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Saturday, January 24, 2004

EXCHANGE ON THE US ECONOMY, A FOLLOW-UP TO THE PREVIOUS ARTICLE

From Michael Jabbra, a former and unusually talented undergrad at UCSB, the following brief set of queries arrived. They are reproduced here, along with the buggy replies

Prof Bug

I was wondering if you could comment on the similarities between the U.S. and the E.U. with regard to economic problems. What will the national debt ($7 trillion, according to the Bureau of the Public Debt website) and the devaluation of the dollar do to US economic strength? Isn't the refusal of both parties to address the growing debt and dollar devaluation a sign of bureaucratic or legislative inertia?

THE BUGGY REPLY

Good questions, Michael --- which I will try to deal with in greater detail later on. Note that they were delved into at length last summer in several articles, about 8 or 9, on the US economy; even so, I'm happy to take them up again, both now and later.

THE FEDERAL GOVERNMENT DEFICIT: TO WORRY OR NOT?

1) Briefly, we went through a very similar period of worry back in the 1980s about rising federal government deficits, a swelling trade deficit, and a falling dollar (after 1985). The federal deficit reached 6.0% of GDP at one point (this year, it will be about 4.2%). What happened? Any noticeable harm?

2) Not, far from it. In the end, faster economic growth and to an extent the Clinton tax-rises of 1993 not only ended the rising government deficit, but reversed it by the late 1990s. It took a decade or so for the new economic dynamism to kick in, based on clear rises in productivity (by two- to three-fold). Thanks to those rises, the US enjoyed the longest boom in its history --- 10 years in all. There was another benefit. As unemployment fell to near-historic lows in the last four years of the boom, 1996-2000, the income of the bottom 20% income earners actually rose faster than that of the top 20%.

So . . let's wait and see what happens again. The highly regarded, non-partisan Congressional Budget Office noted the new fiscal stimulus --- which has been essential to get us out of slow growth after 2000 (the US generating 95% or more of all world economic growth since 1996, according to international studies) --- would bring in more revenue in the future, plus contain automatic reversals of the tax-cuts in some areas. [As we'll see, the soaring trade deficit reversed itself after 1985 --- thanks to a negotiated decline of the skyrocketing $US in exchange markets by then --- and by 1991 was in a slight surplus.]

Added remark, January 27, 2004: The CBO's latest projections --- taking into account new spending commitments in health of around $700 billion over the next decade and some technical adjustments --- are less optimistic. They do estimate that the high-peak deficit this year of around 4.2% will fall to around 3.4% or so next year --- and will, given certain assumptions about spending and taxes that don't seem politically realistic, fall to 1.8% of GDP by 2008 --- but the CBO is worried about the long-term commitments being undertaken in health and social security . . . the revenue for which will fall increasingly short if the tax cuts are made permanent.

All the more pressure will likely follow, then, to pare spending somewhere; or alternatively reject the proposal to make the tax cuts permanent: some of all of them. Or, as another option, some combination of permanent cuts and reduced government spending.

Note that total national debt as a percentage of GDP will be around 64% by the end of the current fiscal year (September 30) --- still below its high points in the mid-1990s. Total debt here includes unfunded social security commitments, which have to be covered by current tax revenue. See the chart, including projections.




3) In technical terms, our economy badly needed a big fiscal stimulus in 2003 --- or earlier --- what with the slow job-creation that followed the recovery from the 2001 recession. It's technical because we rediscovered the Keynesian view --- embraced by Gregory Mankiw, Bush's Chairman of the Council of Economic Advisers the last year, and one of the world's leading neo-Keynesians --- that low interest rates and monetary stimuli won't by themselves necessarily kick-start fast economic growth in the recovery phase of the business cycle . . . especially if nominal interest rates are very low anyway and there's no problem of inflation. See the article on this by Martin Feldstein of Harvard, likely to be Alan Greenspan's successor at the Fed one day: Fiscal Activism.

