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University of Rochester
William E. Simon Graduate School of
Business Administration

BRADLEY POLICY
RESEARCH
CENTER
SHADOW OPEN MARKET COMMITTEE
(SOMC)
Policy Statement and Position Papers
March 10-11,1996
PPS 96-01
Public Policy Studies
Working Paper Series

TABLE OF CONTENTS

Page
Table of Contents

i

SOMC Members

ii

SOMC Policy Statement Summary

1

Policy Statement

3

The Road to Recession
H. Erich Heinemann

11

Balanced Budgets, Limited Government, and Economic Well-Being
Lee Hoskins

29

Economic Conditions
Mickey D. Levy

41

Unemployment, Gold, Money and Forecasts of Inflation
Allan H.Meltzer

63

The Debt Ceiling
William Poole

73

A Note on the Behavior of Interest Rate Spreads in Expansions
and Near Cyclical Peaks in the U.S.
Robert H. Rasche

83

The Mexican Loan Repayment Sleight of Hand
Anna J. Schwartz

95




i.

SHADOW OPEN MARKET COMMITTEE
The Shadow Open Market Committee met on Sunday, March 10, 1996 from 2:00 p.m. to
5:30 p.m. in Washington, DC.
Members of the SOMC:
Professor Allan H. Meltzer; Graduate School of Industrial Administration; Carnegie
Mellon University; Pittsburgh, Pennsylvania 15213 (phone 412-268-2282, fax 412-2687057, e-mail am05@andew.cmu.edu); and Visiting Scholar; American Enterprise
Institute; Washington, DC (phone 202-862-7150)
Mr. H. Erich Heinemann; Heinemann Economic Research; Division of Brimberg &
Co.; 7 Woodland Place; Great Neck, NY 11021-1034 (phone 516-466-3893, fax 516466-3872)
Dr. W. Lee Hoskins, Chairman and CEO; Huntington National Bank; 41 S. High Street;
Columbus, Ohio 43287 (phone 614-480-4239 phone, fax 614-480-5485)
Dr. Mickey D. Levy, Chief Economist; NationsBanc Capital Markets, Inc.; 7 Hanover
Square, New York, New York 10004 (phone 212-858-5545, fax 212-858-5741, e-mail
mlevy@ncmi-ny.com)
Dean Charles I. Plosser; William E. Simon Graduate School of Business Administration
and Department of Economics; University of Rochester; Rochester, New York 14627
(phone 716-275-3316, fax 716-275-0095, e-mail plosser@mail.ssb.rochester.edu)
Professor William Poole; Department of Economics; Brown University; Providence,
Rhode Island 02912 (phone 401-863-2697, fax 401-863-1970, e-mail william_poole
@brown.edu)
Professor Robert H. Rasche; Department of Economics; Michigan State University;
East Lansing, Michigan 48823 (phone 517-355-7755, fax 517-432-1068, e-mail
rasche@pilot.msu.edu)
Dr. Anna J. Schwartz; National Bureau of Economic Research; 50 East 42nd Street,
17th Floor; New York, New York 10017-5405 (phone 212-953-6200 ext. 106, fax 212953-0339, email aschwarl@emaiLgc.cuny.edu)




ii

SOMC POLICY STATEMENT SUMMARY
Washington, D.C. March 11—The Shadow Open Market Committee warned
today that Federal Reserve policy is "too restrictive" and "is not consistent with
maintaining steady growth with price stability." The Committee noted that growth of the
monetary base (bank reserves and currency) had fallen to a rate of 2 percent. The SOMC
warned that "a likely result of continued 2 percent growth of the monetary base would be
sluggish growth and possible recession."
The Shadow, a group of academic and business economists who comment
regularly on public policy, said that "We again urge the Federal Reserve to lower its
interest rate target until the monetary base grows at an annual rate of 4 percent." Such a
course, the SOMC said, would help achieve "price stability with sustained economic
growth."
The Shadow Open Market Committee, which meets in March and September, was
founded in 1973 by Professor Allan H. Meltzer of Carnegie-Mellon University and the
late Professor Karl Brunner of the University of Rochester.
The SOMC attacked economic nostrums advanced by Republican Presidential
candidate Patrick J. Buchanan. "His claims about trade and wages are nonsense, without
any basis in theory or any factual support."
The Committee took news organizations to task for not questioning the substance
of Mr. Buchanan's statements. "The political campaign shows the disgraceful extent of
economic literacy."
The SOMC cautioned Presidential candidates not to overstate the possible
benefits of tax reform, including a flat tax. "Our committee has always favored a
consumption tax in place of the corporate and personal income taxes. These reforms
would raise saving, encourage investment and increase living standards for workers and
owners of capital." However, "tax reform should not be sold on politicians' false promise
of substantially raising the economy's sustained long-term growth rate."
The Committee charged the Clinton Administration had misled the public about
Mexico. "The recent Mexican loan repayment was a media event staged to show that




1

Mexico could now repay U.S. loans. The repayment was achieved by increasing
Mexico's loans from the International Monetary Fund and by borrowing in Europe at a
higher rate of interest than on the U.S. loan. The cost of Mexicans of such mistaken
policies rose again."
The SOMC also called on Congress to "eliminate the (federal) debt ceiling,
refocus its efforts on tax reform and control of government spending—especially
spending on entitlements." Failing that, the SOMC said, "Congress should vote for a
straight extension (of the debt limit) without adding other budgetary matters."




2

SHADOW OPEN MARKET COMMITTEE
Policy Statement
March 11,1996

The Committee issued the following statement:
Monetary policy remains too restrictive. It is not consistent with maintaining
steady growth with price stability. The recently announced February employment and
unemployment data, properly analyzed, do not change the basic picture. Unemployment
is a poor predictor of inflation.
The political campaign shows the disgraceful extent of economic literacy. Many
in the media are critical of Patrick Buchanan's allegedly conservative views, but they
often counter their criticism by saying: "At least he speaks to an important issue." Few
go on to say that his claims about trade and wages are nonsense, without any basis in
theory or any factual support.
The Clinton administration has recently again acted to mislead the public about
Mexico. The recent Mexican loan repayment was a media event staged to show that
Mexico could now repay U.S. loans. The repayment was achieved by increasing
Mexico's loans from the International Monetary Fund and by borrowing in Europe at a
higher rate of interest than on the U.S. loan. The cost to Mexicans of their mistaken
policies rose again.
The debt ceiling has never served to restrict spending or the size of budget
deficits. Congress should eliminate the debt ceiling, refocus its efforts on tax reform and
control of government spending—especially spending on entitlements.
MONETARY POLICY
Conventional wisdom denies that money growth bears any relation to inflation or
growth of nominal output. This is an error. Our record for the past 2 1/2 years is
summarized below to show that forecasts based on money growth accurately foreshadow
the main movements in the economy. The following excerpts from the past five meetings
of the committee show that Federal Reserve policy has been successful because, by




3

chance, it has followed polices very close to the policies we advocated based on an
adaptive monetary rule.
September 1993: The monetary base had grown 11 percent for the year ending in
August. We described Federal Reserve policy as "imprudent" and predicted that longterm interest rates, then approaching 5 3/4 percent, would increase either because
inflation would increase or because the Federal Reserve would reduce growth of the
monetary base and money. Although standard forecasts saw no danger of inflation or
rising long-term interest rates, based on our rule, we urged the Federal Reserve to act
promptly to control inflation by reducing growth of the monetary base to a maximum of 8
percent. The Federal Reserve moved in February 1994 to increase short-term interest
rates.
March 1994: Annual growth of the monetary base had slowed to 10 percent. We again
urged the Federal Reserve to tighten policy. Further increases in short-term interest rates
reduced growth of the monetary base to 8.7 percent in August 1994, thereby reducing the
threat of higher inflation.
September 1994: Our rule implied that the economy was on a path "consistent with 2
percent to 3 percent inflation," at a time when standard forecasts talked of a
reacceleration of inflation in 1995. Based on our rule, we urged the Federal Reserve to
reduce the growth rate of the monetary base to a 7 percent annual rate. By raising interest
rates several more times, the Federal Reserve reduced the growth rate of the base.
March 1995: Annual base growth was 6.7 percent for the year ending in March. We
urged the Federal Reserve not to "overreact as it often has in the past." Our rule
suggested that the Federal Reserve maintain base growth at 7 percent to maintain high
growth with declining inflation.
September 1995: By September, annual growth of the base had fallen to 4.5 percent.
We praised the Federal Reserve for achieving growth with low inflation. We urged it to
"promptly reduce short-term interest rates until the monetary base grows at a 6 percent
annual rate." We warned that there was a rising risk of recession if base money growth
did not increase. The economy was weak in late 1995 and remains weak at present.




4

Currently: Growth of the monetary base and money remain below the rate that our rule
suggests is consistent with steady growth in output and price stability. We again urge the
Federal Reserve to lower its interest rate target until the monetary base grows at an
annual rate of 4 percent. The Federal Reserve can, at last* achieve price stability with
sustained economic growth. Current Federal Reserve policy will not do that.
If the base continues to growth at the 2 percent annual rate of the past year,
nominal GDP growth can grow at the 3.8 percent rate of 1995 only if velocity increases.
This is a matter of arithmetic. To bring this about would require an increase in long-term
interest rates, equivalent to the 1995 decline. A likely result of continued 2 percent
growth of the monetary base would be sluggish real growth and possible recession.
Periodically the Federal Reserve is accused of preventing output from growing at
a higher rate. The claim is that the Federal Reserve keeps the growth of chain-weighted
output to a maximum rate of 2 percent. We have long been critical of the Federal
Reserve's use of unemployment or real output as short-run indicators of monetary policy.
We believe use of these indicators increase variability and mislead the Federal Reserve at
times like the present.
The Federal Reserve cannot affect the long-term real growth rate. If the critics
were correct that money growth was too slow on average, the price level would fall, but
the long-term rate of real growth would not be changed.
NONSENSE ABOUT TRADE AND WAGES
Evidence from several countries suggests that the distributions of income and
worker compensation have changed in recent years. Upper-income groups have gained
relative to lower-income groups. The United States is one of the countries in which this
has occurred. But it is evident also in data for other countries whether they have trade
deficits—such as Britain and Canada—or trade surpluses—such as Japan.
One candidate for President has used changes in income distribution and the U.S.
trade deficit to attack trade agreements and open trade disadvantageous to American
workers. This premise is false.




The widely used data on compensation showing

5

declining hourly wages and salaries are but one of several measures of compensation
trends. Other measures show gradual increases.
More importantly, the discussion reveals a degree of economic illiteracy that is
shocking even by the low standards of political discussion. Neither the media nor the
other candidates expose the fallacious reasoning. Indeed some appear to bless the
argument by commenting that Candidate Buchanan speaks to an important issue. They
do not add that what he says is nonsense.
The wider spread between high and low incomes reflects changes in the demand
for different types of employees in an economy undergoing technological change. The
demand for skilled, educated workers has increased relative to the supply of such
workers, so their wages and incomes have increased. The demand for unskilled workers
has increased slowly relative to supply, so wages and incomes for these workers have
increased slowly or declined in some cases.
Many of the unskilled are not only computer illiterates, they are functionally
illiterate. Texas Governor George W. Bush, in a recent speech, noted that 25 percent of
the students failed the reading examination in Texas's public schools. Not only can these
students not operate computers, they cannot even read the screen. They are destined to
work at jobs that do not require literacy. Such jobs require little skill and pay low wages.
For years, governments at all levels have promised to improve the educational
system. A decade ago, we heard about a nation at risk. Later we had the education
president and Goals 2000. Yet, most of these promises are unfulfilled; school systems
have done little to increase the reading and computational skills of their students.
U.S. exports are dominated by products requiring for their production not just
literacy but considerable skill. Our principal exports include aircraft, machine tools,
computers, software and many different services ranging from health care and
professional education to financial services and entertainment.
Many of the proposals to raise incomes would make the problem worse. Trade
barriers would bring retaliation and restrictions on our exports, lowering the demand for
both skilled and unskilled workers. It is not clear that the income gap would narrow but,




6

if it did, it would be because of a relative decline in the wages of the skilled workers in
the export industries as other countries retaliated.
Raising the minimum wage would reduce the employment opportunities for lowskilled workers. This would worsen the problem and deprive unskilled workers of onthe-job training, one of the most important sources of their education.
The way to shrink the difference between rich and poor is to improve education
and skills, remove barriers to trade, expand trade, increase saving, and shift resources
toward investment. The federal government should abandon its role in education. It is a
job for local government and private markets.
TAX REFORM
Tax reform is an urgent public policy issue.
Proper tax reform should encourage private saving, reduce the enormous burden
of record-keeping, accounting, and compliance, and curb opportunities for special favors.
Important reforms include simplification, integrating corporate and personal income
taxes, and reducing the double taxation of incomefromcorporate capital.
Our committee has always favored a consumption tax in place of corporate and
personal income taxes. This reform would raise saving, encourage investment, and
increase living standards for workers and owners of capital. Resource use would be
improved, and the economy would be more efficient.
Tax reform should not be sold on politicians' false promise of substantially
raising the economy's sustained long-term growth rate. Except for very brief periods, the
United States did not have an income tax for its first 127 years. From 1916 to 1930,
income tax rates were low and the income tax was paid by only a small fraction of the
population. Income and output did not average substantially higher growth than in the
postwar years for any sustained period.
THE DEBT CEILING AND SPENDING
The debt ceiling has been in place since 1917. Whenever the ceiling was
approached, it was raised. The debt ceiling has never prevented deficit spending. The




7

debt has grown from a few billion dollars in 1917 to almost $5 trillion today. This
measure of debt does not include future obligations for social security and health care.
The recent discussion of default is intended to force a reduction in the growth of
spending, particularly spending on entitlements. We favor these reductions, but a threat
of permanent default is not credible and should not be contemplated. A temporary
default would do nothing to reduce the outstanding debt. Debt issues would be delayed,
not prevented.
To date, there is no evidence that the market anticipates a default. If a default
were considered likely, government bond rates would rise relative to corporate bond rates
and might exceed interest rates on high quality corporate bonds. This has not happened.
The spread between high quality corporate and government bonds has not changed.
We agree with the administration: Congress should vote for a straight extension
without adding other budgetary matters. A better proposal would be repeal of the debt
ceiling. The way to control deficit finance is not by preventing the sale of debt after the
spending has been voted. Congress must vote to control the growth of spending.
The Congress has shown foresight and courage by voting to reduce farm subsidies
and the rate of growth of spending on welfare and health care. Every knowledgeable
person knows that these programs—and social security—must grow more slowly in the
future. The least painful way to reduce spending on these programs is to legislate well in
advance.
The Clinton administration has so far missed the opportunity to reduce
permanently the growth of spending on entitlements. Its unwillingness to reduce growth
of spending is irresponsible.
MEXICAN DEBT
Last year Mexico borrowed heavily using short- and medium-term debt. The
short-term debt to the United States was repaid in October 1995 and January 1996. The
administration used the occasion of the final repayment to promote the idea that the
reason Mexico could repay its debt was that it was emerging from its recent crises.




8

This is misleading. The repayments of short-term debt to the Federal Reserve and
the Treasury's Exchange Stabilization Fund were financed by (1) drawing on the
International Monetary Fund and (2) borrowing from German banks. The German loan
carries a 9 3/8 percent interest rate for five years. This rate is higher than the interest rate
on the loans that were repaid and reflects the market's assessment of the true risk.
Mexico remains in debt to the United States.

The Treasury's Exchange

Stabilization Fund has $10.5 billion of medium-term loans outstanding to Mexico.
Mexico has open lines of credit that permit additional borrowing from the U.S. and the
IMF.
Mexico has borrowed from the U.S. to stabilize the peso-dollar exchange rate on
many occasions since 1936. Atfirst,the loans were for $40 million. The limit was raised
many times thereafter until it reached a maximum of $20 billion in 1995. Mexico is the
only Latin American country to have swap arrangements with both the Federal Reserve
and the U.S. Treasury.

The existence of these borrowing arrangements probably

contributes to Mexico's periodicfinancialcrises by encouraging imprudent practices.
In the past, the Treasury hasfinancedsome of its Mexican lending by borrowing
from the Federal Reserve. This lending, called warehousing, is a type of off-budget
finance made without Congressional appropriation. Authority for warehousing remains
at the discretion of the Federal Reserve. Congress should revoke this authority.




9




10

THE ROAD TO RECESSION
H. Erich HEINEMANN
Heinemann Economic Research
Division of Brimberg & Co.
Federal Reserve Chairman Alan Greenspan told Congress last month that in late
January "the evidence suggested sufficient risk of subpar performance going forward to
warrant another slight easing of the stance of monetary policy." The Fed cut its target for
short-term interest rates of 5.25 from 5.5 percent (third such action since last summer)
and approved an identical reduction in the discount rate.
Mr. Greenspan, just named by President Clinton to a third four-year term as Fed
Chairman, was less than candid with his Congressional mentors in calling the central
bank's action as "an easing," slight or otherwise. Since the Fed's first rate reduction in
July 1995, the DROP in total bank reserves accelerated to an annual rate of 8.1 percent,
more than double the 3.7 percent contraction from February 1994 to July 1995. This
January and February, reserves fell at an annual rate of 14.5 percent.
Bank reserves act as raw material for the U.S. money supply, the basic fuel for
total spending in the economy. Sustained changes in reserve growth are the best
yardstick of Fed policy. Rapid increases in reserves usually show easy money; declines
normally indicate restraint.
The immediate result of the sharp cut in reserve growth over the last two years is
likely to be a recession, perhaps in time for this fall's Presidential election. Longlingering aftereffects of Mr. Greenspan's money freeze from 1988 through 1991 helped
put Mr. Clinton in the White House. Mr. Greenspan may want to do the same thing for
the Republican nominee this year to prove that Fed policy is non-partisan.
Investors who are counting on stable prices and low interest rates to support the
stock market should recognize that the longer-run effects of excessive monetary restraint
are likely to be inflationary. If history is a guide, Fed officials are likely to compensate
for money which is too tight with money which is too easy.




