76. Paper Prepared in the Department of the Treasury1
REQUIREMENTS FOR A SECURE U.S. BALANCE-OF-PAYMENTS POSITION
The purpose of this note is to set forth U.S. views regarding the requirements for a secure U.S. balance-of-payments position. We view such a position not simply as in the interests of the U.S. but as a prerequisite [Page 180]for a return to a smooth and orderly functioning international monetary system. Actions are needed which both compensate for the past erosion of the U.S. external position and offer the prospect of a strong position in the future. To achieve these results after years of deficit, the U.S. will require the reasonable prospect of some surplus in its basic external accounts for several years.
Achievement of a secure U.S. payments position presupposes an improved performance of the domestic economy. The President has taken such action. However, success plainly also requires the correction of certain elements which adversely affect U.S. international transactions. It is not proposed to deal here with the nature of the actions required but with the magnitude of the adjustment problem. For its part, the U.S., of course, remains determined to follow those domestic economic policies necessary to control inflation and make the economy more competitive. This paper is developed on that basis.
This paper does not deal with the future shape of the monetary system. No matter what the system, an improvement in the U.S. position along the lines described below will be necessary.
The Erosion of the U.S. Position
The deterioration of the U.S. external payments position is traced in the table on the following page.2 The United States recorded persistent but not unmanageable balance-of-payments deficits throughout the 1960s. From 1960 through 1969, the net liquidity balance was in continuous deficit, averaging $3.1 billion per year. The official settlements balance was also in deficit during most of that period, averaging $1.1 billion per year. The deficit on current and long-term capital accounts (the basic balance) averaged $1.4 billion per year. A deterioration in the U.S.’ basic position since 1964 is evident, with current and long-term capital accounts in deficit by $3 billion in 1970.
The situation turned sharply worse in 1970 and 1971. By the first half of 1971, the deficit on current and long-term capital accounts rose to an annual rate of $8.6 billion. While temporary factors presumably contributed, these data confirm an eroding trend.
With continuing payments deficits, the United States reserve position has been severely and persistently weakened. Gross reserves have fallen from a high of $26.2 billion in 1949 to the present level of $12.2 billion and now stand at about 27 percent of estimated 1971 imports, well below other countries’ average level of reserve holdings relative to trade. Furthermore, liquid liabilities have risen sharply, from $21 billion [Page 181]in 1960 to more than $60 billion; liabilities to official holders amount to more than $44 billion.
The erosion of the merchandise trade position has been a primary element in the unsatisfactory U.S. balance of payments in the past several years and the major source, directly or indirectly, of the recent deterioration in the basic balance. The trade balance has deteriorated by more than $8 billion in the seven years 1964-1971 and is now in deficit. In 1964, the U.S. had a trade surplus of $6-3/4 billion, which amounted to 1.1 percent of GNP. In the entire first half of 1971, the trade deficit was running at a seasonally adjusted annual rate of $1.5 billion.
As in the case of the overall balance of payments, the deterioration in the trade position has accelerated recently. Before the President’s new program was announced, trade deficits were forecast by U.S. Government experts of about $2 billion for 1971 and $3.5 billion for 1972. The forecast deterioration from 1970 to 1971 was $4 billion, partly attributable to special factors and partly to cyclical factors. Nevertheless, quite apart from the cyclical influences, the U.S. merchandise trade position is experiencing a continuing trend deterioration of more than $1 billion annually. This trend has also been observed by the OECD Secretariat and the IMF.
Over the years, the deterioration in the U.S. trade position is most pronounced in trade with Japan, Canada, and the European Community, although the recent sharp deterioration has been more widespread. The following table traces the deterioration in the trade balance between 1964, when the U.S. trade surplus reached its peak, and 1970, and more recently, by area:
Change in U.S. Trade Balance ($ millions)
|Between 1964 and 1970||Between 1970 and Second Quarter 1971 (Annual Rate)|
|Other W. Europe||250||-830|
|Rest of World||-340||-340|
The deterioration in the trade position has carried through into the balance on goods, services and private remittances. The contribution to an improved position from rising investment income receipts has been insufficient to overcome mounting outpayments resulting from the rapid growth of U.S. liabilities and high interest rate levels. The heavy [Page 182]burden of defense expenditures abroad has also served to offset potential improvements in the services accounts.