4) Another technical, easy-to-follow point: you have to distinguish between cyclical and structural deficits. When the economy falls into recession, the federal budget should decline and turn red: the automatic recessionary stabilizers --- tax receipts down, unemployment benefits up --- help keep up aggregate demand and offset some or most of the recessionary impact. If the economy, however, continues to run deficits once a recovery is under way and GDP growth is near its sustainable non-inflationary rate --- potential output, set by supply side inputs of capital investment, labor-force growth and quality, technological progress, and trends in productivity growth --- then we have a structural deficit.

Where are we now? Well, it took about 15 months after the 1991 recession for the economy to return to sustainable growth, with unemployment coming down (from a much higher level --- over 7.0% in those days compared to 6.3% at the peak last May). Right now, we're in the 29th month of the recovery, and job-creation has been dismal. Whatever the causes --- and some of them are statistical (the Bureau of Labor's survey of business payrolls is higher than its monthly surveys of households, a problem that also emerged in the early 1990s) --- we need to have a big fiscal boost. With the US contributing to an astonishing 96% or so of world economic growth since 1996 --- a mind-boggling statistic! --- the global economy would be in depression, not just recession, without strong American economic growth.

5) Will President Bush's new proposal in the State of the Union to make the tax-cuts permanent be a problem here? Frankly, I don't know. No one does. It depends on what programs will be cut back or ended. Otherwise, expenditures could outrun revenue even in a fast-growing economy. More to the point, the Bush team --- conservatives after all --- probably hopes that reducing revenue will force cut-backs in government expenditures. Which ones? Ah, that's the rub.

Liberals and conservatives will differ and bicker here, as will every politician with a stake in this or that government program. Some programs are more useful for economic growth than others; some for equity; others for cushioning market-engendered dislocations in people's lives. All of them involve trade-offs. And many reflect political horsetrading, nothing else, and should be cut drastically.





 

THE TRADE DEFICIT AND A FALLING DOLLAR:

1) As for the trade deficit --- really a current account deficit (in the trade of goods and services, plus flows of profits in and out of the US from our multinationals abroad and foreign ones here) --- it has risen steeply for four reasons:

  • Slow growth abroad, fast growth here, plus a reliance by Europe and Asia on export-led growth: that leaves the US as the only market for vigorous export growth.


  • Slow growth abroad, in turn, limits US exports to their economies and increases our current account deficit. It also accentuates the determination of governments and firms abroad to concentrate all the more on exporting to the US market, essentially the only way they have to sustain GDP growth and corporate profits. And with the US economy found to have generated over 95% of world economic growth since 1996, directly or indirectly, the previous sentence isn't an exaggeration. Period




  • Huge inflows of investment capital into the US assets markets from private firms and individuals abroad: specifically, their investments in American bonds, stocks, corporate bonds, real estate, and US companies. That raises the price of the dollar compared to other economies and hence keeps boosting the inflow of cheaper imports to the US. Nor is that all. To ensure that the dollar stays high, Asian and other governments have sold huge quantities of their own currencies and buy dollars with them. These dollars, in turn, are then re-invested in American financial assets.


  • Alternatively viewed, we run a current account deficit --- offset by capital inflows on capital account --- because US consumption and investment needs, private and governmental, exceed our savings rate. The gap is filled by the inflow of investment capital from foreigners, which reflects their desire largely for liquid, short-term assets of a secure sort in the US market. The more dynamic our economy appears compared to others, the greater will be the inflow. We, in turn, can then use the short-term capital inflows for long-term investment, here and abroad.


To clarify briefly: After 2001, the one change has been in Eurozone investments, forcing a big rise in the price of the euro compared to the dollar: from 0.86 to the dollar to around 1.25. 4. The determination of Asian governments, whose central banks hold a staggering $1.6 trillion, to keep their exports booming to the US by buying dollars with their own currencies in exchange rate markets. Japan alone spent over $200 billion the last 18 months to try halting the rise of the Yen; China spent almost as much to keep the Yuan fixed at 8.3 to the dollar. The other Asian central banks do the same.



