Let's Get Growing
Can America grow faster?
Right now, that may seem like an odd question. Employment is surging, the stock market is strong, and corporate profits are up. In the second quarter, economic growth could top a 4% annual rate.
But hardly anyone expects the current spurt to last much longer. Forecasters predict that the economy will soon revert to an average annual growth rate of 2% or so, continuing the long growth slide that began in the mid-1970s. In fact, growth since 1990 has averaged only 1.9%.
Such lukewarm gains aggravate virtually every economic and social problem that plagues the country. Slow growth means stagnant wages, slipping standards of living, and insecure jobs. Americans feel as if they're scraping by: It's hard for families to save for retirement, it's hard for governments to pay for essential services, it's hard for corporations to expand.
Raising the long-term growth rate by just one percentage point, from 2% to 3%, could produce a massive payoff in wages, living standards, and economic security. As a result, a vigorous new growth debate has sprung up, fueled in part by election-year politics. There are those who regard 2% to 2.5% growth as if it were some iron law of nature. For instance, some members of the Federal Reserve, joined by a Cassandra-like chorus of bond-market vigilantes, fear that any attempt to boost growth above that rate will only reignite inflation. But many business leaders disagree, saying the U.S. could enjoy an economic boom if only the Fed would ease off the brakes. Republican Presidential candidate Bob Dole says the economy could double its growth rate with big tax cuts--but that would likely increase the deficit. President Clinton responds that the economy is doing quite nicely on his watch--but he, too, is prepared to stimulate growth with a set of budget-busting handouts.
The truth is, this economy can achieve faster growth without higher inflation--but not by resorting to quick fixes or trendy tax plans. Instead, the U.S. must attack its twin fundamental problems: too little savings and too little investment. Net national savings--the funds available for new investment--average less than 5% of the nation's output, down from the 11% average of the 1960s, when the economy zipped along at a 4% average annual pace. And despite massive spending on computers and other technical gear, business investment is barely keeping ahead of depreciation on existing plant and equipment. As a result, net business investment is languishing at an astonishingly low 2% of GDP (chart).
That's why BUSINESS WEEK believes the U.S. has to go back to economic basics: It must save more so it can invest more in new machines, new technologies, and better-educated workers. Increased savings will lower interest rates and cut the cost of capital. Cheaper funds will encourage investment, which will fuel stronger growth without higher inflation. It's simple, says Boston University economist Laurence J. Kotlikoff. "Countries that don't save, don't invest--and countries that don't invest, don't grow."
QUICK RESPONSE. Shifting to a pro-savings, pro-investment economic policy can lift the economy over the next few years to a long-term growth rate of 3% or more. The pay- off from such an acceleration would be enormous. A decade from now, the economy would produce an extra $3,000 in goods and services for every American adult and child. In 30 years, faster growth would add 35% to economic output, assuring comfortable retirements for baby boomers.
A pro-savings, pro-investment policy is the most direct way to boost the country's competitiveness in international markets. With more and newer machines and equipment, U.S. workers would be more productive. And higher levels of investment would also enable companies to more quickly adopt new technologies.
BUSINESS WEEK's growth plan will require three major changes in government policy. To begin with, the next President and Congress must remove Washington's drain on saving by balancing the budget. How? Not by raising taxes, as President Bush did in 1990 or President Clinton did in 1993, but by cutting spending. Putting the budget on a five- to eight-year path toward balance would lower long-term interest rates by almost two percentage points and make it easier for businesses to get the funds they need to invest.
Second, the tax system needs to be overhauled and simplified. The goal is to let capital flow freely to the investments with the best economic return. That doesn't mean taking the radical step of shifting to a flat tax. Instead, BUSINESS WEEK advocates closing tax loopholes that distort investment and savings decisions. The resulting savings would pay for a tax cut to bring individual rates back to or below the 28% top bracket of 1986, from today's top rate of about 40%.
