The Morning After
America has let its infrastructure crumble,its foreign markets decline,its productivity dwindle its savings evaporate,and its budget and borrowing burgeon. And now the day of reckoning is at hand
BY PETER G. PETERSON
IN 1981 RONALD REAGAN TOOK THE HELM OF A NATION whose economy was reeling, with inflation in double digits, the prime rate hurtling past 20 percent, and the national spirit sagging into bewilderment. Today other countries gaze enviously over an American economic landscape that shows little trace of past convulsions and, indeed, seems to burst with new businesses, new jobs, new Dow Jones records, and a newfound confidence.
Yet, six years after the radical reforms of Reaganomics got under way, Americans are about to wake up to reality: for some time now the foundations of their economic future have been insidiously weakening. This awakening is currently being delayed by the widespread preoccupation with “competitiveness.”Under the prodding of a trade balance in manufactured goods that collapsed from a $17 billion surplus in 1980 to a $139 billion deficit in 1986, including the first deficit ever in high-technology goods, and with additional shoves from a shaky dollar, from nervous financial markets, and from stagnating real wages, the socalled competitiveness problem is quickly climbing to the top of America’s political agenda.
What does competitiveness mean? In many American households today it means worry about future living standards and about whether one’s children, ten to fifteen years into their careers, will be able to out-earn their parents. In corporate boardrooms competitiveness means the executive nightmare of seeing Americans gorge themselves on goods from foreign firms.
For many blue-collar workers competitiveness has an even cruder meaning: layoffs and the understandable desire to get even with the anonymous forces behind them. Over the past three years America’s import deluge has resulted in pink slips for one to two million domestic manufacturing workers each year. More than a third of them remain indefinitely out of work; more than half the rest have taken pay cuts of 30 to 50 percent in new jobs that cannot make use of their experience. Economists are looking closely at this dislocation for signs of structural disintegration in U.S. communities, and of the decay of skills and habits that once made manufacturing an engine of U.S. comparative advantage in world trade.
In Washington competitiveness seems to mean both nothing and everything. Some senators advocated a speed limit of sixty-five miles an hour on rural highways as a “competitiveness” measure. House members are justifying yesteryear’s jobs bills by renaming them “competitive adjustment programs.” And lobbyists are arguing for stricter world cartels on everything from shoes to semiconductors on the grounds that such agreements will improve our “competitiveness.” After announcing in its 1987 Economic Report of the President that recent U.S. performance in manufacturing has vindicated our competitiveness, the White House has refused to be upstaged on the issue, even going so far as to claim that the Strategic Defense Initiative is “pro-competitive.”
Democrats are demanding that the Administration get back America’s “rightful share” of jobs and wages through protectionist measures. If imports are cut back, they say, the jobs and income generated by producing for American consumers will be miraculously transferred from foreign to U.S. firms. Get tough on the other guys and our situation will improve—that seems to be the general idea. What all public statements on “getting back” our competitiveness neglect to mention is that Americans will have to give up something to get it back. Over the next few years policymakers will wake up to the true cause of our “competitiveness" predicament: the incalculable damage we have inflicted on our economy in recent years.
An x-ray of the damage would show its antecedents stretching far back in the past, across several Administrations. Our national preference for consumption over investment—the root malady—did not begin with the Reagan Administration. Still, that set of policies loosely known as Reaganomics has certainly worsened the damage. In the finest tradition of Euripidean irony, measures meant to save us have worked in the end to afflict us, so much so that even our nation’s non-economic hopes—cultural, social, and strategic—have been clouded by our disastrous fiscal mismanagement. It has been a hard lesson in the law of unintended results.
Intent: From a decade of feeble productivity growth (0.6 percent yearly in the 1970s) and early signs of rising poverty rates, we entered the 1980s flush with expectations of “supply-side” prosperity. Result: We have ended up with still feebler productivity growth (0.4 percent yearly from 1979 to 1986) and, despite a debt-financed rise in personal income, with an upward leap in every measure of overall poverty. More important, we have witnessed a widening split between the elderly, among whom poverty is still declining, and children and young families, among whom poverty rates have exploded—a development with dire implications for our future productivity.
Intent: After a decade of worry about our low level of net private domestic investment (6.9 percent of GNP from 1970 to 1979) and an unsustainable real decline in the construction of public infrastructure, we wanted the 1980s to be a farsighted decade of thrift, healthy balance sheets, and accelerating capital formation. Result: We have ended up with by far the weakest net investment effort in our postwar history (averaging 4.7 percent of GNP from 1980 to 1986) and have acquiesced in the crumbling of our infrastructure. Moreover, far from renewing our saving habits or our balance sheets, or bolstering the “supply side" of our economy, the 1980s have turned out to be the most consumption-biased “demand-side” decade experienced by any major industrial country during the postwar era.
Intent: In 1980 American voters decisively endorsed a smaller and leaner federal government, with special exceptions for defense spending and for poverty-related “safety-net” benefits. Result: We ended up with a significantly higher level of federal spending in 1986 (23.8 percent of GNP) than we had in 1979 (20.5 percent of GNP)—with most of the growth concentrated in precisely what needed to be controlled: interest costs and entitlement benefits unrelated to poverty (or, to put it bluntly, welfare for the middle class and up). Federal interest payments on the national debt, $136 billion in 1986, are now equivalent to the total taxpayer savings originally projected from the 1981 income-tax cut. As for federal benefits doled out regardless of financial need, these have grown from about $200 billion in 1979 to $400 billion in 1986. They totaled $46 billion in 1968.
Intent: Entering the 1980s, we acknowledged that it was bad policy to allow federal outlays to exceed federal revenues (with deficits averaging 1.7 percent of GNP from 1970 to 1979). We promised ourselves to do better. Result: We made the gap between spending and taxes wide beyond precedent (with deficits averaging 4.1 percent of GNP from 1980 to 1986, and rising to 4.9 percent of GNP, or 90 percent of all private-sector net savings, in 1986). Our publicly held federal debt is nearly three times larger now than it was in 1980. The projected deficit numbers have improved somewhat, but the much heralded future declines are premised on very rosy assumptions—no recession, for example, and an interest rate of 4.0 percent.
Intent: Americans voted in 1980 for leadership that emphasized greater global competitiveness and freer world markets as the most advantageous means of achieving balanced economic growth. Result: America’s steep decline in savings during the 1980s has precisely reversed our intentions. We were promised a $65 billion trade surplus by 1984; instead we suffered a $123 billion trade deficit. Today, despite four years of extraordinary luck on the energy front, we have managed to twist the global economy into the most lopsided imbalance between saving (foreign) and spending (American) ever witnessed in the industrialized era. In the process—as we all know—we have transformed ourselves from the world’s largest creditor into the world’s largest debtor. In reaction to this shift the rest was inevitable: a more than tripling (from about five percent to 18 percent) in the share of U.S. imports subject to quotas, a colossal about-face in public opinion away from free trade, and the appearance of the most blatantly protectionist bills before Congress since the days of Senator Reed Smoot and Congressman Willis C. Hawley—despite the President’s free-trade convictions.
Intent: America came into the 1980s longing to strengthen its military defenses and to project its power abroad more effectively. Result: We now find that budget deficits and an evaporation of the public’s pro-defense consensus are drawing an ever tighter circle around all our strategic options. Not only must we now replay the wasteful 1970s by cutting short production runs on dozens of weapons systems, but once again we are about to demonstrate to the rest of the world that America is incapable of sustainable long-term defense planning.
Intent: More than just a defense build-up, Americans wanted a more assertive, unilateral foreign policy, a way to make ourselves stand tall again in our leadership of the free world. Result: Our fast-growing debt to the other industrial countries has diverted our diplomatic energy into placating foreign central banks with exchange-rate agreements (already by May of this year the interventions to support the dollar amounted to a staggering $70 billion), into jawboning foreign governments to get their people to buy more of our exports, and into pawning off our Third World financial leadership onto more solvent economies. When action requires money, we now scrape our “discretionary” budget to procure the most meager support. We spend virtually nothing to try to avert the growing risk of social, economic, and political chaos right at our doorstep in Mexico. An additional $50 million was nearly considered too much to send to the Philippines after the 1986 democratic election of Cory Aquino. Even the Administration now publicly declares that our “foreign-affairs funding crisis” could mean “the end of U.S. global leadership.” Eight years ago no one imagined an austerity-led shift toward U.S. isolationism. Now we’re seeing it: an attempt to stand tall on bended knees.
Intent: Going into the 1980s, America’s deepest wish was that renewed economic strength might foster a renewed cultural and ideological strength and an ethic of saving, hard work, and productivity. We wanted to replace malaise with a confident sense of forward motion. Result: As the ideological enthusiasm of 1981 has gradually been worn down by economic reality, this wish, too, has foundered, leaving many of our political leaders as defensive and uncertain as those of a decade ago—and almost relieved to have us fixated on public and private scandals.
While many in the Administration believe or act as if there is no problem—and hence no need for a solution— others want to avoid all association with the dreaded next act of the economy. The Democrats’ fears show up in a darkly humorous story told by Democratic leaders: On January 20, 1989, after the inauguration, President Reagan flies off to Santa Barbara. While he is in the air, the stock and bond markets crash, the dollar plunges, and interest rates soar. When Reagan lands in Santa Barbara, he announces to a swarm of reporters, “See, I told you the Democrats would screw up the economy!”
FOR THE TIME BEING, THE COMPETITIVENESS ISSUE remains a sort of curtain that Americans have hung between Reaganomics and the future. Neither political party dares to disturb it, for it allows every policy leader to keep our attention fixed on the trivial. For example, we are told to get furious about the trade effects of Japanese “dumping” of semiconductors or enthusiastic about the federal sale of loan assets as a way to plug the budget deficit, even though every expert denies that such things make much difference one way or the other.
The truth is that the most astonishing success of Reaganomics has been the myth of our own invincibility. This myth rests upon an enduring, bipartisan principle of American political life which in the 1980s has become gospel: never admit the possibility of unpleasantness—especially when it appears inevitable.
If you allow for unpleasantness, the mechanics of our trade deficit cease to be confusing. America runs a deficit because it buys more than it produces. By systematically discouraging measures that would boost its anemic net savings rate, the United States has acquired a structural deficit economy, meaning that at no stage of the business cycle can we generate the amount of savings necessary for minimally adequate investment. In 1986, in fact, nearly two thirds of our net investment in housing and in business plant and equipment would not have occurred without dollars saved by foreigners. (This level of investment was, to be sure, very low by historical standards, but without the capital inflows that accompanied our trade deficit in 1986 it would have been at the rock-bottom level of a severe recession year—lower, in fact, than during the recession years of 1980, 1975, 1970, and 1958.)
Washington debate over trade policy invariably neglects this elementary fact about our balance of payments: dollars that flow abroad to buy imports always flow back. (Since foreigners don’t use dollars, they spend them as soon as they get them.) The only question is how our dollars flow back—to buy our goods and services or to buy our IOUs. During the 1980s we have decided that our biggest “export” should be IOUs. In 1986 we sold to foreigners, net, a total of $143 billion in U.S. financial assets. Most of this consisted of stocks, bonds, T-bills, repos, bank balances, and other assorted paper, but a steeply increasing proportion of it was in real estate and other direct investment. This financial surplus was the flip side of our trade deficit, and if we had invested more at home, our surplus (in selling IOUs) and deficit (in selling trade goods) would have been even greater. As long as we cannot function without dollars saved abroad, exchange rates will fluctuate and interest rates will go up until we can attract those dollars back as loans. America must learn the basic distinction between capital flows for investment, which produce future return, and capital flows for consumption-related debt (for example, inflows to fund the budget deficit), which simply produce future debt service.
