Global: Policy Blunder
Stephen Roach (New York) Morgan Stanley
Apr 25, 2003
morganstanley.com
It’s hard to argue against the logic of tax reform -- the “apple pie” of fiscal
policy. Who wouldn’t want a more efficient tax system? But like all good
things, such efforts have their time and place. Sadly, today’s saving-short
US economy simply can’t afford to indulge in the luxury of tax reform. While
a counter-cyclical fiscal stimulus may be in order in a soft economic climate,
multi-year deficit spending is not. To the extent that Bush administration
policy proposals lead to ever-mounting federal budget deficits, serious new
risks might afflict the US economy -- namely, an exploding
balance-of-payments gap, a plunging dollar, and rising interest rates. These
aftershocks would swamp any hopes for a windfall of economic growth and
job creation.
The macroeconomic impacts of fiscal initiatives are best seen in the context
of a national saving framework -- the means by which investment, the
sustenance of longer-term economic growth, is funded. The government
sector plays an important role in the determination of national saving.
When the federal government runs a budget surplus, it is making a positive
contribution to the pool of national saving. Conversely, when the
government budget goes into deficit, the public sector is then “dissaving”
-- in essence, offsetting the private saving generated by households and
businesses. If the private sector has an ample reservoir of saving, the
economy can afford large government budget deficits. However, if private
saving rates are low, fiscal profligacy becomes unaffordable.
The latter set of circumstances depicts the perils of today’s saving-short
US economy to a tee. America’s net private saving rate -- by net, I mean the
saving left over after allowing for the depreciation and/or replacement of
worn-out capital stock -- stood at just 4.1% of GDP in the fourth quarter of
2002. While that’s up from the 2.4% low hit in the spring of 2001, it remains
less than half the 8.8% average prevailing over the 40-year interval, 1960 to
1999. Unfortunately, the modest increase in private sector saving that has
occurred over the past year and a half does not represent a new American
penchant for national saving. Instead, courtesy of the first round of Bush
administration tax cuts, it merely reflects a transfer of saving from the
government to the private sector. The government sector’s net saving rate
-- federal plus state and local units, combined -- went from a surplus of 1.1%
of GDP in the second quarter of 2001 to a deficit of 2.8% in the final period
of 2002.
The result is that America’s net national saving rate -- the aggregation of
saving by households, businesses, and the government sector -- plunged
to a record low of 1.3% of GDP in the second half of 2002. By way of
comparison, this rate has now fallen to only one-fourth the 4.8% average of
the 1990s and even further below the longer-term 40-year average of 7.6%
recorded over the 1960 to 1999 interval. Undoubtedly, some of the recent
decline in national saving reflects the temporary impacts of a deteriorating
business cycle climate. After all, due to the impacts of built-in “automatic
stabilizers,” government budget deficits always widen in recessions. But in
late 2002, the net national saving rate fell to half its prior low of 2.5% hit in
mid-1992. America’s plunging national saving rate is now plumbing new
depths. And the risk is it is about to go even lower.
A sharply deteriorating federal budget position, in conjunction with Bush
administration policy proposals that are now on the table, can only make
matters worse as seen through the lens of America’s national saving
framework. The non-partisan Congressional Budget Office estimates that
the President’s proposals will add about $800 billion of deficit spending
over the five year time frame, 2004-08. The ten-year estimate is an
astonishing $2.7 trillion. In both cases, these totals are roughly double the
estimated impacts of the first tax cut enacted in 1991. At the same time,
budget analysts are scrambling to update their assessment of the current
state of the US fiscal balance. In its March 2003 review, the CBO estimated
the Bush Administration budget would produce deficits averaging about
$310 billion during fiscal 2003-04 -- even after allowing for the so-called
dynamic-scoring feedback effects that have long captivated supply-siders.
Morgan Stanley’s latest estimates are closer to $375 billion for both years,
and other analysts are even less sanguine, with numbers topping $400
billion.
Federal budget deficits of this magnitude would equal about 3.5% of GDP
over the 2003-04 period -- fully 1.2 percentage points larger that the shortfall
hit in late 2002. Consequently, barring a spontaneous revival in private
sector saving -- highly unlikely in times of economic distress --
ever-widening federal budget deficits could well be sufficient in and of
themselves to all but erase the thin margin of net national saving in the
United States. The likelihood of a “zero” net national saving rate -- or even
a negative saving rate -- now looks to be a real possibility if Washington
opts for another fiscal gambit.