11

The pattern of go-stop-go policy has been especially evident since the 1980s.
Bank reserves grew at a rate of 14.75 percent in 1985 and 1986 (full-year average to fullyear average), but only 2.33 percent from 1988 through 1991. In 1992 and 1993, reserve
growth averaged 15.39 percent. In 1994 and 1995 it was less than three-tenths of one
percent.
The Baseline Forecast by Heinemann Economic Research predicts that the Fed's
policy of super-tight money will play the key role in triggering a recession beginning in
the fourth quarter of 1996. Jobs, industrial production, and corporate profits are all likely
to show substantial declines through the first half of 1997. Unemployment will be up.
Real gross domestic product—output of goods and services measured in fixed-weight
1992 dollars—is likely to decline about $150 billion, roughly 2 percent.
The forecast indicates that the Fed is likely to respond in classic fashion to the
onset of economic weakness. Bank reserves are likely to decline on balance in 1996, but
then rise more than 10 percent in 1997. If history is a guide, monthly growth rates of
reserves will likely be in a range between 15 and 20 percent.
At first, rapid growth of high powered money may help to hold long-term interest
rates down and could even push them lower. Over time, however, easy money will
reignite of inflationary fears and push rates up and bond prices down.
Remember the bond market debacle in 1994. Bonds collapsed in early 1994
because tradersfinallyrecognized the inflationary potential of three years of easy money.
Bonds rallied in 1995, even though Fed policy was progressively tighter, because traders
understood that Mr. Greenspan's preemptive strike would prevent inflation from taking
root. Investors take note.
The battle over "balancing" the federal budget by 2002 has already led to a
violent, unsustainable tightening of fiscal policy. If the economy declines later this year
as we expect, the Treasury's red ink will increase, regardless of budgetary plans on
Capitol Hill.
The surplus in the U.S. Treasury's operating, or primary budget (revenues minus
outlays except net interest) soared to a record $89 billion at an annual rate in the fourth




12

quarter, up sharply from a rate of $68 billion during the summer months. This surplus
was equal to 1.21 percent of gross domestic product.
Except for 1989, this ratio was the highest in almost a quarter century. Note that
the Treasury's operating surplus of 1.28 percent of GDP in he first half of 1989 was
followed by a recession within a year. A surplus in the Treasury's operating budget has
preceded every downturn since World War II.
The double-barreled drag from tight money and tight fiscal policy has already
slowed business activity. Even with a big surge in nonfarm payrolls in February, job
growth has dwindled. Moreover, more than 80 percent of the new jobs that employers
added in the year ending February 1996 appear to have been in new businesses in the
private service sector. These firms are not only typically very small (less than five
workers per company), but also they are unstable—here today and gone tomorrow.
The Labor Department's index of hours worked in the private nonfarm economy
averaged 132.57 (1982=100) in the three months ended February, essentially unchanged
in the past year. In the comparable period of 1994-95, hours worked rose 4.23 percent.
The gross value of industrial output—measured in constant 1992 dollars—shows a
similar pattern. Based on three-month moving averages, output rose one-half of one
percent in the year ended January 1996, downfrom5.1 percent the year before.
A key component of this slowdown was a drop in the production of business
equipment. However, a remarkable turnaround in demand for civilian aircraft is likely to
sustain the capital goods market for an extended period. Except for aircraft, the inflow of
new orders to the nation's manufacturers has slowed substantially.
New orders for aircraft, by contrast, almost doubled in the six months ended
January compared to the 1994-95 period. Jet aircraft are big-ticket items with very long
lead times. Shipments of aircraft, which fell much less than new orders from 1993
through early 1995, are likely to increase slowly in the months ahead. Shipments, of
course, determine actual investment in producers' durable goods.
Business and government employers added more than 8.2 million workers to their
payrolls since the end of the last recession in March 1991. Almost 90 percent of these
new jobs were full time. According to the employees themselves, 70 percent of the new




13

workers (5.9 million) were hired for managerial, technical, sales or administrative
occupations.
As one consequence, after-tax income (in current dollars at a seasonally adjusted
annual rate) has increased more than $1.1 trillion. Per capita income, in both nominal and
real terms, has also rise materially.
The Bureau of Labor Statistics recently published revised measures of
productivity showing that real output per hour rose at an average annual rate of 2.04
percent during the period 1959-1995 compared to its earlier estimate of mean growth rate
of 1.81 percent. The new measure shows a faster rate of productivity growth in each
decade except for the 1990s. The shortfall appears to be in nonmanufacturing businesses.
Faster growth in productivity is consistent with huge investments in recent years
in information processing and communications equipment.

At the same time, the

slowdown in productivity in nonmanufacturing (mostly private services and construction)
reflects the fact that gains in employment in the 1990s have been concentrated in business
sectors (retailing and health services are good examples) with relatively low levels of
output per worker.
Less credible is the picture of productivity and real compensation in
manufacturing. The data say that worker pay, adjusted for inflation, has hardly changed
over the last 20 years, while productivity has gone up more than 50 percent. This result is
not consistent, either with economic theory or our understanding of typical business
practices in both union and non-union sectors. BLS should take another look at its
numbers.
Small, often newly-formed firms in the private service sector have been the
primary force driving the growth in employment. Recently, however, the incentive for
these employers to hire has started to erode.
While large multinational corporations (which dominate the stock market) have
record profits, small service businesses (which create new jobs) face a profit squeeze.
Growth in revenue has slowed, and costs are up—not the least from the increase in the
work force. When it becomes unprofitable for small businesses to add workers, they will
stop doing so, and the recession will begin.




14

HBNEMANN ECONOMIC RESEARCH/DIVISION OF BRIM BERG * CO.
Baseline Forecast • March 1996
Iir97F
IV97F
r%F
ir97F
1*97 F
IV95A
IP96F
IV96F
IH'96F
THE ECONOMY:
$6,814.0
Gross Domestic Product ($92)
$6,918.0
$6,725.0
$6,778.7
$6,842.6
$6,821.2
$6,868.6
$6,874.0
$6,834.2
Pet Chg
6.2%
5.4%
1.3%
1.50%
-3.1%
-3.2%
1.5%
0.3%
-2.3%
$4,605.0
$4,570.2
Personal Consumption (S92)
$4,543.0
$4,640.4
$4,626.5
$4,592.6
$4,642.7
$4,647.3
$4,639.0
Pet Chg
3.1%
2.4%
1.04%
-4.3%
-3.9%
1.2%
-0.3%
-0.4%
0.6%
Business Investment ($92)
$752.6
$779.2
$732.5
$745.7
$749.8
$741.2
$760.6
$754.9
$768.2
Pet Chg
11.4%
14.9%
•6.9%
8.34%
-4.8%
-6.7%
4.1%
4.7%
5.9%
Structures ($92)
$180.8
$182.6
$184.5
$184.6
$186.3
$190.1
$192.0
$190.1
$186.2
Prod. Dur. Equip. ($92)
$598.4
$570.0
$548.0
$570.4
$556.7
$559.3
$576.1
$563.6
$564.8
Residential Invest. ($92)
$296.7
$277.8
$264.6
$265.4
$255.4
$265.5
$268.2
$266.2
$252.1
1
Pet Chg
'
30.1%
21.6%
4.33%
15.2%
5.3%
3.1%
-0.1%
•21.9%
1.1%
$9.7
Change in Inventory ($92)
($5.3)
($30.3)
$12.7
($20.3)
$4.7
$8.7
$21.7
($5.3)
Net Exports ($92)
($58.5)
($60.3)
($84.4)
($61.9)
($64.9)
($75.0)
($88.8)
($78.5)
($70.5)
$1,285.8
Govt Cons & Invest ($92)
$1,278.9
$1,277.1
$1,264.3
$1,258.6
$1,270.3
$1,255.1
$1,264.0
$1,265.2
Pet Chg
2.2%
0.6%
1.1%
2.2%
2.0%
0.3%
1.8%
-3.55%
-0.4%
$6,966.7
$6,879.6
$6,817.2
Final Domestic Sales ($92)
$6,914.3
$6,944.3
$6,938.4
$6,863.9
$6,888.3
$6,910.0
Pet Chg
5.2%
3.7%
-2.7%
-2.6%
0.3%
1.4%
1.5%
1.05%
-2.0%
Gross Dom. Prod. ($ Current)
$7,915.1
$7,766.8
$7,348.1
$7,632.4
$7,615.8
$7,540.4
$7,451.0
$7,655.3
$7,662.2
Pet Chg
7.9%
7.2%
4.1%
5.7%
-0.4%
4.9%
2.75%
-1.2%
2.5%
$5,141.4
Disposable Income ($92)
$5,083.4
$5,055.7
$5,064.3
$5,034.3
5010.2
$5,054.2
$5,051.8
$5,046.5
Pet Chg
4.6%
2.2%
3.64%
0.7%
-0.6%
1.0%
1.4%
1.9%
•0.8%
Savings Rate (Percent)
5.3%
5.6%
5.8%
5.4%
4.90%
5.8%
5.7%
5.5%
6.0%
Operating Profits ($ Current)
$511.9
$540.8
$493.9
$569.1
$581.8
$574.8
$564.5
$524.8
$544.3
Pet Chg
24.5%
15.4%
-19.9%
•3.9%
1.8%
-13.6%
-6.4%
-21.5%
-16.3%
Industrial Prod. (1987*100)
120.4
117.7
122.39
124.0
123.1
116.2
120.0
123.7
122.6
Pet Chg
9.5%
5.1%
1.0%
2.4%
0.20%
-11.9%
-4.7%
•8.2%
2.0%
Housing Starts (Mill. Units)
1.47
1.398
1.50
1.41
1.42
1.37
1.41
1.33
1.26
Pet Chg
9.7%
13.0%
-11.7%
4.0%
•5.3%
23.4%
•0.9%
•26.8%
31.1%
Tot Vehicle Sales (Mill Units)
13.11
14.21
13.98
14.37
14.92
12.72
13.39
14.73
13.88
Pet Chg
12.6%
-4.1%
-4.9%
-3.15%
29.6%
-18.5%
-13.3%
-9.1%
-9.6%
Nonfarm Payroll Jobs (Mill)
117.195
117.6
116.8
118.0
117.5
116.5
117.7
117.7
117.9
Pet Chg
0.8%
2.9%
0.8%
0.9%
1.0%
1.42%
•3.9%
•0.8%
-0.1%
Unemployment Rate (Percent)*
5.57%
7.0%
5.9%
5.7%
5.7%
6.9%
6.7%
6.5%
6.2%
Corap. Per Hour Non-Farm Bus* 9
116.6
113.0
109.9
115.7
112.0
110.9
117.6
114.9
114.0
Pet Chg
4.0%
3.2%
3.7%
3.7%
3.6%
3.2%
4.1%
2.8%
3.6%
Productivity Non-Farm Bus**
103.2
102.4
102.4
102.1
102.2
102.2
101.3
101.1
101.7
Pet Chg
0.1%
4.6%
-0.5%
0.7%
0.3%
*3.4%
0.8%
-2.4%
-2.2%
Unit Labor Cost Non-Farm Bus**
107.6
113.9
110.5
109.4
108.5
114.2
113.7
113.9
112.1
Pet Chg
3.4%
4.1%
4.1%
2.0%
5.7%
6.0%
3.4%
0.3%
•1.3%
GDP Deflator (1992s 100)
110.8
108.9
114.0
109.8
107.72
114.4
113.5
112.9
112.1
Pet Chg
4.4%
3.7%
4.9%
3.3%
1.22%
1.7%
2.9%
2.0%
1.5%
Consumer Prices (1982-84=100)
158.0
155.3
153.87
162.7
161.7
156.7
159.5
163.8
160.6
Pet Chg
3.2%
2.37%
3.6%
3.9%
2.7%
2.8%
4.0%
2.3%
2.8%
($126.1)
Fed! Deficit ($ Current N I A )
($151.1)
($126.4)
($148.7)
($168.6)
($158.6)
($139.1)
($152.1)
($175.2)
FINANCIAL MARKETS:
Federal Funds Rate
4.8%
3.4%
4.4%
5.5%
3.4%
3.8%
5.2%
5.72%
3.6%
4.5%
Three-month Bills (Discount)
4.9%
5.1%
5.26%
4.0%
3.1%
3.1%
3.4%
3.2%
8.77%
Prime Rate, Major Banks
7.5%
7.1%
7.9%
8.2%
6.1%
6.1%
6.5%
6.3%
10-Year Treasury Bonds
5.4%
5.89%
5.6%
5.7%
5.1%
5.3%
5.2%
5.2%
5.3%
$1,133.4
Money Supply ( M - l , $ Current)
$1,128.5
$1,112.8
$1,115.0
$1,235.4
$1,262.0
$1,161.7
$1,293.0
$1,199.4
Pet Chg
7.6%
-5.01%
-0.8%
12.6%
10.4%
8.9%
-4.7%
10.2%
13.6%
Velocity (Ratio: GDP to M - l )
6.72
6.78
6.18
6.51
6.15
6.60
6.68
6.12
6.36
Trade-Weighted $ (1973« 100)
88.1
84.44
87.2
95.4
97.3
93.5
89.9
86.1
91.7
A=Actual F= Forecast Billions of dollars unless noted.
* Break in series, January 1994. ** Compensation, productivity and unit labor costs are index numbers, 1992 =100.
Sources: Haver Analytics; Heinemann,Economic Research




1995 A

1996 F

1997 F

$6,768.7
2.29%
$4,591.4
2.51%
$723.2
10.46%
$181.4
$541.8
$262.8
-2.27%
$35.7
($108.0)
$1,263.6
0.17%
$6,840.9
2.66%
$7,247.7
4.56%
$4,948.5
3.44%
4.53%
$579.4
10.03%
121.97
3.28%
1.355
-6.32%
14.735
-1.85%
116.606
2.26%
5.61%
108.22
3.56%
101.76
1.05%
106.32
2.48%
107.07
2.23%
152.49
2.81%
($161.0)

$6,854.8
1.3%
$4,642.3
1.1%
$758.4
4.9%
$189.6
$568.7
$263.0
0.1%
$5.2
($77.1)
$1,263.0
-0.0%
$6,926.7
1.3%
$7,567.3
4.4%
$5,051.2
2.1%
5.6%
$568.2
-1.9%
123.4
1.1%
1.36
0.6%
14.30
-3.0%
117.8
1.0%
5.9%
112.4
3.9%
102.1
0.4%
110.1
3.6%
110.4
3.1%
157.4
3.2%
($136.2)

$6,808.9
-0.7%
$4,577.7
-1.4%
$752.5
-0.8%
$183.5
$568.9
$273.6
4.0%
($11.6)
($61.4)
$1,278.0
1.2%
$6,881.9
•0.6%
$7,742.4
2.3%
$5,081.7
0.6%
5.7%
$517.9
-8.9%
118.6
-3.9%
1.43
5.1%
13.30
-7.0%
117.1
-0.5%
6.8%
116.2
3.3%
102.0
•0.1%
113.9
3.5%
113.7
3.0%
162.2
3.1%
($163.6)

5.84%
5.49%
8.84%
6.58%
$1,141.9
-0.29%
6.348
84.30

5.0%
4.6%
7.7%
5.5%
$1,130.7
-1.0%
6.69
87.8

3.6%
3.2%
6.3%
5.2%
$1,247.5
10.3%
6.21
94.5

CYCLICAL CHANGES IN MONETARY POLICY

c
H
A
N 15* 4
G
E
10y.

I
N
S/. A
a\




P
E
R
0
C
E
N -5x
T
Jan
1951

Jan
1956

Jan
1961

Jan
1966

Jan
1971

Jan
1976

Jan
1901

Jan
1906

Jan
1991

Jan
19%

Notes: The chart shows annual percentage changes in total bank
reserves adjusted for shifts in legal reserve requirements.
FRB St. Louis monetary base minus currency. Three-month
moving averages, SA. Uertical lines shou recessions.
Sources: Haver Analytics; Heinemann Economic Research

CYCLCIAL CHANGES IN HIGH-POUERED MONEY

A
N

Jan
1969

Jan
1972

Jan
1975

Jan
1978

Jan
1981

Jan
1984

Jan
1987

Jan
1998

Jan
1993

Jan
1996

Notes: The chart shous annual changes in the monetary base less its
mean rate of change, 1969-1995 (7.8X). Federal Reserue Board
concept adjusted for reserue requirement changes. Current $.
Janaury 1996 plotted. Vertical lines show recessions.
Sources: Hauer Analytics; Heinemann Economic Research




A RECORD SURPLUS IN THE PRIMARY BUDGET
B
I
L
L
I
0
M

$80 |

TT

i—i—r
U.S. Treasuryj Primary Budget Balance

00




-$120
Ql
969
Motes:

Ql
1972

Ql
1975

Ql
1978

Ql
1981

Ql
1984

Ql
1987

Ql
1990

Ql
1993

The chart shous the primary balance in the federal budget
revenues minus outlays except net interest. Billions of
current dollars, NIPA concept. Third quarter 1995
plotted. The vertical lines shou recessions.