Correcting the current imbalance assumes that America can embark on an enormous shift from consumption to savings, and that this shift will not throw the world’s economy into a tailspin, either by trade-led recessions in the other industrialized countries or by a chain of debt defaults among the less-developed countries (against whom we will be competing for trade surpluses). The alternative to this daunting scenario, of course, is the crash: a huge plunge in the dollar, unaffordable imports, a long recession, garrison protectionism, rampant inflation, and a marked decline in American living standards. The crash alternative prescribes that we pay off our debts through indefinite poverty. Can we avoid the crash? Yes, but doing so will require Americans to produce more while consuming less, and very close macroeconomic coordination among nations.
A European critic is reported to have said this about the link between America’s fiscal and international deficits: “Your policies in the 1980s remind me of Christopher Columbus’s travels. Like you, he didn’t know where he was going. He didn’t know where he was when he got there. And he didn’t know where he’d been when he got back. All he knew for sure was that the whole trip had been financed with foreign money,” Or, as Fred Bergsten, the director of the Institute for International Economics, recently quipped, “We finally understand the true meaning of supply-side economics: foreigners supply most of the goods and all of the money.”
How AMERICA HAS REACHED THE END OF AN AVENUE with no pleasant exit is too long a story to be told here. But it is worth mentioning the key contribution made by two sweeping institutional developments that have taken place since the beginning of the 1970s. Both are what might be called changes in the rules of the game, rules that used to protect us from our own folly.
The first change has been in how we legislate federal budgets. Until fifteen years ago most federal spending was discretionary and unindexed, and federal tax policy still functioned under the very strong presumption that federal dollars spent should be paid for out of revenue. Large deficits, therefore, were difficult to achieve, because so many easy corrective options were available, both in spending and in taxing. The spending rule was eliminated in the early 1970s by our decision to transform most non-poverty benefit programs into untouchable and inflation-proof entitlements. The taxing rule was eliminated in the early 1980s by the jihad prayers of supply-side economists. Our deficit has thus become no one’s responsibility. It is subject to “projection” but no longer to control.
The second big change has been the transformation of the world financial system. Back in the early 1970s we all accepted the basic postulates of the postwar Bretton Woods arrangements: fixed exchange rates and relatively little mobility of capital between nations. But the problem with fixed exchange rates was that they led to inconvenient balanceof-payment crises and didn’t allow us the freedom to determine our own macro-economic fate. So we closed the gold window in 1971 and shook ourselves loose from fixed parities by 1973. By the late 1970s and early 1980s, as the dollar sloshed up and down in ever larger waves, the world financial community accommodated our proud creation, the “float,”and greatly liberalized the flow of capital across borders. The inevitable result has been to give every nation—especially the United States, as the owner of the world’s reserve currency—much greater latitude to borrow as it pleases, with few restrictions other than the specter of national bankruptcy in the mind of the creditor. Fifteen years ago if the United States had begun to borrow the equivalent of 3.5 percent of its GNP from abroad, that would have created a national emergency, with Churchillian presidential addresses and wartime austerity measures. Today it creates—well, nothing, really. It’s a number you can read about toward the end of the business section of your newspaper.
Most of these rule changes, with the exception of the new revenue-ignorant tax policy, took place before Ronald Reagan assumed office. Countless commentators have decided that Reaganomics represents a total reversal in inherited economic policy. But not so many years from now historians may simply be calling it an acceleration of inherited policy.
For staying the course while double-digit inflation was tamed—the only Reagan, or Reagan-Volcker, measure that seriously tested our threshold of pain—President Reagan deserves credit, as he does for courageously taking on the air-traffic controllers (which helped moderate the wage binge of the 1970s). He deserves credit as well for helping renew the popularity of markets and of entrepreneurial risk, here and abroad, and for persuading us to abandon the worst vices of regulation in such industries as airlines, banking, and energy. And he was surely correct in advocating cuts in marginal tax rates. We now know, for instance, that a maximum tax rate of 50 percent actually generates more revenue from the wealthy than a maximum tax rate of 70 percent, and provides real incentives for budding entrepreneurs. And for now, at least, Reagan has swept off the agenda such policies as national planning, wage-and-price controls, and wide-scale jobs programs.
We need, though, to be honest: as far as the basic allocation of our economy’s resources is concerned, Reaganomics has either opted for or acquiesced in some of the worst, future-averting choices America has ever made, the full implications of which will not be known for years.
TO BEGIN TO GRASP WHAT REAGANOMICS HAS wrought, go back to the presidential campaign of 1980. It was the evening of October 28, and the eyes of many American voters were fixed on the television debate between Ronald Reagan and Jimmy Carter. Facing the camera squarely, Reagan posed his famous question: “Are you better off than you were four years ago?" The next day newspaper polls began to report a surge of support for Reagan, which led to a Reagan landslide one week later.
Now, imagine that Reagan had immediately followed up his question with this guarantee: “I promise to make you feel better. While real personal consumption per fully employed American hardly budged during the Carter presidency, I will make it rise by about $300 per worker every year over the next six years. I’m also going to kick in another $140 per worker per year that we in government will be spending mainly to repair the fall in our defense budget during the seventies.
“How will I do it? Well, let me tell you. I will not do it by increasing the quantity of real goods and services produced per working American to any appreciable degree. Instead, I will do it by diverting to consumption, between last year and 1986, about three quarters of the resources per worker now devoted to savings. Half of the money will be obtained by simply cutting domestic investment, and to do this we will run enormous federal deficits—so big that the federal debt the public has bought since the time of the Founding Fathers, about $645 billion at the end of 1979, will have nearly tripled by the end of 1986. The other half will come from borrowing abroad. By 1986, in fact, our foreign borrowing alone will fund all of our net housing investment and a good 40 percent of our declining level of net business investment—freeing up by that year a fantastic $2,100 of extra personal consumption per employed American. From the end of last year to the end of 1986 our national per-worker balance with foreigners will fall from a credit of $989 to a debt of $2,500; and our federal per-worker balance with creditors, wherever they are, will plunge from a debt of $6,750 to a debt of $16,562. I’ll bet you’re feeling better already. Thank you and good night.”
This speech might not have won the presidency for Reagan. But it would have forecast precisely the performance of the economy during the candidate’s subsequent term of office.
Reagan was right in the debate with Carter: the 1970s were tough by comparison with the 1960s. He was also right in observing that lower productivity growth and higher federal-benefit growth during the 1970s “squeezed out" defense spending in favor of privately earned spending on consumption. What looks quite significant in retrospect, however, is that at least the squeezing did take place. Few Americans watching the debate in 1980 ever imagined that over the coming decade we would just decide to ignore the law that limits consumption to production.
This is, quite simply, the dirty little secret of Reaganomics: behind the pleasurable observation that real U.S. consumption per worker has risen by $3,100 over the current decade lies the unpleasant reality that only $950 of this extra annual consumption has been paid for by growth in what each of us produces; the other $2,150 has been funded by cuts in domestic investment and by a widening river of foreign debt. From 1979 to 1986 the total annual increase in workers’ production amounted to about $100 billion (in 1986 dollars). The comparable total for increases in personal consumption plus government purchases was about $300 billion. That leaves a difference of a bit more than $200 billion—just slightly more than the increase in annual federal deficits over the past six years. Deficit spending, of course, has been the primary engine behind this consumption bacchanalia—a superhot and superKeynesian demand-side tilt that replaced the reviled “Tax and spend" motto of the 1970s with the new motto “Borrow and spend.” In every previous decade we consumed slightly less than 90 percent of our increase in production; since the beginning of the 1980s we have consumed 325 percent of it—the extra 235 percent being reflected in an unprecedented increase in per-worker debt abroad and a decline in per-worker investment at home. This is how we have managed to create a make-believe 1960s—a decade of “feeling good” and “having it all"—without the bother of producing a real one.
We cannot, of course, go on borrowing from foreigners indefinitely to finance our consumption. Soon we must stop and, at that point, decide whether to repay them the principal or to forever commit ourselves (and our children) to pay annual interest to foreigners as the price for our 1980s binge. Nor can we go on starving domestic investment to finance our consumption. Soon we must stop and replenish the factories, bridges, and schools we have forgone or else forever relegate ourselves (and our children) to slower growth in our standard of living. Supply-side economics without the “supply" can have only one sequel— something we may soon call vicious-circle economics.
It is therefore all but inevitable that our level of consumption must slow its climb, or even fall, while our level of production catches up. But of course the speed with which it can catch up depends in turn on how much we can invest, which depends on how much we can save.
THE CONNECTION BETWEEN EXPLODING PUBLIC deficits and a lower national saving rate is not absolute and unbreakable. Conceivably, we might have left overall national savings untouched if we had engineered a huge rise in private-sector savings at the same time that we embarked on a huge rise in deficit spending. In fact, however, net private savings—the net income saved by private households and firms—has been declining very sharply over the past decade (from 8.1 percent of GNP in the 1970s to 6.1 percent of GNP in the 1980s). Consequently, net national savings, which equals net private savings minus public-sector dissaving, has been declining over the past decade, from 7.1 percent of GNP in the 1970s to 3.4 percent in the 1980s. In fact, during three of the past six years—1982, 1983, and 1986—U.S. net national savings has dipped below two percent of GNP. Huge capital inflows from abroad have thus been inevitable.
The conservative stewards of Reaganomics, ironically, have themselves created the Keynesian nightmare—large and permanent deficits—they so much feared. And Americans have endured it with remarkably little protest, because, after all, if conservative Kevnes-haters didn’t know the dangers of deficits, who did?
Apologists for Reaganomics once claimed that “rational expectations" would lead people to increase private savings to compensate for public deficits and that the tax cut of the early 1980s would lead to a savings surge. The latter line of reasoning is legitimate and important—at the margin and over the long haul. Unfortunately, it is an idea that works well only when we tax saving less and consumption more. Most of the 1981 tax cut was simply an across-theboard cut in personal income-tax rates and thus did little to alter the relative tax burden on savings versus consumption. In any case, what is truly inexcusable is the expectation that we could come out ahead simply by cutting the overall level of taxation while still allowing federal spending to grow. When tax cuts go unmatched by spending cuts, they must be accompanied by additional public borrowing from households and firms—thus by a dollar-fordollar reduction in otherwise investable private savings. Therefore, in a near-full-employment economy only a tiny fraction of the cut is likely to show up as additional private savings. If families and firms treat the tax cut just as they treat other income, the savings might be six or seven cents on the dollar—a tiny margin that can disappear entirely if there is a negative shift in the private sector’s overall inclination to save. As we have already observed, there was such a negative shift.
Other apologists for the 1980s “boom" have claimed that there is no historical correlation between public-sector deficits in bust years and negative trade balances. Even after budget deficits had soaked up some private savings, they point out, there was still enough left over for Americans to be net investors abroad; that’s why bust years typically brought us an improvement in our trade balance. Evidence that this time-tested pattern no longer obtained, however, was already surfacing in 1982, when the steepest recession in thirty years was accompanied by such largescale federal borrowing that our current account—the ledger of our financial transactions with foreigners—did not break even. Since then we have been sailing in uncharted waters: a cyclical recovery accompanied by enormous and widening foreign-capital inflows.