The third, and most controversial, step: Convert Social Security to a fully funded pension system, complete with individual savings accounts. Privatizing Social Security would boost national savings and increase U.S. plant and equipment by 25% by 2020. The massive flow of funds into the equity markets would substantially reduce the cost of capital and encourage investment. Sure, the shift to a privatized system would force workers to bear more risks. But far more menacing are the threat of slow growth and the danger of a breakdown in the current Social Security system.
Other changes are needed as well. Along with more investment and savings, the economy needs better-educated workers. Indeed, the return on investment in human capital is higher than the payoff on physical capital: Economists estimate that spending on education yields 10% to 15% annual returns, after inflation. Ideas to reform schools and ease access to higher education are crucial to the economy's long-term growth.
But even the best-educated worker cannot succeed without the right equipment. Americans simply aren't saving enough to support the growth they want. Individuals and businesses alike are saving far less of their income than they did 30 years ago, thanks to a societal shift away from thrift and toward financial innovations that allow more debt.
One clear result: Capital costs are a lot higher than in the fast-growth '60s. In that decade, when inflation averaged 2.5% a year, triple-A corporate borrowers could issue long-term bonds at 5%, a real interest rate of 2.5%. In the 1990s, average inflation is only slightly higher, at 3.3%, but corporate rates have averaged 8.2%--a real rate of almost 5%.
DEFICIT DRAIN. With the increasing integration of the global economy, some analysts argue that domestic savings don't matter. The trillions of dollars that move through foreign exchange markets create an immense river of capital, ready to flow to the economy that offers the highest returns. In theory, a low-savings country such as the U.S. can finance its growth by borrowing from Japanese or European savers. To some extent, that's what has been happening. The U.S. financed its 1980s consumption spree in part by borrowing from abroad.
But global capital markets haven't broken the link between a country's savings and its ability to invest. "Maybe one-third of the world's capital is in the global pool--the rest stays home," says Stanford University economist Paul R. Krugman. So economies with high savings rates, such as Japan, Korea, and Taiwan, maintain much higher investment rates over long periods than low-savings countries such as Britain, Canada, Sweden--and the U.S. High savings don't wipe out the business cycle: The Japanese, who still tuck away 13% of their income, have suffered through a four-year recession. But as the Japanese boom of the '80s demonstrated, savings can power strong growth.
Even if more foreign capital were available, borrowing from abroad to finance investment at home is a losing proposition. Although the dollar is gaining strength now, foreign investors still demand an interest-rate premium to protect themselves from the risk of exchange rate losses. And like any loans, foreign borrowings must be repaid with interest. By the end of 1994, the latest data available, Americans had borrowed so much abroad that they owed a net $584 billion to foreigners. The result: "We're sending a growing share of the fruits of our labors to foreigners, instead of using them to improve our own living standards," says Harvard University economist Benjamin Friedman.
Raising the capital for faster growth at home has its price. To save more, Americans must consume less--and that includes the government. Federal deficits, not including Social Security, have risen from their 1960s' average of 0.9% of gross domestic product to 4.2% in the 1990s. Even with the deficit coming down from its peak, Washington still consumes more than a third of a meager pool of private savings. "We've tried all kinds of tax breaks and other things to boost savings, with no result," says Martha Phillips, executive director of the antideficit Concord Coalition. "The one thing we know will work is, balance the budget."
That's not just some arcane economic theory. In 1993, the passage of deficit-cutting legislation triggered a bond rally that cut interest rates 1.4 percentage points in 10 months. Over the long run, a credible plan to eliminate the budget deficit could, by itself, give the economy a one-time boost of 0.8% of GDP and raise the long-term growth rate by one-quarter of a point, according to DRI/McGraw-Hill estimates.
TAX ROULETTE. How should the goal of a balanced budget be reached? Earlier this year, the Republicans and the Democrats came within an eyelash of agreeing on a deal to balance the federal budget by 2002 solely through spending cuts. That deal broke down--a historic opportunity lost to political posturing. Any plan to cut the deficit should follow similar lines. That means slowing the 9% annual increases in Medicare and Medicaid spending, while holding the already slow growth in defense and other domestic spending below the rate of inflation.
