The Strong Case for Optimism About U.S. Growth
There is merit to some of the arguments for continued weak U.S. economic growth in the near-term, though the pessimism about the long-term prospects for the U.S. economy is unjustified.
Without question, federal government debt, fueled by big deficits -- which were propelled by weak revenue and jumping federal outlays -- is a major problem. It’s also true that in today’s economy, in which voters expect much from government, the chances are slim that significant and enduring budget surpluses will reduce the debt appreciably, even in periods of rapid economic growth.
From 1946 to 1961, real gross domestic product grew at a 3.9 percent annual rate and nominal GDP climbed 6.5 percent a year on average. Even during the Cold War, defense spending in relation to GDP after the 1950-1953 Korean War was relatively small compared with World War II levels. Yet even in the 1950s and early 1960s, before the Vietnam War and the Great Society programs caused federal spending to explode, federal surpluses were few and small.
With deficits relatively small and robust GDP growth, the ratio of federal debt to GDP, the meaningful gauge of looking at government debt, dropped from 122 percent in 1946 to 43 percent 20 years later. This may well happen again, but there are caveats.
The ratio fell even further in the late 1960s and 1970s as inflation generated by increased federal spending created huge tax revenue by pushing individuals into higher tax brackets and imposing corporate taxes on under-depreciation and inventory profit. But the unwinding of inflation starting in the early 1980s gradually removed that government advantage, and with slow GDP growth, the debt-to-GDP ratio again rose.
A more recent example of a reduction of the federal debt-to-GDP ratio was in the 1990s. GDP growth was robust, rising 5.5 percent nominally a year, and deficits shrank to the point that small federal surpluses existed for the fiscal years from 1998 to 2001. Federal tax receipts rose 7 percent on average, faster than nominal GDP, and outlays grew slower, 3.6 percent. The dot-com bubble pushed up individual income tax receipts at an 8 percent annual rate and corporate taxes by 8.3 percent a year. On the outlays side, national defense spending fell 0.2 percent a year as the Cold War ended. Medicare spending jumped 7.2 percent annually but was only 7.8 percent of outlays in the 1990s. Social Security spending climbed 5.1 percent a year, less rapidly than social insurance receipts, which rose 5.6 percent annually because baby boomers were paying Social Security taxes but weren’t yet receiving benefits.
In contrast, in the 2000-2012 years, nominal GDP growth slowed to 3.9 percent. Meanwhile, recession-inspired tax rebates and cuts shrank federal receipts’ annual growth to 1.6 percent as outlays climbed at an average 5.8 percent rate, driven by spending for the wars in Iraq and Afghanistan and higher Medicare costs. Not surprisingly, the resulting huge deficits drove gross federal debt-to-GDP to 103 percent in fiscal 2012.
The lesson drawn from contrasting the 1990s with 2000-2012 is clear. Rapid economic growth, as in the 1990s, pushes down the federal debt-to-GDP ratio directly as the denominator rises, and indirectly as individual taxpayers are pushed into higher tax brackets and corporate profit grows much faster than the economy while tax cuts and government spending on welfare are curtailed.
Conversely, slow economic growth as we saw in the 2000-2012 era pushes the ratio up directly, and it rises even further as the weak economy leads to tax cuts and countercyclical outlays.
So the resumption of rapid economic growth is the answer to the federal debt problem, assuming that government expenditures don’t explode. In this case, of course, the issue is the increasing outlays for Social Security and, especially, Medicare as members of the baby boom generation age. And President Barack Obama’s Affordable Care Act will probably not pay for itself as the administration assumes. So far, Congress and the administration have preferred gridlock to solving the looming entitlement deficits, and the more time that passes, the more disruptive the solutions will have to be.
I believe, however, that the federal government will do what’s necessary when there is no other choice.
Besides the return to rapid economic growth, there is another solution to the heavy federal debt problem: Inflate it away. Some believe in an insidious plot to promote rapid inflation to reduce the real value of federal debt. I doubt that. In the many years I’ve been talking to administration officials and Congress members of both parties, I’ve never even heard inflation mentioned as a federal debt-reducing tool.