Some apologists for the 1980s have gotten so carried away with the idea of market expectations—Reaganomics is all about psychology and expectations—that they can justify any catastrophe by references to a rosy future. Alan Reynolds, the supply-side guru, believes that heavy foreign borrowing is a sign of economic strength. He has compared our huge current-account deficit today to Japan’s big trade deficits in the 1950s, claiming that what the two situations clearly have in common is buoyant growth expectations. Although some U.S. observers in the 1950s were dubious about the wisdom of Japan’s foreign imbalance, “in retrospect, U.S. worries about Japan’s trade deficits look rather foolish.”Likewise for the United States today. “What has happened in the 1980s,” Reynolds writes, “looks like a reversal of roles, with the U.S. becoming the relatively vigorous tax haven, attracting foreign capital and goods, while Europe and Japan slip into the stagnant, export-dependent role that the U.S. experienced in the Eisenhower years.”
The argument is half right. Japan was a capital importer in the 1950s, because it was a rapidly growing economy—more than that, it was a country literally reconstructing itself after a war that had largely wiped out its industrial base. It borrowed abroad to finance a higher investment level than would have been possible by relying on its already hefty savings rate alone. The result was an incredible net investment rate of well over 20 percent of GNP. Did such capital inflows make sense? Of course, for they rapidly paid for themselves in increased economic output. From 1950 to 1960 the Japanese economy grew at an average real rate of nearly 10 percent a year; real net output per worker grew at the extraordinary rate of 6.6 percent a year. The relative burden of financing the nation’s foreign-capital inflows (which ceased by the mid1960s) thus fell over time.
The parallel between the United States and Japan, however, utterly escapes me. Over the course of the 1980s the U.S. investment rate has been the second-lowest in the industrialized world (just above Britain); meanwhile, the rate of growth in our real net output per worker, absolutely the lowest, has averaged about 0.4 percent a year. That is less than one fifteenth of what the Japanese were experiencing thirty years ago. Japanese productivity in the 1950s, in other words, grew more in nine months than ours now grows over ten years. And unlike Japan, we have been borrowing abroad for consumption, not investment.
To find the proper historical parallel for the United States in the 1980s we should not look to Japan in the 1950s, nor should we look to our previous experience with heavy borrowing from foreigners. That was in the 1870s, when we issued bonds (at half the current interest rate) to Europeans in order to finance our huge investment in railroads and heavy industry. Instead, we must look to those rare historical occasions when an economy’s large size, its world-class currency, and its open capital markets have allowed it to borrow immense sums primarily for the purpose of consumption and without regard to productive return. The illustrations of lumbering, deficit-hobbled, lowgrowth economies that come most easily to mind are Spain’s in the late sixteenth century, France’s in the 1780s, and Britain’s in the 1920s.
So there we have it: a conservative Republican Administration that promised us a high-savings, high-productivity, highly competitive economy, with trade surpluses, and gave us instead a torrid consumption boom financed by foreign borrowing, an overvalued currency, and cuts in private investment, with debt-financed hikes in public spending and huge balance-of-payments deficits. It’s the same script, proceeding toward the same woeful finale, that we have seen played out over the years by many a Latin American debtor. As one wit has put it, just as the 1970s saw the “greening" of America, the 1980s is seeing the “Argentining" of America.
Now let us examine the pieces of this fiscal debacle in more detail. We will turn first to the critical nearand medium-term challenge of reducing our foreign-credit inflow—and, at the same time, of coping with the harsh policy choices and the danger of global crisis that must accompany such a reduction. Then we will take a longerterm view of the inexorable link between investment and living standards. Finally, we will discuss the manner in which American public policy treats our future. If before the 1980s this manner was one of neglect, today it borders on open contempt.
“Owing It to Ourselves” No Longer
HOW MUCH, EXACTLY, DO WE NOW OWE THE REST OF the world? Officially, our net position (what we are owed minus what we owe) at the end of 1986 was a negative $264 billion. By the end of 1987 we will be closing in on a negative $400 billion. The incredible speed of America’s transformation from creditor to debtor can hardly be exaggerated. Only six years ago, at the end of 1981, the United States had achieved its all-time apogee as a net creditor, with an official position of a positive $141 billion. Over the past six years, in other words, the United States has burned up more than $500 billion, net, by liquidating our foreign assets and by borrowing from abroad. That’s an immense flow of capital, even in global terms. By 1986 our net borrowing had dwarfed the fabled bank recycling of OPEC surpluses after the oil price hikes of 1973 and 1979. The sum was twice the size of all foreign interest payments by all the less-developed debtor nations, and about half the approximate dollar value of total net investment in all less-developed countries combined.
What does the future have in store for a nation that is borrowing such sums from foreigners? As a net debtor of growing proportions, the United States must inevitably become a sizable net exporter of goods and services. (I repeat: exporter.) This proposition is just a matter of arithmetic. Since our indebtedness cannot grow indefinitely as a share of our GNP—beyond some point, foreign creditors will regard us as a growing credit risk, a risk that must be compensated for by prohibitively high interest rates—our current-account deficit must eventually decline substantially. And when that happens, we will have to export more than we import in order to service our deficits on interest and dividend payments to foreigners. Just to say that something is inevitable, of course, does not tell you when it will happen. But I think it’s fair to say that the growth of America’s foreign debt may push us—painfully—to a current-account balance and a trade surplus by the mid-1990s, and almost certainly will do so by the year 2000.
Our opportunity for a relatively smooth readjustment is perilously narrow. On the one hand, it seems likely that the rest of the world will grow reluctant to keep lending to the United States once our net indebtedness rises much beyond 35 percent of our GNP, or a bit more than $1 trillion at today’s prices. Some experts suggest that this debt may entail net U.S. debt-service payments equivalent, as a share of exports, to those of many developing nations and about on a par with Germany’s reparations burden following the First World War. The experts agree that it is quite impossible for the United States to go on indefinitely borrowing principal at or near its current rate of 3.4 percent of GNP per year. Such borrowing, combined with accumulating debt-service costs, would dictate an absurd $3 trillion in net debt by the end of the century, and foreign investors would close down the pipeline long before we got there.
On the other hand, it is practically inevitable that our net debt will reach the $1 trillion mark by the early 1990s no matter how vigorously we act to stem the inflow of foreign savings. Obviously, there are limits to the speed with which the United States can curtail consumption and generate growth in net exports. Consider, for instance, a scenario in which the United States, starting next year, makes steady additions to the value of its net exports such that its current account reaches zero by 1994 and its net debt is reduced to today’s level by the year 2000. That sounds like a rather modest achievement. Yet it will still lead to a net debt of about $1 trillion by 1994 and will require a real improvement in U.S. net exports of more than $20 billion a year, each year, for the next ten years, or a total positive shift of more than $200 billion. As Fred Bergsten has observed, the magnitude of the necessary adjustment facing us is equivalent to about two thirds of our entire defense budget and is several times larger than the total shift resulting in the United States from the 1970s oil shocks.
According to the adjustment scenario above, we need to reduce our foreign borrowing stream by $20 billion yearly, or $200 yearly for each of our 100 million workers. Yet real net product per worker has been growing each year by just $135. Further, our continuing debt growth will mean that about $40 per worker per year must be devoted to rising foreign debt-service payments. And to increase productivity sufficiently to raise net exports will require at least our 1970s level of net investment at home—an additional $60 per worker per year over a decade.
So where are we going to find, each year, the extra $20 billion in unconsumed exportable production necessary to make this readjustment scenario work? Over the next decade, with only $35 per worker available ($135, minus $40, minus $60), consumption per worker in the United States may have to decline by $165 each year. That’s $1,650 overall for the average worker, and of course we can expect those Americans with the most vulnerable incomes—minority workers, young adults laboring under two-tier contracts, and service employees who receive no benefits—to suffer losses that are far greater than average. Neither the American public nor the nation’s politicians have even begun to face this prospect. In comparison, during the 1970s—a decade now known to most of us as “hard times”—U.S. consumption per worker nonetheless rose by $200 each year. What the early 1980s gave us, the 1990s may well take away.
IN WHAT EXPORTS, SPECIFICALLY, IS THE UNITED STATES going to see the enormous gains it must achieve to lower its trade deficit? First of all, we can forget about any major contributions from the 22 percent of our trade exports now composed of agricultural goods and raw materials. The $25 billion trade surplus we had in agricultural exports in 1981 shrank to $3 billion last year. Over the past decade the European Economic Community has raised its grain balance, improbably enough, from a deficit of 25 million tons to a surplus of 16 million tons. India, Pakistan, and China have all become net farm-product exporters. Even the Soviet Union now seriously asserts the breathtaking goal of becoming a net food exporter by the year 2000. We will therefore be lucky to slow the current decline in our agricultural balance. Much the same goes for raw materials.
As for oil imports, nearly all experts expect that declining U.S. production will push our current 25 to 30 percent dependence on oil imports to 50 to 60 percent during the 1990s, and at higher prices. Philip Verleger, Jr., a visiting fellow at the Institute for International Economics, estimates that the value of our oil imports will rise from $44 billion in 1985 to $120 billion or $130 billion by the mid1990s. The 1980s have been happy, quiescent years from an energy standpoint, but we may, in the 1990s, again face some of the energy turbulence of the 1970s. The $70 billion real improvement (in 1986 dollars) in the energy balance that Americans have enjoyed since 1980, in other words, will reverse direction. Let’s be optimistic and assume that our annual total farm and raw-materials balance for the foreseeable future will decline by only $10 billion per year. That means we need a good $30 billion yearly improvement in the remaining 75 percent of our exports— namely, manufacturing.
Some critics balk at this point and complain that this logic unfairly omits our exports in services. According to a recent Fortune article titled “The Economy of the 1990s,” the United States will improve its balance on services by $125 billion between now and the year 2000. This service surplus, like some deus ex machina, is supposed to more than pay the debt service on what Fortune admits will be a “debt mountain” of some $1 trillion by the mid-1990s. This analysis confuses a large flow of services that are actually debt service (for example, the payment of interest and dividends) with a much smaller flow of services that are actually current production (for example, travel, shipping, and insurance). We already know what will happen to the balance on the former type—it’s going to go deep into the red. And U.S. exports of the latter type, unfortunately, are both too small (a total of $49 billion in 1986) and too inflexible to make much difference. Two thirds of these exports consist of shipping, transportation, and travel; the rest consist of business services that usually accompany trade exports. In fact, since so many of our high-tech service exports are linked to manufacturing exports, it strikes me as virtually meaningless to project one without the other.
Let’s be optimistic and assume that service exports will eventually grow by fifty percent. That still leaves us with a need to increase our manufacturing exports by $275 billion, or achieve a real annual growth rate of 10 percent over the next decade. Can we emulate Japan and sustain such a prodigious performance in manufacturing over so many years? Perhaps we can, but the prospect seems daunting. So far in this decade our manufactured exports have actually declined in real terms, but over the coming decade we will be aiming for a higher export growth rate than we have yet achieved in the twentieth century. In every respect the achievement would be unprecedented: we would have not only to break our earlier record but to do it with a lower average level of domestic business investment, with a complete freeze on imports, and with steadily declining living standards.
