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/l q I
SEN ATE

100m CONGR

1St Session

REPORT
100-11

THE 1987
JOINT ECONOMIC REPORT

REPORT
OF THE

JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
ON THE

JANUARY 1987 ECONOMIC REPORT
OF THE PRESIDENT
TOGETHER WITH

MINORITY, ADDITIONAL, AND DISSENTING VIEWS

MARCH 5, 1987.-Ordered to be printed
Filed, under authority of the order of the Senate of March 3, 1987

U.S. GOVERNMENT PRINTING OFFICE
69-874

WASHINGTON: 1987

JOINT ECONOMIC COMMENCE
[Created pursuant to Sec. 5(a) of Pubic Law 304, 79th Cong.]
PAUL S. SARBANES, Maryland, Chairman
LEE H. HAMILTON, Indiana, Vice Chairman
SENATE

WILLIAM PROXMIRE, Wisconsin
LLOYD BENTSEN, Texas
EDWARD M. KENNEDY, Massachusetts
JOHN MELCHER, Montana

HOUSE OF REPRESENTATIVES
AUGUSTUS F. HAWKINS, California

DAVID R. OBEY, Wisconsin

JAMES H. SCHEUER, New York
FORTNEY H. (PETE) STARK, California
JEFF BINGAMAN, New Mexico
STEPHEN J. SOLARZ, New York
WILLIAM V. ROTH, JR., Delaware
CHALMERS P. WYLIE, Ohio
STEVEN D. SYMMS, Idaho
OLYMPIA J. SNOWE, Maine
ALFONSE M. D'AMATO, New York
HAMILTON FISH, Ja., New York
PETE WILSON, California
J. ALEX McMILLAN HI, North Carolina
JuDITH DAVISON, Executive Director
RicHmam F. KAuFUAN, General Counsel
STEPHzN QuIcK, Chief Economist
RoBsaT J. ToeraauD, Minority Assistant Director
(II)

LEITER OF TRANSMITTAL

MARCH 5, 1987.
Hon. ROBERT C. BYRD,
Majority Leader, US. Senate,
Washington, DC.
DEAR MR. LEADER: Pursuant to the requirements of the Employment Act of 1946, as amended, I hereby transmit the Report of the
Joint Economic Committee. The analyses and conclusions of this
Report are to assist the several committees of the Congress and its
Members as they deal with economic issues and legislation pertaining thereto.
Sincerely,
PAUL S. SARBANES, Chairman.
(III)

CHAIRMAN'S INTRODUCTION
The Annual Report of the Joint Economic Committee for 1987
surveys a $3.7 trillion economy whose tranquil appearance obscures
the danger signals that lie just below the surface. 1986 GNP
growth, at 2.5 percent, has been described variously as "sluggish"
or "moderate"-not indicative of a sharp downward trend from the
previous year's 2.7 percent but not indicative of a health expansion, either. The unemployment rate declined very marginally to 7
percent from 7.1 percent the previous year-in the process falling
below 7.1 percent only for the first time since 1980. By year's end,
there were signs that the declining value of the dollar might make
U.S. products somewhat more competitive in world markets-but
the January trade figures reinforced the widespread assessment
that the largest trade deficit in U.S. history was not likely to be
turned around in the near future. Inflation fell in 1986 to 1.1 percent, the lowest level in 25 years, on the strength of a sharp fall in
oil prices-but the Consumer Price Index surged to 0.7 percent in
January alone.
The international economy also appeared tranquil-on the surface. The serious strains created by misaligned foreign exchange
rates in the industrial world were alleviated somewhat by the
Paris agreement in February on currency exchange rates, but a
satisfactory resolution cannot be assumed. A major default did not
occur among the Third World debtor countries, but the continuing
problems in assembling the loan package for Mexico and the announcement by Brazil that it would not be able to meet its debt
service obligations indicate that a new stage in the debt crisis could
be imminent.
A close inspection of the economy reveals that the current recovery, while long, is fragile, and we are skating on thin ice. This
Report sets out warning signs wherever they are warranted.
For example, the slow growth of the past year has been sustained almost exclusively by consumption. Investment has weakened significantly and the current pattern is unlikely to be reversed in the near future, given the recent revision in the tax laws,
the substantial excess capacity in manufacturing, fierce interna- tional competition, and sluggish corporate profitability.
While consumption has been the spur to economic activity, consumption has been sustained to an extraordinary degree by debt.
Households, the Federal Government, and corporations all have
taken on debt at record rates in the last few years-households in
part because income growth has remained disappointingly low and
unemployment stubbornly high. Real wages for production workers
have continued to stagnate, and the number of workers wanting
full-time work but forced to accept part-time work instead has remained at very high levels.
(V)

The rapid expansion of borrowing by all sectors has significantly
increased their financial vulnerability in the event of a future
downturn. Thus far we have weathered the problems for financial
institutions brought about by excessive borrowing, but the urgent
requests for rescue packages for both the Federal Savings and Loan
Insurance Corporation (FSLIC) and the Farm Credit System underscore the vulnerability of our financial system.
A similar vulnerability is evident in the world economy. World
economic growth has been heavily dependent upon the United
States' running a large trade deficit, and the prospect of a decline
in that deficit sends shock waves through the economies of major
exporters. The Third World debt problem reached such proportions
that even an Administration once disposed to ignore it came forward in late 1985 with a major policy initiative. While an important recognition of the problem, this initiative does not appear adequate to the task of reducing the financial crisis in the developing
world to manageable proportions. Recent developments, with
debtor countries unilaterally limiting interest payments, declaring
themselves unable to pay interest, and breaking off debt negotiations with the banks, are clear signals of a renewed crisis.
Even in the area of inflation, where the surface indicators have
been positive, there are signs of increasing pressure. The Nation
has allowed dependence on foreign oil to rise at an alarming rate,
exposing the economy to potential future price shocks. The Nation
has also relied on the strong dollar and low import prices to help
hold down domestic prices, a pattern now being reversed. The
sharp jump in the inflation rate in January, while only for one
month, is out of line with predictions of a modest increase in inflation in 1987.
In the agricultural sector, once the pride of the Nation and the
world, depression-level conditions prevail with little hope of an imminent turnaround.
The potential for disruption in the economy is magnified by the
limited range of economic policy tools available to combat any
future downturn. The current recovery has been considerably
longer than the average for the postwar period and is unlikely to
continue indefinitely. At present there are no obvious signs of recession, but a review of past business cycles shows that obvious
signs of recession were not generally visible beforehand.
When the next cyclical downturn arrives, the tools available to
deal with it will be few and limited. The flexibility of the traditional tools of macroeconomic policy, fscal policy, and monetary policy
has been severely curtailed by the economic policies of recent
years. Countercyclical fiscal policy is jeopardized by the enormous
structural budget deficits that have actually risen as the economy
has come back from the recession, rather than declining as occurred in the past.
Furthermore, the Administration's priorities have not recognized
that American's future economic strength depends upon willingness to make prudent investments in a number of pivotal areas,
among them education, training and retraining, health, research
and development, and physical infrastructure. Failure to do so only
sets America back in the effort to build a more prosperous and
competitive economy.

VII

Monetary policy is severely constrained by the extraordinary
trade deficits of the past several years. Because the United States
is now dependent on foreign borrowing to meet its capital requirements, the need to defend the exchange value of the dollar, rather
than responding to demand and output growth in the domestic
economy, could become the paramount factor in setting monetary
policy. Policies designed to address pressures on the dollar abroad
could mean rising interest rates, with severe consequences for the
domestic economy.
This Report provides a review of both the short-term and the
long-term outlook for the U.S. economy. It explores a number of
problems which have developed below the surface of our economy,
and the changes in the world economy in which the United States
must compete. Facing these challenges realistically is essential to
the future health of our economy, on which our national strength
both at home and abroad inevitably depends.

CONTENTS
Page

I. Economic Performance and P rospects ..........................................................
1
A. The Recent Past .
.........................................................
.
1
B. What Lies Ahead .
.........................................................
.
35
1. The Short-Term Outlook ..........................................................
35
2. The Longer Term Outlook ..........................................................
37
H. The Challenges
.
.
.
43
A. The Domestic Dimension ..........................................................
43
B. The International Economic Environment .
...................................................
51
1. U.S. International Trade ........................................................
51
a. Trade Patterns Since 1980 .
....................................................... 52
b. Trade In 1986
.
.
............................... 52
c. Barriers to Trade .........................................................
54
d. Trade Law Enforcement .
....................................................... 55
e. Future Trade Policy ........................................................
58
f. Effects of the Trade Deficit on Growth .
............................................
58
g. Remedies ..........
...............................................
60
2. World Economic Growth ........................................................
61
a. Demand Growth in the Industrialized World: Limits and Possibilities .
.......................................................
.
62
b. Demand Growth in the Developing World: Limits and Possibilities .
.......................................................
.
63
c. Monetary Reform .........................................................
68
C. Productivity and Resource Utilization .
.......................................................
78
1. Productivity.
..................................................................................................
78
a. Productivity and International Competition
.
. .
78
b. Sources of Productivity Growthapital Formation, Education, and R&D.
...................................................................................
80
c. Outlook for Productivity .
....................................................... 83
2. U.S. Capital Resources .........................................................
85
85
a. Savings/Investment ........................................................
b. Economic Implications of Merger and Acquisition Trends ..........
100
c. Infrastructure.
.......................................................................................
107
3. U.S. Human Resources .........................................................
112
a. Employment/Unemployment .
.......................................................
112
114
b. Income and Poverty ........................................................
c. Education and Health..........................................................................
116
D. Sectoral Crises .
.......................................................
.
123
1. Agriculture .........................................................
123
127
2. Energy ...............
.........................................
a. Oil Prices and Infla..
.
...
127
128
b. Oil Prices and Consumer Purchasing Power .
c. Oil Production and Oil Dependence .
.................................................
129
E. The Statistical Base .
..........................................................
136
1. Trade...............................................................................................................
136
2. Growth of the Service Sector .
..........................................................137
3. The Federal Role .
..........................................................
138
Additional views of Senator William Proxmire .
........................................................
140
..........................................................
142
Additional views of Senator Lloyd Bentsen .
145
Additional views of the Honorable Augustus F. Hawkins .......................................
Minority views..................................................................................................................
146
Dissenting views of Honorable Olympia J. Snowe ....................................................
207
(OX)

100TH CONGRESS
1st Session
I

REPORT

SENATE

100-11

THE 1987 JOINT ECONOMIC REPORT

MARCH

5, 1987.-Ordered to be printed

Filed, under authority of the order of the Senate of March 3, 1987

Mr. SARBANES, from the Joint Economic Committee,
submitted the following

REPORT
together with
MINORITY, ADDITIONAL, AND DISSENTING VIEWS

69-874

ECONOMIC PERFORMANCE AND PROSPECTS
A.

THE RECENT PAST

Many of the economic challenges that face the Nation in the
years ahead have their roots in the policies and performance of
the recent past. This chapter reviews the performance of the
American economy during the 1980's and then examines the
short-term and long-term prospects.
RECENT ECONOMIC PERFORMANCE:

THE RECESSION AND RECOVERY

The economic performance of the 1980's has been dominated by
the severe recession of 1981-1982 and the ensuing recovery. The
recession was the worst since the Great Depression,1/ and has
left a legacy of relatively high unemployment, substantial excess
capacity, and sharp regional and sectoral disparities which
continue despite the subsequent recovery.
The recovery since the depth of the recession in 1982 has
been brought about by substantial fiscal stimulus from the
Federal deficit and a dramatic turnaround in monetary policy.
Yet despite these strong pressures toward economic expansion,
overall economic growth for the past 18 months has been
"relatively sluggish,' according to the latest Council of
Economic Advisers'(CEA) Report.
The same conclusion does not hold with respect to
consumption.
Domestic demand expanded at a brisk 3.6 percent
pace during 1986, but much of this demand was filled by imports,
and domestic production rose only 2.5 percent. Present economic
policies appear to have produced an increase in consumption which
is not matched by a similar increase in production, and it is the
divergence of these trends which provides the strongest
indication of the fragility of the current recovery.
_/ The civilian unemployment rate exceeded 10 percent from
September 1982 through June 1983 for the first time since 1940,
and peaked at 10.7 percent in November 1982.

-1(1)

2
CHART

PRODUClION AND CONSUMlON
INTHE
AMERICAN
ECONOMY
$3.9 -

$3.8
DOMESTIC
CONPlN

$3.6

$ .7 -

$352

$3.14
1983:1

1983:4

1984:3

2 -

195:2

1986:1

1986:4

3
Production
Gross National Product t(GNP)
While consumption was growing a healthy 3.6 percent in 1986,
production, as measured by GNP, rose only a weak 2.5 percent.
This was below the sluggish 2.7 percent growth registered in 1985
and only marginally above the average annual growth rate of 2.4
percent for 1981-1985. By comparison, real growth averaged 2.8
percent in the 1970's and 3.5 percent between 1950 and 1980.
It should be pointed out that the average for the 1980's is
distorted by the extraordinarily strong growth performance of the
economy in 1984. As Table I shows, the 6.4 percent real growth
of that year was the strongest of any year since 1951, but this
has proved to be a one-time event with other recent years far off
the course.

TABLE I
REAL GNP GROWTH
1980
1981
1982
1983
1984
1985
1986

---

------

-0.2%
1.9
-2.5
3.6
6.4
2.7
2.5

Industrial production, the key index of output growth in the
manufacturing sector, rose only 1 percent for 1986, only half the
rate of the previous year and only one-quarter of the average
annual growth rate which prevailed in the 1970's.

-3-

4
CHART II

GNP GOWN RAE
7
6
5
4
3

z
2
L

0
-l
-2
-3
1970

1972

1974

1976

- 4 -

1978

1980

1982

1984

1986

5
Productivitv.
A principal reasomifor sluggish output-growth in a number of
sectors is slow productivity growth;'-Incredases in productivity
have accounted for 71 percent of the total increase in output in
the American economy between 194.7 and 1965, but fell to 50
percent between 1965 and 1973, and dropped again to 29 percent
between 1973 and 1986. With this slow productivity growth, the'
expansion of output in the economy is excessively dependent on
expansion of the labor force, and the rate of labor force growth
is projected to slow considerably in the years ahead. The most
recent productivity statistics provide little encouraging news.
Productivity growth in the nonfarm business sector rose only 0.5
percent in 1985 and 0.7 percent in 1986. In the fourth quarter
of 1986, nonfarm productivity actually fell 1.7 percent.
A significant portion of this overall decline in
productivity growth is accounted for by the shift toward services
in the employment and output mix of the economy. As Federal
Reserve Chairman Paul Volcker told the Committee on February 2:
One of the problems in the inflation area is
[that]...in the services area productivity growth
is zilch, basically, if one believes the figures.
Employment and Unemployment
'Because of the relatively slow growth in production,
employment growth has been constrained and unemployment remains
high. Civilian employment rose 2.4 million in 1986. While this
was above the 1.7 million average annual, increase in employment
registered between 1980 and' 1985, it was barely enough to keep
pace with the-year's labor force growth, and it is far below the
annual rate of job growth of four million which prevailed in
1978. After rising to a post-Depression high of 10.7 percent in
November 1982, the unemployment rate has declined gradually,
averaging 7.0 percent in 1986, compared to 7.1 percent in 1985.
The number of people unemployed declined only marginally from 8.3
million in 1985 to 8.2 million in 1986. Between 1980 and 1986,
the unemployment rate fell only 0.1 percent, from 7.1 percent to
7.0 percent, while the average number of people unemployed
actually rose by 600,000.
Recent experience confirms the secular upward trend in
unemployment which is demonstrated in Chart V. Each recession
drives the unemployment rate to new heights, and each recovery
tops out with a higher rate of unemployment than its predecessor.

-5-

6
CHART III

PRODUCElVTY GROW
(Non-Fann Busiss)
3

z
IL

-2

-3.
1970

1972
1972

17
1974

1l
1976

- 6 -

1
1975

1
1950

1952

1l
1954

19l
1956

C(H-ARTIV

EMPLOW GROWTH
A Jobs

n
m
0
bL

0
I

-1

-2
1970

1972

1974

1976

- 7 -

1978

1980

1982

1954

1986

8
CHART V

CAN UNLOYMENT RATE
11.00

10.00

9.00

Loo

7.00

6.0011

5.00-

4.-Oc
j

3.001

19601 19626 1964:11 1967:4 1969:9 19722 1974:7 1976:12 19795 1981:10 19643 19868

- 8 -

9
There is also evidence that the structure of employment is
changing in ways which may not be positive for the long-run
growth in earnings and productivity in the American economy.
Since the economy reached its last peak in July 1981, more than a
million manufacturing jobs have been permanently lost. Job
creation has been in lower skilled, lower paying service-sector
jobs, many of which are without such traditional benefits as
health insurance or pension rights.
In addition to these sectoral shifts, there remains a very
high level of Americans who are forced to accept part-time work
because full-time work is not available.
The number of
discouraged workers -- those who wish to work but are not
actively looking because jobs are not available -- is also very
high, averaging more than 1.1 million in 1986.
Blacks, who make
up 12 percent of the labor force, constitute 26 percent of
discouraged workers.
Wages, Incomes. and Povert,
With persisting high unemployment, substantial rates of
involuntary part-time work, and a shift to lower paying service
jobs, overall growth in wages and family incomes has been
extremely modest over the past several years.
The income picture for most traditional blue-collar workers
is shown best by the Labor Department's series on average weekly
earnings for non-supervisory.production workers.
As Chart VIII
illustrates, real weekly earnings have fallen substantially since
the early 1970's, and rose only 0.4 percent in 1986.
This weak
growth leaves the figures no higher than they were in 1980.
Figures on hourly compensation portray a similar picture of
stagnant growth in the real returns to work in the American
economy.
The Labor Department's index of real compensation per
hour has remained virtually stagnant since the early 1970's,
following a 20-year period of steady upward movement.

-9-

10
CHART VI

EMPLOYME GROWH
MANUFACTURING
AND SERACE SECTORS
5

0
h.

z
0

-i

1970

1972

1974

1976

1978

1980

1982

+ SERICE

MUACTRG
-

19U

1986

i1
CMART
H
VI I

WORKIG~PAT-1
A.;
~ ~..,;
T- , W...FOR ECONOMI
.... REASONS
.

I .!

X~ .

I ,U' f , : '. .;) , . ', 1

N
I
0
IL

0
B'

z
0

'' '

,I -

i t.,l96O1 .i.963..-.

.
-1

-1, -

I966S 9...
I..
97t1

197&5. :-,19n6t
9 980t1 i 198t5

19869

12
CHART VI I I

AVERAGE EAL WEKLY EARNNGS
(Private Non-Farm Induseries)
200 198196-

192

19051
~188/

1861

184
1801

176-

174172
170

168I
1970

1972

1974

1976

- 12 -

1978

1980

1982

1984

1986

13
CHART IX .

;

-:..:

REAL COWON PER
HOUR;

INDS fl79:IJ0
t i1- I
I.

...-.
.

.
.

,
.,

,
.

...

' '-''''

.
.

{

'
*'

,.'

:
A

' -, .

-:'

0.6 -

/.:

' '

I
or--

0.5 -

' '

....

'. '

'. _

' '

' v

'.
'

..
"

,.
.

;

.,'

... *
'

..
'i."
'

'' .: hi

:''

'. .

.,' . '
F
'

. _.'.

;,
-

I-

.::'

;

'/ ':

_ .

'
.

/
g

.
.

...

;

' f

..
'

.'i

.'
._,

. r
/

;

.':/

:
.

.
'

. ' '' .

' ' 'N

...

S fl

....

[

.
.

0.8 -

.
'

I. I .

0.4 -

88kl''''\t/W'
/

0.7 -

I
,

- ,>t

I
|

, .;

. ......
..

;
-

- .

I
-

..............

I -

0.9

....

.
'

a:.

-:'

' -,

. '.,:'
.

'.
:_,

,
'
.

_ .;. '.

.-.

....

.....

...

...............
I..................
ffnffffffTfIfnInM
I -- I
I
---I-

1947 1950 1953 1956 1960 1963 1966 1969 1973 1976 1979 1982 1986

- 13 -

14
American workers and families have responded to this
stagnation in hourly earnings in-a number of different ways in an
effort to maintain income growth'in a period of slow wage
increases. Labor force participation rates have risen,
especially for women, and more and more families are required to
have two earners just to meet the budget. As a result of this
shift, real--per capita-disposable income has risen significantly
since the depth of the 1981-1982 recession, but this increase has
not been sufficient to bring real per capita disposable income up
to the level it would have achieved if the trend growth of 1946
to 1980 had been maintained (see Chart X). More disturbing is
the fact that real disposable income per capita fell in both of
the final two quarters of 1986.
Taken-together, these trends have combined to produce a
pattern of virtual stagnation in real median family income,
perhaps the best indicator of both the level and distribution of
the American standard of living. As Chart XI suggests, real
median family income has hardly grown since the late 1960's, and
is well below the growth path established during the 1946-1974
period. The recent rise in this statistic reflects the overall
recovery from the 1981-1982 recession, but has not been strong
enough to raise median family income above its 1979 level.
Those at the bottom of the economic ladder have borne much
of the burden of slow income growth and high unemployment. The
Census Bureau's index of income concentration shows the greatest
degree of inequality since 1947, and the 1985 poverty rate was 14
percent. While this was an improvement from the 15.2 percent
poverty rate of 1983, it was a full 20 percent higher than the
rate in 1979. The number of persons living in poverty increased
The most
from 19.7 million in 1980 to 22.9 million in 1985.
recent recovery has done less than previous recoveries in
reducing the poverty rate.
Geoaraxhic Disparities in Economic Growth

There have been significant geographic disparities in
economic growth during the 1980's. As Chart XII shows, the
unemployment rate varies substantially across the Nation.
Inflation

The inflation picture is a brighter spot in the economic
scene. In 1986, the Consumer Price Index (CPI) rose 1:1 percent,
the smallest increase in 25 years. Most of the improvement,
however, was due to a collapse of oil prices and the downward
pressure put on prices by imports generally.

-14-

15
CHART X

REAL PER CAPTA DEPOSABLE NCOME
ACUAL VS194-80 T
12 -

115.
10

N11

-I

'l...... JM..a

n n f rf~

. I E

,-,

-,..
.
--

-,----.
.

. ......

I...................
I

1946 1949 1952 1955 1959 1962 1965 1968 1972 .1975 1978 1981 1985

REAL MEDWLY NCOME
ACIUAL VS. 1946-74MTR
31
30-.
29
28 27 -

~2
22

21-

n 20 -

1N_4
I

171
to-

, 15 -

12 --TTTT

Tri

ii i-TT1FFTTI-TTTl

1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 I1977 N.1980 19831965

- 16 -

17
CHAwr XII

1986 UNEMPLOYMENT RATES BY AREA
10r

U.&. Cu Reg1ona
DMdho
-

_ ,

..
-

z
0

z
Id

I
hi

4
-I

.zz
4

- 17 -

._.-

. ,.

__ ...
.... .

18
Chart XIII tracks inflation in a number of key areas, and
Chart XIV suggests that the CPI presents an unusually optimistic
Excluding the oil price decline, consumer
picture of inflation.
prices rose 3.8 percent in 1986, precisely in line with the 3.9
This was below the high
percent inflation rate of 1982-1985.
well above the
inflation rates of the late 1970's, but still
inflation that characterized most of the 1960's.
Price inflation in key sectors, particularly the service
While prices rose a modest
sector, remains a persistent problem.
1.8 percent in the durable goods sector and actually fell by
nearly 2 percent in the nondurable goods sector, the cost of
legal services rose 8 percent, medical services over 4 percent
Overall, inflation in
and the housing cost index by 5.4 percent.
the services averaged 4 percent last year, an improvement over
not as low a value as the CPI alone
the late 1970's but still
would suggest.
These numbers suggest that inflationary tendencies remain in
the American economy, and that the next external price shock
could lead to a revival of overall inflation.

Money Supply and Interest Rates
Very rapid growth in the money supply, which has been a key
element in stimulating the economy for the past several years,
Ml grew at 16.9 percent for 1986, and M2 grew
continued in 1986.
at 9.1 percent, rates substantially higher than that of growth in
Ml growth was well in excess of the Federal
nominal GNP.
Reserve's target, helping to raise concerns in the financial
markets about the future inflationary consequences of recent
rapid money growth.
Largely as a result of rapid growth in the money supply,
nominal interest rates have fallen significantly during the past
As the CEA Report notes, however, real interest rates
year.
These high real interest
remain at historically high levels.
rates are an important obstacle to renewed capital investment.

-18-

19
CHAir

XIII I

BSECTOR-1
fAON RATESU
(aWPO DrfUThO)

mA~~~~~w
*INl

415

-Is
-31

20
CHART XIV

NUURATE
AD Hamti
Emop Enrg
13
12
11
le
.9
6
.-

6
5

4.3.
2
I0*
1970

1972

1974

1976

- 20 -

1978

1980

1982

1984

1986

21
CHART XV.

RAE OF MONY GROWTH
(PERCENT CHANGE INi-1)
7

1313

61-

171-

101

8191

1981

1982

1983

1984

-21

69-874 0 - 87 - 2

1985

1986

AL CHART V ST RATES
NoMJN

NOMKAMD Wxifj
u
TFrea

I-

hi
L

1970

1972

1974

1976

1978

1980

1982

+ REAL RANE

0 NOMINAL RAT
- 22 -

194

1956

23
Investment. Profits, and CapacitV Utilization
Investment in plant and equipment, which had risen strongly
in the two previous years" fell in 1986. This development raises
considerable concern about the future growth rate of the
economy. High real interest rates played a role in depressing
investment, as did the high level of idle capacity in the
industrial sector and depressed corporate profitability.
Consumption

The strong growth in domestic demand was largely produced by
a very substantial reliance on debt. Firms, households, and
government all borrowed heavily during 1986, sustaining
consumption but at the price of accumulating large obligations
which must be serviced out of future earnings.
The Federal Deficit
In Fiscal Year (FY) 1986, the Federal deficit was $220.7
billion, the largest ever recorded. The 1981 tax cut, combined
with an increase in defense spending, more than compensated for
reductions in spending on domestic programs, stimulating the
economy and raising the deficit to more than 6 percent of GNP fof
the first time in the postwar period. This on top of similar
large deficits throughout the 1980's brought the national debt to
$2.1 trillion by the end of FY 1986.
Between 1980 and 1986, the
national debt more than doubled from $0.9 trillion to $2.1
trillion.
Household Debt
Households also took on record amounts of debt in 1986, with
the ratio of consumer installment debt to disposable income
rising to 21 percent, the highest level on record. This was
accompanied by a fall in the household savings rate to 3.9
percent, the lowest level in 40 years. Any attempt by households
to reduce some of their debt burden could have a major chilling
effect on domestic demand in the economy.

-23-

24
CHART XVI I

WPLAN m ) E(W

F~mEEpdw
400
380
360
340
320
300
I

- 280

260

240

220

0
3

200

-I

180
160
140
120
100
80
1970

1972

1974

1976

- 24 -

1978

1980

1982

1984

1986

fPfTE PROMS

AFTER TAX

AS ASHARE OF
CORPORATE
PRODUCT

4aI

19r2

1981:1

1981:4

19823

1983:2

- 25 -

I II II I I I

1984:1

1984:4

1985:3

198:2

26
CHART XIX

CRAM
TUTATI RATES
96 94
92 goq

8812
'A

682

78
76j
74-

68]

1970

1972

1974

1976

- 26 -

1978

1980

1982

1984

1986

CHART XX

-EFOOL DEFICR
(FbWd Yomr)
240]
220 200180 -

.140

kL.

120-

0
J
i

60
40J

1970

1972

n1914
1976

- 27 -

1978

1980

1982

1984

1986

28
CHART XXI

lIE NAMONAL DEBT
L2.
2.0 A

1.71

g
O
z
o

l.4

1.35]

