in the U.S. balance of payments will involve little or no surplus on the trade account not too many years in the future, unless the United States is to engage in very large capital exports or much larger aid contributions than are now foreseen-and both of these latter possibilities raise major questions of their own.

III. POLICY IMPLICATIONS

The projected balance of payments position of the United States shown in Table 8 is not such as to cause alarm. Nevertheless, it should not be the basis for complacency; in particular, the projection was based on an assumption that the United States will be successful in controlling inflation in the next five years, with the wholesale price index rising an average of just over 2 percent per annum. This, then, is the first and most important policy implication of our exercise: an official settlements balance in 1975 is very dependent on the U.S. ability to bring its inflationary pattern of the last half of the sixties to a halt.

Even if the United States is successful in restoring price stability, an equilibrium position in the balance of payments is by no means assured. What happens to our balance of payments obviously depends on economic trends in other countries as well as in the United States. If foreign countries have less inflation than indicated by our postulated 2.8 percent average per annum increase in foreign wholesale prices, then the U.S. payments position may come under strong pressures, with the merchandise balance slipping into deficit. On the other hand, foreign countries may be less successful in controlling inflation, in which case the United States may find itself with a sizable payments surplus in the not too distant future.

In the event of a sizeable imbalance in either direction, the question will arise as to whether the imbalance can and should be financed; whether changes in exchange rates should be made; or whether direct actions of one sort or another should be taken on the components of the balance of payments. These, of course, are the classical questions which arise in the event of payments disequilibria.

During the postwar period the workings of the international adjustment process have been something less than ideal. There is growing agreement that the adjustment process needs to be strengthened. Recent exchange rate adjustments have generated better balance among the industrial countries, and have underscored the need for prompter use of such measures in the future. Prompter and more symmetrical exchange rate adjustments abroad than have occurred in the past should serve to reduce speculative strains on the international financial system.

IV. ADDENDUM

The addendum addresses two questions. The first explores the cost of slowing domestic expansion in the U.S. to improve its trade balance in

1971. The second examines the effect on the trade balance forecast of errors in projecting the variables which determine U.S. imports and exports: U.S. income, prices and the unemployment rate and foreign income and prices. Both problems are explored using models which were developed for the Council of Economic Advisers to forecast the U.S. trade balance.1

One way for the United States to improve its trade balance is to slow the expansion of domestic demand. This reduces income available for expenditure on imports. It also reduces the domestic rate of inflation. so that U.S. goods become more competitive, both with imports and in foreign export markets. The U.S. unemployment rate increases as domestic demand is reduced and in some of the trade models used, this increase captures certain cyclical phenomena (not fully reflected in income and prices) which reduce the demand for U.S. imports and increase the supply of U.S. exports. Regardless of which model is used, we face a trade-off between reduced income and more people out of work on the one hand, and less inflation with an improved international trade balance on the other. The Council of Economic Advisers has provided the interrelationships among three out of four of these variables 2 (real income, unemployment rates and prices) while the effect of these three on the fourth (the trade balance) is explained using the trade model. These models did not consider (in their estimation step) the feedback effect of trade on the domestic variables. This omission is not serious, however, since trade is only about 4% of domestic production in the United States.

The trade-off problem can be resolved by answering the following hypothetical question: what reduction in U.S. real GNP, employment and price levels would be required to increase the U.S. trade balance by $1 billion in 1971? The Council estimates that a reduction of 1 percent in real GNP growth implies a 0.33 percentage point increase in the unemployment rate; this leads, in turn, to an ultimate reduction in the growth rate of the GNP deflator of 0.55 percent. We shall assume that this implies a reduction in wholesale price growth of about 0.30 percent.

We are now equipped to estimate the effect of these three changes on the U.S. trade balance. As noted in Mr. Houthakker's testimony, the U.S. trade model predicts that in 1971, a reduction of real GNP by 1 percent leads to an improvement in the U.S. trade balance of $650 million; an increase in the unemployment rate of 1 percentage point increases the trade balance by roughly $700 million; and a reduction in wholesale price growth of 1 percent leads to an improvement of $1,300 million. If we maintain the income-unemployment-wholesale price relationships, then a reduction of 0.79 percent in U.S. real GNP

'These models are discussed in Stephen P. Magee, "A Theoretical and Empirical Examination of Supply and Demand Relationships in U.S. International Trade,” a study for the Council of Economic Advisers, October, 1970.

I am indebted to Frank C. Ripley, Senior Staff Economist, for providing these estimates.

leads to a $511 million trade balance improvement; the unemployment rate increases by 0.26 percentage points, yielding a $183 million improvement; and the wholesale price index grows 0.23 percent slower, giving a $306 million improvement.

The sum of these three changes is an increase in the U.S. trade balance of $1 billion in 1971.3 This is accompanied by a reduction in GNP deflator growth of approximately 0.43 percent. These benefits, however, must be weighed against the reduction of real income in the United States of almost $6 billion and the loss of employment of more than 218,000 persons. It should be emphasized that these calculations represent the most optimistic forecast of the reduction in income and employment required to achieve a $1 billion trade balance improvement.

