The U.S. economy always seems to surprise forecasters in the fourth quarter. For the past several years the economy has finished the year with unexpected strength. While forecasters are still predicting steadily accelerating growth during the second half of this year with the fourth quarter being the strongest, the fourth quarter might actually be the weakest.
The scenario of weakening growth is not confined to the United States. Europe's primary engine of growth, Germany, is slowing under the weight of weakening domestic demand growth and mediocre export growth. The French economy is being steadily asphyxiated by the high real interest rates necessary to maintain the strength of the French franc against the deutsche mark. The British economy has run out of the capacity to continue its export-led growth while domestic demand continues to be held in check by the realization of many British homeowners that their homes are worth less than they paid for them.
The Japanese economy, while perhaps rescued from a dangerous self-reinforcing deflation, has drifted onto a plateau of complacency, thanks to a weakening of the yen, a fifth fiscal stimulus package, and an ever-present underlying desire on the part of policy makers to assume that everything will be all right.
Underlying reasons for the emerging global economic slowdown are clear. The central banks continue to be enchanted by the steady fall of inflation rates, notwithstanding the Bank of Japan's recent realization that accelerating deflation is too much of a good thing. In the United States, inflation is still falling faster than the short-term interest rates controlled by the Federal Reserve.
Despite a quarter of a percentage point reduction of the federal funds rate in July to 5.75 percent, this rate adjusted for inflation is actually a quarter of a percentage point higher than at the beginning of the summer. This might not be too much reason for concern except that the inflation-adjusted federal funds rate at 3.25 percent is a full percentage point above its average level during economic expansions and 1.5 percentage points above, or approximately double, its average level over the past thirty years.
The Federal Reserve's disinflationary bent has not gone unnoticed. The U.S. yield curve has flattened, with long-term interest rates having fallen by almost two full percentage points since the beginning of the year while yields on two-year notes have dropped below the federal funds rate. Financial markets are impressed by the Fed's slowness to cut interest rates in the face of falling inflation to a point where investors are willing to accept lower yields on two-year notes than the 5.75 percent yield on overnight loans. That rate configuration makes sense only if investors expect that the federal funds rate will be cut while inflation will remain at the current level of about 2.5 percent for at least two years thereafter.
Tackling the U.S. Budget Deficit
Some analysts have attributed the drop in U.S. interest rates to the prospect of eliminating the federal budget deficit over the next seven or eight years. While some relief is in order from the efforts by the Republican Congress to eliminate the budget deficit by the year 2002, that prospect is a far less tangible reason to vote for lower interest rates than the actual slowdown in inflation and in the economy that has appeared during 1995.
It is useful to view the U.S. deficit reduction exercise in a broad perspective. At 2.2 percent of the gross domestic product, the U.S. budget deficit is already the lowest among the G-7 industrial countries by a wide margin. The 2.2 percentage points of GDP reduction of the deficit proposed over seven years is modest by standards of recent U.S. budget history. Between 1986, when the deficit was 5.2 percent of GDP, and 1989, when it was 2.9 percent of GDP, the deficit fell by 2.3 percentage points of GDP. Since its last peak at 4.9 percent of GDP in 1992, the deficit has come down by 2.7 percentage points of GDP in just three years, or more than twice as rapidly as the proposed reduction of the budget deficit by 2.2 percentage points of GDP over the next seven years.
Lowering the budget deficit by about two percentage points of GDP is tame stuff by the standards of some European countries that are scrambling to meet the criteria for joining Europe's monetary union. The Swedish government has promised to reduce its huge budget deficit by 7.5 percentage points of GDP over the next three years while the French government, without much credibility to date, has promised to reduce its budget deficit by about 2 percent of GDP over that period. Against the backdrop of slowing economies both in Europe and globally, these promises suggest a kind of bold, masochistic abandon regarding the virtues of fiscal stringency not seen since the pre-Keynesian 1930s.
The best aspect of the U.S. effort to cut its budget deficit is not that the deficit will probably be within $50 billion of zero after the turn of the century. Rather, the impressive feature is this year's adjustment of the nearly 60 percent of federal outlays that had previously remained untouched in the deficit reduction exercise--entitlements including social security, Medicare, and Medicaid are being adjusted. The proposed action would diminish the growth rate of outlays on federal health insurance programs to a level that, while still above the growth rate of outlays in private sector insurance programs, would avoid pushing the budget deficit back up over 4 percent of GDP by the late 1990s.
Reductions in the growth of outlays on Medicare and Medicaid from close to 10 percent annually to 5-6 percent annually--with even less reduction in real terms in view of rapidly decelerating inflation in the health care area--would produce such large savings that Congress could include a $245 billion tax reduction, composed primarily of a $500 per household tax credit, in its package of deficit reduction.
