Can Putin Survive?
The Lessons of the Soviet Collapse
America's reach, it is said, exceeds her grasp. Some see a gap between our foreign commitments and military strength, and want us to spend more on defense. According to others, the more dangerous gap is economic. To avoid the fate of overextended empires of the past, they say, we must spend less on defense, and adjust our international involvements accordingly.1
I concentrate here on the second, or economic hypothesis, but not in order to promote the first. On the contrary, I find persuasive the experts who believe that with some redirection, and subject to a change in external circumstances, a constant or even somewhat reduced level of real defense spending would adequately support the arrangements that have been central to American foreign policy since the late 1940s.2 But whatever the right level of defense may be, faulty economic analysis should not govern the choice, any more than it should govern how much we spend on education or health.
The air is full of warnings against overestimating America's economic strength. The more likely error, I think, is the opposite. Prompted by a mistaken sense of economic weakness, we are apt to behave as though we were just another beleaguered nation that has to use all its muscle to stay ahead of the pack. Ironically, such devil-take-the-hindmost American conduct would make it harder to cope with the economic difficulties the misunderstanding of which will have caused our failure of nerve.
The hypothesis that the American economy is so overstretched that we must curtail our commitments abroad or suffer economic decline at home-that there is no third choice-is odd even on its face. U.S. national output per family of average size (3.21 persons) exceeds $63,000 a year. We are richer than in the past and spend a smaller fraction of our income on defense than during 27 of the last 40 years. We remain one-and-a-half to two times richer than our faltering military rival, and richer also, though by a shrinking margin, than our richest friends.3
Much has been made of the decline in our relative share of world output, both overall and in manufacturing. But I have not been able to find a reasoned examination of whether the American share is likely to continue to shrink, at what pace, and to what level-or, for that matter, of the consequences for America's national interest of a smaller American share. Presumably it makes a difference whether the nations that are increasing their share are large or small, rich to start off with or poor, democratic, status-quo-minded and friendly or autocratic and expansionist, and whether they are likely to continue growing rapidly. Given plausible assumptions about relative economic size five, ten or 25 years from now, who will and will not be able to do what to whom to advance what possible interest, or defend against what plausible threat? Saying that "China has become virtually a third superpower," or that "Japan has become a financial superpower and is simultaneously committing itself to a productivity revolution . . . ," does not shed light on the consequences for American safety or well-being.4
An intersecting line of reasoning relies on the daunting list of our current economic ills: the twin deficits, rapidly growing debt, a volatile dollar, productivity growth that is much slower than in the past, diminished competitiveness, a deteriorating infrastructure, the growing number of poor, the weaknesses in American education, and so on. Unless we trim our foreign commitments now, the reasoning seems to run, those problems will become unmanageable and cause us to become, if not outright poor, inadequate to the task of protecting our interests in the future.
On some things we can all agree. A continuing international deficit that is not matched by additional investment at home to offset the increase in foreign debt is not a desirable condition or one that can persist. Sluggish productivity growth is not a good thing either, especially in a heterogeneous, achievement-oriented democracy like the United States. Slow income growth is apt to make us stingy and our conduct abroad erratic; in the very long run it might even force us to adopt a diminished role. On both counts-the need to repair the international deficit and the more fundamental need to speed up domestic productivity growth-we must at the margin redirect resources: import less, export more, and invest much more in plant, machinery and infrastructure, and in R & D and education too. The proportionate share of domestic investment and net exports in output must rise.
That much is agreed. But it does not follow that the share of defense must fall-unless, that is, the share of civilian public and private consumption (the latter, at 66.4 percent of the GNP, is by far the largest share) cannot be cut, or at least not by enough to spare defense.
Taken literally, that is of course not true. The federal government could reduce its own civilian purchases. By reducing its transfer payments and raising taxes, and thereby reducing personal disposable income, it can make personal consumption go down. By adopting the right mix of taxes and transfers the government can make sure that it squeezes the consumption share of the non-poor. Even relative to ambitious targets for domestic investment and net exports, we are far from having reached the technical limits of taxable capacity.5
It is said, in rebuttal, that cutting the share of consumption is infeasible because the American people will not stand for it;6 the election of 1984 is cited as evidence. The argument relies on an intrinsically uncertain political forecast to justify a prescription favored on other grounds. It is a dubious procedure, resembling that of a doctor who recommends major surgery without telling you that a stringent diet would do just as well, because he thinks he knows from past experience that sticking to diets is not your thing. The right question in a prescriptive analysis is not whether we will reduce the consumption share, but whether we should. The silent minor premise of the economic gap hypothesis is that we should not do so, or not enough to spare defense-that at the margin, consumption is more valuable than the marginal percentage point or two of defense. But this is a matter of opinion that cries out for informed debate.7
Suppose we stipulate that the share of potential output available for domestic investment and net exports, and for the consumption of the poor, should increase. Because public civilian consumption, the personal consumption of the non-poor and defense are all that remain, it follows that their share, taken together, must shrink. The hard, divisive questions-the questions we should be arguing about but are not-concern quantities and speed: how large an increase in domestic investment, in net exports and in the consumption of the poor should American policymakers aim at, and how soon? What fraction of the added investment should go to increase private fixed capital, to improve public facilities and to enhance education and research? How large a part of the offsetting cut should be absorbed by each of the remaining shares: defense (and within defense the NATO share, the mischievously popular target of the most ardent believers in an economic gap); public civilian consumption and the personal consumption of the non-poor?
Typically in American discourse we ignore those questions of resource allocation entirely, or consider partial answers ("increase investment/cut defense") that obscure many of the trade-offs being proposed. Like befuddled sailors who squabble about the trim of the sails but pay no attention to their compass bearings, we argue about taxes, spending and interest rates, and disregard the prior question: What economic outcome do we want those policy instruments to achieve? (That even skillful macromanagers will not often score a bull's-eye does not make target choice irrelevant; they have to know what to aim at.)
What outcome one thinks best depends on one's values and interests; reasonable people will disagree. To resolve those differences we rely on political processes. But it will improve our politics, and confer a greater consistency and legitimacy on the choices we make, if every proposal that we spend more on this or less on that is forced to confront in quantitative terms both the recent facts and the true slate of alternatives.
In that spirit, Part III of this article documents the startling size of the shift from investment to consumption since 1981, and explains why this shift is what matters, not the trade deficit as such. Part IV examines the causes of the shift, link by link, in light of the evidence. Part V explores the central issue: How painful must rectifying the investment-consumption mix be, and to what degree does it depend on what we do about defense? I explore a number of alternative allocations of the national product among investment, public and private civilian consumption, and defense. The purpose is not to promote a particular allocation, but to give the reader a sense of the slate of choices that we face, and to let him test his own preference. Because neither billions of dollars nor percentages engage one's intuition, each hypothetical allocation is given in the form of the corresponding budget of a representative family, and compared with such representative budgets during the recent past.
