The economy is growing, the deficit is shrinking, trade
is expanding. Yet President Clinton's economists forecast
slower growth through the 1990s than in the 1980s, tacitly
acknowledging that the U.S. economy's structural problems
persist. In addition, interest-rate increases and other
economic evidence signal that the current expansion could
well end by early 1996. The President has ample time,
however, to combine good policy and good politics by
adjusting his program to target these problems and promote
strong sustained growth.
The basic challenge for the rest of 1994 and into 1995
is to adopt policies that can, at once, permanently increase
the economy's long term productivity and help extend the
current expansion. In the main, this course closely tracks
the economic strategy proposed by Governor Bill Clinton in
1992. First, next year's budget should include fundamental
entitlement reforms to both break the structural budget
deficit once and for all, and deliver another timely dose of
low long-term interest rates. Second, the President's next
budget also should provide for substantial public investment
in education, training, research and infrastructure,
financed by deep cuts in unproductive business subsidies.
Third, Congress can promote growing demand for U.S. products
next year and into the future by implementing the GATT
agreement this year. Fourth, the President can boost
business and job formation by deregulating small and new
businesses.
These steps build on the Administration's considerable
achievements. Last year's budget reforms have reduced
federal spending's claim on the economy over the next five
years to an annual average of 21.5 percent of GDP, as
compared to 23 percent under Presidents Reagan and Bush.
And approval of NAFTA and conclusion of the GATT should
extend the global economic reach of American workers and
firms.
Yet these reforms have not significantly altered the U.S.
economy's long-term prospects. The President's Council of
Economic Advisers (CEA) forecasts that real growth for the
rest of this decade will average only 2.6 percent a year --
significantly less than the 2.8 percent average of the 1980s.
That will be too slow to generate meaningful income gains for
most working Americans. In the 1980s only highly educated and
skilled workers -- professionals, managers, investors --
gained significant economic ground, while the middle class saw
their incomes inch up by less than 5 percent over the decade.
If the CEA is correct, the 1990s will be the fourth
consecutive decade of declining rates of growth and income
gains.
The economy's problems are evident in the current
expansion, which has been weak and could soon end. It began
more than three years ago in April 1991, and so already has
lasted longer than all but three of the eight business cycles
since World War II. Its first year (April 1991 to March 1992)
was the slowest first year of any postwar cycle, with economic
demand growing by 1.8 percent, versus the average 6.5 percent.
The cycle accelerated in 1992 as the campaign ended and the
President's program was implemented, and demand in the second
and third years of the expansion grew one-third faster than
the average. This year, however, will be weaker than the
fourth year of other postwar expansions lasting this long.
How long will this cycle last? No one can be certain
when the current expansion will naturally end, but it
probably has at least four more quarters to go. Over the
last year, growth accelerated as long-term interest rates
fell and a recapitalized banking system responded to rising
demand for credit at the lower rates. Through the rest of
this year and into 1995, strong corporate earnings should
support healthy business investment, and higher cash flows
for the many households benefiting from mortgage refinancing
and rising stock prices in 1993 and early 1994 should drive
consumption spending.
The Federal Reserve's recent interest-rate hikes may
help lengthen the cycle by moderating the recent spurt of
strong growth, but the Fed alone cannot sustain the
expansion much beyond its natural course. Consider the
problem from the point of view of factory capacity and
employment. Expansions normally expire when the economy's
capacity to expand production and employment is exhausted.
Factories and offices run at full capacity and additional
workers are hard to find at prevailing wages, but demand
continues to grow. This gives rise to inflationary
pressures so the Fed steps down hard on demand with higher
interest rates, and the economy snaps back and down.
Today, 83 percent of the economy's factory capacity is
in use, less than two percentage points lower than the peak
for the 1980s expansion, which ended quickly after the
"capacity utilization rate" hit 84.8 percent. There should
be a bit more room this time since strong business
investment and corporate downsizing have increased the
economy's productive capacity. As a result, peak capacity
utilization is now probably about 86 percent. Similarly,
the current unemployment rate is 6.4 percent, or just about
one percentage point from the lowest (adjusted) point in the
1980s expansion.
