The connection between fiscal policy and the balance of payments has received much attention in the mid-1980s. The simultaneous appearance of the United States’ “twin deficits”—the federal budget deficit and the trade deficit—has been much discussed and debated among economists and policymakers (see Figure 1). Much of the disagreement has been about whether a causal relationship exists between the twin deficits and, in particular, whether a sharp reduction in the U. S. budget deficit is a necessary condition for a reduction in its trade deficit.

The connection between fiscal policy and the balance of payments has received much attention in the mid-1980s. The simultaneous appearance of the United States’ “twin deficits”—the federal budget deficit and the trade deficit—has been much discussed and debated among economists and policymakers (see Figure 1). Much of the disagreement has been about whether a causal relationship exists between the twin deficits and, in particular, whether a sharp reduction in the U. S. budget deficit is a necessary condition for a reduction in its trade deficit.

Figure 1.
Figure 1.

Overall U.S. Deficit and Foreign Investment, 1979–87

(In billions of U.S. dollars, from first quarter to first quarter)

Source: U.S. Department of Commerce, Survey of Current Business, various issues.

This paper will explore the connection between fiscal policy and measures of external balance. Fiscal policy will be largely construed to mean budget policy, but some discussion of tax policy will be included, since it is relevant to the U. S. experience during the 1980s. The phrase “measures of external balance” is used on occasion in the text in place of the “balance of payments” used in the paper’s title, because the balance of payments in a formal sense always balances, and it is necessary to specify whether one wishes to examine the much touted and maligned merchandise trade balance or alternatives, such as the current account balance or its mirror image, net capital inflows.

It is also important to specify whether one is operating under a regime of freely flexible, partly flexible, or fixed exchange rates. The transition from flexible to partly flexible exchange rates, particularly since the February 1987 Louvre Accord, is important to recognize, since it affects the observed adjustment mechanism that operates in response to a fiscal disturbance like a larger budget deficit.

I shall begin with a general discussion of fiscal policy and the balance of payments and then examine some familiar ground within the context of a simple full-employment model for a small country. Next, the discussion is modified to more readily accommodate the case of the United States in the 1980s. Assumptions of a small country and full employment are relaxed. These discussions are next employed in conjunction with the behavior of other Group of Seven countries to focus explicitly on the recent U.S. experience with fiscal policy and external imbalances. Where appropriate, the role of attendant monetary policies is discussed in conjunction with fiscal policy.

The discussion throughout is heuristic, eschewing specific modeling with equations or diagrams. Those who prefer more specificity or who wish to read “between the lines” are referred to Makin (1986).1

I. A General Discussion of Fiscal Policy and the Balance of Payments

The proximate impact of fiscal policy on the balance of payments is simple enough to explain. If by “fiscal policy,” one means the relationship between government spending and tax revenues, and by “balance of payments,” one means the current account balance (merchandise trade plus net services and investment income), the following is true: more government spending, while holding constant revenues and net private saving (private saving minus private investment), will enlarge the current account deficit largely by raising the merchandise trade deficit. The corollary proposition is that the current account deficit (capital inflows) cannot fall without a corresponding (not causal) fall in the budget deficit unless net private saving rises. The rise in net private saving may coincide with a collapse of private investment and a recession, particularly if accommodating capital inflows are only available at a higher interest rate.

A relationship between fiscal (tax and spending) policy and the balance of payments would normally be discussed within the context of a regime of fixed exchange rates. More expansionary fiscal policy would put incipient upward pressure on domestic interest rates. In a Mundellian, small-country world with infinite mobility of capital, capital inflows accommodate the fiscal expansion at a given world interest rate. The positive impact upon aggregate demand is not mitigated by the “crowding-out” that results in a closed-economy setting in the absence of monetary accommodation by the central bank or an infinitely elastic (with respect to interest rates) money demand schedule.

The net impact of fiscal expansion on the balance of payments in the fixed-exchange-rate case is zero, but that masks a change in its components. The increased capital inflow will, barring a change in private net saving or official intervention in foreign exchange markets, be reflected by an equal rise in the current account deficit. In short, a rise in national dissaving is accommodated by a capital inflow from abroad, which, in turn, is reflected in a larger current account deficit.

If private capital is not infinitely mobile, part of the capital inflow may come from official intervention in the foreign exchange market aimed at pegging the exchange rate, provided that the higher interest rate does not raise net private saving by an amount exactly equal to the rise in government dissaving. If the increase in net private saving is below that critical level and private capital inflows are inadequate to match the rise in national dissaving, then there will be an excess demand for foreign exchange. If the exchange rate is fully flexible, the currency depreciates until a combination of higher interest rates and currency depreciation increases net private saving by an amount equal to the increase in government dissaving.

If, alternatively, the exchange rate is pegged, official intervention in support of the home currency will, if not sterilized (not allowed to affect the money supply), reduce the domestic money supply and/or raise the money supply abroad. All of the adjustment pressure is thereby thrust upon the interest rate, which must rise by enough at home to elevate private net saving and capital inflows by an amount equal to the increase in government dissaving. A drop in the foreign interest rate enhances capital inflows. Higher prices at home and lower prices abroad help the adjustment by increasing imports and cutting exports, thereby raising required capital inflows. Higher prices at home may also elevate private net saving at home, and lower prices abroad may cut net private saving abroad through the real balance effect on saving. If the intervention employed to peg the exchange rate is sterilized, the adjustment mechanism is prevented from operating. The excess demand for foreign exchange by the home country becomes chronic, and intervention continues until the prospect of sharp adjustment (usually a devaluation by the deficit country) is realized, at which time a combination of currency devaluation and higher interest rates brings about either the needed reduction or net private dissaving.

II. U.S. Fiscal Policy and External Adjustment: A Large Open Economy With Flexible Exchange Rates

A discussion of the impact of U.S. fiscal policy in the 1980s on the external balance might better be focused on exchange rates than on the balance of payments. A careful study of the external effects of countercyclical fiscal policy in a large open economy with flexible exchange rates and a significant non-traded-goods sector reveals that, contrary to the conclusions reached with small-country models developed by Robert A. Mundell, J. Marcus Fleming, and others in the 1960s, fiscal policy is a potent countercyclical tool.

A corollary, seemingly obvious, conclusion is that exchange rate stability requires active coordination of fiscal and monetary policies among large open economies. Notwithstanding a stated desire for exchange rate stability by most Group of Seven finance ministers and central bankers, no such coordination has emerged during the 1980s.

An appropriate engine of analysis for consideration of the external effects of fiscal and other policy measures in a large open economy requires some modification of the simpler models developed for small open economies that were discussed in the preceding section. The minimum serviceable model includes, in addition to the usual equilibrium conditions in the traded-goods sector and the monetary sector, a market-clearing condition in the non-traded-goods sector, specification of equilibrium conditions in labor markets, and equations satisfying interest parity, Fisher conditions, and purchasing power parity. Such a model, developed in Makin (1986), can be solved to endogenize the home country’s terms of trade, which in turn determines the impact of changes in fiscal and/or monetary policy on exchange rates, output, and employment.

Such a model, augmented with ad hoc expectations-generating mechanisms, captures well the U.S. experience of the 1980s. Expansionary fiscal policy results in sharp currency appreciation, which in turn puts deflationary pressure on prices. The deflationary pressure from currency appreciation moderates money-wage demand, which, along with an improvement in the terms of trade, causes output and employment to rise. Such a combination of events characterized the U.S. economy in 1984. During 1987/88, in Japan, following the introduction of a fiscal expansion package, coupled with currency appreciation, the Japanese situation resembled the 1984 U.S. experience.

If the exchange rate is relatively ineffective at eliminating an excess demand or supply condition in the market for traded goods, as it is in the United States, the model under consideration suggests that wide swings in exchange rates may also accompany shifts in monetary policy undertaken to offset the negative impact on the supply side of the traded-goods sector arising from a sharp currency appreciation.

