No.35
Governmegt Expeitditure aRd the Balance of PaymeRts:Budget Deficit, Financial Integration, and Economie Diplomacy
Hireshi Shibuya
November 1996
Department‑ of Otaru University
Economics of Compterce
i
Government Expenditure and the Balance of Payments:
Budget Deficit, Financial lntegration, and Economic Diplorriacy"
by
Hiroshl Shlbuya
Departri3ent of Ecenomics Otaru Univer$ity of Commerce
November1996
CotTespondence to: Hiroshi Shibuya, Departrnent of Economics, Otaru University of Cor!3r!3erce, Midori 3‑5‑21, Otaru, Hokkaido 047, japan; Domestic Fax: Ol34‑27‑‑5213;
lnternational Fax: 81‑134‑‑27‑5213; E‑mail Address: shibuya@otaru‑uc.ac.jp
" Thi$ is a revised version of the paper preseRted at the international conference on
Evolving Roles of Governrnent in japan and the Unlted States, held in Washington,
D.C., August 30, G996. Iwould like to thank the following people for helpful corr;rrients
and suggestions: Masao Satake, Megumi Suto, Hiroo Hojo, and participants at the
conference. I would also like to thank my former colleagues at the International
Monetary Fund for helpful discussions. This research was supported by a grant from
the Japane$e Ministry of Education. As usual, responslbility for any errors and
Abstt'act
This paper studies the internationai and intertemporal implications of increased governraent expenditure. First, it reviews the conventional proposition that increased gevernraent expenditure raises interest rates, crowds out investment, and reduces growth. Then, it shows that this proposition does not necessarily hoid in an open economy with integrated international capital rRarkets. This creates a possibility of the strategic intertemporal rnacroeconoraic policy, which minimizes the adverse effects of increased government expenditure on macroeconornic performaBce. En particular, a country can use economic diplomacy ln such a way that government expenditure does not affect its interest rate and potential national income. It offers a new interpretation of the U.S. macroeconomic policy and economic diplomacy toward Japan in the 1980s and 1990s.
Keywolds: government expenditure, balance of payments, financial integration, econoreic diplomacy, U.S.‑japan economic relations, twin deficlts
JEL C/assification: E6 F4
'
1. lntroduction
The U.S. econemy was characterized by the so‑‑called "twin deficits" in the 1980s: the combination of a large budget deficit and a large current account deficit in the balance of payments. AR increasing nurnber of economists expressed concern about the adverse effects of the large budget deficit on the growth of the U.S, economy.
'They also worried abeut the external position of 'the U.S. economy because of the stronger dollar and the mounting deficit in the current account of the balance of payments. Morris (4985), for example, warned that the "twin deficits" if left alone would end with a hard landing of the U.S. economy: namely, the dellar would fall very sharply and, as the confidence in the dollar ebbed, a strong upward pressure on U.S. interest rates would lead to a recesslon in the URited States.
The U.S. economic pollcy makers, therefore, faced the following chailenge: how to deal with the problem of the budget deficit in the preseRce of the current account deficit at the same time. It is important to recognlze, in this context, that the budget deficit and the current account deficit are closeiy related phenomena, particularly, with the financial liberalization and globalization ofthe 1980s. Iwill argue that the financial integration of international capital markets has made it posslble for the U.S. policy makers to exploit the relationship betweep government expenditure and the current account, and to use eceBomic diplomacy as an effective means to deal with the adverse effects of the budget deficit. The sklllful use of econornlc diplomacy has enabled the United States to initially allow the budget deficitto expand and then reduce it without causing serious swlngs in the business cycle in the medium run and without adversely affecting its potential national income in the Iong run.
Thi$ paper studieS the internatioRal and intertemporal implicatioRs of increased
government expenditure, and presents a new interpretation of the U.S. macroeconomic
policy and economlc dipiorr3acy toward Japan in the G980s and G990s. The conventional
idea is that a rise in gevernment spending will ralse interest rates, crewds out investment,
'
and adversely affect economic growth. This relatioBship holds in a,closed econorny and suggests a substantial macroeconoraic cost to the large govemment or the welfare state. However the financial integration of the world economy that took place in the
1980s has modified this conventional relationship at least ln the medlum run. It has created a new possibllity of reducing the adverse effects of increased government expenditure through intertemporal macroeconomic policy in combination with economic diplomacy. Therefore, we need to reexamine the relationship between government expenditure, interest rates, and economlc growth frora the intertemporal as well as international perspectives.
The macroeconomlc implicatiens of governrnent spending depend en whether the economy is an open or closed economy. They also depend on whe{her eapital is free to move across borders. This paper argues that the conventional relationship does not necessarily hold ln an open economy with lntegrated international capital markets at least in the medium run. It presents a theory of the strategic lntertemporal macroeconomic pollcy, which uses economic diplomacy as an additional policy
instrument and adopts an intertemporal approach to minimizing the adverse effects of increased government spending. 1apply this theory to the recent U.S.‑Japan economic relations and offer a new interpretation ef the U.S. rdacroeconoraic policy and economic diplomacy toward Japan in the 1980s and 1990s.
The rest of this paper is organized as follows: Sectlon 2 reviews the
conveBtional proposltion that increased gevernment expenditure raises interest rates, crowds out investrrieBt, and reduces economic growth. SectioB 3 shows thatthis conventicnal proposition does Bot necessarily hold in an open econorny with integrated international capital markets. Deveioping this analysis further, section 4 shows that a country can use economlc diplomacy in such a way that government expenditure does
2
not affect the ln{erest rate and thus its potential natioBal income. Based on thls posslbility, section 5 presents a theory of the strategic intertemporal rriacroeconomic policy which reduces the adverse effects of lncreased government expenditure, Section 6 argues that this theory offers a new interpretatioB of the U.S. macroeconomic policy and economlc diplomacy toward Japan. Section 7 concludes this paper, pointing out a "fiscal externality" in the world economy and the need for international
coordination of fiscal policies.
