Opinion pieces and speeches by EPI staff and associates.
THIS PIECE ORIGINALLY APPEARED IN THE NEW ECONOMY, Vo. 9, No. 1, IN MARCH 2002
Learning Lessons From the 1990s
Long-Term Growth Prospects for the U.S.
By Christian Weller
According to the widely recognised authority on the matter, the National Bureau of Economic Research based in Cambridge, Massachusetts, the longest U.S. economic boom came to an end in March 2001. The third quarter of 2001 was the first quarter since 1993 during which the economy contracted. While much of the macroeconomic debate has focused on reversing the drop in output in the short run, little attention has been paid to designing policies that can improve the long-term growth prospects of the U.S. Because the 1990s was a decade of extraordinary recovery in growth rates that were sustained for several years, it holds important lessons for macroeconomic policies that could raise the prospects for strong, sustainable growth. Most importantly, without changes in the design of macro policy, the chances of a recovery seem weak, while the possibility of a prolonged period of sluggish growth is real.
The story of the 1990s
Sluggish economic, employment and wage growth marked the period from 1991 to 1995. In comparison, accelerated employment, productivity and wage growth, as well as faster investment and consumption growth were characteristic in the later 1990s through to the end of 2000.
One of the big stories of the 1990s was the acceleration of productivity growth in the latter part of the decade. Productivity growth averaged 2.5% in the second, compared to 1.5% in the first part of the decade. This improvement primarily resulted from more investment in new technologies, mainly computers and software, and from a tightening labor market that forced firms to utilize their existing pool of workers better.
IT investment grew from 3% of GDP at the beginning of 1991 to 4.9% — more than one-third of total investment — at the end of 2000. Subsequently, innovation as measured by multifactor productivity growth more than doubled in second half of the 1990s.
While more private investment was instrumental in making widespread use of new, productivity enhancing technologies, public investment helped to ensure that the new technologies existed in the first place. Integral components to the implementation of the new technologies, such as hardware, software, and the internet were developed with public support through government funded research and development, defense contracts, or publicly funded university research (NRC, 1999).
Given how important public investment was in helping to create the new technologies that ultimately contributed to the productivity boom of the 1990s, it is disconcerting to see that public investment in R&D declined over time. In the 1990s, federal R&D spending dropped below 1% of GDP for the first time in the post-war era, thereby lowering the chances for a repeat performance of the late 1990s.
The acceleration of productivity growth also resulted from a tight labor market, as firms made better use of their workforces. In the second half of the 1990s, firms began to understand that workers constituted an important resource that was increasingly hard to come by. For instance, Morgan Stanley chief economist, Stephen Roach, argued that downsizing in the early 1990s may have led to a temporary surge in productivity growth, but that sustained productivity growth required better skill development through better training and retaining of workers (Roach, 1996).
Slow productivity growth in the early 1990s was matched by sluggish demand. Consumption and investment grew slowly, the trade deficit widened and government expenditures were reduced to limit fiscal deficits. Demand, however, increased in the second half of the 1990s based largely on more consumption and higher investment.
Consumption is both the largest component of GDP and a leading indicator for future investment. Consumption as a share of GDP grew steadily throughout the 1990s to more than 68% by 2000. Investment increased only after consumption had grown for some time. It is a standard finding in economics that investment is determined by consumption as past sales are seen as indicators for future sales. When consumption was slow in the 1990s, so was investment. Private investment did not accelerate until after consumption accelerated, even if it meant investing in the face of higher interest rates. Similarly, when consumption slowed in the second half of 2000, investment followed suit and declined at the end of 2000.
Three factors contributed to faster consumption growth in the 1990s. First, incomes grew due to faster employment and faster wage growth in the second half of the 1990s, following falling unemployment rates. Second, consumption was driven by rapidly rising stock prices. Reasonable estimates suggest that as much as 84% of the increase in consumption between 1997 and 1999 were due to the run-up in stock prices. With a sharp decline in the value of the stock market since early 2000, the so-called wealth effect also disappeared. Third, faster consumption growth depended on more consumer debt. However, by the end of 2000, households reached historically high levels of debt service burden – the share of income dedicated to servicing debt — making future increases in consumer debt a growing hardship on households, as indicated by rising default rates at the end of 2000. Banks reacted by limiting loans to consumers. Thus, the only factor to sustain future consumption growth on a sustainable basis is income growth.
Because demand was strong at home, imports soared, and because demand abroad was sluggish, exports did not keep pace, resulting in growing trade deficits. Throughout the 1990s, per capita GDP growth was slower in all major trading partner countries compared to the U.S., with the exception of China.
