BACKGROUND PAPER

The U.S. Balance

of International Payments

and the U.S. Economy

February 1978

Congress of the United States

Congressional Budget Office

Washington, D.C.

THE U.S. BALANCE OF INTERNATIONAL PAYMENTS

AND THE U.S. ECONOMY

The Congress of the United States

Congressional Budget Office

For sale by the Superintendent of Documents, U.S. Government Printing Office

Washington, D.C. 20402
jjiiii Jii.
PREFACE

The recent deterioration in the U.S. balance of international

payments has been a cause of concern both in the United States and

abroad. Considerable debate has arisen over the causes and consequences of U.S. merchandise trade and current account deficits

and over the appropriate federal policies for dealing with these

deficits.

This paper was prepared at the request of Representative

Charles A. Vanik, Chairman of the Subcommittee on Trade of the

House Ways and Means Committee. It describes the recent history

of U.S. international payments balances and examines the causes

for their rapid deterioration in 1977. It also presents the

major policy alternatives available to the federal government for

dealing with the problems posed by deficits in international

payments. Testimony based on this paper was presented by the

Congressional Budget Office on November 4, 1977 before the Subcommittee on Trade of the Ways and Means Committee. In keeping

with CBO's mandate to provide nonpartisan and objective analysis,

the paper offers no recommendations.

This paper was prepared by Rosemary Minyard and C.R. Neu of

the National Security and International Affairs Division of the

Congressional Budget Office and by Joan Schneider of the Fiscal Analysis Division of CBO, under the general supervision

of John E. Koehler. The authors wish to acknowledge the assistance of Peggy Weeks, Thyra Riley, and Richard Morgenstern,, The

manuscript was edited by Robert Faherty and typed for publication

by Nancy Swope.

Alice M. Rivlin

Director

February 1978

in

' w nmirr
' w mmri
CONTENTS

Page

PREFACE iii

SUMMARY ix

CHAPTER I. INTRODUCTION 1

CHAPTER II. THE CURRENT SITUATION 3

Trade, Services, and Current

Account Balances 3

The U.S. Merchandise Trade Balance 5

CHAPTER III. THE REASONS FOR SLOW U.S. EXPORT GROWTH ... . 11

Slow Economic Growth Abroad 11

Competitiveness of U.S. Products

in World Markets 16

CHAPTER IV. THE VALUE OF THE DOLLAR 21

CHAPTER V. PROSPECTS AND POLICIES 27

Prospects for the Immediate Future 27

Implications for U.S. Policy 28

Conclusion 33

Triwnri"
1JIIJ
TABLES

Page

TABLE 1. U.S. MERCHANDISE TRADE, SERVICES, AND

CURRENT ACCOUNT BALANCES, 1973-1977 5

TABLE 2. VOLUME AND VALUE OF U.S. IMPORTS OF PETROLEUM

AND SELECTED PETROLEUM PRODUCTS, 1973-1977 ... 8

TABLE 3. SHARES OF TOTAL U.S. MERCHANDISE EXPORTS BY

MAJOR END-USE CATEGORIES, 1974-1977 9

TABLE 4. GROWTH RATES OF INDUSTRIAL PRODUCTION

IN SELECTED COUNTRIES, 1975:11 - 1977:11 ... . 12

TABLE 5. DIFFERENCES BETWEEN SIMULATED AND HISTORICAL

VALUES OF SELECTED MEASURES OF U.S. ECONOMIC

PERFORMANCE, 1975:11 - 1977:11 14

TABLE 6. U.S. SHARE OF WORLD EXPORTS OF MANUFACTURES,

1971 - 1977:11 17

FIGURES

Page

FIGURE 1. U.S. MERCHANDISE TRADE BY QUARTERS,

1973-1977 6

FIGURE 2. IMPORTS AS A SHARE OF GNP: MOST RECENT

RECESSION AND AVERAGE OF FOUR PREVIOUS

RECESSIONS . . 7

FIGURE 3. INDEXES OF RELATIVE PRODUCTION COSTS

OF U.S. GOODS 19

FIGURE 4. INDEXES OF EFFECTIVE EXCHANGE RATES 22

Vll
Ill II III IH I JILL
SUMMARY

A great deal of attention has been focused on the large

balance-of-payments deficits that the United States has experienced since the beginning of 1977. These deficits have aroused

concern in the United States because they are seen as aggravating

unemployment--especially in export-oriented industries — and

retarding the recovery of the U.S. economy from recession. The

deficits have also created concern abroad, where they are seen by

some as a threat to the stability of the international monetary

system or as a potential provocation for the United States to

adopt more restrictive trade policies.

Attention has been directed primarily at the U.S. balance

of merchandise trade. The merchandise trade deficit for 1977

is expected to be $30 billion, a marked increase over the trade

deficit for 1976 which was $9.2 billion.

Nontangible services make up an important additional part of

U.S. imports and exports. The largest components of the flows of

services are international payments of fees and royalties and

interest payments on international loans. Also included are

such items as travel services and private services provided by

individuals or businesses to clients in foreign countries. While

the United States is a net importer of merchandise, it is a net

exporter of services to the rest of the world. On the basis of

figures for the first half of the year, the United States is

expected to have a surplus of about $17 billion on services in

1977. This is up from about $13 billion in 1976.

Foreign trade in both merchandise and services is combined

with net unilateral transfers to foreigners to form the current

account balance. (These transfers—mostly government grants and

pensions—are fairly stable and are running at a rate of about $5

billion a year.) Because the surplus for services partially

offsets the merchandise trade deficit, the expected U.S. current

account deficit will be smaller than the trade deficit, but it

will still be very large by past standards. It is expected

to be in the neighborhood of $17 billion, as compared with a

deficit in 1976 of only $1.3 billion. The table that follows

summarizes the components of the expected current account balance

for 1977 and the actual balance for 1976.

IX
mi

U.S. CURRENT ACCOUNT POSITION: IN BILLIONS OF DOLLARS

Merchandise

Services

Net Transfers

1976

(Actual

Figures)

-9.2

13.0

-5.0

1977

(Projected from

Half-Year Figures)

-29.9

17.2

-4.8

Current Account a/ -1.3 -17.6

a/ Detail may not add to totals due to rounding.

To understand how these large deficits have arisen, it

is necessary to look more closely at what has been happening

to U.S. merchandise trade.

U.S. Merchandise Trade

Since the second quarter of 1975, U.S. merchandise imports

have risen rapidly and steadily as the U.S. economy has recovered

from recession. Although the growth of imports has been rapid

(about 30 percent a year), this growth does not appear to be

unusually rapid for such a period of recovery.

Oil imports account for a large share of total U.S. merchandise imports, and they too have grown rapidly during this

recovery period and have contributed to the growing U.S. trade

deficits. In fact, since the middle of 1975, oil imports have

grown somewhat faster than have other merchandise imports. Oil

imports alone, however, do not account for the entire recent

deterioration in the U.S. trade balance. Nonetheless, large

payments for foreign oil are expected to reach $45 billion in

1977, and an effective program to reduce oil imports could improve

the trade balance markedly.

U.S. exports have also been growing since the second quarter

of 1975, but not as rapidly or as steadily as imports. During the

last quarter of 1976 and the first quarter of 1977, the level of

U.S. exports did not grow at all, and large trade deficits arose
as a result. Growth in exports has resumed, but exports now lag

far behind imports and large deficits continue. This slow growth

in exports has not been concentrated in a few industries. Slow

growth has characterized all categories of U.S. exports, and it is

this unusually slow growth of exports coupled with normal growth

of imports that has produced the large U.S. trade deficit in 1977.

Figure 1 in Chapter II shows U.S. merchandise imports and exports

for recent years.

The Reasons for Slow U.S. Export Growth

Aside from actions of foreign governments to bar U.S. products from foreign markets, there are two possible explanations

for the disappointing performance of U.S. merchandise exports.

The first is that foreign demand for U.S. products has been weak

because recovery from recession has not been as rapid abroad as it

has been in the United States. The second is that U.S. exports

may be growing slowly because U.S. products are not as competitive

in world markets as they once were.

Available evidence suggests that the first of these explanations is the more accurate. The major customers for U.S. exports

are the other industrial countries. Unfortunately, most of these

countries have not grown as rapidly as the United States has since

the middle of 1975. Particularly in late 1976 and early 1977,

recovery has faltered in several of these countries. This slow

economic growth has reduced demand in these countries for U.S.

exports.

Econometric simulations performed by the Congressional Budget

Office indicate that, if the other industrial countries had

recovered from recession at the same rate as did the United

States, U.S. net exports of goods and services would have been $13

billion larger (at an annual rate) by the middle of 1977 than they

in fact were. This increase in net exports would have eliminated

most of the expected $17 billion current account deficit. As a

result of this increased demand for U.S. products, the gross

national product would have been some $36 billion higher (again at

an annual rate) than it was, and the unemployment rate would have

been about one-half of one percentage point lower than current

levels.

