CHALLENGES OF MACRO POLICY IN THE OPEN U.S. ECONOMY

CHALLENGES OF MACRO POLICY IN THE OPEN U.S. ECONOMY

WILLIAM POOLE. ROBERT EISNER, ALLEN L. SINAI, MICHAEL R. DARBY*

POOLE: I am Bill Poole, the moderator of our session this afternoon. Our topic is “Challenges of Macro Policy in the Open U.S. Economy.” Chal- lenge is a very nice word. We are going to hear a lot about challenges during the next four months. It is one of those favorite political words, and we are going to put some economics content into it here. We have a panel, and the idea is to put Bob Eisner from Northwestern University out front since he is listed as our speaker. Then we are going to have potshots taken by Allen Sinai and Michael Darby.

We have a well-balanced panel. We have Robert Eisner. a pure academic. We have Allen Sinai from the private sector, The Boston Company, and Brandeis University. I guess we could call him a semi-academic. And we have Michael Darby, who at the moment is a former academic in the Depart- ment of the Treasury. Maybe we could call him a quasi-academic. I am not sure what we call academics in the government. I guess that when I was there, I was called a lot of things.

EISNER: We should have some fun, and I will try to provoke you. I will begin by suggesting that we shun dogma, establishment wisdom, and popular prejudices and misconceptions. We must know what we are measur- ing and about what we are talking.

As we imagine what our macroeconomic policy should be and what problems we face, I suggest that the bottom lines on which we want to focus are employment and real output-for now and for the future. Real output should be measured more broadly than merely by GNP, but GNP or net national product would be a start. We must examine employment and unemployment, and we must examine the growth of product. That means we must examine investment4efined broadly-and measure it correctly.

I am going to argue that many of these things have been done incorrectly. As economists, we tend to have theoretical constructs. We assume that the figures we are using fit the constructs and then go from there. I am going to give a brief analysis of what has happened and discuss what our macroeconomic policy has been, how it has functioned, and how perhaps we should change it.

*This is an edited transcription of a panel session at the 63rd Annual Western Economic As- sociation International Conference, Los Angeles, June 30, 1988. The panelists, in the order listed, are Professor of Economics, Brown University, Providence, R.I.; Professor of Economics, Northwestem University, Evanston, Ill., and 1988 President of the American Economic Associa- tion; Executive Vice President and chief Economist, The Boston Company, New York and Ad- junct Professor of Economics and Finance, Brandeis University, Waltham. Mass.; and Assistant Secretary of Treasury for Economic Policy, U.S. Department of the Treasury, Washington, D.C.

1 Contemporary Policy Issues Vol. VII, January 1989

2 CONTEMPORARY POLICY ISSUES

To begin, we keep talking about budget deficits. Everybody is against them, and it is conventional to denounce them. As I have pointed out, Republicans denounced Democratic deficits for half a century. Ih not sure whether Republicans really won any elections over deficits, but Democrats always were discomforted. Except for brief occasions such as President Kennedy’s famous speech at Yale in 1962, when he tried to correct the myths, the usual attempt was to look the other way. So Democrats were delighted when, during the 1980s, they had a chance to attack Republican deficits. That left nobody to try analyzing what a deficit is, how we measure it, when it is a real deficit, (or, with sale of assets, a decrease in net worth) and how it affects the economy.

A deficit for anybody involves an increase in debt. That should be an increase in the real value of debt. If we view it the latter way, we find that the so-called government budget deficits, in real terms, frequently have not been deficits.

The supposed deficits during the Carter years actually were real surpluses since an inflation tax was eating into the real value of government obligations-and thus into the assets of the private sector-by considerably more than the nominal deficit.

A second point of correction is tremendously important. In its budget accounting, the federal government has a curious practice-unlike any sensible accounting practice-of not separating capital from current expenditures. The usual claim is that when we have a deficit, we are living beyond our means. Well, are we living beyond our means when we invest in a new house, or in new plant and equipment, or in construction? Private individuals and businesses think not-they see such expenditures as an important kind of saving. But the federal government makes no distinction between capital expenditures and current expenditures. If we put the federal government budget on the same basis as that of a private business, we would have to knock about $70 billion off the deficit by substituting capital consumption allowances or depreciation for capital expenditures. The Office of Management and Budget puts these investment expenditures into that special analysis “D” of the budget document.

Third, we should take into account state and local government surpluses. We then would get quite a different picture.

With all these corrections in mind, I will spend a minute or two on all the nonsense regarding Social Security-on this new chorus of cries, “Oh, we can’t count the Social Security surpluses building up. They’re separate.” This is as if one thing you eat goes into one part of your stomach and so you can discount it and leave it out. In fact, of course, surpluses are surpluses. They have a major impact on the economy.

We must reckon with the impact of any move to eliminate the deficit on the rest of the account so as to validate the Social Security surpluses. That would mean establishing a set of surpluses on the unified or total budget.

POOLE et al.: CHALLENGES OF MACRO POLICY 3

EISNER FIGURE 1 Adjusted Deficit and Change in GNP

Note: The greater the price-adjusted high-employment deficit (broken line). the greater the subsequent growth in GNP (solid line).

But again, contrary to the conventional wisdom and to the assertions of some of our colleagues, that may have nothing to do with building up capital and thereby providing benefits for those retired in the future.

Indeed, our macroeconomic policy should be concerned not only with full employment-that is, using all our available resources and developing our resources-but also with our rate of national saving, correctly measured, and providing for not only the present but also the future. But we will see that many conventional arguments are turned on their heads.

Now, let me put you to work. First, note figure 1, which goes back to my book from a coupIe of years ago. You may wonder why, if deficits have been so bad, the sky hasn’t fallen and disaster hasn’t struck. In fact, if we make the inflation adjustment for the deficit and then relate the adjusted high employment or cyclically adjusted deficit to the subsequent growth in GNP, we can see a beautiful relation.

When the deficit is higher, the subsequent growth in GNP is greater. When the deficit is lower, the subsequent growth in GNP is lower or actually is

CONTEMPORARY POLICY ISSUES

EISNER FIGURE 2 Adjusted Surplus and Change in Unemployment

A ,“, surplus or Deficit

1--------- \

\

Note: Smaller surpluses or greater deficits (broken line) go with reduced unemployment (solid line).

negative. And, if GNP goes up more when we have a bigger structural deficit adjusted for inflation, then we can imagine that the unemployment rate will go down more. You see just that in figure 2, which shows a similar beautiful relation-in this case, between the surplus and the unemployment rate.

The next canard to dispose of is the notion that although the deficits may stimulate the economy, because they allow us to consume more, we must be reducing investment. I am dismayed! I wonder-perhaps I am showing my age-what has happened to 50 years of macroeconomic teachings since the General Theory. There is some notion in the “new economics**-which I hope is becoming old again-that if we reduce consumption, then we will get more investment. I did not learn it that way, and I don’t think many of you did. Don’ t forget it, then.

If we tax people more so that they cannot buy Chrysler cars, Lee Iacocca is not going to go ahead and invest more in Chrysler facilities. And generally, as appropriate theory would tell us, less consumption in our economy leads not to more investment but to less investment-and more consumption leads


EISNER TABLE 1 Real High-Employment Budgets, Changes in Monetary Base, and Changes in

Commnents of G W

DCOM, = bolXl + bmXz + blPAHES,-, + b2DMB-I X, = 1, X , = 0 fort = 1962 ... 1966 X, = 0, X , = 1 fort = 1967 ... 1984

Regression Coefficientsb

Constants 1962 1%7-

Component 1966 1984 PAHES,-, DMB,, (COW (boll (boz) (bl) (bz) 2' D-W 6 Consumption 3.401 2.339 -0.642 2.393 0.580 1.91 0.092

(0.675) (0.303) (0.263) (1 S92)

Investment 2.613 1.135 -1.383 3.587 0.570 1.99 0.282 (1.176) (0.541) (0.414) (2.411)

Government 1.195 0.483 -0.113 -0.660 0.354 1.52 0.473 (0.558) (0.270) (0.172) (0.981)

Net Exports -1.615 -0.766 0.399 1.625 0.512 1.45 0.836 (1.273) (1.012) (0.137) (0.811)

GNP 6.208 3.371 -1.568 7.172 0.735 2.03 0.174 (1.295) (0.585) (0.479) (2.830)

Domestic Demand 7.405 3.934 -2.141 5.149 0.767 1.93 0.155 (1 S06) (0.675) (0.560) (3.295)

'From Eisner (1986, table 9.8, p. 110). bLeast squares with Coduane-Orcutt fist-order autoregressive corrections. Standard e m m are

DCOM = change in component as percentage of GNP. PAHES = price-adjusted high-employment surplus as percentage of GNP. DMB = real change in monetary base as percentage of GNP. I? = adjusted coefficient of determination. D-W = Durbin-Watson ratio. i, = autoregression coefficient.

in parentheses.

to more investment. Budget deficits, which have stimulated the economy and stimulated consumption, have also stimulated investment.

