Let's see. We have a slowing $10 trillion economy and the Bush administration is proposing tax cuts that will provide a modest boost to growth while raising the budget deficit by less than 1 percent of GDP over the next year. Meanwhile, critics are saying that the Bush proposal is too aggressive because, we are told, bigger deficits raise interest rates, and so we should scale back the stimulus. Actually, the tax cuts should be larger, not smaller, in view of the weakening economy.
Deficits Don't Raise Interest Rates
Larger budget deficits do not, by themselves, raise interest rates. Interest rate movements are determined by changes in growth (a proxy for the real return on assets) and changes in expected inflation. In fact, we had better be very careful what we wish for. We could have lower interest rates and larger budget deficits, in a full-blown recession where growth falls, pushing down revenues, real rates, and expected inflation. In case some nervous congressmen and senators need reminding, while the budget deficit has swung from a surplus of about 2 percent of GDP to a deficit of about 2 percent of GDP over the past several years, long-term interest rates have fallen by over a full percentage point because inflation has come down and growth has remained low.
Perhaps the closest historical analogy to where we stand now is 1981, when the new Reagan administration passed tax cuts equal to nearly 2 percent of GDP while simultaneously recommending higher military outlays in pursuit of enhanced national security. At the end of 1981, long-term interest rates were nearly 14 percent while the deficit was just 2.5 percent of GDP. Five years later, in 1986, after four years of sustained growth boosted by lower tax rates and falling inflation, although the budget deficit had risen above 6 percent of GDP in 1983 and held at 5.3 percent of GDP in 1986, long-term interest rates had fallen in half to 7.1 percent. That outcome is simple testimony to the fact that interest rates follow growth and inflation. In the first half of the 1980s, a huge 8-percentage-point drop in inflation from more than 12 percent to 4 percent allowed long-term interest rates to fall by about 6 percentage points to around 7 percent while higher growth boosted real interest rates. By 1986, 7 percent interest rates on ten-year notes reflected the sum of 3.5 percent growth (real returns) and about 3.5 percent expected inflation.
Not Out of the Woods
Little noticed amidst the usual New Year hype of a higher growth outlook coming from increasingly desperate equity sales forces, is the fact that the U.S. economy has slowed sharply since August and does not show much promise of picking up. All categories of demand growth have weakened, partly reflecting the ebbing of the fiscal stimulus derived from the 2001 Bush tax cuts and partly reflecting the growing realization by households that rising stock prices are no longer available automatically to increase accumulated savings. Some reduction in consumption spending will continue to be necessary to restore saving to normal levels. The use of consumer credit has fallen sharply since summer from an average monthly rise of about $6 billion to a fall of $2.2 billion in November. Consumers are sharply reducing their use of credit despite lower interest rates because they want to save more.
Consumption growth, the mainstay of GDP growth over the past two years, has slowed sharply. Annualized real consumer spending over the last six months has run at a rate of about 2.7 percent. Over the three months ending in November 2002, real consumer spending growth was nil.
The big reason for the slowdown in consumption is a sharp slowdown in real disposable income growth that, in turn, reflects an end to the contribution from lower personal tax liabilities to disposable income. During the year ending in November 2002, personal income and personal consumption both rose at about a 4.5 percent rate. However, real disposable income rose at a 6.1 percent annual rate, thanks to lower taxes. But during the last three months, the growth rate of real disposable income has dropped sharply to a 2.6 percent annual rate largely because the boost from tax cuts was ending. This sharp drop, coupled with efforts to rebuild savings, is what pushed real consumer spending down to a 0 percent growth rate during the three months ending in November. December spending does not look much better. The only contributor to spending strength during December was a surge in automobile sales prompted by aggressive additional incentives from U.S. auto companies attempting to regain market share from imports. Excluding autos, nominal retail sales were flat in December and down in real terms.
Despite persistent claims of an incipient rise in investment spending, no such increase is yet evident in the data. Nondefense capital goods shipments (excluding aircraft), the most widely used proxy for investment spending, fell at a 6.4 percent annual rate in the three months ending in November 2002. Investment spending was a modest drag on growth in the third quarter and very likely will be a slightly more substantial drag in the fourth quarter.
It is true that the worst of the slowdown in investment spending has probably ended, but in a normal recovery investment spending would by now be rising at a 10 percent annual rate. Companies have stopped cutting capital purchases, except through depreciation, but aggregate investment spending growth is still just below zero. This really is not very surprising since demand is still inadequate to produce sales growth that yields profits for most companies. In fact, profit growth for domestic industries slowed from a 5.5 percent annual rate during the second quarter to 0 percent in the third quarter. While year-over-year growth rates have looked more encouraging, this is due largely to a collapse in the growth of profits for the third quarter of 2001. Going forward, year-over-year comparisons will be more difficult. Technicalities aside, profits growth is weak because final demand growth, as indicated by 4 percent year-over-year nominal GDP growth, is still too low to generate profits for most companies. As a result, cost cutting has become the most prevalent method of sustaining profits growth.
For most firms, about two-thirds of costs are attributable to labor. The most recent employment data, covering the period through December 2002, suggest that firms may be starting to accelerate layoffs as a means to control costs. Private nonfarm payrolls fell by an average of more than 100,000 during the months of November and December 2002. Meanwhile, in the separate household survey used to calculate the unemployment rate, the number of unemployed grew at a 27 percent annual rate during the three months ending in December as the rate of unemployment rose from a 5.6 percent rate in September to a 6.0 percent rate in November and December.
