for now
reasonably close to an appropriate adjustment in that area.
Whether that will remain a fair judgment is, of course, dependent



-11heavily on prospects for enhancing productivity in industry
and maintaining reasonable price stability.
I realize that, even with the dollar more than 30
percent below its average level in early 1985 (and about 40
percent lower in terms of the Japanese yen and the West
German mark), our overall trade balance has yet to improve.
That is not entirely surprising.

We are still experiencing

some of the lagged effects of the extraordinary strength of
the dollar earlier.

Many of those exporting to us have

been willing to reduce previously wide profit margins, or
for a time to forego profits for market share.

Some U.S.

industries operating at a relatively high level, and reluctant
to expand capacity, have raised their own prices as the
exchange rate has fallen.

Moreover, when prices of imports

rise, so for a time will the total import bill, widening
the trade deficit until competitive adjustments are made.
More broadly, we need to recognize that exchange rate
changes alone will not assure the lasting competitiveness of
our industry or the large shift of resources necessary here



-12and abroad to restore better balance to the world economy*
Indeed, without support of other policiesf exchange rate
changes can be counter-productive in important respects

—

inflationary in the United States, and a restraint on
demand and economic activity abroad.
Fortunately, the sharp decline in oil prices has,
until now, more than offset the effects of the declining dollar
exchange rates on producer and consumer prices in the United
States.

The countries with the greatest exchange rate

appreciation —

Japan and Germany —• have experienced a

levelling or even decline in the volume of exports and some
increase in imports, as they inevitably must if their
trade surpluses are to decline.
Looking ahead, the relevant question is whether the
large shift in resources implicit in reducing our trade
deficit, and the surpluses of others, can be accomplished
in a framework of non-inflationary growth, here and abroad.
It is that underlying question that seems to me to lie




-13behind so much of the active trans-Atlantic and trans-Pacific
economic dialogue in recent months —

a question that

sometimes seems to be obscuredr rather than enlightened,
by focus on the timing or wisdom of particular policy
measures^ fiscal or monetary, by one country or another.
The basic point is that the adjustments required, by
their nature, must be two-sided.

The United States, if it

is to reduce its trade deficit substantially, must be prepared,
in relative terms, to reduce the rate of growth in domestic
consumption in favor of the external sector and investment.
At the same time, we will have to be prepared to rely less
on capital inflows to finance domestic needs.

For other

countries, with excessively large trading surpluses, the
opposite must be true —

relatively stronger growth in

domestic demand and consumption and more fully utilized
domestic savings as their trade balances decline.
The clear implication is that broadly complementary
approaches are necessary in the common interest.




For the

-14United States, orderly reduction in the budget deficit remains
a key, and the external sector (and manufacturing activity)
should provide more of the impetus to growth.

For other countries

some appropriate mix of monetary, fiscal, and other policies to
sustain and enhance domestic demand are required if their trade
surpluses are to decline in a context of healthy world growth.
While international consultations and discussions
can help clarify these issues, decisions on the precise
nature and timing of particular fiscal or monetary measures
naturally will remain within the province of national governments, subject to their individual analyses of economic
developments and outlook.
particular actions —

Sometimes, coordination of

such as monetary policy decisions

—

may indeed be important to avoid unwanted effects on exchange
markets or financial markets generally.

But what is far

more critical than the precise timing of particular measures
is achieving a realistic understanding of the interactions




-15among national economies, and acting upon that understanding
to maintain the momentum of non-inflationary growth.
The most recent developments are reasonably encouraging
As I noted earlier, we do appear to be making some progress
toward reducing our budget deficit, even if all the optimistic
assumptions underlying the program now under Congressional
debate are not borne out.

Economic activity —

and parti-

cularly domestic demand —

turned stronger in the spring

and summer in Germany (and to a lesser extent in Japan),
following substantial sluggishness.
I realize questions are raised about the "staying
power" of those changes, here and abroad.

That is why it is

so important that there be full understanding among governments of what is at stake and of the need for continuing
appraisals of progress and the possible need for complementary
actions.

As you know, the Economic Summit at Tokyo last

spring strongly emphasized the need for maintaining close
contacts among economic officials, for close review of




-16economic indicators, and for mutual assessment of the
outlook.

The series of meetings before the annual sessions

of the Governors of the IMF and the World Bank next week
will provide ample opportunity to further that effort.
The Heavily Indebted Developing Countries
Those meetings will also devote a lot of attention to
the continuing problems of many countries in Latin America
and elsewhere burdened with heavy debt as they work to restore
greater growth and stability.

