Article

Why Does the Current Account Matter?

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1980
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Since the onset of generalized floating in 1973, the current account has largely replaced the balance of payments as a barometer of the need for adjustment in a country’s macroeconomic policies. But while there is a fairly natural presumption that the cumulative balance of payments should equal zero over some specified period, the appropriate analogue for the current account is less obvious. In view of the significance accorded to the current account within official circles and the financial community, it would appear useful to know more about what constitutes its equilibrium level and distribution across countries.

Two criteria—sustainability and optimality—readily suggest themselves as suitable equilibrium concepts for the current account and standards for determining the appropriateness of adjustment action in any instance. Sustainability is ultimately imposed as a condition by external forces: The drying up of sources for financing a deficit presents a clear signal that a particular current account has become unsustainable and that a change in policies is required. More discretion over the timing of adjustment is associated with deviations from optimality, since this objective is motivated by a purely internal consideration, viz., the presumed desire to maximize social welfare, somehow defined. At the same time, departures from the social optimum are less easy to read than the more visible indications from the financial community and involve the exercise of considerably more judgment on the part of those who make policy.

Fundamentally, it is a country’s overall level of savings relative to investment that determines its current account. Hence, any assessment of a particular current account turns on the sustainability or optimality of the magnitudes of these underlying variables. For example, a sustainable current account deficit is one that is consistent with continued financial solvency and economic viability. Even though there is a deficit, the country is not living beyond its means. Rather, it is borrowing abroad to invest and, in so doing, to enhance its future earning power. In different circumstances the same deficit would be unsustainable if the country were borrowing abroad to finance current consumption. Similarly, the optimal current account can be deduced, at least conceptually, from the levels of optimal savings and efficient investment.

While sustainability is of immediate concern to a country’s creditors, it is also important to the country’s trading partners, since departures from it signal the urgency of adjustment measures that will directly affect them. From this perspective the optimal current account is similarly relevant, since a country may elect to change policies to achieve it. Focusing on the external effects of a country’s policies raises the surveillance-related question of the potential for conflict over the international distribution of current accounts. And, although some scope for conflict is possible over countries’ long-run optima, it is more likely to arise in the pursuit of their shorter-run macroeconomic policy objectives. To be specific, one long-run effect of a country’s increased savings is a fall in the worldwide real interest rate. This is likely to produce a decline in the collective current account balance of the rest of the world, but in a benign manner—through an induced reduction in optimal savings and an increase in efficient investment. In the short run to medium run, however, as the world economy proceeds to this new long-run equilibrium, there may be unemployed resources because global investment adjusts only slowly to a level commensurate with the higher rate of global savings. In addition to shortfalls in world demand precipitated by one country’s desire or need to adjust, exogenous forces frequently cause significant departures of investment, in particular, from its long-run efficient level. In both cases, a country’s medium-term current account target may exceed the optimal, long-run level, if its employment objectives would be served by channeling its excess savings into net exports, which, like investment, provide a medium for the productive deferral of consumption. The efficacy of using the current account in this way and—by extension—the scope for mutual inconsistencies in countries’ current account targets, however, depend rather critically on the operative connection between the current account and the level of employment.

Two different views of this connection are prevalent. One is Keynesian. Accordingly, an increase in net exports, prompted either by an exogenous shift in tastes or by a decrease in their relative price through currency devaluation, tends to increase aggregate demand and the level of output if the initial situation is characterized by unemployment. Because the magnitude of the devaluation is subject to discretion, virtually any current account becomes feasible. The desired current account, then, is that which, in combination with actual investment and the desired levels of private and public consumption, yields full employment. Note that under this rubric the current account and the level of employment are related positively. Hence, in a period of widespread stagnation there is clearly the potential for conflict among countries: witness the competitive depreciations and other “beggar-my-neighbor” policies of the 1930s. The alternative view concentrates on labor’s concern about purchasing power. While it would concede that an exogenous increase in export demand could improve simultaneously the current account and employment, it would question the ability of devaluation to achieve this same result because of the ensuing wage/price spiral. This model suggests that only the existence and persistence of slack in the economy will facilitate the requisite decline in relative export prices. Hence, changes in the current account and the level of employment, which policy has the power to effect, tend to be related negatively.

These two competing explanations of the way that devaluation works have decidedly different implications for a country’s desired current account and the degree of potential conflict among nations over the international distribution of current accounts. Yet, to try to determine to what degree each of the alternative theories is operative at present is beyond the scope of this paper. Rather, the purpose is the more limited one of identifying the different facets of the current account, reconciling them analytically, and, in general, developing a fairly broad view of the current account with particular emphasis on its dual role in the adjustment process, that is, as an indicator of the appropriateness of initiating adjustment and as an influence on the selection of specific measures to effect adjustment. Accordingly, the body of the paper elaborates on the analysis outlined here in its rudiments, while reserving one section for a survey of official statements on the current account.

I. Theory

the long run

This section provides a simple theoretical framework that places the current account in a macroeconomic context. It is interesting to see whether or not a particular value of the current account is necessary for the attainment of some long-run goal and is, for that reason, desirable. To this end, the underlying determinants of the actual current account balance are presented first. Because these reduce to the difference between the economy’s savings and investment, the next question concerns their preferred levels. Two criteria are suggested for the former—sustainability of the implied consumption stream and optimality of the implied consumption stream. World savings and efficiency in the international allocation thereof will determine the level of investment in any country. Finally, the nature of worldwide equilibrium and the associated distribution of current balances are indicated.

Determinants

A convenient starting place is the relationship between aggregate output and the components of demand. Equation (1) indicates that net domestic product (NDP) is divided among private consumption (Cp); public and private net investment (I); government spending for consumption-type goods (Cg); and net exports (X – M).

Net domestic product can differ from net national product (NNP) if assets are owned abroad and generate a stream of returns. Noting this, we substitute for NDP NNP minus net foreign receipts (F). Hence,

Substituting net savings (S)1 for NNP minus private consumption minus taxes (T) and rearranging, we have

where G is the government deficit for consumption-type purposes, that is, G = Cg – T. In words, the current account surplus equals the excess of private net savings over the sum of net investment and public (deficit) consumption. From this it may be inferred that the current account surplus will be higher the greater is the accumulation of private wealth, the smaller is the accumulation of capital, and the larger is the budget surplus of the government. Any positive judgment about the long-run sustainability, or normative judgment about the optimality, of the level of the current account derives from corresponding judgments about these variables. 2

Sustainability

Inspection of equation (3) indicates that the same current account is consistent with a number of variations in the composition of aggregate demand. For example, a current account deficit can result from a high level of either investment or the government deficit relative to savings. In the first case, total savings (S – G) may be positive, while in the second it may be negative—yet both exhibit the same current account. Moreover, the former conforms to a pattern of consumption that is within the country’s budget and is, for that reason, “sustainable”—even though part or all of its investment is financed by foreign borrowing. 3 In the latter, the country is borrowing abroad or liquidating assets to pay for the excess of its consumption over its income. As the country’s associated external debt rises without a commensurate increase in its assets, risk of devaluation and to some extent actual default rises, and with it the cost of borrowing. That the same current account deficit is sustainable in one instance and not sustainable in the other suggests that the current account per se is not a good indicator of the need for adjustment. Rather, it is the relationship between an economy’s income and consumption, that is, its savings, that matters.

While we have some basic understanding of what is generally meant by sustainability in the context of discussions about the current account, there is clearly some merit in trying to make the concept both more precise and more operational. Underlying the notion of a sustainable current account is an assessment of the sustainability of the consumption pattern. As noted earlier, a country cannot continue borrowing indefinitely to consume, nor can it continuously spend out of wealth. Hence, a deficit resulting from too much consumption is not sustainable in the long run, although it may be sustainable over a variety of short periods. For a consumption level to be sustainable over the long run, the economy must be saving enough to maintain its wealth and income at its present level. That is, the economy must be in some kind of steady state or on a positive trajectory away from a steady state. With constant population, this simply translates into the stipulation that neither net savings nor the expected return on investments, net of debt service and principal repayment, is negative. Otherwise, part of the funds earmarked for these investments must be logically construed as consumption expenditure. 4 In an economy with a growing population, net savings have to be positive 5 if per capita levels of wealth, income, and consumption are to be maintained. Savings rates below these respective lower limits imply that the economy will ultimately have to alter its consumption pattern, regardless of whether the present “excess” of consumption is being financed by incurring debt or by running down wealth. 6

The implications of this analysis for assessing the sustainability of a particular current account deficit or determining a country’s maximum sustainable current account deficit are rather straightforward. If the economy has positive net savings, 7 then the actual deficit will tend to be sustainable. Conversely, if net savings are negative, the deficit will be unsustainable over any prolonged period. Hence, the maximum sustainable deficit corresponds to the economy’s zero savings position, which, according to equation (3), is given by the level of investment. 8 Because the sum of the economy’s profitable investment opportunities 9 establishes the upper limit on the amount of external financing that tends to be available, it becomes meaningful to speak of sustainability in terms of both the current account and the capital account; it also confirms the intuitively plausible notion that the maximum sustainable current account deficit and the maximum sustainable capital account surplus should be mirror images of each other. 10 Accordingly, as a practical matter, the market’s appraisal of a particular current account deficit as expressed in the magnitude and terms of private financing readily forthcoming is a reasonable gauge of its sustainability. At the same time, historical observations on the magnitude of private capital inflows over some period tend to be inconclusive about the limits of the potentially sustainable deficit, since a much larger deficit may also evoke a counterbalancing capital inflow.

