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Thursday, June 24, 2004

AN EXCHANGE WITH A VISITOR ON THE US ECONOMY'S ALLEGED DANGERS: 1st of 2 Articles

The following brief comment was left by John, a lawyer who has spent long stints working in West Europe, including a year's internship with the German government. He returns to Europe frequently for professional reasons as well as for vacations, and so he has followed our series on development --- just about ready to be extended to a 6th article --- and especially how Anglo-American capitalism differs from the EU welfare-state sort, with particular interest.

Note that the buggy reply to John unfolds with lots of twists and turns; and though they shouldn't be hard to follow, they added up to a fairly hefty commentary . . . so much so that the reply has been divided into two articles. What follows is the 1st of the two. The second will immediately ensue, a direct continuation of the overall argument.


From John

Prof Bug:

In this wonderful ongoing series of yours on the performance of the US economy --- especially compared to its rivals abroad in the last decade or so --- would you be willing to discuss what many of us worry about more and more: whether, to put it bluntly, the US economy isn't heading into troubled waters as the Federal government's deficits rise and rise and the US current account, our trade in goods and services with the rest of the world, does the same? Aren't these big problems lying ahead for us?

I have to come clean here. What particularly worries me is that these problems would be compounded by one political party coming to dominate the Federal government after the elections this year. If that happened, might not the President and Congress --- unable to agree on the need to cut back on federal spending --- panic and sooner or later institute big jumps in federal taxes to offset the federal deficits?

If that should happen, note the irony, buggy prof.

The American economy would be stuck with both growing levels of governmental spending and ever higher taxes --- a sure-fire recipe, it seems, for hobbling economic competitiveness and dynamism in the future, as it has done, apparently, in West Europe for two decades now. All this, moreover, might be occurring as the EU countries moved in the opposite direction. Faced with structural problems galore and near stagnant economic growth, their welfare-oriented, regulation-obsessed governments might have no choice but to launch more and more market-oriented reforms: in particular, cut government spending, cut taxes, de-regulate, and in these ways reinvigorate their economies. If they did, then --- as we were moving toward an EU level of spending and taxation --- they would be moving toward our system of free-market Anglo-American capitalism that you've discussed. Wouldn't that be a joke! Above all on us Americans.

Now take the irony a step further. If all this did happen on both sides of the Atlantic, wouldn't the huge existing lead of the US in per capita income and dynamism --- roughly 30-35% higher now than the EU average as you note --- be gradually overcome, vindicating the theory of convergence catch-up growth as the gap narrowed? Are we shooting ourselves in our economic foot, so to speak, prof bug?

 

The Buggy Reply

John: Many thanks for your comment. It allows for some extended replies that deal with contemporary worries about the course of US finances and the growing trade deficit. As for the the last part of your comment --- the EU moving toward a Anglo-American free-market form of capitalism even as the US moves toward more spending and taxation --- I'll be much briefer here, taking up the two related points in the next article or two in this series.

PART ONE:
WILL TAXES RISE HERE AGAIN? SHOULD WE EVEN WORRY ABOUT
THE FEDERAL AND TRADE DEFICITS?


Will Taxes Rise Rapidly in the US?

Most likely not, even though a future Congress and the next President might decide to raise them back to the 2002 levels before the third round of Bush tax cuts last year (2003). To explain, consider this quintet of points:

1) Presumably, by a single party federal government, you are referring to . . . well, possibly a Republican majority for several years in Congress along with a Republican president. If so, I'm not sure that will happen even this fall; but if it did, it wouldn't last long. Back in 1964, when Johnson pasted Goldwater, there was talk about a dominant Democratic majority for decades. It lasted exactly four years as far as the presidency went. Then, in the 1980s, the balance shifted toward Reagan and the Republicans, but Clinton was able to get elected twice in the 1990s.

If, oppositely, you're thinking about a Democratic sweep in both the Congressional and Presidential elections this fall, then yes . . . Democrats would probably be more reluctant to reduce government spending while raising taxes slightly. Or, more likely --- a scenario that will appear at the end of this article --- they would shift the tax burden more toward the affluent, while agreeing with Republicans to cut back on some expenditures. Raising taxes on the broad middle class, by contrast, would be politically unpopular, something Democrats and Republicans both are aware of.

2) As for any tax rises, to go on with this latter point, the likeliest outcome would be that the next president and Congress do exactly what the tax reductions of 2003 intended (unlike those in 2001 and 2002): phase out many of them as the economy, thanks to the big fiscal boost those tax reductions caused (plus very low short-term interest rates), continues to grow at a high pace the next few years.

