L a r r y Promise1 Introduction May 21, 1984

The U.S.

External P o s i t i o n

This afternoon we w i l l provide a long-term perspective on the external p o s i t i o n o f t h e United States.

Our presentation w i l l use the

package o f m a t e r i a l s t h a t has been d i s t r i b u t e d t o you and w i l l be i n three parts. F i r s t , Peter Hooper w i l l analyze how we got t o where we are, focusing on t h e unprecedented d e f i c i t now being observed i n t h e U.S. account. Peter I s a r d then w i l l discuss where t h e present h i g h l e v e l of the dollar current

--

i f i t were maintained

-- would take us.

i n t e r m s o f our current

account and our external investment p o s i t i o n . F i n a l l y , Dale Henderson w i l l consider the i m p l i c a t i o n s of a l t e r n a t i v e scenarios

-- embodying both exogenous and policy-induced

declines i n the dollar. L e t me t u r n t o Mr. Hooper.

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Peter Hooper Part I

The f i r s t c h a r t i n t h e package o f m a t e r i a l s places recent movements i n t h e U.S. c u r r e n t account i n a h i s t o r i c a l perspective.

As

shown i n t h e t o p panel, t h e United States r a n a c u r r e n t account surplus, on average, d u r i n g most o f t h e post-war period. The c u r r e n t account was

about i n balance i n 1980, but i t has dropped sharply over the past two years, reaching an estimated d e f i c i t o f about $85 b i l l i o n a t an annual r a t e i n t h e f i r s t q u a r t e r o f t h i s year, more than f i v e times as l a r g e as any annual d e f i c i t recorded p r i o r t o l a s t year.

As shown i n t h e bottom

panel, t h e recent d e c l i n e i n the c u r r e n t account i s l e s s dramatic when expressed r e l a t i v e t o GNP, b u t i t s t i l l reaches a l e v e l t h a t i s well o u t s i d e t h e post-war h i s t o r i c a l range o f p l u s o r minus one percent o f GNP

.
The t o p panel of Chart 2 presents two measures of t h e U.S. The s o l i d l i n e shows t h e

e x t e r n a l investment p o s i t i o n , o r t h e l e v e l o f U S . assets held abroad minus f o r e i g n assets held i n t h e United States.

o f f i c i a l l y recorded external investment p o s i t i o n , and t h e dashed l i n e , which begins a t t h e recorded p o s i t i o n i n 1948, shows movements i n t h e cumulated c u r r e n t account.
B e i t h e r measure t h e e x t e r n a l investment y

p o s i t i o n has been s u b s t a n t i a l l y p o s i t i v e d u r i n g most o f t h e past 35 years, c o n t r i b u t i n g t o a comfortable surplus on U.S. income r e c e i p t s . net investment

I n recent years, t h e cumulated c u r r e n t account has This d i f f e r e n c e l a r g e l y

f a l l e n s u b s t a n t i a l l y below t h e recorded series.

r e f l e c t s recent increases i n t h e s t a t i s t i c a l discrepancy, o r unreported t r a n s a c t i o n s , i n t h e U.S. i n t e r n a t i o n a l accounts. The s o l i d l i n e

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i m p l i c i t l y t r e a t s t h e discrepancy as unreported c u r r e n t account transactions, w h i l e t h e dashed l i n e i m p l i c i t l y t r e a t s i t as unreported c a p i t a l flows. W have reason t o b e l i e v e t h a t much o f t h e discrepancy e

does r e f l e c t unreported c a p i t a l flows, so t h a t the recorded series, or t h e s o l i d l i n e i n t h e chart, gives an o p t i m i s t i c p i c t u r e o f our present e x t e r n a l investment p o s i t i o n . I n any event, t h e evidence p o i n t s t o a s u b s t a n t i a l d e c l i n e i n t h e U.S. external p o s i t i o n . The developments underlying t h i s d e c l i n e can The f i r s t i n v o l v e s

be analyzed a t two l e v e l s , as o u t l i n e d i n Chart 3.

accounting f o r t h e e f f e c t s o f t h e proximate determinants o f t h e t r a d e and non-trade components o f the c u r r e n t account. include: The proximate determinants

(1) changes i n U.S.

p r i c e competitiveness, (2) movements i n t h e

r e l a t i v e c y c l i c a l p o s i t i o n s o f the United Sates and i t s major t r a d i n g partners, and ( 3 ) changes i n other f a c t o r s t h a t have d i r e c t l y a f f e c t e d t h e c u r r e n t account. These other f a c t o r s i n c l u d e i n t e r n a t i o n a l debt

problems. which have a f f e c t e d our exports, and changes i n o i l p r i c e s and

o i l consumption, which have a f f e c t e d our imports.

The second l e v e l o f

a n a l y s i s i n v o l v e s accounting f o r s h i f t s i n more fundamental f a c t o r s t h a t a f f e c t t h e c u r r e n t account i n d i r e c t l y , through t h e i r impacts on t h e proximate determinants. I n p a r t i c u l a r , these i n c l u d e f i s c a l and monetary

p o l i c i e s - - h e r e and abroad--and other exogenous f a c t o r s a f f e c t i n g i n t e r n a t i o n a l asset preferences. Movements i n t h e f i r s t proximate determinant, U.S. price

competitiveness, are i n d i c a t e d i n t h e t o p panel o f Chart 4, which shows t h e weighted average f o r e i g n exchange value o f the d o l l a r adjusted f o r r e l a t i v e consumer prices. O t h i s index, t h e d o l l a r rose more than 40 n

percent between the f o u r t h quarter o f 1980 and t h e f i r s t quarter o f 1984.