Sources: Haver Analytics;

Heinemann Economic Research

Ql
1996

SURPLUS OR DEFICIT - TUO UIEUS 8F THE FEDERAL BUDGET
P
E 5.Ox
R
C
E 2.5*
N
T

—
—

U.S. Treasury: Primary Budget Balance
U.S. Treasury: Ouerall Budget Balance

OS

Ql
Ql
Ql
Ql
Ql
Ql
Ql
1952 1956 1960 1964 1968 1972 1976

Ql
Ql
Ql
Ql
Ql
1980 1984 1988 1992 1996

Notes: The chart shows the federal government's primary budget
balance (revenues minus outlays except net interest, line)
and overall balance (revenues minus outlays, dot) as a
percent of GDP. The vertical lines show recessions.
Source: Haver Analytics; Heinemann Economic Research




CYCLICAL CHANGES IN LABOR INPUT
C
H
A
N
G
E

8x
4*

I
N
0
to
O

P
E
R -fe A
C
E
N -8X ]
T
Jan Jan Jan Jan Jan
Jan Jan Jan Jan Jan Jan Jan
1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998
Notes: The chart shous year-ouer-year percentage changes in the
Bureau of Labor Statistics index of hours worked in the
private nonfarm economy. Three-month moving averages.
February 1996 plotted. The vertical lines shou recessions.
Sources: Haver Analytics; Heinemann Economic Research




NET JOB CREATION BY EXISTING EMPLOYERS

(N

Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul
1989
1990
1991
1992
1993
1994
1995
1996
Notes:

The chart shous annual changes in priuate nonfarm jobs minus
the Bureau of Labor Statistics' monthly "bias adjustment"
for net job creation by neuly-formed employers. Nillions
of jobs. Vertical lines show the 1990-91 recession.

Sources: Haver Analytics;




Heinemann Economic Research

THE CYCLICAL SLOWDOWN IN CONSUMER SPENDING
C
H
A
N
6
E

—

Real Retail Sales ($82-84)

I
N
to

P
E
R
C
E
N
T




Ql
I960
Notes:

The chart shous annual changes in total retail sales deflated by the commodities component of the consumer price
index (CPIU). 1982-84 Dollars. Fourth quarter 1995 plotted,
The vertical lines shou periods of recession.

Sources: Haver Analytics;

Heinemann Economic Research

THE CAPITAL G88DS BOOM IS COOLING
C
H
A
N 25. Ox
G
E
12.5K

—

Gross Ualue of Business Equipment ($92)

1

I
N
0
P
E
B -12.5x
C
E
N -25.fr/. H
T
Ql
1977
Notes;

Sources:



(N

Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql Ql
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997

The chart shows quarterly changes at seasonally adjusted
annual rates in the real gross ualue of industrial production of business equipment. Fourth quarter 1995 plotted.
The uertical lines show periods of recession.
Haver Analytics;

Heinemann Economic Research

EXCEPT FOR AIRCRAFT, MANUFACTURING IS SLOWING

S




Notes: The chart shows orders for manufactured products except
civilian aircraft (left scale, line) and for civilian aircraft (right scale, dot.) Six-month moving averages;
January plotted. The vertical lines shou recessions.
Sources: Haver Analytics; Heinemann Economic Research

LONG-TERM TRENDS IN PRODUCTIUITY
I
1
N
D
E 120X

n

1
1

•• •
1
• •••• •• ••*• • f

^0^

0*

#

1

1

I

['"

m

m

m

m0

>

mmm0

m>m0

00

i

i

Ql
1964
Motes:

1

1

1

1

I

1 '•

1

1

1 I—1

,

0m"'

-*
'"
*

1 '•

i

i

1
1

B

TmmHH^r"

1

1 '-I

1 — T—T—I—1

1—1

1

1 ' l'4 — i

i i—i i

i—r-4

Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997
The chart shous BLS indexes of output per hour in the business sector (line), in manufacturing (close dot) and a
separate index of real private service consumption per hour
(Hide dot). 1992=100. The vertical lines shou recessions.

Sources: Haver Analytics; Heinemann Economic Research




~

*
1
^ f ^"lll -MI mm*9*

...-—-"*

60

* !

\

m—i

— Productivity: Business Sector
— Productivity: Manufacturing
. . Productivity: Private Services
..

1 1009
9
2 801
0
0

1—i

MANUFACTURING PRODUCTIVITY AMD COMPENSATION
I
N 175
D
E
X

TT

E

TT

TT

TT

Manufacturing: Real Output per Hour
Manufacturing: Real Compensation per Hour

ON




50
Ql
1959
Notes:

i

Ql
1963

Ql
1967

Ql
1971

T — r — i — r

i 'i

Ql
1975

Ql
1979

Ql
1983

i

Ql
1987

i

i

i

Ql
1991

i

i

Ql
1995

The chart shows Bureau of Labor Statistics indexes for
manufacturing of real output per hour (line) and real compensation per hour (dot). Rebased by Heinemann Economic
Research, 1977=100. The vertical lines show recessions.

Sources: Haver Analytics; Heinemann Economic Research

i

THE U.S. SHARE 8F CONSUMPTION AND INVESTMENT
Federal Outlays for Consumption ft Investment

1929
Notes:

1935

1941

1947

1953

1959

1965

1971

1977 1983

The chart shous real federal spending for consumption and
gross investment as a percent of real gross national product. The horizontal line is the value for 1995, 7.02X
Data prior to 1959 estimated by Heinemann Economic Research.

Sources: Haver Analytics; Heinemann Economic Research



1989

1995




28

BALANCED BUDGETS, LIMITED GOVERNMENT,
AND ECONOMIC WELL-BEING
LeeHOSKINS
The Huntington National Bank

"EVERYBODY WANTS TO GO TO HEAVEN BUT NOBODY WANTS TO DIE"
Everybody in Congress and the Administration says they want a balanced budget
but nobody actually want to do it. If they do, why are they waiting until 2002? And why
back-end load the spending cuts and wrangle over CBO scoring? The answer is law
makers fear the steps to a balanced budget lead to political death. By focusing on the real
reason to balance the budget, legislators can solve a pressing public policy problem and
get credit for it. The reason to balance and reform the budget is to raise economic growth
by (1) restraining the government grab, (2) shifting spending from consumption to
investment, and (3) reforming tax policies to reduce disincentives to work, save and
invest. The real culprit is the size and composition of government spending combined
with flawed tax policies that lead to misallocation of society's resources. In a kernel, a
balanced budget discipline can help prevent the central government from eating the
nation's seed com.
Bringing spending into balance with current revenues, while changing the mix in
favor of investment, would boost the economy by giving individuals better choices and
greater freedom in making spending, saving, and investment decisions. Although the
budget can be temporarily balanced without altering Social Security, both the deficit and
the share of spending devoted to consumption will increase without changes to current
law. The economy's full potential cannot be unearthed without fundamental reform of
federal entitlement programs. By increasing future economic growth through higher
investment and fixing the insolvent1 Social Security System, Congress can preserve the
promise of rising living standards to future generations while keeping promises to current
retirees.




29

BALANCED BUDGET: A MEANS TO AN END
Economists search for the effects of deficits on interest rates, saving and
investment, productivity and exchange rates. The results of their efforts are inconclusive.
The reason to eliminate deficits cannot be found in the data alone but rather in the goal of
improving economic performance by holding the government accountable for spending
only what it raises through explicitly legislated taxes. Deficits allow government to
spend without being accountable to the electorate. The incentive for government to spend
more than it raises in tax revenues stems from the fact that the benefits of spending
programs are concentrated on the few while the costs are spread across all present and
future taxpayers. Beneficiaries of spending programs have strong incentives to lobby and
contribute to the election of those officials who grant the largess. The cost of individual
taxpayers of each spending program is so small that they have insufficient incentive to
lobby against them separately. Future taxpayers have no say at all.
The fiscal history of the last 40 years in the U.S. shows that unchecked spending
is the source of the deficit (Chart 1). Annual revenues have been 18-20 percent of GDP
since 1956, despite numerous changes in the tax laws. Revenues amounted to 19.3
percent of GDP in 1995. Spending increased from 17.0 percent of GDP in 1956 to a peak
of 24.4 percent in 1983 and was 21.6 percent of GDP last year.
The main source of spending growth has been outlays for entitlement programs
that fuel consumption. From 1966 to 1995, more than half of the increase in non-interest
outlays occurred in nonmeans-tested transfer programs. These categories grew more than
twice as fast as total non-interest spending. As a result, the share of consumptionoriented transfers in total federal outlays roughly doubled to 46 percent between 1966 and
19953(Chart2).
The way to balance the budget is to restrain growth in entitlement spending. The
reason to do it is to reverse the bias toward consumption and away from investment.
Thus, restraining the growth of spending as a share of GDP is a principal reason for
balancing the budget. Demands for term-limits and a balanced budget amendment are
efforts to reduce the incentive to spend and hold government accountable.




30

As government spending increases relative to the economy, economic growth is at
risk because the private sector, which manages resource more productively, is reduced in
relative terms. There are but two ways to organize our economy's resources. One is to
rely on individuals to make decisions about work, investment, and consumption in
competitive markets. The other is to allow government to direct resource use through
spending programs, regulations, and tax policies. The historical landscape of the last 50
years is littered with economies wrecked by government direction of resources. Market
economies with limited government direction have thrived.

To paraphrase Ronald

Reagan, government direction of economic resources is the problem not the solution. A
balanced budget amendment that would bring the government expenditure share of the
economy down to the tax share, is a good vehicle for enhancing growth prospects for the
economy.
The time to start is now. Yet neither the Balanced Budget Act of 1995 nor the
Administration's 1997 budget are projected to make any progress until 1988. Even under
favorable economic assumptions, both plans pack approximately half of the deficit
reduction into years six and seven.4 (Charts 3-5).
Concerns that quickly bringing outlays into line with revenues would imperil the
economic expansion are steeped in Keynesian mythology.

As Mickey Levy has

explained, balancing the budget by reducing nonmeans-tested transfers, such as Social
Security and Medicare, relative to the economy would raise the long run rate of economic
growth.5
SHIFTING RESOURCES FROM CONSUMPTION TO INVESTMENT
How the budget is balanced or the deficit reduced has a significant bearing on
how efficiently resources are used in our economy. Budget actions that reduce or
eliminate biases against saving and investment throughout the economy will promote a
higher future standard of living.

Actions that hinder saving and investment will

negatively impact living standards. Increases in saving to build the capital base and raise
productivity require reductions in the rate of consumption. The portion of national




31

income directed to consumption must shrink to permit the increases in saving and
investment necessary for faster growth in incomes.
These measures to balance the budget should focus on shifting rresources away
from consumption and towards investment. Taxes on saving should be eliminated.
Taxes should be levied on consumed income. Current proposals to replace the current
federal income tax system with a consumed income tax (Nunn-Domenici), a national
sales tax (Archer), or a flat tax (Armey-Shelby-Craig and others) are steps in the right
direction.
Spending programs that are biased toward consumption should be reduced,
capped, or eliminated. Programs that directly misallocate the economy's resources, such
as agricultural subsidies, should be eliminated. Progress is being made in agriculture.
This means revising most of the "entitlement" programs put in place over the last 60
years. These programs are not uncontrollable. Much of the increase in outlays is due to
legislated changes in benefits and eligibility requirements.

The Great Society has

collided with the nation's budget constraint, requiring that benefits and eligibility
standards be lowered and tightened and some programs entirely eliminated. Entitlement
programs shift resources away from savers to high consumption groups. Such actions,
while reducing the deficit, will more importantly increase growth in domestic
investments, meaning each U.S. worker will have more capital to work with. More
productive labor earns higher real wages. Growth of our economy is key to a more secure
economic future.

Charles Plosser has pointed out that "the difference between an

economy that grows at 2 percent a year and one that grows at 3 percent a year is
enormous due to compounding. After 30 years the economy growing at 2 percent is
about 80 percent wealthier while the economy growth at 3 percent is almost 150 percent
wealthier."6
The silver lining in the current Washington budget follies is that both parties are
talking about tax reduction and spending cut backs. They may actually stumble into
actions that shift the bias away from consumption and towards investment. A balanced
budget requirement, limiting expenditures to 20 percent of GDP or less, would provide
the incentive for Congress to enact pro-growth measures and strip out programs and




32

regulations that hinder investment. The only way for lawmakers to get more dollars for
spending on constituents to ensure their political viability would be through a faster
growing economy. Politically doable? A balanced budget amendment recently failed by
one vote in the Senate and many state governments have found a balanced budget
requirement politically achievable.
GROWING CAPITAL, ALLEVIATING SOCIAL INSECURITY
Even if Congress were to achieve a balanced budget by 2002, its reprieve from
budget pressure would be short lived. By 2013—and possibly sooner—payments from
the Social Security System will exceed receipts. By 2030 the Trust Fund will be broke.
Tinkering around the edges with marginal changes in the retirement age and the payroll
tax rate and limit will buy little time. A fundamental fix is to alter economic policies to
promote the saving and investment necessary to expand the rate of growth in the
economy. Another alternative is to privatize the System. Individuals can provide more
effectively for their well-being in retirement than can the government. For example, if
individuals bom in 1970 invest the amount they currently pay in Social Security taxes in
financial markets, they will receive an estimated six times the benefits they are scheduled
to receive under Social Security. Moreover, there is a safety net in place for those who
misplan or fall upon unfortunate circumstances—welfare, preferable delivery at the state
or county level, as well as neighborhood charitable organizations.
Eliminating Social Security has little political support. A more likely outcome is
a patch to the current system—raising the eligible retirement age, cutting the cost-ofliving adjustment, increasing taxes or perhaps privatizing a compulsory system. As
Mickey Levy pointed out in his recent Congressional testimony, Social Security reform
o

needs to be included in the current fiscal debate. Failure to make adjustments now only
exacerbates the problem. We, as a society, have simply not accumulated the capital
necessary to permit a relatively smaller work force to generate the promised benefits.
Growing the economy by saving more now is the key to a higher standard of
living. Curbing the growth in Federal expenditures to generate saving will not derail the




33

economy in the short run as long as the fiscal plan is credible and shifts spending away
from consumption and towards investment. The long-term benefits are substantial.
TAKING THE FIRST STEP
The persistent structural budget deficit is not a crisis. The country is not at a
crossroads. If it were, Americans would recognize and overcome the challenge. Instead,
the threat is the insidious erosion of living standards compared with what they would be
in the absence of distortions in resource allocation and disincentives to saving and
investment. The public perception that the economy is falling short of expectations might
be the beginning of enlightenment. By the time the source of the threat is widely
acknowledged, if ever, it will be too late. The path to the solution is clear, and it leads to
higher living standards, not political death. Lawmakers must take the first step by
embracing fiscal reforms that remove the bias against saving and incentive to consume
and begin to dismantle growth-inhibiting entitlement programs. A balanced budget
amendment is a good vehicle for carrying this load.




34

Notes
Based on current law and mid-range projections of economic activity and
demographic changes, the net present value of the Social Security Trust Fund is deeply
negative.
2

Economic Report of the President, February 1996, p. 368.

historical Tables, Budget of the United States Government, Fiscal Year 1996.
4

Budget of the United States Government, Fiscal Year 1997 and "The Economic
and Budget Outlook: December 1995 Update," CBO Memorandum.
5

Mickey Levy, "Perspectives on the Federal Debt Ceiling and Budget Policy,"
Testimony to the Committee on Banking and Financial Services, U.S. House of
Representatives, February 8,1996.
6

Charles Plosser, "Is a Balanced Budget the Key to Our Economic Future?"
Presentation in Rochester, New York, December 4,1995.
William G. Shipman, "Retiring With Dignity: Social Security vs. Private
Markets," Cato Institute Social Security Project no. 2, August 14,1995.
8




Levy. op.cit.

35




Chart 1
Federal Government Outlays and Receipts

26

1955

1960

1965

1970

1975

1980

1985

1990

1995

Fiscal Year
— Outlays
—

Receipts

Chart 2
Noiuneans-Tested Transfer Payments
50

40

8

50

-40

30H

30

| 20

-20

10

hlO

1963

1967

1971

1975

1979

1983

- Total Nonmeans-tested Transfers
- Social Security plus Medicare
- Nonineans-tested Transfen other than Social Security and Medicare

36

1987

1991

1995




Chart 3
Deficit Reduction Timing
Billions of $
1995
Deficit

Half Way
to Balance

h50

95

96

97

Balanced Budget Act of 1995

98
•

99

1997 Administration Budget

37

00




Chart 4
Federal Government Outlays and Revenues

1960

1967

CBO Outlays
Congress Outlays
Administration Outlays
Historical Outlays

1974

1981
Fiscal Year

1988

1995

2002

• CBO Revenues
Congress Revenues
Administration Revenues
1
Historical Revenues

Chart 5
Federal Government Budget Deficit

1960
CBO

1967
—

Congress

1974

1981
Fiscal Year

••• Administration

38

1988

• " • Historical

1995

2002

Chart 6
Mandatory Federal Government Spending
Excluding Net Interest

Chart 7
Discretionary Federal Government Spending

12 H

16

14

15

12

fe 9
o

16

14

15

12 H

h 12

hlO

h9

O

o

2

8

1

6

6

4

61

8

M

3H

1965 1970 1975 1980 1985 1990 1995 2000 2005
Fiscal Year
Historical
CBO Baseline
Congress •••• Administration
Note: Social Security, Medicare, and Medicaid comprised
three-quarters of mandatory spending in 1995.




1965 1970 1975 1980 1985 1990 1995 2000 2005
Fiscal Year
Historical — CBO Baseline
Congress
••• Administration

Chart 8
Net Interest

3H

r3

Q

O

2H

1965 1970 1975 1980 1985 1990 1995 2000 2005
Fiscal Year
— Historical
—
- - - Congress

CBO Baseline
•••• Administration

39

Chart 9
Mandatory Federal Government Spending
Excluding Net Interest

70

Chart 10
Discretionary Federal Government Spending
r80

80 n

r70

60 H

h60

50 H

50
40

I
* 30

[-30
h20

20 H

10

10

1965 1970 1975 1980 1985 1990 1995 2000 2005
Fiscal Year
— Historical
CBO Baseline
— Congress •••• Administration
Note: Social Security, Medicare, and Medicaid comprised
three-quarters of mandatory spending in 1995.




