What a difference thirty days can make! Just a month ago, most
economists still fretted over the "overheated" economy and
inflation pressures. Candidate Al Gore promised rising budget
surpluses that would be safeguarded in "lock boxes". Fed
officials were unsure that they had raised interest rates sufficiently
to slow "unsustainable" growth. And while stock prices had
stagnated—especially those listed with Nasdaq—most observers still
believed that the "New Economy" was a real phenom
that would banish recessions to the dustbin of history. Now new
President Bush advocates a $1.3 trillion dollar tax cut to try to
cushion the hard landing that more and more economists are coming to
recognize as a distinct possibility. Fed watchers push for interest
rate reductions. The New Economy is all but forgotten, and the only
question that remains about Nasdaq is whether every high tech
firm will go bust. Oh for the good old days of early November,
2000.
In this note, I will first examine the causes of this recession. I
next turn to an analysis of adjustments that should be made,
immediately, to the federal budget to prevent this recession from
deteriorating to a hard landing. I believe that the required fiscal
adjustment is very large—on the order of at least $450 billion. This
means that the budget will be shifted from a surplus of more than 2%
of GDP to a deficit of 2.5% of GDP. Note that if this discretionary
adjustment is not made, the budget will automatically move to deficit
as economic growth turns negative, as household income falls, and as
unemployment explodes to double digits—because tax revenues will
automatically fall and spending on unemployment compensation and other
social programs ("welfare", crime, food stamps) rises. Indeed, if
Japan's recession is any indication (and our present situation looks
eerily similar to that of Japan at the end of the 1980s), the cyclical
budget deficit could reach 10% of GDP if nothing is done soon to halt
the downturn. In a sense, we can now choose to immediately (and
discretionarily) move the budget to a deficit of perhaps 2.5% and
thereby prevent a hard landing that might otherwise generate a much
larger deficit along with a long period of stagnation.
Evidence
This slowdown is probably the sharpest in living memory. Growth of
real GDP fell from 5.6% in the second quarter of 2000 to 2.2% in the
third quarter. Nominal GDP growth similarly fell by more than
half—from 8.2% to just 3.8% over the same quarters. Personal income
actually fell in October, while purchases of durable goods fell by
2.2% in October. Real nonresidential fixed investment fell by nearly
half between the second and third quarters. Retail sales growth is
down, and undesired inventories are rising rapidly. The speed of the
slowdown has, if anything, picked up over the fourth quarter.
Industrial production fell by 0.2% in November, while manufacturing
output fell 0.5%. Excluding energy output (boosted by cold weather),
output of consumer goods (durable and nondurable) is down
significantly. Industrial capacity utilization fell to 81.6% in
November, half a percentage point below its long-term (1967-99)
average. Every day another handful of top corporations announces that
earnings will fall short of expectations. Auto sales are weak, and
layoffs are growing throughout the auto industry. A recent survey of
purchasing managers indicated the fourth straight monthly decline.
Heavily indebted telecom firms are slashing investment. The S&P
recently hit a 52 week low, and NASDAQ is down by nearly half since
September 1. California's largest utility companies are in such
terrible financial shape that it took an intervention by Energy
Secretary Bill Richardson to force generators to sell electricity to
them. There seems to be no end to the avalanche of bad news.
Causes
What are the major causes of the recession? Many commentators
attribute the downturn to the Fed's rate hikes. These, in turn, were
believed to be necessitated by the "unsustainable" nature of the boom,
which was said to be so robust that it would cause inflation. While I
agree that the boom was unsustainable, I view the unsustainability in
a much different light. The problem was not inflation, but rather the
unsustainable processes long analyzed by Wynne Godley (see Godley
1999). For our purposes, there are three main factors that generated
the slowdown. First, growing government surpluses have reduced private
sector disposable income and wealth. Government surpluses, in turn,
were driven by the obsession with achieving a government budget
balance, which once achieved generated an even more bizarre obsession
with eliminating outstanding government debt (which, by definition, is
net nominal wealth of the private sector). Second, the US trade
deficit similarly reduces American income and wealth. Our trade
deficit results from a number of complex processes, however, it could
be reasonably argued that tight fiscal and monetary policy in the US
have helped to keep the dollar strong and our trade balance negative.