1.1-

IL~
*

1 I.i
07
0.
0.62
0.6 -

0.5 0.4
0.3

,,,

1970

1972

IA
1974

,
1976

- 28 -

1978

1980

1982

1984

1986

29
CHART XXII

SAVNGS BY EIVIUALS
UO

~~~~~~~~~~~~~~~~~~~I

450-_
350-

200~
300

250

0'.,g

100-

so~~~~~~~~~I

1970

1972

1974

1976

D NOmImAL$
- 29 -

1978

1980
+ 1967 $

1982

1984

30
Corporate Debt
Corporations significantly increased their borrowing during
the year, using much of the new funds obtained to engage in
Debt was used in record amounts to
mergers and acquisitions.
retire equity, shifting the balance sheet of the corporate sector
Since debt must be repaid no matter
sharply toward debt finance.
what a firm earns, while equity rides out the ups and downs of
corporate fortune, the increasing importance of debt on corporate
balance sheets raises serious concerns about the ability of many
in the corporate sector to weather any future recession.
International Deficits and Debt
The country as a whole also took on a vast amount of new
debt last year in the form of foreign borrowings needed to
finance the huge U.S. current account deficit. The merchandise
trade deficit continued to deteriorate in 1986, reaching $170
The trade deficit now
billion compared to $148 billion in 1985.
amounts to over 4 percent of GNP, the worst record in our
history. Despite the decline in the dollar that began in
February 1985, a turnaround in the deficit is not yet in sight.
For all of 1986, imports rose $26 billion while U.S. exports rose
only $4 billion.
The sharp growth in the merchandise trade deficit has been
The result has
associated with vast capital imports from abroad.
been a sharp reversal in the U.S. international asset position,
from the world's largest creditor in 1981 to the world's largest
The United States has reversed all precedent
debtor in 1986.
and, instead of filling an advanced nation's traditional role of
supplying capital to the rest of the world, has been borrowing
savings from the rest of the world at an unprecedented rate.

-30-

31
CHART XXIII

THE TRADE DEFIT
1SO
170
160
150
140
130

120

j 11
0
a 100
o

60
50

1980

1981

1982

1983

- 31 -

1984

1985

1986

32
C4ARr XXIV

TRADE DECIT AS PERNTAG OF GNP

0
&
M
I

1980

1981

1982

- 32 -

1983

1984

1985

1988

33
QMART
XXV

NE ASSETPOSION OF THE U.S.
(1986 Eanated)
150

100o

aoIL
o

\
-50

-150

-200

-250

f1980

-l
1981

.1982

- 33 -

193

198u

1985

1986

34
CHART XXVI

NIERCHANDSE AND SERcES NET TRADE
20

-10-

-20 -50-

-60-

-70 -

-90 --

-110-120-1N0- t
1970

1-w
1372

1376

1374

Mooe+
-

- 1-

r!-

1380

1382

1384

35
B.

WHAT LIES AHEAD

This section of the Report is intended to assess what lies
ahead for the American economy, keeping in mind that while it is
not possible to predict the future with precision it would be
imprudent to make important policy decisions disregarding.future
probabilities. In fact, the construction of forecasts and
projections is a standard feature of economic analysis, widely
employed in the private sector and required by statute of both
Congress and the Executive.
The distinction between the two is important: forecasts are
formal predictions of what will occur in the near term, that is,
over a year or so, while projections are informed judgments of
what might occur over longer periods, recognizing that economic,
political, and other uncertainties make hard predictions
impossible. Two or more projections are frequently made for the
same period, using varying assumptions, in order to show how
changes in one or more factors might alter the overall results.
With respect both to forecasts and projections, their reliability
depends greatly on the reasonableness of the assumptions
underlying them.
1.

THE SHORT-TERM OUTLOOK

There is significant variation between the 1987 forecast
presented in the Economic Report of the President and forecasts
developed by analysts in the private sector. For 1987, the
Administration forecasts the following: real GNP growth of 3.2
percent; a civilian unemployment rate of 6.7 percent; and an
inflation rate as measured by the CPI of 3.8 percent. The
Administration forecasts slight improvement in each category for
1988.
Most professional economic forecasters are more pessimistic
than the Administration about the short-term prospects. While
differing somewhat among themselves, witnesses who presented
testimony earlier this year to the Joint Economic Committee all
forecast lower growth rates, as does the consensus forecast of
the Blue Chip Indicators, a composite of more than 50 forecasting
firms and institutions. Chart XXVII summarizes the differences.

-35-

36
CHART XXVII

SHORT TERM FORECASTS
For 191

6.7

6-/

z
L

3.2[/

UNEMPLOM

GNP

EZ AWWIRmooN
- 36 -

mNs

6.9

37
Although the current Administration forecast is closer to the
consensus than earlier ones, there is reason to believe it is
unrealistic. First, the Administration's own assumptions of
somewhat higher inflation, a slowdown in consumer spending, a
substantial falloff in spending for housing, and budget
constraints set by Gramm-Rudman-Hollings (GRH) all point to
slower growth. Second, the Administration believes an increase
in net exports will contribute significantly to economic growth
in 1987. However, there are major uncertainties about how the
fall of the dollar and slow economic growth here and abroad will
influence trade.
The Administration assumes there will be import price
adjustments to reflect the dollar's decline and expanded markets
abroad for U.S. products. But even if the prices of foreign
imports rise, U.S. exports are unlikely to increase on a major
scale in the absence of resumption of economic growth among the
world's debtor nations, particularly in Latin America, and major
policy shifts in West Germany and Japan. The January trade
deficit figures, somewhat larger than originally anticipated,
raise the question whether the expected 1987 decline in the trade
deficit will be sufficient to generate the modest growth
predicted by the Administration.
Disagreement over the short-term forecast, while in a narrow
band, is more significant than it may appear. A year ago, the
Administration predicted GNP growth of 4.0 percent in 1986 and
again in 1987, describing that rate as a return to healthy
expansion after 18 months of relatively sluggish" growth.
Growth in 1985 had been only 2.7 percent, but instead of growing
to 4 percent as predicted, it fell to 2.5 percent for 1986. The
consensus forecast suggests that sluggish growth will continue,
with all that implies for unemployment, productivity, and other
problems.
2.

THE LONGER TERM OUTLOOK

The Full Employment and Balanced Growth Act of 1978 requires
the President to submit an annual long-range plan designed to
reduce the unemployment rate to 4 percent within a period of five
years. This year, as in the past, the Economic Report of the
President fails to fulfill that requirement, instead providing
what it calls "long-range" economic assumptions for the years
1988-1992.
These assumptions project that real GNP will grow an
average of 3.4 percent per year during the next six years. This
is almost 40 percent higher than the average real growth actually
achieved by the economy during the past six years.
Even with six
years of 3.4 percent growth, the Administration projects that the
unemployment rate will fall no lower than 5.5 percent by 1992,
still significantly higher than the 4 percent unemployment rate

-37-

38
Furthermore, the Administration offers
stipulated in the Act.
to substantiate its assumptions, saying that the
little
projections are based on long-term trends, a continuation of
current monetary policy, and enactment of Administration budget
policies.
As in the case of the short-term forecasts, the
Administration's longer term outlook is significantly more
The Committee
optimistic than those of the private forecasters.
examined in detail long-term projections of three major
forecasting firms, Data Resources, Inc. (DRI), Chase
Econometrics, and Wharton Econometric Forecasting Associates.
The
Each takes a longer look ahead than does the Administration.
Chase analysis goes through 1995, Wharton to 1996, and DRI makes
25-year projections through 2011.2/
DRI
The private outlooks also vary 'somewhat in approach.
and Chase examine four scenarios incorporating varying
a "trend case' based on recent trends, a cyclical
assumptions:
case assuming recurrence of typical business fluctuations, an
optimistic-case, and a pessimistic case. Wharton makes a single
long-term "forecast," which includes the effects of the business
Table II compares Wharton's forecast and the DRI and
cycle.
Chase trend-line projections for the period 1987-1996 with the
Administration's long-term assumptions.
2/ It should be noted that this discussion of the long-term
outlook for the American economy has largely ignored the
possibility of another cyclical downturn within the projection
This omission is justified by the obvious difficulty in
period.
forecasting with any precision when and how the next cyclical
But it should not obscure the fact that the
downturn will occur.
business cycle has not been repealed and that some cyclical
variation in economic performance is likely to remain a part of a
free-market economy.
Cyclical forecasts are only suggestive of future
possibilities, but their implications should not be totally
If potential business cycle effects were taken into
ignored.
account in developing future projections, the results would be
more pessimistic than those based on a continuation of baseline
Today's recovery is long by postwar standards, and there
trends.
are a number of significant imbalances in the economy which could
set off a new recession within the next few years.

-38-

39
TABLE II
LONG-TERM OUTLOOK, 1987-1996
1987

1988

1989

1990

1991

1992

1993

1994

1995

Real GNP Growth
Chase
DRI
Wharton
Administration

2.4
2.6
2.7
2.7

2.7
3.1
3.6
3.5

2.7
1.9
2.4
3.6

2.8
2.8
0.4
3.6

2.8
3.1
5.2
3.5

2.7
2.6
2.7
3.4

2.8
2.4
3.4

2.7
2.4
2.6

2.8
2.4
3.0

2.4
2.4

Inflation
Chase
DRI
Wharton
Administration

3.4
3.7
.3.5
3.0

4.4
4.3
4.9
3.6

4.4
4.0
5.2
3.6

4.2
4.0
5.6
3.2

4.3
4.5
4.8
2.8

4.4
4.8
4.3
2.2

4.5
4.9
4.6

4.5
5.3
4.9

4.5
5.6
5.5

5.6
5.4

Unemployment
Chase
DRI
Wharton
Administration

6.9
6.9
6.9
6.7

6.8
6.6
6.5
6.3

6.7
6.7
6.6
6.0

6.5
6.6
7.5
5.8

6.2
6.4
7.1
5.6

5.9
6.3
6.9
5.5

5.5
6.4
6.7

5.1
6.4
6.7

4.7
6.5
6.9

6.5
7.4

-39-

1996

40
The projections of the three private forecasters show
sluggish average growth over the next 10 years, and inflation and
unemployment rates somewhat higher than the Administration's
It should be noted that the DRI and Chase
assumptions.
projections are relatively optimistic in that they assume no
If less optimistic assumptions and
major mishaps or recessions.
possible recessions are taken into account, there would be slower
growth and higher unemployment.
When the annual changes are examined, the differences
between the Administration and the private forecasters are more
striking. The Administration shows growth peaking at 3.6 percent
in 1989 and then declining only slightly by 1992, while inflation
The three private firms see
and unemployment decline steadily.
little or no improvement in the rate of growth of GNP throughout
the entire period. Both DRI and Wharton see growth slowing down
to 2.4 percent by 1996. The Administration assumes inflation
will be 2.2 percent in 1992, while the three firms estimate it
will be twice as high that year, and DRI and Wharton project
about a 5.5 percent rate for 1996. Wharton projects a 7.4
percent unemployment rate in 1996, while DRI projects a 6.5
percent rate.
An important feature of the private outlooks is that the
underlying assumptions in the projections are not particularly
pessimistic and may even be overly optimistic. They assume no
international shocks from supply interruptions or sharp price
rises of the sort that occurred in the 1970's.3/ They concur in
demographic projections of the U.S. Census Bureau showing a
slowdown in the growth of the population and the labor force, a
trend which would contribute to slower growth of output but would
also help to prevent unemployment from rising much above current
levels. All expect labor productivity growth to average about
1.5 percent annually during the next 10 years, a substantial
improvement over the past 10 years. They assume that wage
increases and consumer spending will be held down and that real
interest rates will remain high, although Chase expects them to
decline somewhat.
3/ Both Chase and DRI provide alternative projections with less
optimistic assumptions. By 1995, in Chase's low-growth scenario,
real GNP growth is 1.5 percent, inflation is 6 percent, and
unemployment is 6.6 percent. In DRI's pessimistic.projection,
real GNP growth is 2 percent, inflation is 7.4 percent, and
unemployment is 6.9 percent in 1996.

-40-

41
With respect to oil prices, Chase assumes they will rise
sharply in 1988 and 1989 and then grow by 6 percent annually
through 1995. Wharton anticipates moderate price increases until
at least 1996, and DRI sees no significant energy inflation until
the mid-1990's. While their estimates obviously differ, none
foresees price explosions of the magnitude that occurred in the
1970's.
Most private forecasters expect growth among the Western
industrialized countries also to be sluggish over the next
several years. For example, Chase projects Japan's annual growth
to average 2.3 percent through 1990, and it projects the European
members of the Organization for Economic Cooperation and
Such projections are
Development (OECD) to average 2.4 percent.
consistent with the prevailing view in Europe. The OECD
forecasts 2.75 percent growth for Japan in 1987, rising to 3.25
percent in the first half of 1988; and 2.5 percent growth for
OECD Europe in 1987 and 2.25 for the first half of 1988.
The long-term average rate of economic expansion for the
United States, prior to 1981, had been about 3.5 percent. This
growth rate produced record numbers of jobs and accounts for the
preeminent place of the United States in the global economy.
Fueled by the ability to grow at even more rapid rates for
sustained periods of time, and reinforced by the national
commitment to goals such as full employment and low inflation,
the U.S. economy has offered unprecedented opportunities for the
American people and provided leadership for the rest of the
world.
Economic growth is now averaging about 2.5 percent, and
there is a broad consensus among private economists that we will
continue on this slow path for the foreseeable future. This path
raises a number of serious problems, however, especially with
respect to unemployment and the trade deficit.
First, it will not be possible to achieve a significant
reduction in unemployment at a 2.5 percent annual growth rate.
The Administration's own projections show unemployment at 5.5
percent in 1992, well above the statutory goal but, in the
Private
opinion of most economists, still too optimistic.
forecasters assume that at the current rate of growth
unemployment will remain at about today's high level of 6.7
percent at least through 1996, with serious implications for the
standard of living, poverty, and a host of related problems.
Moreover, there are a number of developments that could cause
unemployment to rise: a recession; or growth even more sluggish
than projected; or more rapid growth in the labor force than
currently anticipated.

-41-

42
Second, the most effective means to address the trade
imbalance is to increase exports. In a period of sustained
weakness, imports probably would decline as demand softened, but
there would not be a corresponding increase in exports unless
Assuring a stronger competitive
they are made more competitive.
position, however, would require greater emphasis on productive
capital investment, research and development (R&D), productivity,
worker training, and infrastructure, all more difficult to
achieve in a period of slow growth.
Most economists expect productivity to be weak, Federal
deficits to remain high, slow growth to continue in the Western
industrialized nations and Japan, and short-term prospects for
debt-burdened developing nations to remain inauspicious. As long
as these conditions continue, world markets for U.S. goods are
not likely to expand and net U.S. exports are not likely to grow.
CONCLUSION
Continuing growth, albeit tepid, and the absence of any
obvious signs of recession obscure the extent to which the
economy is vulnerable to abrupt dislocation, and the limited
In the
means available for responding to unanticipated problems.
short term, slow growth represents a missed opportunity for the
U.S. economy, and is particularly hard on the poor and unemployed
who suffer most from slow economic growth. If growth increased
to 3.5 percent, however, unemployment would fall, and would
continue falling if growth stayed at the faster pace. In the
longer term, the causes of today's sluggish growth, if untreated,
will cloud the prospects for a healthy and competitive economy
and raise the prospect of a declining standard of living in the
United States.

-42-

43
II.
A.

THE CHALLENGES

THE DOMESTIC DIMENSION

The consensus among private economists is that present
trends and policies will produce sluggish growth and relatively
high unemployment over the medium and long term.
This finding
should be cause for both concern and action by government, since
slow growth holds the economy well below.its potential.
Responsible economic policy must develop a way of getting higher
growth and lower unemployment than the consensus forecast
predicts.
Accepting the growth challenge means taking a hard look at
the American economy, delving below the surface and recognizing
the fundamentally new challenges which the economy faces.
If the
forecast is for.sluggish growth, it is because the forecasters do
not believe that successful responses have been developed to meet
these challenges.
For this reason, the remainder of this Report is devoted to
an analysis of the fundamental economic challenges facing the
American economy -- challenges which must be met if the United
States is to do better than the tepid growth and stagnant
unemployment which the forecasters predict.
One of the principal obstacles to meeting the challenges of
the future is the current impasse in domestic economic policy.
Recent statistics tell of a slowing in the growth of incomes and
an increase in the level of inequality in the American economy.
Younger workers are finding it more difficult to earn enough to
provide their families with the essentials of the American dream
-- good housing, adequate health care, decent education, and a
reasonable degree of retirement income security.
If these trends
are to be reversed, if the economic growth rate is-to be raised,
ways must be found to improve the ability of American producers
to increase rapidly the efficiency and productivity of the entire
economy, not just those firms which produce for export or compete
against imports.
The challenges facing the United States range across the
entire spectrum of economic activity -- from increasing the
sluggish rate of productivity growth, to dealing with low savings
rates, to renewing the economic infrastructure, to expanding
investment in ideas and people, to reducing the growth
disparities between sectors and regions.

-43-

44
Subsequent sections of this Report will address each of
these areas in turn, seeking to identify the critical obstacles
Where obvious responses to these challenges
to stronger growth.
In a number of
are evident, we will draw conclusions for policy.
areas where there is no obvious consensus on the best approach to
meeting the challenges, we believe the constructive response is
to start a national dialogue on the problem, not simply to ignore
it.
Meeting the domestic and international challenges will
require decisive action by government in a number of areas.
Unfortunately, the legacy of the recent past makes it extremely
difficult for government to use the traditional economic tools of
This
fiscal and monetary policy to address these new challenges.
legacy makes anticipatory action now quite difficult, and may
well cause a more serious crisis should economic policy be asked
to cope with the strains of a new recession.
Central to the
The dilemma is clearest on the fiscal side.
debate about meeting the challenges of the future is the problem
The deficits built up over the
of the Federal budget deficit.
last six years constitute an immense claim on the future output
of the economy, and it is important for future generations that
steps be taken to bring the deficits down now.
The nature of the budget problem is portrayed in Chart
shows the pattern of growth in
The first
XXVIII and Chart XXIX.
Expenditures have
Federal revenues and expenditures since 1970.
continued to rise at a rate of growth similar to the pre-1980
historical average, but revenues dropped sharply in 1982-1983 and
since then have not grown at a rate sufficient to close the gap
with expenditures.
The second chart demonstrates clearly that the reason for
the continued upward momentum reflects in part greatly increased
In real terms,
purchases of defense-related goods and services.
civilian purchases in 1986 were 8 percent higher than their 1980
levels, but defense purchases were some 46 percent higher.

-44-

45
CHART XXVIII

FEDERAL O

ROPT AND EB
$1.10 ,-i

$0.90 -

0
J0

$0.80
$0.70

Y
E--

$0.60 -

0
iI.

$0.30 -

197 198
$0.20-

$0.10

1970

1972
OaE

1974

1976

+
- 45 -

EJWIhDflURES

192

'18

46
CHART XXIX

FEDEALORM PRCHASES
WIJARY AN MUMN

260

240

220-

200'

3 1809
a

160 2
* 140120

100
80 E

60401
20

i
1970

1974

1972
UU

1976

1978

1980
+ CMUAN

ARY
- 46 -

1982

19U

1986

47
The deficit problem is thus caused by a sharp rise in
defense spending and a sharp reduction in the revenue base.
This year, there appears to be a notable shift in
Administration budget policy. As Treasury Secretary Baker told
the Committee:
Some have suggested that our budget is a
carbon copy of previous budgets and I think
nothing could be further from the truth.. .we are
recommending $22.4 billion in deficit reduction
through changes affecting receipts.
Over half of
this amount involves temporary measures that do
not represent a permanent revenue stream.. .while
the remainder of the receipt changes do represent
permanent revenue proposals....
Such statements represent a departure from previous budget
policy, and suggest that the Administration may be moving toward
acknowledgment of the need for a balance between revenue and
expenditures in the budget process.
Such changes, however, may be too late to avoid a dangerous
fiscal policy situation created by GRH passed last year. That
legislation, which was strongly supported by the Administration,
establishes a rigid formula for balancing the budget by 1992
which could potentially create serious economic problems in the
year ahead.
Steady and responsible budget reduction needs to be
integrated with two other priorities; the need to assure
economic growth, and the need to address a number of key problems
which are standing in the way of economic growth.
Balancing economic growth with the deficit targets
established by last year's GRH law is likely to be exceptionally
difficult in the coming year. Sluggish growth -- the consensus
forecast for the coming year -- in the past two years has been
associated with a rising deficit, suggesting trouble ahead for
the deficit in a slow-growth economy.
To ignore this reality, and impose large reductions in the
deficit on a weakened economy, runs the risk of tipping the
balance from sluggish growth into recession. A year ago, the
Committee took the view that the strength of the economy at that
time would permit the deficit reduction required under GRH in FY
1987 without precipitating a recession. The outlook this year is
much less certain. A substantial contraction of Federal fiscal
stimulus, which would be required to reach a deficit target of

-47-

48
$108 billion, runs the risk of imposing too big and too sudden a
burden on an already aging recovery. As Allen Sinai, Chief
Economist of Shearson Lehman Brothers, told the Committee:
A point of no return has been crossed where it is
now counterproductive to explicitly and actually
meet the GRH targets. Even if attempted, the
necessary adjustments by the Federal Reserve to
compensate for the lost economic activity could
not be taken quickly enough nor coordinated well
enough to smooth the adjustment process in an
economy that is already fragile.
Fiscal policy --

as constrained by GRH --

thus poses some

threat to sustained economic growth. The threat is made more
severe by the relative inflexibility of the recession provisions
in the GRH law. Constraints on fiscal policy are removed under
GRH only after two consecutive quarters of growth under 1 percent
or when either the Congressional Budget Office (CBO) or Office of
Management and Budget (OMB) projects a recession. Yet the
economy could be moving deep into recession because of fiscal
policy before the required two quarters of data could be posted.
According to Allen Sinai:
Although the GRH legislation contains a trigger
mechanism that shuts off spending cuts once real
growth declines, the negative growth would be
perceived too late to prevent accelerating
weakness.
The "escape clause, provisions of GRH have another serious
limitation in terms of fiscal policy. Two quarters of less than
1 percent growth or a forecast of a recession remove the deficit
ceilings, but for that fiscal year only. Once the economy began
to grow again, the law would require the Federal budget to return
to the targets established in the original law, with no
adjustment in the target to reflect the interim year in which the
If a recession caused suspension of the
law was suspended.
deficit target and a rise in the deficit, the law would require
massive new budget cuts to meet the old targets in the subsequent
recovery year. Such an extreme fiscal drag could easily
suffocate a recovery and ensure that the economy would be thrust
back into recession again. For this reason, GRH may have the
effect of deepening and prolonging any recession.
The issue of macroeconomic fiscal stimulus is only one of
the threats posed by the current budget dilemma. As everyone,
including the Administration, now recognizes, there are clearly
areas in which meeting the challenges of the future require an
increased, rather than a decreased, Federal commitment. It is

-48-

49
impossible to safeguard the long-run growth potential of the
economy if prudent current investments by government are
neglected.
These concerns suggest that both the spending and revenue
sides must be considered if the budget deficit is to be put on a
sustained, downward path. At the same time, this 'glide path"
should not be so steep as to drive the economy into recession
(which would only exacerbate the deficit problem), and the
balance between revenues and spending should not be so rigid as
to force the government to ignore needed initiatives in areas
critical to economic growth.
If fiscal policy is constrained by the history of large
deficits and the GRH law, monetary policy is constrained by a
different set of factors associated with the dollar and the trade
deficit.
For the past two years, the Federal Reserve has been able to
pursue an aggressively expansionary monetary policy without
running into serious inflationary problems or serious foreign
exchange problems. In fact, the generally recognized need to
lower the value of the dollar in the past made it easier for the
Federal Reserve to permit interest rates to fall. Domestic needs
for lower interest rates as stimulus to investment coincided with
international needs for a reduction of interest-rate
differentials and a lower dollar.
This relatively benign confluence of events is coming to an
end. There is now substantial concern about the inflationary
effects of a declining dollar and the buildup of monetary
pressure arising from the recent rapid growth in the money
supply. At the same time, the increased reliance on foreign
sources of capital in American investment markets means that the
Federal Reserve can no longer be as aggressive as in the past in
lowering interest rates and driving the dollar down.
In this new context, monetary policy may not be as readily
available as a policy tool to combat subsequent weakness in the
economy. With today's dependence on foreign capital inflows, and
the inflationary potential of further dollar devaluations,
monetary policy might be unable to play a stimulative role should
the economy turn soft. If the Federal Reserve feels compelled to
defend the dollar, this may sharply constrain monetary policy
whatever the consequences for interest rates and the domestic
economy.
Interest rates show signs of beginning to drift upward, a
possible indication that the era of monetary stimulus may well be
at an end. Concerns about inflation and the value of the dollar

-49-

50
could force the Federal Reserve to maintain or even raise
interest rates in response to a perceived weakening of the dollar
or a renewal of inflation, as Chairman Volcker indicated in his
February 2 testimony before the Committee.
Taken together, the outlook for fiscal and monetary policy
is thus not very encouraging. It is possible that our policy
apparatus will be able to sustain a sluggish rate of overall
economic growth. But the traditional tools of macroeconomic
policy are not now capable of contributing to a strong surge in
economic growth, nor do they appear adequate to the task of
moderating any future recession.

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51
B.
1.

U.S.

THE INTERNATIONAL ECONOMIC ENVIRONMENT

INTERNATIONAL TRADE

The unprecedented 1986 U.S. trade deficit of $169.7 billion
is an urgent signal of serious problems in the U.S. economy, and
As the 1987
in U.S. economic policy, that cannot be ignored.
Report of the Council of Economic Advisers notes:
By any measure, the United States has experienced
an unprecedented deterioration in its
international payments position.
The 1986 trade deficit surpassed the previous record of
$148.4 billion, set in 1985, by about 15 percent and represents
about a 4 percent share of GNP, a situation often characteristic
of developing countries.
The United States has had a small merchandise trade deficit
since 1975, but that deficit has more than tripled over the past
The magnitude of the increase has caused the U.S.
six years.
current account, which includes investment income and trade in
services as well as merchandise trade, to shift from surplus to
deficit.
While the United States has occasionally posted current
account deficits for a single year, the current account has
generally been in surplus, resulting in a steady accumulation of
This net creditor position
foreign assets by American investors.
has been sharply eroded in recent years, and today, for the first
time in 65 years, the United States is a debtor nation instead of
a creditor.
The new status of the United States as debtor nation creates
an entirely new set of pressures on the traded-goods sector.
Traditionally, the United States could tolerate a modest
merchandise trade deficit because investment income on our assets
was more than sufficient to offset these deficits and keep the
Now investment payments to
current account in balance.
foreigners are greater than U.S. investment income from abroad,
and add to the current account deficit rather than subtracting
from it.
While the United States has been borrowing heavily from
abroad in the past five years to finance the current account
doubt that this pattern must stop
deficit, there is little
eventually.
Foreigners will not be willing to lend indefinitely
To end borrowing will
to a country living beyond its means.
require at least a balance in the current account, and a current
account surplus would be required to reduce the size of the U.S.
Balancing the current account in the presence of
external debt.

-51-

52
substantial net interest outflow on the existing debt means
posting a large surplus on merchandise trade. Since the United
States has posted a merchandise surplus in only three years since
1970, the task facing the traded-goods sector is formidable.
a.

Trade Patterns Since 1980

Deterioration in the U.S. account has been extremely
broad-based. As the 1987 CEA Report states:
The trade balance has deteriorated against
virtually all major trading partners and in
virtually all major product categories.
Stagnation or decline in exports from virtually all sectors
of the U.S. economy, combined with sharply rising imports, caused
a decline in the overall merchandise trade balance including
sectors such as manufactured goods, services, food, and high
technology.
b.

Trade in 1986

Because the value of the dollar reached its peak on foreign
exchange markets in February 1985, and declined steadily
thereafter, in theory reducing the price of U.S. goods abroad and
raising import prices, it was widely assumed that the U.S. trade
While
balance would begin to improve in 12-18 months' time.
prices rose for selected imports -- about 20 percent in the case
of photographic equipment, optical goods, and cutlery; 10-20
percent in the case of automobiles, electrical equipment,
glassware, pharmaceuticals, and watches -- export growth
continued to lag the growth in imports. The monthly average of
U.S. exports in fourth quarter 1986 was $18.7 billion compared to
$17.4 billion in fourth quarter 1985, a rise of $1.3 billion,
while the comparable figures for imports were $32.7 billion and
$31 billion, a rise of $1.7 billion, and more than 30 percent
greater than the rise in exports. The trade deficit for just the
last quarter of 1986 was higher than the trade deficit for any
full year prior to 1982.

-52-

53
CHART XXX

U.S. TRADE GROWTH
400 -

350 -

300

0
0
LL

z
o

200
150

loo -A

50-i

1965

1967

1969

1971

1913

D EoPORS
- 53 -

69-874 0 - 87 - 3

1975

1977
+

1179

SPORTS

1981

I I

1983

1985

54
The prospects for significant rapid improvement in the trade
deficit are limited. According to the CEA Report, "after
deducting 0.7 percent from economic growth in 1986, real net
exports are expected to contribute a similar amount to growth in
In commenting on the trade deficit figures, however, CEA
1987."
Chairman Beryl Sprinkel told the Committee:
And the best you can say even up until today,
in my opinion, is that it ceased getting worse.
We think it is on the verge of improvement. There
was a slight seven plus billion improvement in
exports in the fourth quarter in the first
preliminary estimate of GNP, but we haven't really
started a significant improvement in that area
yet. We think it will happen.
Controversy continues over the failure to improve the trade
balance in 1986, and indeed over the degree to which the dollar
has declined on foreign exchange markets in the last two years.
The traditional Federal Reserve index shows a rise in the dollar
of more than 40 percent in 1980 to March 1985, and a 32 percent
decline since then. It must be kept in mind, however, that the
Federal Reserve index is based on historical rather than
contemporary trade patterns and attaches much greater weight to
the European industrial countries than to U.S. trading partners
in Asia. As a consequence, it reflects less than 60 percent of
U.S. global trade volume and may not be a fully accurate gauge of
the dollar's value.
c.

Barriers to Trade

In the short term, foreign trade barriers that keep U.S.
products out of markets abroad protect jobs abroad and make it
difficult for the United States to earn foreign exchange from
exports, thereby aggravating the trade deficit.l/ With reliance
on non-tariff barriers, which are less readily identifiable than
overt tariffs and quotas, there are indications that the use of
unfair trade practices by U.S. trading partners has grown in the
1980's.
1/ Japan is one of the worst offenders in this regard. DRI has
projected that reduction in Japanese trade barriers would boost
U.S. domestic employment by 250,000, including 100,000 jobs in
manufacturing.

-54-

55
The number of petitions filed by U.S. firms with the
International Trade Commission (ITC) alleging unfair trade
practices by foreign firms has risen dramatically.
In the
1955-1975 period, the average number of petitions filed annually
asserting dumping in the United States by foreign firms of
products at below-market prices was 24; since 1982, that average
has more than doubled.
From 1972 to 1981, the annual average of
petitions alleging the use of unfair government subsidies abroad
and requesting the imposition of countervailing duties was less
than 14; the average since 1982 has been 51.
d.

Trade Law Enforcement
Imoorts

Enforcement of existing U.S. trade laws has reinforced
trends toward managed trade and more restrictive trade laws.
The General Agreement on Tariffs and Trade (GATT), to which
the United States and 91 other trading nations subscribe,
includes "escape clause" provisions explicitly designed to permit
temporary relief for industries in process of adjustment to
changing trade patterns.
Escape clause import protection can be
provided to give firms showing injury a breathing spell while
adjusting to vigorous but fair competition from abroad.
However,
U.S. trade laws give the President the authority to refrain from
invoking the temporary escape clause provisions of the GATT, and
the Administration has exercised that authority to deny relief in
three of the six instances where the ITC has made a formal
finding of injury.
The Administration has preferred instead to negotiate
orderly marketing agreements in which import restraints are
negotiated independent of market conditions.
These managed trade
agreements do not adequately deal with the fundamental issues of
industrial adjustment and foreign trade barriers.
Furthermore,
they are readily circumvented by foreign competitors who
deliberately take steps to soften the impact -- e.g., Japan and
semiconductors; or by competitors who were not a party to the
negotiations
-- e.g., the Koreans with respect to auto
imports.

-55-

56
TABLE III
UNFAIR TRADE PETITIONS

(1955-1986)

Year

Dumpina

1955-1971

417

1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
Source:

39
27
10
10
28
19
47
30
40
19
68
47
48
46
68

Congressional Research Service

-56-

Foreign
Government
Subsidies

4
2
3
32
14
16
28
15
10

15
124
34
42
29
28

57
The Administration's refusal to invoke the escape clause
provisions under GATT also has caused domestic firms facing undue
competition to seek relief under existing U.S. law, rather than
through the international GATT. Escape clause filings since 1981
have been at barely one-third the pace of the late 1970's as
domestic firms have turned instead to the anti-dumping and
countervailing duty provisions of U.S. trade law. These laws
provide compensatory tariff protection for U.S. firms faced with
competition from foreign firms selling below cost (dumping) in
the United States or enjoying government subsidies for their
products. Petitions for relief under both the anti-dumping and
countervailing duty laws have risen dramatically during the
1980's and the number of petitions being found meritorious by the
International Trade Administration in the Commerce Department and
the independent International Trade Commission has more than
doubled.
Exports

There
Administration export policy also has been wanting.
has been no serious effort to address the fact that the existing
export tax exemption program does not offset foreign border tax
rebates to competitors abroad, or that the existing export
financing by the Export-Import Bank (Eximbank) and other programs
is inadequate when compared with foreign competitors. More
fundamentally, the Administration has failed to stem the use of
export subsidies abroad, particularly European Community (EC)
subsidies for agriculture export designed to shrink internal
surpluses; the threat earlier this year to impose very high
tariffs on cheese, alcoholic beverages, and wine reflected the
magnitude of this festering problem, and the extent to which the
Administration had to respond with a threat carrying severe
implications.
Unfair trade practices abroad affecting U.S. exports are the
subject of Section 301 petitions filed under the Trade Act of
1974 by private industry. Since Section 301 cases are directed
at foreign-government targeting and other unfair trade practices,
industry complaints must be resolved through U.S. Government
negotiations, either on a bilateral basis or through the GATT if
the government in question is a member of GATT and the issues are
within the purview of GATT.
In an independent review of the record, the General
Accounting Office (GAO) concluded that "Section 301 has not
provided substantial results" in removing trade injury. In
evaluating all Section 301 cases initiated or pending between
1980-1985, GAO found the average period required for dispute
settlement to be 34 months -- virtually three years. Evaluating

-57-

58
the success of Administration negotiators in these cases, GAO
found effective remedies achieved in only three of the 35 cases
surveyed.
In addition, the Administration has not forcefully
taken up cases -- e.g., Korean insurance and Japanese leather
import barriers, where foreign governments have reneged on
Section 301 agreements.
It should also be noted that the
Administration did not initiate any Section 301 cases prior to
the fall of 1985, when the problem already had reached urgent
proportions.
e.

Future Trade Policy

In addition to the
underlying the alarming
protracted indifference
implement existing GATT
important factors.

broad economic policy mismanagement
deterioration in the U.S. trade position,
to currency misalignment and failure to
provisions and U.S. trade laws are also

A new round of negotiations in the GATT opened late last
year and is scheduled to continue for several years.
Since GATT
is the international forum for resolving trade disputes, the
negotiations offer a clear and immediate opportunity to identify
and rectify unfair trade practices.
Unfortunately, the
objectives outlined by the Administration thus far are relatively
limited, focusing on trade in services, trade-related investment,
agriculture, and improvements in escape clause provisions and
intellectual property rights.
Failure of the Administration to
make a forceful commitment in principle to strengthen GATT's role
as a guarantor of free trade has diminished GATT's effectiveness
and accelerated the decline toward managed trade.
f.

Effects of the Trade Deficit on Growth
Economic Growth

The explosive growth in imports and stagnation in exports
during the 1980's has retarded economic growth, job growth, and
income growth.
Real domestic demand rose 3.5 percent in
1981-1986, but GNP grew only 2.5 percent with the trade gap being
responsible for the difference.
Had the trade balance not
deteriorated since 1981, economic growth in the 1980's would have
exceeded the pace of the preceding decade.
In contrast,
according to a recent report by the ITC, 42 percent of Japan's
economic growth in 1983-1984 was directly due to export surplus.
Job Loss
Any method of measuring the employment effects of trade
deficits raises significant conceptual problems.
Perhaps the
most useful analysis was prepared last year by David Lund of the

-58-

59
Policy Division of the Department of Labor. Using output ratios,
Lund determined that deterioration in the trade balance was
responsible for the loss of two million domestic jobs in
1981-1983.
(This figure is the sum of direct and indirect
employment loss. It includes job loss in export industries due
to productivity growth in the face of stagnant volumes as well as
job loss in import-competing industries and agriculture.)
Manufacturing was the source of over one-half of the jobs lost in
exports and nearly all of the jobs lost in import-competing
industries during this period. On that basis, about 1.3 million,
or three-quarters of the 1.7 million manufacturing jobs lost in
1981-1983, were trade related. While the Lund analysis does not
extend beyond 1983, the accelerated broad-based deterioration in
the trade balance since then would suggest that the trade deficit
continues to act as a brake on employment growth.
The attrition in jobs has taken place despite a diminishing
growth in the labor force which has lessened pressures for job
creation. Compared to the annual labor force growth rate of 2.7
percent in the 1970's, the average growth rate since 1980 has
dropped by 40 percent to 1.6 percent.
TABLE IV
JOB LOSS DUE TO TRADE
(1981-1983)
Export-Related:

1.1 million

Import-Competing:

0.7

Agriculture:

0.2
2.0 million

Source: "Employment Effects of U.S. International Trade
Changes," David Lund, Department of Labor, January 14, 1986

-59-

60
Income Growth
The rising trade deficit has been reflected in the
distribution of the 9.1 million jobs created since 1981, where
nearly one million manufacturing jobs have been lost while nearly
10 million have been added to the labor-intensive service-sector
work force. The 1987 CEA Report, recognizing this trend, noted
that:
Although many employees in service-sector
industries (such as health care, and banking and
finance) are high-skill, high-wage workers, wage
rates in service-sector industries are generally
below average wage rates in manufacturing,
indicating that skill levels are also lower.
Specifically, wage rates are relatively low in the
two service-sector industries (retail trade and
business services) that have recorded the
strongest employment gains since 1981.
Even in manufacturing, total compensation in the United
States since 1980 has lagged behind growth in compensation
abroad. Bureau of Labor Statistics (BLS) data indicate that,
over the past six years, real compensation for workers in
manufacturing in six major trading competitors has grown much
more rapidly than in the United States, so that several countries
now nearly match U.S. levels.
The loss of higher paying jobs in manufacturing, and this
past year in the mining and minerals sectors, plus the
concentration of job growth in lower paying service jobs, has
retarded income expansion. Average weekly earnings in the
private nonagricultural sector were $172 in 1980 (1977 dollars)
but $170.3 in December of 1986.
g.

Remedies

The decline in the trade sector is in large part responsible
for the erosion in economic, employment, and income growth since
1980. A broad range of trade and economic policies, carefully
developed and implemented, will be required to reverse the trend.
It will be difficult to eliminate the trade deficit through
import shrinkage. Major trading competitors will be reluctant to
give up hard-won shares of the U.S. market, as the willingness to
cut profit margins in the face of less favorable currency
exchange rates suggests. More to the point, to the extent that
reduced import levels mean reduced U.S. consumption, they will
mean a decline in the domestic standard of living.

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61
Historically, the most frequent solution to the trade
deficit problem has been to cut consumption dramatically. This
is a familiar pattern in the Third World, where countries with
current account deficits exceeding 3 percent of GNP are often
required, as a condition of assistance from the International
Monetary Fund (IMF), to implement stringent austerity programs
that cut demand, raise unemployment, and in effect engineer
Curbing the deficits through demand restraint is not
recession.
unknown in the United States. Domestic demand declined
significantly in the 1974-1975 recession, transforming the 1974
merchandise trade deficit of $11 billion into the 1975
merchandise trade surplus of $2 billion.
The immediate task is therefore to redress a trade imbalance
which if left uncorrected may lead to a recession, and to do so
through a policy framework that embraces world economic growth,
currency revaluation, more open markets abroad, and trade policy
reform at home.
Even assuming an export orientation is achieved, the
problems of export expansion should not be underestimated.
In
1986, merchandise imports were 60 percent larger than exports, so
that exports would have to increase 60 percent faster than
imports simply to keep the trade balance from deteriorating.
Sustaining such differential growth rates for a prolonged period
will be extremely difficult.
2.

WORLD ECONOMIC GROWTH

As important as a new export orientation is on the part of
the American economy, it will be ineffective in the absence of
increased demand abroad for U.S. products. For the past six
years, the United States has been virtually the world's only
source of import demand growth,.in effect supporting the
economies of other major trading nations by importing their
products.
In the 1968-1977 decade, world trade measured in
volume terms grew at an annual rate of nearly 8 percent. Since
then, the growth rate has declined by more than half, to 3.2
percent. World trade volume was stagnant in 1980-1983 in the
wake of the 1979 oil price shock, grew 8.6 percent in 1984, but
declined again to an annual rate under 4 percent in 1985-1986.
Yet in 1984-1986, U.S. import volume expanded by more than 42
percent, according to the IMF, while the comparable figure for
Europe was 19.4 percent and for Japan was 19.5 percent. Securing
a foothold in the U.S. market has become a cornerstone, perhaps
the cornerstone, of other nations' trade policies. The
experience of the past two years, when the dollar fell sharply
against other currencies, suggests that the foothold, once
secured, is not easily reduced.

-61-

62
a.

Demand' Growth in the Industrialized Worlds
Possibilities

Limits and

The industrialized nations of the world, particularly the
EC, Japan, and Canada, are by far the most important American
trading partners, accounting for roughly 57 percent of U.S.
exports and imports.
For the past several years, domestic demand growth in the
other industrialized nations has fallen below the historical
average growth rate of 3 percent, reaching only 1.5 percent in
1983, 1.9 percent in 1984, and 2.3 percent in 1985. In addition
to the downturn in demand, other characteristic signs of
In Europe, unemployment
stagnation or recession have appeared.
is generally in the 9-11 percent range and substantial excess
capacity exists in the manufacturing sector. In Japan,
unemployment has also risen to a postwar high of 2.75 percent,
and economic growth has fallen to 2.25 percent, less than half
the 1984 rate. Prudent analysis would suggest opportunities for
expansion and demand growth in the industrialized world without
at this time incurring problems of supply bottlenecks or renewed
inflation.
Nonetheless, Administration efforts to induce faster growth
policies, particularly in Germany and Japan, thus far have had
limited success. Fiscal policy in virtually every other
industrialized country has been restrictive and monetary policy
has also been relatively tight, particularly in West Germany
which has resisted repeated requests by France and other European
nations for reduction in its very high interest rates. Latest
OECD projections suggest that in 1987 the growth rate in Germany
and Japan will not exceed 3 percent, the weakest since the
recession of 1981-1982.
Assuming current trends, there is little reason to expect a
An OECD staff
significant shift in existing trade balances.
analysis foresees the possibility of continuing U.S. current
account deficits in the range of $100 billion and 2.4 percent of
GNP "for many years to come.'
While faster growth in Europe and Japan would have a
positive effect on the U.S. trade balance, its importance should
The October 1986 IMF World Economic Outlook
not be exaggerated.
concluded that a one percentage point increase in domestic growth
in Japan and Germany, even if maintained over three years, would
have an effect on the U.S. trade balance in the $5-$10 billion
range since the industrial structures of the two nations are
similar to the American and income elasticities of demand for
U.S. exports are very modest.

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63
b.

Demand Growth in the DeveloDing World:
Possibilities

Limits and

Because of the limited potential for growth in the
industrial world to reduce the U.S. trade deficit, resumption of
demand growth in the developing world is central to restoring a
healthy world trade balance and indeed to the health of the world
economy.
In contrast to the industrial nations, developing
nations -- particularly in Latin America -- have shown a much
higher propensity to consume imports as their economies expand.
Between 1976-1980, for example, the developing world accounted
for 44 percent of the net increase in U.S. exports, even though
their average share of U.S. exports was only 37 percent.
For the
entire decade of the 1970's, the growth rate in U.S. exports to
the developing world significantly exceeded the growth rate in
exports to the industrialized world.
A major factor in improving the U.S. trade balance will be
assuring a resumption of healthy growth in the Third World, and
reversing the drastic economic contraction brought on by the debt
crisis. Growth will be difficult, however, so long as the debt
crisis remains unresolved.
Economic theory and historical
example both argue that borrowing from abroad is a sound and
indeed necessary practice for developing countries which have
abundant natural resources and labor but insufficient savings and
equipment to develop them.
Savings are limited by low levels of
national income and inadequately developed mechanisms for
promoting savings, while equipment is not yet manufactured
domestically and must be obtained from abroad. Countries facing
import and savings constraints can increase growth rates
substantially by borrowing resources from abroad -- as the United
States, Canada, and Australia did at earlier periods in their
economic development, repaying loans used to finance development
as productive capacity expanded and trade deficits turned into
trade surpluses.
The expansion in borrowing prevalent in the developing world
in 1968-1977 permitted an annual growth of import volume of 9.2
percent at a time when industrial world imports expanded at a
slower (but still
considerable) 7.4 percent annual rate. While
the annual average growth rate in the industrialized countries
declined in 1973-1982 in response to the oil crises to 2.8
percent from 4.4 percent in the previous 15-year period, the
growth rate in the non-oil Third World declined only marginally
over the same period, from 5.8 to 5.1 percent.
Expanded
borrowing provided the buffer against reduced imports and reduced
growth rates that price increases would otherwise have required.

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64
The 1982 announcement by the Mexican government that
payments would be suspended on outstanding debt focused attention
on changes in economic conditions in the Third World, brought on
by declining commodity prices on the one hand and the rising
interest rates on the other. Export earnings were no longer
adequate to finance both debt service and domestic growth, and
new bank borrowings declined.
TABLE V
NET EXTERNAL BORROWINGS FROM PRIVATE CREDITORS
1981

1982

1983

Total Developing World

15 Heavily Indebted
Countries*

-2.6

* These countries are: Brazil, Argentina, Peru, Ecuador,
Bolivia, Colombia, Mexico, Venezuela, Chile, Uruguay, Ivory
Coast, Philippines, Nigeria, Morocco, and Yugoslavia.
Source:

IMF World Economic Outlook

In response to creditors' pressure for expanded exports and
curtailed imports to assure debt service payments, imports to the
15 heavily indebted countries declined by 36 percent in volume
terms since 1981.
The Latin American experience is especially important to the
United States. Between 1981-1984, the trade balance in Latin
America moved from a $4 billion deficit to a $38 billion surplus,
a $42 billion swing attributable largely to import reductions.
The effect on U.S. exports was immediate and dramatic. Over that
same period, U.S. iron and steel exports to Latin America fell 73
percent, construction equipment exports to the region fell 75
percent, and agricultural machinery exports dropped 71 percent.
On a broader scale, the IMF estimates that import restraint in
the developing world has meant a 2.5 percent decline in export
growth worldwide. The recent OECD Economic Outlook (December
1986) concluded that weakness in demand from the developing world
has retarded GNP growth in the industrial world by approximately
one percentage point, from the 3 percent projected in 1985 to the
2 percent actually realized for 1986.

-64-

65
. CHART XXXI

LATp AMECAN E ORTS
TO
MAJOR COUNTRES

I
it

I
J
h.
0

0
j
-j

1965

1967

1969

1971 .1973

- 65 -

1975

1977

1979

1981

1983

1985

66
In addition to reducing imports, with adverse consequences
for U.S. producers, debtor countries increased their own exports
significantly in order to improve their foreign exchange
In contrast to other major industrial countries, the
earnings.
United States has provided a ready market for their expanded
exports, with further adverse consequences for U.S. producers.
A consequence of vastly increased exports on the part of debtor
countries has been greater supplies on the world market, with a
In volume terms, exports from the 15
concomitant drop in prices.
most heavily indebted countries increased 6.7 percent in 1983 and
9.6 percent in 1984, a rate three to four times higher than the
While driving down
2.4 percent average from 1968 to 1977.
commodity prices for all producers, the developing countries'
exports have not produced sufficient export earnings to permit
them to meet their debt service obligations and at the same time
achieve needed rates of domestic growth.
The pain of adjustment to the Third World debt problem has
*been borne disproportionately by some but not all segments of
Debtor countries have borne the burden of declining
society.
U.S. farmers and
national incomes and severe domestic austerity.
industrial exporters have also borne a heavy burden in terms of a
collapse in U.S. export markets to the debtor countries and
Taxpayers in the industrial world
increased export competition.
have borne some of the cost, as World Bank and IMF lending has
been increased to help countries cope with the sudden collapse of
However, the financial system as yet has not
private lending.
debt has been written off,
borne similar burdens as very little
and debt re-schedulings have deferred the date for the repayment
of principal without providing any major concessions on the
interest rates charged to troubled debtors.
New initiatives which balance better the burdens of
adjustment to the debt problem clearly need to be considered.
New Initiatives
It is to the credit of Treasury Secretary James Baker that
upon assuming his cabinet position in 1985 he reversed the
Administration's policy of ignoring both the debt crisis and the
The Baker
crisis arising from the overvaluation of the dollar.
announced in 1985 at the IMF meeting in Seoul, Korea,
Plan, first
established as a goal the resumption of growth in debtor nations
The Plan recognizes that such a
of both imports and GNP.
resumption of growth will be impossible without renewed access to
external finance, and outlines a program for expanded lending by
the World Bank accompanied by renewed lending on the part of
private commercial banks, conditioned on the borrower's
commitment to carrying out certain domestic reforms.

-66-

67
Nonetheless, the Plan appears to be inadequate in scope and
unrealistic in its expectations.
It calls for some $9 billion
annually in new financial flows over the next three years, but
World Bank and other estimates suggest that the needs may be
close to $20 billion per year for the next five years. The Plan
assumes willingness on the part of commercial banks to resume