The long-term capital account was not a factor in the deterioration of the overall U.S. position until 1971, when uncertainty about exchange rates apparently had a large adverse effect. The net private long-term capital outflow declined from $4.5 billion in 1964, before comprehensive restraints on capital outflows came into effect, to $1.5 billion in 1970.
In 1964 the U.S. was a net supplier of long-term private capital to all areas of the world. Canada received $1.1 billion, Europe and Japan $2.2 billion and the rest of the world $1.2 billion. With capital restrictions, higher interest rates in the U.S., and a surge of investment in U.S. securities, this situation shifted sharply. From 1968 through 1970 the U.S. was a net importer of private long-term capital from the major industrial countries other than Canada, as follows:
Net Movements of Private Long-Term Capital ($ million)
|(average) 1966–7||(average) 1968–9||1970||5-year Average|
|U.K. and EC||-745||1,731||529||500|
|Total, these areas||-1,617||481||-878||-631|
The Importance of Adjustment
The deficit in the U.S. balance of payments could not be allowed to continue: (a) It was leading to rapid depletion of U.S. reserve assets and the accumulation of an unstable mass of liquid liabilities. (b) Its nature and extent became so widely recognized as to generate speculation. (c) It led to an intensification of protectionist pressures within the U.S. (d) It intensified the difficulties in maintaining an appropriate share and level of both international assistance to less developed countries and responsibilities in the area of global military security. (e) It subjected the economic foundations of the international monetary system to recurrent shocks. (f) It is not compatible with a sustainable world payments equilibrium required for the fulfillment of mutually shared national objectives.
Because the deficit has been so large and has continued for so long, the solution of these problems now requires a complete and convincing elimination of the deficits; this cannot be achieved without aiming at some period of surplus in the U.S.’ basic accounts. Sustained reductions of liquid liabilities would of course require significant surpluses continued for a period of several years.[Page 183]
The world financial community should recognize that a period of unquestioned strength in the U.S. external position is a necessary condition for a strong and stable financial system. Although a U.S. surplus would require temporary deficits (exclusive of SDR allocations) on the part of some countries which have experienced the surpluses which were the mirror image of past U.S. deficits, it should be fully compatible with the legitimate balance-of-payments aims of other nations.
The U.S. cannot be put in the position of running further deficits however reasonable its domestic performance, as a means of reconciling the goals of other countries. Such a result would be financially unsustainable.
The Extent of the Improvement Required to Meet U.S. Needs
In specific terms, the U.S. will need a balance-of-payments position which for some years assures, at a minimum: (a) at least a modest surplus in its basic accounts. Statistically, this is taken in this paper as a surplus of around $3 billion annually on current and long-term capital accounts, or less than $2 billion after allowing for errors and omissions.3 (b) a surplus on goods, services and private remittances sufficient to finance a foreign aid program appropriate to the United States position and to accommodate foreign demands for U.S. long-term private capital in the absence of U.S. Governmental restraints. Thus, the U.S. requires a surplus on goods, services and private remittances of roughly $2 billion more than the net deficit on government grants and capital, direct investment and other private long-term investment and errors and omissions.
Such a position allows for no net short-term capital outflows, and thus would approximate equilibrium on official settlements and only a modest reduction in official dollar balances. Thus, it appears a minimum target for the initial adjustment.
While a surplus on merchandise trade account is not necessary in theory, there is no prospect at this time, particularly with the current net expenditures on military transactions, that these requirements can be met unless the U.S. has a substantial merchandise trade surplus. Without a surplus on merchandise trade (and therefore in the U.S. current account) and an end to the trend deterioration in the trade balance, payments on foreign investments in the U.S., including interest on liquid liabilities, are likely to rise as much as the income from U.S. investments abroad, eliminating the likelihood of net improvement in the services accounts.[Page 184]
Before recently announced actions, the U.S. balance-of-payments position and prospects as appraised by U.S. Government experts internally were as follows:
|Goods, services and private remittances||+2.2||-1.0||-2.7|
|Government grants and long-term capital||-5.2||-7.4||-6.1|
|Current and long-term capital account||-3.0||-8.4||-8.8|
The U.S. economy has not been operating at a high employment level. Adjusting for cyclical factors—estimating what the figures would be if the U.S. economy and those of all of its major trading partners were operating at levels of capacity consistent with domestic objectives—the U.S. payments position and prospects, prior to the recent actions, were as follows:4
|Goods, services and private remittances||-1/2||-2-1/2 to -3||-4|
|Merchandise trade||-1||-3-1/2 to -4||-5|
|Grants and long-term capital||-5||-5||-6|
|Current and long-term capital account||-5-1/2||-7-1/2 to -8||-10|
|Normal errors and omissions||-1|
The foregoing suggests that the U.S., taking account of no adverse trend beyond 1972, needs an improvement in its current and long-term [Page 185]capital account in 1972 of $13 billion to achieve a minimal surplus in its basic accounts (and therefore assured equilibrium in its official settlements accounts) for a period of years. A measure of improvement based on the actual U.S. position in 1970 or even on the cyclically adjusted position in that year would not be adequate. It would not take account of the very serious trend deterioration in the underlying position which must be expected to continue until a fundamental correction is achieved.