Part VI, at last, tackles the question that is usually taken up first: What should we do about taxes, spending and money supply? But it does so in relation to the underlying question: What allocation do we wish those policy instruments to achieve? How much budget tightening would the different allocations demand, by what date, with what implications for monetary policy? I consider baseline adjustments in the federal budget, as well as the transient readjustments that may be needed to avoid inflation or recession. Part VII then explains why setting arbitrary limits on the growth of debt, whether foreign or domestic, is a bad idea, and why, as a general rule, we should not make a target of the exchange rate. Part VIII sets forth my own beliefs about which allocations, and therefore what policies, would serve us best, and why.
It is a long story with a short moral. It is not true that to solve our problems we must either suffer great pain at home or change American policy abroad. Once we get economic policy even approximately right, our current difficulties will shrink from the status of a chapter to that of a paragraph in American history. The reason is that we are rich-in what is, I believe, Professor Paul Kennedy's wry phrase, embarrassingly rich. That is not to say that all will be well. The task facing American policymakers is both large and delicate. Mistaken policies-doing too little or too much, or too late or too soon, or acting in ways that ignore the problems or preoccupations of the rest of the world-can easily produce a chapter's worth of trouble both here and abroad.
In 1987, for the fifth year in a row, we purchased more goods and services than we produced, and covered the shortfall of $123 billion by importing more than we exported.8 With the additional $38 billion that we paid foreigners in interest owed them by the U.S. government and in subsidies and gifts, the rest of the world acquired from the United States $161 billion more than it spent on American goods and services. Perforce, foreigners increased their holdings of American property and debt and currency by $161 billion more than we increased our holdings of their property and debt.9
It sounds bad, and it was, but it need not have been. Had we matched American disinvestment offshore by investing more at home, the resulting increase in our domestic assets would have offset the increase in our net liabilities abroad. To the extent that the return on such domestic investment would have exceeded the extra interest and profits we had to pay abroad, it would actually have been good business for us (subject to the usual balance-sheet considerations involving liquidity and fixity of obligations, and to reasonable safeguards against excessive foreign control of critical industries). As long as the interest and profit that foreigners earn on their American investments exceeds what they could have earned at home, it is also good business for them.
What matters mainly is our wealth overall (what Americans own abroad and at home, less what we owe to the rest of the world), and whether we are saving and investing enough of our national income to make that total grow fast enough. The answer depends, of course, on how one values consumption in the future in relation to consumption now. Still, the facts are startling.
In 1987 net domestic investment-private investment in residential housing and business-owned plant and equipment, net of investment needed to offset depreciation, and equivalently "hard" net civilian investment by government-amounted to $261 billion, or 5.8 percent of the GNP. Subtracting the $161 billion of American disinvestment abroad, we devoted $100 billion, or 2.2 percent of the GNP, to increasing U.S. net worth exclusive of investment in household durable equipment, defense and "soft" investment in health, education and the like. That 2.2-percent net-national-investment-to-GNP ratio in 1987 compares to average ratios of 9.4 percent during the 1950s, 9.7 percent during the 1960s and 8.1 percent during the 1970s. As recently as 1979, the ratio was 8.2 percent; the 1982-87 average was 2.7 percent. The 1982-87 ratios set a record low for the 39 years for which there exist comparable figures.10
Between 1950-79 and 1987, the share in GNP of net national investment-the share that measures the net increase in our wealth overall-went down by 6.8 percentage points. Three shares went up. About a quarter of the 6.8 percentage points that were no longer going into net investment went instead into extra "replacement" investment that was needed to offset faster depreciation of the private and public physical capital stock, a consequence of a shorter-lived capital stock. Not quite another quarter went into increased government civilian consumption and defense. Over one-half went to increase the share of personal consumption, which increased from 63 percent of GNP in 1950-79 to 66.5 percent in 1987. As a result, personal consumption per representative family of 3.21 persons increased, on an inflation-adjusted basis, from $33,500 in 1979 to $39,700 in 1987. Had the consumption share remained at its 1950-79 average of 63 percent, consumption per family in 1987 would have been only $37,600. (Measured in 1987 dollars, consumption per family was $19,200 in 1949, $22,100 in 1959, and $28,000 in 1969.)
Some other facts are worth noting:
-There are no official statistics on the consumption of the poor, but I estimate from related data that in 1987 the average consumption of persons below the poverty level came to about $8,100 per representative family of 3.21 persons; that of non-poor families of the same size was about $44,600 (itself an average of a very uneven distribution). The officially poor-13.6 percent of the population-accounted for only 2.8 percent of personal consumption.11
-The 1.4-percentage point increase in the combined shares of government civilian consumption and defense between 1950-79 and 1987 reflects a 2.9-point increase in the share of state and local government consumption (10.2 percent in 1987), a virtual standstill in the share of federal civilian consumption (1.5 percent), and a reduction in the defense share from 8.1 percent to 6.5 percent. The part played by defense depends of course on what years one compares 1987 with. Between 1978 and 1987, the defense share increased from a post-1948 low of 4.8 percent to 6.5 percent.
Investment during the last half-dozen years (including American foreign investment that results from net exports) has been much lower than before, and consumption (private plus public, including defense) markedly higher. At the same time, the sum of the two-total spending on American goods and services-has been just right: we have enjoyed, at least until very recently, a picture-perfect, inflation-safe recovery. Both results-one presumably bad, the other good-have been the product of the same macroeconomic policy. (The answer to the hotly debated question whether recent macroeconomic policy has been good or bad is that it has been both.)
Consider investment. Its share has been low mainly because high American real interest rates-higher than those abroad during 1981-1985-caused it to be low. By raising the cost of capital, high American real interest rates discouraged domestic investment in plant, equipment, inventories and housing. By inducing foreigners to bid for dollars to buy high-yielding American securities, high rates in the United States relative to rates abroad caused the dollar to appreciate; the expensive dollar caused our imports to rise and our exports to fall (Figures 1, 2 and 3). Had foreign money not been as responsive to the interest premium available in New York, the exchange rate would have risen less, but American interest rates would have risen even more. As a result, net exports would have suffered less, but domestic investment would have suffered more.
Other things played a part. To keep trade in balance after 1980, the dollar would have had to depreciate to offset the effect of faster real income expansion and faster inflation here than abroad, and perhaps also to offset what may be a gradual deterioration in our underlying competitive position. But whatever the truth about the underlying trend, the exchange rate has played the crucial mediating role. It follows that the real interest rate differential that caused the exchange rate to rise (except for the speculative blow-off during the last few months of 1984) has been crucial.
Ask an American newspaper reader what caused American interest rates to be so high; he will blame the federal budget deficit. Though not wrong, that answer is incomplete. It misses the decisive part played by the Federal Reserve.
