AGENDA AND PAPERS FOR THE APRIL 12 MEETING

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85-01156R000100120003-1
• Release Decision: RIPPUB
• Original Classification: K
• Document Page Count: 13
• Document Creation Date: December 21, 2016
• Document Release Date: August 20, 2008
• Sequence Number: 3
• Publication Date: April 8, 1983
• Content Type: MEMO

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? THE WHITE HOUSE
WASHINGTON
1P
CABINUf AFFAIRS STAFFING MEMORANDUM
DATE: 418/83
DUE BY:
Tuesday, April 12, 1983
SUBJECT: Cabinet Council on Economic Affairs
8:45 a.m. Roosevelt Room
ACTION FYI
ALL CABINET MEMBERS
Vice President
State
Treasury
Defense
Attorney General
Interior
Agriculture
Commerce
Labor
HHS
HUD
Transportation
Energy
Education
Counsellor
CoAB
UN
USTR
CEA
CEQ
OSTP
REMARKS:
Baker
Deaver
Clark
Darman (For WH Staffing)
Harper
Jenkins
ACTION FYI
CCCT/Gunn
CCEA/Porter
CCFA/Boggs
CCHR/Carleson
CCLP/Uhlmann
CCMA/Bledsoe
CCNRE/Boggs
NUMBER: 118612CA
The Cabinet Council on Economic Affairs will meet
April 12, 1983 at 8:45 am in the Roosevelt Room.
and papers are attached.
General Revenue Sharing/CM357
Economic Consequences of a
Strong Dollar/CM#052
Farmers Home Lending/CM#113
RETURN TO: ^ Craig L. Fuller
Assistant to the President
for Cabinet Affairs
456-2823
Becky Norton Dunlop
Director, Office of
Cabinet Affairs
456-2800
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distributed 4/1/83
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April 8, 1983
MEMORANDUM FOR THE CABINET COUNCIL ON ECONOMIC AFFAIRS
FROM: ROGER B. PORTER
SUBJECT: Agenda and Papers for the April 12 Meeting
The agenda and papers for the April 12 meeting of the
Cabinet Council on Economic Affairs are attached. The meet-
ing is scheduled for 8:45 a.m. in the Roosevelt Room.
The first agenda item is the administration's position
on reauthorizing general revenue sharing. This continues
the Council's discussion of this issue at the April 5 meet-
ing. The paper for this agenda item was distributed to Coun-
cil members on April 1.
The second agenda item is a review of the economic con-
sequences of a strong dollar. At the March 15 meeting the
Council raised this issue and requested Martin Feldstein to
prepare a paper on it to serve as the basis for discussion.
The paper prepared by Martin Feldstein is attached.
If time permits, Secretary Block will present a brief
report on the economic impact of Farmers Home Administration
lending.
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THE CABINET COUNCIL ON ECONOMIC AFFAIRS
April 12, 1983
8:45 a.m.
Roosevelt Room
1. Reauthorization of General Revenue Sharing (CM#357)
2. Economic Consequences of a Strong Dollar (CM#052)
3. Economic Impact of Farmers Home Lending (CM#113)
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THE CHAIRMAN OF THE
COUNCIL OF ECONOMIC ADVISERS
April 8, 1983
MEMORANDUM FOR THE CABINET COUNCIL ON ECONOMIC AFFAIRS
FROM MARTIN FELDSTEIN 0
SUBJECT: Is the Dollar Overvalued?
Introduction
The notion that the dollar is overvalued has become
a commonplace assertion in discussions of the inter-
national position of the American economy. American
businessmen point to an overvalued dollar as the primary
reason for their loss of overseas markets and their
problems in competing with imports from abroad.
Officials of foreign governments also assert that the
dollar is overvalued and often suggest that the United
States should join with other nations to prevent the type
of currency fluctuations that have caused the dollar to
be overvalued. This idea of stabilizing the exchange
value of the dollar is also mentioned with increasing
frequency in this country.
Although the idea of an overvalued dollar is rapidly
becoming part of today's conventional wisdom, the notion
of an overvalued dollar is very difficult to define and
even more difficult to defend. Just what does it mean to
say that the dollar is overvalued? In the years before
1973, when exchange rates were fixed by government
intervention, the notion of an overvalued currency had a
clear operational meaning: the dollar was overvalued if
permitting it to float freely would cause its value to
fall relative to other currencies. In other words, the
exchange rate in a free market was the standard by which
to judge whether an historically fixed exchange rate was
currently overvalued or undervalued.
