Budget deficits, trade, and the dollar
Boston — In his inaugural address, President Reagan sounded a cheery note: ``A dynamic economy, with more citizens working and paying taxes, will be our strongest tool to bring down budget deficits.'' Richard F. Hokenson, an economist with the Wall Street brokerage house Donaldson, Lufkin & Jenrette, basically agrees. Indeed, he says he expects a stronger recovery and a faster-declining deficit than the administration itself.
Mr. Hokenson is part of a wave of optimism washing the shores of the business establishment. After this decade got off to a bad start with two recessions in a row, double-digit inflation, record high interest rates, and a scary international debt crisis, many Americans began to expect the worst.
Mr. Reagan told them, contrariwise: ``In this blessed land, there is always a better tomorrow.''
His ``always'' may overstate the case. Recessions can pull down living standards for a short time. There often is negative economic news mixed in with the predominant good news these days. This article examines some economic areas where the outlook today could well be brighter than many believe. The budget deficit
In the President's latest budget message, he called for restraining the growth in federal spending in fiscal 1986 to 1.5 percent over what the government expects to spend this year. Outlays would amount to $959.1 billion, leaving a deficit of $178 billion. That's down from the more than $209 billion the administration projects for the current fiscal year ending Sept. 30. (These numbers do not incorporate ``off budget'' statistics, such as funding for the Strategic Petroleum Reserve and the Rural Electrication Administration. Neither do Mr. Hokenson's.)
In a sense, such a budget is a bargaining position. The President probably does not expect Congress to approve what amounts to a sizable drop in real spending after inflation is considered. His budget will be competing with that being put together by Sen. Robert Dole (R) of Kansas.
The Democrat-controlled House of Representatives will have a different sense of priorities than the President, probably trimming the growth in defense outlays by a larger amount and raising civilian spending somewhat. The Congressional Budget Office, as usual, is more gloomy than the President's Office of Management and Budget (OMB) for the deficit. Assuming only 3 percent growth, it projects the deficit growing from $215 billion in fiscal 1986 to $296 billion by 1990, without action to reduce the deficit. The White House assumes 4 percent growth and projects the deficit reaching $224 billion by 1990, again without proposed cuts.
But will it actually be so bad?
Brokerage house economist Hokenson says it won't. After looking at the actual budget numbers for the first three months of the fiscal year, he figures the deficit this fiscal year will be ``only'' $155 billion and next year $140 billion to $145 billion, including spending cuts.
Last winter, the OMB said the fiscal 1984 deficit would be $183.6 billion. Hokenson and a colleague, Gert von der Linde, projected a deficit of between $150 billion and $160 billion. It actually came in at $175 billion. The optimism of the two was justified, but overly strong.
``We underestimated the impact of the sharp growth in investment,'' explained Hokenson.
Investment climbed an extraordinary 20 percent last year, and because of two features of the tax system -- accelerated depreciation and investment tax credits -- business was able to sharply reduce its tax burden. Federal revenues did not grow quite so fast as the two economists had anticipated.
This year Hokenson figures revenues will grow faster than the cautious OMB predicts for two basic reasons. First, business investment will peter out somewhat -- say 11 to 13 percent. So corporations and other businesses will have less of an opportunity to trim their taxes. Moreover, tax law changes of 1982 and 1984, reducing the benefits of accelerated depreciation, will start to bite this year, boosting the tax bills of business. Further, Hokenson expects the economy to grow slightly faster in real terms than the 4 percent projected in the budget message. That will bring in more revenues.
The OMB calculates that an extra 1 percent growth in national output would reduce the deficit by $4.1 billion next year, around $17 billion in fiscal 1987, and as much as $73 billion by fiscal 1990.
With industrial capacity growing more quickly than the increase in demand in recent months, Hokenson holds that there is ``lots of room'' in the economy for increased output without accelerating inflation. This, he says, will be recognized by the Federal Reserve System. It will keep credit sufficiently loose to stimulate faster growth. Unemployment remains high too. So labor costs for both business and government will grow only modestly, Hokenson adds.
On the expenditure side, he expects Congress to cut fiscal 1986 spending by only $30 billion to $40 billion, less than the $51 billion Reagan requested.
He also assumes no legislated increase in taxes.
However, Hokenson also sees several other trends producing less red ink. The Department of Defense, he says, will continue to have trouble spending all the money Congress has appropriated. Last fiscal year defense outlays ran $5 billion below budget. Last winter Hokenson and von der Linde had estimated a $6.5 billion shortfall. The pattern of defense orders in calendar 1984 offers some indication that the military will underspend again this year, he says.
Interest costs also will be down from earlier budget projections. If interest rates remain at their present level, the savings on outstanding debt would be $8 billion this year and $15 billion in fiscal 1986, Hokenson reckons. Another element saving the government money will be less inflation. The government says prices will rise 4 percent this fiscal year. Hokenson says between 3 and 4 percent.
Of course, because his assumptions could prove wrong, Hokenson's budget-deficit predictions could be overly shiny. Only small percentage changes in revenue or spending levels are needed to dramatically shrink or enlarge deficits.
If he is right and the deficit does continue to decline, it should ease fears about the economic impact of the deficit. Many economists see the huge deficits as the root of almost all economic evil. They blame them to a large degree for high interest rates. These rates, they add, in turn create an overly strong US dollar, massive trade deficits, and an extra cost burden for debt-troubled developing nations. The trade deficit
In 1984, the nation experienced a record trade deficit of $123.3 billion. Getting this news late last month, Alexander B. Trowbridge, president of the National Association of Manufacturers, immediately issued a statement calling this massive excess of imports over exports ``deplorable.''