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Movements i n r e l a t i v e c y c l i c a l p o s i t i o n s are i l l u s t r a t e d i n the bottom panel, which shows real G N P i n the United States and other G-10 countries. Since the fourth quarter o f 1980, U.S.

G N P has r i s e n about

three percent more than foreign GNP. place over the past year, as the U.S. deeper recession i n 1982. Chart 5 shows U.S.

Most o f t h i s r e l a t i v e increase took economy recovered f a s t e r from a

exports t o developing countries.

As

indicated by the s o l i d l i n e , our t o t a l exports t o t h i s area declined between 1980 and the f i r s t quarter o f 1984. This decline r e f l e c t s , i n

p a r t i c u l a r , the e f f o r t s o f countries burdened by debt t o c u t back on t h e i r imports.
U.S.

exports t o the ten major countries experiencing

serious debt problems, indicated by the dashed l i n e , f e l l by $15 b i l l i o n over t h i s period. Chart 6 provides a s u n a r y a l l o c a t i o n o f the $85 b i l l i o n decline i n the current account since 1980 among the main proximate determinants. Based, i n part, on model simulations. we would a l l o c a t e p r i c e competitiveness. roughly

about $70 b i l l i o n t o the decline i n U.S.

$20 b i l l i o n t o the r e l a t i v e strength o f the U S . c y c l i c a l recovery, and another $15 b i l l i o n t o the contraction of demand fo developing rm countries w i t h debt problems. Working i n a p o s i t i v e d i r e c t i o n was a $20

b i l l i o n e f f e c t due t o the decline i n o i l prices during t h i s period and f u r t h e r declines i n domestic o i l consumption. Several fundamental developments under1i e the s h i f t s i n these proximate determinants. The change i n U.S.

f i s c a l p o l i c y over the past
The top l i n e i n Chart

three years has attracted considerable attention.

7 shows the increase i n the structural, o r high employment, federal
budget d e f i c i t fo i t s low o f $30 b i l l i o n i n 1981. rm The s t r u c t u r a l

d e f i c i t i n 1984 i s expected t o have r i s e n by about $100 b i l l i o n since

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1981, o r by about 3 percent o f current GNP.

The c h a r t a l s o shows modelW estimate t h a t t h e e

based estimates o f t h e e f f e c t s o f t h a t increase.
U.S.

f i s c a l expansion w i l l increase r e a l GNP t o a l e v e l about 2-1/2

percent above where i t otherwise would be i n 1984, c o n t r i b u t i n g s u b s t a n t i a l l y t o t h e growth o f import demand. growth, t h e f i s c a l expansion keeps U.S. Assuming unchanged money

r e a l i n t e r e s t r a t e s about 2-1/2 Taking i n t o

percentage p o i n t s above where they otherwise would be.

account some sypathetic increase i n f o r e i g n i n t e r e s t rates, such a r i s e i n U.S. i n t e r e s t r a t e s suggests t h a t t h e d o l l a r i s about 8 percent higher f i s c a l expansion.

i n 1984 as a r e s u l t o f t h e U.S.

The a p p r e c i a t i o n o f t h e d o l l a r , i n turn, has two e f f e c t s . F i r s t , by reducing t h e p r i c e o f imports, i t l a r g e l y o f f s e t s t h e i n f l a t i o n a r y e f f e c t s o f t h e expansion, l e a v i n g t h e path o f domestic p r i c e s about unchanged, as shown i n l i n e 5. Second, i t c o n t r i b u t e s ,

along w i t h t h e expansion o f r e a l GNP, t o t h e widening o f t h e c u r r e n t account deficit--shown i n l i n e 6. The c u r r e n t account i s also a f f e c t e d

by the r i s e i n i n t e r e s t rates, which has a small e f f e c t on net investment
income r e c e i p t s , and which tends t o depress exports t o c o u n t r i e s wi th d e b t problems. The net impact o f the f i s c a l expansion on t h e c u r r e n t

account by 1984 i s an estimated $30 b i l l i o n l a r g e r d e f i c i t . These estimates leave most o f the r i s e i n t h e d o l l a r and i t s impact on t h e c u r r e n t account unexplained. This s h o r t f a l l c o u l d r e f l e c t , I n particular,

a t l e a s t i n part, t h e l i m i t a t i o n s o f t h e models employed.

t h e models do not i n c o r p o r a t e forward l o o k i n g expectations and, t h e r e f o r e , miss t h e e f f e c t s o f a n t i c i p a t e d f u t u r e budget d e f i c i t s on r e a l i n t e r e s t r a t e s and exchange rates. However, i t also i n d i c a t e s t h a t o t h e r

fundamental f a c t o r s were i n f l u e n c i n g t h e d o l l a r .

