New from the Levy Institute: Fiscal Policy to the Rescue.
(my apologies...I did not receive line format problems on the preview...as a result I do not seem to be able to format this better)
Fiscal Policy To The Rescue by Wynne Godley : Policy Note 2001.01
levy.org
The U.S. expansion of the past eight years has been fueled by a rise in
private sector indebtedness. In 1997 U.S. private sector spending
exceeded income for the first time since 1952, and since then the gap
between the two has risen markedly. The situation closely mirrors that
experienced in the United Kingdom during the 1980s, when a two-year
slowdown resulted in absolute declines in GDP and a
three-percentage-point increase in the unemployment rate.
U.S. PRESIDENT GEORGE W. BUSH may eventually have to propose tax cuts
or public expenditure increases far larger than those he currently has in mind.
The reason is simple: the medium-term outlook for the U.S. economy could be
much more depressed than most economists now expect.
For some years it has been fashionable, when discussing macroeconomic
policy, to concentrate almost entirely on supply-side factors. The outstanding
achievements of the United States with respect to innovation and productivity
seem to have led people to suppose that demand can be ignored. Indeed,
Columbia University's Edmund Phelps wrote last year that the U.S. experience
could not have been caused by demand expansion and concluded that growth
had become "structural" (Financial Times, August 9, 2000).
Yet aggregate demand obviously has risen in the United States, and the motor
driving it has been both unique and unsustainable. During the 45-year period
between 1952 and 1997, total private expenditure was almost always below
disposable income (see chart). In the third quarter of 2000, spending
exceeded income by 8 percent. This excess was possible only because the
private sector has been realizing assets and borrowing on an increasing scale;
the indebtedness of the personal sector reached 1.1 times its annual flow of
disposable income-a record-while debt of the private sector as a whole
reached 1.7 times disposable income-another record.
It is often pointed out that the huge increase in asset prices has put household
balance sheets in a strong position despite the increase in debt. But debts
have to be serviced with cash, and this sets a ceiling on the extent to which
they can prudently be incurred. In addition, businesses have become
increasingly indebted: their investment has been growing in excess of internally
generated funds, yet they have simultaneously been net purchasers of equity.
Recent levels of private expenditure relative to income cannot be sustained
unless the flow of net lending continues on at least its present scale, requiring
a further rapid increase in indebtedness. The daunting implication is that
aggregate demand will fall if the growth of debt merely slows. If the level of
indebtedness were to fall, implying that debts are actually being repaid, the
effect on aggregate demand would be even larger. This "hard landing"
scenario has nothing to do with the problems that would be created by a
traditional end-of-cycle inflation surge which so obsessed many Wall Street
economists as recently as last summer.
There are now clear
signs that the limits to
business sector
borrowing are being
reached, while the fall in
stock prices and the
decline in consumer
confidence make it
unlikely that lending to
the household sector
will be sustained at
recent levels far into the
future. The present
situation in the United
States has close
parallels with what
happened in Britain 12
years ago. Then, similar claims were made that a new era had dawned as a
result of Margaret Thatcher's supply-side reforms. But aggregate demand then
was powered by an expansion of net lending, just as the U.S. miracle has
been. Moreover, at its peak-the first quarter of 1989-the United Kingdom's
private sector deficit expressed as a percent of GDP was almost exactly the
same as that reached in the United States during the third quarter of 2000. In
the subsequent two years, as the United Kingdom's private deficit fell to zero,
its GDP fell absolutely and unemployment rose by about three percentage
points.
One does not need an econometric model to conclude that a similar rise in
U.S. private net saving could result in a recession of comparable magnitude; it
would imply a fall of 8 percent in total private expenditure relative to income as
well as a shift of the budget back into deficit. The implications for the rest of the
world would be serious.
The Federal Reserve's recent decision to lower interest rates by half a
percentage point was possible because inflation is still not a concern, as it was
in the United Kingdom 12 years ago. Yet monetary policy alone cannot do the
trick. True, the cut in interest rates backed up by subsequent cuts could stem
the fall in asset prices and relieve the burden of interest payments. But cutting
rates could only reverse a deceleration in aggregate demand by
re-establishing the asset price and credit boom. Such measures would do
nothing more than postpone the day of reckoning.
The only effective antidote to a shock caused by a reversion of private net
saving would be a significant fiscal relaxation. The fact that fiscal policy cannot
be used to counteract short-term fluctuations in the economy in the way most
policymakers and economists advocated in the 1960s, does not mean that the
fiscal stance should not be relaxed if it gets too tight on a medium-term basis.
President Bush is looking for a tax cut worth about 1.5 percent of GDP spread
over 10 years. The shortfall in domestic demand could rise to 5 or 6 percent of
GDP. So perhaps President Bush should be thinking of numbers about three
times bigger than what he is now proposing.
Related Levy Institute Publications
Wynne Godley, Drowning In Debt, Policy Note 2000/6.
Wynne Godley, "Notes on the U.S. Trade and Balance of Payments Deficits,"
Strategic Analysis, Interim Report, 2000.
Wynne Godley, Seven Unsustainable Processes: Medium-Term Prospects and
Policies for the United States and the World, Special Report, 1999.
Wynne Godley and Bill Martin, How Negative Can U.S. Saving Get? Policy Note
1999/1.
L. Randall Wray, Can the Expansion Be Sustained? A Minskian View, Policy
Note 2000/5.
This article first appeared in Financial Times, January 21, 2001.
Copyright © 2000 by The Jerome Levy Economics Institute.
The Jerome Levy Economics Institute is publishing this research with the conviction that it
is a constructive and positive contribution to discussions and debates on relevant policy
issues. Neither the Institute's Board of Governors nor its Board of Advisors necessarily
endorses any proposal made by the author. |
