The US external deficit will fall significantly during 1988 and 1989, but this improvement will not be large and sustained enough to achieve an acceptable balance over the longer run, according to research reported by Ralph C Bryant and Gerald Holtham at a CEPR lunchtime meeting on February 29. Modifications are needed in domestic macroeconomic policies both in the US and in other industrial countries, entailing further depreciation of the dollar. Without such changes, any short-run improvement in the US external deficit is likely to be eroded after 1989. Simulations of a range of multi-country econometric models clearly identified policy changes which would benefit all major countries, but these changes will be postponed for at least another year because of political obstacles and short-sighted inertia in national decision-making, Bryant and Holtham concluded.
Bryant and Holtham spoke at a meeting to mark the European launch of two new books published by The Brookings Institution, stemming from a research programme jointly organized by Brookings and CEPR and financed by the Ford Foundation, the Alfred P Sloan Foundation, and the US National Science Foundation. Ralph C Bryant is a Senior Fellow in Economic Studies at The Brookings Institution, Washington, and Gerald Holtham is International Economist at Credit Suisse First Boston in London. The meeting at which they spoke was financed by the German Marshall Fund of the United States. The opinions expressed by Bryant and Holtham were their own, however, and not those of the German Marshall Fund or of CEPR, which takes no institutional policy positions.
In External Deficits and the Dollar: The Pit and the Pendulum, five US economists, including Bryant and Holtham, examine the causes and consequences of the US external deficit and the wide swings in the dollar's value. The large appreciation of the dollar was the single most important reason why the US deficit soared between 1980 and 1986; faster growth in the US than in the other industrial economies was also significant. These two factors account for virtually all of the deterioration in the US external account between 1980 and 1986. These findings led Bryant and Holtham to reject explanations of the deficit based on increased protectionism abroad or structural changes in the US or foreign economies (for example, because of an increased desire to save by Japanese consumers).
The two volumes of Empirical Macroeconomics for Interdependent Economies arise from a worldwide cooperative research programme sponsored by the Brookings Institution in 1985-7. With their systematic comparison of alternative multi-country models, the books provide the best available summary of existing empirical knowledge about international macroeconomic interactions and the implications of that knowledge for macroeconomic policies.
Growing interdependence in the world economy, Bryant and Holtham argued, means that governments should in principle coordinate their economic policies. Yet uncertainty about the size, and at times even the direction, of interactions among economies severely undermines the ability of governments to achieve such coordination. A greater consensus of analytical views is necessary for progress in policy coordination.
The research reported in the books aims to identify areas of agreement and disagreement. They contain the results of simulation experiments performed with multi-country econometric models from North America, Europe and Japan which give quantitative estimates of interactions among economies. Although these estimates were still subject to substantial uncertainty, they did reveal the areas of disagreement between models and demonstrated a number of areas where a rough consensus exists.
Bryant and Holtham used this research to interpret the current world economic situation. The failure of the US external deficit to decline in 1986 in response to the depreciation of the dollar that began in early 1985 should not have been regarded as surprising, they argued; empirical models of the US current account all predict that the external deficit responds strongly to changes in exchange rates only after substantial lags. Early in 1987 Bryant and Holtham had prepared projections, using a weighted average of the model simulations, which predicted a substantial improvement during 1987 and 1988 in the deficit measured in volume terms. The projections did not, however, indicate a large improvement in the current dollar value of the trade balance until 1988. The projections were pessimistic about the US external deficit over the longer run. Given existing policies and the amount of dollar depreciation that had occurred by the time the projections were made, the models on average were unable to predict a level for the deficit in current dollars that fell below $100 billion during 1987 and 1988. Indeed after 1989, both the current-price and constant-price balances showed renewed deterioration. The events of 1987 have largely borne out these forecasts, Bryant and Holtham noted.
To indicate how the world economic outlook might be improved, Bryant and Holtham discussed the likely consequences of a major contraction in US fiscal policy combined with an offsetting relaxation of Federal Reserve monetary policy. Simulations using a variety of models indicated that such a change in the mix of US policies could substantially reduce the US budget and external deficits while leaving economic activity in the United States essentially unchanged. But these changes in US policies, however desirable, had an important drawback: if adopted in isolation, they would cause a severe contraction in the other OECD economies. European governments who urge the US to reduce its fiscal and trade deficits should therefore be prepared to take concurrent expansionary actions to sustain demand in their own economies, Bryant and Holtham warned.