America’s fragal New Year

Press, 4 January 1988, Page 12

America’s fragal New Year

the ‘Economist,*

From

London

FOR THEIR own sakes and for the rest of the world, Americans need to tighten their belts in 1988. This simple truth is what every analysis of the country’s huge and intractable trade deficit boils down to. It has been obscured by the befuddling details of budget deficits, exchange rates, foreigncurrency intervention, international economic co-operation and the rest. So much so that in the minds of many American policymakers these complicated things have become ways of avoiding pain altogether, rather than ways of tightening with the least distress. In an election year that delusion is a tempting one for many American politicians. But it is storing up trouble that may not have the good manners to wait until America has chosen its next President. The only certainty is that the feast is coming to an end — one way or another. A country with a big external deficit is, by definition, consuming more than it produces. That can be financed by borrowing for only so long. Then the country has no choice but to consume less or produce more. If it is already working at full stretch, it cannot easily produce more. Therefore it has to consume less. It can do that by dulling its appetite, in which case nothing too drastic need happen. Or it can wait until the plate is rudely snatched away by forces beyond its control. All this is familiar enough to Europeans, who are experts in set-piece balance - of - payments crises. In the 1960 s and 1970 s they learned, above all, that

currency depreciation by itself is not enough to correct an external deficit. America has less experience in this field. That is why, for all its gnashing of teeth over the trade deficit, it has still not grasped that it is in the middle of an oldfashioned European-style balance - of - payments crisis, and that there is no painless way out of it. This is not to say that the dollar’s fall has been pointless. In September, 1987, America exported 15 per cent more in volume terms than in the same month of 1986. Imports, disappointingly, were 4 per cent higher in volume terms, but at least the dollar’s slide has checked their earlier much faster rate of growth. This volume improvement is masked when the trade deficit is expressed in depreciated dollars. Further adjustment will undoubtedly come as America continues to move round its J-curve: export volumes should continue to rise, and import volumes start to fall, as price changes work through to consumers’ decisions. So the devaluation really is working, albeit more slowly than expected. However, there is a limit to 'how much it can do. Currency depreciation switches spending. Thanks to the cheaper dollar, American firms are simultaneously facing stronger demand at home (because foreign goods are becoming less competitive) and in foreign markets (because they are cutting their export prices). But higher demand cannot mean higher output in an economy that is running flat out.

In the European tradition it causes higher inflation instead, which in turn offsets the helpful price effects of the currency depreciation and leaves the exchange rate little changed in real terms. The dollar’s depreciation will not work as it should unless America has, or soon creates, some spare capacity. As of now, it has virtually none. Output in manufacturing — the sector that will need to expand if exports are to rise — is, on most estimates, already approaching 85 per cent of capacity. In the past, higher rates than that have usually signalled rising inflation. America’s unemployment rate is less than 6 per cent; most economists reckon that to be close to “full employment.” So reducing America’s trade deficit' by 1 per cent of G.N.P. a year over the next two or three years will mean cutting the growth of domestic demand to roughly that much less than the rise in total output — say 2 per cent a year against an over-all growth rate of 3 per'cent. That reverses the luxurious pattern of the past few years. Remember, too, that the long period of dollar over-valuation up to 1985 switched new investment in America from manufacturing to services. Manufacturing investment will have to rise sharply if exports are to carry on rising; that will leave even less room for consumer spending withing the feasible rise in. domestic demand. On some estimates the average American’s private consumption will actually have to fall. Those with an excessively de-

terministic view .of financial markets think that this decline in consumer spending was exactly what the crash of October 19 was trying to bring about. The politicians in Washington had shown themselves incapable of decisive action on America’s budget de-, ficit. As a result, domestic demand was set to carry on growing, leaving little prospect of an unforced cut in the trade deficit. By wiping one-third from the value of America’s stocks and shares, Wall Street stepped in where Congress feared to act. Together, the dollar’s fall, the stockmarket crash and Congress’s reluctant budget-cutting are the elements of America’s needed economic adjustment in 1988. But because that adjustment has been so long delayed it is having to happen in a dangerously uncontrolled way. The Administration’s justified fear is that the crash might cut demand so much that it tips America into a full-blown recession. Its first priority, rightly, is to guard against that. But its second priority should be to understand and explain why it will be necessary, nonetheless, to accept a perceptible brake on consumption. By insisting that election-year Americans will be able to consume as much as they would have done if the dollar had not fallen, or if the markets had not crashed, or if the budget deficit had not been cut, the Reagan Administration is really saying that it wants to block the principal means by which those changes can bring the external accounts back into balance.

The policy dilemma is sharpest of all for Mr Alan Greenspan, the chairman of the Federal Reserve. In the immediate aftermath of the crash it was easy enough to know what to do: supply liquidity to guard against’ a slump. Already the balance of risk, as perceived by the markets, is inching back towards .fears of inflation. There are no convincing signs of a slowdown in America. And long-term interest rates are starting to creep up relative to short rates — a sure sign of anxiety about inflation. It is too soon for. the Fed to be sure what it has to do next. It needs more evidence on how nominal demand (money-G.N.P.) is growing before it tightens monetary policy a lot. But it would be wise to give short-term interest rates a nudge up. That would help to stabilise the dollar (which has already fallen further than it needs to), and long-term rates might then fall because of reduced inflationary fears. I In any case the silent Mr Greenspan should start telling the Administration (a) that trying too hard to prevent a slump in 1988 might mean another tumble for the dollar, an involuntary hike in long-term interest rates, another crash on Wall Street and a slump a little later than the one he first thought of; and (b) that acceptance of a moderate fall in consumer spending is the best way to lessen the dangers in (a). Unless Mr Reagan wants those risks to hit the fan during his last year in office, he would do well to agree. Copyright —. The Economist