n 1981 Ronald Reagan took the helm of a nation whose economy was reeling, with
inflation in double digits, the prime rate hurtling past 20 percent, and the
national spirit sagging into bewilderment. Today other countries gaze enviously
over an American economic landscape that shows little track of past convulsions
and, indeed, seems to burst with new businesses, new jobs, new Dow Jones
records, and a newfound confidence.
Yet, six years after the radical reforms of Reaganomics got under way,
Americans are about to wake up to reality: for some time now the foundations of
their economic future have been insidiously weakening. This awakening is
currently being delayed by the widespread preoccupation with "competitiveness."
Under the prodding of a trade balance in manufactured goods that collapsed from
a $17 billion surplus in 1980 to a $139 billion deficit in 1986, including the
first deficit ever in high-technology goods, and with additional shoves from a
shaky dollar, from nervous financial markets, and from stagnating real wages,
the so-called competitiveness problem is quickly climbing to the top of
America's political agenda.
What does competitiveness mean? In many American households today it means
worry about future living standards and about whether one's children, ten to
fifteen years into their careers, will be able to out-earn their parents. In
corporate boardrooms competitiveness means the executive nightmare of seeing
Americans gorge themselves on goods from foreign firms.
For many blue-collar workers competitiveness has an even crueler meaning:
layoffs and the understandable desire to get even with the anonymous forces
behind them. Over the past three years America's import deluge has resulted in
pink slips for one to two million domestic manufacturing workers each year .
More than a third of them remain indefinitely out of work; more than half the
rest have taken pay cuts of 30 to 50 percent in new jobs that cannot make use
of their experience. Economists are looking closely at this dislocation for
signs of structural disintegration in U.S. communities, and of the decay of
skills and habits that once made manufacturing an engine of U.S. comparative
advantage in world trade.
In Washington competitiveness seems to mean both nothing and everything. Some
senators advocated a speed limit of sixty-five miles an hour on rural highways
as a "competitiveness" measure. House members are justifying yesteryear's jobs
bills by renaming them "competitive adjustment programs." And lobbyists are
arguing for stricter world cartels on everything from shoes to semiconductors
on the grounds that such agreements will improve our "competitiveness." After
announcing in its 1987 Economic Report of the President that recent U.S.
performance in manufacturing has vindicated our competitiveness, the White
House has refused to be upstaged on the issue, even going so far as to claim
that the Strategic Defense Initiative is "pro-competitive."
Democrats are demanding that the Administration get back America's "rightful
share" of jobs and wages through protectionist measures. If imports are cut
back, they say, the jobs and income generated by producing for American
consumers will be miraculously transferred from foreign to U.S. firms. Get
tough on the other guys and our situation will improve--that seems to be the
general idea. What all public statements on "getting back" our competitiveness
neglect to mention is that Americans will have to give up something to get it
back. Over the next few years policymakers will wake up to the true cause of
our "competitiveness" predicament: the incalculable damage we have inflicted on
our economy in recent years.
An x-ray of the damage would show its antecedents stretching far back in the
past, across several Administrations. Our national preference for consumption
over investment--the root malady--did not begin with the Reagan Administration.
Still, that set of policies loosely known as Reaganomics has certainly worsened
the damage. In the finest tradition of Euripidean irony, measures meant to save
us have worked in the end to afflict us, so much so that even our nation's
non-economic hopes--cultural, social, and strategic--have been clouded by our
disastrous fiscal mismanagement. It has been a hard lesson in the law of
unintended results.
Intent: From a decade of feeble productivity growth (0.6 percent yearly in the
1970s) and early signs of rising poverty rates, we entered the 1980s flush with
expectations of "supply-side" prosperity. Result: We have ended up with still
feebler productivity growth (0.4 percent yearly from 1979-1986) and, despite a
debt-financed rise in personal income, with an upward leap in every measure of
overall poverty. More important, we have witnessed a widening split between the
elderly, among whom poverty is still declining, and children and young
families, among whom poverty rates have exploded--a development with dire
implications for our future productivity.
Intent: After a decade of worry about our low level of net private domestic
investment (6.9 percent of GNP from 1970 to 1979) and an unsustainable real
decline in the construction of public infrastructure, we wanted the 1980s to be
a farsighted decade of thrift, healthy balance sheets, and accelerating capital
formation. Result: We have ended up with by far the weakest net investment
effort in our postwar history (averaging 4.7 percent of GNP from 1980 to 1986)
and have acquiesced in the crumbling of our infrastructure. Moreover, far from
renewing our saving habits or our balance sheets, or bolstering the "supply
side" of our economy, the 1980s have turned out to be the most
consumption-based "demand-side" decade experienced by any major industrial
country during the postwar era.
Intent: in 1980 American voters decisively endorsed a smaller and leaner
federal government, with special exceptions for defense spending and for
poverty-related "safety-net" benefits. Result: We ended up with a significantly
higher level of federal spending in 1986 (23.8 percent of GNP) than we had in
1979 (20.5 percent of GNP) --with most of the growth concentrated in precisely
what needed to be controlled: interest costs and entitlement benefits unrelated
to poverty (or, to put it bluntly, welfare for the middle class and up).
Federal interest payments on the national debt, $136 billion in 1986, are now
equivalent to the total taxpayer savings originally projected from the 1981
income-tax cut. As for federal benefits doled out regardless of financial need,
these have grown from about $200 billion in 1979 to $400 billion in 1986. They
totaled $46 billion in 1968.
Intent: Entering the 1980s, we acknowledged that it was bad policy to allow
federal outlays to exceed federal revenues (with deficits averaging 1.7 percent
of GNP from 1970 to 1979). We promised ourselves to do better. Result: We made
the gap between spending and taxes wide beyond precedent (with deficits
averaging 4.1 percent of GNP from 1980 to 1986, and rising to 4.9 percent of
GNP, or 90 percent of all private-sector net savings, in 1986). Our publicly
held federal debt is nearly three times larger now than it was in 1980. The
projected deficit numbers have improved somewhat, but the much heralded future
declines are premised on very rosy assumptions--no recession, for example, and
an interest rate of 4.0 percent.
Intent: Americans voted in 1980 for leadership that emphasized greater global
competitiveness and freer world markets as the most advantageous means of
achieving balanced economic growth. Result: America's steep decline in savings
during the 1980s has precisely reversed our intentions. We were promised a $65
billion trade surplus by 1984; instead we suffered a $123 billion trade
deficit. Today, despite four years of extraordinary luck on the energy front,
we have managed to twist the global economy into the most lopsided imbalance
between saving (foreign) and spending (American) ever witnessed in the
industrialize era. In the process--as we all know--we have transformed
ourselves from the world's largest creditor into the world's largest debtor. In
reaction to this shift the rest was inevitable: a more than tripling (from
about five percent to 18 percent) in the share of U.S. imports subject to
quotas, a colossal about-face in public opinion away from free trade, and the
appearance of the most blatantly protectionist bills before Congress since the
days of Senator Reed Smoot and Congressman Willis C. Hawley--despite the
President's free-trade convictions.
Intent. America came into the 1980s longing to strengthen its military defenses
and to project its power abroad more effectively. Result. We now find that
budget deficits and an evaporation of the public's pro-defense consensus are
drawing an ever tighter circle around all our strategic options. Not only must
we now replay the wasteful 1970s by cutting short production runs on dozens of
weapons systems, but once again we are about to demonstrate to the rest of the
world that America is incapable of sustainable long-term defense planning.
Intent: More than just a defense build-up, Americans wanted a more assertive,
unilateral foreign policy, a way to make ourselves stand tall again in our
leadership of the free world. Result: Our fast-growing debt to the other
industrial countries has diverted our diplomatic energy into placating foreign
central banks with exchange-rate agreements (already by May of this year the
interventions to support the dollar amounted to a staggering $70 billion) into
jawboning foreign governments to get their people to buy more of our exports,
and into pawning off our Third World financial leadership onto more solvent
economies. When action requires money, we now scrape our "discretionary" budget
to procure the most meager support. We spend virtually nothing to try to avert
the growing risk of social, economic, and political chaos right at our doorstep
in Mexico. An additional $50 million was nearly considered too much to send to
the Philippines after the 1986 democratic election of Cory Aquino. Even the
Administration now publicly declares that our "foreign-affairs funding crisis"
could mean "the end of U.S. global leadership. Eight years ago no one imagined
an austerity-led shift toward U.S. isolationism. Now we're seeing it: an
attempt to stand tall on bended knees.
Intent: Going into the 1980s, America's deepest wish was that renewed economic
strength might foster a renewed cultural and ideological strength and an ethic
of saving, hard work, and productivity. We wanted to replace malaise with a
confident sense of forward motion. Result: As the ideological enthusiasm of
1981 has gradually been worn down by economic reality, this wish, too, has
foundered, leaving many of our political leaders as defensive and uncertain as
those of a decade ago--and almost relieved to have us fixated on public and
private scandals.
While many in the Administration believe or act as if there is no problem--and
hence no need for a solution--others want to avoid all association with the
dreaded next act of the economy. The Democrats' fears show up in a darkly
humorous story told by Democratic leaders: On January 20, 1989, after the
inauguration, President Reagan flies off to Santa Barbara. While he is in the
air, the stock and bond markets crash, the dollar plunges, and interest rates
soar. When Reagan lands in Santa Barbara, he announces to a swarm of reporters,
"See, I told you the Democrats would screw up the economy!"
For the time being, the competitiveness issue remains a sort of curtain that
Americans have hung between Reaganomics and the future. Neither political party
dares to disturb it, for it allows every policy leader to keep our attention
fixed on the trivial. For example, we are told to get furious about the trade
effects of Japanese "dumping" of semiconductors or enthusiastic about the
federal sale of loan assets as a way to plug the budget deficit, even though
every expert denies that such things make much difference one way or the
other.
The truth is that the most astonishing success of Reaganomics has been the myth
of our own invincibility. This myth rests upon an enduring, bipartisan
principle of American political life which in the 1980s has become gospel:
never admit the possibility of unpleasantness--especially when it appears
inevitable.
If you allow for unpleasantness, the mechanics of our trade deficit cease to be
confusing. America runs a deficit because it buys more than it produces. By
systematically discouraging measures that would boost its anemic net savings
rate, the United States has acquired a structural deficit economy, meaning that
at no stage of the business cycle can we generate the amount of savings
necessary for minimally adequate investment. In 1986, in fact, nearly two
thirds of our net investment in housing and in business plant and equipment
would not have occurred without dollars saved by foreigners. (This level of
investment was, to be sure, very low by historical standards, but without the
capital inflows that accompanied our trade deficit in 1986 it would have been
at the rock-bottom level of a severe recession year--lower, in fact, than
during the recession years of 1980, 1975, 1970, and 1958.)
Washington debate over trade policy invariably neglects this elementary fact
about our balance of payments: dollars that flow abroad to buy imports always
flow back. (Since foreigners don't use dollars, they spend them as soon as they
get them.) The only question is how our dollars flow back--to buy our goods and
services or to buy our IOUs. During the 1980s we have decided that our biggest
"export" should be IOUs. In 1986 we sold to foreigners, net, a total of $143
billion in U.S. financial assets. Most of this consisted of stocks, bonds,
T-bills, repos, bank balances, and other assorted paper, but a steeply
increasing proportion of it was in real estate and other direct investment.
This financial surplus was the flip side of our trade deficit, and if we had
invested more at home, our surplus (in selling IOUs) and deficit (in selling
trade goods) would have been even greater. As long as we cannot function
without dollars saved abroad, exchange rates will fluctuate and interest rates
will go up until we can attract those dollars back as loans. America must learn
the basic distinction between capital flows for investment, which produce
future return, and capital flows for consumption-related debt (for example,
inflows to fund the budget deficit), which simply produce future debt
service.