If the improvement required to meet U.S. objectives were to be brought about through exchange rate action and U.S. domestic measures or through trade measures, the improvement would have to be found predominantly in the merchandise trade account. Although the dollar income from foreign investment could be expected to rise and travel expenditures might decline somewhat with an exchange rate realignment, the increased dollar equivalent of foreign currency costs of U.S. military expenditures abroad together with increased shipping costs would be likely to offset much of these improvements. The only foreseeable means of reducing to some extent the required adjustment in trade would be a modification of arrangements for financing U.S. military expenditures in NATO countries or in Japan.
An improvement of $13 billion in the U.S. merchandise trade position from the cyclically adjusted deficit projected for 1972 would mean a surplus of only $8 billion. Such a surplus would be little more than the surplus which the U.S. had in 1964 ($6.8 billion) when the total volume of world trade and production was much lower. Prior to recent developments, Germany and Japan were expected to have trade surpluses of around $6 billion in 1971. It would also be much less in relation to U.S. GNP—less than 0.65 percent—than the surpluses which many other countries have been running, none of which has anything approaching U.S. responsibilities for defense nor a role as a major private capital supplier for LDC’s and others. In 1970, for example, Germany had a trade surplus in excess of 3 percent and Japan one in excess of 2 percent.
The $6 billion allowance made in the above calculations for net private capital outflows and government aid amounts to about 1/2 of 1 percent of estimated high employment GNP (approximately $1.2 trillion for 1972). As a proportion of GNP, this would represent a substantial reduction from earlier years. In the 1960-1964 period, such flows averaged $5-3/4 billion annually or 1.04 percent of GNP; in the 1965-1970 period, with U.S. capital restraints programs in effect, they averaged $5-1/2 billion or 0.65 percent of GNP.
The net outflow on Government grants and capital is expected to rise, from $3.7 billion in 1970, to $3.8 billion in 1971, and $4.1 billion in 1972. If the net outflow on all long-term capital plus government grants [Page 186]is not to exceed $6 billion, net private long-term capital outflows cannot exceed $2 billion. That figure will have to allow for both private investment in developing countries and resort by international lending institutions to the U.S. capital market.
In recent years net flows of capital and government grants to LDC’s have averaged over $5-1/2 billion annually. Increased borrowing on the U.S. capital market by international lending institutions is possible. Thus an expected net grants and long-term capital flow in the $6 billion range in 1972 represents essentially a flow to LDC’s, without significant net capital outflows to industrial nations. In fact, a level of grants and long-term capital outflow of 1/2 percent of GNP—even though it all goes to LDC’s—is likely to be subject to criticism as being grossly inadequate in comparison with 1 percent of GNP targets accepted by a number of other donor countries.
The improvement in the U.S. position to be achieved would thus be:
|Trade||Goods, serv & remittances||Grants & long-term capital||Current & long-term capital|
|High employment position in 1972 expected in absence of corrective action||-5||-4||-6||-10|
|Position required for surplus of $3 billion on basic balance*||8||9||-6||3|
The $13 billion estimate for the amount of improvement needed in the goods and services accounts in the U.S. views is a minimum, and may be conservative.
- The full impact of changes in exchange rates is not felt immediately but only with a considerable lag. The full effects of any such change in 1971 would probably not be realized until 1973 or even beyond. If the trend deterioration in the U.S. position continued [Page 187]through 1972, an additional $1 billion or more would need to be added to the $13 billion figure for the improvement needed to produce the required surplus in 1973.
