It is a pleasure to appear before you to provide my assessment of the outlook for U.S. economic growth and employment and the appropriate public policies to promote those objectives. I will divide my remarks into seven sections. In the first, I will discuss the overall prospects for the short and medium term. In the remaining sections, I shall address specific policy concerns.
I. The Overall prospects
While economists always look into the future with cloudy crystal balls, they are particularly cloudy when it comes to forecasting turning points. The question that is repeatedly asked is, is the recession over? I think, however, that that is the wrong question. There is little doubt that for the past year, the economy has been performing substantially below its potential. The potential growth rate of the economy clearly improved through the 90's, and even if the robust growth of the late 90s could not be sustained, there is a widespread consensus that the economy has a potential for growth of between 3 to 4%. Taking the mid-point in that range of 3.5%, even a positive growth of .5% would represent a shortfall of $300 billion in our ten trillion economy--an enormous wastage of resources, even if we were to ignore the tribulations imposed on those forced into unemployment. Moreover, we should remember that America's unemployment insurance program is one of the poorest in the advanced industrial countries. It is unconscionable that benefits be terminated after 26 weeks. The argument that providing extended benefits would attenuate search incentives is nonsense: the problem is a lack of jobs, not the lack of job seeking. I shall return to this later.
While a great deal of pleasure is being taken in the fact that the rate of job destruction has been reduced, our economy needs to create a couple hundred thousand jobs a month to break even, to ensure that employment keeps pace with the growing labor force. It is not a mark of success if the unemployment rate comes down because workers have become discouraged from working, so the number of job seekers is reduced.
Broadly, there are three types of recessions--those associated with inventory cycles, overinvestment in capital and housing, and financial crises. The current downturn is a combination of the first two. Some of the downturn was associated with a decrease in the stock of inventories. There were reasons to believe that with the New Economy, inventory cycles would be attenuated and become less important as a source of economic volatility, as better control mechanisms kept inventories better in control, as production methods (just in time production) reduced the required size of inventories, and as the overall size of manufacturing in the economy declined. As the economy nears the end of the period of inventory retrenchment, this source of negative drag on the growth of the economy will be eliminated. This, by itself, would suffice to bring an end to the recession; but it will not be enough to restore the economy to robust growth.
The overinvestment in certain key sectors of the economy has left an overhang, which will take some time to redress fully. The good news is that some of these areas are those in which technological advances have been proceeding at a rapid pace, so that much of the old IT equipment will become obsolete relatively quickly, before the equipment wears out, and this will help restore demand for new IT.
There are a number of other negative forces which suggest that the economy will continue to operate substantially below its potential, and which represent a substantial risk for a strong recovery.
(a) Consumer spending. Robust consumer spending has sustained the economy. The U.S. savings rate remains dismally low, which is not good for the long run prospects for growth. Part of the explanation for the sustained spending is the mortgage refinancing which resulted from the lowering of interest rates, part from the special deals that automobile dealers were offering. Given that consumption has not fallen in the way that it does in a typical downturn, it is unlikely that an increase in consumption will provide a strong impetus for growth in the short run. Moreover, there are several reasons to believe that the forces which have sustained consumption could weaken. (i) Mortgage rates may well rise; as it is, they have fallen far less than the short term interest rates have fallen, partly for reasons that I will discuss later. (ii) Similarly, it is not obvious that the special deals on automobiles will continue. (iii) The heavy indebtedness of the consumer may impose an important dampener on spending, one which will become especially important if interest rates rise. As it is, by some estimates, consumers are spending 14% of their income on debt service. (iv) If the unemployment rate is not soon brought down significantly, fears of job security may increase, and given the poor unemployment insurance system, workers may be induced to save as a precautionary measure. (v) One of the primary reasons for the low savings rate is that through the nineties, households saw their wealth increase through capital gains, even without putting aside money out of disposable income. But with stock prices down or increasing slowly, it will gradually dawn on consumers that their wealth is less than it once was, or than they thought. The switch to defined contribution pension systems may exacerbate the resulting instability. Today, individuals must bear the risk of stock market fluctuations.
