http://www.nytimes.com/2001/04/09/opinion/09MODI.html?pagewanted=print

April 9, 2001

America Is Borrowing Trouble

By FRANCO MODIGLIANI and ROBERT M. SOLOW

AMBRIDGE, Mass. — Many have criticized President Bush's proposal for a deep and lasting cut in income taxes, but hardly anyone has addressed its implications for what may well be the greatest potential danger facing the economy in the years to come: the large and growing deficit in our international trade balance. A massive, permanent tax cut would make the international economic position of the United States worse, not better. This is in addition to its other disadvantages.

The past decade has been one of exceptional economic vigor: output increased nearly 40 percent, investment more than doubled and consumption grew just over 40 percent, pushed by a spending spree that reduced personal saving to near zero. But this rosy picture was accompanied by one worrisome development: throughout this period, spending grew faster than what the country earned, spilling over, in large part, into a growing trade deficit. By the end of 2000, the excess of expenditure over income had reached about 4 percent of America's gross domestic product and was apparently still on the rise.

For a country, just as for a family, there are only two ways of getting the money to spend more than one's income: borrowing it and selling assets. In the case of nations, the creditors and the buyers of the assets are foreigners. And indeed, throughout this prosperous past decade the United States sold more and more assets, like government bonds and shares in its companies, and went deeper and deeper into debt.

But why should one worry about this development? It is not serious as long as the debt is small and remains under control so as not to worry creditors. But if the debt is not under control, or if some event makes the debtor appear less creditworthy than before, the creditors may decide that they are not willing to finance a country's growing debt — for fear of a depreciation of the debtor's currency that lowers asset values in their own currencies. They may even want to liquidate part of their investment in search of diversification. If such a thing happened to the United States, there could be very unpleasant consequences for Americans.

Depreciation of the dollar would make imports so expensive and exports so cheap as to eliminate the trade deficit. But this depreciation would create a further motive for foreigners to liquidate their American assets, dumping the dollars so obtained in exchange for foreign currency. The size and power of the American economy has protected us from capital flight in shorter episodes of unfavorable trade balance, but there is no guarantee that this will remain true. Nor could the dollar be propped up through purchases by the Federal Reserve or the Treasury, since their small reserves of foreign currency would be woefully inadequate to stem the tide. (The United States reserves amount to some $60 billion compared with a current trade deficit of $400 billion a year, just two months' borrowing.)

Thus a flight from the dollar would produce a deep devaluation and accompanying rise in the prices of imports and of things made with imports. At worst we might experience a wage and price spiral, calling for sharply higher interest rates. The final result could be falling investment and output, and high unemployment. And our weakness would be very likely to spread to other countries.

Few believe that this hard-landing scenario is an immediate threat. But there is good reason to believe that if nothing is done to change the current course, the probability of a costly ending will keep increasing. To avoid that danger, the administration and Congress should develop a plan that promptly stops the growth of the trade deficit, then reduces it to zero and possibly produces a positive balance, allowing for some repayment — and all this without an appreciable increase in unemployment.

The success of such a plan would rest on two main ingredients: a gradual reduction of total domestic expenditure relative to income — that is, a rise in national saving — and an increase in net exports. These two components should proceed hand in hand; indeed, given the current level of demand for domestically produced goods and services, if we added to it by shifting more of our output to exports prematurely, the result would be inflationary pressures. Conversely, a reduction of domestic demand would have to be countered by an expansion of net exports to avoid creating a contraction in output and employment.

Unfortunately, there is no evidence that the administration and Congress are concerned with the balance of trade issue or are even aware of it. On the contrary, President Bush is galloping in exactly the wrong direction with his advocacy of using the likely (though by no means certain) large forthcoming budget surplus for a deep, permanent tax cut, rather than for retiring the debt or endowing Social Security — or both.

The president's proposal is just the opposite of the needed increase in national saving, and the consequences would be very negative. First, it would raise consumption by roughly one dollar for every dollar of tax reduction — which is precisely what the supporters of the bill claim to be its justification. But, given the limitations on our labor force and our ability to produce, the rise in consumption would sooner or later produce some combination of the following unhealthy outcomes: significant inflationary pressures, in part undoing the tax rebate; a likely rise in interest rates to counter the inflation, leading to a reduction in investment; and a further increase in the trade deficit.

Can anyone really favor encouraging a further expansion of the recent spending spree at the expense of investment, the source of future growth? Or reducing taxes at the expense of a sharp addition to future taxes, required to service a much larger debt at higher interest rates? Or supporting a tax cut financed with money borrowed abroad, even in the favorable case in which foreign lenders would be prepared to finance a rapidly growing debt?

If Congress is acting responsibly, the least it can do is to postpone a deep permanent tax cut until this trade balance has turned positive.

But, some tax-cut proponents will argue, what if right now there is a clear danger of a significant economic contraction? If this were clearly the case — and it is still in doubt — then some measure to support demand might be appropriate. But the best approach would be to expand net exports, helping both domestic demand and the trade balance — perhaps by aiming at a controlled, limited devaluation of the dollar and by encouraging other countries, like Europe, to pursue more expansionary policies in their own interest.

It may even be justifiable to consider a modest, temporary tax cut, but with a warning that theory and evidence suggest that transitory tax cuts are likely to produce only limited, quick effects.

Franco Modigliani and Robert M. Solow are Nobel Prize winners in economics and professors emeriti at the Massachusetts Institute of Technology.

-- Swissrose (cellier3@mindspring.com), April 09, 2001