The connection between budget deficits and interest rates is more complicated than the usual story about government bonds absorbing private saving. In the absence of countervailing action by the Federal Reserve, a passive increase in the budget deficit-an increase caused by a spontaneous reduction in private demand that causes producers to curtail output, thus reducing national income and the tax base, as in a recession-will be generally accompanied by a decrease in the demand for money and credit, and therefore a decline in interest rates.
It takes an active increase in the deficit, as caused for example by tax legislation that boosts after-tax incomes, spending and output, to put upward pressure on interest rates. Faced with financing a larger dollar volume of transactions, corporate treasurers and households typically try to increase their average working balances of "money" (currency and checkable deposits). The increase in the demand for money will cause interest rates to rise unless the Federal Reserve allows the supply of money to rise in step with the demand for it.
By means of its open-market purchases and sales of government securities and their effect on bank reserves, the Federal Reserve exercises virtually complete control over short-term interest rates. It also exerts-certainly can exert-a great deal of control over long-term rates. In 1983, with inflation under control, Paul Volcker and his colleagues could easily have held interest rates down. They chose instead-I think they were right-to drive rates up, and then to keep real rates at record levels (during 1983-85, much higher than rates abroad).
Figure 4 suggests why. During 1983, the first year of recovery, output grew at an appropriately rapid 8.3-percent rate, causing the unemployment rate to fall from 10.2 percent to 7.9 percent in January of 1984. But by late 1983, with idle capacity and unemployment still shrinking rapidly, and with potential, inflation-safe output growing only by about 2.5 percent a year, the Federal Reserve-determined to prevent too rapid a tightening of labor markets and goods markets from putting undue pressure on the price level-decided it had to slow down the pace of growth. It succeeded brilliantly, driving up interest rates just enough to assure a gradual, inflation-safe approach to full employment.
This is where the federal budget comes in. To achieve that inflation-safe approach, the Federal Reserve contrived to hold the increase in the annual rate of total spending, between the first half of 1984 and the first half of 1985, to $238 billion. But a stimulative federal budget in the face of a falling personal saving rate was causing two of the four components of total spending-government purchases and personal consumption-to increase by $265 billion. To make room, the Federal Reserve used high interest rates to reduce the other two components of spending-investment and net exports-by $27 billion. The resulting $238 billion increase in total spending caused total real output to grow at a desirably moderate, inflation-safe rate of 3.3 percent. But all that growth and more went into personal consumption (up by 4.4 percent) and government purchases (up by 6.7 percent, with federal purchases up by 9.7 percent). Domestic investment fell by 2.4 percent, and the excess of imports over exports grew by almost 18 percent.
For domestic investment and net exports to have retained the shares they had in early 1984 within the $238-billion increase in total spending, they would have had to increase by $39 billion, instead of falling by $27 billion-a $66-billion difference. That would have been possible had government purchases been scaled back by $66 billion. Or taxes could have been raised and transfers cut by about $88 billion, enough to cause a scaling back of personal consumption by $66 billion.12 Or some combination. Depending on the mix, the budget would have had to have been $66 billion to $88 billion "tighter" than it actually was. If at the same time the Federal Reserve had succeeded in lowering interest rates enough to cause investment and net exports to take up the slack, the federal budget deficit would have been smaller by between $66 billion and $88 billion. And investment and net exports would have been greater by $66 billion.
Since 1983 and at least until recently, the Federal Reserve has been remarkably successful in nudging the economy along an inflation-safe recovery path. To keep total spending in check, in the face of the large budget-driven increases in government purchases and personal consumption, it has had to use high interest rates to crowd out investment and net exports. That more net exports were crowded out than domestic investment was coincidental. Tight fiscal policies abroad and Third World debt depressed foreign demand for U.S. goods. A speculative rush in 1984 drove the dollar higher, and with central bank assistance kept it overvalued longer, than can be explained by the interest rate differential alone. Portfolio managers responded to the positive interest rate differential more quickly, and buyers and sellers of goods responded to the cheapening dollar after early 1985 more slowly than in the past. Investment as a whole was hurt by the spontaneous decline in the personal saving rate-a decline not well understood, though demographics and rising real-estate and equity prices played a part. But a much tighter federal budget during 1984-87, combined with a much easier monetary policy, could have offset the effect of all that on the national investment rate.
During 1973-82, plagued by oil price shocks and then a very high inherited rate of underlying inflation, the policymakers had no cheerful choices available. During 1984-88 that was not the case; neither external events nor even errors in forecasting played a role. The successes and the failures both have been the predictable result of policy.
Suppose we wanted to: (1) quadruple by 1993 the percentage share of net national investment in potential GNP, restoring it to its 1950-79 average value of nine percent; (2) allow government civilian consumption to grow in step with potential output; and (3) maintain real defense spending at its 1987 level. How much would we have to tighten our belts?
Option A in Table I suggests the answer. Even under the pessimistic assumption that the extra investment will yield no extra potential output until after 1993, the representative family would not have to suffer any reduction in its standard of living. While the share of personal consumption in GNP would fall to its lowest point since World War II, the level of real personal consumption per representative family of 3.21 persons would actually rise a little, from $39,655 in 1987 to $39,833. At least it would rise as measured in terms of command over goods and services produced in the United States. Assuming that between now and 1993 the dollar will have to depreciate another 10-15 percent in real, inflation-adjusted terms, the 1993 basket of goods and services available to a representative family, including the more expensive imports, would be about $500-$700 smaller than that. But a mere 9-12 months of growth during 1994 in line with potential output-or, if you will, extending the target date into late 1994-would offset that.13
While these numbers are meant to suggest only approximate magnitudes, the lesson is clear. We can maintain real defense spending at its 1987 level, allow civilian consumption by government to increase in step with potential output, and quadruple the share of national investment in potential output, all within six or seven years, without ever having to reduce real personal consumption per representative family below the nearly $40,000 per year that it reached in 1987. If the extra investment were to yield any extra potential output before 1993, we could do even better.
From this perspective the level of defense spending is of secondary importance. Because consumption has at present a share of GNP ten times that of defense, large relative changes in the defense budget give rise to small relative changes in consumption. For example, increasing defense spending in step with potential output, from $295 billion in 1987 to $345 billion in 1993, would reduce the consumption of the representative family in 1993 by only $625 below the nearly $40,000 that it otherwise could be. Conversely, were we to reduce the share of defense in potential output to its 30-year low of 4.8 percent, the resulting $39-billion saving in defense spending would allow the representative family to increase its consumption by only $488. (Real defense spending would fall to its 1984 level of $256 billion.)
