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Q:Based on the current economic scenario, and taking into account the recent interest rates increases, how probable is the hypothesis of a “soft-landing” for the American economy?


LRW:  It is highly improbable that an economic slowdown could stop at a “soft-landing”, given economic conditions that exist today. The U.S. expansion of the past half dozen years has been driven to an unprecedented extent by private sector borrowing. Indeed, the private sector has been spending more than its income in recent years, with its deficit reaching 5.5% of GDP in 1999. In order for the economy to continue to grow, this gap between income and spending must continue to grow. My colleague at the Jerome Levy Economics Institute, Wynne Godley, has projected that the private sector’s deficit would have to climb to well over 8% of GDP by 2005 in order to keep economic growth just above 2.5%. Even that is below the current rate of growth (about 4%). A smaller private sector deficit would mean even lower growth. There are two problems with this scenario. First, our private sector has never run deficits in the past as large as those experienced in this current expansion. In the past, private sector deficits reached a maximum of about 1% of GDP and then quickly reversed toward surplus as households and firms cut back spending to bring it below income. Not only are current deficits already five times higher than anything achieved in the past, they have already lasted two or three times longer than any previous deficits. Even more importantly, the private sector has had to borrow in order to finance its deficit spending, which increases its indebtedness. Private sector debt is already at a record level relative to disposable income. As interest rates rise, this increases what are known as debt service burdens—the percent of disposable income that must go to pay interest (and to repay principal) on debt. In combination with an economic slowdown, which reduces the growth of disposable income, many firms and households will find it impossible to meet their payment commitments. Defaults and bankruptcies are already on the rise, and things will only get worse. Thus, I believe there is a real danger that an economic slowdown could degenerate into a deep recession—or even worse.


Q:In your view, what policy actions are needed to achieve a “soft-landing”? What would be the timeframe for this to happen?


LRW: In order to answer this question, I must first say something about the processes that brought us to this point. As everyone knows, our government began to run budget surpluses last year (in fact, if you take together state and local governments as well as the federal government, we’ve had an overall government budget surplus for more than three years). At the same time, the U.S. has had a large and growing trade deficit. At the national level, there is a relationship among these three balances that must hold true. The government budget surplus plus the trade deficit equals the private sector deficit. In other words, because our government spends less than its income (its tax revenue) and because the US buys more from abroad than it sells to foreigners (in a sense, spending more than its foreign income), its private sector must spend more than its income to keep GDP from falling. There is little the U.S. can do about its trade deficit—a point I’ll return to. This means that the only way to maintain growth as the private sector begins to cut back its spending is for the government to step up to the plate and spend more than its income. To put this in the simplest possible terms, the only way the US can achieve a soft-landing is for the government’s budget to move quickly and sharply to deficit as the economy slows. Obviously, this is very unlikely—due to political reasons and all the nonsense about the importance of running surpluses in order to retire government debt and to “save” for the future.


Q: What is the possibility of a credit crunch in the coming months as a consequence of interest rate increases? Is a recession approaching?


LRW: Yes, a recession is approaching, although it is difficult to say exactly when it will begin. Delinquency rates and bank charge-off rates are rising, in large part due to rising household debt service ratios. Ironically, the U.S. is just now revising bankruptcy laws in a way that will make it harder for debtors to default. While that will make it easier to collect on debts, it also means that indebted consumers will have to cut back spending elsewhere. This will make it harder to get out of a recession because consumers will still be stuck with debt run-up during the Clinton expansion. Given the record-level of indebtedness of the private sector, it is likely that a downturn will generate a large increase in bad debts held by financial institutions, which may well cause them to cut-back lending. It is noteworthy that the highest debt service ratios were reached in the late 1980s, and that the recession at the end of that decade led to a serious credit crunch. We may well be in for another credit crunch that will make recovery from the coming recession all that more difficult.


Q:Do you agree with some analysts’ forecasts that the price of petroleum could reach US$40,00 a barrel or more? If so, what would be the impact on the American balance of payments? How much bigger can the American trade deficit grow and remain sustainable? Is it indispensable that the dollar loses strength?


LRW: Well, neither of these are my main areas of research, but I’ll speculate. In the short run, I would not be surprised to see oil prices rising further, given robust U.S. demand for petroleum and OPEC’s resolve. However, it must be remembered that there are vast reserves left in Russia and other formerly socialist states, so that I expect prices to come down significantly in the medium term. The U.S. trade deficit may well continue to rise for another few quarters. There will be some improvement as we head into recession, although as our recession spreads to the rest of the world, the trade deficit will settle on some still significant level. I should also note that if, against all odds, the U.S. were to continue to grow robustly, our trade deficit would probably rise above 5% of GDP. Is this sustainable? Probably not for the long run, but I don’t worry much about sustainability, because most economic processes are not sustainable if you carry them out sufficiently far. A lower dollar would probably reduce our trade deficit, but not by much. I worry much more about the government surplus—which sucks away private income—than I do about the trade deficit. A trade deficit just means that the rest of the world works hard to send us goods while we send to them dollar-denominated pieces of paper—which is mostly a good deal. I do worry about the employment effects in the U.S., but there are other ways to achieve full employment rather than relying solely on shipping your products to foreigners.