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The p r i c e adjusted d o l l a r i s shown again as t h e s o l i d l i n e i n Chart 8. The dashed l i n e i n t h e c h a r t shows t h e d i f f e r e n t i a l between long-term r e a l i n t e r e s t r a t e s and a weighted average o f I n theory, t h i s d i f f e r e n t i a l provides a In

a measure o f U.S.

f o r e i g n long-term r e a l r a t e s .

l i n k between t h e exchange r a t e and u n d e r l y i n g economic p o l i c i e s .

p r a c t i c e , t h e r e l a t i o n s h i p between t h e r e a l i n t e r e s t r a t e d i f f e r e n t i a l and t h e real exchange r a t e has v a r i e d c o n s i d e r a b l y i n t h e s h o r t run, b u t

i t i s e v i d e n t t h a t t h e longer-run movements i n t h e two s e r i e s have been
f a i r l y c o n s i s t e n t l y c o r r e l a t e d over most o f t h e f l o a t i n g - r a t e period. Since mid-1979.
U.S.

r e a l i n t e r e s t r a t e s have r i s e n more t h a n Most o f t h i s r i s e

6 percentage p o i n t s r e l a t i v e t o f o r e i g n r e a l rates.

f o l l o w e d t h e move t o g r e a t e r monetary r e s t r a i n t i n t h e U n i t e d States t h a n abroad, beginning i n l a t e 1979.
B t h e t i m e t h e s h i f t i n U.S. y

fiscal

p o l i c y was implemented a t t h e end o f 1981, t h e i n t e r e s t r a t e d i f f e r e n t i a l had begun t o l e v e l o f f . Some o f the e f f e c t s o f t h e U.S. f i s c a l expansion

c o u l d have been a n t i c i p a t e d e a r l i e r .

However, t h e primary e f f e c t o f t h a t

expansion, a g a i n s t a background o f f i s c a l r e s t r a i n t abroad, was t o keep

rm t h e i n t e r e s t d i f f e r e n t i a l fo f a l l i n g t o a s u b s t a n t i a l l y lower l e v e l i n
1982 and beyond.

As i n d i c a t e d i n t h e c h a r t , t h e r i s e i n t h e r e a l i n t e r e s t
d i f f e r e n t i a l s i n c e 1979, has been associated w i t h much o f t h e d o l l a r ' s a p p r e c i a t i o n i n r e a l terms. However, t h e d o l l a r continued t o r i s e a f t e r A good deal o f t h i s

t h e i n t e r e s t d i f f e r e n t i a l l e v e l e d o f f i n 1982.

subsequent gap nas been a t t r i b u t e d t o exogenous p o l i t i c a l and economic developments abroad, i n c l u d i n g "safe haven" considerations, t h a t have s h i f t e d preferences i n f a v o r o f dollar-denominated assets. I n the

absence of these f a c t o r s , t h e d o l l a r would have been n o t i c e a b l y lower and t h e i n t e r e s t r a t e d i f f e r e n t i a l somewhat higher.

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I n conclusion. a rough accounting o f t h e various fundamental f a c t o r s suggests t h a t changes i n economic p o l i c i e s i n recent years can e x p l a i n most o f t h e widening o f the c u r r e n t account d e f i c i t due t o c y c l i c a l factors.

To t h e extent t h a t these p o l i c y changes were

responsible f o r changes i n r e a l i n t e r e s t rates, they could a l s o e x p l a i n more than h a l f o f the increase i n the d e f i c i t due t o reduced p r i c e competitiveness. This combined e f f e c t would amount t o about two t h i r d s

o f t h e widening o f the c u r r e n t account d e f i c i t , excluding t h e f a v o r a b l e movement i n o i l imports. Much o f the remaining increase i n t h e d e f i c i t

r e f l e c t s t h e e f f e c t s o f other exogenous developments t h a t have i n f l u e n c e d i n t e r n a t i o n a l asset preferences.

Mr. I s a r d w i l l now continue our presentation.

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Peter Isard Part I1

1 w i l l focus on the implications f o r our i n t e r n a t i o n a l accounts
during the r e s t o f the decade i f the d o l l a r remains around i t s current average value.

I will

also discuss why the s t a f f believes t h a t t h e

current high l e v e l o f the d o l l a r i s not sustainable. The top panel o f Chart 9 shows a simulation o f how the U.S. merchandise trade and current account d e f i c i t s would expand through 1990 w i t h the average nominal foreign exchange value o f the d o l l a r unchanged a t i t s recent index level of 130. The lower panel shows the simulated The simulated values f o r 1984 and

values o f key explanatory variables.

1985 are based on the s t a f f ' s current Greenbook projections, but are adjusted t o be consistent w i t h the assumption t h a t the value of the d o l l a r w i l l remain constant; the Greenbook forecast i s t h a t the d o l l a r

w i l l depreciate by roughly 15 percent by the end o f 1985.