Plainly, those problems will to

some extent be with us for some time —

warning enough of the

wisdom of seeking solutions to our own "adjustment" problem
before it reaches crisis proportions.

The evident fact

that large difficulties remain should not, however, obscure
the very real progress that has been made.
Indeed, for most of the indebted countries the
necessary external adjustment has already been substantially
achieved.

Taken as a group, the 15 heavily indebted countries

more or less arbitrarily associated with the so-called



,^^mmm:

-17"Baker Plan11 were in rough current account balance
in 1984 and 1985.

In 1981 and 1982, in contrast, they had

an aggregate deficit of about $50 billion.

In other words,

the collective trade surpluses of those countries rose to
the point that they offset interest payments on outstanding
debt.

Interest payments themselves, reflecting developments

in world financial markets, are now moving lower.
To be sure, that effort for a time was accompanied
by sharply lower imports, recession, and lower standards of
living.

Moreover, for about two years, there has been little

new net lending to those countries by the world's commercial
banking system.
to change.

As we look ahead, those circumstances need

Ultimately, the debt burdens can be carried only

in the context of healthy growth, which in turn implies more
investment and imports.

For most of the indebted countries,

some margin of funds will be required from abroad to meet
those needs although not nearly so much as during most of
the 1970s and early 1980s.




-18Fortunately, there are encouraging signs of progress
in those directions.

A number of the heavily indebted countries

are now growing again, in some cases with vigor.

That is true

in the case of the largest single debtor country, Brazil.

Helped

by the reduction in world interest rates, external interest
burdens are being reduced appreciably in some countries
relative to exports or other measures of capacity to pay.
A number of Latin American countries have also taken striking
initiatives toward dealing with chronic inflationary problems.
Potentially equally important, considerable if uneven
progress has been made toward liberalizing the economic
structures of borrowing countries in ways that should
encourage more growth and productivity over time, in the
process justifying new equity investment and some lending by
international institutions and banks.

That progress has been

particularly evident with respect to the trade sectors of a
number of countries.




-19The main motivation clearly is to improve the
efficiency and competitiveness of their own export industries.
However, the result should certainly be to enhance opportunities
for exports from the United States and other industrial countries,
A more favorable attitude toward private investment, both by
their own citizens and by foreigners, is another indication
of a generally more outward-looking market-oriented approach.
It would be too much to claim that this progress
is uniform or yet firmly ingrained in economic or political
structures*
past —

But against the very different pattern of the

a pattern extending over decades of inward looking

efforts at self-sufficiency and strong state control of
industry —

the sense of change is impressive.

I believe

it is deeply in those countries' interest, and ours, to see
that process continue and mature, for it will ultimately
provide the basis for renewed prosperity, higher living
standards, and greater political stability.

To achieve

that end, it is also evident that much will depend upon the




-20cooperation of creditor banks and governments in supporting
effective economic programs, sustaining a reasonably favorable
world economic climate, and maintenance of open markets.
The sharp decline in oil prices earlier this year
threatened to set back the entire effort.

To be sure,

pressures on some countries were moderated by lower oil
prices.

But that same development had an enormous adverse

impact on major oil exporters such as Mexico, Venezuela,
Ecuador and Nigeria.

At the low oil prices reached this summer,

for instance, Mexico would lose more than a third of its
total 1985 exports, perhaps a fifth of its government
revenues, and the equivalent of more than 5 percent of
its GDP.

With the exception of Venezuela, there was no

large cushion of external reserves to buffer the shock.
Inevitably, that situation has posed a severe new
challenge to all the parties concerned.

Mexico, Nigeria and

Ecuador have each responded with strong new efforts to deal with




-21budgetary deficits, to improve efficiency, and to promote
longer-run efficiency and longer-run adjustment.
In the case of Mexico, the basic orientation is
symbolized by a long-debated decision to join GATT.

In

that spirit, import restrictions are being rationalized
and liberalized, some state-owned enterprises are being
made available for sale (or, if too inefficient, shut down),
subsidies are being reduced and eliminated, and procedures
for approving foreign investment are being eased.
The IMF is supporting those efforts.

It has agreed in

its own lending program to imaginative new approaches to help
assure growth and guard against further adverse oil contingencies,
The World Bank is ready to provide sizable new credits to
assist sectoral and structural adjustment, with appropriate
monitoring of progress.