2. GovernmentExpendltureandMacroeconomicPetformance
The conventional idea ls that although increased government'spending raises national income in the short run, lt crowds out private investment through higher interest rates and therefore adversely affects economic growth in the Iong run. To see this, consider the following simple raodel of a closed economy:
y,=c(yt)+i(rt)+g, (1)
mt :m(yt, rt) (2) YP, :YP( i,.,) (3)
where y represents real natioBal incorrie <GDP), c real prlvate consumption,ireal private investment, g real governrnent expenditure, r the real interest rate, ra real money supply, and yP the potential level of real national income, which depends on the past investment. AII variables ln this paper represent rea/ variables. I make the following standard assumptions: O<dc/dy<1,co<di/dr<O, O<dyP/di<1, ray >O, and m, <O.
Idistinguish between the short‑, mediurn‑, and Iong‑‑run equilibrium as follows:
The short‑run equilibrium refers to the economy at the beginning of period twhere y,
and q arejointly determined by equations (1)and (2). In the short run, na{ional income
can deviate from its potential level. This corresponds to the standard ISILM model.
The medium‑run equilibriurri refers to the economy at the potentiaHevel of natienal income at the end of period t (y, = yP,) where the interest rate (r, ) is determined by equations (1)underthe condition of y, = yP, = yP( i,.,) = yP( i(r,.,)) where r,., is given. The long‑‑run equilibriura refers to the stationary economy (y=y"(i)=y"(i(r)) where the real interest rate (r) is determlned by equations (1) and (3).
The important characteristics of this model are the following: The model has two endogenous varlables y and rin the short run, two endogenous variables r and m in the medium run, and three endogenous variables yP, r, and rn in the long.run. National income (y) is determined by the demand side or equation (2) in the short run, while it is determined by the supply side orequation (3) in the medium and long run. Real money supply (rn) is exogenously given in the $hort run, while it is endogeRousiy determined by equation (2) in the rRedlum and long run, glven y=y" and r. The presumption here is that the price will adjust so that reai rrioney supply will sa{isfy equation (2) in the rriedium and long run. Finally, the real interest rate (r,)can differfrorri r,‑, in the medium run, while the real interest must be constant in the long run.
Now, with the closed econorny model of equations (1)‑(3), it is straightforward to prove the following proposition:
Proposition 1 (Closed Economy): An iRcrease in governraent spending raises national income and the interest rate in the short run. However, lt raises the interest rate further and crowds out private investment in the raediurn run. Therefore, it reduces the potential Ievel of national income in the long run.
This proposition has an important policy irnplication for the countries that set the welfare state as a national goal. It implies that the pursuit of the welfare state will increase governmeBt expenditure and raise interest rates. It wilKherefore crowd out
4
private investment and reduce the potential level of national income in the long run.̀
This has been the typical macroeconomic situation in which rnany European countries found themselves ln the f970s and the 1980s. It also applie$, perhaps to a iesser extent, to the economies of the United States and Japan in more recent years.2 Proposition 1 thus lead$ to the following policy prescriptlon:
Corollary 1 (Policy lrriplication'of Proposition 1): A couBtry must control govemndent expenditure associated with weKafe programs if it wants to avoid a crewding‑‑out of private investment and a fall .in the potential level of national income in the Iong run.
The poin"s {hat if the implementa{ion of many welfare programs comprornises
economic growth, it will put the very foundation of the welfare state at risk.
Propositlon 1 represents the cenventional view on {he relationship between government expenditure, interest rates, and economic grewth. A new development in the 1980s, however, has created a need to modify the conveBtional view. The financial liberalizatlon and globalization, which have advanced very rapidly since the early 1980s, Ied to the integratien of international capital markets. Capital began to move freely across borders. This Rew development has forced economists to reexarRine
macroeconomlc events and policy issues frorn lnternational and intertemporal perspectives.3
t Welfare program$ also affect economic growth because they undermine self‑
reliance and the incentive to work (OECD, G994). They also encourage free‑riding behavior and becomes an income support system with special interests making any effective reform very difficult (Roberti, 1989).
2 Tanzi and SchukRecht (1 995) and Kawai and Onitsuka (1996) provide some empirical evidence that support Propositlon 1.
3 Frenlsel.and Razin (1992) present a general theory of intertemporal
macroeconomlcs ln an open economy.
3. GovernmentExpenditureandtheCurrentAccount
Nextlconsider the macrceconomic effects of increased gevernrrient expendlture in an open economy with integrated international capital markets. The purpose here i$ to examine how the financiai developrnents of the 1980s have modified the conventioBal relationship stated in the prevlous section. The first implication of
i'ntegrated international capital markets is that the bapital account and therefore the current account of the balance of payments could substantlally deviate frorri zero in the mediurn run. That is,‑ in the fundamental equation of the balance of payments (ca, + ka,
= O), it has becorne possible for the current account and the capital aecount to have the followiBg relationships:
cq=‑keq<<O or ca,:‑ka,>>O (4)
where ca represents the current account and ka the capital account. Double
inequalities indicate a substantial deviation from zero. Since financial llberalization and globalization started in the early 1980s, the U.S. current account imbaiance has risen and reached 4 percent ef GDP. It was less than 1 percent of GDP before 1980.
The second implication of integrated internatioRal capital rriarkets is that arbitrage should link the interest rates of industrialized ceuntries. In particular, international arbitrage should establi$h a parity between interest rates and the exchaBge rate and equalize real interest rates across countries. It is straightforward to prove that real interest rates will be equalized lf the purchasing power parity holds iB the international goods markets and the interest r;ate parity holds in the lnternational capital markets. In other words, if the world economy has both highly integrated international goods and capital markets, the real interest rates of all countries would converge to a common world interest rate. In this case, we could treat the interest rate
6
of each country as given by the world interest rate.