That is not to say that such a $39-billion saving in defense spending is trivial. The $488 increase in average family consumption that it would make possible in 1993-from $39,833 with a constant real defense budget, to $40,321-may not seem like much. But suppose the entire saving were deployed to increase the consumption of the poorest 13.6 percent of the population (the percentage now counted as poor) from $8,100 per poor family in 1987 (and $8,900 in 1993-94 with defense spending flat) to $12,500? Anyone who believes that the condition of the poor in the United States is a disgrace, as well as grossly uneconomic, and that the defense budget contains a lot of fat, should want to ask some very hard questions of the proponents of that last $39-billion of defense. At the same time he should remind himself that we could effect the same improvement in the consumption of the poor, with real defense spending constant and investment quadrupling, by reducing the consumption of the rest of us from $44,635 per family currently to $44,137 by 1993-94.14
There is nothing intrinsically desirable about the 1950-79 investment share of nine percent-my purpose here is to explore, not to advocate. In any case, a nine-percent investment share by 1993 would probably prove to be too ambitious a goal. Six or even seven years is a very short time for a peacetime reallocation of resources comparable to the four-year shift to defense and investment during the Korean War. The task would be still harder now: we began in 1949 with lots of idle capacity, and allowed output to increase far beyond the economy's inflation-safe capacity, relying instead on price controls.
A more leisurely program, as in Option B of Table I, would put us on track to achieve a nine-percent investment share in 12 years, not six or seven; long before we reached the end, we could review the results and change our minds. With real defense spending held constant for six years, the national investment share in Option B increases only to 5.4 percent in 1993. Still, that would be more than twice the 1987 ratio. And as a result of that slower pace, personal consumption per family, instead of remaining flat for six or seven years, as in Option A, could continue to increase from $39,655 in 1987 to $42,114 by 1993-94.
Option C reflects a compromise. It would put us on track to reach a nine-percent investment ratio by 1997. By 1993 the national investment share would reach 6.3 percent, in contrast to Option B's 5.4 percent. As a result personal consumption per family would reach only $41,486 by 1993.
These are rudimentary calculations, partial and arbitrary in many ways. A national economic commission with the right mandate-or a national administration that is serious about the allocation of resources in the United States-would want to explore many more options in more refined detail, and pay attention to a number of issues I have ignored altogether (for example, how investment is divided among claims on foreign countries, domestic plant and equipment, housing, infrastructure, education, research and so on, and the future benefit, inevitably uncertain, that each kind may yield.) Still, the general approach of Table I and even the rough orders of magnitude are, I think, right, and they point to two qualitative truths: first, we have a lot of choice; and second, we can, if we will, solve our problems without great pain. If, nevertheless, we suffer pain, inescapable economic scarcity will not be the cause.15
Balancing the budget is an exercise equated with prudence and virtue, and there is no doubt that, in combination with a stimulative monetary policy, it would have done the country a power of good in the last five years. As a general guide to action, however, balance is not a helpful rule-not, that is, if prosperity, growth and keeping inflation in check are the aim.16
The case against balance is clearest when the deficit is rising because the economy is declining. Then to raise taxes or cut spending, in a perverse attempt to make the deficit smaller, is like shooting holes in your parachute: it will make the economy fall faster. A less damaging rule calls for balance in the structural budget, that is, what the budget would be at potential output, or full employment. On this basis a deficit that would occur automatically during recession would shrink to vanishing point when recovery came; surpluses during booms would help counter inflation. Swings in the budget caused by swings in the economy would help restrain the economic fluctuations that caused them.
Requiring balance in the structural budget would at least keep the government from doing active fiscal damage. The responsibility for taking countercyclical action would be left to the Federal Reserve. The trouble there is that, in fighting recession, monetary policy by itself may not be very effective. With orders and sales falling, and lots of capacity idle, even much lower interest rates might not induce businessmen to step up their investment spending. But even if the Federal Reserve were completely successful there is no presumption that the resulting fiscal outcome, a budget in continuous near-balance, would yield a satisfactory economic outcome. The question, once again, concerns investment versus consumption.
The point can be illustrated by the experience of 1987. The federal deficit, at 3.5 percent of the GNP, measured $158 billion. If federal noninvestment purchases had been $158 billion lower, and if-a critical "if"-domestic investment and net exports had been $158 billion higher, the federal budget would have been in balance, and the investment share, at 5.7 percent, would have been 3.5 points larger. That would have been an enormous improvement, but the investment share still would have been smaller than in any year between 1950 and 1981-smaller by a third than the 1950-79 average.
That leads to the bad news. Unless private saving rates improve dramatically, making room for enough investment will entail more stringent fiscal action than merely balancing the structural budget.17
To supplement meager private saving, we need positive government saving. Making the investment actually happen-drawing the resources released by fiscal tightening into producing machine tools and exports-will require timely and aggressive monetary action. And avoiding damage abroad-an important American goal-will require fiscal and monetary action by foreign governments. How much American action, and what kind, depends on what total output and composition of output we want to try for.
Consider, for example, the U.S. fiscal steps that would be needed to make possible Option B's relatively modest 3.8-percentage point increase by 1993 in the combined shares of domestic investment and net exports. Built-in changes in the Congressional Budget Office's baseline structural budget would by 1993 compress federal purchases and personal consumption by perhaps 1.5 of the needed 3.8 percentage points. To make up the 2.3-point shortfall-it would amount to $153 billion in 1993 prices (˜ .023 X $6,670 billion, the CBO's estimate of potential nominal GNP in 1993)-we could cut purchases in the 1993 baseline budget by $153 billion. Or we could raise taxes, or cut transfer plus interest payments, by 1.33 X $153 billion = $204 billion, thus compressing personal consumption by $153 billion.18 Or, more reasonably, we could combine the two methods. Depending on the mix, we would have to keep tightening the baseline budget each year for six years by an extra $26 billion to $34 billion, or $23 billion to $30 billion measured in current prices, including interest savings. Instead of an operating deficit of 3.4 percent of GNP, as in 1987, the structural budget in 1993 would show a surplus of between 0.4 percent and 1.2 percent, or $31 billion to $82 billion in 1993 prices. Such a program, marginally more ambitious than Gramm-Rudman-Hollings, would make possible by 1993 a 5.4-percent rate of net national investment. That would be more than twice 1987's 2.2-percent rate, but still less than two-thirds the nine-percent investment rate of 1950-79.19
Achieving the much more ambitious target of Option A, full restoration by 1993 of a nine-percent rate of national investment, would entail much stronger action. Under Option A the baseline structural surplus in 1993 would have to be $388 billion in 1993 prices (5.8 percent of potential output), as against $31 billion to $82 billion in the slow adjustment program. To achieve that, we would have to tighten the baseline budget an extra $85 billion each year for six years ($75 billion in current prices), for an annual saving by 1993 of $510 billion in 1993 prices. Option C lies in between. Six yearly tax increases or transfer plus interest payment reductions of $48 billion ($43 billion at current prices), sufficient to produce a structural surplus by 1993 of $165 billion in 1993 prices, would free enough resources for an investment rate by 1993 of 6.3 percent.
