[Senate Hearing 107-]
[From the U.S. Government Publishing Office]
S. Hrg. 107- 940
THE U.S. ECONOMIC OUTLOOK
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
ON
THE CURRENT ECONOMIC OUTLOOK IN THE SHORT- AND LONG-TERM; PREDICTIONS
CONCERNING THE ROBUSTNESS OF THE ECONOMIC RECOVERY; EFFECTS OF
INCREASED UNEMPLOYMENT; CONTINUED WEAKNESS IN THE GLOBAL ECONOMY; AND
RECOMMENDATIONS FOR MONETARY AND FISCAL POLICY
__________
MARCH 12, 2002
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
87-933 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpr.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
PAUL S. SARBANES, Maryland, Chairman
CHRISTOPHER J. DODD, Connecticut PHIL GRAMM, Texas
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado
EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming
ZELL MILLER, Georgia CHUCK HAGEL, Nebraska
THOMAS R. CARPER, Delaware RICK SANTORUM, Pennsylvania
DEBBIE STABENOW, Michigan JIM BUNNING, Kentucky
JON S. CORZINE, New Jersey MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii JOHN ENSIGN, Nevada
Steven B. Harris, Staff Director and Chief Counsel
Wayne A. Abernathy, Republican Staff Director
Aaron D. Klein, Economist
Martin J. Gruenberg, Senior Counsel
Thomas Loo, Republican Senior Economist
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
?
C O N T E N T S
----------
TUESDAY, MARCH 12, 2002
Page
Opening statement of Chairman Sarbanes........................... 1
Opening statements, comments, or prepared statements of:
Senator Carper............................................... 2
Senator Bennett.............................................. 20
Senator Reed................................................. 26
Senator Corzine.............................................. 30
WITNESSES
Robert M. Solow, Nobel Laureate in Economics, 1987; Professor of
Economics, Massachusetts Institute oF Technology............... 2
Prepared statement........................................... 39
Joseph E. Stiglitz, Nobel Laureate in Economics, 2001; Professor
of Economics and Finance, Columbia University.................. 5
Prepared statement........................................... 41
Alan B. Krueger, Bendheim Professorship in Economics and Public
Affairs; Professor of Economics, Princeton University.......... 10
Prepared statement........................................... 46
David R. Malpass, Chief Global Economist, Bear Stearns & Co.,
Inc............................................................ 14
Prepared statement........................................... 52
(iii)
THE U.S. ECONOMIC OUTLOOK
----------
TUESDAY, MARCH 12, 2002
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:15 a.m. in room SD-538 of the
Dirksen Senate Office Building, Senator Paul S. Sarbanes
(Chairman of the Committee) presiding.
OPENING STATEMENT OF SENATOR PAUL S. SARBANES
Chairman Sarbanes. The hearing will come to order.
I am pleased to welcome before the Committee this morning
this distinguished panel: Robert Solow, Professor Emeritus of
Economics at MIT and a Nobel Laureate in Economics; Joe
Stiglitz, Professor of Economics and Finance at Columbia, and
recipient last year of a Nobel Prize in Economics; Alan
Krueger, the Benheim Professor of Economic and Public Affairs
at Princeton; and David Malpass, Chief Global Economist for
Bear Stearns & Co., Inc.
Actually, all of these witnesses are well-known to the
Committee and to Washington. Professor Solow, of course, has
testified before Congress many times. Joe Stiglitz served as
Chairman of the Council of Economic Advisers under President
Clinton, Chief Economist at the World Bank. Alan Krueger served
as the Chief Economist at the Labor Department in the mid-
1990's. And David Malpass was at the Department of the Treasury
under Presidents Reagan and Bush. He was also the Staff
Director of the Joint Economic Committee of the Congress.
I want to thank all the witnesses for appearing today and
for the care and effort they took in preparing their written
remarks. Your full statements will be included in the record.
I was going to make a few comments about the current
economic situation, but I think I will save that until the
question period.
Before yielding to Senator Carper, though, I do want to
note with great sadness and with very deep respect the passing
yesterday of James Tobin, really one of our Nation's preeminent
economists, a man who I knew. I knew him well and he was a man
of extraordinary ability and great civility, and very
fundamental decency. He had very strong views about public
policy, but he put them forth in a way that led to really a
very rational and reasonable debate I think with others. And I
think he had a profound influence on the thinking in this
country.
I actually was Administrative Assistant to Walter Heller
when he was Chairman of the Council of Economic Advisers under
President Kennedy. Jim Tobin was a Member of that Council,
perhaps one of the most distinguished, certainly amongst the
most distinguished that we have had.
Senator Carper.
COMMENTS OF SENATOR THOMAS R. CARPER
Senator Carper. Thank you, Mr. Chairman. I had not heard of
Dr. Tobin's passing until this moment. He was one of those
people who could disagree with you without being disagreeable.
Chairman Sarbanes. That is for sure.
Senator Carper. Any number of times, I remember him sitting
in forums in the House and the Senate like this and providing
his guidance and counsel to those of us who were fortunate
enough to be in the room with him.
I just want to thank our witnesses today for joining us. I
had a chance to welcome you individually and would do so
collectively.
David Malpass, who used to work for Bill Roth, my
predecessor from Delaware, we are especially glad that you are
here today.
I will be slipping out in a little bit. We are taking up
the energy bill, as we wrestle with developing a comprehensive
energy policy for our country and we are anxious to make
progress on that today and certainly this week starting this
morning at 10:30 a.m.
You are here really right after we passed an economic
stimulus package last Thursday. Some have said that it is a day
late and a dollar long.
[Laughter.]
Time will tell if we have, indeed, spent money that we did
not have for a recession that is over. Maybe you will have some
thoughts on that today.
We are glad you are here and we look forward to your
testimony. Thanks very much.
Chairman Sarbanes. Thank you, Senator.
Dr. Solow, we would be happy to hear from you and then we
will go right across the panel.
STATEMENT OF ROBERT M. SOLOW
NOBEL LAUREATE IN ECONOMICS, 1987
PROFESSOR OF ECONOMICS
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
Dr. Solow. Thank you very much, Senator Sarbanes.
I want to add my word about Jim Tobin, whom I worked at the
Council when Senator Sarbanes was Walter Heller's Assistant. He
was a role model for all of us from my generation and others,
and a person of remarkable integrity. Someone once asked me
whether he would be a suitable person for a very delicate and
responsible job. My response was that whenever I find myself
having to make a hard decision as between right or wrong, my
universal method is to ask myself what Jim Tobin would do, and
do exactly the same. It is too bad that you cannot be hearing
from him today.
I am going to just comment briefly on a couple of important
points that were raised in the written statement that I turned
in, without trying to read it all.
This is, after all, a Senate Committee. We should be
thinking about fiscal policy.
There is a problem with fiscal policy. It takes too much
time to make decisions. It is hard to avoid getting those
decisions mixed up with the search for political advantage. The
decisions that are made in fiscal policy are often not easily
reversible if the facts change. And that creates a problem in
using fiscal policy devices in the business cycle context in
the short run, just as was mentioned by Senator Carper.
The current stimulus package is an excellent example. The
bill that finally passed last Thursday was an okay bill, though
it could have been better and it should certainly have been
much quicker. If it had been a term paper, I would have graded
it a ``B,'' but I would have penalized it for being handed in
late.
The contrast with monetary policy is, of course, very
strong. Monetary policy is much more flexible, at least in some
hands, at least in the United States in some hands. It is more
reversible when facts change, when our reading of the economic
situation changes. And so, monetary policy is generally
accepted to be a more suitable way to do tactical economic
policy, short-run-oriented tactical policy. I had hoped that we
were getting to the point where we could call more on fiscal
policy, but the recent episode is not an optimistic indication
on that point.
We used to get a lot of help from what are called automatic
stabilizers, from the built-in tendency for the Federal budget
to move sharply toward surplus in a strong boom and to move
just as sharply toward deficit in a sharp slump. The automatic
stabilizers were a very important part of fiscal policy 30
years ago, or 40 years ago. They are especially important
because no one has to act and no one has the opportunity to
obstruct. They happen automatically.
The strength of the automatic stabilizers in our economy
has been weakened over the years, not on purpose, not as a
deliberate decision, but because the mechanisms on which those
automatic stabilizers rest have changed. Cyclical transfer
payments are a smaller part of our economy now than they used
to be. State and local governments are a larger part of
government purchases of goods and services these days than they
used to be, and State and local governments are statutorily not
able to conduct their own fiscal policy in a counter-cyclical
way. The general reduction in tax rates and the diminishing
importance of corporate profit tax revenues in the total
budget--I am not now speaking about whether that is a good
thing or a bad thing--only that those are the mechanisms that
used to make the Federal budget very sensitive to economic
conditions and make it less sensitive now. The automatic
stabilizers are not likely to get stronger, so we are not going
to be able to rely on them in the way that we used to.
One possibility--this is a theoretical possibility that
appealed to Jim Tobin and to me 40 years ago--would be for
Congress to legislate once and for all a standard stimulus
package which would be effective and temporary and politically
neutral; the same package could work in reverse as a standard
sedative package. Congress could then turn this package, and
only this package, on and off by straight up-or-down votes when
the situation called for it.
You could arrange such a package at a number of levels--
weak, moderate, strong. It could be triggered by events or
proposed by the President and then subject to an up-or-down
vote by the Congress.
I realize that won't happen. I know that. But it is what
would be needed as a substitute for the automatic stabilizers
if we are to turn fiscal policy into a tool for countering the
business cycle.
The next point I want to make is a very different kind.
Think how uncertain we have been over the past few months about
whether there was or wasn't a recession. If there was one, when
did it begin? When will it end? Where are the next few months
going to go? The four of us sitting here could go back and
forth on that for days, weeks.
That cannot be the right intellectual background for
conducting macroeconomic policy, especially fiscal policy.
There is simply too much noise and too much nonsense in trying
on the basis of yesterday's data to predict next week's
economy. Here is an idea that will be very familiar to Senator
Sarbanes because Jim Tobin and Art Oakun and I and others were
talking about it when he was at the Council of Economic
Advisers.
It would make much more sense and be much more relevant to
look at the concept that we call potential output, potential
GDP. It is the number we come up with when we ask: What is the
economy's capacity to produce with reasonably full use of its
resources? Our focus should be to compare where we are now with
where potential GDP is. That would be a far better indicator of
which way fiscal policy should be pushing.
In the written statement that I have submitted to you, I
point out that real GDP now is right about within a percent or
so of where it was a year ago, the beginning of 2001, or 2000.
And by the standard estimates of what has been happening to
potential output on which the current Council of Economic
Advisers and the Congressional Budget Office and private
economists like myself tend to agree--by those standards, we
have built up slack, room for expansion in the economy of about
4 percent of GDP.