Such an interpretation is.no longer applicable. The
dollar now floats freely relative to the other major
currencies of the world and its value reflects the
balance of supply and demand for dollars. By the
traditional standard, it is as meaningless to.say that
the dollar is overvalued as it is to say that apples or
typewriters are overvalued.
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The Dollar and the U.S. Trade Balance
Some of those who now assert that the dollar is
overvalued no doubt mean that the current exchange rate
fails to balance imports and exports. In 1982, the value
of merchandise imports into the United States exceeded
the value of merchandise exports from the United States
by $36 billion, a record amount. Moreover, experts
predict that this year's export-import imbalance, known
technically as the merchandise trade deficit, may exceed
$60 billion. A lower value of the dollar relative to
other currencies would encourage more exports and would
reduce imports, thereby shrinking the trade deficit
toward zero.
But why should a balance between goods exported and
goods imported be a standard for judging whether the
dollar is appropriately valued? Individuals and firms in
this country also receive payments for services sold to
foreigners (e.g., banking, insurance and transportation
services) and, even more important, earn interest and
dividends on overseas investments. Last year, the net
sale of services and the earnings on foreign investments
together offset virtually the entire merchandise trade
deficit. Pension payments and other unilateral pay-
ments were responsible for essentially all of what is
known as the "current account deficit" of about $8 billion
that had to be financed by borrowing from abroad or by
reducing U.S. investments overseas and by selling U.S.
assets to foreigners.
This year, the current account deficit may exceed
$25 billion. A country cannot expect to go on running a
current account deficit forever. Over time it must earn
enough from sales or investment income to pay for its
purchases from the rest of the world. It is tempting,
therefore, to say that the dollar is overvalued if it
leads to a current account deficit. By that standard,
the dollar is currently overvalued.
But why should we expect or want a current account
balance in every year? For the three decades from the
end of World War II through 1976, the United States had a
current account surplus in nearly every year and
accumulated a substantial stock of overseas investments.
Although the dollar must eventually adjust to cause a
long-run current account balance, there is no reason for
it-to do so this year, or next year, or any time in the
near future. The conclusion that the dollar may be
overvalued in some long-run sense does not imply anything
about its appropriate value in the current year.
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Since the notion that the dollar's value is too high
cannot be defined by reference to an objective standard,
it must have a normative meaning; that is, those in this
country who say that the dollar is too high must believe
that a lower value of the dollar relative to other
currencies would be beneficial to the United States
economy. It is, of course, one thing. to believe that a
lower value of the dollar would be beneficial and quite
another to believe that it would be appropriate to take
whatever policy actions would be needed to lower the
dollar's value.
How High is the Dollar?
The widespread interest in the dollar's value is in
large part a response to the dollar's substantial rise in
the past two years and to the resulting trade deficit.
For example, the German mark was worth 55 cents in 1980
and is now worth only 41 cents. Relative to the D-mark,
the dollar has appreciated 34 percent. Moreover, over
this same period, domestic prices in Germany rose less
than domestic prices in the United States. As a result,
the real exchange rate -- that is, the exchange rate
adjusted for the changes in the purchasing power of the
domestic currencies -- rose approximately 40 percent
since 1980. This means that a dollar now buys 40 percent
more German goods, relative to its purchasing power in
American goods, than it did about two and a half years
ago.
The German experience was rather typical of the
worldwide rise in the dollar's value. The multilateral
trade-weighted real value of the dollar -- a measure that
averages the real exchange rates between the dollar and
other currencies in proportion to the amounts of trade --
rose 36 percent between 1980 and the end of 1982.
Much of the concern about the dollar's value focuses
on the exchange rate with the Japanese yen. The current
exchange rate of 240 yen to the dollar is about 7 percent
higher than the 1980 rate of 225 yen to the dollar.
After adjusting for the faster rate of inflation in the
United States than in Japan, the real value of the dollar
fias risen 17 percent relative to the yen.
The consequence of the generally higher real value
of the dollar has undoubtedly been a fall in U.S. exports
and a rise in our imports. Coming on top of the severe
recession that now depresses the demand for our exports
in other industrial nations and the financial problems
that are now forcing the developing countries to contract
their imports, the strong dollar has led to the largest
trade deficit that our country has ever known.