So far, the discussion has neglected the effect of cyclical influences on the current account and, correspondingly, on the usefulness of the concept of long-run sustainability developed earlier for signaling the appropriateness of adjustment action. For example, because of clearly temporary factors a larger than usual current account deficit might evoke an equally unusual capital inflow, neither being sustainable over an indefinite period. Nevertheless, adjustment measures would not necessarily be required, particularly if the market makes the additional financing available at the country’s normal borrowing rate. The availability of funds not only allows a country to maintain its consumption pattern but also suggests that the market views the disturbance as a temporary one. Thus, judgments about the sustainability of a country’s position during a particular period should draw on information about its borrowing costs relative to other periods as well as its cyclically adjusted levels of savings and investment. 11

Optimality

The question of sustainability leads directly to a consideration of optimality. Specifically, one wants to know whether there is an optimal level for the current account. The literature on economic growth has dealt with the question of optimality by deriving the consumption stream that maximizes the present discounted value of utility of present and future generations. 12 This analysis usually assumes that current consumption is preferred to future consumption and that there is a diminishing marginal rate of substitution between consumption in any two periods. The optimal consumption path is that which equates the marginal rate of substitution with one plus the rate of return on capital. 13

For our purposes, several features of this analysis are noteworthy. First, optimality is sought with respect to consumption, a variable that enters the individual’s utility function. Second, for every rate of return on capital there exists an optimal consumption stream and an implied optimal savings stream. Third, in the closed economy, the alternative to consumption is investment, and in that analysis, whatever is not consumed is added to the capital stock. In the open economy, of course, exports provide an additional outlet for savings. 14 Recalling the earlier discussion of the determinants of the current account, particularly equation (3), we thus note that conditions of optimality constrain the sum of the current account plus investment, but not investment or the current account per se.

Efficiency

With respect to sustainability and optimality alone, there is not a unique level for the current account. In each instance, investment plays the same role in allowing consumption to be productively deferred to the future. Introduction of conditions of efficiency in the international allocation of investment, however, does break this nexus. In particular, economic theory indicates that an efficient distribution of a fixed amount of investment in the world is characterized by the international equalization of the expected rates of return thereon. Accordingly, the level of investment in any one country is determined by its marginal productivity of capital schedule vis-à-vis that in other countries and total world savings. With its own (private plus public) savings determined by intertemporal utility considerations, its current account is totally determined. With investment effectively exogenous, the minimal sustainable current account as well as the optimal current account can be derived from the respective savings level.

This consideration leads to a more general comment about the current account in the long run. As several writers 15 have emphasized, and as the optimizing approach makes clear, the level of the current account is not important in and of itself. Granted, there is an optimal current account, but its level is incidental to the optimal consumption stream.16 Hence, if a country’s attitude toward thrift were to change, the optimal consumption stream would be altered and, along with it, the optimal current account. Moreover, in terms of targets, while it is true that a determinate optimal current account exists, the appropriate public policy control variable for maximizing social welfare is not the current account but the government deficit. It is this variable that has a direct link to the level of savings.

Worldwide equilibrium

In long-run equilibrium, the intersection of the schedule of the supply of world savings and the schedule of the marginal efficiency of investment determines the real interest rate. Each country then takes this rate as given and saves in accord with its tastes (i.e., it may choose a sustainable consumption stream, it may optimize, it may consume all its wealth in the first period) and invests geographically until, at the margin, all projects are equally profitable. 17

Panel (a) of Figure 1 depicts savings and investment schedules as functions of the interest rate, rA, 18 for a hypothetical country A. If this were a closed economy, the market-clearing interest rate would be r*A. Panel (b) of Figure 1 portrays the excess of savings over investment at each interest rate as the corresponding current account, CAA. Because, as drawn in Panel (a), the level of savings is never negative, the current accounts shown in Panel (b) are all sustainable for an economy with constant population. 19 Note that the current account is zero at r*A. Figure 2 overlays two such schedules for different countries, A and B, as functions of the world interest rate, rw. Equilibrium obtains at r*w, where the surplus of country A just equals the deficit of country B.

Figure 1

Figure 2

The diagrams are useful in clarifying two aspects of the current account. First, international inconsistencies in countries’ desired current accounts are precluded in Figure 2 by the schedules’ being drawn with some slope. Accordingly, an incipient excess demand for current account surpluses, that is, an excess of world savings over world investment, would be extinguished by a decline in the interest rate, decreasing savings and increasing investment in both countries. Nevertheless, it is conceivable, although certainly not optimal, that countries would have current account schedules that are always vertical, 20 raising the possibility of mutual inconsistencies. Second, unsustainable deficits have also been ruled out by the construction of Figure 2, in which savings are never negative. As noted earlier in the discussion of sustainability, an unsustainable deficit can occur and can continue, but only temporarily. The logic of its prolonged persistence would be that the surplus country was financing foreign consumption out of its own savings, so that it could continue the act of saving and not so that it could increase future consumption. This conclusion is due to the inevitability of arriving at the point where the deficit country’s debt service burden exceeds its income, and, while possible, it would be irrational for the surplus country to perpetuate such a state. 21

shorter-run considerations

The preceding section outlined the factors that bear on the current account in the long run. It showed that, in principle, there exists a current account that is consistent with optimality and efficiency. While this may be taken as a long-run norm, the dual questions of what is the desired current account and should it be pursued as a policy target are surely meant to apply over the short run. Moreover, these questions have operational content at this level only when viewed in the context of disturbances that beset the economy and cause it to depart from its long-run equilibrium. In what follows, two kinds of shock are differentiated—permanent and temporary. The former necessitates adjustment, that is, embarking on the path to the new long-run equilibrium. In this respect, the question is, What is the desired level of the current account during the adjustment period? Regarding the latter, it is whether an economy should pursue its desired current account as a target in the face of reversible shocks that would otherwise cause its desired and actual current accounts to diverge.

Reversible shocks

Temporary, reversible shocks, when unchecked, have ramifications for the level of employment, prices, and the current account. Stabilization policy, to some extent, is directed at minimizing the disutility associated with departures of these variables from their longer-run, desired levels, and its formulation can be viewed as the selection of target variables and the assignment of policy instruments for their achievement. The literature on targets and instruments allows for two interpretations of the word “target.” In one, the current account would be a final target, desired for its own sake and in the pursuit of which other goals would be sacrificed. In the other, the current account would be a “proximate” target, aimed at because of its relation to the true target and its more direct controllability. In this case, its desired level would be derived from the desired level of the true target.

If one were to ask whether the current account should be added to the economy’s short-run employment and price stability goals, the answer would surely be No. Our long-run analysis indicates that the current account matters primarily because of its relation to savings. Savings, however, are important for maintaining the path of consumption, that is, optimizing behavior would have savings varying in the face of fluctuations in income, so that a steady consumption stream could be maintained over all. The same reasoning applies to the current account. Hence, the current account should be included as a short-run target only if it helps to stabilize employment and prices.

Using aggregate demand as a proxy for employment and inflation, 22 we find that an exogenous increase in domestic expenditure tends to increase aggregate demand and to crowd out net exports. Similarly, an exogenous increase in net exports enlarges total aggregate demand and displaces some purely domestic expenditure. Stabilizing the current account in the latter case tends to stabilize aggregate demand, whereas, in the former, it aggravates the effect of the disturbance on overall aggregate demand—the primary target. This suggests that countries for whom the largest source of exogenous variance in aggregate demand is the foreign sector might find it advantageous to pursue current account targets. On the other hand, those countries where domestic expenditure is exogenously the more variable component would be well advised to have the current account act as a shock absorber. The transformation of this general principle into a specific program for policy, however, depends on the availability of an effective instrument of control.