Now consider the fellowing simple model of a small open economy:
yt :c(yt)+i(rt)+gt+ca(yt, y"t, et) (5)
rn,=m(y,, r,) (6) YPt :Y"<i,.t) <7)
where e represents the real exchange rate and y" the foreign real national income. We make the foliowing assumptions: cay(y, y'", e)<O, ca,.(y, y", e)>O and ca.(y, y', e>>O. A rise in e represents a depreciation of the exchange rate, which increases the current account. The last condition corresponds to the Marshall‑Lerner condition. Now assume the potential level of GDP (y = y") and integrated international capital markets (r = r' where rf represents the werld interest rate) so that the exchange rate <e) and real moRey supply (rn).become the endogenous variables in the rnediurn and long run.
Then, an increase in governrnent spending (g) will lead to a fall in the current account (ca) by the same arnount through appreclation of the exchange rate (e). Therefore, in the case of a small open econerny wlth integrated international capital markets,
increased government expenditure wlll not result in the crowding‑out of private investment. Here, unllke the case of a closed econorny, an increase in government spending will not adversely affect economic growth.
To sum up, in the small open econorny ef equatlons (5), (6), and(7), we have the following relationship underthe conditions of y=yP and r=r":
d(ca)/dg = ca.(.) de/dg = ‑ 1 (8)
where the change in the current account is produced through a change in the exchange
rate. The same condition (8) also holds in the short run because y must remain constant
in equation (6) given r = r* and m :constant in the short run, Therefore, frorri this relationship, it is straighttorward to derive the following prepesition:
Proposition 2 (Small Open Economy): With integrated international capital rr}arkets,
a rise in govemment spending leads to a fall in the current account through
appreciation of the exchange rate in the short and medlum run. It does not affect the interest rate and therefore potential natiohal income in the long run.
This proposition implies that a country can lncrease governrnent spending without a higher interest rate and the crowding‑out of private investrRent in the short and medium run. The financial integration of international capital rnarkets has, therefore, changed the validity of the conventlonal relationship.
Proposition 2 also implies that fiscal policy has become less effective as a means of stimulating the econorny. In fact, lt is easy to see in the above model that dy/dg = O in the short run, given r=r' and m=constant. In an open economy with integrated internatlonal capital markets, the effect of governraent spending will appear in the current account, which wili offset the increased aggregate demand produced by the initial govemment spending. Thatis, it does Bot produce a Keynesian multiplier effect on output. Therefore, the fiRancial liberalization and globalization of the A980s have made fiscal poiicy Iess effective as an instrument of stabllization policy.̀
4. EconomicDlplornacyasMacroeconomlcPollcy
The above discussion has e$tablished a close link between government expenditure and the current account, which has been strengthened by the financial integration of the world econorfiy. Now this link exists Rot only ln a home country but
̀This, of course, is the well‑known impllcatlon of the Mundell‑‑Fleming rnodei.
8
also in a foreign country. Moreover, a home country's current aocount deficit is a foreign country's surplus. These relationship$, combined together, create an international Iinkage between government expenditures, and rnake economic diplomacy as an
important instrument of macroeconorriic pollcy. For example, if a country can induce the other country to reduce gevernment spending through ecenomic diplomacy, then
it will become possible for the country to increase its government spending without causlng a higherinterest rate and thus reduclng lts petential national income, IB short, a forelgn country's govemment expenditure becomes an important instrument of macroeconomic policy through economlc diplomacy.
Let rae elaborate on this polnt further, using a simple two‑country model of the world economy. Consider the following model of the world ecohomy, which censists of the United States and Japan:
America: y= c(y)+i(r) +g+ca(y, y", e) (9)
Japan: y'=c(y'k)+i(r")+g"+ca(y'le, y, e*) (1 0)
where e" :11e. Herelhave omitted m and m' as well as yP and yP" equations and also tirae subscripttfor sirnplicity. They are, however, irnplicit in the model. In the medium run, with integrated international capital rriarkets, the world interest rate (r"=r) and the exchange rate (e) essentially become the two eRdogeRous variables of the rnodel.5 As one counby's current aocount surplus is the other country's deficit in the two‑‑
country model, we can derive the following two fundart3ental equatioBs from the above modei:
5 To be precise, m and rn' also are endogenous variables of the full However, they are not essential for the present purpose.
model.
ca(y, y", e) = ‑ ca(yee, y,1/e) (")
y + yt = c(y) + c(y") + i(r) + i(r") + g + g* (12)
Now we have y :yP and y'=yP' iR the rnediurn run, and r:rt with integrated international capital rnarkets. Frorn these equations, it is easy to see that equation (M) determines the equilibrium exchange rate, twhile equatiofi (12) determines the equilibrium world lnterest rate ln the medium run.
The important irr)plication of this model is that two countries can "swap" their goverBment expenditures (dg = ‑ dg") without affecting their interest rates in both the short and medium run and therefore potential natioBal incornes in the Iong run. For example, the United States caR reduce its government spendlng without affecting the interest rate and potential GDP if Japan increases its government spending by the sarne arnount. Conversely, the United States can increase its government spending without affecting the interest rate and potential GDP lf japan reduces its government spendipg. Thls is because swapplng goverRment expeRditures (dg = ‑ dg") will leave the rest of the equation$ unchanged so that we have drldg = de/dg :dy/dg =O under the condition of dg = ‑dg". Consequently, the following proposition holds fora large open econorayl
Proposition 3 (Large Open EconorRy): ln the shert and rnediurn run, with integrated international capital markets, if a country can induce the other country to reduce (increase) governmen{ spendlng through economic diplomacy, it can increase (reduce) its own govemment spending without affecting the lnterest rate and potential national
mcome.