The trade models which do not include the unemployment rate as an explicit determinant of trade require that real income and employment fall even more. The model without unemployment rates has the same impact multipliers on the trade balance as the previous one for 1 percent reductions in real GNP growth ($650 million) and wholesale price growth ($1,300 million). Thus, in order to get a $1 billion improvement in the U.S. trade balance in 1971, real GNP must grow 0.96 percent slower, the GNP deflator 0.53 percent slower, wholesale prices 0.29 slower and the unemployment rate must rise by 0.32 percentage points. This translates into a $7.3 billion reduction in real GNP and an increase in unemployment of almost 270,000 persons.

In short, manipulation of the domestic economy in order to obtain a $1 billion improvement in the U.S. trade balance in 1971 comes at a high price. While growth of the GNP deflator is slowed by 0.43 to 0.53 percent, there is a reduction of real GNP by $6 billion to $7.3 billion and a loss of between 218,000 and 270,000 jobs. These decreases in real GNP imply an average reduction in real income of between $70 and $87 per member of the civilian labor force.

The second portion of this addendum considers the effect on the trade balance forecasts of errors in projecting domestic and foreign variables. In the models with unemployment rates, the country model forecasts a trade balance of $633 million and the (five category) commodity model forecasts $1,450 million in 1975. Because of the conceptual superiority of the country model, it is used in the calculations in Table 1. The level of each variable in 1970 is shown in column (2). Column (3) shows the assumed growth rate of the variable to 1975 and column (4) its level in 1975. The information in column (4) implies the 1975 trade balance of $633 million. Column (5) shows how much this forecast changes if we reduce the variables in column (4) by 1 percent (or 1 percentage point in the case of the U.S. unemployment rate). Column (5) is roughly symmetrical so that it can be applied both to increases and decreases in the variables.

Table 1 allows the reader to make his own forecast of the 1975 U.S. trade balance. For example, if one feels that U.S. GNP will grow by This sum of $1,000 million equals 0.79 (650) + 0.26 (700) + 0.23 (1,300).

4.8 rather than 5.2 percent between 1970 and 1975 (holding the other variables constant for simplicity), then the level of the GNP index falls 1.9 percent from 209.3 to 205.2 in 1975. This implies a U.S. trade balance of $2,800 million-the base projection of $633 million plus 1.9 times $1140 or $2167.

In summary, the model is sensitive to income and price developments, especially the latter. The level of the U.S. trade balance in 1975 depends heavily on the ability of both monetary and fiscal policy to reduce inflation in the U.S. Unless some success can be found in obtaining full employment with low rates of inflation it may be difficult to achieve both internal and external equilibrium. Of course, the results of both exercises in this paper should be viewed in perspective: we have considered only one of several accounts in the balance of payments; we have not specified what mix of monetary and fiscal policy is used in restraining domestic demand in the 1971 simulation; and we have used only one of several conceptual approaches to the relationship between domestic income, prices and the rate of unemployment in that exercise.

TABLE 9.-The Independent Variables and Their Effect on the
U.S. Trade Balance in 1975

[Projected United States trade balance in 1975: $633 million]

A compound average rate of growth of 4.8 percent from 1970 to 1975 yields (162.2) (1.048) 205.2.

THE BALANCE OF PAYMENTS OF THE
UNITED STATES AND OTHER COUNTRIES:
AN EQUILIBRIUM VIEW

By Lawrence B. Krause

1. STRUCTURE OF WORLD BALANCES 1967-68. II. BASIC TRENDS
OF THE 1970s. III. THE STRUCTURE OF WORLD BALANCES IN
1975. IV. ALTERNATIVE ASSUMPTIONS. V. CONCLUSIONS AND
IMPLICATIONS.

The recent history of the international economy strongly suggests that everyone's welfare is furthered when a single country assumes responsibility for managing the system as a whole. The record of economic growth and international stability both before World War I, when Britain performed this function, and after World War II, when the United States predominated, stands in sharp contrast to the inter-war years when irresponsible economic nationalism prevailed. As we look forward to the first half of the decade of the 1970's, it appears inevitable that the United States should continue to serve in this role. The foreign sector of the United States has relatively little direct consequence on the economic welfare of its citizens compared to other countries, yet it is extremely important in the world economy. Thus the United States has both the necessary power and the ability to make use of it.

In its role as economic leader, the United States predominates as the world's largest banker, investor and trader, but in different relative degrees. In its banking and investing functions, the United States is without a close rival. U.S. banks operate a worldwide system making the dollar the best currency for international and even for domestic transactions in many places outside the United States as well as at home. Many American business firms have expanded their direct operations abroad so that they have become truly international in outlook and together with some foreign-based enterprises comprise the phenomenon of world production so often recognized of late. Also equities and debt issues of American corporations have increasingly become the chosen vehicle for investment by foreign savers helping to build a universal capital market with great depth. The U.S. trade position, however, is not as strong as was once the case. While still the world's largest, some

Lawrence B. Krause is a Senior Fellow at the Brookings Institution. The views expressed are those of the author and do not necessarily represent the views of the trustees, the officers, or the staff members of the Brookings Institution.