Bush Should Triple His Tax Cuts

Wynne Godley

The US president is right to relax fiscal policy but his plans are not aggressive enough to avoid recession, says Wynne Godley George W. Bush, the US president, may eventually have to propose tax cuts or public expenditure increases far larger than those he has in mind. The reason is simple: the medium-term outlook for the US economy could be much more depressed than most economists now expect. For some years it has been fashionable, when discussing macroeconomic policy, to concentrate almost entirely on supply-side factors. The outstanding achievements of the US with respect to innovation and productivity seem to have led people to suppose that demand can be ignored. Indeed, Edmund Phelps wrote last year that the US experience could not have been caused by demand expansion and concluded that growth had  become "structural" (Financial Times, August 9 2000). 

Yet aggregate demand obviously has risen in the US and the motor driving it has been both unique and unsustainable. During the 45-year period between 1952 and 1997, total private expenditure was almost always below disposable income. In the third quarter of 2000, it exceeded income by 8 per cent. This excess was possible only because the private sector had been realizing assets and borrowing on an increasing scale; the indebtedness of the personal sector reached 1.1 times its annual flow of disposable income - a record - while debt of the private sector as a whole reached 1.7 times disposable income - another record. 

It is often pointed out that the huge increase in asset prices has put household balance sheets in a strong position despite the increase in debt. But debts have to be serviced with cash and this sets a ceiling on the extent to which they can prudently be incurred. In addition, businesses have become increasingly indebted: their investment has been growing in excess of internally generated funds, yet they have simultaneously been net purchasers of equity. 

Recent levels of private expenditure relative to income cannot be sustained unless the flow of net lending continues on at least its recent scale, requiring a further rapid increase in indebtedness. The daunting implication is that aggregate demand will fall if the growth of debt merely slows. If the level of indebtedness were to fall, implying that debts were in fact being repaid, the effect on aggregate demand would be even larger. This "hard landing" scenario has nothing to do with the problems that would be created by a traditional end-of-cycle inflation surge, which obsessed many Wall Street economists as recently as last summer. 

There are now clear signs that the limits to business sector borrowing are being reached, while the fall in stock prices and the decline in consumer confidence make it unlikely that lending to the household sector will be sustained at recent levels far into the future. 

The present situation in the US has close parallels with what happened in Britain 12 years ago. Then, similar claims were made that a new era had dawned as a result of Margaret Thatcher's supply-side reforms. But aggregate demand then was powered by an expansion of net lending, just as the US miracle has been. Moreover, at its peak - the first quarter of 1989 - the UK's private sector deficit expressed as a percentage of gross domestic product was almost exactly the same as that reached in the US during the third quarter of 2000. In the subsequent two years, as the UK's private deficit fell to zero, GDP fell absolutely and unemployment rose by about three percentage points. 

One does not need an econometric model to conclude that a similar rise in US private net saving could result in a recession of comparable magnitude; it would imply a fall of 8 per cent in total private expenditure relative to income as well as a shift of the budget back into deficit and a large improvement in the balance of payments. The implications for the rest of the world would be serious. 

The Federal Reserve's recent decision to lower interest rates by half a percentage point was possible because inflation is still not a concern, as it was in the UK 12 years ago. Yet monetary policy alone cannot do the trick. True, the cut in interest rates backed up by subsequent cuts could stem the fall in asset prices and relieve the burden of interest payments. But cutting rates could reverse a deceleration in aggregate demand only by re-establishing the asset price and credit boom. Such measures would merely postpone the day of reckoning. 

The only effective antidote to a shock caused by a reversion of private net saving would be a significant fiscal relaxation. The fact that fiscal policy cannot be used to counteract short-term fluctuations in the economy - in the way most people advocated in the 1960s - does not mean that the fiscal stance should not be relaxed if it gets too tight in the medium term. 

Mr. Bush is looking for a tax cut worth about 1.5 per cent of GDP spread over 10 years. The shortfall in domestic demand could rise to 5 or 6per cent of GDP. Mr. Bush should, therefore, be thinking of numbers about three times bigger than those he is now proposing.


 Financial Times Published: January 21 2001 20:07GMT