December 1999
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The Myth of Clintonomics
By John H. Makin
Economic "golden ages," periods of sustained noninflationary growth led by strong investment, emerge during peacetime when governments are less involved in resource allocation and inflation is low. The latter half of the nineteenth century was a golden age of golden ages, and the 1990s too have been a golden age for the U.S. economy. The policies of the Reagan administration—ending the Cold War, deregulation, free trade, and falling inflation—reinforced by those of the Bush administration—successfully quelling the threat to global peace from rogue states in the Gulf War and placing a durable cap on government spending growth with the 1990 budget agreement—contributed far more to the emergence of a golden age in the 1990s than did Clintonomics.
The main contribution of Clintonomics was to do relatively little harm to the favorable economic environment it inherited. Efforts to create an expensive and unwieldy program of health care and the higher tax rates enacted during the 1993 budget agreement created burdens for the economy to overcome; fortunately, the Clinton health care program was defeated. Rising marginal tax rates have tied deficit reduction to a rising stock market rather than to smaller government. Those marginal tax rates will exacerbate the economic downturn that accompanies a falling stock market, since government revenues will fall more rapidly than usual during the next recession. A vanishing budget surplus and, possibly, a return to deficits will increase the sense of malaise that accompanies a recession, and may extend its duration. The shock of sudden budget deterioration will make it more difficult to move toward the lower and uniform tax rates that could be an important part of the next economic expansion.
There is a great irony about the economic and policy environment of the early 1990s. The environment helped to set in place the conditions for the most powerful sustained economic expansion of the twentieth century, and yet its most painful elements, coming as they did during 1991 and 1992, helped to end the Bush presidency. The Clinton presidency needed only to be sufficiently ineffective during its first term as not to derail the powerful economic momentum that was created during the expansion of the 1980s and extended by the policy measures of the early 1990s.
Hard Decisions Late in the
Bush Presidency
Nine years ago this fall, President George Bush and his military and economic advisers were forced to engage in some very heavy lifting. On the military front, they were laying the groundwork for a decisive victory in the Gulf War, which would establish America as a guarantor of global peace and help to launch the U.S. economy and its stock market on a trajectory that has created a prosperous and peaceful decade. On the economic front, budget negotiations were underway wherein the Bush team successfully designed the spending caps—successors to the Gramm-Rudman deficit reduction measures—that held down the growth of government spending. The capped low rate of government spending growth in a decade of great wealth-generation made possible the elimination of the budget deficit by 1997 and is set to create a trillion dollars in cumulative surpluses over the first decade of the new millennium.
The likely benefits of the conditions—low inflation, steady growth, and rising stock prices—that fostered the decade's generation of great wealth went unnoticed as recently as 1995. In that year, my characterization of the American expansion as a "golden-age" investment-led recovery that could continue for a long time without inflation was met with great skepticism, as were my "bold" calls for a Dow reaching 6,500. In 1995, the Congressional Budget Office was estimating that, by 1999, the federal budget deficit would increase from just short of $200 billion to close to $300 billion—and would reach $500 billion by 2005.
In retrospect, it seems very hard to understand how
Bill Clinton won the 1992 election.
The Bush-Created Golden Age Has
Benefited Clinton
The slow start to the powerful U.S. economic expansion of the 1990s was politically costly to George Bush and his administration. In retrospect, it seems very hard to understand how Bill Clinton won the 1992 election, given the great military and economic contributions put together by the Bush team in the midst of a recession in 1990. After the historic military victory of early 1991 and the solid record of economic accomplishment during the 1980s, George Bush, with some logical if not political justification, seemed to believe that everyone would simply understand what extraordinary things he had accomplished in the dark days of late 1990. But the flush of military victory faded throughout 1991, and the economy, which was in the listless early stages of a golden age, displayed only hints of the powerful, investment-led recovery that later materialized.