There seems to be little evidence that U.S. products are

losing their competitive position in world markets. The share of

total world exports of manufactured goods that is held by U.S.

XI

11T TTIMHTT'
HIM

products has not declined noticeably in the past year. Neither

has the price of U.S.-produced goods risen dramatically relative

to the price of foreign products. Figure 3 in Chapter III shows

indexes of relative costs of U.S. goods based both on wholesale

prices and on unit labor costs after adjusting for changes in

exchange rates. Both indexes show similar movements. The competitive position of the United States improved dramatically from

1971 to 1973 as a result of major devaluations of the dollar.

From 1973 through 1975, both measures showed erratic movements, as

U.S. competitiveness declined somewhat. Since the beginning of

1976, however, both indexes have shown a very slow loss of competitiveness for U.S. goods. By either measure, U.S. goods are

more competitive today than they were in 1970.

It would seem, then, that trade and current account deficits

have risen mostly because of increased oil imports into the United

States and because of relatively slow growth in other industrial

economies. A part of these deficits may be the result of some

deterioration in overall U.S. competitiveness, but the evidence

for this is weak.

The Value of the Dollar

In a system of floating exchange rates, large U.S. current

account deficits might be expected to lead to a decline in the

value of the dollar. This would make U.S. products cheaper

relative to foreign goods and could eventually lead to an improvement in the U.S. current account position. Over the last year,

the dollar has fallen relative to some currencies—for example,

the German mark and the Japanese yen. It has risen, however, with

respect to other currencies, such as the Swedish krona and the

Canadian dollar. The effective value of the dollar—that is, its

value relative to the average value of the currencies of the

United States' trading partners—held relatively steady throughout

most of 1977. Only at the end of 1977 did the effective value of

the dollar decline, losing 5.4 percent in the last three months of

the year. Figure 4 in Chapter IV shows the effective value of

some major currencies during the last few years.

One reason that the dollar has not fallen further is that

foreigners seem to be willing to hold dollars or dollar-denominated assets. Many of these dollars paid out to foreigners for

imports to the United States are returning to the United States

as foreigners buy assets in this country. In 1977, these capital flows were sufficiently large to make the United States

xn
a net importer of capital, a reversal of its traditional role

in international finance. In the first half of 1977, net capital

flows into the United States amounted to somewhat more than $4

billion. By comparison, in 1976, there was a net capital outflow

of $8.4 billion.

For the most part, the flow of foreign capital into the

United States has taken the form of deposits in U.S. banks and

purchases of U.S. Treasury securities—not direct investment.

Fears that foreign holdings of U.S. government securities may pose

a potential threat to U.S. government financial operations appear

to be unfounded. Only about 3 percent of U.S. federal debt is

held by foreigners outside of the industrial countries of Western

Europe.

A decline in the value of the dollar would prove a mixed

blessing to the U.S. economy. In the long run, perhaps after a

year or so, U.S. exports could be expected to increase and imports

to decrease. In the short run, however, a declining dollar would

add to inflationary pressures by increasing the price of imports.

Prospects and Policies

The prospects for improvement in the U.S. trade and current

account balances in the near future appear dim. Most forecasts

predict continued slow growth in the other industrial countries

for at least the next year, and even a highly effective energy

program cannot be expected to reduce U.S. oil imports quickly.

It would seem that the United States must reconcile itself to

continuing trade and current account deficits for the immediate

future.

The present deficits do not appear to be a reflection of any

fundamental weakness in the U.S. economy. On the contrary, they

are to a large extent a reflection of the relative success of the

United States at recovering from recession. Associated with these

deficits, however, are some serious problems. Slow export growth

contributes to unemployment—particularly in export-oriented

industries—and slows the growth rate of the U.S. economy. Increased competition from imports produces temporary dislocation

of U.S. workers as U.S. industries adapt to a changing competitive

environment. Simply reducing U.S. deficits will not necessarily

alleviate these problems. Much will depend on the particular

policies -employed.

Xlll

TTIBIfl"
Some policies might do more harm than good. Restrictive

trade policies might reduce deficits in the short run, but they

could lead to the adoption of retaliatory policies by other

nations and could ultimately result in even slower growth for U.S.

exports. Attempts by the United States to reduce the value of the

dollar are unlikely to be successful. Even if they were, they

would have mixed results. In the long run, U.S. products would

become more competitive relative to foreign goods. In the short

run, however, currency market intervention could disrupt domestic

monetary policy and add to inflationary pressures by increasing

the cost of imports.

Among policies that might prove helpful would be more expansionary fiscal and monetary policies that would offset weak

foreign demand for U.S. goods. An effective program to reduce

imports of oil could, in time, reduce trade imbalances caused

by U.S. dependence on imported oil. Continued efforts to encourage other industrial nations to adopt more expansionary

policies might prove fruitful; in any event, it seems that such

efforts can do little harm. Finally, expanded programs to aid

workers and industries suffering from loss of export markets or

severe import competition could smooth the adjustment to new

patterns of trade.

xiv
CHAPTER I. INTRODUCTION

The U.S. balance of international payments has been the focus

of much attention in recent months. Since the beginning of 1977,

U.S. imports have far exceeded exports, giving rise to large

merchandise trade and current account deficits that are without

precedent in U.S. history. These deficits have caused concern in

the United States because they are seen as contributing to unemployment, retarding the U.S. recovery from the recession of 1974

and 1975, and threatening the value of the dollar. Recent deficits have also been seen as a reflection of more fundamental

problems in the U.S. economy. Some see them as an indication that

U.S. goods are no longer competitive in world markets. Others

claim that U.S. goods are as competitive as ever but that U.S.

producers have been victimized by predatory trade policies adopted

by foreign governments. Still others claim that the deficits are

the direct result of the United States' failure to reduce its

dependence on foreign oil. Finally, some have argued that the

present def-icits are the natural result of an economic recovery in

the United States that has been more rapid and more complete than

the recovery in the nations that are the principal customers for

U.S. exports.

The recent U.S. deficits have also aroused concern abroad.

The high level of U.S. imports has been a blessing to many countries because it has increased the demand for their products and

has stimulated their economies. Nevertheless, some of these

countries have called for the United States to take steps to

reduce its deficits. Presumably, these nations would prefer

that the United States undertake moderate programs to slow the

growth of U.S. imports rather than adopt restrictive trade policies that would limit foreign access to U.S. markets far into the

future.

Another cause for concern among foreigners is that U.S.

deficits may threaten the stability of world monetary arrangements. International financial markets are only now beginning to

settle down after the period of wide fluctuations that followed

the change from a fixed to a floating exchange rate regime in

1973. It is feared that a sudden outpouring of dollars because of

a large U.S. current account deficit might introduce a new element

of uncertainty and instability into the international financial

situation.

"IT TTIWIfir
ILJliilllJ

Th ere is not a simple, direct relation between trade and

current account deficits and the performance of the U.S. economy.

The effects of these deficits can vary depending upon what set of

economic conditions gives rise to them. If, for exampl-e, deficits

arise because foreign products displace domestic products in U.S.

markets or because demand for U.S. exports abroad is weak, the

expected result would be increased unemployment in some U.S.

industries and slower overall economic growth in the United

States. If, on the other hand, large deficits arise because of

increased imports of goods that do not compete directly with U.S.

goods (for example, oil, some raw materials, coffee, or tea), then

there would not necessarily be any reduction in U.S. employment or

economic growth. In fact, it seems quite likely that increased

imports of oil and raw materials are required (at. least in the

short run) to sustain economic growth.

The effect of current account deficits on the value of the

dollar will depend on the preferences and actions of holders of

dollars. As long as individuals, businesses, and governments are

willing to increase their holdings of dollars for one reason or

another, the value of the dollar need not fall. But even a

current account surplus would not maintain the dollar's value if

these asset holders chose to exchange their dollars for other

currencies.

The problems associated with trade and current account

deficits cannot necessarily be eliminated simply by eliminating

the deficits. Unemployment resulting from slow growth of exports

will not be eliminated simply by reducing imports, even though

this may reduce the trade deficit. Similarly, a program to

encourage U.S. exports will not provide relief for industries

facing increased competition from foreign producers.

Thus, to understand the significance of recent U.S. trade and

current account deficits and to formulate policies for dealing

with these deficits, it is necessary to consider their causes

and their possible consequences. This paper describes the recent

changes in the U.S. balance-of-payments position and discusses the

possible causes for the present situation. It also discusses the

prospects for the immediate future and outlines the alternative

policy measures that are available to the United States for

dealing with the present large deficits. Throughout the paper,

the emphasis will be on the effects of international payments on

the U.S. economy. The possible effects on international monetary

arrangements of large imbalances in U.S. payments, while of great

importance, remain beyond the scope of this paper.
CHAPTER II. THE CURRENT SITUATION

TRADE, SERVICES, AND CURRENT ACCOUNT BALANCES

Recent attention has focused primarily on the U.S. merchandise trade balance. In the first half of 1977, U.S. imports

of merchandise exceeded exports of merchandise by about $15

billion on a seasonally adjusted basis. JY The U.S. merchandise

trade balance—the difference between total merchandise imports

and total merchandise exports—will be in deficit by some $30

billion for the entire year. 2J This is a sharp increase from

1976, when the U.S. trade deficit was only $9.2 billion. In 1975,

the United States had a trade surplus of $9.0 billion.