The simulated

values f o r 1986 through 1990 were derived by making s i m i l a r adjustments t o an e x t r a p o l a t i o n o f the Greenbook projections, which assumed f a i r l y

s i m i l a r growth and i n f l a t i o n rates i n the United States and the G-10
countries, and a somewhat higher growth r a t e f o r the developing countries. depress U.S. The assumption o f an unchanged value o f the d o l l a r tends t o growth and i n f l a t i o n and t o stimulate foreign growth and

i n f l a t i o n r e l a t i v e t o the Greenbook forecast and i t s extrapolation. Referring t o the upper panel, the simulated values o f the trade and current account d e f i c t s widen t o around $180 b i l l i o n i n 1990. Much o f the widening o f these d e f i c i t s occurs i n 1984. The diminishing

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year-to-year

changes i n t h e t r a d e d e f i c i t fo 1984 through 1987 m a i n l y rm f i r s t , the wearing o f f o f the lagged e f f e c t s on

r e f l e c t three factors:

t r a d e flows o f t h e d o l l a r ’ s appreciation t o date; second, a p r o j e c t e d p i c k up i n f o r e i g n a c t i v i t y growth and slowdown i n U.S. a c t i v i t y growth;

and t h i r d , t h e assumption t h a t the d o l l a r p r i c e o f o i l w i l l remain constant through 1987, which reduces t e m p o r a r i l y t h e growth i n t h e v a l u e o f imports. S t a r t i n g i n 1988, however, t h e t r a d e d e f i c i t again begins t o

widen by $10 t o $15 b i l l i o n a year, and t h a t u n d e r l y i n g t r e n d would continue i n t o t h e next decade had we extended our simulations. p e r i o d beginning i n 1988 i s one i n which imports and exports are simulated t o be expanding a t f a i r l y s i m i l a r percentage r a t e s , and t h e The

rm u n d e r l y i n g t r e n d i n t h e t r a d e d e f i c i t r e s u l t s fo t h e i n i t i a l c o n d i t i o n
t h a t imports exceed exports by nearly $150 b i l l i o n i n 1988.
It may a l s o

be noted fo t h e c h a r t t h a t t h e d i f f e r e n c e between t h e c u r r e n t account rm and t h e t r a d e balance declines f a i r l y g r a d u a l l y and shows o n l y a small d e f i c i t i n 1990. The explanation f o r t h e gradual d e c l i n e i n t h e c u r r e n t account r e l a t i v e t o t h e t r a d e balance i s s m a r i z e d i n Chart 10, which compares t h e simulated values o f c u r r e n t account components f o r 1990 w i t h data f o r 1983. The l a s t column shows that under an unchanged d o l l a r , our n e t

income from p o r t f o l i o investments ( l i n e 4) would d e c l i n e by $62 b i l l i o n

fo 1983 t o 1990. w h i l e our net income fo d i r e c t investments ( l i n e 5) rm rm
would r i s e by $21 b i l l i o n and our net r e c e i p t s from other services and t r a n s f e r s ( l i n e 6) would increase by $15 b i l l i o n . The d e c l i n e i n n e t

rm income fo p o r t f o l i o investments mainly r e f l e c t s the r a p i d build-up of
our external debt. w h i l e a l a r g e p a r t o f t h e r i s e i n net d i r e c t investment income r e f l e c t s a rebound i n earnings on our e x i s t i n g stock o f

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d i r e c t investments overseas as r i s i n g f o r e i g n economic growth and c a p a c i t y u t i l i z a t i o n r a t e s lead t o a s u b s t a n t i a l pick-up i n p r o f i t s from l e v e l s t h a t r e c e n t l y have been very depressed, and as f o r e i g n i n f l a t i o n increases t h e nominal value o f those earnings. Given t h i s s i m u l a t i o n o f how our e x t e r n a l d e f i c i t s would expand

i f t h e d o l l a r remained around i t s c u r r e n t average value, i t i s n a t u r a l t o
ask whether t h e c u r r e n t s t r e n g t h o f t h e d o l l a r i s sustainable. One

a n a l y t i c framework f o r discussing s u s t a i n a b i l i t y i s t o consider whether v a r i a b l e s t h a t seem r e l e v a n t are p r o j e c t e d t o get b e t t e r o r worse. A

s t a r t i n g p o i n t i s t h e question o f whether t h e s t a t e o f U.S t r a d a b l e goods i n d u s t r i e s would get b e t t e r o r worse. question. Chart 1 helps t o address t h i s 1

Under t h e assumptions o f a constant nominal exchange value o f

t h e d o l l a r and i n f l a t i o n r a t e s s l i g h t l y higher i n f o r e i g n c o u n t r i e s than i n t h e U n i t e d States, p r i c e s o f U.S. t r a d a b l e goods would decline I n o t h e r words,

g r a d u a l l y r e l a t i v e t o p r i c e s o f f o r e i g n t r a d a b l e goods.

although t h e value o f t h e d o l l a r would remain unchanged i n nominal terms,
i t would depreciate g r a d u a l l y i n r e a l terms.

I n t h i s sense, U S .

t r a d a b l e goods i n d u s t r i e s as a group would b e n e f i t g r a d u a l l y f r a n an easing o f t h e pressures that they have been placed under by the s u b s t a n t i a l a p p r e c i a t i o n o f t h e d o l l a r over t h e past several years. The

expansion o f economic a c t i v i t y abroad would a l s o s t i m u l a t e t h e volume o f U.S. exports, which a r e simulated t o recover by 1990 t o a volume n e a r l y Even though t h e volume o f

20 percent higher than t h e 1980 peak.

merchandise imports a f t e r 1984 would r i s e a t almost t h e same pace as exports, t h e c o n t i n u i n g growth o f t h e U.S. c o n t i n u i n g expansion i n U.S. economy would lead t o

t r a d a b l e goods i n d u s t r i e s .