 

2) Is it bad for us to run trade deficits?

Not as long as others finance them by buying US assets, whatever their motives. In turn, as long as we use their investment capital to finance our own investment, our GDP rises faster than it otherwise would. Both export-led countries and the US seem satisfied.

Consider the foreign investors. Their investments here in US financial assets bring them a good return in a dynamic, non-inflationary country; they need never worry that we will ever default on paying them their interest or profits, never mind principal, quite simply because we owe them money in dollars; and their governments and big corporations can continue enjoying export-led growth with a cheaper currency compared to the dollar . . . especially if US economic growth continues to boom ahead.

For our part, we benefit too. In particular, given that our domestic-generated savings don't cover our investment needs, we obtain foreign capital that we can use to close the gap and keep investment high. Provided the US GDP grows faster thanks to this new investment, we have a good bargain in the process. Will that always happen? No, not necessarily.

  • If, to be precise, the inflow of investment capital went mainly into consumption, not investment, we'd be doing something foolish. That happened in the 1980s. During the 7 years of the Reagan boom, our national levels of investment didn't rise beyond what they had been in past booms; and so we were doing something foolish. Fortunately, by 1985, the Plaza Accord with Europe and Japan led to a negotiated decline in the value of the dollar --- it fell around 50-60% against the Yen and the German Mark over the next six years --- and by 1991 our trade deficit disappeared, only to return again once the US economy starting growing fast again after 1992, and the Europeans, Japanese, and other Pacific Asian countries got out of recession or slow growth by more export-surges to the US.


  • In the 1990s, by contrast, we were much wiser. As huge inflows of foreign capital arrived in the US economy --- and hence raised the dollar to new highs, resulting in bursting trade deficits from 1993 on --- national investments in the US economy by American business rose to new highs, and what had been foolish turned to wisdom.


A duo of caveats intrudes, by way of clarification:

1. No lasting harm was done to the US economy's long-term future by the high trade deficits of the early and mid-1980s . . . which anyway fell rapidly after 1985, as I noted, thanks to a negotiated decline in the value of the $ in currency markets.

2. The new highs reached in US business investment in the late 1990s led, by the end of 2000, to over-investment, especially in information and telecommunications areas. One reason for the slow job-creation since the recession ended in the fall quarter of 2001 was precisely the outcome of this over-investment. Business firms were reluctant until last summer to invest anew in new techologies --- or inventories in them --- until they had been assured that their built-up inventories were down once and for all, thanks to new business, and until they were certain the rise in customer demand for their products would be sustained for years. (There were other reasons for slow job-creation: the dislocations caused by 9/11's attacks, especially in certain industries like airlines; and the uncertainties created by the wars in Afghanistan and Iraq.)


 

3) Are there other potential drawbacks to trade deficits?

Well, if the dollar does fall rapidly --- though it has declined about 40% against the euro, it has hardly fallen against others or not at all --- there's a fear that it could lead to higher prices of imports that can't be substituted for by domestic goods and services, and hence set off inflation. That hasn't occurred, and in the existing era of global surpluses in almost everything, that's unlikely. The reason why? We are in a unique domestic and global environment, which hasn't existed for decades: unusually low inflation (under 2.0% annual rate), record lows in interest rates, and a booming economy that grew at an astonishing 8.3% annual rate in the third quarter of 2003. [The preliminary estimates of 4th quarter growth should be made public within a week or two.]

The analysis can be sharpened, even in terse ways:

(i.) In all past booms, the Federal Reserve would quickly move to raise interest rates whenever short-term GDP growth rose to such heights: technically, that meant above the sustainable long-term growth potential of the US economy in non-inflationary ways, with the long-term growth path shaped strictly by supply-side inputs: capital investment, growth of the labor force, and technological progress, including the trends in labor productivity.