lending to nations already overburdened with debt service
obligations, although such an undertaking on the part of the
banks involves obvious risks in a climate of falling commodity
prices and uncertain export markets. In fact, nothing resembling.
the Baker Plan has been put into place for any debtor nation
other than Mexico, and the Mexico package has not yet been
implemented because a number of U.S. banks .ontinue to resist new
lending.
Private debt capital flows on the scale envisioned by the
Baker Plan are unlikely to resume until the problem of existing
debt burden is addressed.
A number of proposals deserve serious
analysis. Among these are efforts to encourage repatriation of
"flight capital" to debtor countries (to provide a significant
source of new finance without creating new foreign exchange debt
service obligations); new financial instruments, such as mutual
funds (to provide new sources of investment capital without
worsening the countries debt service ability); debt-for-equity
swaps; and local currency repayment of loans now denominated in
foreign currencies.
Proposals for new capital inflows, however, may have to be
combined with some new approaches to managing the existing debt.
At present, this difficult task can be accomplished only through
arduous negotiations between private lending institutions and the
debtor governments -- a complex and protracted procedure which
carries with it significant financial, economic, political, and
diplomatic risks.
An alternative approach may be the creation of a special
multilateral institution specifically to address the
restructuring of Third World debt. Such an institution could
serve to mediate conflicts between debtors and creditors, and
work out compromises which would balance the interests of various
parties in a common pursuit of renewed world growth. Some
portion of the activities of such an intermediary could involve
the purchase of sovereign debt at a discount from the banks and
passing along the benefits of this discount, and a restructuring
of the remaining debt at better terms and rates to the debtor
countries. Financing for the intermediary should come largely
from countries with strong current account surpluses, since those
surpluses are both a threat to the world trading system and the
major source of investment capital in the world economy.

-67-

68
C.

Monetary Reform
The Problem of Currency Misalianment

Among the causes of the current severe imbalances in
national trading accounts, ranging from the U.S. trade deficit of
$169 billion to the Japanese trade surplus of $82 billion, is the
misalignment of the world's currencies, in particular the
overvaluation of the dollar that began in 1982 and is only now
being addressed.
Since March 1973, when the system of fixed
exchange rates was abandoned, the world economy has operated
under a system of floating rates, which in theory reflects the
underlying flow of goods between countries and permits rapid and
orderly adjustment of currency values through free-market
exchanges.
The experience of the past 13 years has been very different,
however, as exchange rates are increasingly determined more by
capital movements than by trade flows. This is in part the
result of speculation and, over the longer term, of macroeconomic
policy differences between major countries that lead to
substantial capital movements in pursuit of interest-rate
differentials. While international trade in goods and services
now totals approximately $3 trillion annually, foreign exchange
transactions in New York, Tokyo, and London are running at about
$188 billion daily, or $40 trillion annually.
Under these changed conditions, some countries, notably
Germany and Japan, have found it possible to run substantial
current account surpluses for several years without experiencing
a significant appreciation in their currencies, while the value
of the dollar has remained very high despite the rapid expansion
in the U.S. current account deficit.
Volatility

As Chart XXXII shows, the weekly variation of the dollar
with respect to the yen has been substantial, with changes of as
much as 7 percent. in a single week.

-68-

69
cHART XXXI

WEEKLY CHANGES INYENOLLAR RAE

1985d1

1985:18

198535

- 69 -

19M85

1986:17

198634

198651

70
Volatility of this magnitude makes forward planning by firms
engaged in international commerce difficult;. Particularly hard
hit are small firms with limited financial expertise and
insufficient resources to hedge international goods transactions
with financial market options. Concerted intervention in
currency markets by the world's major central banks is a
reasonable and responsible means to assure more orderly and less
volatile markets. The Administration unfortunately resisted such
action until very recently, but appears now to be moving in a
positive direction.
The Value of the Dollar
While there is general agreement that the overvaluation of
the past six years -- to which floating exchange rates and
capital market innovation have contributed -- there is little
agreement on the degree of overvaluation or the extent to which
the dollar must fall in order to produce an exchange rate which
will balance U.S. international goods flows over the long term.
Part of the problem lies in determining the value of the
dollar. As noted earlier, the Federal Reserve Board index, which
is the one most commonly used, is based on historic trade
patterns and assigns primary weight to America's industrialized
trading partners. The Federal Reserve Board index shows the
dollar to have risen 40 percent on a trade-weighted basis from
1980 to its peak in February 1985, and to have fallen 32 percent
since then (Chart XXXIII). Broader indices, such as those
compiled by Morgan Guaranty Trust and both the Dallas and Atlanta
Federal Reserve banks, show a greater rise in the dollar during
1980-1985, and a substantially smaller dollar decline in the
period since.
If the broader indices paint a more accurate picture of the
true trade-weighted value of the dollar, it would appear that the
U.S. dollar remains significantly overvalued against the
currencies of many major trading nations.
Examination of bilateral exchange rates between the dollar
and selected other currencies clarifies the shortcomings of the
Federal Reserve index, as well as the problems associated with
floating exchange rates. Changes in the value of the dollar
against the currencies of Newly Industrializing Countries (NIC's)
have been very small, despite the fact that U.S. bilateral trade
deficits with these countries have grown dramatically. In
addition, the value of the dollar actually has been rising
against the currencies of major U.S. trading partners in Latin
America, in part as a result of debt-induced export promotion

-70-

71
CHART XXXIII

TRADE-WEM EDDLLAR ICES
FEM ANUNFE
2
l9

1.6
1.5
1.4
13
1.2
1.1

0.9
0.8*
0.7~
19701971 1972 1973 19741975 1976 1977 1978 1979 1981981 1982 193 198195 1936

- 71 -

72
efforts which require currency devaluations in the
developing world to stimulate exports and earn foreign exchange
for debt service.
The Taiwan Dollar and the Japanese Yen
A brief look at two bilateral exchange rates -- between the
U.S. dollar and the Taiwan dollar, and between the U.S. dollar
and the yen -- provides some insight into the importance of
considering the question of dollar valuation on a
country-by-country basis.
In 1980-1985, Taiwan built a substantial bilateral trade
surplus with the United States while at the same time the Taiwan
dollar fell in value relative to the U.S. dollar, although trade
flows would have predicted a rise in the Taiwan dollar as the
U.S.-Taiwan bilateral trade deficit grew. Although exchange rate
adjustment is evident from mid-1985, the bilateral deficit has
continued to rise, suggesting that the Taiwan dollar remains
substantially undervalued with respect to the U.S. dollar.
While Secretary Baker is correct in suggesting that exchange
rate adjustments alone will not eliminate the U.S. trade deficit,
it is not yet clear that the dollar has achieved an appropriate
level with respect to the currencies of all major U.S. trading
partners.
The substantial impact which both governmental statements
and direct central bank intervention in currency markets can have
on foreign exchange values is reflected in the recent experience
At the G-5 meeting in September
of the dollar against the yen.
1985,2/ the United States and Japan agreed that the dollar was
overvalued with respect to the yen, and the following day the
Over the next 12 months it
value of the dollar fell 5 percent.
When, in October 1986, the two
fell an additional 25 percent.
governments issued a joint communique announcing that the dollar
was properly aligned against the yen, the two currencies
Both policy communiques were supported by occasional
stabilized.
coordinated central bank intervention in currency markets,
producing an orderly decline in the dollar relative to the yen.
2/ G-5 is a consultative group comprised of finance ministers of
the five major industrialized countries -- the United States, the
The G-7 group is
United Kingdom, France, Germany, and Japan.
comprised of the G-5 plus representatives of the next two
industrialized nations -- Italy and Canada.

-72-

73
CHART XXXIV

TAIWA?(S TRADE SURPLUS WITH U.S.

h.M
III
0
j
i 20

190.1 1980:71981:11981-71982.11952.71983.1 1983:71984:1 I98471985:11985:71986:11986:7

- 73

74
CHART XXXV

TAWAN/US. EXCHANGE MRAT

:rT

Taiwan Dollars Per Us Dollar

47
45-.

U434241

4039 j

37-,
36
-

35-

341
33-t

32-aI
31

198

1981

1982

- 74 -

1983

1984

1985

1986

75
In the final months of 1986, however, the agreement between
the United States and Japan on the appropriate value of the
dollar appeared to have broken down. Officials at the Treasury
and the Federal Reserve were seen as having substantially
different views on the future course of the dollar, and the
foreign exchange markets became highly uncertain about both
currencies.
This uncertainty created a need for more visible signs of
policy agreement among the major governments on exchange rates,
and the G-5 ministers then met in Paris in February 1987,
producing an apparent agreement to stabilize exchange rates and
to promote faster growth in both Germany and Japan. Some
uncertainty surrounds the details of the agreement, particularly
with respect to the commitments by various central banks to
intervene in support of existing exchange rates.
But despite
this uncertainty, the recent Paris agreements represent a step
forward in increasing the coordination of monetary and fiscal
policy among major nations in pursuit of more realistic and
stable exchange rates.
The experience with the yen suggests the desirability and
efficacy of coordinated policy action and improved management of
other bilateral exchange rates, especially in cases of countries
enjoying large bilateral and multilateral trade surpluses whose
currencies have not moved significantly. The Taiwan dollar, for
example, is insulated from normal market adjustment mechanisms by
deliberate government policies with respect to capital controls
and central bank reserves. Taiwan's central bank currently holds
$48 billion in U.S. dollar reserves, more than the central bank
reserves of any industrialized country.
Apart from such targeted initiatives, there is need for
further examination of the entire international monetary system,
the role of capital mobility in the exchange rate system, and the
tensions caused by having the U.S. dollar serve as the central
bank reserve currency.
The complexity of the problems posed by
the international monetary system should not deter the search for
a solution.

-75-

76
CONCLUSIONS
1.
Much of U.S. trade law has been overtaken by a rapidly
changing and increasingly competitive world economy. It is time
for a careful and thorough revision of existing trade laws to
provide a more effective and equitable means for assuring open
foreign markets and expanding world trade, and for facilitating
the adjustment of U.S. firms to the new challenge of
international competition.
2.
A-new round of negotiations is underway in the GATT, the
basic international structure for setting the rules of trade. In
recent years, GATT's scope has proved too narrow to meet changing
conditions and its effectiveness has declined, while at the same
time strains in the international trading system have
intensified.
The Administration should therefore move into the
negotiations with the clear objective of making the GATT a major
guarantor of open markets and expanding world trade. Toward this
end, the Administration should expand its current limited agenda
for the GATT round and assure that the United States will be
represented by skillful and experienced negotiators fully backed
by the Administration.
3.
Although the exchange value of the dollar is a major
determinant of the U.S. international trade position, its
critical role was ignored or minimized by the Administration for
too long. Beginning this year, the Administration should submit
semiannually to the Congress an International Monetary Policy
Report outlining the steps being taken by the Administration to
secure both stability and proper alignment of international
currency values.
4.
Stabilization of international exchange rates will require a
higher degree of coordination in the domestic fiscal and monetary
policies of the major trading nations than has been evident in
the past few years.
Securing this coordination should be a major
goal of economic policy, and an important objective for the
Administration in its diplomatic dealings with U.S. allies.
5.
Under the prevailing system of floating exchange rates,
capital flows are critically important in determining currency
values and in influencing the flow of goods and services between
nations. Data currently available about different types of
capital movements are inadequate and unsystematic, collected by a
variety of different agencies on the basis of widely varying
assumptions and methodologies. To assure better information on
international capital flows, the Administration should review
existing capital flow data and develop plans for comprehensive
and coordinated data collection and publication.

-76-

77
6.
Orderly adjustment in the world economy to a declining U.S.
trade deficit requires strong demand growth abroad. This is
particularly true in the developing world, where in many
countries growth is hampered by excessive debt burdens and a
large transfer of financial resources from debtor to creditor
countries. Administration initiatives to promote growth in the
developing world, while a step in the right direction, have been
insufficient. With the objective of assuring a resumption in
world economic growth, policies must be developed both to reduce
the outflow of funds from the developing world and to increase
the inflow of new capital, and new methods should be designed to
balance the needs of creditors and debtors, and expand the role
of surplus countries in financing world development.

77-

78
PRODUCTIVITY AND RESOURCE UTILIZATION

C.
1.

PRODUCTIVITY

In the postwar period, both the rate of productivity growth
and the share of total output growth due to gains in productivity
have declined consistently. Parallel to the decline in the U.S.
productivity growth rate, and largely caused by it, has been the
drop in the average annual compound rate of increase in real
hourly compensation: 2.9 percent-in 1947-1965, 2.2 percent in
1965-1973, and 0.2 percent in 1973-1986.
TABLE VI
GROWTH OF OUTPUT, PRODUCTIVITY, AND HOURS WORKED,
IN THE NONFARM BUSINESS SECTOR, 1947-1986

Period

Output

Productivity

Hours
Worked

Percentage of
Growth in
Total Output
Due to
Productivity
Gains

1947-1965
1965-1973
1973-1986

3.9%
3.7
2.4

2.7%
1.8
0.7

1.1%
1.8
1.7

71%
50
.29

Source:
a.

Bureau of Labor Statistics

Productivity And International Competition

The United States today lives in a changed world economic
environment and-can no longer ignore international trends,
standards, and conditions. Where productivity is concerned, U.S.
increases fall far short of accomplishments in other countries.
In 1980-1985, overall productivity rose more rapidly in 11 of the
12 countries studied by the BLS than in the United States.

-78-

79
CRAIT XXXVI

GROWT IiGROS DOESTE PRODUCT
sr~~~PrBDw r N

z
I.

/ A5

- 79 -

80
The Japanese case is worth noting. In 1950, the value of
real gross domestic product (GDP) produced by the average
Japanese worker was only one-sixth the value of the production of
the average American worker. By 1960, this ratio had risen to
one-fourth; by 1970, to one-half; by 1980, to more than
The tremendous growth
two-thirds; and by 1985, to three-fourths.
in productivity explains how Japan, with the world's seventh
largest population and virtually no natural resources, has
If this trend
developed into the world's second largest economy.
continues, the average Japanese worker will be more productive
than his American counterpart by the end of the century, a
development which has already occurred in certain industries.
Since 1980, wage increases in manufacturing have been low,
while productivity growth has been much stronger than in the
economy as a whole. The moderation achieved in unit labor costs
has been more than offset, however, by the sharp rise in the
value of the dollar. The Council of Economic Advisers estimates
that between 1980 and 1985 average U.S. unit labor costs fell 4
percent relative to foreign unit labor costs, without adjusting
for exchange rates. But the sharp rise in the value of the
dollar raised U.S. labor costs by 39 percent on a dollar basis
relative to foreign unit labor cost.
In any effort to reduce the trade deficit, the value of the
dollar will be an important factor. Over time, a more realistic
valuation will make U.S. products more competitive and contribute
to reducing the deficit, but adjustment of currency exchange
If productivity
rates alone will not solve the deficit problem.
cannot be improved sufficiently to assure U.S. competitiveness,
United
States
will
be forced to
and
at
home,
then
the
both abroad
resort to alternative measures to bring down the deficit that
will undermine the U.S. standard of living -- using recession to
restrict U.S. demand as a means of discouraging imports; lowering
wages in an effort to make the United States more competitive; or
countenancing the radical devaluation of the dollar.
b.

Sources of Productivity Growth -- Capital Formation.
Education. and R&D

Productivity growth rates rose in 1983 and 1984, consistent
with business cycle trends in which productivity generally rises
rapidly in the early stages of a recovery as output rises without
major increases in the labor force. Since that time, however,
the growth rate has been much lower -- 0.5 percent in 1985 and
0.7 percent in 1986 -- and productivity actually fell at a 1
percent rate in the second half of 1986.
If steady improvement in productivity is to be assured in
the long term, basic questions about the formation and use of
capital resources, and about the skills, competence, and

-80-

81
motivation of the labor force, will have to be addressed. The
CEA Report cites "four important developments' -- demographic
trends, recent energy price declines, R&D expenditures, and tax
revision -- which are "likely to contribute to stronger long-term
productivity growth." The CEA analysis requires brief comment.
First, the CEA places the longer term developments in a very
It is true that over the next 15 years the labor
narrow focus.
force will grow older and more experienced, and that productivity
generally increases with age and experience. The potential for
significant improvement in productivity will be limited, however,
by the extent to which the working population is undereducated,
unskilled, and untrained -- for example, functionally illiterate
40 year-olds are likely to be only marginally more productive
than functionally illiterate 25 year-olds. While the CEA
acknowledges the critical role "government" has to play in
education, the role of the Federal Government goes unmentioned,
consistent with pending Administration proposals to reduce
Federal elementary and secondary school programs and at the
post-secondary level to terminate the work-study program,
radically restructure the Guaranteed Student Loan program, and
further reduce existing grant programs.
Second, where energy prices are concerned, sustained
improvement in productivity will depend on future energy prices
and not simply on those that occurred in 1986. The Producer
Price Index (PPI) for finished energy goods rose 10 percent in
January of this year, and virtually all forecasts, including the
CEA's, foresee additional price increases.
Third, investment in R&D is an important factor in promoting
technological progress and productivity growth. While Federal
R&D expenditures have increased nearly 60 percent in 1981-1986,
the emphasis has been overwhelmingly on the military, which has
more than doubled while nondefense R&D has increased less than 6
percent. As a result, the defense-nondefense balance in the
Federal R&D program has shifted from roughly 50/50 to well above
2/1. Furthermore, as a percentage of GNP, the total U.S.
commitment to nondefense R&D (both private and public) falls
significantly short of West Germany and Japan, and has grown at a
much slower rate.

-81-

82
CHART XXXVI I

OF GW
NON-DfEf ER&D AS AP CE
10

2.9

T--~~~~~~~~-

2.7 -

2A
I~

2.6 -i
2.5 2.4Ski

-n

2.3

2.1

2.0

1.7z
1.6.

1.5 -

1980

1981
awmAMW

1982
+ JAPAd
WU.S
- 82 -

193

83
Fourth, the CEA cites the recent tax revision, indicating
that any "small negative effect on the long-run capital stock
will be accompanied by a reduction "in distortions affecting the
distribution of capital among productive activities." While in
testimony before the Committee CEA Chairman Sprinkel said that
the short-term adverse effects of the tax changes "should end in
1987," most private forecasters believe they are more likely to
begin in 1987. Economists differ significantly over whether the
long-term benefits will exceed the short-term costs, suggesting
that at this time the consequences of tax revision for
productivity growth cannot be assumed with any certainty.
c.

Outlook for Productivity

Keeping in mind that Administration productivity forecasts
have tended in the past to be overly optimistic, the plausibility
of the current forecast can be examined by comparing it with
other current estimates.
In testimony before the Committee, Federal Reserve Chairman
Volcker said that "unhappily there is no solid evidence' that
productivity will "increase above the recent trend of 1 percent
or so.". DRI and Wharton Econometric Forecasting Associates both
see productivity rising at an average annual rate of 1.3 percent
over this period.
Chase Econometrics is slightly more optimistic
at 1.5 percent, but still below the Administration's projection
of 1.9 percent.
It seems that this year, as in the past, the
official six-year forecast of average productivity growth rate is
probably too high by at least a half of a percentage point and
perhaps as much as one percentage point.
Improving productivity will require particular attention to
the service sector, where a growing percentage of the working
population is employed. The CEA Report takes note of this
problem, which reflects the declining share of jobs in
goods-producing industries, especially manufacturing, and a
concomitant increase in service-sector employment. Over the
1973-1985 period, hours worked in manufacturing, agriculture,
transportation, and public utilities -- jobs with good
productivity growth, i.e., 2.2 percent annually -- declined
markedly, while hours worked in wholesale and retail trade and
other service-sector -- jobs with very low productivity growth,
i.e., 0.4 percent annually -- increased to account for 48 percent
of total hours worked.
The challenge of improving productivity
in the service sector is complicated by the fact that output per
hour is difficult to measure.

-83-

84
CHART XXXVI I I

HCREASES NNON-FARM OE[PUT
Average Annual Incruse

"I,

41~~~~~/

1~/,/

.
I

:t~~~~~~~~~V/

1947-1965

1965-1973

Ermuhm

OURSWEED
- 84 -

1973-19B6

85
2.
a.

U.S. CAPITAL RESOURCES
Savings/Investment

Any economy which seeks to grow and develop must save a
significant portion of current output and apply those savings to
investments which will help expand output in the future. As a
general rule, the greater the savings and the more productive the
investment, the greater the long-run growth potential of the
economy.
Historically, the United States has had a savings rate quite
low in comparison to that of other countries. This low savings
rate traditionally has not been a drag on U.S. economic growth.
For most of this century, the U.S. economy generated more savings
than were needed to meet the demands of businesses, households,
and government for borrowed funds.
The United States used some
of this excess savings to finance a portion of the investment
needs of a large number of foreign countries.
During the 1970's, however, the demand for savings began to
press upon the available supply of savings. Borrowing,
particularly by consumers and government to support current
consumption, increased significantly, and concerns began to be
voiced that these consumption-related borrowings would "crowd
out" business investment.
In an environment of increased
borrowing, America's low savings rate became an important issue
in the economic debate.
Increasing the savings rate was a major goal of
"supply-side" economics, a key justification for the 1981 tax
*cuts, and a centerpiece of the Administration's 1981 economic
program. Nonetheless, recent policies pursued appear to have
worsened the savings rate and expanded the pressures of borrowing
on America's shrinking pool of savings. To balance the increased
demands of borrowers with the supply of funds by domestic savers,
the United States has borrowed heavily from savers elsewhere in
the world.
Under these new circumstances, there is growing concern that
the low U.S. rate of domestic savings is no longer compatible
with strong long-term growth in the economy. The rapid increase
in consumption-related borrowing means that needed long-term
investment in the economy can be financed only by borrowing
savings from abroad. While this external borrowing makes it
possible to sustain an illusion of rising living standards in the
present, such borrowings constitute a claim against future U.S.
output and the future earnings of U.S. producers.

-85-

86
The growing gap between borrowing and saving in the U.S.
economy will need to be reduced in the years ahead if the economy
is to achieve its maximum long-run growth potential. Such
adjustment requires both an increase in savings and a decrease in
borrowing to support current consumption or wasteful speculation.
U.S. Savinas Rates:

An International Comparison

Administration policies have not improved the savings
performance of the United States compared to that of the other
In 1984, the last year for which comparable
G-7 countries.
international data are available, gross savings were still a
smaller percentage of GDP in the United States (17 percent) than
in any other major industrial country (Chart XXXIX).
Gross savings, however; may not be the best index of the
resources available to increase a country's capital stock. A
portion of every nation's gross savings must be devoted to
replacing worn out or obsolete capital, but while replacement of
depreciated equipment is essential, such capital consumption
expenditures simply prevent the stock of plant and equipment from
shrinking. For this reason, the amount of savings remaining
after depreciated capital has been replaced -- net savings -- may
be a better measure of comparative savings and investment rates.
According to this measure, the United States lags even further
behind its major industrial competitors.
Not only are gross savings a smaller percentage of GDP in
the United States than in other OECD countries, but a greater
percentage of U.S. gross savings are devoted to replacing worn
In the United States, approximately 75
out capital (Chart XL).
percent of gross savings is used to meet depreciation expenses;
only 25 percent is available for expanding the capital stock. In
Japan, by comparison, less than half the gross savings are used
to replace worn out capital. In the other OECD countries, the
comparable figure is between 57 percent and 63 percent.

-86-

87
CHART XXXIX

GROSS SAVINGS AS APERCENT OF GDP, 1984
32 -.

30
28

26/
24
2220

I
|

1210
a
6
4

.22
U

U.S.

Japan

Germany

France

- 87 -

U.K.

Htaly Canada

Avg.

88
CHART XL

DEPRECMAlON AS APERCENT
GOSSSAINGS, 19lU
801

~7 .

!/
/

V-

WI7 't

,i ,. .

r'7 7

4 i.1- . j

;

,
A , i,,
/.1.f

/
/,

I..

z
U

)
301 '

*,'

/
'

/
.

*
':

; ,

A V
/

I,.

,.'

Japan

.iJ

f,,/

Germany

- 88 -

France

z/'J
UIl.

' i"'A
f'ana,,'d.'

'
I.

i,,, /E j

)

:.''/1

; /

U.S.

30X-

*L¾11

Hai

89
Because the United States saves less than other OECD nations
and then devotes a larger portion of its savings to maintaining
the existing capital stock, the United States lags behind other
countries in terms of the savings (measured as a share of GDP)
that are available to expand the existing stock of capital (Chart
XLI). In the United States, net savings amount to only 4 percent
of GDP.
In Japan, the share of GDP devoted to net savings is
more than four times greater. In the other G-7 countries, net
savings are approximately twice as large as in the United States.
Trends in Savincs
To determine why the United States lags so far behind its
main industrial competitors, it is necessary first to determine
which economic sectors are actually doing the saving as well as
how those savings are invested.
One of the most commonly used indices of U.S. savings is the
personal savings rate -- the amount of disposable, or after-tax,
personal income remaining after deducting all household
expenditures for consumer goods, monthly housing payments, and
other debt service costs such as credit card payments and auto
loans. Measured in terms of personal savings, U.S. savings rates
appear to have declined over the past five years. Between 1981
and 1986, disposable personal income increased by approximately
$850 billion while personal savings declined by $43 billion,
falling from $159 billion in 1981 to $116 billion in 1986.
Thus,
the personal savings rate declined from 7.5 percent of disposable
personal income in 1981 to 6.3 percent in 1984 to only 3.9
percent in 1986. Not only was this the lowest personal savings
rate since 1949 but, as Federal Reserve Chairman Volcker noted
recently, for the first time in decades, "the net influx of
foreign capital appears to have exceeded all the savings
generated by individuals in the United States."
Besides falling to the lowest level in 37 years, the U.S.
personal savings rate was also the lowest of any major industrial
country. In 1984, for example, personal savings rates in the
other G-7 countries ranged from a low of 12.2 percent in the
United Kingdom to a high of 23 percent in Italy. At 16 percent
of disposable personal income, Japan's personal savings rate was
the second highest among the G-7 and approximately 10 percentage
points above the U.S. rate.
Personal savings data, while useful, do not offer the most
complete and informative portrait of an economy's savings
performance. First, personal savings are only one component of
the total savings pool. And second, personal savings do not
indicate how efficiently an economy is investing its savings.

-89-

90
CHART XLI

NET SAVINGS AS APERCENT
OFGROSS
SAVINGS, 1984

201 191 18n171 16s151 14X

131-

121 I..

111-

10O

91-

81-

716151 -

41 33X O1 -

01 - X.S
U.S.

{

/
.

///

//
/,

Japan

Germany

France

U.K.

{,,

Ialy

Canada

91
A more informative measure is the Federal Reserve Board's
gross savings statistic -- total savings in household, business,
government, and foreign sectors before that sector's own capital
expenditures are deducted.
A second important statistic employed
in the Federal Reserve Board's Flow of Funds analysis is "net
financial investment," which measures the difference between each
sector's gross savings and its capital expenditures and is an
index of how much of that sector's gross savings are available
for use by the other sectors.
The household sector has always been the largest source of
gross savings.
More importantly, despite the widely discussed
decline in personal savings, gross household savings increased by
approximately $180 billion between 1981 and the end of the second
quarter of 1986.
Household net financial investment, however,
increased by only $12 billion.
This suggests that even though
households were increasing their gross savings they were also
increasing their consumption of capital goods such as houses and
automobiles.
In a dramatic shift from recent years, only a
relatively small portion of the additional household gross
savings was available to finance the investment needs of the
other domestic sectors.
As recently as 1981, household net financial investment was
sufficient to finance both the savings deficit of the business
sector and the U.S. Government budget deficit.
Not only were
foreign savings not needed, but the United States had a surplus
of domestic savings which it lent to foreign borrowers.
In 1986,
by comparison, the dramatic rise in U.S. Government budget
deficits, coupled with a modest increase in household net
financial investment, created a domestic savings deficit.
To
fill
that gap,. the United States began to draw on foreign
savings.
Trends in Borrowina
Resorting to foreign savings was not the only available
option.
With a more balanced approach, the United States could
have tried either to increase its gross savings or reduce its
borrowing.
Supply-side policies were intended to generate
additional domestic savings, but the same policies also gave rise
to an unprecedented wave of borrowing.
While gross household and
business savings did increase by approximately $28 billion, those
additional savings fell far short of the amount needed to finance
the unprecedented demand for loanable funds, which followed in
the wake of supply-side policies.
The magnitude and origin of the economy's recent borrowing
can be illustrated by examining the ratio of domestic
nonfinancial debt to GNP.
Prior to 1982, domestic nonfinancial

-91-

92
debt -- Federal Government debt plus private-sector debt -- grew
at about the same pace as GNP. Consequently, the ratio of
domestic nonfinancial debt to GNP stayed at a remarkably constant
level of approximately 1.40 (Chart XLII). The ratio varied only
from a peak of 1.45 in 1963 and 1964, to a low of 1.39 in 1969.
Although the overall ratio remained steady between 1962 and
1981, the composition of the outstanding debt underwent dramatic
changes (Chart XLIII and Chart XLIV). Despite Federal budget
deficits in 19 of those 20 years, the ratio of Federal Government
debt to GNP declined steadily. The Federal Government, in
effect, made room in the credit markets for private-sector
investment, home mortgages consumer credit, and lending to
farmers and small businesses. The ratio of private-sector debt
to GNP rose steadily between 1962 and 1981, offsetting the
decline in the ratio of Federal debt to GNP and keeping the
overall ratio constant.
Beginning in 1981, the ratio of total domestic nonfinancial
debt to GNP increased sharply, rising from 1.41:1 in 1981 to
1.72:1 by the second quarter of 1986. In contrast to pre-1981
trends, when a decrease in one component offset an increase in
another, the recent surge has occurred simultaneously in the
Federal Government, household, and nonfinancial business sectors
(Table VII).
Federal Government Borrowing
U.S. Government debt more than doubled from $830 billion in
1981 to $1,706 billion at the end of the second quarter of 1986.
This represents an annual increase in outstanding Federal debt of
close to 16 percent, far higher than the 2 percent rate
experienced during the 1960's and the 9 percent rate of the
1970's. Not surprisingly, the annual pace of Federal Government
borrowing rose from $87 billion in 1981 to a peak of $223 billion
in 1985. By the middle of 1986, it had fallen to approximately
$200 billion annually -- a rate about double the 1981 level.
Interest payments on the U.S. Government debt also doubled
during this period, rising from $95.5 billion in FY 1981 to
$190.1 billion in FY 1986.
In its most recent budget, the
Administration projects that interest payments on the public debt
will continue rising through 1991, albeit at a more moderate
pace.
By FY 1991, interest payments are projected to be $209
billion, or 10 percent above the current level.

-92-

93
CHART XLII

TOTAL DEBT AS APERCENT-OF GNP
173 170X 16 -

1661 -

16411631601I..

1581-

z
hi
a

1561-

154 152 1501148 -

1481-

14211401I1

, 2. .

9. I ...

1962

1966

I I I

1970

- 93 -

1974

. .

1978 .

19
8
1982,

1986

94
CHART XLIII

FEDERALDEBT AS APERCENT OF GNP
.US -

414

33m
43
3916

3411
192

17m17

16390

- 94 -

95
CHART XLIV

PRATE DEBT AS APERCENT OF GNP

z
IL
I

1962

1966

1970

- 95 -

1974

1978

1982

1986

96
TABLE VII: DOMESTIC NONFINANCIAL DEBT AND GNP
(ABSOLUTE VALUES AND PERCENT OF GNP)

GNP

1981

1982
1983
1984
1985
1986

1981
1982
1983
1984
1985
1986

3058.3
3166.0
3405.8
3765.0
3998.0
4175.6

TOTAL
DOMESTIC
PRIVATE
NOjFINANCIAL NONFINANCIAL*
(2)-(3)+(4)
(11-(2)+(5)

HOUSEHOLDS
(3)

4301.2
4679.1
5230.6
5985.4
6851.0
7204.1

3471.1
3687.7
4052.6
4608.7
5250.6
5498.1

1577 . 7
1659.8
1847.5
2082.0
2369 . 7
2482.0

1.41
1.48
1.54
1.59
1.71
1.73

1.13
1.16
1.19
1.22
1.31
1.32

.52
.52
.54
.55
.59
.59

BUSINESS
(4)

1591.3
1704.3
1847.5
2141.6
2388.0
2503.9
.52
.54
.54
.57
.60
.60

*: Numbers do not add due to the omission of a number of
small items that are also a part of the domestic nonfinancial
catagory

-96-

FEDERAL
GOVERNMENT
(5)
830.1
991.4
1177.9
1376.8
1600.4
1706.0

.27
.31
.35 .
-. 37
.40
.41

97
If the Federal Government's debt and annual borrowing
requirements had grown somewhat more slowly, the supply of
domestic savings would have covered a larger share of the
economy's domestic borrowing requirements, and a smaller volume
of foreign savings would have been required to finance the
private sector's investment requirements.
Household Sector Borrowing
During the past six years, disposable personal income rose
by 40 percent, outstanding home mortgage debt increased by 49
percent, and outstanding consumer installment credit increased by
almost 76 percent. The annual pace of household borrowing
increased from $121 billion in 1981 to $283 billion in the second
quarter of 1986, or 134 percent. While disposable personal
income was increased by $850 billion, total household debt was
increased $905 billion.
Some analysts have suggested that the actual growth of
household borrowing and outstanding consumer debt may not be as
rapid as these statistics initially suggest, for two reasons -the growing use of credit cards for "convenience" purposes and
the lengthening of maturities of new consumer loans. For
example, when consumers use their credit cards as a substitute
for paying with cash or check and pay their outstanding balance
at the end of the month, they are not really borrowing, although
every charge transaction counts as consumer borrowing in the
household debt statistics. Similarly, the average maturity of
consumer debt has increased noticeably during the past few years
-- as in the case of the average maturity of auto loans, for
example, from 45 months in 1981 to 51 months today. With longer
maturities, a smaller percentage of the outstanding balance is
retired each month, with the result that the slower repayment
pace would appear to increase the growth of consumer debt even if
the rate of new borrowing does not accelerate.
Estimates prepared by Federal Reserve Board economists
suggest that these two factors were relatively minor,
contributing less than two percentage points to the annual
increase in total household debt.
Business Sector Borrowing
According to the Federal Reserve Board, the business
sector's internally generated funds increased by $67 billion
between 1981 and the second quarter of 1986, with approximately
90 percent of that aggregate increase attributable to the
accelerated depreciation provisions of the 1981 tax bill which
greatly reduced the business sector's tax liability. The funds
generated by the 1981 bill did not prove adequate to meet the

-97-

98
business sector's demand for funds, however, and outstanding
business debt increased by more than $910 billion, or 57 percent,
between 1981 and the second quarter of 1986.
According to the Department of Commerce, net nonresidential
fixed investment was only $19 billion higher in 1985 than in
1981, suggesting that only a small fraction of the additional
borrowing and tax-law-induced depreciation allowances were used
to finance net additions to the business capital stock.
In
general, this has given rise to concerns that business borrowing
in recent years may not have been used to finance productive
investment of the kind that would make U.S. businesses more
competitive and raise U.S. living standards.
For this reason, Federal Reserve Chairman Volcker has
observed that the heavy reliance in recent years on foreign
capital "might be acceptable if we were matching the foreign
borrowing with a surge in productive investment in the United
States.
That's been the case at times in'the distant past in the
United States and in other countries more recently. But we are
not making that match now -- it's
been consumption that's been
leading the economic parade" (emphasis in original).
Conclusion:

"Crowdina Out" in the U.S. Economv

Despite the rapid and simultaneous growth of household,
business, and Federal Government domestic demand for credit
without a corresponding increase in the supply of domestic
savings, crowding out does not seem to have become a problem.
In 1983, 1984, and 1985, the Federal Government's demand for
credit increased at annual rates of 18.8 percent, 16.9 percent,
and 16.2 percent, respectively.
Traditional economic theory
suggests that, when Federal Government borrowing increases more
rapidly than the available pool of savings, interest rates rise
and start "crowding" private-sector borrowers out of the credit
markets.
The private sector is generally the one that retreats in the
face of higher interest rates because businesses must compare the
cost of borrowing with the rate of profit they expect to earn
with the borrowed funds, and households have to weigh the
desirability of borrowing for a new home or car against the costs
of servicing the added debt.
The Federal Government, however,
does not reduce its borrowing merely because interest rates have
increased, and if increased Federal Government borrowing leads to
higher interest rates, growing numbers of private-sector
borrowers postpone their investment and borrowing projects.
Because of higher interest rates, in other words, they are
"crowded out" of the credit markets.

-98-

99
For the past three or four years, government borrowing does
not appear to have displaced private-sector borrowing. On the
contrary, both have increased simultaneously, and at
unprecedented rates, while interest rates have generally been
declining.
Some analysts therefore conclude that crowding out is
in remission.
This conclusion may be premature. Crowding out continues to
occur, but with today's greater international capital mobility,
it takes a different form and affects different economic
sectors. When financial capital was less mobile,
interest-sensitive sectors such as home building and business
investment suffered from crowding out, slowing dramatically when
interest rates rose and regaining strength in the early stages of
recoveries when interest rates are generally low. As the large
influx of foreign savings illustrates, the supply of credit in
domestic financial markets is no longer constrained by the
domestic savings pool. The inflow of foreign savings is now
close to 3 percent of GNP and constitutes just over 20 percent of
the total gross savings generated by the United States.
International capital mobility means that foreign savings
can now be mobilized if the domestic demand for credit outstrips
the domestic supply of savings. This reservoir of foreign
capital, which helps moderate interest rate fluctuations, shifts
but does not eliminate the traditional crowding out process. By
raising the value of the dollar, the influx of foreign capital,
while not affecting interest-sensitive sectors, creates pressures
on those sectors exposed to foreign competition -- in particular,
U.S. exporters and domestic industries that must compete with
foreign imports.
The crowding out process would once again shift back to the
interest-sensitive sectors if for any reason foreign capital
outflows are halted, the dollar falls, and U.S. interest rates
rise.
In a world of international capital mobility and floating
exchange rates, trade-sensitive sectors can also feel the pain of
crowding out when the domestic savings pool cannot accommodate
the domestic demand for credit.

-99-

100
b.

Economic Implications of Merger and Acquisition Trends

The current wave of corporate takeovers and other mergers
and acquisitions is heralded by some as a restructuring and
revitalization of U.S. industry, and by others as a speculative
mania with alarming parallels to the corporate pyramiding that
led up to the 1929 stock market crash.
The trend is
distinguished by two significant features:
first, the growing
number of hostile takeovers, and second, the fact that they are
often accomplished by financial experts with little expertise or
experience in the business of the firms they acquire. The
controversy has been intensified by the recent revelations of
widespread violations of the laws prohibiting insider trading,
implicating leading figures involved in some of the takeovers.3/
Magnitude of Trends
The magnitude of the activities suggests the degree to which
they are capable of influencing profoundly the structure and
performance of the industrial sector and possibly the economy as
a whole. According to figures compiled by W.T. Grimm & Co., a
private research firm, the total value of merger and acquisition
activities was $176.6 billion in 1986, about four times the 1980
amount. The Federal Trade Commission (FTC) formerly collected
and published information about these activities but discontinued
the practice in 1982.
Mergers and acquisitions were more numerous during the peak
period of conglomerate mergers in the late 1960's and early
1970's, but those of the past several years have increasingly
involved larger firms with greater assets.
There was an annual
average of about 4,900 mergers and acquisitions in the 1968-1973
period, with an average value for those reporting a purchase
price in constant 1982 dollars of about $30 million. The number
of mergers and acquisitions averaged about 2,700 per year in the
1981-1986 period, with an average reported value for each of
about $86 million, in constant dollars. Last year alone, there
were 26 takeovers of $1 billion or more.
3/ The Committee's concern is with the economic consequences of
these actions: whether they improve or impair efficiency and the
productive use of capital; and whether, and on what basis,
assessments can be made.

-100-

101
CHART XLV

TOTAL VALUE OF WRGERS AND ACQWS(IOS
60

t
N

0Ii0
N
5

0
j

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

- 101 -

102
Arguments in Support of Takeovers
The proponents take the position that mergers and
acquisitions, even when hostile, are beneficial because they
promote redeployment of assets to higher valued uses, economies
of scale, more efficient forms of distribution and contracting,
technology transfer, and improved management. Responding to
complaints that those engaged in takeover attempts use unfair and
sometimes illegal tactics, the Council of Economic Advisers
stated in its 1985 report that the evidence "suggests that
abusive practices in the market for corporate control are limited
largely to tactics employed by target managements who, in
opposing takeover bids, defeat or deter tender offers at the
expense of their shareholders and the economy."
The Administration's implicit criticism of corporate
management has been stated in more forceful terms by Deputy
Secretary of the Treasury Richard G. Darman.
In a recent series
of speeches, Secretary Darman criticized management officials for
being part of a "corpocracy" which is "bloated, risk-averse,
He has praised takeover bidders
inefficient, and unimaginative.'
as a new kind of populist folk hero, taking on not only big
corporations but the phenomenon of corpocracy itself.
An alternative view, somewhat kinder to target executives,
is that, while takeovers result in more efficient use of assets,
they are not all caused by inefficient target managements;
inefficiency may be only one of several causes.
Economists
working at the Securities and Exchange Commission (SEC), and
others, emphasize the "synergies" that can be realized from asset
In this view, entrenched and inefficient management
combination.
is only one of many possible reasons that outsiders perceive
gains from a takeover.
Proponents argue further that shareholders benefit because
takeovers, and the fear of takeovers, increase stock prices and
make management more attentive. They point to studies showing
that stock increases in value when tender announcements are made
and that shareholders profit in successful takeovers, and they
reject arguments that takeovers are primarily the work of
speculators seeking control of a company in order to sell off
valuable assets for quick gains, although they recognize isolated
cases of that kind.
Criticism of Takeovers
Critics maintain that unfriendly takeovers, especially those
accomplished through leveraged buy outs, do more harm than good,
especially as corporate takeovers as well as defensive stock

-102-

103
redemptions financed by junk bonds have added substantially to
corporate debt and increased debt-to-equity ratios to dangerous
proportions.
The critics view those engaged in unfriendly takeovers as
"raiders, who tend to take advantage of the fact that stock
prices of firms with large long-term investments are often lower
than the stock of firms that avoid long-term investments in order
to pay highe* dividends.
In effect, companies committed to
long-term planning in the interests of preserving and expanding
market shareare more vulnerable to takeover bids. Studies by
Frederick M. Scherer, David Ravenscraft, Edward S. Herman, Louis
Lowenstein, and the Investor Responsibility Research Center
indicate that profitability of companies after a hostile takeover
is no greater than before and that target firms had healthy
average pre-offer returns on stockholder equity. These studies
suggest that the new managers are no more efficient than their
predecessors.
Critics also point to the fact that the success of these
maneuvers has in a number of cases encouraged management of
targeted firms to resort to defensive tactics, causing a shift in
the focus of corporate activities from long-term growth and
development Ito short-term paper profits -- e.g., selling off
divisions and distributing the proceeds to the shareholders, and
closing down plants and laying off managers and workers. Another
common defensive tactic involves buying back the high-priced
shares accumulated by the prospective new management, leaving
targeted companies with sizable debts which impose significant
repayment obligations and constitute an obstacle to investment in
R&D and other projects vital to the long-term health of the firm,
especially in a period of slow economic growth and increased
market competition.
The broader ramifications of merger/acquisition trends,
which have accelerated markedly since 1980, remain very difficult
to assess. While there is a consensus on the need for U.S.
industry toluse capital resources more efficiently, there is no
agreement over whether takeovers do serve this objective.
Proponents maintain that there is, in effect, an unplanned
restructuring of industry that will make the United States more
efficient and competitive, while critics assert that takeover
activities create a bias against long-term planning that will
make industry less competitive, and that the increased
indebtedness threatens financial stability. There is
disagreement as well over whether these trends have led to
greater concentration in industry.

-103-

104
The Need for Information
Many of the economic questions surrounding the
merger/acquisition controversy cannot be resolved in the absence
of more complete information.
Unfortunately, no serious effort
by the Administration is underway to collect and analyze relevant
data in a timely fashion.
With respect to concentration, the
data are not current.
The most recent statistics on
concentration ratios in manufacturing, published by the Census
Bureau, date from the 1982 census, when the current wave of
merger/acquisition activity was just getting underway.
The
results of the census scheduled for 1987 will not be published
for another two or three years.
In other areas, the Administration has actually taken steps
to reduce the number and quality of statistical series bearing on
the effects of mergers and acquisitions.
In 1982, the FTC ceased
collection and publication of information which had been
routinely collected since 1948 about the number and value of
merger and acquisition activities.
This was done on the
initiative of then-FTC Chairman James C. Miller, currently
Director of OMB, on the grounds that virtually identical data are
published in the private sector, although at the time Mr. Miller
acknowledged in congressional testimony that some information
gathered by the FTC under the Antitrust Act was not in the public
domain, and that "the FTC has published more variations of merger
statistics than private reporters."
The Federal Trade Commission also took actions concerning
two other statistical series in 1982.
It transferred the
Quarterly Financial Report Program, which until then contained
some concentration data, to the Census Bureau.
It also suspended
collection of the Line of Business data despite the fact that the
agency was aware that the data could be useful in evaluating the
effects of mergers and in identifying types of industries to
which enforcement efforts might be targeted.
There is a broad consensus about the need for U.S. industry
to improve the efficiency of its use of capital resources and
restructuring could be a step in that direction.
The question is
whether the kind of restructuring imposed upon industry by
hostile takeovers contributes productively to the industrial base
and the economy.
Fuller information about the trends in
concentration, company-financed R&D spending, and long-term
finance is needed to assess the long-term economic ramifications
of current merger/acquisition activities as well as the overall
effects on industrial performance.
At the same time, however,
there is sufficient information to be concerned about two readily
identifiable aspects of merger and acquisition trends.

-104-

105
Current Issues
Insider Trading Abuses
There is already substantial evidence of violations of the
insider trading laws, with many of the violations involving
mergers and acquisitions. Disclosures of abusive practices are
likely to increase in the coming months as SEC, law enforcement,
and congressional investigations move forward.
From an economic perspective, these illegalities and
excesses pose a threat to the integrity of the securities
markets. The importance of these markets to the free flow and
allocation of private capital cannot be overestimated. The
economy depends greatly on the continued operations of these
markets, and if public confidence is to be maintained, it is
critical that the markets function in a fair and open manner, in
accordance with the law.
A major premise of the securities laws is that all
shareholders are entitled to equal treatment with respect to
opportunities to make informed investment decisions. Insider
trading abuses undermine the foundation on which this premise is
built. Over the long term, if abuses are not curbed, public
confidence in the securities markets will be eroded to the
detriment of the overall economy.
Corvorate Debt
There is also substantial information on the effects of
mergers and acquisitions on corporate indebtedness. The surge of
borrowing that has accompanied merger activities raises serious
questions about the extent to which financial resources are being
used for acquiring and reselling existing assets rather than for
investment in new capital plant or research. Some of the debt
incurred in connection with large takeovers takes the form of
junk bonds -- high-yield, low-rated instruments usually obtained
because investment-grade credit ratings are not available. This
type of debt often carries with it interest rates in excess of
the return on investment of the target firms which, when payable,
may require divestment of holdings, cutbacks in R&D and capital
spending, and reductions in employment. The fact that such
decisions are being driven by takeover actions causes many people
to conclude that the need for new investment is being neglected.
Second, the enormous volume of debt causes concern about the
financial viability of large segments of the corporate sector.
During the past several years, corporations have been using their
financial resources to reduce equity rather than to create new
equity. There were net retirements of equity amounting to more

-105-

106
than $80 billion in each of the past two years (see estimates in
Table VIII). The rise of this form of indebtedness is indicated
by the figures for new equity issues and equity retirements
(which include equity retired through mergers, leveraged buy
outs, share repurchases, and other restructuring plans).
In
1983, new issues exceeded retirements by $28 billion.
In 1984,
retirements exceeded new issues by $77 billion; in 1985 and 1986,
retirements exceeded new issues by $81.5 billion and $80.8
billion, respectively.
TABLE VIII
OFFERINGS AND RETIREMENTS OF EQUITY BY NONFINANCIAL CORPORATIONS
New Issues
Including Private Sales

Retirements*

Net Change

- - - - billions of dollars, annual rates - - - -

1980
1981
1982
1983
1984
1985
1986p

21.1
21.5
28.9
40.0
18.0
25.0
38.2

8.2
33.0
17.5
11.7
95.0
106.5
119.0

12.9
-11.5
11.4
28.3
-77.0
-81.5
-80.8

1986-Ql
Q2
Q3
04P

33.0
41.5
31.5
47.0

92.0
120.0
112.0
152.0

-59.0
-78.5
-80.5
-105.0

* Includes equity retired through mergers, leveraged buy outs,
share repurchases, and other restructuring plans.

Source:

Federal Reserve

These data suggest that debt/equity ratios, which had been
increasing for some time, have been rising at an even faster rate
in the past few years. The increase in the high-interest debt
relative to the equity of many corporations raises doubts about
what might occur in the next recession. Felix G. Rohatyn,
testifying to the Senate Banking Committee in January, said of
takeovers and the use of junk bonds, "this activity.. .causes the
weakest sectors to acquire large amounts of risky and possibly
illiquid paper to show performance. Much of this paper has never
been tested in a period of economic downturn."
Rohatyn referred
to this matter as a financial time bomb ticking in the closet.

-106-

107
In the same hearing, Nicholas F. Brady, Chairman of Dillon Reed,
referring to the unsoundness" of junk bond takeover financing,
said:
"conditions in' 1987 are reminiscent of those prevailing in
1968, just before the last big downturn: a boiling stock market,
high profits on Wall Street, and a takeover binge fueled by the
activities of 'go-go mutual funds.-'
c.

Infrastructure

