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1$HE ECONOMIC IMPACT OF FEDERAL DEFICITS,
1984-1989
A STAFF STUDY
PREPARED
FOR
THE
USB
OP
THE
SUBCOMMITTEE ON ECONOMIC GOALS AND
INTERGOVERNMENTAL POLICY
OF
THE
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
APRIL 13, 1984
Printed for the use of the Joint Economic Committee
U.S. G O V E R N M E N T PRINTING OFFICE
33-434 O
W A S H I N G T O N : 1984
JOINT ECONOMIC
COMMITTEE
[Created pursuant to sec. 5(a) of Public Law 304, 79th Congress]
SENATE
R O G E R W . JEPSEN, Iowa, Chairman
W I L L I A M V. ROTH, JR., Delaware
J A M E S A B D N O R , South Dakota
S T E V E N D. SYMMS, Idaho
M A C K MATTINGLY, Georgia
A L F O N S E M. D'AMATO, New York
L L O Y D BENTSEN, Texas
W I L L I A M PROXMIRE, Wisconsin
E D W A R D M. K E N N E D Y , Massachusetts
P A U L S. SARBANES, Maryland
H O U S E OF REPRESENTATIVES
L E E H. H A M I L T O N , Indiana, Vice Chairman
GILLIS W . LONG, Louisiana
P A R R E N J. MITCHELL, Maryland
A U G U S T U S F. H A W K I N S , California
D A V I D R. OBEY, Wisconsin
J A M E S H. SCHEUER, New York
C H A L M E R S P. WYLIE, Ohio
M A R J O R I E S. HOLT, Maryland
D A N I E L E. L U N G R E N , California
O L Y M P I A J. S N O W E , Maine
CHARLES H . BRADFORD, Acting
Executive
Director
JAMES K . GALBRAITH, Deputy
Director
S U B C O M M I T T E E ON E C O N O M I C G O A L S A N D INTERGOVERNMENTAL P O L I C Y
H O U S E OF REPRESENTATIVES
L E E H. H A M I L T O N , Indiana, Chairman
A U G U S T U S F. H A W K I N S , California
O L Y M P I A J. S N O W E , Maine
SENATE
L L O Y D BENTSEN, Texas, Vice Chairman
R O G E R W . JEPSEN, Iowa
A L F O N S E M. D'AMATO, New York
(II)
X>GER W. o r-S£K IOWA.
CHAMMAN
WILLIAM V. ROTH. JR. DEL
JAMES ABDNOM, S. DAK.
STEVEN D. SYMMS. IDAHO
MACK MATI1NGLV. GA.
ALFONSE M. OAMATO. N.T.
UOYDBENTSEN.TEX
WILLIAM PROXMIRE. WIS.
EDWARD M. KENNEDY. MASS.
PAUL S. SARBANES. MD.
LETTERS OF TRANSMITTAL
Congress of thettnftdStates
JOINT ECONOMIC COMMITTEE
(CREATED PURSUANT TO SEC. SM OF PUBUC LAW 304. 7tn< CONGRESS
, B.C. 20510
April 13, 1984
The Honorable Roger W. Jepsen
Chairman
Joint Economic Committee
Congress of the United States
Washington, D.C.
Dear Mr. Chairman:
Transmitted herewith is a study prepared for the Joint
Economic Committee e n t i t l e d , "The Economic Impact.of Federal
D e f i c i t s , 1984-1989.". This study evaluates the economic effects
through the balance of the decade of our enormous Federal
deficits.
This study is an important addition to the debate over
Federal d e f i c i t s .
Subcommittee members, the Joint Economic
Committee and other Members of Congress w i l l find i t a valuable
reference source.
Sincerely,
Lee H. Hamilton
Chairman
Subcommittee on Economic Goals
and Intergovernmental Policy
(III)
LEE H. HAMILTON. WO.
VICE CHAIRMAN
GLUS W. LONG. LA.
PARREN JL MTTCHai. MO.
AUGUSTUS F. HAWKINS. CAU
DAVID A OBEY. WIS.
JAMES R SCHEUER. It*.
CHALMERS P. WYUE OMO
MARJOnE r HOLT. Ma
DAN LUNGREN. CAUF.
OlYMPIA J. SNOWE. MAINE
IV
ROGER W.JEPSEK.IOW*,
CHAIRMAN
WIUJAMV.ROTHJft.OEL
JAMES ABDNOR. S. DM.
S1EVEMO.SyMMS.nAHO
MACK MATT1NGLY, GA.
AUONSE M. O-AMATO. N.Y.
U-OYD BEXfTSEX. TEX.
WILLIAM PROXMIRE. WIS.
EDWARD ML KENNEDY. MASS.
PAUL S. SARSANES. MO.
Congress of thettitfttflStates
JOINT ECONOMIC COMMITTEE
(CREATED PURSUANTTOSEC S<4 Of PUSUC LAW 304.7SW CONGRESS)
VICECHAMMAN
GfcllS W. LONG. LA
PARR8I X MITCMai. MO.
AUGUSTUS F. HAWKINS. CAUF.
0AV1O R. O0EY. WIS.
JAMES H. SOCUER. N.Y.
CHALMERS P. WtUE, OHK>
MARJOMES.HOLT.Ma
DAN LUNGREN. CAUF.
OLYMPIA J. SNOWE. MAINE
fOashfngton, B.C. 20510
April 9 ,
1984
The Honorable Lee Hamilton
Chai rman
Subcommittee on Economic Goals
and Intergovernmental Policy
Joint Economic Committee
Congress of the United States
Washington, D.C.
Dear Mr. Chairman:
Transmitted herewith is a study e n t i t l e d , "The Economic Impact
of Federal D e f i c i t s , 1984-1989."
Using mathematical simulations of
the economy, the study examines the impact of Federal budget d e f i c i t s
on U.S. GNP, housing, employment, savings, investment and productivity*
through 1989. This econometric analysis is the most extensive one
y e t conducted and documents the steady erosion we can expect in our.,
economic base i f these d e f i c i t s are not promptly reduced.
The study was prepared by George T y l e r of the Committee s t a f f ,
with assistance from Paul Manchester and Doris I r w i n .
I t u t i l i z e d the
Data Resources, Inc. econometric model to evaluate the impact of f u t u r e
d e f i c i t s under a v a r i e t y of conditions.
I f no action is taken by the
Administration and Congress to reduce d e f i c i t s , the study found t h a t
i n t e r e s t rates w i l l continue r i s i n g , and the d e f i c i t w i l l grow
inexorably to $306 b i l l i o n by 1989. The study evaluates the economic
impact of the Administration's March proposal, as w e l l .
I t finds that
t h i s proposal is i n s u f f i c i e n t to reverse the d e f i c i t t r e n d , or to
prevent r i s i n g i n t e r e s t r a t e s . The proposal w i l l produce a Federal
d e f i c i t in 1989 of $176 b i l l i o n , near the present high l e v e l .
These r e s u l t s warrant unusual a t t e n t i o n because of the comprehensive dynamic computer simulations used to derive them. The conclusions
are f a r more useful and r e a l i s t i c than the t y p i c a l s t a t i c analysis
u t i l i z e d to evaluate the impact of d e f i c i t s .
I believe members o f the
Subcommittee, the f u l l Committee and other Members of Congress w i l l
f i n d the study useful and i n f o r m a t i v e .
The views expressed i n the study are those of the author and do
not necessarily represent the views of the Committee members or the
Committee s t a f f .
Sincerely
Lloyd Bentsen
Vice Chairman
Subcommittee on Economic Goals
and Intergovernmental Policy
CONTENTS
Page
Letters of Transmittal
Introduction and Summary
HI
1
CHAPTER
I
Economic Impact of Federal Deficits
Simulation Results
Housing
Foreign Trade Sector
Savings Versus Consumption
Supply Side Effects of the Economic Recovery and Tax Act
Savings
Investment
Productivity
CHAPTER
II
Economic Impact of the Administration Deficit Reduction Proposal
Deficit Reduction and Slower Growth
Administration Economic Assumptions
Administration Program Simulation
Savings and Investment
Productivity and the Deficit
A Deficit-Reduction Growth Path
(V)
4
6
9
10
11
12
IS
14
16
20
20
21
24
25
27
28
INTRODUCTION
This study examines the impact of large Federal deficits through the
balance of the decade on U.S. economic growth, savings, investments and
productivity.