If firms continue to cut payrolls, the slowdown in the growth rate of disposable income will accelerate and consumption will weaken further. Weaker consumption, in turn, will further discourage investment spending since lower spending growth will further reduce the prospects for profits growth.
The other sources of growth--government spending and net exports--may also weaken going forward, even with the tax cuts being proposed by the Bush administration. In the period ending in the third quarter of 2002, year-over-year growth was 3.3 percent in real terms with almost 1 percentage point of that growth coming from the government sector. In the coming year, state and local governments will probably subtract about $50 billion from spending growth as rising budget deficits and balanced budget requirements at the state and local level require sharp cutbacks. Even with the proposed tax cuts and increased spending from the federal government for military outlays and additional assistance to state and local governments, the swing in the federal budget into deficit worth another 1.5 percent of GDP will, once again, contribute just about 1 percentage point to growth in the coming year because of the drag from tighter state and local government budgets.
Net exports contribute nothing to growth unless the U.S. external deficit falls. That requires either fewer imports or more exports. A rise in exports is not very likely in view of the weakening condition of the Japanese, European, and Latin American economies as we move into 2003. In fact, a weaker U.S. dollar will initially raise the current account deficit because prices adjust faster than quantities and the price of imports will be pushed up by a weaker dollar. Imports jumped so sharply in November that analysts cut their fourth-quarter growth forecast by more than 0.5 percent. Beyond that, more expensive oil imports, pushed up by a higher global price of oil, will produce an additional drag on the U.S. economy. In fact, the rise in oil prices that has already occurred over the past several months is the equivalent of an additional tax of $40 to 50 billion on U.S. consumers.
More Tax Cuts Needed
On the whole, the additional fiscal stimulus in 2003 of about $150 billion, including about $100 billion worth from the proposed Bush tax cuts, is just sufficient to overcome three exogenous drags on U.S. growth. The three drags, each at about $50 billion, are increased stringency of state and local government budgets, higher oil prices, and an end to the surge of refinancings that has been so supportive of disposable income over the past year. Another $100 billion of payroll tax cuts to encourage hiring and boost demand would help to insure higher growth.
The additional fiscal stimulus of about $100 billion that could come from prompt enactment of the Bush administration's proposed tax cuts is a bare minimum. It needs to be passed quickly and probably enlarged--not reduced--to boost growth toward its sustainable noninflationary level of 3.5 to 4.0 percent. That is the outcome needed to produce sustainable profits growth and higher stock prices.
A year from now, the tax cut proposals of about $100 billion for 2003 that the president has recommended be made effective January 1, 2003, could be seen as too little too late, especially if Congress delays passage or fails to make tax cuts retroactive. Political opposition to the measures could delay their passage until summer of this year and unwarranted fears that they may cause higher interest rates could cause the size of the tax cuts to be pared back. This would be a serious mistake. No evidence from previous episodes when tax cuts have been used to stimulate the economy suggests that the path of interest rates that follows results from anything but changes in real growth and inflation rates. As already explained, in the 1980s interest rates fell while budget deficits rose because inflation fell sharply. If growth had slowed, interest rates would have fallen further, but that would have been an undesirable outcome. The Bush measures to push down marginal tax rates while ending the double taxation of dividends will boost growth potential and reduce inflation pressure as the economy picks up. The result--higher real rates and lower expected inflation--will leave interest rates unchanged.
It is not surprising to find that tax cuts that result in the short run in deficit increases equal to 1 or 2 percent of GDP have no discernable impact on interest rates. U.S. bond markets are huge. The sum of government, corporate, municipal, and money market debt instruments is more than $18 trillion, and this is only the U.S. portion of a massive global market for government and corporate securities. The notion that federal tax cuts that add $100-$200 billion, or between 0.5 percent and 1 percent to this huge stock of debt, will push up interest rates is truly far-fetched. The idea that government budget deficits cause higher interest rates is derived from past experience when higher budget deficits forced central banks to print more money and push up inflation.
The dramatic fall in interest rates in Japan is instructive. There, budget deficits have been running above 8 percent of GDP for several years while the debt-to-GDP ratio has risen over 150 percent. (The U.S. debt-to-GDP ratio is currently about 30 percent.) Japanese interest rates have simultaneously fallen to 0.9 percent on ten-year government notes, testimony to the fact that inflation and real growth are what determine interest rates. Japan's average growth rate has been negative over the past several years while prices have actually been falling. Therefore, short-term interest rates are virtually zero, as low as they can go, while long-term interest rates at below 1 percent are reflecting a risk premium demanded by investors who fear the ultimate inability of the Japanese government to service its massive and rising debt. The corollary to the sad story of Japan is that its government and residents should, indeed, be hoping for higher interest rates, not because of smaller budget deficits but because of higher growth and stable prices. Japan's sad journey to fiscal profligacy was driven by wasteful spending on public works projects with little economic return. Beware of proposals from U.S. state and local governments for more public works spending.
Hope for Higher Interest Rates
The proposal by the Bush administration to have the federal government borrow an additional $100 billion to invest in lower tax rates and a better functioning economy is a move in the right direction. Given the still weakened state of the economy and the limited additional options available to monetary policy, we shall need more tax cutting, not less. Meanwhile, we had better hope that the tax cuts are followed by higher interest rates, which would not reflect rising budget deficits, but instead higher growth and stable prices.
John H. Makin is a resident scholar at AEI.