The efficient functioning of private markets and the
national economy depends significantly upon the physical
infrastructure -- the highways, railroads, bridges, mass transit
systems, and ports that keep products and people moving, as well
as the water and sewer systems essential to service growing
populations.
The importance of a particular facility to a local
community, state, or region is usually self-evident, and every
region of the country can cite part of its own infrastructure
whose economic importance reaches far beyond the region's own
borders.
Much of the Nation's basic capital support system is aging.
Some of the most heavily used sections of the interstate highway
Mass transit systems in older
system are almost 30 years old.
cities date from the turn of the century or before.
The water
Since
systems in most large cities are more than 100 years old.
to
repair
and
the mid-1960's, there has been a general failure
facilities.
maintain these
In 1984, this Committee issued a landmark study on
infrastructure, Hard Choices. A Report on the Increasing Gap
Between America's Infrastructure Needs and Our Ability To Pay for
Them.
The report, a major effort to define the magnitude of the
infrastructure problem as seen by the states themselves,
concluded that a national gap exists between anticipated revenues
and basic infrastructure needs approaching $450 billion through
the year 2000.
Planned spending would have to increase
substantially to meet the perceived needs.
The necessary level of effort remains a subject for
discussion, and there are studies whose estimates are both higher
The question of
and lower than that of the Committee's report.
the relative roles of the Federal and state governments also
remains undecided.
!W:.etheless, there is broad agreement on the
If investment in
need for improved and'expanded infrastructure.
this form of physical capital is not increased, economic growth

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108
CHART XLVI

MAJOR PHYSICAL CAPITAL INVESTMIENT
80

II
iX

N
I
a

0
#1

0 41980

1981

1982

DDUF~SE

1983

198

+ NON-EFENf
E
- 108 -

1985

1986

109
and development will suffer. The complex set of issues
outlined in the Committee Report has been analyzed in some detail
by the American Planning Association (APA).
The APA distinguishes three types of infrastructure decline,
each with different implications for local economic development.
At one extreme is sudden system failure, such as a bridge
collapse or a water-main break. A second problem is general
facility deterioration, or a gradual chipping away" of the
capital plant. Although general deterioration may increase the
probability of sudden failure, the two categories are clearly
distinguishable; some of the sudden failures are caused by design
flaws or external hazards rather than the cumulative effects of
aging. The last type of infrastructure inadequacy identified by.
the APA is capacity constraints, which limit the old
infrastructure network's capacity to handle the volume or
specialized nature of the demands now being placed on it.
An example of system failure is the collapse of the Mianus
River Bridge in Greenwich, Connecticut, in June 1983, just nine
months after the bridge was found "not to be in need of major
repair" by the state's transportation department.4/ Aside from
the direct costs of repairing the bridge, estimated in the range
of $30 million, the indirect costs were borne largely by local
merchants and residents; trucking and related industries; and the
communities and states as a whole.
More common and more preventable than total system failure
is continuing infrastructure decline. In southwestern
Pennsylvania, for example, many bridges have been closed or
posted with weight restrictions because of the high repair costs
and the growing backlog of needs. The resulting detours have led
to direct costs, including additional vehicle costs, additional
driver time, and additional road maintenance costs -- and
indirect costs -- additional costs of providing public services
and costs incurred as a result of lost business. According to
the Pennsylvania Economy League, for the 33 bridges closed and
restricted in the six-county region, measurable costs amounted to
If all of the 540 posted bridges
about $38.5 million per year.
are included, the cost is estimated at $188 million annually.
4/ The report of the National Highway Transportation Safety
Board found that maintenance neglect was a contributing factor,
although a special engineering study commissioned by the State of
Connecticut concluded that the bridge failed because of
inadequate structural support that would have led to failure
regardless of maintenance practice.

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110
The third form of infrastructure inadequacy is capacity
In Houston, a mismatch between slow highway
constraints.
expansion and large increases in vehicle miles traveled has led
to steadily worsening traffic congestion and travel delays of
35-45 minutes during rush hour -- a common situation in
communities around the Nation.
A report prepared by The Road Information Program (TRIP) on
employment effects of Federal highway expenditures concludes
that, for each $1 billion loss in Federal highway spending,
41,600 jobs would be lost in a wide range of industries,
including: highway and related construction; service industries
(business, health, personal services, new auto dealers,
education, auto repair, hotels, and others); and transportation.
Despite fundamental importance and the complexity of the
national infrastructure, Federal funding in recent years has been
erratic. Federal spending for nondefense infrastructure rose
steadily throughout the 1970's, reaching a peak of S35 billion
(in FY 1982 dollars) or 5.5 percent of Federal outlays by FY
1979, but then dropped sharply, reaching bottom in FY 1983 when
real spending totaled $28 billion or 3.5 percent of Federal
Between 1983 and 1986, Federal spending on
outlays.
infrastructure recovered to its FY 1979 level. Despite the
continuing need for maintenance and improvement and the evident
importance to the economy of dependable transportation and water
facilities, the Administration has recommended that Federal
spending for infrastructure be reduced during the next two fiscal
years.
It is all too easy to overlook the problems associated with
infrastructure deterioration, since in a world of limited
resources projects which tend to emphasize maintenance and
improvement are often assigned lower priority than they deserve.
The price of this neglect is considerable, holding out the
prospect of significant dislocation that the economy can ill
afford.

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111
CONCLUSIONS
1.
Growth in productivity is the key to future prosperity.
Improving productivity performance will require steady and
sustained efforts across a broad front -- initiatives to increase
capital formation, to build a vigorous, educated, and skilled
work force, to assure higher levels of civilian R&D, and to
maintain a strong and dependable physical infrastructure.
2.
The policies of the recent past have led to a severe
imbalance between savings and investment in the U.S. economy.
This balance must be restored, but to do so by cutting back
sharply on investments in plant and equipment would pose a threat
to future growth.
Savings must therefore be increased through a
variety of mechanisms, including faster income growth which
stimulates household savings, and a reduction in the dissaving
associated with the Federal budget deficit.
3.
The economic consequences of the recent trends in mergers
and acquisitions have not yet been fully analyzed, in part
because the data needed for thorough evaluation are not
available.
Government.agencies, particularly the FTC and the
SEC, should move swiftly to compile and publish regularly
comprehensive information needed to evaluate the scope, extent,
and effects of takeover activity. While merger/takeover
activities are complex, a prompt and concerted effort must be
made to identify and prohibit abusive practices.
4.
In a number of areas, abusive practices clearly threaten the
integrity of capital markets. Public authorities therefore
should act promptly to enforce existing laws and enact new ones
where necessary to provide full disclosure of information and
guarantees of sound financing for proposed takeovers. These
steps are justified by the present state of knowledge concerning
abusive practices in financial markets, and as new information is
accumulated there may be justification for additional steps to
improve the functioning of our domestic capital market.
5.
Attention to the state of the infrastructure on which the
functioning of the economy depends must be an essential role of
government if the country is to achieve its maximum long-term
growth potential. That role unfortunately has been neglected
over the recent past, and all levels of government should reverse
the policies of neglect which have prevailed over the past
several years.

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112
3.
a.

U.S. HUMAN RESOURCES
Emplovment/Unemplovment

The Employment Act of 1946 recognizes the responsibility of
the Federal Government to use "all practicable means" to promote
full employment, and further requires efforts to reduce the
differences in unemployment rates among youth, women, minorities,
and other labor force groups. Little attention has been paid to
these goals in this year's Economic Report of the President.
The
CEA points out in its report that participation of women in the
labor force has increased (without however addressing the
question of the extent to which the large-scale entry of women
into the labor force is related to declining family income), and
that the unemployment rates for men and women are now roughly the
same. Otherwise, the report pays no sustained attention to the
problem of unemployment and the closely related problem of
poverty, and indeed forecasts only a modest decline in
unemployment in 1987.
While the civilian unemployment rate for 1986 was slightly
below the 1980 rate -- 7.0 percent as opposed to 7.1 percent -the number of persons unemployed actually rose during the same
period, from 7.6 million to 8.2 million. The rate of job growth
in the 1980-1986 period was significantly below the growth rate
of the late 1970's.
Nonetheless, the U.S. economy did generate 10 million new
jobs over the past six years. Continuing the trend of strong job
growth for women established in the 1970's, two-thirds of these
jobs went to women, whose labor force participation rate rose as
unemployment among women also declined. Employment for men also
rose between 1980 and 1986, but at a much slower rate than for
women, and the unemployment rate for men, 6.9 percent, was the
same as the 1980 rate. Total teenage employment fell during the
1980's, consistent with the decline in the teenage population.
Whites continued to fare better than blacks. While in
1980-1986 the white employment rate declined from 6.3 percent to
6.0 percent, the black unemployment rate remained at 13.1
percent. The problem is particularly acute for black teenagers,
for whom the official January 1987 unemployment rate was nearly
40 percent, compared to 15 percent for white teenagers.
Overall, the Bureau of Labor Statistics estimates that the
unemployment rate would be 10.2 percent if involuntary part-time
employment and "discouraged workers" were taken into account.
Although part-time work accommodates the needs of 14 million
workers, there are 5.2 million who work part time involuntarily

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113
either because full-time jobs are not-available or their hours
have been reduced. In addition, there are an estimated 1.1
million unemployed workers who have given up looking for jobs
because they are not available.
These trends should be seen against the background of more
stringent conditions for the unemployed and reduced opportunities
for the employed.
Being unemployed today is a more serious problem than in the
past. The median duration of unemployment has fallen to 7 weeks,
from 10 weeks at the bottom of the 1981-1982 recession, but of
those who are unemployed, 2.2 million have been jobless for 15
weeks' or more, a very high rate for this point in the recovery.
Unemployment insurance can no longer be counted on as a
dependable source of transitional income. Of the eight million
currently unemployed, only 30 percent receive any unemployment
benefits, compared to 62 percent in 1975 and 50 percent as
recently as 1980. The average weekly benefit of $137.00 is
barely 60 percent of the poverty level for a family of four. Job
training is also less widely available as an alternative to
unemployment. Federal outlays for training and employment
services have been cut in half since 1980, from $10.3 billion to
$5.2 billion in 1986. The President's greater emphasis on job
training in his competitiveness initiative is a welcomed
development.
For those who are employed, there have been major changes in
the quality of jobs and wage levels. One of the most serious
problems is the loss of manufacturing jobs. Manufacturing
employment declined by 2.3 million in the 1981-1982 recession,
but in the ensuing 50 months of expansion, only 1.1 million of
those jobs have been recovered.
Of the 20 manufacturing
industries surveyed monthly by the BLS, eight have continued to
lose employment since the bottom of the recession. Virtually all
of the job growth during the past six years has been in
service-producing industries, with the strongest growth occurring
in retail trade, business services, and the finance, insurance,
and real estate industries.
While some service-producing jobs
pay high wages, many pay less than the manufacturing jobs being
lost. In retail trade, the most rapidly growing source of
employment, average hourly wages are only 60 percent of average
hourly wages in manufacturing. Given the shorter hours in retail
trade, average weekly take-home pay is less than half that in
manufacturing.

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114
This shift in the structure of job growth to lower paid
industries is compounded by two other problems -- a shift within
each industry from higher to lower paying jobs, and an actual
reduction in pay for-the same work.
Since 1981, increases in the average hourly earnings index
(which only includes wages for production and non-supervisory
workers) have declined more rapidly than in the employment cost
Since the
index (which includes a wider range of employees).
employment cost index is adjusted to account for changes in the
industrial composition of employment and gross occupational
composition, the CBO interprets the divergence in the two indices
as evidence that the composition of employment has shifted toward
lower paying jobs.
Many workers have had to take lower pay for the same job.
During the last three years, a number of unions have agreed to
Ten
wage cuts and benefit cuts in give-backs to employers.
percent of the workers whose contracts were negotiated during
1986 took pay cuts averaging 9.3 percent, and another 20 percent
received no increases; almost all the wage cuts occurred in
Benefits were also reduced for many
manufacturing industries.
workers, including elimination of cost-of-living adjustments
Two-tier
(COLA's) for 17 percent of workers with 1986 contracts.
wage contracts have a similar result, setting a lower pay scale
for new hires than for more senior workers for the same job.
One final disturbing trend has been the recent growth of job
categories -- part-time and temporary jobs -- that do not include
normal job-related benefits, such as health insurance and
pensions.
These jobs mean reduced costs to employers, since
benefit costs are low or nonexistent and workers in these
categories can be added or laid off more rapidly than permanent
workers as production schedules change.
b.

Income and Poverty

The quality of new jobs has influenced trends in wages and
income.
Real family income today remains below that of 1979, and
considerably below that of 1973, because of declining real wages,
the shift to low-paid service jobs, higher unemployment, an
increase in the number of "low earners" (i.e., workers earning
less than $212 weekly), declining Federal assistance, and
The income of families with
changing family composition.
children has fallen even more in real terms over this period,
reflecting the loss of earning power of many heads of
By 1985, 18.6 percent of married couples were below
households.

114-

115
the poverty line despite the fact that the heads of those
Comparable figures for 1973
households were employed year-round.
and 1979 were 12.7 percent and 14.1 percent.
Overall, real wages have declined. The average 30 year-old
male who earned $23,580 (in constant 1984 dollars) in 1973 earned
only $17,520 a decade later. In 1979, the average gross weekly
wages of non-supervisory workers was $326.68 (in constant 1986
dollars). By 1986, the figure had dropped to $304.85, a fall of
The value of the minimum wage has also fallen. A
6.7 percent.
head of household working full time year-round at the minimum
wage could support a family of three at the poverty line in
1979. By 1986, a similarly situated family would fall 20 percent
below the poverty line.
One result of these trends is growing income inequality -the Census Bureau's-Index of Income Concentration, which measures
inequality, is higher than at any time since the Bureau began
collecting this measure in 1947. Another is unusually high
poverty rates. In 1985, the most recent year for which figures
are available, the poverty rate was 14 percent. This is an
improvement over 1983, when it was 15.2 percent, but is an
extremely high figure for this stage of the business cycle. In
1973 the poverty rate was 11.1 percent, and in 1979, it was 11.7
In 1985 the poverty rate was a full 20 percent higher
percent.
than it was in 1979.
The poverty problem has become especially acute with respect
In 1985, the most recent year for which data are
to children.
available, 20 percent of the Nation's children were living in
poverty. Poverty for families with children has increased over
the past two decades and especially in recent years, a trend that
correlates closely with changes in the unemployment rate and the
number of low earners. High levels of unemployment and part-time
employment and the decline of the real minimum wage have all
contributed to this trend; another factor is the decline in
recent years in direct and indirect government assistance to
families with children.

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c.

Education and Health
Education

While there is no agreement on the precise correlation
between education and productivity, there is general agreement
The CEA Report notes that "Government
that a correlation exists.
has a critical role to play in education, which equips
individuals with the basic knowledge and skills to be productive
workers and lays the basis for much scientific and technical
Other economists, notably Edward Denison, John
advance."
Kendrick, and Isabel Sawhill, have sought to quantify the
benefits to the economy from investments in education and
training.
Other studies have analyzed the cost effectiveness of
A major 20-year study of preschool
specific education programs.
education published in 1984 by the High/Scope Education Research
Foundation concluded that every dollar spent in preschool
programs saves $7 in measured benefits, including special
A 1986 study by the
educational benefits and welfare services.
National Center for Research in Vocational Education estimated
the annual welfare, unemployment, and crime-related costs of the
school drop-out population of nearly one million at $6 billion.
Despite the evident national interest in education, the
Administration has taken the position that Federal education
Treasury Secretary
programs at all levels should be reduced.
a
"I think it's
Baker told the Committee at a January hearing:
You know that
question primarily of where the money comes from.
our view is that this has historically been a state and local
government responsibility for the most part.'
While education certainly remains primarily a state and
local responsibility, the Administration's downward pressure on
Federal education programs -- which for the 1988 Fiscal Year
would reduce funding for the Department of Education to $14
billion from the current $19 billion appropriation, or more than
25 percent -- raises serious questions, especially at a time when
several major reports have documented carefully the deteriorating
"A Nation at Risk," the 1983 report
quality of U.S. education.
of the National Commission on Excellence in Education,
established by then-Secretary of Education Bell, outlined the
magnitude of the problem, identifying, among other pressing
consistent declines in student
issues, the following:
achievement over the past quarter-century; increasing dependence
on remedial education at the college level; and consistently low
U.S. student performance in international comparison tests. On
the last point, the Commission reported that U.S. students never

ranked first or second in a survey of 19 different academic

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117
tests, and in the critical comparison -- i.e., with other
industrialized nations -- finished last seven times. Comparison
studies undertaken by the National Center for Education
Statistics in the Department of Education and the International
Association for Evaluation of-Educational Achievement reported
similar results.
"A Nation at Risk" focused particular attention on the
problem of widespread adult illiteracy, estimating that 23
million American adults today are functionally illiterate. The
report also noted a Department of the Navy estimate that 25
percent of its recent recruits were unable to read at the ninth
grade level -- "the minimum needed simply to understand written
safety instructions." Other estimates of functional illiteracy
in the United States run much higher and, on the basis of the
Census Bureau's basic literacy test, the Department of Education
estimates that 27-30 million Americans are wholly illiterate and
that illiteracy is widely dispersed throughout the entire U.S.
population. In contrast, Japan is reported to have a 99 percent
literacy rato.
In setting out an agenda for better education, the
Commission underscored the necessity of joining two public
commitments: the first to "excellence and educational reform,"
and the second to "the equitable treatment of our diverse
population." Taking a similar position, a 1986 study by the
Carnegie Foundation on Education and the Economy, "A Nation
Prepared: Teachers for the 21st Century," concluded that failure
"to provide to the many the same quality of education presently
reserved for the fortunate few" will mean "a steady erosion in
the American standard of living." In other words, the U.S.
system of education cannot afford to sacrifice either excellence
or opportunity, but must offer both.
The same criteria are applicable to post-secondary
education, where the growing trend toward student indebtedness,
carefully documented in a 1986 study prepared for the Committee,
raises troubling questions-about future access to higher
The study, "Student Loans: Are They Overburdening a
education.
Generation?," found that, although Federal student assistance
programs were originally designed to offer a flexible and
balanced program of grants, work-study opportunities, and loans,
the stringentireductions in the first two programs have
transformed the loan program into "a major source of funds for
low-income students attempting to pay for college." The study
documented wider spread borrowing to finance education,
significtant growth in annual and cumulative borrowing, and
heavier borrowing by students with relatively uncertain income
prospects, and raised a series of important questions:

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118
*

At what point are prospective students deterred by debt
obligations from going on to higher education, and is the
deterrent effect more pronounced among minorities, women,
and students from low-income families?

How does the prospect of indebtedness affect a student's
choice of college or field of study?

To what extent will a graduate's choice of job or career be
limited by debt obligations, and will capable students be
deterred from taking relatively lower paying jobs in
teaching at a time when the need for qualified math and
science teachers is acute and an overall shortage of
teachers is projected for the 1990's?

Will a student's debt repayment obligations, over time,
stand in the way of family, home-buying, or other major
financial obligations?

Responding to the troubling trend in student indebtedness,
the Administration has proposed radical changes in the loan
program that would make repayment income-contingent, tying
interest rates to market rates and extending the repayment period
indefinitely while setting at 15 percent the maximum portion of
annual income allocable to loan servicing. The income-contingent
loan plan makes questions already raised about student
indebtedness even more urgent, since the plan would have the
effect of asking prospective students, at an early point in their
careers, to speculate against future income. Its potential
deterrent effects as well as its implications for long-term
financial obligations demand very thorough examination and
analysis.
Training and retraining programs independent of traditional
education programs have an important role to fill, especially in
a period of rapid change in the economy.
In this area, the
Administration, reversing policy, has proposed for the first time
to expand significantly programs under the Job Training
Partnership Act (JTPA). The new proposal would amend the JTPA to
replace the existing summer youth employment program with a
broader program offering remedial education, basic skills
training, and related support to economically disadvantaged young
people most likely to be unemployed, illiterate, and dependent on
Aid to Families with Dependent Children (AFDC). A separate part
of the proposal would address the problem of worker dislocation
by also combining and expanding current fragmented retraining
programs, providing education, training, counseling, and
relocation services more efficiently than at present, and
extending eligibility to all dislocated workers regardless of the
cause of dislocation.

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119
The new proposal represents a constructive initiative that
deserves careful consideration, especially since existing JTPA
employment and training programs have been estimated to reach
fewer than 5 percent of those eligible. There is an apparent
contradiction, however, between a policy which seeks
simultaneously to reduce Federal support for education and
increase Federal support for training. One Member of the
Committee told Secretary Baker at the Committee's January 30
hearing that he found it difficult to reconcile "your [i.e., the
Administration's] concern that we give more attention to human
capital development with the proposals of the Administration in
the budget to eliminate Federal funding for vocational education
and to substantially cut funding for math and science
education." As he pointed out, "it does not make a lot of sense
to put more money into dealing with unemployment and take money
out of the basic education of people who are going into the work
force at a later time."
Health
Proposals for a catastrophic health program for the elderly
will almost certainly be debated in Congress this year. Measures
are overdue to relieve the financial burden which major illness
can impose on the elderly, but the timely focus on catastrophic
health issues should not obscure other important health issues,
including those which have demonstrated cost effectiveness and
bear directly on the future productivity of the labor force.
Chief among these are children's health care and nutrition
programs.
Z
Childhood immunization has been among the most successful
and cost effective of all government-assisted health programs.
Dr. Frank Oski, Chief of Pediatrics, Johns Hopkins School of
Medicine, testified before the Committee last year that, for
every dollar spent on the childhood immunization program, the
government has saved $10 in subsequent medical costs. The threat
from a range of once-common and often life-threatening children's
contagious diseases -- diphtheria, whooping cough, polio,
measles, mumps, and rubella, the latter strongly associated with
birth defects -- has been greatly reduced. Vaccination has
eliminated small pox. A vaccine for bacterial meningitis has
been recently introduced and several others are under
development.
The immunization programs of the postwar period continued a
long history of Federal commitment to control contagious
diseases, in the first instance to prevent their spread between
states and from foreign countries. Legislation for the licensing
and regulation of vaccines and their manufacture dates to 1902.

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120
In the 1950's, the Federal Government financed the development of
a polio vaccine and, in the 1960's, provided funds for
immunization against polio and other diseases. By the
mid-1970's, approximately 60 percent of all schoolchildren were
adequately immunized. The concerted effort undertaken in
1977-1979 by the Federal Government in cooperation with state and
local governments succeeded, according to Dr. Oski, in adequate
immunization "for all school-age children."
Since then, however,
immunization rates have declined as costs have risen, and the
number of doses has declined significantly -- by roughly 28
percent for diphtheria and whooping cough, 13 percent for oral
polio vaccine, and 28 percent for measles vaccine. A major step
forward in child health has been stalemated by rising costs,
since a program enacted last year to address this problem has not
as yet been funded.
Prenatal and child nutrition programs have also proved cost
effective. The WIC program is a case in point. Numerous studies
have confirmed its effectiveness.5/ A 1985 study by the Select
Committee on Children, Youth, and Families on "Cost-Effective
Programs for Children, concluded that $1 spent in the WIC program
saved $3 in short-term hospital costs, and a $1 investment can
save $3.38 in the care for low birth weight infants.
5/ Among the most recent studies are: Institute of Medicine.
"Preventing Low Birthweight." Washington, D.C.: National
Academy Press. 1985; Schramm, W.F. "WIC Prenatal Participation
and Its Relationship to Newborn Medical Costs in Missouri: A
Cost/Benefit Analysis." American Journal of Public Health. Vol.
75. No. 8. August 1985; Kotelchuck, M., et al. "WIC
Participation and Pregnancy Outcomes: Massachusetts Statewide
Evaluation Project." American Journal of Public Health.
74:1084-1092. October 1984; Kennedy, E.T., et al.
"The Effect
of WIC Supplemental Feeding on Birthweight:
A Case-Control
Analysis." American Journal of Clinical Nutrition.
40:579-585.
1984; and U.S. General Accounting Office.
"WIC Evaluations
Provide Some Favorable but No Conclusive Evidence on the Effects
Expected for the Special Supplemental Program for Women, Infants,
and Children."
GAO No. PEMD-84-4. Washington, D.C. January
1984.

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121
Congress has repeatedly rejected Administration proposals to
reduce the WIC program and has in fact provided for modest
growth, but other nutrition programs have been cut back severely
since 1981. Among these are the food stamp, school lunch, school
breakfast, child care food, and summer food programs.
The Children's Defense Fund has testified to the Committee
that reductions in the food stamp program have cut off several
hundred thousand former food-stamp recipients and reduced the
purchasing power of the benefits for about 18 million additional
recipients.
The bulk of the reductions has affected households
below the poverty line.
Child-specific programs have been reduced more than 25
percent, in real terms, since 1980. Again according to the
Children's Defense Fund, the number of low-income children
receiving free or reduced-price lunches, and the number
participating in the school breakfast program, has declined very
substantially, while cuts in the child care food program, which
provides assistance for children in day care, have totaled nearly
$130 million yearly, forcing some day-care centers to close and
others to raise fees to low-income (working) parents. The number
of children participating in the summer food program, which
continues the school lunch program in some low-income areas, has
been reduced by about 400,000.
Short-term savings in programs to improve child health do
not appear to have been weighed adequately against the longer
term costs not only for medical care but in lost potential.
Beyond a certain point, the loss to health and development in the
early years cannot be made up at some later date. Dr. Oski told
the Committee that 80 percent of brain development has occurred
by the time a child reaches the age of two. While it is possible
to design compensatory programs to deal with certain kinds of
problems not dealt with in a timely manner, it is not now
possible to design compensatory programs to deal effectively with
inadequate nutrition and health care in early childhood.

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CONCLUSIONS
1.
The American economy at present is operating far below its
capacity. There is substantial excess factory capacity, and far
too many willing workers are either unemployed or underemployed.
In these circumstances, clearly there is room for significant
expansion in both employment and production without encountering
the serious labor bottlenecks that could give rise to inflation.
The economy can move toward much fuller employment without fear
of inflation, and a significant reduction in the unemployment
rate should be a major goal of economic policy in the year ahead.
2.
One consequence of a dynamic and changing economy is an
increased level of worker displacement. Coordinated policies
should be developed and implemented to cushion the blow of
displacement on individual workers and facilitate their rapid
reintegration into the work force. The Administration's
displaced worker initiative is a welcome, if belated, recognition
of this reality, but more can be done, particularly in the areas
of retraining and relocation assistance.
3.
Government labor market information services can and should
be improved. The Employment Service is in need of expansion and
modernization, and new mechanisms must be found to increase the
flow of information about job openings and skill requirements.
4.
As change and international competition contribute to
reshaping the economy, the U.S. system of education is being
called upon to prepare students to meet new challenges.
Particularly in light of these circumstances, Federal education
programs have an essential role to play in improving education at
all levels. They should be strengthened, not weakened.
5.
As the government focuses on major health problems, whether
protection against catastrophic illness or the challenge of
debilitating disease, less dramatic but no less important
programs must not be overlooked. Preventive health care
programs, including childhood vaccination and maternal, infant,
and child nutrition, have proven to be prudent, cost-effective
investments in the future health of the population, and require
continued strong support from the government.

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D.
1.

SECTORAL CRISES

AGRICULTURE

There are approximately 5.7 million Americans living on
farms today. Those farm residents, who represent less than 3
percent of the population, produce enough food and feed not only
to meet the needs of the remaining 97 percent of Americans, but
millions of other people around the world as well. In 1933, when
the first Federal farm programs were passed, about 26 percent of
the U.S. population lived on farms; during that decade, the
United States exported only slightly more than it imported. By
1981, despite the dwindling number of farmers -- in both absolute
and relative terms -- U.S. agriculture had a trade surplus of $27
billion.
The increase in production despite the declining number
of farmers reflects an unparalleled productivity growth rate over
the 50-year period during which, as the CEA Report notes, "public
policy has played a major and, in some instances, dominant role
in U.S. agriculture., The success of U.S. agriculture has
enabled Americans to keep food expenses on average below 15
percent of disposable income, by far one of the lowest such
levels in the world.
Since 1981, agricultural policy has been directed, as
then-Secretary of Agriculture Block testified to the House
Agriculture Committee, to reducing "the role of Government in
agriculture both in the marketplace and in the regulatory
process."
Despite this --

or because of it -- American agriculture is

in the throes of what the CEA Report acknowledges to be "its most
severe economic crisis since the 1930's.' At the same time,
commodity support programs, whose annual average costs throughout
the 1970's were approximately $3 billion -- costs which were
projected by the Administration to decline to less than S2
billion yearly under the FY 1982 budget proposal -- soared to
$25.8 billion in FY 1986. These costs are a consequence, not the
cause, of the current crisis in agriculture. Reducing them at
this point, whatever the benefits for the budget deficit, could
intensify the acute problems confronting U.S. agriculture.

-123-

124
CHART

XLVII

U.S. AGRICUTURA EXPORTS
50

U
I

Jo
je
-j,

iOt'1

1975

1976

1977

1978

1979

- 124 -

1980

1981

1982

1983

194

1965

125
These problems can be traced in part to the collapse after
1981 of the export markets that had expanded rapidly in the
previous decade.
Overseas farm commodity sales rose from $6.7
billion in 1970 to a peak of $43.78 billion in 1981. A variety
of factors contributed to the surge in U.S. exports: the
collapse of the Bretton Woods fixed exchange rate regime and the
attendant devaluation of the dollar, the recycling to Third World
countries of petrodollars generated by the Organization of
Petroleum Exporting Countries' (OPEC's) newfound oil revenues,
general global economic growth, and the sudden entry of the
Soviet Union and other centrally planned economies into world
markets as large purchasers of grain.
Responding to favorable market conditions, farmers bought
and planted additional acreage to expand production.
They were
encouraged to do so not only by growth in world demand, but also
by an inflationary climate in the wake of the 1973 oil embargo
and subsequent price shock -- an era that brought very low, even
negative, real interest rates. Farmers were also prodded to
borrow by lending institutions, and were urged by the U.S.
Department of Agriculture to produce "fencerow-to-fencerow."
In
1981, therefore, when fiscal and monetary policy combined, in the
words of the CEA, to drive "ex post real interest rates to
postwar highs,' U.S. farmers were saddled with extraordinary debt
obligations.
Today, the debt load carried by American farmers -just under $200 billion -- exceeds that of any of the major
debtor countries.
Recent agricultural policies have placed little emphasis on
production policies, but at the same time stagnant or sluggish
growth in the world economy -- a response to the 1979 oil price
shock and the 1981-1982 recession -- has meant lowered world
demand, while the overvaluation of the U.S. dollar placed U.S.
agricultural products at an extreme competitive disadvantage in
world markets.
Whereas in 1978-1981 the volume of U.S.
agricultural exports had increased by 45 percent and the value by
60 percent, since 1982 U.S. agricultural export volume and value
have plummeted by 31 percent and 33 percent, respectively.
The debt crisis in the Third World has been a major
contributing factor to this problem as debtor countries have
restricted imports and expanded their own exports in order to
meet debt service obligations. These countries were at one time
the most promising markets for U.S. agricultural goods.
well.

There have been problems with the developed nations, as
In the absence of forceful counteractions from the

Administration --

until recently,

at least -- Japan and the

European Community have pursued both mercantilist and
protectionist trade policies. Japan has strong import barriers

-125-

126
in place that limit market access to American beef, citrus,
tobacco, and rice. Through the Common Agricultural Policy, the
EC has engaged in unfair trade practices, subsidizing the export
of its surplus farm production. The Administration's recent
threat to impose 200 percent duties on European wine, cheese, and
other products -- a threat whose implementation, averted only at
the last minute, might well have touched off a major trade war -is a measure of just how serious the problem has become.
The high value of the dollar has been a serious impediment
to U.S. agricultural trade in recent years. Estimates vary over
the degree to which the dollar was overvalued, but most experts
generally agree it was in the 30-40 percent range vis-a-vis other
major currencies. Until late in 1985, no action was taken to
remedy the misalignment. Since then, the primary focus has been
on bringing down the dollar with respect to the yen and the mark,
since Japan and Germany run the largest current account surpluses
with the United States. Those efforts have had little or no
effect with respect to a number of other major trading countries,
including several with important agriculture export and import
sectors. The problem is compounded in cases where countries have
taken steps to ensure that their currencies rise and fall in
tandem with the dollar.
At the same time, the Administration has failed to make
maximum use of food assistance programs. Despite severe
worldwide hunger conditions in this decade, the value of food
donations in 1986 (in real terms) under the Food for Peace
program (P.L. 480) was 21 percent below the 1980 level.
Shipments under the Section 416 food donation program have been
modest and erratic. These programs not only provide urgently
needed foodstuffs to needy countries, experience demonstrates
that they contribute to the development of commercial markets for
the United States, as developing countries strengthen their
economies, raising their standard of living.
The developments and policies of the past few years have had
Government
truly catastrophic consequences for U.S. agriculture.
direct payments in FY 1986 accounted for 46 percent of net farm
income, whereas in FY 1980 direct payments constituted only 8
It should be added that these payments are made
percent.
disproportionately to large farming entities, some of which are
even owned by foreign nationals. In 1981-1986, average farmland
values declined by 29 percent and, in some states -- Nebraska,
Minnesota, Iowa, and Indiana, for example -- by more than 50
percent. Over the same period, the farm sector's debt-to-asset
ratio rose from 18.2 percent to 26.4 percent, the number of farms
declined by 9 percent, or by 219,000, compared to a decline of
2.5 percent, or 63,500 farms, in 1976-1981. The rate of farmers
exiting agriculture for both personal and economic reasons almost

-126-

127
tripled from 1982-1986, rising from 2.2 percent to 6.2 percent.
A recent survey of banks indicates that an additional 6 percent
will not receive financing during 1987.
The collapse in the farm sector has also placed a variety of
lending institutions at risk.
In September 1986, 20 percent of
the loans in the Farm Credit System portfolio had been designated
nonperforming, as compared to 5 percent three years earlier.
Farm lenders are owed nearly $24 billion by 77,000 operators with
current debt-to-asset ratios above 70 percent, and experiencing
insufficient income to meet financial obligations.
Other major competitive U.S. industries have also been
undermined by virtue of their ties to the farming sector;
suppliers and manufacturers of farm equipment, fertilizer, and
seed are obvious examples. For states where agriculture is an
important source of personal income, the decline represents a
serious revenue loss and creates a heavy drain on resources.
Many people have lost sight of the fact that rural
communities are based upon a complex and delicately balanced
interrelationship among production farming, commercial marketing,
lending activities, and services, all of which are essential to a
healthy tax base. Once broken, that interrelationship is
unlikely ever to be reconstituted, and the landscape of rural
American will be irrevocably transformed.
2.

ENERGY

Oil Prices and Inflation

Oil prices declined steadily between early 1981 and the end
of 1985, falling from about $37.50/bbl to around $27.00. As 1986
began, oil prices plummeted, falling under $10.00/bbl briefly
before recovering to about $18.00 by the end of the year.
Substantial uncertainty surrounds the future outlook for oil
prices in light of weak world demand and the questionable ability
of OPEC to maintain production controls.
The fall in oil prices was initially welcomed in non-oil
producing sectors because it brought lower fuel prices to
consumers and an offset to inflation.
The CEA Report underscores
the primary role played by energy prices in keeping down
inflation.
It notes that the CPI actually declined at an annual
rate of 4.3 percent during the first four months of 1986, while
the index would have risen at a 2.9 percent annual rate absent
the energy offset.

-127-

128
The CEA Report further indicates that energy price declines
were a major factor in the increased consumer spending that was
the "mainstay of overall economic growth;, this raises the
question of how much slower the sluggish 2.5 percent rate of real
growth would have been without the fall in oil prices.
While the 1986'inflation rate was helped by falling oil
prices, it is not yet clear whether these effects will persist
into the coming year. The immediate effects of falling oil
prices were reflected in the CPI, but other products embodying
oil as fuel or raw material may show the effects of falling oil
prices more slowly. There may therefore be further price effects
from the 1986 oil price decreases during 1987, although they may
be more than offset by oil price increases in 1987.
Another imponderable is the apparently asymmetric behavior
of the price indices as prices fell last year. In 1979-1981, oil
prices rose from roughly $15.00/bbl, touched $37.50, and
stabilized at $34.00 by late 1981 -- a $19 increase that more
than doubled crude prices. At the same time, the GNP deflator
rose from 78.6 in 1979 to 94.0 in 1981 -- a jump of 20 percent.
While circumstances are clearly different today than in
1979, the dramatic fall in oil prices in 1986 should have
produced a somewhat greater drop in inflation than actually took
place. Why there has not been such an impact -- or whether it
has been deferred into 1987 and perhaps beyond -- deserves close
scrutiny.
b.

Oil Prices and Consumer Purchasing Power

Beyond the matter of how the fall in oil prices affects
price indices, there is the "real" component of the change in
relative prices within the macroeconomy. Lower oil prices have
resulted in an effective increase in household purchasing power,
but such increases are unlikely to recur.
In testimony submitted to the Committee in January, Dr.
Donald Ratajczak, Director of the Economic Forecasting Center at
Georgia State University, noted:
Purchasing power has been transferred from
agricultural and energy producers to the household
sector.
To the extent that some energy producers
were from abroad, this was a net benefit to the
household sector. In 1986, such transfers
enhanced household purchasing power by $25
billion. No such transfer of purchasing power is
on the horizon for 1987.

-128-

129
c.

Oil Production and Oil Dependence

An additional area of concern is that domestic oil
production is likely to be affected for a number of years by the
recent declines in oil prices, even if prices stabilize this
During the past year, oil production has declined from 9.1
year.
Chart XLVIII 'shows the
mbd to 8.4 mbd, a drop of 8.5 percent.
The trend shown here does
drop in the drilling rate since 1980.
not bode well for future domestic oil production.
The oil industry has always invested heavily in new
drilling, but the current oil price environment clearly does not
provide incentive to support the level of activity seen in the
Demonstrably lower prices have made
early part of the 1980's.
this investment less attractive and, as the CEA notes, "fixed
investment in (the oil and gas) industry declined by more than
half of 1986, accounting for more than
$10 billion in the first
half the decline in real business investment."
Declining investment also has been accompanied by a dramatic
falloff in employment reflected in states where the oil and gas
industries are a considerable factor in the state's economy.
TABLE IX
UNEMPLOYMENT RATES IN MAJOR OIL AND GAS PRODUCING STATES

State*
Alaska
Colorado
Kansas
Louisiana
Montana
New Mexico
North Dakota
Oklahoma
Texas
Wyoming

Unemployment
Rate
Nov. 1985
(Percenti
9.5
6.0
4.8
11.3
7.2
8.6
5.7
7.1
6.5
7.9

Unemployment
Rate
Nov. 1986
(Percent)
11.0
7.6
5.4
13.4
8.3
9.2
6.1
7.6
8.8
8.9

* States where in 1985 more than 2 percent of private employment
was in the oil and gas extraction and refining industries.

-129-

130
CHART XLVIII

OL aN GAS RESOURCE DEVELOPMEN
DrMng g$s
inOpatin

4
S

1II

0
£
V

~~A

a
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983

- 130 -

131
The table indicates that the states which depend most
heavily on the energy sector for their employment have suffered
severe increases in unemployment as a result of the collapse in
oil prices. Unemployment levels in energy states may remain high
for a prolonged period, even if drilling activity increases, both
because a resumption of drilling is likely to be slow paced and
because employment may increase more slowly than new drilling
activity as firms attempt to maximize the productivity of
existing workers.
While employment and production in the domestic energy
sector are falling, lower prices inevitably have led to higher
consumption, and petroleum demand is up 300,000 b/d.
Exacerbating our inability to meet our own energy demands,
the Federal Government has taken several actions over the past
few years that have run counter to long-standing energy
independence policies. The Administration's FY 1988 budget
request would reduce R&D for energy conservation by two-thirds
below existing levels, would reduce purchases for the Strategic
Petroleum Reserve by more than 50 percent, and would sell off the
Naval Petroleum Reserves.
At the same time that petroleum demand is rising and energy
conservation falling, the United States is becoming more
dependent on oil imports.
Imported oil accounted for 32 percent
of U.S. domestic consumption in 1985 and 37 percent in 1986.
Last year, in effect, all the progress made since 1981 in
reducing consumption of imported oil was canceled out. Studies
undertaken by the CBO, the Congressional Research Service, and
the Department of Energy all foresee a steady increase in U.S.
dependence on imported oil to more than 50 percent within the
next five years.
Furthermore, U.S. oil imports from OPEC countries last year
increased at an even faster rate than oil imports in general -rising from 36 percent of total U.S. imports in 1985 to 46
percent in 1986. The United States appears to be reversing the
movement undertaken earlier to reduce dependence on imported oil,
and by the end of 1986, in fact, was relatively more dependent on
imports than in 1973, when the first oil price shock occurred.
Increasing dependence on foreign suppliers with a long
history of volatility is clearly not 'prudent long-term energy
policy for the country. While the recent oil price decline has
brought with it certain benefits, the long-term consequences of
today's import-dependent energy policy may be more harmful to the
economy than today's short-term advantages.

-131-

132
CHART XLIX

U.S. COSUVXON OF MPORTED OL
AS POuW of ToMl U.S. Conumpfion

.1k

401

.301
I-

z
Ii
h
I.

2Dl -

.1U-

II .
1973

1175

1371

1979

- 132 -

1981

1983

1985

133
CHART L

U.S. CONSUPlVON OF OPEC OL
As Pant of Teld Us Consunpbn
561-i--

I
I

I
I
I

V
hi
0
hi

i
p

1973

1975

1977

1979

- 133 -

1981

1983

1985

134
CHART LI

U.S.CONWMONOF OPEC 01
7X

501

IIdI
A.

1973

1975

1977

1979

- 134 -

1981

1983

1985

135
CONCLUSIONS
1.
Present Administration agriculture policy is an expensive
failure, in large part because of its excessive reliance on
export promotion as the sole solution to the farm problem.
Exports are an important market for American agricultural
products, but the experience of the past 15 years -- from the
1972 grain sale to the commodity glut of the early 1980's -suggests the dangers inherent in making domestic farm policy
wholly dependent on volatile external markets. The immediate
challenge is to develop cost-effective agricultural policies
which recognize the economic realities of the American market.
2.
A significant portion of the expense inherent in existing
farm policy is due to poor targeting of benefits.
Improvements
in targeting for Federal agriculture programs must be an
essential part of attempts to reform the system.
3.
U.S. dependence on foreign sources of energy has increased
alarmingly over the past few years.
The benefits of falling
international oil prices should not blind us to our increased
vulnerability to external events. Because of the past history of
volatility in international energy markets, energy dependence
should remain a matter of prime concern.
4.
Recent policy changes have tended to minimize the importance
of conservation and self-sufficiency policies. These should be
reversed, and substantial new initiatives undertaken in both
conservation and the development of nontraditional domestic
energy supplies.

-135-

136
E.

THE STATISTICAL BASE

There is widespread and growing concern about the adequacy
of the Federal statistical base -- its ability to provide the
accurate, comprehensive, and timely information on which major
decisions in the private and public sectors depend, and its
ability to keep pace with the rapid changes in the structure of
the economy. Good statistics do not guarantee prudent decisions
or sound policies, but they are an integral part of the framework
of decisionmaking which make good policies and decisions more
likely.
In a number of specific instances, Federal statistics have a
pivotal significance for the Federal budget.
The CPI, for
example, serves as the base for determining adjustments in
program levels that account for more than one-third of all
Federal expenditures, as well as for indexing personal income tax
brackets and exemptions for inflation; an error of one-tenth of
one percent in the CPI estimate could add nearly half a billion
dollars to the Federal deficit.
State unemployment rates
calculated by the BLS are the basis for determining the
eligibility of states for funding under the JPTA. Local
employment rates also provide the basis for payments in local
areas in a variety of programs, and they are the criterion for
the Labor Department's determination of labor surplus areas for
the purpose of targeting some Federal contracts.
In other cases, the role of Federal statistical information
may be less immediate, but it is no less significant.
In
hearings held in the Committee last year, witnesses identified
areas where concern over statistical programs is especially
acute.
1.

TRADE

Although the U.S. merchandise trade balance is a key to
determining the condition and assuring the future health of the
U.S. economy, and can have significant effects on the foreign
exchange and financial markets, monthly trade data are often
unreliable. Computerized operations are only now being
introduced, and data on imports, which are first obtained by the
Customs Service, are still processed manually. The system has
been unable to keep up with the rapid increase in import volume
in recent years and backlogs have increased to such an extent
that in some months more than half of the recorded imports
actually entered the country in prior months.
Faced with these
delays, the Census Bureau, which processes and reports the trade
data after receiving it from the Customs Service, no longer
attempts to adjust the trade statistics for seasonal variations.

-136-

137
Continuing significant inaccuracies in the published figures led
the Commerce Department last month to delay the monthly trade
figures by several weeks and, as a result, delay the GNP report
by several days, raising the question whether timeliness must be
sacrificed to assure greater accuracy.
Imports now account for nearly 15 percent of real GNP, and
exports account for more than 10 percent, so that inaccurate or
untimely trade data can lead to misleading estimates of the
A dramatic case in point arose in early
strength of the economy.
1985, when the 1984 fourth quarter growth rate of real GNP was
estimated at 4.3 percent. The figure was subsequently revised
downward to 1.5 percent, and roughly two-thirds of the revision
was attributable to corrections in the timing of exports and
imports.
2.

GROWTH OF THE SERVICE SECTOR

Existing data have not been adequate to keep pace with the
In 1969-1986,
changing composition of jobs in the U.S. economy.
employment in goods-producing industries rose by 2 percent, while
jobs in the service sector increased 63 percent. The
service-sector's share of total nonagricultural payroll
employment rose from 65 percent to 75 percent over this period.
Information on output, employment, hours, and earnings are
classified by industry in accordance with the Standard Industrial
Classification (SIC) code, as a study prepared last year for the
Committee noted., the industry definitions used in the SIC code
"profoundly influence the results of industrial analyses" and
"maintaining an adequate code is of the utmost importance." Last
revised 15 years ago in 1972, the code emphasizes goods-producing
industries over service industries to a degree inconsistent with
current realities.
Of the 1,200 individual categories included in the SIC code,
46 percent are in manufacturing, despite the fact that
manufacturing today accounts for less than 20 percent of total
employment. In the services area, in contrast, disparate
establishments are grouped together in much broader categories
and a number of significant new industries, for example, computer
software producers,.do not have separate SIC categories.
The SIC code is now under revision, after an unusually long
delay caused by budget cuts in the early 1980's, but it will be
several years before the employment data reflect the changes.
Until then, the SIC code will continue to reflect the structure
of the economy as it existed nearly 20 years ago.

-137-

138
The Committee has identified other areas of acute concern:
*

At the Internal Revenue Service, the Statistics of Income
Program has suffered deep reductions in recent years. This
program will be essential to provide the data necessary in
evaluating the impacts of the Tax Reform Act of 1986.

At the Federal Trade Commission, the collection and
publication of information on mergers and acquisitions were
discontinued in 1982, just as the takeover phenomenon
developed. As a result, only a private firm provides this
crucial data, and it is more limited than that once
published by the FTC.

At the Department of Agriculturej the accuracy of crop