All of this is shown in table 1, where indeed we can now bring in another element of macroeconomic policy: monetary policy. We find that both the inflation-adjusted, high-employment surplus or deficit and the change in monetary base were related, in ways we might have expected, to the change in GNP. That is on the fourth line from the bottom.


We see that for the high-employment surplus, we get a coefficient of -1.568 that is highly significant. This confirms what the chart showed-that larger deficits are associated with subsequent larger increases in real GNP. We also get a highly significant coefficient for the change in monetary base to confirm what all of us-except monetarists who believe that money doesn’ t matter in the real world-would expect to see.

What I really want to emphasize, however, is that these relationships have various components. Not only GNP rises following a larger deficit. As we anticipated, consumption also rises. There is that negative coefficient. But then look at the coefficient on investment-on gross private domestic investment. That also rises substantially. In fact, these numbers suggest that with a large deficit, we get an even bigger bang out of investment than we do out of consumption.

However, if we look at the net export line, we see that the surplus has been associated with an increase in exports. This means that the deficit has decreased net exports. (The dependent variables here all are expressed as percentages of GNP.)

So, then, what does the historical record show as indicated by these regres- sions-in this case, from 1962 to 1984. and with some going back to 1955? We find that larger deficits have been associated with more consumption and more investment, but with a declining position in trade balance and net exports.

We have heard that we have been on a consumption binge. This leads loose thinkers to assert that we thus have been sacrificing the future-that we have been consuming at the expense of investment.

Table 2 shows shares of real GNP. I just heard a fine paper by Lipsey and Kravis (1988) reminding us of the distinction between real shares and nominal shares. The prices of capital goods in the United States apparently are cheaper than they are in other countries, and they are going down. But some people like to frighten us with figures that show the nominal shares of investment in GNP. They also try to trick us by looking at net investment and net saving. I should spend a moment or two to denounce that measure, which I believe reflects the vagaries and eccentricities of our measures of capital consumption and depreciation considering, among other things, the changing tax laws.

But look at the shares of real GNP from 1979 to 1987. By the way, lest Michael Darby or anybody else thiuk otherwise, I’m not particularly a defender of the Reagan administration. But facts are facts. We will first start with consumption: The consumption share went from 62.8 to 65.4 percent from 1979 to 1987. But the investment share-that is, gross private domestic investment in real terms-held constant at 18 percent. The business fixed investment share went down slightly from 1979 to 1987.

But again, if we look at the 1983 figures, we get the essential truth The one way to knock the hell out of investment is to have a recession, and the


EISNER TABLE 2 Shares of Real GNP (percentage)

1973 1979 1983 1987

Personal Consumption Expenditures Gross Private Domestic Investment Business Fixed Investment Government Expenditures for

Goods and Services Federal Defense Non-defense

State and Local Net Exports

Exports Imports

NIA (percentage of GNP)

bond rate minus current percentage change in gross fixed investment implicit price deflator)

Real Exchange Rate Two Years Earlier

Federal Budget Surplus or Deficit,

Real Interest Rate (corporate Aaa

61.6 19.0 11.6

20.6 8.4 6.2 2.2

12.2 -1.1

8.8 10.0

+0.6

1.9 n.a.

62.8 18.0 12.2

19.1 7.4 5.1 2.3

11.7 +0.1 11.2 11.1

+0.4

-0.1 93.1

65.4 15.4 11.0

19.8 8.4 6.3 2.1

11.4 -0.6 10.6 11.2

-5.2

12.2 100.8

65.4 18.0 11.7

20.2 8.8 6.9 1.9

11.4 -3.5 11.1 14.7

-3.4

7.5 132.0

Source: Economic Report of the President, February 1988, and Economic Indicators, April 1988.

one way to have more investment is to have a full-employment, high-growth economy. Thus, the investment will be forthcoming without idiotic gimmicks such as tax credits and other distortions of the market system.

Again, you really can see the big switch that we have had-that is, a consumption binge, if one can call it that, going from 62.8 to 65.4 percent of GNP. It has not been at the expense of investment. It has been at the expense of our net foreign position, or net exports. We have had a huge increase in the deficit in our current account. Net exports went from +0.1 percent in 1979 to -3.5 percent in 1987.

That leads a lot of people to talk about these twin deficits as if they are related. In the New York Times this morning (June 30, 1988), Leonard Silk wrote about the twin deficits and how we must correct the budget deficit to correct the current account or trade deficit.

We had one huge budget deficit in 1983-5.2 percent of GNP. Indeed, for the unified budget, it was more than 6 percent in 1983. Now, it really is only a little more than 3 percent. So those who are terribly worried about


the deficit can at least take comfort in the official measure. It is about half of what it was as a ratio of GNP. But with that 5.2 percent budget deficit in 1983, we had a net export close to balance-only 0.6 of 1 percent of GNP negative. In 1987, when the deficit was down, net exports were down to 3.5 percent negative. The overwhelming difference-and I h surprised that more economists don’t recognize the importance of these relative prices- was the exchange rate.

Now, make allowance for the usual J-curve-the fact that it takes a couple of years for exports and imports, and particularly imports, to react. Take the real exchange rate two years earlier. In 1983. it was 100.8. By 1987, it was one-third higher, or 132.

If we are really worried about the trade balance or the current-account balance, we can do two simple things. One is to go ahead willy-nilly and reduce the budget deficit-raise taxes or cut expenditures so that people cannot buy as much. Then we won’t buy as many Chryslers or Chevrolets, and we won’t buy as many Toyotas either. Our trade deficit will decline. In other words, we can cure the trade deficit if we have a big enough recession or depression.

The other way is to make the Federal Reserve stop trying to defend the dollar-stop keeping interest rates high to defend the dollar. Let the exchange rate go where it may. Don’t encourage foreign central banks that want to try keeping the dollar high. Then the trade deficit ultimately will take care of itself.

I have a parenthetic note here since so many people worry over what would happen if the foreigners decided to withdraw their funds. How many of us have heard that the foreigners are going to “pull the plug”? That suggests the most elementary kind of misunderstanding on international accounts-which, I must say, too many economists seem to share.

The foreigners invest here when we have a current-account deficit. They cannot help it. If we buy a Toyota, they accumulate dollars. When we pay for the Toyota, the Japanese get dollars. Now, what they do with the dollars is another issue. Do the Japanese want to keep the dollars in a checking account and get no interest? I think they are too smart for that. They might buy government bonds. They have not bought a huge number, but they might. They might buy motels, stock, oil wells, or all types of things.

But foreign investment in the United States simply is the other side of the coin of our current-account deficit. This means there is no way that foreigners can pull their dollars out of here unless we run a current-account surplus or they use their dollars to buy our assets abroad.

A lot of confusion exists here since the individual investor says, “of course I can pull my money out.” Anyone can pull money out of the stock market simply by selling the stock to somebody else. Similarly, the Japanese can sell their dollars to other Japanese and get yen for them. Or maybe they will

POOLE et a].: CHALLENGES OF MACRO POLICY 9

find some lucky Germans who want to take the dollars and give deutsche marks to the Japanese.

We cannot change that net capital position unless we change the current account except for one important qualification: If all the foreigners try to sell their dollars, then what happens? Just as when we all try to sell our stock in the stock market, the dollar goes down in value.

And curiously, then, we are saved, one may say. We do not owe as much to foreigners, and they have taken the beating. They have accumulated all these assets. If they try to recover in their own money and they cannot, then they simply drive down the value of their investments here.

That leads me to two other points, and then to some conclusions as to where we should go from here. First, I should be talking more about national saving since that tends to be the focus of most people. We hear this over and over: The disaster of our policy is that we are borrowing from the future and putting this huge burden on the future. Somehow, we forget that our one real connection to the future is the capital we bequeath-all kinds of capital, and not just the pieces of paper.

I have been working a good deal on a “total income system of accounts.” Remember that what we usually think of as capital-that which goes into gross, private, domestic investment and business investment-really is only the tip of the iceberg.

