The central emphasis in the Administration's trade strategy since the Tokyo summit has been to call for faster economic growth in Germany and Japan. This represents a departure from the policy of exchange-rate adjustment announced last September. Without denying that the dollar must eventually decline further, the Administration now urges expansion of foreign demand in order to increase U.S. exports and reduce the U.S. trade deficit.
Why has this shift occurred? The Administration and the Federal Reserve both are worried that any fall in the dollar could turn into a speculative run resulting in a precipitous drop in the dollar's value. Such a sharp drop in the dollar would raise import costs, putting upward pressure on the U.S. inflation rate. Even more troubling is the fact that a very sharp drop in the dollar could significantly shrink the inflow of foreign capital and thereby cause a substantial rise in U.S. interest rates. That indeed is the paradoxical problem with which the Federal Reserve now is confronted: Lowering the discount rate could start a run on the dollar leading to much higher market interest rates.
A further reason for the Administration's shift may be the domestic political appeal in telling our trading partners that they have to do something to improve our trade situation. American voters certainly prefer that rhetoric to hearing that the dollar must decline.
Whatever the reason for the Administration's new line, the truth is that expanded demand in Germany and Japan would by itself have little effect on the U.S. trade deficit. There is simply no way that expanded demand abroad can be a substitute for a further substantial decline in the value of the dollar.
Real gross national product growth in the rest of the world is projected at about 3.5% a year in 1987 and 1988. Imagine that this could somehow be increased by about a third, to 4.5% a year. What would such an enormous increase in the growth of foreign demand do for our exports? If U.S. exports maintained their share of the increased demand, there would be an extra 1% a year rise in U.S. exports. By the end of 1988 that would raise the annual rate of exports by a total of $5 billion--a trivial amount in comparison to our $100-billion trade deficit.
Economic studies indicate that the temporary effect of increased foreign growth would be somewhat larger than this, but still very small in comparison to our overall trade problem. In the near term, imports from the United States would temporarily rise more than in proportion to the increase in foreign GNP, and this would be accompanied by a temporary reduction in foreign capacity to export to the United States. But, even under these more favorable assumptions, the reduction in the annual trade deficit would only be about $15 billion by the end of 1988.
There also is absolutely no reason to believe that the Germans and Japanese are willing to manage their fiscal and monetary policies for the benefit of the U.S. trade situation. There may be some expansion of demand by the Japanese, but for their own domestic reasons. The Japanese may further reduce their prime lending rate to offset the contractionary effect of the rising yen, although their interest rate is already the lowest in the world. With Japanese unemployment at only 2.9% and with consumer spending up 5.5% over the last year, it is unlikely that Japan will want much more domestic expansion.
The Germans are even less likely to go along with the pressure for additional expansionary steps. The Germans already are expecting domestic demand to grow at more than 4% in 1987 and 1988. They recently cut taxes, and another tax cut is scheduled for 1988. They already are concerned about excessive monetary growth and inflationary pressures. And, although the unemployment rate in Germany is very high, the Germans believe that the real source of their unemployment problem is excessive wages and market rigidities, not inadequate demand.
In short, the Administration's new emphasis on overseas expansion cannot be the basis for a successful trade strategy. The U.S. trade deficit developed in the 1980s because the dollar became dramatically overvalued, rising more than 75% between 1980 and early 1985. Since then the decline in the dollar has erased about two-thirds of that increase. Although lags in the response of exports and imports to the dollar's lower value have meant that the trade deficit has until now declined only slightly, the progress during the coming year will be much more significant.
To eliminate the trade deficit and shrink our dependence on foreign capital, there is no real substitute for a further decline of the dollar. There is not likely to be a better time than now to accept the inflation risks of a falling dollar. And if Congress sticks to its plan for substantial reductions of the budget deficit, there is no reason for the reduced inflow of capital to raise interest rates above their current levels. The Administration should return to its pre-Tokyo strategy and stop fooling the public into thinking that our trade deficit can be solved abroad.