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Published online by Cambridge University Press: 28 September 2012
Nineteen eighty-seven was a year of financial paradox. During the 1980s there was the strong perception that the Americans, the Europeans, and the Japanese were living well, contrasting with the accounting data that suggested the house of cards was about to fall. Three factors dominated the financial economy of 1987: the 25-percent drop in equity prices in mid-October, the apparent collapse of the U.S. dollar in the foreign exchange market, and the formal recognition by the major international banks that their losses on developing country loans would amount to at least $250 billion. The key question at the end of that year was whether the world economy was moving into a period of inflation or deflation. This essay identifies three possible scenarios. First, the decline in the foreign-exchange value of the U.S. dollar would lead to a rapid increase in U.S. net exports, an excessively large increase in demand for U.S. goods, and a run on the U.S. dollar, which would prompt more contractive monetary policies from the Federal Reserve and an increase in interest rates on U.S. dollars. Second, an increase in U.S. net exports would offset the decline in domestic spending from the smaller fiscal deficit and the less rapid growth of consumer spending. Interest rates on U.S. dollar assets would fall, which in turn would facilitate the expansion of income, and the U.S. fiscal deficit would automatically decline. Or, third, a second stock market meltdown might cause consumer and investment spending to decline more than the increase in net exports, resulting in a recession and a decline in the inflation rate and interest rates.
2 The return from forecasting the economic apocalypse apparently is high since the activity has a long and honorable tradition that goes back at least to the Reverend Thomas Malthus and his classic, An Essay on Population. More recent visions include the OPEC shock, the end of technical progress, hyperinflation, the zero-sum society, the doomsdayers like the Club of Rome, and Batra, Ravi, The Great Depression of Nineteen-Ninety: Why It's Got to Happen (Pennsylvania: Scharff Association, 1987)Google Scholar. Each society generates its own Chicken Littles.
3 The process of adjustment of the accounting value of a loan to a change in market conditions involves three steps. The first step is the establishment of a loan loss reserve, the retained earnings of the bank are reduced by the amount of the increase in the loan loss reserve. The value of the bank's assets remain unchanged, as well as the value of its primary capital. The second step, which frequently occurs at a later date, involves a loan charge-off, the reported value of the bank's loans and its loan loss reserve are reduced by the same amount. The third step involves an adjustment in bank income if the asset is sold at a price above the price reflected in the bank's assetsGoogle Scholar.
4 For much of the 1982–87 period, stock prices and bond prices had increased together. About 50 percent of the increase in the Dow Jones from 800 in August 1982 to 1900 at the end of December 1986 is explained by the decline in interest rates on long-term U.S. dollar bondsGoogle Scholar.
5 If government debt is 25 percent of gross domestic product, and interest rates increase by four percentage points, then the ratio of government spending to gross domestic product increases by one percentage point of gross domestic product. If government spending is 25 percent of gross domestic product, then the increase in government spending as a share of GDP attributable solely to the increase in interest rates is four percentage points. It's a matter of arithmeticGoogle Scholar.
6 These tax cuts were marketed to the President and to the American people under the supply-side banner, the central idea being that the stimulus to economic activity from lower tax rates would be so strong that the increase in government revenues would be proportionately larger than the decline in the tax rates. Alas, this economic version of the perpetual motion machine was proved incorrect. It seems unlikely that the President and the American people would have bought this policy under its rightful Keynesian nameGoogle Scholar.
7 Consider the counterfactual case that if the U.S. Government had not cut tax rates in the early 1980s, U.S. national income would have increased at a much less rapid rate and the U.S. unemployment rate would have declined less rapidly. The U.S. government still would have incurred a fiscal deficit, although at a smaller level, and the United States still would have incurred a trade deficit, although this deficit would have been smaller. The choice was between high levels of debt with high levels of income and lower levels of debt with lower levels of incomeGoogle Scholar.
8 The sharpness of the yield curve on U.S. government securities—the excess of interest rates on long-term securities over the interest rates on short-term securities—suggests that investors are concerned about the likelihood of a return to inflationGoogle Scholar.
9 The textbooks tell us that a monopolist can set the price, and then consumers will determine the amount sold. Or the monopolist can decide on the amount to sell, then consumers will determine the price. So it is with money and interest ratesGoogle Scholar.
10 Even now, the rationale for the surge in loans to the developing countries in the 1970s is hard to understand. The growth in bank loans, at rates approaching 30 percent a year for a decade, to oil producing countries like Mexico, Nigeria, and Ecuador might be explained by the belief that the price of oil—the real price of oil—would continue to increase. But then the rapid growth in bank loans to oil-importing countries like Brazil and Chile and the Philippines is difficult to understand. The most general economic explanation for the rapid growth in bank loans to both the oil-importing and oil-exporting developing countries is the belief that real interest rates would remain low and the rates of growth of income would remain highGoogle Scholar.
11 Mexico may buy back some of its loans from the banks, and pay 50 or 55 cents for each dollar of a loan. Mexico would pay for these loans by providing the banks with zero coupon U.S. government bonds that it would buy from the U.S. Treasury with some of its U.S. dollar assets. Thus Mexico would provide the banks bonds with a current market value of $2 billion to acquire loans with a face value of $10 billion. Mexico's current annual interest payments would decline in proportion to the decline in Mexican loans owned by the banks. For the banks, a key question involves the value placed on these bonds in the bank's balance sheetGoogle Scholar.
12 Prior to December 1987 the Bank of Boston had placed $330 million of its $1,000 million of non-traded related cross-border loans to developing countries on a non-accrual basis. Then in December 1987 the Bank of Boston placed an additional $470 million of these loans on a non-accrual basis, and at the same time, charged off an additional $200 million of these loans. As a result, the Bank of Boston has written off or reserved against 63 percent of its total loan exposure. The accompanying press release noted that even after these adjustments, the capital ratios are sufficiently high “to rank Bank of Boston among the strongest of the 15 largest U.S. bank holding companies.”Google Scholar
13 To achieve a U.S. fiscal balance the ratio ot federal debt in the hands of the public to gross domestic product must not increase on a secular basis. The ratio should increase in recessions and in periods when real interest rates are unusually high, and decline during expansions and when real interest rates are unusually low. In the long run federal debt in the hands of the public might increase at a rate of 2.5 percent a yearGoogle Scholar.
14 U.S. government receipts have increased in every year since 1983; receipts in fiscal 1988 are estimated to be 52 percent larger than 1983. Receipts have been increasing at the rate of ten percent a year. The U.S. government can outgrow its deficit if the growth in spending is restrainedGoogle Scholar.
15 The fact that the anticipated return on investments in the United States is higher than abroad shows that the United States is likely to be one of the most rapidly growing of the industrial countries. Hence, the direction of international capital flows enhances economic efficiencyGoogle Scholar.
16 The bottom is likely to become evident after one or two months of good news about the decline in the U.S. trade deficit. The distinction between a bottom for the U.S. dollar and the appreciation of the Japanese yen at a modest rate is the distinction between moving toward a trajectory, and moving along the trajectoryGoogle Scholar.