1965 1970 1975 1980 1985 1990 1995 2000 2005
— Historical
-— Congress

Fiscal Year
CBO Baseline
•••• Administration

Chart 11
Net Interest

1965 1970 1975 1980 1985 1990 1995 2000 2005
Fiscal Year
Historical
Congress

—

CBO Baseline

— Administration

40

ECONOMIC CONDITIONS
Mickey D.LEVY
NationsBanc Capital Markets, Inc.
The economy is sound structurally, but weak cyclically. The probability of
recession remains relatively low, as heightened business efficiencies and the Federal
Reserve's disinflationary monetary policy have reduced potentially disruptive imbalances
in the economy. However, the Fed's sustained monetary restrictiveness has generated
undesirably anemic economic growth, and I forecast the cyclical slump to continue at
least through mid-year 1996. Inflation has begun to recede, a trend that will continue into
1997. This environment of modest economic growth and declining inflation will remain
favorable for financial markets. The structural soundness generated by heightened
business efficiencies and the Fed's disinflationary monetary policy create the foundation
for sustained economic expansion, but a crucial issue is, at what pace, and what can
policymakers do to enhance long-run economic growth? Fiscal reform remains the
missing ingredient to support stronger long-run economic growth and higher standards of
living.
CURRENT ECONOMIC CONDITIONS
Recent economic performance reflects two general trends:

the ongoing

restructuring characterized by dramatic innovations and associated adjustments to
production processes and labor markets, and the temporary cyclical slowdown in
economic activity generated by the Fed's sustained monetary restrictiveness.

The

stalemate in he fiscal policy debate and the uncertainty surrounding it has aggravated the
economic weakness.
The Cyclical Slowdown
The Fed's pre-emptive and aggressive monetary tightening in 1994 generated a
sharp slowdown in demand, paving the way for the desired soft-landing in 1995 and
preventing the widely anticipated cyclical rise in inflation. Inflation is expected to recede




41

in 1996-1997, a favorable trend the Fed correctly recognizes as a necessary ingredient for
healthy sustained economic expansion.
My biggest concern is that economic activity has slowed too much—annualized
quarter-over-quarter real GDP growth was below 1 percent in three of the four quarters in
1995, following 3.5 percent growth in 1994—and that the Fed's restrictive monetary
policy will generate a continued cyclical slump.
Similar to recent cyclical slowdowns, the weakness emerged first in housing and
durable goods consumption. Real consumption, which grew 3.0 percent form Q4:93 to
Q4:94, slowed to 1.9 percent growth in 1995, as auto sales fell and department store sales
slumped. Housing activity weakened sharply, with declining sales of existing and new
homes forcing developers to cut back new construction in order to limit the rise in unsold
inventories.
In response to mounting evidence of weak demand, businesses have slowed
production and become increasing cautious. They have cut output in an attempt to
control inventories, slowed investment growth and trimmed labor inputs. Industrial
production rose a scant 1.5 percent from Q4:94 to Q4:95 compared to 6.6 percent in the
previous year. Inventory building dropped below $20 billion in Q4:95 from an average
$60 billion in 1994.

Absent a rebound in product demand, a further reduction in

inventory building may be necessary. Also in response to the anticipated weakness in
demand and slower growth in corporate profits and cash flows, business investment in
producer durable goods and structures has slowed sharply to 5.0 percent annualized
growth since Spring 1995, half its 1994 pace.
These cutbacks in production have involved a significant adjustment in labor
inputs: non-farm payroll growth has averaged about 110,000 per month since Spring
1995, compared to its 294,000 average monthly gain in 1994, and overtime hours have
been reduced over 8.0 percent in the last year. As a result, aggregate hours worked have
barely grown since early 1995, following their 4.3 percent rise in 1994. This has slowed
growth in disposable personal income. Growing uncertainties about job stability also
have dampened consumer confidence.




42

The delayed budget negotiations in Washington and government shutdown have
subtracted from economic activity in several ways. The decline in real government
purchases has accelerated, subtracting from GDP. In addition, the government shutdown
and the resulting uncertainty have negatively affected a wide array of private businesses
that rely on government functions. The lack of fiscal credibility has a negative impact
that cannot be quantified; at a minimum, the stalled budget negotiations have contributed
to the recent rise in interest rates.
A decline in the net export deficit is contributing positively to GDP, but largely
because of slowing imports, a sign of weakness. Exports continue to growth robustly—
9.4 percent annualized in the second half of 1995—despite weak economic conditions in
Europe and lingering recessionary-type conditions in Japan. The abrupt slowdown of
import growth to 0.5 percent annualized in the second half of 1995 from its earlier 8.2
percent pace reflects the slump in domestic consumption and a moderation of business
fixed investment.
Improved Structural Soundness & Lower Inflation Reduce Probability of Recession
Potentially disruptive imbalances in the economy have been reduced by
efficiencies in production and the heightened ability of businesses to adjust to
fluctuations in aggregate demand, the Fed's credible disinflationary monetary policy, and
the flexibility of wages and prices. This lowers the probability of recession and
establishes a sound foundation for sustained economic expansion.
In recent years, the magnitude of the cyclical fluctuations of current dollar
spending growth has been dampened by the Fed's more persistently disinflationary
policies, which has reduced the adjustments necessary for businesses to modify
production and control labor inputs, supplies, and inventories.

Since 1980, each

succeeding peak in nominal GDP growth has been lower, an every peak-to-trough swing
in aggregate demand has been smaller. This reduces the potential for large disruptive
imbalances.
Moreover, a wide array of innovations and improvements in production processes,
strong growth in business fixed investment, and more efficient uses of labor inputs have




43

raised productivity and constrained unit labor costs. Productivity gains have played a
larger role fueling economic growth this expansion than in recent expansions, while rises
in labor inputs have been more modest. Unit labor costs in manufacturing in the U.S. are
significantly lower than nearly all other industrialized nations. Very low unit labor cost
inflation has enabled businesses to maintain margins. The resulting healthy profit gains
have provided the cash flows necessary for investment and expansion, and reduced the
burden of debt service. At the same time, improving production processes have kept
inventories at manageable levels.

Entering 1995, these improvements provided

businesses a healthy buffer against the cyclical slowdown.
Businesses have cut back production and labor inputs more rapidly and efficiently
in the current demand downdraft than in previous cycles, maintaining healthy
productivity gains, profit margins and cash flows, in sharp contrast to all recent cyclical
slowdowns. In a sense, the efficient business response suggests the unobservable but
powerful impact of the Fed's heightened inflation-fighting credibility—that monetary
policy will remain consistent with a moderate growth/low inflation environment and
relatively small swings in demand.
Recent recessions have occurred as sharp deceleration in demand generated by the
Fed's aggressive monetary tightening in response to rising inflation, coupled with slow
business responses, have generated disruptive imbalances in the economy. Avoidance of
those trends in both demand and supply reduces the probability of recession. The risk
remains, however, that a persistently restrictive monetary policy generates a continued
deceleration of nominal spending, making the adjustments necessary to avoid recession
increasingly difficult.
Labor Market and Wage Trends
In recent years, a stream of corporate layoffs has generated a growing sense of job
insecurity, real wages of laborers have languished, and wage and income differentials
between skilled and unskilled workers have widened. These trends, may of which are
prevalent throughout the industrialized world, are receiving substantial attention, and
some clarification is necessary to avoid policy mistakes.




44

First, continued growth of employment suggests that big-headline layoffs have
been more than offset by new hiring. The average duration of unemployment has not
increased, although some evidence suggests that dismissals may have risen relative to
involuntary job departures. Clearly, unencumbered by the rigidities that inhibit labor
markets in other industrialized nations, the U.S. has significantly larger flows into and out
of jobs. The continuous reallocation of labor is a source of economic strength and longrun job creation, and should not be overshadowed by highly visible layoffs.
Second, the lack of real wage gains reflects in part the rapid growth of nonwage
compensation, the long-term effort by U.S. businesses to re-establish international
competitiveness, and high taxes on labor. In addition, there are notable flaws in the
average hourly earnings statistical series, including the deflators used to arrive at a
measure of real wages; other measures of earnings show an improving trend. In the early
1980s, following a decade during which wage compensation growth soared while
productivity declined, U.S. unit labor costs in manufacturing far exceeded those in other
industrialized nations, driving down U.S. exports. The adjustment of wage compensation
relative to productivity, along with the decline in the U.S. dollar, has reversed those
fortunes. Recently, average real wages have resumed growing, a trend that should
continue as nonwage compensation slows and real wages catch up to the sustained gains
in productivity.
Third, production innovations and the internationalization of the labor markets
have lowered the demand for unskilled labor and raised the demand for skilled workers,
widening wage and income differentials.

Empirical analysis confirms the obvious:

actual and expected compensation is increasingly linked to education and skills.
Growth, enhancing remedies for narrowing wage differentials and lifting
standards of living necessarily involve improving the education and skill levels of the low
skilled, opening international goods and labor markets and promoting free trade, and
reducing taxes on labor andrigiditiesthat inhibit labor supply and demand. The crux of
the problem is raising the value-added of low-skilled job entrants and workers, not
reducing the real wages of high skilled workers. Subsidizing low-skilled, low-wage
earners involves disincentives that raise unemployment; witness the double-digit




45

unemployment rates throughout Europe.

The misguided populist initiative of

protectionism would reduce average real wages, suppress economic activity, and lower
standards of living; ironically, it would be particularly harmful to the low income
workers. It is crucially important that policymakers consider constructive, growthenhancing measures of raising the wages and incomes of the low-skilled, and avoid
wrong-headed initiatives that address the symptoms, not the sources of the problem.
Positive Financial Responses
Interest rates have receded with the slowdown in real economic growth, lower
inflationary expectations, and the associated belief that the Fed will reduce its funds rate
target. These trends are projected to continue. The strength of the stock market has
stemmed from the decline in rates, which raises price/earnings multiples, and production
efficiencies that have lifted productivity and enabled businesses to maintain margins and
achieve growth in profits and cash flows. The expected stream of future earnings has
been enhanced by the perceived low probability of recession. Insofar as the improved
structural soundness and the Fed's credible disinflationary monetary policy represent a
departure from the 1970s-1980s, ranges of P/E multiples in those decades are not
appropriate guidelines for the 1990s. Nevertheless, the largest risk to the stock market is
softening corporate profits in a weakening economy.
More Cyclical Weakness Ahead
Product demand is projected to remain sluggish through mid-year, generating
continued cautious business behavior. Retail sales and employment are not expected to
rebound dramatically in February-March, suggesting that their January declines were not
just weather-related. In response, businesses will modify production and hiring plans in
order to reduce inventory building and operating costs. Real GDP, which grew an anemic
0.9 percent annualized in Q4:95, is projected to grow approximately 1.0 percent
annualized in the first half of 1996.
The anemic growth is decidedly below the projections—and desired ranges—of
official forecasts in Washington and most private forecasters. The Congressional Budget




46

Office and the Administration both forecast 2.2 percent growth from Q4:95 to Q4:96,
while the Federal Reserve's central tendency forecast is 2.0-2.5 percent. The Blue Chip
Consensus, which has become less optimistic in recent months, projects 2.0 percent
growth in calendar 1996.

Economic performance likely will fall short of these

expectations. At the same time, however, I project that consumer price inflation will
recede from its 2.8 percent rise in 1995 toward 2.0 percent by year-end 1996 and remain
low in 1997, while government forecasts are more pessimistic. The CBO projects the
CPI to rise 3.0 percent in 1996 and 3.1 percent in 1997, the Administration projects 2.9
percent inflation in both years, and the Fed's central tendency forecast for 1996 is 2.8753.25 percent. The Blue Chip Consensus forecasts a slight decline to 2.7 percent.
Federal Budget Implications
A sustained cyclical slump would negatively affect federal budget outcomes.
With a lag, weaker-than-projected growth of output and employment would suppress tax
receipts and push up spending growth for unemployment insurance, welfare, and
entitlement programs. The resulting rise in deficits above baseline projections would
heighten the legislation required to balance the budget.
When Will the Economy Rebound Cyclically?
While business investment and restructuring have expanded capacity and set the
stage for healthier expansion, the Fed's restrictive monetary policy continues to generate
decelerating aggregate demand and is the primary source of the cyclical slump.
Accordingly, the speed and timing of a cyclical rebound toward trendline growth depends
primarily on how quickly the Fed adjusts monetary policy toward neutrality. The process
is underway with the Fed's recent rate cuts, but more is needed.
The Fed's Restrictive Monetary Policy
Beginning in late 1994, the Fed's funds rate hikes were associated with year-overyear declines in bank reserves and narrow monetary aggregates, and a sharp flattening of
the yield curve, clear indicators of monetary restrictiveness and accurate predictors of the




47

cyclical slump. Even though the Fed has gradually reduced its funds rate target to 5.25
percent from 6.0 percent in the first half of 1995, it has not kept pace with the declining
equilibrium level of interest rates associated with the weakening economic and credit
conditions, and the result has been a continued contraction of real money supply. In
1994-1995, financial innovations have skewed the relative growth of the monetary
aggregates; in particular, banks' practices of using sweep accounts in order to reduce
required reserves have lowered bank reserves and Ml. However, using the Fed's own
estimates, adjusting bank reserves and Ml for the impact of sweep accounts suggest that
monetary policy remains restrictive, although less so than in 1995.
It is particularly noteworthy that the most interest sensitive sectors of the
economy—consumption of durable goods, business fixed investment and business
investment in inventories—continue to weaken despite the decline in interest rates. I'm
not surprised: rates have declined as a reflection of weakening economic and credit
conditions; while they have provided an effective cushion against economic contraction,
they are not simulative and are not a substitute for monetary easing.
The Fed's failure to ease appropriately stems primarily from it excessively
cautious inflation forecast based on a perceived unemployment rate-inflation tradeoff.
This Phillips Curve approach is a misleading basis for forecasting inflation and for
conducting monetary policy.

Inflation is driven by excess demand, not low

unemployment or real economic growth; the Phillips Curve fails to capture productivity
innovations (either positive or negative), changes in production processes, the
industrialization of the labor markets or other factors. Positive productivity innnovations
likely lower the natural rate of unemployment. But the bottom line is that nobody really
knows what the natural rate of unemployment is, yet analysts talk as if they do and
policymakers base policy on it.
Inflation has begun to recede, despite the unemployment rate remaining below
earlier estimates of the NAIRU. The Fed misinterprets the low unemployment rate as an
indication that the economy is operating full potential and grudgingly lowers its implicit
assumption of the natural rate; in contrast, I believe the low unemployment rate has
occurred as business investment and productivity gains have raised potential output and




48

capacity, while restrictive monetary policy has constrained demand. That suggests
inflation will decline further.
A sustained pickup in aggregate demand is expected to lag the Fed's move to
monetary neutrality; until then, businesses will remain cautious in their production and
hiring plans. Just as the Fed moved pre-emptively to short-circuit inflation pressures in
1994, presently it needs to easy policy to reduce the risk of recession. Importantly, doing
so would be entirely consistent with the Fed's long-run objective of price stability. A
sustained cyclical rebound is not expected until later this year.
The Longer-term Outlook
The economic outlook for 1997-1998 looks favorable; I project stronger growth
than the CBO or the Administration (2.3 percent per year), or the Blue Chip Consensus
(2.1 percent growth in 1997). My optimism for the next several years and beyond is
based on favorable environment created by business restructuring and the Fed's
heightened inflation-fighting credibility. These factors will generate continued healthy
productivity gains, and will raise the portion of nominal spending that is real growth
while reducing inflation.
My assessment is that productivity gains have tilted upward, although there is
insufficient data to verify conclusively any structural shift. The empirical issue about the
trend in productivity is complicated by the new chain-weighted GDP index, which
reveals slower real growth and productivity gains than the fixed weight GDP series, but
similarly fails to capture many of the obvious efficiency improvements in the serviceproducing sectors, thereby understating rising standards of living. Even using the chainweighted index, productivity growth has accelerated during the current cyclical
slowdown, in contrast to every recent cyclical slowdown, and has been steady through the
1990s.
If sustained, seemingly small differences in real GDP growth are huge: sustained
one-quarter percentage point faster growth would raise the level of GDP 5 percent in the
20th year, an equivalent of $337 billion in 1996 dollars; in present value terms, the




49

cumulative increase would be 32 percent of current real output, or $2.13 trillion. Thus,
the importance of lifting potential output overwhelms current concerns about how to
address the current cyclical slump.




50

Mickey D. Levy, Ph.D.
Senior Vice President
Chief Financial Economist

NationsBank
NationsBanc Capital Markets, Inc.
7 Hanover Square - 15th Floor
New York, NY 10004-2616
Tel 212 858-5545
Fax 212 858-5741

Economic and Financial Perspectives

MICKEY D.LEVY
CHIEF ECONOMIST
NATIONSBANC CAPITAL MARKETS, INC.