From the early literature, 23 one would infer that a flexible exchange rate regime is a suitable vehicle for achieving the desired stabilization of aggregate demand in the face of shocks from either quarter. Specifically, according to the version of the Fleming-Mundell model that posits perfect capital mobility, an exogenous increase in aggregate demand prompts an appreciation of the exchange rate that restores aggregate demand to its preshock level. The source of the shock simply determines whether, after the appreciation, net exports are less than or equal to their preshock level. Widespread experience with floating in recent years, however, has greatly increased the perceived importance of the caveats that delimit this analysis. Thus, while the primary source of variance in aggregate demand remains a reasonable criterion for establishing the desirability of stabilizing the current account, knowledge gained since 1973 has rendered the analysis largely irrelevant as a practical matter: Without an instrument of control, it is hardly worthwhile to ponder in what direction the current account should be manipulated.

A primary source of difficulty with the older analysis is its time perspective. Since it relies on a static construct, it necessarily compresses all actions and reactions, which in actuality take varying lengths of time to unfold, into a single moment. Amending the model to allow the posited mechanism of adjustment to proceed in stages, we find that as output and the interest rate drift upward, the exchange rate still appreciates, but by a greater amount. 24 Because trade flows take time to react to price and exchange rate changes, 25 the capital account must equilibrate the market for foreign exchange. Hence, the exchange rate “overshoots” so as to establish expectations of a subsequent depreciation and reduce the otherwise too-high expected rate of return on domestic assets. Over time, if the shock persists for a while, the higher interest rate will reduce consumption and investment, and the appreciation will diminish export demand. In this version, then, floating tends to offset the real effects of expenditure shocks, 26 but the process is far from instantaneous. Hence, over the period of interest here, floating is not an effective means to stabilize demand. There is an additional complication that a change in the exchange rate introduces via its possible effect on prices. Either because of wage indexation or union power in general, exchange rate reductions, even if otherwise they were eventually to be reversed, may become embedded in the cost structure of the economy, thereby requiring their maintenance and aggravating the inflationary bias in the system as well as diminishing the effect of any exchange rate change on net exports. This influence from the supply side of the economy further limits the usefulness of the exchange rate as an instrument of very short-run stabilization policy. 27

The adjustment process

The economy is also subject to shocks of a more enduring nature. Because these tend to alter the long-run position of the economy, adjustment is in order. In this context, the role of stabilization policy is not to buffer temporary shortfalls and excesses in aggregate demand but rather to ease the economy’s transition from one long-run stochastic equilibrium to another. This paper is concerned with two aspects of this problem. First, from the individual country’s point of view, how does the current account, in general, fit into the overall adjustment process? Second, and in particular, is it always preferable to have a higher current account? An affirmative answer here would raise the potential for conflict among countries pursuing similar adjustment goals and would suggest that some scheme for allocating current accounts across countries might be desirable.

Prior to addressing these questions, it is useful to sketch a simple basic framework for thinking about the adjustment process. To this end, consider a negative but permanent demand shock. This could be either an exogenous increase in the domestic savings function or an exogenous decrease in the investment function or the demand for net exports. In either case, aggregate demand falls in the first instance. If prices and wages were fully flexible, downward movements therein would move the economy automatically to a new equilibrium. And, if this were a closed economy, the new output level would be the same as initially—prices and wages would simply be lower. Essentially, lower prices combined with an unchanged money stock reduce the interest rate and cause the level of investment to rise, thereby replenishing real aggregate demand. 28 In the open economy, the picture is only slightly more complicated. Here, as prices fall, the quantity demanded of net exports rises. Incipient decreases in the interest rate prompt a capital outflow that continues until interest rates worldwide are likewise lower. Investment at home and abroad both rise, but full employment at home is restored primarily through exports. In the open economy, the new “full employment” level entails less output and employment as well as a lower real wage to labor, 29 this being necessary to lower the relative price and to generate an increase in the quantity demanded of net exports. 30

In a Keynesian world, money wages and prices are inflexible downward. Introducing this constraint into our shock example, we find that adjustment to the new full employment point will not occur immediately. Rather, unemployment will persist until either the experience of recession weakens prices and wages or policy intervenes. With respect to the latter, the authorities have basically two options—they can either expand fiscally or devalue. 31 Either initiative will restore aggregate demand and employment to their previous levels. The deciding factor is whether it is preferable to increase consumption today or tomorrow. If tomorrow, then, within the confines of the Keynesian model, devaluation facilitates the attainment of this objective. Net exports will increase, and the proceeds can be invested abroad 32 to be redeemed when desired. Note the implications of this model for the political importance of the international distribution of current accounts and the level of the exchange rate between two countries. In response to a negative demand shock, a country’s dual goals of maintaining employment and deferring consumption can be satisfied by increasing its current account surplus, through a devaluation. Clearly, this kind of setting can breed conflict among nations when all are subjected to the same disturbance. This was evident enough during the 1930s, and the sentiments it evokes are not unknown today.

If, however, real wages are inflexible in the downward direction, the power of exchange rate policy is greatly diminished. 33 The preservation of real wages will cause nominal wages to rise with consumer prices, including import prices, and the subsequent effect of increased wages on export prices will offset some or all of the improvement in relative prices arising from the devaluation. While the actual postdevaluation outcome in terms of employment and the current account depends on the accompanying set of demand policies, a general point can be made. If domestic demand is restrained so that the rise in domestic prices following the devaluation is moderated, the current account will improve but the employment situation will deteriorate. Here the prevailing real wage will be in excess of its market-clearing level. Conversely, if domestic demand is expanded to alleviate the unemployment, wages and prices will rise sufficiently to worsen the current account. Here, generous demand conditions raise the market-clearing real wage and the actual real wage may rise as well. In this kind of climate, two alternative policy reactions are possible. Either a recession can be endured until real wage demands have weakened sufficiently that the lower associated relative price of exports can induce export demand in quantities consistent with full employment; or adjustment can be forestalled by a permanent increase in the government deficit, 34 which restores full employment by increasing the market-clearing real wage. As before, the deciding factor should be what path 35—fully accommodating, fully adjusting, or some intermediate position—promises the highest level of total utility.

Probably the most relevant model is one that combines the nominal wage and price rigidities of the Keynesian system with the real wage rigidity of the other. 36 In this kind of environment, a negative shock to aggregate demand results in unemployment on two counts. First, there is inadequate demand for goods and services at current prices. As a consequence, producers employ fewer workers than would be consistent with their equating labor’s marginal revenue product with the wage. 37 Second, because the real wage is too high, there would be excess labor supply even if firms, not being constrained by demand, were to employ labor in accord with their profit-maximizing marginal productivity conditions. Currency depreciation, by increasing the demand for net exports, raises the price that clears the economy’s goods market. Attendant to the prevailing price becoming consistent with equilibrium there, an improvement in the current account and an expansion in output and employment are simultaneously fostered. Hence, an increase in the current account unequivocally improves a country’s situation and is therefore a potential source of friction among countries, but only up to a point. Once the point is reached where downward nominal price rigidity no longer constrains the market-clearing process, devaluation of the currency can improve the current account only as employment falls.

II. Official Views on the Current Account

Economic authorities on the national and the international level have expounded their views on desired current account developments on a number of occasions. This part of the paper presents a selected survey of the views that are best seen in the context of the discussion in the preceding sections. Long-run and shorter-run considerations both apply in varying degrees to national and international pronouncements. Strictly long-run notions about the current account are entertained only implicitly and in very few countries. The majority of pronouncements refer to the adjustment problem over the shorter run.

The fundamental long-run objective of economic policy in all countries is that of prosperity, the current account being conceded a subsidiary role. Most everyone would agree that, “… neither the current account nor the exchange rate should be viewed as an ultimate objective of policy in the same sense that real income and the rate of unemployment are. These external variables do not directly affect the welfare of citizens, although they have important effects on variables that do.” 38 As their sights are set on the full employment of the labor force in the future, the authorities are concerned with long-run developments in aggregate demand in general and in investment and savings in particular. The Netherlands is a case in point. Its authorities pursue what they call a “structural budget policy,” a policy that aims at a level of investment consistent with full employment, given the trends in population, labor force, and savings developments. 39 In view of the apprehension at present that private investment will prove insufficient, the authorities plan to complement it with a rise in public investment. They envisage, therefore, a larger structural budget deficit in years to come. 40 Clearly, then, recalling that the current account surplus is determined by the excess of private plus public savings over private and public investment, the long-run current account developments in the Netherlands will fall out of its structural budget policy given private savings and investment behavior.