It ls lmportant to recognize, however, that this proposition holds only in the short
fo
and medium run. In the long run, the current account rnust be in balance: that is, ca
･= O must hold as the long run average. Therefore, the same proposition rnust hold as proposltion 1 in the long run. This slrnply reflects the fact that a country cannot keep accurnulatlng current account deficits or capital account surpluses indefinitely.
Therefore, we have the followlng propositieB:
Proposition 4 (Large Open Economy>: tn a large ope'n economy, a rise in governrnent spending Ieads to a rise in both national incomes and the world interest rate in the short run. However, it raises the interest rate further and crowds out private iRvestrnentin every country in the mediurn run. Therefore, it reduces growth ef the world econorny in the long run.
This proposition impKes that even in an open econorriy with integrated international capital markets, controlling government spending will be important for maintaining econoraic growth in the Iong run. This proposition should not be surprising once we recognize tha{ the world economy as a whole is a closed ecoRomy. Therefore the proposltion 1 that applies to a closed economy should also apply to the world economy as a whole. However, there is one irnportant difference: The effects of increased government spending in one country will now spill over to other ceuntries in an open ecoBcmy. This creates a "fi$cal externallty" iB the world econemy, lwill return tc this point ln section 7.
5. AStrategiclnterteraporalMacroeconomicPolicy
The propositions in the preceding sections irr}ply that the financial integration of
international capital markets that took place in the 1980s has made economic
diplomacy as an important lnstrument of macroeconomic policy. Before the financial
integratioR ef international capital markets, increased government expenditure would have crowded out prlvate investment and reduced grewth (Proposition 1). However, the intematienal financlal integratlon has made it possible for a country to increase government spending without crowding out private lnvestment and reduclng economic growth (Proposition 2). This is because the country can finance its budget deficit with the inflow of foreign capital at least in the raediura run. Moreover, the international financial integra{ion has created an international linkage between government expenditure$.
Now, in this new international economic environment, the policy makers can develop a strategic macroeconomic pollcy in the following two stages: Suppose that country A ends up with a huge budget deficit for one reasoB or another.6 ln the first stage, in an open economy with iRtegrated internatlonal capital markets, country A can avold higher domestic interest rates and lower private lnvestment if lt caR induce country J to reduce its government spending. In the second stage, coufitry A can reduce its budget deficit without causing an economic recession if it can induce country J to expand governmeBt spending through econoralc diplomacy. If {his $cenario works,
then country A can prevent its budget deficlt frorn adversely affecting its macroeconomic performance in the short, medium, and Iong run. In other words, country A can increase its budget deflcit without crowding out private investment in the first stage. Then It can reduce its budget deficit without an economic slowdown in the
6 Persson and Svensson (1989) present a theory of public debt in which the incumbent policymaker uses public debt to influence the policy choices of future government. They argue that a conservative governri3ent such as the Reagan
adrr}inistration in the 4980s had a strategic bias toward budget deficits, while a liberal governrnent would have the opposite bias toward budget surpluses. Also, Alesina and Tabellini (1 990a, 1990b) argue that the alternating governments who disagree over the composition of pubiie spending tend to create a budget deficlt. This is because both governments perceive the same incentive to restrict next period's public consumption by borrowing more ln the current period. In this case, there will be a bias toward larger budget deficits, whichever goverBment is in pewer.
12
second stage. Such macroeconorgic policy is "strategici' because it uses economic diplomacy as an essential pollcy instrument.7 It is "interternporal" because it comprises a two‑stage policy program.
6. The U.S. Economic Diplomacy toward Japan
The theory of strategic interterrtporal rnacroeconomic policy provides a new interpretation of the U.'S. macroeconoraic policy and economic diplomacy toward Japan in the 1980s and 1990s.8 The United States started pressuring Japan to implement financiaHiberalization and globalization in the early G980s. It was the $ame time when the United State$ was expandlng its budget deficit and Japan was consolidating its fisoal position (FrankeM984). This resulted in a sizable appreciatioB of the dollar and a large U.S. current account deficit. In the second ha[f of the 1980s, the United States pressured japaB to "open up'' its markets beyond capital markets.9 ln 1989, with the Structural lmpediments lnitiative talks, the United States pressured Japan to increase government spending by 430 trillion yen (then equivalent to over 3000 billion dollars) during the G990s. It was followed by the 1993 Economic Frarnework talks under the
7 This scenario irnpllcitly assurr}es asyrrirneby of econornic knowledge and diplomatic skills between the two countries. This seems to have been the case for the bilateral economic relationship betweeR the United States and Japan in the 1980s and G990s. It is anotherquestion, however, lf such asymrrietry will continue te exlst in the future.
8 Most of the asses$ments of the international adjustment and financiBg during the 1980s lack the intertemporal and strategic perspectives thatlhave presented in this paper. See, for exarv3ple, Bergsten ed. (1991).
9 Opening Japan's rRarkets has multiple purposes: First, it helps increase American exports. Second, it helps stop further strengtheniRg of the yen that followed after the Plaza Accord. Third, most importantiy frorn the viewpoint of this paper, it accelerates the convergence of the real interest rates between the two countries.
Recall that the equalization of real interest ra{es requires the international integratien
ef not only financial markets but also goods markets (section 3).
Clinton Administration, which set an explicit goal of reducing japanis current account surplus frern 3 percent to 1･‑2 perceRt of GDP by 1996.iO These actual developments correspond very well to the strategic intertemporal raacroeconomic policy described in the previous sectien.