Alas, the story doesn’t stop there. It is an economic tautology that saving
must always equal investment. But that doesn’t necessarily mean a
saving-short economy can’t grow. Lacking in domestically generated
saving, America has turned to foreign savers for help in funding economic
growth. That requires massive inflows of foreign capital and equally large
current-account deficits to attract that capital. It’s not by coincidence that a
saving-short US economy now has a serious balance-of-payments problem.
It is the only option America has left to keep the growth magic alive.
The US current-account litany is every bit as worrisome as the saving saga.
In the fourth quarter of 2002, the current-account deficit hit an annualized
$548 billion, a record 5.2% of GDP. That surpassed the previous record of
4.5% hit in late 2000 and was well in excess of the 3.4% external gap
recorded in 1987 -- the last time America was faced with a serious
international financing problem. Here’s where the budgetary arithmetic of
saving-short US economy becomes so daunting. If, in fact, the net national
saving rate now heads toward zero, the current-account deficit will have to
widen sharply further, moving toward the 6.5% to 7.0% zone as a share of
GDP over the next couple of years. In that case, capital inflows would have
to total around $3 billion per business day. Neither the United States nor
the world has ever faced an external financing burden of that magnitude.
History is clear on what to expect next. A classic current-account
adjustment appears inevitable. America is on an unstable and perilous path
that simply cannot be sustained. At a minimum, foreign investors will begin
to exact concessions on the terms under which they provide financing for
America. A weaker dollar and higher yields on Treasury securities are likely.
Or the arbitrage could occur in equity or property markets. But whatever the
outcome -- and I tend to favor the dollar-interest-rate correction -- there can
be no mistaking the endgame. America’s runaway budget deficit only
compounds the external financing requirements of a saving-short US
economy. It pushes both the national saving rate and the current account
deficit into unprecedented zones of distress. And it leaves America
plunging headlong down a most reckless path.
Fiscal profligacy, and the current-account funding crisis it might trigger,
could wreak havoc on world financial markets. Most worrisome would be
the distinct possibility of a sharp back-up in long-term interest rates. Even
as the US now flirts with outright deflation, such a possibility can not be
ruled out -- it may well be the premium that foreign investors require in order
to purchase ever larger volumes of dollar-denominated assets. That could
spell serious trouble for overly indebted US consumers and businesses.
Historically low interest rates have been the only means by which rising
debt burdens have not crushed highly levered private sector borrowers.
Low interest rates have also fueled the home-mortgage refinancing bonanza
-- the last line of defense for otherwise beleaguered American consumers.
As the current-account adjustment takes hold, those days could be over.
It is in this context that Washington must come to its senses on the budget
debate. The argument is not over the merits of tax reform, in general, or even
the specific proposal on the table for the elimination of the double taxation
of dividends. Notwithstanding the obvious politics of such initiatives --
especially the class warfare implications of dividend tax relief that pit the
Left against the Right -- the economics scream out for a very different
focus. In a saving-short and weakened US economy, a fiscal stimulus must
instead be focused on getting the maximum bang for the buck in a short a
period of time. It should not provide breaks over a long period of time --
especially ones that may or may not stimulate aggregate demand.
Short-term payroll tax reductions that put high-octane fuel in the hands of
spenders are far more effective than multi-year tax reform initiatives in
getting the economy moving again. The latter approach is at best a very
circuitous means to stimulate a weak economy.
In the end, there’s something more basic at risk, here -- the paradigm of a
US-centric global economy. America’s record and ever-widening
current-account deficit is symptomatic of unprecedented imbalances in the
US and the broader world economy. The US has consumed to excess and
the rest of the world has done precisely the opposite -- perfectly content to
sustain its growth by selling things to Americans. The bill for these
excesses can go unpaid for only so long. Yet Washington is now upping
the ante -- asking for the world to foot an even larger portion of the bill.
Outsize budget deficits that spark a current-account crisis could well the
tipping point that finally brings this house of cards tumbling down. It would
be a policy blunder of monumental proportions. |