These are very rough calculations, and they may be too pessimistic. Private saving rates may improve-demographics point that way-and consumption is unlikely to get the boost from rising home equity and stock market prices that it received during the mid-1980s. Faster-than-expected growth in productivity and income would make revenues grow faster. But barring good fortune, a respectable national investment rate will entail years of positive federal saving. Aggressive budget tightening-more aggressive than would suffice merely to balance the structural operating budget-is a necessary action.
Necessary, but not sufficient. The goal is to shift resources from public and private consumption, not into unemployment and non-use, but into investment and net exports. By itself, fiscal tightening will serve only to compress consumption and government purchases, thus releasing resources-that is, workers and capacity. Except when the economy is overheated, that is not a desirable outcome. To draw those resources into producing capital goods and exports, three other things must happen. The Federal Reserve has to drive American interest rates down not only to encourage business investment (and state and local investment), but also to cause the dollar to become cheap enough to induce foreigners and Americans to switch more of their spending from foreign goods to American goods. To keep such switching from causing a recession abroad, foreign governments, especially the Germans and the Japanese, have to take expansionary fiscal action. Third, the U.S. government must increase its own investment spending.
Bringing about a large shift of resources from consumption to investment is a massive yet delicate operation, best done gradually and when the economy is expanding. A multiyear budget plan is indispensable. It must contain a definite schedule of year-to-year changes in the structural balance that reflects our preferred allocation targets. But such a plan must leave room for temporary adjustments. While fiscal compression works predictably and quickly, monetary easing, working in part through the exchange rate, works only uncertainly and slowly-the lags are variable and long. Timing is critical. Mistakes are bound to happen. The essential point is that we not respond to mistakes in ways that will compound them. In that respect, responding to the movements of the deficit is likely to produce just the wrong reaction.
Should weakness in private spending, in the face of fiscal tightness, cause total spending to fall below its inflation-safe target, the first line of defense would be for the Federal Reserve to drive interest rates even lower. But should we slide into a full-scale recession, we should be prepared to take temporary fiscal action that will make the deficit grow even faster than the recession would automatically cause it to do. When output is at less than an inflation-safe level-when there is an excess supply of capacity and labor-deficit-financed government spending, or tax-cut-induced increases in consumption, if accompanied by an appropriately accommodating monetary policy, will result in more rather than less investment. (In that kind of situation business investment is limited by too little demand for noninvestment goods. Even at low interest rates, producers are not usually eager to borrow more money to add machines to an already growing stock of idle machines.)
The argument works both ways. In the face of excess demand and imminent inflation, we should not leave it to the Federal Reserve alone to restrain demand. Rather we should tighten the budget even faster than we otherwise would, thus making a shrinking deficit shrink even faster.
In this argument I have left questions of political feasibility aside. Even technically, none of this is easy, and our political arrangements-the sharing of power among disparate, sometimes adversarial, institutions-do not make it any easier. But I believe the decisive cause of our current deadlock is confusion. To find the skill and the will needed for progress, we need a clear understanding of the nature and scope of the problem, and presidential leadership that is informed by that understanding. In particular, we must overcome our preoccupation with false targets.
VII. FALSE TARGETS
Deficits and debt, whether domestic or foreign, are not good or bad as such, any more than are taxes, government spending, high or low interest rates, or a cheaper or dearer dollar. They are good or bad according to what effect we want fiscal and monetary policy to have on national output, employment and inflation, and on the allocation of output among public and private investment and consumption.20 I do not say that those first things do not matter. But within wide limits they matter less, and treating them as goals is likely to be costly. Instruments are scarce relative to targets, and as often as not targets are alternatives, or at least rivals; the more of them you try to hit, the more likely you are to miss some. In hot pursuit of some secondary or shibboleth goal, we are apt to lose sight of what matters.
Setting an arbitrary limit on growth in the domestic public debt is a case in point. Even if it does not get in the way of debt finance during recessions, it diverts attention from the underlying choice between investment and consumption.21
But should we not at least set a target for the trade balance and foreign debt, or, as some have recommended, for the exchange rate? Start with foreign debt. Unlike domestic borrowing, borrowing from abroad makes available for American use extra resources, over and above the domestic resources that are available to us. But in return, foreigners acquire claims on future American output. Whether that is a good bargain depends mainly on what we do with the money. Putting aside the scare talk about the United States having become the world's greatest debtor-we are richer than any creditor, and comparison with Third World countries is silly-borrowing abroad to make extra consumption possible is generally not a good idea, except in a dire national emergency (I think of Britain in 1940). But borrowing to finance additional investment is another matter.
It is entirely possible that, even once we achieve a satisfactory rate of national investment, our international current account will still be in deficit. It depends on the eagerness of savers and investors to own American property and debt. The greater the underlying demand for dollar assets in the face of lower American interest rates-a demand that remains untested as long as the dollar is thought to be overvalued-the less the dollar will depreciate, and the more negative the U.S. trade balance will be. But the inflow of foreign capital would cause American interest rates to be lower still, and, as a result, we would have more domestic investment. U.S. labor productivity would benefit, and even apart from that, we would be somewhat richer as measured by command over foreign goods. Upward pressure on the U.S. price level during the transition would be less, and the adjustment would be less likely to cause a recession and a protectionist reaction abroad. The disadvantage for us would be more foreign debt and foreign owners, but there would be more assets for everybody to own. (In a steady state, I doubt that a large import surplus, fully offset by extra domestic investment, would give rise to much protectionist pressure at home. It is transitions that are tough.)
If we find ourselves in that situation, we should leave well enough alone, at least for the time being.22 Once we have achieved a satisfactory rate of national investment, improving the trade balance by macroeconomic means would be very costly. Driving down U.S. interest rates still further, and thus causing the exchange rate to fall, would certainly stimulate net exports. But if output is already near its inflation-safe potential, the result would be more inflation. Tightening the budget would, by reducing income and thus imports, also improve the trade balance. But for each dollar of improvement we would lose perhaps five dollars of output.
Combining the two methods-fiscal tightening and monetary easing-would result in more domestic investment and more net exports, and not cause inflation. But it would further depress consumption. In our present predicament, that is exactly what is needed. But there is a limit to how much we should favor the future over the present. The one thing we can be relatively sure of, barring some catastrophe, is that, if we take timely action, our children as a whole will be richer than we are, and our grandchildren will be richer than our children.
The temptation to control the exchange rate is more likely to arise in the opposite situation, one in which the rest of the world is reluctant to acquire more dollars-even after adjustment, when the dollar is thought to be near its long-term equilibrium value. The dollar in that event would end up cheaper, domestic interest rates higher and domestic investment lower, but net exports would be stronger. Whatever the advantages or disadvantages of that final outcome, the process of adjustment in a dollar-sated world is likely to be harder. The very anticipation that the dollar has much further to fall makes a run against the dollar more likely.
To say that the rest of the world may stop lending to us is to misdescribe that situation. Literally, it cannot. As long as it sells to us more than it buys from us, it is stuck with lending back to us the excess dollars it earns. Of course, any foreign holder of dollars may sell his dollars. If there are more dollars for sale than demand for them, the foreign exchange price of the dollar will fall to whatever level will eliminate the excess supply. (Foreign central banks, eager to protect their exporters, are among the potential buyers.)