Table 3 shows that in 1981, total business tangible capital came to $5.5 trillion. The total of all capital includes household capital, which is critical in this country-all of our automobiles, television sets, washing machines, and houses-and also includes government capital and the intangible capital of education, research, and health. These items are enormous, and in 1981 total capital came to some $23 trillion.

So when we are concerned over saving for the future, we must look at this total capital. If we are concerned over the future, then we do not want to reduce the budget deficit by ceasing to replace our bridges, build our roads, educate our people, or do research. That would be the most idiotic way of trying to provide for the future. If we cut those things in the name of cutting the deficit, we would be doing exactly the opposite of what we should be doing.

Finally, I want to readdress the matter of foreign investment. I must con- fess that some people keep objecting to my message. A lot of people say, “That is a very interesting idea. I wish I could believe you. But we should reduce the budget deficit.” I need a finishing line.

In fact, I’m not really against reducing the budget deficit-it just depends on how it is done. One argument I hear again and again is, “Look what has happened to our position with the rest of the world. That is a national dis- grace or calamity. We are the world’s greatest debtor nation.” I trust all of you saw the latest figures just out for 1987. We have added another $99 billion to our “net debt to the rest of the world.” It is up to what some people


EISNER TABLE 3 Capital Stocks, 1981, and Average Annual Percentage Real Change

in Capital, 1945-1981a

Component of

Capital

1981 Billions of Current Dollars

1945-1981 Average Annual

Percentage Change (1972 dollars)

Business 6,085.9 Tangible 5,528.9 Intangible (R&D) 557.0

3.616 3.262 8.782

Nonprofit 248.2 3.487

Government 2,220.4 1.340

Government Enterprise 476.3 3.784

Household 14,626.0

Intangible (human) 10,676.3 Tangible 3,949.7

4.566 5.094 4.398

Total 23,746.4 3.857

‘From Eisner (1985, tables 13 and 14, p. 47).

consider a staggering $368 billion. But the figure does not make sense-it is not what people think it is. It is not “debt” to the rest of the world, as some commentators call it. It is, of course, the difference between Depart- ment of Commerce figures on the value of our assets in foreign countries and those on the value of foreigners’ assets here. Most of that is not debt. It includes motels and stocks and all types of other things.

I just heard a nice paper by Dewald and Ulan (1988), who work for the Planning and Economic Analysis Staff of the State Department. They point out, as I do with my figures, that the Department of Commerce measures the value of many U.S. assets in foreign countries at original cost. Of course, it also measures the value of similar foreign assets in the United States at original cost.

The rub is that most of our “direct investment” assets result from investment quite some time ago. The foreign investments here are more recent. When we correct both and then correct for the fall in the value of the dollar during the past two years, the picture is altered greatly.

Paul Pieper and I have made some detailed corrections. I’ll give you a hint as to where our preliminary estimates are heading. (For later results, see Eisner and Pieper, 1988.) Moving from the book value of our direct investment in foreign countries entails corrections on the order of $350 billion. When we make the same correction on the foreign direct investment here,


we need not make an exchange rate change and so the correction is only about $50 billion. That is roughly a $300 billion difference.

Let me give you another correction on the Treasury accounts. Do you know at what price they value our gold? It is part of our positive balance since presumably it relates to the claims that the foreign central banks have on us. The official accounts value our gold at $42 an ounce, which comes out to about $11 billion if we consider the Federal Reserve report. I have not calculated as of yesterday, but there is going to be about another $100 billion difference if we value the gold at market.

Politician after politician and too many of our colleagues tell us that we are the world’s greatest debtor nation, but we simply are not. The market value and gold corrections together virtually wipe out the U.S. “debtor nation” status. True, if we go on with the current-account deficit of $150 billion a year for five more years, then we will “owe” $750 billion. At a 4 percent real rate of interest, which I would hope is extravagant, that is $30 billion a year. Some may say, “My gosh, well have to pay $30 billion a year to these foreigners on their investments in the United States.” Well, it may look like a big figure, but not to economists. We will have a $6 trillion economy, and so that $30 billion will be only one-half of 1 percent of GNP. I would suggest that that’s not the stuff of national disaster.

If we try to eliminate the $30 billion by reducing the deficit or adopting a constraining fiscal policy-let alone, God forbid, having protectionism- to reduce our imports, then a 1 percentage point increase in unemployment would cost us about 2 percentage points in GNP, my estimates suggest. That should put matters in perspective.

Yes. we should concern ourselves with national saving. Our macroeconomic policy should be concerned with maximum consumption, employment, and output not only now but also for the future. That maximum provision for the future should come first, obviously, by providing full employment. I do consider 5.6 percent unemployment a vast improvement over 10.7 percent. I do not consider 5.6 percent unemployment to be full employment.

I do not know why so many economists, most of whom are old enough to remember, forget that we once had a 4 percent target before the political winds changed. I believe we had 3.5 percent unemployment in 1968, just 20 years ago. And I don’t think you will find that the world has really changed to make that unreachable now.

But given the full employment that will maximize private investment, we should have an easy monetary policy. We should stop the nonsense of trying to hold up the value of the dollar-stop trying to fight inflation by repress- ing the economy. We have not had a peacetime excess demand inflation in this country-certainly not in my memory, and perhaps not during this century. We have had excess demand inflation, but it has been connected with wars.


I am afraid that Allen Sinai may disagree with me since I know he has charts and forecasts indicating that demand inflation has occurred. I have seen his newsletters, which are well done, but I differ with him here. And many other people as well will tell us that signs of inflation have occurred.

What signs of inflation? Of course, prices may go up if we have a drought. Certainly, we do not want to try killing that price increase by clamping down on the economy. Prices may go up some because of a drop in the exchange rate, and that certainly should be allowed to take its course. We do not want to combat that inflation. There is no excess demand inflation here. Again, I insist that hardly, if ever, have we had any in this country, except in connection with wars.

In any event, I certainly would take my chances. Roger Brinner of DRI this morning put out charts indicating that an easy money policy would knock about 2 percentage points off the rate of unemployment and would increase inflation by about one-half of 1 percent in a couple of years. Even if I believed that, it certainly is a trade-off I would accept gladly.

I would suggest, then, that we need an easy money policy that would- and I finally make my concession here-reduce the deficit and do so in the healthy way it should be done. That is, we should reduce the deficit by reducing Treasury interest payments. Each percentage point decrease in interest rates would cut some $20 billion off the deficit. We should reduce the deficit by stimulating investment and the economy. We should reduce the deficit because if we pull the plug and let interest rates decline, then we no longer would be supporting the dollar. The lower dollar would increase exports and also stimulate the economy.

I think that our economy has room for expansion. It still has that difference between 5.6 and 3.5 percent unemployment. And if Itn wrong and we begin to get a bit more inflation, then as economists, at least, we should not be guilty of money illusion.

There are ways to fight inflation, and these should be undertaken in terms of the usual deregulation and competition. We know that we have got a drought. I wonder whether we are going to stop subsidizing grain exports. That would be one way to keep grain prices from going quite so high, but that may be one big lobby to fight.

So that is my story: Invest more-invest, by the way, in public capital. I would let private individuals invest as much as they wish. I would not try forcing them to save more. But the big story on investment and providing for the future-which private individuals cannot control-is what the government does regarding our infrastructure, regarding research, and regarding education. If we keep those things in mind, I think that we can build a suc- cessful macroeconomic policy.

POOLE: One thing I particularly like about Bob’s presentation is his careful attention to the data. I think that is a true mark of a healthy science.


But I also think that he has thrown out plenty of red meat for our panelists to go after, and we will let Allen Sinai start.

SINAI: I will avoid potshots since I do want to go to the Dodgers game-Bob is taking me to the Dodgers game tonight. Also, I have stopped eating red meat and I’m watching my diet-lots of fish.

Let me touch on four challenges to macroeconomic policy in an open economy for the next two or three years. I think that in doing so, I will al- lude to several of the issues that Bob talked about.

All the challenges for the next few years have an important international dimension. This dimension has arisen only over the past decade. That is. the role of international economies and of international financial markets in practical business, in financial markets, and in economists’thinking is much more paramount now than it might have been 10 years ago.

Some of the challenges that I will mention are very familiar-that is, old. Some are new and unfamiliar. But all of them require policymakers to understand and take account of the international dimension: the growing open- ness of our economy, the growing interrelatedness of the world economies, the growing maturity of Far Eastern economies, and the new trends in Western Europe. Policymakers must take account of something even more striking, at least to me: the increasingly tight and interrelated global financial markets, the quick movements of flows of funds, and the importance of what international investors do with their money now that they have so much of it.