Although the current account is not, and should not be, a primary target in the long run, its sustainability is considered important. For example, the Norwegian authorities acknowledge that current account deficits accompanied by high rates of capital formation are sustainable while those accompanied by high rates of public consumption may not be sustainable. 41 This echoes the U.S. view that the sustainability of a current account deficit is a question of “…whether the willingness of foreign investors to acquire claims on a country or the willingness of domestic investors to reduce claims on foreigners will remain strong enough to finance a given deficit.” 42

With regard to the medium-term adjustment problem, many countries have made their views known: France, the United Kingdom, the United States, Canada, Japan, the Federal Republic of Germany, Italy, Denmark, Austria, and Norway. France apparently aims at a zero current account balance by 1980. This is an objective that is to be achieved simultaneously with the restoration of full employment. 43 The United Kingdom aims at a trade surplus that would be at least large enough to finance its foreign debt between now and the mid-1980s (estimated at some $20 billion), implying a zero current account balance or a current account surplus on average over the years from about 1978 to 1985. 44 At the same time, the authorities would have to pursue an exchange rate policy that would be consistent with a desired trade surplus of that size. 45 Denmark and Italy are two more countries that have recognized the need to reduce foreign indebtedness and to improve the current account over the next few years as a precondition for a sustainable increase in employment; both countries appreciate that improvement in the current account requires moderation in the rise of income. 46 Austria and Norway, in line with their full-employment policies, have allowed their current accounts to deteriorate substantially in recent years. However, the larger than expected deficits in both countries have prompted the authorities to induce a return to more “normal” levels. In Austria, this would mean a trade deficit that is approximately matched by a surplus on net services, while Norway expects the deficits to turn into surpluses in the 1980s—largely on account of expectations that the current transactions of the oil sector would move from the pattern of deficits that it recorded from 1970 to 1977 to a pattern of surplus.47

The Canadian case is of particular interest, owing to the role that the current account is accorded in the general strategy to realize primary targets. At present the authorities aim at a reduction in both the output gap and inflation over the medium term from 1978 to the end of 1981. 48 Implicit in the output and inflation targets, which may be regarded as primary, is a target for the current account, since exports and the various components of absorption are all assigned specific roles in the realization of desired output and inflation. 49 From this it may be inferred that the primary targets have to be aimed at jointly, rather than individually, and that they will be consistent with only one particular composition of the current account. 50 The Canadian authorities see no difficulty in financing the prospective current account deficit through a net inflow of long-term capital. 51 The situation appears to be one in which all current account deficits within a fairly broad range would be sustainable. Hence, the authorities can pursue their output and inflation targets without being constrained by the size of the concomitant current account deficit.

The situation in Japan is again different. Matching the current account surplus with a net long-term capital outflow has proved more or less difficult in the past five years. At the time that the economic plan for Japan for the second half of the 1970s was formulated, the avowed aim of a zero basic balance seemed easy enough to realize. 52 Soon afterward, however, the Japanese authorities introduced an emergency import program 53 and relaxed capital controls so that a rapidly rising surplus on current account could be offset at least in part by a net outflow of longterm capital. 54 Since late in 1978, the tendency of the current account surplus to rise has been reversed. Owing both to the strengthening of the volume effects in the wake of the preceding yen revaluations and the rise in domestic demand, the current account has moved into rough balance.

The United States does not appear to have set itself any specific current account target, having generally argued against such targets. 55 Nevertheless, it has clearly been concerned over its large trade deficit with Japan, and the emergency import programs, inter alia, may be seen in the context of U. S. promptings to reduce the Japanese surplus.

The authorities in the Federal Republic of Germany, like those in the United States, do not set explicit targets for the current account. Still, the notion appears to be accepted that an advanced industrial country should typically show a current surplus, since it is expected to promote the international transfer of resources through net exports of long-term capital. 56 How large that surplus would be is not a question that is dealt with in any specific way, yet the surplus recorded in 1978, amounting to less than 1 per cent of total output,. was regarded as “normal.” 57 The authorities recognize that, at the present juncture, they cannot rely on exports to sustain recovery because of the need for adjustment of payments imbalances among their trading partners. More than in the past, this is a role that will have to be played by domestic absorption. 58

III. Summary, Conclusions, and Implications

Our analysis suggests that there does exist an optimal long-run current account that is derived from optimal savings behavior and the efficient international distribution of investment expenditure. Economic welfare within a country is reduced by a current account in excess of this level, and the optimal long-run current account may be either a surplus or a deficit. Because optimal savings vary directly, and the number of profitable investment opportunities inversely, with the interest rate, mutual inconsistencies in the international set of optimal current accounts are precluded, in principle, by the establishment of a market-clearing interest rate, which equates the worldwide sums of efficient investment and optimal savings. While the optimal current account is uniquely defined by the economy’s opportunity set and its social welfare function, any number of current accounts are equally sustainable in the long run. This criterion requires only that the economy’s savings rate be high enough to maintain the present level of per capita wealth, income, and consumption. As noted in the text, any level of consumption can be maintained indefinitely if savings equal the product of the rate of growth of population and wealth. A current account deficit consistent with savings greater than or equal to this amount would be sustainable. If savings fall short of this amount, per capita consumption will ultimately have to decline, even though, as long as savings remain positive, long-term financing may still be forthcoming in support of the economy’s remunerative investments.

In a stochastic environment, disturbances occur that cause the economy to cycle about its equilibrium path. Because the optimal policy would stabilize aggregate demand, the authorities would want to stabilize the current account if it is the primary source of exogenous variance in aggregate demand, and to let it act as a buffer if domestic demand is exogenously more variable. Their ability to achieve these alternative goals, however, depends on the availability of an effective instrument of control. In theory, a flexible exchange rate stabilizes aggregate demand in the face of expenditure shocks regardless of source and, accordingly, provides a mechanism for achieving the desired goal. However, in practice, there are many complications (not the least of which are lags in the adjustment of exports and imports to changes in their prices) that seriously detract from the ability of floating to stabilize aggregate demand in the short run; this suggests that the effects of short-run reversible disturbances are fairly impervious to treatment and must simply be borne.

In the medium run, the economy adjusts to disturbances of a more permanent nature. In general, adjustment to a negative demand shock entails unemployment unless offset by a counterbalancing policy response. As in the short-run analysis, the source of the shock influences the desirability of stabilizing net exports. If the shock is to the foreign sector, then both the long-run consumption/savings decision and the short-run goal of stabilizing aggregate demand are served by restoring net exports to their preshock level. If, however, it is investment that falls, the dual objectives are met by an expansion in net exports, that is, the current account should be used as a buffer. Moreover, the general desirability of having the current account perform a particular role translates into a meaningful policy presumption only if a suitable instrument is available to achieve its desired stabilization, in the one instance, or movement, in the other. As it happens, the efficacy of exchange rate policy in accomplishing this task depends on the appropriate characterization of the supply side of the economy. In particular, if it is Keynesian, so that nominal wages cannot fall, depreciation of the exchange rate can simultaneously restore employment and net savings to their desired levels over much the same time that it takes for exports and imports to adjust to price changes. On the other hand, if laborers are determined to maintain their purchasing power so that real wages cannot fall, a wage/price spiral will ensue, offsetting much of the competitive edge gained by devaluation. In this kind of environment, the current account can be improved and full employment restored only after a recession has weakened real wage demands. Over much of the horizon, though, recessionary conditions will be in evidence, and any short-term to medium-term improvement in the current account will be at the expense of employment.

This analysis has some bearing on the importance of exchange rate surveillance. Strictures against anticompetitive exchange rate policy and maintaining an undervalued exchange rate make most sense in an environment that is fundamentally Keynesian. Accordingly, there would be an overall inadequacy of global aggregate demand, and each country would have the incentive as well as the ability to secure “for its own national output a larger share of the existing world demand” 59 through currency devaluation. For a single country intent on reducing unemployment, the alternative is fiscal expansion. This would entail a departure from its prevailing consumption/savings mix, and some of the fruits of expansion would flow abroad. While a certain amount of leakage is inevitable, it is clearly in the interests of the community of nations to control the overexploitation via competitive devaluations of this natural externality to forestall incipient “beggar-my-neighborism.” In the Bretton Woods era, this was accomplished by limiting exchange rate changes to cases of “fundamental disequilibrium.” In the current era, surveillance is the vehicle.

The alternative model (i.e., where real wages are rigid) presents a less optimistic view of the ability of devaluation to circumvent the costs of adjustment to negative demand shocks, and, as a result, reduces the potential for conflict over exchange rate policy. Because the current account and employment are inversely related over the short run to medium run, the incentive to devalue competitively is greatly diminished. Moreover, that this relation is one of trade-off imparts to a country’s attempts to increase its current account a degree of legitimacy lacking in a more Keynesian context, where the current account and employment can be simultaneously improved by currency depreciation. Furthermore, while an improvement in one country’s current account still entails a deterioration in its partner country’s current account, the cost of this interdependence is reduced in the rigid real wage model, 60 since real wages and employment can rise there.