At the rate at which business has brought on line its
unused capacity and hired new workers over the last two
years, the current expansion should have about one year to
go before reaching its peak.
We cannot depend on Fed fine-tuning to forestall the
downturn. There are those who say that the Fed can continue
to fine-tune the cycle, using incremental interest rate
changes that modulate demand and so ensure that the
expansion never hits the ceiling. The Fed has never been
able to pull this off in the past; and its ability to do so
now is less than it used to be, because financial
deregulation and global capital have weakened its control
over the total supply and price of credit. Besides, will a
Republican Fed chairman, who tried hard to promote a strong
economy for a GOP president in 1992 -- and failed -- do
better this time?
The bottom line: Under current policies, the expansion
could stall by mid- to late-1995, without addressing the
economy's nagging structural problems.
What should President Clinton and Congress do? First,
they should understand why the great expansions of the 1960s
(which lasted 34 quarters) and 1980s (which lasted 30
quarters) survived so long. The 1960s cycle, after nearly
expiring when the Fed hiked interest rates sharply in 1966,
drew new strength from persistent productivity gains,
Vietnam War spending and rising trade surpluses. Several
factors contributed to the long life of the 1980s expansion.
The deep recession of 1981-82 left the economy with
unusually high levels of unused factory capacity and
unemployed labor, so the cycle could draw on large amounts
of idle equipment and workers before hitting the wall.
Inflation also was checked for a while by competition from
cheap imports. In addition, from 1986 to 1989, exports grew
as the dollar weakened, and financial deregulation and
falling interest rates supported massive credit expansion
that offset declining budget deficits.
In both cases, fiscal and monetary policies moderated
each other, so that one could expand as the other
contracted, rising foreign demand offset weakening domestic
demand, and the economy benefitted from bursts of new
business activity.
These lessons can be adapted to change the conditions
of this business cycle. The President should advance four
policy adjustments that could both address structural
problems in the economy and raise the odds of sustaining
growth for several more years.
1. Entitlement reform. The most powerful tool at
President Clinton's disposal is the ability to alter the mix
of fiscal and monetary policies. Fiscal stimulus won't
help, because it would drive up long-term interest rates.
Nor is short-term fiscal tightening an answer, because it
cannot be reliably timed to precisely offset inflationary
pressures.
Instead, the President should build a solution around
new measures for long-term deficit reduction that could
relieve pressures on long-term interest rates and expand
private investment. His next budget should include
proposals for permanent entitlement reform which, once
passed, would deflate long-run inflationary pressures and so
promote declining long-term interest rates in mid- to late-
1995. Enacting these reforms in 1995 to phase-in for 1997
and beyond, moreover, would protect the economy from a
short-term contraction without reducing its anti-
inflationary punch.
To achieve this, the President could propose to (a)
accelerate the currently scheduled increase in the
retirement age for full benefits under Social Security and
other retirement programs; and (b) reduce the spending and
tax benefits for retirement and health care for people with
incomes of $100,000 a year or more.
Next year may offer a rare political opening for these
reforms. The Kerrey-Danforth entitlement commission could
absorb and answer the initial opposition and help mobilize
support, if its leading members believe that the White House
would ultimately support serious reforms. The President
also can draw on a growing consensus that serious Social
Security reforms are needed in any event, just to ensure the
system's long-term solvency. Pulling off entitlement reform
will make President Clinton and Congress genuine heroes for
finally taming the permanent deficit, and thus helping to
create the conditions for long-term national prosperity.
2. Cut-and-invest. As we ask middle-class people to
accept less in future entitlement benefits, we should also
offer economic reforms that will strengthen their future
prospects: namely, greater public investment in their
training and education, basic research and transportation
systems. These investments should be financed by asking
specific industries to give up their special subsidies. As
public investment can strengthen national productivity and
efficiency, these subsidies reduce the economy's potential,
by insulating favored sectors from healthy market pressures
to upgrade themselves, and by raising the cost of capital
and labor for those without subsidies.