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Although t h e projected s t a t e o f U.S.

t r a d a b l e goods i n d u s t r i e s

does not appear t o suggest that t h e c u r r e n t s t r e n g t h o f t h e d o l l a r i s unsustainable. a d i f f e r e n t p i c t u r e emerges from f o c u s i n g on t h e e x t e n t t o which t h e United States would be r e l y i n g on saving fo abroad. rm I n Chart

12, t h e t o p panel shows t h a t our c u r r e n t account d e f i c i t , o r net c a p i t a l i n f l o w , would be absorbing a growing p r o p o r t i o n o f f o r e i g n net saving. Although estimates o f f o r e i g n saving a r e n e c e s s a r i l y crude, we estimate t h a t w it h an unchanged exchange r a t e t h e f r a c t i o n would r i s e t o about 61/2 percent i n 1984 and 7-1/2 percent i n 1990. The lower panel shows

t h a t our c u r r e n t account d e f i c i t i s expected t o expand t o about 2-1/2 percent o f our GNP t h i s year and would exceed 3 percent o f GNP i n 1990.
I f we extended our simulations beyond 1990, we would expect these r a t i o s

t o continue t o grow gradually, r a t h e r than t o move back toward zero.

An important i m p l i c a t i o n i s i l l u s t r a t e d i n Chart 13.

Based on

the estimate t h a t our recorded external investment p o s i t i o n was $135
b i l l i o n a t t h e end of 1983 (which, as Hr. Hooper suggested, may w e l l o v e r s t a t e t h e t r u e p o s i t i o n ) , and also making t h e assumption t h a t f u t u r e s t a t i s t i c a l discrepancies i n t h e balance o f payments accounts w i l l average t o zero, t h e simulated stream o f c u r r e n t account d e f i c i t s would l e a d t o a n e t debtor p o s i t i o n f o r t h e U n i t e d States o f around $800 b i l l i o n by t h e end o f 1990. Moreover, as i n d i c a t e d i n t h e lower panel,

t h e stock o f our net external debt would expand by 1990 t o about 14 percent of t h e GNP a v a i l a b l e t o service t h e debt, and t h a t r a t i o would n o t l e v e l o f f over t h e foreseeable f u t u r e . The prospect o f a r i s i n g r a t i o o f e x t e r n a l debt t o GNP over t h e foreseeable f u t u r e i s t h e basis f o r t h e s t a f f ' s view t h a t t h e c u r r e n t s t r e n g t h of t h e d o l l a r i s not sustainable over t h e long run.

As

-12-

h i g h l i g h t e d i n Chart 14, i n our view, and consistent with a n a l y t i c models o f steady-state equilibrium, an essential requirement f o r s u s t a i n a b i l i t y i s t h a t our external investment p o s i t i o n r e l a t i v e t o GNP must s t a b i l i z e . O the assumption t h a t f o r e i g n GNP and wealth variables w i l l grow a t n about the same r a t e as U.S. GNP over the long run, our s u s t a i n a b i l i t y c r i t e r i o n i s a l s o a requirement f o r s t a b i l i z i n g the share o f U.S. t h e p o r t f o l i o s o f foreign wealth holders. debt i n

As an approximation, meeting

the s u s t a i n a b i l i t y c r i t e r i o n requires t h a t the d o l l a r depreciate, i n r e a l

terms, s u f f i c i e n t l y t o eliminate the trade d e f i c i t .

With the trade

accounts roughly i n balance, the growth r a t e o f the stock o f net external debt would be approximately equal t o the nominal i n t e r e s t rate, since the change i n t h e external debt

-- namely,

the current account d e f i c i t

--

would be approximately equal t o net investment income payments, or t o the stock o f debt m u l t i p l i e d by the nominal i n t e r e s t rate. Thus, t o t h e

extent t h a t the nominal i n t e r e s t r a t e can be expected t o be approximately equal i n the long run t o the growth r a t e o f nominal GNP, w i t h the trade accounts roughly i n balance over the long run, the growth rates o f external debt and nominal GNP could be expected t o be approximately the same, thus s a t i s f y i n g the s u s t a i n a b i l i t y c r i t e r i o n . The issue o f s u s t a i n a b i l i t y should be distinguished fran considerations of d e s i r a b i l i t y , which are also highlighted i n the chart. I n the short run, the strength o f the d o l l a r and our current account d e f i c i t provide several benefits. Our current account d e f i c i t reduces

the upward pressure on domestic i n t e r e s t rates t h a t would develop if l a r g e federal budget d e f i c i t s and growing p r i v a t e domestic demands f o r c r e d i t had t o be financed fran domestic saving alone. growth of U.S. Moreover, the

imports has expansionary e f f e c t s on economic a c t i v i t y

-13-

abroad and eases t h e process o f adjustment i n c o u n t r i e s burdened w i t h debt. Over t h e l o n g e r run, judgements about d e s i r a b i l i t y can be framed

i n terms o f two questions.

To what extent i s borrowing from abroad
And i s

l e a d i n g t o g r e a t e r c a p i t a l formation i n t h e U n i t e d States?

borrowing by t h e United States c o n s i s t e n t w i t h an e f f i c i e n t and e q u i t a b l e a l l o c a t i o n o f w o r l d saving

--

t h a t i s , w i t h w o r l d saving being channeled

i n t o c o u n t r i e s where i t can be invested most p r o d u c t i v e l y , o r where i t i s d e s i r e d t o support consumption l e v e l s t h a t a r e considered t o be a p p r o p r i a t e on t h e basis o f w e l f a r e judgements? While these issues o f d e s i r a b i l i t y a r e important, a more c e n t r a l focus o f our p r e s e n t a t i o n today i s on t h e i s s u e o f s u s t a i n a b i l i t y . which Mr. Henderson w i l l now address f u r t h e r .