(ii.) Short-term GDP growth, by contrast --- quarter to quarter and over part of the business cycle's ups and downs --- is determined mainly by demand-side trends: private consumption, business investment, and government consumption and investment . . . plus the trade sector (exports - imports in goods and services). In effect, a current account deficit in goods, services, and remitted profits to and from the US economy involving others will detract from aggregate demand. Oppositely, though, the inflow of foreign capital that is the offset of the current account deficit --- adding up the two, owing to double-entry book-keeping, always equals zero on the bottom line --- keeps interest rates lower than otherwise and allows businesses and government to finance more investment, while also permitting households to buy more consumer durables and residences.

(iii.) One other advantage of the trade competition --- of a pressure-steamer sort in the US economy --- is that it keeps US companies relentlessly searching for ways to improve productivity and cut back costs and hence offset any tendencies toward inflation. Note that on a trade-weighted basis --- multiplying the rise and fall of dollars against Yen, Yuan, Euros, pesos etc by the % of our imports and exports to those countries --- the dollar has only fallen about 8-9% anyway.



 

4) Another drawback might be more serious: bursting imports into the US economy that are concentrated in certain industries --- like China's --- can undermine production and jobs there quickly . . . faster anyway than firms and workers can adjust, even if costs and unemployment are cut to become more competitive and new technologies are introduced.

More specifically, the reallocation of capital, managerial talent, scientific and technical talent, and skilled workers to other, more promising industries --- mfg. or service-oriented --- can't proceed fast enough to prevent unemployment from rising. What will likely happen?

In the upshot, demands for trade-protection can soar . . . something we've seen. The solution isn't permanent protection, which always backfires: it did in steel recently, where more jobs were lost in steel-using industries than saved in steel (though the steel firms did improve their productivity over 18 months of protection).

What then should be . . .



. . . THE SOLUTION TO HARMED INDUSTRIES? A COMPLEX OF POLICIES

Several attacks on the bursting import competition are needed. So far, the Bush administration has been bungling here --- waffling too, especially with the proclamation in the State of the Union speech last week about job-training. Job-training! Whenever you hear politicians resort to this ruse, be careful! They are engaged in theatricals, nothing else. The record in the US of government-sponsored training programs is clear here. It's even clearer --- no, blatantly evident --- in the EU, where government-sponsored training programs have been tried with no benefits, and lots of costs, for decades now.

So what to do?

  • Some uses of temporary safeguard measures, assuming they're in line with WTO requirements that allow transitional protection tied to a convincing plan to overhaul and make the protected industry more competitive, would be useful. Interestingly, the protection thrown around our steel industry in early 2002 --- largely, it seems, for political reasons (the forthcoming Congressional electio0ns) --- didn't meet those standards.


  • A more effective program of trade-adjustment assistance, which is several decades old in the US economy, is desirable. Courtesy of it, the workers laid-off in industries owing to foreign competition can be subsidized by the federal government for retraining and relocation to other jobs. The hitch is to find a way to give the laid-off workers two incentives: to accept the assistance rather than press their local Congressmen and Senators for protection, and to use the money to get retrained and find new work as promptly as they can. Setting a time-limit on the assistance helps here. So does enough money to wean workers threatened with lay-offs to accept the inevitability, rather than join management and local officials to urge quotas or tariffs. And the job-training should be done by businesses: they know what they want and want they can use. Governments don't.


Recently, the government has experimented with a successful pilot program here: as soon as workers accept a new job, or are full-time enrolled in an accredited training program run by the private sector, their existing income will be increased up to 18 months or so to match what they were formerly getting in the uncompetitive industry

  • A booming economy with lots of new jobs would definitely be a plus too. Threatened workers might even prefer, some of them anyway, to move on. American labor is very flexible and mobile. They respond to new opportunities better than their counterparts anywhere else.


