One challenge here comes from the supply-side/new classical camp, the other from a more traditional viewpoint that questions the closeness of world capital market integration. We consider each in turn.
Do Budget Deficits Affect National Savings? An extensive debate within the economics profession has swirled around the issue of whether government deficits reduce the national savings rate.
This debate is far too elaborate to summarize here; however, the key issues are fairly simple. Against the prima facie case that government dissaving reduces national savings an influential "Ricardian" view argues that government deficits will be offset by increases in private savings. Suppose that the government cuts taxes without any prospect of future reductions in spending.
Then households should know that in the future the government will have to raise taxes again, both to restore the original cuts and to service the increase in its debt. In present value the total expected tax liabilities of the private sector will not have changed. Thus the private sector will not increase its consumption. and all of the tax cut will be saved.
The theoretical rejoinder to this argument has several strands. First, some of the tax liability resulting from a temporary tax cut will fall on unborn generations; those currently consuming will therefore experience some reduction in their lifetime tax burden. Second, some households may be liquidity constrained. Unable to borrow at the same rate at which they can lend, they prefer a marginal dollar of consumption to a marginal dollar of savings but are not willing to borrow to spend more than their income.
For these households an increase in current income will be spent even if the present value of their lifetime income has not changed. Third, the assertion that tax cuts will be fully saved requires a high degree of sophistication on the part of all households; they must understand the future tax implications of the current budget. If a sizable fraction of households behaves in a less sophisticated way using some rule of thumb rather than a careful calculation of future government fiscal prospects, much of a tax cut will similarly be spent rather than saved.
The facts of the 1980s certainly do not provide any support to the Ricardian view. Data showed, the U.S. fiscal deficit was reflected fully in a decline in national savings, with no offset from the private sector. This could of course be a coincidence. National savings might have fallen for other reasons, such as expectations about future cuts in government spending on goods and services or a future surge in productivity and output. I find such explanations wildly unconvincing, and the continuing popularity of the Ricardian view a triumph of theoretical nicety (of a kind that happens to serve a political purpose as well) over both macroeconomic evidence and any plausible description of individual behavior.
However, the Ricardian challenge need not occupy much space in this chapter, because it is not, as we have noted, central to the international debate. National Savings and the Current Account Whether or not the budget deficit is responsible for the fall in the U.S. national savings rate, there is a legitimate question over whether the equal and opposite movement of U.S. savings and the current account was a normal occurrence, and whether a reversal of the budget deficit should be expected to lead to an unwinding of the trade deficit. Changes in budget deficits can in principle be reflected in changes in domestic investment rather than in changes in the external account. Was it just chance that the u.s. budget deficit spilled over entirely into the trade deficit? There are several pieces of evidence that might lead one to suspect this.
First, even with perfect capital mobility one should not expect the U.S. budget deficit to crowd out only the trade balance, with no effect on domestic investment. The United States forms roughly a third of the world market economy. Even in a world in which crowding out is completely global, we would expect U.S. investment to absorb about one-third of the fall in national savings, with the external balance absorbing the other two-thirds. In fact much of the world is not open to free capital mobility, so the external side should absorb less of the deficit. Furthermore, if the appreciation of the dollar is perceived as temporary, it must be sustained by a rise in U.S. real interest rates relative to those abroad. This further concentrates the crowding out on U.S. rather than foreign investment (a point made by Frankel 1986). A back-of-the-envelope calculation suggests that something less than half of a change in the U.S. budget deficit should be reflected in the trade balance and that correspondingly something more than half should be reflected in domestic crowding out (Krugman 1985a).
To explain why virtually all of the deficit was reflected in the external balance, it is necessary to invoke special factors. The effect of u.s. fiscal expansion on the current account was reinforced by nearly equal fiscal contraction in the rest of the OECD (see Blanchard and Summers 1984).
There may have been an increase in investment demand in the United States as a result of tax cuts and increased optimism. Finally, "safe haven" motivations may have helped push the dollar up. While these additional factors are plausible and do not contradict the basic conventional view about the way the world works, they do indicate that the perfect correlation between budget and external deficits was indeed too good to be true, and in part a coincidence.
