VENICE ECONOMIC SUMMIT OUTLOOK FOR ECONOMIC POLICY COORDINATION ISSUES

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP92T00533R000100060012-2
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 19
• Document Creation Date: December 21, 2016
• Document Release Date: May 9, 2008
• Sequence Number: 12
• Publication Date: May 8, 1987
• Content Type: REPORT

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Central Intelligence Agency
-8 May 1987
Venice Economic Summit: Outlook for Economic Policy Coordination Issues
Summary
The non-US, Big Six Summit participants continue to be driven by
domestic, rather than international considerations in setting their
strategies for economic policy coordination discussions. At
Venice, all will urge the United States to cut the fiscal deficit
in order to reduce domestic demand and thus reduce the large
current account imbalances facing the major countries. There will
also be pressure on Japan and West Germany to ease their fiscal
policies but they remain reluctant to go beyond changes already
announced. Because there is little hope for agreement on a
coordinated package of policy changes that would reduce imbalances,
the Summit leaders could emerge from their discussions at Venice
facing more exchange market volatility, increased pressures for
protectionism, and even bleaker prospects for growth and
employment.
A series of simulations
indicate that a combination of US fiscal restraint, West German
and Japanese fiscal expansion, and further appreciation of the mark
and yen could substantially reduce these three countries'
imbalances without worsening the current accounts of other Summit
countries or inducing recession. None of these developments alone
would reduce all of the trade imbalances and some by themselves
would stall growth or reignite inflation.
This memorandum was prepared byl Ithe Office of European
analysis, with contributions from country analysts also from that office and
and queries are welcome and may be addressed to the Chief, Issues and
Applications Division
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Our analysis indicates that unless some kind of coordinated
approach is agreed upon, further dollar depreciation is likely.
Although the West German surplus will probably trend down under
current G-7 economic policies, the US and Japanese imbalances will
not fall to what we believe are sustainable levels. Growth
throughout Western Europe and Japan would be substantially lower as
a result of renewed dollar weakness because of the negative impact
on exports and business confidence. Declining growth prospects
would strengthen the positions of those advocating expansion in
Japan and West Germany and could lead to fiscal relaxation in both.
The prospects are poor for agreement at Venice on more binding
policy coordination procedures. The West Germans, Japanese, and
British in particular will almost certainly reject any proposals --
including those based on economic indicators -- which would limit
their policy autonomy. We expect continued Big Six support for
joint central bank intervention to stabilize exchange rates, a
policy, however, the member countries view as effective only in the
Because of mounting West European irritation over growing
bilateral trade deficits with Japan, Tokyo runs the risk of
becoming isolated in policy coordination discussions. We do not
believe, however, that Japan will offer any more than piecemeal
trade concessions. The perception in exchange markets of a
generally acrimonious, anti-Japan Summit would probably hasten the
yen's appreciation. Beyond the Summit the Japanese may react to
Western European criticism by increasingly turning to bilateral
discussions with the United States on substantive policy issues.
The Policy Coordination Setting
The major economic imbalances now facing the Summit countries are
potentially more threatening than the problems they faced earlier in the
decade. In response to the emergence of huge fiscal and current account
imbalances, the procedures for coordinating their economic policies have been
strengthened over the last two years, but the governments generally have not
yet attacked the imbalances in a coordinated way. Instead, non-US Summit
country macroeconomic policy changes have been largely a reaction to domestic
and currency market developments (see Text Box 1).
Recent Policy Changes
The Summit countries made good progress in dealing with the problems of
unemployment, inflation, high interest rates, and sluggish growth that they
faced in the early 1980s. Prior to the Tokyo Summit, inflation and interest
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Economic Policy Coordination: Key Developments During the Decline of the Dollar
1985
February The dollar peaks at 263 yen and 3.47 deutsche marks ... private market and
central bank sales precipitate dollar decline ... foreign reaction is
positive.
September G-5 Plaza Accord ... citing US trade deficit and protectionist pressures, G-5
agree orderly dollar decline is desireable ... dollar falls nearly 8 percent
against yen and mark the following week ... marks G-5 unanimity on exchange
rates.
December Dollar finishes year at 200 yen and 2.46 marks, 24 percent below peak against
yen, 29 percent lower against mark, and 12 percent down on real, trade-
weighted basis.*
1986
March Coordinated half percentage point cuts in US, Japanese, and West German
central bank discount rates ... high-water mark of active policy coordination.
May Tokyo Econanic Summit ... "objective" economic indicators cited for study as
foundation of policy coordination, intended to de-politicize and focus
discussions ... G-7 created ... preceded by half-point cuts in US and Japanese
discount rates ... raises profile of policy coordination efforts, but no
fundamental policy changes announced.
