TO THE U.S. FROM THE IMF: SHAPE UP! As America's foreign debt swells, the scourge of prodigal nations prescribes cutting the federal budget deficit and consuming less. A growing number of economists agree.
(FORTUNE Magazine) – LAST MONTH'S 100-point drop in the Dow, triggered by disappointing news about the U.S. trade deficit, was a glint on the sword that hangs over the world financial system. In another month or so, America's foreign debt will shoot past $500 billion -- more than Brazil, Mexico, and Argentina together owe. The amount, awesome in absolute terms, isn't the problem. What is alarming is the rate at which the debt has been increasing. FORTUNE hates to keep pestering its readers, but the problem simply won't go away on its own (see ''The Dollar and the Deficits,'' December 7). For most of the Eighties, Americans have been accumulating record trade deficits by living - far beyond their means. Last year consumers, business, and government spent 3.5% more than the GNP. They made up the difference with $160 billion from abroad, obtained partly by selling off U.S. assets (see Money & Markets) but mostly by taking out loans. The longer the borrowing binge continues unchecked, the greater the risk that not just U.S. stock markets but world financial markets and, indeed, the world economy will teeter into chaos. The range of views held by economists on the subject remains extraordinarily broad. The optimistic extreme is represented by the Claremont Institute's John Rutledge, who argues that the borrowing is ''great'' because it is helping the U.S. reindustrialize. At the other end is a calculation by Rimmer de Vries, Morgan Guaranty's chief economist, of what will happen if the U.S. tries to keep the dollar at its present level and the federal budget deficit heading down, as it pledged to do in the February 1987 Louvre Accord with the six other major industrial nations in the so-called Group of Seven. The U.S. would have to give up all economic growth for several years, says De Vries, accepting double-digit unemployment in order to bring domestic demand to heel. Toward this sobering end of the spectrum lies the prescription of the International Monetary Fund, well known for the belt-tightening remedies it proposes for wastrel Third World nations. Like all serious schemes for dealing with the trade deficit, the IMF plan calls for a gradual but steady unwinding of the U.S. current account deficit, which is the balance on trade in goods and services including net investment income. The reduction is to be achieved mainly by cutting the U.S. federal deficit and boosting demand in the creditor countries. Until recently, most mainstream U.S. economists were prepared to argue that the prescription was unduly harsh because of the restraints it would impose on U.S. domestic demand. Many are now beginning to worry that the plan is not far off the mark. Reflecting a growing consensus, Federal Reserve Chairman Alan Greenspan told the Joint Economic Committee last March: ''At some point we will have to revert to financing our future from our own resources. Indeed, the pressures experienced in the foreign exchange and financial markets last year suggest that those limits are closer than they were before.'' Not that the optimists can't make a case. The U.S. economy, they point out, is in good health. Inflation is modest, unemployment is at a 15-year low, and manufacturing's share of national output has recently been running above its postwar average. Aided by an export surge, the current account deficit shrank relative to GNP last year for the first time since 1981, as did the current account surpluses of West Germany and Japan. EVEN THE MONSTER debt pile does not look so terrifying in relative terms. At the end of last year, the $425 billion net foreign liabilities of the U.S. amounted to less than 10% of GNP. The proportion is about 40% for Brazil and Canada. America's foreign debt is also dwarfed by its tangible wealth, which the Commerce Department estimates at about $12 trillion, exclusive of raw land and mineral deposits. And nearly 30% of what is broadly referred to as debt isn't debt at all. Some 13% of total U.S. liabilities consisted of foreign- owned corporate stocks, and another 16% of real estate, factories, and other so-called direct investments. So the net debt at the end of last year was closer to $300 billion than $425 billion. Accounting conventions also tend to magnify the debt. For example, direct investment is carried in the official accounts at book, not market, value. Since 70% of U.S. acquisitions were made in the Fifties and Sixties, while 75% of foreign acquisitions in the U.S. have been made in the Eighties, the worth of U.S. properties is greatly understated compared with that of foreign-owned direct investments. On the other hand, the official count of U.S. liabilities very likely misses $200 billion worth of unrecorded foreign holdings of U.S. debt accumulated over the past ten years, much of it the result of capital flight from troubled Third World countries. But forget the precise magnitude of the debt: It's the trend that counts. ''You don't want to divert attention from the real problem by quibbling with the quality of the numbers,'' says Jacob A. Frenkel, the University of Chicago international finance expert who is now research director and economic counselor at the IMF. Most of the progress to date and just ahead reflects the dollar's two-year decline; the policy changes needed to keep shrinking the debt are nowhere in sight. At this rate, the IMF reckons, by the end of 1989 the U.S. will increase its net foreign liabilities by another $130 billion to $140 billion a year to $700 billion -- or 15% of GNP. Even the relatively optimistic projections of the DRI economic consulting firm, which assume somewhat slower domestic demand, show the current account deficit leveling out at around $100 billion after 1990. Dollar depreciation can do only so much to close the gap. As long as domestic demand continues to grow strongly, the U.S. will suck in imports, and inflation will nibble away at its competitiveness in global markets. And as the debt mounts, its growth becomes increasingly difficult to contain. Net payments to foreigners become a bigger and bigger share of each year's current account deficit. The Organization for Economic Cooperation and Development estimates that more than one-third of the expected improvement in the U.S. trade deficit through 1989 will be offset by an increase in such payments.