As a direct consequence of America’s appetite for consumption, capital inflows soared helping to finance a lending boom that found its largest outlet in higher consumption. Capital inflows also contributed to the dollar’s appreciation, thereby making it harder for U.S. exporters to compete. The overvaluation of the dollar was furthered by more capital inflows after the Mexican and Asian crises, when investors fled into the dollar as a safe haven.
The share of US government debt owned by foreigners rose from 18% in 1994 to more than 35% at the end of 1998. As an increasing share of domestic income has to be used in the future to pay for this accrued international debt, the ever-widening trade deficit made the U.S. economy financially more vulnerable. However, despite this growing vulnerability arising from its overvalued currency the U.S. government has continuously refused to consider concerted efforts by the world’s leading central banks to lower the value of the U.S. currency in an orderly fashion.
Structural reasons also contributed to a widening trade deficit (USTDRC 2000). Restricted access through formal barriers (e.g., China) or informal barriers (e.g. Japan), subsidies and other government assistance have given America’s trading partners competitive advantages. Traditionally, the U.S. has also been a lax enforcer of trade and anti-dumping agreements. Further, the growing number of international trade and investment agreements the U.S. has entered into have made it easier for U.S. based multinationals to locate overseas, particularly in countries with lower labour and environmental standards. As further trade agreements, particularly with low wage countries, are negotiated, and as there are few signs that the U.S. will become more likely to enforce existing trade agreements, the chances for more balanced trade are slowly diminishing.
The Fed and irrational exuberance
In the domestic arena, the po
licy emphasis throughout the 1990s was on the use of monetary policy since discretionary fiscal policy was subordinated to the goal of deficit reduction. Even the discussion over a fiscal stimulus at the end of 2001, when the economy was well in a recession, was stymied by the counterproductive desire to maintain fiscal austerity.
Throughout the 1990s, except in the case of recessions or substantial slowdowns, the Federal Reserve Bank showed a penchant for fighting presumed inflationary pressures, at the expense of strong employment growth. It was only when economic growth was seriously threatened in the wake of the Asian financial crisis in 1998, and at the end of 2000, that the Fed reversed its course and lowered interest rates rapidly.
In 1994 and 1995, the Fed raised short-term interest rates by three percentage points. As long-term interest rates rose faster than short-term rates, employment growth fell from 3% to below 2%. Similarly, when the Fed raised interest rates in 1999 and 2000 by 1.75 percentage points, this precipitated an economic slowdown that led to slower employment growth and rising unemployment, though there were no signs of accelerating inflation.
However, the Achilles heel of the 1990s expansion was financial market speculation, especially on the stock market. The stock market bubble was sustained by the widespread use of stock options as executive compensation. As companies issued record numbers of stock options and outright stock grants, corporate managers had an incentive to use corporate resources to maintain high stock prices. Corporations repurchased their own shares at record rates so that net equity issues were negative in every quarter but one throughout the end of 2000. Also, corporations paid out more than 40% of their record profits in dividends. The demand for U.S. stocks experienced an added boost as investors sought a safe haven following the Mexican and Asian financial crises. The unsustainable stock market bubble came to an end by early 2000. The stock market decline resulted in the destruction of $1.8 trillion in household wealth between March 2000 and December 2000.
Lessons for sustainable long-term growth
The experience of the 1990s offers four lessons that, if heeded, could substantially improve the chances for strong, stable and sustainable long-term growth.
First, consumers matter. Consumption is an important engine for sustainable growth since it constitutes the largest component of GDP. Only consumption fuelled out of income growth, instead of paper wealth created from an overvalued stock market or out of consumer debt, can provide a solid basis for sustainable growth.
What is needed is a monetary policy that takes the mandate of full employment seriously. The experience of the 1990s shows that the Fed was too quick in raising interest rates absent of any evidence of increased inflationary pressures. Without a change in the priorities of the Fed, a major piece of the macroeconomic policy puzzle will be missing. While the Fed has reacted rapidly to the decline in output growth in 2000 and 2001, it took a recession for the Fed to abandon its anti-inflationary stance. It is likely that a resurgence in growth will lead the Fed to prioritize inflation again, with proposals circulating to formalize inflation targeting to limit discretion in monetary policy decisions. Instead of formalizing the prioritization of the anti-inflationary bias of the Fed’s monetary policy, attempts should be made to give full employment an equal footing with inflation.
Increasing the representation of workers inside the Fed could do this. The nine-member boards of each of the twelve regional Federal Reserve Banks already provide for three board seats for the public, which should be appointed with due, but not exclusive, consideration of various groups, among them labour and communities. Since the regional Federal Reserve Banks are directly involved in monetary policy decision making a stronger representation of labour and community interests could help to change the Fed’s priorities, and help to stymie the push to formalize its anti-inflationary bias. Since 1997, the federation of American trade unions, the AFL-CIO, has been engaged in efforts to increase the number of labour and community representatives on regional Fed boards with minor success.