Any way one looks at it, the arithmetic is cruel and inescapable. It’s hard to imagine huge growth in our manufacturing output, for instance, without a very large increase in domestic business investment. But to further increase investment at home we may have to undergo a further decline in consumption, in order to hold constant our net export improvement. And, clearly, we are not going to see any decline in consumption in favor of saving unless there is a radical change in our public policy, especially our fiscal policy (something I will discuss later on), and in our politics as well.
THERE REMAINS, MOREOVER, YET ANOTHER PROBlematic assumption in our readjustment scenario: the willingness, or even the ability, of the rest of the world to absorb our proposed huge increase in manufacturing exports. Current thinking on this problem seems to grow out of two separate theories. One theory emphasizes foreign economic growth, the other exchange rates.
The foremost proponent of the first theory is the Reagan Administration, which has repeatedly insisted that higher rates of growth abroad—particularly in the stagnant-demand economies of West Germany and Japan— will solve our problem. This is a worthy idea but hardly a solution. Consider, for instance, a sustained one-percent real increase in economic growth in the rest of the world— say, from about the current 2.5 percent to 3.5 percent (surely we cannot expect more). Then imagine that all this growth is purely domestic. Using rosy “multiplier" assumptions, we could get a twoor even four-percent real increase in exports. Recall, however, that we need a 10 percent real increase.
The second theory, to which many economists subscribe, is that any level of net export improvement is possible as long as we endure a “sufficient” decline in the exchange rate—that is, a continued fall in the value of the dollar relative to other currencies which will make our goods more attractive to foreign buyers.
Experience demonstrates, however, that exchange-rate adjustment also has its difficulties. Over the past few years nearly all economists have been humbled by how far they had overstated the extent to which world trade balances would adjust to the recent fall in the dollar. Given this track record, it is cause for deep reflection that forecasts now being made in major think tanks say that even a 25 percent further devaluation of the dollar will be lucky to push the annual U.S. current-account deficit much below $100 billion over the next few years. The underlying problem might be posed as follows: even if we accept a lower dollar, which I believe to be virtually inevitable, will economies in the rest of the world accept it? The challenge lacing America—generating a $275 billion positive swing in manufactured exports over the next decade—sounds tough enough without worrying about whether our trading partners will accommodate our necessities. Yet we often forget that our objective of huge yearly increases in U.S. net exports translates directly into decreases in the net exports of our major trading partners (recently the very source of much of their growth). It’s not just a question of our resolve; it’s also a question of their resolve, something over which we have little or no control.
What we hope, of course, is that our trading partners will accept our agenda. In general, we want them to raise the demand for goods and services in their countries at the same pace at which we are suppressing demand, with smaller fiscal deficits and higher private savings rates, in our own country. Specifically, we hope they will stimulate their domestic demand with looser fiscal policy, keep their currency strong with restrained monetary policy, and pull down import barriers so that U.S. exports can expand with minimal pressure on exchange rates. Our unspoken assumption is that once we decide to act, they can be expected to cooperate.
In reality, foreign economies may be otherwise inclined. Instead of loosening fiscal policy, they may continue to tighten—raising their own national savings rates in tandem with ours even at the risk of a collapse in global demand. And instead of embracing a lower dollar, they may continue to resist it, either by pushing their exports harder (with price cuts and aggressive marketing) or by discouraging imports (with official or unofficial import barriers or simply a social consensus not to “buy American”). Either way, readjustment may entail risks that persuade all parties to abandon the effort. In the former case the risk is worldwide economic stagnation. In the latter the risk is a precipitous fall in the dollar and the danger of financial panic.
Why might our trading partners not want to cooperate? For one thing, foreign leaders may be slow to believe that the United States will do what it says it intends to. Look at it from their point of view. Ever since 1983 the l nited States has been assuring the rest of the world that it is just about to cut back on its budget and currentaccount deficits and that other countries should therefore immediately begin stimulating their domestic demand in order to “pick up the slack.”Other countries have responded with caution, and in retrospect—the U.S. deficits having grown rather than shrunk—their leaders must now be glad they were cautious. They still have their exports, they still have their productivity growth, and they still have stable prices.
Given the recent sharp fall in the dollar, many Americans figure that our trading partners have begun to see the handwriting on the wall. Surely, we think, Europe and Japan must soon opt for large-scale domestic stimulus in their own interest—especially when it means the instant pleasure for their own citizens of more disposable income and more consumption. Yet here we confront a deeper issue—the vast differences in culture, history, and politics which make it just as hard for other industrial countries to do what we find natural (stimulate consumption) as it is for us to do what they find natural (stimulate savings). We find inflation worth risking, but the West Germans, scarred by the memory of the 1920s, would rather risk recession. We find it easy to sacrifice exports on the altar of the high dollar, but the Japanese, who have spent generations fighting to earn dollars to pay for their food, raw materials, and oil, find the equivalent idea tantamount to economic surrender (particularly considering their long-sought, stunning manufacturing trade surplus of $150 billion, or about eight percent of their GNP). The necessary reversals in national economic direction are profound. If we assign Japan one third of the needed adjustment, for example, or $50 billion annually by 1994, this would amount to eight percent of its total manufacturing output (in a negative direction). To those who argue that Japan adjusted successfully to two oil shocks, and so can handle this challenge, I argue that those shocks required the Japanese to do more of what they had always been doing (namely, exporting), while the present predicament will require them to do less. American leaders think that stimulating domestic demand is child’s play. Most leaders abroad do not. They are, in fact, extremely doubtful that their consumers will be able to pick up where exports to America leave off.
To allay doubts about our intentions, we must change our policy in credible and irrevocable ways, and announce these changes ahead of time. Readjustment becomes sticky when, even in the face of changing prices, foreign exporters hope to preserve their sunk costs, their hardwon market shares, and their relentless productivity and cost-reduction efforts—as Americans hooked on imports hope to preserve their buying habits. Those hopes are our enemy. We cannot cloud the air with chatter about painless global growth when in fact we are asking exporters abroad and importers at home to endure inevitable hardships.
Second, to eliminate uncertainty about the implications of our policy, we must talk realistically about a genuine transformation of the world’s major political economies. “Fair trade” (whatever that means) isn’t really the point. Our objective is to raise U.S. exports so that we avert a tragedy that threatens everyone—a global crash, finally, to encourage political as well as economic balance in the world, we must renounce our recent policy of “global Keynesianism”—the policy of being everyone’s buyer of last resort. The mercantilist aggressions bred by such a policy, including retaliatory protection and games of “chicken” with exchange rates, have themselves become a major obstacle to readjustment. Confidence, not fear, is the best way to get foreigners to retool their export plants for their own domestic markets.
IF WE SIMPLY PROCEED WITH THE “BUSINESS AS USUAL” approach to the world’s growing imbalance, America’s foreign creditors will ultimately become aware that the situation is unsustainable. At that point anything, from a small decrease in the value of the dollar to a mild political crisis, could cause investors around the world to decide to rid themselves of dollar-denominated assets, if the resulting plunge in the dollar’s exchange rate persuades ever larger numbers of investors to follow suit, the “dollar overhang” might at last turn into the worst freefall nightmare of Paul Volcker, the former Federal Reserve chairman: an avalanche pouring down on the dollar’s financial capitals, from London to San Francisco.
The United States, in response, would have little choice but to raise interest rates sky-high, in order to attract at least some investors to the dollar to finance our budget deficits. We would also have to acquiesce in a long and almost deliberate recession, both to shut down most of our foreign borrowing (in a matter of months rather than years) and to suppress U.S. demand for imports. Actually, the recession is likely to be of the “stagflation” variety, since higher import prices may double our inflation rate even before we prime the pump. The peak-to-trough downturn could be quite steep indeed and could easily become our most severe economic crisis since the 1930s. Nor have I yet mentioned how the razor-edge plight of many less-developed debtor nations will add to the danger. Every forecast I have seen warns that the largest South American debtors will be pushed from illiquidity to insolvency by a far milder recession, and far smaller interest-rate hikes, than those envisioned here. Many have even suggested that spreading defaults among less-developed countries may precipitate the crisis.
No one knows, of course, how long such a hard landing would last. It is possible, I hope, that it would be limited to a financial crunch followed by a severe but brief recession, rather than a lengthy depression. The economy could recover with relatively moderate increases in world unemployment, but surely the value of the dollar would be much lower and U.S. import levels would be much reduced. This is what I call the “bumpy start-and-stop” scenario—the one that has afflicted postwar Great Britain. Under this scenario the standard of living in the United States would have dropped, its indebtedness would be little changed (but no longer growing), its international responsibilities would be necessarily curtailed, and its people would be aware, through occasional jumps in interest rates and the yo-yo behavior of the dollar, that their economic fate was hostage to the tenuous and nervous confidence of outsiders. The British economist Michael Stewart recently observed that “anyone who has lived through our 40 years of balance of payments crises, and seen the constraints they have imposed on domestic policies, must stand amazed at the insouciance with which the United States is piling up external debt.” These constraints, of course, were not only domestic; they also hobbled British foreign policy—most dramatically in the Suez crisis of 1956, when the United States, which held reserves of British sterling as foreigners hold our dollars today, warned the British that we would declare war on the pound if they did not stop their invasion of Egypt. So much for the perils of dependence on foreign investors.
Should we have the worst hard landing—a lengthy U.S. depression—let us simply be forewarned that our traditional policy responses would be of limited use. Hardshipbloated budget deficits would prevent us from applying more fiscal stimulus; a low and skittish dollar would defy our attempts to loosen monetary policy. Whereas the “start-and-stop” landing presumes that Americans could pay for their debts by a one-time shock in living standards, and thereafter by slower productivity growth and reduced international leadership, the true-depression hard landing presumes that Americans would service and pay off their debts through indefinite impoverishment. Either scenario could, of course, lead to a resurgence in state control over the economy (on a scale that might put Jimmy Carter’s credit controls to shame)—an ironic last act in an opera that opened with the chorus singing praises to laissez-faire.
SOME OBSERVERS PLAY down the possibility of such a crisis. They point to the apparent ease with which the world has so far endured a substantial decline in the dollar’s value. Clearly, however, the easy stage is now coming to an end. In trade, the dollar has now reached the point at which further declines can no longer be absorbed by exporters’ profit margins and will leave no foreign alternative other than structural change or economic stagnation. Just as the American economy has since 1980 suffered the trauma of de-industrialization, so the Japanese economy has begun to suffer from what some Japanese call the “hollowing out” of their industries—worker layoffs, unused capacity, and a scramble toward offshore assembly. In finance, further dollar declines are likely to be accompanied not by lower U.S. interest rates, as in the past, but by unchanged or even higher interest rates, as we experienced last spring. This will present the Fed with a no-win choice between defending the dollar and loosening credit. And it will hit foreign investors with the double whammy of further exchangerate losses compounded by losses in bond-market values. The preconditions for a dollar-dump panic, in short, may already be moving into place.
Of course, one hopes that Americans will never have to live through these dismal outcomes. But avoiding them will take great effort—not just in changing policy but ultimately in changing our very self-image and in persuading our trading partners to change theirs. Japan’s problem, a senior official there told me recently, is global-asset management; ours, alas, is global-debt management.
