Depressing Our Way to Recovery

Two and a half years after the official start of the recovery from the 1990--1991 recession, the U.S. economy is still experiencing weak growth and is generating relatively few jobs. (See the chart "A Feeble Recovery.") Employment has barely regained its pre-recession peak in 1990. More people who seek full-time work have had to settle for part-time employment. Comparatively well-paid manufacturing jobs continue to disappear, replaced by jobs in restaurants, hotels, and temporary employment agencies. Investment growth has also been the slowest of any postwar recovery.

Yet remarkably, most of the nation's political leadership, whether Democratic, Republican, or Perotista, thinks the cure is further deficit reduction. A constitutional amendment to require a balanced budget by fiscal year 1999 (which begins in October 1998) has a very good chance of passing in this session of Congress. Conservative Democrats have joined Republicans in pushing the administration to accept deficit cuts beyond those of the 1993 budget deal, which cuts the deficit by $496 billion over five years. A large majority of the congressional freshman class--mostly Democrats--equates deficit reduction with both responsiveness to voters and economic recovery.

While deficit reduction is the current craze among politicians and commentators, virtually all economists (including those who support rapid deficit reduction) acknowledge the following:

In the next three to four years, deficit reduction will lower effective demand, slow economic growth, and impede job creation.

Spending cuts or tax increases will have the same short-term effects: both pull money out of the economy and retard growth.

The impact of deficit reduction on investment is slow, indirect, and uncertain. Deficit reduction has limited influence on interest rates, and lower interest rates only marginally increase investment.

The impact of deficit reduction on U.S. exports is also slow and indirect. It will depend both on how exchange rates respond to changes in interest rates and on how trade adjusts to changes in exchange rates. Most evidence indicates that exchange rates respond slowly and erratically to changes in interest rates and that trade flows take two or three years to respond to changes in exchange rates.


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Advocates of deficit reduction think they are trading short-term pain for long- term gain. Yet lost in the debate is the nature of that pain. The real pain of deficit reduction is not primarily the higher taxes or spending reductions touted as virtuous and necessary belt tightening by deficit hawks but the higher unemployment and slower growth that deficit reduction will bring about. (See the table "Experts Agree.") These latter costs are wholly unnecessary sacrifices--the bitter fruits of wrongheaded policy.

When government cuts spending, workers that used to be employed by the government and suppliers of materials to government and recipients of transfers from government lose income and jobs. There also is a secondary, "multiplier" effect that results from the falloff in consumption, which causes other workers to lose their jobs. The effect is essentially the same for a tax increase. Higher taxes reduce the money that individuals have available to spend, leading them to reduce their consumption expenditures. This leads to layoffs, which again have the same sort of secondary multiplier effect.

What do deficit hawks think they are accomplishing? Deficit reduction, whether via spending cuts or tax increases, is supposed to help the economy, first, by freeing resources for investment. More investment should raise productivity and hence wages. In addition, deficit reduction will supposedly boost exports, providing more domestic jobs and reducing our foreign debt. But in both cases, the logic is badly flawed.

Studies have failed to find a statistically significant effect between public deficits and interest rates. And the interest rate is only one of many factors that firms consider in making investments. Virtually all studies that sought to measure empirically the effect of interest rates on investment have found that the most important factor is the rate of growth of demand. Even Barry Bosworth, a prominent Washington deficit hawk, came to this conclusion in his study Savings and Investment in a Global Economy. This should not be surprising, since firms are unlikely to invest in a new factory or expand an existing one when they are already operating well below capacity.

Another important factor in the investment decision is the cash flow of firms. Most investment is financed out of firms' retained earnings, since it is generally easier for firms to use their own money than to get bank loans or issue stock. Recent econometric studies indicate that cash flow is also more important than interest rates in promoting investment. Unfortunately, deficit reduction, by initially slowing the economy, will actually reduce demand and hence sales and cash flow (lower sales mean reduced profits and thus lower cash flow).

Even if lower interest rates stimulate investment, they will not do so immediate- ly. Companies cannot devise and execute plans for new facilities overnight. Most econometric models estimate that it takes about two years for lower interest rates to make a significant impression. Any increase in investment will come long after deficit reduction has shrunk the economy.

What's more, recent estimates show that the amount of investment stimulated by lower interest rates is so low as to be of little consequence in affecting total output. In Investment and U.S. Fiscal Policy in the 1990s, economist Steven Fazzari concludes that even a 2 percentage point drop in real interest rates (about twice the decline we have actually seen) would increase investment by just over .5 percent, or approximately $25 billion dollars.

Fazzari concludes that even this increase would take two years to be felt. Barry Bosworth found the relationship between interest rates and investment statisti- cally insignificant. But this is hardly news. Many studies over the last decades have made the same conclusions; economists have generally found the effect of interest rates on investment to be small or nonexistent.