predictions is now being questioned, and data are not
available by states for the Farm Costs and Returns Survey,
which provides information at the farm level on farm costs,
assets, debt, and various components of the balance sheet.

THE FEDERAL ROLE

The Administration has repeatedly taken the position that to
a significant extent the private sector can and should assume the
responsibility for providing statistical information.
Sidney
Jones, Under Secretary of Commerce for Economic Affairs in
1983-1985, took issue with this position, telling the Committee
in hearings last year that:
The Federal Government should gather,
compile, publish, revise, and preserve the core
statistics necessary to create a comprehensive,
logical, objective, and continuous information
system. Individual government agencies, academic
institutions, trade and professional associations,
and private companies do not have the data
collection authority or capabilities to perform
these important functions, even though they are
the actual sources of much of the information
collected and they naturally develop many specific
statistics and analytical reports.
Over the past six years, the labor force has grown more than
10 percent, real GNP has risen by 15 percent, and import volume
has increased more than 51 percent. These figures are
illustrative of the growth in the statistical system's work load,
as determined by the size and variety of economic phenomena to be
measured.
In addition, the number of important uses for economic
statistics has increased.
Failure of the Federal statistical
system to keep pace with the rapid and fundamental changes in the

138-

139
U.S. economy will inevitably make private decisionmaking more
difficult and complicate further the task of dealing effectively
with pressing economic problems.
Spending on all U.S. statistics programs accounts for less
than two-tenths of one percent of the Federal budget. What
constitutes very minor savings in terms of the Federal budget can
have a crippling effect on existing vital statistical programs,
and could make it impossible to develop the new programs
necessary to keep pace with the rapidly changing economy. Other
nations are much less cavalier than the United States in their
respect for a national statistical base. Modern statistical
programs in Japan were established only after 1945, yet Japan
today has a National Statistics Law and a month-long national
celebration in honor of statistics; last year's theme was
"Statistics are the beacon of a happy life.'
Over the past several years, too little attention has been
paid to the need for providing the accurate, comprehensive, and
timely information on which critical decisions in both the
private and public sectors depend. The Federal statistical base
must be strengthened to develop, maintain, and disseminate the
statistical data essential to a changing economy.
CONCLUSIONS
Three conclusions may be reached with regard to our
statistical program. First, as former Under Secretary of
Commerce Sidney Jones stated, the Federal Government has a
responsibility to maintain the core statistics necessary for a
comprehensive information system. Second, maintenance of the
quality of our data will require adequate funding of our
statistical agencies. Third, in addition to maintaining the
quality of current statistical programs, statistical research
programs must be strengthened and new statistics reflecting
emerging developments in the economy must be developed.

-139-

ADDITIONAL VIEWS OF SENATOR WILLIAM PROXMIRE
The Joint Economic Committee's Annual Report does an excellent job of outlining the problems facing our economy. It paints the
picture of an economy living for today while squandering tomorrow's opportunities. Unfortunately, that is an accurate picture.
Where do we go from here? Many of the problems identified in
the Report can be traced, directly or indirectly, to dissaving by the
Federal Government. The national debt went from $1 trillion to $2
trillion in about five years. It may well exceed $3 trillion before
this decade ends. This orgy of spending is unparalleled in American history.
I can see no evidence that his trend has changed. Congress
passed the Balanced Budget and Emergency Control Act of 1985
and the 1986 Federal deficit promptly reached a new record high of
$221 billion. That Act set a target for the 1986 deficit of $172 billion; we will be fortunate to meet that target by 1988. The $108 billion target for 1988 is unreachable unless Congress and the Administration change their ways.
There is little or no evidence that such a change is in prospect.
Spending pressures continue to build. The Strategic Defense Initiative, the Administration's highest priority, could cost trillions of
dollars. The Defense Department now has about $300 billion in the
bank, unspent but already appropriated by Congress. That money
will be spent over the next few years. The Report itself identifies a
number of domestic needs, which will be costly to meet.
Meanwhile, the 'fact that interest rates have dropped has disguised a ticking time bomb in the budget. That bomb is the unavoidable necessity to pay interest on the national debt. If interest
rates increase even slightly, a distinct possibility, all of our efforts
to reduce the deficit could come to naught. For example, the Administration has proposed spending cuts of about $15 billion in its
FY 1988 budget. If interest rates increase by about 1.5 percent,
roughly to the level they were in February 1986, then the additional costs of paying interest on the national debt would cancel all the
Administration's proposed spending cuts. If we face some type of
supply-side shock-a rapid increase in oil prices-and interest rates
jump three or four points, then we would have to spend roughly
another $30 billion or more merely to pay interest. I cannot overstress to my colleagues the dangers inherent in this situation.
We are in a race to see if we can reduce the deficit to a less dangerous level before the next recession hits. If we lose that race, the
deficit could increase to the $300-$400 billion range, and the national debt would truly be out of control. This Nation would then
face economic problems akin to those faced by some Third World
countries. Our living standards would hit the skids and the social
turmoil would be shattering.
(140)

141
The odds of such a scenario taking place are small but increasing. A near-term recession would increase them enough to be really
worrisome. To avoid this possibility, we should first reduce the Federal deficit. To the extent that we do need to spend more on selected programs, we should force ourselves to spend less on other, less
important programs. The revenues we raise should be dedicated to
reducing the deficit.
We face extraordinary risks and opportunities over the next few
years. Unless we reduce the Federal Government's dissavings, we
increase the risks and miss the opportunities. Making such a reduction should be our first priority.

ADDITIONAL VIEWS OF SENATOR LLOYD BENTSEN
I congratulate Chairman Sarbanes and the Majority staff of the
Committee for producing a comprehensive Report. It raises a
number of issues and provides a provocative perspective on the economic challenges we face. These Additional Views will elaborate
my position on several of the economic questions confronting the
Untied States.
Deficit Reduction Targets.-As the Report notes, meeting the deficit target of $108 billion for Fiscal Year 1988 will be difficult because economic growth has slowed in the last two years. But I am
not yet convinced that delaying progress toward that goal will
unduly jeopardize economic growth. Moreover, the deficit reduction
target should be achieved on the spending side and in a bipartisan
fashion with active support and cooperation from the White House.
Third-World Debt.-The dramatic rise in U.S. Government debt
since 1981 has been partly financed with foreign capital inflows. To
that extent, the budget deficits may be crowding out investment in
Third World nations and jeopardizing their efforts to service their
own international debt. Reducing the Federal budget deficit will
reduce that phenomena directly and reduce Third World service
obligations through lower interest rates, as well. Moreover, the interests of creditors and debtors alike would be enhanced if the current account surplus nations of Japan and Germany would divert
some of their promised increase in domestic demand toward Third
World goods. These macroeconomic and trade steps may avoid the
need to establish a special international multilateral institution as
suggested by the Report.
Labor.-The Report correctly notes that the Administration's dislocated worker initiative is overdue and welcomed. Expansion of retraining and relocation assistance beyond the White House proposal should await assessment of the new proposal's success. In addition, expansion of the Employment Service is one of many options
which should be considered to improve labor market information
and accelerate the return of valuable and experienced men and
women on layoff to the work force.
Agriculture.-The Report criticizes the export focus of agricultural programs. I disagree. American farmers and ranchers are the
most productive in the world. We have a comparative advantage in
their products. The failure of agricultural exports to grow apace in
recent years has been a failure of trade policy to eliminate unfair
trade barriers confronting U.S. agricultural exports abroad. Foreign government production subsidies, import barriers, and export
subsidies have increased dramatically. European sugar beet farmers receive over three times the world price in export subsidy payments, for example. And trade barriers in Japan raise the price of
many citrus and rice imports to four times world levels. The failure
of our farms programs in recent years reflects in part the failure of
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143
our trade policy. And reforming trade policy to promote free trade
is one of the most effective steps we can take to improve American
agriculture.
Energy.-The Report correctly notes the rising dangers of oil dependency. The abrupt price movements engineered by the Organization of Petroleum Exporting Countries (OPEC) since late 1985
have crippled our domestic energy industry. And OPEC's demonstrated willingness to permit continued price volatility will prevent
adequate investments in exploration and drilling sufficient to stabilize future domestic oil production. As a result, we face a future of
eroding domestic production and climbing demand, with the widening gap filled with imports.
The most recent data for 1987 show that domestic crude and natural gas liquid production is off nearly one million barrels compared to the comparable period last year, while demand is some 2
percent higher. As a result, oil imports this year are averaging 6.3
million barrels per day, up 20 percent from 1986. Foreign oil is now
providing 39 percent of domestic consumption, compared to 27 percent little more than a year ago. And groups ranging from industry
organization to economic forecasting firms to the Congressional
Budget Office are predicting that oil production will continue falling and that dependence will exceed 50 percent by 1990. Chase is
forecasting 30 percent of stripper wells to be shut-in by then as
well. And Dr. William Fisher of the University of Texas has noted
that the giant Prudhow Bay field will begin declining in 1988 by as
much as 200,000 barrels per day. Alaskan production boosted overall U.S. production in the 1980's but it will soon begin to exacerbate the production decline.
Rising dependence has alarmed some in the Administration.
Former Energy Secretary and current Interior Secretary Hodel has
said that "people will be sitting in gas lines anytime within the
next two to five years," with OPEC back "in the driver's seat."
Moreover, he has noted that an energy crisis like 1973 is "almost a
certainty" without a recovery in domestic oil production. These
fears are warranted. Higher oil prices in the 1970's and early
1980's reduced worldwide oil demand by seven million barrels per
day while increasing non-OPEC production by six million barrels
per day. Awash in oil, world prices declined. OPEC's stranglehold
on world oil markets was loosened with its own production ebbing
to 16 million barrels in 1985 from 31 million barrels in 1973. But
that stranglehold will reemerge in the future as price volatility
continues to shrink non-OPEC output. OPEC is the only major
source of oil to offset these production declines and meet rising oil
demands. Indeed, OPEC's production expanded a sharp 16 percent
to 18.6 million barrels last year. And the combination of rising
demand and falling production will increase U.S. imports by four
million barrels at the end of this decade. Similar trends elsewhere
will cause OPEC production to soar in the years immediately
ahead, dramatically increasing the probability of oil price shocks
and embargoes.
This grave outlook jeopardizes domestic economic prospects and
the indepenedence of American foreign policy. It raises considerable national security concerns, as well, which have not been
matched by Administration energy policy. Reducing energy R&D

144
outlays and abandoning vehicle fuel efficiency standards as the Administration has done magnifies rather than reduces our alarming
dependence on insecure OPEC oil.
The Administration must join with Congress to craft a bipartisan national energy policy designed to limit U.S. oil dependence. I
have proposed legislation designed to establish such a policy, entitled the "Energy Policy and Security Act." It is designed to limit
dependence to 50 percent of domestic demand. This legislation does
not mandate any specific action by the President to cap imports.
Rather, it would require that he examine oil demand, supply, and
import trends, and propose effective and far-reacing steps to cap
imports should they threaten to exceed one-half of domestic production. Other approaches may be merritorious, as well. But the
crafting of an effective and thoughtful national energy policy to
minimize the dangers posed by imports to national security is an
urgent task which cannot be done by Congress alone. It will require presidential leadership.

ADDITIONAL VIEWS OF HON. AUGUSTUS F. HAWKINS
I would like to commend Senator Sarbanes, the JEC staff, and
the other Members of the Committee for presenting a clear and
comprehensive review and analysis of the state of the American
Economy. I applaud the format the Chairman uses in the Report,
for it makes it easy for all to understand how each element of the
economy has impacted our overall capacity for growth and ability
to meet the challenges of domestic and international markets. Such
analysis will make an important contribution to our current economic debate.
While the Chairman mentions the need for more effective presidential leadership and the need for a serious effort to fashion a
workable package of expenditures and revenues to support national
priorities, this Report does not take the next step and specifically
recommend what those programs and policies should be. While I
believe we should be presenting a broad analysis of short-term and
long-term trends, the Joint Economic Committee should not shy
away from making specific recommendations on what programs
the Congress should be promoting to bring about full production,
full employment, and price stability.
As pointed out in the Annual Report, the President's Economic
Report did not submit an annual long-range plan designed to
reduce the unemployment rate to 4 percent within a period of five
years, as required by the Full Employment and Balanced Growth
Act of 1978. I believe this Committee should be submitting such a
plan in this Annual Report. We lose an important opportunity to
make a meaningful contribution to the coordination of economic
policy by not putting forth our own specific recommendations and
policy alternatives.
Statute requires the reduction of unemployment and attainment
of price stability to be the central focus upon which our economic
policy decisions turn. I urge both the Administration and a majority of the Congress to provide the political will to implement this
important policy directive.

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MINORITY VIEWS
REPUBLICAN JOINT ECONOMIC COMMITTEE ANNUAL REPORT
I. INTRODUCTION

The current economic expansion is well into its fifth year. Dr.
Walter E. Heller of the University of Minnesota and Dr. Richard
Rahn of the U.S. Chamber of Commerce agree that real gross national product growth during 1987 (year-over-year) will be 3.0 percent. Only slightly more optimistic is the Administration's forecast
of 3.1 percent. A survey of 41 economic forecasters provided by
Blue Chip Economic Indicators shows a real GNP growth consensus
of 3.4 percent for 1988, a marked improvement over 1987. Virtually,
no one predicts a recession in either 1987 or 1988. The "Blue Chip'
forecast for the unemployment rate in 1988 is 6.6 percent, a decline
from its forecast of 6.9 for 1987. According to the same economic
forecasters the consensus is that inflation and interest rates will
remain low and under control. The Joint Economic Committee's
Republican staff supports the consensus findings for 1988 of these
41 independent forecasters.
The economy appears to be on a path of stable growth. We're
comfortable with the current low rate of inflation, hopeful that interest rates will continue to decline, optimistic that employment
opportunities will continue to improve, and confident in this Nation's resilient, innovative, and diversified economy.
This is not to say that all is well. Because our economy is dynamic and relatively free of governmental control, it permits and generates change. Change causes uncertainty, which fires the political
furnaces. But governmental intervention must not defy economic
principles of the free market upon which long-term growth depends.
The United States is not deindustrializing nor are geographic regions of it doomed to economic extinction. A tighter labor market
will lead to greater earning opportunities, particularly for minorities and new immigrants who will be making up an increasing proportion of the Nation's labor force. Educating and training this
labor force will be essential-not for the purpose of placating the
social conscience, but for U.S. economic well-being. U.S. business
decisions regarding investment, research and development, and
productivity will pose challenges as economic growth becomes increasingly dependent upon successfully competing in the global
marketplace. Unless our policies are mutually supportive of U.S.
labor and capital, we face the danger that the world may have
little use for either.
The greatest economic challenge facing the 100th Congress"The Centennial Congress"-is reducing the Federal deficit. The
deficit-reduction program of Gramm-Rudman-Hollings, which calls
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147
for $36 billion annual reductions in deficits, must be minimum adhered to. Achieving a reduction of the deficit to $108 billion in
fiscal 1988 must be pursued with all vigor. Like the patient suffering from a life-threatening disease, we must keep up the treatments. Similarly, we must not renege on tax cuts pledged in the
1986 Tax Reform Act. Regarding monetary policy, we believe that
the Federal Reserve has maintained the right balance, achieving
price stability along with continued economic growth.
Over the longer term, there are several major forces which are
influencing the direction of the U.S. economy. The issue of "competitiveness" will receive much attention from this Congress, but
we caution against overly active political intervention in the economy. The ability of our market-based economic system to react and
adjust to a global marketplace will prove to be our best weapon in
the competition for world markets. At home, there is a desperate
need to rethink national policies dealing with welfare, Federal regulations, and agriculture. This report presents an agenda by which
the Joint Economic Committee can fulfill its mission to'lead the
Congress in analyzing and debating these issues.
11. ECONOMIC OUTLOOK

The economy has been growing since late 1982. Although this is
an extremely long expansion by historical standards, 1987 shows
every sign of being another good year.
The Administration's official forecast says that real gross national product will grow 3.1 percent (year over year). This is slightly
higher than the consensus of private economic forecasters but we
believe that the chances are excellent that the Administration's
forecast will prove to be accurate.
Interest rates are expected to continue to decline slightly, largely
due to growing confidence that inflation will not be a problem for
the foreseeable future. Furthermore, the economy's moderate
growth rate suggests that an investment boom is not likely to push
up interest rates. The ease with which investment funds cross national borders also makes a run up of U.S. rates unlikely. '
Inflation in 1987 will probably be around 3.5 percent (average
Consumer Price Index, year over year year), which is toward the
upper end of an acceptable range of 0 to 4 percent. At that level it
will be somewhat over 1986's 1.9 percent rate, which was the
lowest in decades. These favorable developments on the financial
side owe much to the successful monetary policy carried out by the
Federal Reserve during the past several years.
The unemployment rate for all civilian workers dropped in 1986,
and it is expected to average under 7 percent during 1987. As discussed later in this report, long-term demographic trends are reducing the growth of the labor force, which will result in somewhat
tighter labor markets.
Housing starts may equal their sustained performance during
1986, which were strengthened when mortgage interest rates
dropped below 10 percent for the first time in almost a decade.
Nineteen eighty-seven should also be a good year for housing, with
about 1.8 million starts likely, especially if mortgage rates continue
to hold at less than 10 percent.

148
Auto sales in 1987 will be somewhat less than the 1986 total of
11.3 million units. For the U.S. economy, the import share will be
the crucial variable. This is uncertain. On one hand the fall of the
dollar will tend to raise import prices and promote the market
share of American made cars. On the other hand, foreign sellers
may be faced with a surplus of cars due to the rising popularity of
American built cars, which would indicate the need for foreign producers to cut prices.
Why Does the Expansion Continue?
Economic growth this year will be helped by an improvement in
the trade balance, brought about by the decline in the foreign exchange value of the dollar. Foreign economies will, by and large, be
strong enough to increase their demand for U.S. exports. Our monetary policy has achieved the appropriate degree of expansion, and
it is clear that the Federal Reserve is alert to any warning signs
from the economy, should they occur.
The economic situation is not without potential problems. The
fall in the dollar may lead to higher interest rates if it affects the
willingness of foreign investors to hold U.S. assets. Business investment appears to be weak, at least during the early months of 1987.
Both the farm economy and the energy-producing regions of this
country have not recovered from their economic slumps.
Sometimes economic policy is itself the cause of economic problems. Economic expansions rarely die of old age; they succumb to
bad policy. One potential danger is the possible passage of a protestionist trade bill. In January, the Blue Chip panel of economists
strongly endorsed the statement by the Council of Economic Advisers that "international protectionism would be a burden on our
economic life and a threat to our long-term economic prosperity."
A 10-point-scale rating of 8.6 rejecting protectionism was among
the highest that the Blue Chip survey has ever recorded on a
public policy issue.
Some analysts worry that efforts to delay income until 1988,
when tax rates will be lower, will slow the economy this year. We
do not believe that this effect will be large. Because the greatest
share of personal income comes from wages and other sources that
are not easily deferred, delays in income receipts can be made only
at the margin. Often these delays are only nominal (like an author
delaying his contracted income for a week or two) and do not affect
the actual level of economic activity.
Overall Economic Performance
Economic performance consists of more than just growth in gross
national product. Low unemployment, low inflation, and low interest rates are of comparable importance. When viewed in this broader context, the economic policy of the Reagan Administration is
clearly even more successful than when judged by growth alone.
Even the most casual review of the data reveals that inflation and
interest rates are far below the alarming levels they had reached
at the end of the Carter Administration.
Is there any way to generalize about overall economic performance? Can we capture the essence of policy makers' success-or
lack of it-in just one statistic?

149
A recent report by the Republican staff of the JEC attempted to
do just that. In "Measuring Economic Performance," released late
last year, we constructed an index of 10 widely used measures of
economic conditions:
Gross national product (constant dollars);
Disposable personal income per capita (constant dollars);
Fixed nonresidential investment (constant dollars);
S&P index of stock prices;
Productivity;
Exports (constant dollars);
Corporate profits (constant dollars);
Consumer price index;
Interest rates; and
Unemployment rate.
The Federal deficit is not included because there is disagreement
over its effect on the economy. Whatever its effect, it should be reflected in the values of the 10 variables that were selected.
These 10 variables were weighted by their relative importance in
assessing economic conditions, as judged by the Blue Chip panel of
economic experts. The resulting statistic-the Economic Performance Index (EPI)-was computed for each year from 1953 through
1986. (For more details, see "Measuring Economic Performance,"
Joint Economic Committee, November 7, 1986.)
According to this broadly based measure of economic performance, the Reagan Administration has produced the greatest improvement during the 33 years that were examined. The actual
level of economic performance was highest during the early 1960s,
when growth was rapid, unemployment was low, and inflation was
moderate. But the trend since then was downward until the reversal during the Reagan years, which has been quite remarkable.
New calculations, incorporating forcasts of the 10 variables for
1987, show that the overall record of the Reagan Administration is
now the second best of any administration during the post-1953
years. It is behind Kennedy-Johnson, but slightly ahead of the Eisenhowever Administration and well ahead of Nixon-Ford. The
Economic Performance Index for the Carter years is by far the
worst of any administration, owing mainly to high interest rates,
high inflation, and lackluster economic growth.
Summary
The economy has been growing since late 1982, and we expect
growth to continue through 1987. The Administration's forecast of
*3.1 percent real GNP growth (year over year) is more optimistic
than the average of private forecasters, but we believe that the
chances are excellent that this forecast will prove to be accurate.
Interest rates will continue to decline slightly, though prices will
increase by about 3.5 percent (average CPI, year over year), somewhat over the very low rates experienced in 1986. The unemployment rate should stay under 7 percent.
Problems on the horizon include the falling dollar, which may
lead to higher interest rates, and the continued weakness of the
farm and energy sectors.
Overall economic performance during, the Reagan years, according to our analysis, compares favorably with any since the early

69-874 0 - 87 - 6

150
1960s, thanks to the marked reductions in inflation and interest
rates, plus the return to economic growth.
m. ECONOMIC TRENDS AND POLICY

Introduction
This chapter provides an overview of some of the more important
micro trends that exert a strong influence on economic growth,
present and future. The first to be discussed are the shifts in the
composition of U.S. industry. The second section examines expected
changes in the labor force and the opportunities that will present.
The next section considers the determinants of improvements in
productivity, particularly capital formation and technological innovation. The final section of this chapter examines the regional implications of economic growth.
Industry Composition
After countless articles detailing the rise of the service industries, it is hardly news that the service-producing sector is growing
faster than the goods-producing sector of the economy. By now it
must be common knowledge that this increase in services is not signaling the "deindustrialization" of the United State. The absolute
decline in our industrial base that is implied by the term deindustrialization has not occurred and probably never will. Real output
in manufacturing is at an all-time high, with investment at historically high levels.
I
In addition, there has been no significant decline in the relative
importance of manufacturing output as the service sector has
grown. In 1950, the manufacturing industries produced 24.9 percent of total GNP (excluding government services) and the service
sector produced 51.8 percent. The manufacturing sector's share has
remained fairly constant, except for cyclincal swings, and in 1985
this sector produced 24.4 percent of GNP.
During this same period, however, services experienced a substantial rise in output share of 11 percentage points. The relative
gain by services was at the expense of the other goods-producing
industries-construction, agriculture, and mining, but not manufacturing. Even during this period of relative decline, the real level
of goods-sector output increased by approximately 150 percent
during the 35 year period. Service output simply grew faster at 275
percent.
The only areas where there has been an absolute decrease in
manufacturing is in employment. There are currently 9 percent
fewer jobs in the manufacturing sector than there were in 1979,
the peak employment year. The relative rise of the service sector is
not a recent phenomenon. As seen in Table III.1, the shift toward
services is evident at least as far back as 1959 and the BLS forecast
for 1990 shows this trend continuing. Only the durable manufacturing industries are projected to experience sufficient employment
gains by 1990 to achieve a relative gain in employment. Agriculture and the other goods-producing industries will continue to lose
share, but the rate of decline appears to be leveling.
Even though the aggregate level of employment for the goods
sector is currently rising, there are specific industries that will con-

151

tinue to experience declines. H3wever, it is important to distinguish between two very different causes of employment decline:
those caused by productivity improvements and those caused by declines in demand for the product. A recent study by Ronald
Kutscher and Valerie Personick of the Bureau of Labor Statistics
("Monthly Labor Review," June 1986), examines the output and
employment changes of 150 industries between 1969 and 1984.
They consider three categories of change. Industries were both
output and employment increased during the period, the first and
largest category, comprise one-half of the industries studied. For
virtually all of the industries in this category, the increase in
output is greater than the increase in employment, implying gains
in labor productivity.
TABLE III-.-DISTRIBUTION OF U.S. EMPLOYMENT, 1959-1990
Industry
Total (thousands)................................................................................

Agriculture2 ..............................................

1959

1969

1979

1985

p1990

67,784

81,508

101,471
Percent

109,489

116,856

3.3
8.2..........................................
4.4

Durable..
Nondurable..

5.
25.1

Man'ufacturing ................................
.
.

0.9

Mining0.........................................................................................
Construction5................................................................................

27.6

31.1

31.8

Goods-Producing .......

8
25.1

6
5.4
21.1

2.9

2.7

24.2

23.8

0.0.7 6 0.6
5.3
5.7
5.8
17.9

17.9

14.1
12.8
1
0.711.0
14.8
...........................................................................
10.3
8.3
7.2
6.9
......................................................................
11.0

.....................
Service-Producing

60.0
.
.

64.5
..........

69.1

72.9

73.5

5.1
5.3
5.1
6.3
5.7
Transportation, communication, andpublic utilities .....................
23.2
22.0 20.522.8
19.9
.
........................................................................................
Trade..
6.0
5.4
6.0
4.7
4.4
insurance,
andrealestate............................................
Finance,
25.1
7 . 20.75 18.624.0
1
.1....................................................................................
Services
14.2
15.7
15.0
11.9
15.0
Government1.................................................................................
byPersonick
astabulated
andsala jobs
andself-employed,
Incoudes
wage
moderate
growhfigures
'The projections
aretheU.S.Bureau
ofLabor
Statistics
' Inedespriyatebosehhtds.

through
1995,"Monthly
Labor
Revirew
(November
OutDut
andEnmont Trends
Source
Vauriek Pe'sonik,
"A Second
Lookat Industry
provided
by Personick).
1985),tabe 1. (Updates

In addition, the results show that:
Among the goods-producing industries which are included in [these] growing industries are 4 of the 7 agricultural
industries [food and feed grains, agricultural products
n.e.c., forestry and fishery products, and agricultural, forestry, and fishery services], 2 mining industries [coal and
chemical and fertilizer minerals], maintenance construction, and numerous manufacturing industries. Most of the
latter on the list of output and employment gainers are
durable goods industries, particularly those which are included in 1 of the 3 high-technology definitions developed
earlier by BLS (p. 8).
The second category specified by Kutscher and Personick contains those 24 industries where output is increasing but employment is declining. The 37 industries in this grouping have most
likely experienced gains in productivity that exceed the increase in

152
demand. The industries in this goup include "[m]any of the food
processing, textile, chemical, metal products, and industrial machinery industries . . ., as well as motor vehicles (p 9)".
The third group, which can be considered to be the declining industries, are those that have experienced declines in both output
and employment during the 15 year period. The industry that
dominates the list in output and employment loss is the blast furnaces and basic steel products industry. Other big decliners were
also in the "basic" industries, such as iron and ferroalloy ores
mining, rubber products except tires, and leather tanning and finishing.
The results from this study illustrate that while there does exist
a group of troubled industries, there is no basis for concluding that
the goods-producing sector or the manufacturing industries, in general, are in a state of decline. In fact, the industries in the first and
second categories are growing in a positive manner, i.e., through
productivity growth. What appears to be happening is a maturing
process as the economy shifts away from those (relatively few) industries where it no longer has a comparative advantage. The decline of industries is not a new phenomenon (and there are laws
designed to maintain vital defense industries).
The current situation in the manufacturing sector of increasing
output and declining employment is similar to that experienced by
the agricultural sector since 1950. For almost fifty years there has
been an increasing spread between output and employment in agriculture indicating increased productivity, not sectoral decline. Improvements in agricultural processes significantly reduced the
number of people necessary to produce any given level of output.
This increased the labor available to the expanding manufacturing
sector during the 1950s. The continuing upward trend in manufacturing output again demonstrates that the United States is not
losing its manufacturing base. And the decrease in employment
relative to output is an indication of increased productivity.
Two other forces combined with rising manufacturing productivity to increase the relative share of services: a large increase in the
labor force and the end of the postwar global expansion (19481973). Labor force participation for women rose between 1973 and
1985 by 10.3 percentage points to the level of 54.7 percent. This
along with the entry of the "baby boom" generation into the work
force caused a significant rise in the labor force during this period.
At the same time there was generally sluggish growth in world
demand for manufactured goods, combined with increasing supply
as many of the lesser developed countries established their own
manufacturing sector.
The combination of falling demand for goods with a rising supply
of labor would have had a very serious negative effect on the economy if the service sector had not expanded as it did. But in the last
15 years almost 30 million new jobs were created in the United
States and over 95 percent of those were in the service industries.
This performance is a strong contrast to the European experience
of virtually zero employment growth over the same period. According to BLS projections this trend will continue, with 90 percent of
the 16 million new jobs projected to occur by 1995 to be in the service-producing industries ("Monthly Labor Review," November 1985,

153
p. 26). Therefore, this relative shift toward services is not a flaw
that needs to be corrected; it is the natural direction of growth in
the economy.
Nor is the shift toward services signaling a decline of the middle
class: employment growth has not been concentrated at the low
and high extremes of the wage scale. As a recent Bureau of Labor
Statistics study reports, it is the top two-thirds of the employment
distribution that is increasing contrary to the "bipolarization
thesis" espoused by some (McMahon and Tschetter, "Monthly
Labor Review," September 1986).
In addition, some manufacturing firms are laying off white collar
workers and contracting out to service firms to obtain the work
previously done in house. This reduces manufacturing employment
statistically, but it is not a structural shift from manufacturing.
The above discussion is not meant to imply that there is no badnews component to the shift toward services. The worker dislocation that has occurred as a direct result of this structural change is
not a minor problem, particularly since many of the declining industries are regionally concentrated. However, because the growth
in the labor force is slowing considerably, the next 10 to 15 years
should be a period of opportunity where both industries and individuals will attach a high value to training and retraining. The evidence is strong: Services will continue to comprise a growing part
of the economy. Efforts to interfere with this long-term trend
would be costly and of little effect. The only sound policy to pursue
is one that is sensitive to the trauma of worker dislocation and one
that allows the maximum flexibility for change.
Labor
After going through a period where the labor force grew rapidly,
we are now entering a period of slower growth. Additions to the
labor force are projected to be at the lowest rate since the 1930s.
BLS predicts that by 2000 the growth rate will be down to 1 percent annually, owing mainly to decrease in the number of young
workers. In 1985, workers aged 16 to 24 made up 20 percent of our
Nation's work force, but by 2000 this percentage is projected to
drop to 16 percent. In addition, even though labor force participation among women will continue to rise, the increase will occur at
a decreasing rate.
The racial and ethnic composition of the labor force will also be
changing. The proportion of minority youths in the labor market
will increase and by 1990 one out of five new labor force entrants
will be a minority youth. Immigrants too will significantly affect
the future labor force as their numbers continue to increase at a
rate faster than at any time since World War I.
These changes create both an opportunity and a challenge: The
tighter labor markets will make possible a reduction in unemployment, particularly among groups considered to be disadvantaged,
but only if sufficient training is provided so that those seeking employment have the job skills needed by the employers. The educational system must emphasize attainment of the basic verbal and
analytical skills that form the basis for further learning. While employers will become increasingly willing to provide job-specific
training as the pool of potential employees shrinks, the training

154
process will be more successful if the employees already have these
basic skills. Our educational system must prepare students to succeed in the economy.
In addition to improvements in our educational system, there are
cultural and structural issues that must be addressed in order to
take advantage of this "window of opportunity" to help groups
with long-standing labor market problems. The Department of
Labor is presently undertaking a major examination of these issues
in its Work Force 2000 project. The study has identified three
broad categories of policy goals they consider to be most important
for the next 15 years:
Promoting change.-A key ingredient for economic growth
over the next 15 years will be a willingness by individuals,
companies, unions, governments, and other institutions to
adapt and respond to a rapidly changing economy. Individuals
must learn new skills, organizations must be able to adopt new
technologies and organizatonal systems, unions and managers
must find new ways to relate to each other, and government
must rethink historical ways of regulating, taxing, and promoting industrial growth. Because many members of our rich and
aging society will be increasingly resistant to change, government policies should be designed to promote change by individuals and institutions.
Increasing the numbers of qualified workers.-Slow labor
force growth presents a serious potential constraint on American economic growth and international competitiveness. To
maintain our position in the world, including our economic
preeminence and military strength, we must find better ways
to employ the disadvantaged, immigrants, and women who
have not been able to contribute fully to our economy.
Enhancing the skills of the work force.-As the world economy becomes more competitive and intergrated, and increasingly focused on services and information tasks, [our] economic
success will depend to a greater degree on our human capital.
By the year 2000 there will be few high-wage, unskilled jobs;
industries that require only unskilled labor, and jobs that require only basic human skills will increasingly be done abroad.
High American wages will be paid only to those whose knowledge or skills give them as edge in national and world labor
markets. As a matter of equity within American society, and
competitiveness around the globe, more attention must be paid
to improving the skills of all segments of the U.S. labor force.
The research of Work Force 2000 is continuing as the Department of Labor begins examination of specific policy options in
achieving the above goals. This project is a significant initiative because it questions which policies should be undertaken to take advantage of the coming demographic changes. Too often policymakers are constrained by both time and money to deal only with problems of the present. Projects such as this, which are investments in
the future, recognize the gains that can be realized by preparing
for change as opposed to trying to prevent it.

155
Productivity
One goal of an economic system is to increase the average standard of living by increasing the quantity and quality of goods and
services produced. It is this absolute increase that allows us to
afford more of everything from better cars to improved social programs. Economic growth is the term usually associated with this
notion of potential improvements in "well-being". The primary
engine of economic growth is productivity. The ability to produce
more and better goods and services using fewer inputs is fundamental to increasing economic growth.
The forces that influence productivity growth are diverse, but
there is a general consensus that investment in plant and equipment, human capital, and research and development are the major
categories. Even within these categories are extremely diverse investments, and there is no reason to expect spending on different
investments to have an equal impact on productivity growth. While
we can identify the factors that influence the productivity growth
rate, the strength and timing of their impact on productivity is
highly variable. These factors tend to interact with one another
and their net impact on productivity is felt only after a period of
time. Therefore, to attribute the success or failure of attempts to
increase these measures on any one factor is usually not accurate
and fails to recognize the complexities of a free market economy
that produces a total output of our $4 trillion yearly.
Not only does the composition of investment affect its eventual
effect on productivity; it will affect the timing also. For example,
the impact of changes in the quality of education at the grade
school level may take many years before productivity is improved,
resulting in a better prepared work force. In contrast, the replacement of an old machine with a new improved one may have an immediate level.
Aggregate labor productivity for the entire business sector (i.e.,
everything but agriculture and government), while increasing, is
not increasing very quickly. The average increase for the current
business cycle (1979-85) has been just over 1 percent annually. This
aggregate hides some very significant variations that occur among
the components of the business sector. One of these components,
manufacturing, has been experiencing substantial increases in productivity during this period. The annual increase for 1985 was 4.4
percent and the 1986 increase should be between 2.5 and 3.5 percent.
Manufacturing productivity should continue its increase as real
capital expenditures, particularly for equipment, continue the
strong growth they have shown during this recovery. This investment growth is likely despite the 1986 tax revision that largely
eliminated the investment tax credit, retroactive to January 1,
1986.
The low growth in business sector productivity is largely due to
low estimates for its component service sector productivity. This
slow growth may, in part, be due to measurement problems. These
problems are not new, but the increasing size of the service sector
has made the measurement problems of services more significant.
Because productivity is a measure/of output per unit of input or

156
input group, it is important to have a good measure of both components. It is difficult to derive an adequate measure of service
output because it is likely to be an intangible, such as legal advice,
and may consist of many discrete parts that can be consumed in
different combinations. For example, an advertising agency can
produce the ad concept alone, leaving actual production to a video
agency, or it can produce both. A bank offers an array of services,
from accepting demand deposits to devising investment plans; a
customer may use one or many of these services during a single
visit. Measuring productivity improvement in such diverse and abstract activities is extremely difficult.
Government policies that support investment, and thus productivity growth, fall into two categories. In the first group are those
investments that the government undertakes itself through direct
expenditure. An important component of this category is investment in infrastructure. Roads, bridges, and sewers have an essential, but largely unmeasurable, positive effect on productivity
growth.
The effects of other types of government investment, such as in
basic research and development or education, are more easily
measured. These types of expenditures support productivity improvements by increasing our collective store of knowledge. Additional programs in several of these productivity improving categories have been given high priority status in the President's current
budget proposal. Even with the need to cut Federal expenditures,
the Administration recognizes the importance of this government
function. Its budget proposal includes provisions for:
funding basic biomedical research;
$200 million increase for compensatory education for educationally disadvantaged children; and
increases in funding for clean coal technology demonstrations, as well as research on acid rain formation and its environmental effects.
Policies in the second category are those that affect productivity
by benefitting the economic environment in a general way. These
are policies that provide for the attainment and maintenance of a
stable economy make investment generally more attractive. Businesses invest less if they cannot predict with any confidence economic conditions for the next quarter or next year. Runaway inflation and extremely high interest rates send mixed signals to producers and encourage a wait-and-see attitude that leads to a stall
in investment. The current economic environment, which features
an inflation rate of about one percent for last year (December 1985
to December 1986) and a prime rate of interest that is less than
half of what it was five years ago, is an important force in extending the current expansion.
Regional Differences
At the national level, economic growth is generally measured by
changes in real gross national product (GNP). This chapter has concentrated on some of the important determinants of economic
growth at the national level. But a step back from this very important aggregate concern is the equally important consideration of
how this growth is allocated among sections of the country. If eco-

157
nomic growth is highly concentrated geographically, that would
have very different policy implications than a more spacially dispersed growth pattern.
Unfortunately, there is not a state or regional counterpart to
GNP, therefore another proxy must be chosen. The Federal Reserve should have value-added data by Federal Reserve District
which divides the country into 12 regions. One output measure that
is commonly used is personal income. Another approach is to consider an input measure such as employment. A third option is
income per capita, which takes into account the welfare aspect.
There is also the question of regional breakdown. Recognizing
that there is no "best" level of aggregation, this section will explore regional growth issues using the census regions and divisions.
Choice of any regional level is arbitrary.
States aggregated into any regional breakdown will exhibit differences. For example, while both Connecticut and Maine are usually grouped together with the New England states, Connecticut
has an average income per capita that is 30 percent above the national average and Maine's average is 14 percent below the national. States themselves also are not homogeneous; there may be differences among metropolitan and nonmetropolitan areas, coastal
and noncoastal areas, etc. Consider Florida, which has an unemployment rate approximately equal to the national average. Recent
estimates of unemployment rates for selected metropolitan areas of
the state range from 4.0 percent in Gainesville to 14.8 percent in
the Lakeland-Winterhaven area.
Two different types of regional patterns are described in this section, one short-term and the other long-term. The variations in
intra-cyclical income growth rates are an example of the shortterm pattern. For periods of four or five years it does appear that
parts of the country are favored over others. However, looking back
over several business cycles we will see that the periods of dominance are short lived. Other regional patterns appear to indicate
long-term trends. The trend toward convergence of regional income
per capita and the shift in population and jobs from the North and
Midwest to the South and West are examples of these movements,
which will probably continue.
PersonalIncome
In order to exclude cyclical effects, growth rates for real personal
income were examined for the four most recent business cycles
(peak-to-peak). Table III-2 lists the real annualized growth rates
and the rankings for the nine census divisions during each of the
cycles. There is considerable variation in the growth rates not only
among periods, but also among divisions in the same period. The
movement in rankings indicate that each business cycle seems to
favor a different section of the country. Strong performance in one
cycle does not carry over into the next because the underlying conditions affecting growth change from cycle to cycle.

158
TABLE 111-2.-GROWTH INPERSONAL INCOME BY REGION ANNUALIZED REAL RATES OF CHANGE
(1982 DOLLARS)
1958-69

1969-;3

1973-79

197945

Percent Rank Pegnt
Rank Pewnt
Rank Percent Rank
chanle
change
chang
change

New England
............................................................
4.6 6
2.9
8
1.7
8
Middle
Atlantic .........................
4.1
9
2.5 9
0.8
9
East'North Central
.........................
4.2
7
3.5 7
1.9 6
West
North
Central
.........................
4.1
8
5.7 4
1.8 7
South
Atlantic .........................
5.8
1
6.3
2
3.0
5
East
South Central .........................
4.8
5
5.7 3
3.4
4
West
Souttth
Central .........................
4.9
4
5.5 5
5.3 1
Mountain.........................................................
..
4.9
3
7.8
1
4.9
2
Pacific..
.
...................................................................
5.4
2
3.5 6
4.9
3
United
States
.........................
4.7
4.2
2.7

3.3
2.3
0.3
1.1
3.5
1.4
3.1
2.9
2.8
2.2

2
6
9
8
1
7
3
4
5

CENSUS REGIONS AND DIVISIONS

Northeast
New England-Maine, New Hampshire, Vermont, Massachusetts, Rhode Island,
and Connecticut.
Middle Atlantic.-New York, New Jersey, and Pennsylvania.
MIDWEST

East North Central.-Ohio, Indiana, Illinois, Michigan, and Wisconsin.
West North Central.-Iowa, Missouri, Nebraska, Kansas, Minnesota, North
Dakota, and South Dakota.
SOUTH

South Atlantic.-Delaware, Maryland, District of Columbia, Virginia, West Virginia, North Carolina, South Carolina, Georgia, and Florida.
East South Central.-Kentucky, Tennessee, Alabama, and Mississippi.
West South Central.-Arkansas, Louisiana, Oklahoma, and Texas.
WEST

Mountain.-Montana, Wyoming, Colorado, Utah, Idaho, Arizona, Nevada, and
New Mexico.
Pacific.-California,Hawaii, Washington, Oregon, and Alaska.

The period with the least variation among divisions is 1959-69.
The combination of the war in Viet Nam and the Great Society
programs created an overheated economy, with temporary growth
that was paid for by the inflation later on. The 1969-73 business
cycle featured a booming agricultural sector-real net farm income
doubled during this four year period. During the next cycle, 197379, it was the energy-producing states that experienced the strongest growth, while the energy-dependent states suffered. Problems
were particularly severe in the industrial Northeast. In the current
cycle, the New England and Middle Atlantic divisions have succeeded in turning their economies around by creating favorable
business environments, while the fall in energy prices and the loss
of agricultural exports have limited growth in the other regions.
Employment
Employment growth, like that of personal income, does not occur
at the same rate in all sections of the country. The South and West
have been growing relatively faster than the rest of the country.

159
Chart III-1 shows the change in nonagricultural employment by
census division over the last two business cycles. Over half (52.5
percent) the nonagricultural jobs in the country were in the Northeast and Midwest in 1973, but this was reduced to 47 percent by
1985. This shift is the result of higher rates of job formation in the
West and South rather than a decline in employment in the Northeast and Midwest. Only the East North Central region actually experienced a loss in employment in one of the periods (1979-85).
There has been a substantial shift in unemployment rates between the regions. As seen in Chart III-2, the rates of unemployment went from being the highest in the Northeast in 1975 to the
lowest in 1985. Unemployment rates also show a great deal of variability within regions.

CHART III.1

DISTRIBUTION

OF NONAGRICULTURAL
EMPLOYMENT

S..-.

33.2
Xn

ffi830.35

211

~24.8

1 9.9
.17.2

PAYROLL

BY REGION
17
1t973

CHART III.2

UNEMPLOYMENT RATES BY CENSUS DIVISION
11.0-

10.0_Northeast -.

9.09.0-~~~~~N ~~West'..
8.0-

...

Midwest
_-South

7.0

6.0-VA

r
75

Source: Bureau of Lxnbor Statistics

77 78

79 80

83 84 85

162
PersonalIncome Per Capita
As would be expected, the ability of capital and labor to move
between sections of the country has led to a lessening in regional
differences in personal income per capita (PIPC). Yet as would be
expected, labor mobility is not perfect and the convergence has not
been a smooth, uniform process. Regardless of these variations, it is
evident from Chart III-3 that there is a long-run trend toward convergence of PIPC. In 1930 the PIPC was 139 percent higher in the
Northeast than in the South, but by 1980 that percentage had
dropped to 18 percent. Although the differential has risen slightly
since 1980, there is no reason to believe that this is signaling a
change in the long-run trend toward equality.
As the regional averages converge, it becomes more likely that
variations in one of the component divisions can cause deviations,
such as the one evident in the recent data. Looking at Chart III-4,
which shows the PIPC as a percent of the U.S. average for the
census divisions, it can be seen that the recent deviation at the regional level is caused by the increase in relative PIPC in the New
England region. This increase, in turn, is driven by increases in
two of the six New England states, Connecticut and Massachusetts.
The relative increase of the New England division is approximately
the same as the decrease in the West North Central division that
occurred between 1948 and 1956. That deviation from the trend
toward convergence did not cause a variation at the regional level
because the variance of the regional level was much higher at that
point. In other words, observed variation among regions is most
likely statistical artifact, devoid of policy implications. In fact, preliminary indications are that the 1985 deviations have begun to reverse.

CHART II1.3

Personal Income Per Capita as a Percent
of the National Average for Census Divisions
140

130
120
110 -

Centrr

~
30

30
90

20 70

g0 -

Soum

9wrm of Es
c ondi Am

140
130

CHARTJ 'III.

New

PERSONAL INCOME PER CAPITA AS
A PERCENT OF THE NATIONAL AVERAGE

tnglandtic

120 East

110 100 -

FOR CENSUS REGIONS

. .

North

------

Central

.............

19d

70
or
.---

90 -

80 -

- ..

.o---.-.
.

7<-,85
.. , ..2

Mountain
West North
Central

"'i I %

/- I ,

... , - ..

South Atlantic I ' . - . ..

70 West South
Central

60 East South
Central