A deeper criticism of the fiscal-external link is that the apparent link for the United States in the 1980s is pretty much unique for industrial countries. Historically the link between national savings rates and the current account has been at best weak, and the link between national budget positions and the current account virtually nonexistent.
Feldstein and Horioka (1980) showed that there was little correlation between the national savings rates of OECD countries and their current accounts, or equivalently that differences in savings rates seem to have been reflected primarily in differences in investment. While these results have been extensively criticized and elaborated (see Frankel 1986), the basic point still stands: The cross-sectional evidence suggests that capital mobility among industrial countries is fairly limited. As for the link between budgets and trade, the cross-sectional evidence is not present at all: Japan during the first half of the 1980s combined the largest current account surplus of the G7 countries with the largest inflation-and-unemployment corrected budget deficits (see Gordon 1986).
Again, this cross-sectional evidence can be rationalized. High savings rates and high investment rates might arise from the same causes. Further, since saving is measured by investment plus external balance, a bias in the measurement of investment would weaken the apparent correlation between savings and the external balance. However, it must be recognized that the assumption that capital markets are virtually perfectly integrated, which has become conventional wisdom in much discussion of international issues, is a view maintained in the face of substantial contrary evidence rather than an established fact.
Did Monetary Policy Do lt? Some supply-side defenders of the U.S. tax cuts of 1981, such as Roberts (1987), argue that the U.S. current account deficit is the result not of the fiscal deficit but of excessively tight monetary policy. This argument can actually be rationalized within a perfectly standard demand-side macroeconomic view.2 In the standard Mundell-Fleming model with high capital mobility and sticky prices, a monetary contraction will lead to a real appreciation and a trade deficit. The savings-investment identity will hold because the fall in net exports produces a contraction of national income, leading to a fall in both government revenues and private income. Hence both private and government savings fall.
Many economists would agree that this is a good story for the early stages of the rising dollar and the emerging external imbalances in 1981 and 1982. However, it is a difficult story to maintain for the persisting
imbalances of 1984 and after. The reason is that an unavoidable side implication of the story is that the country experiencing a monetary contraction must also be experiencing a decline in output-if not in absolute terms, at least relative to the rest of the world. This flies in the face of the fact that the widening of external imbalances continued during the U.S. recovery of 1982-85, which wag dramatically more rapid than that of other industrial countries and has brought the United States close to most estimates of the minimal unemployment rate consistent with stable inflation.
In the standard view of the sources of the U.S. external deficit it sometimes seems as if economists have forgotten about money and monetary policy. It would be more accurate, however, to say that what proponents of the standard view assume is that monetary policy in each economy is targeted on keeping the economy near what the monetary authority believes is its full-employment level, so the analysis of fiscal policy can proceed as if the economy were in fact continually at full employment. This seems to be a reasonable description of the situation in the mid-1980s, though not of the early years of the decade. Monetary policy of course could have been different, but to say that "monetary policy failed fully to accommodate fiscal expansion, and therefore the dollar rose," is very far from assigning monetary policy per se an independent role in causing the external imbalances.
Significance of the Critique
The view that monetary policy was responsible for the U.S. external deficit in the mid-1980s can be rejected as inconsistent with the basic facts. However, this does not demonstrate that fiscal policy did it. There is an important debate over the relationship between the budget deficit and saving, and an equally important debate over whether savings rates normally spill over into trade balances. Thus it is important to acknowledge the uncertainties over these links, which have become closely identified with the standard view about the sources of, and cure for, current account imbalances. However, it is important to notice that critiques of the fiscalexternal linkage have no bearing on the puzzling trade developments since 1985.
The point is that the U.S. fiscal deficit has not changed much since 1985, nor has the U.S. national savings rate. The puzzle is how it was possible, given the lack of change in these factors, for the dollar to move so much-and how it was possible for the dollar to decline so much without much effect on external imbalances.
Read More: Does Fiscal Policy Drive the Current Account?