It utilizes mathematical simulations based on the Data
Resources, Inc. Annual Econometric Model. Such simulations have only a
spotty
record in successfully predicting future economic variables,
especially years in the future.
They can be extraordinarily helpful,
however,
in
evaluating
the
relative
future impact of different
macroeconomic policy patterns. The relative effect of various fiscal and
monetary policy mixes on real GNP growth, for example, are readily
determined using econometric simulations even if absolute future GNP levels
cannot be confidently "pinpointed.
The use of econometric simulations
permits the future impact of Federal policy on the economy to be evaluated
in a realistic, dynamic context.
For that reason, there is a sharp
distinction between the future economic outlook derived from the analyses
used in this study and those presented, in particular, in Administration
budget documents. The analyses utilized for the budget and elsewhere, as
well, give a different and essentially misleading static picture of the
effects of Federal economic policy.
Tax increases or spending cuts
designed to shrink future deficits, for example, directly influence a
multitude of variables in addition to the actual magnitude of deficits.
They may reduce economic growth, for one, altering future investment and
productivity as well as Federal receipt and expenditure streams.
These
second order or dynamic effects can be quite substantial. Yet, they have
been largely ignored in the deficit debate.
This study is designed to
rectify that shortcoming.
.
The analyses of the dynamic effects of Federal deficits are divided
info two chapters.
The future economic impact of a failure by the
Administration and Congress to adopt any tax and spending policy designed
to reduce loaning Federal deficits is evaluated in Chapter I. The
econometric simulations utilized in that analysis found that a hands-off
attitude toward Federal deficits will cause interest rates to continue
rising and will reduce U.S. investment and productivity. The recovery will
continue this year, but crowding-out will push interest rates up and
sharply reduce future economic growth. The deficit will rise steadily to
$306-billion by 1989 when government interest payments on the debt will
exceed $236 billion.
Continued high real interest rates will greatly
intensify the unbalanced nature of the recovery.
Lagging housing and
foreign sector firms will continue to drag down the rate of growth. The
housing industry will return to a recession pattern through at least 1989.
Inventory and nonresidential fixed investment will increase handsomely this
year. But continuing high real interest rates through 1989 will depress
savings, investment and productivity well below historic levels.
The future economic impact of the Administration's March $150 billion
deficit-reduction proposal is reviewed in Chapter II.
The simulations
indicate that the proposal is of insufficient strength to reverse the
deficit trends. It will have virtually the same debilitating impact on
future investment, savings and productivity as the no-action scenario
examined in Chapter I. Its modest size will not prevent higher interest
(1)
2
rates this year which will sharply reduce economic growth in 1985 and
beyond. In slowing the recovery, the proposal will cause government
receipts to lag and spending to rise. This combination of modest deficit
reduction and slower growth will cause Federal interest costs on the debt
to continue rising rapidly and prevent progress against the deficits. Even
as late as 1989, the Administration's proposal will result in a Federal
deficit of $176 billion, quite near current levels. Finally, the proposal
will not halt the downward trend in U.S. productivity growth.
The simulations utilized in this analysis found that a deficit
reduction package larger than proposed by the Administration is needed to
actually achieve a reversal of the deficit trend.
By substantially
reducing Treasury demands for credit, a larger package would permit
interest rates to decline and enable a robust recovery to continue beyond
1984. In sparking more robust growth and lower interest rates than the
meek Administration proposal, such a package would enable the present
investment boom to persist. As a consequence, such a package, similar in
magnitude to the proposal recently offered by Senate Democrats and approved
by the House of Representatives, would succeed in reversing the sagging
U.S. productivity trend, as well.
Summary
If no action
Federal deficits:
is
taken by the Administration and Congress to reduce
*
The Federal deficit will reach $306 billion by 1989.
*
The National debt will more than double by 1989 to $2.85 trillion.
Government outlays to pay interest on the debt will double to $237
billion in 1989.
-
*
Crowding-out of financial markets by the deficit will occur in
1984 and 1985, pushing real interest rates up another percentage
point by 1985.
*
The current investment boom will end and economic growth will.fall
nearly one-half in 1985.
*
High interest rates will decrease housing starts by fifteen
percent in 1985. They will remain at that level through 1989.
*
The deficit-bloated dollar will enlarge the net export deficit 13fold by 1989 and cost the U.S. 3 million jobs in export and basic
industries in addition to the 1.2 million jobs already lost.
*
National
investment
on
plant and equipment will sag and
productivity growth will decline 10 percent below even the weak
level of the 1970's, cutting GNP in 1994 by $2,000 per person.
3
If the Administration's $150 billion deficit-reduction package proposed
in March is enacted:
The proposal is too weak to reverse the rising deficit trend and
Federal deficits will remain at or above $173 billion through the
end of the decade.
The national debt will double to reach $2.8 trillion by 1989.
Interest rates will rise in 1984, and Government outlays for
interest on the national debt will jump 50 percent to exceed $170
billion annually by 1989.
High interest rates, lagging exports and investment will slow the
recovery after 1984. Real GNP will only grow at the same speed it
would if no steps at all are taken to reduce the deficit between
now and 1989.
Slower growth and high interest rates rise will hobble U.S.
investment in new, more productive plant and equipment.
The share of personal disposable income being saved by individuals
through 1989 will drop over 20 percent from the post-war average.
As a result, over $260 billion less will be saved from 1985 to
1989 than would have been saved at historic savings rates.
Productivity-enhancing
investment
will
not rise above the
recession level of recent years when less than 12 cents of every
GNP dollar was spent on new plant and equipment.
The declining U.S. productivity growth trend will not be reversed.
It will fall more than 20 percent below the pace of the 1960's and
reduce future GNP growth by $448 billion between 1985 and 1989 —
or $1,700 per person.
33-434 0 - 8 4 - 2
CHAPTER I
Economic Impact of Federal Deficits
The economic and budgetary impact through 1989 of prospective Federal
deficits are evaluated in this chapter under the assumption that deficitreduction steps are not taken by the Administration or Congress. This
prospective impact is compared with recent United
States
economic
experience.
The simulations used in this analysis are modifications to the Data
Resources, Inc. (DRI) annual econometric model.
The specific baseline
utilized in evaluating the economic impact of inaction on looming federal
deficits is the DRI current services budget projection for 1984-1989.
Current services budgets depict an economic outlook based on existing
federal tax and spending statutes. They do not contain suggested policy
revisions.
That is, an econometric simulation of current service budgets
will depict future trends in the absence of any federal action to reduce
deficits.
The specific baseline selected for simulations bears importantly on
econometric results. The DRI current services budget estimates are in line
with other such estimates. They closely resemble the most recent current
services baseline estimates, for example, prepared by the Congressional
Budget Office, and presented in the CBO document An Analysis of the
President's Budgetary proposals for Fiscal Year 1985, (February, 1984).
The modest CBO-DRI areas of difference in current services estimates are
noted in the March, 1984 DRI publication, Review of the U.S. Economy.
The actual economic point estimates for out-years presented in this
analysis are based on dynamic interactions within the simulations involving
Federal budgets, monetary policy, ttie international economy and domestic
demand and supply variables.
These dynamic interactions have dramatic
effects on nominal values. Evaluating the impact of prospective deficits
in a dynamic context, as this study does, provides a far more realistic
perspective than does the more traditional and much more common static
context.
Assumptions:
Evaluating the economic outlook consistent with specific government
policy mixes in a dynamic context requires the selection of monetary and
fiscal
policy assumptions.
Selecting fiscal policy assumptions was
straightforward. The DRI current services budget baseline-denoting future
spending and tax trends was adjusted for the particular deficit reduction
proposal under review. Since the economic impact of- inaction on the
deficits is reviewed in this chapter, that baseline was not revised to
conduct the simulation examined here.