The financial expert David Hale has written, “The U.S. is a debtor nation with the habits of a creditor nation while Germany and Japan are creditor nations with the habits of debtor nations.” Needless to say, America must soon change its habits, including its fixation on creative consumption. Our ability to do so safely, however, will depend on more than just our own hard work and determination. It will also depend on whether we can persuade our trading partners to change their habits, at the same speed and at the same time that we are changing ours.
Turning Away From Posterity
OUR GROWING FOREIGN DEBT AND TRADE DEFICIT not only threaten a sacrifice in our consumption levels but also symptomize our unwillingness to acknowledge a deeper and more long-standing disease: a steady thinning out of those activities and attitudes that tend to generate, over the long term, a rising level of productive efficiency. When the seriousness of this problem became increasingly apparent, during the 1970s, we should logically have chosen to allocate fewer of our resources toward consumption and more toward investing in productive physical and human capital. Instead, under a supply-side banner, we have blindly chosen to do the opposite.
Does it matter that our productivity is growing only a fraction as fast as it was in the 1950s or 1960s? Indeed it does. To recognize some of the consequences, we have only to consider that to end foreign borrowing with no change in per-worker consumption or domestic investment will take us twelve years of productivity growth at the current rate. The same task would take us only a bit more than three years at the growth rate of the 1960s or only a bit more than two years at the rate of the 1950s. To put it another way: Our per-worker flow of foreign borrowing, as we have seen, is now running at about $1,350 a year. But whereas the net product per worker that is left after we service our debt, and that we can apply to reducing our current-account deficit, is rising by only $95 a year now, it would be rising by $630 a year at 1960s growth rates and by $985 a year at 1950s growth rates.
Yet it would be wrong to see productivity differences solely in terms of our foreign balances. Far more important is the role such differences must play in determining longterm growth in our future living standards. The cumulative impact of small differences in yearly growth rates cannot be underestimated. Consider the year 2020, when those who are now infants will be in the prime of their working life. If productivity growth proceeds at its 1980s rate (and does not decline still further), the average worker in 2020 will be producing $40,100 worth of real goods and services, only about 14 percent more than his or her parents are producing today ($35,300). Under the smoothestpossible-readjustment scenario already described, which would result in declining per-worker consumption through most of the rest of this century, even by 2020 his or her yearly consumption will have risen only eight percent above the 1986 level.
America’s standard of living, for the first time in its history, will have hardly budged for a span of forty years. The 1980s and 1990s may be remembered, with bitterness, as a turning point in America’s fortunes—a period of transition when we took the British route to second-class economic status. Britain’s decline took seventy-five years of productivity-growth rates that were half a percentage point lower than those of its industrial competitors. Because America’s corresponding gap is more than three times as large, its relative decline is proceeding far more swiftly.
If, however, U.S. productivity now started growing again at the 2.4 percent average rate that prevailed during the 1950s and 1960s, miraculous though that would seem, our sons and daughters in 2020 would each be producing $77,200 worth of real goods and services—some 120 percent more than their parents are each producing today. Consumption standards would rise by nearly as much, since we would have been able both to close our foreignborrowing gap and to recoup our foreign liabilities by the early 1990s. In this case our grandchildren would look back on us as relative paupers, and by 2020 Americans would be enjoying buoyant prosperity and widening social opportunities in a nation that would still be a leading force in the world’s economic and political affairs.
Understandably, most Americans do not want to confront the painful idea that we are headed toward the wrong future. Yet that is the melancholy fact of the matter. What is less understandable is the strident defense that so many opinion leaders offer for our present course. We hear time and again that the U.S. economy in the present decade has grown “as fast as" or “faster than" the collective economy of the rest of the industrial world. So far as this claim goes, it is correct. From 1979 through 1986 real U.S. GNP grew by a rate of 2.1 percent a year—about the same growth rate as that of the collective GNP of all other industrial nations. However, in the United States most of the growth (70 percent) was due to increases in the number of workers, while in the other countries most of the growth (85 percent) was due to increases in output per worker.
The rapid growth in U.S. employment has partly been the consequence of an entrepreneurial and new-business surge, the flexibility of our labor markets, and several booms (for example, a consumption boom, providing jobs in distribution; the health-care-for-the-elderly boom; the home-services and eating-out boom; and the postwar Baby Boom, which has no counterpart in other countries). According to a recent Commerce Department report, from 1981 to 1986 the equivalent of nine million full-time jobs were created. And yet, contrary to the widespread impression, this represents a job-creation slowdown; over the previous six years the equivalent of 14 million fulltime jobs were created.
In any case, this kind of growth must cease within a few years, when all the Baby Boomers are employed, and reverse itself in future decades, when young adults will be scarce and retiring workers ever more plentiful. More important, it is not the kind of growth that raises our standard of living. Augmenting production by adding more working bodies (what classical economists used to call the “dismal”
Asian model) does not enhance the standard of living. Only augmenting production per working person does that, and Europe and Japan do that far more successfully than we do. The employment of the largest and best-educated generation of Americans in history should have caused U.S. GNP to rise far faster than GNP in any other country—as it should also have pushed up our savings rate, since presumably this working generation of young adults will want to allocate some of the extra production to provide for their children and their own retirement (as the Baby Boom becomes the Senior Boom). Instead, with the part-time nature and much lower value-added character of many of the new jobs, we have barely managed to keep pace with the GNPs of our competitors, and our savings rate has declined. This is not success but a large-scale admission of failure.
Yet it is surely true, the optimists say, that productivity growth and investment performance in the other industrial countries have declined sharply over the past fifteen years, and this must mean that we are doing better than they are. Not really. Because the performance of the other countries was so superior to begin with, and because our own performance has also fallen, product per worker is still growing considerably faster abroad than here in the United States.
How have these economies managed? The most apparent factor has been much higher investment levels. Here, Japan is the leader. From the 1960s to the 1980s its total net investment as a share of GNP (including investment in public infrastructure as well as in all private structures and equipment) has fallen from 22.6 percent to 16.1 percent; the latter figure, however, is still three times larger than the equivalent U.S. figure for the 1980s (5.3 percent). In fact, at 1986 exchange rates (as the dollar falls, the comparison is getting worse) Japanese net investment in 1986 amounted to $300 billion, while U.S. investment amounted to only $270 billion. (This has been the result, in part, of a cost of capital in Japan that has consistently been less than half ours—a situation not at all helped by the 1986 Tax Reform Act.) It is a spectacle that ought to shock Americans: a population half the size of our own, living on a group of islands the size of California, is adding more each year to its stock of factories, houses, bridges, and laboratories—in absolute terms—than we are to ours. And Japan still has savings left over, about $80 billion in 1986, to lend to thriftless foreigners. (About $50 billion of that sum was lent to us.) Between the two countries, therefore, the 1986 disparity in net savings ($380 billion in Japan versus only $125 billion in the United States, a six-toone per capita difference) was even more lopsided.
FOR YEARS MANY U.S. EXPERTS HAVE BEEN PREDICTing that the relative productivity-growth advantage of the other industrial countries would soon slow down. Back in the 1960s and early 1970s such predictions were based on the “postwar reconstruction” thesis. Industrial phenomena like Japan and West Germany, it was said, were growing faster merely because they still had to “replace” the capital stock they had lost in the Second World War. More recently this line of reasoning has been abandoned, because it obviously cannot explain why these countries have replaced most of their business plant and equipment several times over since the early 1950s. In Japan, to take the extreme example, there is hardly a single factory now standing that has not been built, rebuilt, or entirely re-equipped since the mid-1970s. Indeed, each Japanese worker is supported by more than twice the plant and equipment that supports his or her American counterpart. A new argument, therefore, has become popular. This is the so-called convergence thesis, according to which other countries are getting a free ride by copying American technological breakthroughs. Once the other countries reach our level, it is said, their productivity growth must slow down sharply. At that point they will have to do the same tough “pioneer” work that we do.
The convergence thesis makes sense only if we assume that the other countries’ overall disadvantage relative to the United States is spread about equally across every economic sector, and that it is especially marked in manufacturing, where technology presumably is most important. Unfortunately, this assumption isn’t plausible. Most economists agree that America’s remaining absolute advantage is due mostly to superior productivity in agriculture, raw materials, and services, and that little if any of it is now due to superior productivity in manufacturing.
Instead of hoping for convergence, we Americans ought to recognize that we are already getting beaten in manufacturing. We must also recognize that over the foreseeable future the biggest productivity-growth opportunities in Europe and Japan will lie in improving efficiency in agriculture and services—something that requires no big research-and-development breakthroughs and could occur with disquieting suddenness.
The defenders of Reaganomics, of course, protest against any such conclusions. The growth of U.S. manufacturing productivity, they claim, has been one of our great achievements in the 1980s. And now that the dollar is back down where it was when President Reagan took office, American exporters will no longer have to compete against absurdly cheap foreign labor costs. The future, then, looks bright.
But does it really? True enough, U.S. manufacturing productivity has recently run against our economy’s declining trend. For example, from 1979 to 1985 Ford reduced its global employment by nearly 30 percent while reducing its car and truck output by only about five percent. Overall growth in manufacturing productivity rose from a yearly average of 2.3 percent in the 1970s to nearly 3.2 percent in the 1980s. What the optimists do not point out, however, is that such numbers are the perverse if pro-competitive result of seven catastrophic years for U.S. manufacturers— two domestic recessions (1980 and 1982-1983) followed by a high dollar export recession (1984-1986).
Still less do the defenders of the 1980s want to point out that U.S. manufacturing productivity, even with the help of its recent job-slashing acceleration, grew more slowly during the 1980s than the average for our major industrial competitors. And far from granting slower real pay raises, foreign manufacturing exporters have been using their productivity advantage to grant their workers much larger pay raises than firms in the United States have done. Since 1969 real manufacturing pay has risen by only 17 percent in the United States, but by a colossal 115 percent in Japan.
The fact that U.S. wages have grown even more slowly than U.S. productivity certainly reflects the adverse exchange-rate climb of the dollar during the early 1980s. But since the gap in wage growth was already apparent at the end of the 1970s—before the dollar’s long climb—some experts suggest that it may also reflect a negative shift in the image of U.S. goods for quality and reliability. Our decline in underlying competitiveness, in other words, may be even greater than what the output-per-worker numbers indicate. For this reason the recent emphasis on quality by many U.S. manufacturers can only be regarded as gratifying.
A FINAL DEFENSE OF OUR ECONOMIC PERFORMANCE IN the 1980s rests on the sweeping claim that none of this “smokestack” productivity matters anymore because our economy will henceforth thrive on our alleged global monopoly on information and inventions. Pure products of the mind have limited appeal as final consumer products, however, and so one wonders how they can generate wealth unless we have the capability—the plants, tools, and production skills—to turn them into salable goods and services. Perhaps, it is said, we could sell this intellectual property directly to foreigners. A good idea, but the numbers hardly indicate that such sales could ever drive our economy by themselves. In 1986 our total net receipts from royalty and licensing contracts with unaffiliated foreigners (including movie and TV rights) amounted to about $1.5 billion, or about four ten-thousandths of our GNP. And in inflation-adjusted dollars our receipts of this kind have actually been declining over the past decade.