During the critical years of 1991 and the first half of 1992, talk of a "jobless" recovery hurt George Bush's bid for reelection. Fiscal policy, by virtue of the mandated and strict spending caps engineered by the Bush team in the budget agreement of late 1990, continued to be a drag on the economy. After the end of the Gulf War, and the disappearance of any incipient oil crisis, inflation collapsed—falling by 3 percentage points from December 1990 to December 1991. By late 1990, the Federal Reserve realized that a recession had started, and it cut rates to 4 percent, down from 7.75 percent in November 1990, in a series of thirteen rapid 25- and 50-basis-point steps by the end of 1991. The Fed further cut rates to 3 percent in three more rapid steps by September 1992. But because inflation was falling even faster than interest rates during 1991, the real federal-funds rate actually rose by more than a full percentage point over the first eight months of the economic expansion that began in March 1991. Economic growth was slow to recover during 1991, and year-over-year growth did not turn positive until the end of the year. Even though the economy grew at a 4 percent rate during the second quarter of election year 1992, that was not enough to give voters a foretaste of the remarkable economic performance that lay ahead. In the February 1992 Economic Report of the President, George Bush expressed his disappointment clearly: "Nineteen ninety-one was a challenging year for the American economy. Output was stagnant and unemployment rose." For him politically, that was a leaden age.
Precursors of a Golden Age
The early part of the ultimately vigorous investment-led expansion of the 1990s was unusual in a number of other ways that turned out to be constructive for a long, sustainable expansion—and disastrous for an incumbent president trying to get reelected in November 1992.
Supply-side expansions like the one in the 1990s tend to start slowly. As cautious employers seek to conserve on labor, the unemployment rate may even rise initially before dropping to record lows (as it did in the 1990s). Simultaneously, a sharp drop in inflation, as seen in 1991, can catch the central bank by surprise, push up real interest rates, and further depress demand growth. The 1990s have been the first decade in over sixty years in which disinflationary and deflationary surprises have prevailed globally. Japan is the most dramatic example, but there have been many others. The International Monetary Fund's restrictive policy prescriptions following the crisis of excess capacity in Asia exacerbated the deflationary problems and caused currencies to collapse even further, as countries like Thailand, Indonesia, South Korea, and eventually Brazil desperately tried to export their deflation.
During the postwar era, policymakers became more attuned to demand-led expansions. These expansions usually begin with a sharp drop in the unemployment rate after a sharp easing of monetary policy. That easing pushes up consumer demand by creating a more dramatic, though less sustainable, demand-led recovery. Comparing the data from early in the current expansion with early data from previous expansions reveals the difference between the preconditions for a sustainable supply-side expansion and those associated with a more dramatic but less sustainable demand-growth expansion.
GDP growth shows that the U.S. economy was clearly expanding from March 1991. During the year ending in the second quarter of 1992, just after the March 1991 recession trough, the economy expanded at a respectable 3 percent annual rate, despite both a slight 0.1 percent drag from government spending and the sharp rise in real interest rates that accompanied the 1991 collapse in inflation. That performance paled, however, beside the far more dramatic first year of the demand-led expansion of the 1980s that accompanied the relaxation of monetary stringency and the stronger growth of government spending. By the third quarter of 1993, GDP had risen over 5 percent from a year earlier, propelled by a consumption surge of 6.2 percent and a jump in investment at a 15.4 percent annual rate. A sharp rise in government spending at a year-over-year rate of 4.7 percent also helped to launch a powerful demand-led recovery in the 1980s. After the Fed started to ease in the middle of 1982, short-term interest rates fell dramatically, from a Fed funds rate of 14 percent as late as June 1982 to 9 percent in June 1983.
The term "jobless recovery" sounded a death knell for the Bush reelection bid.
For the Bush presidency, one of the most damaging aspects of the early stages of the 1990s recovery was the lack of employment growth—and the rise, in fact, of the unemployment rate. The unemployment rate stood at 6.8 percent in March 1991 when the recovery began. But slow demand growth and the tendency of producers to concentrate on increased investment spending sent the unemployment rate to 7.5 percent by the fall of 1992, when the election occurred. The term "jobless recovery" sounded a death knell for the Bush reelection bid. The creation of more output with fewer workers is viewed as a good sign today, with the unemployment rate approaching 4 percent. But in 1992, accompanied as it was by a surge in investment, the labor-conserving rise in productivity created the erroneous impression that the only beneficiaries of growth during a Republican administration were capital-intensive businesses; labor was left behind.
The staying power of an investment-led, supply-side expansion that starts slowly but builds steadily on a favorable climate for investment can be seen most clearly by comparing capital formation during the 1990s with capital formation in the demand-led expansion of the 1980s. Strong investment growth did not begin until a year after the current expansion started in the spring of 1991. Two years into the expansion, investment was only about 7 percent above where it had been at the economic trough. Two years into the 1980s expansion, however, investment had risen nearly 30 percent from the trough—and rose over the next five years by only an additional 15 percent, to peak at a level only 45 percent above trough levels. In contrast, during the 1990s expansion, after eight years (the length of the 1980s expansion) investment spending had nearly doubled, to a level 90 percent above trough levels. Investment spending has continued to accelerate over the past year and has reached a level more than twice the trough level, outstripping even the performance in the 1960s expansion by over 10 percent.