In the face of a run against the dollar, should the macromanagers try to protect the exchange rate? If the domestic economy is then suffering from too much total demand, and the stock market is not in a panic, there is no dilemma. The right reaction then is to tighten fiscal policy faster, and temporarily to allow interest rates to go higher. The hard choice comes if a flight from the dollar occurs at a time of incipient or actual recession, whether or not it triggers a stock market panic. Tightening money then to protect the exchange rate, or even taking restrictive fiscal action, would damage the real economy. The less risky course would be to commit ourselves as best we could to whatever future budget tightening would serve our long-term investment targets, but in the near term to counter the upward pressure on interest rates by means of aggressively expansionary monetary action even though that would exacerbate the fall in the exchange rate.
With respect to the exchange rate in such an emergency situation, the right step would be to engage the other major central banks in a crash negotiation. The object would be not to try to support the dollar at an unsustainable level but to bite the bullet, get ahead of the market and agree to a publicly announced floor for the dollar. It would be essential that the floor be set low enough to assure all buyers of dollars, including central banks, that at that price the dollar was a spectacularly good buy in terms of fundamental value.
From the U.S. perspective, such a rapid decline in the exchange rate would not be an unmitigated disadvantage. It is not even clear that the effect of a rapid depreciation on the underlying inflation would be greater than that of a slow depreciation, assuming that we take timely fiscal action to offset the effect on demand of the resulting spurt in net exports.23
The greater burden would fall on the countries whose currencies would have suddenly become much more expensive. Potentially, that would make them richer. It will certainly help them contain inflation. But the relatively rapid switch of world spending toward American goods and away from foreign goods that would result, on top of the switch that is already occurring as a result of past depreciation, would have to be offset by foreign governments taking very strong expansionary fiscal action.
What about targeting the exchange rate in the absence of an exchange market crisis? The direct stake of the rest of the world in the speed at which the dollar depreciates is greater than our stake. The U.S. position should not be one of benign neglect, or a callous disregard of their problems-arrogant talk of "unwanted foreign advice" is not helpful. Rather, we should encourage them to intervene in the exchange markets according to what path of depreciation will best serve their needs. At the same time, we should explain to them why we think it would be foolish for us, and for them, if we drove up American interest rates or took fiscal action that would throw the American economy and very likely the world economy into a recession or depression.
The general rule is: concentrate on the major targets-national output, employment, inflation and the division of output among public services, personal consumption, and private and public investment.
Unless we care much less about the future now than we ever did before, we need to increase investment-hard and soft, public and private. Without more investment or unreasonably good luck, our incomes are likely to grow much more slowly than we became accustomed to during the first 25 years after World War II. With not enough new wealth to go around, any one person's gain would have to come mostly from other people's losses. Increasingly, conflict over the distribution of wealth would become our main political preoccupation.
Exactly how much more investment we should eventually try for is a question we don't have to settle now. Because there is uncertainty about the payoff, the way to proceed is by trial and error.24 With a relatively modest program along the lines of Option B, or even with Option C's somewhat more ambitious effort, we are unlikely to overdo it. In five or six years we can see what the payoff has been and set new targets. The point now is to get started. For that we have to decide how much of the shift to investment should come out of government civilian consumption, how much out of defense, and how much out of personal consumption.
I start from the premise that it is our money, not the government's. It follows that it would be much better to cut wasteful public consumption than to cut even frivolous personal consumption. The question is what to do if, for whatever organizational or political reason, we cannot get our hands on anywhere near enough wasteful government consumption. Forgoing the investment, or cutting public consumption that is patently more valuable than the least valuable dollars of personal consumption, is not a good idea. The question takes on even more force if one believes, as I do, that to avoid having to raise taxes or cut middle-class transfer payments, we have been seriously skimping on civilian public services-in education, for example-that are far more important than the least important kinds of personal consumption.25
In my opinion, neither the relatively small amounts of federal civilian consumption, nor the part of state and local consumption that is directly affected by the federal budget through grants-in-aid, offers a promising target. While I recognize that spending more money is only a necessary and not a sufficient condition for improvement, we can afford-and I think we need-not fewer but more and better public services.
The question of defense seems to me more complicated. Maybe there are unmet defense needs that could not be provided for out of current levels of defense spending-defense needs that are of higher value than the least valuable kinds of personal or public civilian consumption. But I think that the burden of proof lies with those who think so. That there is waste in the defense budget-not just "waste and abuse" waste, but spending on fundamentally misconceived programs-is acknowledged by even the most energetic advocates of defense. Moreover, unlike most civilian government consumption, defense is entirely under federal control, and absorbs four times the resources absorbed by federal civilian consumption. (Federal transfer payments are another matter, but they subsidize mainly personal consumption, not public consumption.)
So it is not my intent here to defend the present defense budget-it has defenders enough. But I do want to defend what I think are the second most valuable set of defense dollars, those required to maintain a large American army in Europe. Next to a secure, controllable strategic deterrent with plenty of reserve capacity, and a very few other things, the soldiers in Europe, appropriately backed up, matter most for American safety. Reducing their number unilaterally under the current, promisingly uncertain international circumstances or even threatening to cut them to secure a better sharing of the defense burden would be a great mistake. Not that I think that the Russians are about to invade Western Europe, or that they would do so following a major American cutback. Deterrence has proved itself to be very robust indeed, despite the conventional superiority that the Warsaw Pact enjoys. And it is reasonable to hope that during the next several years we may be able to negotiate major rearrangements in both conventional and nuclear forces that will lead to even greater stability and also reduce costs.
But as long as Germany is divided, oversized Russian armies are poised on the Elbe, Eastern Europe's political future is in flux and Moscow's politics and policies are subject to sudden change, nuclear deterrence is necessary, no matter who is saying what in the Kremlin. Credible nuclear deterrence demands in turn that there remain in Germany a large American conventional force, at least until there exists a truly European nuclear force that Germans, who are on the frontier, will confidently entrust with their own nuclear protection. A large American contingent is needed (1) so that Russians and West Europeans will know that any trouble on the frontier or in Berlin would inextricably engage the United States on a scale large enough to make the U.S. strategic force a vividly relevant counter despite the inescapable vulnerability of American cities, and (2) to give the United States adequate direct power in the management of a crisis, and in the likely absence of crisis, adequate influence.