Also, international financial markets in various countries are becoming more open. This is very new. We would not have thought much about it just 10 years ago.

I want to review a little history, as Bob did, through perhaps a somewhat different framework regarding the role of deficits. But I would ask the question: Who can deny the importance of the international dimension or global factor-however one may define that-following the turbulent 1978-1988 period, when an increasingly open U.S. economy in an environment of flexible exchange rates changed the contextual backdrop of practical macroeconomic affairs and, I hope, of analyses?

During the early 1980s. we had massive fiscal stimulus-let’s call it loose fiscal policy-rnixed with a tight monetary policy. By the way, that mix is very unusual in our history, as described in a paper by Andy Brimmer and myself (1986). That particular mix produced a booming economy during 1983-1984. There were massive tax cuts, a good-sized military buildup, and high nominal and real interest rates. The magnitude of the fiscal stimulus- a legislated $750 billion of tax cuts, a $250 billion rise in defense spending, and planned $600 billion reductions of non-defense outlays during 1981- 1985-was immense. The central bank followed a monetary growth target- ing policy during the early 1980s. keeping nominal and real interest rates high. With flexible exchange rates, the dollar rose sharply in this situation,


causing rising imports and decreasing exports. An extra downward push on U.S. inflation occurred because of the rising dollar which, in terms of inflation analysis, was not noticed that much.

My own calculations have shown that the soaring dollar had a lot to do with the falling U.S. inflation rate during the early 1980s (Sinai, 1985). Be- cause inflation went down, that, in turn, helped the dollar in terms of relative inflation rates here and abroad since relative inflation rates, and expectations of them, are part of the money flows that go into the currency markets. The dollar overshot. That overshoot and a strong U.S. economy led to a surge of imports from both a substitution effect and an income effect, fewer exports, and an unprecedented trade deficit. It also led to sizable losses of market share for our basic industries.

For those who make a case for the connection between budget deficits and trade deficits, what I have described is a non-technical exposition of how it happened. It started with loose fiscal policy. There was also a tight monetary policy but, quantitatively, loose fiscal policy had the larger effect of the two. The strong economy and high interest rates were a key to the soaring dollar, which in turn was a key in the developing trade deficit.

The trade deficit process is not symmetrical. Losing markets actually can be easy but, getting them back can be quite difficult. Competitors in trade did not react the same way as did the United States when the dollar rose and the currencies fell. U.S. consumers and businesses remain heavier buyers of overseas goods than before the dollar’s ascent and descent.

During late 1984 and in 1985, the magnitude of the trade deficit grew so much that a major slowdown occurred in the economy. It came in early 1985, just after the presidential election.

The economy slowed down considerably. By all standards, in fact, the manufacturing sector had its own recession, but it had become too small a part of the economy to pull the whole economy down. The result was a trade- induced slowdown, identifiable by February 1985. I don’t recall any other time when the trade side of the U.S. economy got so important that it slowed down the economy into what for a couple of quarters was a growth recession.

The weakness from the manufacturing recession helped depress prices and push down U.S. inflation rates even more for awhile. With commodity prices falling, the agriculture and mining sectors also became depressed. A big chunk of the economy really was in a recessioddepression configuration even though the overall GNP numbers kept climbing.

One consequence of a weak economy-lower interest rates-came with that slowdown. With a still high trade deficit finally came the falling dollar. The Plaza Agreement in September 1985 helped propel the dollar lower and faster, since it codified a policy intent by the G-5 countries to take actions to push the dollar down and the other currencies up. However, the dollar


would have fallen a good deal on its own no matter what happened in Washington.

Most recently, the dollar decline has helped to lift U.S. exports. The up- turn in exports has helped the industrial sector revive. We now have a strong industrial sector and a wave of capital spending occurring in manufacturing. It is a big year for capital spending, mostly in equipment. The U.S. economy now is undergoing a strong upwave, or a period of general prosperity, as the weak areas come back-mainly due to the lever of the falling dollar.

I went through this recitation of history just to provide the flavor of a practical interpretation of open-economy macroeconomics with flexible exchange rates, since that is the appropriate analytical framework, I believe, to understand what has happened during past years. It reflects an international dimension which, until recent years, was not prevalent in textbooks or in discourses among economists.

For policy, taking account of the international dimension should be of more concern now, since open economy macroeconomics is going to remain the way to think about things. One reason is the development and larger role, quantitatively. of the rest of the world in the world economy and financial markets.

The influence that overseas policymakers and overseas investors have on our financial markets and our economy is, in a quantitative sense, no longer inconsequential. Thus, all the challenges that I will now discuss should be thought about in that context.

The first challenge is an old one: inflation and unemployment. It is the perennial trade-off between inflation and unemployment. I think it is back again. It was absent during the 1970% when there was stagflation: inflation and unemployment went up together. The Phillips curve trade-off, if you believe in that, did not exist then. During much of the 1980s. inflation and unemployment both went down. With so much slack and excess capacity in the economy, strong growth could proceed even as inflation rates fell. The slack in the economy was the problem, inviting policies designed to stimulate growth without a by-product of rising inflation.

But now I think that slack no longer is the problem. What is and will be new for policymakers during the next two or three years is that our economy is running out of the slack and excess capacity that existed during the 1980s. Until now, this slack made it easy to keep growing and to accrue big budget deficits, always with some potential for inflation problems later on but never really during the earlier time period.

Figure 1 shows estimates of potential GNP and actual GNP since 1961. The shaded area is the gap, or the difference, in billions of 1982 dollars, between potential and actual GNP. Potential GNP varies over time with capital, labor, energy, R&D, technological change, and real money balances.

Note the tremendous gap in the 1980s. Of course, the figures can be sub- ject to a fair amount of error, but the errors can exist in both potential and


SlNAI FIGURE 1 The “Gap”-Potential GNP minus Actual GNP

(billions of 1982 dollars)

4150-

3513-

2875.

2238.

1600. I I I I I I l l l l l l l l l l l l l l l l l l l ~ 61 62 63 64 65 66 67 61 69 70 71 72 73 74 75 ?6 TI 78 79 80 I1 82 83 84 85 86 87 88

r I 9

Note: “Potential” GNP is estimated as 2.4 percent per m u m at the current time. Historical figures are from 1961:l to 1988:3, and forecast figures are from 1988:4 to 19892. Ihe “Gap” is shaded.

actual GNP. The vertical line is where we are now, with a 2.4 percent growth rate of potential output per annum-up somewhat from 1% years ago. At one point, it was running 3.5 percent. It should go higher during the next couple of years but still remain below the historical average of 3 percent. The gap essentially has been eliminated. Allowing for error, the figure this quarter is only $20 billion. That is a tiny gap. The figure in 1982:4 was $378 billion.

What led me to take another look at this gap was my noticing inflation everywhere. Inflation figures for the past two or three months-or past four or five months-are really accelerating. The CPI has gone up to a 5.3 percent annual rate during the past three months. The PPI is up to a 5.8 percent annual rate. As for wages, average hourly earnings are up 5 to 7 percent, an- nualized, during the past two months.

Some 22 of the states are at 5 percent unemployment rates or below- essentially full employment. I’m not talking about unemployment rates from a social sense-5 percent is too high on that basis. But in terms of unemployment rates that trigger or are associated with accelerating inflation,


price and wage inflation does seem to be showing such a scenario. From the inflation data, it looks as though the natural unemployment rate-if you believe in that concept-is in the 5.5-to-6.0 percent range, which are the unemployment rates in the data recently.

The recent inflation is not just drought-related, either. Food prices are small potatoes in the CPI (17.6 percent) and are not that big in the PPI. In the PPI, the weight is 25.6 percent-23 percent for processed foods.

Regarding capacity utilization rates, one-third of U.S. industries are at peak operating rates or higher compared with the late 1970s. A lack of slack is an old problem, although periodic in nature. We have seen it throughout the postwar history. What does the U.S. do when close to “full employment”? I call it the “full employment zone.” How do we handle this? Policymakers have had to face this question for a long time.

Frankly, policymakers never have figured out how to finesse the full employment zone without developing more excesses, imbalances, and inflation than society has been willing to tolerate. And then, we have had to en- dure high interest rates and a downturn as a result.