If the economy grows at 3 percent during the four quarters
of this year, which is what the standard forecast right now is,
we will not cut into that gap at all. We will still in the
first quarter of 2003 have room for expansion amounting to 4
percent of GDP.
By the way, many people, including on Mondays, Wednesdays,
and Fridays met, thought that 2 years ago, when the
unemployment rate was down to 4 percent, we were maybe a little
too close to the risk of inflation.
That is okay. One could make that adjustment in the kind of
thinking that I am suggesting, and still get a much clearer
picture of where the economy stands relative to where we should
want it to be, and to use that as an indicator of what we
should do.
That is not a foolproof way of making fiscal policy or
monetary policy or anything else. Nothing is. But the raw
materials are there both within the Government and outside the
Government. By going back to thinking in those terms, we would
avoid a lot of intellectual wheel spinning.
That is why I was content to give the stimulus package a B.
Even having been handed in late, the stimulus package was a
good idea; and this has nothing particular to do with there
never having been a recession or the recession already having
been over or being the only one-quarter recession in the
history of mankind or that thing, but because there is room for
the economy to expand.
I want to say just one last sentence: As I read Alan
Greenspan's testimony before this Committee last week, it was
not in contradiction to what I have just been saying. Mr.
Greenspan spent a lot of time waffling over what happened last
week and what will happen next week. Waffling is what that kind
of conversation calls for and he is a master of it. But the
general picture of where the economy is relative to a
reasonable standard we might set is certainly consistent with
what I have been saying. I think that what we have to hope for
from monetary policy is that we will get the same kind of
flexibility, nondoctrinaire flexibility, in dealing with the
next year or two that we did get to our great advantage over
the past 4 or 5 years from the Fed.
Thank you very much.
Chairman Sarbanes. Good. Thank you very much.
Dr. Stiglitz.
STATEMENT OF JOSEPH E. STIGLITZ
NOBEL LAUREATE IN ECONOMICS, 2001
PROFESSOR OF ECONOMICS AND FINANCE
COLUMBIA UNIVERSITY
Dr. Stiglitz. Thank you, Mr. Chairman.
I want to begin by seconding what Professor Solow just
said, that the critical issue is not the one that has been
focused upon, but whether the recession is over or not.
The real point is that the economy for the last year has
been performing substantially below its potential. I think that
there is absolutely no doubt about it. And if we go from minus
one-half a percent to plus one-half a percent, it is still
performing substantially below its potential. Even the most
optimistic people do not see any change in that prospect, that
it was very likely to perform below potential.
The numbers that I talked about in my written statement are
substantially more conservative than those of Professor Solow.
I talked about a 3 percent GDP shortfall. But one should try to
remember what that entails. In a $10 trillion economy, a
shortfall of 3 percent is $300 billion per year. If it goes on
for 2 years, we have lost $600 billion. That is an enormous
wastage of resources.
The consequence also is that there is unemployment. Alan
will talk a little bit more about the unemployment problem. But
even as the economy in this recession--if it is true--ends,
long-term unemployment has remained high. And the suffering
that that causes is significant.
The step that was made to finally--and again, too late--
provide for extended benefits last week was an important step
in the right direction. But it only extends for 1 year and
there is little prospect that the long-term unemployment
problem will be resolved in the course of a year.
I wanted to move on and talk a little bit about the nature
of this current economic downturn and the reason why I am not
optimistic that there will be a robust recovery.
In my written testimony, I talk about the number of
negative factors. I go through each of the major categories of
expenditure--consumption, capital expenditure, exports--and
explain why I think that the prospects of a robust recovery are
limited.
I note that the one positive from a macroeconomic point of
view is the increased expenditures in military. That does help
sustain economic recovery. But I emphasize there that unlike
investments in education or roads, they do not contribute to
long-term economic growth. They are a utilization of resources
that does not promote the long-term economic strength of our
economy. And one needs to take that into account when one looks
at the overall long-run picture. A lot of what I am going to be
saying is focusing on the medium- and long-term.
I want to move on in my discussion to address the sources
of our current problem.
I believe that if we are to formulate policies aimed at
enhancing the strength of the economy in the middle- to long-
run, we must understand better the sources of our current
downturn, of the massive under-performance of the U.S. economy.
While every boom comes to an end, there are lessons to
each. Earlier booms and the busts that follow taught us the
dangers of inflation and the effects have been too hard on the
brakes to stop it. The recession of 1991 can ultimately be
traced back to the weaknesses in the financial sector. Those in
turn impart to the excessive deregulation of the 1980's. I am
not sure that we have learned the lessons of excessive
exuberance of the late 1990's.
In some ways, it is a familiar pattern. Deregulation in a
sector--here telecommunications--leading to excessive
investment in that sector, in this case, the problems
exacerbated by breathtaking technological developments and--I
want to emphasize this--deregulation in the financial sector.
The Glass-Steagall Act was concerned with the problems
raised by the conflicts of interest. It was foolhardy to think
that such behavior would not reappear with its repeal.
At the time I served on the Council of Economic Advisers,
we raised strong concerns about conflicts of interest and
problems in accounting standards and practices, particularly as
they related to derivatives and options. Our concerns have
proved to be on the mark. There were, of course, others who
raised similar concerns. Arthur Levitt was right in calling
attention to these conflicts of interest in accounting firms
when they simultaneously provide consulting services.
The FASB called for a changing of accounting practices to
more accurately reflect the costs of options given to
executives.
I have devoted much of my academic life to the economics of
information, and to the consequences of imperfections of
information. The proposed revisions would have improved the
quality of information. To be sure, some firms' economic
prospects might have looked worse as a result, and its stock
market price might have fallen as a result--as well it should.
It was inevitable that a day of reckoning would come.
Providing misleading information only delayed the day of
reckoning. But worse, it led to a massive misallocation of
resources, as overinflated stock prices led to the excessive
investment which is at the root of the economic downturn.
Some contend that it is difficult to obtain an accurate
measure of the value of options. But this much is clear--zero,
the implicit value assigned under current arrangements, is
clearly wrong, and leaving it to footnotes to be sorted out by
investors is not an adequate response, as the Enron case has
brought home clearly.
If we are to have a stock market in which investors are to
have confidence, if we are to have stock markets which avoid
the kind of massive misallocation of resources that result when
information provided does not accurately report the true
condition of firms, we must have accounting and regulatory
frameworks that address these issues.
I am convinced that leaving it to the market will not work.
I served on an SEC commission on valuation on which Ken Lay
also served. Many on that commission believed that leaving it
to the market was the view of many of those, and I think we see
perhaps why and certainly the consequences.
As derivatives and other techniques of financial
engineering become more common, these problems too will become
much more pervasive. While headlines and journalistic accounts
describe some of the inequities, those who have seen their
pensions disappear as corporate executives have stashed away
millions for themselves, what is also at stake is the long-run
well-being of our economy. The problems of Enron and Global
Crossing are part and parcel of the current downturn.
So, I want to emphasize that, while typically,
macroeconomics
focuses on macroeconomics, there are important microeconomic
foundations to the problems and, as is often the case, this is
the case today.
In the limited amount of time, I want to spend a few
minutes talking about a couple of particular issues. The first
is the tax cut.
When we were talking about fiscal policy in the early
1990's, 1993, 1994, the economy was facing an economic
downturn. We focused very much on the question of what was
called a low-cost stimulus. How to stimulate the economy using
fiscal measures and at the same time having a minimal budgetary
impact.
My view is that the tax cut that was passed by Congress in
the spring was extremely badly designed. It provided very
little stimulus to the economy, at the cost of a substantial
adverse effect on the overall fiscal position of the United
States. The result is that, while short-term interest rates
have come down significantly, long-term interest rates have
come down very little. And many people believe it is the long-
term interest rates which are more relevant for investment.
One of the reasons that many people do not see a strong,
robust recovery is precisely because there has not been that
decline in long-term interest rates. That means, looking
forward, that there should be a certain degree of pessimism.
As I point out in my written testimony, there are tax
reforms that, for instance, would have done far more to promote
investment in the short-run with far lower budgetary costs,
like the net investment tax credit, and better income-averaging
provisions.
Both you and Professor Solow talked about the legacy of Jim
Tobin. One of his legacies was the investment tax credit. And
that was one of the sources of economic growth that began in
the 1960's. We now know how to even improve upon that through a
net investment tax credit. That was not the stance that was
taken. It was really much more corporate giveaways rather than
trying to design a tax reform that would have been good for the
overall performance of the economy.
I strongly side with those who believe that when one makes
a mistake, one should recognize it. It is not just the size of
the tax cut that was a mistake, but its design. Given the
peculiar structure of the tax bill, with provisions that expire
in 10 years, it is inevitable that the issues will have to be
revisited. It is better that that be done sooner than later.
As you all know, I have spent a lot of time in the last 4
years involved in foreign economic policy and I want to spend a
few moments talking about that because it is related to our
current macroeconomic situation.
One of the sources of strength of the U.S. economy during
the 1990's was increased export to emerging markets. This was
partly a result of trade opening, partly a result of the robust
economy in those regions.
Mismanagement of international economic policy by the IMF
has contributed significantly to a worsening of prospects, and
I think that will have adverse effects not only on the
political position of the United States and how it is perceived
around the world, but also on our economic prospects.
It is also the case, let me emphasize, that the problems
that we face in our exports are caused largely by the strength
of the dollar. And the strength of the dollar, in turn, is
caused by our macroeconomic stance.
In the early 1980's, a large tax cut was enacted, and that
led to a massive worsening of the fiscal situation. The trade
deficit is simply the difference between what we invest and
what we save. National savings--including public savings--has
gone down from what it otherwise would have been. The trade
deficit would have been even worse, were it not that investment
too has gone down. But when our economy recovers, investment
will increase, and with it, there is a good chance that the
trade deficit will worsen.
We should be clear--it is not protectionist policies abroad
or unfair trade practices or just the failed macroeconomic
policies that have caused our current trade deficit problems.
Whether they get reflected in the steel industry, the
automobile industry or elsewhere, it is our overall
macroeconomic framework, including the tax cut that was passed
last May. And I suspect that the full adverse effects of the
tax cut on our international economic position are yet to be
fully felt.
You mentioned that you were going to have a vote on energy
policy, and let me just make a few brief remarks. I think that
this is important for the long-run economic prospects of the
economy.
There is a widespread agreement among economists that GDP
does not provide a good measure of economic well-being. At the
very least, we should take account of the degradation of the
environment and natural resources. Bad information systems can
lead to bad decisionmaking, as we have recently seen in the
corporate world, and I referred to that earlier.
Nowhere is this more true than in energy policy. Extraction
of oil and natural gases may increase our measured GDP, but it
does not increase our economic well-being commensurately.