Partially offsetting the large trade deficit in the first

half of 1977 was a surplus on the balance of service transactions. Included in this balance are such things as international payments of fees and royalties, interest payments on

international loans, income from foreign investments, travel and

I/ Because imports and exports of some products fluctuate in

regular seasonal patterns, trade figures for only a part of a

year can sometimes be misleading. For some purposes, it is

useful to adjust trade data to eliminate these seasonal

variations. Such "seasonally adjusted" figures provide a

better measure of the underlying trends in trade than do

unadjusted figures that reflect both underlying trends and

seasonal variations.

2/ U.S. trade balances are calculated by a number of methods, and

the balances derived by one method differ somewhat from those

derived by other methods. Generally, the differences involve

the valuation of imports and exports (for instance, whether

shipping charges are included), the treatment of transactions

involving U.S. territories like the Virgin Islands, and the

treatment of military assistance. The figures given here are

balance-of-payments basis figures as reported by the Bureau of

Economic Analysis of the Department of Commerce. Unless

otherwise noted, all figures in this paper will be balance-ofpayments basis.

23-487 O - 78 - 3

ur
ILJIJlllJ JBL

transportation services, and other services provided by individuals and businesses for foreign clients. 3_/ In the first half

of 1977, the U.S. services balance was in surplus by about $17

billion on an annual basis. This represents a marked increase

over 1976, when the services balance was in surplus by $13 billion. By far the largest components of the flow of payments to

the United States for services are income from foreign loans and

investments and payments of fees and royalties. Thus, the large

and growing surpluses in the U.S. services balance are primarily a

reflection of this country's position as a net creditor to the

rest of the world and the developer of production methods now used

widely in other countries.

Unilateral transfers—mostly government grants to foreign

countries and pension payments to foreigners—have in the past

accounted for a further net outflow of about $5 billion a year

from the United States. In 1977, net transfers were at about this

same level.

A summary of these international nonfinancial transactions is

obtained by combining the three payments measures—trade balance,

services balance, and net unilateral transfers—into one measure,

the current account balance. A deficit on current account indicates that a country has paid out more for goods, services, and

transfers to foreigners than it has received from foreigners for

these same purposes. In order to make up the difference, a

country in deficit must either reduce its holdings of foreign

currencies, using them to meet its obligations abroad, or borrow

foreign currencies from abroad to meet these obligations. The

foreign currencies can be borrowed either directly, through loans

from foreigners, or indirectly, through foreign investment or

foreign-held deposits in domestic banks.

Adding together the expected U.S. deficits for merchandise

trade and net transfers and subtracting the offsetting surplus for

services gives an expected U.S. current account deficit of between

$17 billion and $18 billion for 1977. This is sharply higher than

the 1976 current account deficit, which was only $1.3 billion.

Table 1 provides a summary of the components of the U.S. current

account balance in recent years.

U.S. sales of military arms to foreign countries are classified as service rather than merchandise transactions in

balance-of-payments accounts.
TABLE 1. U.S . MERCHANDISE TRADE, SERVICES, AND CURRENT ACCOUNT BALANCES,

1973-1977: IN BILLIONS OF CURRENT DOLLARS

1973

Merchandise Trade

Merchandise exports

Merchandise imports

Trade Balance

Services

Military transactions, net

Investment income, net

Travel and transportation, net

Other services, net

Services Balance

Unilateral Transfers, Net

Current Account Balance c/

71

70

0

-2

4

-3

3

2

-3

-0

.4

.5

.9

.3

.8

.1

.°.

.6

.9

.4

1974

98

103

-5

-2

8_O

4

7

-7

— S

.3

.7

.4

.1

.7

.1

.0

.5

.2 b/

.0

1975

107

98

9

-0

6

-3

4

6

-4

11

.1

.0

.0

.9

.0

.0

.6

.7

.6

.6

1976

114

123

-9

0

9

-2

4

13

-5

-1

.7

.9

.2

.4

.8

.1

.9

.0

.0

.3

1977 a/

119

149

-29

2

13

-3

5

17

-4

-17

.9

.8

.9

.0

.3

.4

.3

.2

.8

.5

NOTE: Figures are balance-of-payments basis.

SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis.

a/ Annual rates predicted on the basis of data for the first half of the year.

_b/ Unusually high because of extraordinary transaction with India.

c_/ Sum of trade balance, services balance, and net unilateral transfers.

Detail may not add to total because of rounding.

THE U.S. MERCHANDISE TRADE BALANCE

The figures presented above make clear that it is the deteriorating merchandise trade balance that is responsible for the

growing U.S. current account deficits. Thus, the explanation of

the present current account deficit must be sought in the behavior

of U.S. merchandise trade during the first half of 1977.

The behavior of U.S. merchandise imports and exports during

the last few years is shown in Figure 1. Following weakened

consumer demand and slowed growth of industrial production in the

United States in late 1974, U.S. merchandise imports declined

~W TTFlf If ¥'
mi i:i JIM

Figure 1.

U.S. Merchandise Trade by Quarters, 1973 -1977

(Balance-of-Payments Basis, Seasonally Adjusted)

Billions Of Dollars

40

1973 1974 1975

Calendar Years

SOURCE: U. S. Department of Commerce, Bureau of Economic Research

1976 1977

sharply, falling by about 20 percent in the first half of 1975.

As the economy began to recover in the last half of 1975, so did

the demand for imports. Since the second quarter of 1975, U.S.

merchandise imports have grown steadily and rapidly—at a rate of

about 30 percent a year.

On the basis of past experience, the import growth rates that

have occurred during the past two years are not unusual for a period of economic recovery. Figure 2 shows the ratio of merchandise

imports to gross national product (GNP) during the recession of

1974-1975 and the recovery period that followed. Also shown is

the average value of this same ratio for the four most recent previous periods of recession and recovery. What is unusual about

the 1974-1975 recession is how sharply merchandise imports fell as

a fraction of GNP. At the beginning of the 1975 recovery period,

imports as a fraction of GNP recovered more rapidly than in previous recoveries, but in the later stages, import growth has been

similar to historical patterns. Merchandise imports have not,

however, regained the level relative to GNP that they held before

the recession. In this respect, the recovery of merchandise imports in 1976 and 1977 was slower and less complete than recovery

after earlier recessions.
Figure 2.

Imports as a Share of GNP: Most Recent Recession

and Average of Four Previous Recessions

Index: Five Quarters Before Trough = 100

100

90

80

70

Average of Four Previous Recoveries

—^ Most Recent Recovery

'73:4'74:1 23 4 '75:1 23 4 '76:1 2

Calendar Years

4 '77:1 2

Much of the increase in the value of U.S. merchandise imports

has been accounted for by the increased value of oil imports.

Total oil imports are expected to be $45 billion for 1977, up

from only $8.3 billion in 1973. In 1974 and 1975, most of the

increase in oil imports came about as the result of oil price

increases imposed by the Organization of Petroleum Exporting

Countries (OPEC); during these years, the volume of oil imported

by the United States declined. Since the beginning of economic

recovery in 1975, however, increases in the value of oil imports

have been attributable primarily to an increased volume of oil

imports. Table 2 summarizes the growth of U.S. petroleum imports

since 1973.

Not only do oil imports account for a large share of all

U.S. merchandise imports (about 30 percent in 1977), but they have

been growing at a faster rate than have other merchandise imports.

From 1975 to 1977, the value of oil imports to the United States

increased by 69 percent, while imports of all other types of merchandise increased by only 46 percent. About half of the increase

in the U.S. trade deficit from 1976 to 1977 can be attributed to

increased oil imports. It is important, however, not to let the

~ iir Trrmrr
TABLE 2. VOLUME AND VALUE OF U.S. IMPORTS OF PETROLEUM AND

SELECTED PETROLEUM PRODUCTS, 1973-1977

1973

1974

,1975

1976

1977 b/

Volume

(Millions

of Barrels)

2,494

2,409

2,369

2,851

3,448

Percent

Change

-3.4

-1.7

20.3

20.9

Value

(f.a.s.) a/

(Billions

of Dollars)

8.3

26.4

27.0

34.6

45.6

Percent

Change

217.8

2.6

28.0

31.8

a/ Free alongside ship.

b/ Annual rate based on January-September 1977 figures.

rapid growth of oil imports obscure the fact that other merchandise imports have grown rapidly also. Indeed, since 1975, increased oil imports have accounted for only 36 percent of the

total increase in U.S. merchandise imports.