Eliminating the deficit, while essential, is only part of the growth prescription. The U.S. also needs a streamlined tax system. A new tax code must lower rates and eliminate distortions that punish savings and investment. With a few exceptions for clear social goals, such as encouraging homeownership and charitable giving, reformers must wipe out subsidies and special tax breaks that turn business decisions into tax roulette.
This doesn't mean massive tax cuts or a shift to a radically new tax system. While such calls may win applause on the hustings, neither will guarantee a prosperous 21st century. Look at the precedent: Ronald Reagan's massive tax cut of 1981 didn't produce any surge in savings or investment.
Moreover, studies suggest that a new system that taxes consumption and exempts savings--such as the 17% flat tax trumpeted by Steve Forbes in the GOP primaries--could at best enlarge the economy by a meager 4% after a decade, says University of California at Berkeley economist Alan J. Auerbach. Even this effect would be further diluted by adding in low-rate brackets to ease the burden on the poor and special benefits to ease business' switch to a new code.
BEHAVIOR CHANGE. A better idea is an overhaul rather than a replacement. Congress and the White House should strive to improve upon the Tax Reform Act of 1986, which closed loopholes and shut down tax shelters to fund a sharp reduction in tax rates. The goal should be to roll rates down to or below the 1986 brackets of 15% and 28%.
That will require eliminating a host of special-interest tax breaks. Many such cuts will hit specific industries--such as financial services ($12 billion in annual tax breaks), energy ($2.5 billion), and mining ($1.5 billion). But Congress should look hard at tax breaks that favor individuals, too. While the deduction for mortgage interest helps support homeownership, the cap on such deductions could be significantly reduced: Anyone who can afford a $1 million mortgage can get by without full deductibility. Congress should also look again at interest deductions for home-equity loans, 58% of which fund car purchases or other consumption, not home improvements or other investments.
A tax overhaul should also put to an end the bickering over how to tax capital gains. The right approach: Tax gains just like other types of investment income, such as interest and dividends. Giving special tax breaks to capital gains can distort investment decisions. Moreover, after years of wrangling, economists can produce little clear evidence that lower rates on gains boost the investment in equipment and human capital that the economy needs to grow. Instead, much of the advantage from a lower rate on gains goes to buyers and sellers of real estate. The revenue that would be lost by giving preferential treatment to capital gains could better be applied to lowering rates for all taxpayers.
Cleaning up the tax code will help ensure that investment follows market forces, not political dictates. And a simpler code with fewer deductions and lower rates will reduce the compliance burden. By freeing up more money to boost savings and investment, a revamping of the tax code could quickly pay dividends in terms of improved growth.
In the long run, though, the single biggest boost to savings and growth will come from privatizing Social Security--converting it to a combination of social insurance and worker-owned investment accounts. This dramatic change is the best opportunity to create more of a savings culture in the U.S.
BUSINESS WEEK's plan for boosting growth would break Social Security into three parts, following a proposal by five members of the President's Advisory Council on Social Security. Each part would be funded by a share of the existing 12.4% payroll tax now paid by workers and employers.
The first part would be a standard pension for all workers, supported by a 5% payroll tax. Second would be survivors' and disability insurance, run by the government just as it is now and financed by a 2.4% payroll tax. These would comprise the safety net.
The last five points of payroll would fund Personal Security Accounts (PSAs)--individual accounts that workers could invest in stocks, bonds, or other approved investments. In effect, these would be defined-contribution retirement accounts, much like today's 401(k) accounts. The new system would be phased in over some 70 years. Today's retirees and workers aged 55 or over would collect benefits under the current Social Security plan. Workers 30 to 54 at the time the PSA plan is implemented would get credit for their earnings in the old system, as well as the proceeds of their PSA accounts. Twentysomething workers and future generations would be wholly in the new plan.