We should take account of the depletion of our resource
base and the degradation of our environment as a result of
carbon emissions. An energy policy which focuses on drain
America first is not even good for our long-run national
security, for it leaves us potentially more vulnerable in the
future. Long-run economic growth-- correctly measured-- and
long-run security both suggest that we should focus more on
conservation. And basic principles of economics suggest that
what is required is incentives. Why should we think that moral
suasion would be more effective in this arena than it is in any
other area of economic activity?
I want to conclude with a few remarks about one of our
long-term problems-- our Social Security system.
That program has been an enormous success. We have brought
the elderly out of poverty and we have provided a new measure
of economic security to the aged. Transaction costs are low.
Improvements in the design of the program over the years have
reduced some of the unintended inequities, reduced any adverse
effects it might have on labor supply, and increased overall
efficiency. There is still a way to go to put it on sound
financial grounds.
Economics is traditionally described as the science of
choice. The legacy of the Clinton years, a huge fiscal surplus,
provided us with an opportunity to make some choices. We could
have used some of these funds to put the Social Security system
on sound financial ground. We could have fully funded that
system. We could have decided on how to proceed in the future.
We have largely squandered that opportunity.
Proposals for partial privatization typically leave the
fiscal situation of our Social Security system worse off. Any
reform proposal which does not begin by addressing the question
of how current unfunded liabilities are to be financed is
irresponsible, and should be a nonstarter.
Elsewhere, I described at greater length common myths
concerning Social Security. One that has recently received some
attention is the low return on Social Security accounts. We
should be clear--Social Security funds are invested well, but
conservatively. To the extent that capital markets work
efficiently, then any higher returns that might be received
would simply reflect higher risk.
It is imprudent for those approaching retirement to invest
all, or even most, of their assets in highly risky investments.
If there were a decision to undertake greater risk, the public
Social Security system could do so, again, at low-transactions
costs.
Just to put things into perspective, the transaction costs
in the privatized part of the British system have been
estimated to reduce benefits by 40 percent from what they
otherwise would have been. This is how privatized systems work.
Part of the reason that in partial pay-as-you-go Social
Security systems, it appears that returns are low is that some
of the returns are used to bear the costs of the unfunded
liabilities. The problem of funding those unfunded liabilities
does not go away with partial or complete privatization. It
will have to be borne elsewhere.
To assess the merits of any reform proposal, therefore, one
must know how, and who, will bear those costs. To do otherwise
is dishonest. It may put in jeopardy the long-run prospects of
our economy, for a day of reckoning will undoubtedly come.
Let me conclude by saying that I continue to believe that
the basic fundamentals of the U.S. economy remain strong. But I
have seen the fortunes of countries change quickly as a result
of economic mismanagement. The decisions, the choices, we take
today will affect not only economic performance during the next
year, but also our long-run prospects.
I believe that the tax cut that was enacted last spring was
based on a serious miscalculation of our economic situation. It
is a decision which, however, is reversible. If we do not
revisit the issue, in the light of the new information which
has come to light and the new situation which has evolved, the
damage which could be done may itself be irreversible--or at
least it will take a long time to undo it. Much is at stake.
Thank you.
Chairman Sarbanes. Thank you very much.
Dr. Krueger.
STATEMENT OF ALAN B. KRUEGER
BENDHEIM PROFESSORSHIP IN
ECONOMICS AND PUBLIC AFFAIRS
PROFESSOR OF ECONOMICS, PRINCETON UNIVERSITY
Dr. Krueger. Thank you, Senator Sarbanes. I appreciate the
opportunity to talk about the economy this morning.
Let me begin by seconding Joe Stiglitz and thirding Bob
Solow by saying it is not very productive to debate whether
there was a recession. It is quite clear looking at the labor
market that the labor market turned down in 2001 and March
marked the turning point in the labor market.
The unemployment rate reached a 30 year low of 3.9 percent
in April 2000. It hugged pretty close to 4 percent until the
end of 2000. March 2001, the unemployment rate stood at 4.3
percent. Then it increased to 4.9 percent by August 2001,
before the September 11 attacks, and reached a recent high of
5.8 percent 2 months ago. The last 2 months, the unemployment
rate has ticked down a bit to 5\1/2\ percent.
I think it is a bit too premature to celebrate the recovery
in the labor market. In terms of employment, 1.4 million jobs
were lost in the 11 months since March 2001, and 1.8 million
jobs were lost in the private sector. If we compare that to the
recession in the early 1990's, 11 months after the start of the
recession in 1990, 1\1/2\ million jobs were lost in both the
private sector and in total.
This downturn has not been less mild as far as job losses
is concerned. In fact, if we compare the total job loss in the
recession in the early 1990's, even in the period after the
recession ended when jobs continued to drift down, total job
loss in the private sector was 1.8 million jobs then and 1.8
million jobs now.
So in terms of job loss, as I said, this recession so far
has been about as severe as the one in the early 1990's.
This recession seems to me to have two distinct phases in
the labor market. The first phase was quite a surprise.
Ordinarily, in a downturn, less skilled workers and minorities
are the hardest hit.
In the first 4 months of this recession, from March to July
of 2001, the unemployment rate actually increased more for
highly skilled workers than for less skilled workers. So for
college graduates, the unemployment rate increased from 1.9 to
2.2 percent. For high school drop-outs, the unemployment rate
held steady at 6.8 percent.
I have to say that that was quite a surprise to those of us
who watched the labor market. By past history, we expected the
labor market to turn down more quickly for the less skilled and
also because of welfare reform, I certainly expected that those
last hired would have been the first fired and thought we would
see more difficulty among the less skilled at the beginning of
the recession.
Well, since the summer, the typical pattern has emerged.
From July to February, the unemployment rate has risen much
more for the less skilled than for the highly skilled. And
these numbers are reported more fully in my written statement.
But the unemployment rate for high school drop-outs increased
from 6.8 percent in July, up to 8.3 percent last month.
I should also add, while the overall unemployment rate went
down last month, an amount that was not statistically
significant, the unemployment rate did increase for high school
drop-outs last month. So the situation does not appear to have
turned around for the less skilled.
Meanwhile, the unemployment rate in the last 7 months
increased for highly skilled workers, but not by as much as it
increased for the less skilled.
So if you look over the whole period of the downturn, the
unemployment situation has worsened more for less educated
workers than for more highly educated workers, as is the
typical pattern. And we get a similar picture if we look by
race. It looks like there were two phases.
In the first phase, the unemployment rate increased for
white workers and actually fell for black workers, which was
again quite a surprise. And then in the second phase, the
unemployment rate has been rising more for black workers than
for white workers.
Now the usual pattern is for unemployment to linger at a
high level after a recovery begins. If we go back to the
experience in the early 1990's, the unemployment rate stayed
high and continued to rise for 15 months after the recession
officially ended.
There are several explanations for why jobs are slow to
grow after economic growth resumes. One is that employers are
simply uncertain how long the conditions will last. I think all
of us here are uncertain what type of a recovery we are about
to have. That naturally leads employers to be cautious in terms
of hiring and rehiring workers.
Another explanation is called labor hoarding. During a
recession, firms will sometimes hold onto workers, particularly
those who they invested a lot in their training, because it
would be costly to rehire workers with such skills after the
recession ends.
Another factor is called upskilling of positions. Employers
often will raise the standards for jobs in a recession and will
hire highly skilled workers to do the kind of work that
previously was done by less skilled workers, and not until
demand increases rather smartly will they adjust the standards
and begin to hire the less skilled workers again.
Then, finally, I would add that recessions give firms an
opportunity to reorganize, to rethink the way they do things
and change the way they do things. And that often leads them to
prefer to hire more highly skilled workers than less skilled
workers because more highly skilled workers are more flexible.
This also dovetails with the purchase of new equipment,
implementing new equipment, which tends to go hand-in-hand with
more highly skilled workers.
So, looking forward, my guess is that the soft labor market
situation will linger for a while. That has been the past
practice. Also, if you look at the numbers and say, well,
suppose the recession ended in the fourth quarter of 2001,
which is a reasonable guess at this point. Well, then, it has
been the case that unemployment has continued to climb for the
less skilled workers and climbed overall since the recession
ended because it is higher now than it was in the fourth
quarter of 2001. But I have to confess a fair amount of
uncertainty in this prediction that unemployment will remain
stubbornly high, even if we are in the midst of a recovery.
The first reason for my uncertainty is that the beginning
of this recession was unusual. I am somewhat heartened in the
sense that I see a familiar pattern in what has happened since
the summer. But one does have to admit that different forces do
seem to be at work in this recession, as Joe pointed out
earlier.
Another difference is that productivity growth has remained
strong in this recession, stronger than is ordinarily the case
in a recession. And that might imply that there has been less
labor-
hoarding, that firms might be leaner coming out of this
recession than is typically the case and they might be quicker
to expand employment.
And that leads me to the third factor which might lead the
labor market to recover sooner than is usually the case.
It seems that we have gone through some fundamental changes
in the labor market, that the way in which employees find jobs
has changed over the last 10 or 15 years. Unfortunately, the
data are not terrific, but it looks like the number of
vacancies at a given unemployment rate is lower than it used to
be, and there are several hypotheses for why that is the case.
One explanation is that temporary help firms make the labor
market more efficient, speedier in terms of placing workers,
make it easier for firms to adjust to hire workers, and also
make it easier for them to reduce their workforce. There is
also more outsourcing. And I suspect that the web has changed
things. A remarkably high number of people search for work by
looking at Internet job boards and using techniques that did
not exist even 10 years ago.
In spite of these factors, my best guess would be that the
labor market will remain soft, even if we are in the midst of a
recovery.
What I think is probably most important to bear in mind for
policy, at least in the short run, is that, to avoid a jobless
recovery, we should look at what kinds of options we have to
increase employment for less skilled workers.
The unemployment rate is much higher for less skilled
workers. It is been growing for less skilled workers relative
to more highly skilled workers. And if we are to reduce
unemployment further, I think it will come mainly from reducing
unemployment for less skilled workers.
Now, Bob Solow mentioned that fiscal policy in this
instance has been slow to respond. I think I certainly agree
with that. I remain somewhat optimistic that if the recession
was more severe, fiscal policy might have been a bit quicker.
But fiscal policy does come with the types of problems that Bob
mentioned.
And that leads me also to discuss automatic stabilizers. I
commend the Congress for extending unemployment benefits,
although I think Bob Solow's is a softer grader than I am. I do
not know if I would have given a ``B.'' I think more could have
been done in this situation.
One thing would have been to expand benefits for workers
who seek part-time jobs. Part-time employees pay into
unemployment insurance. Yet, in most States, they do not
qualify for benefits.
