The United States is about to get a much tighter fiscal policy, thanks to Gramm-Rudman. Since the massive federal budget deficits of the early 1980s have been widely blamed for almost every imaginable economic ill, one might expect that this tightening of U.S. fiscal policy would improve performance across the world economy. Unfortunately, that expectation is badly misguided, and the imposition of the Gramm-Rudman deficit reductions will cause serious problems abroad unless budget policies in Europe and Japan become significantly more expansionary.
Massive U.S. Treasury borrowing and a restrictive monetary policy in this country produced high real interest rates. This attracted huge capital flows from abroad, bidding the dollar up sharply and leaving the United States with a 1985 trade deficit of $148.5 billion.
This trade deficit has had devastating effects on U.S. agriculture, mining and a range of manufacturing industries, encouraging an outbreak of protectionist sentiment. As the United States shifts toward a tighter budget and an easier monetary policy, real interest rates should fall, capital inflows should decline and the dollar should depreciate to the levels of the late 1970s. Then U.S. tradable goods industries should recover. It seems so simple, but unfortunately it isn't.
The problem is that our trade deficit is the rest of the world's surplus, a surplus that has recently been a major source of economic growth in Europe and the developing countries that don't produce oil. As the U.S. current account (merchandise trade plus services) deteriorated by more than $100 billion between 1981 and 1984, current account results in those non-oil developing countries improved by $65 billion. Industrialized countries other than the United States had a gain of $72 billion over the same period.
As the United States adopts a set of fiscal and monetary policies that should bring the dollar down sharply and significantly improve its trade account performance, the effects abroad will be decidedly harmful unless simultaneous policy adjustments occur in Japan and Europe. A $100 billion improvement in the U.S. trade balance means a trade-account deterioration and loss of aggregate demand of that amount in foreign countries. If no other policy changes occurred, the European recovery from the recession of the early 1980s would be slowed or halted, and the improved economic performance in many of the non-oil developing countries would be reversed.
The prospects for debtor countries in the Third World would be particularly grim. Their exports would be hurt both by the improved U.S. current account and by slower growth in their European markets. Since these debtor countries are critically dependent on growing export revenues to pay interest and principal to U.S. banks, debt-servicing problems would worsen, and some large banks in New York could be in serious trouble.
The appreciation of the U.S. dollar that results from larger federal deficits largely drains the expansionary impact of those deficits out of this economy through a worsening of our trade balance. But the parallel improvement in the trade accounts of foreign countries means that this expansionary impact is drained into their economies. Europe and the non-oil developing world cannot afford such a restrictive shock at present.
The United States has played the role of Keynesian "locomotive" for the rest of the world for four years, but the costs of playing this role have been very large in terms of an overvalued dollar, devastated export-and import- competing industries and mounting indebtedness to the rest of the world. Since 1982 the United States has squandered a net creditor position of well over $100 billion and is now accumulating net indebtedness at the rate of about $120 billion per year.
The rest of the world has benefited from our playing this role, but the costs to the United States have been excessive. The problem is how to eliminate these costs to the United States without pushing Europe toward a recession and the debtor developing countries toward bankruptcy.
The answer is a tightening of the U.S. budget that is coordinated with an easing of fiscal policies abroad, particularly in Japan and Germany. If the stronger industrialized countries cut taxes or increase government expenditures by total amounts that match the reduction of the U.S. deficit under Gramm-Rudman, aggregate demand in the world economy will be approximately unchanged. This pattern of adjustment would avoid a recession in Europe and a deterioration of trade balances and debt-servicing abilities in the developing countries. Only Japan and West Germany now have sufficiently strong fiscal situations to undertake such a policy shift, so the major burden of adjustment must fall on them.
Unfortunately, Japan and Germany now have budgetary policies that are moving in exactly the wrong direction. Austerity has been imposed in both countries, bringing deficits down sharply. Their deficits fell from an average of about 3.9 percent of GNP in 1981 to 1.4 percent of GNP in 1985 and are expected too fall further in 1986.
If existing German and Japanese fiscal policy trends are maintained, the major tightening of the U.S. federal budget required by Gramm-Rudman will have dangerous effects abroad. The reduction of U.S. deficits must be accompanied by a reversal of the fiscal policies being pursued in Bonn and Tokyo. It is time for our stronger allies to take on the role of Keynesian "locomotive" as the United States gives it up.