Lecture Twenty Four
The 1980s Budget and Trade Deficits
(Economics 100b; Spring 1996)
Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net
March 22, 1996
Administration
Case Study: the 1980s Budget and Trade Deficits
Administration
Case Study: the 1980s Budget and Trade Deficits
Let me begin with a fact seemingly far removed from trade: that
for the past fifteen years, ever since the tax cuts proposed by
President Reagan as the first item of business in his presidency, the
United States budget has been running a large deficit. Large deficits
had been seen before during wartime, and during deep recessions when
there is an argument that they are beneficial to the economy to raise
employment. But peacetime deficits, large in size relative to total
federal spending and to the size of the economy, in both bad times
and good times had never been seen before.
The $200 billion or more federal deficit (reduced under President
Clinton, from $300 billion to $160 billion) that we have seen for the
past fifteen years has been a new factor, placing previously unknown
stresses on the American economy. What are these stresses? Well,
every year the federal government has gone into the New York
financial markets and snapped up $200 billion in extra borrowing that
would otherwise have gone to fund investment in capital goods and
structures to make America's private sector more productive. And as a
result businesses seeking to raise capital in New York have been
forced to try to outbide the Treasury: offering higher interest rates
when they do borrow, and cutting back on investments to make their
firms more productive where they do not feel they can afford to pay
the higher interest rates caused by the presence of the $200 billion
gorilla called the U.S. Treasury on the borrowers' side of New York's
financial markets.
One thing that could have happened--that President Reagan's CEA
Chairs Murray Weidenbaum and Martin Feldstein feared was going to
happen--was that investment in the U.S. might have fallen by the full
$200 billion a year sucked out of the capital market by the
government: we might now be a country with $300 billion a
year--$5,000 per year per family--lower incomes because of Reagan's
mistake.
Instead, things aren't that bad. Estimates of the reduction in
American productivity levels and living standards as a result of
Reagan's miscalculation are only half as large. Why? Because
foreign investment flowed into the United States in the 1980s
and early 1990s. People in London, Frankfurt, Paris, and Tokyo took a
look at high interest rates and ample profit opportunities in the
U.S., and poured their money into this country in the form of
foreign-financed investment. The $200 plus billion annual federal
deficit was mostly matched by a $200 minus billion annual inflow of
foreign-owned capital.
And here we--finally--have the link to trade and the international
economy. Foreigners can only buy shares in or make loans to U.S.
companies, or invest directly in U.S. operations, if they have
dollars to spend: dollar-denominated deposits at U.S. banks. They can
get these deposits in two ways: (i) by taking financial flows that
would otherwise or previously have been spent buying American goods
and shipping them overseas as exports from America to other
countries, or (ii) by increasing how much they import into America,
and taking the proceeds from the sales of these increased imports and
using them to finance investment in America.
In either case U.S. producers--shareholders, bondholders, managers,
and workers--take it in the neck. Firms producing for export find
that foreign demand has dried up--because the dollars that used to
buy their products and ship them overseas are now buying Treasury
bonds or New York real estate or equipping a NEC plant in Roseville.
Firms that face competition from imports suddenly find that
competition fiercer because there are lots of investors in Tokyo or
Frankfurt willing to pay handsomely for the dollar-denominated assets
earned by selling to the U.S. market.
So this shift in demand away from export industries and
import-competing industries as a result of the U.S. budget deficit is
unfair, right? We should do something about it, right? It is
unfair, and we should do something about it, but the something
that should be done is to eliminate the federal deficit. Suppose we
took steps to shut off our current trade deficit, and were
successful. We would find production and employment in our
import-competing and our export industries booming. But we would
alsoo find that one of the important sources of funds financing
investment--and thus employment in construction, and in capital-goods
producing industries--drying up.
Unless the Federal Reserve could be persuaded to substantially lower
interest rates to boost investment, and allow unemployment to fall so
that the expansion in employment in export industries was not
accompanied by an equal and opposite fall in employment in capital
goods-producing industries--and that is not going to happen; the
Federal Reserve is pinning the unemployment rate between 5.5 and 6.0
percent because it fears a lower unemployment rate would reignite
inflation. So should we manage to undertake economic policies that
eliminate the trade deficit but do not touch the budget deficit, we
would find that we would have boosted employment in export and
import-competing industries by about 4,000,000 workers--with
associated gains for managers, shareholders, and so forth--but at the
price of starving our construction sector and our capital
goods-producing sectors of demand, and destroying some 4,000,000 jobs
in those industries.
So which is better? Best is probably to eliminate the budget deficit,
so that we can maintain a high level of investment in America and a
high level of exports. Second-best is probably the path we have
implicitly followed: to sacrifice some of our export industries in
order to allow the inflow of foreign investment needed to keep the
American economy--and American productivity--growing. In the long run
we would probably be better off with a higher productivity level here
at home than with greater world market share in traded-goods
industries.
Worst would be to have preserved our export industries at the price
of our investment goods-producing industries--and thus to have
further slowed productivity and real income growth.
So if you ask the question, "Are America's international economic
policies and its economic links to the wider world helping or hurting
America's businesses?" The right answer is "Yes."
- Export industries (and import-competing industries) have been
harmed by policies that have pushed up interest rates (and kept
the dollar higher than it would otherwise been), and attracted
foreign investment with the consequence of boosting imports and
retarding exports.
- Capital goods-producing and construction industries have been
helped because the inflow of foreign investment has prevented the
federal deficit from causing economic disaster in those sectors.
- Other businesses have gained because they have been able to
boost their productivity through investment more easily than
otherwise.
- And consumers have probably gained too by having cheaper
access to a lot of imported consumption goods.
The right way to think of it is that, once we had embarked on a
policy of large federal deficits, some particular industrial sector
or sectors had to get the short straw. Our close linkages with
the world economy meant that the sector that drew the short straw was
the exporting sector. And that was probably best for the rest of
us.
But it was not best for those who have worked or invested in export
or import-competing industries over the past fifteen years. And it is
in no sense "fair": the people who benefited from the 1981 Reagan tax
cuts, or from the inflow of foreign investment, are not the people
who lost as a result of the chronic U.S. trade deficit.
Better to have kept the federal budget in rough balance in the 1980s
and early 1990s (as it had been between 1945 and 1981), and to have
avoided the entire chain of events.
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