SOLVING THE DEFICIT DILEMMA

Despite the marked fall in the value of the dollar, the U.S. trade balance has not manifested any tendency to improve. Various explanations have been put forward to account for this.

One is that changes in foreign exchange parities require considerable time before they have an effect on commercial transactions, usually one to two years. Although this is correct, I believe this is mainly true for exports and much less for imports.Another is that the fall in the value of dollar has not fully redressed purchasing power parities so as to make the U.S. economy internationally competitive. For this purpose, the dollar should have been devalued even more, by another 25 percent to 30 percent.

By contrast, policy-makers and economic experts in the United States are generally of the opinion that a substantial drop in the value of the dollar would result in its undervaluation.

What is urgently required is to restore an equilibrium in international economic relations and payments and not to substitute one kind of disequilibrium for another.

The chairman of the Federal Reserve Board, Paul Volcker, has insistently asked West Germany and Japan - countries whose trade balances demonstrate steadily increasing surpluses corresponding to the deficits of the United States - to boost their economies and increase their imports from the United States. They would thus contribute to a contraction in the deficit of the U.S. trade balance.

Such proposals fail to cope with the main cause of the trade deficit. As long as this is not removed, the deficit can not be effectively contained.

In my opinion there is a certain misunderstanding with regard to cause and effect, which underlies the various pronouncements such as the following: ''The trade deficit generates a flow of foreign lending that the United States needs to finance its dangerously unbalanced budget."

It is generally recognized that when the currency of a country is substantially overvalued, a deficit develops in its trade balance (and correspondingly in its balance on current account), which is covered with ad hoc borrowing from abroad.

On the other hand when a country has internal monetary equilibrium and a realistic foreign exchange rate, it is possible for a deficit in its balance of trade (and current account) to occur if an autonomous inflow of capital into that country takes place.

In such a case, the inflow of capital will be reflected in an increase in imports leading to the creation of a trade deficit. This will remain as long as the capital inflow continues. This is the case in the United States after the sharp decline in inflation and the drop of the dollar close to a level of external equilibrium.

When the federal budget deficit began to increase some years ago reaching the enormous figure of $230 billion in fiscal 1986, interest rates, both nominal and real, started rising, three to five percentage points above those in the main industrial countries. This induced a continuing autonomous inflow of capital that covered about half of the budget deficit. This development fostered a simultaneous rise in the value of the dollar, enhanced by speculative profiteering.

Dollars entering the United States in this manner could only have an impact on the trade and current account balances, resulting in a sustained growth of respective deficits. To some extent this development was also the result of a simultaneous appreciation of the dollar and its overvaluation. The appreciation of the currency, however, was not in itself enough to account for the entire rise in the trade deficit, and particularly in imports.

Following the subsequent steep decline of the dollar, the sustained net inflow of capital remained virtually the sole determinant of the huge trade deficit. This meant that, under the conditions prevailing in the last few months, and as long as the large inflow of capital is sustained, we cannot expect a substantial reduction in the trade and current account deficits.

As long as the budget deficit remains at high levels, the U.S. economy will depend on a substantial net inflow of foreign capital, which in turn will perpetuate large trade and current account deficits.

The misunderstanding that characterizes this issue is due to the notion that capital follows commodities, when in reality commodities follow capital.

In the last analysis, the main source of the deficit in the trade and current account balances is the huge deficit of the federal budget. As long as this remains at high levels, it will sustain higher interest rates in the United States than international ones, and will attract correspondingly large inflow of capital.

One sensible solution exists to the present impasse. This is to undertake a drastic curtailment of the federal budget deficit. Parallel to that, close cooperation and a spirit of solidarity also is required among the Group of Five to coordinate their economic, monetary and foreign exchange policies.

At this moment their collaboration in interest rate policies is of great importance. Further unilateral downward adjustments of interest rates on the part of the United States may generate a flight from the dollar and a sharp drop in its value. This would create new imbalances in international markets and payments, and cause a resurgence of protectionism, obstructions in the free movements of capital, and eventually a new international economic recession.

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