- 14-

Dale W. Henderson P a r t 111

According t o t h e a n a l y s i s presented by Mr.

Isard, i f t h e

f o r e i g n exchange value o f the d o l l a r were t o remain a t i t s c u r r e n t h i g h

.. l e v e l , t h e US

e x t e r n a l p o s i t i o n would be unsustainable,

i n t h e sense

t h a t our n e t external debt would continue t o r i s e r e l a t i v e t o our GNP. Such a n a l y s i s has l e d many observers t o conclude t h a t sooner o r l a t e r t h e r e will be a s u b s t a n t i a l drop i n t h e exchange value o f t h e d o l l a r . Therefore,

I w i l l f i r s t discuss t h e i m p l i c a t i o n s o f two p o s s i b l e paths o f

d o l l a r d e p r e c i a t i o n t h a t are shown i n Chart 15. I n each case, t h e d o l l a r ' s d e p r e c i a t i o n i s assumed t o be caused by a s h i f t i n market sentiment against t h e d o l l a r w i t h no change i n US .. o r f o r e i g n economic p o l i c i e s . r e a p p r a i s a l o f the U.S. This s h i f t might result frm a negative

e x t e r n a l p o s i t f o n o r a r e d u c t i o n i n "safe haven" The path o f gradual d e p r e c l a t i o n i s t h e p a t h

demand f o r d o l l a r assets.

p r o j e c t e d by t h e S t a f f i n t h e Greenbook p l u s an extension through e a r l y 1988. Along t h i s path t h e d o l l a r f a l l s fo i t s c u r r e n t l e v e l t o about rm

i t s average l e v e l f o r t h e f l o a t i n g r a t e p e r i o d through 1980 d e p r e c i a t i o n o f about 30 percent.

-- a t o t a l

Depreciation could f o l l o w t h i s p a t h I f

a l l p r i v a t e agents g r a d u a l l y revised t h e i r views about t h e prospects f o r
t h e d o l l a r o r i f some groups r e v i s e d t h e i r views l a t e r than others. Another p o s s i b l e path i s t h e path o f r a p i d depreciation. Along t h i s

path, t h e d o l l a r f a l l s over two years from i t s c u r r e n t l e v e l t o one t h a t

i s roughly consistent w i t h a s u s t a i n a b l e e x t e r n a l p o s i t i o n
d e p r e c i a t i o n o f about 45 percent.

-- a t o t a l

T h i s path might be generated by an

abrupt change i n o p i n i o n about t h e i m p l i c a t i o n s o f t h e c u r r e n t value o f t h e d o l l a r f o r our e x t e r n a l p o s i t i o n .

-15-

The e f f e c t s o f t h e two d e p r e c i a t i o n s on t h e US .. p o s i t i o n are shown i n Chart 16.

external

As shown i n t h e t o p panel, both t h e

gradual d e p r e c i a t i o n and t h e r a p i d d e p r e c i a t i o n c o n t r a c t t h e c u r r e n t account d e f i c i t r e l a t i v e t o the l e v e l i m p l i e d by an unchanged d o l l a r . However, as shown i n t h e bottom panel o n l y t h e r a p i d d e p r e c i a t i o n generates a sustalnable U.S. e x t e r n a l p o s i t i o n by stopping t h e d e c l i n e The d e p r e c i a t i o n

i n the e x t e r n a l investment p o s i t i o n r e l a t i v e t o GNP. required f o r s u s t a i n a b i l i t y

is l a r g e r t h a n t h e one that would be

necessary t o r e t u r n t o h i s t o r i c a l exchange r a t e r e l a t i o n s h i p s because i t must compensate f o r a permanently lower l e v e l o f demand f o r our e x p o r t s by both developed and developing countries.

Chart 17 shows some o f t h e e f f e c t s o f t h e two h y p o t h e t i c a l

.. d e p r e c i a t i o n paths on t h e US

economy.

As shown i n t h e t o p panel, U.S.

r e a l GNP i s i n i t i a l l y higher w i t h t h e d e p r e c i a t i o n s than w i t h an
unchanged d o l l a r because t h e depreciations s t i m u l a t e demand f o r US .. goods. However, r e a l GNP i s subsequently lower because demand i s choked

off by i n t e r e s t r a t e increases.

The average annual growth r a t e o f r e a l

GNP along a l l three paths i s about 3 percent.
The bottom panel i n d i c a t e s t h e e x t e n t t o which t h e depreciations a f f e c t t h e r a t e o f consumer p r i c e i n f l a t i o n b o t h d i r e c t l y , through t h e p r i c e o f imports, and i n d i r e c t l y , through t h e l e v e l of econcinic a c t i v i t y . The i n f l a t i o n rate, l i k e r e a l GNP, i s f i r s t h i g h e r

and l a t e r lower than w i t h an unchanged d o l l a r .

