Allies Now Vital to Fluttering U.S. Finance

In the next few weeks America’s industrial allies are going to have to answer two questions. First, is the United States on a path that will lead, sooner or later, to more stable global economic conditions? Second, how prepared are allies to help finance the United States during 1988? The answers to both questions, but especially the latter, will in large part determine whether the economy slips into recession over the course of 1988.

The evidence that can be marshaled to answer the first question is mixed. The U.S. trade and budget deficits remain excessive; the rapid accumulation of foreign and domestic indebtedness continues; the policy-making process is bankrupt--as evidenced by the months-long effort to prevent the 1988 budget deficit from much exceeding the 1987 level. Fundamentally, the U.S. savings rate is inadequate, keeping growth and investment hostage to the inflow of foreign capital.

On the positive side, this foreign influx of capital has helped to finance a resurgence of American manufacturing industry. Partly because of the low dollar but also partly because of industrial restructuring, many U.S. manufacturers are increasing production, creating new jobs, improving profits and rates of return, and increasing sales at home and abroad. Exports are growing steadily, up almost 14% during the first 10 months of 1987 compared to same period in 1986. And imports seem likely to fall as oil prices drop, as worried American consumers reduce purchases of imported luxury goods and as the sharp two-year decline of the dollar continues to work through to prices.

Some good news can even be found in the budget numbers: Federal government spending has slowed appreciably in 1986 and 1987, compared to the five previous years.

On balance, however, governments in Europe and Japan seem reluctant to trust that the vagaries of the U.S. political process will produce or sustain prudent economic policy. They know 1988 is a political year in which no real policy initiatives are possible; they view the possible political successors to President Reagan with little enthusiasm. They are even less inclined to recognize the improvements in the manufacturing sector that are occuring here.

Thus, there is little movement in Bonn, Tokyo or elsewhere toward a coordinated international strategy that would help stabilize global economic conditions while the U.S. continues to chip away at its deficit.

Nevertheless, our industrial allies must also answer the second question--the financing of the U.S. economy. Regardless of what improvements may occur in the trade balance during 1988, the overall current account deficit--the net export of goods and services to the rest of the world--will remain enormous, perhaps as much as $140 billion compared to $155 billion or more in 1987. This deficit must be financed; the issue is at what combination of interest rates and exchange rates.

Essentially, there are only two possible sources of finance: foreign governments or their central banks, and private investors. The foreign governments seem largely indifferent to the return they earn or the dollars they purchase. They buy dollars that the private sector does not want, to keep the value of the dollar higher and the value of their own currencies lower than would otherwise be the case, in order to support their exports and exporters. Private investors, however, quite sensitive to what they earn on their investments, often demand higher interest rates and higher overall returns.

In 1985 the entire current deficit was financed by private investors. By contrast, in 1987 foreign central banks financed the equivalent of about one-third of the U.S. current deficit.

Why does this matter? In present circumstances, if foreign governments refuse additional finance, U.S. interest rates will almost certainly have to rise, even as the dollar falls, to attract private investment. Eventually, a much lower dollar would mean higher U.S. export earnings and lower import payments, thereby reducing the financing need. In the meantime, though, the trade deficit would remain large and, one way or the other, must be financed. If interest rates have to rise too high to attract capital inflows, economic activity would inevitably decline.

Washington wants to avoid a recession, especially in an election year; Bonn and Toyko want to avoid--or at least delay--another round of dollar depreciation. These mutual interests should provide the basis for a new currency pact which, properly designed and implemented, would not only help stabilize currencies, but also sustain global growth. The economic components are clear and have been much discussed: more growth in Germany and Japan, and more saving in the United States, partly through reductions in the budget deficit.

There must also be financial elements. In effect, foreign central banks must renew their willingness to help finance the U.S. economy in 1988, perhaps even in larger volume than in 1987. One U.S. contribution to such finance could be to sell Treasury bills paid repayable in marks or yen. This would signal to the markets America’s willingness to stabilize the dollar and, more concretely, would take some of the pressure off the dollar bond markets. But the bulk of the financing effort inevitably will rest with foreigners.

This would be an unpopular strategy among many American economists who see only unilateral advantage--more American exports--from a falling dollar. But these critics forget the economy’s vulnerability to the whims of foreign investors and the important role that foreign central banks have played in keeping U.S. interest rates from increasing. They also underestimate the risk to global economic stability posed by a constantly declining dollar. As it is seen from Europe, “malign” neglect of the dollar is as threatening in the 1980s as was protectionism in the 1930s.

If finance ministers and central bankers fail to define coordinated financing strategy within the next few weeks, then renewed financial turmoil and, consequently, economic decline will almost surely follow. And that is a prospect no one can want.