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Why is the Dollar so High?
To assess whether it would be desirable to have a
lower value of the dollar, one must first ask why the
dollar is so high. The key to understanding the dollar's
value is recognizing that the dollar is a portfolio asset
for international investors and, like stocks and bonds,
will only be held if it can be expected to provide a rate
of return as high as the return available on other
assets. A rise in the real interest rate on dollar
securities will increase the dollar's value. The longer
that the interest rate rise is expected to last, the
greater will be the dollar's rise. Since the yield on
bonds reflects the expected future yields on short-term
assets, the rise in the real long-term interest rate is
the principal reason for the dollar's appreciation.
To understand why this is so, it is useful to look at
the way in which a rise in the U.S. real interest rate
affects the exchange rate between the dollar and the
German mark. An increase in the interest rate on U.S.
Treasury bills makes them a more attractive investment to
a German investor. To increase his investment in U.S.
Treasury bills, the German must exchange marks for
dollars and then use the dollars to buy Treasury bills.
This increased demand for dollars raises their value
relative to the mark.
How high will the dollar rise? There are two
separate factors that limit the increase in the dollar.
First, uncertainty about the future dollar-mark exchange
rate limits the amount of dollar assets that German
investors want to hold. Second, and more fundamental,
the German investors know that any rise that occurs in
the dollar's value must eventually be reversed as the gap
between the dollar interest rate and the interest rate in
Germany narrows and returns to its original value. This
anticipated fall in the exchange value of the dollar
reduces the German investor's total rate of return on
dollar securities. Indeed, abstracting from the problem
of uncertainty, the dollar will rise until the
anticipated rate of decline in the exchange value of the
dollar just offsets the higher dollar interest rate.
A rise in the long-term dollar interest rate means
in effect a higher rate of interest for many years to
come. For each future year, the exchange value of the
dollar must be expected to decline by enough to offset
the higher interest rate. Thus, whenever the real
long-term interest rate increases, the dollar must rise
by enough to permit its value to fall in future years
and still leave it ultimately at a level that is
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consistent with long-run current account balance. The
greater the rise in the real long-term interest rate, the
greater will be the initial rise in the dollar.
Changes in the real interest rate reflect changes in
the supply and demand for funds. The primary reason for
the recent rise in the real long-term interest rate in
the United States is the prospect of large budget
deficits in the coming years.
If there are no legislative changes, the budget
deficits will be about six percent of GNP for the
remainder of the 1980s. To put this number in
perspective, note that net private savings have averaged
only seven percent of GNP during the past two decades. A
budget deficit equal to six percent of GNP would thus
absorb an amount equal to virtually all net private
savings. To shrink net private investment to the funds
available after this government borrowing, the real
interest rate would have to rise substantially. It is
the anticipation of these future real interest rates that
is reflected in the real long-term rate on bonds and that
keeps the dollar's value high.
Capital Inflows
To summarize, the currently anticipated budget
deficits cause high real interest rates which raise the
exchange value of the dollars and thereby cause an
enlarged trade deficit. In short, budget deficits beget
trade deficits and this requires a high exchange value of
the dollar.
The current trade deficit and the resulting current
account deficit mean that the United States will be a net
capital importer this year and may continue to be one for
several years to come. These capital inflows add to
domestic saving and help to finance domestic investment.
In 1983, the current account deficit is likely to
correspond to a capital inflow equal to approximately one
percent of GNP, a very significant sum in relation to the
net national saving of less than two percent of GNP even
if it is small in comparison to this year's budget
deficit of more than six percent of GNP.
Would it be desirable to have a lower exchange value
of the dollar? A weaker dollar would raise exports and
reduce the substitution of imports for domestically
produced goods. As such, it would be welcomed by those
U.S. industries that are now being hurt by the strength
of the dollar.
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But a weaker dollar and smaller trade deficit would
also mean less capital inflow from the rest of the world and
therefore a lower level of domestic investment in plant and
equipment and in housing. The rise in the dollar is a
safety valve that reduces pressure on domestic interest
rates; the increase in the trade deficit allows the extra
demand generated by the budget deficit to spill overseas
instead of crowding out domestic investment.