Q:Is the current borrowing wave sustainable? What would be the consequences of a credit crunch for the domestic economy and for the rest of the world? How would European and Japanese economies react to a “hard-landing” in the U.S., including the possibility of a weaker dollar?


LRW: It should be clear from what I said earlier that I believe the record private sector deficits and debt levels are a big cause for concern. While no one can say for sure when the private sector might retrench and return to a more normal relationship between spending and income, I think it is highly probable that this will come sooner rather than later. Because the U.S. has been the major engine of growth for the world economy, a recession in the U.S. is likely to spread to the rest of the world. While the U.S. is likely to grow more slowly, and while this might reduce its trade deficit somewhat, it is impossible to predict what might happen to the dollar. A recession that begins in the U.S. and spreads to the rest of the world may well cause the dollar to appreciate. Note that I do not believe that “credit crunches” cause recessions, but rather that they can hinder recoveries—as the credit crunch in the early 1990s made it difficult to get an expansion going even in the presence of huge government deficits.


Q:How do you analyze the current situation of low unemployment and tamed inflation? Is there any threat of rising inflation?


LRW: While many analysts see low unemployment and low inflation as an unusual situation, history shows—at least for the case of the U.S.—that low unemployment is normally associated with low inflation, while all of our high inflation periods have come during periods of high unemployment. I don’t think this is so hard to explain. Low unemployment and strong growth allow firms to operate closer to capacity, hence more efficiently. They adopt labor-saving techniques, raising labor productivity. They can reduce mark-ups over costs on a greater volume of sales and still achieve growing profits. Especially in the context of the “new global economy” with substantial competition from low-wage countries, it is very difficult for U.S. firms to raise prices no matter how high demand is. Of course, higher energy costs (that also are incurred by competitors abroad) will probably lead to some price hikes. The Fed’s interest rate hikes have the same effect on domestic firms and on foreign firms to the extent that other central banks follow the Fed’s lead. This is because interest is much like a tax on doing business since most firms use short-term loans to finance “working capital” expenses (to hire labor and purchase raw materials). Thus, apart from OPEC, the main inflationary threat comes from the Fed—however, I think the rate hikes are finished. The evidence is pretty strong that the economy is slowing so it is unlikely the Fed will raise rates further.


Q:Did the income distribution improve in recent years with decreasing unemployment rates? How equitable is the American economy nowadays?


LRW: Yes, I think that almost all research on this topic shows a significant turn-around of the income distribution toward greater equality. I think it is particularly interesting that this has occurred even with the run-away stock market boom, which has greatly increased income and wealth at the top. This shows just how important it is to reduce unemployment if you are concerned with income distribution. As most research shows, inequality in the U.S. fell from WWII until 1973, and then started to rise. Most economists were surprised to find that it continued to increase even during the Reagan expansion—which contradicted the old theory that a “rising tide lifts all boats”. Clearly, economic growth alone does not necessarily lift boats at the bottom. During the Clinton expansion we finally got unemployment rates down—close to those enjoyed during the 1960s—and finally inequality stopped rising. However, it would be misleading to claim that everything is fine down at the bottom. Research I’ve done shows that even during the Clinton expansion, there has been very little improvement in job prospects at the bottom. Things are particularly bad for high school dropouts (those who have not graduated from high school)—about 17% of the adult population. Unemployment rates do not tell the whole story, because most of the lowly educated who do not have jobs are counted as “out-of-the-labor-force”, rather than as unemployed. Many of these are people who simply don’t bother to look for work because they’ve given up hope of ever finding a job. My estimate is that perhaps 15 million people have been left behind by the Clinton rising tide—people who would be expected to be “ready, willing, and able” to work, but who are not employed even at the peak of the business cycle. Most of these have low educational attainment (high school graduation or less). In addition, the U.S. currently has 2 million adults in prison or jail—half a million more than China even though our population is only one-fifth its size. Our incarceration rate is easily tops in the world. Most of those in prison are young, poorly educated males who had very low employment rates prior to incarceration. Finally, many analysts have found that a large proportion of Americans are forced to work two or more jobs to make ends meet, given that real wages had been falling since 1973; while real wages have risen in the last couple of years, the real incomes of many groups (especially families with young and lowly educated heads of household) are actually below what they had been in 1973.