Correcting the current imbalance assumes that America can embark on an enormous
shift from consumption to savings, and that this shift will not throw the
world's economy into a tailspin, either by trade-led recessions in the other
industrialized countries or by a chain of debt defaults among the
less-developed countries (against whom we will be competing for trade
surpluses). The alternative to this daunting scenario, of course, is the crash:
a huge plunge in the dollar, unaffordable imports, a long recession, garrison
protectionism, rampant inflation, and a marked decline in American living
standards. The crash alternative prescribes that we pay off our debts through
indefinite poverty. Can we avoid the crash? Yes, but doing so will require
Americans to produce more while consuming less, and very close macroeconomic
coordination among nations.
A European critic is reported to have said this about the link between
America's fiscal and international deficits: "Your policies in the 1980s remind
me of Christopher Columbus's travels. Like you, he didn't know where he was
going. He didn't know where he was when he got there. And he didn't know where
he'd been when he got back. All he knew for sure was that the whole trip had
been financed with foreign money." Or, as Fred Bergsten, the director of the
Institute for International Economics, recently quipped, "We finally understand
the true meaning of supply-side economics: foreigners supply most of the goods
and all of the money."
How America has reached the end of an avenue with no pleasant exit is too long
a story to be told here. But it is worth mentioning the key contribution made
by two sweeping institutional developments that have taken place since the
beginning of the 1970s. Both are what might be called changes in the rules of
the game, rules that used to protect us from our own folly.
The first change has been in how we legislate federal budgets. Until fifteen
years ago most federal spending was discretionary and unindexed, and federal
tax policy still functioned under the very strong presumption that federal
dollars spent should be paid for out of revenue. Large deficits, therefore,
were difficult to achieve, because so many easy corrective options were
available, both in spending and in taxing. The spending rule was eliminated in
the early 1970s by our decision to transform most non-poverty benefit programs
into untouchable and inflation-proof entitlements. The taxing rule was
eliminated in the early 1980s by the jihad prayers of supply-side economists.
Our deficit has thus become no one's responsibility. It is subject to
"projection" but no longer to control.
The second big change has been the transformation of the world financial
system. Back in the early 1970s we all accepted the basic postulates of the
postwar Bretton Woods arrangements: fixed exchange rates and relatively little
mobility of capital between nations. But the problem with fixed exchange rates
was that they led to inconvenient balance-of-payment crises and didn't allow us
the freedom to determine our own macro-economic fate.
So we closed the gold window in 1971 and shook ourselves loose from fixed
parities by 1973. By the late 1970s and early 1980s, as the dollar sloshed up
and down in ever larger waves, the world financial community accommodated our
proud creation the "float," and greatly liberalized the flow of capital across
borders. The inevitable result has been to give every nation--especially the
United States, as the owner of the world's reserve currency--much greater
latitude to borrow as it pleases, with few restrictions other than the specter
of national bankruptcy in the mind of the creditor. Fifteen years ago if the
United States had begun to borrow the equivalent of 3.5 percent of its GNP from
abroad, that would have created a national emergency, with Churchillian
presidential addresses and wartime austerity measures. Today it creates--well,
nothing, really. It's a number you can read about toward the end of the
business section of your newspaper.
Most of these rule changes, with the exception of the new revenue-ignorant tax
policy, took place before Ronald Reagan assumed office. Countless commentators
have decided that Reaganomics represents a total reversal in inherited economic
policy. But not so many years from now historians may simply be calling it an
acceleration of inherited policy.
For staying the course while double-digit inflation was tamed--the only Reagan,
or Reagan-Volcker, measure that seriously tested our threshold of
pain--President Reagan deserves credit, as he does for courageously taking on
the air-traffic controllers (which helped moderate the wage binge of the
1970s). He deserves credit as well for helping renew the popularity of markets
and of entrepreneurial risk, here and abroad, and for persuading us to abandon
the worst vices of regulation in such industries as airlines, banking, and
energy. And he was surely correct in advocating cuts in marginal tax rates. We
now know, for instance, that a maximum tax rate of 50 percent actually
generates more revenue from the wealthy than a maximum tax rate of 70 percent,
and provides real incentives for budding entrepreneurs. And for now, at least,
Reagan has swept off the agenda such policies as national planning,
wage-and-price controls, and wide-scale jobs programs.
We need, though, to be honest: as far as the basic allocation of our economy's
resources is concerned, Reaganomics has either opted for or acquiesced in some
of the worst, future-averting choices America has ever made, the full
implications of which will not be known for years.
Vicious-Circle Economics
To begin to grasp what Reaganomics has wrought, go back to the presidential
campaign of 1980. It was the evening of October 28, and the eyes of many
American voters were fixed on the television debate between Ronald Reagan and
Jimmy Carter. Facing the camera squarely Reagan posed his famous question: "Are
you better off than you were four years ago?" The next day newspaper polls
began to report a surge of support for Reagan, which led to a Reagan landslide
one week later.
Now, imagine that Reagan had immediately followed up his question with this
guarantee: "I promise to make you feel better. While real personal consumption
per fully employed American hardly budged during the Carter presidency, I will
make it rise by about $300 per worker every year over the next six years. I'm
also going to kick in another $140 per worker per year that we in government
will be spending mainly to repair the fall in our defense budget during the
seventies.
"How will I do it? Well, let me tell you. I will not do it by increasing the
quantity of real goods and services produced per working American to any
appreciable degree. Instead, I will do it by diverting to consumption, between
last year and 1986, about three quarters of the resources per worker now
devoted to savings. Half of the money will be obtained by simply cutting
domestic investment, and to do this we will run enormous federal deficits--so
big that the federal debt the public has bought since the time of the Founding
Fathers, about $645 billion at the end of 1979, will have nearly tripled by the
end of 1986. The other half will come from borrowing abroad. By 1986, in fact,
our foreign borrowing alone will fund all of our net housing investment and a
good 40 percent of our declining level of net business investment--freeing up
by that year a fantastic $2,100 of extra personal consumption per employed
American. From the end of last year to the end of 1986 our national per-worker
balance with foreigners will fall from a credit of $989 to a debt of $2,500;
and our federal per-worker balance with creditors, wherever they are, will
plunge from a debt of $6,750 to a debt of $16,562. I'll bet you're feeling
better already. Thank you and good night."
This speech might not have won the presidency for Reagan. But it would have
forecast precisely the performance of the economy during the candidate's
subsequent term of office.
Reagan was right in the debate with Carter: the 1970s were tough by comparison
with the 1960s. He was also right in observing that lower productivity growth
and higher federal-benefit growth during the 1970s "squeezed out" defense
spending in favor of privately earned spending on consumption. What looks quite
significant in retrospect, however, is that at least the squeezing did take
place. Few Americans watching the debate in 1980 ever imagined that over the
coming decade we would just decide to ignore the law that limits consumption to
production.
This is, quite simply, the dirty little secret of Reaganomics: behind the
pleasurable observation that real U.S. consumption per worker has risen by
$3,100 over the current decade lies the unpleasant reality that only $950 of
this extra annual consumption has been paid for by growth in what each of us
produces; the other $2,150 has been funded by cuts in domestic investment and
by a widening river of foreign debt. From 1979 to 1986 the total annual
increase in workers' production amounted to about $100 billion (in 1986
dollars). The comparable total for increases in personal consumption plus
government purchases was about $300 billion. That leaves a difference of a bit
more than $200 billion--just slightly more than the increase in annual federal
deficits over the past six years. Deficit spending, of course, has been the
primary engine behind this consumption bacchanalia--a superhot and
super-Keynesian demand-side tilt that replaced the reviled "Tax and spend"
motto of the 1970s with the new motto "Borrow and spend." In every previous
decade we consumed slightly less than 90 percent of our increase in production;
since the beginning of the 1980s we have consumed 325 percent of it--the extra
235 percent being reflected in an unprecedented increase in per-worker debt
abroad and a decline in per-worker investment at home. This is how we have
managed to create a make-believe 1960s--a decade of "feeling good" and "having
it all"--without the bother of producing a real one.
We cannot, of course, go on borrowing from foreigners indefinitely to finance
our consumption. Soon we must stop and, at that point, decide whether to repay
them the principal or to forever commit ourselves (and our children) to pay
annual interest to foreigners as the price for our 1980s binge. Nor can we go
on starving domestic investment to finance our consumption. Soon we must stop
and replenish the factories, bridges, and schools we have forgone or else
forever relegate ourselves (and our children) to slower growth in our standard
of living. Supply-side economics without the "supply" can have only one
sequel--something we may soon call vicious-circle economics.
It is therefore all but inevitable that our level of consumption must slow its
climb, or even fall, while our level of production catches up. But of course
the speed with which it can catch up depends in turn on how much we can invest,
which depends on how much we can save.
The connection between exploding public deficits and a lower national saving
rate is not absolute and unbreakable. Conceivably, we might have left overall
national savings untouched if we had engineered a huge rise in private-sector
savings at the same time that we embarked on a huge rise in deficit spending.
In fact, however, net private savings--the net income saved by private
households and firms--has been declining very sharply over the past decade
(from 8.1 percent of GNP in the 1970s to 6.1 percent of GNP in the 1980s).
Consequently, net national savings, which equals net private savings minus
public-sector dissaving, has been declining over the past decade, from 7.1
percent of GNP in the 1970s to 3.4 percent in the 1980s. In fact, during three
of the past six years--1982, 1983, and 1986--U.S. net national savings has
dipped below two percent of GNP. Huge capital inflows from abroad have thus
been inevitable.
The conservative stewards of Reaganomics, ironically, have themselves created
the Keynesian nightmare--large and permanent deficits--they so much feared. And
Americans have endured it with remarkably little protest, because, after all,
if conservative Keynes-haters didn't know the dangers of deficits, who did?
Apologists for Reaganomics once claimed that "rational expectations" would lead
people to increase private savings to compensate for public deficits and that
the tax cut of the early 1980s would lead to a savings surge. The latter line
of reasoning is legitimate and important--at the margin and over the long haul.
Unfortunately, it is an idea that works well only when we tax saving less and
consumption more. Most of the 1981 tax cut was simply an across-the-board cut
in personal income-tax rates and thus did little to alter the relative tax
burden on savings versus consumption. In any case, what is truly inexcusable is
the expectation that we could come out ahead simply by cutting the overall
level of taxation while still allowing federal spending to grow. When tax cuts
go unmatched by spending cuts, they must be accompanied by additional public
borrowing from households and firms--thus by a dollar-for-dollar reduction in
otherwise investable private savings. Therefore, in a near-full-employment
economy only a tiny fraction of the cut is likely to show up as additional
private savings. If families and firms treat the tax cut just as they treat
other income, the savings might be six or seven cents on the dollar--a tiny
margin that can disappear entirely if there is a negative shift in the private
sector's overall inclination to save. As we have already observed, there was
such a negative shift.
Other apologists for the 1980s "boom" have claimed that there is no historical
correlation between public-sector deficits in bust years and negative trade
balances. Even after budget deficits had soaked up some private savings, they
point out, there was still enough left over for Americans to be net investors
abroad; that's why bust years typically brought us an improvement in our trade
balance. Evidence that this time-tested pattern no longer obtained, however,
was already surfacing in 1982, when the steepest recession in thirty years was
accompanied by such large-scale federal borrowing that our current account--the
ledger of our financial transactions with foreigners--did not break even. Since
then we have been sailing in uncharted waters: a cyclical recovery accompanied
by enormous and widening foreign-capital inflows.