Finally, these first two considerations necessarily imply that
economic growth could take place only as the private sector spent in
excess of its income, financed by an ever-growing mountain of debt.
Indeed, the government surplus means, by accounting identity, that the
private sector must reduce its net (or "outside") domestic nominal
wealth by surrendering its holding of government bonds, while the
trade deficit implies that the US must reduce its net international
wealth holdings. These reductions of net (domestic and international)
wealth and disposable income made it impossible for the private sector
to continue to spend without at the same time increasing its net
indebtedness. As lenders observed this growing indebtedness and rising
leverage of prospective net income flows, they began to tighten
credit—what some are already beginning to call a "credit crunch".
Unfortunately, at the aggregate level this can only make matters
worse, because if the private sector cannot increase its borrowing, it
will not be able to increase its spending. If economic growth
subsides, credit quality will be further eroded-leading to further
credit tightening. Hence, the credit crunch and the spending slowdown
are connected in a reinforcing manner. While maintenance of "easy"
credit could perhaps postpone the day of reckoning, the unsustainable
processes in place make a hard landing virtually inevitable.
The problem, then, was not that growth was too high, but rather that
the twin "surpluses" endangered it—the US government budget surplus
and the foreign sector surplus (that is, the US trade deficit).
Together, these required ever-rising private, domestic, sector
deficits that were "unsustainable". Household spending was already
slowing during the second quarter, so that growth was primarily driven
by high investment. This, however, could not continue for long as
falling capacity utilization rates caused firms to rethink their
capital needs.
Balance Sheet Implications
The rising budget surpluses meant that government debt held by
private investors had to be declining in quantity—from $3.4 trillion
in 1997, to 3.175 trillion in 1999, and to just $2.987 trillion by
June 2000. Thus, these budget surpluses sucked about half a trillion
dollars worth of safe assets out of private portfolios. At the same
time, the stock market peaked, raising the value of equities in
private, noncorporate (household and nonprofits) portfolios from $5.8
trillion in 1997 to $8.643 trillion by the end of the first quarter of
2000. However, as equity prices fell, by the end of the second
quarter, the equities in these portfolios were worth only $7.9985—a
loss of over $0.64 trillion. Added to the loss of aggregate wealth due
to budget surpluses, we are talking of a loss of well over a trillion
dollars of the value of portfolios of private noncorporate investors
by June. This does not include losses over the third and fourth
quarters. Since September 1, NASDAQ alone has lost half its value.
Indeed, the crash of high tech stocks has so far wiped out over $3
trillion of stock market value (obviously, not all of this was in
household portfolios—much was in business portfolios, which is no more
comforting). It is not surprising that a "hit" of this magnitude might
depress private sector spending. Note that this does not take account
of the worsening net wealth position of the USA private sector
vis-à-vis the rest of the world. Furthermore, as budget
surpluses are projected to continue to increase, net wealth positions
of the private sector will continue to worsen, even if the stock
market falls no further. On current projections, the surpluses
increase even if growth falls to 2.5% per year.
Policy Implications
In order to allow the private sector to bring spending more closely in
line with its income, the government's budget stance must be changed
significantly and immediately. If the household sector (which was
responsible for most of the private sector deficits) were to balance
its budget in the first quarter of next year, just to hold GDP
constant this would require that the federal budget make a move of
perhaps 6% of GDP, from surpluses of more than 2 percent of GDP to
deficits of 4 percent of GDP. As the economy continues to slow, it is
possible that the trade deficit will fall due to reduction of
household purchases of imports. Further, slower growth will reduce the
size of state and local government surpluses (by lowering tax receipts
and increasing social spending) that are draining private sector
income. Thus, it is likely that the private sector's deficits will be
reduced automatically as imports fall and state and local government
surpluses fall. If this does occur, the size of the fiscal adjustment
required would be smaller than 6%, meaning that a federal budget
deficit somewhat smaller than 4 percent of GDP might stabilize GDP.