SHADOW OPEN MARKET COMMITTEE
WASHINGTON, DC
MARCH

USA

http://fraser.stlouisfed.org/
Official Sponsor
1994/1996
Federal Reserve Bank of St. Louis

10-11,1996

1

—=—
QUARTERLY DATA

1 Nominal GDP
GDP
Domestic Demand
Final Sales
Domestic Final Sales
Disposable Personal Income
Consumption
Residential Investment
Business Investment
Inventory Investment
Government Purchases
Exports
Imports
Current Account
GDP Deflator
Employment Costs (Private)
Unit Labor Costs (Non-Farm)
Productivity (Non-Farm)
Compensation (Non-Farm)
Corporate Profits A/T
Operating Profits A/T
Net Cash Flow
fa

S

N

A

P

S

g

H
:

Q1-95
1 7147.8
6701.6
6816.9
6647.5
6762.7
4895.5
4530.9
265.9
704.4
54.5
1263.0
755.8
874.9
(cj
-39.0
1
106.7
12473
105.3
101.0
106.4
(ai
376.8
(aj
559.6
1
616.9

T

Yr4o-Yr% Change.
•
Levels
T ; Quarterly % Change (annualized) I
1995
••::•: :: : " ::~I - • • > • • • • : • • • • • • • : • • : • • : : 1 9 9 5 = - . • • : J : : ; : : - : : - 1995
Q2-95
03^95
Q4-95 ~~l Q1 # 5 Q2-95
Q3-95
04^95
IQ l - 9 5
Q2-95
Q3-95
04-95
3.9
7348.1 I
2.7 I
5.5
5.8
2.8
7298.5
7196.5
4.4
3.8
4.5
0.6
6783.8
0.9
0.5
6768.3
6709.4
1.4
3.6
1.9
1.9
3.0
1.4
0.9
6875.3
6879.4
-0.2
3.2
2.8
1.2
1.9
2.1
6832.0
3.4
1.8
0.7
6763.9
2.4
1.8
2.8
6733.3
6677.4
1.9
2.6
2.6
2.2
6855.4
3.0
1.5
6844.4
1.7
2.4
2.7
0.6
6799.9
4.5
3.4
4.9
0.0
3.0
2.4
3.6
4992.0
4950.3
2.9
4896.1
1.9
2.6
2.5
0.8
2.5
2.8
3.4
0.8
4609.7
4600.4
4568.8
-1.9
-3.0
0.9
9.2
-13.3
-6.4
4.5
-5.5
265.2
262.3
256.6
7.5
9.0
6.3
12.1
5.2
3.6
11.1
15.3
730.7
719.7
710.6
NA
NA
NA
NA
NA
NA
NA
NA
20.4
33.2
30.6
-3.7
-0.7
-1.2
-0.6
-1.1
1.3
0.9
0.9
1251.7
1263.6
1265.8
6.5
8.0
10.9
11.1
4.6
7.5
8.5
2.6
799.6
779.1
764.3
4.3
0.1
1.0
7.7
9.1
11.9
8.7
893.7
6.6
893.4
891.2
NA
3.8
0.2
NA
-8.8
-4.2
4.3
NA
-5.3
-39.5
-43.3
2.6
2.6
2.6
2.2
2.5
2.3
2.3
3.4
107.9
107.3
108.5 J
2.8
2.5
3.5
2.9
2.3
2.9
2.3
2.8
12710 |
125.9
125.2
107.5
3.3
3.1
2.0
3.4
1.5
2.7
2.3
4.7
106.6
105.9
-0.4
1.6
3.2
-1.2
0.8
1.1
1.4
1.0
102.1
102.2
101.8
109.7
4.1
4.1
3.4
3.0
2.6
4.1
5.4
3.8
108.9
107.8
NA
-0.7
11.9
13.2
25.5
NA
2.9
5.6
NA
385.1
374.1
22.7
-1.6
11.8
NA
5.6
NA
9.6
0.3
NA
614.9
561.1
14.4
-0.2
NA
6.9
7.7
2.0
3.0
628.2
615.8
NA I
NA I
Monthly % Change
"H
12Month~% Change
Levels

MONTHLY OATA

f
I
ll
I

|
|

}|

NovMfe
Dec-96
Jan^96
"Feb^T
I Nov-95 Deo95 Jan-96 Feb*96"""1 Nov-95 Det>95 Jan-96 Fet^96"~!|
-17.9
-22.6
-21.5
^TEcFl
0.0
^£9
23H
M2~
46.0
46.0
1 Purchasing Managers Index
43X1
^T3
1.55
1.18
-201
1.51
Non-Farm Payrolls
(bl 117.212 117.373 117.172
NA
212
161
NA
NA
-1.39
-0.91
-0.84
NA
-29
44
-72
NA
NA
18.244
18.316
18.272
Manufacturing Payrolls
(b)
NA !
0.0
0.1
0.2
NA
0.1
0.0
0.2
NA
5.8
5.6
5.6
Unemployment Rate
(cl
-1.7
-0.6
-3.2
-0.3
-1.2
-0.6
NA
NA
NA
33.7
34.3
34.4
Average Workweek (sa)
1
NA j
3.0
3.5
3.1
NA
0.0
0.3
0.5
NA
11.68
11.62
11.58
Avg. Hourly Earnings (sa)
-1.6
-11.7
-3.1
NA i
14.7
4.8
NA H
4.2
7.8
NA
14.0
15.9
Total Vehicle Sales, incl. Lt. Truck
-3.7
-2.4
-14.7
15.8
4.3
10.0 I
1.6
8.2
7.6
6.6
7.7
7.1
Domestic Unit Auto Sales
-0.6
1.6
0.9
0.1
NA
0.2
0.2
NA
NA
121.9
122.6
122.4
Industrial Production
-3.8
-2.8
NA
-0.1
-0.1
-1.0
-2.1
NA
NA
81.9
82.7
82.8
Capacity Utilization
2.0
2.2
2.3
NA
0.4
0.6
0.3
NA
NA
129.9
129.5
PPI
128.7
2.2
NA |
-0.1
2.7
2.5
0.4
NA
0.2
NA
141.4
141.5
141.2
PPI Ex. Food & Energy
153.8
2.6
2.6
2.7
NA |
0.1
0.2
0.4
NA
NA
154.7
154.1
CPI
!
3.0
3.0
3.0
NA
0.1
0.1
0.3
NA
NA
163.8
163.3
163.1
CPI Ex. Food & Energy
-0.3
198.4
3.5
4.1
3.0
NA
0.9
0.6
NA
NA
199.1
199.7
Retail Sales
-3.1
-8.0
-5.0
5.5
NA
7.9
4.4
NA
NA
1446
1385
1458
Housing Starts
-7.2
6.6
4.1
6.1
NA
4.6
2.1
NA
NA
1372
1478
1448
Permits
-142.7
-156.5
-146.4
10.1
-1.2
NA
3.6
NA
NA
19.3
5.3
-38.5
1 Federal Budget Surplus/Deficit (d)
-0.8
165.2
3.7
4.9
3.7
NA
3.1
0.2
NA
NA
170.6
170.2
I Durable Goods Orders
3.6
-0.1
3.3
3.1
NA
1.7
0.5
NA j
NA
311.1
309.5
304.1
Manufacturing Orders
5.5
5.4
4.6
NA
0.3
0.6
0.1
NA
NA
6249.6
6242.1
6203.7
Personal Income ($)
-0.5
4.2
4.9
4.1
NA
0.8
0.8
NA
NA
5157.4
5181.6
5138.1
Personal Outlays ($)
-0.4
-0.2
0.8
0.2
0.3
NA
0.7
NA
NA
5.3
*
4.6
4.8
Personal Saving Rate
(c)
-1.9
-1.9
-2.3
-0.5
-0.2
NA
0.2
NA
NA
100.2
100.7
100.5
Leading Economic Indicators
-0.4
980.7
7.3
6.3
NA
NA
0.0
NA
NA
NA
976.3
NA
Total Business Inventories
0.04
0.03
-0.01
-0.02
NA
NA
NA
NA
NA
NA
1.40
1.42
Inventory/Total Sales
(c]
3.0
1.4
-0.1
-6.7
1.1
NA
NA
NA
NA
NA
-6.8
NA
International Trade
(c]
-0.46
-0.71
-0.22
-0.14
-0.17 1 6.07
6.08
4.83
-0.94
5.00
5.14
5.36
3 Month Bill
(c)
-2.40
-1.67
-2.27
-0.21
-0.16
-0.08
-0.22
-2.08
5.03
5.11
5.32
5.48
2 Year Note
(c
-2.13
-0.06
-2.10
-0.11
-2.03
-0.22
0.16
5.81
-1.66
5.65
5.71
5.93
10 Year Note
(c
-1.80
-1.81
-0.01
-0.11
0.19
-1.82
-0.20
6.24
-1.37
6.05
6.06
6.26
30 Year Bond
(c
33.7
36.2
30.1
5518.7
39.6
3.7
4.1
0.8
6.6
5179.4
5136.1
4935.8
DJIA
32.1
35.0
-0.0
29.2
34.8
2.2
3.2
5.7
649.54
614.42
614.57
595.53
S&P500
-2.3
-4.1
-5.1
86.4
0.0
1.1
1.4
0.2
86.2
85.1
84.1
-1.0 J
U.S. Dollar (FRB)
-0.1
1.7
4.0
6.0
7.7
1.1
3.8
0.0
102
106
106
102
Yen/$
-4.4
-2.3
-8.3
1.47
-7.9
0.2
1.6
1.6
0.2
1.46
1.44
1.42
DM/$
-2.6
-0.4
-1.7
-2.1
-0.2
-0.5
NA
NA
NA
1119.0
1124.8
1129.0
M1
4.8
NA
0.4
4.6
0.3
0.5
4.2
NA
NA
3684.8
3670.2
3653.2
M2
-6.0
-1.3
-5.3
-5.1
NA
-1.0
0.1
NA
55594
NA
56334
56269
Bank reserves
-0.4
10.4
10.4
NA
NA
1.5
NA
NA
NA
NA
907.8
894.4
C&l Loans & Non-Financial CP
NA
13.3
NA I
NA I
NA
0.8
NA
1.0
13.3
NA I
1.0
I
1.0
[ Consumer Credit
1
asssss
—
—
(a) Quarterly % changes are not annualized
03/07/96
(b) Monthly changes are in levels
(c) All changes are in levels or basis points
(d) Monthly: change from same month last yean
Annual: sum of past 12 months
Note: All GDP data reflect chain-weighted measures. Monthly real consumption data are not yet available.

|j.

•_ • • •
_•

'

DigitizedMickey D. Levy, Chief Financial Economist
for FRASER


52
Peter E. Kretzmer, Economist




Chart 1
MONETARY THRUST AND DOMESTIC PRODUCT
Real M1
(yr/yr % change)

*i

i i i i i i i i i i t i i i < i i i i i i i i i i i

68 70 72 74 76 78 80 82 84 86 88 90 92 9^

Spread of 10-YrT-Bond minus Federal Funds Rate
400-

-400

-600-1

-800

i

i i

i i i i i i i i

i i i i i i

i i i i i i i

68 70 72 74 76 78 80 82 84 86 88 90 92 94

Real Gross Domestic Product
(yr/yr % change)

i i i i i i i i i i i i i i i i i i i i i i i i i i i

68 70 72 74 76 78 80 82 84 86 88 90 92 94

53

03/05/96

Chart 2
Nominal Spending Decelerates
Nominal GDP
20.0

0)
O)

c
sz
O
<S

15.0

CO

u.
CO
CD

10.0

CD

>
C
O

75

76

77

78

79

80 81

82 83 84

85

86 87

88

89 90 91

92 93

94

95

96

Growth Patterns During Expansions
Annualized Growth From Recession Trough:
Real GDP
Real Disposable Income
Employment
Productivity
Note:

91:Q2
2.4
.2.4
1.6
1.4

75:Q2
4.4
3.9
3.5
1.6

82:Q4
4.2
3.5
2.8
2.0

71:Q1
5.2
5.6
3.3
3.1

61:Q1
5.6
5.5
2.7
4.3

For each expansion, except Q1:71, the table measures annualized growth for its first 19 quarters;
the 1971 expansion was only 12 quarters long.

RONDTBLE.WK4




54

NationsBanc Capital Markets, inc.

03/05/96

Chart 3
Aggregate Demand Remains Sluggish
Housing Activity

Retail Sales
3%
2%

I 1%

-1%
-2%

•

•

93

— Housing Starts, Total (SAAR, Thous)

i.l. Ill II I LI 11111 hl

n

S. 0%

1

1

1

•

•

•

•

•

•

i

•

•

94

t

•

•

1

1

1

1

1

1

1

1

1

1

1

1

1

1

1

1

1

1

95

1

1

1

96

• T o t a l Retail Sales, Mth/Mth % Change

— New 1-Family Homes Sold

Imports

Unit Auto Sales
20%

|
CO

15% 5
7o

5%

<D

§

o% I
— Imports: Goods & Services (BOP Basis)
— Year-over-year % Change

-Unit Auto Sales, SAAR, Mil
-Year-over-year % Change

Final Sales

Real Consumption

— Final Sales to Domestic Purchasers, SAAR Bil Chn $92
— Final Sales of Domestic Product, SAAR Bil Chn $92

— Personal Consumption Expenditures, Yr/Yr % Change
RONDTBLE.WK4




55

NationsBanc Capital Markets, Inc.

03/06/96

Chart 4
Production and Employment Soft
Employment

Industrial Production & Capacity Utilization

— Industrial Production: Total Index (Yr/Yr)
— Capacity Utilization: Total Industry (%)

• Non-Farm Payroll Employ B Manufacturing Payroll Em
—6-Month Avg
— 6-Month Avg

NAPM

Aggregate Hours Worked
65
60

r

!Ni

50

45
40
93

94

95

93

96

94

95

— NAPM: Composite Index

—Weekly Hours Index, Private Nonfarm, Yr/Yr % Change
Labor Productivity-Nonfarm Business

NAPM Details

1.5%
<D
O)
C
CO

sz

Change in Last

6 Months

ver-y

0.0%

?

a -0.5%

-2.6
-6.4
-2.6
-0.6

-9.1
-11.4

Inventories
Employment

0.5%

c
o
<D

JZUoolte

Composite Index
Production
New Orders
Supplier Delivery

1.0%

o

w.

96

-1.0
-1.2

Prices
New Export Orders

<D

>-

Imports

-1.0%
93

94

95

-10.5
-11.2
-3.4
-5.6

-10.6
-5.7

-4Z8

-4.5

-5.0

-7.5

96

RONDTBLE.WK4




56

NationsBanc Capital Markets, Inc.

03/04/96

Charts
Business Investment Decelerates and Inventory Adjustment Accelerates
Change in Business Inventories

83

84

85

86

87

88

89

90

91

92

93

94

95

96

• • Change in Business Inventories (Bil, Chn 92$)

Business Investment in Producer Durable Goods

83

84

85

86

87

89

90

91

92

93

94

95

—

Nonresidential Fixed Investment, Producer Durable Equipment, (Bil, Chn 92$)

—

96

Year-over-year % Change

Business Investment in Structures

84

85

86

87

88

89

90

91

92

93

94

95

Nonresidential Fixed investment, Structures, (Bil, Chn 92$)
Year-over-year % Change
RONDTBLE.WK4




57

NationsBanc Capital Markets, Inc.

03/05/96

Chart 6
Income and Profit Growth Moderate
Personal Income
10%
c
CO

o
#
CO
<D

8% h
6%

>s
CD

g

4%

(S

a>

>-

2%
94

93

95
—

96

Personal Income, (Bil $)

Disposable Personal Income

-2%

4500
93

94

96

95

Disposable Personal Income (SAAR, Bil Chn $92)

— Year-over-year % Change

Corporate Profits
650

/

600
/

\

1

/

40%
c

30%

CO
J=

O

•5 550 •

-

1

500 h-

/

X'^SN

20%

\

\

\

/y

'

/

\
10%

450

CO

0)

1
iL

CO

0)

400

I . I

93

1

_i

i

1

94

Corporate Profits with IVA & CCAdj (SAAR, Bll$)

— i —

1

1

95
—

1

i

0%

>-

96

Year-over-year % Change

RONDTBLE.WK4




58

NationsBanc Capital Markets, Inc.

03/06/96

Chart 7
Optimism on Inflation: Low and Going Lower.
Consumer & Producer Price Indexes

89

90

91

92

93

94

95

Productivity

89

96

90

91

92

93

94

95

96

— Nonfarm Business Sector: Output Per Hour of All Persons
— Manufacturing Sector: Output Per Hour of All Persons

- CPI-U, All Items (SA) - PPI-U, All Items, (SA)

Import Price Index

Unit Labor Costs

10%

-4%

90

91

92

93

94

95

89

96

90

91

92

93

94

95

— Import Price Index: All Imports (Yr/Yr)

— Unit Labor Costs: Nonfarm Business

— Import Price Index: Non Petroleum (Yr/Yr)

96

— Unit Labor Costs: Manufacturing

NAPM: Survey of Prices

CommodityPrices
100

89

90

91

92

93

94

95

96

- C R B FPI: Industrial Materials
— NAPM Survey-Diffusion Index, Prices, SA, (%)

— CRB Spot Commodity Market Index: Raw Industrials
MTGPACK.WK4




59

NationsBanc Capital Markets. Inc.

03/07/96

Chart 8
Money and Credit Market Conditions
Adjusted Reserves and M1

Broad Money: M2

2> 30
-E 20 h
2
CD

^

10

CD
CD

>»

&

0

^?<r

k

NN^^^

2
CD - 1 0

—IIIIIIIIIIIIIIIIIIIIII

89

90

i n i i i m i i iiiiiiiiiimxiiiiiiniiiiiiiii

91

92

93

U l-Lll-Llllllltlllllli

94

95

96
89

- M o n e y Stock, M1 (SA, Bil$)

90

91

— Adjusted Reserves of Depository Institutions

92

93

94

95

96

- Money Stock, M2 (SA, Bil$)

Bank Reserves & M1

Loan Demand

Adjusted for Sweep Accounts'

C 20
D
c

'

£ 15 h
|

10

CD
CO
CD

1 -5
2

[

!

i

! L

:/0"\i|

*^~^
/f / i
v
Vv ! / y
^^^^c^-^

i

CO

1
1
1
;
t

•10

- Money Stock, M1 (SA, Bil$)

1 m mI I I I I I I I I I

89

— Adjusted Reserves of Depository Institutions

90

92

91

92

93

94

93

iiiini mini

94

95

96

— Consumer Loans

Consumer Delinquencies

Government Securities

90

91

— C & I Loans

* Based on FRB estimates.