The U.S. economic diplomacy to "open up" Japan's financial market started in the early 1980s. IB 1983, U.S. Treasury Secretary Regan and Japanese FinaRce Minister Takeshlta agreed to eight specific measures regarding financial market liberalization in Japan. They set up an ad hoc Yen/Dollar Working Group to rr}oBitor progress in lmplerrientlng those rneasures. The measures fell into the following four categories: (1) Liberalization of japanese barrlers against the inflow and outrflow of capital, (2) internationallzation of the yen, (3) more favorable treatment of U.S. financial institutions wishing to conduct business in Japan, and (4) deregulation of domestic Japanese capital rnarkets, allowing more lnterest rates to be market‑determined rather than fixed by the governrnent. Accordlng to Frankel (t984), the United Stated got almost all it asked for, at least in the first three categories.
In the Structural lmpediments lnitiative talks that started ln 1989, the Unlted States requested Japan to increa$e government spendiBg by 430 trillion yens (over 3000 billion dollars) during the ro years beginnlng 1991. Mo$t people in japan viewed this demand as an atterapt to reduce the current account imbalances by increasing Japane$e imports through the Keynesian muitiplier effect on national income.
However, with integrated international capitai markets, an increase in government spendlng (dg") results in the corresponding decrease in the current account (‑ d(ca")) through a yen appreciation. In otherwords, the decline,in the current account will offset the increase in the effective demand iBitiated by governrnent spending. Therefore,
̀O Bergsten and CIIne (a985), Cline (1989), Bergsten and Noland (1993), Tyson (G 992) offer supporting arguments for the U.S. trade policy.
14
increased government spending would not produce the desired Keynesian multiplier
effect.
Moreover, the decline in the japanese current account means the corresponding increasd in the U.S. current account (in the two‑countiy rriodel). This implies that the U.S. effective demand will not decline even if the United States reduces its budget deficit by the same amount. If the United States tries te reduce its budget deficit by itself, it will bring about a U.S. economic slowdown. However, if the United States can induce Japan to expand government $pending through economic diplomacy, it will be able to cut the U.S. budget deficit by the amount of increase in the U.S. current account orthe amount of increase in the Japanese government expenditure. The United States can achieve this without causing a higher interest rate and an economic slowdown.
I believe that this is the true reason why the United States has insisted on the expansion of the Japanese government spending and the reduction of the U.S."apan current account imbalance. That is, the real problem forthe U.S. policy makers was not the Iarge U.S. current account deficit itselC but the fact that the large current account deficit rnade it more dlfficult fer the UBited States to reduce its budget deficit. In other words, the real problem for the United States was not its trade deficit with Japan per se, but it was the domestic politloa1 and economic diracuities it would face if it attempted to reduce its budget deficit. Reducing the current account deficit by pressuring Japan
to expand its government spending provided the United States with the most convenient means to reduce the U.S. budget deficit without causing a U.S. economic slowdown.
This resolves the puzzle why the United States inslsted on the reduction of the current account imbalance, although the U.S. deraand was apparently nonsense from
the viewpoint of pure econornic theory. Economic theory tells us that a c' urrent account
deficit is a problem only if it is unsustainable in the long run. Few economists thought
that the U.S. current account deficit had reached an unsustainable level. Therefore, the U.S. current account deficit posed Ro $erious preblem from a theoretlcal point of
view. Moreover, the current account deficit was desirable in the sense that intertemporal welfare maximization required medium‑･run current aqcount imbalances.
In fact, the United States weuld have suffered from higher interest rates and slower economic growth in the G980s if lt had prevented foreign capital from financing its budget deficit and its current account deficit from rising.
Nevertheless, the United States started to demand strongly the reduction of the U.S.‑japan current account imbalance in the late 1980s and the expansion of {he Japanese government expenditure in the1990s. Why? There seem to have been both political and economic reasons. First of all, raising taxes er cutting expenditures would have been politically undesirable in the 1980s forthe reasons of domestic politics. The U.S. po"cy makers therefere had to adopt a policy of initially allowing the budget deficit to expand, while rriinirnizing lts adverse effects. They could accorripli$h this, first by liberalizing international capital raarkets in the 1980s and then by iRduciBg Japan to expand governmeRt spending in the a990s. Second, demanding Japan to open lts rnarkets and reduce its trade irnbalaRce with the United States was more popular arnong Arnerican voters than raslng taxes and cutting expendlture. This strengthened the political $upport for demanding Japan to reduce the trade imbalance by expanding its government spending. At the same tirne, it helped persuade Japan {o accept the demand te expand governraent expenditure in order to avoid protectionist moves in the U.S. Congress. Third, a reduction of the U.S. current account deficit by expanding the japanese government spending would help reduce the U.S. budget deficit without adverse effects on the U.S. economy, TherefQre, it made petfect sense for the U.S.
policy makers to demand that Japan reduce its trade irr;balance by expanding government expenditure iB the G990s,
16
7. Concluding RerRarks
Most of the popular econornic problems that concern both the United States and Japan revolve around trade issues. They include overshooting of the yen/dollar exchange rate, Japanese distribution systera, access to the Japanese market, industrial groups called Keiretsu, and industrial policy.it These issues are lmportant. However, a more important iss"e for both countries concerns the long‑run effects 6f government spending pn macroeconomlc performance. The point is that the expansion of government speBdlng will crowd out lnvestment through higherinterest rates and adversely affect economic growth.