With this framework in mind, it is possible to review some broad, stylized facts concerning U.S. fiscal policy during the 1980s and accompanying policies elsewhere. Viewed broadly, the 1980s was a period of fiscal retrenchment for most large industrial countries outside the United States. In the seven largest Organization for Economic Cooperation and Development (OECD) economies, public expenditure had risen from 33 percent of gross domestic product (GDP) in 1972 to 41 percent of GDP in 1982. But by 1982, the OECD’s measure of government financial balances indicated a sharply expansionary posture in the United States, a neutral posture in Japan, and a strongly contractionary posture in the Federal Republic of Germany (see Figure 2). In the following two years, the U.S. posture remained sharply expansionary, Japan’s posture turned contractionary, and the German posture remained contractionary, though slightly less so than in 1982.

Figure 2.
Figure 2.

Change in Structural Budget Balance, Inflation-Adjusted, 1980–88

(In percent of nominal CNP/CDP)

Source: OECD Economic Outlook (Paris: Organization for Economic Cooperation and Development, various issues).1 Average of six major countries, excluding the United States.

The broad pattern of fiscal retrenchment outside the United States exacerbated the pressure on dollar appreciation created by the highly expansionary posture of U. S. fiscal policy. The effect outside the United States was to cushion the domestic impact of fiscal retrenchment. The strong dollar and the rapid pace of U.S. economic growth, especially in 1984, permitted a sharp increase in exports to the United States or other dollar areas.

After the Plaza Accord (1985), and especially during 1986, the U. S. monetary policy eased sharply, and the dollar began to depreciate against most currencies, but most drastically against the yen and the deutsche mark. During 1987, the pressure for a weaker dollar was intensified by a move in U. S. fiscal policy to a more restrictive stance and an easing of Japanese fiscal policy, coupled with some sterilization of the Bank of Japan’s dollar support during the middle of 1987.

By 1987, especially after the February Louvre Accord, a macroeconomic dilemma had become evident in the United States. Five years later than most industrial countries, the United States was beginning to move to control its fiscal deficits. The result was that fiscal policy was stuck in neutral, or slightly in reverse, and was therefore not available as a countercyclical tool.

A decision to peg the dollar exchange rate in a narrow range against the deutsche mark and the yen at a time when accommodating capital flows to the private sector from abroad were beginning to slow created a dangerous situation. Strictly speaking, a country with an exchange rate target loses control over monetary policy. In the case of the United States during 1987, the central banks of Germany, Japan, and elsewhere provided $100 billion-plus of accommodating inflows in an attempt to peg the dollar exchange rate at a time when U.S. absorption was not dropping rapidly enough to allow a falloff in capital inflows.

Contrary to the stated objectives of many Group of Seven policymakers outside the United States to bring about more U.S. adjustment, the extra liquidity provided by official intervention in support of the dollar only delayed U.S. adjustment by accommodating U.S. absorption on easier terms. Of course, the objective of the dollar support was to cushion the loss of exports to dollar markets. It revealed a powerful ambivalence that has always characterized the attitude in more open economies to a U. S. adjustment: “the United States should spend less, but not on imports from my country; the (great, big) United States should not expect to eliminate a merchandise trade or current account deficit by selling more to my (poor, little) country.”

The exchange rate-pegging exercise ran into difficulty in May-June 1987 when Japan embarked on an expansionary fiscal policy, coupled with some sterilization of its intervention in support of the dollar. The expansionary fiscal policy placed strong upward pressure on Japanese interest rates, which was accentuated by a housing construction boom during the summer of 1987.

As a result of exchange rate pegging, the higher interest rates in Japan were transmitted to the United States. By September, the United States was forced to tighten monetary policy in view of its agreement to peg the exchange rate within a narrow range. This move highlighted the dilemma facing the Federal Reserve. Maintaining expansion called for easier money, whereas defending the dollar called for tighter money. Unable to do both, the Federal Reserve opted for slightly tighter money and raised the discount rate by ½ of 1 percent early in September. In effect, the Fed was making an adjustment that ought to have been made in April after the initial sharp run-up in interest rates.

The upward pressure on U. S. interest rates intensified in October, especially after the October 14 release of the August trade deficit. By October 19—“Black Monday”—interest rates had risen so high that the temptation to sell stocks and then to buy bonds became unbearable. The result was a collapse of equity prices, as investors rushed to the relative safety of bonds.

The pervasive view was that if a cycle of weak trade numbers and higher interest rates were to continue until the U.S. recovery was choked off, the outlook for corporate earnings was bleak. The reaction was therefore to sell shares. Once the sale of shares accelerated on Black Monday, the combination of 10 percent-plus interest rates on government bonds and a prospective recession caused the rush into bonds. The only check on further bond buying since has been the fear of a possible rise in inflation due either to a dollar collapse, faster money growth, or both.

The stock market collapse was in part the result of an accumulated need for a correction of U. S. fiscal policy. Viewed in the simplest terms, it reflected a stark fact: foreign capital would accommodate U.S. consumption in excess of production only with interest rates at a level high enough to undercut equity prices, particularly when those equity prices had reached price/earnings multiples above their historical norms.

More broadly, the market crash signaled a vision of the future. The United States would have to reduce consumption either by means of ever higher interest rates or by means of a negative wealth effect created by a collapse of equity values, which would, in turn, reduce U.S. consumption and investment and, thereby, U.S. absorption, to a point at which accommodative capital inflows would occur at an interest rate consistent with equity prices.

The interconnections between commodity and financial markets were made unusually clear during the last quarter of 1987. Excess U.S. outlays on commodities—the current account deficit—caused bond prices to fall until interest rates threatened to cut expenditure sharply. Then, share prices fell and bond prices rose to less than half their March 1987 highs. The markets are now groping for a new configuration of equity and bond prices that will clear markets at levels consistent with a level of U.S. net absorption that external lenders will accommodate. That level of accommodation depends on the rate at which non-U.S. markets increase absorption of U.S. exports and the rate at which the United States cuts absorption of non-U.S. exports.

III. U.S. Fiscal Policy and Structural Adjustment

Discussion so far has focused on the macroeconomic effects of the unusual configuration of U. S. fiscal policy during the 1980s. The unusual nature of that policy, coupled with some major changes in tax structure enacted in 1981 that tended to exacerbate the effects of the budgetary impact of lower tax revenues and higher spending, resulted in significant structural microeconomic effects that must be analyzed to understand the overall impact of U.S. fiscal policy in an international setting.

A thorough understanding of the profound structural effects on the U.S. economy that resulted from tax and budget measures enacted in 1981 and 1982 provides a broader basis for an understanding of the origins of the U.S. trade legislation that emerged during 1986 and 1987. An understanding of these structural factors is also helpful for predicting the likely course of U.S. trade legislation in the immediate future. The microeconomic tax changes effected by the 1981/82 tax reform acts, when coupled with the budgetary and exchange rate impact of changes in aggregate spending and taxation, created a dangerous combination for U.S. manufacturers in the traded-goods sector.

The aggregate tax cuts enacted in 1981 were part of a normal correction for the upward creep in U. S. tax burdens that routinely occurs as a result of a largely unindexed tax system. The rapid inflation of the 1970s had sharply increased marginal effective tax rates on income from capital as well as tax rates faced by individuals. Total revenues of the federal government as a share of gross national product (GNP) had risen above 19 percent, somewhat above the 1962–85 average of 18.5 percent.

As a result of the tax cuts and incentives put into place in 1981–82, revenues as a share of GNP fell briefly to 18 percent in 1983–84 and then began to rise back to above-normal, post-World War II levels, reaching over 19 percent by 1987. The major budgetary impact came from a sharp increase in spending. In effect, spending on entitlements programs, nearly half of total federal outlays, continued to rise rapidly, accompanied by a brief but even more rapid acceleration of military spending. As the deficits accumulated, spending on interest on the debt also rose.

The major structural or microeconomic feature of the 1981/82 tax acts was a sharp reduction in the marginal effective tax rate on new investment. This was accompanied by a liberalization of accelerated depreciation allowances, along with investment tax credits that amounted to partial expensing allowances for qualified investments. Such measures sharply reduced marginal effective tax rates on income from new investments, and in some cases—equipment investments in particular—marginal effective tax rates were negative. The federal government was actually paying private firms to purchase certain forms of qualified equipment.