September G-5/G-7 meeting ... non US countries maintain united front against further
dollar decline and insist on US fiscal restraint ... Japan and West Germany
refuse to cut discount rates ... signals lack of G-5 consensus on policies for
reducing external imbalances.
October US-Japan agreement to stabilize dollar-yen exchange rate ... Japanese
government promises supplemental budget ... Bank of Japan cuts discount rate
... dollar firms against yen but slides against mark through late December....
greeted cautiously in western Europe.
December Dollar finishes year at 159 yen and 1.94 marks, down from peak 40 percent
against yen, 44 percent against mark, and 20 percent on real trade-weighted
basis.*
1987
January Sharp dollar decline triggered by unexpectedly large US trade deficit and
perception that US officials seeking lower dollar ... induces EMS realignment
and half-percentage point cut in West German discount rate ... dollar
stabilized by expectations of G-5 action.
February G-6 Louvre Accord ... Italy boycotts G-7 meeting but others agree to resist
"further substantial shifts among their currencies" ... touted as the
successor to Plaza ... re-establishment of consensus on exchange rates.
March-April Markets shrug off Louvre ... perceive growing US-Japanese tension and doubt US
willingness to intervene ... yen appreciates sharply.
April G-5/G-7 meetings reaffirm commitment to halt dollar's slide ... G-5/G-7 role
controversy resolved but markets disappointed by lack of concrete policy
changes ... dollar falls below 140 yen and 1.80 marks late in month ..
intervention fails to support exchange rates.
*Morgan Gaurantee Trust trade-weighted real exchange rate against 18
industrialized and 22 developing countries.
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rates were reduced and the growth of unemployment was halted on average in the
seven major countries. However, incompatible fiscal programs in the Big Three
-- the United States cut tax rates and boosted spending while the West Germans
and Japanese chose fiscal contraction -- led to large US, West German, and
Japanese trade imbalances (see Table 1). The fiscally-driven surge in US
growth in 1983 and 1984 and the extraordinary real appreciation of the US
dollar caused large US trade deficits, permitting West Germany and Japan to
tighten their fiscal positions while still boosting GNP in large part through
exports to the United States.
Officials in other Summit countries believe the Plaza accord in September
1985, which officially sanctioned the dollar's decline, marked a turning point
in multilateral policy coordination. The dollar's decline had already begun in
early 1985, precipitated by private market and foreign central bank dollar
sales (see Figure 1). Most foreign officials viewed Plaza as a stop-gap
measure to help maintain order in the foreign exchange markets until more
fundamental changes in exchange rate policies could be agreed upon at the 1986
Tokyo Economic Summit.
The Tokyo Summit did not forge a consensus on policy changes, but instead
focused on strengthening the coordination system itself by seeking to
depoliticize it, make it more disciplined, and base it on an improved
analytical framework. The two specific achievements at Tokyo -- establishment
of the G-7 and agreement to develop a set of "objective indicators" -- have led
to consensus on some issues and friction on others. While all foreign Summit
governments agree that use of indicators will aid policy discussions, they
differ over their potential for guiding policy in part because of disagreement
on how the adjustment burden should be divided between deficit and surplus
countries. Though careful to avoid the "fine-tuning" label, the French are
seeking a relatively activist system in which each country's economic policies
could be influenced by the indicators. The West Germans, Japanese, and
British, in contrast, want indicators to serve merely as a basis for
consultations and want no automatic triggers or ties between trends in the
indicators and policy responses.
The Economic Outlook Heading into Venice
The same problems that motivated the push to strengthen policy coordination
at Tokyo haunt the Venice Summit:
-- The US fiscal and current account deficits remain high with observers
forecasting only small reductions at best through 1988.
-- The West German and Japanese current accounts this year will remain near
their 1986 levels in dollar terms.
Economic growth in 1987 for the other six Summit countries will average
about 2.5 percent, the same as in 1986, but prospects for certain countries are
worsening. In particular, the widely predicted 2.7 percent growth for Japan
this year is now less likely because these forecasts were based on the yen
remaining above 150 to the dollar. At current exchange rates,
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Summit Countries:
Trends in Key Economic Indicators
1980
1981 1982 1983 1984
1985
1986
Real GDP Growth: G-7
1.1
1.6 -0.6 2.8 5.0
3.0
2
5
United States (GNP)
-0.2
1.9 -2
5 3
6 6
4
.
Japan (GNP)
4.3
.
.
.
3.7 3.1 3.2 5.1
2.7
4.7
2.5
2
3
West Germany (GNP)
1.5
0.0 -1.0 1.8 3.0
2.5
.
2
4
France
1.1
0.5 1.8 0.7 1.5
1
4
.