Since a “rising tide” won’t lift the boats at the bottom sufficiently, other well-targeted programs are needed. For this reason, I’ve been advocating a “public service employment-assured jobs program” (PSE) in which the federal government provides funding of wages and benefits for a jobs program for all who are “ready, willing, and able” to work. The central idea is that only the federal government can provide a perfectly elastic demand for labor, supplying the funds to hire all those who show up for work. It is not necessary that the federal government actually do the hiring—indeed, I would decentralize the program as much as possible so that most of the jobs would be supplied by state and local government as well as by not-for-profit organizations. The wage and benefit package would be fixed, setting a base rate for the economy. In economic booms, private employers would recruit workers out of the PSE program, shrinking government spending on the program. In recessions, the private sector would shed workers, who would then find jobs in PSE—automatically increasing government spending. In this way, full employment would be maintained even as stability of wages would be ensured—preventing inflation or deflation. Furthermore, workers who had previously been considered to be “unemployable” (such as high school dropouts, especially blacks and other minorities, in the US) would gain skills and work experience, changing the private sector’s assessment of their employability. If, as recent US experience shows, lowering the measured unemployment rate by a few percentage points can improve income distribution significantly, then full employment with price stability through a PSE program would have to be much more effective at achieving such a goal.


Q:How would the present scenario change with the plans announced by the presidential candidates?


LRW: I cannot see any major differences in the economic proposals of Gore and Bush. Both plan to maintain budget surpluses (although they have slight differences in their plans concerning “what to do with the surplus”) for the indefinite future. Neither will consider the necessity of reversing course in the very near future to move the budget sharply toward deficit. That said, deep recessions have a habit of turning everyone into “Keynesians”. The problem is that given the current political mood, efforts to reduce taxes and increase government spending in order to fight the recession will likely come too late. The first recourse will be to call on the Fed to lower interest rates. I think Japan has proven that even with four years at zero interest rates, monetary policy is helpless in recession. Neither presidential candidate appears to have even the slightest hint of an understanding of the dangers faced by the U.S. economy, so it is not surprising that neither of them is proposing solutions.


Q:How would you compare the current economic cycle with past experiences, especially the boom cycle witnessed during the Reagan administration?


LRW: The current expansion appears to be more precarious than the Reagan expansion. Recall that even at the height of the Reagan expansion, the government was still running huge deficits. While our trade deficit then was comparable to our current trade deficit, the large government deficit under Reagan fueled economic growth with only a small private sector deficit—which peaked at just over 1% of GDP. When the private sector retrenched, combined with state and local government surpluses generated by the expansion, the economy slowed into recession. At that point, the federal budget deficit boomed and helped to pull the economy out of recession, although as I discussed earlier, the credit crunch hindered recovery. Now, however, the federal budget is biased toward surpluses—even when the economy slows, the budget will remain in surplus. Only a very deep recession will cause a federal budget deficit. Hence, I would compare our current situation with that of the UK or Japan at the end of the 1980s, rather than with the US’s situation at that time. In both the UK and Japan, the government budget moved sharply toward surplus at the end of the 1980s, and remained in surplus as the economy faltered. In Japan, the government budget actually remained in surplus for six years and drove the economy into a deep recession from which it has never recovered. In some ways, the UK’s experience is even more relevant, because like the US it ran trade deficits. Thus, its private sector deficit also peaked well above 5% of GDP before turning sharply around toward surplus, generating a very deep recession. Unemployment in the UK was driven to double digits and remained there for a long time. This is probably the closest available example to what might happen in the US.


Q:Do you think the increased productivity and activities related to the so-called “New Economy” can avoid a “hard-landing”?


LRW: For the most part, the increased productivity simply results from operating the economy nearer to full capacity—it is just a residual that falls out of the equation that relates GDP per capita to the employment rate multiplied by output per employee. When GDP grows robustly, that is, faster than employment, measured productivity rises. Most of this talk about a “new economy” is just nonsense. Neither GDP growth nor productivity growth has been unusually high in this expansion, rather, they have simply returned toward long-run US averages. Thus, while they are unusual compared with the poor performance of our economy after 1973, they are not unusual if one takes a longer period for comparison. Certainly, things don’t look unusual when compared with the so-called “Keynesian” era—the three decades after WWII. In an important article, economist Robert Gordon has shown that the increased productivity can be entirely attributed to a short-term cyclical effect plus increased productivity in the computer manufacturing sector. Surprisingly, there has been no “spill-over” of “new economy” productivity to other sectors. What this means is that any “new economy” effects on productivity have been limited only to the production of computers, with no benefit accruing to the sectors that actually use computers. That is a very strange result. However, what this tells me is that the current expansion is not at all unusual, that it has nothing to do with the “new economy”, and, hence, that the “new economy” is not going to save us from a hard landing.



posted  October 9, 2000