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World Economic Problems For the Summit:
Coordination, Debt, and the Exchange Rate System

Dr. Rudiger Dornbusch

Bissell Paper Number Six
Centre for International Studies, University of Toronto
May, 1988

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The post-crash budget summit in the U.S. had as its major result that during 1988 - an election year- there will be no discussion of the budget. That postpones budget cutting to January 1989, when the new President takes office.

There are two scenarios. In the soft landing scenario rising inflation in 1988 motivates the incoming President to undertake immediately a budget cut. The budget cut (to ensure full employment and growth) is accommodated by easy money. As a result investment and net exports improve while consumer spending growth declines. GNP growth is sustained and the twin deficits evaporate over the next few years. The key point here is the recognition that increasing inflation provides the political excuse for raising taxes, an excuse that was missing in 1987.

The hard landing scenario shows too little inflation in 1988 and hence imprudent talking by all the candidates about never raising taxes. By 1989 inflation will come and at that time, because the initial opportunity was missed, fiscal policy is slow to respond since yet another election year lies ahead. The monetary authorities will raise interest rates, keeping the dollar overly strong and creating a recession. The external balance improves but the budget deteriorates and no problem is solved.

There is no fiscal crisis in America. The debt-income ratio is basically stable now and the non-interest budget is balanced. (see Figure 6) The problem is a national saving rate which is too low (see Table 5) or overheating of the economy.

Table 5: U.S. Savings, Investment, and the Budget
(percent of GNP)
State and
Local Surplus

The hard landing scenario arises from the risk that asset markets become concerned about the buildup of inflationary pressures, and extrapolate these into expectations of restrictive monetary policy. The resulting rise in long-term interest rates, and the induced decline in asset prices, would put a world recession into the express lane. Because there is basically no other way to raise savings than to cut the budget, the major risk for the world economy, thus, is budget complacency of the incoming President. The risk is that the new President looks at budget forecasts, rather than macroeconomics.

Budget cutting, however, carries a major piece of good news, It allows monetary authorities to maintain far lower interest rates. This in turn implies relief in the budget and thus makes budget cutting easier. The consideration is important because the financial fragility today, not only in developing debtor countries, results from excessive debt. A low real interest rate strategy is the only cure for this vulnerability .

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