Mr. Trowbridge warned: ``This is costing our economy 2 to 3 percent of GNP [gross national product -- the output of goods and services] growth a year. Failure to correct the situation is inevitably leading to calls for import protection.''
This year, according to Citibank, the trade deficit could be $152 billion. But, the bank adds wistfully, the deficit is ``worsening more slowly.'' Further, it has not stopped the US economy from enjoying a strong recovery. And it has helped recovery abroad.
What has led to this huge deficit is the unusual strength of the US dollar. In the last four years, the dollar rose by nearly 60 percent against an average of other currencies, weighted by their shares in world trade. Even if relative inflation rates are taken into account here and abroad, the real appreciation of the dollar comes to 52 percent.
Economic consultant Michael J. Hamburger points out that part of this gain in the value of the dollar represents a recapturing of the 28 percent in nominal value the greenback lost in the late 1960s and the 1970s.
Nonetheless, American exporters and domestic firms competing with imports have been hit badly in many cases by the strong dollar.
The muscular dollar is usually blamed on the budget deficit and high interest rates. But, as Mr. Hamburger notes, there is more to it than that. He lists three other factors:
1. Reduced expectations of inflation, and that is good news.
2. Increased real interest rates (rates after subtracting the inflation rate) in the US -- not such good news.
3. Consideration of the US as a ``safe haven'' for investment, which is better than being a danger spot for money.
Foreign investors, says Hamburger, have come to appreciate the firm anti-inflation commitment of the Reagan administration and the Federal Reserve System. This change of sentiment first happened in 1982, and again last summer when the demand for housing slowed, interest rates turned downward, and stock prices jumped by 10 percent. Foreign investors once more started to buy US financial assets.
(That decline in interest rates continued after budget director David Stockman raised his deficit projection above $200 billion after the fall election. Interest rates track budget deficit trends very poorly, as Treasury officials constantly point out.)
Hamburger says the rise in real interest rates stems from the 1981 cut in business taxes. These changes boosted the after-tax profitability of investments in plant and equipment. Investors could pay higher interest rates for borrowed money and still make a profit. As a result, business investment in plant and equipment increased by 30 percent since the start of the recovery in December 1982, a move which is three times that which has occurred in the first seven quarters of economic expansions since 1965. And this increase in demand for money helped maintain high interest rates.
Residential construction also initially climbed faster than usual, though it has since slipped back in line with historical experience.
Martin Feldstein, former chairman of President Reagan's Council of Economic Advisers, admits the high return on investment is one cause of high interest rates, but he emphasizes the pressures put on the money markets by the need to finance the huge budget deficits.
The better news about the trade situation is that exports rose 8.7 percent last year.
After noting that this increase occurred in the face of intense competition from abroad and the severe erosion of competitiveness caused by the dollar's relative strength, Manufacturers Hanover stated: ``It reflects, among other things, the rise of industries producing items unique to the US in terms of quality, technology, etc.''
In other words, the US economy continues to demonstrate remarkable sophistication and strength. The developing-country debt deficit
Economist William B. Cline describes the debt problem as a ``dead issue'' -- at least for those major debtor nations whose financial collapse might have threatened the world financial system.
``There is very major progress, and it is encouraging,'' says this research fellow of the Institute for International Economics.
The 16 largest third-world debtors have $520 billion of debts, with servicing charges running around $55 billion a year. Back in mid-1982, the nine largest US banks had loans outstanding to developing countries and Eastern Europe amounting to 280 percent of the banks' capital. Most of those banks had loans to Brazil and Mexico equal to more than 100 percent of their capital.
If any major debtor defaulted on its debts, it was feared, these banks would become technically insolvent and need to be rescued by their nations' central banks.
In the spring of 1983, Mr. Cline put together an econometric model examining the problem. It projected substantial improvement in the balance of payments and relative debt burden of most debtor countries, should economic recovery in the industrial nations continue as expected. By the late 1980s, he found, the ratio of debts to exports would be back to levels previously associated with creditworthiness. The model indicated that the debt problem was one of illiquidity -- a shortage of foreign exchange due to the world recession, low commodity prices, high interest rates, and a strong dollar -- for these debtor nations, rather than insolvency.
So far, reports Cline, the major debtor nations -- Brazil, Mexico, Argentina, and Venezuela -- are ahead of the track projected by his model.
The faster-than-anticipated growth in the industrial countries, by sucking in third-world exports, has more than offset the negative impact of continued weak commodity prices, the strong dollar, and high real interest rates.
Cline sees the possibility of some smaller debtor nations that are highly dependent on the sale of commodities, particularly metals, stumbling into worse debt-servicing problems. He mentions Chile and Peru as examples. But the financial system can handle such upsets.
With the US apparently resuming faster growth and the economies of Western Europe picking up steam, Cline expects the major debtors to be able to resume faster growth at home and continue to make progress in servicing their debts. 1. Revolutionary Cuba
Toward accommodation or conflict? 2. Soviet leadership in transition
What impact on superpower relations? 3. Iran-Iraq war
What role for the US in Persian Gulf? 4. Budget deficit, trade, and the dollar
The economics of foreign policy 5. The Philippines
What future for democracy? 6. Population growth
Critical North-South issue? 7. Future of the Atlantic alliance
Unity in diversity? 8. Intelligence operations
How undercover diplomacy works
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