A sustained rise in investment means a steady increase in the capital-labor ratio, which, in turn, explains the high level of productivity growth and moderate increase in labor costs that have characterized the most recent stage of the current economic expansion. U.S. labor productivity is now 14 percent higher than it was at the start of the expansion, and it is still growing. At the end of the eight-year 1980s economic expansion, labor productivity had risen by a total of only about 11 percent, and thereafter it began to fall, in contrast with the continuing rise in U.S. labor productivity over the past year. U.S. unit labor costs (the difference between productivity growth and wage growth) are only 18 percent higher now than they were at the economic trough in March 1991. In contrast, unit labor costs rose by nearly 25 percent over the eight years of the U.S. demand-led economic expansion of the 1980s, and they continued to rise in the brief recession that followed.
Thanks to the effective Bush budget caps, real government expenditures did not rise at all from the beginning of 1991 to the beginning of 1996. Government spending rose modestly with low inflation. During the first five years of the 1980s expansion, however, real government expenditures rose a total of 23 percent, exceeding by a wide margin the higher inflation rate of the 1980s and revealing a little-appreciated source of bipartisan congressional approval of "Reaganomics." There was a sharp, well-timed jump in real government spending to a 1.4 percent annual rate during the election-sensitive second quarter of 1996 that helped to push the overall growth rate to 6.9 percent during that quarter. During the three years after 1996, however, real government spending has risen by a total of about 9 percent. Of course, the deficit has dropped sharply, thanks to the surge in revenues tied to the sustained growth in the economy and to the doubled level of the stock market.
The stable, noninflationary U.S. growth of the past nine years is a consequence of the unusually high level of investment during this period.
The U.S. investment-led recovery has enabled the nation to benefit from the growth in world trade during the 1990s. During the first year of the expansion, when monetary and fiscal policies were acting to constrain demand growth, U.S. exports rose by 10.6 percent, thereby helping to cushion the drag from weak government spending and the moderate growth of investment and consumption. Subsequently, the rise in U.S. exports paralleled the strong performance of the 1980s—until 1997, that is, when financial crises emerged in Asia and Latin America. During the 1997ÿ1998 crisis in Asia and emerging markets, the United States became the buyer/consumer of last resort, and imports surged at annual rates of 10 to 15 percent, thereby helping to cushion the deflationary impact on the global economy that resulted from the financial crises of 1997ÿ1998. With the resumption of global growth in 1999, U.S. export growth has begun to recover: it reached a 12.4 percent annualized growth rate in the third quarter of 1999. And U.S. import demand continues to be robust, at a 17.2 percent annual growth rate during the third quarter. The rapid surge in import growth has helped to cushion the U.S. economy from cost pressures that might otherwise have intensified during a period of global growth. U.S. producers have benefited from lower-cost imported components, while U.S. consumers have benefited from access to lower-cost imported goods.
In sum, America's golden-age expansion in the 1990s has been characterized by remarkable stability, low inflation, and a strong (twice the average) contribution from investment. Since 1950, America's average growth rate has been 3.5 percent—which is equal to the growth rate in the current expansion. But the standard deviation of the growth rate since 1950 has been 3.7 percent, more than double the 1.8 percent standard deviation of growth during the current expansion. The average contribution of investment to growth since 1950 has been 0.6 percentage point, only about a sixth of the total 3.5 percent growth, while increased investment has accounted for over a third of overall economic growth, 1.2 percentage points in the current expansion. Expanded consumption growth, at 2.5 percentage points—versus a long-run average of 2.4 percentage points—has been responsible for two-thirds of growth in the current expansion. In contrast, government spending has accounted for just 0.2 percentage point of growth since 1991, versus 0.5 percentage points over the long run. The balance of the growth data show a moderate drag from net exports.
The stable, noninflationary U.S. growth of the past nine years is a consequence of the unusually high level of investment during this period. The outlook going forward is fundamentally bright, provided that the investment returns on the newly enlarged stock of capital can be sustained and will satisfy the high level of expectations that drove the investment boom.
What Comes Next?