89

I I I I I I I I I I I 1 U I 1 UJJJ 1111111 t i l l i i m t n t

95

89

96

— Bank Credit, All Commercial Banks (SA, Bil$)

90

91

92

93

94

95

96

— Consumer Installment Debt Delinquent +30 days (%)

MONEY.WK4




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Chart 9
Selected Interest Rates
Federal Funds Rate

Selected Interest Rate Yields

89

90

91

92

93

94

95

96

— 2-Year Treasury Note Yield

90

91

92

93

94

95

— 30-Year Bond Yield

96

Inflation Adjusted Federal Funds Rate

Inflation Adjusted Yields

~ 4
c

Q

I

limn

89
_2

nil

90

niiminiinini

in

91

93

92

mi

94

" " " • ' " " " " " "

95

96

' — n i " 111111111111111111111111111111111111111111111 n 1111 n 11111111 m 111 m n 11 i» 11

89

90

91

92

93

94

95

— 2-Year Treasury Note — 30-Year Bond

96

Inflation Adjusted Bond Yields

Short Term Eurocurrency Rates

89

90

91

+France

92

93

— Japan

94

95

96
• France

— Germany

— Japan

— Germany

SOMC.WK4




61

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62

UNEMPLOYMENT, GOLD, MONEY AND FORECASTS OF INFLATION
Allan H. MELTZER
Carnegie Mellon University and
American Enterprise Institute
Conventional wisdom in the United States holds that money growth is now
irrelevant forjudging Federal Reserve action or inflation. Various reasons are offered to
explain this striking departure from basic economics. The most common explanation is
that financial innovation has distorted the growth rates of monetary aggregates and the
meaning of "money."
Several measures are now widely used to predict inflation. Chief among them is
the unemployment rate. High unemployment is said to lower inflation. Almost every
time a new statistic appears, market watchers and the financial press report that strength
(weakness) in the economy will cause inflation to rise (fall).
Chart 1 compares the annual rate of inflation (four quarter average) to the lagged
unemployment rate quarterly of the past ten years. At times the two series move in the
same direction (1985-86, 1990, 1992-94); at times they move in opposite directions as
suggested by the belief that inflation and unemployment are negatively related (1987-89,
1991-92). On average, the predicted negative relation comes through and is statistically
significant. But the forecasting power is weak, as the chart suggests.
Quarterly inflation rates are more variable than average annual rates, so the
relation is weaker for quarterly than for average annual data. Chart 2 compares the
lagged unemployment rate to the quarterly rate of inflation (annualized). Again, there is
evidence of the predicted negative relation on average. There are also periods in which
the two move in he same direction.
The conclusion to be drawn form these data is that there is a weak association
between inflation and the unemployment rate. The unemployment rate contains some
information about inflation; but, as discussed below, the information is not superior to the
information in some monetary aggregates.




63

The Wall Street Journal advocates use of the level of the gold price to predict the
rate of inflation. This is at best a mistake. Inflation is calculated as the rate of change of
some broad index of prices. The level of the gold price cannot and should not be
expected to predict the rate of inflation.
Chart 3 compares the lagged rate of change of gold prices to the rate of inflation
using annual rates (four quarter average). Chart 4 uses quarterly data (at annual rates).
There is no evidence of any relation at all. Inflation rises with falling gold prices from
1987 to 1990 and falls with rising gold prices from 1992 to 1995. This is opposite to the
alleged relation. Computation shows that there is a negative relationship on average, but
it is weak and not statically significant. Changing the lag structure does not improve
forecast accuracy.
Contrary to repeated assertions, money growth continues to play a useful role in
forecasting inflation. Chart 5 shows that the forecast of inflation improves significantly
using a forecasting equation that assigns importance to Federal Reserve actions. This
equation includes the annual growth rate of the monetary base relative to the average
growth of the real base, lagged one quarter, the lagged value of the unemployment rate
and lagged rates of inflation. The estimated equation implies that a 1 percent change in
the growth rate of the monetary base—say from 3 to 4 percent—changes inflation by 0.4
percent within a quarter. The direct effect on the measured rate of inflation is about the
same as a 3/4 percentage point change in the inflation rate (from 5 1/2 to 6 1/4 percent).
If the two variables changed in the same direction in the proportion 1 and 3/4, the
combined effect would approximately cancel for the inflation rate.
This comparison appears to make the unemployment rate and the growth of the
monetary base about equally important. However, the base is more variable than the
unemployment rate, so a 1 percent change in its growth is a smaller relative change than a
3/4 percentage point change in the unemployment rate. A 1 percent change in the base is
about 1/2 the standard deviation of the growth of the base (56 percent), but a 3/4
percentage point change in the unemployment rate is more than a full standard deviation
of the unemployment rate (118 percent).




64

Table 1 compares forecasting accuracy of the three forecasting methods. The
average rate of inflation for the period is 3.2 percent. Two times the standard error from
the equations tells the range within which the forecast error would lie 95 percent of the
time using the particular method of forecasting. For the unemployment rate and the rate
of change of gold prices, the range is 100 percent or more of the average rate of inflation.
A central bank using either of these methods, to achieve say 2 percent inflation during
1985-95, could expect no better than that the inflation rate would remain between -1 and
+5 percent using only the unemployment rate to forecast inflation. (Using the rate of
change of gold prices gives an even larger range.) Neither variable has been useful for
forecasting inflation during this period.
Table 1
Measures of Forecast Accuracy
Standard Error
Unemployment rate

±15

Percentage change in gold price

±1.7

Base money growth plus (see text)

±0.7

A more precise version of the relation between unemployment and inflation
would introduce the "natural rate" of unemployment or NAIRU as an additional variable.
Deviations of unemployment from NAIRU, not the unemployment rate itself, are said to
be negatively related to the rate of inflation.
A problem with this explanation is that NAIRU is not constant, and it cannot be
expected to remain constant. Changes in regulation, tax rates, the terms of trade, and the
demographic composition of the labor force affect the value of NAIRU. In recent years,
the assumed value of NAIRU has drifted from 6.5 percent to 6 percent to 5.8 percent to
5.6 percent.
NAIRU appears to be near the prevailing level of unemployment, whenever that
is, as long as inflation is not rising. Inability to find the value of NAIRU removes most
of the contentfromthis explanation of inflation.




65

The point of this exercise is not to suggest that we at the Shadow Committee can
forecast inflation with sufficient accuracy to offer a short-term forecasting procedure. We
cannot, and neither can the Federal Reserve. Table 6 shows their forecast errors for the
period based on the mid-point of the projections they release at the Humphrey-Hawkins
hearings.
Our point is a different one. Federal Reserve officials and market watchers, who
profess or act as if inflation depends closely on the unemployment rate, have to recognize
that such dependence as there is in the data gives no basis for the belief that the Federal
reserve can control the inflation rate by responding to the unemployment rate.
As we noted at our September 1995 meeting:
(1)

there is substantial uncertainty about the value of the "natural rate of
unemployment and how it changes in response to changes in tax rates, regulation,
the real exchange rate and other forces;

(2)

there is substantial uncertainty also about how much inflation responds in the
short-run to changes in unemployment.
Money growth remains the principal determinant of long-run inflation and

changes in the growth rate of the base have an important influence on short-run changes
in the rate of inflation. As shown in Chart 5, based on our rule, inflation will continue to
fall toward zero even if the Federal Reserve would increase the growth rate of the
monetary base to a 4 percent annual rate from the current rate of 2 percent or less. The
projected path for 1996, shown in Chart 5, is based on an annual 4 percent growth rate in
the monetary base beginning in fourth quarter 1995 and a 5.8 percent unemployment rate.




66

Chart 1

Annual Inflation versus Unemployment
8.0%

1985.1




T

1986.1

1987.1

1988.1

1989.1

1990.1

1991.1

1992.1

1993.1

1994.1

1995.1

7.0%

Chart 2

Quarterly Inflation versus Unemployment
8.0%

9.0%

2.0% -c

1.0% J

0.0%
1985.1




i

i

i

i

1986.1

i

i i

i i i

1987.1

1988.1

i

i

i

1989.1

i i

1990.1

H—I—I—f-

1991.1

1992.1

Unemployment ——Quarterly Inflation

1993.1

1994.1

1995.1

-2.0%

Chart 3

Annual Inflation versus Annual Rate of Change of Gold Price Lagged 4 Quarters
8.0%

30.0%

?

20.0%

<D
O)
U)

CO
-J

•c

10.0%

o
O 2

2 1 o.o%
0)

CO

SO
o
15

&

1

-10.0% 4-

CO

"5
3

§ -20.0%
<

-30.0%




Annual Rate of Change of Gold Price Lagged 4 Quarters —Annual Inflation

Chart 4

Quarterly Inflation versus Quarterly Rate of Change of Gold Price Lagged 4
Quarters
120%
100% 4
a
O)
O)
<0
-J

80% I

o
u

2 860%
o•
—

o

O

at

°i
a<40%

| e
«§ «20%
at O
CO

la'

C
O
3

o
-40% -l




-3.0%

Quarterly Rate of Change of Gold Price Lagged 4 Quarters (Annualized) — Quarterly Inflation (Annualized)

Chart 5

Actual vs. Forecast Inflation; Base Growth = 4%

1985.1 1986.1 1987.1 1988.1 1989.1 1990.1 1991.1 1992.1 1993.1 1994.1 1995.1 1996.1 1997.1




CHART 6

FOMC Forecasts of Inflation vs. Realized Inflation

CO

o

a
a.
a
a

Forecast Inflation
• Realized Inflation
•Forecast Error

01

c
IS

O

19B5

-1%

-2%



1986

1987

1988\ 1989*

1990

199t

1992

1993

1994

1995

THE DEBT CEILING
William POOLE*
Brown University
No Money shall be drawnfromthe Treasury, but in Consequence of
Appropriations made by Law; and a regular Statement and Account
of the Receipts and Expenditures of all public Money shall be published
from time to time.
(Constitution of the United States, Article I, Section 9.7)
A monumental battle over the federal budget began last year; the impasse over
raising the debt ceiling is a part of that battle. The Constitution provides that the
Congress must approve all federal spending, but that does not mean the current Congress.
Today, only about one-third of the budget is so-called "discretionary" spending; two
thirds is "mandatory," reflecting permanent spending programs enacted into law by prior
Congresses plus interest on the federal debt. Much discretionary spending is necessary,
such as some base level of defense, the court system, routine operation of Congress, and
so forth.
So unless Congress changes mandatory spending the amount of spending that can
be cut is only a small part of the total. The budget problem cannot be solved without
addressing mandatory spending. Mandatory spending is an auto pilot, and can only be
changed by legislation signed by the President, or passed over the President's veto. The
Republican majority in the Congress can, and has, passed bills to reduce mandatory
spending but the President has vetoed these bills. The current majority does not
command enough votes to pass important budget legislation over the President's veto. In
an effort to gain control over spending decisions, the Congress has refused to raise the
debt ceiling. Is this a satisfactory strategy which will in fact enable the current Congress
to make progress in controlling federal Spending? So far, the answer is clearly "no."
At the end of the last fiscal year, 29 September 1995, the total federal debt subject
to the debt ceiling was $4,884,605 billion, just $15,395 billion below the debt ceiling of
$4,900 billion.1 For fiscal year 1996 through the end of January, new borrowing from the
public was $28,588 billion.2 By any normal accounting, a simple subtraction ($28,588




73

billion less $15,395 billion) suggests that the federal government must have violated its
debt ceiling by about $13 billion. But, as everyone knows, the federal government does
not adhere to generally accepted accounting principles, and perhaps not even to the usual
rules of addition and subtraction.
In this memorandum I'll provide a little background on the debt limit, take up
some budget issues that lie behind the fight over the debt limit, and then return to debtlimit issues once again.

DEBT AND THE DEBT LIMIT
The Congressional Budget Office has recently discussed debt-limit issues
(Chapter 4 in The Economic and Budget Outlook Update, August 1995). The CBO noted
that, "Before World War I, the Congress generally had to approve each separate issuance
of federal debt. Since the Second Liberty Bond Act was passed in 1917, however, the
Congress, by statute, has simply set an overall dollar ceiling on the amount of debt that
the Treasury can issue." The CBO points out that the debt limit does not apply to certain
debt issued by the federal government, such as obligations of the Federal Financing Bank
and of federal agencies such as the Tennessee Valley Authority. At the same time, the
debt limit does apply to most of the Treasury obligations owned within the federal
government by trust funds such as the Social Security trust fund. Although the debt
ceiling was $4.9 trillion at the end of lastfiscalyear, the amount of federal debt owned by
the public was just a bit over $3.6 trillion. Thus, about $1.3 trillion of official Treasury
debt reflects internal bookkeeping transfers.
Whatever may have been the original merits of the requirement for congressional
approval of individual debt issues, or of the overall amount of debt, today the debt limit is
a confusing mishmash. The debt limit does not apply to some debt issued to the public
and does apply to internal bookkeeping transfers within the federal government. Battles
over the debt limit have never affected the amount of bonds sold to the public, at least so
far.
As a matter of accounting, the difference between total government spending and
total government revenue must befinancedby some combination of issuing new debt to




74

the general public and printing money. Fortunately, no one has suggested that current
budget issues could be resolved by printing money beyond normal Federal Reserve
practice, and so the government has in fact been issuing new debt to the public equal to
the difference between spending and revenue. This fact is obscured by intergovernmental
transfers; a number of government trust accounts hold securities issued by the Treasury.
Under existing law, the Treasury is able to stop investing funds in certain trust accounts
running surpluses to leave room to issue more securities to the public without violating
the debt ceiling. Instead of accumulating Treasury securities that count against the debt
ceiling, these accounts accumulate Treasury I.O.U.s that do not count against the ceiling.
It is important to realized, however, that these intergovernmental accounts, though
useful for a number of purposes, have no bearing on the accounting identity that for the
federal government as a whole the difference between total spending and total revenue is
financed by selling additional bonds to the public. The thousands upon thousands of
hours of time devoted by Congress, the Treasury, and others to the debt-limit issue have
not affected by one dollar the amount of debt the government has sold to the general
public. Most will regard the current system of substituting I.O.U.s that do not count
against the debt limit for Treasury securities that do count against the limit as simple
foolishness.
For the debt limit to make any conceivable sense, it would have to apply to all
debt held by the public. If this debt is not permitted to rise, and if revenue is determined
by existing tax law, then enough spending must be cut to live within existing revenue,
short of printing money to pay bills. If Congress and administration cannot agree on
what spending to cut, then the Treasury must somehow decide what bill not to pay, or to
defer paying. The Treasury cannot write checks on an empty checking account.
The recent (and still current) battle over the debt ceiling is not just a part of the
overall budget battle, but is the same thing as the budget battle, given the accounting
identity linking debt issuance to the difference between spending and revenue. It may
seem politically convenient to argue over the debt ceiling rather than over revenue and
spending, but I doubt that anyone's views on budget issues are much affected by putting
the debate this way.




75

On the surface, it might appear to some that the federal government would be
O.K. if it were to stop paying interest on its debt. Excluding interest, spending is below
revenue at this time. But, of course, many financial institutions would be insolvent if the
value of government debt went to zero, which means that the federal government would
immediately be faced with huge demands to make good on deposit insurance. Just
starting to spin out a scenario such as this shows how silly the exercise is. The federal
government won't walk away from its debt because the voters would demand that the
government live up to its obligations.
What about a temporary default for, say, two weeks? A temporary default would
resolve nothing. At the end of the two weeks, the government would still have to sell
bonds to finance the difference between spending—including interest if the default were
not to continue—and revenue. One way or another, Congress and the Administration
must decide this year's spending and revenue, and finance the difference (if any) with
new debt.
Given the absurd structure of the debt limit in current statues, and the methods the
Treasury can (and should) use to avoid breaching the limit, it is clear that recent disputes
over the debt limit have nothing to do with debt management itself. Congress, recently
and on a number of occasions over the last 15 years,4 has tried to use the debt limit to
pressure the administration and to make a public statement about the budget debate.
Given the intensity of feeling in the debt-limit debates of recent months, it makes sense to
comment briefly on the current budget debate.
THE BUDGET DEBATE
The U.S. budget debate started in earnest during the Reagan years. President
Reagan spoke often and eloquently of the need for our society to trim government, and
the budget deficit that arose in the early 1980s drew much additional attention to budget
issues. President Reagan was successful in constraining growth in total spending, but he
was not successful in rolling back spending in any significant way. More importantly, he
was not successful in addressing the need for major structural reforms in Social Security
and Medicare.




76

President Reagan was unsuccessful

because Congress—including most

Democrats and most Republicans—and the American voting public were not prepared in
the 1980s to face the reality of our budget situation. It is instructive to look closely at the
Reagan budget for Fiscal Year 1986, which was perhaps the most complete and serious
effort during the Reagan years to introduce fundamental reforms in spending programs.
This budget proposed spending reductions in numerous politically sensitive areas,
including many affecting traditionally Republican constituencies.