The political and military shape of Europe is an American interest of the first order. It follows that, until there is some kind of resolution, if only by gradual evolution, of what remains a most unnatural condition in the center of Europe, the United States must play a major part. In Thomas Schelling's phrase of some three decades ago, Americans and West Europeans share a common frontier. On these large matters, we and they are in the same boat. Arguments about burden sharing are secondary. Whatever the rights and wrongs of the present distribution of the burden, the costs involved are negligible in my opinion when measured against the importance to the United States of confidence in the American commitment. In the absence of such confidence, the chances for cooperative Atlantic politics, and a safe winding down of the cold war, are slim.26
I am not saying that we cannot reduce defense spending safely. I am saying that we should cut only carefully, and that economic need should not be a major consideration. Within very wide limits, we can afford whatever defense we need. Just how much that is remains an open question. Much will depend on whether we and the Soviets manage to take advantage of the enormous opportunities for mutual gain that are available. But for us, if not for them, the political issues are paramount. When tempted to make defense cuts for narrowly economic reasons-defense cuts that would have negative political repercussions-we should keep in mind the results of Table I. We can quadruple net investment by 1993-94, while holding defense constant, without reducing personal consumption per representative family below the $40,000 a year or so that it is at present.
Failing a really dramatic breakthrough in arms control, most of the cuts to make room for the investment will have to come from personal consumption. The question is whose: taxpayers' in general? entitlement recipients'? how much from each? This is not the place to spell out a detailed program. Cutting some middle-class entitlements strikes me as sensible. I think, for example, that income from Social Security should get the same tax treatment as any other income. But in general we should be careful about reneging on what people think they have been promised. Sin, energy and pollution taxes are simply good economics. Beyond that I would start by raising personal income taxes, but also, perhaps by 1992-93, phase in some kind of national sales tax, taking care to avoid damage to the poor. When thinking about the total tax burden we should remember that, in relation to national income, we are taxed much less than any other Western industrial nation.27
These views are based on personal value judgments. If anyone tells you that technical considerations of efficiency and incentives are a sufficient basis for these decisions, don't believe him. Incentives do matter, but in the end, the larger questions are inherently political.
But "political" does not mean arbitrary. There are real choices to be made here: choices not about deficits, or debt, or taxes, but about the best use of our labor and material resources. Opinions will differ about the best choices; that is what makes the problem political rather than merely technical. Helping to form, compare and compromise such opinions is the task for political leadership at its highest. Unless our elected leaders take the trouble to understand what these choices are, and have the courage to help explain them to the rest of us, we will continue to make them blindly and get what we want only by chance.
I have had the benefit of helpful suggestions from too many friends to list here. For page-by-page commentary and editorial advice, I am especially indebted to McGeorge Bundy, Mark Kleiman, Elizabeth Midgley, John Midgley, Russell Murray and Edith Stokey. Evelyne Rodriguez, Alexander Schuessler and Pedro Zorilla provided superior computational assistance.
Note One. To adjust for rapidly shrinking household size, all per-family figures are calculated for a 3.21 person family, the 1986 average. Statistical Abstract of the United States, 1988, Table 55.
When I say that the United States is richer than in the past, I mean that real GNP per standardized family has never been as high as it is now. (The reported stagnation of real median family money income, as estimated by the Census Bureau, results from three statistical artifacts: shrinking household size, the exclusion of noncash income, and overcorrection for inflation by the consumer price index (see Paul Ryscavage, "Reconciling Divergent Trends in Real Income," Monthly Labor Review, July 1986.) To be sure, part of the reason we are richer is that we are working more. To keep getting richer faster without working more, we have to increase the rate of productivity growth. Much of this article is about what macroeconomic steps we need to take to make that happen.
The U.S.-Soviet comparison is based on data from the Handbook of Economic Statistics 1988 (Central Intelligence Agency, Washington: G.P.O., September 1988).
For the comparison of national income per capita, I rely on Organization of Economic Cooperation and Development figures which compare the purchasing power of those incomes where they are earned and spent, including local prices of imported goods. See OECD Economic Studies, Autumn 1987. Changes in spot exchange rates do not measure changes in economic capacity or standard of living.
Note Two. The underlying data come from: (1) The National Income and Product Accounts of the United States, 1929-82 (NIPA), and the Survey of Current Business July 1986, 1987 and 1988, U.S. Department of Commerce/Bureau of Economic Analysis; (2) Trends in Public Investment, Congressional Budget Office, December 1987, and worksheets provided by Jenifer Wishart, principal author of that excellent report; and (3), for population, Bureau of the Census Release, CB 88/48, Apr. 1, 1988.
Note Three. NIPA does not divide personal consumption between poor and non-poor consumers. The Census Bureau estimates the income of the officially poor, but counts only cash incomes (excluding, e.g., food stamps and health insurance). To estimate the income of the poor, I multiplied the NIPA figure for total pre-tax personal income by the Census Bureau's estimate of poor persons' share in cash income. To estimate the consumption spending of the poor, I assumed that they spend all of their pre-tax personal income on consumption. (See Trends in Family Income: 1971-1986, Congressional Budget Office, February 1988. I am grateful to Roberton C. Williams, the principal author of that report, and to Charles Nelson of the Census Bureau for advice.)
Note Four. The assumptions behind the calculations in Table I are as follows:
-Potential GNP. I follow the Congressional Budget Office in assuming that, between 1987 and 1993, average labor productivity-potential output per worker hour-will continue to grow at only 1.1 percent per annum; that the labor force will grow at 1.34 percent per annum; and therefore that potential output will grow at a relatively sluggish rate of 2.46 percent per annum. (Options B and C assume the same rate of growth after 1993, with faster productivity growth offsetting slower growth of the labor force.)
-Population. Between 1987 and 1993, population is projected to grow at an average rate of 0.85 percent per annum (Bureau of the Census Release, CB 88/48, Apr. 1, 1988.)
-Defense. Real Defense Spending is maintained at 1987 levels until 1993.
-Government civilian consumption. Federal civilian plus state and local consumption are assumed to grow in step with potential output.
-Option A stipulates a net national investment rate of 9.04 percent for 1993. With net imports assumed to fall to zero by 1993, and an interest rate of five percent on the buildup of foreign debt in the interim, net private plus public domestic investment must increase to 10.26 percent by 1993.
-Option B stipulates a target investment rate of 5.37 percent in 1993, on the way to 9.04 percent by 2000. The current account deficit falls to zero by 2000. Real defense spending grows with potential output after 1993.
-Option C stipulates a 1993 net investment target of 6.31 percent, on the way to 9.04 percent by 1997. The current account deficit falls to zero by the year 2000. Real defense spending starts rising with potential output after 1997.
Note Five. The calculation of what federal fiscal actions are necessary to achieve the investment targets of Options A, B and C assume that (1) private saving habits remain unchanged; (2) the operating surpluses of state and local governments increase in step with potential output; and (3) that, under current rules, federal taxes and transfer plus interest payments in 1993 would accord with the current CBO baseline budget (The Economic and Budget Outlook: An Update, CBO, August 1988).
2 See, for example, William W. Kaufmann, "A Defense Agenda for Fiscal 1990-1994," in John D. Steinbruner, ed., Restructuring American Foreign Policy, Washington: Brookings Institution, 1988.