  • Putting pressure on the Asians to let their currencies rise in value --- in an orderly manner --- would lessen our trade deficits with them. Whether they would do this is another matter: they can buy endless amounts of dollars in currency markets by using their own national currencies for that purpose. The threat of counter-protection by the US government might help force an appreciation of their currency rates compared to the dollar, but there is a double problem here: making it credible (they will threaten to retaliate moreover), and ensuring it meets WTO rules. All of us benefit from those rules. We lose some cases, but we also win some when we go to the WTO with our trade complaints.


 

WHAT SHOULDN'T BE DONE

It's Fairly Clear.

Two alleged elixirs aren't going to work. In particular,

  • Permanent protection isn't a solution with staying-power, just the contrary: as with the recent the steel imports, it will create problems, rigidities, and job-losses in other industries that now have to buy more expensive inputs into their own production.


  • Nor is putting pressure on US multinationals to stop transferring jobs abroad going to work. In a globalzing economy, that will continue. In the short run, it's true, some skilled workers --- like unskilled ones in mfg. industries in earlier decades --- will lose out to cheaper workers in other countries. Patriotic appeals or the President's using a bully-pulpit won't have any noticeable impact either. The competitive pressures on firms are just too intense and multisided for them to work.


But what can be said by way of something positive? For the answer, ponder briefly the historical record of the US economy. Why? Because . . .

What It Shows Is Very Encouraging:

  • Our economy has a remarkably unmatched ability to generate new, well-paying jobs, something it has been doing for two centuries now.


  • There has never been a big breakthrough in the rate of labor productivity in the past that wasn't followed by such job-creation and rising standards of living for the American people.


  • Over time, a cheaper dollar in currency markets will stimulate job-creation in this country. It will do so in two ways.


      • First, US exports will eventually increase, and at some point imports will fall over: how sharply and quickly depends on the dollar's exchange rate and on economic growth abroad in the EU and Asia and Latin America.


      • Second, though jobs are being lost as US multinationals transfer some abroad, foreign multinationals keep investing in the US economy and creating jobs. We're the biggest recipient of such multinational inflows. No less important, a cheaper dollar will encourage even greater inflows of such foreign mulitnational implants in the US economy. Why? In part, as Toyota and Nissan have made clear, they can't sustain their profit margins from their big sales in the US economy by means of exporting: the dollars they earn from their sales here translate into fewer Yen back home, squeezing their margins.


  • Markets, however --- even those in the US, which are unusually flexible and fluid by international standards --- are not automatically self-adjusting, an assumption usually found in a great deal of mainstream economics. Dislocations are inevitable: it takes time for capital and labor and skilled scientists and engineers and managers to move to other industries.


 

This latter set of points is crucial. It deserves to be clarified with care, and in a sub-section of its own:

CAPITALIST DYNAMISM: INEVITABLE DISLOCATIONS AND A RETURN TO PROSPERITY



Given the recurring shocks of capitalist change, including new technologies and constant shifts in economic dynamism around the world, what will usually happen in the US economy is this: the combined changes cause short-term dislocations and at times even economic and social upheavals. Whole regions of the US can experience big ups and downs in economic vigor: prosperous one decade or two, only to fall into decline quickly in the next decade. Families income can be hurt too. And what were once prosperous towns and cities can become rust-belts within a few years. All the same, our remarkably flexible economy, the willingness of Americans to move around the country to find new jobs if need be --- or get re-trained for that purpose --- and the matchless ability of start-up businesses to create whole new industries from scratch, with booming future prospects . . . all these combine, eventually, to keep our standards of living rising, restore hurt regions to prosperity, and keep the American job-machine humming along.

Yes, it takes time: often a decade or two, usually not longer. And it always happens, this return to regional prosperity and whole new industries with jobs galore.

 

You want some specifics? Consider Two Examples.