The cornerstone of President Clinton's strategy for
reviving U.S. growth and productivity in a global economy is
investment -- not only private investment by companies, but
also public investment through the government in the
training, education, basic research and infrastructure that
can make every worker and firm more productive. This
approach is fundamentally sound; but congressional
resistance to cutting programs that don't work and subsidies
for special interests has denied this strategy the resources
it needs to succeed. As a result, funding for these
economy-wide public investments is rising by just two-or-
three percent a year -- not nearly enough to affect national
productivity and growth.
To finance meaningful public investment, the
Progressive Policy Institute recently compiled a list of 68
tax and spending subsidies totalling $225 billion over five
years, each one currently protected by its favored
industry.1 For example, on the spending side the list
includes subsidies to defray airlines' costs to expand and
upgrade terminals, payments to farmers whose commodities
sell at below government-set prices, and cut-rate power from
federal hydroelectric plants for private utilities in
selected states. On the tax side, the list includes special
credits for firms producing ethanol or natural gas from
certain geological formations, a tax holiday for profits
earned by firms on their operations in Puerto Rico and other
U.S. possessions, a special one-year deferral for
agribusiness on taxes for much of the income from crops, and
many other singular provisions.
Phasing out these subsidies could clearly provide the
resources for aggressive public investment, as well as a
measure of tax relief for middle-class families with
children. Yet the prospects of cutting subsidies for such
powerful interests are slim, especially if we try to cut
them one at a time. One way to break this gridlock is to
attack subsidies as a whole. President Clinton should press
Congress to create a national commission on industry
subsidies modeled on the successful base-closing effort.
This commission would prepare a package of proposed subsidy
reforms and cuts, and Congress would have to approve or
reject the package without amendment. This effort will not
be easy, but success would make the President and Congress
real champions of the general welfare and a genuine scourge
of the special interests.
3. Promptly implement the GATT agreement. America's
leadership in the global economy, already fostered by last
year's approval of NAFTA, should be advanced further by
implementing the GATT agreement this year. By early 1996,
our current expansion, like other protracted business
cycles, will need to tap rising foreign demand. Therefore,
prompt American action on GATT is required -- including
finding $14 billion to finance it under our budget laws --
if President Clinton hopes to take advantage of next year's
expected economic recoveries in Europe and Japan and expand
U.S. exports.
The President and Congress should make no mistake about
GATT's importance. Even a year's delay could mean its
defeat, as opposition among environmentalists and ultra-
conservatives matures by the day. If GATT fails, American
exports will decline, which in turn will exert downward
pressures in 1995 and 1996.
4. Deregulate small business. Another factor in both
an enduring expansion and long-term growth is well-timed
bursts of business creation and job expansion. Here,
President Clinton can act directly and decisively by
relaxing the federal regulation of small and new businesses,
except in truly vital areas of health and safety. Most
economists (and virtually all business people) now agree
that federal regulation of small businesses, especially new
ones, exerts a substantial drag on investment and jobs. As
it happens, the Regulatory Flexibility Act of 1980 already
directs federal agencies to consider ways of reducing the
regulatory burdens on small entities, but most agencies have
ignored this mandate. The President can make this law an
aggressive instrument of new entrepreneurial activity by
issuing executive orders directing agencies to follow
through -- in specific areas and specific ways, now.
These four course corrections are an insurance policy
for sustaining the current expansion. In many respects, the
specifics are no more than President Clinton pledged in
1992, and fulfilling these pledges would leave few Americans
in doubt about his present commitment to their economic
interests. Whatever the political outcome, a program of
long-term fiscal discipline, renewed public investment, open
trade and business deregulation will leave a splendid legacy
of a stronger American economy for years to come.