As Krugman (1994) has pointed out, the main source of economic welfare is productivity grow{h: "Productlvity isn't everything, but in the long run it is almost everythiBg. A country's ability to irriprove lts $tandard of living over tirne depends almost entirely on its abiKty to raise its output per worker." This proposition is true whether we are talking about a closed or an open economy and whether we are talking about Iiberalized or regulated international capital markets. The irrtportant issue is
therefore how to prornote growth through economic policy. In this context, macroecenomic policy becomes particularly lmportant because of the recognition that an increase in governraent spending will crowd out private investment and deter economic growth,
The appropriate rnacreeconoraic policy, however, depends on whether it is a closed economy or an open economy and whether it has an integrated international capltal market. In a closed economy, the appropriate policy is straightforward: Control governraent expenditure so that it wi" not raise interest rates, crowd out investment, and deter economic growth. In an open econoray with integrated international capital
"These issues are dlscussed iR Krugman ed. (1991).
markets, however, raacroeconoriiic policy becomes more complicated because of its intertemporal and international implications.
The major question that the U,S. policy makers faced in the 1980s and i990s was how to minimize the potentially adverse effects of the huge budget deficit on growth. The right answer turned out to be a$ follow$: First, liberalize aRd integra{e intemational capital markets so that the United States can borrow capital from abroad, particularly from japan,‑to finance the U.S. budget deficit without causlng higher doraestic interest rates and crowding‑out of investment in the 1980s. Second, persuade japan to expand it$ governraent expenditure so that the United States could swap budget deficits with Japan in the 1990s. This scenario of strateglc intertemporal macroeconomic policy could inltially allow the U.S. budget deficit to expand and then reduce it without serious adverse effects on the growth of the U.S. econemy.
A question arises, however, whether this scenario of strategic intertemporal macroeconor¥3ic policy would briBg benefits to the japanese economy. First of all, the fundamental fact about Japan is that its population is aging rapidly and welfare‑related expenditures are expected to rise in the next few decades. FiBding ways to control government expenditure is almost certaln to becorRe a major economic and political issue in Japan. Moreover, fiscai policy has become ineffective in stimulating the economy with integrated international capital rnarkets. Therefore, it is .difficult to argue that japan should substantially expand government spending in the 1990s, despite the fact that the country remalns trapped in a prolonged recession. The main rriessage of this paper is that poiicy makers must consider the international and intertemporal implications of their macroeconomic policy actions. Iwonder if Japanese policy makers have beeB fully aware of the implications of the strategic interteri3poral macroeconomic policy.
Finally l would llke to point out a i'fiscal externalityi' problem and the resulting
18
need forinternational coordination of fiscal policies. It is true for both closed and open economies that increased government spending will adversely affect economic growth in the long run. However, there is an important dlfference between the two cases: IB a closed economy, the adverse effects of increased government spending will appear within that economy. This gives the gevernment an incentive to be careful about its own fiscal policy and its effects. In an open econoray, however, the impact will spill ever beyond the border so that the country can "export" the adverse effects of its increased governmeBt spending to other countries. It creates a "fiscal externality" in the world economy. Each government has less constraints in an open economy than in a closed econorny to expand government spending. This in turn implies a greater need for fiscal policy coOrdination among countries as the world economy is becoming more and more open and integrated. The problera here is the sarne as that of the
"prisoner's dilemma" game: In an open world econorny it is often in the interest of each governmeBt to expand governrnent spending for the reasons of domestic politics.
However, if they all do so, it would raise the world interest rate, crowd out investment,
and reduce growth of the world economy. Further investigation of this preblem ls the
task of future research.
References
Ale$ina, Alberto and Guido Tabellini (1 990a): "Vetlng on the Budget Deficit," Amen'can
Economic Review 80: 37‑49.
'
Alesina, AIberto and Guido Tabellini (1990b): "A Positive Theory of Fiscal Deficits and Government Debt," Revievv offfconomic Studies, 57: 403‑414.
Bergsten, Fred ed. (1991): lntemationa/ Aojustment and Financing: 7Zhe Lessons of 7985‑‑7997,Washington,D.C.:lnstituteforlRternatienalEconomics. '
Bergsten, Fred and Williarri Cline (f985): 71he United States‑Japan Economic Problem, Policy Analyses in lnternatlonal Economlcs 13, Washington, D.C.: lnstitute for International Economics.
Bergsten, Fred and Marcus Noland (1993): Reconcilable differences?: United States‑
Japan ffconomic Confiic. ts, Washingtop, D.C: lnstitute for lnternational Economics.
Cline, Williara (1989): United States EIxtema/ Actiustment and the Wbrid Economy, Washington, D.C.: lnstitute for lnternational EcoRomics.
Frankel, Jeffrey (1984): 71he YG)n ‑ZDof/arAgreement: Libera/izing Japanese Capital Markets, Policy Analyses in lnternational Ecenomics 9, Washington, D.C.:
lnstitu{e for lnternational Economics.
Frenkel, Jacob and Assaf Razin (1992): Fiscal Poficies and the VYbrtd Economy (second edition), Carnbridge, Massachusetts: The MIT Press.
Kawai, Masahiro and Yusuke Onitsuka (f996): "Fiscal Policy, Global Saving and lnvestment, and ffconomic Growth," in C. Eugene Steuerle and Masahiro Kawai eds., 7‑he Nevv Wbrid Fiscal Ofider Implications for industriaiized Nations, Washlngton, D.C.: The Urban lnstitute Press.
Krugman, Paul ed. (1991): hacte wth Japan: Has the Door Opened W7der?, Chlcago:
The Universi{y of Chicago Press.
Krugman, Paul (1994): the Age ofDiminished Expectations: U.S. Economic Policy in the 7990s (revised and updated edltion), Cambrldge, Massachusetts:The MIT Press.
Morris, Stephen (4985): Deficits and the DoUar 7he llVbrid Econorny at Risk
(updated ln 1987), Policy Analyses in lnternational Economics 14, Washington,
D.C.: lnstitute for lnternational Econornics. ･ ' '
Organization for Economlc Cooperatlon and Development (f994):
for Social Poficy, Paris: OECD.