The current situation is different. Demand-pull inflation has not been present in our economy for eight or nine years. The challenge for policymakers is how to keep the expansion going without developing too much inflation. The latter forces the kinds of events that no one likes and can bring a recession.

There has been an international dimension to the inflation recently, since much of the surge in economic activity has come off the international side- a consequence of the falling dollar.

What is the standard medicine if we get to full employment? We have a choice: cut the budget, cut spending, raise taxes, raise interest rates, or do any combination of these. Such actions probably are the thing to do here, but this time there would be substantial iuternational effects.

Policymakers’ second challenge concerns deficits and debt. This is a challenge if only because it is a new phenomenon, at least in the magnitudes that present themselves. I would concur with Bob as to the measurement difficul- ties on the international debt side.

If we calculate the budget deficits at full employment, the resulting structural budget deficits are far above previous situations at full employment. Current estimates suggest $120 billion to $130 billion in the structural full- employment budget because of tax and spending changes and other shifts in our economy.

The estimated federal budget deficit at full employment is large, but what does it tell us? It does not say that the deficit is a problem, and I don’t think that we should argue over whether it is a big problem for the real economy until a rising inflation is triggered at near full employment. The deficit is a good thing for growth, as Bob’s chart shows.


The amount of pump priming contained in the deficits-especially the tax cuts-was the most important factor in propelling the economy to so good a year in 1988. The President can leave and say, “Look, we’ve pretty well licked the full employment problem,” and then hand to somebody else the responsibility of dealing with the other side of that problem-inflation.

At close to full employment, large budget deficits as well as a strong private sector are going to generate too much aggregate demand relative to supply. Inflation rates will head higher, interest rates will rise, and the Federal Reserve will have a dilemma. The Fed must figure out what to do to sustain full employment but also must make a stand on inflation-the tradeoff.

This time, however, there is another deficit-an unprecedented merchan- dise trade deficit partly connected to the budget deficit. The two together are quite unusual.

There is no time in postwar history when this combination of big budget deficits and big trade deficits existed at so close to full employment. The budget and trade deficits are improving, but when the debt that goes with these deficits is added up and expressed as a proportion of GNP, some un- usually large numbers result. By 1990, without further significant changes in policies, the debt associated with the budget and trade deficits could be as high as 55 percent of GNP and the interest payments to service the debts about 3 percent of GNP. Three percent of GNP has been the ratio of the unified budget deficit alone to GNP in some postwar years of high budget deficits.

I do not know where all this really leads. And it is time to make the calculations Bob is making to determine the right measurement of deficits and debts . But even if the international debt calculation was cut by $300 billion to $350 billion off gold and market value calculations of direct foreign investment, the trend is clear. So long as the deficits exist, debt will keep adding up. Such total debt as a percentage of GNP has no parallel in history.

In practical terms, what does this mean? How does the challenge posed by the deficits and debt show up in the data? I will just make some obser- vations. One is that we generate a lot of dollars in world markets. Depend- ing on what international holders of dollar assets do with their investments, that may be a negative factor in the status of the dollar.

A falling dollar should help reduce the trade deficit. But a falling dollar has other effects as well, including higher inflation and higher interest rates. It presents the Federal Reserve with a problem of how to prevent inflation above a certain rate. The higher is inflation and the higher are interest rates, the lower is American purchasing power and standard of living.

Most households need at least two working members to make ends meet now and to maintain their standard of living. For most of our young people, shelter is particularly difficult to afford. How many, especially in Califor- nia, can afford to buy a home at existing prices? Young couples must have

POOLE et at.: CHALLENGES OF MACRO POLICY 19

two people working, making a total of $6O,OOO to $70,000 a year, to buy homes costing $150,000 or else call on savings from elsewhere-perhaps from parents. That represents a decline in the standard of living. That so many are working so hard and so long to make enough to spend the way we want to spend is a change in our standard of living.

The current high nominal and real interest rates also is a change. My calculations on how deficits affect interest rates suggest premia of 2 to 2.5 percentage points due to expectations effects from these deficits.

Another empirical observation deals with how the rest of the world per- ceives the U.S. and how the rest of the world allocates its investments. I do not know what to make of these trends-relatively less funds flowing to U.S. financial assets, greater allocations to real assets, and growing trade and commerce within regional blocs. During the past two years, the allocation of funds by foreign holders of dollars has shifted radically-first out of fixed- income securities such as corporate and U.S. government bonds, then out of U.S. stocks, and then very heavily into direct foreign investment, real estate, land, buildings, businesses, and establishing businesses in the United States.

One argument is that these changes are very positive and good for our economy. The other argument is more of a question: What happens as more and more real assets fall into the hands of the rest of the world? What happens to ownership and control? How much leakage of profits and rent occurs and with what consequences? Do these changes lead to sociological and political problems in our country and in relations with other countries?

I do not know the answers. I don’t think that there are theoretical answers. But these trends are occurring and are pronounced in the data. They are occurring because of very large current-account deficits. These deficits must be financed and foreign investors with funds to invest must decide how to allocate assets-among cash, bonds and stocks, and real investments. And they must decide how to allocate assets across the whole world.

As investment opportunities open up for Japanese and German investors in countries other than the United States, there is no reason why they must invest here. As Bob says, they will not suddenly withdraw their assets. That does not happen since markets adjust. What does happen is that asset prices may gyrate wildly. U.S. interest rates will rise if foreign money moves into Canada or into the United Kingdom rather than into the United States-if the money is Japanese, it moves perhaps back to Japan, That can have an effect here.

Market actions in the past year indicate that this influence has been significant in financial markets. It is not just a short-run, day-by-day effect. It is a longer-term effect with which we must reckon.

I will mention two more challenges but will say little more about them since I am more than exhausting my allotted time.

One is a challenge to policymakers regarding what can be done about potential growth. I mentioned that the U.S. potential is now rising at 2.4 per-


cent a year-that is low for the U.S. economy by historical standards. If potential growth could be somehow raised to 3 percent, that would make matters a lot easier. We might not develop any upward pressure on inflation quite so quickly. And, the business expansion could stretch out longer without higher inflation and higher interest rates.

The last challenge is international policy coordination. There is a solution for sustaining the expansion without imbalances and without adding to our productive capacity. The solution, I believe, is a policy mix twist in the framework of an open economy with reasonably flexible exchange rates. The solution has an international dimension.

As the economy approaches full employment, the policy mix must be right. Full-employment budget deficits cannot exist at the same time trade is improving, consumption spending is fairly strong, and capital spending is rising nicely. That would constitute an economy that is too strong and surely would result in too much inflation.

Policies to tighten the budget and ease up on monetary policy would be appropriate-a reverse twist of the policy mix during the early 1980s. Fis- cal restraint need not create a recession in an economy of this size. The easing of monetary policy would cushion the fiscal restraint. Reducing interest rates would likely push the dollar down. But lower interest rates and a lower dollar would permit a crowding-in of trade and also a crowding-in of housing and of capital spending. Potential GMP growth would be more than otherwise. The international dimension would involve policy coordination to reduce the trade imbalances, perhaps through additional fiscal stimulus.

The difference I have with Bob is that policies to sustain full employment should not involve easier monetary policy alone. At this stage, too big a chance with inflation would be a consequence. It would make the expansion go on a while longer but could produce a boom-bust situation.

How do we cut the budget deficit? That is a political problem Washington has been unable to solve. We should have a simple rule. If it is $120 billion of budget deficits that must be reduced, do $50 billion in year one, $40 billion in year two, and $30 billion in year three. In an expectation sense, front- loading the deficit reductions would convince financial market participants that deficit reduction was credible.

Of the $50 billion reduction in year one, one-third should be in defense, one-third non-defense, and one-third taxes. The one-third taxes would not amount to much considering that taxes were reduced by more than $1 trillion from prior law during the past eight years. A $17 billion tax increase is not that hard to do, though $17 billion cuts in each of defense and non- defense would be tough.

Under such a deficit reduction program, market interest rates will come down due to expectations effects. The Federal Reserve then would have to decide whether it must lower interest rates more so as to keep the economy


at an adequate pace of growth. A $50 billion reduction in the deficit would slow growth about 11/2 percentage points, which could be desirable in a fully employed economy.

Well, deficit reduction is easy in concept. It is easy for someone like me to say. Deficit reduction is a lot more difficult to work out in practice.

POOLE: Michael Darby from the U.S. Treasury is going to finish this off. At the Treasury, he is best known as a Federal Reserve correspondent, right? He too is going to tell us why Robert Eisner’s defense of Reagan administration deficits may not be correct.