Reagan proposed

reductions in subsidies to business, to upper-income groups, to agriculture, to Amtrak,
and to others. He proposed reductions in Medicare, in certain veterans' programs, in
retirement programs for military and civilian government employees, and on and on.
The FY1986 budget was a courageous one, but it went nowhere at the time.
Nevertheless, many of the budget issues raised during the Reagan years are now
attracting serious attention, and new proposals reflecting equal political courage are on
the table. The current budget battle is a battle over priorities and the role of government
in our society.
Our nation will survive if fewer wasteful programs are cut than the SOMC would
prefer. But the really big issue is Social Security and Medicare; our society will be
shaken to its foundations if we do not face this issue soon, before the Great Retirement
begins. At present, there are about 3.3 workers for each Social Security beneficiary. Just
five years from now that ratio will begin a rapid decline, reaching only 2.0 workers per
beneficiary by 2030, according to intermediate population estimates. Financing existing
Social Security and Medicare benefit schedules might require an addition to the payroll
tax of 10 percent of the covered wage base as more and more retired workers will have to
be supported by each member of the labor force. If we do not act, within 25 years we
face a generational conflict between retirees and workers totally unprecedented in our
history.
The urgency of acting soon is nicely illustrated by The 1995 Annual Report of the
Board of Trustees of the Federal Hospital Insurance Trust Fund. This report, which
covers the hospital part of Medicare, is signed by the trustees, including Secretary of
Treasury Robert E. Rubin, Secretary of Labor Robert B. Reich, and Secretary of Health




77

and Human Services, Donna E. Shalala. The Report concludes that, "[the] HI program is
severely out of financial balance and the trustees believe that the Congress must take
timely action to establish long-term financial stability for the program. ... The trustees
believe that prompt, effective, and decisive action is necessary."6
The current budget debate includes proposals for revisions to Medicare; the
Congress would do more, and the Administration would do less. Neither Congress nor
Administration would address Social Security at this time.
Some future Congress and Administration will address Social Security, because
the demographic facts cannot be brushed away. We need to adjust the Social Security
and Medicare programs to encourage later retirement and more efficient use of medical
resources. The adjustment would have been easier if we had started 10 years ago, and
easier yet if we had started 20 years ago. The longer we wait, the more difficult the
adjustment will be, and the greater the chance of serious generational conflict.
Much of the acrimony over the debt limit reflects the political pain of retirement
policy issues. I am very sympathetic to those who ask this question: "If we cannot begin
now by introducing reforms to Medicare, how will we ever be able to begin again, before
it is too late, to tackle the even more difficult issues that surround Social Security?"
THE DEBT LIMIT ONCE AGAIN
It is easy to understand the frustrations of those in the Congress who want to
begin to set our fiscal affairs on a sustainable long-run path, and who are willing to hold
up an increase in the debt limit until the Administration negotiates a satisfactory budget
deal. Nevertheless, the debt limit is the wrong place to force a confrontation. The
unwritten rules of political engagement do not include risking the credit of the United
States Government.
Some argue that the market has reacted benignly whenever threat of default was
raised in recent months; others attribute increases in interest rates to the threat of default.
Both misread the evidence. In fact, the evidence is clear that the market has never
assigned any significant probability to default. If default talk had changed views in the




78

bond market, we would have seen a dramatic narrowing of the spread between highquality corporate securities and Treasury securities. We haven't seen any such thing.
Consider four examples.
•

•

•

•

On Monday, 25 September 1995, The Wall Street Journal carried this headline:
"Gingrich's Threat Spooks Bond Investors." The Journal article said that the threat
was unveiled the previous Thursday. On Wednesday, the 30-year Treasury bond
closed at 6.46 percent, and on Thursday rose to 6.56 percent. At the same time the
long Treasury bond yield was rising by 10 basis points, Aaa corporate bonds were
rising by 8 basis points; the spread between the two narrowed by 2 basis points,
which is a trivial amount. Changes in the spread of this amount are common, and
mean
nothing.
On 10 November 1995 The Wall Street Journal quoted White House spokesman
Mike McCurry as saying the previous day that, "default is becoming increasing
likely," The day of McCurry's statement the 30-year bond yield rose by four basis
points, and the spread with Aaa bonds narrowed by a mere one basis point.
On Friday, 5 January 1996, The Wall Street Journal ran a headline saying, "GOP's
Threat Against Rubin Roils Markets." The stock market fell and the 30 year bond
yield rose from 5.96 percent to 6.03 percent. However, the spread with Aaa
corporates stayed constant at 75 basis points.
On Wednesday, 24 January 1996, The Wall Street Journal began its story on the
credit markets this way: "Bond prices tumbled as some investors began to fear that
the Clinton administration might not get congressional approval to raise the
government's borrowing limit in time to avoid a default." The 30-year Treasury bond
yield rose by five basis points, whereas the Aaa corporate bond yield rose by four
basis points. The spread fell from 75 to 74 basis points.
Clearly, the debt-ceiling battle has from time to time created uncertainty in the

markets, but the uncertainty has been about the general course of the fiscal policy debate
and not over default per se. The market simply does not believe that default can occur.
We should be comforted by this finding, for it demonstrates that our nation's finances are
truly strong. Default is unthinkable, and the market believes that the political process
will find a way, somehow or other, to service the debt. Neither political party will in fact
jump over that cliff. Congress should recognize that public sentiment for honoring our
federal government obligations is overwhelming, and that the issue of default should be
put behind us by routine action to increase the debt limit whenever required for the
government to pay its bills without interruption. No constructive purpose is served by
forcing the Treasury to engage in strangefinancialgymnastics.




79

CONCLUDING REMARKS
An important principle of our government is that it must honor its contractual
commitments.

We may today regret that certain commitments were made by the

government in the past, but we must still honor them. Servicing the debt is one of those
contractual commitments.
Little mandatory spending, other than interest, is contractual in a legal sense, but
it is quasi-contractual in a political sense. How the government should modify Social
Security and Medicare promises, and other quasi-contractual political commitments, is a
difficult issue. The government will have to modify those promises, but until the political
parties are in closer agreement, or one party is strong enough to control both Congress
and White House, or strong enough to pass legislation over the President's veto, we will
just have to live with a political stalemate. That this stalemate permits continued
mandatory spending at a high rate as a consequence of decisions made in prior years is
the unavoidable result of living under the provisions of the U.S. Constitution.
The debate over the debt limit has served the useful purpose of emphasizing just
how important our budget issues are. But our disputes are over spending an taxes, and
not over servicing the debt. It is time to put this phase of the political debate behind us;
Congress should pass and the President should sign a simple extension of the debt limit.
Over the longer term, the Congress should examine whether the debt limit serves any
useful purpose in our current fiscal system. It seem clear to me that the debt limit no
longer serves any useful purpose and so should be abandoned.
The larger budget issue, however, must not be allowed to die. We must make
some choices and the sooner we make them the better off we will be. The United States
will face budget issues for the indefinite future, and the longer we wait to cut the more
difficult the job will be.




80

NOTES
* Portions of this memorandum were included in my recent testimony on the debt
ceiling before the Committee on Banking and Financial Services of the United States
House of Representatives, 8 February 1996.
treasury Daily Statement, Friday, September 29,1995, Table III-C.
Treasury Monthly Statement, For Fiscal Year 1996 Through January 31, 1996,
and Other Periods, Table 7.
3

The Economic and Budget Outlook Update (August 1995), p. 47.

See Congressional Budget Office, The Economic and Budget Outlook Update
(August 1995), Table 22, p. 53.
5

This estimate is from the 1995 Annual Report of the Board of Trustees of the
Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds. Table
III.C1 shows a combined Social Security and Medicare surplus of 0.29 percent of GDP in
1995. Under intermediate projections, in 2030 the combined surplus has become a deficit
of 3.63 percent of GDP; the swing from surplus to deficit amounts to 3.89 percent of
GDP (0.29 percent plus 3.63 percent). In Table III.C2, under the intermediate projection,
the taxable payroll will be 0.389 of GDP in 2030. Thus, we can express the swing from
surplus to deficit in Social Security and Medicare combined as either 3.89 percent of
GDP or 10 percent of the payroll taxable under these programs.
The 1995 Annual Report of the Board of Trustees of the Federal Hospital
Insurance Trust Fund, p. 4.
7

Kevin Jewell and Chris Tachiki dug out these examples for me; I appreciate their

help.




81




82

A NOTE ON THE BEHAVIOR OF INTEREST RATE SPREADS IN
EXPANSIONS AND NEAR CYCLICAL PEAKS IN THE U.S.
Robert H.RASCHE
Michigan State University

The shape of the yield curve of interest rates has attracted attention both as a
potential leading indictor of inflation and of real economic activity. The purpose of this
note is to review the behavior of the term structure of U.S. government securities during
expansions and near cyclical peaks.
The interest rates considered here are the Federal funds rate, the three month
Treasury bill rate and the rates on U.S. government notes and bonds at constant maturities
of one, three, five and ten years. The data are obtained from F.R.E.D. at the Federal
Reserve Bank of St. Louis World Wide Web site (http://www.stls.frb.org). Each of the
latter five rates is plotted against the Federal funds rate in the top panel of Figures 1-5.
The shaded areas in those graphs represent NBER dated periods of recession, starting
with the recession of 1958. The second panel in each of these figures indicates the spread
between the funds rate and one particular longer maturity rate, if the economy is in an
recovery or expansion phase of the business cycle and the rate spread is positive. This
variable is set to zero for all observations during periods of recession.
The spread between the Funds rate and the Treasury bill rate during periods of
recovery and expansion behaves differently that the spread between the Funds rate and
longer maturity rates. As seen in Figure 1, this spread is generally very small during
early recovery phases, alternating between positive and negative (plotted as zero in the
lower panel), but then shows different patterns as the economy approaches a cyclical
peak. Prior to the 1958 and 1960 cyclical peaks, there was no systematic pattern. As the
economy approached the 1970, 1973 and 1980 cyclical peaks, the Funds rate-T Bill rate
spread increased rapidly. During the recovery and expansion of 1982-90, this spread
remained large and did not exhibit any particular trend; if anything the spread had a
negative trend before the 1990 cyclical peak. Since 1990 the pattern of this spread seems
to have reverted to the characteristics of the pre-Vietnam inflation period.




83

The spreads between the Funds rate and the longer term government rates
(Figures 2-5) show very similar patterns across the maturity spectrum. Prior to the mid
60s, these spreads generally remained negative; the dominant pattern was a positive slope
in the yield curve during recovery and expansion phases of the business cycle. After
1965 the pattern changed. In the beginning of the recovery phase the spread was negative
at all maturities. This pattern continued after the 1990-91 recession. In the late stages of
the expansions after 1966, the spread between the Funds rate and the rates with maturities
over one year became positive; in this range the slope of the yield curve became negative.
In the middle of several expansionary periods there are episodes during which the spread
became positive, but then reversed, only to become positive again immediately before the
cyclical peak. With the exception of the 1990 peak, the spread reached a maximum at the
cycle peak. In 1989 the positive Funds rate spread at all of these maturities reached a
maximum and then disappeared before the 1990 cyclical peak. In 1995, the spread
between the Funds rate and the intermediate maturity rates (up to five years) has again
become positive, but relatively small compared to the maximum spreads achieved before
the last four cyclical peaks.
Table 1 provides some quantitative information on the size and duration of the
positive Funds rate spreads prior to cyclical peaks since 1966. For each maturity and
each business cycle peak, the months during which the indicated Funds rate spreads was
positive is recorded, together with the duration of the positive spread in months, and the
mean of the spread during the months prior to the cyclical peak. In the 1990 peak, two
sets of statistics are recorded. The first is based on the number of months between the
first occurrence of the positive Funds rate spread and the cyclical peak, including the
months immediately before the peak during which the rate spreads became negative. The
second is based only on the duration of the last interval of a positive Funds rate spread
prior to the cyclical peak. The final set of statistics reports similar data for the positive
Funds rate spreads prior to the end of the sample period (December, 1995).
There is some suggestion of a pattern over the past five business cycle peaks in
the behavior of the Funds rate spread against government securities with maturities of one
year or more, but it is probably dangerous to read too much into these patterns. The




84

sample is very small, and all observations are drawn from an inflatinary period.
Generally it appears that the positive rate spreads have emerged 12 to 18 months prior to
the cyclical peak and have averaged from 75 to 150 basis points. The exception is prior
to the 81 peak, but the duration of the positive spread here is restricted by the short period
between the credit controls recession in early 1980 and the onset of the 1981-82
recession. This period also coincides with the New Operating Procedures experiment.
Compared against this standard, the positive Funds rate spreads at these maturities during
recent months have been of short duration and relatively small magnitude.
Perhaps a more interesting leading indicator of cyclical peaks is provided by a
different segment of the government security yield curve. Figures 6-8 show the spreads
between the three, five and ten year maturity rates and the one year rate when the
economy is in a recovery or expansion phase and those spreads are positive (this segment
of the yield curve is positively sloped). With the exception of the 1990 cyclical peak, the
slope of the yield curve in these maturity segments has consistently approached zero, or
become negative prior to all cyclical peaks since the mid 1950s. In 1989, the slope in
these maturity segments went negative for a few months, but then became positive again
prior to the 1990 cycle peak. Note that in recent months the slope of the yield curve in
these maturity segments has become very small, but still remains positive. In the latest
weekly data available on these rates (mid February, 1996), the spreads between these
maturities and the one year rate have become smaller in the three to five year range, but
larger at the ten year maturity than they were at the end of December, 1995.
There is another interest rate spread that has been mentioned as a leading indicator
of real economic activity in recent years. In a number of studies employing VAR
analysis, Friedman and Kuttner (1989,1992,1993a, 1993b) argue that the spread between
the commercial paper rate and the Treasury bill rate of comparable maturity contributes
significantly to forecasts of future changes in measures of real economic activity.
However, a recently published study (Emery, 1996) shows that the Friedman/Kuttner
results on this interest rate spread depend critically on the inclusion of two observations:
one in 1974 at the time of the Franklin National Bank crisis and the second in 1980
coincidental with the imposition of the Carter Credit controls. Emery argues that without




85

the inclusion of these two observations there is no significant evidence for a role of the
commercial paper-Treasury bill rate spread in predicting future changes in the growth of
real economic activity. These particular incidents do not contaminate the results in
Figures 1-8, or in Table 1, since both occurred during periods dated by the NBER as
recessions.




86

REFERENCES
Emery, K. M. (1996), "The Information Content of the Paper-Bill Spread," Journal of
Economics and Business. 48:1-10.
Friedman, B. and K. Kuttner (1989), "Money, Income and Prices After the 1980s,"
NBER Working Paper 2852.
Friedman, B. and K. Kuttner (1992), "Money, Income, Prices and Interest Rates,"
American Economic Review. 82:472-92.
Friedman, B. and K. Kuttner (1993a), "Another Look at the Evidence on Money-Income
Causality," Journal of Econometrics. 57:189-203.
Friedman, B. and K. Kuttner (1993b), "Why Does the Paper-Bill Spread Predict Real
Economic Activity?," in New Research on Business Cvcle Indicators and Forecasting.
(Stock and Watson, eds.), Chicago: University of Chicago Press.




87

Table 1
Spreads between the Federal Funds Rate and Selected Interest Rates
before Business Cycle Peaks
1 NBER Cycle 1 T-billRate
Peak
68:4-69:11
20
1.10
71:8-73:10
27
0.85
77:2-79:12
35
0.73
80:8-81:6
11
2.09

73:11
80:1
81:7

90:7

1

1
last
1 observation
1
(95:12)

j

3-year
Government
Rate
69:1-69:11
11
1.23
73:3-73:10
8
1.93
78:9-79:12
16
1.22
80:10-81:06
9
3.11

5-year
Government
Rate
69:1-69:11
11
1.30
73:3-73:10
8
2.06
78:9-79:12
16
.1.40
80:11-81:6
8
3.70

10-year
Government
Rate
69:1-69:11
11
1.56
73:3-73:10

1
1
1
1
1
1
1

82:12-90:6
91
0.77

69712

1-year
Government
Rate
69:2-69:11
10
1.23
73:1-73:10
10
1.19
79:5-79:12
8
0.89
80:10-81:6
9
2.37
89:1-90:6*
18
0.49

89:2-90:6*
17
0.48

89:2-90:6*
17
0.51

89:1-90:6*
18
0.48

1
1
1

_

89:1-90:2
14
0.62
95:9-95:12
4
0.25

89:1-90:2
12
0.67
95:11-95:12
2
0.22

89:2-90:1
12
0.72
95:11-95:12
2
0.10

89:1-90:1
13
0.66
—

1
1
1
|

95:2-95:12
11
1
0.39

8

1

2.09
78:9-79:12
16
1.46
80:10-81:06

1
1
1
1
1

9

1

3.69

1

*The differential between the Funds rate and these rates went negative before the cycle peak in July, 1990.
These entries indicate the number of periods and the average spreadfromthe date at which the spread first
went positive to the peak in July, 1990.




88




72

75

78

81

84

87

Panel B

+**K
63

81

89

-T—i—i—i—r-

84

87

90

93

54




57

60

63

66

Panel B

i

57

i'

r

60

»

63

J

^ M \ 1, 72
n
69

66

90

-1—i—r

75

78

81

84

id
87

90

JL
93

54

57

60

Panel B

l

54




57

60

\

i

i

63

i

i"r

66

r

\

'
i

69

'
i

i

i

72

9
1

75

78

81

84

87

90

i

i

93

i

kJL

-i—r-*-r

54

57

60

Panel B

7
DIFGS5

6
5

4 H

3 -I
2

N

1 H

o

54




57

r

60

i

i

63

i

i

AJi 69
66

»'

72

92

i

75

i

•

i

78

81

84

•

•

\

87

I' I

90

I

I

93

I'

Figure 5
Panel A

Panel B

7

DIFGS10

6

5 H
4

3 H

N

2
1 H

o

1

54

57




r

i

11
i

60

63

AH
66

69

72

75

93

i

i 'i

78

81

84 ' 87

h

90

I

I

l

93

I

Figure 6
Spread between 3 year and 1 year Government Rate

1.75

WFG1.3

1.50

H

1.25 -A
1.00

-|

0.75
0.50
0.25

H

0.00

i ' i1

—i—i

54

i i1

57

t

60

i

i

i

63

i

r

—i

66

72

69

75

i

T ' I

'•>•

78

'l

81

I

I

84

I "T

87

Figure 7
Spread between 5 year and 1 year Government Rate
2.5

OIFG1 5

2.0

H

1.5

H

1.0 - ]
0.5
0.0

i

i

7 '

54




i'

57

i

»f'

t

60

»

'

i

63

i—T

f

66

i'"f'

';

69

'i—i

i'

72

'i

i'

i

i

75

\

.

78

i

i

i

81

.