Simulations
evaluating
the
Administration's March deficit-reduction proposal are examined in Chapter
II. The DRI current services estimate of future tax and spending streams
(4)
5
was adjusted to r.eflect the Administration's three-year $150 billion
package as noted in more detail in that chapter. A similar procedure was
utilized with simulations evaluating the economic impact of a larger
deficit-reduction package, as well.
The monetary policy assumptions utilized are more subjective. The
simulation results discussed below are based on the assumption that a
moderate monetary policy will continue to be pursued by the Federal Reserve
Board. The growth of Ml, for example, is presumed to remain at recent
growth rates and within the current Federal Reserve Board's target range of
4-8 percent (fourth quarter to fourth
quarter).
Underlying
this
presumption is continued Federal Reserve Board devotion to price stability
through the balance of this decade.
That devotion may be sorely tested in 1984 and 1985, for inflationary*
signs abound. The recovery is continuing at an unusually robust rate with
real .GNP growth at an annual rate being revised upward to 5 percent in the
fourth quarter of 1983 (83:4). It rose even faster during 84:1. Indeed, a
genuine capital spending boom is underway, confirmed by both McGraw-Hill
and Corrmerce Department surveys. For example, the Department's JanuaryFebruary survey of capital spending plans found that plant and equipment
spending is-expected to rise 12.2 percent this.year in real terms — up
over 40 percent frcm the 8.5 percent (real) projection based on its "earlier
November-December survey.
This broad-based boom, led by autos, gas
utilities, textiles, electrical machinery and railroads will..certainly
tail off. According to Wharton Econometric projections, it will slacken to
only a 5 percent annual pace by 84:4.- Yet, its impact on capacity limits
and prices this year will be magnified by increased inventory investment as
industries reverse the 1983 trend which saw sales exceed inventory gains.
Tine current surge in nonresidential fixed investment comes even as a
number of industries are already approaching full capacity.
Overall,
industrial capacity rests at 81 percent.
But a number of industries,
including plastics, paper and electrical machinery are closer to 90
percent.
As a result, the leading indicator of inflation compiled by the
Center for International Business Cycle Research has risen 14 percent in
One component of that index, which measures 13 freely
the last year.
traded industrial inputs like tallow, rose an even faster 20 percent during
the same period.
Other indicators of rising inflationary pressure exist. The number of
firms reporting slower delivery of goods is rising sharply, At the
comparable period following the 1974-75 recession, the vendor-performance
indicator found that 50 percent of surveyed firms were experiencing
delivery slowdowns.
It sits at 67 percent now on a rising trend, up frcm
41 percent last year. Moreover, productivity growth fell to a scant .9 of
one percent annual rate in 83:4 — providing little cushion when wages and
labor costs begin rising due to the surprisingly rapid decline in
unemployment.
Adding to the portents for faster inflation is the
potential effect should the dollar decline- anew on foreign exchange
markets.
A precipitous decline could add as much as two percentage points
to the Consumer Price Index.
6
The GNP Price Deflator is on a strong upward trend. Since rising at an
annual rate of 3.6 percent in 83:3, it has increased at progressively
faster rates of 3.9 percent in 83:4 and a preliminary 4.4 percent in 84:1.
Moreover, the fixed-weighted price index, designed to wash out the
inflationary effects of a changing output composition, rose at an annual
pace of 5.1 percent in 84:1 —.nearly a one percentage point jump frcm the
83:4 annual -pace cf 4.2 percent.
This price surge paralleling the
strikingly robust first quarter GNP growth has raised fears of a quick
return to the traditional boom-bust cycle. Reinforced by rising credit
demand, short-term rates have reflected that fear as investors have sought
to maintain existing real interest rate levels in the face of rising
prices. T-Bills have increased over 80 basis points since early February.
The prime interest rate rose 100 basis points in late March and early
April. And, 90-day Certificates of Deposit are now one percentage point
above the 9.35 percent averaged in January.
The Federal Reserve has
reacted to this trend by increasing the discount rate to 9 percent from 8.5
percent April 9, for the first change in over 15 months. The Federal Funds
rate has risen even more.
Yet, these steps appear to be in response to
market pressures rather than symptomatic of a switch in Federal Reserve
policy. And, while the Federal Reserve is sensitive to inflation, • the
simulations utilized here assume that it does not cut short the recovery
with tighter money.
Simulation Results
The percentage * point increase in nominal interest rates over recent
months has nearly restored real interest rates to the levels maintained
throughout most of 1983. The simulations utilized to evaluate the economic
impact of prospective Federal deficits indicate that increasing pressure in
financial markets will continue to boost nominal interest rates in 1984 and
1985. More significantly, the pressure generated by Treasury financing
operations will force real interest £ates up, as well, over the next two
years.
They will ease down thereafter as economic growth slows, and the
economic expansion will continue through 1989, albeit at a diminishing
pace. The simulations project that real GNP will grow at an annual average
of 3.5 percent from 1983 to 1989, including a robust 5.2 percent this year.
As Table I notes, this period average is at the lower end of real GNP
growth attained in other postwar recoveries', despite the fiscal thrust
provided by deficits which rise steadily to a projected $306 billion in
1989 from $183 billion in 1984. This deficit picture is similar to results
obtained from other economic impact assessments of deficits, including
Congressional Budget Office evaluations.
7
Table VII
Real GNP Growth
During Postwar Recovery Periods
1948-1989
Period
1948-1953
1955-1957
1959-1969
1971-1973
1976-1979
Simulation (1983-1989)
Source:
Growth Annual Average(%)
4.9
3.5
4.4
5.0
4.7
3.5
Economic Report of the President, February 1984 and
Economic Simulations by Joint Economic Committee.
8
As noted in Table II, Federal net interest payments on the debt will
rise more than 100 percent to a projected $237 billion by 1989.
Crowdingout of capital markets by Treasury deficit financing operations will push
up real interest rates through 1985. After spiking about 50 basis points
in 1984 and 60 basis points in 1985, they are projected to subside slightly
thereafter through 1989 in this simulation due to a slowing in real GNP
growth beyond 1984.
Table II
Economic Impact of the Deficits
1984-1989
Real GNP Growth (%)
1984
5.2
1985
3.2
1986
3.7
1987
2.7
1988
3.3
1989
3.4
Real Interest Rates (%) 1/
5.4
6.0
5.7
5.3
5.0
. 4.8
Federal Deficit (Billions $)
183
• 209
231
267
282
306
Net Interest Payments
(Billions $)
117
137
159
184
210
237
1/ New high grade Corporate Bonds.
Source:
Joint Economic Committee Simulations.
Real GNP growth is projected to decline substantially from a robust 5.2
percent in 1984 to an average 3.3 percent thereafter through 1989.
Contributing to this decline is a projected further weakening in the U.S.
foreign trade sector as the dollar declines less than 10 percent over the
balance of the decade.
Slackening growth is projected to slow progress
against joblessness after this year, as well, with unemployment still at
7.0 percent of the labor force at the end of the decade despite a sharp
drop in the number of new market entrants.
The persistence of high real interest rates through the balance of the
1980's due to growing deficits will aggravate the unbalanced nature of the
present recovery.
As they traditionally do in recoveries, interestsensitive industries played major roles in sparking the 1983 recovery.
Yet, housing and exports, in particular, are not sharing fully in the.
current recovery. This situation is projected to worsen due to the
deficits through 1989.
9
Hous ing:
Treasury deficit-financing pressure on capital markets will keep fixed
rate, long-term nominal mortgage rates at or above current levels through
1989. And real mortgage rates in 1989 will be virtually identical to those
projected for 1985. After this year, as a result, housing starts are
projected to decline to about 1.5 million units annually through the
balance of this decade. Housing starts were up sharply last year after
three sluggish years.
Yet, despite a substantial backlog in demand,
activity fell well short of the average 1.9 million housing units on which
construction was started annually in the late 1970's.
