CHAIRMAN GREENSPAN STILL DOESN’T GET IT
L. Randall Wray
Professor of Economics and Senior Research Associate
Center for Full Employment and Price Stability
University of Missouri, Kansas City
Even as the Goldilocks economy fades into memory, Chairman Greenspan calls for more of the blood-letting that killed her. In testimony before the US House Committee on the Budget (September 12, 2002), the Chairman exhorted Congress to renew its commitment to “fiscal responsibility” by “restoring fiscal discipline”. He bemoaned the federal budget’s return to “chronic deficits”, now projected to last through at least 2005. More ominously, he warned that “growing contingent liabilities” in the form of future Social Security and Medicare (and other) benefits promised to today’s workers represent a “daunting long-term fiscal challenge”. He recommended that those future benefits be included somehow as an expenditure in reckoning current budgets. Given that these contingent liabilities “amount to many trillions of dollars”, not only are long-term reforms of these programs required, but a “disciplined approach to fiscal policy” must be renewed today. If not, chronic deficits will return, absorbing the nation’s savings, pushing interest rates up, lowering private investment in capital, and thereby diminishing our future ability to take care of retiring baby-boomers.
There are at least three critical errors in Mr. Greenspan’s reasoning.
First, it was “fiscal responsibility” that doomed Goldilocks, and it is “fiscal responsibility” that prevents recovery. A federal budget surplus results when Washington spends less than its tax revenue. This can occur only by reducing the nongovernment sector’s disposable income. During the Goldilocks expansion, the nongovernment sector maintained its own spending in spite of fiscal drag, but only by borrowing heavily. Indeed, by the end of the expansion, the domestic private sector taken as a whole was spending an amount in excess of its income equal to fully 6% of GDP—by far and away an all-time record for the USA. Just to be clear, this means the typical household or firm in America was spending $106 for every $100 of income. No doubt this was partially fueled by the so-called wealth effect that resulted from the Wall Street boom, but this could not go on forever because it required ever-rising private sector indebtedness. Not only was the federal budget surplus reducing after-tax income, it was also reducing the net (“outside”) wealth of the private sector as government bonds were retired (effectively, the non-government sector “paid” its taxes by surrendering treasuries) even as private sector debt grew. When equity markets turned down, the net balance sheet positions of the private sector worsened—and for the first time ever, net wealth actually fell.
Second, federal government surpluses cannot add to national savings, but in fact represent a deduction from private sector savings and net wealth. According to the Chairman, “between 1992 and 2001, decreasing federal budget deficits followed by surpluses were important to maintaining national saving in the face of declining private saving”. But it was precisely the tightening of federal budgets that caused the decline of private saving! At the level of the economy as a whole there are three sectors: government (including federal, state, and local governments), private (households and firms), and foreign (usually summarized as the balance of payments—essentially exports less imports). In order for one of these sectors to run a surplus, another must run a deficit. In the case of the US, at the peak of the Goldilocks expansion the government sector ran a surplus of about 1.5% of GDP and our balance of payments deficit reached to 4.5% of GDP. By simple arithmetic, then, the private sector must have run a deficit equal to about 6% of GDP—and this arithmetic is validated by the data, as discussed above. Note that in the aftermath of 9-11 as well as the economic slowdown that has been in progress over the past year and a half, the government sector’s surplus has evaporated, with the budget adjusting by about 4.5% of GDP (to a deficit of about 3% of GDP). “Miraculously”, the private sector deficit has adjusted by the same 4.5% of GDP, to a deficit of about 1.5% of GDP. Given our trade deficit (which is not likely to improve significantly in the near term), the private sector will not achieve positive saving (that is, run a budget surplus) until the government sector’s deficit reaches some 5% of GDP. Hence, the Chairman has got it precisely wrong: only by abandoning “fiscal responsibility” and allowing the government budget deficit to expand can we restore private sector saving.
Finally, Chairman Greenspan continues to claim that the fiscal stance of the federal government pressures interest rates—with deficits raising them and surpluses lowering them. But that position is inconsistent with the facts. It takes little sleuthing to discover that the Fed actually raised interest rates when the federal budget moved toward surplus in the mid-1990s, or that the Fed has lowered interest rates in recent months even as the budget moved toward deficit. Further, Mr. Greenspan is surely aware of the case of Japan—which has for half a decade maintained near-zero interest rates in spite of government budget deficits that reach to 8% of GDP (currently by far the highest among developed nations). The facts are plain: no matter what happens to the government budget, the Fed can set its interest rate target anywhere it likes.
In conclusion, a return to fiscal “discipline” is not needed or desired in the current economic climate. American households have been hit with declining wealth (due to declining equity markets and the budget surpluses that removed treasuries from private portfolios), declining income (as lay-offs occurred and hours were cut), growing debt (due to private sector deficits), and loss of confidence. The economy has been living on borrowed time, as zero-interest auto loans and low mortgage rates encouraged consumers in one last round of expenditures. But firms have already cut-back their spending, postponing investment decisions, trimming labor forces, and eliminating excess inventory. State and local governments, reeling from the effects of lower tax collections, are already making massive budget cuts across the country. Economies in most of the world have slowed, making it highly unlikely that the US can rely on exports to boost domestic production. It is time for the federal government to step up to the plate, through further and decisive relaxation of the fiscal stance.
posted September 25, 2002