Should the negotiations on slowing the growth of outlays on government health programs become too contentious, a new degree of freedom has been identified with respect to adjusting the growth of outlays on social security. Currently social security outlays are increased each year by the full amount of inflation. It has now become politically feasible to put forward the long-known idea that the consumer price index overstates the increase in costs faced by households, especially by retirees.
Congress may reduce the annual inflation indexing of social security benefits to a level equal to the consumer price index less, say, 1 percent; such a move would leave most retirees fully protected against inflation while substantially reducing federal outlays. Use of this formula (CPI minus 1 percent) would save the federal government about $685 billion over the next decade and would leave federal outlays $100 billion lower than otherwise by the year 2005.
The major conclusion from a careful examination of the federal budget is that modest reductions in the growth of outlays on the nearly 60 percent of total outlays for entitlements can easily reduce the budget deficit to zero. Were it not for congressional sugarcoating of the deficit reduction in the form of a $500 tax credit for households and other goodies, the budget deficit could easily be eliminated by the turn of the century simply by a modest reduction in the growth of outlays on entitlements.
While some observers will credit the deficit reduction package for the falling U.S. interest rates, the real reason lies with the modest demand growth engineered by the Federal Reserve together with the surge in capital spending that has made the U.S. economic recovery dating from the spring of 1991 into a supply-side recovery.
While dramatic in terms of the elimination of the budget deficit at some point in the foreseeable future, the U.S. deficit reduction effort is actually quite gradual. But, as a corollary, the fiscal drag from this process will be modest indeed. For the 1996 fiscal year, which began October 1, the fiscal drag from the drive to eliminate the budget deficit by 2002 will be about $20 billion, or less than one-third of 1 percent of GDP.
The possibility that U.S. economic growth during the fourth quarter may be 1 percent instead of the expected 3 percent should not be allowed to derail the deficit reduction effort. In fact, as weaker economic numbers appear, the tactical advantage could dangerously shift to the White House, which desires less deficit reduction and, more significant, less cutting of outlays on federal health care programs. Republican leaders in Congress would be advised to press for resolution of the budget issue by mid-November rather than delaying and thereby shifting the tactical advantage to the White House, which could point to a slowing economy as reason to blunt the deficit reduction drive.
In view of the unusually high level of the federal funds rate controlled by the Federal Reserve, the Fed could quietly offer Congress a reduction of at least one-half percentage point in interest rates on completion of the deficit reduction exercise.
A Federal Default?
A great favorite of journalists covering the battle over the federal budget deficit this year is the prospect of a train wreck--the government is shut down while Congress and the White House wrangle over the details of deficit reduction. The occasion for the train wreck will be the debt ceiling, which defines the maximum level of federal debt outstanding and therefore must be periodically raised to accommodate additional federal borrowing, which currently runs at a level of about $150 billion per year.
The debt ceiling will probably be reached by mid-November; at that time the federal government could theoretically have no funds available to cover its expenses, including interest on the federal debt. The more radical members of Congress along with some prominent players in the financial markets have suggested that temporary default on federal debt interest payments is a price that should be paid if it leads to elimination of the federal budget deficit.
Excluding the trivial impact on financial markets of eliminating the industrial world's smallest budget deficit over a period of seven years, default on the federal government's interest payments on its debt is not necessary and is certainly not advisable. In numerous train wrecks of past wrangling over the budget deficit, the Treasury has devised ample means to continue to service its debt. Specifically, the federal government's trust funds now hold about $1.25 trillion. It is a simple matter, for which there is ample precedent, to borrow from some of the trust funds to service federal debts while Congress and the White House wrangle over the details of their modest deficit reduction program.
To their credit, responsible leaders in Congress and Treasury Secretary Rubin have voiced assurances that the federal debt will be serviced without interruption. The need to do this is almost a nonissue, since the charters of many investors including huge pension funds and mutual funds would prohibit their holding any assets on which there had been a default.
Fortunately the train wreck of the debt default issue has already been amply played out in the press. It will not be a shock to financial markets when, in the heat of the battle of deficit reduction during November, some well-intentioned freshman House Republican suggests that defaulting on the debt and burning down the White House are small prices to pay for elimination of the federal deficit.
Slowing U.S. Growth
It is probably well to be fortified with an understanding for the reasons behind a likely slowdown of the U.S. economy in coming months. Analysts who predict an economic pickup during the fourth quarter of the year are relying on the observation that over the past two quarters the growth of final sales has exceeded the growth of output and thus inventories have been reduced. The reduction in inventories, it is reasonable to suppose, will prompt an increase in production to restore inventories to their original level.