~~~~~~~~~Source:
Bureau of Economic

Analysis

165
Conclusion
Even though there is disagreement concerning the exact magnitude of future GNP growth, there is a strong consensus that we can
expect substantial growth over the next five years. This extension
of what is already one of the largest expansion in the post-World
War II period can be attributed partially to policy changes that reflect a greater reliance upon the free market. These policy changes,
as evidenced by measures such as reductions in the degree of government regulation and the adoption of a more neutral tax code,
have formed the basis for new growth. They have provided a general improvement in the economic landscape by improving such variables as the inflation rate and interest rates.
This growth, however, has not occurred without cost. As we have
seen, recent structural change has caused worker dislocation as
manufacturing in particular has had to regroup in order to become
more competitive. Rather than moving towards deindustrialization,
we see a leaner-but stronger-manufacturing sector emerging.
The structural change has been accomplished by shifts in regional growth rates. Differences in regional growth have always existed, and there is no reason to expect that to change. The differentials in regional income and employment growth are the result of
an uncountable number of decisions made each day by businesses
and individuals on such issues as where to locate, what to produce,
and what to buy. It is misleading to take a given set of growth
rates for a given period and project those rates into the future, for
such "trends" are unlikely to continue for very long. There is already some indication that the patterns of growth in the current
business cycle have begun to change. The high-technology boom
that underlies the strong growth in New England may have crested
(NJ, 12/13/86) and the decline in heavy industry may be close to
bottoming out.
The dynamic nature of our free market economy creates many
new challenges and opportunities. Unavoidably, the price of this
progress is disruption. However, with a well-trained work force and
efficient capital markets, the disruption can be minimized. This
should be the goal of economic policy: To facilitate progressive
change, not to stop it.
Summary
Economic growth is not a smooth and uniform process. The various industrial sectors and geographic regions of the U.S. economy
develop along paths determined by complex interactions of demand
and supply conditions. The availability of suitable labor, the development of productivity-enhancing technoligical innovations, and
the existance of sufficient output markets dictate the direction and
distribution of the more aggregate measures such as GMP and unemployment.
During its development, this country has experienced periods
where first agriculture, then manufacturing became a driving force
in the economy by virtue of the number of jobs they generated.
Even though output continues to rise in both of these sectors, the
service sector has taken over as the main source of job creation and
this trend is expected to continue.

166
The labor requirements of the service sector, in addition to the
requirements of an increasingly technologically sophisticated manufacturing sector, place a strong importance on improving the quality and quantity of high school and college graduates. The projected decline in the number of new labor market entrants make this
goal even more important: with fewer new workers, all will be
needed to create and maintain a competitive economy.
IV. THE UNITED STATES IN THE GLOBAL ECONOMY

As the world's largest and most dynamic economy, the United
States confronts a major challenge as it adjusts to the competitive
realities of the late 1980s and beyond. That challenge involves our
ability to retain hard-won domestic successes-i.e., low inflation,
declining interest rates, and robust job growth-while improving
our international economic performance. In the face of large trade
and current account deficits, this will be a major task. Careful application of America's formidable competitive strengths, however,
can enable us to accomplish just that.
Our underlying competitive strengths should not be underestimated. The United States has traditionally enjoyed a comparative
advantage in agriculture and services. Productivity in manufacturing constitutes the decisive test for this country as it strives to
regain export market shares. There are reasons for us to be confident on this front. According to the President's Council of Economic Advisers (CEA), output per hour in manufacturing has expanded
at an average annual rate of 3.8 percent since third quarter 1981.
This is substantially higher than the 1.5 percent growth rate in
manufacturing productivity between 1973 and 1981; it also eclipses
the 2.6 percent post-World War II average. Similarly, recent
growth in unit labor costs has been modest. Since early 1983, it has
averaged 0.8 percent. Rapid appreciation of the dollar through the
first half of this decade partially nullified these gains. But decline
in the value of the dollar since 1985 should now provide a powerful
assist in helping the United States to translate its underlying comparative advantage into larger market shares, abroad and at home.
In sum, the United States is well positioned to reduce its external deficits by competing more effectively for sales in the global
marketplace and here at home. The goal should be to reduce those
imbalances in a manner which preserves, rather than destroys, the
post-World War II network of multilateral commercial arrangements which still provide the best guarantee for future economic
affluence and security. This goal can best be pursued through four
major policy initiatives, each of which is discussed below:
Reduce the Federal budget;
Help stimulate growth abroad;
Expand U.S. exports; and
Strengthen the global trading system.
Budget Reduction.-Over the space of four years, 1982-86, the
United States has been transformed from the world's largest net
foreign investor to the largest capital market in the world. The
magnitude of this shift is reflected in the growth of net capital inflows as a percentage of U.S. gross national product over this same

167
four year period-moving from near zero in 1982 to a preliminary
estimate of 3.5 percent in 1986.
What has caused this recent large inflow of capital into the
United States and decline in capital outflows? Strong U.S. economic performance is undoubtedly a part of the explanation. This is because capital markets direct resources to those economies offering
the most attractive investment opportunities. Lower taxes, enhanced incentives to invest, deregulation, and sustained, non-inflationary growth over the past 49 months have made the United
States an especially attractive haven for foreign investors and lenders. Likewise, U.S. investors have chosen to keep their money here
rather than invest it abroad.
But a more fundamental reason behind the large increase in capital inflows involves the inability of the United States to align government expenditures with government revenues. Foreign capital
has been used to bridge the expenditure/revenue gap-enabling
the United States to temporarily finance a growing budget deficit.
The U.S. trade and current account deficits are a mirror reflection
of all our capital account inflows. As capital inflows substitute for
domestic savings in buying U.S. Treasurys to finance the budget
deficits, domestic savings can go instead to buy imports of goods
and services, which adds to our trade deficit.
This link between U.S. budget and external payments deficits is
spelled-out in a recent Commerce Department paper:
The critical element in producing these [external] imbalances was the uninterrupted expansion of the federal deficit from about $60 billion in 1980 to $200 billion in 1985.
Absent the very large government deficits, private saving
probably would have been more than adequate to meet
U.S. investment needs, the dollar exchange rate would
probably have been lower, and the net foreign capital inflows and the accompanying very large current account
and trade deficits probably would not have occurred (p. 58,
United States Trade, "Performance in 1985 and Outlook,"
U.S. Dept. of Commerce, October 1986).
Compared with our major competitors, Japan and West Germany, the relative size of the U.S. Federal deficit is troubling. In 1985,
for example, it reached 5.4 percent of GNP, contrasted with 1.4 percent for Japan and 1.5 percent for West Germany, both of whom,
not surprisingly, have been generating record current account and
trade surpluses. The key goal for the United States, then, is to
reduce the need for foreign capital by cutting the Federal deficit,
thereby contributing to the effort of the United States to return to
balance in its external accounts.
Stimulating Global Expansion.-1986's record U.S. trade deficit
of $172 billion continues to reflect the divergent growth paths of
the American economy and its industrial partners. Compared with
the rest of the world, U.S. economic performance has been impressive throughout most of this decade. This fact is reflected in a
recent OECD survey on relative purchasing power in the major industrial economies, including Canada, West Germany, France,
Japan and the United States. The United States came out on top.

168
l

A brief resume of this survey is provided in the London Economist
(p. 106, February 21-27, 1987).
One significant indicator of superior U.S. economic performance
is job creation. Notwithstanding pockets of high regional joblessness, the U.S. employment record is impressive. With the exception
of Japan, America's employment level stands favorable in comparison with its Western allies. American industry has generated 11.5
million new jobs over the last four years. No other nation's economy can match that pace. By way of contrast, since 1976 employment in Western Europe has been stagnant or even falling. As a
result, by late 1986, while American unemployment stood at 7 percent of the work force, the average Western European rate was 9.5
percent.
Superior U.S. economic performance vis-a-vis its industrial partners broadly reflects differences in total Inational demand growth.
Between 1982 and 1985, while this indicator jumped by 5.6 percent
in the United States, average domestic demand grew by a modest
2.4 percent in the other major market economies. This gap between
foreign and U.S. demand growth narrowed in 1986.
To be sure, some substantial benefits have derived from this divergence between the United States and its trade partners. Strong
recovery in the United States during the early 1980s helped pull
the rest of the world out of deep recession. The United States performed this task by providing a vital market for developed and developing country exporters. In Latin America alone, this resulted
in a 95 percent increase in that region's merchandise exports to the
United States between 1982 and 1984. But Latin America is hardly
an exception. Over the past five years, most of our partners have
relied on export sales to the United States for between one-quarter
and one-half of their domestic growth. The result, was that between
1981 and 1986, U.S. merchandise imports jumped from $273 billion
to $387 billion.
This divergence also contributed to U.S. recovery. In its 1987
Annual Report, the President's Council of Economic Advisers explains why:
At first, the deterioration of the U.S. payments position
helped ... the U.S. economy. During the first six quarters
of the expansion, real GNP grew at a healthy 6.8 percent
annual rate; domestic demand grew even faster, averaging
8.8 percent. In effect, growing net imports allowed desired
increases in spending to be satisfied without pushing production growth to levels that would have caused bottlenecks. Although the strong appreciation of the dollar reduced U.S. international competitiveness, the resulting decline in import prices boosted real incomes in the United
States and helped to ameliorate inflationary pressures (p.
107, Economic Report of the President, January 1987).
But this deterioration has gone far enough. For the 1981-1986
period, the U.S. trade imbalance will approach $600 billion. These
cumulative imbalances are unsustainable in the long-run. As will
be discussed presently, a considerable portion of the responsibility
for reducing these imbalances must be undertaken by American
firms and workers. Some of the adjustment must be shouldered by

169
the United State's trade partners. How? Through stronger, domestic-led expansion in Western Europe and Japan. Such an opening
would provide the United States with an important opportunity to
generate new sources of growth in the domestic economy through
revitalized U.S. exports. Similarly, expanded growth in key allied
countries would also provide heavily indebted Third World nations
with alternative export markets.
Recent U.S. efforts to get the allies to take greater responsibility
for stimulating the global economy have met with mixed results.
Concerns about future inflation emboldened finance ministers in
Western Eurpoe and Japan to reject U.S. efforts to promote a turn
away from export-led expansion and toward domestic growth,
which in turn could generate a stronger demand for foreign goods.
Western Europe and Japan could indeed provide a major stimulus to global recovery through expanded imports of goods, particularly from Third World countries. While the United States continues to pull in about 60 percent of developing world manufacturing
products, Western Europe's percentage remains in the 28-30 percent range, while Japan's has actually dropped from 8 to 6 percent
over the past few years. This situation was recently summed up by
Goldman Sachs Vice President, Robert D. Hormats before the Joint
Economic Committee: ". . .popular opinion in these nations has not
yet come to terms with the notion that the long-term interest of
their societies will be served by their assuming a greater portion of
the global economic management role that the U.S. took on after
World War II."
Export Expansion.-Despite the magnitude of the U.S. trade imbalance, U.S. and global economic interests would be poorly served
by. crash efforts to reduce it through sharp import cutbacks. It
bears remembering that the last U.S. trade surplus ($2.2 billion)
was generated in 1975 in the midst of a severe recession. The large
U.S. merchandise trade imbalance cannot be sustained indefinitely.
So what can be done to restore balance in that account? Looking
toward 1987 and beyond, one answer is to be found in expanded
U.S. exports.
The growth in America's exports since 1980 has been modest
indeed. But the dollar's depreciation since September 1985 along
with manufacturing productivity gains should provide the United
States with a major opportunity to substantially boost U.S. exports
in the future.
There has been some erosion of U.S. competitiveness in certain
sectors. But America's underlying comparative advantage in world
markets remains strong across a broad range of products, including
pharmaceuticals, petroleum refining equipment, aircraft engines,
electronic computing, and medical equipment. Especially strong
export prospects are provided by the service sector. Data Resources
Incorporated (DRI), for example, believes that the United States
can significantly improve its competitive position through expanded overseas sales of engineering and legal services, data processing,
banks, airlines, plus income derived from franchising fees and technology licenses. DRI estimates that if this come to pass, the U.S.
surplus in services exports could reach $170 billion by the year
2000.

170
But future American efforts to boost exports hinge on two other
developments, namely U.S. corporate competitiveness and, more
broadly on exchange rates. First, consider the American corporate
position in markets outside of the United States where the cost of
doing business is cheaper. According to Robert Lipsey and Irving
Kravis of the National Bureau of Economic Research, nearly half
of U.S. multinationals' exports derives from production outside this
country. Lipsey's and Kravis's research further indicates that while
U.S.-based corporations' share of world exports declined from 18
percent in 1966 to 14 percent in 1984, the global market share of
U.S. owned corporations has remained at 18 percent. Their study
further suggests that improved U.S. export performance substantially depends on the ability of domestic firms to boost their productivity and foreign marketing efforts.
Exchange rates constitute a larger consideration in assessing
future U.S. export competitiveness. The decline of the dollar in
1986 helped contribute to a "relative" decline in the growth of
America's trade deficit. This trend should strengthen in 1987 and
1988 as U.S. goods became increasingly attractive to both domestic
and international purchasers-at least with respect to the Japanese and West German competition. The yen and the mark have
since September 1985 appreciated 40-50 percent against the U.S.
dollar.
Further significant declines in the dollar's foreign exchange
value vis-a-vis these key currencies might disrupt U.S. trade relations with West Germany and Japan. A more radical "free fall" of
the dollar could pose significant risks to the United States in the
form of inflation caused by sharp jumps in import prices. In sum, it
makes sense to give the present realignment process another year
to work its effect on the U.S. trade account. That being said, some
consideration might be given to efforts to lower the dollar vis-a-vis
a number of other foreign currencies maintained at unfavorable
parities by government intervention. Potential candidates include
Canada, South Korea, and Taiwan.
Strengthen the Global Trade System.-Improved performance in
the global marketplace provides the United States with the best
long-run opportunity to balance its trade account. According to US
Trade Representative Clayton Yeutter, "some 5 million American
jobs depend on U.S. exports--more than in any other nation. The
days when we could wall ourselves off from the rest of the world
are gone, never to return." Growing interdependence virtually requires that a substantial portion of future U.S. domestic growth be
generated from trade. The challenge facing us then is to improve
our performance on that front. How? As previously mentioned, the
single most important step the United States can do in this area is
to reduce its budget deficit. But U.S. trade fortunes also depend on
the ability of this nation to establish more open markets and equitable commercial rules to enable U.S. firms to compete more effectively. How? Through three related steps:
First, some revisions in existing U.S. trade laws are overdue.
This involves imposition of firmer time limits in settling all "unfair
trade practices" cases brought under Section 301 of the Trade Act
of 1974; changes in Section 201 of the same Act to expand the
range of relief remedies available to the Chief Executive; tighten-

171
ing of present antidumping and countervailing duties statutes to
prevent circumvention; and stronger laws against imports which
infringe U.S. patents and violate other intellectual property rights
(e.g., patents and trademarks).
Second, the United States must likewise continue to press for improved market access for American firms. The Reagan Administration has accelerated these efforts over the past 18 months. In fact,
more than 60 percent of all Section 301 cases have been launched
under the present Administration, eight of them since September
1985 alone, of which seven have been satisfactorily resolved. These
actions include Japan's agreement to open its cigarette market to
American firms, and settlement of two separate 301 cases with
Korea involving intellectual property rights and insurance.
Finally, the United States needs to press for stronger international trade arrangements designed to halt the spread of restrictive
trade practices, running the gamut from "buy national" policies to
the subsidization of ailing sectors.
Compared with most of its partners, the U.S. market is relatively
open. But protectionism here, too, is on the rise. Estimates by Gary
Hufbauer indicate that the amount of imports entering the United
States subject to high tariffs and less-visible restraints reached 20
percent of total 1986 imports or about $80 billion worth of goods. In
1975, the comparable figure was 8 percent. The United States is
hardly alone, however. Japanese protectionism has become an increasingly serious source of concern for the global trade community. Unfortunately, it is harder to pin down Japanese violations of
free trade rules since most of them are based on ingrained habits
in the form of traditional procurement practices. A JEC report
("Japan's Economy and Trade with the United States," December
9, 1985) addresses one aspect of this problem: "Defacto 'by Japan'
procurement policies of Japan's public corporations have . . . been
major impediments to selling manufactured products in Japan. The
fact that approximately 115 Japanese public corporations and agencies purchase a small but significant share of all manufactured
goods consumed in Japan without providing much opportunity for
foreign firms to win a share of the business has been a continuing
source of complaint." Japan's unwillingness to import large
amounts of goods from its neighbors has been a substantial source
of friction with them; and it could become a source of concern for
the United States as well. Consider South Korea. One possible
cause of the large U.S. trade deficit with Korea may be found in
the diversion of large volumes of Korean goods from Japan's heavily protected marketplace to the more open one provided by the
United States.
Negotiations will not end protectionism. They can, however,
create an international censensus against such measures. The
United States should devote attention to two key negotiations. The
first involves a comprehensive trade agreement with Canada, the
largest U.S. trade partner. Likewise, we need to press forward with
a new round of multilateral trade talks under the auspices of the
General Agreement on Tariffs and Trade (GATT). These bilateral
and multilateral talks could be pivotal in determining whether we
engage in a war of protection or work toward mutual interests with
our trading partners.

172
Trade remains the most important growth catalyst in the world
economy. Since 1945, combined world exports and imports grew between 1 and 2.5 percentage points faster than gross national product. This is because trade expansion generates domestic growth by
putting each country's resources to their most productive uses.
Since 1984, trade growth has slackened, and with protectionism on
the rise, there is a greater need than ever to restore international
economic cooperation. The U.S./Canadian negotiations can set the
example. The new GATT round can broaden the consensus for
trade cooperation rather than confrontation. The new GATT round
comes at a crucial moment.
The United States has a strong incentive to negotiate better commercial arrangements with its trade partners. The United States
left the GATT preparatory meeting in Punta del Este, Uruguay,
last September with some encouraging portents-specifically, the
acceptance of two key American proposals for the upcoming
agenda. One was the establishment of new rules to help facilitate
fairer trade in services (insurance, telecommunications, and banking, etc.). The other called for major reductions in agricultural
export subsidies worldwide.
It is critical that the new GATT round be used to effectively
strengthen the world's trade rules at this decisive moment in world
economic history.
Summary
Underlying U.S. competitive strengths and dollar devaluation
should result in future improvements in American international
trade performance in 1987 and beyond. To help facilitate this process, the United States needs to reduce its budget deficit, help stimulate growth abroad, expand U.S. exports and strengthen the
global trade system.
The United States is well positioned to compete in the global
economy of the 1980s. In addition to increasing exports of service
and agricultural goods, the key to future U.S. trade success is manufactured goods, which constitute approximately % of total U.S. exports. Since late 1981, output per hour in manufacturing has expanded at an average annual rate of 3.8 percent. Until recently
these gains were substantially nullified by over-valued U.S. dollar.
Now that the dollar has depreciated on foreign exchange markets,
however, we can expect to reap the full advantage of domestic productivity gains in the international market.
Enhanced growth prospects abroad and strengthened trade rues
would also help the United States return to a more balanced trade
posture. During the first half of the 1980s, the American marketplace played a decisive role in world recovery by pulling in record
volumes of imports. To keep the recovery alive and help the U.S.
return to greater balance in its trade account, however, the United
States is calling upon countries such as West Germany and Japan
to stimulate their economies in order to absorb larger volumes of
imports.
Finally, the United States needs to negotiate better commercial
arrangements with its trade partners to help the U.S. adjust to
changes in the global market. Key items in this regard involve bi-

173
lateral negotiations on a comprehensive free trade agreement with
Canada and the conduct of a new multilateral trade round.
V. FISCAL POLICY

Introduction
Fiscal policy uses the power of the government to tax and spend.
Measured by the nominal growth in expenditures, this power has
increased almost 10-fold since 1960. Back in 1940 the non-government sector accounted for 90 percent of gross national product.
Today almost 25 percent of all the goods and services produced by
the U.S. economy are absorbed by the Federal Government. The
authority to tax combined with the virtually unrestrained ability
to borrow has led to a massive and undesirable expansion of governmental power. Therefore it is not surprising that the size of the
Federal budget has become a central issue in economic analysis. It
is important for the public to understand the theory and practice of
fiscal policy and how large the Government has come to be.
The Budget: Trends, Outlook, and Policy
During the last 25 years the Federal Government has greatly expended its command over economic resources. This control has
been exercised directly through the budget and indirectly through
regulation, court decisions, and other means. Until comparatively
recently, however, the expansion of Federal expenditures was constrained by an informal acceptance of a "balanced budget rule."
Through most of American history budget deficits were regarded
as a sign of moral and financial erosion. Though temporary deficits
arising from war or economic downturn were tolerated, their removal was considered the first goal of Federal policy. This taboo
against budget deficits was regarded as an unwritten article of the
Constitution. This rule governed the policy of all major political
parties. Prior to 1920, there was not even a formal fiscal year or
central budget office in the Executive Branch, yet the consensus
against deficit finance was absolute. Over the last few decades,
however, the orthodox policy of balanced budgets has been undermined by the idea that fiscal policy should be used to fine-tune the
economy. According to Nobel Laureate James Buchanan and Richard Wagner:
* * * the pre-Keynesian norm of budget balance served
to constrain spending proclivities so as to keep governmental outlays roughly within the revenue limits generated by
taxes. The Keynesian destruction of this norm, without an
adequate replacement, effectively removed the constraint.
Predictably, politicians responded by increasing spending
more than tax revenues, by creating budget deficits as a
normal course of events.
In the absence of this budget constraint Federal spending grew
briskly. Between 1960 and 1986, Federal outlays jumped from $92.2
billion to $989.8 billion, a rise of 973 percent. In constant 1982 dollars, this amounted to a real increase of 155 percent, and an
annual average real growth rate of 4 percent. This rate of outlay

174

expansion outpaced that of the of economy, pushing the Federal
outlay share of GNP from 18 percent in 1960 to 24 percent in 1986.
Meanwhile, Federal receipts climbed from $92.5 billion in 1960 to
$769 billion in 1986, a rise of 681 percent. Much of this increase
resulted from unlegislated tax increases due to bracket creep. In
the early 1960s less than three percent of taxpayers filing joint returns faced marginal tax rates in excess of 28 percent; by 1980 over
one third faced marginal rates exceeding this level. In any event,
due to bracket creep, higher social security taxes, and a variety of
other factors, the government revenue share of GNP climbed from
18.3 percent in 1960 to a peacetime high of 20.1 percent in 1981,
then slipped to the postwar average of 18.5 percent in 1986. Far
from starving the Treasury, the controversial 1981 tax cuts merely
restored the revenue share of GNP to its "normal" level.
What does this vast expansion of Federal spending mean for
public policy? While the benefits of some government expenditures
exceed their costs,, this is clearly not always the case. At the
margin, every dollar spent by the government is one less dollar
available to the worker, farmer, small businessman, and consumer.
To finance its expenditures, the government must tax, borrow, or
inflate. At some point, government spending and taxing become excessive and government becomes a burden upon the people it is
supposed to benefit. We believe that this point has been reached
and that the upward trend in the share of economic resources devoted to government must be contained.
The table below illustrates the growth of the Federal budget
during this period:
TABLE V-1.-OUTLAYS, RECEIPTS, AND DEFICITS
[Dolar
amounts
inbillions]

Yrear

1960 ........................
1965
........................
1970 .........................
1975
.........................
1980
........................
.
1985
........................
1986

Outlays
Amount Perco
Aust GNP
$92.5
118.2
195.6
332.3
590.9
946.3
989.8

18.2
17.6
19.8
21.8
22.1
24.0
23.8

Receipts
Derxits
PA nt Of
Percent A
ut
Anuit
GNP
Anmi
GNP
$92.5
116.8
192.8
279.1
517.1
734.1
769.1

18.3
17.4
19.5
18.3
19.4
18.6
18.5

$0.3
-1.4
-2.8
-53.2
-73.8
-212.2
-220.7

'0.1
0.2
0.3
3.5
2.8
5.4
5.3

Surplus

While the revenue share of GNP in recent years has been close
to the postwar average of 18.5 percent, the outlay share of GNP
has been closer to 24 percent, about three percentage points above
the postwar average. This historically high level of Federal spending has generated large deficits. If the fiscal 1986 outlay share of
GNP had equaled the postwar average of 21 percent, the deficit
would have been around $125 billion lower.
Deficits are dangerous because in the long run they lead to an
unsustainable increase in the national debt and debt-servicing
costs. These costs are passed on to future taxpayers. If the deficits
bought public goods that would be available for future use, such as
highways, dams, or aircraft carriers, they could be defended at

175
least in principle. But the overwhelming majority of the deficit and
new national debt reflects the explosion in transfer payments used
to finance current consumption.
Notwithstanding many problems with the budget, there are signs
of improvement. After the enactment of Gramm-Rudman-Hollings
(G-R-H), the pace of Federal spending slowed dramatically. In
fiscal 1985, total Federal outlays were up $94.5 billion-the largest
increase in American history. In fiscal 1986, the first year G-R-H
became effective, outlay growth slowed to a rate of 4.6 percent,
which was a real growth rate of only 2 percent.
Another budget trend is the change in the composition of Federal
spending. The runaway pace of Federal outlay growth has been
fueled by a dramatic expansion of domestic spending. Between 1960
and 1986 transfer spending (payments for individuals) has leapt
from $24.2 billion to $448 billion in 1986, an increase of 1751 percent. In real terms this reflects an increase of 432 percent. During
the 1970s the growth rate was high enough to boost total outlays as
well as to crowd out other parts of the budget, particularly defense
spending.
Between 1960 and 1980, the share of total outlays and GNP devoted to transfer spending rose steadily. In 1960 transfer programs
accounted for 26 percent of the budget and 4.8 percent of GNP. By
1980 these ratios had grown to 47 percent of the budget and 10.4
percent of GNP. Even after all the supposedly deep cuts in domestic spending mandated by the Reagan Administration, transfer payments in 1986 still amounted to 39.7 percent of the budget and 9.4
percent of GNP. Measured in constant 1982 dollars, real transfer
outlays increased from $344.3 billion in 1981 to $389.4 billion in
1986, a rise of 13 percent.
In contrast, defense outlays went from 52 percent of the budget
and 9.5 percent of GNP in 1960 to 22.7 percent of the budget and 5
percent of GNP in 1980. The so-called massive Reagan defense
buildup pushed 1986 defense spending to 27.6 percent of the budget
and 6.6 percent of GNP, still far below their levels in the early
1960s. Despite the much more serious threat now posed by Soviet
military forces, U.S. defense spending, as a percentage of GNP, is
about 30 percent below its 1960 level.
During this period budget priorities have been reversed. Whereas
over half of the budget used to be devoted to defense, its current
share is closer to 25 percent. Meanwhile, the share of the budget
absorbed by transfer payments had climbed from a little over 25
percent to almost 50 percent by 1983, and only recently has started
to decline. Essentially, the large increase of transfer spending has
pushed total outlays higher and crowed out defense as the top
spending priority of the national government.
As the deficits and national debt have mounted, net interest payments have also grown, and now comprise 13.7 percent of total
annual government expenditures. Fortunately, declining interest
rates have kept net interest outlays from rising sharply in recent
years, but any future increase in interest rates would make a serious problem much worse.
The Table V-2 shows the composition of outlays between 1960
and 1986:

TABLE V-2.-COMPOSITION OF FEDERAL OUTLAYS AND FEDERAL OUTLAYS AS A PERCENT OF THE GNP
Federal
outlays

1986
1975
1980
1985
1965
1970
1960
ol
of Percent
of Prent ot Percent
Percent
of Pencent
of Percent
ot Perrent
of Percent
of Percent
o
ot Percent
of Percent
of Percent
Percent
of Pecent
outlays
GNP
outlays
GNP
outlays
GNP
GNP
outlays
GNP
outlays
GNP
outlays
GNP
outlays

Total
outlays .......................
18.2
National
defense
.......................
9.5
Nondefense
paynents forInds
.......................
4.8
All other grants to Stateandlocalgovern0.9
meents
.
Netinterest
.......................
1.4
2.6
Allother .......................
Undistributed offsetting receipts
.......................
-1.0
8.7
Totalnondefense
.......................