(b) Capital spending. Long term interest rates have not come down anywhere near as much as short term interest rates. One of the reasons for this may be the increasing uncertainty about the country's long term fiscal position, caused in part by the large tax cut, where we seemed to be spending money before we got it. In addition, there is continuing worry about problems of valuation in the corporate sector. I served on the SEC Commission on Valuation, which focused on the difficulties of valuation in the new economy. While there was general recognition that old accounting principles might be ill-suited for providing accurate pictures of the economic prospects of firms, many on the Commission believed that the market should be relied upon. Enron and Global Crossing confirmed the suspicions of the skeptics, and today, many if not most investors feel high levels of uncertainty about the numbers that many corporations are reporting. This may dampen stock market prices, at least for a while.
(c) Exports. The strong dollar and the weak international situation suggests prospects for exports remain diminished.
(d) Technology. A source of some concern is that the economic downturn has led many firms to decrease significantly their investments in R & D. And investments in long term research--the kind that is likely to result in productivity increases down the line--has been particularly hard hit, in ways that are hard to assess from the numbers alone. This is likely to be one of the lingering costs of not having responded to the economic downturn earlier, with stronger measures (I do not include the House or Administration so-called stimulus package among the stronger measures that would have made a big difference.)
The one positive (from a macro-economic perspective) is the increased military expenditure; but such expenditures detract from resources that could be used to increase long term productivity, and hence to not contribute to the long term strength of the U.S. economy.
It will be noted that I have not listed the tax cut as a major positive factor. Its net impact on the economy is in fact ambiguous. It was not designed to stimulate the economy, and its regressive features and other elements of its design suggest that the bang for the buck is likely to be quite low. On the other hand, the quickly diminishing surplus (and, in some years, the emerging deficit) that resulted lead to upward pressures on interest rates. The Fed only controls the short term interest rates. What firms care about far more is the longer term interest rates that they have to face, and the tax cut has changed the yield structure adversely, and in ways which are quite dramatic: there has been an almost 4% reduction in short term interest rates, with less than a 25 basis reduction in some long term interest rates. And while this weakens the prospects for a robust short term recovery, its implications for the longer term are even more bleak.
II. Tax Cut
This brings me naturally to the subject of the tax cut. The tax cut was not only ill-designed for stimulating the economy in the short run; it was also badly designed for promoting long term economic growth, (I put aside for the moment broader concerns about equity.) There are tax reforms, for instance, that would have done far more to promote investment in the short run with far lower budgetary costs, like the net investment tax credit and better income averaging provisions. I strongly side with those who believe that when one makes a mistake, one should recognize it. It is not just the size of the tax cut that was a mistake, but its design. Given the peculiar structure of the tax bill--with provisions which expire in ten years--it is inevitable that the issues will have to be revisited. It is better that that be done sooner rather than later.
III. Foreign Economic Policy
One of the sources of strength of the U.S. economy during the 1990s was increased exports to emerging markets. This was partly a result of trade opening, partly a result of the robust economy in those regions. Mismanagement of international economic policy by the IMF has contributed significantly to a worsening of prospects. Much of Latin America today faces stagnation, recession, or depression. As people in these countries look at the performance of their economies over the so-called reform decade, they see growth rates that are half those that prevailed in the much criticized pre-reform period (the so-called import substitution era), though, to be sure, better than during the lost decade of the 80s. There is a growing disillusionment with the IMF, and with the U.S., which is seen as responsible for its policies. While there was consensus in the U.S. that in the face of an economic downturn, there ought to be a fiscal stimulus--the debate was only over how to design the most effective stimulus--the IMF was seen as pushing for contractionary policies. The question is being asked everywhere, why? The asymmetries associated with trade liberalization of the past have increasingly come to be a source of resentment, and recent actions in steel have only heightened a perception of hypocrisy. The European initiative of unilaterally eliminating trade barriers for the poorest countries ("Everything but arms") is one of the few positive developments, but the U.S., by failing to take corresponding actions, is increasingly losing standing. Unless the U.S. does something, both to ensure that the IMF pursues policies which are more in accord with the economic well-being of the developing countries, and especially the poor in those country, and to ensure that there are movements towards a more balanced trade agenda, it is hard to see a renewal of the kind of growth in exports to these countries that has played such an important role in our own country's growth in the future. (There are even more important consequences for global economic and political stability.)