Nevertheless, because currency depreciation retains in this model the important role of facilitating the adjustment to negative demand impulses in the face of downward nominal rigidities, some risk of international friction remains. Specifically, with both prices and real wages rigid, a decrease in aggregate demand tends to cause unemployment on two counts: Output prices become too high for the goods market to clear, and the real wage becomes too high for the labor market to clear. With the real wage rigid, devaluation can do nothing about the unemployment deriving from the latter. However, it can remedy the former by inducing an increase in demand for exports via a decrease in their foreign price. As the goods market clears, the demand for factor inputs, including labor, can rise. That currency depreciation can circumvent Keynesian unemployment for one country suggests that the complementary appreciation abroad will exert a contractionary influence there if prices are not flexible downward. Granted, this can be offset by fiscal expansion, but that country may not want to alter its consumption/savings mix. The same reasoning suggests that a general shortfall in global demand, such as that attending the petroleum price rise in 1973-74, can produce a setting in which, by devaluing, any one country individually can improve its current account and employment situation at the expense of its trading partners, even while its wages are fully indexed. In such an environment, surveillance retains an important role.

The present economic situation of the industrial countries is probably best characterized by the combined rigid price and rigid real wage models. For both the importance of surveillance and the efficacy of global expansion, the relevant questions then become: To what extent is the present slack attributable to inadequate aggregate demand, that is, the effect of nominal rigidities, and to what extent are we observing the requisite recessionary adjustment to a lower path of real wages? Based on the material presented in Section II, we note that most countries in their official statements appear cautious about their current account prospects. Their concern seems to reflect the view that adjustment is in order now, and that employment must be sacrificed to attain the desired improvement in the current account. This attitude is consistent with the view that the present slack is adjustment-related rather than deriving from Keynesian inadequate demand. 61 On the other side, several countries are on record as favoring adjustment of their own current account balances within the framework of an internationally coordinated program of expansion. 62 However, the broadest support for this idea has come from international bodies 63 in terms of the “concerted action program,” which envisages current account adjustments in the context of an internationally coordinated expansion of aggregate demand. 64 Nevertheless, there are those who would strongly disagree with the wisdom of concerted action at this time. 65 Recalling the record of the joint expansion in 1972 and 1973, they argue that a rapid rise in import prices in general and commodity prices in particular would ensue, causing inflation to accelerate in the process. A similar conclusion, that is, that expansion will simply go into prices over the medium run, emerges from this analysis if the primary cause of the slack is excessive wage demands. In our view, it would be fruitful to investigate empirically to what extent the present situation is one of inadequate demand 66 or a period of necessary adjustment to overinflated expectations.

Ms. Salop, economist in the Special Studies Division of the Research Department, is a graduate of the University of Pennsylvania and Columbia University. Before joining the Fund, she was on the staff of the Board of Governors of the Federal Reserve System.

Mr. Spitäller, economist in the External Adjustment Division of the Research Department, is a graduate of the University of Graz, Austria, and of the School of Advanced International Studies of the Johns Hopkins University, Washington, D. C. He was formerly on the staff of the Organization for Economic Cooperation and Development.

The authors would like to thank Victor Argy, John Bilson, Peter B. Kenen, and their Fund colleagues for comments on earlier drafts of this paper.

Net savings are equal to gross national product minus consumption minus depreciation.

Accumulation of private wealth and capital reflects attitudes toward thrift, on the one hand, and the productivity of capital, on the other hand. A high propensity to save and a low productivity of capital relative to the values of the corresponding parameters abroad will tend to make a country a structural surplus country. If, for some reason, the authorities wanted to reduce the current account surplus, they could do so by increasing the government deficit. They would have to realize, however, that unless they were prepared to do so on a permanent basis, the surplus could be reduced only if either private attitudes toward thrift or the productivity of capital, or both, were made to change. See Charles P. Kindleberger, “Germany’s Persistent Balance-of-Payments Disequilibrium Revisited,” Banca Nazionale del Lavoro, Quarterly Review, No. 117 (June 1976), pp. 118-50. See also Ronald I. McKinnon, “America’s Role in Stabilizing the World’s Monetary System,” Daedalus: Journal of the American Academy of Arts and Sciences (Winter 1978), pp. 305-24. McKinnon points out that Japan’s surplus reflects a high propensity to save relative to the current flow of investment opportunities.

It is also possible to argue, although difficult to take seriously, that in the long run the government cannot affect the current account. Rather, private savings would offset any public dissavings as the private sector perceived the course of national wealth straying from its desired path. Accordingly, there would be a “natural” current account, which would be beyond the powers of government to alter. While such counterbalancing behavior of the private sector may be operative to some extent, the conditions under which it functions as a perfect offset are very limiting.

As long as the expected real rate of return on capital does not fall short of the cost of borrowing, future debt service and repayment of principal will be generated by the projects so financed.

This is particularly relevant to developing countries where, according to Tun Wai, “government investment is a large component of total investment and government decisions on the level of investment are not usually made on the profitability of the project in the short run.” See U Tun Wai, “The Optimal Size and Ideal Structure of Financial Markets in Developing Countries” (unpublished, International Monetary Fund, August 4, 1978), p. 16.

In specific terms, total savings must not fall short of the rate of growth of population times wealth.

Such savings behavior may constitute the adjustment to a new lower desired stock of wealth and should not necessarily signal the need for a policy response.

As before, if population is growing, savings must be at least equal to wealth times the rate of growth of population for the consumption stream to be sustainable.

Clearly, many caveats apply here. Most important is the always implicit ceteris paribus and the condition set out earlier—that the expected real rate of return on capital does not fall short of the cost of borrowing.

If capital is fairly immobile internationally, the level of net investment in any instance offers a poor guide to the maximum sustainable deficit. As the deficit rises, foreign borrowing costs will likewise rise and will choke off investment. In such an environment, the principle outlined in the text applies, that is, that investment sets the limit for the deficit, but the appropriate investment figure is not current investment. Rather, a maximum investment level would have to be calculated, based on the interest sensitivities of financing, that is, both domestic savings and foreign inflows, and investment.

In an economy with a growing population, the current account deficit associated with a zero savings position could elicit the requisite foreign financing, even though the underlying consumption level would not be sustainable. In such cases, the maximum sustainable deficit is smaller than net investment. In keeping with the requirement that savings must be such as to maintain the per capita level of wealth, the maximum sustainable deficit is investment minus the rate of growth of population times wealth.

For the computation of cyclically adjusted, underlying trade balances, see Jacques R. Artus, “The Cyclical Adjustment of Foreign Trade Flows and the Estimation of Underlying Trade Balances” (unpublished, International Monetary Fund, November 12, 1973). While valuable, this work does not provide the information required by the criterion of sustainability. In keeping with the argument developed in the text that the magnitude of net savings is the key variable in determining sustainability, the cyclically adjusted level of net savings is paramount in making such a determination in an environment that is subject to fluctuation.

For an individual, the optimal consumption stream is that which maximizes his utility over time. While the concept of a utility function is admittedly somewhat artificial, it nevertheless makes some sense at this level. For an economy, however, there is an additional complication, viz., whose utility is referred to. If it is the sum of the individuals, then the private sector should save in accord with its individually determined optimal consumption stream, and the public sector should provide public goods and assign property rights to avoid inefficiencies resulting from externalities. The only areas of discretion, and therefore a matter of public choice, are (a) who pays for the public goods and (b) to whom are property rights assigned. Once these questions are resolved, optimization is a private matter. In most countries, however, the role of the state is larger and includes the overall management of the level of economic activity. Conceptually, we can think of some social welfare function that incorporates interpersonal and intergenerational trade-offs into a single ranking, although it would be difficult to make this concept operational.

For the approach of maximizing the present discounted utility of the future stream of consumption that is followed in the literature on optimal growth, see David Cass, “Optimal Growth in an Aggregative Model of Capital Accumulation,” Review of Economic Studies, Vol. 32 (July 1965), pp. 233-40.

See J. H. Williamson, “On the Normative Theory of Balance-of-Payments Adjustment,” Ch. 7 in Monetary Theory and Monetary Policy in the 1970s: Proceedings of the 1970 Sheffield Money Seminar, ed. by G. Clayton, J. C. Gilbert, and R. Sedgwick (Oxford University Press, 1971), pp. 233-56, and the discussions by Marcus H. Miller, ibid., pp. 257-59, and P. M. Oppenheimer, pp. 260-63. See also John Williamson, “Payments Objectives and Economic Welfare,” Staff Papers, Vol. 20 (November 1973), pp. 573-90.

Williamson (1971) assumes fixed exchange rates and prices, a constant rate of time preference, and a negative relation between income and the trade balance. In his analysis (p. 239), “there exists a steady-state stock of foreign assets where the marginal rate of return on foreign assets is equal to the rate of time preference (the ‘Modified Golden Rule’), and this position is approached asymptotically.” Hence, he implicitly assumes that the rate of return on foreign assets is inversely related to the stock of those assets held domestically. While this is an undefended and possibly indefensible assumption, the basic idea of his analysis (p. 238) that “a payments surplus, or a high growth rate, is a means to an end and in no sense an end in itself,” remains valid. Moreover, his overall approach of maximizing the present discounted value of the future stream of consumption is consistent with that followed in the literature on optimal growth.

