Economy will adjust to imbalances

By Randall J. Pozdena Assistant Vice President Federal Reserve Bank ofSan Francisco

T ue SPECTACLjLAR dectines

I in the stock market in October of 1987 illustrate that financial markets do not always adjust smoothly to developments in the economy. A lthough trading and port- folio insurance programs may have contributed to the pattern of retrenchment in the market. the market likely had wearied of persistent imbalances

The high rates of spending by the household and government sectors have been enabled by capital inflows from abroad. The inflow of capital to the U.S. is the mirror image'of our trade imbalance; the dollars spent by Americans on foreign suppliers are being "borrowed back" by Americans to finance profligate private and public spending.

Such borrowing from foreigners need not be deleterious. If the borrowing were being done to finance real investment, that investment would generate the future incomes for Americans that will be needed to pay back the accumulated indebtedness. Unfortunately, it appears that both at the government and household levels, the excessive spending is on consumption, rather than investment goods. This does not bode well for future living standards.

Thus, despite relatively high currentincome growth (fueled by heavy consumption spending), the prognosis would appear to be for slower future growth. Thus, despite a current real GNP growth rate of 3.3% and an unemployment rate that is at a lO-year low, it seems likely that the "piper must be paid" soon in deterioration of this pattern.

As foreign lenders increasingly recognize the imprudence of U.S. spending patterns, their willingness to lend will put continued upward pressure on interest rates. This will induce increased domestic saving in order to finance existing debt. Consumption of both durable and non-