Some apologists for the 1980s have gotten so carried away with the idea of
market expectations--Reaganomics is all about psychology and expectations--that
they can justify any catastrophe by references to a rosy future. Alan Reynolds,
the supply-side guru, believes that heavy foreign borrowing is a sign of
economic strength. He has compared our huge current-account deficit today to
Japan's big trade deficits in the 1950s, claiming that what the two situations
clearly have in common is buoyant growth expectations. Although some U.S.
observers in the 1950s were dubious about the wisdom of Japan's foreign
imbalance, "in retrospect, U.S. worries about Japan's trade deficits look
rather foolish." Likewise for the United States today. "What has happened in
the 1980s," Reynolds writes, "looks like a reversal of roles, with the U.S.
becoming the relatively vigorous tax haven, attracting foreign capital and
goods, while Europe and Japan slip into the stagnant, export-dependent role
that the U.S. experienced in the Eisenhower years."
The argument is half right. Japan was a capital importer in the 1950s, because
it was a rapidly growing economy--more than that, it was a country literally
reconstructing itself after a war that had largely wiped out its industrial
base. It borrowed abroad to finance a higher investment level than would have
been possible by relying on its already hefty savings rate alone. The result
was an incredible net investment rate of well over 20 percent of GNP. Did such
capital inflows make sense? Of course, for they rapidly paid for themselves in
increased economic output. From 1950 to 1960 the Japanese economy grew at an
average real rate of nearly 10 percent a year; real net output per worker grew
at the extraordinary rate of 6.6 percent a year. The relative burden of
financing the nation's foreign-capital inflows (which ceased by the mid-1960s)
thus fell over time.
The parallel between the United States and Japan, however, utterly escapes me.
Over the course of the 1980s the U.S. investment rate has been the
second-lowest in the industrialized world (just above Britain); meanwhile, the
rate of growth in our real net output per worker, absolutely the lowest, has
averaged about 0.4 percent a year. That is less than one fifteenth of what the
Japanese were experiencing thirty years ago. Japanese productivity in the
1950s, in other words, grew more in nine months than ours now grows over ten
years. And unlike Japan, we have been borrowing abroad for consumption, not
investment.
To find the proper historical parallel for the United States in the 1980s we
should not look to Japan in the 1950s, nor should we look to our previous
experience with heavy borrowing from foreigners. That was in the 1870s, when we
issued bonds (at half the current interest rate) to Europeans in order to
finance our huge investment in railroads and heavy industry. Instead, we must
look to those rare historical occasions when an economy's large size, its world
class currency, and its open capital markets have allowed it to borrow immense
sums primarily for the purpose of consumption and without regard to productive
return. The illustrations of lumbering, deficit-hobbled, low-growth economies
that come most easily to mind are Spain's in the late sixteenth century,
France's in the 1780s, and Britain's in the 1920s.
So there we have it: a conservative Republican Administration that promised us
a high-savings, high-productivity, highly competitive economy, with trade
surpluses, and gave us instead a torrid consumption boom financed by foreign
borrowing, an overvalued currency, and cuts in private investment, with
debt-financed hikes in public spending and huge balance-of-payments deficits.
It's the same script, proceeding toward the same woeful finale, that we have
seen played out over the years by many a Latin American debtor. As one wit has
put it, just as the 1970s saw the "greening" of America, the 1980s is seeing
the "Argentining" of America.
Now let us examine the pieces of this fiscal debacle in more detail. We will
turn first to the critical near- and medium-term challenge of reducing our
foreign-credit inflow--and, at the same time, of coping with the harsh policy
choices and the danger of global crisis that must accompany such a reduction.
Then we will take a longer-term view of the inexorable link between investment
and living standards. Finally, we will discuss the manner in which American
public policy treats our future. If before the 1980s this manner was one of
neglect, today it borders on open contempt.
"Owing It to Ourselves" No Longer
How much, exactly, do we now owe the rest of the world? Officially, our net
position (what we are owed minus what we owe) at the end of 1986 was a negative
$264 billion. By the end of 1987 we will be closing in on a negative $400
billion. The incredible speed of America's transformation from creditor to
debtor can hardly be exaggerated. Only six years ago, at the end of 1981, the
United States had achieved its all-time apogee as a net creditor, with an
official position of a positive $141 billion. Over the past six years, in other
words, the United States has burned up more than $500 billion, net, by
liquidating our foreign assets and by borrowing from abroad. That's an immense
flow of capital, even in global terms. By 1986 our net borrowing had dwarfed
the fabled bank recycling of OPEC surpluses after the oil price hikes of 1973
and 1979. The sum was twice the size of all foreign interest payments by all
the less-developed debtor nations, and about half the approximate dollar value
of total net investment in all less-developed countries combined.
What does the future have in store for a nation that is borrowing such sums
from foreigners? As a net debtor of growing proportions, the United States must
inevitably become a sizable net exporter of goods and services. (I repeat:
exporter.) This proposition is just a matter of arithmetic. Since our
indebtedness cannot grow indefinitely as a share of our GNP--beyond some point,
foreign creditors will regard us as a growing credit risk, a risk that must be
compensated for by prohibitively high interest rates--our current-account
deficit must eventually decline substantially. And when that happens, we will
have to export more than we import in order to service our deficits on interest
and dividend payments to foreigners. Just to say that something is inevitable,
of course, does not tell you when it will happen. But I think it's fair to say
that the growth of America's foreign debt may push us--painfully--to a
current-account balance and a trade surplus by the mid-1990s, and almost
certainly will do so by the year 2000.
Our opportunity for a relatively smooth readjustment is perilously narrow. On
the one hand, it seems likely that the rest of the world will grow reluctant to
keep lending to the United States once our net indebtedness rises much beyond
35 percent of our GNP, or a bit more than $1 trillion at today's prices. Some
experts suggest that this debt may entail net U.S. debt-service payments
equivalent, as a share of exports, to those of many developing nations and
about on a par with Germany's reparations burden following the First World War.
The experts agree that it is quite impossible for the United States to go on
indefinitely borrowing principal at or near its current rate of 3.4 percent of
GNP per year. Such borrowing, combined with accumulating debt-service costs,
would dictate an absurd $3 trillion in net debt by the end of the century and
foreign investors would close down the pipeline long before we got there.
On the other hand, it is practically inevitable that our net debt will reach
the $1 trillion mark by the early 1990s no matter how vigorously we act to stem
the inflow of foreign savings. Obviously, there are limits to the speed with
which the United States can curtail consumption and generate growth in net
exports. Consider, for instance, a scenario in which the United States,
starting next year, makes steady additions to the value of its net exports such
that its current account reaches zero by 1994 and its net debt is reduced to
today's level by the year 2000. That sounds like a rather modest achievement.
Yet it will still lead to a net debt of about $1 trillion by 1994 and will
require a real improvement in U.S. net exports of more than $20 billion a year,
each year, for the next ten years, or a total positive shift of more than $200
billion. As Fred Bergsten has observed, the magnitude of the necessary
adjustment facing us is equivalent to about two thirds of our entire defense
budget and is several times larger than the total shift resulting in the United
States from the 1970s oil shocks.
According to the adjustment scenario above, we need to reduce our foreign
borrowing stream by $20 billion yearly, or $200 yearly for each of our 100
million workers. Yet real net product per worker has been growing each year by
just $135. Further, our continuing debt growth will mean that about $40 per
worker per year must be devoted to rising foreign debt-service payments. And to
increase productivity sufficiently to raise net exports will require at least
our 1970s level of net investment at home--an additional $60 per worker per
year over a decade.
So where are we going to find, each year, the extra $20 billion in unconsumed
exportable production necessary to make this readjustment scenario work? Over
the next decade, with only $35 per worker available ($135, minus $40, minus
$60), consumption per worker in the United States may have to decline by $165
each year. That's $1,650 overall for the average worker, and of course we can
expect those Americans with the most vulnerable incomes--minority workers,
young adults laboring under two-tier contracts, and service employees who
receive no benefits--to suffer losses that are far greater than average.
Neither the American public nor the nation's politicians have even begun to
face this prospect. In comparison, during the 1970s--a decade now known to most
of us as "hard times"--U.S. consumption per worker nonetheless rose by $200
each year. What the early 1980s gave us, the 1990s may well take away.
In what exports, specifically, is the United States going to see the enormous
gains it must achieve to lower its trade deficit? First of all, we can forget
about any major contributions from the 22 percent of our trade exports now
composed of agricultural goods and raw materials. The $25 billion trade surplus
we had in agricultural exports in 1981 shrank to $3 billion last year. Over the
past decade the European Economic Community has raised its grain balance,
improbably enough, from a deficit of 25 million tons to a surplus of 16 million
tons. India, Pakistan, and China have all become net farm-product exporters.
Even the Soviet Union now seriously asserts the breathtaking goal of becoming a
net food exporter by the year 2000. We will therefore be lucky to slow the
current decline in our agricultural balance. Much the same goes for raw
materials.
As for oil imports, nearly all experts expect that declining U.S. production
will push our current 25 to 30 percent dependence on oil imports to 50 to 60
percent during the 1990s, and at higher prices. Philip Verleger, Jr., a
visiting fellow at the Institute for International Economics, estimates that
the value of our oil imports will rise from $4 billion in 1985 to $120 billion
or $130 billion by the mid-1990s. The 1980s have been happy, quiescent years
from an energy standpoint, but we may, in the 1990s, again face some of the
energy turbulence of the 1970s. The $70 billion real improvement (in 1986
dollars) in the energy balance that Americans have enjoyed since 1980, in other
words, will reverse direction. Let's be optimistic and assume that our annual
total farm and raw-materials balance for the foreseeable future will decline by
only $10 billion per year. That means we need a good $30 billion yearly
improvement in the remaining 75 percent of our exports--namely,
manufacturing.
Some critics balk at this point and complain that this logic unfairly omits our
exports in services. According to a recent Fortune article titled "The Economy
of the 1990s," the United States will improve its balance on services by $125
billion between now and the year 2000. This service surplus, like some deus ex
machina, is supposed to more than pay the debt service on what Fortune admits
will be a "debt mountain" of some $1 trillion by the mid-1990s. This analysis
confuses a large flow of services that are actually debt service (for example,
the payment of interest and dividends) with a much smaller flow of services
that are actually current production (for example, travel, shipping, and
insurance). We already know what will happen to the balance on the former
type--it's going to go deep into the red. And U.S. exports of the latter type,
unfortunately, are both too small (a total of $49 billion in 1986) and too
inflexible to make much difference. Two thirds of these exports consist of
shipping, transportation, and travel; the rest consist of business services
that usually accompany trade exports. In fact, since so many of our high-tech
service exports are linked to manufacturing exports, it strikes me as virtually
meaningless to project one without the other.
Let's be optimistic and assume that service exports will eventually grow by
fifty percent. That still leaves us with a need to increase our manufacturing
exports by $275 billion, or achieve a real annual growth rate of 10 percent
over the next decade. Can we emulate Japan and sustain such a prodigious
performance in manufacturing over so many years. Perhaps we can, but the
prospect seems daunting. So far in this decade our manufactured exports have
actually declined in real terms, but over the coming decade we will be aiming
for a higher export growth rate than we have yet achieved in the twentieth
century. In every respect the achievement would be unprecedented: we would have
not only to break our earlier record but to do it with a lower average level of
domestic business investment, with a complete freeze on imports, and with
steadily declining living standards.