See, for example, Harry G. Johnson, The Canadian Quandary: Economic Problems and Policies (Toronto, 1963), and Williamson (1971, cited in footnote 14).

The literature on economic growth, which addresses the question of optimal consumption paths, relies heavily on the concept of the steady state. This construct has all real magnitudes growing at the rate of growth of population, usually denoted by n. In per capita terms, let KD be the domestic capital stock and KF be net ownership of capital abroad. Letting r represent the rate of return on capital, one can rewrite equation (3):

This is true because rKF is factor payments from abroad; n(KD + KF) is the steady-state level of savings that keeps per capita wealth constant; nKD is per capita investment that maintains the capital/labor ratio. Simplifying equation (3’) to

we note that the countries that are net owners of foreign capital will have current account surpluses. Moreover, for “normal” utility functions that display some time preference for present consumption, the optimal rate of savings and capital accumulation will be such that the rate of return on capital will exceed the rate of growth, that is, r > n. Hence, the trade account will be negative.

The meaning of this is straightforward. In the steady state, the pattern of current account surpluses is set by the pattern of ownership of foreign assets. For example, if country A owns capital abroad, its imports will exceed its exports, but because it will continue to replenish its holdings abroad, it will not consume all its factor payments. Rather, it will invest a portion; hence, its current account will remain positive.

This, of course, assumes perfect capital mobility. Without it, interest rates can differ across countries, and the determination of the worldwide equilibrium becomes more complicated, although it continues to be governed by the same forces. For some interesting empirical analyses that challenge the appropriateness of the assumption of perfect capital mobility, see Jacques R. Artus, “Persistent Surpluses and Deficits on Current Account Among Major Industrial Countries” (unpublished, International Monetary Fund, May 24, 1979); and Martin Feldstein and Charles Horioka, Domestic Savings and International Capital Flows, Harvard Institute of Economic Research, Discussion Paper Series, No. 700 (April 1979), pp. 1-28.

Economic theory would have the interest rate determine the desired levels of the stocks of wealth and capital, rather than the flows of savings and investment. The posited relationships between the interest rate and these flows can be derived in one of two ways. First, the economy can be in a steady state with growing population. Here, savings and investment will vary directly with wealth and the capital stock, respectively. Hence, any interest-rate-induced change in these variables will likewise prompt a permanent change in the corresponding flow variables. In addition, there could be a stock adjustment mechanism that causes actual wealth and the capital stock to approach their desired levels only over time. Accordingly, a change in the interest rate would evoke flows of savings and investment, which could persist for some time, even if the ultimate equilibrium was one of constant wealth and capital.

Of course, if A is growing, minimal sustainable savings will exceed zero. The largest sustainable current account deficit would be reduced correspondingly.

This formulation would imply that savings move inversely with the interest rate and, in fact, follow the course of the investment schedule.

While an unsustainable deficit necessarily gives rise to a complementary, unsustainable surplus, the surplus country can dictate the timing of adjustment to the deficit country in a way that the deficit country cannot do in reverse. Hence, while a surplus may not be sustainable, it is a matter of national discretion when and how it adjusts. This difference between surplus and deficit positions frequently causes the free market’s allocation of the burden of adjustment to fall more heavily on deficit countries, and explains the continuing quest for a resolution of this asymmetry at the international level. This same issue caused Robinson to write some 30 years ago, “The rules of good neighbourly behavior in international trade require that a country should have a surplus no larger than its continuous lending can cover.” See Joan Robinson, “Exchange Equilibrium,” in her Collected Economic Papers, Vol. 1 (Oxford, 1951), pp. 214-24, especially p. 221.

If aggregate demand is too high, inflation will accelerate. If it is too low, there will be unemployment. Hence, stabilizing aggregate demand tends to facilitate the continuous attainment of the economy’s inflation and employment targets. This treatment is consistent with much of the literature on stabilization policy, which seeks to minimize a quadratic loss function with respect to the values of the policy instruments. The quadratic form allows excesses and shortfalls in aggregate demand to enter with equal weight. See, for example, William Poole, “Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model,” Quarterly Journal of Economics, Vol. 84 (May 1970), pp. 197-216.

J. Marcus Fleming, “Domestic Financial Policies Under Fixed and Under Floating Exchange Rates,” Staff Papers, Vol. 9 (November 1962), pp. 369-80; Robert Mundell, “Flexible Exchange Rates and Employment Policy,” Canadian Journal of Economics and Political Science, Vol. 27 (November 1961), pp. 509-16.

See Rudiger Dornbusch, “Exchange Rate Expectations and Monetary Policy,” Journal of International Economics, Vol. 6 (August 1976), pp. 231-44, for an analysis that places the Fleming-Mundell model in a framework where asset markets clear faster than goods markets.

See Helen B. Junz and Rudolf R. Rhomberg, “Price Competitiveness in Export Trade Among Industrial Countries,” American Economic Review, Papers and Proceedings, Vol. 63 (May 1973), pp. 412-18; and C. A. Enoch, “Measures of Competitiveness in International Trade,” Bank of England, Quarterly Bulletin, Vol. 18 (June 1978), pp. 181-95.

Even within the confines of the Fleming-Mundell analysis, the general presumption that flexible exchange rates tend to stabilize aggregate demand depends on the comparative stability of the goods market relative to the money market. Consider the effects of a shift in the demand for money under both fixed and floating exchange rates. Under the former, the country’s stock of international reserves will change. Under the latter, the interest rate and the exchange rate will change, both with repercussions for the real economy. Hence, as a general rule, if most disturbances are of the monetary variety, the country should fix its exchange rate, or at least have an active intervention policy directed at ratifying monetary shocks. See Victor Argy and Michael G. Porter, “The Forward Exchange Market and the Effects of Domestic and External Disturbances Under Alternative Exchange Rate Systems,” Staff Papers, Vol. 19 (November 1972), pp. 503-32.

In a closed economy framework, Poole (1970, cited in footnote 22), found that a money supply target is the preferred strategy if most shocks to the economy are of the expenditure variety, whereas an interest rate target would better stabilize aggregate demand if more variance is due to the money market. In his analysis, the selection of targets must be made in advance, before knowledge is available about the source of the shock in any particular instance. The choice of fixed versus floating exchange rates can be seen in a similar light: If the type of disturbance is not apparent when an offsetting policy measure could most profitably be used, then it is preferable to have a rule the pursuit of which maximizes expected utility.

See Jürg Niehans, “Some Doubts About the Efficacy of Monetary Policy Under Flexible Exchange Rates,” Journal of International Economics, Vol. 5 (July 1975), pp. 275-81.

In the long run, the lower real interest rate would be consistent with reduced stocks of wealth and capital if the initial shift were a decrease in investment or with increased stocks of both if the initial shift were an increase in savings.

In the closed economy, both labor and its employers deal in the same commodities. In the open economy, employers are concerned about the price of their products, that is, exports. Labor consumes both exportables and imports. It can be shown that this dichotomy causes a one-to-one positive relation between the relative price of domestically produced goods and the real wage to labor. Moreover, if it is assumed that the supply of labor services varies positively with its wage, the full employment level of output likewise varies positively with the relative price of exports and the real wage. In such a model, a negative shock would lower both the real wage and the full employment level of output. See Joanne Salop, “Devaluation and the Balance of Trade Under Flexible Wages,” in Trade, Stability, and Macroeconomics: Essays in Honor of Lloyd A. Metzler, ed. by George Horwich and Paul A. Samuelson (New York and London, 1974), pp. 129-51.

Clearly, if the demand for exports is perfectly elastic so that any domestic reductions in demand are absorbed by exports, the real wage need not fall in response to a negative demand shock.

Or cause the exchange rate to depreciate by expanding the money supply.

Presumably, domestic investment is already being carried out efficiently, so that the marginal product of capital equals the rate of interest.

See Victor Argy and Joanne Salop, “Price and Output Effects of Monetary and Fiscal Policy Under Flexible Exchange Rates,” Staff Papers, Vol. 26 (June 1979), pp. 224-56; W. M. Corden, Inflation, Exchange Rates, and the World Economy: Lectures on International Monetary Economics (University of Chicago Press, 1977), p. 33; Jeffrey Sachs, “Wage Indexation, Flexible Exchange Rates, and Macro-Economic Policy” (scheduled for publication in the Quarterly Journal of Economics); Tibor Scitovsky, “Asymmetries in Economics,” Scottish Journal of Political Economy, Vol. 25 (November 1978), pp. 227-37.

If investment or export demand were to fall exogenously, clearly an increase in government consumption would not be consistent with optimality, if the preshock path had been optimal. If it is consumption that falls, the judgment is more complicated: If private sector consumption falls, does one infer a shift in time preference toward the future? Should the government offset it?