The stagnation of this key interest-sensitive industry due to the
deficits will not enable housing to keep pace with family formations. As
Table III notes, because of the collapse in housing construction over the'
1980-1982 period, growth in households ran far ahead of growth in the net
This pattern will continue, although at a reduced pace,
housing stock.
through 1989. The impact of the deficits on real interest rates will
prevent the recovery from providing a compensatory spurt in housing
sufficient to eliminate the housing supply gap.
As a consequence,
household formations will far exceed housing stock growth for the entire
decade of the Eighties.
This weak housing outlook for the balance of the decade is in sharp
contrast with that sector's-experience during the two previous-- decades.
From 1960 to 1979, the housing stock grew an average 2 percent faster than
the number of households. From 1984 to 1989, however, fewer than eight
additional housing units will be provided for every ten additional,
households; residential real fixed investments will actually decline in
three of the five years from 1985-1989.
Table III
The Housing Outlook
1960--1979
Change in the Housing Stock 1/
Change in total householdsi/
Ratio of housing stock/
Household change
1980-1982
1984--1989
1,.3
1.,27
.78
2.07
1,,25*
1..63
1.,02
.37
.77*
1/ Million of housing units per year.
Source:
Bureau of
Committee.
the Census
and
(*) Simulations by Joint Economic
10
Foreign Trade Sector:
A second major sector being severely damaged by deficits is U.S. export
and import-competing industries. In adding several percentage points to
danestic
real interest rates, the deficits have lured billions in
investment frcm abroad. The U.S. experienced a $30 billion net foreign
capital inflow in 1983 alone, for example. These capital inflows pushed
the dollar up 46 percent in real trade-weighted terms on foreign exchange
markets between 1979 and last December. U.S. exports plunged as a result,
while imports surged. The merchandise trade deficit of $60.6 billion in
1983 alone reduced real U.S. GNP nearly 2 percentage points. As the first
full year of recovery, 1983 should have been a year of sharp improvement in
Instead, it worsened by 66 percent.
the merchandise trade balance.
Moreover, since trade balances typically deteriorate as recoveries proceed,
real GNP growth this year could again be suppressed 2 percentage points or
more by the foreign trade sector due to the deficit.
Indeed, the trade
deficits in 1983 and projected for 1984 alone equal the total of all other
U.S. trade deficits since the Colonial era.
There are a number of reasons why the U.S. foreign sector will not .show
improvement this year and in 1985 unless the deficit-bloated dollar shrinks
substantially.
First, economic growth in the United States will exceed
growth in both Japan and Europe, adding to the U.S. import flood.
The
International Monetary Fund, for example, is projecting a 1.7 percent real
GNP increase in West Germany during 1984 and 3.5 percent in Japan — nearly
two percentage points below the expected U.S. growth rate. Second, despite
some wage concessions, U.S. firms have not been noticeably successful in
trimming production costs to meet lower priced imports. U.S. goods and
services continue to be substantially overpriced compared to foreign goods.
Third, the dollar has remained surprisingly resilient on foreign exchange
markets. While declining 6-7.5 percent in value since January, the
deficit-bloated dollar has not collapsed despite a sagging domestic stock
market and staggering budget deficit /' projections.
Finally, as noted
above, the U.S. trade deficit typically deteriorates as recoveries mature.
Domestic firms turn away from foreign markets to sell in growing home
areas, and foreign firms become more aggressive in selling here, especially
if their own economic recoveries lag the U.S. recovery.
Taken together,
these factors led the Administration to project more than a $100 billion
trade deficit for 1984 and a $70 billion net foreign capital inflow. Other
projections go higher.
Underlying the sharp decline in the U.S. trade position is the striking
price disadvantage confronting U.S. exporters and import-competing firms.
Since 1979, for example, U.S. electrical machinery exports have risen 26
percent in price against competing Japanese and German products. The price
of non-electrical U.S. machinery exports has jumped 33 percent, and U.S.
transport equipment export prices are up 39 percent.
As prices rose,
export sales dropped.
Between 1981 and 1984, for example, U.S. exports
fell 13 percent or $37 billion.
The looming Federal deficits will worsen this picture of a foreign
sector depression in the midst of a domestic boom. With deficit-driven
11
real interest rates -rising, the dollar is projected to decline less than 10
percent on foreign exchange markets over the next five years. Imports are
projected to grow a startling 13 percent annually during the period 19841989, and the U.S. net export position will continue deteriorating.
The
net export position is the net of U.S. merchandise and service imports
and exports. It reflects both the price competitiveness of U.S. goods and
services in world markets and the stage of business cycles here and abroad.
Like the merchandise trade balance, this indicator should have shown
improvement as the economy recovered last year. Yet, it deteriorated
sharply in 1983 instead, declining to a deficit of $7.1 billion from a
surplus of over $17 billion in 1982. The impact of the budget deficits on
the dollar in foreign exchange markets simply overwhelmed conventional
cyclical factors influencing U.S. trade patterns.
That phenomenon is projected to continue. Indeed, by 1989, if thex
budget deficits are left unattended, the reeling foreign trade sector will
be a- much larger brake on economic growth than it is today. The U.S. net
export deficit is projected to climb steadily and reach an enormous $95
billion by then. The Department of Commerce estimates that each additional
$30,000 in merchandise exports produces one new job.
If a comparable
relationship exists for service sector exports, the 1983 net export deficit
due to the budget deficit cost the U.S. over 200,000 . jobs.
By 1989, if
left unattended, the budget deficit's- impact on foreign sector employment
will soar and cost the U.S. 3 million jobs. That job loss will come in
addition to the 1,200,000 jobs already lost in merchandise export-and basic
industries since 1982.
Savings Versus Consumption;
The unbalanced nature of the ongoing recovery will impose lopsided
burdens on the housing and foreign trade • sectors in the near and
intermediate term. In the longer term, however, the simulations conducted
for this analysis found that productivity will be seriously debilitated by
the deficits, as well.
The deficits are projected to act as a brake on
future economic expansion and U.S. competitiveness in world markets by
crippling savings and productivity-oriented investment.
Moreover, the
looming Federal deficits through 1989 will eliminate any gains in savings
or" investment which may have accrued from the Reagan Administration's
economic program implemented in 1981. As Dr. Feldstein noted in testimony
before the Joint Economic " Committee on November 8, 1983, "The primary
effect of large budget deficits is clearly to absorb savings and therefore
to reduce the rate of capital accumulation and the potential rate of
economic growth."
The diversion of scarce national savings to finance the ever-growing
projected Federal deficit reflects an implicit national decision to favor
current consumption over savings . Rather than permitting scarce domestic
savings to be available for new and more productive plant and equipment
investment, the Treasury will preempt a hefty and growing share of such
savings to finance deficits — the bulk of which is promptly converted to
consumption spending.
This conversion of scarce national savings to
current consumption by Federal deficits will continue to grow inexorably in
33-434
0 - 8 4 - 3
12
magnitude, reaching a projected $306 billion by 1989. These deficits will
become increasingly structural in nature, composed largely of interest
payments on the burgeoning national debt.
They are already of such
magnitude that net interest outlays this year will be nearly double the
entire Federal deficit for any year prior to 1982. And they are projected
to climb over 14 percent annually if no steps are taken to reduce the
deficit.
This massive diversion of savings to consumption will accelerate
in line with rising net interest payments for the balance of the decade.
It will occur regardless of interest rate levels and is unaffected by any
crowding-out phenomenon.
The impact of this diversion of scarce national savings to consumption
by the deficits is largely ignored in the current deficit debate
. In
part, this reflects the reality that the debilitating impact on savings and
investment of deficits is largely hidden and incremental in nature.
Moreover,
while
the impact of deficits on housing or exports' is
straightforward, their impact on savings and investment is less clearly
defined.
In addition, these effects are not immediate; they erode a
nation's economic structure and output only over an extended period of
years.
Supply Side Effects of the Economic.Recovery and Tax Act:
The
Reagan Administration rode a crest of rising Congressional
awareness with the productivity issue to success in gaining passage in 1981
of the
Economic Recovery and Tax Act (ERTA). By the late 1970's,
sufficient documentation had accumulated to
demonstrate
that
U.S.
investment and productivity growth was lagging well behind that of
international competitors such as Japan and
West
Germany.