At the same time, significantly

larger financial resources than anticipated earlier for
Mexico will have to be marshalled from both official and
banking sources abroad to help ease the transition, to




-22maintain continuity in debt servicef and to provide a solid
base for renewed growth.
That combination of adjustment, structural changef
and appropriate financing in support of renewed growth is
the essence of the approach set out by Secretary Baker at
Seoul last year.
What remains to be done in the case of Mexico is
completing financial agreements with commercial bank creditors
both to restructure outstanding debt at acceptable terms and to
provide the needed margin of new credits, comparable in total
to those supplied by official sources.
The net amount to be made available by commercial
banks through the end of next year would run to a little less
than 7 percent of outstanding loans.
but it should be kept in perspective.

That is a sizable amount,
It is so large only

because of the size of the decline in oil prices —

a

decline that has reduced expected financing needs of some
other countries.




Looking back, commercial banks1 claims on

-23Mexico appear not to have increased significantly for more
than 2 years•

Taking Latin America as a whole, present

indications are that lending volumes, taking one year with
another, both for official and commercial bank lenders,
should remain generally within the amounts foreseen by
Secretary Baker a year ago.
Moreover, taking the entire period since mid-1982,
there has been a striking decline in the exposure of
American banks to the heavily indebted countries of Latin
America relative to their capital.

That ratio for all

significant lending banks fell from about 120 percent of
bank capital to less than 75 percent at the end of March
1986, a decline of 40 percent.

Those exposures are actually

considerably less than in 1977 when the data were first
collected.
Success in dealing with the debt problem in Mexico,
as elsewhere, remains totally dependent upon a strong sense
of inter-dependence and commitment by borrowing countries,



-24commercial bank lendersr international institutions/ and
governments.

Each of the parties has a lot at stake.

The

debtor countries plainly both want to maintain their
creditworthiness and to restore growth and stability
and those objectives are closely related.

—

Major commercial

banks remain heavily exposed and want borrowers to be able
to service their debts.

Governments and international

institutions, like the borrowers and private lenders, have
a strong interest in international financial order, in
expanding markets, and in reduced imbalances.

And, of course,

relationships beyond the purely economic are at stakef for
the United States most of all.
That sense of mutual interest is being strongly
tested once again, under the pressure of oil prices that
few had anticipated.

But after months of delay, substantial

progress is now being made, not only in Mexico but elsewhere.
Obviously, the job is not complete, and time is short.

But I

know of no other workable approach to meet the basic objectives,



-25And all of the parties —

borrowers or lenders

—

have an enormous interest in the success of the whole.
Moreover, success in the Mexican effort —
crucial stage —

now at the

will set a most promising example for

dealing with the needs of other countries.
Among the beneficiaries of renewed growth in Latin
America should be the U.S. trade position.

Traditionally,

we had a sizable surplus in manufactured goods with that
area, and a small surplus overall.

Those surpluses fell

away in the 1980s as the United States absorbed the brunt
of the necessary adjustments in the trade position of the
borrowers*

But now, Latin America imports should resume

growth more or less in line with their exports, and, with
adequate financing, probably faster.
natural market for us.

Latin America is a

With a more competitive dollar,

our exports are in a position to gain both absolutely and
relatively.




-26An Interdependent World
It has become a cliche to refer to the interdependence
of national economies in the world today•
it is a reality, and our policies —

But cliche or not,

those of the United

States and other countries -— must recognize that reality.




The range of considerations and policies I have
touched upon today illustrates the points
-

The United States must continue to work
toward reducing the federal budget deficit,

•- We must keep inflation under control, partly
to preserve the competitiveness of U.S. goods,
but also to contribute to greater stability of
exchange rates and prices in markets generally.
—

Other industrial countries must ensure adequate
growth of domestic demand as their external
trade surpluses shrink.

'-

Developing countries need to work forcibly and
effectively to improve their economic efficiency
and stability.

•-

International financial institutions and commercial
bank creditors need to support those efforts.

—

All countries must resist protectionist pressures.

If all these things are done reasonably well, then
the outlook for sustained and more balanced growth in the
world economy for the period immediately ahead is good.

-27If we can go still further, and incorporate some of the
lessons of the past into more coherent and effective
trading and monetary systems, then we will have greatly
enhanced the prospects for sustaining good performance
in the more distant future.

That is the challenge for

the years ahead.




*******