The effect of measures to stimulate investment is temporary. A reduction in the tax burden on new investment creates an increase in the desired capital stock for firms eligible for the investment incentives. As a result, other things being equal, these firms increase their purchases of capital. The observable counterpart is a rise in investment flows that continues until the capital stock reaches its desired level. At that time, the only net, ongoing impact on investment is a small increase in gross investment, provided that firms continue to replace the depreciated portion of a larger capital stock.

The positive impact on new investment of the 1981/82 tax incentives was delayed by the recession of 1982. By late 1983, private investment in the United States was accelerating rapidly, just as the federal budget deficit was beginning to rise as well. The result was a sharp increase in overall U.S. expenditure that was not matched by an increase either in government tax revenues or private saving.

The sharp increase in U.S. absorption was accommodated on unusually easy terms by a large increase in lending from abroad. This was due partly to a continuous relaxation of controls on capital outflows in Japan and elsewhere and partly to the attraction of a rapidly growing U. S. economy in which it appeared that inflation was being brought under control.

The problem for U. S. traded-goods industries lay with the sharp appreciation of the dollar that accompanied the surge in private investment and government spending during 1983/84. Many of the U.S. companies that responded to the investment incentives in the 1981/82 tax acts found that they were unable to sell the goods produced with new stocks of capital when faced with competition (both in domestic and foreign markets) from goods produced abroad. In effect, the failure to anticipate the sharp appreciation of the dollar implicit in the unusual configuration of U.S. fiscal and monetary policies and the accompanying retrenchment of fiscal policies abroad caused U. S. investors to set hurdle rates too low for investment projects in traded-goods industries. As a result, by 1985 much of the new addition to the capital stock in the United States had been rendered economically redundant by virtue of a sharp appreciation of the dollar.

The U.S. economy in 1985 was really two economies. The nontraded sector was prospering, thanks to the stimulative effects of a surge in government and private spending; and the traded- or manufactured-goods sector was saddled with heavy excess capacity and an inability to compete in U.S. and world markets.

This uncomfortable dual economy set two forces in motion. The first was legislative, which took the form of heavy lobbying by U. S. industry for a trade bill with heavy emphasis on the opening up of foreign markets and the removal of nontariff barriers impeding sales abroad. Second, at the Plaza meeting in September 1985, the Reagan Administration reversed its stance on the dollar and indicated a willingness, and indeed a perceived need, for dollar depreciation. A rapid growth in the U.S. money stock, accompanied temporarily by monetary tightening in Japan, gave additional momentum to a dollar depreciation that had begun earlier in 1985.

The extreme pressure on the international competitiveness of U.S. manufacturing during the 1981–85 period resulted in structural adjustments that meant that the U.S. current account balance would likely be less responsive to exchange rate adjustment than has historically been the case. As a result of a long-sustained real appreciation of the dollar, many U.S. companies accelerated or initiated plans to locate manufacturing facilities abroad. This relocation trend is not likely to be reversed, but rather to be maintained as a hedge against the problems related to exchange rate volatility that come from competing in world markets. It is important to remember that the volatility, in turn, flows from a failure to coordinate economic policies among industrial countries.

The internationalization of U. S. business has of course been matched by the internationalization of businesses whose managements are based in other countries. A typical pattern shows managerial expertise in financial and research areas headquartered in a home or base country, with manufacturing facilities located around the world. This is partly due to the above-mentioned need to hedge against sharp changes in exchange rates. It is also likely due to the large economies of scale that can be realized by virtue of centralized financial and managerial capital. A multinational firm that operates worldwide, sourcing and manufacturing in markets dictated by financial and real market conditions, is very likely to be an increasingly prevalent phenomenon. The rapidly increasing presence of “American” firms in Europe and Japan and “Japanese” and “European” firms manufacturing and operating in the United States only serves to underscore this point.

The consequences for policymakers of this internationalization of business will be many. First, standard measures of merchandise trade balances may have to be discarded, or at least read with additional qualifications in mind. The more a country’s firms tend to locate their manufacturing facilities abroad, the smaller will be that country’s recorded commodity exports. Yet, such a weak showing on traditional merchandise trade figures may mask a sharp increase in dominance in world markets by the country’s manufacturers.

The results of U.S. budgetary and tax policy in the 1980s will also require a rethinking of policies developed largely in a closed-economy setting. No thought was given by U.S. policymakers in 1981, when investment incentive measures were enacted into the tax code, to the possibility that the budgetary implications of revenues lost through investment incentives, coupled with deficit increases resulting from other deficit-increasing measures, would result in an exchange rate appreciation that frustrated the original purpose of the tax incentives. The crowding-out of investment occurred ex post due to currency appreciation, instead of ex ante due to higher interest rates. Unfortunately, the new investment could not be undone in the face of ex post crowding-out. The new investments, given the depreciation of the dollar, have since become more viable, but the wait for the delayed positive returns was costly.

More broadly, the advisability of tax measures designed to enhance competitiveness where exports are capital-intensive is called into question by traditional trade theory. If a country like the United States enacts measures that lead to a large increase in the capital stock, then, as we know from the Rybczynski theorem, the relative price of capital-intensive exports will fall, or, equivalently, the United States’ terms of trade will deteriorate. The result is that many of the supposed benefits of investment incentives spill out of the United States to the rest of the world.

There has been much talk of loss of U. S. competitiveness and the ability of tax policy to restore that competitiveness. Based on comparisons with Japan, U.S. competitiveness in the early 1980s had largely been restored to the level of 1970, prior to adjustment for exchange rate changes. Figure 3 shows the path of U. S. competitiveness versus Japanese competitiveness in the manufacturing sector, with 1970 set at zero, based on the path of labor productivity and labor compensation.2 The second line shows the real appreciation of the dollar and the subsequent impact on competitiveness that resulted from sharp dollar appreciation. The effect on competitiveness of exchange rate volatility dominated the effect of traditional measures based on movements in the productivity and real cost of factors of production.

Figure 3.
Figure 3.

Measures of U.S.-Japanese Competitiveness, 1970–86

(Competitiveness index)1

Source: U.S. Department of Labor, Bureau of Labor Statistics, various releases.1 For additional details, see Makin (1987).

Figure 3 also shows that the rapid depreciation of the dollar that began after 1985 ought to have more than compensated for the level of real competitiveness based on relative factor productivity and relative factor cost. The failure of the U.S. merchandise trade balance measured in dollars to fall even in 1987, two years after the depreciation of the U.S. dollar began, is a reflection of two factors: first, the large volume of U. S. imports relative to exports, which means that price effects dominate quantity effects, particularly in view of relative elasticities that favor foreign suppliers to the U.S. market; and second, strategies of non-U.S. exporters to maintain their U.S. market share even in the face of a much weaker dollar.

IV. Looking Ahead: The Process of Adjustment to U.S. Fiscal Policy in the 1980s

The persistence, although at considerably reduced levels, of the U.S. trade and current account deficits three years after the depreciation of the dollar began is a symptom of the fact that the broad adjustment to the U. S. fiscal experiment of the 1980s continues. The required adjustments are made more extreme by the fact that the post-1981 fiscal expansion coincided with a widespread fiscal retrenchment in other Group of Seven countries, especially Japan, the Federal Republic of Germany, and the United Kingdom.

The basic question facing the United States and the world economy is whether the adjustment can be achieved without a U. S. recession. In theory as well as in practice, such an adjustment without a U.S. recession requires that the United States spend less while the rest of the world spends more. Specifically, in terms of the theory outlined in this paper, the United States needs to continue its fiscal retrenchment in exchange for an easing of monetary policy in other Group of Seven countries, especially Japan and Germany.