3) If the president and Congress do let the reductions phase out, then the CBO -- Congressional Budget Office --- projects that the federal deficit will fall from around 4.0% of GDP this year to around 1.5% (or lower) in 2009. We should also start to see a noticeable decline by 2006 under way toward that goal. Remember, if GDP rises faster than the annual federal deficit, the total of US government debt as a % of our annual GDP will continue to fall --- a desirable outcome. As for government surpluses, they may or may not be desirable. It all depends on the growth rates of GDP and job-creation.

4) If, by contrast, a Republican Congress and president decide to make the tax cuts permanent, then one of two things will happen: either they will also agree on major reductions in government spending --- alas, with little chance that most of the pork barrel will be cut out --- or then we will be back in the Reagan era of the 1980s and structural fiscal deficits (as opposed to cyclical ones in a recession and coming out of it ) will then mount rapidly. In that case, the CBO projects mounting deficits after 2009 that, like the Reagan deficits, couldn't be sustained too long, absorbing far too much of our national savings.

5) All that said, some figures, John, might help allay much of your worry. First, here's a table that sets out the data on Federal government spending, receipts, the size of the deficit, and so on across the administrations of all presidents since 1946, with particular breakdowns for the Reagan, George Bush Sr., and Clinton years, compared with the estimated figures for 2004 in the George Bush Jr. year.

Untitled Document

 

Comparison of Bush Budget (FY'04) with Past Budget Averages:
Important Buggy Note:
This table is taken directly from the TaxFoundation web site, written by its chief economist, John S. Berry, and all citations should be explicitly to that web site:
FY'04
Proposal
Post-WWII
Average
(FY'46 - FY'02)
Clinton
Budgets
(FY'94 – FY'01)
G.H.W. Bush
Budgets
(FY'90 - FY'93)
Reagan
Budgets
(FY'82 - FY'89)
Total Receipts as percent of GDP 17.0% 17.9% 19.4% 17.7% 18.0%
Total outlays as percent of GDP 19.7% 19.5% 19.6% 22.0% 22.3%
Deficit (-)/Surplus as percent of GDP -3.8% -1.6% -0.1% -4.3% -4.3%
Annual growth in total receipts (average % change from previous fiscal year, FY96 $) 2.7% 2.9% 4.9% 0.5% 2.5%
Annual growth in total outlays (average % change from previous fiscal year, FY96 $) 2.2% 2.3% 1.5% 1.9% 2.7%
Defense spending as a percent of total outlays 17.5% 35.5% 17.1% 21.7% 26.7%
Non-defense discretionary spending as a percent of total outlays 19.2% 19.4%* 17.6% 16.6% 17.1%
Net interest costs as percent of total outlays 7.9% 10.5%* 13.9% 14.5% 13.2%
Other mandatory spending as a percent of total outlays 55.4% 41.6%* 51.4% 46.2% 42.9%
Debt held by public at end of fiscal year as percent of GDP 36.9% 44.0% 43.0% 46.3% 36.7%
Gross Debt at end of fiscal year as percentof GDP 64.8% 56.2% 63.4% 61.8% 45.4%
* includes only data back to 1962 since the distinction between discretionary and mandatory began
only in that year


A few brief comments:

1) As you can see, federal taxes as a % of GDP right now are actually slightly lower than the post-WWII average through the first two years of George Bush Jr's tenure in the White House. Total expenditures --- outlays --- are a tad higher than that average (19.7% of GDP vs. 19.5%) or the Bill Clinton average over his 8 year tenure, but noticeably lower than in both the Reagan and George Bush Sr. era.

2) The federal deficit for this fiscal year --- estimated originally to be about 2.7% of GDP (and hence way below the Reagan and Bush Sr. levels) --- will actually be around 3.8 - 3.9% of GDP, depending on economic growth in the spring and summer quarters for 2004 . . . which ends the fiscal year. See this link. From that angle, it is in the same league as the average federal deficit in the period from 1982 through 1993, when the US economy began to grow strongly in the Clinton era, and taxes were raised slightly, no more.

3) Defense spending as a % of total government outlays, as you can see, is about half the average that prevailed between 1946 and 2002 . . . contrary to what the political left believes. It's hardly higher than the Clinton average, though if you add in the supplemental spending for Iraq it will be roughly 0.7% higher over this and the next two fiscal years --- or for fiscal 2004 around 17.8% vs. the Clinton era average of 17.1%

4) Most of the big leap in spending --- besides for defense and Iraq --- is actually going to be for medicare, education, and some other domestic programs.
 