Shifting to such a combined system would spur savings and economic growth. Fully funding Social Security will boost savings within the system, argues Harvard economist Martin S. Feldstein: Obligations owed to current beneficiaries will shrink as they age and die, while higher returns will help workers' private accounts grow faster. Feldstein estimates that the switch will bring the cost of capital down by 1.4 to 2 percentage points. Feldstein and Boston University's Kotlikoff both conclude that privatization will add 0.5 percentage points to the economy's growth rate over the next 25 years.
At the same time, privatization could help restore "an attitude that we've got to put something aside for tomorrow instead of just living for today," says Kotlikoff. Savings behavior can be changed, as employers have shown when they vigorously promote their 401(k) retirement plans. By focusing on the need for fully funding the retirement of today's and future workers, Americans might actually be induced to save more, something that they are not doing now. Baby boomers, especially, are saving only one-third of what they'll need to retire in reasonable comfort, says Stanford University economist B. Douglas Bernheim.
RISK AND REWARD. Privatization will benefit workers in another important way. Currently, payments into the Social Security trust funds earn the equivalent of about 2% annually, after inflation. That's far below the 7% average real return seen on stock market investments over the past 70 years. Under privatization, if account holders get market returns on their funds, Social Security's actuaries calculate that PSA balances will total $14.7 trillion by 2020 and $118.3 trillion by 2045. By contrast, the latest projections show the current Social Security trust fund peaking at $3 trillion in 2018--and falling to zero by 2029.
Any such wholesale switch will force retirees and workers to accept more risks. Today's Social Security is immune to personal imprudence--no one can take Social Security benefits in a lump sum and blow them on a bad investment. It is indifferent to the ups and downs of the financial markets. And it offers what economists call insurance against longevity, because a retiree can't outlive his or her benefits.
The PSA privatization plan advocated by BUSINESS WEEK would keep some of the safety-net features of Social Security. Disability and survivors' insurance would still be retained. But privatization asks workers and retirees to assume greater risks. In most cases, the dangers can be minimized--and the rewards will outweigh the risks.
Take financial risk. Private accounts invested in stocks and bonds would be vulnerable to crashes or bear markets--raising the specter of 65-year-old workers seeing their accounts decimated just before retirement. But that fear flies in the face of the stock market's record. Since the end of World War II, the return on equities has beaten Social Security's 2% inflation-adjusted return in almost every 20-year period. Going further back, of course, the crash of 1929 and the ensuing depression wreaked havoc on stockholders. But another Great Depression would force government to step up its income support in any case.
FRAGILITY. Minimizing other risks may require strict regulations. Workers may be required to keep their Social Security savings in trust accounts with approved investments--publicly traded stocks, bonds, mutual funds, and other securities, and perhaps some regulated real estate partnerships--to ensure that retirees don't sink their mandated savings into speculative franchises or collectibles. To provide longevity insurance, lump-sum distributions may be banned, or retirees might be required to put some of their funds into long-lived annuities. Even with such protections, government might have to provide a safety net. "When this debate heats up, you're going to hear a lot about the poor elderly widow who outlives her savings," warns Massachusetts Institute of Technology economist Peter A. Diamond.
Privatization may pose risks--but today's Social Security is already resting on a fragile foundation. "If we keep going as we are, we're gambling that the whole system won't collapse or be repudiated by future generations," warns Sylvester J. Schieber, vice-president for research at benefits consultant Watson Wyatt Worldwide in Washington and one of the main advocates of the PSA. "The current system runs on political capital--the promise that the government will tax workers hard enough to keep paying your benefits." The PSA plan "would replace that with real capital."
Perhaps the biggest unanswered question is how to pay for the enormous transition costs of moving to a privatized system. Right now, the benefits promised to future retirees far exceed the amount of money available from the Social Security trust funds. This shortfall is enormous: Social Security's unfunded promises to future retirees are worth $8 trillion to $12 trillion. Privatizing Social Security and converting it to a fully funded pension system will force the government to recognize and somehow pay for this unfunded liability.