Because investment is unresponsive to interest rate changes but captive of down- turns in sales growth and cash flow, deficit reduction is not a good strategy to promote investment and productivity growth.

It is even less likely that deficit cuts can induce gains from export growth. Supposedly, this works by lowering the value of the dollar against other currencies, which makes U.S. exports cheaper in world markets. Although interest rates have fallen significantly in recent months, the dollar has actually risen against most major currencies. (This should not be surprising. Economists generally acknowledge that speculative factors can cause large movements in currency prices over the short term. For example, Bosworth argues that it often takes one year or longer for changes in fundamental factors such as interest rates to have an impact on exchange rates.)

The dollar has fallen significantly only against the Japanese yen. In the past, much larger drops in value of the dollar relative to the yen have had only minimal impact on the U.S. trade deficit with Japan. There is little reason to believe the situation will be any different now. Furthermore, Japan, along with most of the rest of the world, is in its own economic slump. This means that demand for all products, including U.S. exports, is likely to be growing slowly, if at all. Recent figures confirm this. The International Monetary Fund recently cut by half its estimate of world growth for 1993-1994. Germany is now forecasting that its economy will shrink 2 percent this year. Anyone waiting for an export boom to stimulate the U.S. economy could be waiting a long time. In any event, as Barry Bosworth estimates, the full impact of exchange rate changes on exports takes about three years. Add that to the year it takes exchange rates to respond to interest rates, and the total lag grows to at least four years.

Of course, even insofar as a lower dollar can stimulate exports, it does so in part by reducing the nation's living standards. A fall in the dollar makes imports more expensive, meaning that the more imported goods people buy, the greater the decline in their purchasing power. The price of domestically produced goods that compete with imports will also rise somewhat, leading to a further decline in purchasing power. Also, any increase in net exports, unlike investment, does nothing to raise productivity and wages.

A last possible benefit of a fall in interest rates is increased consumption. If borrowing costs fall, households can afford to buy more, and this may produce a short-term boost to the economy. However, here also the effects are likely to be very limited. It is important to realize that for every borrower paying less interest or getting a cheaper mortgage, there is a lender receiving less invest- ment income. Although borrowers on average may be somewhat poorer and therefore might spend a somewhat higher percentage of their available income, their in- creased spending will still be largely offset by decreased spending by lenders. Therefore any net increase in spending through this route is likely to be small. And of course, these are demand-side benefits that have nothing to do with the supposed direct effect of deficit reduction on investment and productivity.

Interest rates had already bottomed in the summer of 1992. Many people refinanced their mortgages before rates began to rise again later that fall. These people are not going to be refinancing again just because interest rates fall slightly. Also, as long as people remain anxious about unemployment, they will be reluctant to take on large amounts of additional debt in the form of mortgages or car loans. Although debt has recently dropped slightly, as a percentage of disposable income it is still near a record high. Saving also remains historically low, which makes it unlikely it can fall much further (higher consumption means lower saving, by definition). Consumer confidence is also in the gutter and is likely to remain there as long as job creation is weak and people's employment prospects are unclear. For all these reasons, it is unlikely that lower interest rates will lead to any surge in consumer spending.

In short, the overwhelming body of economic theory and evidence suggests there is a great danger from excessive deficit reduction in the current weak economy. While lower deficits may be desirable in some circumstances, reducing the deficit when the economy is already stagnating is almost guaranteed to worsen the economic situation. The near-term impact is to lower growth and raise unem- ployment. Any positive effects will not be felt for some time, and the short-run damage done to the economy by weakening demand, with the resulting downturn in investment, may never be offset by any subsequent increase in investment brought on by lower interest rates.

Furthermore, insofar as deficit reduction is accomplished by cutting public investment (Clinton's 1994 budget actually has less money for public investment than Bush's 1993 budget), there will be a definite long-term cost of lower productivity compounded by the short-term costs of slower growth and higher unem- ployment.

Any effort to lower the deficit must be carefully calibrated to the current state of the economy. When the economy is strong and near full employment, it will be able to withstand the contractionary impact of deficit reductions without a significant falloff in growth and job creation. This is not the case today, when the economy is barely sputtering out of a recession and employment levels have been nearly stagnant for three years. The politicians who have embraced deficit reduction on the premise that low interest rates will power a recovery should go back and review their basic economics.

If our current crop of political leaders can't get themselves to review their economics lessons, perhaps they can at least be persuaded to review the lessons of the 1992 election. Ross Perot was the candidate who ran on the platform of bringing the deficit down quickly. Ross Perot didn't win the 1992 election. Bill Clinton did. During his campaign, Clinton constantly emphasized the importance of public investment as the way to get the economy going. In the short-term, additional spending will provide a much-needed boost to demand. In the longer term, investments in infrastructure, education, and training will pay off in the form of a more productive work force. When the economy is again near its full-employment levels of output, and we are beginning to realize the productivity dividend from a better equipped and better educated work force, we can focus on reducing the deficit to free resources for private investment.

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