2
0
United Kingdom
-2.3
-1.2 1.5 3.5 2.7
.
5
3
.
2
3
Italy
3.9
0.2 -0.5 -0.2 2.8
.
2
3
.
2
8
Canada
1.5
3.7 -3.3 3.1 5.5
.
4.0
.
3.4
Inflation (CPI):
G-7 1
2.0
9.9 7.0 4.4 4.4
3.8
1
9
United States
1
3.5
10.3 6.2 3.2 4.3
3
6
.
1
9
Japan
7.8
4.9 2.7 1.9 2.3
.
2
0
.
0
6
West Germany
5.4
5.3 4.8 2.6 2.1
.
1
7
.
-0
1
France
1
3.3
13.3 12.0 9.5 7.7
.
8
5
.
2
5
United Kingdom
1
8.0
11.9 8.6 4.6 5.0
.
6
1
.
3
4
Italy
2
1.2
19.3 16.4 14.9 10.6
.
8
6
.
6
1
Canada
10
.2
12.5 10.8 5.8 4:3
.
4.0
.
4.2
Unemployment Rate:
G-7 5
.6
6.5 8.0 8.2 7.5
7
4
4
7
United States
7
.2
7.6 9.7 9.6 7.5
.
2
7
.
0
7
Japan
2
.0
2.2 2.4 2.7 2.7
.
2
6
.
2
8
West Germany
3
.4
4.9 6.8 8.2 8.1
.
8.2
.
7
9
France
6
.6
7.7 8.4 8.6 10.0
10
4
.
10
7
United Kingdom
6
.5
10.1 11.8 11.3 11.1
'
.
11
3
.
11
6
Italy
7
.6
8.4 9.1 9.9 10.4
.
10
6
.
11
1
Canada
7
.5
7.5 11.1 11.9 11.3
.
10.5
.
9.7
General Government
Deficit to GNP
Ratio: G-7
-2
.5
-2.6 -3.9 -4.1 -3.4
-3
4
2
-3
United States
-1
.3
-1.0 -3.5 -3.8 -2.9
.
-3
5
.
4
-3
Japan
-4
.4
-3.5 -3.6 -3.7 -2.1
.
-1
0
.
-1
1
West Germany
-2
.9
-3.7 -3.3 -2.5 -1.9
.
-1
1
.
-1
1
France
0
.2
-1.8 -2.7 -3.1 -2.9
.
-2.6
.
-2
9
United Kingdom
-3
.5
-2.8 -2.3 -3.7 -3.9
-2
8
.
-3
2
Italy
-8
.0
-11.0 -12.9 -14.0 -13.2
.
-13
7
.
-12
1
Canada
-2
.8
-1.5 -5.7 -6.6 -6.6
.
-6.6
.
-5.4
Current Account
to GNP Ratio
United States
0
.1
0.2 -0.3 -1.4 -2.2
-2.9
-3
3
Japan
-1
.0
0.4 0.6 1.8 2.8
3
7
.
4
4
West Germany
-1
.9
-0.7 0.6 0.6 1.1
.
2.2
.
4
0
France
-0.
6
-0.8 -2.2 -1.0 -0.8
0.0
.
0
5
United Kingdom
1.
4
2.5 1.4 1.0 0.4
1
0
.
0
0
Italy
-2.
5
-2.5 -1.7 0.2 -0.8
.
-1
2
.
0
9
Canada
-0.
4
-1.5 0.8 0.7 0.8
.
-0.1
.
-1.8
Interest Rates*
United States
11.
6
14.1 10.7 8.6 9.6
7
5
6
0
Japan
W
10.
9
7.4 6.9 6.4 6.1
.
6
5
.
4
8
est Germany
F
7.
8
10.4 7.7 5.7 5.6
.
4
9
.
9
3
rance
U
it
12.
0
15.3 14.9 12.5 11.7
.
9
9
.
7
7
n
ed Kingdom
15.
1
13.0 11.5 9.6 9.3
.
11
6
.
10
4
Italy
15.
9
19.3 10.2 17.8 15
3
.
13
9
.
11
1
Canada
12.
8
.
17.7 13.6 9.3 11.1
.
9.4
.
9.0
*Short-term money market rates in Japan and France, Treasury bill rates in
others.
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Summit Countries: Red Trade-Weighted
Exchange Rates*
`(1980=100)
glut 221mou
U1261d [so~d?m tOgn_? Untted st t. __
*Source: Based on Morgan Guaranty Trust trade-weighted real exchange
rates ?g?1et 18 industrialized and 22 developing countries.
ragure 1
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the Japanese economy could slip into a
recession late this year. Japanese fiscal stimulus plans will probably not be
settled until the fall and will come too late in the year to offset any further
rise of the yen.
