HOW TO REDUCE THE TRADE DEFICIT

To eliminate the trade deficit and service our debt, we must lower costs of production relative to prices. There are four options:

* We can inflate, as many now urge. Inflation lowers the value of the debt and devalues the dollar. The decline in the value of the debt transfers wealth

from the rest of the world but, sooner or later, inflation raises all prices including interest rates and wages. The rise in wages and other costs of production offsets the effect of the devaluation on trade.To reduce the trade deficit permanently, we must reduce the cost of domestically produced goods. Inflation not only fails to solve the trade problem but, by encouraging consumption it makes the problem worse.

* We can protect against imports using quotas, surcharges and perhaps tariffs. This lowers spending on imports but invites retaliation and shrinks the amount of world trade. A lower level of trade makes more difficult the task of squeezing out $60 billion to pay interest on our foreign debt.

In addition, to all the other, well advertised disadvantages of trade restrictions, we must add that they are in a real sense counterproductive when we view the trade and debt problems as a whole.

* We can devalue the dollar. We have done a lot of that in the past two years. A real devaluation, unlike inflation, raises prices relative to costs of production. This method of adjustment, like protectionist policy, reduces standards of living relative to foreigners and perhaps in absolute terms. We cannot avoid devaluation, but we should avoid policies aimed at manipulating exchange rates and "talking the dollar down."

* We can increase productivity. There are many ways to do this, none easy to accomplish. At the national level, the four most important policy changes in my judgment, are: (1) Without increasing taxes, shift taxation from capital to consumption so that the share of consumption spending falls and the share of capital spending rises to levels substantially above those achieved in the last twenty years; (2) Reduce government spending, particularly consumption spending and, if possible, shift government spending from consumption to productivity enhancing investments in infrastructure; (3) Make a commitment to maintain these policies - and a long-term to pro-growth strategy - to reduce uncertainty about future after tax returns to investment. Elements of this strategy include more deregulation, less costly means of reducing pollution, enforcing product liability, safety and health. (4) Shift from a policy of lending to foreign debtors to a policy of encouraging repatriation of foreign capital and debt reduction by foreign debts. It makes little sense for a debtor country, the United States, to borrow and sell assets to finance loans to Latin American debtors. Instead, we should encourage Latin Americans to sell equity in their large state sectors or to adopt policies that attract some of the capital held abroad by their citizens.

The problems of trade and debt require that we produce more relative to what we spend and that we transfer part of the difference abroad to service the debt.

The four options take different approaches to the problem. Inflation does little to solve the trade problems. Devaluation (in real terms) and protection solve the problem by lowering standards of living at home relative to living standards abroad.

None of these options works to increase output and productivity. A general tax increase to reduce the budget deficit would raise the tax on investment to maintain government spending on consumption. This is the opposite of a policy to close the gap between spending and production by increasing production.

It is only by adopting measures that increase productivity that we can hope to service our debt while shifting output from domestic use to exports without increasing inflation and without permanently reducing standards of living relative to foreigners and, perhaps, absolutely. Reductions in government spending on consumption, higher taxes on private consumption and lower taxes on investment and capital shifts resources toward investment and raises productivity.

A few numbers bring the problem into perspective. Interest payments by the end of the decade will be about 1 1/2 percent of real output. If real output grows at an average rate of 2 1/2 percent to 3 percent a year, output per capita will rise at no more than 2 percent a year. The interest payments

absorb all, or most, of the increase. In addition, we must eliminate the current net exports deficit of 2 1/2 percent.

These numbers imply that per capita incomes do not rise to the end of the decade, and may fall. If such a fall is to be avoided, the options must include more than inflation, protection and devaluation. A pro-competitive, pro-growth policy achieved through a permanent change in taxation must be part of our policy. This policy does not avoid a reduction in current consumption, but by increasing output per worker, it assures that the reduction is temporary, not permanent.

There is no easy way out. Selling assets buys time, but something must be done with the time that we buy. To avoid having all of the problem solved by permanently reducing the real wages of American workers and the real incomes of American consumers, through inflation, devaluation and protectionist policy, we must begin, now, on a sustained effort to increase productivity.

A shift of taxes from capital to consumption is an important first step. If we could add just one-half, of 1 percent to the average growth rate for the next four years, we would have $100 billion more available for consumption, exports and investment in 1990.

Much depends on our choices. For the past 40 years, the United States has had the relative wealth and power to maintain or impose a degree of political, economic and trade stability on much of the world. We have not always

succeeded, we have made mistakes, but we have avoided the return to the disorder that characterized the interwar period, particularly the 1930s.

If we solve our problems of trade and debt by reducing our relative wealth, we move to a position of co-equal in a multicentered world. New arrangements must develop for sharing responsibility for defense, finance, trade and the maintenance of such order as can be provided.

We have done little to develop arrangements commensurate with the reduced role that our relative wealth and power will bring. If we fail to increase productivity, such planning is essential to avoid a return to the uncertainties of the interwar period.

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