Can the U.S. add $100 billion or more to its foreign debt each year indefinitely? In principle, yes, because the current account deficit will be shrinking as a percent of GNP. On DRI's trend assumption, for example, it will be 1.7% during the early 1990s, vs. today's 3.6%, and heading lower. The U.S.'s trading partners will need to invest their surpluses, and as the world's richest market, America will remain an attractive -- and safe -- place to put the money. What's possible in principle may not be so in practice, however. As the debt grows, so do flows to foreign lenders. Last year Americans sent $4 billion more abroad in interest payments and profits than they received from their foreign holdings. The net payment amounted to just 0.1% of GNP, a mere $16 per American. But assuming that the debt grows as fast as projected by DRI and the interest rate is 8%, net interest payments could reach 0.5% to 1% of GNP by the early to mid-1990s -- more than consumers spent on American cars last year. Sending more interest, rent, and dividends abroad wouldn't be a problem if the foreign borrowing financed investment in productive capacity. But there's not much evidence of a boom. Capital spending shot up in the first quarter (see Forecast) but has generally been running at around its postwar average. And it is that high only because foreign investment has replaced domestic saving, which has been consumed by the federal deficit. Private consumption, by contrast, averaged 66% of GNP last year, its highest share since 1950. Spending by the government for increases in entitlements and defense has risen to about 16% of GNP from a postwar average of 13%. True, some of what looks like consumption may more properly be called investment -- spending on consumer durables and borrowing to pay for a defense buildup, which may yield treaties that reduce defense spending requirements in the long run. Nonetheless, says DRI's chief economist, Roger Brinner, ''it's pretty hard to argue that there's going to be any yield that will help us pay back the debt.'' GROWING indebtedness also tends to hamstring domestic economic policy. For example, if interest rates should rise abroad, the Federal Reserve could be forced to boost U.S. rates for fear of losing foreign investments. That will make the next recession extremely hard to escape from. Even assuming the U.S. could afford these costs, the rest of the world may not let it indulge itself. Says Frenkel: ''Is the present trend sustainable -- does it make sense? Will the markets absorb it? It's unlikely.'' Because the dollar is the world's reserve currency and chief means of international exchange, foreign private investors and central banks aren't going to dump the $1.5 trillion of dollar assets they already hold or refuse to stock up on more. But they can exact a higher price for their support -- and indeed have already done so. During the first half of last year, as private investors made themselves scarce, foreign central banks financed more than a third of the U.S. current account deficit. Since then the investors have returned, but only because the differential between long-term U.S. and Japanese bonds is about five percentage points now, up from two in early 1987. The costs will keep rising if the U.S. and its major trading partners continue to do nothing. ''If politicians don't deal with the problem, the markets will,'' says De Vries. ''Crudely, rudely, and not smoothly.'' One far from impossible scenario, sketched in the IMF's 1988 World Economic Outlook: Foreigners, foreseeing a continual steep rise in U.S. indebtedness, shy from further investments. The dollar falls and interest rates head up. The trade deficit would shrink, but not enough to prevent recession. A recovery would follow, but growth potential would be damaged for years to come. The federal deficit would still be huge, crowding out domestic investment. The only way to lower such risks is to steadily reduce the current account deficit into the mid-1990s. But what should be the goal? Not zero, as some economists argue. That may not be possible, and in any case it hardly seems desirable given the shocks it would imply both for the major industrial nations and for Third World debtors who desperately need to run export surpluses. The IMF does not reveal its own target, but economists like De Vries believe that it is roughly $50 billion