The outlook for West Germany now is also gloomier than it was just a few
months ago. The five leading West German economic institutes for example,
recently revised downward their 1987 growth forecasts from an average 3.0
percent made last October to 1.7 percent. Poor export performance and
declining business confidence are primarily responsible for the change in
outlook.
The French economy will probably grow less than 2 percent this year as a
result of sluggish consumer and government demand. Both the UK and Italy are
expecting more robust -- up to 3 percent -- growth this year; private
consumption and investment in both are fueling the expansion.
The major threat to Big Six growth is the further decline of the dollar.
Growth throughout Western Europe and Japan would be substantially lower as a
result of renewed dollar weakness because of the negative impact on exports and
business confidence.
Alternatives to Reducing the Economic Imbalances
In order to reduce the huge current account imbalances without one or more
of the major countries experiencing a recession, we believe a complementary set
of nn1inv nhanoac are needed.
one feasible approach to reducing the economic imbalances
among the Summit countries without a major negative impact on growth includes a
combination of yen, and to a lesser degree, mark appreciation, moderate
economic stimulation in Western Europe, substantial fiscal expansion in Japan,
and sustained gradual cuts in the US fiscal deficit.*
Any one of those changes alone either would not reduce the current account -
imbalances significantly, or would induce a recession somewhere in the Summit
countries. Our simulations also strongly suggest that over the medium to long
term the trade imbalances are primarily a US-Japan problem. Even barring mark
appreciation, with moderate growth in the West German economy, we expect Bonn's
surplus to trend down.
* We do not think monetary policy can play a major role in the adjustment
process. The dangers raised by an increase in dollar interest rates to a world
economy heavily burdened with dollar-denominated debt suggest that the role for
US monetary policy is limited. Similarly, with the Japanese economy awash in
liquidity, further monetary easing is not likely to have a sustained effect on
Japanese demand. While we do not believe any econometric model can predict the
short run results of policy changes with pinpoint accuracy, we do believe
sufficiently reliable ball-park estimates to enable us to
separate a justment packages likely to succeed from those likely to fail.
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Baseline Scenario
To assess the impact of various policy alternatives, we first estimated how
the current account balances of the major countries would evolve in the absence
of policy or exchange rate changes. This "baseline" scenario is not our
forecast of summit country current accounts and real growth, but rather a
projection of recent economic trends. Indeed, we believe the baseline is not
sustainable. The baseline, therefore, serves to draw out the implications of
current trends and the apparent need for policy changes, and as a standard
against which to assess the likely impact of various policy combinations. For
the 1987-1990 baseline we assumed:
-- Real GNP growth averages 3.5 percent annually in Japan and 2.5 percent
annually in the rest of the OECD.
-- Real exchange rates remain unchanged after April 1987; nominal rates
change just enough to offset differentials in inflation rates.
-- Oil prices average $16.75 a barrel in 1987 and stay constant in real terms
through 1990. Fuel import volume rises 2.0 percent annually from 1985
levels in the net fuel importing Summit countries, while Canada's net fuel
exports rise and the UK's fall by small amounts.
-- Foreign exporters -- who on average raised export prices in 1986 by only
50 percent of the amount required to offset currency appreciation -- do
not try to restore profit margins during 1987-1990.
-- West Germany goes through with its planned 14 billion mark tax cut in 1988
and Japan implements its proposed 5 trillion yen fiscal stimulation
package.
Under this baseline, the US current account improves in 1988 but worsens
after that primarily for two reasons: (1) the balance on investment income
plunges from an estimated $23 billion surplus in 1986 to a $25 billion deficit
in 1990, and (2) the fuels deficit worsens steadily from $29 billion in 1986
to $38 billion in 1990 (see Table 2). The US bilateral deficit with Japan
declines to about $30 billion while Japan's overall surplus initially falls
because of an increase in the oil import bill, then begins rising again after
1988. Japanese net exports of non-fuel goods shrink in real and in yen terms.
In dollar terms, imports grow at a much more rapid rate than exports but,
because the starting imbalance is so great, the surplus continues to grow.
Also, Japan's surplus on investment income increases from roughly $8 billion in
1986 to $19 billion in 1990.
The West German surplus temporarily jumps in 1987 because real GDP growth
is only 1.5 percent. The surplus, however, would rise less in 1987 and fall
more in subsequent years should actual 1987 growth prove higher, as three of
the West German institutes are predicting. The bilateral trade surplus with
the United States all but vanishes by 1990.