More Comparative Data: Bush Tax Cuts vs. Others In The Past

Kennedy, Reagan, and Bush Tax Cuts Compared
Again, all references to this table should be to the Tax Foundation web site here


Untitled Document
Tax Legislation Tax Cut in Billions of Current Dollars (a) Tax Cut in Billions of Constant 2003 Dollars Tax Cut as a Percent of National Income (b) Surplus or Deficit (-) as a Percentage of National Income (b)
The Kennedy Tax Cuts — Revenue Act of 1964 -$11.5 -$54.9 -1.9% -1.0%
The Reagan Tax Cut — The Economic Recovery Tax Act of 1981 -$38.3 -$68.7 -1.4% -2.8%
The Bush Tax Cuts      
The Economic Growth and Tax Reform Reconciliation Act of 2001 -$73.8 -$75.8 -0.8% 1.5%
The Job Creation and Worker Assistance Act of 2002 -$51.2 -$52.0 -0.6% -1.7%
  2003 Tax Cut -$60.8 -$60.8 -0.6% -3.8%
  The Bush Tax Cuts if Combined in 2003 NA -$188.1 -2.0% -
(a) First year estimate.
(b) National Income as measured by Net National Product.


In effect, aside from a couple of follow-up remarks, these stats speak for themselves.

1) Contrary to the worried hype in some circles, the combined Bush tax cuts over three years are virtually identical as a % of GDP to those in the Kennedy period, hailed as a great breakthrough for Keynesian economics in those days --- a much needed boost to a slow growing economy that would pay for themselves when GDP growth rose in the aftermath. The main difference really? The economy wasn't in recession in the early 1960s when the Kennedy tax cuts were adopted. In 2001, it was; and worse, though GDP growth did pick up in 2002 and 2003, unemployment kept rising until last summer.

2) As for the size of the Federal deficit, it was --- as we noted a moment ago --- projected in May to fall from around $521 billion this fiscal year to $421 billion, precisely as a result of another $100 billion tax revenue generated by the big surge in GDP growth since last summer.

 

PART TWO.
A THEORETICAL FOLLOW-UP: IS CROWDING OUT OF INVESTMENT INEVITABLE IF FEDERAL DEFICITS CONTINUE TO RISE RAPIDLY?


The brief blunt answer: no, probably not --- and this time for a couple of reasons:

1) Claims About Crowding Out Of Investment Aren't Borne Out By The Evidence

Should the latter scenario just sketched in materialize --- the 2003 tax cuts made permanent, and not matched by offsetting cuts in government spending --- then, it's argued, there would likely be a problem for the US economy. Economists refer to it as "crowding out". The concept's easy to grasp: as the US Treasury sells more and more securities to finance a Federal government deficit, it competes with private investors for a given pool of national savings. The result will be a rise in interest rates, and in the process private investment --- and consumers' purchases of durables like cars and houses --- will fall.

In the full robust version of crowding out, the fall in private investment would exactly match the federal deficit for the year. If that's the case, note, there could be no fiscal stimulus at all to GDP; even so, in the long run, economic growth would be harmed because of the lower levels of private investment. The longer the fiscal deficits continued, the greater the harm to cumulative private investment. Most economists don't go that far. Most buy a more moderate version: some crowding out will occur, not full crowding out. Even so, private investment would still suffer from the higher interest rates that the deficits caused.

A question quickly prompts itself: is such crowding out, either fully or partially, inevitable?

Whatever the theory claims, no --- not really. And a small number of economists agree. Hard to see how they couldn't. The evidence, past and present alike, contradicts the crowding out claims.

  • From 1986-1991, to get down to cases, the Federal deficits kept rising and rising, yet long-term interest rates --- which the Federal Reserve doesn't control directly (but can influence in adverse ways, mainly by letting an inflationary spiral start and hence leading to long-term lenders demanding ever higher interest rates) --- didn't rise, but came steadily down. That was especially true of a key rate, the 10-Year Treasury Bond. It fell throughout the late 1980s even as structural Federal deficits rose and rose.


  • Similarly, as the Federal Deficit rose rapidly again after 2000 in the recession and afterwards --- reversing a fairly large US budget surplus in the late 1990s --- interest rates, both short-term and long-term, have been at near record lows. That's been the case for a good three years now. And though, in the near future, they will begin to rise again, the driving force isn't some hypothetical crowding out of private investments as the US Treasury continues to sell Treasury securities, rather a renewed concern, muted so far, that inflationary pressures might be building up again.