I think for stabilizing the economy, another more important
point is that the automatic stabilizers built in for extended
benefits to kick in are no longer realistic.
The insured unemployment rate in a State must exceed 5
percent and then some other conditions have to be met for
extended benefits to turn on. The trigger used to be 4 percent
in the 1980's. It increased to 5 percent. Since then, the
insured unemployment rate relative to the overall unemployment
rate has drifted down.
In other words, the unemployment insurance extended
benefits and the automatic triggers rely on the fraction of
people who are receiving benefits, receiving unemployment
benefits relative to the workforce rising, but the take-up rate
for unemployment insurance has declined and because of that, it
makes it much harder to reach the automatic triggers. Moreover,
the national rate of unemployment appears to have declined,
which also means that the triggers are beyond reach, even with
the fairly substantial increase in unemployment.
I think one fairly straightforward thing to do would be to
lower the triggers for State benefits to turn on. That way, it
wouldn't be necessary for Congress to deliberate in a downturn
whether it is necessary to extend benefits. And I think that if
extended benefits were available more quickly, it would shorten
the length of downturns and could also save money because it
wouldn't be necessary to extend benefits nationwide, but they
could be targeted more to the States which are suffering the
most.
Some other changes in unemployment insurance which I think
would also be important would be to improve the experience
rating in the system. Employers are supposed to pay a higher
tax rate if they have had a worse record laying off workers. In
a number of States, experience rating has lapsed. There are
very few rates. Some States, only two rates.
In essence, what we are doing is subsidizing employers who
lay off workers. We are subsidizing them by providing benefits
to their workers when they lay them off and we are not charging
the firms for those costs.
Then I would also add that the taxable base for
unemployment insurance in many States is quite low. The taxable
base in the majority of States is between $7,000 and $10,000,
which means that for higher-income people, they do not pay any
unemployment insurance tax after their first $10,000. This
leads to very regressive financing. And if we were to raise the
tax caps, we would be able to lower the rates, which I think
would have a favorable impact on employment demand.
Let me conclude by saying that I think this is a time to
think about how we can make Government policy respond more
quickly in the event of a downturn. One of the most important
automatic stabilizers we have now is the tax system, not by
design, but just the way it works.
Progressive taxes work as an automatic stabilizer. If
income falls, people fall into lower tax brackets. So, I think
it is important to bear in mind that this is one aspect of
progressive taxation.
I think another policy to consider at this point would be
job training, how that connects with unemployment insurance.
Funding sufficient job-training programs, especially for youth,
which were cut during the Clinton Administration and the Bush
Administration has proposed cutting even deeper.
Last, I would just add that I think it is important that we
think about these policies in the context of a budget that is
sustainable and a budget that is forward-looking and helps us
to prepare for the retirement of the baby boom generation.
Chairman Sarbanes. Thank you very much.
We will now turn to David Malpass, the concluding panelist.
STATEMENT OF DAVID R. MALPASS
CHIEF GLOBAL ECONOMIST
BEAR STEARNS & CO., INC.
Mr. Malpass. Mr. Chairman, I want to thank the Committee
for the opportunity to make a statement today. My written
statement covers the economic outlook and gives some thought on
U.S. monetary and fiscal policy. It also includes a final
section dealing with some foreign economic policy issues.
I am going to use some of the graphs from the written
statement, if you have one to look at while I go through.
I am the Chief Global Economist at Bear Stearns. So part of
my comments for the Committee today also relate directly to the
financial markets.
One of the global economic features of the 1990's was the
sharp increase in the U.S. share of world GDP. Part of this is
a tribute to our economic system, but another part reflects the
relatively poor economic performance in Japan and many
developing countries. As we count our many blessings and work
to make our own economy better for all, I think it is in our
interest to also spend considerable time and attention working
on an appropriate U.S. international economic policy.
The first graph in my statement shows the nominal world
growth rate in the 1990's. And what we can see is that in the
first part of the 1990's, world nominal dollar growth was
strong. Then in the latter half of the 1990's, it tailed off.
Part of this is the strong dollar, but part of it also is the
weakness of economies, particularly abroad.
As we think about the economic outlook, I expect a broad-
based U.S. recovery in 2002, with support from consumption,
inventories, Government purchases, and second-half strength in
business investment. The U.S. economy's natural tendency is to
grow. The latest improvement in the outlook over the last
couple of weeks is justified, in my view, by the solid U.S.
strengths--strong productivity growth and relatively full
employment.
And I will go into that in a moment.
In recent months, Americans have shown their optimism and
their patience when confronted with adversity, traits that I
think auger well for the recovery.
After some recessions, growth accelerates to high levels
early in the recovery due to pent-up demand. I do not expect
that pattern in this recovery. The second graph in the
statement shows the consumption rate in this period versus the
average recession. And what we see is that you can barely see
that there was a recession if you just look at the consumption
growth this time around. It did not dip the way it normally
does in a recession.
In many ways, the economy is reacting as if it is enjoying
relatively full employment. For perspective, we have today a
5.5 percent unemployment rate. At the end of the 1991
recession, in March, the unemployment rate was 6.8 percent. We
are well below that. So in many ways, the economy and the
consumption growth are responding to an unemployment rate that
by longer-term historical standards, is relatively full
employment.
Of course, I would like to see the unemployment rate
substantially lower. Given the strong productivity growth, it
is clear in my mind that the U.S. economy can again be able to
enjoy a sub-5 percent unemployment rate without it being
inflationary.
I am going to skip the housing section here and turn to
corporate profits.
Even though the recession seems to be over, there are still
intense pressures in the economy. I think they reflect the
aftermath of a deflation caused by dollar strength in the late
1990's. We should in this environment see a piece-by-piece
recovery unfolding in the economy, meaning that some
industries, companies, and employee groups have absorbed most
of the shock, while others are still in its grip.
In my view, the intensity of the corporate adjustment is
pushing the economy quickly through the deflation process, that
brings it closer to completion. This ability to digest mistakes
and move forward is one of the hallmarks of the American system
of business and labor flexibility and is a key factor in our
strong, long-term growth rate.
The graph labelled Behavior of Profits in Recession shows
that in an average profits recession, corporate earnings
decline. In this profits recession, they have declined much
more deeply than in an average profit recession.
So this brings me to some cautions, not in the statement.
As we look at why those corporate earnings have gone down
as much as they have this time around, one of the reasons is
that nominal growth rate is weak. Economists typically deal in
real growth rates and that is appropriate for many times. But
as we move into a very low inflation environment--in fact,
recall that the GDP deflator in the fourth quarter was minus
three-tenths of a percent of GDP. And nominal growth rate was
lower than the real growth rate. So as we look at the nominal
growth rate in this recession, it has been deeper, the slow-
down has been deeper than in many previous recessions.
Another caution for us right now is that part of the
strength in real GDP is related to the weather and also to the
increased security costs that we have had after September 11,
and the Government spending that went along with them.
So these will all tend to be short-term or not long-term
growth-creating factors for the economy. Those are some
cautions looking forward.
I want to now turn to monetary policy, I offered a few
thoughts in my prepared statement.
As the U.S. recovery broadens, U.S. monetary policy will be
faced with the question: Is growth itself inflationary? And if
not, does it require monetary policy response?
The graph shows that over the 1990's, the range of the
short-term interest rates of the U.S. has been relatively wide
as the Fed tries to respond to these growth swings.
My view is that inflation and deflation are more related to
changes in the value of money--let's call it the strength of
the dollar--than to economic growth. When a currency loses
value, it puts upward pressure on prices. Likewise, when a
currency rises in value, it puts downward pressure on prices.
Since the dollar is very strong right now, as judged by several
factors, and the graph shows the trade-weighted value of the
dollar reaching a very high level in most recent years, I think
there is more likely to be downward pressure on prices than
upward pressure.
So even with a recovery, it looks as if CPI inflation will
fall substantially in coming months and be low, relatively low,
for the foreseeable future. This makes an argument against a
rapid increase in interest rates and bond yields. As a policy
matter, I would like to see a more explicit recognition of the
connection between the value of the currency and the inflation
or deflation rate that is expected. I think it is important for
us to achieve stability in the value of the dollar as a step
toward price stability.
In addition, I wanted to offer some thoughts on fiscal
policy. It is obviously a very complicated subject, both from
an economic and a political perspective. These are, therefore,
very general thoughts.
It looks like the budget may now actually be in surplus or
close to it in fiscal 1902, and also in fiscal 1903. This is
the result of several positive factors. They include--a
shallower-than-expected recession, the remarkable change in the
interest rate policy in 2001, strong U.S. productivity growth,
and also Congress unusually well-timed tax cut in 2001.
The Federal budget reflects tremendous growth in spending
and even faster growth in Federal receipts. The graph in the
text shows nominal spending and nominal revenues and you can
see us trading back and forth between surplus and deficit.
Note that this graph is using CBO's February 1902
forecasts, the ones that they made last month, and I imagine if
they reestimated the budget today, there would be a much
smaller deficit showing, if any, for the fiscal year 1902
budget.
The budget outlook is very sensitive to growth assumptions.
No one is very good at forecasting growth rates in either the
near-term or long-term. I am skeptical of the process of trying
to calculate potential GDP or using it as a rule or a guidepost
for monetary policy because of this difficulty in actually
projecting short- or long-term growth rates.
The bar graph in my statement shows the size of the miss by
both CBO and OMB in the 1990's versus the actual growth rate.
Year after year they systematically, under-estimated both the
potential and the actual growth rates for the U.S. economy.
I should note that in the 1980's it would show the flip
side. There was a systematic over-estimate of the growth rate
by both agencies during that period of time. I think it makes
it difficult to use this kind of projection as a guidepost for
monetary policy.
If economic growth is as solid as I expect, then the
glidepath for the pay-down of the national debt will be rapid
and would not be, in my view, good economic policy. In effect,
our current policy is to levy a stiff level of taxation on
workers and the profitable portion of the private sector in
order to pay off relatively low-cost Federal debt. The effect
is to improve the Federal Government's balance sheet while
putting pressure on the public's balance sheet.
Given the economic recovery, then, Congress will probably
revisit the 1990's debate about what to do with the fiscal
surplus. In my view, tax cuts would help maximize the growth
rate and gains in median incomes. In addition, I think a fiscal
surplus, if it emerges, should also provide an opportunity for
an improvement in the
Social Security system.
Finally, I wanted to offer some thoughts on international
economic policy.
The U.S. economic recovery is good news for foreign
economies. It will probably spark a recovery in Europe and may
even help Japan break out of its deflation spiral. Some
developing countries will be able to participate in the global
expansion, helping them raise their living standards.