DARBY: While it never is pleasant to be the cleanup man-and I mean that as in Allen Sinai’s baseball analogy, not in Don Regan’s circus parade context-this is rather an interesting act to follow. First, Bob Eisner showed us many unclothed emperors and empresses in the data, and that was quite enjoyable. Then Allen told us all the conventional wisdom that is pretty much conventional and wisdom. I guess that I like my emperors unclothed, and so I will try to strip a few of them today.

The increased integration of the world’s goods and capital markets certainly has made macroeconomic policymaking more difficult. Furthermore, policymakers too frequently have increased this difficulty by proffering in- accurate causal relations. As a result, they have proposed inappropriate and often counterproductive solutions.

There is a critically important challenge facing policymakers today. It is simply to correctly identify the cause of the problems confronting them so that they can devise effective solutions.

The persistence of the U.S. trade and current-account deficit exemplifies this challenge. A popular interpretation of the U.S. trade deficit is that since it indicates we are buying more goods and services from foreigners than we are selling to them, U.S. producers no longer are competitive in world markets. We have not heard that today, but we are seeing legislation enacted on that basis.

In this view, U.S. labor is too expensive and too unproductive for U.S. producers to compete with foreign producers. In this view, the U.S. trade deficit as a microeconomic phenomenon has engendered proposed solutions that miss the point and in some cases would be counterproductive-closing markets instead of opening them to international trade.

Another popular view-one that we have heard today-is that the U.S. trade deficit is a product of the U.S. federal government deficit: the so-called twin deficits or twin towers. In this view, specifically, the unprecedented federal deficits have driven up U.S. real interest rates and attracted foreign capital flows into the United States.

The trade deficit is another name for the number that we sometimes call net capital inflows, and so greater inflows can happen only if the trade deficit goes up. The price that adjusts to equilibrate the quantities is the dollar exchange rate. Higher values in the dollar exchange rate promote-with a lag-

22

-6

CONTEMPORARY POLICY ISSUES

-

- Ireland

0 -

! I I I I I I ! ! I I 1 !

DARBY FIGURE 1 Budget and Trade Surpluses, 1970-1984

-4t

Total Government Surplus as a Percentage of GDP

higher imports and lower exports, resulting in a large trade deficit. In this popular view, the proposed solution obviously is to reduce the budget deficit.

When we examine the data, however, the twin towers hypothesis fails the “ha ha” test. National saving clearly does not move in tandem with changes in the government deficit. As a pointed example, GNP last year increased by about $250 billion. Some of this increase was due to increasing transitory income or falling unemployment, if you prefer. So we would expect a private saving increase of $20 billion to $30 billion. The total government deficit- government dissaving-fcll by about $40 billion.

Twin towers adherents should expect national saving to have increased by the total of these two numbers, or $60 billion to $70 billion. In fact, national saving increased by only half this much, or about $33 billion, which is little more than would have been predicted from GNP growth alone. I will return to this, but this type of evidence indicates that something like Ricar- dian equivalence undoes most of the effect-whether for good or for ill- on national saving of changes in the government deficit.


Nor does cross-country analysis support the twin towers deficit argument. As figure 1 indicates, the close relationship frequently hypothesized between government budget deficits and trade deficits is not apparent for the OECD countries. Randomly selected pairs of trade and budget deficits are more likely to have the same sign than are those deficits that actually occurred. The hypothesis is a lousy predictor.

The proponents of the twin deficits arguments seemingly have relied too heavily on manipulating national income identities. We must dig a little deeper to determine more accurately the nature of the underlying relationships. The government budget deficit has turned out to be a convenient scapegoat.

If, however, the trade deficit is not the result of too expensive and too unproductive labor, or of the federal deficit, then the solutions based on these explanations will be ineffective. More important, they may injure the economy.

I would like to explore a third explanation today: The trade deficit is due mostly to increased investment demand from 1981 through 1985. The national income accounts report one number summarizing the U.S.’s external position. As I noted before, we may call this number the current-account or trade balance, or net capital inflows. But the same number also is the difference between national investment and national saving. Countries with trade surpluses are those for which investment opportunities are relatively weak compared with national saving. Countries with strong investment demand relative to national saving run trade deficits.

This occurs for the same reason that companies in a dynamic industry find it profitable to issue stock or debt to finance expansion while firms with limited expansion opportunities invest excess retained earnings in securities issued by other firms. It is literally impossible for the trade deficit to fall unless investment falls relative to national saving.

Thus, the trade deficit is fundamentally a macroeconomic problem requiring macroeconomic solutions if we are to deal with it effectively. What really has occurred in the United States is that foreigners have been financing more factories and other investments here than Americans have been financing abroad. Foreign capital has been attracted by a dynamic and growing US. economy, which has provided more investment opportunities than U.S. national saving can finance.

The flip side of this net capital inflow is a trade deficit and, until early 1985, a strong dollar. In other words, I believe that the United States is running a trade deficit not because it lost competitiveness but that the United States lost competitiveness at the then-current exchange rates because it had to run a trade deficit to finance high investment.

Policies that improve the competitiveness of particular industries without affecting the saving-investment relationship will not reduce the trade deficit. They are like squeezing a balloon-the bulges simply appear elsewhere.


DARBY FIGURE 2 Gross National Investment and Saving

(as shares of current-dollar GNP) .

I 19

18

17

16

15

14

Gross lnvestmen 13

12 1950 1955 1960 1965 1970 1975 1980 1985

As figure 2 shows, saving and investment in the United States tended to move together during the postwar period until the early 1980s. Since then, investment has been at a rather high level as a share of GNP while saving has been quite low. How do we interpret this experience?

The changes in tax law and regulatory climate inaugurated with Reagan in 1981, and the dramatic decline in the inflation rate shortly thereafter, greatly increased investment demand in the United States. This is particularly the case for the key business fixed investment portion, as figure 3 shows.

This increased desire by both U.S. and foreign investors to invest in the United States was reflected first by higher real interest rates and an appreciat- ing dollar and then, following the usual two-year lag, by an increase in both the trade deficit and the gap between investment and national saving.

It is important to note that both the rise in real interest rates and the ap- preciation of the dollar predated either the increase in the federal deficit or any expectations of higher future deficits. Reagan was expected to reduce Carter deficits. Hence, the twin deficits argument also does not hang together as a matter of timing.

POOLE et al.: CHALLENGES OF MACRO POLICY

DARBY FIGURE 3 U.S. Gross Investment as a Percentage of GNP

Percent Pel

Total Private Domestic Investment

BC

'. *- :**ma*

: * Capacity Utilization 3 m ~ m * am

-**- (Fight Scale)

25

ent

90

ao

70

60

Note: Capacity utilization data prior to 1967 are for manufacturing sector only.

The wider trade gap resulted not only from higher investment but from a decline in both personal saving and national saving. Robert Gillingham, John Greenlees, and I have estimated two consumer expenditure functions based on two measures of income capable not only of explaining saving and expenditure behavior during the postwar period but also of forecasting out of sample into the 1981-1987 period.

We did not pick the basic model out of air post hoc. It is basically my 1975 consumer expenditure function. We refer to one model as the Ricar- dian model: It is sort of a gussied-up version of my basic model since it em- bodies the Ricardian theory that private saving will offset government dissaving .

We refer to the other model as the traditional model. This is the basic 1975-vintage model that focuses on more traditional income measures. The upper panel of figure 4 contains the actual personal saving rate from 1981


DARBY FIGURE 4 Personal Saving Rates

Actual and Predicted Saving Rate as a Percent 01 GNP

I

3%

2%

- Actual ..-. Traditional Prediction Ricardian Prediction

Equaltons EShmaled 47.1 lo 87'4

I l l I l l I l l I l l I l l I l l I l l Actual and Out-of-Sample Predictions

4% 1 I

EqUalims Estimated 47:l lo 80:4 I I I I I I

through 1987 along with the two predicted saving rates derived from our consumer expenditure equations, which include 1981 through 1987 in the es- timation sample. The lower panel presents out-of-sample predictions for equations estimated only through 1980.

You need very good eyes to tell the difference between the two predictions since they essentially are the same results within the 1981-1987 period. I think figure 4 demonstrates that normal, fairly standard macroeconomic relations can adequately explain the atypical behavior of personal saving during the 1980s. That is, the atypical behavior of saving reflected the atypical behavior of the underlying variables.

