The massive U.S. trade deficit, which has rapidly developed over
the recent period of economic expansion, is the most obvious and
concrete reflection of this country's underlying economic imbalances.
The trade deficit, in an immediate sense, has been primarily
related both to the strength of the dollar in the exchange markets
and to relatively slow growth elsewhere in the world. In effect,
muchof the world has been dependent, directly or indirectly, on
expanding demand in the United States to support its own growth.
Put another way, growth in domestic demand in Japan, Canada, and
Europe has been less than the growth in their Gross National
Products, which is the converse of our situation.
Even with surging exports to this market, output has been
increasing too slowly to cut into high rates of unemployment in
Europe and elsewhere. As a consequence, the demand of others for our
products has been relatively weak.
The strong competition from abroad, in an immediate sense, had
benefits as well as costs for this country. It has been a powerful
force restraining prices in the industrial sector and in encouraging
The related net capital inflow has eased pressures on our interest
rates and capital markets. We have been able to readily satisfy the
higher levels of consumption driven in party by the budget deficit.
However, those benefits cannot last. Sooner or later our external
accounts will have to come much closer toward balance. Indeed, as
our debts increase, we will have to earn more in our trade to help
pay the interest.
In the meantime, the flood of imports, and the perceptions of
unfairness which accompany it, foster destructive protectionist
forces. The domestic investment we will ultimately need is
discouraged while our companies shift more of their planned expansion
The larger the external deficits and the longer they are
prolonged, the more severe the subsequent adjustments in the exchange
rate and in our economy are apt to be. We will have paid dearly
indeedfor any short-term benefits.
These considerations have tempered the conduct of monetary policy
for some time. Specifically, our decisions with respect to providing
reserves and reducing the discount rate have been influenced to some
extent by a desire to curb excessive and ultimately unsustainable
strength in the foreign exchange value of the dollar.
We have also, however, had to recognize the clear limitations and
risks in such an approach.
The possibility at some point that sentiment toward the dollar
could change adversely, with sharp repercussions in the exchange rate
in a downward direction, poses the greatest potential threat to the
progress we have made against inflation. Those risks would be
compounded by excessive monetary and liquidity creation.
There is little doubt that the dollar could be driven lower by
"bad" monetary policy - a policy that poses a clear inflationary
threat of its own and undermines confidence. But such a policy could
hardly be in our overall interest. It would, in fact, be destructive
of all that has been achieved.
The hard fact remains that so long as we run massive budgetary
deficits, we will remain dependent on unprecedented capital inflows
to help finance, directly or indirectly, that deficit. The net
capital inflows will be mirrored in a trade deficit - they are
As things now stand, if our trade deficit narrowed sharply, both
the budget deficit and investment needs would have to be financed
internally, with new pressures on interest rates and a squeeze on
other sectors of the economy.
Some of these are now doing relatively well, such as housing.
Some, such as farmers and thrift institutions, are already under
strong financial pressure. The implications for our trading partners
and for the heavily indebted developing countries would be severe as