Recovery and Deficit: Where Is the Us Economy Going?

Listener: 21 February, 2004.

Keywords: Macroeconomics & Money;

Many New Zealanders assumed that when our economy stagnated in the late 1980s and early 1990s, the rest of the world stagnated, too. In fact, it boomed, and New Zealand’s per capita GDP fell from the OECD average to 15 percent below. Similarly, there has been a tendency to assume that there was no world recession in the first few years of the millennium, because New Zealand was hardly affected by it.

The millennium recession seems over, but the subsequent course of the international economy troubles economic observers. Probably, the Bush administration tax cuts, coupled with generous increases in government spending, were the main factor expanding the world economy. Yet the recovery has been more sluggish than usual, and it is only recently that commentators have been sure of the end of the recession. It remains a jobless recovery, and Bush may go into the presidential election at the end of the year with a smaller work- force than when he was elected.

Future voters may have more to worry about, for the enormous government deficit from the tax cuts and spending is generating rapidly rising government debt. Just about every sober commentator considers this course unsustainable, although there is less consensus as to what happens after.

George W Bush seems to be following Reaganomics –– you will recall his father described it as “voodoo” economics –– which also opened up the deficit and escalated debt. After Reagan and Bush Sr moved on, Clinton made deficit reduction his number one economic priority, because the debt path was unsustainable. Yet, addressing it was not without risks. As one of his economic advisers, Joseph Stiglitz, wrote in The Roaring Nineties:”[It] meant, of course, putting aside the social agenda that had motivated [Clinton] …… standard economics held that deficit reduction would slow down the recovery and increase employment. [We] were, of course, aware that reducing the deficit was traditionally thought to worsen the economy, and if that happened, the whole strategy could backfire: slower growth would lead to even larger deficits.”

Stiglitz says that these fears were not realised because of a “sequence of events that was neither expected beforehand nor fully understood as it unfolded”. Long-term interest rates fell sharply (by over a third), the value of bonds rose, and the banks, whose balance sheets were under pressure, were able to recapitalise and get back into the business of financing investment. Right policy for the wrong mechanisms.

So deficit management is considerably more complicated than what first-year textbooks tell. Even so, under all plausible assumptions, the indications are that Bush Jr has a fiscal deficit that is unsustainable. Even its defenders rely on it generating record economic growth, with no evidence that the concomitant productivity increases will occur.

How to explain the jobless (or low job) growth. My guess is that the wonky balance sheets that we associate with corporate failures such as Enron and Worldcom were more widespread (although the illegalities may not have been). So the cash that the deficit pumped into the economy was first used to improve corporate finances, rather than for investment. Additionally, imports grew faster than exports, so a lot of the jobs were generated offshore. Most of the rest of the world is expanding, too.

The US trade deficit opened because the American people could not supply the savings to fund the US Government deficit, and so it has fallen to others –– notably Japan and China –– to purchase the US Government bonds. There is an important difference here from New Zealand trying the same strategy. Foreigners are happy to buy US dollar denominated bonds (but not our ones).

Or at least they are at present. When they decide they have had enough may be the point at which the unsustainability of the US internal and external deficits become internationally evident. Already, foreign financial institutions are increasing their holdings of Euro-denominated assets. Although the world is a long way from using the Euro as the currency of choice, today it is an option.

The other worrying weakness of the US economy is the military spending, especially tied up in expensive operations in the Middle East. Although colonies and neo-colonies will benefit some of the interests in the imperial power, they are usually an overall drain on the economy. At some stage –– possibly this US election, more likely the next –– the Americans will revolt over the burden of Iraq. Again, we cannot be sure what happens after that.

Despite the rhetoric of the Bush administration, we may see a relative weakening of the US in the world economy. My preference is for a pluralistic world, not dominated by any single power. But that should arise by the strengthening of other nations, rather than by an absolute weakening of the US because it overextended itself.