Any way one looks at it, the arithmetic is cruel and inescapable. It's hard to
imagine huge growth in our manufacturing output, for instance, without a very
large increase in domestic business investment. But to further increase
investment at home we may have to undergo a further decline in consumption, in
order to hold constant our net export improvement. And, clearly, we are not
going to see any decline in consumption in favor of saving unless there is a
radical change in our public policy, especially our fiscal policy (something I
will discuss later on), and in our politics as well.
There remains, moreover, yet another problematic assumption in our readjustment
scenario: the willingness, or even the ability, of the rest of the world to
absorb our proposed huge increase in manufacturing exports. Current thinking on
this problem seems to grow out of two separate theories. One theory emphasizes
foreign economic growth, the other exchange rates.
The foremost proponent of the first theory is the Reagan Administration, which
has repeatedly insisted that higher rates of growth abroad--particularly in the
stagnant-demand economies of West Germany and Japan--will solve our problem.
This is a worthy idea but hardly a solution. Consider, for instance, a
sustained one-percent real increase in economic growth in the rest of the
world--say, from about the current 2.5 percent to 3.5 percent (surely we cannot
expect more). Then imagine that all this growth is purely domestic. Using rosy
"multiplier" assumptions, we could get a two- or even four-percent real
increase in exports. Recall, however, that we need a 10 percent real
increase.
The second theory, to which many economists subscribe, is that any level of net
export improvement is possible as long as we endure a "sufficient" decline in
the exchange rate--that is, a continued fall in the value of the dollar
relative to other currencies which will make our goods more attractive to
foreign buyers.
Experience demonstrates, however, that exchange-rate adjustment also has its
difficulties. Over the past few years nearly all economists have been humbled
by how far they had overstated the extent to which world trade balances would
adjust to the recent fall in the dollar. Given this track record, it is cause
for deep reflection that forecasts now being made in major think tanks say that
even a 25 percent further devaluation of the dollar will be lucky to push the
annual U.S. current-account deficit much below $100 billion over the next few
years. The underlying problem might be posed as follows: even if we accept a
lower dollar, which I believe to be virtually inevitable, will economies in the
rest of the world accept it? The challenge facing America--generating a $275
billion positive swing in manufactured exports over the next decade--sounds
tough enough without worrying about whether our trading partners will
accommodate our necessities. Yet we often forget that our objective of huge
yearly increases in U.S. net exports translates directly into decreases in the
net exports of our major trading partners (recently the very source of much of
their growth). It's not just a question of our resolve; it's also a question of
their resolve, something over which we have little or no control.
What we hope, of course, is that our trading partners will accept our agenda.
In general, we want them to raise the demand for goods and services in their
countries at the same pace at which we are suppressing demand, with smaller
fiscal deficits and higher private savings rates, in our own country.
Specifically, we hope they will stimulate their domestic demand with looser
fiscal policy, keep their currency strong with restrained monetary policy, and
pull down import barriers so that U.S. exports can expand with minimal pressure
on exchange rates. Our unspoken assumption is that once we decide to act, they
can be expected to cooperate.
In reality, foreign economies may be otherwise inclined. Instead of loosening
fiscal policy, they may continue to tighten--raising their own national savings
rates in tandem with ours even at the risk of a collapse in global demand. And
instead of embracing a lower dollar, they may continue to resist it, either by
pushing their exports harder (with price cuts and aggressive marketing) or by
discouraging imports (with official or unofficial import barriers or simply a
social consensus not to "buy American"). Either way, readjustment may entail
risks that persuade all parties to abandon the effort. In the former case the
risk is worldwide economic stagnation. In the latter the risk is a precipitous
fall in the dollar and the danger of financial panic.
Why might our trading partners not want to cooperate? For one thing, foreign
leaders may be slow to believe that the United States will do what it says it
intends to. Look at it from their point of view. Ever since 1983 the United
States has been assuring the rest of the world that it is just about to cut
back on its budget and current-account deficits and that other countries should
therefore immediately begin stimulating their domestic demand in order to "pick
up the slack." Other countries have responded with caution, and in
retrospect--the U.S. deficits having grown rather than shrunk--their leaders
must now be glad they were cautious. They still have their exports, they still
have their productivity growth, and they still have stable prices.
Given the recent sharp fall in the dollar, many Americans figure that our
trading partners have begun to see the handwriting on the wall. Surely, we
think, Europe and Japan must soon opt for large-scale domestic stimulus in
their own interest--especially when it means the instant pleasure for their own
citizens of more disposable income and more consumption. Yet here we confront a
deeper issue--the vast differences in culture, history, and politics which make
it just as hard for other industrial countries to do what we find natural
(stimulate consumption) as it is for us to do what they find natural (stimulate
savings). We find inflation worth risking, but the West Germans, scarred by the
memory of the 1920s, would rather risk recession. We find it easy to sacrifice
exports on the altar of the high dollar, but the Japanese, who have spent
generations fighting to earn dollars to pay for their food, raw materials, and
oil, find the equivalent idea tantamount to economic surrender (particularly
considering their long-sought, stunning manufacturing trade surplus of $150
billion, or about eight percent of their GNP). The necessary reversals in
national economic direction are profound. If we assign Japan one third of the
needed adjustment, for example, or $50 billion annually by 1994, this would
amount to eight percent of its total manufacturing output (in a negative
direction). To those who argue that Japan adjusted successfully to two oil
shocks, and so can handle this challenge, I argue that those shocks required
the Japanese to do more of what they had always been doing (namely, exporting),
while the present predicament will require them to do less. American leaders
think that stimulating domestic demand is child's play. Most leaders abroad do
not. They are, in fact, extremely doubtful that their consumers will be able to
pick up where exports to America leave off.
To allay doubts about our intentions, we must change our policy in credible and
irrevocable ways, and announce these changes ahead of time. Readjustment
becomes sticky when, even in the face of changing prices, foreign exporters
hope to preserve their sunk costs, their hard-won market shares, and their
relentless productivity and cost-reduction efforts--as Americans hooked on
imports hope to preserve their buying habits. Those hopes are our enemy. We
cannot cloud the air with chatter about painless global growth when in fact we
are asking exporters abroad and importers at home to endure inevitable
hardships.
Second, to eliminate uncertainty about the implications of our policy, we must
talk realistically about a genuine transformation of the world's major
political economies. "Fair trade" (whatever that means) isn't really the point.
Our objective is to raise U.S. exports so that we avert a tragedy that
threatens everyone--a global crash. Finally, to encourage political as well as
economic balance in the world, we must renounce our recent policy of "global
Keynesianism"--the policy of being everyone's buyer of last resort. The
mercantilist aggressions bred by such a policy, including retaliatory
protection and games of "chicken" with exchange rates, have themselves become a
major obstacle to readjustment. Confidence, not fear, is the best way to get
foreigners to retool their export plants for their own domestic markets.
If we simply proceed with the "business as usual" approach to the world's
growing imbalance, America's foreign creditors will ultimately become aware
that the situation is unsustainable. At that point anything, from a small
decrease in the value of the dollar to a mild political crisis, could cause
investors around the world to decide to rid themselves of dollar-denominated
assets. If the resulting plunge in the dollar's exchange rate persuades ever
larger numbers of investors to follow suit, the "dollar overhang" might at last
turn into the worst freefall nightmare of Paul Volcker, the former Federal
Reserve chairman: an avalanche pouring down on the dollar's financial capitals,
from London to San Francisco.
The United States, in response, would have little choice but to raise interest
rates sky-high, in order to attract at least some investors to the dollar to
finance our budget deficits. We would also have to acquiesce in a long and
almost deliberate recession, both to shut down most of our foreign borrowing
(in a matter of months rather than years) and to suppress U.S. demand for
imports. Actually, the recession is likely to be of the "stagflation" variety,
since higher import prices may double our inflation rate even before we prime
the pump. The peak-to-trough downturn could be quite steep indeed and could
easily become our most severe economic crisis since the 1930s. Nor have I yet
mentioned how the razor-edge plight of many less-developed debtor nations will
add to the danger. Every forecast I have seen warns that the largest South
American debtors will be pushed from illiquidity to insolvency by a far milder
recession, and far smaller interest-rate hikes, than those envisioned here.
Many have even suggested that spreading defaults among less-developed countries
may precipitate the crisis.
No one knows, of course, how long such a hard landing would last. It is
possible, I hope, that it would be limited to a financial crunch followed by a
severe but brief recession, rather than a lengthy depression. The economy could
recover with relatively moderate increases in world unemployment, but surely
the value of the dollar would be much lower and U.S. import levels would be
much reduced. This is what I call the "bumpy start-and-stop" scenario--the one
that has afflicted postwar Great Britain. Under this scenario the standard of
living in the United States would have dropped, its indebtedness would be
little changed (but no longer growing), its international responsibilities
would be necessarily curtailed, and its people would be aware, through
occasional jumps in interest rates and the yo-yo behavior of the dollar, that
their economic fate was hostage to the tenuous and nervous confidence of
outsiders. The British economist Michael Stewart recently observed that "anyone
who has lived through our 40 years of balance of payments crises, and seen the
constraints they have imposed on domestic policies, must stand amazed at the
insouciance with which the United States is piling up external debt." These
constraints, of course, were not only domestic; they also hobbled British
foreign policy--most dramatically in the Suez crisis of 1956, when the United
States, which held reserves of British sterling as foreigners hold our dollars
today, warned the British that we would declare war on the pound if they did
not stop their invasion of Egypt. So much for the perils of dependence on
foreign investors.
Should we have the worst hard landing--a lengthy U.S. depression--let us simply
be forewarned that our traditional policy responses would be of limited use.
Hardship-bloated budget deficits would prevent us from applying more fiscal
stimulus; a low and skittish dollar would defy our attempts to loosen monetary
policy. Whereas the "start-and-stop" landing presumes that Americans could pay
for their debts by a one-time shock in living standards, and thereafter by
slower productivity growth and reduced international leadership, the
true-depression hard landing presumes that Americans would service and pay off
their debts through indefinite impoverishment. Either scenario could, of
course, lead to a resurgence in state control over the economy (on a scale that
might put Jimmy Carter's credit controls to shame)--an ironic last act in an
opera that opened with the chorus singing praises to laissez-faire.
Some observers play down the possibility of such a crisis. They point to the
apparent ease with which the world has so far endured a substantial decline in
the dollar's value. Clearly, however, the easy stage is now coming to an end.
In trade, the dollar has now reached the point at which further declines can no
longer be absorbed by exporters' profit margins and will leave no foreign
alternative other than structural change or economic stagnation. Just as the
American economy has since 1980 suffered the trauma of de-industrialization, so
the Japanese economy has begun to suffer from what some Japanese call the
"hollowing out" of their industries--worker layoffs, unused capacity, and a
scramble toward offshore assembly. In finance, further dollar declines are
likely to be accompanied not by lower U.S. interest rates, as in the past, but
by unchanged or even higher interest rates, as we experienced last spring. This
will present the Fed with a no-win choice between defending the dollar and
loosening credit. And it will hit foreign investors with the double whammy of
further exchange-rate losses compounded by losses in bond-market values. The
preconditions for a dollar-dump panic, in short, may already be moving into
place.
Of course, one hopes that Americans will never have to live through these
dismal outcomes. But avoiding them will take great effort--not just in changing
policy but ultimately in changing our very self-image and in persuading our
trading partners to change theirs. Japan's problem, a senior official there
told me recently, is global-asset management; ours, alas, is global-debt
management.
The financial expert David Hale has written, "The U.S. is a debtor nation with
the habits of a creditor nation while Germany and Japan are creditor nations
with the habits of debtor nations." Needless to say, America must soon change
its habits, including its fixation on creative consumption. Our ability to do
so safely, however, will depend on more than just our own hard work and
determination. It will also depend on whether we can persuade our trading
partners to change their habits, at the same speed and at the same time that we
are changing ours.
