The Rubin Recession

March 25, 2004; Page A16

Robert Rubin will never admit it, but the recession that began in the third quarter of 2000 was the direct result of the Clinton administration's attempt to pay down the federal debt. The Clintonites did this, you'll remember, by leaving tax rates high enough from 1995 to 2000 so as to direct a larger and larger share of the surge in growth of personal income to be paid in federal taxes. In the four quarters from the second quarter of 1999 to the second quarter of 2000 individual income tax receipts of the federal government increased by 11.4% -- exactly twice the 5.7% growth rate of personal income.

Most of our post-World War II recessions were the result of monetary expansion leading to an increase in inflation which gave the Federal Reserve little choice -- tighten money sufficiently to restrain the growth of the debt/credit expansion. Typically, the Fed encountered difficulty restraining credit growth without producing a recession. Though some would suggest the FOMC was six months too late in easing monetary restraint in January 2001, there's little doubt that the monetary ease fueled a 2001-2002 increase in household debt countering the GDP slowdown to 2.4% in 2001. In the four quarters to the end of the years 2000, 2001 and 2002 household debt growth increased at annual rates of 8.3%, 9.1%, and 10%.

Most economists would prefer to see corporate and other business debt grow more while household and government debt grew less. Few are willing to recognize that when household and government debt grows too slowly then growth in business debt abruptly slows as businesses have no need to borrow to finance an increase in employment and output. That is exactly what happened to the growth of business debt in 1999 and 2000 as a 12.2% growth of business debt in 1998 slowed in the next four years to 11.2%, 9.5%, 6% and 2.8%.

The motives to pay down the federal debt were laudable -- first, to increase national saving by reducing federal debt; second, to reduce the so-called use of Social Security excess of receipts over outlays to fund federal government spending -- and naove. Naove as hardly anyone seemed to realize that increasing national saving in the federal sector would reduce national saving in the household and business sectors.

The "pay down the federal debt" advocates, led by Mr. Rubin, apparently did not understand in 1996 and do not understand in 2004 the first principal of macroeconomics -- output growth is not sustainable without a growth of total credit and debt. If federal debt grows more slowly than total debt then household and business debt must compensate by accelerating their growth rate above the desired rate of output growth. If federal debt is to be paid down the necessary increase in household debt would sooner or later increase household debt as a share of GDP to levels that would not be conducive to a continuation of the growth of household spending on goods and services. Whenever financing household debt becomes too burdensome to sustain household spending then a reduction in the rate of household spending would be followed by a plunge in the rate of increase in business debt.

From 1998 to 2002 the growth rate of business debt slowed from 12.2% to 2.8%. Only by monetary policy actions which both succeeded in lowering interest rates on home mortgages and sustaining the rise in home prices could household debt accelerate from 8.2% in 1998 to 10.0% growth in 2002. However the increase in household debt to 85.6% of GDP has handicapped the rate of output and employment growth in 2003 and 2004. And this household debt burden continues to require both low interest rates and rising household wealth from real estate and the stock market to avoid deflationary pressures.

The recent peak in federal debt as a percentage of GDP averaging 49% from 1993 to 1996, compared with the all-time peak in 1946 of 109%, was rapidly reduced by an annual pay-down of the debt of 1.4%, 1.9% and 8% successively in 1998, 1999, and 2000. Unfortunately, the rapid pay-down of the debt slowed the growth of GDP from 6.2% in 1998 to 2.9% in 2001. Any serious economist knows such a slowdown in growth of GDP would result in a slowing of tax receipts whether tax rates were reduced, remained the same, or even increased. But, especially if tax receipts were stock-market boosted by a surge in taxation of retirement income and capital gains, then tax receipts would fall with the decline in the economy and the decline in stock prices.

By paying the federal debt down by 12 percentage points from 46% of GDP in 1997 to 34% in 2001 it was necessary that monetary policy accommodate an increase in household debt by 19 percentage points from 67% in 1997 to 86% in 2003. Our household sector is saddled by a 28 percentage point increase in the household debt-to-GDP ratio to 86% as compared to a 34-year average of 58%. Does it make sense for politicians to say we must not leave this federal debt to our children and grandchildren when in fact it is only a question of whether the debt is federal, household, or business debt? Ironically the attempt to "pay down the federal debt," seems to have coincided with a 37 percentage point increase in non-federal debt and a 38 percentage point increase in total non-financial debt to 204% of GDP.

For the sake of my children and grandchildren I hope for a less hysterical view of debt -- an understanding that high debt levels compared to the ability to service the debt is a disadvantage to households as well as to governments. I favor policies that lead to rising levels of income and well being with the realization that if debt burdens are too high they may well spawn desirable changes toward more thrift. The mantra of paying down the national debt has necessitated a reduction in interest rates that could eventually be accompanied by a too-casual approach to debt -- low interest rates make debt appear to be less burdensome. And that is a worry.

What worries me more is the rate of growth of government spending. Government spending tends to crowd out private spending whether it is financed by taxes or by borrowing. Federal debt does not crowd out private sector investment spending through any channel than higher interest rates. The concern for now is that interest rates are likely to remain too low to motivate more thrifty responses. If, in the future, total debt increases result in interest rates that are higher than necessary to motivate saving and to discourage private sector borrowing, then those higher rates would surely crowd out federal spending as well as private spending. The only crowding out is from the size and rate of increase in federal spending -- it is spending that diverts labor and capital away from private capital goods production, not the increase in debt.

Only hysteria, an outburst of emotion and fear, could produce the irrational response of the Congress and the public to the supposed danger of federal debt left to our children and grandchildren. Save your outbursts for reining in the growth rate of government spending. Then we will be able to keep tax rates conducive to faster increases in output and thereby add to both the well-being of our people and to future tax receipts available to the Congress.

Mr. Angell, member of the Federal Reserve Board of Governors from 1986 to 1994, is a former Bear Stearns chief economist


posted March 25, 2004