This sequence is normally true. The scenario, however, excludes the possibility that the reduction in inventories over the past two quarters is actually desired and therefore will leave inven-tories at levels that do not require any increase in production. The unusually high level of short-term interest rates and falling inflation are both factors that increase the cost of carrying inventories.
Analysts are used to looking at inventories in the context of the inflationary 1970s and 1980s, when inventory levels were not carefully monitored because, as inventories built up for several quarters, steadily rising prices increased their value and thereby reduced the cost of carrying them. In the disinflationary 1990s, however, the cost of carrying inventories is higher, since they typically must be financed at short-term interest rates, and with inflation falling, they may actually be a losing proposition for producers.
For goods produced during the first half of the year, when commodity prices were firmer, producers must have anticipated being able to pass on the higher cost of producing the goods to consumers. Over the summer, however, retailers have experienced difficulty in this pass-through and have had to reduce prices to maintain sales volume. Even with these efforts, inventory-to-sales ratios for wholesalers and retailers during the summer were significantly above average levels for 1994.
Therefore the disinflationary environment together with relatively high short-term interest rates has produced an incentive to keep inven-tories low or even to pare them further. The result will probably be relatively weak production schedules during the fourth quarter and modest growth at an annual rate of 1-2 percent.
The slowdown in U.S. growth toward the end of 1995 will be accentuated by weakness in the global economy. The worst in the collapse of exports to Mexico and Latin America is behind us. But little recovery seems to be in prospect in view of the sharp reduction in growth in the Latin American countries required to move them into a current account surplus and thereby to create the expectation that they will be able to service their considerable foreign debts. Meanwhile, the economies of Canada, Japan, and Europe, also major customers of U.S. exporters, are all weak or slowing. Falling U.S. exports will continue to be a modest drag on U.S. growth.
A U.S. Revival Possible
In a look ahead to 1996, U.S. growth is likely to revive, provided that capital spending reaccelerates. Strong double-digit growth of capital spending has been the primary force behind the four and a half years of disinflationary U.S. supply-side recovery. Investment-led recoveries eventually end because the substitution of capital for labor reduces the return on new investment. Many large American companies have maintained profits by cost-cutting efforts through high levels of capital investment with parallel reductions in their labor forces. While the productivity of the remaining labor force goes up, constant downsizing and layoffs, while moderating wage increases, eventually take their toll on consumer confidence.
The tepid level of confidence among U.S. consumers is reflected in a slowing growth of retail sales and in falling inflation pressures. For the three months ending in September, the annual growth rate of retail sales was just 1.5 percent, down sharply from the 7.5 percent growth rate during 1994.
The corollary to this slowdown in consumer spending is a moderation of consumer price inflation. During the three months ending in September, the annual consumer price inflation rate was 1.6 percent, down from a 2.7 percent inflation rate during 1994. Goods inflation was only 0.6 percent at an annual rate during the three months ending in September. Even price inflation for services decelerated to a 2.6 percent annual rate during the three months ending in September, down from a 3.4 percent inflation rate over the previous twelve months.
While the disinflationary trend is heartening in the light of the Federal Reserve's effort to slow inflation over the past fifteen years, the accompaniment of weakening demand growth suggests that maintaining profits by controlling costs and by substituting capital for labor may be reaching its limits. Still, the Federal Reserve, having maintained short-term interest rates at relatively high levels especially in view of the disinflationary trends, has the means to prolong the recovery through an ability to cut interest rates without risking higher inflation.
The most likely scenario for 1996 would see an interest rate cut by the Federal Reserve of about half a percentage point some time between Thanksgiving and Christmas and a revival in demand growth sufficient to maintain investment spending into 1996. Under this scenario, the 1-2 percent growth rate during the fourth quarter of 1995 would probably recover to a healthier 2.5 percent growth rate early in 1996. That, in turn, would encourage maintenance of capital spending and a continuation of the U.S. economic recovery.
The major threat to the U.S. economic recovery probably lies abroad in Japan, Europe, and Latin America. In Japan, a fragile financial system could still collapse and transmit a major deflationary impact to the world economy. A slowing Europe, together with efforts to reduce budget deficits, could derail European economic growth. A slowing U.S. economy and high U.S. short-term real interest rates could also prove to be a lethal combination for the struggling economies of Latin America.
The major antidote to these problems is, as always, prompt recognition that they exist and modification of policies in a way that helps to encourage continued demand growth. The inflationary excesses of the 1970s and the long struggle of the 1980s to eliminate them understandably have left central banks loath to stop fighting inflation. But the slowing global economy and the preponderant disinflationary and deflationary trends of the mid-1990s are signs that monetary policy should shift from tight to neutral. Otherwise we risk the need, already present in Japan, for a potentially destabilizing shift from tight to very easy monetary policy.
John H. Makin is a resident scholar at the American Enterprise Institute.