Knowledge and innovation, to be sure, are an absolutely vital precondition for long-term economic growth. But we Americans tend to overrate the significance of our leadership here. We forget that intellectual glitz and scientific glory do not always translate into the humble, wealth-generating chores of commercial innovation. Although we like to point out that we lead the world in the share of GNP that we devote to research and development, we neglect to add that much of this is devoted to obscure weapons R&D that leads to few commercial spinoffs. In civilian R&D we lag behind both Japan and West Germany. We should be pleased with the rapid growth of venture and equity financing for small high-tech businesses during the 1980s, but we should also be cautious: thus far we have seen no comparable surge in small-business R&D, no reversal in the downward trend in U.S. patent applications, and no resurgence in high-tech exports. As for U.S. universities, they are indeed a global showcase for Nobel laureates and pathbreaking research. Yet most of the brilliance emanating from our universities is as freely available to foreigners as it is to our own citizens.
More important, it is hard to imagine any long-term economic renaissance—especially one built on “working smarter"—without a determined investment in the most precious of our assets: the skills, intellect, work habits, health, and character of our children. Yet this is precisely where we may be courting our most catastrophic failure. In the words of one analyst cited by the 1983 National Commission on Excellence in Education, “For the first time in the history of our country, the educational skills of one generation will not surpass, will not equal, will not even approach, those of their parents.”Recent trends indicate that each year the typical American child is increasingly likely to be born in poverty and to grow up in a broken family. And a study by the Committee for Economic Development points out that without major educational change, by the year 2000 we will have turned out close to 20 million young people with no productive place in our society. The CED study continues, “Solutions to the problems of the educationally disadvantaged must include a fundamental restructuring of the school system. But they must also reach beyond the traditional boundaries of schooling to improve the environment of the child. An early and sustained intervention in the lives of disadvantaged children both in school and out is our only hope for breaking the cycle of disaffection and despair.”Our children represent the furthest living reach of posterity, the only compelling reason that we have to be serious about investing in the future. And we are failing them.
The Politics of Debt
THERE IS NO QUESTION THAT FEDERAL FISCAL POLICY deserves much of the blame for our national failure to invest during the 1980s; recall that the 1986 federal deficit consumed the equivalent of 90 percent of all private-sector savings that year. On the one hand, opinion polls consistently show that the American public overwhelmingly favors, in theory, a balanced budget. On the other hand, serious attempts to reduce the deficit continue to encounter, in practice, enormous bipartisan resistance. Congress and the Administration invent countless reasons why solving the problem can be postponed just a bit longer or why the deficit can’t really be doing us that much harm.
We have little time left to get beyond such rationalizations. It is sometimes asserted that our economy’s saving behavior would be pretty much the same today without a federal deficit. But, again, consider the numbers. During the 1980s we have succeeded in nearly tripling the national debt, from $645 billion (at the end of fiscal year 1979) to $1,745 trillion (at the end of fiscal year 1986). We have, in addition, saddled ourselves with an informal debt of nearly $10 trillion in unfunded liabilities in Social Security, Medicare, and federal pensions. That astronomical figure is the difference between the benefits today’s workers are now scheduled to receive and the future taxes today’s workers are slated to pay for them. It amounts to a hidden tax of $100,000 on every American worker, and its toll will be exacted on our children.
For Americans to believe that their national balance sheet is in the same shape now as it used to be, they would have to believe that the enduring investments made by the federal government during the past seven years are comparable to all those made during the preceding two centuries—including the taming of the frontier, victories in several wars, the Marshall Plan, miracle vaccines, the Apollo missions, Grand Coulee Dam, and the interstate highway system.
From fiscal year 1979 to 1986 federal revenue fell from 18.9 percent to 18.5 percent of GNP, while federal outlays rose from 20.5 percent to 23.8 percent of GNP. Why has federal spending risen? The big growth areas over the past seven years have been defense, entitlement benefits, and interest on our national debt; all other spending has been cut back dramatically. Over the longer term, however, entitlement benefits dominate the picture. Since 1965 they have grown from 5.4 percent to 11.5 percent of GNP; all other spending excluding interest (which simply represents the permanent cost of cumulative deficits) has declined from 11.0 percent to 9.5 percent of GNP. This growth in entitlements over the past twenty-one years is equivalent to 6.1 percent of GNP—an amount greater than the entire investment we currently make in all business plant and equipment, plus all civilian R&D, plus all public infrastructure. Even defense spending, as a share of GNP, has risen only half as much during the 1980s as it declined during the 1970s. At 6.6 percent of GNP in 1986, defense spending is still lower than it was in any year from 1950 to 1973.
Our budget-cutting efforts during the 1980s have failed because they have allowed continued growth in the one type of spending—for entitlement benefits—that had already risen to unprecedented heights. Even where the 1980s budget ax has fallen hard, the major victims have been precisely those rare federal programs whose purpose is physical or human investment rather than consumption.
This last point is worth emphasizing, for it explains the unique vulnerability in recent years of that small area of the federal budget called discretionary non-defense spending. That’s the old-fashioned type of spending in which Congress—unconstrained by automatic-indexing formulas and prior-year contracts—votes on bills each year, presumably for the best interest of our national future. Unfortunately, since the future has no lobby, no formula, and no contract, the Administration and Congress have found this the perfect place to demonstrate their budget-cutting zeal publicly even while allowing all other types of spending to keep rising. By 1986 discretionary non-defense spending had been cut to 4.09 percent of GNP, its lowest level since 1961.
This spending category includes that bellwether of federal investment activity, the maintenance and construction of America’s public infrastructure. Net real investment in roads, bridges, mass transit, and other public works has dropped by 75 percent over the past two decades; much of our infrastructure is wearing out far more rapidly than it is being replaced. We do not have a new generation of infrastructure technology, from high-speed trains to underwater tunnels, because we have chosen not to pay for it.
But the steep decline in federal investment during the 1980s has not been limited to infrastructure. Investment in our environment and in human capital—research, education, job skills, and remedial social services—has also plummeted. These, too, have now been deemed superfluous. From 1979 to 1986, in real dollars, federal spending on natural resources has been cut by 24 percent, non-defense R&D by 25 percent, aid to schools by 14 percent, and energy preparedness by 65 percent.
Far from forcing a “revolution” in the role of the federal government, the 1980s have instead seen the federal budget become an ever larger and more efficient consumption machine. In the mid-1960s checks mailed out automatically (to bond owners, health insurers, retirees, state and local benefit administrators) accounted for about 58 percent of all federal non-defense spending. By 1979 their share stood at 68 percent; today it has grown to nearly 80 percent. We have now reached the point, in fact, where even if we eliminated all discretionary non-defense spending (imagine that we could fire all civil-service employees and replace them with a giant check-writing machine), the federal budget would still be running a deficit. Our government’s function as an investor, a steward of our collective future, is small and shrinking. Its function as a consumer, a switchboard for income transfers, is large and growing.
Surely, it is argued in defense of the growth in entitlements, the alleviation of poverty also constitutes “investment” of a sort—an investment in the long-term social and economic benefits of preventing serious material hardship. If the premise were valid—that federal entitlements go to the poor—this would be a worthy argument. Unfortunately, the facts seem to be otherwise. In 1986 the U.S. public sector spent about $525 billion, or 12.5 percent of GNP, in benefit payments to individuals. Of this total, about $455 billion was financed at the federal level: about $360 billion consisted of cash payments, and the rest consisted of inkind payments (for example, health care, food stamps, and rental assistance). How much of all this went toward alleviating poverty? No one knows for certain, but probably no more than about 20 percent of the total, or approximately $100 billion. The rest represents income transfers from non-poor taxpayers to non-poor beneficiaries (and, increasingly, to non-poor purchasers of federal debt).
THIS RESULT SHOULD NOT BE SURPRISING, CONSIDering that of the $455 billion dispensed from the federal budget, 85 percent was not means-tested—in other words, was not targeted to people living in poverty. These non-means-tested benefits went, by and large, to those groups least likely to be poor. The lion’s share, $271 billion, consisted of Social Security and Medicare payments, which went indiscriminately to nearly every elderly person. The elderly now enjoy the lowest poverty rate—less than three percent when the calculation includes total benefit income—of any age group. Far from targeting the poor, Social Security cash benefits are actually regressive, in the sense that those with the highest lifetime incomes receive the highest monthly payments. Another $47 billion was spent on the two most generous pension systems in America: civil-service and military retirement programs. Among the beneficiaries of these programs poverty is practically unheard of; most are not “retired” at all but working at another job and earning a second pension. The average annual income for a federal pensioner is now more than $35,000. Still another $26 billion went to agricultural subsidies. Though this is equivalent to about $18,000 per person working in agriculture, it doesn’t help many farm workers. Instead it goes primarily to the owners of the farms with the largest sales, and to banks to service farm debt. Finally, about $43 billion was spent on assorted other non-means-tested programs, such as veterans’ health care (going mostly to elderly people with higher-than-average incomes and without service-related illnesses). Unemployment compensation, amounting to less than $18 billion, almost gets lost in this sea of money.
Many of these programs, and especially Social Security, provide invaluable income support to millions of people who would be in poverty without them. This is true especially for members of what Stephen Crystal, in Americas Old Age Crisis, calls the “multiple jeopardy” groups—those who can be characterized in two or more of these ways: over seventy-five (a group expected to grow by more than 50 percent by the year 2000), widowed, single, divorced, in poor health, without a private pension, and nonwhite. For example, the mean income of the black elderly was only 54 percent of the mean income of the white elderly in 1980. But these people are helped mainly by dint of the enormous sums of money spent, not by virtue of any rational allocation scheme.
It is also argued that federal retirement benefits “belong” to the recipient—despite the consensus among experts that the benefits payback for Social Security and Medicare is five to ten times greater than the actuarial value of prior contributions; plainly put, even middleand upper-income groups get back vastly more than they put in (including interest and employers’ contributions). As for civil-service retirement, we are told that it is a genuine pension system, under which federal workers and federal agencies each contribute seven percent of payroll to a “trust fund” in behalf of every worker’s retirement or disability. Yet the pension level is so high (averaging 56 percent of pre-retirement pay), the retirement age so young (age fifty-five after thirty years of service), and the disability criteria so easy (one quarter of all civil-service pensioners are “disabled”) that every outside actuary has found, here too, that benefits far exceed contributions. Most say that recipients get somewhere between two and three extra dollars for every dollar they contribute. Unlike any private pension, moreover, civil-service pensions are 100 percent indexed to the Consumer Price Index—with the absurd result that federal pensioners often outearn their successors in office.
As for military retirement, here we confront the ultimate bonanza. The serviceman contributes nothing to a trust fund, but upon reaching a median age of forty-one (and completing at least twenty years of service), he is entitled to 50 to 75 percent of pre-retirement pay, indexed yearly, for life. Typically, military pensioners—including many of the most valuable members of our Armed Forces, who are induced to quit by the retirement bonanza—spend more years collecting benefits than they ever spend in the service. Only one quarter are over age sixty-five, all are eligible for Social Security, and most pursue second careers to achieve a “triple-dip” private pension.
The Administration and Congress have often boasted of “cutting back” on excessive benefit spending. Unfortunately, nearly all the painful and high-visibility cuts have been made in the 15 percent of all benefit programs that are means-tested. One result is that means-tested benefits have hardly grown at all as a share of GNP during the 1980s (in fact, excluding Medicaid, they have actually shrunk; hardly any poverty cash benefits are indexed). Another result is that such benefits target the poor even better now than they did in the 1970s, since most of the cuts have effectively excluded many near-poor beneficiaries, those whom we do not consider truly needy. Meanwhile, the tremendous non-means-tested programs—protected by powerful middle-class lobbies and automatic 100-percent-of-CPI indexing—have burgeoned.