 

2) An Alternative Theory of Crowding Out: US Exports Take The Hit As Foreign Capital
Streams Into The US


An alternative twist of the "crowding-out" has been offered to explain why private investment wasn't hurt by the sharply rising Federal deficits in the late 1980s or again since the start of 2001. It's not a new twist. It goes back again to the early years of the Reagan era, when Federal deficits started soaring in the wake of the Reagan tax-cuts. Tersely put, the twist claims that crowding out can be shifted to the US current account --- trade in goods and services --- with the harm showing up, the argument goes, not in a sharp fall in private investment, but rather in US exports to the rest of the world.

The logic behind the theoretical alternative here? It's pretty straightforward. Worried about the inflationary pressures being generated by the Reagan Federal deficits stimuli to GDP and employment, kept short-term rates high, the Federal Reserve tried to offset those pressures by hiking short-term interest rates to near record levels. In turn, the more rapidly US interest rates rose, the more zealously foreigners invested in the US economy to take advantage of those rates; simultaneously, the faster they exchanged their Deutsch Marks or Yen or pounds or francs for dollars in order to buy US Treasury bills and bonds or equity shares in the US stock market --- or Rockefeller Plaza or MGM or shift production to this country as Toyota and Honda started doing --- the higher the dollar's value soared in currency markets.

The result? It's three-fold:

(i.) As just noted, the higher short-term interest rates that the Federal Reserve was responsible for attracted more and more capital into the US economy: in turn, the large capital inflows from abroad --- which have scarcely abated since the 1980s, though with some ups and downs over this lengthy period --- offset crowding-out in private markets whenever the US Treasury sold its bills and bonds in order to finance the US federal deficit. It offset any crowding out because the capital inflow from abroad added to available US savings and kept long-term interest rates from rising: in fact, along with declining inflationary worries, helped send them lower: witness the 10 Year Treasury Bill.

(ii.) Crowding-out still occurred between 1981 and 1986, it's argued --- only in this instance, what was crowded out were US exports abroad, not interest rates at home. The cause was largely the high dollar, itself a result of private foreign investors seeking to invest their capital in the US in bursting quantity. And between 1981 and 1986, it's true, that kind of crowding out did occur: the US Federal deficit rose rapidly, US interest rates did too, capital inflow was at a record-high for that era, and consequently the dollar's value soared and so did the US Current Account deficit.

So far, nothing new here. Enter a new-new twist to this alternative theory of crowding-out, active these days: the behavior of foreign Central Banks, especially in Asia. Their behavior deserves some brief illumination.

First off, note that motive-force driving large inflows of private investment into the US economy from abroad remains as powerful as ever. Since the mid-1990s, though, Central Banks in Asia (and to an extent elsewhere save in West Europe) have also begun investing at rocketing levels in American financial assets. In particular, the Central Banks in China, Japan, South Korea, and Indonesia --- plus quite a few others around the world --- have sold large amounts of their own currencies like Yuan or Yen or pesos to buy dollars, mainly to keep the exchange rate of the dollar from falling against their own currencies. In this way, they enjoy an undervalued currency that keeps their exports streaming to the booming US economy . . . export-led growth the main stimulus to their domestic economy's GDP performance.

In just the last two years, for this purpose, the Central Banks of Japan and China alone appear to have bought dollars to the tune of around $250 billion each for that purpose. In January alone of 2004, one short month, Japanese investors bought $67 billion worth of US financial assets --- a large chunk, apparently, by Tokyo's Central Bank! As a result, the governments of Pacific Asian countries now have around $2.0 trillion dollars in their reserves of foreign currencies.

What do they do with vast dollar reserves?

Obviously, except for a tiny percentage of those reserves needed for operating purposes --- to supply, say, a Japanese firm with dollars if they want to buy a US-made imported good or a Japanese family preparing to travel to Hawaii --- they don't actually keep the currency stuffed away in their coffers. What they do is invest the vast bulk of their dollars in US Treasury securities as well as other US financial assets, earning in this way good safe returns on their investments, year-in, year-out.

 

Are there drawbacks to their strategy? Yes, one danger stands-out above all else:

Specifically, a markedly undervalued currency like those in most of Pacific Asia these days can generate inflationary pressures in the domestic economy, and especially if GDP growth is high and nearing full capacity. In such circumstances of economic booms, imported goods and services rise sharply. The result is predictable: the surging imports --- extra-expensive because they have to be paid for with more and more relatively cheap Yuan (to single out China) --- wiil add to domestic inflationary pressures.

That's the case of the booming Chinese economy, the stand-out example here. The more the country's GDP has leapt ahead the last few years, the more Chinese firms and households have had to import foreign energy, minerals, food, manufactured components, and the like. In the upshot, the country now faces a serious inflationary outbreak, at a time --- despite the boom --- when unemployment in the rust-belt of the Northwest and in the backward areas of the interior is dangerously high, with social conflicts themselves a daily affair in those areas. The very likely outcome: to help fight inflationary pressures, the Chinese government will soon have to revalue the Yuan.