And for good reason. We recall the distorting effects of high inflation in the late 1960s and 1970s, and the disruptions required to bring it under control. Many worry that inflation would raise the already-high costs of Social Security and Medicare benefits for the postwar generation. There is also a recognition that the effects of inflation in reducing real federal debt are mitigated by the related increases in the costs of government purchases and benefit payments.
Federal Reserve officials, like all central bankers, are concerned about inflation but, these days, both the Fed and the Bank of Japan are more afraid of deflation and both want to increase inflation to their 2 percent targets. Deflation has reigned in Japan more years than not in the last two decades despite annual money supply growth of about 3 percent. In June,
The Fed’s favorite measure of price changes, the personal consumption deflator (excluding food and energy), rose 0.2 percent from May to June and rose only 1.3 percent compared with June 2012. Investor forecasts for inflation over the next decade, as measured by the spread between 10-year Treasury inflation-protected security yields and 10-year Treasury note yields, dropped from 2.5 percent to below 2 percent at the end of June before creeping up to just 2.1 percent. Prices for U.S. exports of consumer goods (excluding autos) dropped 0.7 percent in July from a year earlier.
There are a number of deflationary forces in the world, including falling commodity prices, aging and declining populations, economic output well below potential, growing protectionism (including competitive devaluations), declining real incomes, income polarization, declining union memberships, high unemployment, and downward pressure on federal, state and local government spending. Aggressive monetary and fiscal stimuluses probably have delayed but not prevented chronic deflation in producer and consumer prices.
The Fed clearly fears deflation. Steadily declining prices can induce consumers to wait for still-lower prices, resulting in excess capacity and inventories that force prices lower still. The Fed also worries that with deflation, it can’t create negative interest rates that encourage borrowers to borrow. Because central bank target rates can’t go below zero, real rates are always positive when price indexes are falling.
Furthermore, if chronic deflation sets in, the Fed can’t raise interest rates. That means it would have no room to cut them to stimulate the economy when the next bout of economic weakness looms.
The Fed is also concerned that deflation increases the real value of debt and could produce considerable financial strains in a debt-laden economy. Debt remains unchanged in normal terms, though as prices fall, it rises in real terms and debtors become less able to pay it off. Because the incomes and cash flows of debtors fall in nominal terms, their ability to service their debts is questionable. This is similar to the situation facing many homeowners today who can’t make monthly mortgage payments because their incomes have been reduced by layoffs, pay cuts and moves to lower-paying jobs, even as their mortgage payments remain fixed.
Congress and the administration also hate deflation because it reduces nominal revenue as corporate profit and household incomes fall and taxpayers drop to lower brackets.
In Part 1, I mentioned the thesis of Northwestern University’s Robert J. Gordon, who thinks that all the big growth-driven technologies are fully exploited. I don’t agree. Much of today’s new technology is in its infancy, and with rapid growth, will increasingly drive the economy. These innovations have the potential to rival the rapid growth and productivity-generating effects of the Industrial Revolution and the development of railroads in the late 1800s.
Today’s new technologies -- including the Internet, biotechnology, semiconductors and computers, wireless devices, robotics, and additive manufacturing and 3-D printers -- may also compare with mass-produced autos and the electrification of factories and homes that spawned electric appliances and radio in the 1920s.
Once private sector deleveraging is completed, in about five years, real GDP growth will probably return to its long-run trend of 3.2 percent a year, an improvement on the 2.1 percent growth in the recovery so far.
Tax simplification may be an oxymoron to rank with military intelligence, vegetarian vampires and airline food, but it may be coming. Corporations are clamoring for lower tax rates, even at the expense of cherished loopholes. Individual taxpayers yearn for an easy-to-understand tax structure.
But tax simplification and complication move in cyclical patterns, so don’t expect any reforms to be permanent. After the 1986 tax cut simplified individual taxes, I praised my friend Barber Conable, who previously had been the ranking Republican on the House Ways and Means Committee for that good work by Congress. “Don’t get too excited,” he warned me. “Almost everything we do for our constituents involves the tax code, so it will get more and more complicated from here until it’s so burdensome that another tax reform results.” Sadly, his forecast proved true.
Beyond the bright prospects for a return to rapid economic growth and a reduction in debt, the U.S. has many long-run advantages in a globalized world, which I will describe in my next column.
(Gary Shilling is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” This is the second in a three-part series. Read Part 1.)
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