I n 1985 and 19R6,

i n f l a t i o n i s 2 percentage p o i n t s h i g h e r w i t h t h e gradual d e p r e c i a t i o n and
3 percentage p o i n t s higher w i t h the r a p i d depreciation.

For both

d e p r e c i a t i o n s t h e l e v e l o f consumer p r i c e s i s always higher.

-16-

As shown i n Chart 18. g i v e n an unchanged path o f money, t h e
i n i t i a l increases i n GNP and p r i c e s l e a d t o s u b s t a n t i a l increases i n t h e Treasury b i l l rate. These increases e x p l a i n why r e a l GNP i s The

e v e n t u a l l y lower f o r a t i m e than w i t h an unchanged d o l l a r .

d e p r e c i a t i o n s have c o n t r a c t i o n a r y e f f e c t s abroad; weighted average f o r e i g n r e a l GNP and consumer p r i c e i n f l a t i o n are lower throughout t h e s i m u l a t i o n horizon. So f a r I have discussed t h e i m p l i c a t i o n s o f exchange r a t e changes t h a t might r e s u l t f r a n a s h i f t i n market sentiment w i t h no change i n economic p o l i c i e s . The gradual d e p r e c i a t i o n by i t s e l f does not appear

t o be enough t o s t a b i l i z e t h e r a t i o o f t h e e x t e r n a l investment p o s i t i o n t o GNP by 1990. However, t h e gradual d e p r e c i a t i o n combined with

p l a u s i b l e p o l i c y a c t i o n s can achieve t h i s r e s u l t . i m p l i c a t i o n s o f two p o s s i b l e p o l i c y scenarios. c o n t r a c t i o n w i t h no change i n monetary p o l i c y .

I w i l l consider t h e

The f i r s t i s a f i s c a l The second i s a change i n

t h e p o l i c y mix. t h a t i n v o l v e s t h e same f i s c a l c o n t r a c t i o n accompanied by

a monetary expansion s u f f i c i e n t t o keep r e a l GNP roughly unchanged.

In

b o t h cases, t h e f i s c a l c o n t r a c t i o n represents a 40 percent r e d u c t i o n i n t h e s t r u c t u r a l budget d e f i c i t beginning i n 1986. Chart 19 shows how t h e two p o l i c y a c t i o n s a f f e c t t h e exchange v a l u e o f the d o l l a r .

As you have already seen, t h e d o l l a r depreciates
I t s value i s even

s i g n i f i c a n t l y along t h e gradual d e p r e c i a t i o n path. lower w i t h t h e p o l i c y a c t i o n s

-- an average

o f 4 percent lower w i t h t h e

f i s c a l c o n t r a c t i o n and 1 percent lower w i t h t h e change i n p o l i c y mix. 1

The d o l l a r i s lower with t h e p o l i c y a c t i o n s because US ..
a r e lower.

interest rates

- 17Chart 20 shows how both p o l i c y a c t i o n s r e i n f o r c e t h e e f f e c t s o f t h e gradual d e p r e c i a t i o n alone on t h e U.S. external p o s i t i o n .

As

i n d i c a t e d i n t h e t o p panel, both actions l e a d t o s u b s t a n t i a l narrowing o f t h e U.S. c u r r e n t account d e f i c i t i n t h e l a s t f i v e years o f t h e decade. interest

These reductions occur because the value o f t h e d o l l a r and U.S. r a t e s are lower with both actions. lower w i t h t h e f i s c a l contraction. I n a d d i t i o n , U.S.

GNP and p r i c e s are

The e f f e c t o f t h e change I n mix i s

g r e a t e r than t h a t o f t h e f i s c a l c o n t r a c t i o n because t h e decreases i n t h e value of the d o l l a r and U.S. i n t e r e s t r a t e s are so much larger.

As

i n d i c a t e d i n t h e bottom panel, combining e i t h e r p o l i c y a c t i o n w i t h a gradual d e p r e c i a t i o n y i e l d s a roughly sustainable e x t e r n a l p o s i t i o n . With t h e f i s c a l c o n t r a c t i o n t h e U.S. e x t e r n a l investment p o s i t i o n

r e l a t i v e t o GNP stops d e c l i n i n g by t h e end o f t h e s i m u l a t i o n period. With the change i n mix that r a t i o a c t u a l l y s t a r t s t o r i s e . Some o f the e f f e c t s o f t h e two p o l i c y actions on t h e U.S. economy are s u n a r i z e d i n Chart 21.

As shown i n t h e top panel, with the

change i n p o l i c y mix, r e a l GNP f o l l o w s t h e gradual d e p r e c i a t i o n path by assumption. With t h e f i s c a l c o n t r a c t i o n alone, r e a l GNP i s below t h e

gradual d e p r e c i a t i o n path from t h e f o u r t h q u a r t e r o f 1985 on by an averge of one percent. The bottom panel shows t h e impacts o f t h e p o l i c y a c t i o n s With t h e f i s c a l contraction,

on the r a t e o f consumer p r i c e i n f l a t i o n .

i n f l a t i o n i s i n i t i a l l y higher than w i t h o u t it, because o f t h e a d d i t i o n a l depreciation of the dollar. However, t h e e f f e c t s o f t h e a d d i t i o n a l

d e p r e c i a t i o n a r e t r a n s i t o r y , and i n f l a t i o n i s e v e n t u a l l y lower because o f t h e reduced l e v e l o f economic a c t i v i t y . With t h e change i n p o l i c y mix.

t h e increase i n i n f l a t i o n i s more pronounced and longer l a s t i n g than w i t h

- 18-

t h e f i s c a l c o n t r a c t i o n because t h e r e i s even more a d d i t i o n a l depreciation. According t o t h e t o p panel o f Chart 22, w i t h t h e f i s c a l c o n t r a c t i o n t h e Treasury b i l l r a t e i s lower by an amount t h a t reaches two percentage points. The b i l l r a t e i s lower because nominal GNP i s lower.