Politically that won't be easy. Squeezing out inflationary pressures, once they're serious, is difficult in any economy: not only will GDP growth have to be cut noticeably, unemployment will surge too. In China, the attack on inflation will be doubly charged with political menace. In particular, the Chinese CP will have to deal more directly with all the discontent, unemployment, vast inequalities, structural problems, environmental harm, and lack of access to health services --- not to mention the lack of a social security safety-net outside the dwindling state-owned enterprises --- that its export-led economic growth, focused on the prosperous and privileged south-coast cities, has aggravated.

So far, the boom has tended to mask some of those hot-wire social problems and discontent, even to an extent in the backward areas.

When it ends as it likely will in the next year as the government struggles to stamp out inflation, those problems will not only flare, the Chinese CP itself --- 60 million very privileged, powerful people (especially the top few thousand) who are besot with wealth-making and corruption of their own --- will have to figure out a new developmental strategy that tackles all the huge market-inefficiencies and institutional problems that its existing strategy has let build up. It's not clear they will succeed easily, if at all --- serious reform requiring, in effect, the CP to commit political suicide and renounce all its vast privileges connected with its political monopoly. (On this built-in conflict between a CP monopoly of power and the logic of sustained economic development to make China a rich modern country, see the buggy professor series last fall, some four articles. Start here. )

Japan, by the way, isn't worried that a cheap currency, its Yen, will create inflation; in fact, it's only recently that its economy, stagnant for a decade, has been crawling out of a self-created hole of deflation. A rise in its general price level would be welcome by the authorities there.


(iii.) Meanwhile, recall that the key question raised a moment ago has been left hanging fire: is crowding out of US exports inevitable as Federal Deficits rise? The answer is, no . . . not inevitable. Why? Here again the historical evidence runs against the alternative crowding-out theory.

Specifically, this second kind of crowding out --- Federal Deficits leading to higher short-term interest rates, which in turn led to booming capital inflows from abroad that raised the price of the dollar and hurt US exporters while facilitating US imports --- ended abruptly after 1986. In the next five years alone, the dollar fell swiftly against other currencies, and US exports more than doubled. And yet --- a clear refutation of the crowding-out theory in its alternative form --- US Federal deficit continued to rise yearly from 1986 for the next several years. (We'll illustrate these points with charts in a moment or two. Meanwhile, note that the annual Federal deficit slowed down by the mid-1990s, and then reached a surplus starting in 1997-98.)

 

What Concretely Happened After 1985 To Refute The New Crowding-Out Theory?

Well, in late 1985, foreign governments agreed with the US government --- which was facing more and more protectionist backlashes against the soaring imports of manufactured goods from Europe and above all Asia --- that the dollar was too high. As a result, they also agreed to a coordinated effort at currency interventions: foreign Central Banks sold dollars, lowering the exchange rate, and they and the US Treasury (which manages the dollar exchange rate here) bought large quantities of Yen and Deutsch Marks and other European currencies.

What occurred afterwards?

One thing for sure: not any crowding out --- whether rising interest rates or rising trade deficits.

Even though Federal deficits continued to soar in size until 1991, they hurt neither US long-term interest rates nor US exports. Far from it, the opposite occurred. The interest rate of the 10-Year long-term Treasury bond fell steadily into the 1990s; simultaneously, between the start of 1986 and 1995, the dollar fell about 50% against a basket of other currencies and enormously boosted US exports. Against a basket of the Deutsch Mark, the Japanese Yen, the British pound, and the Swiss france, the other major currencies in the world at the time, the dollar fell almost by 60% in those five years. Small wonder that, in those five years alone, US exports more than doubled.

In the upshot, as long-term interest rates continued to fall, the current account deficit --- trade in goods and services --- turned more less into balance in 1990 and 1991, and even a tiny surplus the latter year. And so? If crowding out were sound, at least one of these two outcomes shouldn't have materialized. Ergo . . . well, you can dot the i's and cross the t's yourself.



(Here, by the way, is a chart that plots the dollar's gyrations in value against a broad basket of other currencies since the 1970s, not just the major ones like the ones just mentioned. Against them, the gyrations would be even higher.

 

Note:The actual source for this particular chart, created originally by the Federal Reserve, is Robert Blecker, "Let It Fall: The Effects of the Overvalued Dollar On US Manufacturing and the Steel Industry" (Oct. 2002), and all references should be strictly to it.