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Summit Countries:
Baseline Projections of Current Account Balances*
(billions US $)
1986
1987
1988 1989
1990
United States
-141
-144
-143 -156
-180
Japan
82
71
67 73
86
West Germany
36
43
32 24
24
France
4
1
-2 -4
-1
United Kingdom
0
-3
-5 -9
-12
Italy
5
-4
-9 -11
-12
Canada
-7
-3
-4 -6
-8
* These baseline projections are not forecasts. They assume that the real
exchange rates and government policies in place or planned in late April are
unchanged.
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LX
The UK and Italy are the only other two countries. which experience a
significant change in current account balances in the baseline scenario.
Italy's shift from a surplus to deficit country occurs mostly because of the
increase in its fuel bill. The UK shifts from balance in 1986 to a $12 billion
deficit in 1990 in part because of an assumed continued loss of world market
share, but primarily because a relatively large portion of British exports go
to areas which have experienced depreciating currencies -- the United States
and LDCs.
Scenario 1: A coordinated approach involving currency rate adjustments,
fiscal easing in the Big Six, and US fiscal restraint.
Our model indicates that a coordinated adjustment package involving the
United States, Japan, and West Germany rids the major economies of the serious
imbalances implied by the baseline case without inflicting major economic
hardship on any Big Six country (see Table 3). For this scenario we assumed:
-- The Japanese yen and West German mark appreciate 20 and 10 percent
respectively against all other currencies in real terms.*
-- All non-US Summit countries modify their fiscal policies to sustain
baseline real GNP growth; this requires substantial fiscal easing in Japan-
and West Germany.
-- The United States restrains fiscal policy and keeps real GNP growth 1
percentage point below the baseline at 1.5 percent. 25X1
This combination of policies and exchange rates quickly reduces the US and
Japanese trade imbalances sharply by 1990 and restrains the build-up of US net
foreign debt and Japanese net foreign assets. The West German surplus nearly
vanishes while the balances of the other Summit countries collectively change
little. We also estimate the US unemployment rate would hover around its
current level, remaining 2.1 percentage points above baseline in 1990.
Stimulation of domestic demand in West Germany and Japan would help offset the
negative impact on both countries of lower US growth, allowing the Summit
countries collectively to grow at an average rate of 2.3 percent. The US
general government fiscal deficit ratio would fall steadily to zero percent by
1990 while the Japanese ratio would rise to 4.8 percent, and the West German
ratio to 2.6 percent.
*An acceptable adjustment package appears to require that the mark and yen
rise against both the dollar and the other Summit country currencies. If
instead the dollar depreciates uniformly against all currencies, leaving the
mark unchanged within the EMS, the Western European Summit countries and Canada
would all develop unsustainable current account deficits without greatly
reducing the West German surplus.
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Table 3
Scenario 1: 10 percent real mark appreciation, 20 percent real yen
appreciation, non-US summit countries stimulate domestic demand to maintain
baseline GNP growth, US restrains demand by cutting fiscal deficit.
United States Japan West Germany Other Summit
Level Change Level Change Level Change Level Change
from from from from
Baseline Baseline Baseline Baseline
Current Account
(billions US $)
1987
-129
15
64
-7
44
3
-11
-2
1988
-100
43
32
-35
23
-11
-20
0
1989
-84
72
20
-53
8
-16
-30
0
1990
-72
108
20
-66
3
-21
-39
-6
Real GNP Growth
(percent)
1987
2.0
-1.0
3.0
0
1.5
0
2.6
0
1988
2.0
-1.0
3.5
0
2.0
0
2.4
0
1989
1.5
-1.0
3.8
0
2.8
0
2.5
0
1990
1.5
-1.0
3.8
0
2.8
0
2.5
0
Unemployment
(percent)
1987
6.5
0.4
3.5
-0.1
7.9
0
11.4
0.2
1988
6.3
1.0
3.6
-0.1
8.0
0
11.6
0
1989
6.4
1.5
3.6
-0.2
7.9
0
11.7
-0.1
1990
6.7
2.1
3.7
-0.2
7.7
0
11.8
-0.1
Inflation
(percent)
1987
2.7
-0.3
-0.6
-0.6
0.1
-0.6
3.9
0.6
1988
2.4
-0.6
0.6
-0.4
1.5
-0.5
4.4
0.7
1989
3.0
-1.0
1.8
-0.2
1.8
-0.2
4.9
0.7
1990
2.8
-1.2
1.9
-0.1
1.9
-0.1
5.0
0.8
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Other Scenarios
Less comprehensive adjustment packages would have a far smaller impact on
the current account imbalances. Moreover, in some cases they produce results
that would likely erode the policy coordination process and prove highly
objectionable to some governments. All of the following scenarios leave the US
current account deficit well above $100 billion by 1990, and rising. Each
includes some, but not all of the elements of Scenario 1 (see Table 4): 25X1
-- Scenario 2: 10 percent real mark and 20 percent real yen appreciation
against all currencies, and non-US fiscal expansion to sustain baseline
growth (Scenario 1 without US fiscal restraint). We believe this
simulation helps to highlight the importance of US demand restraint in
reducing the imbalances. Under this scenario the Japanese and West German
surpluses would be greatly reduced, but because US growth picks up the US
deficit is not much improved. The Japanese and West German fiscal deficit
ratios would rise to 4.4 and 2.1 percent of GNP respectively. 25X1
-- Scenario 3: 30 percent real dollar depreciation. We believe this
simulation illustrates the ineffectiveness of relying solely on exchange
rates for adjustment. Under this scenario the US deficit would be only
slightly reduced. Higher growth in the United States and a high US
propensity to import combine with poorer growth in US export markets to
largely offset the positive effects of cheaper dollars on US exports.