Turning Away From Posterity
Our growing foreign debt and trade deficit not only threaten a sacrifice in our
consumption levels but also symptomize our unwillingness to acknowledge a
deeper and more long-standing disease: a steady thinning out of those
activities and attitudes that tend to generate, over the long term, a rising
level of productive efficiency. When the seriousness of this problem became
increasingly apparent, during the 1970s, we should logically have chosen to
allocate fewer of our resources toward consumption and more toward investing in
productive physical and human capital. Instead, under a supply-side banner, we
have blindly chosen to do the opposite.
Does it matter that our productivity is growing only a fraction as fast as it
was in the 1950s or 1960s? Indeed it does. To recognize some of the
consequences, we have only to consider that to end foreign borrowing with no
change in per-worker consumption or domestic investment will take us twelve
years of productivity growth at the current rate. The same task would take us
only a bit more than three years at the growth rate of the 1960s or only a bit
more than two years at the rate of the 1950s. To put it another way: Our
per-worker flow of foreign borrowing, as we have seen, is now running at about
$1,350 a year. But whereas the net product per worker that is left after we
service our debt, and that we can apply to reducing our current-account
deficit, is rising by only $95 a year now, it would be rising by $630 a year at
1960s growth rates and by $985 a year at 1950s growth rates.
Yet it would be wrong to see productivity differences solely in terms of our
foreign balances. Far more important is the role such differences must play in
determining long-term growth in our future living standards. The cumulative
impact of small differences in yearly growth rates cannot be underestimated.
Consider the year 2020, when those who are now infants will be in the prime of
their working life. If productivity growth proceeds at its 1980s rate (and does
not decline still further), the average worker in 2020 will be producing
$40,100 worth of real goods and services, only about 14 percent more than his
or her parents are producing today ($35,300). Under the
smoothest-possible-readjustment scenario already described, which would result
in declining per-worker consumption through most of the rest of this century,
even by 2020 his or her yearly consumption will have risen only eight percent
above the 1986 level.
America's standard of living, for the first time in its history, will have
hardly budged for a span of forty years. The 1980s and 1990s may be remembered,
with bitterness, as a turning point in America's fortunes--a period of
transition when we took the British route to second-class economic status.
Britain's decline took seventy-five years of productivity-growth rates that
were half a percentage point lower than those of its industrial competitors.
Because America's corresponding gap is more than three times as large, its
relative decline is proceeding far more swiftly.
If, however, U.S. productivity now started growing again at the 7.4 percent
average rate that prevailed during the 1950s and 1960s, miraculous though that
would seem, our sons and daughters in 2020 would each be producing $77,200
worth of real goods and services--some 120 percent more than their parents are
each producing today. Consumption standards would rise by nearly as much, since
we would have been able both to close our foreign-borrowing gap and to recoup
our foreign liabilities by the early 1990s. In this case our grandchildren
would look back on us as relative paupers, and by 2020 Americans would be
enjoying buoyant prosperity and widening social opportunities in a nation that
would still be a leading force in the world's economic and political affairs.
Understandably, most Americans do not want to confront the painful idea that we
are headed toward the wrong future. Yet that is the melancholy fact of the
matter. What is less understandable is the strident defense that so many
opinion leaders offer for our present course. We hear time and again that the
U.S. economy in the present decade has grown "as fast as" or "faster than" the
collective economy of the rest of the industrial world. So far as this claim
goes, it is correct. From 1979 through 1986 real U.S. GNP grew by a rate of 2.1
percent a year--about the same growth rate as that of the collective GNP of all
other industrial nations. However, in the United States most of the growth (70
percent) was due to increases in the number of workers, while in the other
countries most of the growth (85 percent) was due to increases in output per
worker.
The rapid growth in U.S. employment has partly been the consequence of an
entrepreneurial and new-business surge, the flexibility of our labor markets,
and several booms (for example, a consumption boom, providing jobs in
distribution; the health-care-for-the-elderly boom; the home-services and
eating-out boom; and the postwar Baby Boom, which has no counterpart in other
countries). According to a recent Commerce Department report, from 1981 to 1986
the equivalent of nine million full-time jobs were created. And yet, contrary
to the widespread impression, this represents a job-creation slowdown; over the
previous six years the equivalent of 14 million full-time jobs were created.
In any case, this kind of growth must cease within a few years, when all the
Baby Boomers are employed, and reverse itself in future decades, when young
adults will be scarce and retiring workers ever more plentiful. More important,
it is not the kind of growth that raises our standard of living. Augmenting
production by adding more working bodies (what classical economists used to
call the "dismal" Asian model) does not enhance the standard of living. Only
augmenting production per working person does that, and Europe and Japan do
that far more successfully than we do. The employment of the largest and
best-educated generation of Americans in history should have caused U.S. GNP to
rise far faster than GNP in any other country--as it should also have pushed up
our savings rate, since presumably this working generation of young adults will
want to allocate some of the extra production to provide for their children and
their own retirement (as the Baby Boom becomes the Senior Boom). Instead, with
the part-time nature and much lower value-added character of many of the new
jobs, we have barely managed to keep pace with the GNPs of our competitors, and
our savings rate has declined. This is not success but a large-scale admission
of failure.
Yet it is surely true, the optimists say, that productivity growth and
investment performance in the other industrial countries have declined sharply
over the past fifteen years, and this must mean that we are doing better than
they are. Not really. Because the performance of the other countries was so
superior to begin with, and because our own performance has also fallen,
product per worker is still growing considerably faster abroad than here in the
United States.
How have these economies managed? The most apparent factor has been much higher
investment levels. Here, Japan is the leader. From the 1960s to the 1980s its
total net investment as a share of GNP (including investment in public
infrastructure as well as in all private structures and equipment) has fallen
from 22.6 percent to 16.1 percent: the latter figure, however, is still three
times larger than the equivalent U.S. figure for the 1980s (5.3 percent). In
fact, at 1986 exchange rates (as the dollar falls, the comparison is getting
worse) Japanese net investment in 1986 amounted to $300 billion, while U.S.
investment amounted to only $270 billion. (This has been the result, in part,
of a cost of capital in Japan that has consistently been less than half ours--a
situation not at all helped by the 1986 Tax Reform Act.) It is a spectacle that
ought to shock Americans: a population half the size of our own, living on a
group of islands the size of California, is adding more each year to its stock
of factories, houses, bridges, and laboratories--in absolute terms--than we are
to ours. And Japan still has savings left over, about $80 billion in 1986, to
lend to thriftless foreigners. (About $50 billion of that sum was lent to us.)
Between the two countries, therefore, the 1986 disparity in net savings ($380
billion in Japan versus only $125 billion in the United States, a six-to-one
per capita difference) was even more lopsided.
For years many U.S. experts have been predicting that the relative
productivity-growth advantage of the other industrial countries would soon slow
down. Back in the 1960s and early 1970s such predictions were based on the
"postwar reconstruction" thesis. Industrial phenomena like Japan and West
Germany, it was said, were growing faster merely because they still had to
"replace" the capital stock they had lost in the Second World War. More
recently this line of reasoning has been abandoned, because it obviously cannot
explain why these countries have replaced most of their business plant and
equipment several times over since the early 1950s. In Japan, to take the
extreme example, there is hardly a single factory now standing that has not
been built, rebuilt, or entirely re-equipped since the mid-1970s. Indeed, each
Japanese worker is supported by more than twice the plant and equipment that
supports his or her American counterpart. A new argument, therefore, has become
popular. This is the so-called convergence thesis, according to which other
countries are getting a free ride by copying American technological
breakthroughs. Once the other countries reach our level, it is said, their
productivity growth must slow down sharply. At that point they will have to do
the same tough "pioneer" work that we do.
The convergence thesis makes sense only if we assume that the other countries'
overall disadvantage relative to the United States is spread about equally
across every economic sector and that it is especially marked in manufacturing,
where technology presumably is most important. Unfortunately this assumption
isn't plausible. Most economists agree that America's remaining absolute
advantage is due mostly to superior productivity in agriculture, raw materials,
and services, and that little if any of it is now due to superior productivity
in manufacturing.
Instead of hoping for convergence, we Americans ought to recognize that we are
already getting beaten in manufacturing. We must also recognize that over the
foreseeable future the biggest productivity-growth opportunities in Europe and
Japan will lie in improving efficiency in agriculture and services--something
that requires no big research-and-development breakthroughs and could occur
with disquieting suddenness.
The defenders of Reaganomics, of course, protest against any such conclusions.
The growth of U.S. manufacturing productivity, they claim, has been one of our
great achievements in the 1980s. And now that the dollar is back down where it
was when President Reagan took office, American exporters will no longer have
to compete against absurdly cheap foreign labor costs. The future, then, looks
bright.
But does it really? True enough, U.S. manufacturing productivity has recently
run against our economy's declining trend. For example, from 1979 to 1985 Ford
reduced its global employment by nearly 30 percent while reducing its car and
truck output by only about five percent. Overall growth in manufacturing
productivity rose from a yearly average of 2.3 percent in the 1970s to nearly
3.2 percent in the 1980s. What the optimists do not point out, however, is that
such numbers are the perverse if pro-competitive result of seven catastrophic
years for U.S. manufacturers--two domestic recessions (1980 and 1982-1983)
followed by a high dollar export recession (1984-1986).
Still less do the defenders of the 1980s want to point out that U.S.
manufacturing productivity, even with the help of its recent job-slashing
acceleration, grew more slowly during the 1980s than the average for our major
industrial competitors. And far from granting slower real pay raises, foreign
manufacturing exporters have been using their productivity advantage to grant
their workers much larger pay raises than firms in the United States have done.
Since 1969 real manufacturing pay has risen by only 17 percent in the United
States, but by a colossal 115 percent in Japan.
The fact that U.S. wages have grown even more slowly than U.S. productivity
certainly reflects the adverse exchange-rate climb of the dollar during the
early 1980s. But since the gap in wage growth was already apparent at the end
of the 1970s--before the dollar's long climb--some experts suggest that it may
also reflect a negative shift in the image of U.S. goods for quality and
reliability. Our decline in underlying competitiveness, in other words, may be
even greater than what the output-per-worker numbers indicate. For this reason
the recent emphasis on quality by many U.S. manufacturers can only be regarded
as gratifying.
A final defense of our economic performance in the 1980s rests on the sweeping
claim that none of this "smokestack" productivity matters anymore because our
economy will henceforth thrive on our alleged global monopoly on information
and inventions. Pure products of the mind have limited appeal as final consumer
products, however, and so one wonders how they can generate wealth unless we
have the capability--the plants, tools, and production skills--to turn them
into salable goods and services. Perhaps, it is said, we could sell this
intellectual property directly to foreigners. A good idea, but the numbers
hardy indicate that such sales could ever drive our economy by themselves. In
1986 our total net receipts from royalty and licensing contracts with
unaffiliated foreigners (including movie and TV rights) amounted to about $1.5
billion, or about four ten-thousandths of our GNP. And in inflation-adjusted
dollars our receipts of this kind have actually been declining over the past
decade.