The change i n p o l i c y mix generates a much more r a p i d and l a r g e r drop i n t h e p a t h o f t h e b i l l r a t e because i n t e r e s t r a t e s must f a l l by enough t o keep t h e path o f GNP unchanged i n t h e face o f t h e f i s c a l contraction. These decreases i n t h e i n t e r e s t r a t e e x p l a i n why b o t h p o l i c y a c t i o n s cause a d d i t i o n a l d o l l a r d e p r e c i a t i o n and why t h e change i n mix causes more. The bottom panel o f Chart 22 shows t h a t b o t h p o l i c y a c t i o n s generate s i g n i f i c a n t improvements i n t h e f e d e r a l budget d e f i c i t . With

t h e f i s c a l c o n t r a c t i o n t h e d e f i c i t i s reduced by an amount t h a t reaches $95 b i l l i o n by t h e end o f t h e s i m u l a t i o n horizon. The r e d u c f i o n i n t h e

a c t u a l d e f i c i t i s less than the r e d u c t i o n i n t h e s t r u c t u r a l d e f i c i t because t h e decrease i n nominal GNP leads t o a loss i n t a x revenues t h a t more than o f f s e t s t h e d e c l i n e i n i n t e r e s t payments. With t h e change i n

p o l i c y mix, t h e d e f i c i t i s reduced by an amount t h a t reaches $140 b i l l i o n by 1990. The r e d u c t i o n i n t h e actual d e f i c i t i s g r e a t e r than t h e

r e d u c t i o n i n t h e s t r u c t u r a l d e f i c i t because t h e p r i c e l e v e l and, t h e r e f o r e , nominal income and t a x revenues are higher and because i n t e r e s t payments are lower. Both p o l i c y a c t i o n s have r e l a t i v e l y small e f f e c t s abroad. The

US ..

f i s c a l c o n t r a c t i o n s l i g h t l y reduces f o r e i g n r e a l GNP and f o r e i g n I n t h e case of t h e

i n f l a t i o n d u r i n g t h e l a s t f i v e years o f t h e decade.

.. change i n t h e US

p o l i c y mix

-- o f t e n suggested by Europeans -- f o r e i g n

r e a l GNP i s roughly unchanged compared t o j u s t a gradual d e p r e c i a t i o n

-19-

w h i l e f o r e i g n i n f l a t i o n i s reduced by somewhat l e s s than 1 percent on average over t h e simulation period.

e Let m summarize t h e presentation we have made t h i s afternoon.
The enlargement o f the U.S. c u r r e n t account d e f i c i t i n t h e 1980's can be p r i c e competitiveness recovery

d i r e c t l y a t t r i b u t e d t o t h e sharp reduction i n U.S.

and, t o a l e s s e r extent, t o t h e r e l a t i v e s t r e n g t h o f t h e U.S. and reduced imports by developing countries.

I n turn, these developments

can be t r a c e d i n l a r g e p a r t t o changes i n monetary and f i s c a l p o l i c i e s a t home and abroad and, i n t h e case o f t h e r e d u c t i o n i n p r i c e competitiveness, t o a s h i f t i n asset preferences i n f a v o r o f t h e d o l l a r . I n our view an unchanged d o l l a r exchange r a t e i m p l i e s a U.S. external p o s i t i o n t h a t i s not sustainable i n t h e long run because our net e x t e r n a l debt would r i s e f a s t e r than our nominal

GNP.

Our scenarios i l l u s t r a t e several ways i n which t h e r a t i o o f o u r
e x t e r n a l investment p o s i t i o n t o

GNP could be s t a b l i z e d by 1990.

One

p o s s i b i l i t y i s an abrupt s h i f t i n market sentiment away fo t h e d o l l a r rm t h a t generates a r a p i d d e p r e c i a t i o n of t h e d o l l a r by 45 percent from i t s current high level. Another p o s s i b i l i t y i s a more gradual s h i f t i n

sentiment away from t h e d o l l a r t h a t takes t h e d o l l a r down t o h i s t o r i c a l average l e v e l s combined with one o r another p l a u s i b l e U.S. macroeconomic

p o l i c y a c t i o n t h a t takes the d o l l a r somewhat lower f o r a t o t a l d e p r e c i a t i o n o f 35 t o 40 percent. F i n a l l y , I would l i k e t o emphasize t h a t our scenarios are intended t o be i l l u s t r a t i v e o f t h e general process o f c o r r e c t i o n : s t a b l e r a t i o of net external debt t o a

GNP could be achieved by other

combinations o f changes i n sentiment about t h e d o l l a r and p o l i c y a c t i o n s

here and abroad.

Moreover, a s t a b l e r a t i o need not be achieved by 1990.