Over the past generation federal benefits have grown roughly twice as fast as our economy. What is most ominous about the long-term trend in the cost of non-meanstested benefits, however, is that these benefits will necessarily continue to grow faster than our economy even if we do nothing explicit to increase benefit levels. Just leaving the budget on “automatic pilot” will lead to fiscal disaster. The forces guaranteeing this result are threefold: the aging of America, the hyperinflation in health care, and the uncontrollability of benefit indexing.
The aging of America: Well over half (about 56 percent) of all federal benefits now go to the 12 percent of our population who are age sixty-five and over. We now direct, on average, about $9,500 a year in federal benefits to each elderly American (largely consumption). In contrast, we direct less than $950 in federal benefits, including aid to education, to each American child (largely investment). In fact, total federal spending on net infrastructure investment and non-defense R&D, the benefits of which will last several generations, amounted to only $357 per child in 1986. That’s equivalent to the increase in federal benefits per elderly person that now occurs every six months.
But even if benefits per elderly person henceforth grow no faster than our economy, we can be certain that the total cost burden will. By about the year 2015 the age composition of the entire United States will be the same as that of Florida today. By 2040 there may be more Americans over age eighty than there are Americans today over age sixty-five. Over the next fifty years, depending on future fertility and longevity, our working-age population will grow by two to 18 percent, while our elderly population will grow by 139 to 165 percent.
The more “pessimistic” projection (to use the strange term applied by the Social Security Administration to the projection involving longer life-spans) implies that our labor force will grow by only six million people while our elderly population will grow by 46 million. Today each retired Social Security beneficiary is supported by the payroll taxes of 3.3 workers. By the year 2020 the ratio will have declined to at most 1:2.3. The official pessimistic picture shows the cost of all FICA-funded Social Security benefits rising to an obviously unacceptable 36 percent of every worker’s taxable pay by 2040, from 13 percent today.
Health-care hyperinflation: The novel cost-saving reforms introduced four years ago to Medicare and Medicaid (such as the new prospective pricing now used by Flospital Insurance) stirred widespread hope that we had turned the corner on the rapid growth of health-care spending. Today such hope has faded. Although total U.S. health-care spending as a share of GNP fell slightly in 1984 (from 10.5 percent to 10.3 percent), it rose anew, to an unprecedented 10.7 percent, in 1985, and further, to 10.9 percent, last year. We already know that the rate of inflation for medical care was 7.9 percent in 1986, a rate about seven times higher than the rise in the Consumer Price Index. Optimistic projections made by federal health officials just two years ago are already in shreds. As the Health Care Financing Administration admitted in its report last year, “Little relief appears to be in sight .... The decline in the share of GNP going to health in 1984 appears to be a one-time blip in the historic trend rather than the start of a new trend.” Health-care benefits as a share of the federal budget, meanwhile, did not experience even a one-year dip. They have risen every year of the 1980s and now amount to about $120 billion annually, or 25 percent of all federal benefit spending.
The underlying causes of America’s health-care cost explosion have been discussed at length elsewhere: the rapid climb in real technological and labor costs per treatment, the impressive increase in the number of treatable acute and chronic illnesses, and, of course, the stubborn persistence, in both the public and private sectors, of inefficient health-care regulations and perverse, cost-plus reimbursement systems that insulate both health-care professionals and patients from the cost of treatment. Amazingly—even with the federal reforms enacted in this decade—Medicare has shown nearly the same real rate of annual growth in the 1980s (8.2 percent from 1979 to 1986) as it did in the 1970s (8.7 percent from 1969 to 1979). As recently as 1975 Medicare’s total cost was only $14 billion. Last year it was $74 billion, and it may well hit $100 billion by 1990. By 1991 outlays for Hospital Insurance, which account for two thirds of Medicare benefits, may already start to exceed payroll-tax revenue. Thus, without further reform the Hospital Insurance trust fund will almost certainly go bankrupt by the end of the 1990s.
Why have the reforms thus far proved ineffective? A large part of the problem is that per capita health-care costs are rising much faster for the elderly than for the population as a whole. Longer life expectancy means disproportionate growth in the oldest age groups, and it is well documented that every measure of health-care utilization rises steeply from age sixty-five on. In 1982, for instance, the average reimbursed hospital cost for Medicare enrollees over age eighty-five was two thirds higher than that for enrollees aged sixty-five to seventy-five. The average per capita cost of long-term care is ten times higher for the “old” elderly than for the “young” elderly, and the high cost of long-term nursing care for the elderly, which is not covered by Medicare, is steadily encroaching on means-tested public benefits not primarily designed for the elderly. In 1984, for instance, though the elderly made up only 10 percent of Medicaid’s beneficiaries, they accounted for nearly one third of Medicaid’s total spending.
Experts at the Health Care Financing Administration now project that health-care spending in the United States will hit 15 percent of GNP by the year 2000. Do we really think we can become competitive in trade while allocating a still larger proportion of our scarce supply of capital and skilled labor to health-care consumption? According to Lee Iacocca, the Chrysler Corporation pays more money to Blue Cross/Blue Shield every year than it does to any other supplier. Sooner or later we must debate health-care spending in terms of affordability. We must ask why, for instance, we continue to devote so many resources to comforting us at the end of life (more than half of an American’s lifetime health-care costs are incurred after age sixtyfive), while we pay a Head Start teacher less than $10,000 annually to prepare us at the beginning of life. Other industrial countries are facing such questions with both common-sense humanity and a steady eye on the future. We alone are not.
Uncontrollable indexing: The history of the indexing of non-means-tested benefits is one of the sorriest stories in federal policy-making. Perhaps the most flagrant case in point was the egregious “double-indexing" of Social Security cash benefits enacted in 1972, which essentially pushed up the benefits for new retirees by two CPI indexes at once. This was a colossal error that caused the average retiree benefit to grow far faster than either prices or average wages during the mid-to-late 1970s. The error was apparent to nearly every policy expert as soon as the legislation was passed. But though Congress took only several weeks to debate and pass the 1972 Social Security amendments, it required several years to correct the mistake. In the late 1960s only six percent of all benefits were indexed; today 78 percent of all benefits are indexed to one price index or another, including nearly every non-meanstested cash benefit. The result, quite simply, has been to render outlays for benefits uncontrollable by either Congress or the President.
Most important, indexing makes it impossible for elected policy-makers to reorder their spending priorities by gradually allowing real benefit levels in some programs to fall behind inflation while committing new resources to new problems. This perversity is highlighted by the names that we give to these two types of spending (“discretionary" to outlays earmarked for national investment, and “entitlements" to outlays earmarked for personal consumption).
Back in the early 1970s, when most federal benefit programs were first indexed, none of these problems seemed to matter much. Back then, after all, real federal spending, real GNP, and real wage levels were all still growing rapidly. Today such problems obviously do matter. Facing the prospect of declining or (at best) stagnant real consumption per worker over the next ten or fifteen years as we do, it follows almost by definition that during many of these years we will see prices rising faster than after-tax wages. Each year this occurs, indexing will automatically cause benefit spending to grow faster than wages are growing. The very nature of indexing will then pose genuine questions of equity: to what extent should beneficiaries not in poverty be “held harmless" from downward jolts in the standard of living that affect all other Americans?
To say that the fundamental forces driving up federally financed consumption are aging, health-care inflation, and indexing is not, of course, to say that there is any painless way to avoid them. They cannot be avoided, precisely because all three forces are so closely connected to the shape of our population, as well as our technology, expectations, and political culture. We can, however, speculate on the consequences of trying to avoid them. Recently I asked James Capra, an expert on the federal budget (an unequaled forecaster of our current deficits), to make a fortyyear projection of the federal budget—given no change in defense or domestic policy and using the same long-term economic and demographic assumptions that are used by the Social Security Administration.
The results? Using the official pessimistic assumptions, total non-means-tested benefit spending—in the absence of any new benefit provisions—will rise by an amazing 9.6 percent of GNP by 2025, as the retiring Baby Boom generation claims its health-care and cash retirement benefits. By then the explosion in Medicaid-funded nursing care will add another 1.2 percent of GNP. All told, assuming that the totality of other federal costs grows no faster than our economy, the total projected federal outlays for fiscal year 2025 will amount to about 35.4 percent of GNP. Outlays for benefits will consume 22.3 percent of GNP—a sum nearly equal to the entire federal budget today—and outlays for Social Security and Medicare alone will consume more than 31 percent of workers’ taxable payroll. These incredible results are most certainly not predictions; instead they are projections of the future of our present policies. That these outcomes seem impossible is a virtual guarantee that they will be just that. What they mean is that today’s policies are unsustainable. They will be radically changed. The only question is how—whether in a political spasm or gradually, allowing those affected to plan ways of coping.
From Denial to Reconstruction
WE FACE A FUTURE OF ECONOMIC CHOICES THAT are far less pleasant than any set of choices we have confronted in living memory. What, concretely, will these choices entail? Looking into the future is always a dangerous task, but here is my attempt to sketch a sequence of future economic issues that will change our lives. My sketch follows the probable chronological order—near-term, medium-term, and long-term— in which reality will impose these issues on us.
The near term (1988 to 1992): Over the near term (a period that already exceeds the “long-term" time horizon of almost every legislator and executive policy-maker) America’s primary economic challenge will be to extricate itself from growing foreign indebtedness without touching off a global crisis. The single most important step toward a successful outcome will be for America to generate steady, large, and predictable increases in its net national savings rate over the next several years. This, in turn, cannot be accomplished without steps to eliminate the federal-deficit drain on private savings. Fiscal balance is thus the cornerstone of any plan to cut our trade deficit.
So long as the U.S. demand for foreign savings remains insatiable, any attempt to force-feed U.S. exports to foreigners in any one sector or to any one country will simply be vitiated by a stronger dollar, which will tend to worsen the U.S. trade balance in all other sectors or with all other countries. It’s like placing a few sandbags on top of an overflowing dam: you can change where the water will spill over, but you can’t change the fact that it will spill over somewhere. If there is little action on the federal budget over the next five years, therefore, the odds of a global crash landing will certainly grow.
As we have seen, a successful escape from our foreignsector imbalance (barring an improbable near-term leap in U.S. productivity growth) could be accompanied by a decline in real consumption per U.S. worker. Over the next five years, in other words, we must be prepared for a perceptible tall in real after-tax employee compensation combined with a similar decline, or at best a stagnation, in real government spending—both in benefit payments and in defense spending. On the positive side, we can look forward to a rapid expansion in U.S. manufacturing output and employment, a steady improvement in our trade balance, and a steady decline in the rate of foreign-capital inflows (slowing, though not stopping, the deterioration of the net U.S. investment position by 1992). But, in order to avoid the crash scenarios, there is plenty that we must also prepare for on the negative side: a further (though modest) decline in the exchange rate of the dollar, considerable inflationary import-price pressure, and a very tough assignment for the Federal Reserve Bank and its new chairman, Alan Greenspan—finding an interest rate high enough to control inflation and keep the dollar from collapsing, yet low enough to avoid a serious U.S. recession. Most likely, the Fed will have to strike a balance between bad news on both fronts: some accommodation to inflation (as import prices rise) and some accommodation to higher interest rates (as foreign lenders get finicky).