All these shocks and dislocation happened to New England in the last century: twice. By 1900, it was the richest area of the US, full of booming ship-making, textile industries, gun-making, iron-forging, shoe manufacturing, and the fishing industry. More specialized manufacturing also flourished there, such as the production of heating equipment and later air-conditioning. By the interwar period, all these regional industries were in decline. After WWII, it recovered and became a big high-tech area in the 1970s and early 1980s . . . only to experience another big downturn as high tech moved to the Southwest and California, as well as elsewhere in the US in that decade. In the meantime, standardized manufactuers like autos, specialized steel, advanced textiles --- their decline in part offset by foreign multinationals locating here --- preferred to install themselves in the South and California, with more flexible labor markets. Even so, by the late 1990s again, the adjustments had been largely absorbed in New England, and it was an area of high-tech expansion once more. Tourism and education are also big income-earners for that region, as is the steady flow of retirees out of big cities to New Hampshire, Vermont, and Maine.

The Mid-West went through even more unsettling changes, under greater pressure, in the 1980s and early 1990s. Several million unionized, well-paying jobs with benefits --- probably 5 to 6 million --- were lost as US mfg. found itself outperformed by foreign exports to the US (as in autos or consumer electronics or steel or textiles), or stuck with high-costs. Fortunately, the adjustments were rapidly absorbed. By the mid-1990s, the Mid-West had carried out one of the most astonishing economic transformations in modern history: it emerged everywhere with streamlined mfg. industries, booming high-tech centers, all sorts of new businesses related to high-tech. Scarcely any city hasn't fostered improvements in its local colleges and universities and encouraged close interaction with high-tech firms to tap their local offerings: research facilities, engineers, technicians, inexpensive land and energy, and tax breaks.

 

AND SO THE CRUCIAL LESSON

All of this, it's important to note, is in line with the dynamic, shock-filled nature of global capitalism. Smooth, relatively friction-free market adjustments are an imaginary oasis set out in large numbers of economic textbooks. They don't exist anywhere in the real world.

Given these realities, any decent country will find ways to try cushioning the shocks, such as with a decent system of social security, unemployment insurance, portable health benefits, portable pensions, and offers to sustain income for a while as job-retraining is undertaken . . . preferably by the private market, the record of government-sponsored programs in that area, either here or in Europe, a big bust. The trick is to have enough cushioning that the dynamism and flexibility of the national economy aren't undermined. Incentives for workers and capital to move, relocate, get new industries and jobs going, are the key.

But note carefully. Overdoing the cushions --- the big problem in Japan and most of the EU --- will not only slow-down market-generated adjustments caused by technological breakthroughs and globalizing shifts in economic dynamism, they will invariably create rigidities and political horse-trading backed by huge vested interests that lead to high levels of permanent unemployment and threaten a country's standard of living in the future. At some point --- the challenges facing, say, Japan, Germany, France, and Italy --- making the inevitable changes comes belatedly and amid far more rooted resistance to them. It remains an open question how effectively these four big industrial countries manage to restore their economic dynamism . . . all the more problematic, come to that, as their populations are rapidly aging. Older people are more averse to change and risk. They are also living longer, and their state-financed pensions will have to be paid by increasing taxes on the shrinking work forces in those countries . . . unless, of course --- an unpalatable alternative to all four of their peoples --- far more immigration is allowed than now exists.



 



REMEMBER:

If the US economy --- which accounts for only about 25% of the world's total GDP of about $40 trillion --- has generated 95% of world economic growth since 1996, directly in this country and indirectly through our imports from others, the world economy would apparently have fallen into a huge Depression without the US trade deficits in goods and services. The same thing, by the way, was the case in the early 1980s. In both instances, we would be badly hurt along with the foreign countries.

But . . . it does all point up a huge lopsided problem in the global economy: rich countries or regions like Japan and the EU should be able to generate their own domestic-led growth. And China with 1.3 billion people has essentially relied on export-led growth --- $120 billion worth of trade surplus alone with this country the last year (20% of China's overall GDP growth, not counting multiplier effects!) --- instead of carrying out the reforms needed to sell more goods and services productively to its huge population, especially in the Northwest and interior away from the booming south coast.