by 1995. Though DRI's projection allows for a current account deficit of over $100 billion, Brinner himself believes the U.S. will have to get it below that. ''As the debt grows, so will skepticism about our ability and willingness to pay,'' he says. His target: $70 billion by the end of the next Administration. The IMF's prescription calls for the U.S. to narrow the gap between spending and income by about half a percentage point of GNP a year, in good measure by adopting a ''considerably more ambitious approach to fiscal policy'' than the Administration and Congress have shown so far. To economists familiar with the IMF's position, that implies that the federal deficit would have to come down more or less on the Gramm-Rudman-Hollings schedule. Such an adjustment would be painful. As the U.S. weans itself from foreign borrowing, living standards would suffer, though they are not likely to fall, as some Cassandras have been saying. At best, most economists reckon, the economy's growth potential is around 2.5% or 3.0% a year. With population expanding about 1% a year, per capita consumption could not rise much faster than 1% annually. Compared with the more than 2%-a-year rates for the Eighties so far, that will strike most Americans as pretty miserly -- though they will be cushioned a bit by the pile of consumer durables that they amassed during the fat years. The IMF has remedies for the U.S.'s main trading partners too. Japan and Germany must boost their domestic demand a percentage point faster than GNP, mainly by making substantial structural reforms in their economies, and South Korea and Taiwan will have to ease trade barriers. Though the IMF is mum on the subject, many U.S. economists think also that the dollar will have to fall as much as 10% or 15% in real terms. Not surprisingly, the IMF's medicine is too bitter for most of the intended patients. And indeed, it's entirely possible that milder doses may do the job. As Frenkel says, ''More is involved than a number. Sustainability is not mechanical, but how the markets perceive the trend.'' In other words, if the markets conclude that the U.S. current account deficit is on a steady downward path, foreigners will remain confident enough to keep investing. The U.S. and its trading partners have to decide how much risk they are willing to live with. The IMF plan carries risks of its own -- its economic assumptions, after all, may not be flawless. But a growing number of economists agree that it offers the most prudent target. The further from it the major industrial nations stray, the more likely they are to face wrenching dislocations as they head into the Nineties.
CHART: NOT AVAILABLE CREDIT: ILLUSTRATIONS BY ANDERS WENNGREN CAPTION: A Debtor's Dilemma The bigger the debt, the greater the danger to the U.S. -- and other coun tries. It is not likely to balloon according to the worst-case scenario sketched by Morgan Guaranty, because a trend that bad would itself force policy changes. Modest belt tightening would help, but more and more economists argue for tough action. DESCRIPTION: United States foreign surplus or debt from 1980 through 1987 with projections through 1992 based on following present policies, making modest changes, making substantial changes; color illustration: hand throwing coins in upside-down Capitol dome.
CHART: NOT AVAILABLE CREDIT: ILLUSTRATIONS BY ANDERS WENNGREN CAPTION: The Check Is in the Mail The weaker dollar is helping to shrink the U.S. current account deficit and the corresponding surpluses of Japan and West Germany. But the bills are still stacked high. DESCRIPTION: Total current account balance for Japan, West Germany and United States from 1980 through 1987 with projections through 1989; color illustration: bills on Capitol dome.
CHART: NOT AVAILABLE CREDIT: ILLUSTRATIONS BY ANDERS WENNGREN CAPTION: So Long, Big Spender The U.S. has been consuming more than it produces for most of the Eighties. Its creditors have been doing the opposite. As the nation brings its foreign borrowing habit to heel, the growth of U.S. consumption will keep slowing. DESCRIPTION: Total United States consumption and production for 1980 through 1987; total percentage of real private consumption expenditures for United States, Japan and West Germany from 1980 through 1987 with projections through 1989; color illustration: scissors cutting credit card.