3 Note One in the Appendix gives supporting detail.
4 Paul Kennedy in letter to The New York Times, July 3, 1988.
7 The assumption that we will fail to raise taxes or cut civilian spending-out of place in a prescriptive analysis-is only flimsily supported by the evidence. Between 1983 and 1987 a divided Congress managed to do both, despite head-on opposition to any tax increase by an intransigent president. In its lumbering way, and with some defense cuts thrown in, the Congress succeeded in reducing the baseline budget deficit from five percent to about three percent of GNP. What the Congress does and what the American people will accept is affected by what the president of the United States asks them to do. (It has become a favorite axiom of the political press that for a politician to propose higher taxes is tantamount to professional suicide. But does anyone really believe that the outcome of the 1984 election would have been significantly different had President Reagan announced during the previous spring that his next budget would call for a large tax increase-and had he carefully explained why-even if Vice President Mondale had come out flatly against any tax increase? Or that in January 1985, the year of Gramm-Rudman-Hollings, the Congress would have failed to respond?)
8 Throughout, I use official U.S. National Income and Product accounting conventions. For sources, see Appendix Note Two. All figures in the text are rounded.
9 That does not count capital losses and gains incurred during the year that resulted from exchange rate movements, the stock market crash and the like, and does not take into account a large statistical discrepancy. Counting those, the rest of the world's "international investment position" improved by only about $100 billion. To the extent that the statistical discrepancy reflects the flow of flight capital into the United States, the $100 billion understates the deterioration in the U.S. position. To the extent that the net import figure fails to account for U.S. service exports, say to Canada, the $161 billion is an overstatement.
10 The reduction in the net national investment share, from its average value of nine percent during 1950-79 to 2.2 percent in 1987, has been masked to a degree by the fact that two-thirds of the 6.8-percentage-point decline occurred not in net private investment at home, but rather in net government civilian investment, and in net U.S. investment offshore, a consequence mainly of the shift from net exports to net imports. (These figures do not take into account investment in defense assets such as durable military equipment. Augmented by net defense investment, the 1959-79 national investment share does not change at all. However, the 1987 national investment share increases by about one-half a percentage point. Counting defense investment, therefore, the decline in the investment ratio was about 6.3 percentage points. The calculation in the text is thus conservative with respect to the conclusion that, within wide limits, we can afford whatever defense we need.)
11 For the method used in estimating the division of personal consumption between the poor and non-poor, see Appendix Note Three.
12 As a rough rule of thumb, it takes a $1.33 cut in household disposable (after-tax) income to elicit a $1 cut in personal consumption.
13 In the above calculations, I follow the Congressional Budget Office in assuming that, between now and 1993, potential output will continue to grow at a relatively sluggish rate of 2.46 percent per annum. For the other assumptions that lie behind these results, see Appendix Note Four.
14 In these calculations I have assumed, implausibly, a costless transfer of income from the non-poor to the poor. Because of overhead costs and perverse incentive effects, transfers are necessarily much less than perfectly efficient. (Poverty, of course, generates its own inefficiencies.) It remains true that $39 billion, which could make a very large impact on the incomes of the poor, would make only a small impact on the incomes of households generally.
15 If readers of Foreign Affairs react the way participants in the executive programs in which I teach react when exposed to these calculations, a majority will vote for the ambitious program of Option A. If you do, please remind yourself of that vote after reading Part VI.
16 Throughout, "budget" will refer to the federal government's current-account ("operating") budget, including Social Security, but excluding federal investment. "Deficit" and "surplus" will refer to the balance in that budget.
17 In principle we could change the tax structure in ways that would encourage private saving, for example by taxing only real, as distinct from nominal, investment income. There is, however, a good deal of uncertainty about the responsiveness of private saving to relatively higher after-tax real yields. Another objection is that most such measures would increase the inequality of income. As Professor James Tobin put it, "We should be cautious in seeking remedies that would increase contemporaneous inequalities of income and wealth in order to increase saving and investment for the benefit of future consumers, most of whom will be better off than most Americans today." (Tobin, "Comment," in Stanley Fischer, ed., NBER Macroeconomics Annual 1988, Cambridge: MIT Press, p. 109.)
18 I rely again, cautiously, on the empirical observation that a $1.33 cut in disposable income will elicit something like a $1 cut in personal consumption.
19 Note Five in the Appendix spells out the assumptions behind these calculations. (Obviously the exact numbers are not the point; to keep the arithmetic consistent, and thus comprehensible, I have resisted the temptation to round them off even further.)
20 I spell out the reasoning behind these assertions in great detail in "Fiscal and Monetary Policy: In Search of a Doctrine," in Studies in Tax/Fiscal Policy, Washington: Center for National Policy, 1982.
21 It would be different if the federal public debt as such constituted a danger. It doesn't. Briefly during the early 1980s, the debt/GNP ratio increased at an explosive tempo, but the Social Security Commission and Gramm-Rudman fixed that. Currently, at 43 percent of the GNP and slated to fall to 41 percent by 1993 without any further budget tightening, it simply does not pose a first-order problem. Excessive private debt is another matter. In a recession, it could cause serious trouble. The ratio of the federal debt held by the public to GNP fell from 114 percent in 1946 to 24.3 percent in 1974 and 26.3 percent in 1981. (From Economic Report of the President, Washington: G.P.O., January 1989.)
22 Over the longer term, it seems to me unwise for the world's richest country to remain a net importer of savings, even if economic efficiency would be served by a still greater concentration of capital. We have a considerable stake in the economic development of the poor countries. To serve that interest, we should eventually position ourselves to become once again a net exporter of capital.
23 The question comes down to whether nominal wage rates respond more strongly to a sudden one-time jump in the consumer price index, or to a longer-lasting gradual increase of the same total magnitude.
24 Economists are unable to distinguish sharply how much of past growth in potential output has been due to investment of various kinds, and how much to those changes in knowledge, skill, health and organization that are not closely tied even to soft investment. With respect to the future, the uncertainty is an order of magnitude greater. Still, there is strong cross-national evidence that high investment rates go with faster growth in potential output. At the least, we know we can earn the real financial interest rate: three to five percent, just by buying back our own foreign debt. But in the end, the inevitably political choice about the national level of saving and investment entails a gamble.
25 The government does not have to decide which items of personal consumption are least important. The effect of higher income taxes, or lower transfer payments, is to squeeze out what the affected individuals think is least important. When the government decides what taxes to raise, and what transfers to cut, it is inescapably involved in deciding what classes or groups of people should have to reduce their consumption.
27 In relation to national product, the current receipts of all levels of government in 1986 measured 31.3 percent in the United States, 44.7 percent in West Germany, 47.1 percent in France, 41.9 percent in the United Kingdom, 39.2 percent in Canada, 61.5 percent in Sweden and 35 percent in Switzerland. The Japanese ratio was 31.3 percent. (OECD Economic Outlook, December 1988.)