The Economic Consequences of Mr Reagan

The American Congress and President Reagan are locked in a debate on tax reform and future reductions in the federal deficit. At a CEPR lunchtime meeting on June 19, William Branson argued that a major downward movement in US interest rates and the US dollar will come only when a credible programme of deficit reduction emerges from the debate. Branson also predicted that if there were a cut of $50 billion in the fiscal deficit, long-term US interest rates would fall by 1.5 percentage points and the value of the dollar by 15%. With no action the US economy faced a 'hard landing', with a falling dollar but rising interest rates. Branson is Professor of Economics and International Affairs at Princeton University, Programme Director for International Studies at the US National Bureau of Economic Research (NBER), and a Research Fellow in CEPR's International Macroeconomics and International Trade research programmes.

Branson argued that a credible announcement of a substantial future reduction in the cyclically-adjusted or 'structural' budget deficit might permit a 'soft landing'. Financial markets would expect interest rates to fall in the future, as government financing requirements are reduced. If interest rates were expected to fall, the market would expect bond prices to rise; buying in anticipation of this rise will pull bond prices up and push interest rates down, but only when the fiscal announcement becomes credible. With interest rates falling, the US dollar would also depreciate. The immediate fall in interest rates and the dollar would stimulate US investment and exports, but only with a lag of approximately one year, according to available research results. With luck, Branson suggested, the stimulus to investment and exports would be felt at the same time as the shift toward fiscal tightness, keeping the economy on a path of gradual expansion.

To support his view, Branson discussed the behaviour of interest rates, exchange rates, and the US Federal budget since 1980. Short-run nominal interest rates rose with the shift in US monetary policy in late 1979. Only in mid-1981, however, was there a significant increase in long-term real interest rates in the US, from 2% to the 6-8% range. The first major upward movement in the US dollar also came in 1981, when the dollar appreciated by 20% in real, effective terms. Since then the dollar has appreciated further, so that by 1985, the real appreciation is about 50% compared to the end of 1980.

This real appreciation has had dramatic consequences for the US economy and its manufacturing and agricultural sectors. The appreciation has raised US manufacturing costs by 50% relative to those of its trading partners. This has reduced exports of manufactures and increased imports; the US trade deficit will be around $150 billion in 1985, Branson predicted. While overall employment in the US has risen by 7 million since 1980, manufacturing employment has gone down by 2.3 million, or about 12%. With a current account deficit running around $150 billion annually, the US economy had become a net international debtor by the end of 1984.

Branson's research points to the shift in the Federal budget position in 1981 as the cause of the leap in interest rates and the dollar and the resulting imbalances in the US economy. The effects occurred through two channels. First, the actual increase in the structural deficit beginning in 1982 was in effect a reduction in US national saving. This fall in savings had to be offset by a reduction in US domestic investment or by a current account deficit or both - eventually some $200 billion in 1985. Investment was 'crowded out' by the usual mechanism, rising real interest rates. The current account deficit is a form of international 'crowding out' which operates through the appreciation of the dollar. The $200 billion fiscal deficit in 1985 is being financed by a $50 billion reduction in investment and a $150 billion current account deficit.

The deficit had its second 'announcement' effect through the financial markets, which anticipated these movements in investment and in the current account. This helps explain the 1981 increases in interest rates and the dollar that followed the announcement of the future budget programme. Branson agreed that periodic shifts of international demand for dollars have moderated the upward movement of interest rates and supported investment. But the simultaneous rise in the dollar and in interest rates points to the shift in the structural deficit as the causal factor.

The 1981-84 US experience, Branson argues, suggests that a 'soft landing' is possible. Announcement of a credible cut in the deficit beginning in Fiscal Year 1986 would bring down interest rates and the dollar now. The resulting stimulus to investment and exports would occur with a lag at the time when fiscal policy actually tightens. A cut of $50 billion in the deficit would bring long-term US interest rates down by perhaps 1.5 percentage points and bring the dollar down by perhaps 15%, Branson predicted.

If there is no deficit reduction, the US may face the alternative of a 'hard landing'. In that case, international investors would become increasingly reluctant to absorb the additional dollars necessary to finance the deficit. The dollar would come down but US interest rates would go up further. This would shift the burden of financing the deficit further toward US domestic investment and away from the foreign sector. This would eventually slow US capital formation and growth.

Branson predicted that there would be only minimal progress towards a credible deficit reduction, at least in 1985. This would cause renewed upward pressure on long-term interest rates. Only an imminent hard landing would stimulate the political action necessary to reduce the US deficit.