Also, because of growth differentials -- and because of the new nominal
currency rates -- the Japanese and West German surpluses would rise in
dollar terms, although both would fall in real and national currency
terms. We calculate non-US OECD growth would be nil in 1987 and 1988 --
Japan and France would be in recession in 1987 -- and also that US
inflation would hit 7 percent by 1989. 25X1
-- Scenario 4: 30 percent dollar depreciation plus fiscally-boosted growth 1-
percentage point above baseline in the non US Summit countries. We
believe this simulation demonstrates that even a broader-based adjustment
package is inadequate if it omits US demand restraint. Under this
scenario, faster Big Six growth would complement the dollar depreciation
but because US growth is not restrained, the US current account deficit
would remain above $100 billion. The Japanese surplus would be sustained
by buoyant West European imports, though in yen terms it would settle well
below the 1986 level. The West German surplus measured in dollars would
fall only modestly and the other Summit countries would develop very large
current account deficits. We also calculate the US economy would overheat
with inflation hitting 9 percent.
25X1
E I
-- Scenario 5: Fiscally boosted growth 1 percentage point above the baseline
in the non-US Summit countries. We believe this simulation highlights the
importance of exchange rate realignments, particularly yen appreciation.
Under this scenario the reduction of the US and Japanese imbalances would
be extremely small because of the limited US-EC trade relationship and the
extremely low Japanese import propensity. The European Summit countries
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Other Scenarios: Effects of Alternative Adjustment Packages on the US, West
German, Japanese, and Other Summit Country Current Accounts, (billions US $).
United States Japan West Germany Other Summit
Level Change Level. Change Level Change Level Change
from from from from
Baseline Baseline Baseline Baseline
Scenario 2: 10 percent mark and and 20 percent yen appreciation, non-US
countries maintain baseline growth.
1987 -146 -2 67 -4 46 3 -7 2
1988 -142 1 40 -27 27 -5 -11 9
1989 -154 2 32 -41 14 -10 -15 15
1990 -177 3 36 -50 12 -12 -17 16
Scenario 3: 30 percent dollar depreciation.
1987 -156 -8 80 9
1988 -125 18 71 4
1989 -122 34 78 5
1990 -144 36 98 12
62 19 -2 -7
60 28 -32 -12
53 29 -61 -31
57 33 -73 -40
Scenario 4: 30 percent dollar depreciation and faster non-US growth.
1987 -149 -5 72 1 57 13 -22 -13
1988 -110 35 51 -16 47 15 -83 -63
1989 -99 57 49 -24 32 8 -145 -115
1990 -116 64 58 -28 28 4 -190 -157
Scenario 5: Faster growth in non-US summit countries.
1987 -142 2 70 -1 40 -3 -16 -7
1988 -139 4 64 -3 27 -5 -35 -15
1989 -150 6 68 -5 14 -10 -53 -23
1990 -172 8 79 -7 9 -15 -69 -36
Scenario 6: Severe US fiscal restraint in 1987 and 1988.
1987 -122 22 67 -4
1988 -99 44 57 -10
1989 -103 53 59 -14
1990 -111 69 68 -18
41 -2 -11 -2
30 -2 -25 -5
22 -2 -37 -7
21 -3 -43 -10
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 Implications
It is likely the dollar will have to fall further -- particularly against
the yen -- before Japan, and to a lesser extent West Germany, would
significantly alter their fiscal policies. We believe that domestic concerns
will continue to dominate economic policy discussions in the Big Six.
Moreover, the Summit countries' refinement of policy coordination procedures
probably will not be enough to generate any major changes at or before Venice.