Offsetting this, however, is the probability that a substantial
portion of tax cuts will be "saved" or used to retire debt, implying a
larger tax cut will be required to produce the necessary stimulus. For
the purposes of our analysis, I will presume that the Federal
government should aim for a deficit of 2.5% of GDP for next year. If
growth still turns negative, the federal budget deficit target should
be increased.
President Bush has proposed tax cuts totaling $1.3 trillion over the
next several years. Precise details have not been forthcoming, but
discussion during the campaign leads me to believe that when a
concrete proposal is made, most of the cuts would come in the future,
with only small cuts proposed for next year—perhaps only $150 billion,
which would still leave a budget surplus of more than half a percent
of GDP. In order to get to the required deficit of 2.5% of GDP, tax
cuts of another $300 billion would be required. What kinds of tax cuts
would give the "biggest bang for the buck"?
a. Payroll Taxes
Most of the federal budget surplus can be attributed to the huge
surpluses run up by Social Security—about 90% of the surpluses
achieved to date are "off-budget", and most of that is in the Social
Security program. Over the past two years there has been a great deal
of discussion about these surpluses, said to be "accumulated" in the
Social Security Trust Fund. However, it is now widely recognized that
the Trust Fund is nothing more than an accounting fiction. It is also
widely recognized that this fictional Trust Fund cannot do anything to
help provide for retiring babyboomers in the future. Most observers
recognize that there is no way to "lock away" payroll tax receipts for
future use. Nor does elimination of the Trust Fund entail any
financial risk to the government's ability to pay Social Security
benefits in the future as they come due. Indeed, the government's
ability to pay these benefits is not dependent on tax revenue at all.
Hence, there is no reason to try to preserve budget surpluses in the
Social Security program. (All these matters are discussed in more
detail in Bell and Wray 2000.)
Indeed, there are very good reasons to cut payroll taxes. Economists
have long recognized that payroll taxes are regressive; indeed, for
most lower income households, the payroll tax is much more burdensome
than is the income tax. Further, the payroll tax is specifically
levied on working, providing a powerful disincentive to employment.
Not only does it raise the costs to every employer of creating new
jobs, it also discourages people from working. Payroll taxes make
American labor more expensive, discouraging investors from locating
plant and equipment in the US (thus, contributing to the trade
deficit). Payroll taxes are inflationary because they increase the
costs of production. They distort the market mechanism, by raising the
costs of labor relative to the costs of capital. For these reasons,
much of the additional $300 billion tax cut should be targeted to the
payroll tax. Furthermore, a cut of the payroll tax is simple to
administer and easy to understand, it has an immediate impact
(increasing take-home pay from the moment it is implemented), and it
benefits workers of all types as well as businesses.
There is an additional, important consideration. Since the primary
goal of the tax cut is to raise private demand for our nation's
output, the ideal tax cut should put more disposable income into the
hands of families that will increase consumption (and, possibly,
spending on residential and nonresidential investment). It is
generally accepted by economists that the household propensity to
consume varies inversely with income, thus, a tax cut that favors
lower income households should have a larger impact on consumption
than would a tax cut that favors high income households.
How large should the payroll tax cut be? To return the OASDI portion
(the "retirement" and disability insurance part) of the Social
Security program to balance, a payroll tax cut of something more than
$150 billion would be required. If we allocate the entire, required,
$300 billion tax cut to OASDI, the program would run an accounting
deficit of about $150 billion. I emphasize that an accounting deficit
has no impact on the government's ability to pay Social Security
benefits, now or in the future.
b. President-elect Bush's proposal
Note that this tax cut is in addition to President Bush's likely
proposal (which will cut marginal income tax rates), and is consistent
with the desired characteristics of a tax cut as stated by Bush during
his campaign. His campaign platform argued that he favors a tax cut
that would:
- Trust People: Governor Bush believes all
taxpayers should be allowed to keep more of their own money.