Because the recession of 1974 and 1975 was felt in almost all

industrialized countries, demand for imports was reduced in

almost all nations. As a result, U.S. merchandise exports declined, although they did not decline as sharply as did imports.

In the second half of 1975, U.S. merchandise exports began to grow

again but not as rapidly or as steadily as imports did. During

the last quarter of 1976 and the first quarter of 1977, U.S.

merchandise exports did not grow at all and the trade deficits

increased rapidly. Export growth has since resumed, but now

exports lag far behind imports and large trade deficits persist.

The slow growth of U.S. merchandise exports during this

recovery has not been restricted to one or two sectors. Instead,

it has been widely distributed across all kinds of exports.

Table 3 shows the shares of total U.S. merchandise exports by

major end-use categories in recent years. The fact that these

shares have remained quite stable indicates that all categories

of exports have experienced similar slow growth.
TABLE 3. SHARES OF TOTAL U.S. MERCHANDISE EXPORTS BY MAJOR ENDUSE CATEGORIES, 1974-1977: PERCENT OF TOTAL

End-Use Categories 1974 1975 1976 1977 a/

Capital Goods

(except automotive) 33 31 34 32

Industrial Supplies

and Materials 29 31 28 29

Foods, Feeds,

and Beverages 18 19 17 17

Automotive Vehicles,

Parts, and Engines 10 9 11 11

Consumer Goods

(nonfood, except automotive)

All Other

Total b/

6

4

100

6

4

100

7

3

100

7

3

100

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

aj Estimated.

b/ Details may not add to totals because of rounding.

Some traditional U.S. trade surpluses deteriorated in 1977.

The U.S. surplus on agricultural products was some $1.3 billion

less in 1977 (on the basis of data for the first nine months of

the year) than the $12.2 billion surplus registered in 1976. This

was because of good harvests in most parts of the world and

relatively low prices for some products (most notably grains)

that the United States exports. Also, the prices of some U.S.

agricultural imports such as coffee rose sharply in 1977. These

changes in agricultural trade were attributable primarily to

natural conditions and are not usually seen as a cause for longterm concern. In the short run, however, low grain prices can

reduce farm revenues, and rising costs of imported agricultural

products can raise consumer prices.

mr
ILJilJI

More disturbing to some has been a marked decline in the

traditional U.S. surplus for trade in manufactured goods. _4/ In

1976, the United States had a surplus for manufactured goods of

$12.7 billion. In 1977, this shrank to only $4.1 billion (on the

basis of figures for the first nine months), and in each quarter

of 1977, the surplus in manufactured goods declined from the

previous quarter. 5/ This decline has caused some concern over

whether U.S. manufactured products are still competitive in

world markets.

In summary, then, the U.S. merchandise trade balance deteriorated during 1977 because imports grew at a much faster rate

than did exports. Increased petroleum imports were a major factor

in the growth of imports, but other merchandise imports grew

rapidly also, and the overall rate of import growth does not

appear to be unusually high for a period of economic recovery.

The disappointing performance of U.S. exports, however, requires

more explanation.

4/ The manufactured goods classification includes chemicals,

machinery, basic manufactured goods, transport equipment, and

miscellaneous manufactured goods. The term "capital goods"

refers to machinery and heavy transportation equipment (civilian aircraft and railroad locomotives, but not automotive

products). The term "industrial supplies and materials"

refers to chemicals, steel, paper, fibers, nonferrous metals,

and related products.

5J These data are census basis, rather than balance-of-payments

basis. The major difference between these two bases is

the exclusion from census data of imports and exports of

the Virgin Islands and of imports and exports of nonmonetary

gold. In the case of manufactured goods, neither of these

exclusions will be very significant, and census basis figures

and balance-of-payments basis figures should be quite similar.

10
CHAPTER III. THE REASONS FOR SLOW U.S. EXPORT GROWTH

Aside from actions by foreign governments to bar U.S. products from their domestic markets, there are two possible ex-:

planations for the disappointing performance of U.S. merchandise

exports. The first is that foreign demand for U.S. products has

been weak because recovery from recession has not been as rapid in

other countries as it has been in the United States. The second

is that U.S. exports may be growing slowly because U.S. products

are not as competitive in world markets as they once were. This

chapter discusses the evidence for each of these two hypotheses.

SLOW ECONOMIC GROWTH ABROAD

The other industrial nations are the primary customers for

U.S. exports. In 1976, nearly 60 percent of U.S. merchandise

exports went to Japan, Canada, and the industrialized countries of

Western Europe. . Since recovery from worldwide recession began

in the second half of 1975, however, these countries, with the

exception of Japan, have been growing at slower rates than has

the United States. At the end of 1976 and the beginning of 1977,

the growth of industrial output in some of these countries faltered noticeably. Table 4 shows the rates of growth in industrial

production during the past two years for the major industrial

countries.

This relatively slow growth in other industrial countries

has reduced demand in these countries for foreign products and

has contributed to the slow growth of U.S. exports. Because the

U.S. economy has grown relatively rapidly, U.S. demand for foreign products has grown rapidly, and the result has been an increased trade deficit for the United States.

Just the reverse of this phenomenon occurred in 1974 and

1975. The recession began earlier in the United States than it

did in most of the other industrial countries, and the decline in

industrial output was sharper in the United States than in other

countries (again, with the exception of Japan). This had the

effect of reducing U.S. demand for imported goods sharply, while

similar demand in other industrial countries remained relatively

strong. The result was a merchandise trade surplus in 1975. It

11

liF
HIM

TABLE 4. GROWTH RATES OF INDUSTRIAL PRODUCTION IN SELECTED

COUNTRIES, 1975:11 - 1977:11: ANNUAL RATES BY QUARTERS

Quarter

1975:11

1975:111

1975: IV

1976:1

1976:11

1976:111

1976: IV

1977:1

1977:11

United

States

3.7

23.8

9.9

13.3

6.9

4.6

2.2

6.3

10.5

Canada

-2.1

0.3

5.3

11.5

7.5

-1.5

2.9

8.7

1.3

Japan

12.5

9.3

2.6

25.3

20.0

6.5

7.8

2.1

3.4

Western

Europe

-11.2

-1.0

17.1

12.1

9.7

1.8

8.5

9.3

-8.5

might be contended that current U.S. deficits and their causes are

merely the mirror image of the earlier surpluses and their causes.

It remains the case, however, that the perceived problems beginning in late 1976 were coincident with the relative slowdown of

foreign economies.

About one-quarter of U.S. merchandise exports goes to developing countries, and these countries also reduced their imports in

1977. Throughout the recession of 1975, the developing countries

as a group continued to grow, but this growth required many of

them to borrow heavily tQ finance the imports needed to sustain

economic growth. By 1977, the foreign debts of some developing

countries had reached a level at which further borrowing became

difficult. To maintain their creditworthiness and their access to

international financial markets, some of these countries were

forced to restrict their imports sharply. Among the countries

that reduced imports most dramatically were Mexico and Brazil,

which are both important markets for U.S. exports. Between the

first half of 1976 and the first half of 1977, Mexico and Brazil

reduced their total imports by 24 and 15 percent, respectively. I/

±J Testimony of Anthony M. Solomon, Undersecretary for Monetary

Affairs, U.S. Treasury, before the Subcommittee on International Economics, Joint Economic Committee, October 11, 1977

(processed).

12
On the basis of data for the first half of 1977, U.S. exports to

these two countries alone will be $1.2 billion less in 1977 than

they were in 1976.

To measure the impact of slow growth abroad on U.S. trade and

current account deficits, econometric simulations were made to

estimate what the U.S. trade position would have been if other industrial countries had recovered from recession at the same pace

as the United States. 2] For the purposes of this simulation,

industrial production indexes for Canada and Western Europe were

adjusted so that their growth equaled that of the U.S. index in

each quarter during a period running from the second quarter of

1975 to the second quarter of 1977. This had the effect of

equalizing the timing as well as the magnitude of growth in the

United States, Canada, and Western Europe. Since Japan's growth

over this period was greater than U.S. growth, no adjustment was

made in the index of Japanese industrial production. The differences between the actual and simulated behavior of some important

trade and macroeconomic variables are shown in Table 5.

Simulated net exports of goods and services are $13.1 billion

higher (on an annual basis) than were actual net exports during

the second quarter of 1977. _3_/ This means that by the second

quarter of 1977, the United States would have had a small net

surplus of goods and services exports over imports. Total exports

of goods and services in the second quarter of 1977 would have

been 10.8 percent higher than actual, while total imports of goods

and services would have been 3.2 percent higher.

Among the census end-use categories of merchandise goods,

net exports of capital goods (excluding automotive products)

would have gained significantly from more rapid recovery elsewhere. Net exports of industrial supplies and materials would

have increased somewhat less. This is important because U.S.

export performance depends heavily on exports of capital goods and

of industrial supplies and materials. Table 5 also shows that

net exports of consumer goods would have increased as rising

2j A model of the U.S. economy developed by Data Resources,

Incorporated was used for this simulation.