Both adjustments have so far been only partially completed. A structural, downward adjustment in the U.S. budget deficit will require fundamental changes on the expenditure side. The entitlements programs, which constitute half of total federal spending and remain the largest and most rapidly growing budget category, will have to be modified with new legislation. The growth of entitlements benefits, including social security and government and military retirement programs, will have to be slowed by an adjustment of the formula that indexes the outlays on these programs to inflation. A widely discussed approach would be to subtract 2 percent from the inflation rate when cost of living adjustments are calculated for these programs. Such a change, given currently foreseen rates of inflation, would reduce outlays on these programs by nearly $80 billion over the next five years.

The savings would continue to grow over time, owing to a lowering of the growth path of outlays on entitlements. Such spending reductions would not be subject to alterations by congressional appropriations committees as would discretionary spending programs. As such, they would provide stable, prospective deficit reductions needed for a long-run, successful structural realignment of U.S. fiscal policy.

The recipients under entitlements programs are typically retired middle-class citizens, well organized by special interest groups such as the American Association of Retired Persons. Voter participation among these groups is unusually high. For these and other reasons, politicians are reluctant to adjust these programs.

The other major category of U.S. spending—defense—has already been curbed. Defense spending in nominal dollar terms has been virtually flat for two years and falling in real terms.

Many have argued that in view of the political difficulty hampering the adjustment of U. S. federal government spending, new sources of revenue ought to be sought. It is to be hoped that revenue proposals will be guided by sound basic principles of taxation. Any new taxes should be levied at low rates on a broad base.

For a country with the world’s lowest saving rate, a broad-based consumption tax comes to mind. The rough rule of thumb is that each percentage point of a consumption tax, with protection for low-income taxpayers built in, yields about $15 billion in revenue. A national value-added or sales tax in the 3 percent to 5 percent range would yield $45 billion to $75 billion annually.

An administratively simpler and perhaps preferable alternative to a national sales tax, which requires an elaborate machinery to implement, might be a broadly based devaluation of the United States’ $400 billion worth of tax preferences. Currently, tax preferences that allow deduction from taxable income of interest, tax, and other expenses associated with owner-occupied housing, health insurance premiums, and many other measures constitute a regressive revenue loss for the federal government. If all tax preferences were devalued by about 20 percent, roughly $60–70 billion in revenues would be available.

The approach featuring devaluation of deductions and tax preferences has the great benefit of administrative simplicity. Taxpayers could simply calculate their deductions under the existing code and then be allowed to take only 80 percent of the value of the calculated deductions as a reduction in taxable income. The revenue yield would be sufficient to bring the U.S. structural budget deficit back into line with pre-1981 levels.

When considering the stubbornness of the U. S. budget deficit, it is useful to remember that if the total outstanding debt of the federal government stood now at its 1981 level, the U.S. budget deficit would be in the $40–50 billion range. That level is typical in absolute terms of the past 25 years and, at about 1 percent, unusually low as a share of GNP.

The addition of $1.3 trillion of national debt has meant that the interest burden on debt has risen by about 2 percent of GNP, or a steady-state total of $90–100 billion. The useful guidelines, therefore, for revenue measures would be to design measures that are aimed at servicing the new larger stock of debt while ensuring that other large programs like entitlements are not allowed to increase outlays too rapidly. A value-added tax in the 3–5 percent range or a 20 percent devaluation of tax preferences would accomplish this. As already noted, the tax preference devaluation measure has in its favor administrative simplicity. It could also be put into effect more quickly and with far less administrative cost than a value-added tax.

Viewed broadly, the U. S. current account and budget deficits of the late 1980s are manifestations of the late stages of a major economic shock rolling through the industrial world. Long-run studies of growth, like that conducted by Maddison (1987), suggest that secular growth rates in industrial countries tilted downward after 1973. For the 1950–73 portion of the postwar period, the real growth rate for five countries outside the United States (France, Germany, Japan, Netherlands, and United Kingdom) was 5.6 percent. For the United States, the average 1950-73 growth rate was 3.7 percent. For the 1973–84 period, the five-country rate decelerated to 2.1 percent, and the U.S. rate decelerated to 2.3 percent. There was a recognition delay in most industrial countries during the latter 1970s. As a result, budgetary stringency was not applied, deficits mounted, and pressure for monetary accommodation grew until inflation surged worldwide in 1979/80.

It has been widely noted that most major industrial countries, excluding the United States, began fiscal retrenchment in the early 1980s. It has also been widely noted that the adjustment was made far more easy for countries like Germany, Japan, and the United Kingdom by the fiscal monetary configuration in the United States after 1981. By 1983, this configuration had resulted in a rapidly growing U.S. economy and an appreciating dollar, both of which combined to allow a surge in export sales to the United States; these exports, in turn, acted as a cushion for the fiscal retrenchment in the countries sending the exports.

Another factor contributing to earlier adjustment by the five countries outside the United States may have been the sharper post-1973 growth slowdown: 5.6 percent down to 2.1 percent for the five countries, versus 3.7 percent down to 2.3 percent for the United States. The 1950–73 period saw a more rapid resurgence of growth outside the United States due to replacement of production facilities destroyed during World War II, whereas the growth surge in the United States was less sharp, and the post-1973 slowdown, less dramatic.

Whatever the reasons for the unsynchronized fiscal retrenchment in industrial countries, there have been disquieting signs that an inability to coordinate fiscal policy among the Group of Seven countries has created extreme tension in financial markets. The collapse of the U.S. equity market in October 1987 signaled that the level of interest rates required to provide capital inflows to the United States sufficient to finance its current account deficits is inconsistent with attractive prospects for growth of the U.S. economy.

What is clear in the aftermath of the collapse of equity markets is that, barring any significant expansionary policies abroad, the reduction of U.S. absorption will be accomplished either by a high level of interest rates or, as now seems more likely, by a negative wealth effect achieved by means of a further collapse in equity markets.

The U.S. trade and current account deficits cannot be reduced arithmetically without a reduction in the U. S. budget deficit unless there is either a collapse of investment or a surge of private saving. The discouraging spectacle of desultory budget negotiations in the United States after the 1987 crash suggested that public sector dissaving would not be reduced by much. The modest reduction in government dissaving during fiscal 1987/88 was in fact accompanied by some reduction in private sector absorption. A combination of high real interest rates and a sharp drop in equity values and, thereby, in the wealth of U.S. equity owners, helped to reduce private absorption.

The role of official intervention in currency markets in this process has been largely to postpone adjustment. The largely sterilized $100 billion intervention to support the dollar after the February 1987 Louvre Accord suggests an ambivalence on the part of other countries about U.S. adjustment. As noted earlier, most countries act as if they would like the United States to reduce its absorption while continuing to buy exports from that country and not successfully selling to that country. Rather, there is a preference for the United States to reduce its absorption through higher taxes and lower government spending. Significant adjustment of this sort seems unlikely. Meanwhile, world financial markets are left to struggle with a prolonged delay in structural fiscal adjustment termed “muddling through” in the United States.

V. Summary and Concluding Comments

During the 1980s the impact of U.S. fiscal policy has been more unusual by virtue of its size and persistence than by its inconsistency with standard macroeconomic theory.

A combination of very expansionary fiscal and nonaccommodative monetary policy in the United States from 1981 to 1984, with some intervals of monetary relaxation, produced rapid economic growth by 1983 and the onset of sharp dollar appreciation. Mirroring these events was a sharp deterioration of the U.S. trade and current account balances and an attendant improvement in comparable balances elsewhere.

Exacerbating the responses to the policy mix just described were micro-incentives enacted in the U.S. tax code in 1981/82, which encouraged investment and thereby increased U.S. net dissaving. At the same time, Japan’s progressive relaxation of controls on capital outflows from December of 1980 acted, along with other capital flows, to encourage the transition to a large deficit in the U.S. current account. The requisite capital inflows were provided at lower than expected interest rates, owing partly to the release of a large pool of Japanese and European savings into U.S. financial markets and partly to the relative attractiveness of investments in U.S. financial and real assets.