As a result, we believe the three major current account imbalances will not
fall substantially this year -- and probably not in 1988 -- and that private
investors will likely read the lack of major policy changes as a signal that
further exchange rate changes are needed. We generally expect Big Six support
at the Summit for joint central bank currency market intervention, but only as
a stop-gap measure to help calm markets. Disputes among Summit countries over
intervention policies are likely to grow if, as we expect, private investors
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would experience a modest deterioration of their external balances, while
the US economy would not be strongly affected.
-- Scenario 6: Extreme fiscal restraint holds US growth 2 percentage
points below baseline in 1987 and 19 We believe this simulation
illustrates the inadequacy on the one hand, and potential dangers on the
other, of a strong US response to foreign charges that the imbalances can
be dealt with by a cut in US demand alone. Under this scenario, the rapid
US fiscal deficit reduction to -0.3 percent of GNP in 1990 would reduce
the US external imbalance by about $70 billion compared to the baseline.
The Japanese surplus, however, would fall by only $18 billion, while the
European Summit country current accounts would decline modestly. We
believe these results may not convey the full risks associated with this
scenario, however, because the contractionary effect of such rapid and
severe US restraint would be compounded by a likely weakening of business
confidence in the United States and elsewhere, including debt-ridden LDCs.
bring new pressure to bear on exchange rates.
With further currency appreciation in West Germany and Japan, the potential
for economic stagnation would grow. Declining growth prospects would
strengthen the positions of those advocating expansion in Japan and West
Germany and could lead to fiscal relaxation in both; other Summit countries in
West European would probably follow suit. There is a risk, however, which we
do not consider high now, that the fiscal stimulus would not forestall West
European and Japanese recessions.
We believe a further substantial depreciation of the dollar would also
precipitate protectionist reactions in Western Europe, impede any trade
liberalization Japan was considering, and generally hinder GATT negotiations.
Rising unemployment in Western Europe and Japan would compound these problems
and also jeopardize medium run structural adjustment programs. LDC exports to
these countries also would be hurt and debtors would likely raise new calls for.
an overhaul of the international monetary system.
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The propects for an agreement strenghtening the policy coordination
procedures at Venice are poor. As long as the US fiscal and current account
deficits persist, the West Germans, Japanese, and British will adamantly refuse
to surrender any degree of policy autonomy. Specifically, they will almost
certainly block any proposal for the prescriptive, rather than purely
descriptive, use of economic indicators. Except possibly for the French, the
Big Six probably would prefer to see Summit country policy coordination remain
a non-binding search for consensus.
The dispute over Japanese trade policy and stimulation of their domestic
economy is likely to be one of the key topics for policy coordination
discussions at Venice. Prime Minister Nakasone will probably try to avoid
criticism that Japan is still failing to accept its international
responsibilities by fleshing out the proposed $34 billion stimulation package.
We believe the dollar's decline would probably be hastened by perceptions of an
essentially anti-Japan Summit. If after the Summit Tokyo still finds itself
isolated and on the defensive, it would probably react by increasingly turning
to bilateral discussions with the United States, while continuing to attend
G-7/G-5 meetings.
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Country Priorities for Venice
The Big Six are all approaching the Venice Summit with the goal protecting
their short-term interests rather than devising a medium-term coordinated
strategy. They will continue to pressure the United States to reduce domestic
demand by cutting the fiscal deficit, arguing that a credible US commitment to
fiscal restraint is needed to restore investor confidence in the dollar. But
they are divided over the need for changes in their own policies. Bonn and
Tokyo remain opposed to aggressive fiscal or monetary stimulation while the
other four would like these two countries to ease their economic policies.
French and Italian officials, in particular, believe that more buoyant West
German demand is necessary before they stimulate their own economies. The EC
Commission agrees, motivated in part by the belief that more vigourous growth
within the Community is an essential prerequisite for achieving its goal of
completing internal market reform measures by 1992.
The West Europeans are increasingly irritated by their growing bilateral
trade deficit with Japan and fear increased diversion of Japanese exports from
US to Western Europe. Indeed the EC Commission recently proposed a contingency'
trade retaliation plan to head off this diversion. The West Europeans are
likely to stress at the Summit that Japanese structural change and trade
liberalization are essential complements to needed fiscal stimulation.
On other key issues, we believe the Big Six at Venice will:
coordinated central bank intervention.
-- Reaffirm their commitment to stabilize exchange rates in the short run by
-- Support the use of objective indicators to focus policy coordination
discussions while rejecting any automatic link between indicators and
policy changes.
-- Affirm the status of the G-7 as the main forum for formal policy
coordination discussions.
Beyond Venice, we believe West Germany and Japan increasingly will rely on less
formal, non-public bilateral consultations with the United States to set policy
coordination strategies, a move the French and British have feared since Tokyo.