The issue of the optimal speed of adjustment is simply a complication, albeit a thorny one, to the optimal consumption problem discussed earlier. The same utility function applies, the only difference arising in the economy’s ability to transform production today into production tomorrow. It does not seem unreasonable to assume that there exists some positive relation between the level of employment within a period and the degree of adaptation of real wage demands, that is, more unemployment earlier will cause real wages to adjust faster and will prevent unemployment later. This being true, an adjusting economy can productively defer consumption from today until tomorrow via exports and investment as before, but also by enduring unemployment today. More unemployment today permits there to be less unemployment tomorrow and more production and consumption then. The general solution would have the rate of return on deferring consumption via investment or via unemployment equal on the margin. Because the relative price of exports, for a given real wage, falls as the level of unemployment rises, net export demand rises with the level of unemployment. This relationship follows from the profit-maximizing condition of the firm, whereby labor is employed up to the point where its marginal revenue product equals the nominal wage, and from the assumption that labor earners deflate their nominal wage by a price index that includes both imports and domestically produced goods. A fall in the price of the exportable good will be met with a smaller proportional decline in the nominal wage. The rise in the relative cost of labor services causes demand for them to decline.

The increase in oil prices is the most important recent example of a large shock necessitating adjustment, and its effects are most fruitfully analyzed in terms of the combined model. In the first instance, the oil shock raised the value of imports. This had a doubly contractionary effect on oil consuming countries. First, the level of nominal and real aggregate demand was reduced. Second, on the supply side, the market-clearing level of the real wage fell. Both effects could be reversed by a cut in taxes. However, if the consumption path prevailing prior to the price increase had been optimal, such a response would not be consistent with continued adherence to such a criterion. Instead, some adjustment to a lower consumption path should occur.

Treating the industrial countries as a single entity, we note in IS-LM terms that a shock, such as the withdrawal of purchasing power accompanying the price increase by the Organization of Petroleum Exporting Countries (OPEC), shifts the IS curve to the left. As shown, aggregate demand falls from Y0 to Y1. The contractionary effect on nominal aggregate demand can be reversed by either a fiscal or a monetary expansion each of which shifts its respective locus to the right. As previously noted, however, the oil price rise also reduced the market-clearing level of the real wage. If real wages were not to fall commensurately, employment would have to fall. Attempts to increase employment above the level determined by these real wage demands would result in nominal price and wage increases with no lasting employment effects. The ability of expansionary policy to have real effects depends, then, on the level of potential output determined by these supply forces relative to the level of actual output. In terms of the diagram, one may ask whether potential output is in the neighborhood of Y1, in which case expansion would affect mostly prices; or whether it is in the neighborhood of Y0, in which case real output could be increased by expansionary demand measures. If the latter is true, then currency depreciation by a single country can be effective in simultaneously improving the current account and expanding output.

In their analysis of the coincidence of the high unemployment and inflation rates that have beset the industrial countries in recent years in the wake of the oil crisis and other supply disturbances, Bruno and Sachs stress the importance of the level of potential output, determined by supply factors, relative to the level of actual output, determined by aggregate demand. See Michael Bruno and Jeffrey Sachs, “Supply Vs. Demand Approaches to the Problem of Stagflation,” National Bureau of Economic Research, Working Paper No. 382 (August 1979). See also Knut Anton Mork and Robert E. Hall, “Energy Prices, Inflation, and Recession, 1974-1975,” National Bureau of Economic Research, Working Paper No. 396 (July 1979).

For an analysis of the closed economy when firms are demand constrained, see Robert J. Barro and Herschel I. Grossman, “A General Disequilibrium Model of Income and Employment,” American Economic Review, Vol. 61 (March 1971), pp. 82-93.

Annual Report of the Council of Economic Advisers (Washington, January 1978), p. 116.

In their own words, a structural budget policy is a policy that “—disregarding fluctuations of an incidental or cyclical nature—is compatible with the desirable longer term level of saving and investment in the other sectors of the economy.” See Ministry of Finance, The Netherlands Budget Memorandum, 1976, p. 42.

With reference to public investment, the authorities point out that “the impression [is] that the acceptable structural budget deficit could undergo an upward adjustment. On the basis of the likely trends in the period after 1976 a number of factors would also seem to point in the same direction. Private investment will make smaller demands on savings, due among other things to the decline in population growth and, partly in conjunction with this, to a more frequent occurrence of saturation phenomena in the construction industry.” Ibid., p. 43.

Eivind Erichsen, “Economic Planning and Policies in Norway,” Challenge, Vol. 20 (January-February 1978), pp. 5-13.

Annual Report of the Council of Economic Advisers (cited in footnote 38), p. 116.

France considers the restoration of a durable current account balance by 1980 a fundamental objective of the VII Plan, and in view of its aim to restore full employment, the VII Plan pursues maximum growth consistent with equilibrium in the current account. See Philippe Rossignol, “Régler la facture pétroliere,” Economie & Statistique (December 1976), pp. 45-51; Commissariat Général du Plan, “Rapport sur l’orientation préliminaire du VIIe Plan,” Documentation Française, 1975, and “VIIe Plan de développement économique et social 1976-1980,” Documentation Française (1976).

See the speech by Denis W. Healey at the Fund’s Annual Meeting, Summary Proceedings of the Thirty-Second Annual Meeting of the Board of Governors (Washington, 1977), pp. 57-63, and the speech by Gordon Richardson at the Overseas Bankers Club, January 31, 1977.

The desirability of a surplus on current account over the next several years is also expressed in “Economic Commentary,” Bank of England, Quarterly Bulletin, Vol. 17 (December 1977), p. 431: “…after large current account deficits for four years, it seems clearly desirable for the current account now to stay in surplus,” and “It has been the relative weakness of the United Kingdom’s current account position in the post-war period that has underlain the chronic exposure of the United Kingdom’s external financial position and the past instability of sterling. A current account surplus having now been achieved, it would surely be imprudent to re-create those conditions by not maintaining a position of surplus.”

See Guido Carli “Italy’s Malaise,” Foreign Affairs (July 1976), pp. 708-18; Rinaldo Ossola’s statement on Italy in The New International Monetary System, ed. by Robert A. Mundell and Jacques J. Polak (New York, 1977), pp. 37-40; and Raymond Lubitz, The Italian Economic Crisis of the 1970’s, International Finance Discussion Papers, No. 120, Board of Governors of the Federal Reserve System (Washington, June 1978). For the case of Denmark, see, for example, the report by Reuters on a statement by the Danish Finance Minister Knud Heinesen, August 16, 1978.

See Österreichisches Institut fiir Wirtschaftsforschung, Monatsberichte, various issues. In Austria, reduction of the current account deficit in 1978 was in large measure accomplished through restrictive fiscal and monetary policies, including the doubling of the value-added tax on a broad range of goods, many of which are imported, and the substantial tightening of growth in bank credits to consumers. For the Norwegian case, see Erichsen (1978, cited in footnote 41), p. 10.

Canada, Department of Finance, Canada’s Economy—Medium-Term Projection and Targets (February 1978).

Ibid.

Any straying from the charted path, such as a shift from net exports to absorption in pursuit of the output goal, would raise inflation above the target level owing to the depreciation in the exchange rate attending that shift over the medium term. The same would apply regarding inflation if depreciation were used to induce a shift from absorption to net exports. Yet, it is not the current balance per se that matters. What is important is the level of exports and the level of imports that are contingent on the role envisaged for absorption and on the desired improvements in competitiveness. The resulting balance is purely incidental. Aiming at it, for example, through relatively greater reliance on specific measures that reduce imports rather than on expanded exports would likely compromise both the output and the inflation target. This would occur because a shift to import substitutes would tend to boost inflation and, if the real value of wealth is to be maintained, induce a switch from expenditure to savings. Thus, the authorities’ specific output and inflation targets and the current account target—in terms of the levels of exports and imports that are consistent with the desired composition of aggregate demand over the medium term—are mutually dependent and can be reached only simultaneously.

Ibid.

For the aim of a zero basic balance over the medium term in Japan, see Economic Planning Agency, Economic Plan for the Second Half of the 1970s (May 1976). The plan covers the five years from fiscal 1976 to fiscal 1980. See also Ministry of International Trade and Industry, White Paper on International Trade, 1979, Part II (June 1979).

See, for example, the report on Japan’s plan to seek $12.5 billion in “emergency imports” in the Journal of Commerce (August 16, 1978), p. 9.

On an annual average level, the current account showed a surplus of some US$10.5 billion in the years 1976 through 1978—about half of this amount being offset by net long-term capital outflow. See White Paper on International Trade, 1979 (cited in footnote 52).

See The Future Pattern of Current Balances and Related Policy Questions, Organization of Economic Cooperation and Development, Economic Policy Committee, Working Party 3 (75)12 (Paris, October 27, 1975), p. 4.