These
differences transcended cyclical fluctuations.
They had reduced U.S.
flexibility to ease unemployment and absorb rising nominal incomes without
an increase in the pace of inflation. Indicators of savings and investment
displayed a mixed picture. . B u t f e w analysts now doubt that U.S.
investment levels were inadequate to match the sharp rise in labor force
growth experienced in the last decade.
Major components of ERTA were designed to enlarge the after-tax return
for savings and investment at the expense of consumption. The beneficial
effect of these incentives until recently has been negated by the cyclical
impact of the recession.
Only now can such benefits conceivably be
claimed.
For example, real capital spending is projected in 1984 to rise
for the first time since 1981. Even so, a good portion of that increase is
the result of cyclical factors, not ERTA. Productivity was suppressed, as
well, by the recession. It declined slightly in 1982 for the third time in
four years.
The recovering economy pulled productivity in the nonfarm
business sector up 3.1 percent for all of 1983, however, despite tailing
off badly in the fourth quarter.
The conversion of scarce savings to consumption by the Federal deficits
through the .balance of this decade will wipe out any imagined or real boost
to savings, investment or productivity from ERTA. Indeed, by creating a
sizeable mismatch between Federal outlays and receipts, ERTA must shoulder
13
much of the responsibility for the deficit outlook and for its related
failure to stimulate the economy's supply side. With hindsight, ERTA can
be viewed as excessively consumption oriented. Its savings and investmentoriented components were overwhelmed by the needlessly large pump-priming
consumption components.
The simulations evaluating the impact through 1989 of Federal deficits
due to ERTA reveal that they will cripple savings, investment and
productivity growth. Individual savings rates will be depressed below even
recent historically low levels.
The conversion of massive amounts of
savings to consumption by the deficit-financing mechanism will squeeze
U'.S. investment below the rate maintained even in the sputtering 1970's.
Moreover, productivity will decline and remain low throughout the balance
of the decade under the twin pressures of lagging private investment x and
sluggish growth. By 1989, the decade of the Eighties will be viewed as a
once in a lifetime spendthrift binge on borrowed credit, with growing debts
accumulated at the expense of a sharply deteriorating national economic
base.
Savings:
As depicted in Table IV, U.S. savings h^s-historically lagged behind
other major industrial nations. Indeed, the U.S. devotes a smaller share
of national output to savings than any other major industrial country. At
the other end of the spectrum, for example, about one iri' every three
dollars of Gross Domestic Product (GDP) in Japan has historically been
withheld from current consumption and made available as savings for
investment in new production facilities, equipment and housing. The U.S.
has traditionally saved less than one in five dollars of GDP.
Table IV
Gross Saving as Share of Gross Domestic Product (%)
United States
Japan
Germany
France
United Kingdom
Italy
Canada
Source: OECD Economic Outlook.
1962
18.9
34.8
27.3
24.6
16.9
26.0
20.8
1970
18.1
40.2
28.1
26.2
• 21.5
24.2
21.1
1978
20.3
32.3
22.8
22.6
19.4
22.4
20.1
1982
15.9
31.6
21.5
18.5
16.9
18.8
18.0
14
Critical to the maintenance of even this relatively low savings rate
was the tendency of individuals to save around 7 percent of their
disposable income. From 1951 to 1981, for example, an average 6.9 percent
of such income was saved, as shown in Table V. Only in recession years
like 1982 did the rate drop sharply as individuals struggled to maintain
living standards. Even during the latter half of the 1970's as inflation
eroded savings incentives, individuals nearly maintained their historic
savings rate.The simulations conducted for this analysis found that the
projected rate of individual savings will fall below historic recession
levels into the foreseeable future if budget deficits are left unattended.
On average as a share of personal disposable income, the individual savings
rate is projected to fall over 20 percent to 5.4 percent of disposable
income over the period 1984 to 1989 from the postwar average rate of 6.9
percent.
Table V
Savings Rate
1951-1989
Period
1951-1960
1961-1970
1971-1980
1970-1974
1975-1981
1951-1981
1982
Simulation (1984*1989)
1/
Savings 1/
6.8
6.8
7.1
7.9
6.6
6.9
5.8
, 5.4
Individual Savings as a Share of Personal Disposable Income (percent).
Source:
Economic Report of the President, February, 1984.
Investment:
The historically lagging U'.S. savings experience is paralleled by
relatively low investment levels. The United States invests a smaller
share of its national output than its major trading partners. As noted in
Table VI, for example, the five other largest OECD nations devoted a larger
share of GDP during the last decade to investments in plant, equipment,
inventories and housing. Indeed, Japan invested a 75 percent larger share
of GDP than did the U.S.
15
Table VII
Capital Formation in Major OECD Countries
1971-1980
Investment as percent of GDP
Country
Gross
investment
France
Germany
Italy
Japan
United Kingdom
United States
24.2
23.7
22.4
34.0
19.2
19.1-
Gross fixed
investmentl/
22.9
22.8
20.1
32.9
18.7
18.4
"Growth Rate
of output
per hour in
manufacturing
4 8
4.9
4.9
7.4
2.9
2.5
1/ Gross investment less inventories.
Source: Organization for Economic Cooperation and'Development and
Economic Report of the President, February, 1983, p. 81.
Investment in new, more efficient plant and equipment is one of the
major factors forcefully and directly influencing productivity growth. The
lagging U.S. productivity performance in manufacturing during the last
decade noted in Table VI reflects the poor U.S. record of such investment.
Particularly in the latter half of the 1970's, limp U.S. investment rates
barely kept pace with labor force growth. During the 1950's, for example,
net capital stock per U.S. worker rose an average 3.3 percent annually. In
the 1960's, it averaged 3.2 percent. Yet, from 1971 to 1975, it slumped to
a 2.2 percent annual growth rate. And from 1976 to 1980, it collapsed,
rising a scant 0.4 percent annually.
U.S. productivity reflected that
sluggish investment performance almost immediately. With only marginally
more capital per worker available year after year, U.S. productivity growth
shrank. Indeed, it actually declined in three of the four years beginning
in 1979, before rebounding in its usual pattern last year during the
recovery.
U.S. investment outlays devoted to plant and equipment (nonresidential
fixed investment) comprise slightly over fifty-five percent of all gross
U.S. investment. As noted in Table VII, they averaged 11.7 percent of GNP
from 1978 to 1982 when our productivity collapse occurred. Simulations
conducted for this analysis project that the prospective deficits will
force vital U.S. investment spending on key plant and equipment below even
the inadequate levels maintained then. They will slump to a projected 11.4
percent of GNP from 1983 to 1988.
16
Table VII
Gross Private U.S. Nonresidential Fixed
(Plant and Equipment) Investment
1978-1988
Year
1978
1979
1980
1981
1982
1978-82
Simulation
(1983-88)
Source:
Share of GNP (%)
11.5
12.0
11.7
11.8
11.3
11.7
11.4
Economic Report of the President, February, 1984 and
Joint Economic Corrmittee Simulations.'
The decline, in U.S. investment activity due to the looming deficits
appears modest. Yet, the cumulative impact by the end of this decade, will
be enormous.
For example, by 1989, the U.S. will have spent $59 billion
less on vital new plant and equipment than had such outlays at least
matched the average GNP share of such outlays in recent years. The impact
of this modest decline in an already weak investment picture is reflected
in projected productivity figures. >
Productivity:
Productivity is the fulcrum upon which rising living standards hinge.
There is a broad and on-going debate among analysts regarding the major
determinants of productivity growth. A bewildering variety of factors
influence productivity, including labor force growth, labor force age,
training, attitude and composition, government regulations, the business
cycle, international exchange rates, the level of input prices like energy
or capital, R&D spending and results, incentives for entrepreneurial
activity, technical innovation
and
dissimination,
the degree
of
competition, management incentives and capability and others. Investment
is among the more important determinants and may be the single most
important factor. Certainly the failure of plant and equipment investment
to offset labor force changes, government regulations and the impact of
rising energy prices is a dominant factor in the recent U.S. productivity
slump. In addition to lending an inflationary bias, lagging productivity
inevitably yields a smaller increase in real per capita income. Indeed,
17
increases in any society1 s real per capita GNP over time come from an
improved net real export position or increasing productivity. By crippling
both U.S. trade and productivity growth, Federal deficits will have a major
enduring negative impact on national income growth in the United States for
many years to come.