_3/ Measured by the National Income and Product Accounts (NIPA),

the accounts used to measure the economy's current output or

GNP and its components.

13
TABLE 5. DIFFERENCES BETWEEN SIMULATED AND HISTORICAL VALUES OF SELECTED MEASURES OF U.S. ECONOMIC PERFORMANCE, 1975:11 -

1977:11: IN BILLIONS OF DOLLARS, UNLESS OTHERWISE SPECIFIED

Selected Measures 1975:11 1975:111 1975:IV 1976:1 1976:11 1976:111 1976:IV 1977:1 1977:11

GNP

Real GNP (billions

of 1972 dollars)

Implicit Price Deflator

0.3

0.2

2.6

MACROECONOMIC VARIABLES

16.1 21.7 25.1

5.6 10.1 13.0 14.2

28.8

15.9

32.1 36.5

17.2 18.7

(Index: 1972 =1.0)

Rate of Unemployment (percent)

Net Exports of Goods

and Services a/

Exports of goods

and services a/

Imports of goods

and services a/

0.0

0.0

0.3

0.3

0.0

0.0

0.0

2.2

2.5

0.3

0

-0

5

6

0

.001

.1

.7

.6

.9

TRADE FLOWS

Industrial Supplies and Materials

Exports

Import s

Capital Goods, Except Automotive

Export s

Imports

Consumer Goods, Except Automotive

Exports

Imports

0.0

0.0

0.02

0.0

0.07

0.00

0.44

0.06

0.31

0.05

0.28

0.02

1

0

1

0

0

0

.26

.26

.17

.20

.45

.09

0.002

-0.2

7.9

9.8

1.8

MEASURED

1.44

0.67

2.15

0.30

0.53

0.22

0.003

-0.3

9.9

12.8

2.9

BY CENSUS

1.83

1.18

3.17

0.41

0.60

0.32

0.005

-0.4

11.1

15.0

3.8

END-USE

2.10

1.67

3.83

0.54

0.67

0.38

0.

-0.

12.

16.

4.

,005

.5

,0

,7

.7

0.006

-0.5

12.0

17.4

5.4

0.008

-0.5

13.1

18.9

5.9

CATEGORIES

2,

2.

4.

0.

0.

0.

.55

.02

,25

.66

.72

,36

2.67

2.42

4.41

0.74

0.78

0.38

3.03

2.76

4.75

0.83

0.84

0.42

NOTE: Simulated values assume faster growth of industrial production in Canada and Western Europe. All figures are

yearly rates. Data do not include imports and exports of the U.S. Virgin Islands.

_£/ Measured by the National Income and Product Accounts.
income levels abroad allowed consumers there to buy more goods

from the United States. Imports of consumer goods into the United

States have been strong to date and would not have increased by as

much as U.S. exports of consumer goods. Thus, the simulation

shows an improved net balance for consumer goods.

Increased demand for U.S. exports would have acted as a

stimulus to the overall economy. The simulated level of U.S.

GNP for the second quarter of 1977 is higher (again on a yearly

basis) than the actual level by $36.5 billion, an increase of

about 2 percent. A higher level of GNP would have created more

jobs in the United States, and the unemployment rate would have

fallen by about one-half of one percentage point. The simulation

also indicates that increased demand for U.S. exports would have

led to only a small increase in prices—less than 1 percent. This

is because the industries experiencing the largest increases in

demand—capital goods industries—now have excess productive

capacity, and output could be expanded relatively easily, kj

In summary, these simulations indicate that a large part

of the recent deterioration in the U.S. balance of goods and

services can be explained by the relatively slow rate of recovery

in other industrial countries. If economic growth in these

countries continues at rates lower than in the United States,

the prospect is for continued U.S. trade deficits.

4/ Different hypothetical scenarios could have been chosen as

the basis for this simulation. It might be argued that it

is unrealistic to expect the other industrial countries to

have recovered from recession at the same rate as the United

States because, with the exception of Japan, none of these

countries experienced a reduction in industrial output as

great as the United States did in late 1974 and early 1975.

If, instead of assuming growth rates equal to those experienced in the United States, it is assumed that the depth

and timing of and the recovery from recession were the same

in all other industrial countries as they were in the United

States, a somewhat different picture emerges. In this hypothetical case, the increase in net U.S. exports would have

been only $2.5 billion (on an annual basis) as compared with

$13.1 billion in the original simulation by the second quarter of 1977. The increase in U.S. GNP would have been approximately $7 billion a year as opposed to $36.5 billion in the

first simulation.

15

11T
COMPETITIVENESS OF U.S. PRODUCTS IN WORLD MARKETS

Some argue that U.S. trade deficits have occurred not only

because of slow economic growth among our principal customers

but also because U.S. goods are being displaced in world markets by products from other countries. Rising labor costs,

increased prices for industrial materials, and the costs of

meeting new environmental standards have all been blamed for

increasing the price of U.S. goods relative to foreign goods

and subsequently causing reductions in U.S. exports and increased competition from imports in domestic markets. Certainly,

some U.S. industries have been losing their competitive position relative to foreign producers. Steel is the most visible

example of such an industry. Whether there has been any overall

decline in the competitiveness of U.S. industry, however, is

much less clear.

One measure of the competitiveness of U.S. products is

provided by the share of total world exports of manufactured

goods that is held by U.S. producers. If U.S. products were

becoming less competitive, one would expect the U.S. share of

total exports to fall. Table 6 shows the U.S. shares of total

manufactured exports and of some important subcategories of

manufactured exports in recent years. 5/ Share values have

gone up and down since 1971, but these are small fluctuations

around an average value and do not constitute a noticeable downward trend. The U.S. share of total manufactured exports in

the second quarter of 1977 was 20 percent, in line with recent

experience. Except for the transportation equipment category,

recent U.S. shares are larger than those during 1971-1973. The

transportation equipment category share fluctuates more than

others, and its recent drop is not cause for alarm. Erratic

delivery schedules and an unusual shift in commercial aircraft

sales can produce wide variations in this category and account

for the low value in early 1977. Overall, this table suggests

that U.S. exports are lagging not because the United States is

losing market shares to other suppliers, but because total world

trade is not expanding as rapidly as it has in the recent past.

The volume of world trade increased by about 11.5 percent in

_5_/ Movements in these shares can come from changing volumes and

prices of the products and from a changing exchange rate of

the dollar.

16
TABLE 6. U.S. SHARE OF WORLD EXPORTS OF MANUFACTURES, 1971 -

1977:11: PERCENT OF TOTAL SHARES a/

Chemicals

1971

1972

1973

1974

1975

1976

1977:1

1977:11

20

18

19

18

20

20

21

21

.0

.6

.1

.6

.1

.6

.1

.6 '

None lee .

Mach .

25

25

25

26

27

26

26

25

.6

.1

.2

.3

.8

.8

.3

.3

Elec. Transport

Mach . Equipment

21

20

21

23

22

23

23

23

.1

.9

.6

.0

.3'

.3

.4

.4

29

26

27

29

27

25

22

23

.7

.4

.0

.0

.8

.1

.3

.8

Basic

Mf gs .

10

10

11

12

12

11

11

11

.8

.5

.4

.3

.5

.9

.7

.5

Misc .

Mfgs.

16

15

16

17

17

17

17

16

.1

.5

.2

.3

.3

.1

.0

.9

Total

Mfgs .

20.1

19.1

19.5

20.2

21.2

20.5

19.9

20.0

NOTE: The term "manufactures" refers to nonfuel industrial

supplies and capital goods. Total world exports are

defined as exports, excluding shipments to the United

States, from 15 major industrial countries that account

for approximately 80 percent of world exports of manufactures: United States, Austria, Belgium-Luxembourg,

Canada, Denmark, France, Federal Republic of Germany,

Italy, Netherlands, Norway, Sweden, Switzerland, United

Kingdom, and Japan.

SOURCE: U.S. Department of Commerce, Commerce America.

a/ Shares are calculated from values of exports of the six

commodity groups from each of the 15 countries. Beginning in

1971, when exchange rates began to fluctuate widely, share

calculation is based on export-weighted exchange-rate indexes

for each supplier, using official rates of exchange vis-a-vis

67 principal markets.

17

iir
mill

1976; the increase for 1977, however, is expected to be only

about 7 percent. 6/

Another measure of the competitiveness of U.S. products

in world markets is provided by a comparison of the costs .of

production in the United States with the same costs abroad. Tj

To reflect fully changes in competitive position, production

costs must be adjusted to account for changes in exchange rates.

If, for example, production costs in the United States rise

by 5 percent relative to costs in other countries simultaneously

with a fall in the value of the dollar by 5 percent relative

to other currencies, the costs of U.S. goods to foreign buyers

and of foreign goods to U.S. buyers remain the same and no

change in the relative competitive positions results. For

changes in costs and exchange rates that do not exactly offset each other, competitive positions will change.