However, I am worried about the polarization of the world
economy, meaning the wide gap between the U.S. growth rate and
growth rates abroad. With each new burst of U.S. growth in the
1990's, it became increasingly apparent that the United States
was producing and consuming an increasingly large share of
world output. It reached roughly 35 percent and it is climbing.
In my view, it is important that developing countries grow
faster and begin to narrow the gap in global living standards,
but very few are.
Over the years, I have advocated a rethinking of our
international economic policy and the international financial
institutions. I favor a vision of economic development based on
stable currencies, lower tax rates, trade liberalization, and a
firm belief that people at the bottom of the economic ladder
should be able to move up. I do not think these principles are
applied frequently enough in our international economic policy.
My worry is that world growth may remain substantially below
its potential, with the shortfall coming disproportionately
from the poor.
In conclusion, Mr. Chairman, the likely U.S. economic
recovery is very welcome, particularly given the war on
terrorism and the turmoil in international affairs. The
recovery provides a real opportunity for thoughtful economic
debate. My statement noted the importance of monetary policy
decisions relating to growth and inflation; fiscal policy
decisions in the event of renewed surpluses; and the
opportunity for constructive change in our international
economic policy.
Thank you.
Chairman Sarbanes. Well, thank you very much.
There is a vote going on and I have to recess the hearing
briefly to go and vote. I think some other Members will also be
joining us. So, we will resume in short order. The Committee
stands in recess.
[Recess.]
Chairman Sarbanes. The hearing will come to order.
I want to ask a couple of almost preliminary questions.
First of all, the figure for the economic output in the fourth
quarter originally came in at two-tenths of 1 percent. That was
subsequently revised to 1.4 percent. And we had a big change in
the productivity figure, too. Revised from an increase of 3.5
to 5.2 percent.
I have had an interest in these economic statistics
infrastructure of the Federal Government. My own view is that
we do not invest enough in it. We are talking about really
small amounts of dollars. But we could substantially improve
the infrastructure. I do not know if this is a good example of
it or not. I guess that is the question I am leading into. But
we start thinking about policy decisions off of one set of
figures and then later we learn that the really accurate set of
figures is something substantially different.
How much of a problem do you see this as being and how much
attention should we give to it? That wasn't the purpose of
today's hearings, but I would like to elicit some response on
that.
Dr. Solow. It is a problem. Here we are talking about
policy and the information on which our discussions and your
decisions are based, is changing under our feet as we talk.
Part of that could, I think, be helped by investing a little
more in the data collection process that underlies the national
accounts. Not all of it, however, can be helped that way.
For instance, part of the reason for the problem is that we
rush the process. We want those summary numbers as soon as
possible, or sooner. The quarter is barely over before we ask
the Department of Commerce to produce the figures.
We need, I think, to realize early in the game, that the
first numbers are going to be revised and can be revised
substantially. But there is a lag in the collection of some
numbers that could be shortened by spending, as you say,
trivial sums of money by the standards of the Federal budget.
Dr. Stiglitz. Let me make a couple of comments.
First, I agree with what Bob says that part of the problem
is the fact that there are always going to be revisions. The
first numbers are going to come in are going to be different
from what next will be the case. At the same time, I think we
have to recognize that the point that you made, the investment
in this area is inadequate and that we could do better. When we
get the revised numbers, they could be reliable. We could do
better samples.
So, I think there is enormous room for improvement.
You focused on numbers of GDP and productivity. The flip
side of that is the CPI, the cost of living, the inflation. It
is very clear that productivity, when we revise upward
productivity numbers, that revises downward the inflation and
that means that the staffs at the Fed should be more
conservative, and less concerned about inflation.
I always found it very interesting during the debates about
revising the CPI in the context of Social Security, that while
Greenspan often talked about the implications that it had for
the CPI, and for Social Security, there was less attention for
the implications for monetary management. There were obvious
implications, that we needed to be far less concerned about
inflation than he and many of the other members of the board,
Federal Reserve Board, seemed to be. And so, I think that this
is very important.
A third point I want to make very briefly, which is I think
the institutional framework for statistical collection should
be changed. I think it would be desirable to think about
establishing an independent statistical agency.
Chairman Sarbanes. Like Canada?
Dr. Stiglitz. Like Canada. Inevitably, the conflicts of
interest between an operating agency and a data collection
agency can be very great and lack separation.
At the international level, the problems are even greater.
I think that the numbers that are reported for growth, for
instance, for many countries by the IMF are simply made-up
numbers to make their programs work and have nothing to do with
scientific, economic-based forecasting, and that is not well
known. I think that moving the statistical responsibilities out
of the IMF would be a very important move in the right
direction.
Chairman Sarbanes. Alan.
Dr. Krueger. Let me mention, I started the survey center at
Princeton, so these are issues that I have thought about quite
a bit.
I would add that the private sector, as well as the
Government, relies very heavily on the statistics that are
coming out of the Bureau of Labor Statistics and the Census
Bureau and the BEA and so on. And if you add up the costs of
making mistakes for all those who are involved in using these
data for decisions, it is enormous compared to the amount we
are investing in collecting the data.
So, I have a couple of suggestions. I think there are some
problems that could be solved by investing more to collect more
information. And one of the problems is the economy has become
harder to measure. The economy has become more diverse.
Manufacturing now is a much smaller share. We are investing
more in collecting the data, but the economy is getting harder
to measure at the same time. So it is kind of a race where we
are left standing in place.
One suggestion I have is that we should be more aware of
the magnitudes of the revisions.
For example, in my written testimony, I pointed out that
the employment growth last month was 66,000, according to the
payroll survey. The typical revision from the first report to
the third revision, which is 2 months later, is on the order of
magnitude of around 50,000 jobs, plus or minus.
So when you think about these movements, you have to
recognize that you need a wide confidence band around them.
There are some numbers where you need a wider band than others.
I think it would be helpful if the numbers were reported more
frequently with those bands and if we think about those bands
when we think about using the numbers.
But there are some critical areas where I think we just do
not measure or we stopped measuring what is going on. One area
has to do with vacancies. Bob Solow and I co-edited a book
together. There is a lot of discussion on the relationship
between vacancies and the unemployment rate. We are forced to
rely on help-wanted ads as a measure of vacancies. There are
big changes in newspaper costs and in the way help-wanted ads
are placed and so on.
The BLS has just revised or just started again a new survey
on vacancies. But I think that that was a critical gap, and
there are other areas where we are just not measuring enough.
Chairman Sarbanes. David.
Mr. Malpass. We maybe should have lower expectations of
what we are really getting out of the data, because it is so
complicated to actually measure what is going on in the
economy.
Chairman Greenspan, in his testimony last week, mentioned
again what he calls conceptual capital. In part, it is the
human capital element of what is going into GDP. It is becoming
more and more important. It is very hard to measure what that
actually is, how productive it can be. So, I think we have to
have some limits on what we can really expect from the data.
We probably all have individual statistics that we dislike
the most. I will layout one domestic and one international that
I think are misleading.
Personal savings is a statistic that we see every month. It
gives us the impression that Americans are terrible at saving.
That statistic produced by the Government is heavily biased. It
keeps track of all the expenditures that people make, but
doesn't keep track of all the income or cash flow savings.
For example, when someone refinances their home, say they
save $200 a month in their payment and spend $100 of that. The
Government keeps track of the spending. If they then put $100
extra every month into savings, we would think of it as their
savings rate going up. But the Government's going to conclude
that their savings rate actually went down by the $100 of
spending. They do not record it properly.
We have the impression of a terrible performance by the
American saver and it actually wasn't nearly as bad as that
statistic.
On the international front, people focus on foreign direct
investment as the solution for foreign economies. But what we
find is that the data often comes from corporate reporting to a
government that they want to please. The government comes to
corporations and says, how much did you invest in our economy
this year? And the corporation, of course, has an incentive to
say a large number. It radically overstates the actual
attractiveness. This is particularly true in some developing
countries.
I agreed with what Joe Stiglitz said on the IMF producing a
lot of data that really is just way off and is known to be off.
That is part of their job, I guess.
Chairman Sarbanes. Thank you.
Well, I have a number of questions, but my time has
expired. I yield to Senator Bennett. I will come back.
STATEMENT OF SENATOR ROBERT F. BENNETT
Senator Bennett. Thank you, Mr. Chairman. I appreciate your
holding this hearing.
I look around the room for the hordes of visitors and
observers and they are not here, which is too bad because I
think the economy really is the starting place of virtually
everything else.
One of the cliches that I repeat often and often again, and
like most cliches, it happens to be true--money does not come
from the budget.
We here in Congress forget that. We think we can pass a
budget that creates a surplus or pass a budget that creates a
deficit. We are always surprised. Nobody's prediction of what
the fiscal year is going to produce is ever right or even close
to right, except the one that is issued with only 1 month left
in the fiscal year, and that is usually pretty close. But at
the beginning of the fiscal year, we are always either overly
optimistic or overly pessimistic.
Money comes from the economy. If the economy is doing
extremely well, then we get surpluses that we did not predict.
If the economy turns south, why, we get deficits that we did
not predict. And too many people blame the predictors and do
not realize that you are dealing with so many variables.
The example I like to use is a little like the weather
forecaster. There are some who say, well, the weather
forecaster is never right, so he cannot be any kind of a
scientist. Actually, he can be a very good scientist. He is
just dealing with so many variables that you have to cut him a
little slack.
Economists get snorted at because their forecasts are never
any good. Actually, I think you are scientific and you do
pretty well.
With that having been said, let me raise an issue that came
out of my exchange with Chairman Greenspan, when he was before
us last week, that has to do with the role of capital gains and
the amount of income that came from capital gains.
I made the observation to Chairman Greenspan that tax rates
are at historic highs. They have never been higher as a
percentage of GDP than they are now. He said, yes, that is
true, except that we have had a tremendous amount of tax
revenue coming from people cashing in on capital gains, and we
have had some tax revenue on people cashing in on stock
options. If you go below those to the income that comes from
what one might consider more normal kinds of tax sources, the
situation doesn't look quite so great.
Nonetheless, in macro terms, the tax burden on the economy
is very high and the question is raised whether or not the
economy over time can sustain a tax burden that is in excess of
20 percent of GDP, which we have not had. Does that produce
some kind of a drag that will bring the economy down? And if it
does bring the growth rate of the economy down--nothing's going
to bring the U.S. economy down. We are not going to be
Argentina. We are not even going to be Japan. But if our growth
rate slows, then we are back into deficits rather than
surpluses, however much we politicians would like to think we
can control whether we are in deficits or surpluses.
If our growth rate slows, we are back into deficits rather
than surpluses. We have other kinds of problems. I would like
you to address that question of the overall 20 percent-plus tax
burden that we have had. Then, if you would, in that, let's
talk about capital gains because I view the capital gains tax
as a tariff on money as it moves from one purpose to another.