100.0
52.2
26.2

17.6
7.5
4.9

100.0
42.8
28.0

19.8
8.2
6.5

100.0
41.8
33.1

21.8
5.7
10.1

100.0
26.0
46.2

22.2
5.0
10.4

100.0
22.7
47.0

24.0
6.4
10.8

100.0
26.7
45.0

23.8
6.6
9.4

100.0
27.6
39.7

4.9
7.5
14.4
- 5.2
47.8

1.1
1.3
3.7
-. 9
10.0

6.1
7.3
20.9
-5.0
57.2

1.6
1.5
2.8
-.9
11.5

7.9
7.4
14.4
-4.4
58.2

2.2
1.5
3.2
-. 9
16.1

10.0
7.0
14.9
- 4.1
74.0

2.2
2.0
3.3
-. 7
17.1

10.1
8.9
14.8
- 3.4
77.3

1.5
3.3
2.9
-. 8
17.6

6.1
13.7
12.0
-3.5
73.3

2.0
3.3
3.3
-.8
17.2

8.6
13.7
13.7
-3.3
72.4

177
Budget Outlook
The current policy baselines calculated by both the Congressional
Budget Office (CBO) and the Office of Management and Budget
(OMB) indicate an improving economic and budget outlook. Both
forecast increased Federal revenues, decreased Federal spending
growth, and a declining Federal deficit. As Table V-3 indicates,
both sets of forecasts are based on reasonable economic assumptions. Table V-3 also presents the consensus projections for the
same economic variables compiled by "Blue Chip Economic Indicators" from a survey of 50 top economists.
TABLE V-3.-ECONOMIC ASSUMPTIONS
[Percentage
change,
yearto year]
1987
OMB

CBO

1988
BC

OMB

CBO

RealGNP
.............................
CPI
.............................

3.1
3.0

2.8
3.5

2.3
3.3

3-month
T-bill .............................
Unemployment.................................................................

3.5
3.6

3.0
4.3

3.4
4.2

5.4
.

5.6
6.7

5.5
6. 6
6.9

5.6
6.3

5.7
6.5

6.2
6.6

Based on its economic assumptions, the Congressional Budget
Office forecasts an improving budget outlook under current policy,
with deficits steadily declining for the next five years. According to
this projection, by fiscal 1992 the deficit would fall to a level of $85
billion, or 1.4 percent of GNP.
This path of declining deficits marks a reversal of the previous
trend toward larger deficits. One major cause of this change is the
projected slowdown in Federal spending growth, largely due to legislated cuts in defense budget authority. Over the next five years
the annual increase .in Federal outlays is expected to average $59
billion. This represents a lower rate of growth than that of the
economy. Consequently, the Federal outlay share of GNP will decline from 22.9 percent in 1987 to 21.1 percent in 1992.
Meanwhile, Federal revenues under current policy are projected
to rise at an annual average of $77 billion over the next five fiscal
years. In other words, almost $400 billion will be added to baseline
revenues by fiscal 1992 without any change in the tax law. As a
share of GNP, Federal revenues are expected to climb from 19.0
percent in 1987 to 19.7 percent in 1992.
Under current policy baseline deficits are projected to decline by
an average of $18 billion per year. Over five years about $90 billion
would be shaved from the fiscal 1992 deficit. However, it will be recalled that these projections are very sensitive to changes in economic assumptions. The budget forecast is too fragile for complacency about deficit spending, but is encouraging enough to conclude that feasible policy changes can bring the deficit under the
G-R-H targets.

178
TABLE V-4.-CBO BASELINE PROJECTIONS
[Byfiscalyear]
1986
actual

1987
base

1988

1989

Projections
1991
1990

In billions of dollars:
900
962
1,050
769
834
Revenues...........................................................
1,008
1,124
1,069 1,184
Outlays..............................................................
990
174
134
221
169
162
Deficit...............................................................
108
72
36
Balanced
Budget
Act target .......................
172
144
1,746
1,910
2,077
2,236
2,367
Debtheldbythepublic ..........................
Asa percent of theGNP:
19.4
18.5 19.0
19.2 19.1
Revenues...........................................................
23.8
22.8
2 2.9 21.9
22.3
Outlays.
.............................................................
5 .3 3.2 4.02.5
Deficit.
.............................................................. 3.6
44.4
43.8
Debtheldbythepublic ..........................
41.9
43.4 44.2
5,033
5,406
4,399
4,698
Reference:
GNP
(inbilions of dollars) ............. 4,163

1992

1,138
1,220
1,247 '1,305
109
85
0.
2.437 2,556
19.6
21.5
1.9
42.7
5,792

19.7
21.1
1.4
41.3
6,186

Although both CBO and OMB project a declining 1988 deficit, it
is still well above the Gramm-Rudman-Hollings deficit targets.
With the CBO1988 baseline deficit at $169 billion, it exceeds the GR-H target of $108 billion by $61 billion.
Budget Policy
Since taking office in 1981, the Reagan Administration's fiscal
policy has been simple and consistent. Hold the line on taxes and
reduce the growth of government spending. Obviously a congressional policy calling for an expansion of domestic spending programs would put us back on the path of growing deficits.
Too often forgotten is the fact that the Congress has the primary
responsibility for setting taxing and spending policy. Article I of
the Constitution states. 'No money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law . . ."
Every dime of deficit spending must be voted by the Congress; any
comprehensive effort at budget control depends on congressional
action.

Nonetheless, the President is required by statute to submit a
budget proposal to Congress. Though we cannot endorse every item
in the President's budget, we do agree with its general approach.
Continued restraint of domestic spending, no significant tax increases, and adequate funding for defense. Furthermore, it should
be noted that the President's budget was submitted on time and at
least technically complies with the G-R-H law. The burden is now
on the budget committees and the Congress to meet the G-R-H
timetable and approve a budget in compliance with the FY 1988
deficit ceiling of $108 billion.
Once again the Congress faces the opportunity to further reduce
the Federal deficits. It remains to be seen whether G-R-H will be
effective in enforcing fiscal discipline. Though there is much to be
said in favor of other institutional reforms such as a constitutional
amendment requiring a balanced budget and a line item veto, their
enactment will not come soon enough to help the Congress achieve
fiscal responsibility. To hit the G-R-H deficit target of $108 billion
in FY 1988, the choices are also simple: Cut spending growth while
not raising taxes; or reduce, maintain, or increase spending and

179
raise taxes. Further direct pressure upon the American taxpayer
by an apparently insatiable government is clearly undesirable. We
do, however, support the increased use of user charges. Some Republican Members would favor additional taxes on alcohol, tobacco,
and some luxury items as part of a larger package to reduce the
deficit. Also, we recognize the concern of those in the Congress who
foresee conditions which may make it impossible to meet the G-RH deficit target of $108 billion for fiscal 1988 and therefore have
proposed a scheduled reduction of $36 billion. We strongly feel,
however, that any consideration of this option should only come at
the end of the budget cycle and as a last resort.
The Theory and Practiceof FiscalPolicy
The last two decades have seen a remarkable change in the attitudes of Americans towards their government. In the early 1960s,
much of public policy relied on the assumption that government
could manipulate macroeconomic aggregates to improve economic
welfare. According to this view, the superior wisdom, motivation,
and efficacy of public policymakers, in stark contrast to those in
the private sector, would enable government to improve living
standards, eradicate poverty, and eliminate inefficiencies resulting
from "market failure." Fiscal policy, it was believed, could be used
to fine-tune the economy to control business cycles and minimize
unemployment.
The public's expectations with respect to government are much
more modest these days. Fine tuning-and even the notion of discretionary fiscal policy-has fewer advocates than in earlier decades. The Congress implicitly repudiated the concept of fine tuning
when it enacted the Gramm-Rudman-Hollings law, which mandates reduction and eventual elimination of the deficit. The decline
of discretionary-fiscal policy probably has its roots in the 19 7 0s
when, on numerous occasions, the Federal Government demonstrated its ineptness.
As a result, Americans today are a bit more self-reliant and a bit
more cynical. Recent years have witnessed the influence of a new
way of viewing government policy-making. This new view of government is embodied in the now prominent theory of "public
choice." Public choice is a school of thought drawing on elements
from economics, political science, and other fields. Its influence is
reflected in the 1986 award of the Nobel Prize in economics to
James Buchanan, the economist who developed this theory in collaboration with a small group of colleagues.
The pubic choice approach applies economic reasoning to political decisionmaking. It dispenses with the conventional presumption
that public officials always act on superior motives or knowledge.
Rather, it recognizes public officials in a democracy are truly "of
the people." With this distinction between the bases of private and
public decision-making erased, public choice uses microeconomic
theory to analyze the formulation of public policy. Public choice is
useful in analyzing a wide range of policies produced under democratic decision processes.
One of the many important concepts introduced by public choice
is the notion of fiscal illusion. Fiscal illusion is the distortion of the
cost-benefit calculus by the way publicly provided goods and serv-

180
ices are financed. One example is the practice of off-budget spending, under which the benefits of marginal government programs
are provided to constituents at apparently no budgetary cost. The
use of indirect rather than direct taxation is another practice
which tends to mask the actual cost of government expenditures
from the taxpayer. For example, proponents of tariffs may argue
that their burden falls on foreign producers rather than on American consumers.
Probably one of the most dangerous forms of fiscal illusion is the
incresase in tax revenues through bracket creep generated by inflation. Another avenue for increasing tax revenue is to play off the
various income classes against one another. More government benefits can allegedly be provided, for instance, if only a small group
of wealthy taxpayers are taxed more heavily. But this targeting of
the rich-seen by some as a noble gesture-can be used as a
smokescreen to directly or indirectly increase everyone's taxes. Another example is the practice of income tax withholding, under
which tax liabilities are usually more than satisfied by tax levies
periodically extracted throughout the year. While we recognize the
necessity of withholding, it is likely that the tax cost of government goods would be felt more keenly if there were no withholding
and taxpayers were dunned at the end of the year in one startling
tax bill. As it is, most taxpayers are glad to receive their tax refunds, which amount to interest free loans to the Treasury caused
by over-withholding. Under withholding, some of the sting is taken
out of tax payments, and government programs appear less expensive.
Public finance textbooks often assume the existence of an objective and omniscient public authority using the instruments of
taxing and spending to maximize national wellbeing. In raising a
given amount of revenue, for example, traditional public finance
theorists aim for a tax system which promises the best mix of efficiency, simplicity, and equity. The government is assumed to
emplov the principles of taxation in a disinterested manner to facilitate the raising of a predetermined amount of revenue to finance necessary expenditures. Fiscal policy instruments, it is assumed, can be finely calibrated to increased aggregate demand, improve economic performance, and to reduce unemployment. The
fundamental assumption is that the elected or appointed decisionmaker is up to this daunting task.
In contract, public choice theory assumes that the actors in the
political arena have neither higher nor lower motives and intelligence than others. While not devoid of interest in higher motives
and fully conscious of their calling and responsibility, public officials share the same fallibility and weaknesses as everyone else.
This commonsensical view has important policy implications. For
example, many types of government intervention have been justified on the basis of "market failure." Under the public choice approach the possibility of market failure would not be sufficient to
compel government intervention, because this intervention, designed and implemented by imperfect human beings, would also be
susceptible to failure. The burden of proof should be on the advocate of government intervention to show that a specific government
action would remedy an alleged market failure without itself fail-

181
ing. This approach provides a more balanced and realistic framework for decisionmaking than the naive view that government officials are always able and willing to promote economic efficiency,
social welfare, or any other perceived national goal.
Far from being unduly cynical about political life, the public
choice literature is entirely in spirit of the founding fathers as expressed in The Federalist and elsewhere. As James Madison observed in Federalist 51: "If men were angels, no government would
be necessary. If angels were to govern men, neither external nor
internal controls on government would be necessary. In framing a
government which is to be administered by men over men, the
great difficulty lies in this: you must first enable the government
to control the governed; and in the next place oblige it to control
itself."
Lest one think this view was confined to Federalists, Thomas Jefferson's statement "Let no more be heard of confidence in man, but
bind him down from mischief with the chains of the Constitution"
is also in keeping with this view. The founding fathers and leading
public choice theorists agree that restrictive groundrules in the
form of a Constitution are needed to control the discretion of public
officials and to protect the rights of citizens.
The Need for Budget Rules
Despite the best intentions of elected officials and their constituents, the pressures promoting deficit spending are very powerful.
For most of U.S. history, and informal balanced budget rule functioned as an unwritten article of the Constitution. Desired increases in public expenditures were constrained by this postulate,
which generally kept government spending and taxation within
reasonable bounds. Though deficits did emerge periodically, usually
as a result of war or economic downturn, these temporary deficits
were a result of external forces, and were not intentional. Tragically, the shame associated with deficit spending is apparently no
longer an integral part of our national character. The discipline, no
longer inherent, must be imposed.
Special interest pressures upon legislators in support of expanded constituent programs can be contained by a formal balanced
budget rule. This would shift the burden to program advocates to
show that the value of their proposed expenditures is at least equal
to those of other programs that would have to be cut back, or, alternatively, to the costs imposed by additional taxation. In other
words, the potential benefits of new expenditures would have to be
balanced with their costs. This would require policymakers to
choose budget priorities in keeping with the level of projected tax
revenues provided by law.
Rational evaluation of government program costs and resultant
public benefits becomes almost impossible in the absence of a requirement to link expenditures with revenues. Spending is simply
too easy. Currently, there is a treacherous asymmetry in fiscal decisionmaking. While the merits of each program are visible (and
often amplified by lobbyists) the costs of the decision are not. A
vote for a particular program will include the consideration that
only a small part of its expense will be borne by the beneficiaries.
Viewed in this context, the benefit-cost ratio of the program seem-

69-874 0 - 87 - 7

182
ingly approaches infinity. Logrolling supported by a coalition of
special interests can secure a sufficient number of votes to pass
many such measures in a package. If each of these programs was
forced to stand alone they would likely be defeated. Logrolling ensures blatant parochialism. What's more, by resorting to debt financing, government costs can be shifted forward onto future taxpayers. The prospect of current and future diffusion of program
costs introduces and inherent spending bias into democratic legislatures. This inability to properly evalutate program costs and benefits properly is one type of "fiscal illusion." Without a specific or
even general link between program expenditures and taxes, chronic overspending will continue.
Ideally, such a rule would require that each additional expenditure be linked to a specific tax measure. This earmarking would
aid the Congress in making an informed judgment about whether
the program was cost-effective. It would also limit the discretion of
public officials regarding the disposition and possible diversion of
these revenues. However, a more general rule requiring balance of
aggregate revenues and outlays would still function as a powerful
constraint.
The lack of a balanced budget rule distorts the taxpayers' appraisal of costs and benefits of government programs. The provision of every public good or service has price-a "tax-price. The
tax-price of public good results in a certain quantity of that public
of good being demanded by the taxpayer. However, if the tax-price
of the good is lowered by hiding part of the tax, a corresponding
increase in the demand for that public good results. In this case,
the tax price may fall below the cost of providing the public good.
This misallocation of resources generates economic waste.
Consider the analogy (which originated with Buchanan) of 10
people going out to dinner together under two alternative arrangements. In the first case, the diner assume that the total bill will be
evenly split regardless of the cost of each meal. In the second case,
an agreement is made before dinner that each diner will pay only
for his own meal. Human nature being what it is, the total dinner
check in the first instance will be larger than in the second.
If, under the first arrangement, one person attempts to be frugal
while the others do not, he will receive only one-tenth of the savings generated by his frugality. The other diners will enjoy the
same savings, while also enjoying a better meal. Thus there is little
incentive to economize, and everyone will spend more than they
really want to pay for. As a result, all diners are worse off.
A balanced budget rule would also tend to force the government
to price public goods and services more accurately so that taxpayers could see what they were getting for their money. A shift from
an artificially low tax-price to a full tax-price would inhibit
demand for additional program expenditures; only those programs
that are clearly seen by the public to be worthwhile would be
maintained. The ability to increase government spending without
specifying the source of tax financing tends to lower the apparent
tax price of each unit of government goods and services, seemingly
providing something for nothing. This type of fiscal illusion would
be removed by a requirement that each expenditure, or at least

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total expenditures, must be linked to a tax measure at the time of
its consideration.
Public choice theory should not be construced as a denial of an
economic role for government. For example, it is clear that a certain degree of income assistance to those in poverty is deemed necessary by voters, by Congress, and by the Executive. Public choice
theory then becomes useful in designing the most efficient programs possible-programs that concentrate upon aiding the poor,
not upon expanding a welfare bureaucracy.
The theory of public choice-as intuitive as it is-has a great
deal to offer in improving our understanding of government generally and fiscal policymaking particularly. Its lesson is that fundamental institutional reforms are necessary to change the groundrules under which public decisions are made. the development and
recognition of the theory of public choice while our Nation celebrates the bicentennial of our Constitution seems particularly appropriate.
Summary
During the last 25 years the Federal Government has greatly expanded its command over economic resources. Between 1960 and
1986, Federal outlays jumped from $92.2 to $989.8 billion, a rise of
973 percent. In constant 1982 dollars, this amounted to a real increase of 154 percent, and an annual average real growth rate of 4
percent. This rate of outlay expansion outpaced that of the economy, pushing the Federal outlay share of GNP from 18 percent in
1960 to 24 percent in 1986.
The runaway pace of Federal outlay growth has been fueled by a
dramatic expansion of domestic spending. Between 1960 and 1986
transfer spending has leapt from $24.2 billion to $448 billion, and
increase of 1751 percent. In real terms this reflects an increase of
432 percent. During the 1970s the growth rate was high enough to
boost total outlays as well as to crowd out other parts of the
budget, particularly defense spending.
The rapid increase in Federal spending reflects the lack of constraints on the political system's ability to confer benefits on favored groups. Special interest measures can be formally or informally linked through logrolling, resulting in the passage of spending measures that would be defeated if considered alone on their
own merits. This suggests the need for institutional constraints
that would make it harder to push federal spending higher. Such
constraints would establish some type of linkage between the level
of Federal revenue and outlays, resulting in slower outlay growth
and declining deficits. Gramm-Rudman-Hollings is one such constraint. This theory of how budget (and other governmental) decisions are made under democratic institutions is public choice. Its
significance was recently recognized by the award of the Nobel
Prize to the economist who developed it, James Buchanan.
The Gramm-Rudman-Hollings reform, though not perfect, has
the potential of limiting spending growth. We believe Congress
should meet the target by restraint of federal spending, without
significant tax increases. In the event changed conditions make it
absolutely impossible to meet the deficit target for fiscal 1988, a

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deficit reduction of $36 billion, in keeping with the spirit of GRH,
might be considered at the end of the budget cycle.
VI. MONETARY POLICY

For 35 years, following World War II, the relationships among
growth in nominal national product, fluctuations in the money
supply, the rise and fall in interest rates, and other measures of
economic performance (such as unemployment rates, the balance of
payments, and industrial capacity utilization) were fairly regular
and increasingly understood by economists.
The major achievement in this learning experience was the gradual acceptance by the economics perfession of insights into the
central role of monetary policy. Economists at the University of
Chicago are regarded as the founders of the postwar revisionist
movement. They took the generally accepted neo-classical systhesis,
associated with the names of J.M. Keynes, John Hansen, Paul
Samuelson, Franco Modigliani, and James Tobin, and replaced its
emphasis on the association between changes in the rate of growth
in the money supply and the growth in nominal GNP.
By 1967 the unanimous Joint Economic Report of this committee
stated, "The committee urges that the monetary authorities adopt
the policy of moderate and relatively steady increases in the money
supply, avoiding the disruptive effects of wide swings in the rate of
increase or decrease. The committee is impressed with the increasing weight that many economists give to the importance of a
steady rise in the money supply. Such rate of increase should be
more or less consistent with the projected rate of growth-generally within a range of 3-5 percent per year." [90 Cong., 1st Sess.,
Report No. 73, Mar. 17, 1967, p. 14]
The unanimous view of the 1967 Joint Economic Report was the
majority view of Congress and the law by 1978. The amendments to
section 2A of the Federal Reserve Act in P.L. 95-523, the Humphrey-Hawkins Act, required the Federal Reserve to report semiannually to the Banking Committees of the Congress on monetary
growth projections and to explain the relationship of the monetary
growth "objectives and plans" to the short-term goals of "employment and unemployment, production, real income, productivity,
Federal outlays as a proportion of gross national product, and
prices" that the Act required as public policy. More pointedly, the
Federal Reserve was mandated to declare annually its "objectives
and plans with respect to the ranges" of money supply growth for
the subsequent year.
In the light of recent experience with large increases in both
budget deficits and trade deficits, monetary expansion, and the reduction in both inflation and interest rates, the accepted theoretical relationships that informed the public policy process in the previous decades seem to have changed.
The Phenomena Since 1981
Beginning in the third quarter of 1981, major shifts in the longstanding relationships began to occur. The phenomenon of note
here is the velocity of Ml, the ratio of nominal GNP to the narrowly defined money supply. For 33 years, the velocity of Ml had in-

185
creased at a trend rate of 3.4 percent annually. In spite of significant quarter-to-quarter shifts and a cyclical component that always
made the velocity of money a centerpiece in the debate, somehow
the trend.in velocity always reasserted itself.
It was the underlying stability of the velocity of money that
played a central persuasive role in the general acceptance of the
monetarist interpretation of macroeconomics-just as it had been
the seeming irrelevance of monetary policy in the 1930s and 1940s
that had focused ecomomists' attention on the income-expenditures
multiplier in the early postwar period. As Chart VI-1 shows,
CHART VI.1

VeOWty of Ml
Rao df NamiM

fAnd

1947

Sty:w

1953
Dommt ci C

1959

1965

o "d Bawd at

GNP to Ml

1971

1977

dat
tinFlt

Rnme Soneu

1983 1986

beginning with the third quarter of 1981, we can identify a period
in which velocity has been declining sharply except for a brief
upturn in 1983. It is this ahistorical behavior in the velocity of
money that has shaken the theoretical foundations of macroeconomic theory in the past few years.
From December 1985 to December 1986 the Ml money supply
grew 16.5 percent (15.3 percent on a fourth quarter to fourth quarter measurement). During the third quarter of 1986, it grew 17.6
percent and sustained this rate at 18.2 percent in the fourth quarter, reaching 35.1 percent in December.

186
A monetary growth rate of 1986 magnitudes in the 1960s or
1970s would have been highly inflationary. The CPI jumped 6.1
percent in 1969 following a 7.7 percent growth in Ml the previous
year, and the CPI grew 13.3 percent in 1979 following an 8.3 percent growth in Ml the previous years-in both cases the highest
rates in both price level and money supply increases in the respective decades.
On February 2, 1987, the Chairman of the Federal Reserve testified before the Joint Economic Committee, in response to a question whether these rates of expansion were excessive:
Well, the test of whether you've got too much money
chasing too few goods lies in the eating I guess. Are prices
going up?
Now I agree you cannot judge that instantaneously. We
will know whether we had too much money a couple of
years from now rather than today. Now obviously our
policy, so far as I am concerned, is based upon a judgment
that that is not the case. But I can't prove it to you until
1989 and some things will depend on what happens between now and 1989.
It is the decline in the velocity of money that has accommodated
the rapid increase in the money supply since 1982, and has belied
all predictions about rapid monetary growth leading to a resumption of inflation.
The Success of Bold Leadership
As we reported in the August 1986 JEC, The Politics of Triumph,
the success of monetary policy in ending the inflation and bringing
down the double-digit interest rates of the -1970s has been an
achievement of historic proportions. In 1981, the nation's economy
was in the midst of stagflation and a growing loss of confidence in
our role as a world economic power. The achievement of the
Reagan Administration may be underestimated by some because it
reduced the crisis to only a few months. Although not as histrionic
as the New Deal of the Roosevelt Administration-which holds a
watershed position in American economic history precisely because
the initiatives did not solve the economic crisis and therefore the
crisis is more deeply embedded in the memories of American families-the Reagan program restored confidence in the dollar and the
capacity of the U.S. economy to grow.
To a very large degree, this achievement was done with the tool
of monetary policy. If we examine the published forecasts and editorial assessments in 1981 of the coming year by those economists
who may be identified as Keynesian, or demand-side fiscalists,
their expectations about inflation, unemployment and GNP given
the tax reduction and the size of the Federal deficit, was generally
for a strong GNP growth, falling unemployment and continuing inflation. Of course, the strong action of the Federal Reserve to implement the President's anti-inflation goal, and the unwavering
support given to the Fed by the Administration during the extreme
1981-82 tightening, succeeded in breaking inflationary expectations. With these expectations broken, a strong monetary stimula-

187
tion beginning in 1982 produced the spectacular recovery and
growth of 1983-84 without the side effect of renewed inflation.
Conversely, in 1983 the adherents of monetarism, whose view of
monetary velocity as a phenomenon with a long-run track record of
returning to a stable trend over the post-war period, were predicting renewed inflation in 1984 or 1985. It did not happen. Indeed,
the degree of monetary expansion we have seen in 1985-86 so
greatly exceeds the tolerances of the monetarist model that the research agenda of many scholars in macroeconomics today has been
shifted to the demand for money-the underlying process that determines the velocity of money.
Some of the most promising work in progress has been done by
Robert H. Rasche of Michigan State University. In addition to important improvements in the data, some of the most valuable contributions of this work are the testing and elimination of some popular hypotheses: that deregulation of financial institutions has
made monetary velocity unstable, that interest rate volatility
caused it, or the trade deficit, or the tax cuts.
Clearly the velocity of money is sensitive to a complex process of
interaction among market expectations of the future value of
money and the opportunity costs of illiquidity. The period of experience with slowing velocity is so recent that any conclusion must
be tentative, but the sensitivity of the demand for money as a function of interest rates seems to be greater now than in previous decades, and reduced inflation has contributed to the greater willingness to hold cash.
The Paradox of Success
Of course, the paradox of our success in monetary policy is that
today we don't know what the "correct" monetary policy parameters for the coming year will be. Both the Congressional Budget
Office and the President's Council of Economic Advisors recognize
this frightening situation, but acknowledge little can be said to
guide policymakers. CBO cautions:
If the ratio between nominal GNP and the monetary aggregates suddenly rises-that is, if velocity increases-expected inflation may increase, further reducing the desire
to hold money, and further increasing velocity. Similarly,
a downward shift in velocity may raise fears of recession
and may further reduce velocity. The possibility of such instability complicates the management of monetary policy.
[The Economic and Budget Outlook: Fiscal Years 19881992, Jan. 1987, pp. 17-18.]
The Report of the Council of Economic Advisers is less analytic,
but no less cautionary:
Although the nature of the change in velocity behavior
is not fully understood at this time, no plausible assessment of the change in velocity growth would imply a permanent need for such rapid money growth.... The difficult policy issue is one of timing-to assess when sufficient
money growth has been provided to satisfy increased

188
demand for money balances and to determine the extent to
which money growth should be decelerated. [pp. 55-56]
The important of vigilance in monitoring the economic variables
that make up the demand and supply of money during the next
year cannot be overstated. In the absence of a well tested monetary
explanation, and in the absence of a consensus in the financial
markets about the impact on asset prices of different monetary
policy actions, any change in direction of interest rates, consumer
or producer price index measures, exchange rates, or even expectations about the direction of economic policy that may attend the
next cycle of elections or the chairmanship of the Federal Reserve
must be the subject of continuing concern to this committee in
1987.
We recommend that the Joint Economic Committee undertake a
regular program of hearings during the 100th Congress to assess
the research that is emerging on the velocity of money and the
findings of a wide range of theoretical models on the impact of different policy variables. The Joint Economic Committee has established a notable history as the leader among all the economic
policy voices: the unanimous report in 1967 cited above, the publication of Standards for Guiding Monetary Action in 1968, and the
work leading to the adoption of P. L. 95-523 in 1978.
Summary
In the light of recent experience with large increases in both
budget deficits and trade deficits, monetary expansion, and the reduction in both inflation and interest rates, the accepted theoretical relationships that informed the public policy process in the previous decades seem to have changed.
That is, from December 1985 to December 1986 the M. 1 money
supply grew 16.5 percent (15.3 percent on a fourth quarter to
fourth quarter measurement). during the third quarter of 1986, it
grew 17.6 percent and sustained this rate at 18.2 percent in the
fourth quarter, reaching 35.1 percent in December. A monetary
growth rate of 1986 magnitudes in the 1960s or 1970s would clearly
have been highly inflationary. Yet, in 1986, we recorded the lowest
inflation rate in decades.
How can one explain this paradox? Many researchers believe
that it is the decline in the velocity of money that has accommodated the rapid increase in the money supply since 1982, and thereby
belied all predictions about rapid monetary growth leading to a resumption of inflation.
We urge the leadership of the Joint Economic Committee to underake a regular program of hearings during the 100th Congress to
assess the research that is emerging on the velocity of money and
the findings of a wide range of theoretical models on the impact of
different policy variables.
VII. NEW POLICY DIRECTIONS

No government operates in a vacuum. A changing society and
dynamic economy require continual evaluation of Federal policies
and objectives. In the 1980s, changing global and domestic economic conditions, socioeconomic trends, and new research findings

189
have revealed several policy areas that require the attention of policymakers, politicians, and the public.
On the economic front, the apparent decline of U.S. "competitiveness" is causing alarm. Many experts argue that the regulatory
structure is impending our ability to grow. Social and economic
problems are inseparable when evaluating welfare policy. Decades
of accelerating Federal assistance have left many to conclude that
poverty cannot be eliminated. Decades of Federal intervention in
agriculture have yet to solve its distressing economic problems.
The driving force behind much of the invigorated public interest
in these policy issues is the need for trade and budget deficit reduction. If funding were not such a problem itself, many of the associated Federal programs would not arouse interest, let alone concern.
Within that statment is an underlying cause for policy failure: inattention. Decades-old approaches can become stale when policy instigators do not strive to improve their programs. The budget deficit problem has sobered the policymaking process and stimulated
program review.
Policymakers today must perform an agile balancing act. Programs must become more efficient and better focused. They must
be made to achieve more at a lower cost to the economy. Policymakers must understand how even seemingly unrelated policies
are connected and interdependent. They must become aware of unintended results and disincentives that may impede their efforts.
Their rhetoric must match reality.
The policy issues of this chapter-competitiveness, regulation,
social welfare, and agriculture-each urgently deserves policy
reform. They are linked to other broad areas of national interest
and require objective analysis and bipartisan cooperation. Dealing
with them successfully would contribute tremendously to the wellbeing and standard of living of all Americans.
Competitiveness

Much of the prevailing economic discussion among private and
public sector leaders centers around competitiveness. This term
likely will find its way into every economic policy debate of the
100th Congress, from labor and productivity issues to government
intervention in the marketplace. In part, competitiveness is a synonym for industrial policy, where economic priorities are established
by a perceived consensus of public and private leaders. It also
means Uncle Sam's taking off the gloves in the international trade
arena.
Competitiveness endorses those economic principles that foster,
promote, and strengthen competition. In our judgment, competitive
forces operating in free markets at home and abroad hold the key
to economic growth, job creation, rising standards of living, and an
opportunity society. Straying from the principles of competition
and free and open markets in general results in lower production,
higher prices, less trade, and lower standards of living for consumers and producers alike. The world is not perfect, and pure competition does not exist either. Nonetheless, the theory of pure competition is the starting point for good public policy.
The competitiveness issue has emerged out of recent concern for
U.S. prominence in the world economy. Deteriorating exports,

190
worsening balance of trade deficits, lackluster productivity growth,
and sluggish investment and reduced R&D, all have contributed to
the feeling that the U.S. economy is slipping. U.S. performance
abroad has been hampered by barriers to trade and high exchange
rates, while the U.S. market has been open to a rapid expansion of
imports. Several major industries-textiles, semiconductors, and
office equipment, for example-have suffered setbacks or slow
growth as their domestic and foreign market shares were usurped
by foreign competitors. This foreign "assault" has caused considerable dislocation for some industries. But despite the costs imposed
on these industries, the remedy is not wholesale retaliation and
protectionism.
Enhancing our prominent role in global economic affairs cannot
be accomplished by imposing protectionist restraints. The sheer
size of the U.S. economy involved in trade makes us vulnerable to
undesired consequences. Concerns aside, we remain the world's
single largest and strongest economic entity. No other country
stands ready to displace us as the world's dominant economic
factor. Indeed, the United States has buoyed other nations' economies with .over 50 months of growth and hundreds of billions of dollars worth of imports.
Describing Competitiveness
Competitiveness refers to the ability of a nation to sustain and
raise its standard of living by producing and selling goods and services both domestically and abroad, in competition with other nations. This broad definition referring to internationalcompetitiveness can be narrowed to describe industrialcompetitiveness-referring to the ability of an industry to compete, prosper and make a
profit in a global market. Both terms are really just larger versions
of the classical concept of competition in microeconomic theory,
where many firms seek to maximize profits and seek their advantage in the market.
A nation's competitiveness is not static. Economies of major industrial nations are continually growing, changing, and diversifying. At the forefront of economic change are the new technologies
that improve productivity and offer new goods and services. Technical change also alters the mix of capital and human resources
utilized by an economy. Harnessing Western technology allowed
Japan to grow despite the lack of raw materials. By adding labor
value and continually improving its proficiency, Japan has
amassed a sizeable share of world markets, from motor vehicles to
consumer electronics. Their dedication to R&D in a range of sciences and a relatively geater willingness to save and invest may
provide a competitive edge in emerging industries and new applications for years to come.
Economic theory demonstrates that countries benefit by exchanging that which can be produced "cheaper" in terms of the alternative uses of resources. This means a country can be competitive
even if it is not technically superior.
Is the United States losing its competitive edge in the global
economy? In some industries, perhaps, but certainly we are not in
general decline. Instead, the gap between American and foreign
economic performance is narrowing due to the rapid advances of

191
other countries. The world economy of 1987 has little in common
with the one of 30 years ago, when foreign trade was far less. Advances in education, training, technology, production techniques,
transportation, and communications in dozens of nations have facilitated the trading process. Technologies are rapidly and easily
transferred across national borders. Other countries have made tremendous progress in productivity growth, aided by substantial
saving, investment, R&D, and capital formation.
In the same 30 years, U.S. public and private economic priorities
have not been directed similarly. Our advances in growth and productivity have been slowed for many reasons. Lower saving rates
reflect America's inclination for current rather than deferred consumption. The Federal income tax retards incentives to save. Less
saving results in less (and more expensive) investment, capital formation, and R&D, other factors equal. Some analysts suggest a
lack of initiative at the white collar level to apply new technology
or management techniques. U.S. wages and salaries in many instances are much higher relative to their foreign counterparts. Frequently these are the same industries requesting protection from
imports-auto and steel, for example Environmental and safety
regulation, while necessary to a substantial degree, impose an economic penalty on U.S. business not necessarily borne by their foreign counterparts. National security expenditures, while necessary,
siphon off resources and require tax burdens not endured equally
elsewhere in the free world.
Indicatorsof Competitiveness
Measuring competitiveness is as elusive as defining it. However,
several economic indicators and measures can be useful to examine
the components and related factors of competitiveness. The following outline categorizes many benchmark indicators.
Economic Measures
Income.-Per capita, inflation-adjusted, after-tax income is a good
indicator of changes in standards of living that can be compared
among nations.
Returns on Investment.--Profitability is a strong indicator of the
economic performance, efficiency, productivity, and prospects for
an industry or nation.
Gross National Product.-On a per capita, real basis, output of
goods and services demonstrates the economic performance of a
nation vis-a-vis others.
Share of World GNP.-Independent of changes in domestic performance, this measure would track changes relative to other nations.
Merchandise Trade Balance.-Although service trade is growing,
the lion's share of trade at present is in materials and goods. The
composition of merchandise is of major importance, too, because
finished goods have little "value added" potential for the importing
nation.
Determinantsof Competitiveness
Productivity.-Essential to the health of an economy and prosperity of society is the ability to improve the provision of goods and