The question of whether it would be desirable to have a
lower valued dollar is equivalent to asking whether it is
better to allow the temporary increase in the budget deficit
to reduce domestic investment and interest-sensitive
consumer spending or to reduce the production of goods for
export and of goods that compete with imports from abroad.
The answer to this question is clear in principle: it is
better to reduce exports and increase imports.
Why? Since a temporary increase in the budget deficit
implies no change in the profitability of domestic
investment, there is no reason. to reduce domestic spending
on capital formation. Similarly, since a temporary increase
in the budget deficit implies only a temporary fall in the
resources available for private consumption, it would be
inappropriate to reduce consumption immediately by the full
amount of the increased annual deficit. Instead, the
reduction in consumption should be spread over future years
and the temporary budget deficit should be financed by
borrowing from abroad, i.e., by a deficit in the current
account.
In this way, the appropriate response of the nation
to a temporary increase in the budget deficit is
analogous to the appropriate response of a small
businessman to an unexpected business expense. It would
be wrong for him to reduce his business investment or to
pay for the entire expense out of his current year's
consumption. Instead, he should spread the reduction in
consumption over a large number of years and pay for the
original expense by borrowing. For the nation as a
whole, that borrowing is equivalent to an inflow of
capital from abroad and therefore to a current account
deficit.
So much for what would in principle be desirable.
Note that the actual response of the current account
deficit to the increase in the budget deficit has been
much smaller than this line of argument suggests might be
appropriate. Instead of relying almost entirely on
foreign borrowing to finance the budget deficit, the
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current account deficit and the associated net inflow of
foreign funds is only a small fraction of the increased
budget deficit. By this standard, the rise in the
interest rate has been too great and the rise in the
dollar has been too small.
There are, of course, further considerations that
complicate the desirable response of the dollar to a
temporary rise in the budget deficit. The fall in
exports and the rise in imports that result from the
stronger dollar are clearly causing unemployment and
threatening individual firms with possible bankruptcy.
Perhaps these adverse effects are more severe than those
that would result from an equal decrease in the demand
for plant and equipment, housing and other interest-
sensitive goods. Perhaps the firms involved in
international trade are more concentrated, or less
capable of responding to fluctuations in demand, or less
likely to survive until demand returns to its previous
level. If so, a lower value for the dollar might be
desirable. But at present the burden of proof lies with
those who would claim that the industries involved in
international trade are more vulnerable and are therefore
deserving of special protection.
Expansionary Monetary Policy
The case against policies aimed at reducing the
dollar's value is reinforced by considering the measures
that would be pursued to achieve a reduction in the dollar's
value. To reduce the dollar's value relative to other
currencies, the Federal Reserve would sell dollars and
buy foreign currencies. A direct effect of such
transactions would be to increase the supply of money and
therefore to cause an increased rate of inflation in the
United States. Although it is sometimes argued that this
adverse effect can be avoided by substituting Treasury
bills for money, neither economic logic nor empirical
evidence supports the view that such transactions --
known as sterilized intervention in foreign exchange
markets -- can alter the value of the dollar.
The basic fact is that the value of the dollar can be
changed only by modifying the goals for our domestic
economy. A lower value of the dollar requires an
expansion of the money supply that increases the rate of
inflation.
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It is not easy therefore to conclude that it would be
appropriate to lower the value of the dollar. In
addition to establishing that a lower value of the dollar
is itself desirable, it would also be necessary to
conclude that the advantage of a lower dollar outweighs
the disadvantage of the increased inflation that would be
required to lower the dollar's value.
Conclusion
This paper has stressed the negative conclusion that
it would be wrong to pursue policies aimed at lowering
the value of the dollar. There is, however, a more
fundamental and positive implication of this analysis.
The only appropriate way to reduce our structural deficit
in international trade is by reducing the budget deficit
that is its basic cause. If the budget deficit is
reduced, the real long-term interest rate will fall and
this will reduce the pressure that keeps the dollar so
high.
The Administration has proposed a five-year budget
plan that would decrease future deficits by a balanced
combination of reduced spending and increased taxes. It
is now time for Congress to work with the Administration
to enact the legislation that will assure financial
investors and others that the budget deficit will indeed
shrink in the years ahead. When such legislation is
enacted, we will see declines in the long-term interest
rate, a reduction of the dollar, and levels of exports
and imports that permit a more widespread and balanced
economic recovery.
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