And just to put it into simple terms that I can understand,
I know an entrepreneurial type who is willing to invest his
money in relatively high-risk activities because he has learned
that they produce high returns, and he has enough experience to
pick, he believes, the right kind of high-risk activities.
When he is successful, and one such investment becomes much
larger than it was when he got into it, he is loathe to unload
it because if he takes his money out of investment A in an
effort to put it into investment B, there is a tariff on the
movement of the money, from A to B, in the form of the capital
gains tax.
Now there is a widow who is most anxious to buy A because
it is now a mature investment that is producing a stable and
reliable 7 percent per year income, and she thinks that is just
nifty.
He is very anxious to get out of A and into B because, for
him, a mature investment that produces only 7 percent a year is
a real drag. But the capital gains tax stands as a tariff
barrier to prevent him from moving his money from A to B. And
as we have lowered that tariff barrier, we have seen more and
more money move from A to B, and in the process, produced the
capital gains tax revenue that Chairman Greenspan was talking
about.
So, I would appreciate your comment on those two issues.
Dr. Solow. I guess I will start. I am the oldest one here
by a wide margin.
[Laughter.]
Senator Bennett. As I am on this side.
[Laughter.]
Dr. Solow. I do not think that it makes sense to imagine
that there is some natural upper limit to the ratio of Federal
revenues to national income or GDP that we surpass temporarily
or for a longer time at great peril, or that if we fall short
of it, something else happens.
Much more depends on the nature of the taxes we levy, and
the uses of the revenue that we collect, than on any simple
statistic like the fraction of the national income that goes in
taxes.
It is very important I think to focus on an obvious case:
The need for national defense. If the safety of the country,
the security of the country, requires expenditures that are
naturally directed through the Federal Government, we will make
those expenditures and we will tax for them if taxing is the
rational way to finance them, and we will borrow for them if by
any chance, borrowing is the rational method to finance them.
One problem with the illustration that Senator Bennett
mentions is that it under-estimates the ability of the
financial engineer to convert one form of income into another.
In our tax system, we favor capital gains as against other
forms of income, and as a result, there is a thriving industry
of converting large salaries into asset transactions which
appear as capital gains----
Senator Bennett. If I could interrupt you. I have always
heard the argument that, gee, you lower the capital gains tax
and everybody will transfer their income into capital gains. I
have never been able to do it. I have tried, and I have never
heard of anybody being able to do it.
Dr. Solow. You do not hire a fancy enough tax lawyer and
accountant. If, instead of being a poor but honest Senator, you
were a rich movie star, or a rock star, I assure you that
clever people would cluster around you who are anxious to do
just that, for a mere tiny fraction of what they are going to
save you.
Senator Bennett. Yes, I know. And very often, they end up
putting you into something that has wonderful upside protection
and turns out not to be--like a percentage of your movie when
you would have been better off by taking it in salary. There is
always risk connected with the transaction.
Dr. Solow. Of course, there is always risk connected with
any asset transaction. I am merely saying that you cannot
simply look at the gross numbers without asking what incentives
for the private economy, as well as for public servants, are
created by different forms of taxation.
Alan Greenspan was right that, if you look at the numbers,
when we passed through a period in which large asset gains are
being realized and therefore, taxed, even if they are taxed at
low rates, that will increase measured revenues. And they are
not just measured revenues, they are real revenues of the
Federal Government.
The lesson I would draw is that we should try, in thinking
about public finance, to pay attention, more attention than we
actually do, to the incentive effects of every tax increase,
tax decrease, tax change, that we make, incentives that bear on
businesses, bear on individuals, and to a certain extent, bear
on the Government itself.
Senator Bennett. Dr. Stiglitz.
Dr. Stiglitz. Let me try to amplify a couple of points.
I agree with Bob that there are no magic numbers percent.
It really depends in part on what you are doing with the money.
For instance, we have done studies that show that the returns
to investments in R&D by the Government have enormous returns,
and we have not been investing enough in that area. So, my view
is that if we spent more money on that kind of research, that
would be a high-yield return that would help the economy grow.
We were talking about investments in statistical
infrastructure. If the private sector is getting bad
statistics, making bad decisions as a result, and spending more
public money, that can yield very high returns.
The first point is what is the money going for? And we
could obviously waste money. I am not going to tell you how to
do that as well. But if we spend it well, it can yield high
returns.
Second point, the design of the tax structure can make a
great deal of difference. We can design tax structures that
give strong incentives to people who are creative. We can give
strong incentives to people who are engaged in tax shelters
that are basically not creating value. And so, much of the
concern about the debate of tax reform has been the design of
tax structures that enhance productivity versus those who are
advocating tax structures that help the rich or help, unrelated
to their activities with respect to enhancing economic
productivity.
So, I view a very strong part of the burden of the tax
system as having to do with the design. Again, we can have bad
design and good design and right now, I think we have been
moving in the wrong direction.
Third, with respect to capital gains itself, a relatively
small fraction of the capital gains comes from the picture of
the innovative activity that you have in mind. Most of capital
gains comes from real estate speculation.
I do not want to downgrade the importance of real estate as
an important sector of the economy, but I think most of us
think of, what is the strength of the new economy, the strength
of the U.S. economy over the last decade? It has been
innovation. It has been a whole set of activities like that and
not building the kinds of empty office building that led to the
real estate crash in 1988, 1989, or in the 1990's.
Most of the capital gains goes to the real estate sector,
not to innovation. I am more sympathetic with special treatment
for capital gains for innovation sectors than I am to real
estate, but other people do not believe in that kind of
differentiation.
I think it does make sense.
The final point I want to make is to reemphasize the point
Bob made that the kind of financial engineering that one saw in
Enron has been well known and can be used for--if you have
special tax treatment of capital gains, can be used to avoid
taxes.
I wrote a paper a number of years ago detailing how that
could be done and how you could actually basically get rid of
most of your capital gains.
Chairman Sarbanes. It is probably in the Enron files.
[Laughter.]
Dr. Stiglitz. Over the years, the tax authorities have
tried to circumscribe one or the other of these kinds of
devices and it explains a lot of the complexity of our tax
code. And that complexity is part of the downside cost of our
tax system.
Unfortunately, a lot of the creativity of our economy is
going not into producing new products, but trying to circumvent
the tax laws and finding out loopholes, on accounting and in
this area. I think it is a mistake to try to provide them even
more incentives to do that. And afterwards, if you want to find
some advice on how to use our current tax system to avoid
taxes, we can arrange for that.
Senator Bennett. I am not talking about using the current
tax system to avoid taxes. I understand that perfectly.
I do object to the canard that I hear over and over again
that people will simply change their form of compensation to
take advantage of the lower capital gains tax rate. And I hear
that in the debate often.
Michael Jordan doesn't take shares in the Wizards. Michael
Jordan takes cash. And if you say, we are going to give you
shares in the Wizards so that you can get capital gains
advantage when the price of the Wizards goes up and his knee
goes out, he wishes he did not take shares in the Wizards.
You cannot transfer income from normal income, ordinary
income, or earned income. To use the tax phrase, you cannot
transfer from earned income to capital gains income without
risk. It is not something that you just need a good accountant
to do. Risk is always there and you are compensated for the
risk. As Enron demonstrated, stocks go down just as much as
they go up, and options become worthless just as often as they
become valuable.
I was hired as the CEO of a company and was compensated in
options. And I did such a wonderful job in the company that the
options never ever exercised because the stock price never got
as high as it was on the day I was hired.
Dr. Stiglitz. Can I just say, much of the paper that I
wrote was how you manipulate within the capital sector itself,
borrowing money, moving within that, and avoiding. But it is
also the case that there has been a lot of discussion, and I
think some evidence, that firms--one of the reasons they use
stock options is for the favorable treatment.
What a number of corporations are doing as the stock goes
down of resetting the strike price, so implicitly, they are
sharing the risk. They are absorbing the risk.
And if you look at the studies that have looked at overall
compensation, what you see is that many executives do not bear
the risk that you would appear to see that they would bear from
the stock options because when things do not work out as well,
there are other ways of giving them money, either through
resetting the strike price or through other forms of
compensation.
Chairman Sarbanes. Does anyone else want to add anything
before we move on?
Mr. Malpass. I have a few points, if I may, Mr. Chairman.
Chairman Sarbanes. Yes. Go right ahead.
Mr. Malpass. In very rough terms, Federal revenues are $2
trillion per year and State and local governments add another
roughly trillion dollars. So there is a lot of tax revenues.
Chairman Sarbanes. Rates or revenues?
Mr. Malpass. CBO, in its recent report, goes through some
scenarios. Over the life of the budget, the 10 year life of the
budget, even with last year's tax rate cut, they expect
revenues from personal income taxes to rise from 12.8 percent
of GDP now to 13.6 percent of GDP. And if we have a good
economy, they will rise to 15.5 percent of GDP.
So even apart from the capital gains issue, we have the
personal income tax as a burdensome tax. Also, the Social
Security tax is a very burdensome tax on labor itself. It puts
a wedge between the employer and what the employee really
receives.
Now, as far as capital gains taxes, we should note that
each time the rate is cut, the proceeds from capital gains are
way above the projections.
We have a systematic bias in the way capital gains are
perceived in the Government computer models. They don't fully
account for, the fact that, when the rate is cut, there is more
activity and more economic growth or simply transactions, and
the total capital gains receipts get a good bump.
One of the debates last year that was very confusing to me
was the assertion that if the capital gains tax rate had been
cut, the stock market would fall.
I believe that economists would by and large agree that if
you cut the tax on an exit from a given investment position, it
adds to the value of that position.
I think it is demonstrable and almost a certainty that if
you had a lower capital gains tax rate, you would see a big
positive impact on the value of capital assets--stocks, bonds,
and real estate. So that was a confusing debate to me on the
sidelines last year.
A final point is the distribution of tax receipts from
capital gains taxes, the issue of who actually pays capital
gains. What I am struck by is that the rich actually can avoid
much of the capital gains tax by selectively taking gains. Also
through the estate tax system and through the charitable
contributions system.
I was just at a dinner the night before last with a big
group of universities that receive a lot of charitable
contributions. One of the sizable tasks that they have is
taking care of rich people as they donate their appreciated
property into the university before their death.
The rich person avoids capital gains taxation and gets
higher current income from the charitable contribution. The
whole process is driven by the heavy taxation of capital gains.
On the other side of it, the small business owner really
doesn't have those mechanisms in order to avoid or work around
the capital gains tax.
I think that the distribution of capital gains taxation
falls very heavily on the middle class and entrepreneur,
precisely the people that you would really rather leave the
proceeds with.