The major adjustment undertaken thus far to the imbalances engendered by the U. S. program of fiscal expansion, coupled with fiscal retrenchment programs in other major industrial countries, has been to allow the dollar to depreciate rapidly against other major currencies, especially the yen and the deutsche mark. In view of the high level of U.S. imports relative to exports, elasticities generally unfavorable to rapid U.S. adjustment to external imbalances, and market strategies of exporters to the United States designed to maintain market share, the expenditure-switching engendered by the sharp depreciation of the dollar has been insufficient to reduce the dollar level of the U.S. merchandise trade deficit below $160 billion. The current account deficit has persisted in the $140–150 billion range.

Completion of the adjustment process still requires expenditure-reducing measures in the United States, such as lower government spending, higher taxes, or both. Failing these, reduction of private sector dissaving will be accomplished by market forces either in the form of collapse in equity values, high real interest rates, or both.

Since the U. S. economy accounts for over one third of economic activity in the industrial world and absorbs nearly one quarter of all world exports, it seems desirable from a worldwide economic viewpoint to cushion the required adjustment in the United States by means of modest demand-expansion measures undertaken in other industrial countries. These measures should take the form of easier monetary policies in the Federal Republic of Germany and Japan, coupled with maximum reduction of trade barriers.

Although growth of monetary aggregates in those countries is high by historical standards, the evidence of consistent appreciation of their currencies and the absence of any pressure on commodity prices measured in their currencies suggests that the demand for money is growing more rapidly than the supply of money. This is a situation reminiscent of the United States’ situation in 1982. The deflationary atmosphere brought on by a strongly appreciating dollar caused sharp growth of money demand, evidenced by sharp drops in velocity. Stable prices were consistent with high rates of growth of the money supply. The corollary: monetary policy was tighter than the central banks imagined it to be.

The broad lesson of the 1980s is that a regime of flexible exchange rates is no more congenial to poorly coordinated fiscal policies than it was to poorly coordinated monetary policies in the 1970s. Exchange rate volatility or, more specifically, the sharp rise and fall of the dollar from 1983 to 1988 is only a symptom of a low level of fiscal policy coordination, largely among the Group of Seven countries.

If past experience is any guide, industrial countries will continue to have difficulty undertaking coordination of policies. This in itself is a bearable though difficult fact of life for an increasingly integrated world economy. The major danger inherent in the large trade imbalances and exchange rate volatility that accompany poor coordination of monetary and fiscal policies is ill-advised attempts to treat symptoms rather than underlying causes. Attempts, such as the Louvre Accord, to peg exchange rates when poor policy coordination ultimately requires adjustment elevate rather than lower the negative by-products of uncertainty about future exchange rates. Attempts to reduce trade imbalances by restrictive trade legislation, tariff and nontariff barriers, or beggar-thy-neighbor efforts to undervalue currencies raise the risk of curtailing world trade, thereby sharply lowering living standards worldwide.


Gert Haller

John Makin’s paper gives a clear and comprehensive description of U.S. fiscal policy and its international repercussions. I have little to add to the overall analysis. But since I come from the Federal Republic of Germany, a country on which the impact of economic policies in the United States is strong and far-reaching, I would like to focus a little more on the German economic situation and the stance of German fiscal and financial policies. If I may, I would like to look at the picture from a German point of view.

For me, it was interesting to learn that the U. S. budget deficit is not so much the outcome of the tax cuts in the early 1980s, but more the result of an inability to limit the increase in public spending, especially the growth of entitlements and transfer payments. I recall very well the famous bipartisan decision of the U.S. Congress in the summer of 1981. At that time, one could have gained the impression—at least I had the impression—that the U.S. Administration and Congress had succeeded in permanently cutting government outlays by some $30 billion or $40 billion, and had thus paved the way for the intended tax cuts. It was some time before I learned that only a few of these spending cuts actually passed the related congressional appropriations committees. This inability to reduce public spending contrasts sharply with the political announcements before and after the presidential election of 1980.

Three aspects of the U. S. fiscal and current account deficits and their international consequences deserve special attention: the significance of public deficits for business activity; the policy mix in the United States; and the stance of fiscal and financial policies in the main trading partners of the United States. It is common theory that in the traditional Mundell-Fleming world with flexible exchange rates, fiscal policy is a rather blunt tool for stimulating economic activity. In the U.S. case, however, the Mundell-Fleming model does not work. As Makin very clearly describes, for the U.S. economy, which has a large non-traded-goods sector, an expansionary fiscal policy proved to be a powerful tool for strengthening economic activity, even with flexible exchange rates. However, it seems doubtful to me whether this example can simply be transferred to other countries. In contrast to the United States, the export sector of the Federal Republic of Germany accounts for more than 30 percent of the whole economy. Empirical studies show, moreover, that Germany’s foreign sector is closely interlinked with the rest of the German economy. Therefore, the strong appreciation of the deutsche mark since 1985 harmed not only export business but also most other parts of the economy. Current slow growth in business investments is not least an outcome of the fast rise of the exchange rate between the deutsche mark and the U.S. dollar.

This brings me to my second point. A comprehensive description of economic policies in the United States in the early 1980s must focus especially on monetary policy. At a time of increasing fiscal relaxation, the stance of U.S. monetary policy was still highly restrictive. I think it is not unfair to say that at that time the policy mix of the United States was to some extent extreme. Thus, the combination of an expansionary fiscal policy and a restrictive monetary policy resulted in extremely high interest rates, both in nominal and in real terms.

It is certainly true that the strong economic expansion in the United States and the appreciation of the dollar have helped to cushion the negative impact of fiscal retrenchment outside the United States. But it is also true that a different policy mix in the United States would have permitted different monetary policies in other countries and, thus, a different pattern of economic events. High interest rates in the United States prompted the capital inflows from abroad (in particular from Japan, but also from Germany). Of course, this is the mirror image of the U.S. current account deficit. These high capital flows to the United States had a threefold effect: high interest rates outside the United States; a loss of funds that could have been invested at home; and the accompanying rise in current account surpluses. Of course, all these effects are interrelated; they reflect the same thing from a different point of view.

From a German perspective it is noteworthy that the German central bank, the Bundesbank, found itself in a difficult situation. By trying to stop, or at least to slow, the depreciation of the deutsche mark—a policy the Bundesbank called “leaning against the wind”—it made monetary policy in Germany rather restrictive, both in terms of the development of monetary aggregates and in terms of real interest rates.

I will not deny, of course, that the increasing imports of the United States had an expansionary effect on other countries, not least on Germany. But one could certainly ask whether this is only a short-run argument. In the longer run, high capital outflows and strong exports contributed—other things being equal—to a smaller capital base in Germany and to an overexpansion of the export sector. When the dollar reached its peak of US$1 = DM 3.50, even shoelaces were shipped to the United States. I am not convinced that these kinds of exports from Germany to another highly developed country like the United States are a contribution to an efficient international division of labor.

To come to the current situation in the Federal Republic of Germany, I would first like to say a few words on the general stance of German fiscal and financial policies. To evaluate these policies correctly, one has to go back again to the early 1980s when the German Government decided to reduce the ratio of public spending to gross national product (GNP), which had risen over the 1970s by more than 10 percentage points. In contrast to the intentions of the United States to bring down public spending, in Germany, this policy has succeeded. By a strict limitation on expenditure growth, the ratio of public spending to GNP was brought down between 1982 and 1986 from some 50 percent to about 46½ percent. Up to 1985, the scope thus created was used primarily to reduce the high deficit of public budgets.

Starting in 1986, a program of tax cuts and tax reform was undertaken. Net tax relief was set to be as follows.

1986 DM 10.9 billion, or roughly 0.6 percent of GNP

1988 DM 13.7 billion, or 0.7 percent of GNP (including DM 5.2 billion brought forward as agreed in the Louvre Accord)

1990 DM 20 billion, or roughly 1 percent of GNP

This program will provide total net tax relief of about DM 50 billion, or 2½ percent of GNP. By 1990, taxes will take a share of some 22 percent of GNP—the lowest this ratio has been since 1958.

These tax reform measures have led and will further lead to a renewed increase in public sector deficits (central government figures are in parentheses).