Looking forward, we must ask what the outlook is for the remarkable American expansion. The answer to the question is as important for American businesses and workers as it is for the politicians who will vie for the presidency in the 2000 elections. Mixed economic data over the past year have caused markets to oscillate from a rosy vision of indefinitely sustainable growth, with no inflation, to sudden waves of fear about moderate signs of overheating. The consequent need for some Fed tightening could push interest rates to levels that might be dangerous for currently elevated stock prices. Usually, investment-led expansions end when the capital stock gets too large and the return on new investments falls sharply. Since the global economic rebound of 1999, however, the U.S. expansion is facing the possibility that a rise in demand growth that outstrips sustainable (noninflationary) supply growth may jeopardize the expansion and, ultimately, the current level of equity prices.
Signs of excess demand growth have begun to appear in the United States. GDP growth measures the growth of output or supply, while final sales growth measures the growth of demand. Over the past three quarters, year-over-year growth rates of final sales have exceeded year-over-year growth rates of GDP by an average of about 0.5 percent. Simultaneously, another measure of excess demand growth, the current account deficit, has risen sharply, from below $20 billion per month to about $30 billion per month. The larger external deficit reflects the combination of a sharp drop in private savings in the United States, to a negative 4 percent of GDP, and its mitigation by a rise in public savings measured by government budget surpluses. Even so, government spending growth has begun to accelerate moderately again, to an average of about 3 percent over the past year. Only powerful revenue growth tied to a rising stock market and high levels of capital gains and rising incomes have kept the government surplus rising.
Clearly, the tension is rising in global markets over the sustainability of a noninflationary expansion in the United States.
The stronger growth of global spending and a rising level of U.S. demand in excess of supply have produced a steady, though moderate, acceleration of inflation pressures over the past year. Most broadly, year-over-year CPI inflation rose from 1.6 percent at the start of the year to 2.6 percent in September. That rise reflected a steady buildup of pipeline pressures in the producer-goods sector. During the three months ending in October, producer prices rose at an annual rate of 6.9 percent—up sharply from the year-over-year growth rate of 2.7 percent. The core PPI rose more slowly, at an annualized rate of 3.9 percent over the past three months (up from 1.9 percent over the past twelve months), which reflects the strong impact of rising energy prices on the overall PPI. Still, a sustained rise in energy prices is symptomatic of a sustained rise in global demand pressures that could become inflationary. Intermediate and crude goods also displayed accelerating inflationary pressures, which suggests that there will be further increases in the PPI inflation rate.
U.S. interest rates, in tandem with the one percentage point rise in inflation since the start of the year, have also risen by about one percentage point. The recent drop of U.S. long-term interest rates by about 30 basis points reflects renewed optimism, based on strong productivity numbers and moderate wage pressures, that the noninflationary U.S. economic expansion can continue, despite faster demand growth in the global economy and accelerating wealth-generated demand growth in the United States. Indeed, the drop in U.S. interest rates during November was driven entirely by a somewhat implausible sudden drop in long-term inflationary expectations that was tied, in turn, to optimism about moderate wage growth and continued productivity growth.
By early next year, the most likely scenario will see inflation worsen, with the broadest measure of inflation—the CPI—creeping higher toward a 3 percent year-over-year rate. That rise will push long-term interest rates toward 7 percent and adversely affect the debt markets, which in turn could impose downward pressure on stock prices. As the U.S. expansion continues at the current pace, U.S. interest rates must remain at levels that enable the United States to borrow $30 billion per month from the rest of the world. The ability to do so depends critically on the prospect of continued, sustainable growth in the United States while growth abroad moderates. Should such capital inflows prove to be unsustainable, the clearest sign would come from a sharply weaker dollar, which, in turn, would reinforce an expected rise in U.S. inflation, higher U.S. interest rates, and weaker stock and bond markets.
Clearly, the tension is rising in global markets over the sustainability of a noninflationary expansion in the United States, especially as U.S. inflation and the current account deficit creep upward while U.S. stock prices continue to move higher. Unfortunately for the presidential candidates, it is impossible to predict whether the rising imbalances that ultimately will end a sustainable U.S. economic expansion will reach a critical level before or after next November's election. My bet is that the day of reckoning will come next spring. Now that the Fed has taken back its 75 basis points of emergency easing, continued inflation pressure is likely to suggest to markets that more tightening is in order. A resulting sharp decline in the stock market and an inflationary drop in the dollar would take the bloom off Clintonomics and give Republican candidates a leg up in the elections. That would be payback for the unusually good luck enjoyed by Bill Clinton, courtesy of George Bush, in 1992 and 1996.
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