Issue Summary: Economic Growth PAGE UNDER CONSTRUCTION 9/1/2003
Issue Summaries contain a quick reference to Centrists.Org policy ideas. They will be revised and updated periodically for clarity and usefulness, and as events and policy ideas change. Questions or comments? Please contact us at information@centrists.org .
Basics:
Problem Solving and Economic Growth
Traditional Thinking: Monetary and Fiscal Policy Levers
Supply Side Ideology: An Overused Idea
Confidence and The Ability of A Nation's Political System to Solve Problems
Charts, Graphs, and Data
Problem-Solving, Confidence, and Economic Growth: Theories of economic growth come and go. For a while, economists believed that economic growth could be managed by pulling the "levers" of monetary and fiscal policy. However, the experience of the 1970s, with both high inflation and high unemployment discredited that theory, at least in part.
Since then, economists have argued over which is more important: low taxes or balanced budgets. The Reagan Adminstration emphasized low taxes, that that seemed to work for a while. However, the Reagan Administration's disregard for balanced budgets led to another period of economic stagnation in the early 1990s.
In the mid-and late-1990s, the Clinton Adminstration and the increasingly Republican Congress emphasized low interest rates and balanced budgets over tax cutting, and again, that theory seemed to work for a while. But the economic slowdown of the last three years has now called Clinton's policies into question.
Now President Bush's economic advisors seem to be flailing for an alternative. The Adminstration is trying both to stimulate the economy with huge fiscal deficits and with supply-side tax cuts. Neither seems to be working very well -- the federal deficits have grown to worrisome levels even while the economy remains hesitant.
Now which levers should be pulled? Cut tax rates even more? Raise taxes and balance the budget?
One thing is certain: the U.S. economy does well when consumers and investors have a sense of confidence that the government will be able to solve or smooth over any problems that arise. In the face of recession and high unemployment, President Reagan brought this sense of confidence to the people and the business community, and it worked for the economy in the mid-1980s.
President Clinton's economic team also created a sense of confidence that whatever financial or economic problems might arise, they would not interfere with prosperity and good business. In fact the Clinton team may have allowed a sense of overconfidence to flourish, which led to overinvestment in some technology and telecommunications areas in the late-1990s, and helped precipitate the recession of 2001.
Traditional Thinking: Monetary and Fiscal Policy Levers. Traditionally, economists believed that the economic growth and business cycles could be managed by enlightened used of monetary policy (higher or lower interest rates and growth in the money supply) and fiscal policy (the degree to which governments ran surpluses or deficits). By raising interest rates or suppressing the money supply, and raising taxes or cutting spending, booms could be moderated. Likewise, lowering interest rates or expanding the money supply, coupled with tax cuts or spending increases, could pull the economy out of recession.
The traditional "levers" of monetary and fiscal policy were intended mostly to affect what economists call demand: the desire of people to purchase items for consumption and for businesses to make investments in plants or equipment.
In the 1970s, however, as the economy suffered both high inflation (usually a symptom of overly rapid economic growth) and high unemployment (usually a symptom of recession or too-slow growth), economists searched for other answers.
Supply-side theory blossomed in President Reagan's first term (1980-1984). Supply siders believed that the monetary and fiscal policy could create plenty of demand, but were not in themselves sufficient to entice producers to produce products and services to meet that demand.
Supply siders argued for deregulation of industries (to allow more potential businesses to enter markets), reduced power for unions (to allow businesses more flexibility and lower-cost labor), and reduced taxes (to create greater after-tax returns on work and investment).
Taxes were lowered, unions diminished, and businesses deregulated throughout the 1980s, and economic growth surged, at least temporarily. Meanwhile, the federal deficit soared following tax cuts and increases in defense spending, creating a highly simulative fiscal policy. To counteract that stimulus, the Federal Reserve ran a contractionary monetary policy throughout the 1990s, with high interest rates.
The economy did well throughout the mid- and late-1990s under those policies, but the persistent deficits and tight monetary policy ushered in an extended period of economic stagnation in the early 1990s.