Two standard measures of production costs are used to form

indexes of competitiveness for U.S. industrial goods. One

measure is the wholesale price index for industrial products.

The index of competitiveness is formed by computing the ratio

(after adjusting for changes in exchange rates) of U.S. wholesale prices to a composite measure of wholesale prices in those

industrial countries that are chief rivals of the United States in

6/ International Monetary Fund, Annual Report 1977 (September

1977), pp. 9-10.

Tj For this comparison, production costs of industrial goods only

are used because nonindustrial goods (mostly agricultural

products) are traded in markets where the costs of production

have a less direct impact on price. For many nonindustrial

products, goods from one country are indistinguishable from

goods from another country and one price prevails, regardless

of how costs of production may differ from one country to

another. For industrial goods, the products of one country

are not exactly the same as those of another country, and

prices are generally set by adding some margin to the costs of

production. If the costs of production rise in one country

relative to costs in other countries, the price of its products in world markets will rise also, assuming that profit

margins and exchange rates do not change.

18
the production of industrial goods. 8_/ The higher the resulting

index, the higher the price of U.S. products relative to competing

foreign products. The other measure of production costs used is

the unit labor cost of industrial production—the cost for the

labor required to produce one unit of output. A measure of

competitiveness based on unit labor costs is computed in the same

way as that based on wholesale prices. _9/ Figure 3 shows the

movement of these two indexes of competitiveness since 1970.

Figure 3.

Indexes of Relative Production Costs of U.S. Goods

Index: 1970 = 100

1970 1971 1972 1973 1974 1975 1976 1977

Calendar Years

SOURCE: International Monetary Fund, International Financial Statistics.

8/ This composite wholesale price measure is a weighted average

of the wholesale price indexes of 10 industrial countries.

Weights are proportional to the amount of bilateral trade

each of these countries had with the United States. The 10

countries are Canada, Japan, the Federal Republic of Germany,

France, the Netherlands, Italy, the United Kingdom, Sweden,

Switzerland, and Belgium.

JV The only difference is that Belgium is excluded from the

comparisons of. unit labor costs because labor cost data are

not available for Belgium.

19

HIT"
• nil I a Jii

Both measures show roughly the same pattern, although they

differ in detail. From 1970 to 1973, the competitiveness of. U.S.

goods improved markedly as a result of two major devaluations of

the dollar. From 1973 through 1975, both measures showed erratic

movements that resulted in a net loss of competitiveness. This

may have been because of readjustments in exchange rates that followed the 1973 devaluation, which some argue was larger than was

justified. The temporary worsening of the relative labor cost

measure in late 1973 and early 1974 was caused by the onset of recession in the United States before it began abroad. At the beginning of recessions, the amount of labor used per unit of output goes up temporarily because output falls quickly, while the

labor force is reduced only slowly; this pushes up labor costs per

unit of output. Since the beginning of 1976, however, both indexes have shown the same trend: a very slow loss of competitiveness for U.S. goods. The loss was 1 to 3 percent in a year and a

half, depending on which measure is used. By either measure, U.S.

goods are more competitive today than they were in 1970.

These two measures show that U.S. goods have become only

slightly less competitive during the last two years. Because

changes in relative prices are thought to affect the flow of

trade only after a period of one to one and a half years, some

of the deterioration in the U.S. trade account that occurred

in 1977 may be attributable to losses in competitiveness that

took place as long ago as 1975. The relatively stable behavior

of the measures over the last year and a half suggests that no

significant further weakening of the U.S. trade position because of these factors should be expected in the near future.

These indexes are deficient to the extent that they do not

reflect the growing competition to U.S. producers that is posed by

industrialization programs in some developing countries. For the

most part, these programs have concentrated on the development of

light industry (clothing, textiles, shoes, and electronic components, for example) and have contributed to the decline of similar

industries in the United States. Unfortunately, reliable data on

the costs of all manufacturing in developing countries are not

available, and no systematic comparisons with the United States

can be made.

Despite this deficiency in the measures of competitiveness

used here, it seems that the evidence supporting the hypothesis

that U.S. trade deficits are attributable to a loss of competitiveness is weak. Rather, most of the present deficit can be

explained by differences in growth rates among the developed

countries.

20
CHAPTER IV. THE VALUE OF THE DOLLAR

According to the simple textbook descriptions of how a

system of floating exchange rates should operate, the large

current account deficits the United States is now experiencing

should be self-correcting. A large deficit reflects a flow of

dollars out of the United States and into the hands of foreigners.

As the stock of dollars outside the United States increases, one

would expect the value of the dollar to fall. This would reduce

the price of U.S. goods relative to foreign goods and should

ultimately result in increased U.S. exports and decreased U.S.

imports.

But the present situation is not exactly like that described

in textbooks. In the last year, the dollar has fallen in value

relative to some currencies; the German mark and the Japanese yen

are the most notable examples. Relative to other currencies—the

Canadian dollar and the Swedish krona, for example—it has risen

in value. The most comprehensive measure of the value of the

dollar is provided by the effective exchange rate of the dollar.

This exchange rate is the weighted average of bilateral exchange

rates of the dollar relative to other major currencies. To calculate this weighted average, each bilateral exchange rate is

given a weight proportional to that currency's importance in the

international transactions of the United States. Figure 4 shows

the effective exchange rates of the dollar and of some other major

currencies over the past few years. The effective value of the

dollar fell in the early 1970s as a result of the large devaluations in 1971 and 1973. Since then, the dollar's value has

increased somewhat. What is striking, however, is the relative

stability of the value of the dollar from 1976 on. Only at the

end of 1977 did the effective value of the dollar decline. During

the last three months of 1977, the dollar declined 5.4 percent by

this measure, but during the first month of 1978, it recovered

somewhat.

The reason that the value of the dollar has not fallen

further is that foreigners have been content to hold increasingly

large amounts of dollars and dollar-denominated assets. Many of

these foreign holdings of dollars are returning to the United

States in the form of capital flows into this country. So large

has been this return flow of capital that in 1977 the United

21

~ m
JLJIIIilllL JIM

Figure 4.

Indexes of Effective Exchange Rates

(Based on International Monetary Fund's Multilateral Exchange Rate Model)

Index: May 1970 = 100

140

120

100

80

60

-

-

-

/

/

„ «•••••

m

•

^ V

^^^mmt ^*^

* ^^^^^^*

X" '••

X^^

Geri

—••••''

*<^=-^

nan Deutscl

-7C=

«*^^"

^-

/*

e Mark /

x — \

•*** Japj

Fren

U o

X^-h

^+~~

/' Knese Yen _

rV"

ch Franc

[ . Pound -

1970 1971 1972 1973 1974 1975 1976 1977

Calendar Years

SOURCE: International Monetary fund, International Financial Statistics.

States became a net importer of capital, a reversal of the role it

has traditionally played in international financial markets. In

the first half of 1977, the net flow of capital into the United

States was about $4 billion. By contrast, in 1976, there was

a net outflow of capital from the United States of about $8.5

billion.

For the most part, the flow of foreign capital into the

United States has taken the form of deposits in U.S. banks and

purchases of U.S. Treasury securities. From time to time, highly

publicized purchases by foreigners of U.S. businesses or property

give rise to fears the foreigners are "buying out" Americans, but

purchases of real assets in the United States by foreigners are

only a very small part of the inflow of foreign capital. In the

first half of 1977, for example, such direct investment accounted

for only 7 percent (about $1 billion) of total foreign purchases

of assets in the United States.

Some have voiced fears that large purchases of U.S. government securities by foreigners (and particularly by foreign governments) might eventually leave the United States vulnerable to

22
attempts by foreign holders of U.S. debt to disrupt U.S. financial

markets. In theory, if holders of a significant share of outstanding federal debt were to sell their U.S. government securities at the same time, the price of all U.S. government securities

would fall. This would lower the receipts of the U.S. Treasury

from the sale of government securities and would require the

payment of higher interest rates on those securities the Treasury

did sell.

In practice, however, such a chain of events seems unlikely

any time in the foreseeable future. In July 1977, the total U.S.

federal debt outstanding was $685 billion. Of this total, only

$90 billion was held by foreigners or by international institutions. Further, $70 billion of this amount was held by the

industrialized nations of the Organization for Economic Cooperation and Development (OECD) and by international institutions.

It seems highly unlikely that these nations or institutions would

have any motive for disrupting U.S. financial markets. The

remaining $20 billion of foreign-held assets are scattered

among a large number of nations, which would have difficulty

acting in concert. Even if they were to do so, though, the

effects on U.S. Treasury operations would be temporary and

slight. In the month of August 1977, for example, the Treasury

issued about $40 billion worth of new securities. The offering of

an additional $20 billion would have a noticeable, but hardly

catastrophic, effect.