•

•

84

•

87

Figure 8
Spread between 10 year and 1 year Government Rate

^ ^

90

93

THE MEXICAN LOAN REPAYMENT SLEIGHT OF HAND
Anna J. SCHWARTZ
National Bureau of Economic Research
When the spectacular devaluation of the peso occurred at the end of 1994, 91-day
swap lines of credit of $3 billion each—dollars for pesos—were available to the Bank of
Mexico at the Federal Reserve and the Treasury's Exchange Stabilization Fund (ESF).
These were known as regular swap lines. The first response on January 2, 1995, of the
authorities to Mexico's crisis was to establish in addition temporary swap lines, initially
of $1.5 billion at the Fed and the ESF, on February 1 increased to $3 billion at the Fed,
but not at the ESF.
On January 31, 1995, President Clinton announced that the ESF would provide a
$20 billion line of credit, less any outstanding drawings on the short-term facilities, that
would be available for medium-term swaps and government securities guarantees
between the Mexican government and the ESF.
I report on transactions during the past year first at the short-term and then at the
medium term facility. I also discuss Mexico's total indebtedness to official agencies and
the private market, and I offer some observations about Mexico's dependence on the
United States for financial succor over the past 60 years. I conclude with comments on
the FOMC's discussion in March 1990 of foreign exchange market intervention and
warehousing of ESF foreign currencies.
MEXICO'S 90-DAY SWAP BORROWINGS
Mexico has drawn only on the regular swap line the amount of $1.5 billion at each
source, $500 million on two dates in January, and $1 billion on February 2. Table 1
shows the original amounts of the 91-day swap facility with the Bank of Mexico at the
Fed and at the ESF, dates the amounts advanced were renewed, dates and amounts of
drawings and repayments.
Neither the Federal Reserve nor the ESF in their usual quarterly reports publishes
the interest rate charged on swap drawings. However, the Mexican Debt Disclosure Act




95

of 1995 (passed after the drawings had taken place) requires the Secretary of the Treasury
to report to appropriate congressional committees "the interest rates and fees charged to
compensate the Secretary of the Treasury for the risk of providing financing." The table
shows the Treasury's data in the monthly reports on interest rates charged since 31 May,
1995, pursuant to the Mexican Debt Disclosure Act of 1995.
The swap agreements with the Bank of Mexico set the rate as the latest auction
rate on U.S. 91-day T-bills. The January borrowings of $500 million each from the Fed
and the ESF were repaid on time on March 14. The February 2 borrowing of $1 billion
from each source was renewed when due 91-days later on May 3, and again on August 1.
The rate was reset on each of the renewal dates based on the latest T-bill auction. The
renewal date after August 1 would have been October 30. On October 10, however,
Mexico repaid $350 million of the $1 billion it owed to each authority, and the rate on the
balance of $650 million was reset on October 30. It was this balance that was repaid on
January 29,1996.
The repayment of $700 million in October 1995 and $1.3 billion in January of this
year in total extinguished Mexico's short-term borrowing from the Fed and the ESF.
Each repayment was the occasion of congratulatory remarks by Treasury Secretary
Robert E. Rubin on Mexico's achievement. What he failed to remark was that in both
cases Mexico replaced its U.S. loans with other loans. On October 5, 1995, Mexico sold
to German banks 1 billion DM-denominated 5-year Eurobonds, roughly equivalent to
$700 million, paying 9 3/8 percent interest, similar to an earlier issue in the German
capital market in July 1995. The interest rate on both borrowings was about 400 basis
points higher than German bonds of comparable maturity paid. That was also the margin
by which the U.S. loan was underpriced. On December 20, 1995, before the January 29
due date for the $1.3 billion, the IMF increased its loan to Mexico by $1.3 billion
(converting 1,104.06 SDR millions into dollars). Is borrowing form Peter to pay Paul a
sign that all is well with Mexico?
It is clear that what motivated the Mexican Debt Disclosure Act was the
Treasury's treatment of Mexico as a triple-A borrower, free of default risk, and entitled to
the risk-free rate at which the Treasury itself borrowed short term. It cost Mexico




96

between 3.475 and 4.125 percentage points more to repay the United States with money it
borrowed in Germany than the U.S. loan cost, so its annual interest payments will
increase between $104 million to $124 million over the term of the German loan
compared to the U.S. loan.
From the Treasury's viewpoints, a comparison of the T-bill auction rate charged
Mexico and 9 3/8 percent on the mark-denominated 5-year Eurobond is invalid. The
Treasury required Mexico to provide collateral against default in the form of its oil
proceeds on deposit at the Federal Reserve Bank of New York. There is no comparable
backup for the German loan. In addition, in return for U.S. dollars, the Fed and the ESF
show among their foreign currency holdings dollar equivalents of pesos the Bank of
Mexico has swapped. The ESF does not mark-to-market its peso holdings, but the Fed
does. In the final quarter of 1995, the Fed sold about one-third of its peso holdings, the
ESF, which held both short- and medium-term peso swaps, sold 5 percent of the total.
The investment income on Mexican swaps is sold back to Mexico by both authorities.
This episode highlights the senseless duplication of the service of two agencies
(with different accounting procedures) in dealing with a borrower of dollars, when the
need for even one may be questioned. It is also a sucker's game for Mexico, which hasn't
reduced its liability by one hard-currency unit after paying back $3 billion to the United
States.
MEXICO'S MEDIUM-TERM SWAP BORROWINGS
In addition to short-term swap, Mexico borrowed $10.5 billion from the ESF
medium-term facility at four dates in March, April, May, and July, shown in Table 2
along with the amortization schedules. The schedule differs for each tranche. The
amount of the repayment of principal of the March borrowing of $3 billion is $375
million due at the end of each quarter starting June 1998 with a final $750 million due on
December 31, 1999. Repayment of the April borrowing of $3 billion is scheduled to
begin a year earlier than the March schedule, with 11 end-of-quarter paybacks of $245
million and a final $305 million on March 31, 2000. The timing of repayments of the $2
billion borrowed in May is similar to the April schedule, but the 11 end-of-quarter




97

amounts are $170 million, and a final $130 million on March 31, 2000. Amortization of
the July $2.5 billion borrowing begins September 30, 1997, again as 11 end-of quarter
paybacks of $205 million, and afinalpayment of $245 million on June 30, 2000. If there
are no extensions of the amortization schedule, Mexico will repay $1.655 billion in 1997,
$3,605 billion in 1998, $4,355 billion in 1999, and $0,885 billion in 2000.
Legislation sponsored by Senator D'Amato in the Mexican Debt Disclosure Act
of 1995, signed into law on April 10, changed the process of setting the interest rate.
Prior to the enactment of the legislation, the ESF interest rate on medium-term swaps
with Mexico was a sum of the latest auction rate on U.S. T-bills, reset at the end of each
quarter based on the latest T-bill auction rate, plus a credit-risk premium. Under the
April 10 law, the rate is afixedpercentage set at the date of the loan and is not reset at the
end of each quarter. The credit risk premium the ESF has changed has varied between
2.25 percent and 3.75 percent in 1995, according to the Treasury, but it may be as high as
4.50 percent, according to Table 2.
In addition to the amounts of principal Mexico is expected to repay at the end of
each quarter beginning June 30, 1997, it must also pay the interest on its outstanding
loans. In the year ending January 29, 1996, Mexico paid, according to the Treasury,
about $750 million in interest on its short- and medium-term swaps. According to a
GAO report, Mexico made $736 million in interest payments on its U.S. borrowings,
hailed by Rep. Jim Leach of Iowa as evidence that U.S. taxpayers "were earning a profit"
on the loan. He has obviously never known about opportunity cost. (The GAO figure
may differ from the Treasury's because it covers a shorter period.)
MEXICO'S TOTAL INDEBTEDNESS
In arranging the rescue package for Mexico last year, it is not clear that the
administration considered how much debt Mexico had the capacity to service and repay.
The size of the package seems to have been determined by the sum of the short-term
tesobonos and CETES, as well as the dollar-denominated debt with near due dates of
private firms, government enterprises, and banks. (It is widely understood that the socalled Mexican rescue package was instead designed to rescue U.S. funds that had




98

heavily invested in Mexico.) If Mexico's capacity to repay its borrowings had been a
high priority, it is doubtful that repayment of its short-term swaps within a year would
have been stage-managed, since it was in no position to repay without borrowing
elsewhere.
The Mexican government has incurred a liability of hard-currency debt that it will
have to repay in coming years, currently amounting to about $50 billion. I have not seen
an estimate of private sector hard-currency debt. The loans the government has obtained
are mainly from official sources including the IMF, the World Bank, and the InterAmerican Development Bank. Mexico has the right until August 1996 to draw on the
balance of the $20 billion the Treasury extended last year, although it may be politically
difficult. It can draw at least an additional $5.1 billion from the IMF in February, May,
and August of 1996, if it meets the requirements for further borrowing. In addition to
official sources, Mexico owes German banks $1.5 billion dollar equivalent of D-marks.
(Mexico will be in luck should the mark depreciate against the dollar in coming years, as
that will ease the burden of repayment to the German banks.)
What sources can Mexico count on to service and amortize its dollar obligations?
It can draw on its international reserves and the income from foreign trade. Will these
amounts in 1996 suffice to service the U.S. medium-term swap and the debts owed to
official agencies? No data are available on the interest payments the private sector owes
on its hard-currency debt. Accordingly, it is difficult to judge how serious a burden
servicing Mexico's debts constitutes.
A major difference between Mexico's situation in 1982, when it could not service
its $80 billion syndicated commercial bank loans, is that the official agencies, which are
its current creditors, charge lower interest rates and are readier to roll over debt when due
than are private market sources, and even to increase it should Mexico lack the means to
honor its commitments.
Nevertheless, the specter of trouble in meeting its obligations looms over Mexico.




99

A LONGER PERSPECTIVE
An ESF agreement with Mexico to stabilize the dollar-peso exchange rate dates
back to January 1936. The United States then agreed to buy monthly up to 6 million
ounces of newly mined silver from Mexico. Neither the acquisition price per ounce nor
the total dollar outlay was specified. The agreement was renewed in December 1937, and
suspended in March 1938. In November 1941 the agreement was reinstated, but this time
an upper limit of $40 million was stipulated. Periodically renewed until May 1947, the
agreement was then altered to obligate the United States to purchase pesos instead of
silver, and the potential dollar outlay was raised to $50 million. By 1953 the figure was
raised to $75 million.
In 1954, the first time the ESF agreement was combined with an IMF standby
loan of $50 million. In 1958 the IMF standby loan was raised to $90 million and an
EXIM Bank loan of the same amount was arranged. The 1965 agreement for the first
time was refereed to as a reciprocal swap agreement. In 1967 the ESF dollar commitment
was raised to $100 million, and for the first time the Federal Reserve established its own
swap agreement of $130 million in May of that year. The amount was periodically raised
to $180 million in 1973, then to $360 million and to $700 million, until in 1995 the
agreement reached $3 billion regular and $3 billion temporary.
Mexico did not invariably draw on the ESF or the IMF. It made drawings on the
ESF in 1949 when the peso was devaluedfrom4.855 to 8.65 to the dollar, and it drew on
the IMF in 1954, when it devalued the peso from 8.65 to 12.50 to the dollar. It drew on
the Federal Reserve swap line in 1974-76 and in 1982, when it devalued—based on the
new pesos used today from 0.037 per dollar to 0.113 per dollar. In 1982-83 it also drew
on its ESF swap line. In 1986 it drew on both the ESF and Fed lines. In 1989-90 it drew
on the Fed and in 1988-89 also on the ESF.
So from a $40 million stabilization agreement in 1941, in 1995 the ESF raised the
ceiling on Mexico's borrowing needs to $20 billion, a 500 percent increase, far in excess
of any change in Mexico's economic growth rate and in the world inflation rate over the
period from 1941. Nor is Mexico the sole recipient of this Treasury benevolence. At




100

least 14 other Latin American countries at one time or another have had ESF bilateral
stabilization agreements, but none has had as sustained a connection with the ESF as
Mexico, and Mexico is the only Latin American country that has a swap arrangement also
with the Federal Reserve, which, as noted above, increased the authorized amount from
$130 million in 1967 to $3 billion regular plus $3 billion temporary in 1995.
Nearly 60 years have elapsed since the first ESF dollar-peso stabilization
agreement. Is it possible that, far from stabilizing the Mexican economy, the loan
agreements have contributed to a permissive culture there that periodically ignores the
eternal varieties of soundfinance,secure in the knowledge that its transgressions will be
forgiven?
The Treasury has regularly orchestrated loan packages for less advanced
countries, drawing on all the postwar aid agencies. In the aftermath of the Mexican crisis,
proposals to expand loan availability include creation of an emergency bailout fund at the
IMF to aid countries in financial difficulties and doubling of the GAB's lending
authority. What proof is there that loans have succeeded in setting even one country on
the path to stable economic development?
WHY INTERVENTION AND WHY WAREHOUSING?
At the FOMC March 27, 1990, meeting, the participants had a full-dress
discussion of the rapid growth of the Fed's foreign currency balances and the legality of
Fed warehousing of ESF foreign currencies. At that meeting, with three dissenting votes
(Angell, LaWare, and Hoskins), the FOMC raised the upper limit of authorized Federal
Reserve foreign currency balances from $21 billion to $25 billion, and the upper limit of
warehousing from $10 billion to $15 billion.
What worried the FOMC was the political fallout of possible losses on its
expanding foreign currency portfolio, but the majority argued in favor of continuing to
intervene as a means of moderating Treasury initiatives. According to the dissenting
members, warehousing, in effect a loan by the Fed to the ESF, was illegal on its face, and
was subversive of congressional appropriations powers. The Treasury, instead of asking
the Fed to warehouse foreign currencies it could not afford to buy, should have requested




101

an appropriation from Congress. This is also the position of the SOMC but the majority
was persuaded that an opinion of the Board's General Counsel in 1952 justified
warehousing as well as foreign exchange operations. The warehousing operation permits
the ESF to transfer to the Fed major country currencies acquired in its intervention mode
in order to have funds for dollar swaps with less advanced countries. The Federal
Reserve for its part resists transfer by the ESF of currencies other than those of major
industrialized countries.
The FOMC discussion leaves the legal and economic doubts surrounding
intervention and warehousing far from settled.
Did the ESF agreement to lend Mexico $20 billion in February 1995 involve
warehousing? On December 31, 1994, ESF assets totaled $38.2 billion, of which $8.2
billion was a deposit at the Federal Reserve Bank of New York, $10 billion was in SDRs
valued in dollars, and $19.3 billion was in mark and yen balances or government
securities denominated in those currencies. The question is, how did the ESF finance the
loan to Mexico?
The amount of warehousing authorized by the FOMC was reduced to $5 billion in
February 1992. An outstanding amount of $2 billion was repurchased by the Treasury
from the Fed in April 1992, leaving the warehouse empty. Authorized warehousing
would have been inadequate to cover the $20 billion Treasury loan, and would have had
to be increased if it was the means by which the Treasury financed the loan. Indeed, at
the January 31-February 1, 1995, FOMC meeting, the committee approved an increase
from $5 billion to $20 billion (Lindsey and Melzer dissenting) in the warehouse for the
Treasury and the ESF. However, no warehousing operations have been reported to date
since the loans to Mexico in 1995 was extended.
According to the March 31, 1995, ESF balance sheet, the main change in the
composition of ESF assets since the Mexican loan was a $4 billion decrease in the
agency's deposits at the Federal Reserve Bank of New York, matched by the entry of a $4
billion dollar equivalent of Mexican pesos. The June 30, 1995, balance sheet (the latest
one available as of the date of the SOMC meeting), shows that the Federal Reserve Bank
deposit during the second quarter was further decreased by $3 billion and mark and yen




102

balances were decreased by approximately $1.3 billion. Mexican peso balances show a
$5 billion dollar equivalent increase.




103

Table 1

FEDERAL RESERVE AND ESF 91-DAY SWAP FACILITY WITH BANK OF MEXICO

Date

Renewal

Original
Amount

Drawings on
Regular
Swaps

Interest Rate
Charged (per
cent per annum)

Repayments

Outstanding

(billions of dollars)

(billions of dollars)

1. Federal Reserve Arrangements

1225
Jan. 2

Temporary
1.5

Regular
3.0

•*
«
.250 /

Jan.11
Feb. 1

5.90

.500

5.80

1.500

.25oJ

Jan. 13
1.5

Feb. 2

1.000

.500

Mar. 14

y
y

May 3
Aug. 1

5.75
1.000

5.45

v

Oct. 10

1.000

.350

.650

5.25

Oct. 30

1223

.650

Jan. 29
2. Exchange Stabilization Fund Arrangements
1995
Jan. 2

Temporary
1.5

Regular
3.0

Jan. 11

.250 ")

5.90

.500

Jan. 13

.250 j
1.000

5.80

1.500

Feb. 2

.500

Mar. 14
May 3

•

5.75

Aug. 1

V
y

5.45

1.000

Oct. 10

1.000
.350

Oct. 30

5.25

122£
Jan. 29




.650

104

.650

Table 2
EXCHANGE STABIUZATION FUND MEDIUM-TERM FACILITY WITH MEXICAN GOVERNMENT

Date

Original
Amount

Drawings

Interest Rate
Charged and
Reset on
3/14 Swap

Implicit Credit-Risk
Premium (col. 3)

(2)

Implicit Credit-Risk
Premium (col. 5)

(percent per annum)

(billions of dollars)
(1)

Interest Rate
Charged on
4/19, 5/19, and
7/15 Swap

(6)

(5)

(4)

(3)

1995
Feb. 21

20.0 a

Mar. 14

3.0

2.43

8.10

Mar. 31

8.20

2.46

Apr. 19

3.0

10.16

4.46

May 19

2.0

10.16

4.45

9.20

3.67

June 30
July 5

7.80

2.45

2.5

Sept. 30

7.55

2.41

Dec. 31

7.30

2.39

AMORTIZATION SCHEDULE FOR 1995 MEDIUM-TERM SWAPS
(MILLIONS OF DOLLARS)

Mar. 14

Apr. 19

May 19

July 5

Total

1997

0

735

510

410

1655

1998

1125

980

680

820

3605

1999

1875

980

680

820

4355

2000

0

305

130

450

885

Total

3000

3000

2000

2500

10500

3

Less the amounts outstanding from short-term swaps and securities guarantees.




105


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102