U.S. productivity growth has lagged productivity growth in our major
trading competitors since World War II. As presented in Table VIII,
U.S.
productivity has grown only one-fourth as fast as Japanese productivity
since 1950, for example. Moreover, the trend of U.S. productivity growth
in the postwar period has been a declining one. From 1950 to 1965, real
U.S. GDP per worker grew an average 2.4 percent annually. That growth rate
eased to an average 1.6 percent annually from 1965 to 1973 before plunging
to less than one-half of one percent annually over the 1973-1978 period.^
Table VIII
Productivity Measures for Various Countries
1950-1978
Average annual percentage change in productivity17^
1950-65
Japan
West Germany
Italy
France
Canada
United Kingdom
United States
1/
7.2
5.2
5.1
4.7
2.7
2.2
2.4
1965-73
9.1
4.3
5.6
4.5
2.3
3.3
1.6
1973-78
3.1
3.2
1.3
2.8
.8
.9
.4
1950-78
7.0
4.6
4.5
4.3
2.3
2.3
1.8
Measured by growth in real domestic product per employed person,
using own country's price weights.
Source: Bureau of Labor Statistics.
18
A similar pattern is found using the more closely followed indicator of
nonfarm business sector output per hour. As displayed in Table IX, U.S.
average annual productivity growth has stagnated in recent years, after
averaging above two percent during the 1950's and 1960's.
Productivity
jumped during 1983 in the typical pattern for postwar recoveries. Even so,
the 1983 performance raised more questions about the
future
U.S.
productivity trend than it put to rest. The 1983 gain of 3.1 percent in
the nonfarm business sector is a limited one, well below the 4.9 percent
rate averaged during the first year of all other postwar economic
recoveries. Moreover, the already high and projected rising level of real
interest rates due to growing deficits threatens to sharply limit the
current recovery in productivity. After climbing at an annual rate of 7.1
percent in 1983:2, for example, output per hour rose at much smaller rates
of 2.3 percent and .9 percent in 1983:3 and 1983:4,'
Table IX
U.S. Productivity Growth
1950-1989
Period
Growth in
Output per hour (all persons) 1/
1950-1960
1961-1970
1971-1977
1978-1982
1983
Simulation,' 1985-1989:*
2.3
2.4
2.0
0.0
3.1
1.8
1/ Annual average (%), Nonfarm Business Sector.
Source:
Economic Report of the President, February, 1984,
Economic Indicators, Council of Economic Advisers
(various months)and Joint Economic Committee Simulations.
As sensitivity to the productivity peril posed by Federal deficits has
grown, even projections by the Administration of future productivity growth
have been scaled back.
In the January, 1982 Economic Report of the
President, for example, the Council of Economic Advisers projected a
handsome 2.6 percent annual productivity increase for the economy through
1988. Yet, the most recent February, 1984 Economic Report of the President
reduced that projection quite sharply to 1 percent or less by 1988 in light
of the burgeoning budget deficits.
19
The outlook for U.S. productivity created by the enormous prospective
budget deficits has received scant attention.
Yet, the
increasing
diversion of national savings to finance the deficits are projected to have
a direct and major negative impact on future productivity. In turn, that
will have a marked impact on U.S.economic competitiveness, GNP and income.
By slashing savings flows, slowing growth, and raising real interest rates,
the deficits are projected to suppress future productivity growth below
historic levels. Indeed, it will be pushed down even below the weak levels
maintained for most of the last decade. The simulations conducted for this
analysis project that U.S. nonfarm business sector productivity will grow
only an average 1.8 percent per year from 1985 to 1989. This rate is a
scant 75 percent of the productivity growth rate attained from 1950 to 1970
noted in Table IX. It compares favorably only with the disastrous 19781982 period when no productivity growth occurred.
The future for America under the weak projected 1.8 percent annual
productivity growth rate compares poorly with a future featuring the 2.35
percent rate attained from. 1950 to 1970.
For example, by 1994, U.S.
productivity will be 5.7 percent less if growth at the lower projected rate
The lower
occurs instead of at the historic 2.35 percent average rate.
productivity growth rate will reduce nominal GNP a decade hence by a
projected $500 billion — or a loss of output equal to $2,000 in 1994 for
every man, woman and child.
CHAPTER II
Economic Impact. ot_ the Administration Deficit Reduction Proposal
In mid-March, the Administration presented a revised budget proposal
containing a $150 billion nominal reduction in the FY85-87 deficits.
This
chapter evaluates the economic impact of that proposal through 1989. It
concludes with a brief evaluation of the impact of a larger deficit
reduction package, as well.
Deficit Reduction and Slower Growth:
As the simulations discussed in Chapter I make clear, inaction on the
budget deficit will reduce the historic share of' U.S. resources being
withheld from consumption and devoted to investment. Future growth and
investment will be sluggish. The economy for the balance of the decade
will compare unfavorably even with the mediocre 1970's.
White House and congressional action to reduce future deficits may not
redress this consumption bias and improve future growth and living standard
prospects.
By increasing taxes and reducing government spending, deficitreduction plans create fiscal drag which will magnify the projected
economic slowdown.
This slowdown can be avoided by deficit reduction
packages which substantially reduce the deficits, thereby easing credit
markets and lowering interest rates promptly. The major risk is that a
deficit-reduction package will not lower interest rates sufficiently to
avoid an economic'slowdown. By attacking deficits meekly, modest proposals
may simply slow economic growth while their small size proves inadequate to
reverse the rising deficit trend. The magnitude of the Administration's
March proposal falls into this category.
The • econometric simulations utilized here are modifications of the DRI
current services budget baseline. Trie Administration's March proposal was
presented in terms of the February budget proposal, rather than on a
current services budget basis. Restating the March proposal on a current
services budget basis resulted in three modifications. First, it was
necessary to recast the proposed Administration defense outlays reductions
covering Fiscal Years 1985-1987.
The Administration's February budget
proposal projected defense outlays over FY85-FY87 of $931 billion, as noted
in Table X. The Administration's March proposal reviewed here reduced that
spending stream by $40 billion to
$891 billion.
However, the DRI
simulations utilized in this analysis are on a current services budget
baseline, not the February Administration proposed spending levels.
Compared to the CBO current services budget baseline, the Administration's
March defense outlay stream over FY85-FY87 is slightly higher (by $4
billion), not lower by $40 billion.
The second necessary modification was to adjust Federal debt service
outlays to reflect the Administration's deficit reduction
proposal.
Initially, the Administration claimed savings of $18 billion over FY85-87.
The recasting of defense outlays reduces this savings to $12 billion on a
current services basis. Thus, the total nominal deficit-reduction package
(20)
21
proposed in March on a current services budget basis totals $100 billion,
not
$150 billion. In evaluating the March Administration proposal,
therefore, a nominal deficit reduction, package of $100 billion was utilized
for compatibility with the simulations conducted for this analysis.
Table X
National Defense Outlays
Fiscal 1985-1987
(Billions of Dollars)
Current Services, CBO Baseline 1/
Administration February Proposal
Administration March Proposal
Defense Reduction:
Compared to CBO Baseline
Compared to February Proposal:
1985
1986
1987
Total
263
272
266
295
311
295
329
348
330
887
931
891
+1
-18
+4
-40
+3
-6
. -0- .
-16
. 1/ Assumes five percent real increase' in outlays annually.
Sources: CBO, "An Analysis of the President's Budgetary Proposals for
Fiscal~^ear 1985" (February, 1984); Administration Fact
Sheet for March $150 Billion Downpayment(March,1984).
Administration Economic Assumptions:
The third modification was to eschew use of the Administration's
economic assumptions and projections in evaluating its March proposal-. The
Administration's. FY85 budget submissions in February contained both
economic and budget projections covering the period 1984 to 1989.