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Since 1985, when the appreciation of the deutsche mark started, monetary policy in the Federal Republic of Germany has clearly been on an expansionary path. Money market rates have been lowered successively, and in 1986 and 1987 monetary growth was above money supply targets. Germany had the lowest discount rate in the 112-year history of German central banks and, second to Switzerland, the lowest money market rate of all major industrial countries.

I think it is well known that there had been some discussion within the board of the Bundesbank on the question of whether monetary policy was too expansionary. However one answers this question, monetary policy has in the present situation clearly reached its limits. The present monetary situation could be described as a kind of “liquidity trap.” Money demand is highly elastic. In the present situation, it seems that long-term interest rates cannot be brought down appreciably below 6 percent. In view of low money market rates, the interest curve is steep, which clearly indicates an expansionary stance of monetary policy.

In accordance with the shift in economic demand components required to eliminate current account imbalances, domestic demand in Germany has been appreciably higher than aggregate growth since 1986. Growth is thus being fueled exclusively by domestic demand. In contrast, the external surplus has been declining since 1986, both in nominal and, with even greater effect, in real terms as well. Its influence on economic growth is thus inevitably negative.

The following figures show the year-on-year changes in domestic demand and GNP (at 1980 prices).

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The foreign balance in billions of deutsche mark developed as follows (the figures in parentheses show percent of GNP).

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Economic trends in the Federal Republic of Germany are thus exerting a positive influence on the world economy.

Needless to say, asking Germany to increase its contributions to the international adjustment process by faster growth is asking for a rise in internal demand, which has to increase the more the foreign surplus is to be reduced. A reduction in the German current account surplus to a range from 1 percent to ½ percent of GNP by 1990/91 would require a rise in internal demand of about 3½ percent a year. I am quite certain that this figure could only be reached if Germany decided to revert to inflationary policies.

Thus, it will certainly take time to reach a more stable and balanced international economic situation. This conference is not the place to decide the question of whether economics is a moral science, as Kenneth Boulding once put it. There is no use in asking who has to take the blame for the present disequilibria. The problem confronting us is simply due to the inability of the major industrialized countries to coordinate their policies.

What conclusions do we have to draw? First, I fully agree with Makin that there must be some burden-sharing between deficit and surplus countries. A lower rate of government spending in the United States would certainly help. In the Federal Republic of Germany, the increase in public deficits in the years to come will probably be more marked than it presently seems. I am not sure whether there is scope for a more expansionary monetary policy in Germany. To avoid a collapse of world trade, everybody is well-advised to abstain from protectionist measures. The situation requires patience and self-control.

Second, I also fully agree with the conclusion that flexible exchange rates do not allow one country to depart very much from the policies of other countries. The experiment of past years—that is, putting the burden of adjustment almost exclusively on the shoulders of the exchange rate—has proved to be very expensive. This is especially valid for countries with a large foreign sector. Wide exchange rate fluctuations in both directions tend to depress private investment over the whole cycle. When the dollar/deustsche mark exchange climbed to US$1 = DM 3.50, German shoelace producers were well aware that this situation would not last forever.

Third, if policy coordination in a highly interlinked world turns out to be insufficient, then the question arises of whether we need improvements in the exchange rate system, which will increase the obligation to coordinate policies.


Carlo Santini*

I found Professor Makin’s paper both analytically interesting and highly relevant to the policy issues currently facing the United States and other economies in the world.

I shall not present a full-fledged discussion of his arguments, but will address a selected set of points that I regard as being of special interest for the conference. In discussing these points, I shall roughly follow the order that Makin follows in his reasoning.

One can broadly accept his account of the U.S. experience of the early 1980s, when the dollar appreciation, induced by a policy mix of fiscal expansion and monetary restraint, helped to slow down price inflation and wage dynamics. In this context, the terms of trade improved and output and employment expanded.

I have greater difficulty in accepting the strongly worded proposition that “the exchange rate is relatively ineffective at eliminating an excess demand or supply condition in the market for traded goods, as it is in the United States …” (page 58). There is, of course, an element of truth in this rather general statement, but it needs to be qualified, either by reference to the conditions specified in theoretical models or in the light of the abundant evidence collected in empirical studies of the U.S. trade performance.

More specifically, the argument developed in the paper regarding the increasingly dualistic nature of the U.S. economy and the resulting slowness of the adjustment of trade flows to exchange rate movements certainly deserves great attention. Makin’s contention that the decline in U.S. competitiveness caused by the appreciation of the dollar forced companies to relocate manufacturing facilities abroad on a large scale and that this development is not likely to be reversed as the dollar depreciates is of great intellectual appeal but is somewhat lacking in empirical support. Needless to say, it would be interesting to see the relevant statistical evidence. Has the shift really been so large, when account is taken of the lead times involved in investing in new operating facilities overseas? In addition, I find it hard to believe that U. S. companies responded to the appreciating dollar primarily by internationalizing production instead of by reorganizing their domestic activities. This would be an interesting contrast to the experience in Italy, where companies reacted to the strong exchange rate policy by reducing inefficiencies, cutting costs, and enhancing innovation.

If U.S. corporations followed the same course—and it is plausible to presume that they did, at least to some extent—the return of the real rate of the dollar to its 1980 level should have put them in a favorable competitive position. Surely, the recent strong export performance of the U.S. economy indicates that this might actually be the case.

I am in broad agreement with the paper’s analysis of the impact on the dollar of the expansionary fiscal posture in the United States and of budgetary retrenchment elsewhere. One could actually buttress this argument with some empirical evidence about the relationships between saving and investment in the three major economies and the interplay between their current account balances. According to the Organization for Economic Cooperation and Development (OECD), between 1981 and 1986 the ratio of the budget deficit to gross national product (GNP) in the United States increased by 2.5 percentage points, whereas in Japan and the Federal Republic of Germany, it declined by 3.0 and 2.5 percentage points, respectively. The results are similar if the changes are computed on a structural budget basis. Comparable changes in the opposite direction occurred in the current account balances of the three countries: in terms of gross domestic product (GDP), the U. S. current balance moved into deficit by 3.5 percentage points; the Japanese surplus increased by 3.9 percentage points; and the German balance recorded a swing into surplus of almost 5 percentage points. My view is that the shifts in budgetary policies in the three countries, together with the relative stability of the financial balances desired by the private sector (households, corporations, financial institutions), played a significant role in determining the movements in external payments through their influence on the pattern of domestic savings and investment.

I agree with Professor Makin’s suggestion that Europe greatly benefited from the strong U.S. expansion and rapidly appreciating dollar in 1983 and 1984. These developments propagated economic growth in Europe and other areas of the world economy by way of the foreign trade multiplier and, as the paper correctly argues, provided a cushion for the fiscal retrenchment in the countries exporting to the United States.

A good deal of empirical work has been conducted by the Bank of Italy’s Research Department on this subject, with the aim of investigating the trade and output effects on the three major European Monetary System (EMS) countries of the large real appreciation of the dollar and the strong recovery of the U.S. economy.1 The model used is a partial equilibrium one, with a structure similar to that of the International Monetary Fund’s world trade model, except that it encompasses two separate areas rather than the whole world. This permits distinct parameter estimates according to the area considered—that is, the EMS or the non-EMS-OECD area. Several shocks have been simulated, of which the most interesting for the purposes of this discussion is a devaluation of the EMS currencies with respect to the dollar and an increase of domestic demand in the United States.

The exercise shows that the trade balances of the three countries respond significantly to changes occurring outside the EMS area, especially in aggregate demand. Exchange rate changes have a smaller impact because the domestic price reaction dampens their effect on price competitiveness.

In sum, the appreciation of the dollar and the faster growth of U. S. domestic demand facilitated external adjustment in the three EMS countries. The benefits were especially important for France and Italy, since they came in a period when both nations were pursuing anti-inflationary policies that caused their real exchange rates to appreciate. Since no support was provided during that period by the sluggish demand growth in the low-inflation countries of the EMS, it is doubtful whether France and Italy would have been able to follow the same policies in the absence of the external stimulus provided by the United States.