The reasons that foreigners are willing to hold dollars and

to return these dollars to the United States are varied. One

important reason is that the dollar retains its central position

in the international financial system and is still the world's

principal reserve currency. There has been a worldwide incrsase

in official reserve holdings of foreign currencies, and many

countries have chosen to increase their reserve holdings by

acquiring more dollars or dollar-denominated assets. In the first

half of 1977, some 81 percent of the net increase in foreign-owned

assets in the United States was accounted for by increases in

official reserve holdings by foreign countries. Some of the

inflow of capital has also been attracted by the relatively rapid

growth of the U.S. economy. This has provided increased opportunities for investment and has raised interest rates in this

country. Finally, some assets are being transferred to the United

States to escape the political and economic uncertainties that

asset holders face in some other countries.

23

lir
JLJIIIillJlJL Jill

Another reason that is sometimes given for the continued

strength of the dollar is intervention in world currency markets

by the central banks of other nations. It is well known that in

the past year the central banks of several industrial nations have

intervened extensively in currency markets, although there is

no way of knowing exactly the timing and size of these interventions. I/ The intent of recent interventions has been to limit

the rise in the value of certain currencies—most notably the

Japanese yen, the German mark, the British pound, and the Swiss

franc—relative to the dollar. Foreign central banks have been

buying dollars, thus supporting the value of the dollar and

holding down the value of their respective currencies. Recently,

even the United States—through operations of the Federal Reserve

and use of the Exchange Stabilization Fund of the Treasury—have

been intervening in currency markets to support the dollar.

There are two reasons for such intervention. The first is

the desire of all central banks to preserve orderly markets for

their currencies. A rapid fall in the value of the dollar followed shortly by a recovery could disrupt currency markets and

hinder some international transactions. By buying and selling

dollars, central banks can smooth out temporary fluctuations in

the value of the dollar and thus stabilize international markets.

The second reason for currency market intervention is the desire

of some foreign countries that the dollar remain strong. These

countries have an interest in avoiding a permanent decline in

the value of the dollar, since a declining dollar would make

U.S. goods cheaper and could threaten the export markets of other

countries.

There is no way to distinguish between currency market

interventions intended to stabilize markets and those intended

to maintain for an extended period an exchange rate at a level

different from the level that would prevail in a free market.

It seems unlikely, however, that foreign central banks could

maintain the dollar at artificially high levels for very long. It

is generally thought that the value of a currency is determined

in the short run (up to, say, a year) by the actions and preferences of asset holders, not by the flow of international trade.

It is estimated that the total value of dollar-denominated assets

_!_/ See, for example, "Dollar At Record Low Against Yen," The

Washington Post (October 19, 1977), p. B-2.

24
in the world is in the neighborhood of $5 trillion, 2_/ and

extremely large and continuous interventions would be required to

produce lasting changes in the value of the dollar. 3/

Even if the value of the dollar were to decline, it would

prove a mixed blessing for the U.S. economy. In the long run,

perhaps after a year or so, one might expect an improvement

in the U.S. trade position as U.S. goods became more competitive

relative to foreign goods. In the shorter run, however, the lower

value of the dollar would be expected to add somewhat to inflationary pressures because the price of imported goods would be

higher. The higher import prices and lower export prices that

would result from a decline in the value of the dollar would

temporarily increase the U.S. trade deficit.

2] Henry C. Wallich, "Why Exchange Rates Move," Challenge

(July/August 1977), p. 38.

_3_/ An example of how large these interventions would have to

be is provided by recent actions of the Bank of England.

Throughout 1977, the value of the pound had been held down by

very large purchases of foreign currencies—mostly dollars--

by the Bank of England. During the first 10 months of 1977,

British official reserves of foreign currency increased from

$4.13 billion to $20.2 billion, with $3.04 billion being

accumulated in the month of October alone. To finance these

massive purchases of foreign currency, the Bank of England had

to allow large increases in the domestic money supply. Fear

that such rapid monetary growth would increase inflationary

pressures led the Bank of England to announce on October 31

that it would cease its currency market intervention. Free

to move to a market-determined value, the pound initially

rose by about 3.8 percent relative to the dollar, then fell

back to a value in the New York currency market only 1.5

percent higher than had prevailed when the Bank of England was

intervening.

25

inr inwr
.JLBIIIUL Jliill
CHAPTER V. PROSPECTS AND POLICIES

PROSPECTS FOR THE IMMEDIATE FUTURE

The prospects for improvement of the U.S. trade and current

account deficits do not appear bright in the near future if it

is true, as the evidence seems to indicate, that those deficits

are attributable mostly to slow growth in other countries. In its

most recent projections for the industrial economies, the OECD

projects no improvement in growth rates of member countries in

1978. I/ In recent months, both Japan and West Germany have

announced more stimulative fiscal policies, but few observers

expect these modest actions to have a pronounced effect on economic growth. Italy and the United Kingdom are both making

progress at controlling inflation and eliminating large trade

deficits, but neither country can be expected to adopt strongly

stimulative policies in the near future. The general elections in

France scheduled for next spring make the prospects for that

country uncertain. Industrial production in Canada has shown

almost no growth in the first half of 1977, and the prospects

for resumed growth in the near future appear dim.

Among the developing countries, there are some signs of

improvement. Most developing countries have added to their

reserves of foreign currency in 1977, and borrowing by these

countries has decreased somewhat from the high levels of 1975 and

1976. Improvements in the financial positions of the developing

countries may allow the resumption of import growth during the

next year. But until general recovery among the industrialized

countries increases the demand for exports from developing countries, the ability of the developing countries to import will grow

only slowly.

The growth rate of the U.S. economy may also slow slightly in

the next year, 2/ but it is expected to remain higher than those

IJ OECD Economic Outlook (December 1977).

_2/ Congressional Budget Office, Recovery With Inflation (July

1977), p. 22.

27

IT W
I III I

of most other industrialized countries. Thus, the growth of U.S.

imports may slow somewhat, but probably not enough to produce

large reductions in the U.S. trade deficit. U.S. imports of oil

may have declined slightly in the latter part of 1977 because

unusually large stocks were accumulated early in that year, but

in 1978 they are expected to return to the high levels (9.4 million barrels per day) of the early part of 1977. _3/ Oil imports

might be even higher if plans for a strategic stockpile of petroleum are implemented. Overall, then, the prospect is that the

trade and current account deficits that the United States experienced in 1977 are likely to continue at roughly the same level in

1978.

IMPLICATIONS FOR U.S. POLICY

The present U.S. deficits do not appear to be a reflection of

any fundamental weakness in the U.S. economy. Quite the contrary

is true: these deficits are to a large extent a reflection of the

relative success of the United States at recovering from recession. This does not mean that the deficits are not a cause for

concern; the unemployment that results from depressed export

markets and the displacement of U.S. workers caused by import competition are real problems. But there is no direct relationship

between the intensity of these problems and the size of the

U.S. trade and current account deficits, and the solution to

these problems does not necessarily require the elimination of

these deficits. Indeed, there is no guarantee that restoring a

balance to the U.S. current account would contribute anything

toward alleviating these problems. Much will depend on whether

the deficit is eliminated in such a way as to increase U.S.

exports. The remainder of this section will outline the possibilities and limitations of the various policy tools available

to deal with these problems.

Trade Policies

Policies to limit the imports of foreign products or to

expand U.S. exports at the expense of production in other countries may provide temporary relief for some industries, but

_3/ "The U.S. Trade Deficit and Policy Alternatives," World Financial Markets (September 1977), p. 2.

28
such policies are potentially dangerous in the longer run. In

many of the slower recovering industrial countries, economic

conditions are worse than in the United States. Unemployment is

higher—at least by historical standards—in many of these countries than in the United States, unused industrial capacity is

greater abroad than it is here, and many foreign governments have

been reluctant to adopt stimulative policies for fear of inflation. This has forced these countries to rely on growing foreign

demand to lead the way to recovery and, to a large extent, what

recovery there has been in the other industrial countries has been

the result of growing foreign demand.

In these circumstances, it is to be expected that many

governments would be highly sensitive to policies that restrict

their exports to the United States. Protectionist sentiment is

widely reported to be gaining strength abroad, kj It seems

likely that U.S. policies that threaten the major source of

economic growth in these countries would result in strong pressures for retaliatory measures against U.S. exports. If such

retaliatory policies were adopted, U.S. export growth would slow

even further.

There is a further danger in relying too heavily on restrictive trade policies to reduce import competition. The benefits of

such trade policies are highly visible and narrowly focused within

particular industries, and one must expect highly organized and

vocal support for these policies from those who might benefit from

increased earnings and employment in the affected industries.