Japan
Tokyo's chief objectives at Venice will probably be to secure a strong G-7
commitment to restrain the yen -- in exchange for moving forward with its
announced $34 billion stimulus package -- and to limit protectionist policies
in the United States and Western Europe. Business leaders have begun to
express serious alarm over the renewed yen appreciation, and the political
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leadership is now under increasing pressure to find an international
accomodation that will stabilize the currency. The Japanese strongly believe
that their trade surplus is largely the result of excessive private and public
consumption in the United States and that US fiscal restraint is the single
The Japanese government is deeply divided on the issue of domestic fiscal
stimulus, with the Ministry of Finance staff firmly opposed to an aggressive
fiscal easing to reduce their current account surplus. On the other hand,
Finance Minister Miyazawa, and to a lesser extent Prime Minister Nakasone, have
shown some flexibility. Tokyo will probably pursue fiscal expansion with its
proposed $34 billion supplementary budget to be finalized in August or
September. The size and method of financing -- both of which will determine its
expansionary effects -- probably will not have been finalized before Venice.
When growth propects improve, however, Tokyo is likely to return to fiscal
most important policy change needed.
Japan's political and bureaucratic leadership is extremely reluctant to
expose domestic producers to greater foreign competition through trade
liberalization at a time when Japanese unemployment is at a post-war high.
Even on specific trade disputes that have only a small impact on the trade
austerity.
surplus, Tokyo is likely to be inflexible.
West Germany
Bonn's primary policy coordination goal at Venice very likely will be to_
counter calls for German reflation by arguing that a reduction in the US budget
deficit would provide a far larger contribution to world economic adjustment.
The West Germans also probably will press Tokyo to live up to its committment
to provide fiscal stimulus and liberalize trade. Despite these goals, however,
Bonn does not believe that either the US or Japan has sufficient latitude to
enact these policy changes.
The West Germans will almost certainly not be willing to change their
fiscal and monetary policies for the sake of reducing global trade imbalances.
The Finance Ministry believes the 2.0-2.5 percent growth it expects is
acceptable and that the imbalances are at bottom a US-Japan problem. Bonn's
fiscal flexibility at Venice will be constrained by upcoming state elections
25X1
25X6
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Paris's major policy coordination objective probably will be to formalize
and strengthen the G-7 commitment to stabilize exchange rates among the world's
major currencies, which the French see as a prerequisite to stable EMS exchange
rates. They would like to see West Germany and Japan reflate but will probably
defer to Washington during discussions of how to reduce the major trade
imbalances.
In the absence of greater West German growth, the French government is not
likely to significantly boost domestic demand. A debate is beginning, however,
over the need for mildly stimulative measures to improve the rather bleak
economic outlook before next year's presidential election. So far, Prime
Minister Chirac and Finance Minister Balladur have resisted, fearing a loss of
government credibility.
Paris remains enthusiastic about the use of economic indicators to guide
policy coordination but will probably not push for an agreement at Venice
linking movements in indicators to changes in Summit country economic policies..
United Kingdom
London will probably focus on Japanese trade and fiscal policies as the
principal barrier to correcting the major current account imbalances.
Nonetheless, the British continue to believe that the US fiscal deficit must be
reduced and that some West German stimulation is needed. They will, however,
probably avoid criticizing Bonn in order to maintain a solid EC front.
British fiscal and monetary policies will not likely change in the short
term. The current goal is to get the Conservatives reelected later this year
and the economy's "mini boom" has lessened the need for pre-election
pump-priming.
Chancellor of the Exchequer Lawson is optimistic that a limited degree of
international economic cooperation can bring about a period of exchange rate
stability, but believes indicators should only be used as a common basis for
measuring economic trends. London will almost certainly oppose their use to
dictate policy changes.
Italy
Rome will probably be restrained in expressing views on reducing the
current account imbalances at Venice because of its huge public sector deficit
and high interest rates. Moreover, Italy's caretaker government faces an
election on 14 June and thus probably will focus on staging a successful
Summit. The Italians would, however, like to see a combination of more
expansionary policies in West Germany and Japan and fiscal restraint in the
United States.
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? . 25X1
Rome probably will resist proposals for the use of indicators which
infringe on their monetary options. In hopes of stabilizing EMS exchange
rates, and thus strengthening its export sector, Rome will probably support
efforts to stabilize the dollar-yen-ECU rates. Treasury Secretary Goria's
comments to the press indicate that Rome is satisfied that the G-5/G-7
controversy has been settled in its favor by making the G-7 the principal forum
for economic policy coordination.
Canada
Ottawa will probably not attempt to play an important role in the policy
coordination discussions at Venice. The Canadians would like to see exchange
rates stabilized, but Finance Minister Wilson has publicly avoided a commitment
to join official intervention.
13
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