As indicated by their names, the two models of consumer behavior predict very different long-run responses to government deficits. Unfortunately, as the almost overlapping predictions illustrate, the explanatory powers of the two models are virtually identical so that we cannot determine which long- run solution is more likely to evolve. Both models, however, provide similar interesting insights into short-run and medium-run saving behavior.

First, the striking implication of this analysis is that the reduction in the national saving rate during the 1980s was not caused primarily by increased


federal deficits. Instead, our analysis explains the drop in both the personal saving rate and the national saving rate as largely the result of, first, below- trend growth in personal income and, second, a reversal in the downward secular path of real per capita money supply.

Second, both models indicate that changes in government spending on goods and services, on the one hand, and changes in taxation net of interest payments and other transfers, on the other hand, have very different impacts on national saving in the short run. In particular, a spending decrease has approximately four times the short-run impact on national saving as does a tax increase-about 80 cents versus 20 cents on the dollar. Thus, if we were concerned over the effect of the federal deficit on national saving, we would attack the deficit by reducing spending and not by raising taxes.

Let me turn briefly to the federal budget deficit itself. By one estimate, over the past 12 months, 382,671 trees gave their lives to newspaper and magazine stories about the serious problem of the government deficit. The amazing thing to me is how difficult it is to convince someone to take the problem seriously enough to think about how the deficit got to be so large. It apparently is easier to denounce the deficit than to understand it.

The most surprising result that our recent work supports is that the business cycle and compounding high interest rates-not changes in tax structure or programmatic spending-are the primary causes of the 1982-1983 jump in the federal deficit.

By early 1988, the cyclical component of the deficit was all but eliminated, but government outlays remain at high levels both for interest payments and for structural non-interest expenditures. Balance of structural non-interest outlays and receipts has been achieved this year. A substantial surplus would emerge if real outlays were held constant for several years- a quite feasible goal.

With the structural non-interest deficit in balance, both total debt and total deficit fall relative to GNP because GNP growth normally exceeds the after- tax interest rate. Further progress in achieving a structural non-interest surplus will accelerate the trend decline.

Clearly, the trade deficit now is declining. Beginning with the third quarter of 1986, there was a period when we could point only to the real deficit to show the decline. But lately, we have seen the nominal deficit also show substantial progress. Much of this improvement has resulted from the general depreciation of the dollar since early 1985.

Several factors have tended to lower the dollar, in my view. Tax reform, first proposed in early 1985 and enacted in fall 1986, raised taxes paid on U.S. capital. Some of the US. tax cuts enacted during the early 1980s. we may remember, went further than had been planned, primarily because inflation fell more and more rapidly than had been anticipated. This rapid disinflation increased greatly the value of the accelerated depreciation allowances.


Simultaneously, business taxes were being lowered and the business climate was improving abroad, and this appreciated foreigners’ currencies as it had done earlier to ours. Further, as the increase in the U.S.’s relative share of the world capital stock was fulfilled, the demand for new investment naturally declined to more normal levels. Finally, in 1987, the Reagan administration managed to decrease substantially the government deficit, most importantly by actually reducing the level of real federal spending-a remarkable achievement. This helped increase the rate of national saving to some extent.

To summarize, the evolution of the U.S. trade deficit during the 1980s was the product of neither the government deficit nor a sudden and dramatic decline in the competitiveness of U.S. producers. It primarily reflected increased investment opportunities in the United States accompanied by lower domestic saving rates resulting from rational responses to temporarily low income levels and, later, increased real money balances.

The challenge facing policymakers has been and continues to be to correctly identify the factors behind the trade deficit so that we can avoid proposing inappropriate and potentially deleterious policy responses.

POOLE: Who has a question? DAVIS: My name is Larry Davis, from the University of Montana. I’d

like Professor Eisner to address a few questions. One real problem seemingly is the difference between nominal and real

interest rates. This difference seems to be way out of line currently compared with historical relationships. Some suggest that interest rates will fall through easy monetary policy, and others suggest that the rate of price inflation will rise rather rapidly to compensate for this differential. I would like a comment regarding the scenario of closeness between nominal and real interest rates.

Another issue is that we were told the budget deficit really isn’t a problem. We saw the charts indicating that the deficit has been followed by GNP growth and, therefore, that we need not worry too much about it. I have two concerns over that concept.

First, the current debt refinancing costs 17 percent of our budget, and an increasing portion of the debt is held by foreign investors. I heard that we should not worry about that, but I have some concerns over it.

Second, I think economic research will support the view that the redistribution of income has been skewed significantly toward the higher- income groups during the period from 1980 to the present. Some people may question that, and I’d be interested in your response.

But I would like to generalize the response somewhat, so perhaps Profes- sor Darby would expand on that issue. I believe that if we are going to have a huge refinancing of the debt by foreigners, then we might also have a redistribution of income so that we will become even poorer, vis-a-vis other countries, by redistributing our wealth to foreign countries either through


their direct investment or through interest payments, which are relatively high.

We were told not to worry about the investment portion of the deficit since it is going into roads and highways, which we need. I do not believe that is the redirection of expenditures by the Reagan administration. I think that it is being spent on more missiles in the ground.

I am also concerned over the natural rate of unemployment, which you suggested should be about 4 or 31/2 percent. Large numbers of economists believe that is not accurate.

EISNER: Easier monetary policy certainly will reduce the nominal rate of interest in the short run. If it causes some inflation, then it will reduce the real rate of interest even more. The interest payments part of the budget will be reduced if we have a low interest rate.

Foreigners, in fact, do not own a particularly large portion of the federal debt. I don’t think it has gone up from what it was previously, though that is not particularly relevant. Whether foreigners invest in federal debt, in other securities, or in physical assets makes little difference.

Regarding the redistribution of income, Mike didn’t seem to agree but all the figures I’ve seen show that there indeed has been a significant redistribution of income from the lowest groups to the highest groups in the United States. I tend to deplore that, but it was outside of my discussion.

Regarding the question of roads versus missiles, I am against so much defense spending and I am for spending more on roads. I am disappointed that the Reagan administration has been starving our infrastructure.

Regarding the natural rate of unemployment, I deplore the concept. There is nothing natural about unemployment. I believe the notion that there is a non-accelerating inflation rate of unemployment, and that inflation will accelerate if we get below that rate, is one of the monstrous concepts that has been foisted on us with no significant evidence.

It is an extrapolation. We see that unemployment is low, and inflation goes up. Therefore, we somehow project that this is going to be accelerating. In fact, unemployment has gone down substantially and inflation has gone down substantially during the past six or seven years. There is a lot between the cup and the lip on the whole question of unemployment and inflation.

POOLE: Allen? SINAI: The question that I might address concerns high real interest

rates. They have been part of our landscape now for about seven or eight years.

Results of our work suggest that a big chunk of the premium is due to current-market discounting of expected future budget deficits. If such deficits are believed to be permanent, then market investors either fear inflation or fear heavy financing and won’t wait until that actually happens to sell


securities. That tends to push today’s interest rates higher since markets are quick to discount.

Lately in our work, we have found a role for expectations on the trade deficit and on the dollar as well. I believe that these factors combine to produce a 3 percentage point excess premium compared with history. About 2 to 2l/, percentage points of that comes from expectations of future deficits and downside risks on the dollar. Another part comes from the deregulated financial market structure: Funds costs are higher now than before, since financial institutions pay for deposits whereas they didn’t before. These costs get into the interest rate structure.

DARBY: I flew out here with three senators surrounding me and dis- covered that I don’t have what it takes to engage in filibusters. So, unfortunately, I have forgotten part of what I wanted to say before we got to my turn.

I remember, however, that I want to talk about the nominal rates and the income distribution. I want to talk about the nominal rates because now I hear that I am a former academic. I do not expect to have too many other effects named after me, so I believe the concept that income tax shows up in the interest rates is a relevant one to point out.

Real rates are high if we simply subtract the inflation rate from nominal rates. However, the after-tax real rates currently are a little below the average of those for the 1950s and 1960s. For the 1980s as a whole, real after-tax interest rates are-as closely as we can measure them-identical to the average of those for the 1950s and 1960s. The puzzle to me is not why real interest rates are so high now, but why they were so low during the 1970s. That, I believe, is an interesting question. I have some ideas, and Iln sure that other people will, too.

Regarding the income distribution issue, I just want to make a running objection to what has been said. My objection primarily is that we should be talking about the period since 1981. Nearly all of the statistical com- parisons on income distribution or on the burden of taxation turning bad begin in 1977. That was not the Reagan administration, folks. From 1977 to 1981, when things headed south, someone else was in office-I can’t remember his name. But look at the data.