- Lower the Record-High Tax Burden: Federal taxes are the
highest they have ever been during peacetime: Americans work more than
four months a year on average to fund government at all
levels.
- Cut Marginal Rates: As President Reagan demonstrated, the
best way to encourage economic growth is to cut marginal tax rates
across all tax brackets.
- Increase Access to the Middle Class: Under current tax law,
low-income workers often pay the highest marginal rates. For example,
a single waitress supporting two children on an income of $22,000
faces a higher marginal tax rate than a lawyer making
$220,000.
A payroll tax cut accomplishes all these results. A payroll tax cut
will generate significant tax relief for low income earners struggling
to reach the middle class. It provides a powerful incentive to work
harder, generating economic growth. And it will spur consumption
spending by increasing disposable income of those with a high
propensity to consume.
c. Additional Tax Relief
I recognize that even if most observers have come to recognize that
keeping separate accounts for Social Security is just an accounting
gimmick, it may not be politically feasible to pass a $300 billion tax
cut that would generate deficits in the OASDI program. This is because
Social Security has long been analyzed as if its budget were separate
from the rest of the federal budget. Hence, it may be more politically
feasible to advocate a payroll tax cut that would return Social
Security to "pay as you go"—in other words, to a balanced budget. As
discussed above, this would allocate approximately half of the $300
billion tax cut to the Social Security program. This means that
another $150 billion tax cut will be required. In keeping with the
discussion above, these cuts should be designed to increase spending,
to relieve debt burdens, and to distribute most of the cuts to working
households. This could be accomplished, for example, through increases
to the earned income tax credit. This would target the tax cut to the
lowest income households, significantly increasing the rewards to
working. In addition, tax credits for educational expenses might make
college more affordable, and is in keeping with President Bush's
priorities. Finally, tax credits for child care would help working
families. I would also favor substantial spending increases for
education, public infrastructure, childcare, and health care for those
with inadequate coverage. However, it may be more difficult
politically to pass spending initiatives, and the lag time involved in
boosting aggregate demand might be larger than that for a tax
cut.
Conclusion
There is already substantial evidence that the economy is moving
toward a hard landing. The federal budget has become so biased toward
surplus that automatic stabilizers cannot be counted upon to cushion
the downturn. Furthermore, as I have long suspected, the first
reaction of economists and policymakers has been to turn to the Fed to
ask for interest rate reductions. In order for monetary policy to
prevent a recession, the lower rates would have to stimulate private
sector borrowing. However, as I have argued, the private sector had
been fueling the Clinton boom by unsustainable deficits—indeed,
as soon as the private sector stopped increasing its borrowing, the
boom was doomed. It thus is a bizarre policy recommendation to suggest
that the Fed ought to try to induce the private sector to re-embark on
a fundamentally unsustainable borrowing frenzy as a solution! Rather,
it makes much more sense to look to the underlying cause: the
extremely tight fiscal policy that has been sucking private income and
wealth from the economy. Hence, the solution is to rectify the fiscal
imbalance.
In summary, an immediate tax cut of approximately $450 billion will be
required over the next year. President Bush may come forward with a
plan that would cut taxes by as much as $150 billion. I recommend
another $150 billion tax cut through reduction of the payroll tax.
Finally, another $150 billion tax cut would increase the earned income
tax credit, provide tax credits for educational spending and child
care, or provide other similar tax credits. 
REFERENCES
Godley, Wynne. "Seven Unsustainable Processes: Medium-Term Prospects
and Policies for the United States and the World Economy", 1999
(revised 10/2000), Jerome Levy Economics Institute,
www.levy.org.
Bell, Stephanie, and L. Randall Wray. "Financial Aspects of the Social
Security ‘Problem'", January 2000, Center for Full Employment and
Price Stability, www.cfeps.org.
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