Knowledge and innovation, to be sure, are an absolutely vital precondition for
long-term economic growth. But we Americans tend to overrate the significance
of our leadership here. We forget that intellectual glitz and scientific glory
do not always translate into the humble, wealth-generating chores of commercial
innovation. Although we like to point out that we lead the world in the share
of GNP that we devote to research and development, we neglect to add that much
of this is devoted to obscure weapons R&D that leads to few commercial
spinoffs. In civilian R&D we lag behind both Japan and West Germany. We
should be pleased with the rapid growth of venture and equity financing for
small high-tech businesses during the 1980s, but we should also be cautious:
thus far we have seen no comparable surge in small-business R&D, no
reversal in the downward trend in U.S. patent applications, and no resurgence
in high-tech exports. As for U.S. universities, they are indeed a global
showcase for Nobel laureates and pathbreaking research. Yet most of the
brilliance emanating from our universities is as freely available to foreigners
as it is to our own citizens.
More important, it is hard to imagine any long-term economic
renaissance--especially one built on "working smarter"--without a determined
investment in the most precious of our assets: the skills, intellect, work
habits, health, and character of our children. Yet this is precisely where we
may be courting our most catastrophic failure. In the words of one analyst
cited by the 1983 National Commission on Excellence in Education, "For the
first time in the history of our country, the educational skills of one
generation will not surpass, will not equal, will not even approach, those of
their parents." Recent trends indicate that each year the typical American
child is increasingly likely to be born in poverty and to grow up in a broken
family. And a study by the Committee for Economic Development points out that
without major educational change, by the year 2000 we will have turned out
close to 20 million young people with no productive place in our society. The
CED study continues, "Solutions to the problems of the educationally
disadvantaged must include a fundamental restructuring of the school system.
But they must also reach beyond the traditional boundaries of schooling to
improve the environment of the child. An early and sustained intervention in
the lives of disadvantaged children both in school and out is our only hope for
breaking the cycle of disaffection and despair." Our children represent the
furthest living reach of posterity, the only compelling reason that we have to
be serious about investing in the future. And we are failing them.
The Politics of Debt
There is no question that federal fiscal policy deserves much of the blame for
our national failure to invest during the 1980s; recall that the 1986 federal
deficit consumed the equivalent of 90 percent of all private-sector savings
that year. On the one hand, opinion polls consistently show that the American
public overwhelmingly favors, in theory, a balanced budget. On the other hand,
serious attempts to reduce the deficit continue to encounter, in practice,
enormous bipartisan resistance. Congress and the Administration invent
countless reasons why solving the problem can be postponed just a bit longer or
why the deficit can't really be doing us that much harm.
We have little time left to get beyond such rationalizations. It is sometimes
asserted that our economy's saving behavior would be pretty much the same today
without a federal deficit. But, again, consider the numbers. During the 1980s
we have succeeded in nearly tripling the national debt, from $645 billion (at
the end of fiscal year 1979) to $1.745 trillion (at the end of fiscal year
1986). We have, in addition, saddled ourselves with an informal debt of nearly
$10 trillion in unfunded liabilities in Social Security, Medicare, and federal
pensions. That astronomical figure is the difference between the benefits
today's workers are now scheduled to receive and the future taxes today's
workers are slated to pay for them. It amounts to a hidden tax of $100,000 on
every American worker, and its toll will be exacted on our children.
For Americans to believe that their national balance sheet is in the same shape
now as it used to be, they would have to believe that the enduring investments
made by the federal government during the past seven years are comparable to
all those made during the preceding two centuries--including the taming of the
frontier, victories in several wars, the Marshall Plan, miracle vaccines, the
Apollo missions, Grand Coulee Dam, and the interstate highway system.
From fiscal year 1979 to 1986 federal revenue fell from 18.9 percent to 18.5
percent of GNP, while federal outlays rose from 20.5 percent to 23.8 percent of
GNP. Why has federal spending risen? The big growth areas over the past seven
years have been defense, entitlement benefits, and interest on our national
debt; all other spending has been cut back dramatically. Over the longer term,
however, entitlement benefits dominate the picture. Since 1965 they have grown
from 5.4 percent to 11.5 percent of GNP; all other spending excluding interest
(which simply represents the permanent cost of cumulative deficits) has
declined from 11.0 percent to 9.5 percent of GNP. This growth in entitlements
over the past twenty-one years is equivalent to 6.1 percent of GNP--an amount
greater than the entire investment we currently make in all business plant and
equipment, plus all civilian R&D, plus all public infrastructure. Even
defense spending, as a share of GNP, has risen only half as much during the
1980s as it declined during the 1970s. At 6.6 percent of GNP in 1986, defense
spending is still lower than it was in any year from 1950 to 1973.
Our budget-cutting efforts during the 1980s have failed because they have
allowed continued growth in the one type of spending--for entitlement
benefits--that had already risen to unprecedented heights. Even where the 1980s
budget ax has fallen hard, the major victims have been precisely those rare
federal programs whose purpose is physical or human investment rather than
consumption.
This last point is worth emphasizing, for it explains the unique vulnerability
in recent years of that small area of the federal budget called discretionary
non-defense spending. That's the old-fashioned type of spending in which
(Congress--unconstrained by automatic-indexing formulas and prior-year
contracts--votes on bills each year, presumably for the best interest of our
national future. Unfortunately, since the future has no lobby, no formula, and
no contract, the Administration and Congress have found this the perfect place
to demonstrate their budget-cutting zeal publicly even while allowing all other
types of spending to keep rising. By 1986 discretionary non-defense spending
had been cut to 4.09 percent of GNP, its lowest level since 1961.
This spending category includes that bellwether of federal investment activity
the maintenance and construction of America's public infrastructure. Net real
investment in roads, bridges, mass transit, and other public works has dropped
by 75 percent over the past two decades; much of our infrastructure is wearing
out far more rapidly than it is being replaced. We do not have a new generation
of infrastructure technology, from high-speed trains to underwater tunnels,
because we have chosen not to pay for it.
But the steep decline in federal investment during the 1980s has not been
limited to infrastructure. Investment in our environment and in human
capital--research, education, job skills, and remedial social services--has
also plummeted. These, too, have now been deemed superfluous. From 1979 to
1986, in real dollars, federal spending on natural resources has been cut by 24
percent, non-defense R&D by 25 percent, aid to schools by 14 percent, and
energy preparedness by 65 percent.
Far from forcing a "revolution" in the role of the federal government, the
1980s have instead seen the federal budget become an ever larger and more
efficient consumption machine. In the mid-1960s checks mailed out automatically
(to bond owners, health insurers, retirees, state and local benefit
administrators) accounted for about 58 percent of all federal non-defense
spending. By 1979 their share stood at 68 percent; today it has grown to nearly
80 percent. We have now reached the point, in fact, where even if we eliminated
all discretionary non-defense spending (imagine that we could fire all
civil-service employees and replace them with a giant check-writing machine),
the federal budget would still be running a deficit. Our government's function
as an investor, a steward of our collective future, is small and shrinking. Its
function as a consumer, a switchboard for income transfers, is large arid
growing.
Surely, it is argued in defense of the growth in entitlements, the alleviation
of poverty also constitutes "investment" of a sort--an investment in the
long-term social and economic benefits of preventing serious material hardship.
If the premise were valid--that federal entitlements go to the poor--this would
be a worthy argument. Unfortunately, the facts seem to be otherwise. In 1986
the U.S. public sector spent about $525 billion, or 12.5 percent of GNP, in
benefit payments to individuals. Of this total, about $455 billion was financed
at the federal level: about $360 billion consisted of cash payments, and the
rest consisted of in-kind payments (for example, health care, food stamps, and
rental assistance). How much of all this went toward alleviating poverty? No
one knows for certain, but probably no more than about 20 percent of the total,
or approximately $100 billion. The rest represents income transfers from
non-poor taxpayers to non-poor beneficiaries (and, increasingly, to non-poor
purchasers of federal debt).
This result should not be surprising, considering that of the $455 billion
dispensed from the federal budget, 85 percent was not means-tested--in other
words, was not targeted to people living in poverty. These non-means-tested
benefits went, by and large, to those groups least likely to be poor. The
lion's share, $271 billion, consisted of Social Security and Medicare payments,
which went indiscriminately to nearly every elderly person. The elderly now
enjoy the lowest poverty rate--less than three percent when the calculation
includes total benefit income--of any age group. Far from targeting the poor,
Social Security cash benefits are actually regressive, in the sense that those
with the highest lifetime incomes receive the highest monthly payments. Another
$47 billion was spent on the two most generous pension systems in America:
civil-service and military retirement programs. Among the beneficiaries of
these programs poverty is practically unheard of; most are not "retired" at all
but working at another job and earning a second pension. The average annual
income for a federal pensioner is now more than $35,000. Still another $26
billion went to agricultural subsidies. Though this is equivalent to about
$18,000 per person working in agriculture, it doesn't help many farm workers.
Instead it goes primarily to the owners of the farms with the largest sales,
and to banks to service farm debt. Finally, about $43 billion was spent on
assorted other non-means-tested programs, such as veterans' health care (going
mostly to elderly people with higher-than-average incomes and without
service-related illnesses). Unemployment compensation, amounting to less than
$18 billion, almost gets lost in this sea of money.
Many of these programs, and especially Social Security, provide invaluable
income support to millions of people who would be in poverty without them. This
is true especially for members of what Stephen Crystal, in America's Old Age
crisis, calls the "multiple jeopardy" groups--those who can be characterized in
two or more of these ways: over seventy-five (a group expected to grow by more
than 50 percent by the year 2000), widowed, single, divorced, in poor health,
without a private pension, and nonwhite. For example, the mean income of the
black elderly was only 54 percent of the mean income of the white elderly in
1980. But these people are helped mainly by dint of the enormous sums of money
spent, not by virtue of any rational allocation scheme.
It is also argued that federal retirement benefits "belong" to the
recipient--despite the consensus among experts that the benefits payback for
Social Security and Medicare is five to ten times greater than the actuarial
value of prior contributions; plainly put, even middle- and upper-income groups
get back vastly more than they put in (including interest and employers'
contributions). As for civil-service retirement, we are told that it is a
genuine pension system, under which federal workers and federal agencies each
contribute seven percent of payroll to a "trust fund" in behalf of every
worker's retirement or disability. Yet the pension level is so high (averaging
56 percent of pre-retirement pay), the retirement age so young (age fifty-five
after thirty years of service), and the disability criteria so easy (one
quarter of all civil-service pensioners are "disabled") that every outside
actuary has found, here too, that benefits far exceed contributions. Most say
that recipients get somewhere between two and three extra dollars for every
dollar they contribute. Unlike any private pension, moreover, civil-service
pensions are 100 percent indexed to the Consumer Price Index--with the absurd
result that federal pensioners often outearn their successors in office.
As for military retirement, here we confront the ultimate bonanza. The
serviceman contributes nothing to a trust fund, but upon reaching a median age
of forty-one (and completing at least twenty years of service), he is entitled
to 50 to 75 percent of pre-retirement pay, indexed yearly, for life. Typically,
military pensioners--including many of the most valuable members of our Armed
Forces, who are induced to quit by the retirement bonanza--spend more years
collecting benefits than they ever spend in the service. Only one quarter are
over age sixty-five, all are eligible for Social Security, and most pursue
second careers to achieve a "triple-dip" private pension.
The Administration and Congress have often boasted of "cutting back" on
excessive benefit spending. Unfortunately, nearly all the painful and
high-visibility cuts have been made in the 15 percent of all benefit programs
that are means-tested. One result is that means-tested benefits have hardly
grown at all as a share of GNP during the 1980s (in fact, excluding Medicaid,
they have actually shrunk; hardly any poverty cash benefits are indexed).
Another result is that such benefits target the poor even better now than they
did in the 1970s, since most of the cuts have effectively excluded many
near-poor beneficiaries, those whom we do not consider truly needy. Meanwhile,
the tremendous non-means-tested programs--protected by powerful middle-class
lobbies and automatic 100-percent-of-CPI indexing--have burgeoned.