In the 1990s, the Clinton Administration and Republican Congress offered a new theory: global competition was so strong that inflation was no longer a worry. What was needed wasn't new incentives to invest, it was lower interest rates. To convince the Federal Reserve to lower rates, Clinton and the newly Republican Congress worked strenously toward a balanced federal budget.
Supply Side Ideology: An Overused Idea.
Confidence and The Ability of A Nation's Political System to Solve Problems. Business is a gamble on the future. Investors bet that consumers will buy the products of their investments in the production of goods or services.
To make those bets, investors in a capitalist system must be confident in the economic situation in the future, when their investments must pay off.
First, the role of confidence and economic stability may be more important than many economists think. Regardless of fiscal or monetary policies, or supply-side incentives, investors who do not believe the the future economy will be strong will not make long-term, high-risk investments, the types of investments that lead to leaps of innovation or productivity and contribute most to a rapidly growing standard of living.
Second, the role of the political system in creating that sort of business and investor confidence is rarely discussed.
The main reason for Japan's prolonged recession wasn't a lack of fiscal or monetary stimulus -- the government has run deep deficits to pump up demand and the central bank has lowered Japanese interest rates to nearly zero. Instead, Japan's stagnation has been caused by a lack of confidence, particularly in the ability of nation's political system to address structural economic and financial problems.
In an era of sudden change and instant capital mobility, with global investors and consumers more forward-looking than ever, a nation's willingness to address big problems, and the ability of its government to make tough choices to resolve problems and adapt to changing circumstances, can create a sense of confidence that is, in turn, an extraordinary economic asset. In the information age, confidence in a nation's political processes and problem-solving capability is probably a more powerful economic stimulus than ever-lower interest rates or ever-higher budget deficits.
Even small investors can now direct their funds anywhere in the world. Moreover, global investors cannot realistically predict the problems that will occur in particular countries 15 or 10 or even 5 years ahead, when they are counting on their investments paying off. Therefore, they must choose which ventures to fund based on their confidence that whatever problems arise in the host nation, its political system will find a solution and their investments will not be unduly vulnerable.
More than anything else, Japan's prolonged recession and deflation were caused by a lack of confidence that its government and institutions could resolve the big problems that were suddenly thrust into view when the financial bubbles burst: insolvent companies that traditionally were not allowed to fail; banks with bad debts and declining capital values that couldn't make new loans; a corporate culture wedded to export-based manufacturing but slow to embrace new information systems or shift to information age business models; an anti-consumer commercial system with layers of inefficient "middlemen;" and a political system dependent on support from narrow groups of voters concerned with holding on to the status quo for a few more years rather than allowing disruptive, but necessary, economic changes.
Japanese voters simply didn't trust their government to make the tough reforms, so they hunkered down and held on to their wallets. They didn't spend, and they didn't allow their government to undertake expensive bailouts or restructurings of afflicted sectors of the economy. Instead, Japan has approved a stream of smaller tax cuts and pork-barrel public expenditure projects, which have largely failed to re-inflate the economy and are slowly burying the nation under a mountain of public debt. Problems festered and confidence shrunk.
The U.S. government is closely divided, which gives politicians a very strong incentive to pander to narrow constituencies, especially since presidential elections are decided on a state-by-state basis. Even pressing issues like homeland security and energy independence are mired in partisan, constituent-based arguments, with Republicans favoring oil companies and Democrats protecting unions in an old-fashioned tit-for-tat.
To global investors, however, the renewed partisanship means U.S. problems could go unresolved. To be sure, in the late 1990s, partisan gridlock meant neither side could muster the votes to mess up the economy. But bold action is sometimes necessary when the economy sours. For example, in the early and mid-1990s, Congress and the President put their differences aside long enough to balance the federal budget, reform welfare, and expand trade. Although President Clinton's health care reform was not enacted in 1994, it did usher in an extended period of lower health costs, which bought time for the economy to catch up with what had seemed to be an intractable problem.