Paying for the transition--and deciding which generations will bear the burden--will pose an enormous political challenge. The clout of elderly voters is already locking many politicians into a defensive stance. "We will have a lot of people running for Congress in November on the promise of saving Social Security as it is now constituted," warns Charles P. Blauhous III, an aide to privatization advocate Senator Alan K. Simpson (R-Wyo.). And it's not just congressional candidates: During the GOP primaries, Dole lambasted rival Forbes for proposing privatization.
FED FACTOR. Nevertheless, the burden of transition must be shared across generations, by current retirees as well as current and future workers. To finance the switch to a private system, the government could issue new bonds, serviced by a 1% additional payroll tax. Such taxes would hit current and future workers--who will get a poorer return from Social Security than today's beneficiaries. To compensate, the elderly can contribute by accepting lower cost-of-living increases or higher taxes on their benefits.
Are the massive changes in policy proposed by BUSINESS WEEK really needed? Some business leaders and analysts would say they're not. These growth optimists see signs in the current economy that the long growth slide may be ending. They point to three years of double-digit growth in capital spending coupled with downsizing and heavy investment in new technologies. As a result, many U.S. businesses see rising productivity in their operations.
Moreover, the 1990s restructuring of U.S. business could be producing payoffs in quality and service that can't be captured in official statistics. So far, statisticians poring over the economy's indicators can't find a lasting increase in the 1.1% annual rate of productivity growth that has prevailed since 1973. But soaring profits and surging stock prices may be a better indication of the economy's vigor than the sluggish pace of GDP and productivity figures.
That's why many executives claim that growth could surge if policymakers, especially the Federal Reserve, would just loosen the economy's reins. The National Association of Manufacturers (NAM) launched a public campaign on June 26 to urge the Fed to cut interest rates by half a percentage point and boost growth to 3%. "The Fed and the Administration should take risks on the side of growth," argues Dana G. Mead, CEO of Tenneco Inc. and chairman of NAM.
But the economy's recent performance does not suggest that the Fed has been holding back the economy. Indeed, for the past 18 months, unemployment has been below the 6% that the central bank's statisticians once calculated would ignite inflation.
Even if the Fed had its foot on the economy's brake, a tap on the accelerator wouldn't help long-term growth. Suppose the central bank could push down the unemployment rate by a further half-point, to around 5%, without accelerating inflation. The result, says Stanford's Krugman, is that "we'd get one year of 3.2% growth--and that's all. The next year, we'd be back at 2.2%. It wouldn't help the trend a bit."
NEW SPIRIT. In addition, the apparently high rate of business investment cited by the growth optimists overestimates the amount of productivity-enhancing capital actually being added to the nation's economy. Much of the new spending is on computers, which become obsolete within a few short years. To keep up with this rapid rate of depreciation, business investment needs to be far higher to actually get the useful capital stock growing quickly again.
The U.S. can't afford to wait for an uncertain boom. Even if growth is stronger than we think, the economy can still use more savings and investment. If anything, a faster-paced, higher-tech economy will increase the demand for funds. Research spending, on the decline in both federal labs and private industry, depends on a stronger stream of capital. So does the process of getting research and development out of labs and onto the production line: "Capital investment speeds up the spread of technologies," says Berkeley economist Paul M. Romer. The technological seeds planted in the early '90s need cheap and plentiful capital to flower.
A quarter-century of slow growth has robbed America of some of its spirit. The old metaphor of the American economy--a rapidly expanding pie from which everyone can take a larger and larger slice--has been replaced by the notion of the zero-sum game, where each winner's gain is some other player's loss.
To restore the old spirit, Americans must go back to economic basics. Consume less now. Put more away for the future. Invest wisely. Regardless of what political candidates may promise, there is no surer way to guarantee a bright tomorrow for the U.S. economy.