In the bank's 1986 Annual Report, we spelled out the close relation between this country's federal budget and foreign trade deficits. Basically, the difference between what the United States saves and what it invests is foreign capital. The supply of foreign capital is measured by our foreign trade deficit. So, if we want to diminish our reliance on foreign capital, that is, lower the trade deficit, we must either raise national savings or lower domestic investment. We argued that the most effective way of raising national savings is to lower the federal budget deficit.
Two years have now passed since we first presented this analysis. How have events played out? And, more importantly, where do we go from here?
To date, developments have generally been favorable, perhaps more favorable than initially expected. Specifically, the budget deficit has declined significantly from its 1986 peak, largely as a result of the spending restraint embodied in the 1986 Budget Resolution and "enforced" by the Gramm-Rudman-Hollings Act. At the same time, there has been modest improvement in our trade balance and further appreciable expansion in domestic investment. The performance of the overall economy in 1987-88 was good, and the expansion was distinctly better balanced than in its first years.
Recent experience does not suggest, however, that somehow during the past two years we evaded the strictures of the unpleasant arithmetic that binds budget and trade deficits and the "savings surplus" (the difference between domestic savings and investment). Rather, a key ingredient in this positive performance was the significant reduction in the federal fiscal deficit. Such a reduction permitted investment and trade to improve in tandem.
If further progress along these general lines is to characterize the economy this year and next, additional, sizable reductions in the budget deficit must be achieved. If not, progress on the trade front will be arrested and/or investment will be inhibited, unless domestic savings rise fortuitously.
That is, further action to reduce the government deficit can help to sustain a balanced expansion that encourages, among other things, persistent declines in the trade deficit. And, with the economy operating close to capacity, additional fiscal restraint is appropriate to moderate demand and temper inflationary pressures.
Furthermore, since the economic well-being of future generations depends, in part, on investment decisions made today, a smaller budget deficit potentially can contribute to higher living standards in the future, to the extent that it promotes a favorable investment environment. Unfortunately, a preliminary reading on this situation is not encouraging at this time. The Congressional Budget Office has estimated the baseline federal deficit for fiscal year 1990 at about $150 billion. The recent agreement between Congress and the Administration appears to produce less than $10 billion in real reductions in the year ahead. To the extent that we are concerned about the future prosperity, we should continue to reduce the still wide imbalance in our federal fiscal affairs.