New Orientations
20
Persson, Torsten and Lar Svensson (1989): "Why a Stubborn Conservative Would Run a Deficit: Policy with Tirne‑‑lnconsistent Preferences," Quarten(y Journal ef Economics, 104: 325‑345.
Roberti, Paolo (1989): "Some Critical ReflectioBs on the Principles and lnstruments of the Welfare State," Labourr Review ofLabour E!oonomics and lndustrial RekatiOns, Vol. 3: 95‑･G25.
Tanzi, Vito and Ludger Schuknecht (1995): "The Growth' of Government and the Reforrr} of the State in lndustrial Countries," IMF Working Paper (WP/95/G30), Washington, D.C.: lnternational Monetary,Fund.
Tyson, Laura (f992): vatho's Bashing VVhom?: 7tade ConfZiCt in High‑fechnology
Industries, Washington, D.C.: Institute for lnternational Economics.
τhis Disc級ssioa Pa er Ser三es is ρublishe｛i量）y もhe Insもituもe of ！監cono展ic Research aロ〔至 integfates もwo old ◎nes p凱blishe（圭 se玉｝araもely by もhe Bepar七鼠eRも of 8co無。組ics aa（玉 the De玉｝art鳳e黛も o￡ Co胤滋erce．
DiscussiOII Papeτ Series 1astitute of Eco無。田ic 豆esea「ch Otaru甑iversi土y of Co臨erce
賊。． τitle
1．恥キンズ吋イモンの条件に関する諮説の統合について
2． ｝Iot三vaも圭ol主 an〔1 Causa三 IRfeでences i轟 七he 8疑｛圭getary Co蒸もro1
3．npo6JleMblyHpaBJ王eHK只pa60℃｛e黄 CHJIO直Ha HpeA霊p紅∫IT蹟月X双aJ1bKero BocToK：a（co双躍oJloPHqecK：シ！eacrleKTbl）
4． Dyna瓜ic τax 王瓢。圭〔圭eace i簸 a Fi獄ite HGri羅oa ｝【o〔圭e1
5． 8usiaess Cycles with Asseも㌘rice B臓わb三es εLad 七he 丑ole of 擁。駐e七ary】｝01icy
6． ContiRuous Double−Sided Auc毛ioas ia Foreign Exchange ｝Ia灘kets
7． The Existe舷ce of Ra皿sey 冠嵯u三libriu皿 罵ith Co無su鳳pもion Ex七ernality
8． ｝望oa｛｝y， ｝Ie疑traliもy of CoIlsu訟P七io且 窪｝axes， aIK1 〔｝ヨowth ia
王職もerもe瓜poral epti直≧izi119 ｝fodels
9． Pro〔玉uc七 鼠eturns in も鼓e ，｝apanese Distril｝utio琵 Sysもe皿＝A Ca．se S七賎｛圭ソ of a Japanese Wholesaleガs Return ｝しed級ctio狂 置fforもs
10． Dyna磁ics， Co員sisもeRt Con5ec毛賦res and Heteでogeaeous Agents iR the 卸rivate Provision o￡ P紅b三ic ｛｝ooαs
1圭． Iatra−Iadustry 王nvest瓜eRt and I離勲erfecも 涯arke七s A〔墓eo颪！e七ric A！》proach in Si蹴Ple｛｝e臓era1露〔1ui1圭bri犠瓜
12， Sit−Do饗R to Spliも：Flin毛 ｛｝｝i曾or麹ers ia 1937−1939
13． The Co鐵ple風elLもari七ア beも曾eea 奮1L（芝09e職ous ProtectioR aa｛童 1｝irect Foreiga I臓vest蹴en七
14・C・賑s岬ti・蝦axati・且a臓dτax Prepay皿eRt A2pr・ach王翻y耳a撮ic
Ge漁era1 君｛1犠11ibri疑斑｝玉。｛ie王s wiもh Cons田墜er 罫肢2aわ主es
15． Regu圭aもory sysもe臓 a職d supervisio難 of もhe fi獄allcial i難s七コ口utio臓s i駐 Japaa
16． 罫圭nancia｝ restruc宅糠riag and the U．S． regulatory fra盈ewoでk
主7． The 主egacy ◎f もhe bubわ主e eco夏。鼠y in 5apa籍：Decli且iRg cross s氣are数01d乏取9 蓬Lad capital 雪or礁a毛iG且
18． Stocko罵ners琵三ひ ia もhe U．S．：Capita1 野◎で組at三〇瓜 aゑ｛玉 reg級1atio駐
三9。 Int魯rRaもiona1 3Gi註七 ve数t娃τes aR〔1 endoge飛ous protecもion a ρ〇三iもica1−eCOIIo皿y apρr◎a．ch
20．脳蛙をめぐるアメリカ労働吏研究：ファインとエッヅフオースの現場像の吟味
21．卸売業の経営と戦略一一卸売流逓研究会ヒ刃ング調査録（1）：霞用 雑貨卸売企業
22．節売業の経営と戦略一一一卸亮流通研究会ヒアリング調査録（2）：食品・
灘類卸売企業． 、
A疑もhor／s
タ スク9フ。タ，テかイハ。ンカー
Yosh三h三τ0 ｝Ia．とa
AHaTO、πH黄 瓢羅xa鷲JIOB茎4q
斑KyPKHH
Jun−ichi Iもaya
H三foshi Sh員｝登ya
丑yosuke Wa．da
Sa〔1ao Ka職aya
＆ 望｝o瓢oich圭 Shino七suka 3uh一三ch三 Itaya
Jeffery Alan Br畦！主so盈
」娃n一三ch圭 Itaya
＆ 1）ipa疑1ζξしr 玉｝asgupta
Laix臨 Zhao
Sa．もoshi Takaもa Laixua 猛ha．0
J引引一三chi Iもaya
Osa臓u Iもo
JaI主e 翼． D，A2ista
｝｛圭roO ｝｛ojo
Marsha11 ￡． B｝．賎戯e
Laixu」臓 Zbao
高覆聡
卸売流遜研究会
（代裏 高寓城朝則）
卸売流通研究会
（代裏 高宮城朝員の Daもe Ju主。正992 A1芝9．1992
王｛ov●1992
Ja臓．1993
5疑a・1993
Aug．正993 Sep．圭993
聾ov。1993
｝｛ar．三99婆
J紅簸．1994
Oct．1994
Dec。1994 Feb●1995
懸ar．正995
赦ay 1995
Ha，ア．支995．
琶ayg1995
｝lay●三995