The
economic outlook projected by these variables is rosy. While only a token
effort to reduce deficits is proposed, the variables nevertheless depict an
economy enjoying 4 percent annual real growth accompanied by gradually
easing unemployment. The GNP price deflator, is projected settling to a
scant 3.5 percent by 1989. Moreover, the 91-day T-bill rate is presumed to
subside along with inflation, falling over 30 percent to 5.0 percent by
1989 from an average 8.6 percent last year.
While the 1984 and 1985 economic variables are considered forecasts in
the budget documents, out-year
variables - are
assumptions.
These
assumptions bear
no
explicit
relationship to actual or proposed
Administration economic policy, nor are they the fruit of' econometric
22
simulations.
The particular values are said by the Administration to
reflect historical experience, even though current deficits are without
historic
precedent.
Consequently,
they represent little more than
subjective and arbitrary point estimates designed to depict the future in a
particular economic light.
Despite ' their capricious nature, these variables form the foundation
for the Administration deficit projections presented in the Fiscal Year
1985 budget and March deficit reduction proposal. The Administration's
March proposal is a package of spending reductions, reduced debt service
interest costs and tax increases. When compared to current services budget
estimates, it has already been not©3 that the package yields a nominal $100
billion reduction in the projected FY85-87 current services budget deficit.
This represents a reduction of about 14 percent in the projected status quo
current services $707 billion deficit over that three-year period. Based
on its rosy economic assumptions, this package
is
said
by
the
Administration to result in sharply smaller deficits as the decade matures.
That assertion is incorrect and
projections are flawed for two reasons.
the underlying optimistic deficit
First, as just noted, the deficit projections are based on artfully
rosy economic assumptions without empirical or theoretical foundation.
These assumptions do not reflect a likely or even a reasonable scenario for
the balance of this decade in light of the prospective deficits.
Nor - are
they the result of deliberate and careful econometric analyses. Indeed,
they are at variance with all forecasts of such variables, including the
results
noted in Chapter I, and the consensus Blue Chip Economic
Indicators. As noted in Table XI, for example, a recent Blue Chip Economic
Indicators survey contained a consensus estimate that real GNP would grow
-1.7 percent in 1986. The Administration estimate for 1986 was 4 percent,
or 130 percent faster.
Second, the methodology utilized in projecting the magnitude of future
deficits is specious. The Administration's FY85 budget document notes
that:
Budget receipts and outlays depend directly on the level
of economic activity,
inflation,
interest
rates,
unemployment, and other economic factors. Likewise,
both budget outlays and the
tax
structure " have
substantial effects on the state of the economy —
output, employment, and interest rates.1/
1/ Budget in Brief, Fiscal Year 1985 Federal Budget, p.12.
23
Table VII
Administration and Consensus Blue Chip
Economic Projections
1986-1987
1986
1987
Real GNP Growth (%)
Administration:
Blue Chip:
4.0
1.7
4.0
3.2
Consumer Price Index (%)
Admfni strati on:
Blue Chip:
4.5
6.5
4.2
5.7
Short-Term Interest Rate (%) 1/
Administration:
Blue Chip:
7.1
9.2
6.2 '
8.5
Long-Term Interest Rate (%) 2/
Administration:
Blue Chip:
8.6
10.9
7.2
10.2
8.9
2.8
11.6
9.6
Corporate Profit Growth (%)
Administration:
Blue Chip:
1/ 3-month Treasury Bills.
2/ 10-Year Treasury Notes.
Sources:
Economic Report of the President, February, 1984,
and Blue Chip Economic Indicators (March 10, 1984) .
The relationship between budgets and the economy is indeed a two-way
interaction. Yet, the Administration's deficit projections blandly assume
it is but a one-way street. Economic variables such as interest rates
affect the budget, but budget deficits do affect these same economic
variables.
The budget projects economic variables through 1989 in static
terms without reference to the dynamic impact on them of relevant Federal
budgets.
The variables, especially interest rates, simply do not reflect
the impact of the enormous looming deficits.
The resulting set of Administration budget projections, economic
forecasts and assumptions are of little use in assessing economic policy.
24
Of more significance for this analysis, they are useless as a baseline for
evaluating the economic impact of prospective Federal deficits.
Instead,
the DRI annual econometric model using the current services budget baseline
was utilized to evaluate the deficit's impact on savings, investment and
productivity through 1989.
Administration Program Simulation:
Adjustments in the timing of the Administration's March proposal were
made to reflect the calendar year basis of the DRI model.
An Ml growth
rate in the top half of the Federal Reserve Board's 83:4-84:4 target range
was assumed to persist through 1989.
The Administration's budget projected robust growth accompanied by
falling interest rates and low inflation for the balance of this decade.
That would represent a noteworthy improvement over the projected economic
impact, reviewed, in Chapter I, should no steps be taken to reduce the
deficit.
However, the Administration's economic scenario through 1989
could not be confirmed nor even replicated using the DRI annual econometric
model.
Instead, the simulations evaluating the March proposal projected a
continued robust recovery this year with real GNP rising over 5 percent,
compared to 3.3 percent in 1983. However, rising interest rates this year
and continuing high interest rates in the future are projected to yield
sharply lower economic growth after 1985. Indeed, as summarized in Table
XII, the economy is projected to fare* little
better
under
the
Administration's proposal than it would should no action at all occur to
ease the rising deficit trend for the balance of the decade.
Real -growth
is
projected
to be virtually the same, for example, because the
Administration's proposal is too meek to substantially ease interest rates
or relieve the sagging foreign trade sector.
25
Table VII
Economic Indicators
1985-1989
1985-1989 Annual Average
Economic Growth (%)
No Action
Administration March proposal
3.3
3.3
Unemployment Rate (1989 average) (%)
No Action
Administration March proposal
7.0
6.9
Gross Nonresidential Investment (billion dollars)
No Action
Administration March proposal
Gross Nonresidential Fixed Investment (billion dollars)
No Action
Administration March proposal
Source:
594
608
551
565
Joint Economic Committfee Simulations.
Savings and Investment:
The economic simulations'of the Administration's March proposal found
that it will only marginally improve the U.S. investment outlook expected
if no action is taken to reduce deficits through 1989. The combination of
high real .interest rates and sluggish GNP will limit gross private
nonresidential investment growth. As shown in Table XII, such investment
outlays by business will only average $14 billion more annually over 19851989 than they would if no steps are taken to reduce the deficits. And,
key gross plant and equipment (nonresidential fixed) investment under the
Administration's program averages only $14 billion higher than if the
in
deficits are left unattended.
That
weak
investment • prospect
productivity-enhancing plant and equipment is magnified by comparison to
the patterns of gross private nonresidential fixed investment which existed
during the 1970's and early 1980's investment crunch. As a share of GNP,
gross investment in new plant and equipment averaged 11.7 percent during
that sluggish period, as noted in Chapter I. The economic simulations
evaluating the impact of the Administration's March proposal indicate that
it will not improve on this mediocre record.
. The impact on savings of the Administration's March proposal is less
than robust, as well. As*noted in Table XIII, the personal savings rate is
26
projected to average 5.3 percent of disposable personal income for 19851989, well below the post-war average. The savings rate projected to occur
with the Administration's March proposal is slightly less than projected
should no action be taken of any type to reduce deficits, as well.
This
lower savings rate will severely limit the flow of investable funds to
capital markets through 1989, and is the mirror image of the weak
investment, outlook.
The projected savings rate of 5.3 is 1.6 percentage
points below the post-war individual savings rate. Over the period 1985 to
1989, this 1.6 percentage point difference will produce $260 billion less
in personal savings than had the historic rate b^en maintained.
That
foregone savings is nearly twice the total annual current level of personal
savings.
Table XIII
Savings and Productivity
1961-1989
Rate
Savings 1/
1961-1970
1971-1980
1951-1981
Administration Proposal Simulation (1985-1989)
No Action Simulation (1984-1989)
Productivity 2/
6.8
7.1
6.9
5.3
5.4
/
1961-1970
1971-1977
Administration Proposal Simulation (1985-1989)
No Action Simulation (1985-1989)
2.4
2.0
1.8
1.8
1/ As share of personal disposable income (%).
