In folk tales, sometimes a character is punished by being granted his or her wish--because getting what we think we want is often the worst thing that can happen to us. Something like that is now happening to the United States. We all want the trade deficit to disappear, and the latest trade numbers show that it’s finally starting to decline in earnest. But when the trade deficit goes away (or even falls much further), we’ll discover that America isn’t ready for balanced trade.
As everyone except the Republican presidential candidate knows, the trade deficit is a symptom of underlying problems with the U.S. economy rather than a wholly separate problem. In particular, the nation’s plunge into trade deficits in the 1980s reflected the extraordinary decline in U.S. national savings, from 6% of national income in the late 1970s to less than 2% in recent years. This decline in savings, in turn, reflected both the surge in thefederal deficit and a decline in household savings.
Ordinarily, a two-thirds fall in savings would create immediate short-term problems. What is not saved is spent: In the 1980s, personal consumption per worker in the United States has grown almost twice as fast as output per worker. Such a consumption boom normally would have created serious inflationary pressures. To counter these inflationary pressures, the Federal Reserve would have had to raise interest rates to levels that would have crippled the housing industry and discouraged investment across the board.
To everyone’s surprise, however, the collapse of U.S. savings in the 1980s did not have these effects--because a rising trade deficit took the pressure off. When U.S. interest rates started to rise, the desire of foreign investors to put their money in this country sent the dollar soaring; the soaring dollar made U.S. exports less competitive and imports more attractive, and the great U.S. consumption boom, instead of running headlong into the limits of our productive capacity, spilled over into the trade deficit. In other words, the trade deficit acted as a great safety valve that relieved the pressure on the domestic economy.
There is no point in trying to deny the remarkable prosperity of the United States since 1982. Employment, output and consumption all rose, while inflation fell. To many observers it appears that everything about the U.S. economy has been fine except for the trade deficit. This misses the point. Everything has been fine because of the trade deficit, which has allowed consumption to grow faster than output and given us imports at bargain prices.
Since running a trade deficit is so much fun, why should we ever stop? The answer, of course, is that the fun is only borrowed: By running a trade deficit we also run up a foreign debt that must eventually be served by running a trade surplus. The experience of the Latin American debtor nations, which saw foreign-financed booms turn abruptly into painful austerity once they had to service their debt, is an extreme illustration of the kind of problems building up for the United States. And the longer the trade deficit goes on, the bigger the comedown when the party is over. So the sensible advice to the United States is to both raise national savings and stop relying on the trade deficit to cover deficiencies as soon as possible.
And both of those steps need to be taken simultaneously. Reducing the trade deficit without increasing national savings, or vice versa, leads to problems. Raising national savings without cutting the trade deficit would cause a recession; eliminating the trade deficit without increasing savings would close off the safety valve without turning off the heat.
For more than three years the strong dollar, which played a crucial role in generating the trade deficit, has been sinking. This decline partly reflected easier monetary policy, but has mostly happened because of market worries that a much weaker dollar will eventually be necessary to allow the United States to pay its way in the world.
Until recently, however, the declining dollar has had only mild effects. Both U.S. and foreign firms have been made cautious by the exchange-rate roller coaster. Foreign firms, believing that the U.S. market might become profitable for them again if the dollar strengthens, have been reluctant to raise their U.S. prices and lose market share. U.S. firms have been unwilling to take the risk of aggressive moves to recapture markets, fearing that a rise in the dollar may leave them stranded. Yet with the weak dollar persisting, some effects are apparent. The trade deficit has fallen $70 billion since mid-1986. Almost without doubt, there is substantial further improvement already in the pipeline, even if the dollar rises or remains at its current level.
Are we ready for this? The U.S. economy is running pretty much at full capacity. Indeed, given the way that inflation has been creeping up, the evidence of labor shortages and capacity shortages in particular regions and sectors and the lowest unemployment rate in more than a decade, the economy may well be operating above the level of output consistent with a stable inflation rate.
As import prices finally begin to reflect the declining dollar, the trade side is giving us an additional inflationary kick. So we cannot accommodate an increase in the overall demand for domestically produced goods and services. But with foreigners demanding more of our goods, and Americans shifting back from imports to domestic products, the demand for U.S. goods will rise much faster than our capacity unless we restrain the growth in our internal demand.
The right way to restrain the growth in internal demand is by raising our savings rate. Ideally, as the trade deficit comes down, American households will start to save again and--even more important--the new Administration will begin a serious, fairly rapid program of tax increases and a few spending cuts to eliminate the budget deficit. In reality, however, neither situation seems likely. In particular, it’s hard to see how either presidential candidate can fight his way out of the public relations box he has created in time to do anything serious about the budget deficit in the first year of his term.
That leaves it up to the Federal Reserve. Chairman Alan Greenspan does not want to be known as the man who threw away Paul A. Volcker’s victory over inflation. I think we can take it for granted that the Federal Reserve will do whatever is necessary to curb the inflationary pressure generated by the declining U.S. trade deficit. That means sharply higher interest rates, in a U.S. economy that is more debt-ridden than ever before.
My picture of the U.S. economy in 1990 is of a prostrate housing industry, of widespread personal bankruptcies as high interest rates and problems in selling real assets push individuals to the brink, of widespread business failures as highly leveraged firms get squeezed by the credit shortage. The bright spot in the picture will be the buoyant U.S. trade picture. In other words, it will be 1985 upside down: There will be problems everywhere, except for--and because of--the improving trade account.
What can we do to avert this scenario? It’s probably too late to ask the candidates to talk sense. So vote for the man you think will be less embarrassed about facing reality and raising taxes, convert your variable rate mortgage to a fixed rate, and, if you’re thinking about selling your house, do it soon and don’t haggle too much about the price.