Chairman Sarbanes. Now as I understood Chairman Greenspan's
response to this question that Senator Bennett put at the
hearing last week, he made the observation that the capital
gains tax revenues are factored into the numerator. But there
is not an item that is factored into the denominator.
Therefore, the percentage of tax revenues compared with the
gross product will, by virtue of that, be higher. And if you
are getting more capital gains, the figure will look higher
because you do not put any comparable item into the
denominator. You get, in a sense, an overstated figure when you
are trying to make these comparisons or something that
certainly should be taken into account.
Of course, the point is that we have had a lot of capital
gains in recent years with all of what has been going on in the
market and that that had an impact on these percentages.
He was, I thought, very careful to try to make that point
in the response.
Senator Reed.
COMMENTS OF SENATOR JACK REED
Senator Reed. Thank you, Mr. Chairman. Thank you,
gentlemen, for your testimony and your presence here today.
Dr. Stiglitz, you seem to have an urge to say something,
and I do not want to deny that.
[Laughter.]
Dr. Solow. It is always the case, Senator.
[Laughter.]
Chairman Sarbanes. What else is new?
[Laughter.]
Dr. Stiglitz. Very briefly, let me just say that the Social
Security tax, since the contributions that people make under
the Social Security system are reflected in the benefits and
move basically commensurate with the benefits, doesn't have the
distortionary
effect of other kinds of taxes. It is really like an
investment. So viewing it that way I think is fundamentally
misguided.
Second, it is the case that cutting capital gains taxes
leads in the short run to increases in revenues because people
worry that this is a temporary benefit and they want to take
advantage while there is a sale going on.
The econometrics, the statistical evidence shows that over
the long run, cutting the capital gains tax is like cutting any
other tax--it leads in the long run to lower revenue and a
worsening of the fiscal position of the United States.
I will stop at those two points. I have concerns about the
other points, too, but let stop there.
Senator Reed. Thank you, Dr. Stiglitz.
It seems to me that the proponents of tax cuts, and this in
some respects seems to be the Administration's Swiss army knife
for economic policy--it can do everything--base some of their
judgments on a bet that productivity will increase at very
prodigious rates for the indefinite future.
I wonder if Dr. Solow and everyone, if you might comment on
your views on productivity increases.
Dr. Solow. Yes, I would be glad to. I should begin by
saying that these quarter-to-quarter numbers that are reported
are intrinsicly unreliable and volatile. Productivity has a
numerator and a denominator. They can both change
unpredictably. They can both change dramatically, and
particularly when a denominator changes. It can change the
value of the fraction very much. Quarter-to-quarter numbers are
not an indicator of very much at all.
Over the longer run, in the quarter-century after the end
of the Second World War, we had very rapid productivity
increase, reflected directly in the rise in the standard of
living of the country.
For mysterious reasons, for reasons which are not fully
understood by anyone, the following 25 years, from about 1970
to about 1995, had extraordinarily low productivity increase.
We thought, at first, that productivity was growing 1 percent a
year. It turns out to be nearer a percent and a half a year
after the data are revised.
Beginning in 1995, we had very rapid productivity increase
again, and much of that is undoubtedly information technology
related. A lot of it is related to other things, including
organization innovations by businesses, and still other things.
It is very hard to extract from numbers like that what part
is business-cycle-related--there is a normal pattern of
productivity change in the business cycle--and what part is
durable. What we really need to know is what is durable over
the next 5 or 10 years.
I have put some time into studying that question in detail
industry by industry, in fact, and so have many other people. I
think a consensus is emerging that we probably have a durable
benefit from accelerated technological change in the United
States, especially in telecommunications and information
technology, but that the period from 1995 to 2000 exaggerates
considerably what we can hope for over the longer run.
The longer run forecasts, naturally uncertain, that make
most sense to me are those that suggest that we can look ahead
at something like 2 percent a year annual productivity
increase, taking the private economy, the private business
economy as a whole.
Two percent a year ain't hay. A number that rises at 2
percent a year doubles in about 35 years. So doubling the
productivity of American workers in the course of a little over
a generation is not a negligible thing. This is nothing like
the 3, 3\1/2\, 4 percent increases that we saw during that 5
year period, which almost certainly cannot be repeated
regularly.
The 2 percent a year is a little less than we got between
1950 and 1975, which were very good years for productivity. It
is more easily explicable why we did so well in those years
than why we did so poorly in the 25 years.
Senator Reed. Thank you.
Dr. Stiglitz.
Dr. Stiglitz. Just to add one thing. I agree with
everything that he said. One point is that there has been a lot
of research, a lot of thinking over the last 20 years of how
you make decisions under uncertainty. These numbers are
inherently uncertain. One of the principles is you do not spend
money before you have it. And you revise policies as new
information comes in.
So if you made a decision to spend a certain amount of
money when you thought you had a surplus of $5 trillion, or
whatever the number is, when it was a mistake to have spent as
much as was spent, given the uncertainty. But when you have new
information that comes in and that says it is much less than
you thought, it calls for revising the policy decisions that
were made under that framework.
Senator Reed. Thank you, Dr. Stiglitz.
Dr. Krueger.
Dr. Krueger. I agree completely with what Joe and Bob said.
One point I would add is that one of the things that helps
productivity growth and it has helped historically has been
increases in education, increases in the human capital of the
workforce. In the post-World War II period, we had very rapid
increases in college attendance and high school graduation and
so on. That source seems to have slowed down considerably.
So that is one of the reasons why I think it is very hard
to predict going forward. The technological changes that Bob
pointed to I think probably are durable, although the probably
should be underscored, not the durable, in that sentence.
I also think there is a tremendous amount of uncertainty,
even looking over the next 5 years, for what the productivity
growth numbers will be. That is why the budget projections are
so variable and often so far off. And given that reality, I
think what Joe said is absolutely right, that one wants to
adjust when one gets new information about what productivity
growth looks like.
Senator Reed. Mr. Malpass.
Mr. Malpass. Senator Reed, very briefly, in my opening
statement I went through the policy implications of this
question. I think it is, indeed, worthy of a lot of thoughtful
discussion. Could the productivity growth be as high as we have
been recently witnessing? If it is anywhere close to that, as
Dr. Solow says, even if it is 2 percent, that compounds
rapidly.
From the monetary policy standpoint, it means that we may
have a period where the inflationary impact of a given growth
rate is a lot less than what we are used to. That means that
the potential growth of the economy, or the possible growth of
the economy, is higher than what we have thought in the past.
From the fiscal policy standpoint, it means that we may
have surpluses rather than deficits. As I laid out in my
statement, it is worthwhile for Congress to begin thinking
about what we would do if we really had a sizable surplus, to
begin thinking about the glidepath.
Chairman Greenspan laid out a year or two ago the idea that
if we run surpluses, if we have the higher productivity growth
that we think we do, then the glidepath in the pay-down of the
national debt will be uncomfortably rapid. He went through that
in a rather detailed way.
Senator Reed. But that was at the point that we had a
projected surplus of several trillion dollars, which is much
less now. It is not a glidepath. It is a cliff, I think.
Dr. Stiglitz. Can I make one more remark which is a point
that I had in my written testimony having to do with the short-
run?
Whenever you have a recession, a down-turn, even a
shortfall below potential, one of the impacts is that profits
go down, and as his testimony pointed out, they have come down
considerably in this economic down-turn. And when profits go
down, firms cut back on their R&D. The cut-back in long-term
R&D is even more in the short-term. Long-term R&D being focused
on real productivity increases rather than just making sure
that you can compete with the competitor.
I have been at some recent meetings with people who have
been involved very strongly in the high-tech area. They say
that there has been dramatic cut-backs in R&D in their firms
and in their
industry in the last year, last year and a half. And that
portends very strongly for a slowing down of the pace of
productivity over the medium-term, at least in that particular
sector.
Senator Reed. Well, you can correct me. My sense is that
productivity is not at the levels that we saw in the late
1990's, at 2 percent. That, as a result, GDP will not grow as
fast as it tended to grow. With the declining GDP and even a
constant obligation by the Federal and State and local
governments to spend money, the likelihood will be in deficit,
not surplus. Is that your judgment?
Dr. Solow. It is not clear that we will be in deficit
rather than surplus. But any surplus we generate will be much
smaller than the very optimistic numbers that we had before.
You are quite right that with roughly 2 percent
productivity growth and roughly 1 percent employment increase
over the long run, the long-term growth rate for real GDP is
likely to be of the order of magnitude of 3 percent, 3.1
percent, thereabouts. That is the number that I come up with.
That is the number given in the Economic Report that the
President issued a month ago. There is a fairly good consensus
on that.
That is not, I think, going to generate large surpluses,
nor is it going to give us much protection against inflation.
Incomes tend to rise along with productivity. What was so
fortunate about the period from 1995 to 2000 was that there was
an unexpected splurge in productivity, and as a result, an
awful lot of it was fed into cost reduction rather than into
increases in earnings and other nonprofit forms of income.
I do not think that is likely to happen again. This works
the other way, too. The double-digit inflation of the early
1970's that scared us so much came in part from the fact that
wages and other incomes were rising as if productivity were to
continue to go up as fast as it did in the years after 1950. It
did not, and prices went up instead.
Dr. Stiglitz. Let me just make one more point, which is
that the numbers that are often cited include the Social
Security system. We should be putting away money for those
obligations we have.
In addition, we have the long-term problem of Medicare.
There are estimates of what is going to be happening to health
care costs, that it will go up to 17 percent of GDP. And that
is typically not fully accounted in the forecast.
So there is a real risk on that side, as well as on the GDP
side that we have not really taken into account. I think it is
irresponsible to spend the money before we have it and before
we know what these expenditures are going to be.
Senator Reed. Thank you very much. My time is expired.
Thank you, Mr. Chairman.
Chairman Sarbanes. Senator Corzine.
COMMENTS OF SENATOR JON S. CORZINE
Senator Corzine. Thank you, Mr. Chairman. I apologize to
the witnesses for attending another hearing first. This is a
remarkable panel and I intend to read all of your testimony.
Let me ask a question that relates to something that seems
to come up on the floor in our debates fairly frequently with
regard to tax policy. And that is the permanent repeat of the
estate tax, which seems to get tacked onto every piece of
legislation that gets presented to us that has any economic
bearing. Would you all give some of your perspectives on its
impact into the economy long-run capital formation? I hope this
question has not been asked, Mr. Chairman.
I would start with Mr. Malpass and then work the other way,
or vice-versa.
Mr. Malpass. You put me on the spot first.
[Laughter.]
The one observation I would make on the estate tax is that
it places huge costs on the economy. I think it is very hard to
quantify those costs or be aware of how large they are.
I do not really want to go farther into exactly how it
should be revised. But we should recognize the gigantic number
of workers within the economy and systems within the economy
that are devoted to dealing with the estate tax, from lawyers
to accountants to the university systems, which have staffs and
whole processes involved in helping people deal with the estate
tax system.