On the issue raised in the paper of the ambivalent attitudes of most of the United States’ major trading partners to the prospect of a substantial external adjustment in the United States, my view would be the following. The counterpart of the necessary correction in the U.S. external deficit will, of course, be shrinking surpluses. These will obviously have to occur mostly in the rest of the OECD area, since we cannot count on the indebted developing countries in view of the fragility of their financial situation. Yet the reduction of the U.S. deficit should not be absorbed randomly by its partners in proportion to their present payments position, which is what would happen with unchanged policies abroad, in the event of a sharp contraction in the United States. Rather, the adjustment should be managed smoothly and targeted to the major surplus countries. This process would require differentiated demand policies in the OECD area outside the United States, so as to generate sufficient growth in domestic absorption and offset the negative impact of declining net exports to the United States while simultaneously reducing the existing payments imbalances.

As far as the European Economic Community is concerned, although a lower overall surplus is certainly warranted, the distribution of the related adjustment, chiefly between Germany and the other member countries, is a matter of concern and continuing debate, centered on policies designed to produce changes in relative demand growth and on the appropriateness of today’s EMS central rates. The importance of relative demand growth is also being boosted by the increasing priority the EMS countries are giving to stability in exchange rate relations.

Lastly, in his discussion of the policy prescriptions for the near future, I was interested in Professor Makin’s advocacy of a concerted or cooperative package in which the United States should be prepared to offer a “fiscal retrenchment in exchange for an easing of monetary policy in other Group of Seven countries, especially Japan and Germany” (p. 66), with a view to preventing a recession in the United States and other world economies. On this score I have two remarks to make, which perhaps complicate rather than answer Professor Makin’s queries. The first concerns the issue of worldwide fiscal discord and its implications for the observed instability in currency and equity markets. It is, I think, more clearly recognized today, at least by some of the Group of Seven nations, that fiscal policy decisions should be better attuned to the needs of international adjustment; the stimulative action announced in 1987 by Japan is exemplary in this respect. I am of the view that if the leading countries were able to negotiate a fiscal compromise involving less U. S. spending and more spending elsewhere, it would have a considerable stabilizing effect on financial markets (in the short run) and contribute to a reduction in the external imbalances (over the longer term). Yet, I see no mention of the possibility of such international policy coordination in the paper.

My second related point is concerned with the paper’s “optimum policy scenario.” The paper is rather pessimistic about the prospects of fiscal correction in the United States, claiming that “public sector dissaving would not be reduced by much” (p. 69), and that there will be a “prolonged delay in structural fiscal adjustment” (p. 69). The political complexities of the budgetary process in the United States mean that Professor Makin is probably right on this score. He then suggests that we may be facing a catastrophe: a sharp market reaction to the failure or inadequacy of policy decisions in the form of a further collapse of equity prices or a sudden rise in interest rates, resulting in a recession. I find it hard to believe that such a negative scenario can be prevented by coupling fiscal restraint in the United States with easier money in Japan and Germany alone. I still believe that action is needed on the fiscal front as well, and that there is scope for such action in both countries.


Charles Wyplosz

So much has been written about the U.S. twin deficits that it is becoming hard these days to write a paper that floats new ideas that are not outrageous. John Makin has wisely chosen to present a balanced account of the events since the beginning of this decade. That leaves the discussant with few bones to chew on. I shall therefore concentrate on some theoretical points first, and then bring up the European receiving end of the U.S. deficits.

This paper, as I see it, confirms the strong and growing recognition that the Mundell-Fleming model is after all the most efficient framework for interpreting the world macroeconomy. This is amazing for three reasons. First, the Mundell-Fleming model is the open economy version of the IS-LM model that is hardly mentioned in some recent influential macroeconomics textbooks. Second, this model, which is now more than 25 years old, has none of the components that have so changed what graduate students learn and do nowadays, ranging from rational expectations to intertemporal maximization, including time-inconsistency and equilibrium business cycles.

The last reason is that the model is surprisingly robust to a large number of restrictive assumptions, probably setting a record in the application of the parsimony principle, which sometimes escapes modern users. For example, Makin notes that, contrary to a literal reading of the model, the recent experience has shown that fiscal policy is able to affect output under flexible exchange rates. (Remember that according to the Mundell-Fleming model, a fiscal expansion leads to an exchange rate appreciation, and the resulting trade deficit eliminates the impact of fiscal policy.) In describing the effects of the investment tax advantage, Makin points out, quite interestingly, that U.S. firms were prompted to speed up their investment plans, only to discover that the dollar had risen while new equipment was being put in place, so that their overseas markets had shrunk to the point of making the newly installed capital useless. This is, of course, exactly the current account crowding-out effect predicted by the Mundell-Fleming model, with the “simple” distinction that in the model time is collapsed to comparative statics. One could push the advantage further and note that this is a perfect example of a successful case of time-inconsistency. Indeed, once the additional capital is in place, it may well be optimal to tax it (in the U.S. case, to repeal the tax concessions and achieve a terms of trade advantage via an exchange rate appreciation). Forward-looking agents are not supposed to fall into such a trap, and yet they did! Or did they?

This really brings me to one aspect that is overlooked by Makin—namely, the dynamic aspects of fiscal policy. Because any deficit (budgetary or external) leads to debt accumulation, stability conditions require that it be eventually compensated by a primary surplus that is at least sufficient to stabilize the ratio of debt to gross national product (GNP), if not to bring the debt back down in initial level (see Sachs and Wyplosz (1984)). Thus, the eventual reversal of the U.S. twin deficits and the dollar depreciation were predetermined all along from the first day of Reaganomics. Whereas U.S. firms in early 1985 might have felt that they were trapped with excess capital, the same firms in 1988 must be happy to have invested in time to take advantage of the low dollar at a time of near full employment. This is why it makes sense for the United States to hope for a demand expansion abroad when it can finally deal with its budget deficit. The question is whether it made any sense to shift investment spending intertemporally.

In order to answer this question, we must ask ourselves what would have happened in the absence of the investment tax incentives. Belaboring the identity that forms the backbone of Makin’s argument:


it is clear that the budget deficit increase (G-T) could have led to a crowding-out either via net private savings (S -I) or via the current account (CA). With the savings rate notoriously unresponsive to policy actions (notwithstanding the Ricardian equivalence principle), the investment tax concessions pushed all the adjustment onto the current account, thus financing the budget deficit through foreign borrowing, instead of crowding out investment. The question raised above can now be answered as follows. With no investment tax advantage and 100 percent crowding-out of private investment, the policy move would have been smart if the net social return of the budget deficit had exceeded the net social return of displaced investment. With the tax advantage and 100 percent leakage to the current account, the criterion is now whether the net social return of the (larger) deficit exceeds the real cost of foreign borrowing. A case can be made that the latter criterion is less stringent than the former (although not necessarily that it is satisfied; this may depend, among other things, on future foreign demand for U.S. goods). Yet, a superior alternative would have been to limit the sharp interest rate increase and the equally sharp dollar appreciation with a more accommodating monetary policy.

Turning now to the European side, I find Makin’s explanation of “Black Monday” (October 1987) a bit parochial. He notes that the reduction of the U.S. current deficit requires a fall in U.S. absorption (which is correct only because the United States operates at close to full employment). With a serious cut in the budget deficit slow in coming and hard to come by, the absorption can only be reduced through tight monetary policy or a negative wealth effect, or both. Hence, according to Makin, the financial markets simply anticipated the unavoidable. But then, why did stock prices plunge worldwide? Is it not true that absorption should rise outside the United States to help with the adjustment? Are not the world financial markets providing the cure and the poison at the same time? For, if absorption falls overseas and reduces U.S. exports, we are not getting any closer to the solution.