For most working Americans the coming decline in the growth of real household consumption will probably be felt not in any marked change in dollar salary raises but rather in the erosion of real dollar income caused by unavoidably swifter inflation. Wages in manufacturing, exportable business services, and energy will climb much more steeply than wages in other sectors—a trend reversal from the early and middle 1980s which many Americans will welcome. The indexing of federal benefits, meanwhile, will become a major political issue. Not only will steady reductions in budget deficits be difficult to sustain without a major reform of indexing, but 100 percent cost-of-living adjustments for middleand upper-class federal beneficiaries during years of declining real income for most American workers will raise reform as a stark question of equity. The cost-effectiveness of defense and foreign-aid spending will also come under increasing scrutiny. Since we know full well that it will take a heroic effort to find the resources for economic investment alone, it is totally incredible that we could fund both our domestic obligations and our current global military obligations. By the end of this decade, therefore, it is likely that the United States will raise strategic “burden-sharing” as a routine point of discussion in our economic summits with other industrialized powers.
The medium term (1992 to 2007): The fifteen years that follow our near-term period promise to be a crossroads in our nation’s future. As Americans enter this era, five years from now, they may still be uncertain whether the United States has successfully worked its way out of its foreignsector imbalance. Ironically, it will probably be a signal of impending disaster if real per-worker U.S. consumption is significantly higher in 1992 than it is today, and it would almost certainly be a symptom of worsening global imbalance. Other symptoms would include minimal reductions in our budget deficits and in our credit inflows, further cuts in our net domestic investment, high interest rates, and special ad hoc arrangements to keep our creditors happy—such as yen-denominated Treasury bonds or de facto foreign veto power over U.S. monetary policy. More likely, we will see a considerable dampening in real per-worker consumption, and we will be worrying about (or trying to recover from) a long recession characterized by stagnant global demand.
But twenty years from now, when young adults currently entering the work force are approaching the peak of their careers and when the oldest Baby Boomers are contemplating retirement, the foreign-imbalance problem will have been resolved, one way or the other. By then we may have entered one of the prolonged crash scenarios sketched earlier—the decline of the bumpy British variety or the indefinite depression of the 1930s variety. If, on the other hand, we have resolved the problem successfully, we can expect that our current-account deficit will have declined steadily during the early 1990s and will be turning into a modest surplus by the late 1990s. As that happens, the focus of our policy debates will likely shift from the problem of reducing our foreign borrowing to the challenge of raising our level of domestic investment. Over the near term most of our extra savings must be focused on raising net exports, which is our sole means of weaning ourselves away from foreign creditors. Only later will we be able to concentrate on the more rewarding task of reconstructing our future. Only after paying off our credit-card bills, so to speak, can we think of buying a new home.
The long term (2007 on): Should America not make investment its number-one policy priority in the medium term, it will surely have to pay the price in the long term. It will not be a price denominated solely in terms of labor productivity, real wages, and global political influence. The price will also include an utter lack of preparation for the most stunning demographic transformation—from workers to dependents — in American history. In the fifteen years between 2010 and 2025 the number of Americans who are of working age will decline by perhaps as many as 12 million (from 174 million to 162 million). Meanwhile, assuming that current longevity trends persist, the population of elderly will grow from 42 million to 65 million. If investment, retirement, and health care for the elderly seem unaffordable to our society today and for the next twenty years, when a “boom" generation is working and a “bust” generation is retiring, we can only imagine how unaffordable they will be thirty years from now, when the situation is reversed.
If in the medium term the Baby Boom has channeled a sufficient share of its income into education, training, tools, and infrastructure to permit a quantum leap in productivity by the next generation of workers, it may enjoy a prosperous and contented old age. But if the flow of invested endowments from each generation to the next has ceased—and if each generation instead insists on its “right" to consume all its own product and part of the next generation’s as well—then we can count on a meager and strife-torn future.
In any summary discussion of America’s prospects in the near, the medium, and the long term, there is one theme that must be emphasized above all others: the indissoluble bond between the economic behavior of one decade or generation and the economic well-being of the next decade or generation. Over the near term we must accept the punishment we are inheriting from the ill-fated gamble of Reaganomics. Similarly, over the medium term we must overcome the low-investment heritage we have received from thirty years of postwar preoccupation with “demand management.” Both tasks will require a determined effort to save. We will have to raise our net national savings rate, now somewhere between two and three percent of GNP, to between six and seven percent of GNP in the coming five years (a level still beneath our level in the 1970s) and to between 10 and 12 percent of GNP within twenty years (a level far beneath that of Japan’s, but just about on par with the average for today’s industrial countries). By the first decade of the twenty-first century, in other words, we will have to be rechanneling yearly into investment some $450 billion that we now spend on private and public consumption.
THIS BROAD PRESCRIPtion has implications not only for action but also for understanding. The question is not the easy and popular one of where to invest but the brute one, ignored by both political parties, of where to find the resources. Thus, in the coming election year we need to apply a critical yardstick to the policy proposals of the presidential candidates: Does this proposal face up to the longterm problems caused by our neglect of investment in favor of consumption?
Our problems are not, at bottom, economic. We are stymied by our lack of political consensus on economic policy—something unimaginable to our Japanese and German trading partners, for whom national consensus (born of national crisis) informs decisions on savings, investment, productivity-related wage increases, exports, and moneysupply growth.
With the proviso that we must put a very large question mark over the capacity of our political system to deal with the nation’s economic problems, I offer these brief policy suggestions.
First, we must tame the federal budget deficit. Real defense spending has been effectively frozen for the past couple of years, and we may be at a crossroads in foreign policy which will allow us to make substantial future savings in security expenditures. Greater sharing of the burden by our NATO allies is clearly on the horizon; it should proceed proactively, not reactively (that is, not simply in response to one financial crisis or another). I believe the time is also right for a historic arms treaty with General Secretary Mikhail Gorbachev, whose nation’s resources are far more severely constrained than ours and who desperately needs breathing space. The deal I envision would cover the more costly and, when one considers the size of the Soviet tank armies, more plausibly threatening conventional forces, as well as strategic weapons. A new international division of labor remains to be worked out with Japan. The agreement that I think is needed would have Japan provide, for example, far more World Bank support, aid not tied to its exports, and more incentives for major capital flows to Third World countries; further, it would forge a U.S.-Japan strategic-economic partnership in areas of the world critical to both countries—Latin America, say. In turn, the United States would continue to provide military assistance to Japan. Finally, the newly industrializing countries can no longer simply be beneficiaries of an open world economy. They must now join the club of the industrial countries and pay their dues, including aid to the poorer countries.
As for domestic spending, we must above all slow the growth in non-means-tested entitlements, starting with a reform of benefit indexing. Cutting the non-povertybenefit cost-of-living adjustment, or COLA, to 60 percent of the CPI (a “diet COLA”), for instance, would save about $150 billion in federal outlays annually by the year 2000. Gradually raising the retirement age and lowering initial benefits to the relatively well off (for example, those with histories of high wages) should be combined with the taxation of all benefits in excess of contributions, which could save well over $50 billion annually by the year 2000. Note that under this proposal the progressivity of the tax system would leave intact benefits that go to the poor. There are those who protest the “humiliation” of the means test; however, these reforms go far toward honoring the principle of need, doing so implicitly rather than explicitly.
We should also take a more serious look not simply at the unfunded liabilities of our federal retirement programs but at all the various elements of a grievously costly fringebenefit pension program. Civil-service and military retirement programs should be made part of a total compensation package comparable to those in the private sector. They should gradually be made self-supporting (that is, funded as our corporate pension plans are), through a combination of benefit reductions (with special emphasis on lower initial benefits and later retirement, as well, of course, as reductions in COLA indexing) and higher contribution rates.
Second, we must act decisively to put a lid on America’s excessive and wasteful consumption of health care, three quarters of which is either funded directly from public budgets or paid through publicly regulated insurance systems. This is not the place to enter the thicket of specific health-care reforms, but we must begin to experiment in earnest with various means by which to replace the horrendous, indeed perverse, inefficiencies of the current “costplus” system with the discipline of market forces (for example, greater cost-sharing, or the use of medical vouchers).
Third, to the extent that our federal deficits cannot be eliminated in the near term by simply deciding to spend less, we must increase federal revenue. The Reagan Administration has steadfastly opposed tax hikes by claiming that they would permanently sanction an increased “tax burden.” But surely the alternative is worse: to sanction permanently an increased “debt burden.” My choice among revenue options is some form of consumptionbased tax. A phased-in tax on gasoline of twenty-five cents a gallon, for instance, would generate about $25 billion a year by 1990—and also serve to depress world energy prices and moderate the now-rapid rise in our oil trade deficit, without destroying the global competitive position of critical export products such as petrochemicals. A broad-based five-percent value-added tax on all products would of course generate considerably more revenue— more than $100 billion in 1990, or enough to halve the federal deficit.
Fourth, over the longer term we should encourage higher private-sector savings rates by trading off increases in consumption-based taxes for reductions in investmentbased taxes. Our industrial competitors, after all, have already adopted the principle that people should be taxed more according to what they take out of the pot than according to what they put in. Most of those countries do not tax corporate income twice; most of them do not tax interest, dividends, and capital gains as ordinary income; and most of them do not allow sweeping personal exemptions for home-mortgage interest, for employer-paid health care, and for unearned public retirement benefits. At the same time, all our industrial competitors have much higher household and corporate savings rates than we do. It’s time our policy-makers put two and two together.
The least productive enterprise Americans can engage in—though it is virtually second nature—is trying to place the blame for what has happened to our economy in the 1980s on one political party or ideology. Blame is beside the point, for it is something we all share. To be sure, it is easy to find fault with the conservative fiscal leadership of the current Administration. (Indeed, I will confidently predict that in the years to come President Reagan will lament his May, 1985, decision not to support his own party’s leadership in its effort to freeze entitlement COLAs. President Richard Nixon, after all, has come to lament his decision to sign those COLAs into law.)
But, clearly, the liberals and the Democrats are equally to blame. Long before Reagan entered the White House, liberal opinion leaders persuaded the public to regard the budget and the tax code as engines of free national consumption. It was a Democratic Congress that argued in favor of deficit spending for so many years that no one could recall (with only one budget surplus since 1960) the rationale behind fiscal balance. And it was a Democratic President who pioneered the art of disingenuous forecasts (when President Johnson signed the Medicare Act, he said that an extra $500 million in federal spending would present “no problem”; today Medicare costs 150 times more than estimated). The very success that the Democrats enjoyed in promoting consumption, in fact, persuaded Reagan’s conservative backers to dish the Whigs and beat the opposition at their own game.
Reaganomics was founded on a bold new vision for America, yet today—another irony—we hear every politician who is warming up for the 1988 campaign, Republican and Democrat alike, complaining about the lack of vision in America. The reason we feel adrift is that we are waking up to the fact that blind and self-indulgent gusto is not vision at all but denial. True vision requires the forging of a far-sighted and realistic connection between our present and our future. It means recognizing in today’s choices the sacrifices all of us must make for posterity. America’s unfettered individualism has endowed our people with enormous energy and great aspirations. It has not, however, given us license to do anything we please so long as we do it with conviction.