We won World War II, but we also won the Peace that followed. The Marshall plan was not only magnanimous, it also won lasting allies in the struggle for peace and democracy. We stand on the threshold of winning the War against terrorism, but will we win the Peace? Though the link between terrorism and poverty is complicated, this much is clear: unemployment and poverty, especially among young males, provide fertile feeding grounds. The United States has neither provided aid nor trade; among the major more advanced developed countries, it is the stingiest in providing assistance to the less developed. The contention that aid does not work is simply wrong, and those who assert this must neither have looked at the evidence nor gone into the field. I have seen aid work: small irrigation projects that double or triple the incomes of desperately poor, education projects that have brought literacy and meaning to those who otherwise would not have had it, health projects eradicate river blindness and other diseases that have plagued some of the poorest countries of the world. Statistical studies at the World Bank have shown that aid, when appropriately directly, has significant effects in increasing growth and reducing poverty. To be sure, not every dollar of aid is well spent, but the same thing could be said for any other category of expenditures, whether in the public or the private sector. The Monterey meeting in Mexico on finance for development is an occasion on which we could make a commitment both to increased assistance and to explore innovative ways of helping the developing countries more. It is our moral duty; it is also in our self-interest.
The continuing large trade deficit of the United States represents a potential source of instability, not only for the United States, but for the world. If an objective outsider were to conduct the kind of review of the U.S. economy that is regularly conducted for other countries around the world, the grades would be mixed: the abysmally low savings rate, the high trade deficit, the worsening fiscal situation. The problems are all related, and the prospects are that some could even get worse in the short run. The reason that we have a large trade deficit, as I noted, in part is due to the strong dollar. As in the early 1980s, a large tax cut has led to a massive worsening of the fiscal situation. The trade deficit is simply the difference between what we invest and what we save. National savings (including public savings) has gone down from what it otherwise would have been. The trade deficit would have been even worse, were it not that investment too has gone down. But when our economy recovers, investment will increase, and with it there is a good chance that the trade deficit will worsen. We should be clear: it is not protectionist policies abroad or unfair trade practices that have caused our problems, whether they get reflected in the steel industry, the automobile industry, or elsewhere; it is our overall macro-economic framework I suspect the full adverse affects of the tax cut are yet to be felt.
IV. Addressing the sources of our current problem
If we are to formulate policies aimed at enhancing the strength of the economy in the middle to long run, we must understand better the sources of our current downturn, of the massive underperformance of the U.S. economy. While every boom comes to an end, there are lessons to each. Earlier booms and the busts that followed taught us the dangers of inflation, and of the Fed stepping too hard on the brakes to stop inflation. We have learned the dangers of excessive inflation; and inflation was not the cause of the current downturn. The recession of 1991 can ultimately be traced back to weaknesses in the financial sector, those in turn in part to the excessive deregulation of the 1980s. I am not sure that we have learned those lessons, or the lessons of the excessive exuberance of the late 90s.
In some ways, it is a familiar pattern: deregulation in a sector (here telecommunications) leading to excessive investment in that sector--in this case the problems exacerbated by breathtaking technological developments and deregulation in the financial sector. The Glass-Steagall Act was concerned with the problems raised by conflicts of interest. It was foolhardy to think that such behavior would not reappear with its repeal.
At the time I served on the Council of Economic Advisers, we raised strong concerns about conflicts of interest and problems in accounting standards and practices, particularly as they related to derivatives and options. Our concerns have proved to be on the mark. There were others who raised similar concerns. Arthur Levitt, of course, was right in calling attention to the conflicts of interest in the accounting firms, when they simultaneously provide consulting services. FASB called for a changing of accounting practices to more accurately reflect the costs of options given to executives. I strongly agreed. The Secretary of Treasury and the Secretary of Commerce, however, violated basic principles of good governance, which call for the independence of FASB, and intervened to squash the proposed revisions. They succeeded.
I have devoted much of my academic life to the economics of information, and to the consequences of imperfections of information. The proposed revisions would have improved the quality of information. To be sure, some firms' economic prospects might have looked worse as a result, and its stock market price might have fallen as a result--as well it should. It was inevitable that a day of reckoning would come. Providing misleading information only delayed the day of reckoning, but worse, it led to a misallocation of resources, as overinflated stock prices led to the excessive investment which is at the root of the economic downturn.