A view that is also shared by Japan—see Economic Plan for the Second Half of the 1970s (cited in footnote 52)—and by the United States—see Annual Report of the Council of Economic Advisers (cited in footnote 38).

See Jahresgutachten 1978/79 des Sachverständigenrates zur Begutachtung der gesamtwirtschaftlichen Entwicklung (November 1978). As for the future, there are reasons to believe that the structural current account surplus may increase, at least in the long run. The Federal Republic of Germany may no longer continue to attract large numbers of foreign workers and instead may shift production to low-wage countries, inducing a decline in the rate of domestic capital formation and a rise in the current account surplus. Giersch points out that “…more and more of [total household and business savings which is channeled into domestic investment] needs to be and will be invested abroad. One reason is the political decision based on widespread public feeling that we should cease to attract more workers from abroad. If industrial labour becomes scarcer and more expensive in relation to capital we shall have to substitute capital for labour. But this is becoming more and more difficult. Hence there will be an increasing tendency for firms to shift production …to low wage countries….” See Herbert Giersch, “Current Problems of the West German Economy,” Nationaløkonomisk Tidsskrift, Vol. 114 (No. 1, 1976), pp. 46-56, especially p. 47.

See Jahresgutachten 1978/79 (cited in footnote 57).

Ragnar Nurkse, Conditions of International Monetary Equilibrium, Essays in International Finance, No. 4, International Finance Section, Princeton University (Spring 1945); reprinted in Readings in the Theory of International Trade, American Economic Association (Philadelphia, 1949), pp. 3-34, especially p. 14.

See, for example, Victor Argy and Joanne Salop, “Price and Output Effects of Monetary and Fiscal Expansion in a Two-Country World Under Flexible Exchange Rates” (unpublished, International Monetary Fund, May 8, 1979).

Haberler’s assessment of the U. S. economy is of particular interest in this connection. He argues that, while the economy came close to capacity in 1978, the existence in earlier years of relatively high rates of excess capacity and unemployment, on the one hand, and inflation, on the other hand, was largely attributable to real wage rigidity. Accordingly, he finds fault with the Keynesian position that the U. S. current account deficit was a “drag” on the economy in the sense that a reduction of the deficit would have primarily meant higher employment and output rather than higher prices. On the contrary, the deficit is seen to have had a “mild anti-inflationary effect; it has somewhat moderated the speed of cyclical expansion after the recession and thus has helped to lengthen the cyclical upswing which has carried the economy close to full employment in 1978.” See Gottfried Haberler, “Flexible Exchange Rates: Theories and Controversies Once Again” (unpublished, 1979), pp. 19-20, and his “Reflections on the U. S. Trade Deficit and the Floating Dollar,” in Contemporary Economic Problems, 1978, ed. by William Fellner, American Enterprise Institute for Public Policy Research (Washington, 1978), pp. 211-43.

See, for example, Annual Report of the Council of Economic Advisers (cited in footnote 38), p. 117, “… appropriate national policies and international cooperation will be particularly important to ensure that the international financial system remains adequate to the demands that will be made on it and to reduce the large imbalances that exist aside from the OPEC surplus.” See also C. W. McMahon, “Is There an International Monetary System?” Bank of England, Quarterly Bulletin, Vol. 18 (June 1978), pp. 240-43.

Extracts and summaries of reports and statements may be found in various issues of the Fund’s IMF Survey. Specifically, for the relevant passages in the Bank for International Settlements, Annual Report, 1977/78, see the IMF Survey, Vol. 7 (June 19, 1978), pp. 189-90; for the statement of the Interim Committee of the Board of Governors on the International Monetary System, see the IMF Survey (May 8, 1978), p. 129; for the views of the International Monetary Fund, see the address of J. de Larosiere to the Overseas Bankers Club, “Toward a More Stable World Economy,” reprinted in the IMF Survey, Vol. 8 (February 5, 1979), pp. 33 and 43-45, and the address of J. J. Polak to the Economic and Social Council of the United Nations in Geneva, reprinted in the IMF Survey (July 17, 1978), pp. 210-13; for the agreement reached by the members of the Organization for Economic Cooperation and Development, see the IMF Survey (July 3, 1978), pp. 193 and 199. The view of the European Community is given in Jean Claude Morel, “The Medium-Term Economic Programme of the Community,” a speech delivered at the conference of the Austrian National Bank in Baden, Austria, May 30-June 1, 1978, published as “Wirtschaftsprogramm der Europdischen Gemeinschaft und die mittelfristigen Aussichten,” Wirtschaftprognose und Wirtschaftspolitik (Vienna, 1978), pp. 95-103.

In 1974-75, it was widely held that higher import bills of the oil consuming nations coupled with the purportedly limited absorptive capacity of the oil producers would lead to excess savings and rising unemployment on an international level, and that countercyclical demand management was accordingly in order. In the meantime, the absorptive capacity of OPEC has proved larger than was thought possible a few years ago. (See, e.g., Tamir Agmon and Arthur B. Laffer, “Trade, Payments and Adjustment: The Case of the Oil Price Rise,” Kyklos, Vol. 31 (No. 1, 1978), pp. 68-85. See also Bruce K. MacLaury, “OPEC’s Billions,” The Brookings Bulletin, Vol. 15 (Fall 1978), and David R. Morgan, “Fiscal Policy in Oil Exporting Countries, 1972-78,” Staff Papers, Vol. 26 (March 1979), pp. 55-86.) Nevertheless, investment activity in many of the industrial countries has yet to recover convincingly from the recession. A situation of insufficient aggregate demand appears thus to have persisted, although the oil crisis alone can no longer account for it. (See W. M. Corden, “Expansion of the World Economy and the Duties of the Surplus Countries,” The World Economy, Vol. 1 (January 1978), pp. 121-34, regarding the “Keynesian” problem of excess savings in the international economy.) In these circumstances, coordination both in the expansion of demand and in current account adjustment is seen by many as the most appropriate route toward lasting recovery, while the recent increase in protectionist measures appears to signal the urgency of such action. The increasing use of protective trade measures in 1977 and 1978 is documented in the Fund’s Twenty-Ninth Annual Report on Exchange Restrictions (Washington, 1978). See also The Rise in Protectionism, International Monetary Fund, Pamphlet Series, No. 24 (Washington, 1978). Two frequently cited reasons for the sluggishness of investment activity are the high level of public indebtedness, which is purported to constrain public investment, and the uncertainty attributed to exchange rate volatility, which, it is argued, inhibits private investment. Doubts about the role of the exchange rate in the adjustment process have compounded difficulties in this respect. On the one hand, not all exchange rate changes induce changes in production—only those that are considered as lasting. See, for example, Niehans (1975, cited in footnote 27). On the other hand, to the extent that constant real exchange rates prevail, lasting changes are excluded. This point is made, for example, in Corden (1978, pp. 122-34), and in McMahon (1978, cited in footnote 62).

See, for example, Corden (1978, cited in footnote 62), and Gottfried Haberler, Oil, Inflation, Recession and the International Monetary System, American Enterprise Institute, Reprint No. 45 (June 1976).

It should be acknowledged that a finding of inadequate aggregate demand would not imply the inevitability of economic warfare as was experienced during the 1930s. This is most clearly seen in the industrial countries’ response to the OPEC shock. The oil importing countries as a group had two basic options with respect to the distribution of their collective current account vis-à-vis the OPEC countries: either to rely on market forces to effect that distribution or to act in concert and carry out a distributional arrangement. Generally, opinion favored the idea of at least some intervention, for fear that the exchange rate mechanism would not be effective, especially with regard to the correction of payments imbalances in the short run, or that several countries would pursue conflicting policies, from which all would suffer because of the resulting disruption in commercial relations. A number of specific criteria for the distribution of the collective deficit were suggested, and some of these, such as the efficiency or “rate of return” and “economic size” criteria, received fairly broad support. No formal or informal agreements involving any particular criterion for allocation were concluded; although there was clearly some concern in the United States over “caution” by Japan and the Federal Republic of Germany, in general, the period of crisis was weathered in a spirit of cooperation if not actual coordination. See International Monetary Fund, Annual Report, 1977 (Washington, 1977), p. 12; Jacques R. Artus and Andrew D. Crockett, Floating Exchange Rates and the Need for Surveillance, Essays in International Finance, No. 127, International Finance Section, Princeton University (May 1978); Andrew D. Crockett and Duncan Ripley, “Sharing the Oil Deficit,” Staff Papers, Vol. 22 (July 1975), pp. 284-312; John Williamson, “The International Financial System,” Ch. 6 in Higher Oil Prices and the World Economy: The Adjustment Problem, ed. by Edward R. Fried and Charles L. Schultze, The Brookings Institution (Washington, 1975), pp. 197225; and Robert Solomon, “The Allocation of ‘Oil Deficits’,” Brookings Papers on Economic Activity: 1 (1975), pp. 61-87.

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