This support may, however, obscure the full costs of restrictive

trade policies. In general, domestic products face import competition when the costs of the foreign products are lower than the

costs of competing domestic products. To eliminate the importation of cheaper foreign goods is to increase the prices paid by

all consumers of those goods. To insulate U.S. producers from

foreign competition removes one more incentive to efficient domestic production. The costs inherent in restrictive trade policies are widely spread among consumers and are therefore difficult

to observe or measure. They are, nonetheless, real and should be

considered in deciding whether or not to adopt such policies.

4/ The most comprehensive review of the recent rise in restrictive trade policies is provided in International Monetary

Fund, 28th Annual Report on Exchange Restrictions (May 1977),

particularly pp. 4-6.

29

1IT TTIIBT
.ILJilllJLll:. Jill.

This is not to argue that all restrictive trade policies do

more harm than good. There are certainly strong justifications

for policies to prevent "dumping" of foreign products in U.S.

markets—selling at prices below production costs to drive out

competition—or unfair export subsidies given by foreign governments. Similarly, changes in industrial structure necessitated by

changing international economic conditions can be rendered less

painful by providing assistance to domestic workers or industries

suffering from the effects of foreign competition. Whatever the

reasons for restrictive trade policies, however, the benefits

are likely to be more apparent than the less easily observed

but nonetheless real costs.

Exchange Rate Policies

Neither is it likely that policies designed to affect the

value of the dollar would do much to encourage the growth of U.S.

exports. U.S. sales of dollars would, in theory, reduce the value

of the dollar relative to foreign currencies. Such a policy, however, would require large increases in the U.S. money supply as

the Federal Reserve System strove to create enough dollars to

satisfy foreign demand and to drive down the dollar's value. This

rapid growth in the money supply would lower interest rates in the

United States and eventually work to increase inflationary pressures. The growth rate of the money supply and domestic interest

rates are important elements of domestic economic policy. To

allow exchange rate considerations to determine domestic monetary

policy would represent a subordination of overall economic policy

to the requirements of foreign trade, still a relatively small

part of the total U.S. economy.

Except for very short-term interventions to preserve orderly

market conditions, then, the United States could in practice do

little to affect the value of the dollar directly. Further,

attempts to lower the value of the dollar would likely place the

United States in conflict with the central banks of other nations.

In recent months, when the value of the dollar has fallen as a

result of natural market forces, other nations have intervened to

support the dollar. Far from attempting to counteract currency

market interventions by other nations, the Federal Reserve and the

U.S. Treasury have in recent months been intervening in these

markets to support the dollar.

Even if U.S. monetary authorities succeeded in reducing

the value of the dollar, increased growth in U.S. exports would

30
not result for some time. International transactions are often

planned far in advance, and it often takes a year to a year and a

half for the full effects of changed exchange rates to be felt.

In the meantime, a devalued dollar would raise the price of U.S.

imports, worsening the balance of trade and adding to inflationary

pressures.

Macroeconomlc Policy

As the United States has recovered from recession, its

imports have risen about as would be expected. Because foreign

economies have recovered less quickly, however, U.S. exports have

grown more slowly than imports, and a large merchandise trade

deficit has resulted. This deficit could be narrowed by adopting

a more restrictive macroeconomic policy that would reduce the rate

of growth of the U.S. economy and ultimately the demand for

imports. But while such a policy would reduce U.S. payments

deficits, it would do nothing to solve the problems of unemployment and slow growth. Indeed, restrictive macroeconomic policies

would only aggravate these problems.

Demand for U.S. exports is one among a number of factors that

determine total demand for U.S. products and thus determine

employment and GNP. Other factors are the level of domestic

consumer demand, the rate of capital formation, and government

spending. When private demand—either domestic or foreign—is

weak, more stimulative policies will be required to reach any

given set of macroeconomic goals. The failure of foreign demand

to keep pace with the U.S. recovery, particularly in 1977, will

necessitate a more stimulative economic policy to sustain the U.S.

recovery than would have been needed if foreign demand had remained strong. The proper response to large U.S. trade deficits,

then, is a more expansionary, not a more contractionary, macroeconomic policy.

Paradoxically, the expansionary fiscal and monetary policies

required to relieve the worst effects of slow export growth would

be expected to increase U.S. trade deficits. More stimulative

macroeconomic policies would lead to increased demand in the

United States for all goods—domestic and foreign. The increased

demand for domestic goods would stimulate production and lower

unemployment in the United States, but the increased demand for

foreign goods would—all other things being equal—result in

larger U.S. trade deficits.

31

HIM"!"
HI I

Because increased income in the United States leads to

increased demand for imports, stimulative policies in the United

States will inevitably have the effect of stimulating not just the

domestic economy but foreign economies as well. To the extent

that these policies result in demand for foreign rather than

for domestic products, their effectiveness in stimulating the

domestic economy is reduced. But this is not a reason for adopting less stimulative policies. Stimulative policies have been

designed to promote economic recovery in the United States. The

United States has recovered faster than have most industrial

countries, and the fact that we now face large trade deficits is

in large part a reflection of our relative success. To reduce the

U.S. trade deficit through a restrictive macroeconomic policy

would require slowing the rate of U.S. recovery—hardly an attractive option.

Energy Conservation Policies

Oil imports are a major component of total U.S. imports.

The total cost of oil imports to the United States is expected

to reach $45 billion in 1977, and an effective program to reduce

these imports would have a major effect on the U.S. trade balance.

But a reduction in imports of oil will not in itself provide

increased demand for U.S. exports, nor will it reduce the competition domestic producers face from imported products. There are,

of course, many compelling reasons to devise a national program to

reduce oil imports, and the reduction in the U.S. trade and

current account deficits that would result from reduced oil

imports is among these reasons. But even a highly successful

conservation program will not in itself promote higher employment

in the United States.

Foreign Policy

Just as stimulative policies in the United States can foster

economic growth abroad, stimulative policies in the other industrial countries can lead to a faster recovery of the U.S. economy.

It is clearly in the interests of the United, States for the

stronger industrial nations to "reflate"—to adopt more stimulative fiscal policies and to allow their currencies to float upward

in foreign exchange markets—thus increasing foreign demand for

U.S. products. Recent pressure for faster growth has brought some

response in both Japan and West Germany, but the ability of the

United States to bring about further expansionary policies in

these or other countries is questionable.

32
Economic and political conditions abroad are different from

those in the United States, and the interests of other countries

legitimately differ from those of this country. Japan and West

Germany, for example, are usually named as the countries most able

to join the United States in stimulating the world economy, but

for internal reasons, both have chosen to adopt only moderately

stimulative fiscal policies and both are intervening in currency

markets to keep the value of their own currencies down. Both

countries have faced serious inflation—at least in terms of their

recent history—in the past few years, and both have depended

heavily on exports for their recovery from the 1975 recession.

The United States can, of course, continue to call for more

stimulative policies in other nations and to remind these nations

that they have not met the 5 percent growth targets for 1977

that were agreed to at the London economic summit in May of that

year. But the prospects for encouraging other nations to change

prevailing policies seem dim.

CONCLUSION

It would seem that the United States must reconcile itself

to continuing trade and current account deficits for at least the

next year or so. Neither restrictive trade policies nor attempts

to manipulate the value of the dollar are likely to provide more

than very short-term relief from the problems associated with

these deficits. Indeed, these policies could easily create further problems. There are, however, other policy tools available

that could alleviate some of the problems the United States now

faces. Specifically, a more stimulative macroeconomic policy

could help to reduce unemployment and to sustain economic recovery

by compensating for weak foreign demand for U.S. products. An

effective program to reduce imports of oil would provide benefits

both by reducing U.S. dependence on foreign sources of supply and

by reducing the size of the U.S. trade deficit. U.S. encouragement of more rapid growth in other industrial countries has resulted in the adoption of moderately expansionary policies in West

Germany and Japan, and continued pressure for such policies and

for reductions in trade restrictions may prove effective in the

future.

It may also be desirable to provide more relief for the

workers and industries most seriously injured by sluggish export

growth and increased competition. This assistance, however,

should be temporary and limited; there is nothing to be gained by

33
insulating declining industries forever from changing patterns of

world trade. Some assistance of this form is already provided

through programs administered by the Departments of Labor and

Commerce, but only those workers or firms injured because of

import competition are eligible for assistance. As foreign trade

continues to grow in importance to the U.S. economy, it would

perhaps be worth considering the extension of such assistance to

individuals or industries that suffer the loss of export markets.

This assistance could ease the adjustment to a new structure of

trade and could allow industries to survive temporary losses in

export sales.

The analysis of the earlier sections of this study suggests

strongly that the large trade and current account deficits that

the United States experienced in 1977 are not a symptom of any

general weakness in the U.S. economy. On the contrary, the

evidence indicates that they are the result of the success of the

United States in recovering from recession faster than did the

other industrial nations. As such, the greatest danger these

deficits pose to the continued growth of the U.S. economy is that

policies designed to eliminate them will retard the economic

recovery that gave rise to them.

34

U. S. GOVERNMENT PRINTING OFFICE : 1978 O - 23-487