Over the past generation federal benefits have grown roughly twice as fast as
our economy. What is most ominous about the long-term trend in the cost of
non-means-tested benefits, however, is that these benefits will necessarily
continue to grow faster than our economy even if we do nothing explicit to
increase benefit levels. Just leaving the budget on "automatic pilot" will lead
to fiscal disaster. The forces guaranteeing this result are threefold: the
aging of America, the hyperinflation in health care, and the uncontrollability
of benefit indexing.
The aging of America: Well over half (about 56 percent) of all federal benefits
now go to the 12 percent of our population who are age sixty-five and over. We
now direct, on average, about $9,500 a year in federal benefits to each elderly
American (largely consumption). In contrast, we direct less than $950 in
federal benefits, including aid to education, to each American child (largely
investment). In fact, total federal spending on net infrastructure investment
and non-defense R&D, the benefits of which will last several generations,
amounted to only $357 per child in 1986. That's equivalent to the increase in
federal benefits per elderly person that now occurs every six months.
But even if benefits per elderly person henceforth grow no faster than our
economy, we can be certain that the total cost burden will. By about the year
2015 the age composition of the entire United States will be the same as that
of Florida today. By 2040 there may be more Americans over age eighty than
there are Americans today over age sixty-five. Over the next fifty years,
depending on future fertility and longevity, our working-age population will
grow by two to 18 percent, while our elderly population will grow by 139 to 165
percent.
The more "pessimistic" projection (to use the strange term applied by the
Social Security Administration to the projection involving longer life-spans)
implies that our labor force will grow by only six million people while our
elderly population will grow by 46 million. Today each retired Social Security
beneficiary is supported by the payroll taxes of 3.3 workers. By the year 2020
the ratio will have declined to at most 1:2.3. The official pessimistic picture
shows the cost of all FICA-funded Social Security benefits rising to an
obviously unacceptable 36 percent of every worker's taxable pay by 2040, from
13 percent today.
Health-care hyperinflation: The novel cost-saving reforms introduced four years
ago to Medicare and Medicaid (such as the new prospective pricing now used by
Hospital Insurance) stirred widespread hope that we had turned the corner on
the rapid growth of health-care spending. Today such hope has faded. Although
total U.S. health-care spending as a share of GNP fell slightly in 1984 (from
10.5 percent to 10.3 percent), it rose anew, to an unprecedented 10.7 percent,
in 1985, and further, to 10.9 percent, last year. We already know that the rate
of inflation for medical care was 7.9 percent in 1986, a rate about seven times
higher than the rise in the Consumer Price Index. Optimistic projections made
by federal health officials just two years ago are already in shreds. As the
Health Care Financing Administration admitted in its report last year, "Little
relief appears to be in sight....The decline in the share of GNP going to
health in 1984 appears to be a one-time blip in the historic trend rather than
the start of a new trend." Healthcare benefits as a share of the federal
budget, meanwhile, did not experience even a one-year dip. They have risen
every year of the 1980s and now amount to about $120 billion annually, or 25
percent of all federal benefit spending.
The underlying causes of America's health-care cost explosion have been
discussed at length elsewhere: the rapid climb in real technological and labor
costs per treatment, the impressive increase in the number of treatable acute
and chronic illnesses, and, of course, the stubborn persistence, in both the
public and private sectors, of inefficient health-care regulations and
perverse, cost-plus reimbursement systems that insulate both health-care
professionals and patients from the cost of treatment.
Amazingly--even with the federal reforms enacted in this decade--Medicare has
shown nearly the same real rate of annual growth in the 1980s (8.7 percent from
1979 to 1986) as it did in the 1970s (8.7 percent from 1969 to 1979). As
recently as 1975 Medicare's total cost was only $14 billion. Last year it was
$74 billion, and it may well hit $100 billion by 1990. By 1991 outlays for
Hospital Insurance, which account for two thirds of Medicare benefits, may
already start to exceed payroll-tax revenue. Thus, without further reform the
Hospital Insurance trust fund will almost certainly go bankrupt by the end of
the 1990s.
Why have the reforms thus far proved ineffective? A large part of the problem
is that per capita health-care costs are rising much faster for the elderly
than for the population as a whole. Longer life expectancy means
disproportionate growth in the oldest age groups, and it is well documented
that every measure of health-care utilization rises steeply from age sixty-five
on. In 1982, for instance, the average reimbursed hospital cost for Medicare
enrollees over age eighty-five was two thirds higher than that for enrollees
aged sixty-five to seventy-five. The average per capita cost of long-term care
is ten times higher for the "old" elderly than for the "young" elderly, and the
high cost of long-term nursing care for the elderly, which is not covered by
Medicare, is steadily encroaching on means-tested public benefits not primarily
designed for the elderly. In 1984, for instance, though the elderly made up
only 10 percent of Medicaid's beneficiaries, they accounted for nearly one
third of Medicaid's total spending.
Experts at the Health Care Financing Administration now project that
health-care spending in the United States will hit 15 percent of GNP by the
year 2000. Do we really think we can become competitive in trade while
allocating a still larger proportion of our scarce supply of capital and
skilled labor to health-care consumption? According to Lee Iacocca, the
Chrysler Corporation pays more money to Blue Cross/Blue Shield every year than
it does to any other supplier. Sooner or later we must debate health-care
spending in terms of affordability. We must ask why, for instance, we continue
to devote so many resources to comforting us at the end of life (more than half
of an American's lifetime health-care costs are incurred after age sixty-five),
while we pay a Head Start teacher less than $10,000 annually to prepare us at
the beginning of life. Other industrial countries are facing such questions
with both common-sense humanity and a steady eye on the future. We alone are
not.
Uncontrollable indexing: The history of the indexing of non-means-tested
benefits is one of the sorriest stories in federal policy-making. Perhaps the
most flagrant case in point was the egregious "double-indexing" of Social
Security cash benefits enacted in 1972, which essentially pushed up the
benefits for new retirees by two CPI indexes at once. This was a colossal error
that caused the average retiree benefit to grow far faster than either prices
or average wages during the mid-to-late 1970s. The error was apparent to nearly
every policy expert as soon as the legislation was passed. But though Congress
took only several weeks to debate and pass the 1972 Social Security amendments,
it required several years to correct the mistake. In the late 1960s only six
percent of all benefits were indexed; today 78 percent of all benefits are
indexed to one price index or another, including nearly every non-means-tested
cash benefit. The result, quite simply, has been to render outlays for benefits
uncontrollable by either Congress or the President.
Most important, indexing makes it impossible for elected policy-makers to
reorder their spending priorities by gradually allowing real benefit levels in
some programs to fall behind inflation while committing new resources to new
problems. This perversity is highlighted by the names that we give to these two
types of spending ("discretionary" to outlays earmarked for national
investment, and Entitlements to outlays earmarked for personal
consumption).
Back in the early 1970s, when most federal benefit programs were first indexed,
none of these problems seemed to matter much. Back then, after all, real
federal spending, real GNP, and real wage levels were all still growing
rapidly. Today such problems obviously do matter. Facing the prospect of
declining or (at best) stagnant real consumption per worker over the next ten
or fifteen years as we do, it follows almost by definition that during many of
these years we will see prices rising faster than after-tax wages. Each year
this occurs, indexing will automatically cause benefit spending to grow faster
than wages are growing. The very nature of indexing will then pose genuine
questions of equity: to what extent should beneficiaries not in poverty be
"held harmless" from downward jolts in the standard of living that affect all
other Americans?
To say that the fundamental forces driving up federally financed consumption
are aging, health-care inflation, and indexing is not, of course, to say that
there is any painless way to avoid them. They cannot be avoided, precisely
because all three forces are so closely connected to the shape of our
population, as well as our technology, expectations, and political culture. We
can, however, speculate on the consequences of trying to avoid them. Recently I
asked James Capra, an expert on the federal budget (an unequaled forecaster of
our current deficits), to make a forty-year projection of the federal
budget--given no change in defense or domestic policy and using the same
long-term economic and demographic assumptions that are used by the Social
Security Administration.
The results? Using the official pessimistic assumptions, total non-means-tested
benefit spending--in the absence of any new benefit provisions--will rise by an
amazing 9.6 percent of GNP by 2025, as the retiring Baby Boom generation claims
its health-care and cash retirement benefits. By then the explosion in
Medicaid-funded nursing care will add another 1.2 percent of GNP. All told,
assuming that the totality of other federal costs grows no faster than our
economy, the total projected federal outlays for fiscal year 2025 will amount
to about 35.4 percent of GNP. Outlays for benefits will consume 22.3 percent of
GNP--a sum nearly equal to the entire federal budget today--and outlays for
Social Security and Medicare alone will consume more than 31 percent of
workers' taxable payroll. These incredible results are most certainly not
predictions; instead they are projections of the future of our present
policies. That these outcomes seem impossible is a virtual guarantee that they
will be just that. What they mean is that today's policies are unsustainable.
They will be radically changed. The only question is how--whether in a
political spasm or gradually allowing those affected to plan ways of coping.
From Denial to Reconstruction
We face a future of economic choices that are far less pleasant than any set of
choices we have confronted in living memory. What, concretely, will these
choices entail? Looking into the future is always a dangerous task, but here is
my attempt to sketch a sequence of future economic issues that will change our
lives. My sketch follows the probable chronological order--near-term,
medium-term, and long-term--in which reality will impose these issues on us.
The near term (1988 to 1992). Over the near term (a period that already exceeds
the "long-term" time horizon of almost every legislator and executive
policy-maker) America's primary economic challenge will be to extricate itself
from growing foreign indebtedness without touching off a global crisis. The
single most important step toward a successful outcome will be for America to
generate steady, large, and predictable increases in its net national savings
rate over the next several years. This, in turn, cannot be accomplished without
steps to eliminate the federal-deficit drain on private savings. Fiscal balance
is thus the cornerstone of any plan to cut our trade deficit.
So long as the U.S. demand for foreign savings remains insatiable, any attempt
to force-feed U.S. exports to foreigners in any one sector or to any one
country will simply be vitiated by a stronger dollar, which will tend to worsen
the U.S. trade balance in all other sectors or with all other countries. It's
like placing a few sandbags on top of an overflowing dam: you can change where
the water will spill over, but you can't change the fact that it will spill
over somewhere. If there is little action on the federal budget over the next
five years, therefore, the odds of a global crash landing will certainly
grow.
As we have seen, a successful escape from our foreign-sector imbalance (barring
an improbable near-term leap in U.S. productivity growth) could be accompanied
by a decline in real consumption per U.S. worker. Over the next five years, in
other words, we must be prepared for a perceptible fall in real after-tax
employee compensation combined with a similar decline, or at best a stagnation,
in real government spending--both in benefit payments and in defense spending.
On the positive side, we can look forward to a rapid expansion in U.S.
manufacturing output and employment, a steady improvement in our trade balance,
and a steady decline in the rate of foreign-capital inflows (slowing, though
not stopping, the deterioration of the net U.S. investment position by 1992).
But, in order to avoid the crash scenarios, there is plenty that we must also
prepare for on the negative side: a further (though modest) decline in the
exchange rate of the dollar, considerable inflationary import-price pressure,
and a very tough assignment for the Federal Reserve Bank and its new chairman,
Alan Greenspan--finding an interest rate high enough to control inflation and
keep the dollar from collapsing, yet low enough to avoid a serious U.S.
recession. Most likely, the Fed will have to strike a balance between bad news
on both fronts: some accommodation to inflation (as import prices rise) and
some accommodation to higher interest rates (as foreign lenders get finicky).