- The assumption is optimistic that there will be no net outflow of long-term capital to industrial nations. The U.S. wishes to remove its temporary restraints on long-term capital outflows, and believes any long-term equilibrium must properly assume such removal. We cannot be certain that a change in exchange rates would so shift the attractiveness of the U.S. relative to other industrial countries as a site for investment in manufacturing industries that U.S. restraints on capital outflows (including the interest equalization tax) could be removed without resulting in substantial net flow of long-term capital from the U.S. to other industrialized countries, taken as a group. In particular no allowance is made for repayments of foreign debts incurred by U.S. corporations in financing foreign investments over the past few years when the capital controls program was in effect. Moreover, no allowance is made for future Canadian use of the New York capital market nor for any net use of this market by European borrowers. The U.S. has supplied an average of $1.2 billion per year net of private long-term capital to Canada. If this were to continue the U.S. would need a correspondingly larger goods and services surplus (unless long-term funds moved to the U.S. from the EC and Japan). The possibility that net long-term capital outflows are being underestimated is further supported by the fact that improvements in the goods and services balance have almost always been accompanied by substantial increases in net long-term capital outflows. Certainly to the extent that a new increase in exports may involve an increase in outstanding trade credits, an increase would be expected.
- The estimates take no account of the adverse effects upon U.S. trade of the contemplated enlargement of the European Common Market or any preferential trade arrangements concluded or which may be concluded between the enlarged EC and other nations.
- No allowance has been made for any offsetting measures or other actions by any other country, or for any automatic effects on foreign business activity and the related foreign import demand. It may be necessary to take measures which are strong enough to compensate for offsetting actions by or developments in other countries in order to achieve the desired improvement in the U.S. position.
- In previous instances of extended disequilibrium, the normal expectation has been that, in moving for readjustment in exchange rates, countries properly err on the side of safety. A period of sizable surplus to repay debts or rebuild reserves is anticipated. This statement of requirements makes no such allowance.
Prudence would suggest that a swing in U.S. goods and services accounts significantly larger than $13 billion should take place to provide for the lags in effectiveness of measures, the possibility of continuing Canadian borrowing, some repayments of U.S. borrowing in Europe, and a margin of safety.5
- Source: Washington National Records Center, Department of the Treasury, Office of International Monetary Affairs: FRC 56 77 68, Briefing Book for the October 18-20 WP3/G-10 Deputies. Confidential. An earlier draft of this paper is presumably the August 28 paper discussed in the Volcker Group on August 31; see Document 173. In a September 8 letter to Volcker, OMB Assistant Director Dam cautioned against using the paper in G-10 discussions because focusing on quantitative goals before agreeing on the type of international monetary system the administration wanted might constrain long-term options. (Washington National Records Center, Department of the Treasury, Files of Under Secretary Volcker: FRC 56 79 15, PAV—Economic Stabilization Program)↩
- The table is not printed.↩
- A $3 billion surplus on basic balance would be equivalent to less than $2 billion after allowing for errors and omissions because the latter have shown a persistent deficit averaging well over $1 billion annually. This is believed to comprise in the main unidentified current and long-term capital transactions. [Footnote in the source text.]↩
- The OECD Secretariat, in CPE/WP3(71)13 suggests that adjustments in the U.S. balance-of-payments figures for 1970 to correct for cyclical factors should be somewhat larger than those used in the U.S. calculations. The Secretariat’s cyclical adjustment for the goods, services and remittances balance in 1970 is about $1 billion larger than the U.S. figure, largely because the U.S. estimate provides for a downward adjustment of extraordinarily high interest payments in that year. (The figures for this balance used by the U.S. and the Secretariat also differ because the U.S. includes U.S. Government pension payments whereas the Secretariat does not.) [Footnote in the source text.]↩
- Equivalent to less than $2 billion after allowing for E & O. Does not allow for short-term capital outflow.↩
- On December 16 a longer, revised version of this paper was circulated in the Treasury Department by F. Lisle Widman, Director of the Office of Industrial Nations, who noted that the purpose of the paper was to meet inquiries from the public. (Washington National Records Center, Department of the Treasury, Office of the Assistant Secretary for International Affairs: FRC 56 76 108, US/3/005 Studies and Reports, Volume 9) Volcker was opposed to issuing the paper publicly. (Memorandum from Wilson E. Schmidt to Volcker, December 22, and letter from Volcker to Schmidt, December 28; ibid., US/3/006 Commentaries and Reports Volume 2)↩