by C. Fred Bergsten, Peterson Institute for International Economics
Op-ed published in the Financial Times
January 11, 2001
© Financial Times
Dr. Bergsten was Assistant Secretary of the Treasury for International Affairs from 1977 to 1981, also functioned as Under Secretary for Monetary Affairs during 1980-81, and was Chairman of APEC's Eminent Persons Group throughout its existence from 1993 through 1995.
Like Ronald Reagan in 1981, George W. Bush takes office preparing tax cuts that will substantially weaken the US budget position. As with the Reagan tax cuts, Mr Bush's proposed fiscal loosening will have to be financed largely by foreign investors, owing to the very low rate of national saving in the United States.
But there is an important difference: in 1981, the United States was still the world's largest creditor country and ran a current account surplus. Overseas lenders were, for a while, willing to fund Mr Reagan's initiative.
Mr Bush, by contrast, inherits an external deficit of almost $500 billion-one that has been rising by about 50 percent annually for the last three years, atop a net foreign debt that exceeds $1,500 billion. Foreign investors, which already provide the United States with almost $2 billion every working day, may balk at pumping in even larger amounts, especially as United States growth and equity prices have now dropped sharply. A tax cut of anything like the magnitude proposed by the president-elect represents an even bigger "riverboat gamble" than its predecessor of two decades ago.
The imbalances in United States trade and current accounts-approaching 5 percent of gross domestic product-have received surprisingly little attention in the debate over the Bush tax cuts. Foreigners already hold about $10,000 billion in United States assets, much of which could be sold off at short notice. Americans themselves could join any flight from the dollar. Hence the United States is already exceedingly vulnerable to a change in attitude to its currency.
Any foreign unwillingness to continue pouring huge amounts of new money into the United States, let alone substantial liquidation of existing dollar investments, could severely destabilize the United States economy. If the dollar were to fall 20-30 per cent, as it easily might, inflation might rise by 2-3 percentage points, since the economy is still running close to full capacity. The Federal Reserve would be unable to cut interest rates further; indeed, rates would be likely to rise substantially, as the huge deficit would still have to be financed and foreign investors would demand higher yields to offset the falling currency. The stock market would then drop again, compounding the negative wealth effects that are already cutting growth.
True, the United States economy today is much stronger than it was 20 years ago. And it is running a substantial fiscal surplus, whereas the budget had already moved into deficit when Mr Reagan acted in 1981. Moreover, the Bush program is designed to be phased in over several years.
But any decline in a budget surplus reduces public and hence total national saving just as much as an equivalent increase in a budget deficit. Adequate investment and growth can then be maintained only if offsets can be found from increases in domestic private saving or more foreign financing. There may well be some of the former, especially by individual households. But the United States would still have to attract sharply higher investment from abroad to finance the proposed tax cuts when there is already a considerable risk that such capital inflow will fall from its current level.
As for timing, Congress will almost certainly accelerate implementation of the Bush proposals. Democrats as well as Republicans, especially in the House of Representatives with its shorter political time horizon, may even engage in a "bidding war" to expand and take credit for the measures, as they did in 1981. It is true, too, that the Reagan tax reductions were-for a while-financed by increased inflows of foreign capital, promoting a brisk recovery of investment and growth from the recession of the early 1980s, as the United States drew down the foreign asset position that it had built over the previous 60 years. But, inevitably, the dollar fell sharply-by about 50 percent in 1985-87—pushing up interest rates and eventually triggering Black Monday, when the Dow industrial average dropped more than 20 percent.
A large tax cut in 2001 might similarly receive a temporary respite. But any resultant strengthening of the dollar as in the early 1980s would, in addition to further depressing the manufacturing and farm sectors, widen the trade deficit and ensure that the dollar's eventual fall would be even sharper. The respite could not last long in any event, owing to the precarious international financial position that the new administration will inherit.
Given that the Fed has clearly signaled its intention to provide whatever stimulus the economy turns out to need, the far wiser policy course is to rely on further reductions in market and Fed interest rates. Real United States interest rates remain very high by historical standards and could fall substantially without creating inflationary risks. New tax cuts would increase government borrowing and therefore put pressure on interest rates as well as jeopardize continued foreign funding of the external deficit. Tax cuts should be deferred until the United States has restored its international finances to a position that can safely sustain them.