For most working Americans the coming decline in the growth of real household
consumption will probably be felt not in any marked change in dollar salary
raises but rather in the erosion of real dollar income caused by unavoidably
swifter inflation. Wages in manufacturing, exportable business services, and
energy will climb much more steeply than wages in other sectors--a trend
reversal from the early and middle 1980s which many Americans will welcome. The
indexing of federal benefits, meanwhile, will become a major political issue.
Not only will steady reductions in budget deficits be difficult to sustain
without a major reform of indexing, but 100 percent cost-of-living adjustments
for middle- and upper-class federal beneficiaries during years of declining
real income for most American workers will raise reform as a stark question of
equity. The cost-effectiveness of defense and foreign-aid spending will also
come under increasing scrutiny. Since we know full well that it will take a
heroic effort to find the resources for economic investment alone, it is
totally incredible that we could fund both our domestic obligations and our
current global military obligations. By the end of this decade, therefore, it
is likely that the United States will raise strategic "burden-sharing" as a
routine point of discussion in our economic summits with other industrialized
powers.
The medium term (1992 to 2007): The fifteen years that follow our near-term
period promise to be a crossroads in our nation's future. As Americans enter
this era, five years from now, they may still be uncertain whether the United
States has successfully worked its way out of its foreign-sector imbalance.
Ironically it will probably be a signal of impending disaster if real
per-worker U.S. consumption is significantly higher in 1992 than it is today,
and it would almost certainly be a symptom of worsening global imbalance. Other
symptoms would include minimal reductions in our budget deficits and in our
credit inflows, further cuts in our net domestic investment, high interest
rates, and special ad hoc arrangements to keep our creditors happy--such as
yen-denominated Treasury bonds or de facto foreign veto power over U.S.
monetary policy. More likely, we will see a considerable dampening in real
per-worker consumption, and we will be worrying about (or trying to recover
from) a long recession characterized by stagnant global demand.
But twenty years from now when young adults currently entering the work force
are approaching the peak of their careers and when the oldest Baby Boomers are
contemplating retirement, the foreign-imbalance problem will have been
resolved, one way or the other. By then we may have entered one of the
prolonged crash scenarios sketched earlier--the decline of the bumpy British
variety or the indefinite depression of the 1930s variety. If, on the other
hand, we have resolved the problem successfully, we can expect that our
current-account deficit will have declined steadily during the early 1990s and
will be turning into a modest surplus by the late 1990s. As that happens, the
focus of our policy debates will likely shift from the problem of reducing our
foreign borrowing to the challenge of raising our level of domestic investment.
Over the near term most of our extra savings must be focused on raising net
exports, which is our sole means of weaning ourselves away from foreign
creditors. Only later will we be able to concentrate on the more rewarding task
of reconstructing our future. Only after paying off our credit-card bills, so
to speak, can we think of buying a new home.
The long term (2007 on): Should America not make investment its number-one
policy priority in the medium term, it will surely have to pay the price in the
long term. It will not be a price denominated solely in terms of labor
productivity, real wages, and global political influence. The price will also
include an utter lack of preparation for the most stunning demographic
transformation--from workers to dependents--in American history. In the fifteen
years between 2010 and 2025 the number of Americans who are of working age will
decline by perhaps as many as 12 million (from 174 million to 162 million).
Meanwhile, assuming that current longevity trends persist, the population of
elderly will grow from 42 million to 65 million. If investment, retirement, and
health care for the elderly seem unaffordable to our society today and for the
next twenty years, when a "boom" generation is working and a "bust" generation
is retiring, we can only imagine how unaffordable they will be thirty years
from now, when the situation is reversed.
If in the medium term the Baby Boom has channeled a sufficient share of its
income into education, training, tools, and infrastructure to permit a quantum
leap in productivity by the next generation of workers, it may enjoy a
prosperous and contented old age. But if the flow of invested endowments from
each generation to the next has ceased--and if each generation instead insists
on its "right" to consume all its own product and part of the next generation's
as well--then we can count on a meager and strife-torn future.
In any summary discussion of America's prospects in the near, the medium, and
the long term, there is one theme that must be emphasized above all others: the
indissoluble bond between the economic behavior of one decade or generation and
the economic well-being of the next decade or generation. Over the near term we
must accept the punishment we are inheriting from the ill-fated gamble of
Reaganomics. Similarly, over the medium term we must overcome the
low-investment heritage we have received from thirty years of postwar
preoccupation with "demand management." Both tasks will require a determined
effort to save. We will have to raise our net national savings rate, now
somewhere between two and three percent of GNP, to between six and seven
percent of GNP in the coming five years (a level still beneath our level in the
1970s) and to between 10 and 12 percent of GNP within twenty years (a level far
beneath that of Japan's, but just about on par with the average for today's
industrial countries). By the first decade of the twenty-first century, in
other words, we will have to be rechanneling yearly into investment some $450
billion that we now spend on private and public consumption.
This broad prescription has implications not only for action but also for
understanding. The question is not the easy and popular one of where to invest
but the brute one, ignored by both political parties, of where to find the
resources. Thus, in the coming election year we need to apply a critical
yardstick to the policy proposals of the presidential candidates: Does this
proposal face up to the long-term problems caused by our neglect of investment
in favor of consumption?
Our problems are not, at bottom, economic. We are stymied by our lack of
political consensus on economic policy--something unimaginable to our Japanese
and German trading partners, for whom national consensus (born of national
crisis) informs decisions on savings, investment, productivity-related wage
increases, exports, and money-supply growth.
With the proviso that we must put a very large question mark over the capacity
of our political system to deal with the nation's economic problems, I offer
these brief policy suggestions.
First, we must tame the federal budget deficit. Real defense spending has been
effectively frozen for the past couple of years, and we may be at a crossroads
in foreign policy which will allow us to make substantial future savings in
security expenditures. Greater sharing of the burden by our NATO allies is
clearly on the horizon; it should proceed proactively, not reactively (that is,
not simply in response to one financial crisis or another). I believe the time
is also right for a historic arms treaty with General Secretary Mikhail
Gorbachev, whose nation's resources are far more severely constrained than ours
and who desperately needs breathing space. The deal I envision would cover the
more costly and, when one considers the size of the Soviet tank armies, more
plausibly threatening conventional forces, as well as strategic weapons. A new
international division of labor remains to be worked out with Japan. The
agreement that I think is needed would have Japan provide, for example, far
more World Bank support, aid not tied to its exports, and more incentives for
major capital flows to Third World countries; further, it would forge a
U.S.-Japan strategic-economic partnership in areas of the world critical to
both countries--Latin America, say. In turn, the United States would continue
to provide military assistance to Japan. Finally, the newly industrializing
countries can no longer simply be beneficiaries of an open world economy. They
must now join the club of the industrial countries and pay their dues,
including aid to the poorer countries.
As for domestic spending, we must above all slow the growth in non-means-tested
entitlements, starting with a reform of benefit indexing. Cutting the
non-poverty-benefit cost-of-living adjustment, or COLA, to 60 percent of the
CPI (a "diet COLA"), for instance, would save about $150 billion in federal
outlays annually by the year 2000. Gradually raising the retirement age and
lowering initial benefits to the relatively well off (for example, those with
histories of high wages) should be combined with the taxation of all benefits
in excess of contributions, which could save well over $50 billion annually by
the year 2000. Note that under this proposal the progressivity of the tax
system would leave intact benefits that go to the poor. There are those who
protest the "humiliation" of the means test; however, these reforms go far
toward honoring the principle of need, doing so implicitly rather than
explicitly.
We should also take a more serious look not simply at the unfunded liabilities
of our federal retirement programs but at all the various elements of a
grievously costly fringe-benefit pension program. Civil-service and military
retirement programs should be made part of a total compensation package
comparable to those in the private sector. They should gradually be made
self-supporting (that is, funded as our corporate pension plans are), through a
combination of benefit reductions (with special emphasis on lower initial
benefits and later retirement, as well, of course, as reductions in COLA
indexing) and higher contribution rates.
Second, we must act decisively to put a lid on America's excessive and wasteful
consumption of health care, three quarters of which is either funded directly
from public budgets or paid through publicly regulated insurance systems. This
is not the place to enter the thicket of specific health-care reforms, but we
must begin to experiment in earnest with various means by which to replace the
horrendous, indeed perverse, inefficiencies of the current "cost-plus" system
with the discipline of market forces (for example, greater cost-sharing, or the
use of medical vouchers).
Third, to the extent that our federal deficits cannot be eliminated in the near
term by simply deciding to spend less, we must increase federal revenue. The
Reagan Administration has steadfastly opposed tax hikes by claiming that they
would permanently sanction an increased "tax burden." But surely the
alternative is worse: to sanction permanently an increased "debt burden." My
choice among revenue options is some form of consumption-based tax. A phased-in
tax on gasoline of twenty-five cents a gallon, for instance, would generate
about $25 billion a year by 1990--and also serve to depress world energy prices
and moderate the now-rapid rise in our oil trade deficit, without destroying
the global competitive position of critical export products such as
petrochemicals. A broad-based five-percent value-added tax on all products
would of course generate considerably more revenue--more than $100 billion in
1990, or enough to halve the federal deficit.
Fourth, over the longer term we should encourage higher private-sector savings
rates by trading off increases in consumption-based taxes for reductions in
investment-based taxes. Our industrial competitors, after all, have already
adopted the principle that people should be taxed more according to what they
take out of the pot than according to what they put in. Most of those countries
do not tax corporate income twice; most of them do not tax interest, dividends,
and capital gains as ordinary income; and most of them do not allow sweeping
personal exemptions for home-mortgage interest, for employer-paid health care,
and for unearned public retirement benefits. At the same time, all our
industrial competitors have much higher household and corporate savings rates
than we do. It's time our policymakers put two and two together.
The least productive enterprise Americans can engage in--though it is virtually
second nature--is trying to place the blame for what has happened to our
economy in the 1980s on one political party or ideology. Blame is beside the
point, for it is something we all share. To be sure, it is easy to find fault
with the conservative fiscal leadership of the current Administration. (Indeed,
I will confidently predict that in the years to come President Reagan will
lament his May, 1985, decision not to support his own party's leadership in its
effort to freeze entitlement COLAs. President Richard Nixon, after all, has
come to lament his decision to sign those COLAs into law.)
But, clearly, the liberals and the Democrats are equally to blame. Long before
Reagan entered the White House, liberal opinion leaders persuaded the public to
regard the budget and the tax code as engines of free national consumption. It
was a Democratic Congress that argued in favor of deficit spending for so many
years that no one could recall (with only one budget surplus since 1960) the
rationale behind fiscal balance. And it was a Democratic President who
pioneered the art of disingenuous forecasts (when President Johnson signed the
Medicare Act, he said that an extra $500 million in federal spending would
present "no problem"; today Medicare costs 150 times more than estimated). The
very success that the Democrats enjoyed in promoting consumption, in fact,
persuaded Reagan's conservative backers to dish the Whigs and beat the
opposition at their own game.
Reaganomics was founded on a bold new vision for America, yet today--another
irony--we hear every politician who is warming up for the 1988 campaign,
Republican and Democrat alike, complaining about the lack of vision in America.
The reason we feel adrift is that we are waking up to the fact that blind and
self-indulgent gusto is not vision at all but denial. True vision requires the
forging of a farsighted and realistic connection between our present and our
future. It means recognizing in today's choices the sacrifices all of us must
make for posterity. America's unfettered individualism has endowed our people
with enormous energy and great aspirations. It has not, however, given us
license to do anything we please so long as we do it with conviction.
Copyright © 1987 by Peter G. Peterson. All rights reserved.