Nov．1995
Feb．1996 Apτ．ig96
Apr．1996
23. A note.on the impacts of priee shocks on wages in unionized eeonomles
24. Transfer priciRg and the nature of the subsidiary firm 25. The incidence of a tax on pure rent in aR altruistic overlapping geaerations ecoaotay
26. 'Smal} goverRment' in the 21st century
27. Characteristies aRd refortus o￡ pttblic liealtlt !nsuranee system in japan
28. The role of local governments 2n urban developraent policy 29. 0ptima} Taxatioft and the ?rivate ProvisioR of Public Goods
39. Comparison o￡ Agricultural Po}icy ia the U. S. and the Japan 31. US Health lnsurailce:Types, Patterns of eoverate and
ConstraintstoReform '
32. Interftational Capita} Flows and Nationai Xacroecoaomic Po}ieies
33. Finaneial Mbevalization aRd Securitizatioft in Housing Finanee and the Changing Boles o￡ the Government
34. Socia} Efficiency and the 'Karket Revoktion' in gS Hous!Rg Finance
35. Government ExpeRditure aRd tlte Balance of Payments:Budget Deficit, FiRaneial Integyation, and Economic Biplomacy
baixlm Zhao
baixua Zkao Jun‑ichi Itaya
giroshi Shibuya Takashi Nakahama
Yoshinori Akiyataa Jun‑ichi Itaya Pavid de Meza Gareth D. Myies
?oshikazu Tateiwa Dwayne A. BaRks
Jane W. D'Arista
Shinya Imura
Gary 9ymski Porene lseftberg Mroshi Shibuya
May 1996
JuR.1996 Sep.!996
Sep.1996 Sep.1996
Sep,1996 Oct.i996
Oet.1996 Oct.1996
Oct.2996
Oct.1996
ect.1996
Nov.1996
Discuss￡on Paper Series 9epartment o￡ Economics Otaru University of Commerce
No. Tit}e
1, Monetary Policy in a Model of lfiternaeional Trade vith a Seetor Sticky Wage Rate
2. Export Credit Insurance
3. Asset Trading in an Overlapping‑Gefterations Model:Effieiency of Competitive Equilibrium
4. Asset Trading in an Overlapping‑Generatioas Xodel vith Production Shocks
5. Immiserizing !nvestmellt iR a Vertiea}}y aelated InteyRationak Trade
6. Bynamic Tax Incidence in a Two‑‑C}ass Economy
7. A Three Factor Xode} of Internatigna} Trade with Miaimum Wage Bates
8. A Note of the Maximum Number of Firms yith Egual Market Share in a Quantity Setting Supergame
9. Tax Incidence in a ?wo‑‑Sector erowing Ecoftomy wi￡k Perfect Foresight
10. Two Kinds of Information in Price Searclt
Authorls Takashi Fukusliima
& Hideki Funatsu Hideki Funatsu Kenji Yadiamote
KeRji Yamamoto
Masao Satake
Jun‑icki Itaya Hideki Fuaa￡su
Masaru Uzawa
jun‑ichi Itaya
Kaoru Endo
9ate Feb.1985
Feb.i985 Oct.1985
Oct.1985
Kar.1986
May 1986 Xay 1986
Nov.1986
May 1987
Aug.1987
11， 0籠 七蓋e ｝玉ed言i込g aR己 Invest1直ea毛 8ehavior of もhe Co皿peもiもive 罫ir風 絃註der Price ｛1acer七aiR七y
i2． Tax I藏cideロce i敷 a Two−Sector ｛｝rowin9 露co臓o皿y with Pe「fecも Foでesigh七：Long一且un A【Σalysis
13． Co斑parative Statics foτ もhe PriΨate Prov呈sioR of Pub三ic ｛｝oods ill a Conjec乞ural Vaでia毛ioRs ｝｛ode｝． wi七h 董｛etel・ogeゑeDミ1s Agea七s
14． Capiもal Acc級田艮1a毛io鼓 ｛…a風e of 散u三ti書ir置s Adjus七e皿駄も Costs
冒iもh 慧xもerゑa1
三5． Usin9 もhe Corlrect 露cono澱ic 王nもeτPre七aもio臓 も。 Prove the Hawkins−Si伍。臓一Hikaiao ？heore臓：O駐e ｝｛ore 醤。もe
16． Traasversality Co臓diti◎a Proble田s
ia Infinite Ti盈e HorizoI｝ Co鼓cave
ぎ遷琵一ichi Σ七aya
」膿登一ichi I七aya
Dipa豆kar 三｝asg疑，もa
＆ 5登1Σ一ichi 1ta，ya
」ミュ11−ichi I七aya
Dipankar Dasg幾pta
To瓜oichi Shi駐otsuka
Oct●1987
｝Iar．1988
｝Iar鷺199三
｝Iar。圭99ま
」竃1】L。199i
Oct．1991
D生SC姐ssion Paper Series DeI｝art匿ent of Co阻侃erce O七ar琶 Univers王もy oぞ Co組鼠erce
誕。．