2/ Growth in output per hour nonfarm business sector (%).
Source:
Economic Report of the President, February,- 1984,
and Joint Economic Conmittee Simulations.
27
Productivity and -the Deficit:
The
projected
productivity.
performance
generated
by
the
Administration's March proposal is weak.
Weakening growth and
the
continuation of interest rates at high levels through 1989 will limit U.S.
productivity growth. Indeed, the simulations project that it will average
a meek 1.8 percent a year from 1985 to 1989. That projection is below the
rate maintained during most of the last
decade
(1971-1977)
when
productivity growth averaged 2.0 percent annually. And it is well below
the 2.4 percent growth averaged during .the decade of the 1960's.
The
Administration's March proposal will not reverse the declining U.S.
productivity trend. . Moreover, it will produce the same weak productivity
performance which is projected to occur if the deficits are simply left
unattended by the Administration and Congress.
Because of this meek
projected productivity performance, GNP and personal income growth under
the Administration's March proposal will lag well behind growth rates
scored in the 1960's and 1970's. The result of this lagging productivity
performance will be smaller output in the future and substantial foregone
income.
For example, U.S. GNP will be 3.1 percent lower in 1989 "than it
would be if productivity grew at the 2.4 percent annual rate of the 1960's
instead of the lower rate associated with the Administration's proposal.
Three and one-tenth percent is small. But, with -GNP projected _ to reach
$5.6 trillion by then, it represents a loss of $170 billion in national
output, or over $650 for every man, woman and child.
And, over the
entire 1985-1989 period, the lagging productivity performance will slash
GNP by a cumulative $448 billion —
an enormous national income loss
comparable to $1,700 per person.'
The budget outlook is no better. The Administration's March proposal
is a reduction in the FY1985-1987 current services baseline deficits of
$100
billion
in
static
terms and $150 billion compared to the
Administration's FY85 budget. Yet, the dynamic impact of continuing high
interest rates and slower growth limit this proposal's progress against
deficits. The Administration's March deficit proposal will yield lower
productivity growth and less savings than attained by this Nation in the
previous decade. Government debt-servicing costs will continue their pellmell upward pace.
The result is a deficit standoff as Table XIV notes,
"with out-year deficits remaining at current levels. The inability - of the
Administration.'s March proposal to reverse the deficit trend is magnified
by the robust monetary policy utilized in the simulations.
As noted
earlier, Ml growth over the 1984-1989 period was assumed to average in the
top half of the present Federal Reserve Board's Ml target range of 4-8
percent over the 1984-1989 period. The Federal Reserve Board was assumed
to passively accomodate the recovery and avoid overt steps to boost
interest rates and slow inflation.
28
Table VII
Budget Outlook
(Billion Dollars)
1985-1989
1985
1986
1987
1988
1989
Budget Deficit
No Action:
Administration Proposal
209
175
231
173
267
187
282
176
306
176
Net Interest Payment
No Action:
Administration Proposal
137
127
159
137
184
150
210
161
237
170
Source:
Joint Economic Committee simulations.
A Deficit-Reduction Growth Path
When examined in a dynamic context, the Administration's March deficitreduction proposal is too modest to reduce federal deficits.
The fiscal
drag created by this program is not offset by sufficiently lower interest
rates due to its small size. Consequently, economic growth and government
receipts slow, weakening its nominal impact on the deficits. Government
debt service costs continue rising- sharply, further weakening progress
against the deficits.
^
This discouraging finding emphasizes that a larger deficit reduction
package than proposed in March by the Administration is required to ensure
a declining future deficit trend. Indeed, the only certain path to reduced
deficits is a larger deficit reduction package accompanied by continuation
of the monetary policy pace maintained "in 83:3 and 83:4.
Without
continuation of that moderately growth-oriented monetary policy, all
efforts to shrink the deficit will impose excessive fiscal drag and may not
improve the deficit outlook.
The critical role of a growth-oriented monetary policy in offsetting
the fiscal drag of deficit-reduction proposals is not surprising.
ERTA
added a net fiscal stimulus to the economy of some $50 billion in Fiscal
Year 1983. Yet, the switch to an expansionary monetary policy, in mid-1982
played the key role in generating the 1983-1984 recovery. Indeed, the
present expansion can aptly be termed a Federal Reserve Recovery.
The
monetary aggregate Ml, for example, soared 13.4 percent from July, 1982 to
July, 1983, well over double its prior growth rate.
Short-term interest
rates fell 33 percent or over four percentage points between July and
29
October, 1982 as a-consequence, and long-term rates fell almost as .far.
Interest-sensitive industries like housing and autos gradually rebuilt
strength and by 83:1, real GNP was rising and the recovery was underway.
The Federal Reserve Board reduced the economy's inflationary potential
associated with the recovery when it slowed monetary growth in the summer
of 1983.
That potential has increased in probability since then, due to
the surprisingly robust recovery. Thus far, the Federal Reserve Board
remains resolved not to monetize the debt and rekindle inflation, although
its resolve to permit growth to continue apace may be eroding.
A genuinely declining deficit trend requires a major reversal in fiscal
policy and steely Federal Reserve Board resolve to maintain the present
moderately expansionary monetary policy. The simulations conducted for
this analysis indicate that the requisite fiscal policy is a deficitreduction package about 50 percent larger than the $100 billion currerit
services deficit reduction proposed by the Administration in March. Such a
fiscal package was evaluated in conjunction with an Ml growth rate in the
top half of the Federal Reserve Board's current target range of 4-8 percent
(83:4-84:4). The fiscal component of this package represents a $200 billion
nominal deficit reduction compared to the Administration's FY85 budget
projections presented in February. This package is comparable in magnitude
to that proposed recently by the Senate Democrats and the Joint Economic
Committee Democratic Members.
The easing in Treasury credit demands created by this- package is
projected to reduce real interest rates sharply. By 1989, they will be
over 3 percentage points lower than current levels, or those levels
projected to exist with the Administration's proposal.
This easing of
interest rates enables the recovery to continue at a robust pace, and the
projected annual real GNP growth rate for the balance of the decade
averages 4.1 percent compared to 3.3 percent over the same period under
the Administration's proposal. Interest-sensitive industries like housing
are projected to do better with this policy combination because of the more
robust recovery than if no action on the deficit occurs or under the
Administration's proposal.
Exports are projected to be higher, as well,
than projected in the other simulations and will grow more than 7 percent
annually on average after inflation. Moreover, the GNP deflator will rise a
projected moderate average 5.5 percent through 1989.
The substantially reoriented Federal posture associated with this
policy combination'and ensuing continued robust recovery are projected to
restore fiscal equilibrium. Tax receipt growth will exceed the growth in
net interest outlays. As a result, by 1987, the deficit will be $100
billion below the level projected for that year should no action occur on
the deficit. By 1989, as noted in Table XV, the deficit will be a
projected $82 billion, only half the size of the deficit under the
Administration's proposal,
and on a clearly
downward trend.
The
cumulative 1985-1989 deficits will shrink by $593 billion as a result of
this policy combination compared to deficits projected over that period if
no action is taken to reduce deficits. Moreover, they will be $185 billion
less.than projected for the Administration's proposal. And, in combination
with the projected lower interest rates, net government interest payments
30
will be $241 billion less over the 1985-1989 period than projected in- the
no-action
simulation, and $59 billion less than projected for the
Administration's proposal.
Table XV
Budget Outlook
(Billion Dollars)
1985
1986
Budget Deficit
No Action:
Administration Proposal:
Deficit Reduction:
209
175
170
231
173
167
267 - 282
176
187
122
161
306
176
82
Net Interest Payments
No Action:
Administration Proposal:
Deficit Reduction:
137
127
120
159
137
130
184150
142
210
161
148
237
170
146
Source:
Joint Economic Committee Simulations.
o
1987
1988 1989
@FedFRASER