192
services. Productivity growth does not occur automatically; it has
to be pursued vigorously at all levels of production. As a measurement, however, it is lacking in its present form. Services (about 60
percent of the U.S. economy) cannot be gauged like manufacturing
or materials, because of the lack of a physical product. Until a precise measure is devised, productivity measures will not be accurate.
Labor Resources Investment.-Education, training, adaptability,
and effort all have large economic consequences. Enhancement of
workers' skills and endeavor will make a tremendous contribution
to living standards.
Ca ital Resources Investment.-R&D, capital formation and technical applications are catalysts for working smarter and living
better. Labor cannot realize its full potential without sufficient and
advanced capital.
Economic Diversification.-Human wants are unlimited and insatiable; fulfilling them is human nature. The adage "supply creates its own demand" aptly depicts the phenomenon that the emergence of new products or services either elevates the value of all
existing ones or replaces the old with superior ones that will serve
society better.
Regulatory Climate.-Economic and social regulations can
impede growth when the costs of compliance and control exceed
their benefits to society. For example, economic regulation to safeguard against monopolistic power is desirable, but disallowing joint
ventures between U.S. corporations on expensive, high-tech research can result in needlessly lost opportunities seized by foreign
competitors.
Other Factors.-Work attitudes, resource ownership and control,
the size and dominance of government, cultural practices, and consumer choices and preferences are among many factors having a
pronounced effect on the economic performance of a nation. But
these influences on the economy are governed more by social, religious, and political forces than by economic forces per se.
Economic Environment.-Even the best of firms and industries
cannot withstand a poor business climate. Our own history and a
survey of most Third World nations today have proven that departures from a free and open market system results in reduced well
being. A sound economic foundation is necessary on three levels.
At the ground level are microeconomic practices. In a competitive market structure, firms will not survive unless their management of resources is effective and efficient. Success hinges on effective planning, cost analysis, quality control, and marketing, and on
good management, labor, business, and public relations. These
functions are at the heart of competitiveness.
Federal policy governs the next level, macroeconomic factors. On
the domestic front, sound fiscal and monetary policy are imperative for lasting growth and competitiveness. Price stability, adequate credit resources at reasonable interest rates, fiscal policies
that foster investment in the future as well as attend to current
needs, and policies that reward initiative and innovation all make
necessary and valuable contributions to our competitiveness.
Third, international factors require the attention of Federal policymakers. Trading arrangements are not founded solely on economic grounds. Political and cultural considerations are equally

193
important and complex facets of international relations. Abiding by
the principles of free and open trade is difficult when other countries disregard fairness. While the United States is relatively selfsufficient, our economy is still exposed to risk in a trade war. The
United States is vitally integrated into the global economy; future
growth depends on further expansion of world trade and U.S. exports.
Trade is affected by three conditions. First, countries must be capable of trading, by having something to exchange and the financial means to accomplish it. Developing nations saddled with external debt are in a different position. If these countries are to become
a healthy part of the international economy, new policies will need
to be devised by the entire international community, not just the
United States.
Second, the monetary mechanism of trade-exchange rates
among currencies-can be the ultimate determinant of the occurrence of trade. Ideally, exchange rates reflect an economic comparability between countries. Artificial values of currency can offset
any comparative advantage or technical edge of an industry. When
that occurs, the world loses a welfare gain. Obviously, the exporter
loses the sale; less obvious is that the prospective importer is
denied something that would make his society better off.
Third, other barriers to trade-quotas and import restrictions, inconvenient compliance requirements, excessive tariffs and the
like-reveal the protectionist tendencies of all countries. Few industries are faced with as many trade barriers as is American agriculture. Despite the fact that the United States can produce more
abundantly and more economically than any other country, it now
penetrates the world market mostly as a residual supplier. With
starvation so widespread today, food is the most important commodity, but for political, social and national security reasons, many
countries will not diminish their less efficient domestic industry
and risk dependency.
Improving U.S. Competitiveness
Advancing America's prominence in the global economy is a
back-to-basics proposition that requires the commitment and determination of the American people and the cooperation and fairness
of all governments. Furthering our competitive standing is more
than an economic goal. At stake is our global leadership and
national security. Global leadership is also demonstrated by being
forceful in dealing with unfair trade practices of other nations.
Economic rivals are poised to compete directly with us at home
and abroad. Restraint of this competition ultimately will result in
lower living standards for all. Restoring free and fair trade is as
much a diplomatic challenge as it is an economic necessity. Bending to protectionist pressures at home likely will result in even further deterioration of exports-and employment.
To meet the challenge, people must be prepared for a dynamic,
high-tech workplace demanding more skills and flexibility. Advanced education and training are essential to the task of strengthening the U.S. economy. Parents and children, teachers and students, and labor and management working cooperatively with a

194
sense of responsibility and obligation, can make substantial gains.
American ingenuity and ambition are invaluable economic assets.
A healthy economic climate for industrial innovation is essential.
This Administration's overall economic policies have accomplished
much in this regard, and specific actions-such as relaxing antitrust laws applicable to limited partnerships for research and development-have been very helpful. More remains to be done, e.g.,
strengthening and making permanent the tax credit for research
and development.
Capital resources-including foreign sources of capital-must be
expanded and applied to established American business. Even our
new high-tech ventures benefit from access to world capital markets. Harnessing new technology is integral to economic growth
and social advancement. The price for impeding the formation of
capital is slower productivity growth and therefore, the loss of competitiveness.
The United States should not seek fair play through reactionary
protectionism and other trade actions imposed for political purposes and other self-defeating gestures, such as embargoes. Fairness comes from the mutual respect for and understanding of foreign societies' cultures, institutions and goals. But our trade partners must soon recognize that our patience is growing thin. Their
responsibilities extend to maintaining growing economies that
enable their consumers to buy more of our goods.
America's best hope for enhanced competitiveness hinges on persuasion. We must convince the world that competition in free and
open markets is the proven way to elevate standards of living and
is superior to any other system, imagined or contrived. That message must be heeded both at home and abroad if the world economy is to prosper, grow and realize its full potential.
Regulatory Reform
The extensive regulation debate of the Reagan years will take on
a new dimension and intensity in the 100th Congress. At issue is
the extent to which government regulation inhibits U.S. competitiveness. This new twist adds relevance to long-standing complaints
by the private sector that many regulations are needlessly cumbersome, purposeless, and counterproductive. A few general observations are offered to assist policymakers during the deliberation of
regulatory reform.
We believe that Federal regulations and compliance requirements still place an inordinate burden on American business, consumers, and taxpayers. Decades of rulemaking have resulted in a
quagmire of inconsistent and conflicting directives by countless
legal authorities and statutes. Furthermore, regulations by a large
are promulgated in a static, permanent manner, disregarding a dynamic economic setting that requires flexibility to adapt to new
technologies and markets.
Excessive regulatory burdens have contributed to the erosion of
U.S. competitiveness. Paperwork, litigation, and other exhausting
compliance requirements divert resources away from other more
productive activities. Profits consequently are reduce, taking resources away from R&D, innovation, and investment.

195
Administrative initiatives addressing regulatory reform deserve
congressional cooperation. Creating a centralized regulatory oversight authority (Executive Order 12291) and requiring Federal
agencies to establish their regulatory agendas annually (E.O.
12498) have aided reform efforts. The number of regulations submitted to the Office of Management and Budget's Office of Information and Regulatory Affairs decreased 20 percent between 1981
and 1985. In 1985, 13 percent of all submissions were revised to
modify their intent or to reduce their burden on the private sector.
In contrast, only 5 percent were changed in 1981 to reduce their
negative impact. The Reagan Administration has also attempted to
ascertain the costs and benefits of regulations, a commendable
effort to bring to light the economic ramifications.
A second Presidential task force on regulatory relief was formed
in late 1986, calling for government to do all it can to improve productivity and competitiveness-an aim we support. We are convinced that the United States can maintain its regulatory safeguards in a more efficient and less costly manner thereby improving our competitive standing. As this task force and the Congress
deliberate this importation issues, the following considerations
have relevance and pertinence.
1. Reverse the method of regulation from "sticks" to "carrots."Regulation has a bad reputation in part from the way it is implemented and enforced. Human behavior responds much more favorably to incentives than to punishment; economic behavior is not
different. As an example, small businesses and their employees
would be better served by Federal technical assistance on regulatory requirements (such as OSHA rules) than being fined and penalized for violating rules they didn't know existed.
2. Do regulatorypenalties fit the crime?-Severe action for minor
offenses is the archetypical regulatory burden. Minor offenses, however, can and do add up, particularly in the environmental area,
and must not be ignored. Regulatory mechanisms should be capable of dealing with patterns of minor offenses.
3. Regulation should never be a barrier to entry into an industry.-Existing firms in an industry sometimes use regulatory controls to their advantage, resulting in unwarranted and undesired
protection from potential competition.
4. Incorporate flexibility into regulatory design.-Rules governing
,the economy must adjust to changing technology and markets. As
an example, the Environmental Protection Agency recently revised
its approach for reducing air pollution. Instead of imposing rigid
pollution control standards, industries are permitted flexibility to
achieve the desired result under the "bubble" concept. The goal of
pollution reduction is achieved not by equivalent reductions by
each polluter, but rather by the most economical means. Pollution
is best controlled by eliminating it from sources that can be
cleaned up at the lowest cost; the "bubble" concept affords that
flexibility while still continuing to address the more entrenched
pollution problems.
5. Regulators must seek better ways to monitor their programs.New technologies and oversight processes can be harnessed to
reduce the cost of regulation to taxpayers and industry.

196
6. Policymakers must improve internationalagreements to honor
copyrights, patents and property rights.-Domestically, owners are
protected; the United States cannot tolerate intellectual robbery
abroad.
7. The regulation of information-age, high-tech, and other emerging industries must fully reflect global considerations.-TheUnited
States is just one player in new markets; policymakers must develop an appreciation for that fact.
8. Policymakers should evaluate the regulatory climates of major
industrial nations to see how the United States differs.-Such a
comparison could yield new regulatory approaches and show where
the United States may be at a disadvantage. This analysis also
could study whether U.S. multinational corporations have been
driven offshore to escape prohibitive control.
9. America's tradition as a seedbed for innovation and invention
should not be hampered by regulations and paperwork burdens.Upon analysis, one would find that much of today's global economic activity can be traced back to ideas and innovation fostered
within the U.S. economic system. We must revitalize that rule. The
loss of ingenuity because of excessive regulation and time consuming reporting requirements is an economic tragedy.
Walfare Reform
Few issues are closer to the human conscience or are more emotionally charged than the well being of all persons. A life of poverty is tragic, and unfilfilled potentials are lost conbtributions to society. Few would disagree that eradicating poverty is among the noblest of pursuits. Accomplishing that aims, however, is another
matter. Two decades of monumental Federal leadership,. policy initiatives, and massive spending have resulted in little progress.
Why then has our welfare policy failed to achieve its goals satifactorily? Poverty is a complex socioeconomic problem. Money and
the material dimension is only a portion of its. Others have to do
with attitude and behavior. Governmental initiatives lopsided in
just one aspect of poverty have not succeeded. Social assistance
must accommodate both the reduction of physical discomforts and
the promotion of attitudes and behavior that induce independence
and self-worth. The latter goals have proven difficult for government to instill; They instead are better achieved through grassroots
family support, and neighborhood and community activities.
As with other policies, programs must treat causes, not symptoms. Beginning in the 1960s, many analysts concluded that economic growth alone would not reduce poverty. Suggesting the existence of Structural poverty, programs were proposed to eliminate
the handicaps that caused people to be poor. By and large it was
proposed to provide the poor with skills for and access to the labor
market. Simultaneously, politicians spoke strongly against mere
income transfers to help the poor. In 1964, President Johnson
stated in conjunction with antipoverty legislation that "the days of
the dole are numbered." Unfortunately, we are still counting, as
subsequent Federal policy went in the opposite direction. Cash
public assistance payments (inflation-adjusted) increased nearly 10
percent annually from 1965 to 1970, compared to a 4 percent
annual rate in the decade preceding. Poverty program costs contin-

197
ued to soar in the 1970s. Inflation-adjusted per capita Federal pulic
aid increased from about $50 in 1966 to over $200 in 1980.
Despite the rhetoric during the early stages of antipoverty programs, policymakers' philosophy apparently shifted away from
equality of opportunity and toward equality of outcome, Politics had
taken the path of least resistance. It simply was more expedient (in
to short run) to provide payments to the poor than to fund programs to motivate, educate, train, and employ them. Programs to
enable the poor to elevate themselves out of poverty did not prove
to be as cost-effective or completely successful as envisioned, but
they were not abandoned altogether. Ironically, and sadly, income
transfers have not led to equality of outcome, and poverty persists
despite $140 billion in Federal, state and local assistance (FY85).
Current welfare policy had created disincentive effects that make
poverty programs less attractive and harder to implement. For example, income transfers give recipients a "tradeoff" to use that additional income to increase their total income (the potential undesired effect). Furthermore, a "work penalty" has been associated
with welfare payments. When the working poor reach certain
earned income thresholds, they can lose a portion or all of their
welfare benefits. This system in effect imposes a servere "tax" on
the working poor, and the cost associated with losing benefits can
offset their desire and/or ability to become financially independent.
Another disincentive deals with public involvement replacing or
"crowding out" private welfare assistance. In 1955, 22 percent of
private charitable contributions were directed toward social welfare undertakings. In 1983, only 11 percent was. By another analysis, each $1 of additional Federal welfare spending reduces private
contributons by 30 cents. Although the net result is an increase in
welfare spending, it is regrettable that private initiative is stifled
by Federal intervention.
A discussion of welfare reform is not complete without mentioning the changing nature of "home life." Only 69 percent of Americans now live in traditional family circles headed by married couples. Another 15 percent live outside of families (live alone or with
unrealated persons). The remaining 16 percent are "nontraditional" families. These consist mostly of one-parent households, 80 percent of which are headed by females. A pocket of poverty exists
within this group of female-headed households. Only 37 percent of
single parent families with female heads work full time, and
median income for them was about $12,800 in 1984. By contrast,
the median income for traditional families that year was $29,600131 percent higher.
Experience shows that people respond to economic choices, and
welfare recipients are no exception. Improving welfare programs is
a necessary step toward minimizing poverty in society. Progress entails the combined efforts of both individuals and government. The
following list outlines options to remedy some of the shortcomings
of the welfare system.
1. Return to the objective of equality of opportunity.-There is no
substitute for work rewarded by pay. Paychecks help persons in
poverty attain a sense of self-worth, self-reliance and independence.
Well-designed training programs would enable the poor to enter

198
the labor force, and the number of persons on welfare rolls would
decline.
2. Eliminatingpoverty is a teamwork proposition.-Partnerships
joining individuals, families, neighborhoods, grassroots organizations, communities, and State and Federal Governments are the
best way to ensure successful results, Without the commitment of
individuals and local resources, Federal efforts will be ineffective.
3. Eliminate or reduce any disincentives inherent in current policy
and encourage labor-force participation.-The current system penalizes the working poor by taking benefits away from low income
earners near the poverty threshould. An improvement would be to
devise a gradual reduction in payments to working persons so that
incentives to work remain intact. The low income families. The
1986 tax reform bill eases the tax liability on low incomes considerably. Earned Income Tax Credits also encourage low income families to work. Expanding this program may accomplish more than
providing direct cash payments to disadvantaged families.
4. Public sector programs should complement private sector charitable contributions and volunteerism.-Private initiatives serve and
indespensable role in social welfare programs. They shouid not
have to compete with or be displaced by government activity.
5. Education and training are the gateways to self-sufficiency.An increasingly technical economy requires adaptable and innovative laborers. Only through basic education and properly directed
training can one acquire the skills for today s labor market.
Today's labor market is competitive. Good jobs attract many applicants. Job seekers need motivational skills to achieve placement.
Only through such endeavor can one realize his or her capabilities.
6. Strengthen the traditional family structure.-A family with
two parents forms a nucleus for support and self-reliance that can
foster economic independence. While the two-parent family is the
ideal, we recognize that single-parent families are a significant portion of the poverty population in some areas; their problems must
be addressed in any welfare reform so that the cycle of disadvantag e is not continued.
Success in welfare programs is attained easier when economic
growth expands economic opportunities. A strong U.S. economy
creates jobs, and jobs can displace welfare dependency. Therefore,
welfare recipients and low income families have a stake in sound
Federal fiscal and monetary policies that promote stable, noninflationary growth.
Agriculture
Nowhere is the need for new policy direction more evident than
in the Nation's farm program. Despite the budget deficit and the
Gramm-Rudman deficit-reduction targets, unprecedented sums$28.3 billion in FY86 alone-are being devoted to aid the agricultural secton. Although more than $100,000 is being spent this year
alone for every farm family in financial stress, the industry remains in economic chaos.
Indeed, the time has come to recognize that the "cure"-Federal
farm aid-is itself a large cause of the malady. There is little rational relationship between the problem and Federal farm policy.
Not only is the farm program not solving the problem, but the cur-

199
rent production-based approach is actually aggravating it is at least
two ways: First, most of the aid is inequitable, being given to the
largest, most well-to-do operators, thus increasing their already inherent advantages over the average farmer who is being driven off
the land. Second, subsidies tied to production stimulate overproduction and price-depressing surpluses, thereby destroying the natural
regulation of supply and demand by the market and guaranteeing
continuing economic dislocations in the industry.
How has Federal farm policy gone so far astray? And what will
it take to get the industry back on track? The following tabulations
can help to provide some insight into the political imperatives involved. There is no question that a large number of farm families
are struggling and that, politically speaking, their difficulties will
continue to demand the attention of policy-makers. The question is
whether, in the face of massive, uneven, and counterproductive
farm subsidies, the Congress will come to recognize the wisdom of
responding in a more appropriate fashion.
Table VII-1 displays, on a state-by-state basis, the number of
farms, along with the Commodity Credit Corporation (CCC) subsidy
total and the average amount per farm provided in Fiscal Year
1986. The subsidy data portrayed in this tabulation are taken from
USDA's Federal Assistance Awards Data System (FAADS) and
cover the following programs: commodity loans and purchases, deficiency and diversion payments, milk diversions payments, storage
facilities loans and storage payments, wool payments, emergency
feed, and conservation reserve.
The FY86 subsidy per state ranges from a low of $24,306 in
Rhode Island to nearly $3.7 billion to Iowa. On a per farm basis,
the subsidies range from an average of only $32 in Rhode Island to
nearly $40,000 in North Dakota.
TABLE VII-l.-FARM AND FISCAL YEAR 1986 CCC ASSISTANCE PER STATE AND PER FARM
State

State

CCC
assistance
(thousahds) Total
2 (million
Perfarm:
dollars)
(dollars)

~~~~~~~~~~Farms

Iowa
.........................................
111.0
lIinois ....
Minnesota.............................................................................................................
96.0
Nebraska
.........................................
59.0
Texas
.........................................
184.0
Missouri
..............................
115.0
North
Dakota
.........................................
34.0
Keansas.7................................................................................................:...............
72.0
Indiana................................................................................................................
81.0
Cabfomia
.........................................
.
79.0
Alensas.......................................................,.........................................
Ohio
...
89.0
South
Dakota....
36.5
Mississippi............................................................................................................
48.0
Wsconsin8.....................................................................................................8.0.......83.0
Michigan..............................................................................................................
63.0
Colorado
..........................................
.
26.7
Oklahoma
...........................................
71.0
North
Carolina
..........................................
.
76.0
Washington..........................................................................................................
38.0
Louisiana..............................................................................................................
35.5
Kentudcy
..........................................
100.0

$3,692.1
$33,262
2,832.
,8.0..........7 31,474
2,381.3
24,805
2,186.4
37,058
1,832.5
9,959
1,767.2
15,367
1,337.8
39,347
1,215.6
16,883
1,157.8
14,293
1,058.1
13,393
766.0
14,452
726.8
8,166
686.0
18,795
614.
8 12,808
610.2
7,352
539.3
8,561
503.3
18,850
452.9
6,378
424.5
5,586
383.7
9,834
366.6
10,326
309.6
3,096

200
ASSISTANCE PER STATE AND PER FARMTABLE VII-1.-FARM AND FISCAL YEAR 1986 CCC
Continued
State

state

CCC
assistance
~~~~~~~~~Farms
Perfarm:
Total (milion

((oosahos)

dollars)

(dollars)

23.6 286.112,122
.
...........................................................................................
Montana.
10,734
264.1
24.6
....................................................
Idaho.............................
2,499
244.9
98.0
............................................................................................................
Tennessee.
5,389
,........................
210.2
39.0
..........................................................................
Florida.
3,826
191.3
50.0
................................................................................................................
Georgia.
12,874
178.9
13.9
..
Utah
...........................................
2,860
154.4
54.0
..............................................................................................................
Alabama.
15,686
133.3
8.5
............................................................................................
.
Arizona..
3,526
130.4
37.0
................................................................................................................
Oregon.
2,335
128.4
.................................................................................... 55.0
Virginia.
2,440
109.8
45.0
............................................................................................................
NewYork.
158.0
1805
104.7
.....................................................................................................
.
.
Pennsylvania.
3,047
83.8
27.5
.
.
...........................................
SouthCarolina
3,988
71.8
18.0
.............................................................................................................
Maryland.
68.1 4,936
1
3.8
...........................................
NewMexio.
2,950
26.6
9.0
..................................................................................... .
Wyoming.
4,035
14.1
3.5
.
.
Delaware...........................................................................................................
1,316
11.4
8.7
.
.
...........................................
NewJersey
1,210
8.5
7.0
. ..
Vermont..........................................................................................
371
7.5
20.3
,
...
.
WestVirginia .
1,191
3.00.......................
. ......................2.5
................................................................
Navada
217
1.7
7.8
Maine ...................................................................................................................
184
11
6.0
.................................................................................................
Massachusetts.
216
.8
3.8
. . ....
,
, . .
. .
Connecticut ....., , . .
744
.5
.7
..............................................................................................................
Alaska.
69
.3
4.6
....
..........................................................................................
Hawaii.
68
.2
3.4
.
.
...........................................
NewHampshire
32
.0
.8
.
.
.
Isand
Rhode
...........................................
UnitedStates

2284.6

$28,271.1

£12,374

1985.
Statistics,
Agricultural
Source
USDA's
fiscalyear86.
DataSystem,
Award
Assistance
Federal
'SourceUSDA's

Ten states received over $1 billion each in CCC assistance in
FY1986. Together these 10 received approximately 70 percent of
CCC aid, even though they account for only 40 percent of the farms
and 44 percent of the acreage in farms. Interestingly, the value of
U.S. farm real estate is split almost evenly between these 10 and
all 40 of the remaining states, with each group accounting for
about half of the total. On a per farm basis, the average subsidy to
all U.S. farms was about $12,370.
Table VII-2 displays the total farm acreage in each .state, the
"base" acres eligible for subsidies under the acreage-based provisions of the farm program, and the average CCC subsidy according
to each of those measures. The states are ranked in descending
order on the basis of the average subsidy to all farm acres within
each state, with a range of 16 cents per acre in Hawaii to nearly
$110 per acre in Iowa. The U.S. average subsidy per farm acre is

$27.84.

201
TABLE VII-2.-FARM LAND, FARM PROGRAM BASE ACRES AND CCC ASSISTANCE PER ACRE AND PER
BASE ACRE BY STATE, FISCAL YEAR 1986
State

Iowa
......................................
.
Illinois ......................................
.
Minnesota
......................................
Indiana......................................
.
Missouri ...........................
Arkansas......................................
.
Michigan
......................................
Nebraska
......................................
.
Ohio
......................................
.
Mississippi ....................................
.
North
Carolina
......................................
ouisiana
......................................
.
Wisconsin
.
.
North
Dakota
......................................
.
California
......................................
.
United
States
....
..................................
Maryland
......................................
.
Kansas
......................................
Washington
......................................
Delaware
......................................
Kentucky
......................................
Tennessee
......................................
Idaho
......................................
Florida
......................................
Utah
......................................
South
Dakota
......................................
South
Carolina
......................................
Colorado
......................................
Georgia
......................................
Oklahoma
......................................
Texas
......................................
Alabama
...........
Virginia
......................................
NewJersey
......................................
Pennsylvania
......................................
NewYork
......................................
Oregon
......................................
Vermont
......................................
Montana
......................................
Arizona
......................................
West
Virginia ......................................
C onnecticut
......................................
Massachusetts ......................................
New Mexico ......................................
Maine......................................
Wyoming ......................................
.
NewHampshire
.......................................
Nevada
..
:
Alaska
..
.1.5
.............
Rhode
Island
......................................
Hawaii ......................................

- Farm
ares(milliao)
AD
Base

33.6
28.7
30.4

17.0
15.0
13.6
16.4

30.8
16.0
11.4
47.2
15.8
14.2
10.8
10.1
17.7
40.9
32.8
1,015.6
2.7
48.0
16.3
.7
14.5
13.4
14.7
13.0
11.6
44.5
5.5
34.4
13.5
33.0
136.3
11.5
9.6
1.0
8.7
9.2
18.0
1.6
60.9
37.5
3.5
.5
.7
45.0
1.5
34.8
5
8.8
.1
2.0

snob perwe
All

7.3
5.2
4.1
14.2
5.4
3.3
2.9
2.4
4.4
18.8
4.7
240.3
.7
21.3
4.4
.2
2.4
2.4
3.4
.5
.5
11.9
1.6
5.8
3.2
9.6
25.0
1.8
1.2
.2
1.2
1.4
1.8
.0
10.2
1.0
.1
.0
.0
1.7
.1
.6
0
.1
0
.0
0

Base

$110
99
78
7.7

$217
189
175

57
48
47
46
46
43
39
36
34
33
32
28
27
25
23
22
21
18
18
16
15
15
15
15
14
14
13
13
13
12
12
12

241
148
131
154
134
184
146
154
138
71
224
118
100
57
85
.57
127
104
78
411
356
58
54
87
59
47
73
86
106
72
84
79
73
200
28
139
73
36
65
40
24
47
1
42
1
49

7
5
5
4
2
2
2
2
1
1
0
0
0
0
000

' These states have nOfarmpssaram
base acres.

Soures
USk

If only farm-program base acres are considered, the range of subsidies extends from a high of $411 per acre in Florida to a low of
about $24 in Maine. The national average per base acre was just
under $118 per acre. Five states-Kentucky, Florida, Utah, Ver-

202
mont, and Arizona-receive more than the national average per
base acre, but significantly less than the national average when all
farm acres are considered, presumably reflecting the fact that most
farm acres in these states are not covered by the program.
Three states-New Hampshire, Alaska, and Hawaii-have no
farm program base acres. Each received less than 50 cents per
farm acre, however, and all three combined received just over $1
million of the $28 billion in FY86 CCC aid.
Table VII-3 shows the value of farm real estate (land and buildings) by state and ranks the states in descending order according to
the return provided by fiscal year 1986 CCC subsidies.
TABLE VII-3.-CCC SUBSIDY RETURN ON VALUE OF FARM REAL ESTATE PER STATE, FISCAL YEAR
1986
State

1
Value
affarmmal

O
(percnt)
~~~~~~~~~~estatet(ii

10.4
20,964
Nebraska....................................................
10.3
35,754
.
....................................................
Iowa
9.5
25,032
.
....................................................
Minnesota
9.1
14,759
.
NorthDako ....................................................
8.6
20,433
Missouri.......................................................................................................................................
7.5
37,717
Illinois .....................................................
6.2
11,116
.
Souh Dakot....................................................
5.6
20,651
Indiana .........................................................................................................................................
5.6
13,671
Arkansas.....................................................................................................................................
5.4
22,386
..
Kansas.........................................................................................................................................
5.2
.11,863
Mississippi ................................................
4.5
11,990
Michigan .....................................................
4.1
689,809
.
United Stas ....................................................
4.1
17,794
.
....................................................
Ohio
4.0
............
Wisconsin.........................................................................................................................15,254
3.3
15,047
.
....................................................
Colorado
3.1
.13,659
NorthCarolina..............................................................................................................................
2.9
6,066
Utah ..
2.9
12,690
Louisiana....................................................................................................................................
2.5
14,853
.
Washington ....................................................
2.4
4
18,68
Oklahoma...................................................................................................................................
2.4
11,009
Idaho.................................................................................................................................. ...
2.4
13,142
Kentucky......................................................................1...............................................................
13,559 2.1
Montana.......................................................................................
2.1
89,229
Texas. ........................................ ...........................................................................................
1.9
13,156
Tennessee...............................................................................................................................
1.9
56,965
California......................................................................................................................................
1.7
8,844
..
Alabama..............................................................................................................................
1.7
5,036
....................................................
SouthCarolina
1.6
11,676
Georgia.........................................................................................................................................
1.4
7,594
.
....................................................
NewYork
1.3
9,949
Arizona.....................................................................................................................................
1.3
1084
Delaware......................................................................................................................................
1.3
5,663
Maryland.....................................................................................................................................
10,427 1.3
Oregon........................................................................................................................................
1.2
10,587
Virginia..............................1............................................................................................
1.1
1.
19.853
.....................................................................................................................................
Florida
.9
7,484
.....................................................
NewMexico
.8
13,139
...................... ,,.
Pennsylvania
.5
1,730
.....................................................................................................................................
Vermont
.4
6,166
Wyoming......1......................................................................................................................
.4
2,105
.
WestVirginia ....................................................
.3
3,420
....................................................
NewJersey
.1
2,034
Nevada.............................................................................................................
1,335 .1
..................................................................................................................
Maine

203
TABLE VII-3.--CCC SUBSIDY RETURN ON VALUE OF FARM REAL ESTATE PER STATE, FISCAL YEAR
1986 '

Continued
Va doffr
lam real

..........................
1,613
Massachusetts.,....,......,...................,..............................................................................

Coanechcut.1,604
NewHampshire.
Rhode
Island.

.1
.0
.0

80
243

XDatauBaaae forAlaska
andHawat.

USD&

The average return on farm real estate provided solely by CCC
subsidies in FY86 was 4.1 percent, ranging from 10.4 cents on the
dollar in Nebraska to less than a tenth of a cent in New Hampshire and Rhode Island.
Some forms of governmental subsidies are capitalized into the
value of farm assets, and this table shows the inflation potential of
farm subsidies to be considerable in many states. The purchase of
farm assets would be feasibly attractive in those states where the
subsidy return is equal to or greater than the prevailing interest
rate, assuming the present level of governmental largess would be
continued. While farm owners' equity has plummeted almost $300
billion since 1981, the decline would have been even more dramatic
in the absence of Federal subsidies. In addition, USDA estimates
that almost one-half of total net farm income will be in the form of
direct government payments in 1986.
In the face of subsidies of this magnitude and apparent importance, there is little wonder that strong political imperatives have
arisen around the program, and that the inertia against reforms
seems irrestible. Yet the economic dislocations which have resulted
are obviously contrary to the national interest.
Changes in our present farm policy are necessary to ensure the
future competitive vitality of American agriculture. For much of
the past decade, our Nation's farmers have been plagued by a
number of problems. The Congress sought to improve this situation
through the enactment of the 1985 Farm Bill Many of the provisions of this law could be characterized as pluses. There were, however, offsetting minuses of significant dimensions and serious consequences.
Further change in our Nation's agricultural policy is necessary
through a more market-oriented approach to our farm problems.
The artifically high rates of recent years, which were set by statutory formulas instead of marketplace realities, have led to predictable price undercutting by our international competitors, resulting
in the loss of foreign markets and the costly expansion of government-held inventories. The time clearly has come for new directions in farm policy.
Summary
Competitiveness, regulatory reform, welfare reform and agriculture are four issues commanding much attention in the 100th Congress. Renewed interest in these topics is driven by changing global

204
and domestic economic conditions, socioeconomic trends and the
compelling need for deficit reduction.
The competitiveness issue has emerged out of concerns for U.S.
prominence in the world economy. Deteriorating exports, large balance of payments deficits, lackluster productivity growth and sluggish investment have contributed to the feeling that the U.S. economy is slipping. But retaliation and protectionism are not remedies. The sheer size of our economy that is involved in trade makes
us vulnerable to undesired consequences. This section describes
what competitiveness is, how it can be measured and what steps
can be taken to improve it.
The private sector continues to complain about the burden of
regulation, even though progress has been made in recent years.
Administration efforts have stemmed the flow of regulation by
stricter review and by requiring agencies of establish their regulatory agendas annually. Nine ways to improve regulation are discussed, including the use of incentives, incorporating.flexibility and
new monitoring methods into regulatory design, improving international agreements to protect U.S. copyrights and patents, and ensuring that regulations do not inhibit innovation and invention.
The need for welfare reform is obvious because the proverty rate
in 1986 is little changed from 1965, even though Federal welfare
programs have expanded to $140 billion annually. Transfer payments have not solved the problem; rather they are part of it. Current programs contain disincentives to work and achieve independence. Education and training programs are vital remedies, requiring the commitment of the disadvantaged to gain work skills and
the dedication of local, State and Federal policymakers.
Agriculture is in its sixth year of lackluster economic performance. During that time, government farm programs have increased
from $4 billion to $28 billion. Farm policy has not successfully addressed farm problems. Federal price supports have aggravated
surplus production which in turn has driven market prices lower
and made programs more costly. Second, farm program benefits
are not' directed toward farmers who are demonstrating the greatest need for financial assistance.
VIII. REPUBLICAN MEMBERS' AGENDA FOR THE 100TH CONGRESS

Our economic system is one of great opportunity for free enterprise. This is cause for celebration. It's the way market economies
work best. This creates frustration and problems for those who
desire to harness the economy's power and resources for the purpose of achieving some contrived, narrow objective. Economists and
policymakers who have no desire to control or plan the economy,
but still need to understand it, may feel frustrated by the difficulties posed by the size and complexity of the economy.
Understanding the economy is the primary goal of the Joint Economic Committee's work during the 100th session of Congress, and
to pursue this goal we propose three lines of effort to be accomplished through activities similar to oversight of the agencies of the
Federal Government that generate economic statistics:
1. Improving the measuring, reporting, and forecasting of economic conditions and performance;

205
2. Describing the nature and direction of the evolving U.S. economy; and
3. Unerstanding the role of the United States in the world economy and the need for policy actions to improve productivity and
competitiveness.
We feel strongly that the pursuit of this agenda is in the tradition of the Committee and a responsible use of Committee resources.
Measuring economic activity is a monumental challenge in that
the amount of information and data generated by the U.S. economy is comparable to the number of stars in the heavens. It is little
wonder that we have progressed so slowly in our understanding,
explanation, and forecasting of economic events. Yet it is upon
such incomplete analysis that much well-intentioned public economic policy is based. Examples abound of policy proposals justified
on inaccurate analysis. Too often these proposals become law and
when implemented have little, if any, of their intended effect; they
may even cause other problems, thereby stimulating a second generation of well-intentioned policy proposals.
This is not meant to be an indictment of our political system or
the economics profession. On the contrary, America today is the
strongest, most productive economic power in the world. Free
market capitalism is the foundation of America's economy, and it
continues to demonstrate that it is the best means to achieve longterm growth and expanding opportunity. Some, however, would
argue that there is little cause and effect between economic research and analysis and our Nation's economic power and leadership. What needs to be of paramount national concern is the apparent unwillingness of our political system to remedy the painfully
obvious shortcomings of the measurement, reporting, and forecasting of economic conditions and performance. It is an obligation of
government to pursue on a continuing basis a "better" economics
from a more credible and dependable base of economic information.
The payoff from such an effort would be more effective public and
private sector economic decisionmaking-a worthy goal and a valuable contribution of the Centennial Congress. The first item on the
Republican JEC agenda for this congress, therefore, is to begin the
process of improving the measuring, reporting, and forecasting of
economic conditions and performance.
Describing the nature of the evolving US. economy is the second
item on the agenda. What major economic forces are at work and
where will they will lead us? The structure of American industry is
changing in terms of business formation and consolidation and in
its composition with respect to services, manufacturing, and agriculture. In addition, economic growth, output, consumer preferences, educational needs, public works, health, safety, environmental concerns, and a host of other economic characteristics are influenced by the demographic evolution of American society-changes
in the population's size, age, and location. The increasingly significant role of minorities in U.S. society, the labor market, and the
business community, will continue to have a profound effect on the
direction of our economy. Government fiscal, regulatory, energy,
and credit policies will also be major forces shaping the future of
the U.S. economy.

206
Our Nation's role in the global economy is another economic issue
deserving a place on our agenda. More specifically, we plan to investigate problems and opportunities associated with the growing
integration of the U.S. economy into the world marketplace-as
both a seller and a buyer. The U.S. trade deficit, amounting to $170
billion in 1986, raises the question of U.S. competitiveness relative
to other nations. Is the trade deficit an indicator of a long-term decline in our ability to effectively compete in world markets, or is it
a temporary imbalance, largely self-correcting through the ongoing
devaluation of the dollar relative to the yen and the D-mark. For
obvious reasons we need to know. If the problem is indeed longterm, then we. need to direct resources into formulating policies to
improve productivity and to secure fair international trade practices. If the problem is illusory or self-correcting, then we must
avoid overindulgence in governmental actions.

DISSENTING VIEWS OF HON. OLYMPIA J. SNOWE
As with last year's report, insufficient weight is given to the inadequacy of the trade laws of the United States, and to the problems created by unfair foreign trade practices. I largely disagree
throughout with the approach taken toward competitiveness and
trade in general.
One of the most significant problems American industries and
workers face is the utter lack of certainty with regard to our trade
laws; a lack of certainty as to an eventual granting of relief, and as
to the timetable involved in seeking relief. Many of the industries
in my own State of Maine-footwear, potatoes, fishing and
lumber-have pursued trade relief in the face of unfair foreign
trading practices, yet' have been met instead with a process that
promises much while delivering little.
That there is a need to have strong trade laws, and to utilize
those laws, is clear. The Republican Annual Report even cites one
of the facts which illustrates this. "Over the past five years," the
Report says, "most of our partners have relied on export sales to
the United States for between one quarter and one half of their domestic growth." I believe this statistic reflects to a large extent the
degree to which other nations have closed their market, through
tariffs and other trade barriers, to trade in a wide range of goods.
Trade in footwear, for example, has deteriorated to the point
where the United States is virtually the only open market in the
world. We import some 900 million pairs of shoes annually; Japan,
on the other hand, imports about one million pairs, and Brazil's
tariffs effectively block any significant amount of imports.
The footwear case is one illustration of the fact that the United
States is still attempting to be the economic engine pulling the
world economy along behind it. Forty years ago, we were the only
nation that could assume such a role; today, however, the United
States should not be required, through the unfair trading practices
of other nations, to maintain that role. Given the fact that we
absorb 55% of all exports from lesser developing countries, while
Japan absorbs only 9%, the need for reform of our trade laws
should be of the utmost urgency.
There are several avenues to pursue in reforming the trade laws
of the United States: curtailing Presidential discretion under Sections 201 and 301; providing a fasttrack procedure for perishable
agricultural goods; requiring mandatory retaliation for certain
egregious trade practices; and other options as well. The key to
these reforms is that our trading partners will understand that
there are certain trading practices which will simply not be tolerated by the United States, and that we will act swiftly and decisively
in the face of such practices.
Reforming our trade laws is an essential component of the move
toward greater competitiveness in the United States; relying on the
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208
decline in the value of the dollar to turn around our trade problems ignores the fundamental problems our trade laws have created.
Further, the Report does not give sufficient attention to the problems faced by workers facing dislocation due to unfair foreign imports. Programs such as Trade Adjustment Assistance and Title III
of the Job Training Partnership Act have been essential to workers
in my district seeking to overcome the devastation wrought by an
unchecked tide of imports. By tying worker personal benefits to
participation in retraining programs, and by providing adequate
funding for retraining programs, the Congress can ensure that
some glimmer of hope remains for workers facing an otherwise
grim trade picture.
Finally, the discussion in the Republican Report on the federal
budget falls short in several instances, one of which I will raise
briefly. The approach for reducing the deficit advocated herein suggests that further cuts in domestic spending are the best, and only,
areas in which to pursue deficit reduction. I would suggest that the
move to restrain spending in the domestic budget is no greater
than the need to restrain spending in our defense budget. Dollars
spent unwisely in the defense budget should be no more immune
from cuts than dollars spent unwisely on domestic programs.
OLYMPIA J. SNOWE.
0

U.S. GOVERNMENT PRINTING OFFICE: 1987-179-880/60528

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