There is one other thing. Income distribution tables show that there has been a shift toward the higher-income occupations, where employment growth is concentrated. But that does not show up in the averages until these new entrants reach their peak earnings years. What does show up, and what I believe is important to recall, is that during the 1980s-particularly in 1986-we had very high realizations of capital gains compared with what we had before, when rates were so high. That does not necessarily mean that true capital gains income, which should be defined as accrued capital gains, has gone up. It merely means that wete induced people to realize those gains and pay the taxes.


EISNER: That doesn’t necessarily mean that capital gains have gone up, but they have gone up greatly-both realized and unrealized capital gains.

DARBY: Taxes paid as a share of Haig-Simons income-that is, accrued income or command over goods-may have increased at the same time that the tax rate on current income declined. So I think that we must look at those statistics with some eye for naked emperors as well.

GOTTLIEB: I am Manuel Gottlieb, University of Wisconsin at Mil- waukee but retired for some years. I am quite unhappy with both Mr. Darby’s and Mr. Eisner’s opposing versions of the deficit, interest rates, and that en- tire complex.

Mr. Darby’s version disturbs me largely because the deficit jumped up during the first four years of the Reagan administration, and that was precisely the period during which interest rates did not go up but were falling from their previous level. This suggests that the expansion of credit-the expansion in money supply-sustained those lower interest rates. That expansion was not represented in any of the charts or data, yet it had a powerful role in producing the 1983-1984 recovery in the United States. It was associated with the large deficit, of course, and with the trade deficit. It also was associated with somewhat higher interest rates, but not with the panic rates of 1978-1979, which were produced largely by the deficit. I would like to ask Mr. Darby how he, with economics training, can imagine that a borrower could go into the credit market and borrow on an immensely larger scale during 1982, 1983, and 1984 without affecting interest rates-and without making the handling of debt more costly.

On the other hand, I would like to ask Mr. Eisner whether he is surprised that this substantial economic recovery has occurred with cheap finance. Relatively cheap finance has boosted national income and increased jobs quite substantially but has left a fairly large deficit.

If we have that deficit during a recovery, then shouldn’t that warn U.S. political leaders to preserve stable economic conditions and the people’s con- fidence so that the latter’s money won’t go to ruin with irresponsible government spending and continual deficits of a monetary character?

DARBY: I don’t know exactly how to respond. During 1981 and 1982, as well as I can recall, government sector interest payments as a percentage of GIW-and that’s what matters-went from roughly 1 percent to roughly 2 percent.

The effects of borrowing on interest rates really depend on from whom we borrow. When I borrow from myself by putting an IOU in one pocket, it really doesn’t affect market interest rates unless I think I am wealthier and thus spend more.

If the people see through the veil of government and see government as a co-op, then lower taxes financed by borrowing means that either they are going to pay higher taxes in the future or they will be unable to consume as much in the future if their consumption goes up now. So if borrowing in-


creases and taxes decrease, then the people should provide an equal increase in savings.

Our evidence shows that the offset of increased private saving for a tax cut is not perfect. We get about 80 percent Ricardian equivalence. So a tax cut financed by borrowing reduces national saving by about 20 cents on the dollar. That resulted in estimates on the order of one-half of 1 percentage point-it varied within a range of 0.3 to 0.7 percent-of GNP as to the reduction in national saving due to the budget deficit. As I suggested in my remarks, there was some effect from the deficit. The effect simply was rather small relative to the 2 percentage point increase in the gap between investment and saving.

EISNER: First, interest rates went down with huge deficits. Interest rates have been coming up again with lower deficits. Interest rates have a tremendous amount to do with Federal Reserve policy. I do not know why people tend to ignore that and look elsewhere for so much of the explanation.

I might make just one point that I didn't make before, I believe it is important to remember that the big Reagan deficits, adjusted for inflation, began during the latter half of 1982. The deficits are much lower now, yet we keep talking about balancing the budget. In any growing economy-whether for an individual, for a firm, or for a government-the appropriate measure of balance actually is that debt stays in proportion to income and that debt does not outgrow income.

If we look at it that way-and that, I believe, is the useful way to look at it-we now are in a state of balance. OMB (Office of Management and Budget) figures show that the debt held by the public, as a ratio of GNP, was 43 percent in 1987 and is projected to be 43 percent in 1988. That is not to say, however, that even such balance is desirable.

Another way of looking at it is that the total gross debt now is about $2,500 billion. If GNP grows at 7 percent, then the debt can grow at 7 percent. A 7 percent growth in the debt would be $175 billion, and that is somewhat more than we have now.

All this talk about financial markets by Allen or anybody else rather ig- nores the reality. In a growing economy, we expect debt to grow: Private debt grows and public debt grows. We m a y want to reduce it, but there is no great reason to panic or to think we cannot sustain indefinitely a growth in the debt no larger than the growth in GNP or income.

SINAI: There is one new factor: The indebtedness on international account, however measured, can change that ratio. I think that the analysis must be amended to ask the question of what is the effect of the other debt in relation to GNP.

EISNER: No. The correct international measure that we should examine is the U.S. net worth vis-a-vis our debt to the rest of the world. That takes into account not only our gold, but all of our assets and our obligations. If

POOLE el al.: CHALLENGES OF MACRO POLICY 33

we look at that, then we find that our net worth has been growing. In fact, the debt to the rest of the world, however we measure it, is a trivial amount compared with total assets.

SINAI: The debt to the rest of the world is not so trivial, market-wise. I believe that you are right regarding the way we should look at the debt. But it would take a long time to convince people who lend money to look at the debt that way. And as a result, market prices do reflect some illusion. The latter gets built into interest rates and everything else and then can have a substantial effect on economic activity.

POOLE: I think that we have time for one more question provided that it is as short as some of the answers.

BRITSKY: My name is James Britsky, Northwestern Mutual Life In- surance, in Milwaukee.

I agree with Professor Eisner. I believe that the budget deficit relative to GNP essentially is in balance and has not been growing. I also think that is the correct measure.

But U.S. non-financial debt relative to GNP has gone from about 1.4 to 1.8 percent during just the past five years. Professor Gottlieb asked what has allowed the private borrower to borrow at such large scales. That is, the U.S. government debt relative to GNP may be rather stable, but the private sector debt is not. We have been borrowing tremendous amounts of money- replacing our equity with leveraged buyouts, making small downpayments on homes, incurring consumer debt, etc. Could you address the debt over- hang of the private sector?

EISNER: To the extent that private individuals or businesses decide to borrow on their own, I am not trying to second-guess them. To the extent that the federal government has strange tax laws making it advantageous to have debt rather than equity, there may be somewhat of a problem. But I am not a doomsayer on this. Perhaps other people see more reason to worry.

POOLE: Session adjourned. Thank you, panelists. Thank you, audience.

REFERENCES Brimmer. A. F., and A. Sinai, “The Monetary-Fiscal Policy Mix: Implications for the Short-Run,”

American Economic Review, Proceedings, May 1986. 203-208. Darby, M. R., “Postwar U.S. Consumption, Consumer Expenditures, and Saving,” American

Economic Review, May 1975, 217-222. Darby, M. R., R. Gillingham, and J . Greenlees, “The Impact of Government Deficits and

Indebtedness on Personal and National Saving Rates,” Working Paper No. 8702, Office of the Assistant Secretary for Ekonomic Policy, U.S. Treasury Department, August 1987.

Dewald, W. G.. and M. Ulan, “Deflating U.S. Twin Deficits and the Net Foreign Asset Position,” paper presented at the 63rd Annual Western Economic Association International Conference, Los Angeles, June 30, 1988.

Eisner, R., “The Total Income System of Accounts,” Survey of Currenl Business, January 1985, 2&48.


, How Real Is The Fecieral Deficit? The Free Press, A Division of MacMillan, New Yo&, 1986.

Eisner, R., and P. J. Pieper, “The World‘s Greatest Debtor Nation?” presented at the American Economic Association meetings, New York, December 1988.

Lipsey, R. E., and I. B. Kravis, “Comparative National Saving and Investment: A Different View,” paper presented at the 63rd Annual Western Economic Association International Conference, Los Angeles, June 30, 1988.

Sinai, A., “The Dollar and Inflation,” Eastern Economic Journal, July/Sept. 1985, 211-220.

Documents

CHALLENGES OF MACRO POLICY IN THE OPEN U.S. ECONOMY