Some contend that it is difficult to obtain an accurate measure of the value of the options. But this much is clear: zero, the implicit value assigned under current arrangements, is clearly wrong. And leaving it to footnotes, to be sorted out by investors, is not an adequate response, as the Enron case has brought home so clearly. At the Council of Economic Advisers, we devised a formula that represented a far more accurate lower bound estimate of the value of the options than zero. Moreover, many firms use formulae for their own purposes, in valuing stock options (charging them against particular divisions of the firm). However, Treasury, in its opposition to the FASB concerns, was singularly uninterested in these alternatives. I leave it to others to hypothesize why that might have been the case.
If we are to have a stock market in which investors are to have confidence, if we are to have a stock markets which avoids the kind of massive misallocation of resources that result when information provided does not accurately report the true condition of firms, we must have accounting and regulatory frameworks that address these issues. As derivatives and other techniques of financial engineering become more common, these problems too will become more pervasive. While headlines and journalistic accounts describe some of the inequities--those who have seen their pensions disappear as corporate executives have stashed away millions for themselves--what is also at stake is the long run well being of our economy. The problems of Enron and Global Crossing are part and parcel of the current downturn.
V. Energy policy
There is a widespread agreement among economists that GDP does not provide a good measure of economic well being. We should, at the very least, take account of the degradation of the environment and natural resources. Bad information systems can lead to bad decision making (as we have seen recently in the corporate world.) Nowhere is this more true than in energy policy. Extraction of oil and natural gases may increase our measured GDP, but it does not increase our economic well being commensurately. We should take account of the depletion of our resource basis, and the degradation of our environment as a result of carbon emissions. An energy policy which focuses on "drain America first" is not even good for long run national security, for it leaves us potentially more vulnerable in the future. Long run economic growth (correctly measured) and long run political strength both suggest that we should focus more on conservation. And basic principles of economics suggest that what is required is incentives, carrots and sticks.
Why should we think that moral suasion would be more effective in this arena than it is in any other area of economic activity?
VI. Social Security
I want to conclude with a few remarks about one of our long term problems, our social security program. Our social security program has been an enormous success. We have brought the elderly out of poverty, and we have provided a new measure of economic security to the aged. Transactions costs are low. Improvements in the design of the program over the years have reduced some of the unintended inequities, reduced any adverse effects it might have on labor supply, and increased overall efficiency. There is still a way to go to put it on sound financial grounds.
Economics is traditionally described as the science of choice. The legacy of the Clinton years, a huge fiscal surplus, provided us with an opportunity to make some choices. We could have used some of these funds to put the social security system on sound financial grounds. We could have fully funded the system, and we could have then decided on how to proceed in the future. We have largely squandered that opportunity. Proposals for partial privatization typically leave the fiscal situation of our social security worse off. They do not provide additional funds to fill in the gap; some proposals simple force current and future beneficiaries to take a cut in benefits. Any reform proposal which does not begin by addressing the question of how current unfunded liabilities are to be financed is irresponsible, and should be a non-starter.
Elsewhere, with Peter Orszag, I have described at greater length ten myths concerning social security that have been widely circulated. One that has recently received considerable attention is the low return on social security accounts. We should be clear: social security funds are invested well, but conservatively. To the extent that capital markets work efficiently, then any higher returns that might be received would simply reflect the higher risk. It is imprudent for those approaching retirement to invest all, or even most, of their assets in highly risk investments. If there were a decision to undertake greater risk, the public social security system could do so, again at low transactions costs. (The transaction costs in the privatized part of the British system have been estimated to reduce benefits by 40% from what they otherwise would have been!)
Part of the reason that in partial pay-as-you go social security systems, it appears that returns are low is that some of the returns are used to bear the costs of the unfunded liabilities. The problem of funding those unfunded liabilities does not go away with partial or complete privatization. It will have to be borne elsewhere. To assess the merits of any reform proposal, therefore, one must know how, and who, will bear these costs. To do otherwise is dishonest. It may put in jeopardy the long run prospects of our economy, for a day of reckoning will come.
VII. Concluding remarks
I continue to believe that the basic fundamentals of the U. S. economy remain strong. But I have seen the fortunes of countries change quickly, as a result of economic mismanagement. The decisions, the choices, we take today will affect not only economic performance during the next year, but our long run prospects. I believe that the tax cut that was enacted last spring was based on a serious miscalculation of our economic situation. It is a decision which, however, is reversible. If we do not revisit the issue, in the light of the new information which has come to light and the new situation which has evolved, the damage which could be done may itself be irreversible--or at least it will take a long time to undo. It will take political courage. Much is at stake.
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