Second, revive public investment. Low unemployment, rising wages and low inflation are simultaneously possible as long as productivity growth remains solid. This can follow from improved private investment in new technologies. An important complement to private investment is, as the experience of the IT revolution has shown, public investment. More public investment, especially in R&D and education, increases the chances for faster productivity growth in the future.
Third, balance the trade account. Reducing the record U.S. trade deficit without reviving protectionism will require concerted efforts between policy makers in the U.S. and abroad. Abandoning the Fed’s anti-inflationary stance can be of help here, too. Lower interest rates should make it easier to lower the value of the dollar, which could help to improve the demand for U.S. exports.
So far, the fear that lower interest rates will lead to a rapid outflow of capital leading to potentially disruptive turmoil in financial markets has not materialized. Several factors tend to determine capital flows in and out of the U.S. Interest rate differentials between the U.S. and other countries are only one of them. Other factors include the trade balance, economic growth, or unemployment, which proxy the overall strength of an economy. In fact rising interest rate differentials can often be interpreted, rightfully so, as a last effort by monetary authorities to stabilize an already fragile system, thereby leading to capital outflows. Inversely, using expansionary monetary policy to aid a struggling economy may help to stabilize trade and capital flows for the U.S.
This is particularly true for the U.S. as it has the added advantage that its currency serves as a reserve currency for many countries. Even when interest rates fall, investors will continue to hold dollars. With a more expansionary monetary policy in the U.S., other central banks, especially the ECB, may follow suit since external constraints for their monetary policy are lifted.
However, monetary policy alone will not help to balance trade. In addition, the U.S. should pursue a number of structural policies, such as enforcement of existing trade agreements, particularly of anti-dumping laws, inclusion of labour and environmental standards in new trade agreements, and public support (e.g., R&D) for U.S. industries.
Fourth, reign in financial market excesses. The U.S. economy of the past decade has been built on a shaky foundation. It has been characterized by a speculative stock market bubble, a growing debt bubble, which both have been partially fuelled by capital inflows that helped to pay for the trade deficit.
Various measures have been proposed to control stock market speculation. For instance, the Fed could use the already existing tool of margin debt requirements. Higher margin debt requirements would curtail the debt financing of equity purchases. Also, regulatory reform could introduce better accounting standards that would make the true costs of stock options more apparent. Since share repurchases associated with stock options are both a drain on corporate resources and a mechanism to keep stock prices inflated such an accounting change would limit stock options, allow firms to use more of their earnings for investment, and reduce stock price inflation. Tax policy could be revamped to introduce a securities transactions tax (Baker, 2000). This would increase the costs of short-term stock holdings, and thus impact portfolio speculators more than long-term, strategic investors.
Similarly, stronger credit market regulations are needed to curb the oversupply of credit, and to avoid another unsustainable debt bu
ilt-up among households and firms. To reign in excessive credit expansion, financial market regulatory agencies, among them the Fed could revive asset based reserve requirements as a policy tool (Palley 2000). This would allow regulators to adjust the relative attractiveness of various holdings of financial institutions, thereby discouraging overly risky allocations.
The 1990s offer four important lessons for sustainable long-term growth. These are that public investment, especially in R&D, matters for future productivity growth, that consumption has to be based on growing incomes, that asset and debt markets need to regulated, and that the growing U.S. trade deficit may become unsustainable unless it is controlled through macro and structural policies. Without heeding the lessons from the past decade, the chances for sustained long-term growth, beyond the current economic slowdown, are weak, and the possibility that the U.S. will experience a period of prolonged slow economic growth is real.
Baker, D. 2000, The Feasibility of a Unilateral Speculation Tax in the United States. Washington DC: Center for Economic and Policy Research.
National Research Council (NRC), 1999, Funding a Revolution: Government Support for Computing Research. Washington, DC: National Academy Press.
Palley, T. I. 2000, Financial Stability in the OECD: The Missing Dimension in Public Policy.New Economy. Vol. 7, No.3: 179-84.
Roach, S. 1996, The Hollow Ring of the Productivity Revival. Harvard Business Review, November/December 1996: 81-89.
U.S. Trade Deficit Review Commission (USTDRC), 2000, The U.S. Trade Deficit: Causes, Consequences and Recommendations for Action. Washington DC: USTDRC.
[ POSTED TO VIEWPOINTS ON APRIL 10, 2002 ]
Christian Weller is an economist at the Economic Policy Institute in Washington, D.C.