Following Makin’s insight that the stock market crash of 1987 “signaled a vision of the future” (p. 61), then Europe’s future is bleak despite years of financial retrenchment and record high unemployment. The same logic would interpret the simultaneity of crashes as an indication that the United States, where it all started, is pulling Europe into trouble. The truth is probably the opposite. Stock prices fall because of lower expected profits, in present value terms. 1 For U. S. prices to fall then, what must happen is either an (expected) increase in real interest rates or an (expected) reduction of future profits. The latter comes as the consequence of a fall in output, not in absorption. If foreign demand for U.S. goods grows sufficiently, a reduction in U.S. absorption need not lead to lower U.S. output and profits. Thus, the crash cannot be explained only by reference to the U.S. situation. The complete story must include the absence of faster growth overseas.

The important issue, then, is why Europe has not taken the expansionary measures that could have prevented stock crashes worldwide. 2 There are two broad answers. The first one is that the United States was an outlier once in 1982–85 when it embarked on a strong fiscal expansion. It now has to face the second stage of that policy, stabilizing its public debt and, hence, being an outlier again. Although cooperation is, in theory, superior to noncooperation, it does not follow that the rest of the world should always play seesaw with the United States. Indeed, some writers have suggested that Europe should have expanded along with the United States after 1982. Do they suggest a contraction now? Or, if one argues for an expansion now, based on cooperative arguments, was it wise for Europe to contract in the early 1980s? We cannot have it both ways.3

There seem to be two main views. The expansionary-prone view wanted a matching expansion then and wants a compensating expansion now. The tough-minded view wanted restraint then and still wants it now. In both cases, the argument is ultimately predicated upon a particular view of internal conditions in Europe—pretty much as internal conditions exert the dominant influence on U.S. policymaking. Thus, revealed preferences confirm the growing evidence that the gains from transatlantic coordination are too small to be at the forefront of the agenda, notwithstanding summitry rhetoric. The point is simply that the European Communities (EC) and the United States are both fairly closed economies, so that an expansion in the EC would have to be very strong to have significant effects on the United States. For example, simulations conducted with the Organization for Economic Cooperation and Development’s (OECD) Interlink model show that an increase of public investment in all EC countries of 1 percent of gross domestic product (GDP) only worsens the current account of the EC by 0.1 percent of GDP.4 It would take a boost of 10 percent of GDP to bring the current account down by 1 percent, and only a fraction of this would go to the United States (which has a GDP of about the same level as the EC, so that percentages are comparable). Makin’s call for “modest demand-expansion measures” (p. 70) misses that point.

The second broad explanation for Europe’s inaction emphasizes its own economic conditions. European governments appear to be obsessed with the need to continue to apply fiscal and monetary restraint (the United Kingdom being a notable exception, on which more below). This is all the more surprising, given that inflation is now safely locked at low levels; employment, although declining, remained at record high levels outside the United Kingdom; and growth remains slow in comparison with the EC average of 4.8 percent a year over the 1960s. One argument for continuing restraint is that budget deficits in Europe are at least as high as in the United States (4.4 percent of GDP for the 12 EC countries; 2.4 percent for the United States). A second argument is that its economy suffers from “structural problems,” so that the currently high levels of unemployment conceal almost full use of existing capacities. In this view, any expansion would be inflationary. These arguments cannot be dismissed lightly. Until they are, calls for European action based on international cooperation are unlikely to be heeded.

Evidence, however, has begun to accumulate that extreme conclusions are unwarranted. Various studies seem to indicate that most European countries suffer from a mixture of supply-side constraints and somewhat subdued final demand. A reasonable position, given what we know, is that some demand expansion is possible, would reduce unemployment without seriously re-igniting inflation, and would help with the U.S. current deficit.

Of course, what is true for Europe as a whole is not true for each country. Either of the two arguments for no European action may be of more relevance to some countries than to others. In particular, the need for budgetary austerity is overriding in such highly indebted countries as Belgium, Italy, and Ireland. It is hard to take it seriously, however, for the largest European countries (on this point and what follows, see Dreze and others (1987)).

The conclusion is that we ought to differentiate among European countries. Given the relatively high degree of economic integration within Europe, coordination becomes a crucial issue, should any serious change in the policy mix be considered. This contrasts with the low degree of interdependence between Europe and the United States.

The problem, then, is not coordination between the United States and Europe: both sides could benefit from an expansion of demand in Europe. The real problem is a lack of coordination in Europe, at least among the European Monetary System (EMS) countries. The Federal Republic of Germany could alleviate the U.S. deficit just by dealing with its own considerable surplus. As the center country of a de facto asymmetric EMS,5 it would then allow other European countries to adopt a less restrictive stance as well. Indeed, experience has shown that even the larger EMS countries, like France, cannot act on their own, and Italy is quite constrained by its budgetary situation. But Germany shows no sign of moving away from its near-zero inflation target and from a rather strict budgetary orthodoxy. Meanwhile, other countries are certainly not willing to threaten the smooth functioning of the EMS for the sake of contributing to better worldwide balances, unless, of course, another stock market disaster demonstrates that economic independence may be a serious threat.


  • Maddison, Angus,Growth and Slowdown in Advanced Capitalist Economies,Journal of Economic Literature (Nashville, Tennessee), Vol. 25 (June 1987), pp. 64998.

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  • Makin, John H., U.S. Fiscal Policy: Its Effects At Home and Abroad (Washington, D.C.: American Enterprise Institute for Public Policy Research, 1986).

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  • Makin, John H.,American Competitiveness,Working Paper No. 13 (Washington: American Enterprise Institute for Public Policy Research, October 1987).

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  • Commission of the European Communities, European Economy (Brussels), No. 34 (November 1987), Table 29.

  • Dreze, Jacques, and others, “The Two-Handed Growth Strategy for Europe: Autonomy Through Flexible Cooperation,” CEPS Paper No. 34 (Brussels: Centre for Economic Policy Studies, December 1987).

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  • Giavazzi, Francesco, and Alberto Giovannini, Limiting Exchange Rate Flexibility: the European Monetary System (Cambridge, Massachusetts: MIT Press, 1989).

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  • Sachs Jeffrey D., and Charles Wyplosz,Real Exchange Rate Effects of Fiscal Policy,NBER Working Paper 1255 (Cambridge, Massachusetts: National Bureau of Economic Research, January 1984).

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  • Wyplosz, Charles, “The Swinging Dollar: Is Europe Out of Step?” in The Economics of the Dollar Cycle, ed. by Stefan Gerlach and Peter A. Petri (Cambridge, Massachusetts: MIT Press, 1989).

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Chapter 2 contains a specific model that underlies much of the general discussion presented here.


For additional details, see Makin (1987).


The views expressed here are the author’s and not necessarily those of the Bank of Italy.


See Stefano Vona and Lorenzo Bini Smaghi, “Economic Growth and Exchange Rates in the EMS: Their Trade Effects in a Changing External Environment,” Chap. 6 in The European Monetary System: Proceedings of a Conference Organised by the Banca d’Italia, STEP and CEPR, ed. by Franco Giavazzi, Stefano Micossi, and Marcus Miller (Cambridge: Cambridge University Press, 1988).


Some writers have interpreted Black Monday as the happy bursting of a bubble. With hindsight, that explanation is not quite convincing.


In Japan, where some expansionary moves have been accomplished, the fall in stock prices was relatively mild.


Contrary to Makin’s assertions, Europe did not view the U.S. expansion as a help at the time when budget deficits were being reduced in 1982–85. Inflation was then a main target, and the dollar appreciation was perceived as exported inflation with a strong beggar-thy-neighbor flavor. As a result, the European monetary-fiscal mix was probably tightened up further (some econometric evidence is presented in Wyplosz (1989)).


See Commission of the European Communities, European Economy (Brussels), No. 34 (November 1987), Table 29.


The asymmetry argument is developed in Giavazzi and Giovannini (1989).

Editor: Mr. Mario Monti
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    Overall U.S. Deficit and Foreign Investment, 1979–87

    (In billions of U.S. dollars, from first quarter to first quarter)

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    Change in Structural Budget Balance, Inflation-Adjusted, 1980–88

    (In percent of nominal CNP/CDP)

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    Measures of U.S.-Japanese Competitiveness, 1970–86

    (Competitiveness index)1