We should be aware of those costs and also aware of the
distortions that are brought on by the system that we have
right now.
Dr. Krueger. My own view is that the estate tax is largely
an issue of equity. Different people will have different views
about what constitutes equitable taxation.
I think one issue that David raised which is important is
the loopholes. What seems to upset people is having to spend
money on lawyers to avoid the estate tax. I think they would
probably be happier to give that money to the Government than
to their attorneys. My own sense is that part of the outrage
over the estate tax in the public has to do with the loopholes
which they consider to be unfair.
I do think in terms of the economic impacts, there would be
impacts in terms of charitable giving. I think from the
standpoint of universities, for example, they will get fewer
donations with the
repeal of the estate tax.
Dr. Stiglitz. Let me make a couple of points.
First, I think one has to think about the repeal of the
estate tax in a broader context. In particular, in the context
of the issue of the step-up of basis of capital gains tax,
step-up basis for payment of the capital gains taxes. The step-
up of basis, I believe that, as our previous discuss, we said
that there should be a capital gains tax and that without that,
there can be enormous tax evasion or avoidance--tax avoidance,
I am sorry. And that without fully dealing with the problems of
step-up of basis, repealing of estate tax is bad tax policy,
both from efficiency and equity points of view.
The second point, a lot of the criticisms that have been
raised against estate taxes have focused on small businesses,
farms, and all those people who have to sell their property in
order to pay the tax. I think there is a legitimate concern
about that. But that could have been dealt with in a variety of
ways other than the repeal.
For instance, giving people an extended period of repay,
increasing the exemption level maybe to $5 million, but not the
complete repeal. I think that was going far beyond what was
necessary to deal with those problems.
I think there is very little evidence that the repeal will
increase the efficiency. The core issue is the one that Alan
pointed out, the issue of equity and what kind of society that
we want to have.
There are going to be significant impacts on charitable
giving. I think the evidence on that is fairly clear. One of
the strengths of the American society and the American economy
is based on the nonprofit sector. And I think that in some
sense could be some of the most serious adverse effects of the
repeal.
I do not think it is a bad thing that people are encouraged
to give money to nonprofit organizations. But I have to admit
that I have some self-interest in that particular perspective
because I have been one of the beneficiaries of the nonprofit
sector.
Mr. Malpass. But the cost of that in the efficiency, or I
wanted to ask your point on efficiency. Why don't we have to go
through that, in the efficiency of extraction within the tax
system?
Dr. Stiglitz. I think the net cost of that is negligible
compared to what happens more broadly in trying to evade a
whole variety of taxes or to take advantage of special capital
gains provisions, real estate provisions, and so forth. I think
this is really second-order effect.
Dr. Solow. I think everything has been said here. I will
take 30 second and emphasize a couple of points. There have
been studies of the incentive effects on business entrepreneurs
of the existence of the estate tax. And generally, they come up
with very small numbers.
The key technical matter is constructive realization of
capital gains at death. Under the present system, without the
estate tax, there are large capital gains that escape taxation
forever. And that cannot be appropriate as long as we are
taxing capital gains elsewhere in the system.
This is primarily a matter of equity. There is no danger
that well-off parents will be unable to create advantages for
their children by educating them properly and endowing them one
way or the other.
To return some portion of an estate at death to society or
in anticipation of death to charitable organizations does not
seem to me to be a bad thing at all. It seems to be a good
thing.
The evidence is that, well, here we are, the most
entrepreneurial society in the world. You would think that we
had been stifling entrepreneurship for generations by having
this tax. In fact, Route 128 and similar centers are crawling
with businesses like that, somehow. People with the creativity
to create enterprises will do it.
Chairman Sarbanes. We will go around again, but let's move
more quickly. We have four panelists and it takes a lot of time
to get an answer. I am just going to ask a couple of questions
and----
Dr. Solow. Five, counting Joe.
[Laughter.]
Chairman Sarbanes. Maybe if I can get a yes or no or a
short answer.
What is your view of the argument that the projections out
that we would shift from a strong surplus position either to a
weak surplus in the budget or even a deficit, because of the
extensive tax cuts that were made, has had an impact in keeping
up long-term interest rates? And that therefore, some of the
stimulus that could have come to the economy by lower long-term
rates was lost because we did this extensive tax cut and then
people looked out into the future and they saw this.
So that was one way that the tax cut fed back into the
current situation and, in effect, detracted from moving the
economy forward. What is your view of that argument?
Dr. Solow. You wanted a yes or no answer. My answer is,
yes, that has to be the case. Something in the capital markets
has been lifting up expectation of interest rates in the future
and it is at least in part the expected supply-demand balance
for funds in the future. And that cannot help but be affected
by the fiscal policy of the Government.
Dr. Stiglitz. I agree. I have actually written that. One
other factor is the uncertainty that all of us have been
talking about gets reflected in the risk premium that is
reflected in turn in the medium- to long-term interest rates.
And so, it is not just the average numbers we are talking
about. It is the uncertainty by this commitment, seeming
commitment we have made to a tax cut when we are not sure if we
can afford it.
Dr. Krueger. I tend to share those views.
Mr. Malpass. You asked four economists, so that often means
six opinions. I will give you a different opinion.
It is pretty clear from the evidence that the fiscal
deficit doesn't have much impact on bond yields. We have the
experience from the 1980's. It is discussed in detail in my
statement with a graph showing the bond yields versus the size
of the fiscal deficit. As the expectations of the fiscal
deficit and the actual fiscal deficit grew, bond yields
actually came down heavily in the 1980's.
We have had the experience of last week. As it became clear
that the U.S. fiscal deficit was going to be much smaller than
people expected, or perhaps a surplus, yet bond yields are
going up. The rise in yields is reflecting the expected growth
of the economy, the inflation outlook, and I also think the
currency outlook. Those are the dominant variables in a bond
yield.
Chairman Sarbanes. Now what about the argument that doing
this extensive tax cut provided a stimulus to address the
shortfall that we were experiencing here?
I take it this really goes to the question of whether,
somehow, you can borrow frontwards or move frontwards tax cuts
projected out into the future in order to provide a stimulus
now. Does it work that way, or can it work that way?
Dr. Solow. I do not think it had or did. The Economic
Growth and Tax Relief Reconciliation Act of 2001 was not passed
in anticipation of a recession and it is not mainly an
antirecessionary act.
I am sure that the early stages of that tax reduction did
have the usual effect in supporting the demand for goods and
services in the economy.
Chairman Sarbanes. You mean the early stages, what happened
in the current or the next fiscal year.
Dr. Solow. In the current fiscal year. But the notion that
tax reductions scheduled for 5 or 6 years from now, or 4 or 5
years from now, can have a major effect on the current
consumption expenditures of the population seems to me to be
far-fetched.
Chairman Sarbanes. Does anyone disagree with that?
Dr. Stiglitz. No. The only other factor is the point made
earlier that the anticipation of the worsening fiscal position
has had a negative effect through interest rates.
Dr. Krueger. I was going to make the point also that rate
cuts in the future should cause people to delay their labor
supply today.
To the extent that there is some substitution in the way
people work, it would work in the opposite direction, the
future cuts. The rebates might have had some effect, I suspect.
When the history of this period is written, it will probably be
a small impact. But the future cuts, I suspect, were probably
having no effect or a small negative effect.
Mr. Malpass. People spend from their lifetime income
expectations, the after-tax expectations of how much money they
are going to have over their lifetime. So if the Government
changes its view of how much taxes it is going to extract from
people, that certainly has an effect on people's confidence
about their near-term outlook.
If they see that their long-term after-tax income is going
to be more, then that gives them confidence in what they are
doing. I really think that it has to be the opposite of the
points of view that we have just heard.
Dr. Solow. Even a believer in something like the permanent
income theory of consumption, like me, for instance,
understands that permanent income is discounted like other
incomes and increments to anticipated permanent income 5 years
down the line will not generate very large amounts of
consumptions. I am perfectly at home and comfortable with that
way of looking at consumption. But it cannot have any
substantial quantitative impact, I think.
Dr. Stiglitz. The work that I did in connection with the
Nobel Prize emphasized the importance of credit rationing. And
it is one of the reasons why you cannot borrow against income
that you are going to get in 5 years. The evidence in this
particular episode is very strong that it has not had any
effect.
Chairman Sarbanes. Senator Bennett.
Senator Bennett. Thank you.
I have to return to the estate tax for just a minute.
I agree with you, Dr. Stiglitz, that the stepped-up basis
is a stupid idea. And it came because it was an attempt to
ameliorate the impact of the death tax, which I think is
another stupid idea. The problem with the death tax is that
death is not a voluntary decision. It should not be an economic
event. When I decide to sell a stock, I decide to sell a stock
based on my analysis of my needs, the stock market, where
things are. I make a rational decision, taking into account all
factors. When my father dies, there is no such options. He dies
because of uneconomic circumstances.
If his entire estate is cash, that is one thing. If his
estate is a business, his death may occur at the worst possible
economic moment for the survival of that business. But the
Government pays no attention to that, assumes that it is cash,
and demands payment within 9 months.
And so, in an effort to get around the arbitrariness of
death, we get all of the battalion of lawyers, tax accountants,
and others that you have talked about.
I have lived through a number of deaths. The most
spectacular one from an economic point of view was Howard
Hughes'. I was working for Howard Hughes when he died, and I
watched the gyrations that everybody went through in an effort
to preserve his assets, not necessarily for his heirs because
none of his heirs expected to receive any of his assets. We
spent a frantic amount of time trying to find a signed copy of
the will that left everything to charity, which was Mr. Hughes'
intention.
Mr. Hughes, being Mr. Hughes, never bothered to sign the
will. And so, it did end up going to his relatives, none of
whom expected a dime on his death.
I watched the gyrations that people went through to write
down for assessment purposes the value of his assets, in many
instances, to preserve those assets because they represented
businesses that were not at that point in their lives where
they could afford to liquidate into cash.
So, I would much prefer a circumstance that says, death is
not a taxable event.
If Howard Hughes paid $10 for an asset, on his death, that
basis stays unchanged. There is no step-up in basis. When the
asset gets sold, no matter who sells it, it then produces a
capital gain that is taxed at the existing capital gain tax
rate, whether it is 20 percent or 28 percent or 25 percent or
15 percent, wherever it might be. And that means the people who
own the asset can make an intelligent economic decision that
the time has come to sell it and pay the tax, instead of an
involuntary decision that says, uh oh, Mr. Hughes died 10 years
before we expected him to. This business is not in shape to
liquidate. But the Government said to come up with the money,
as if it were cash.
Now comment on the economic impact of saying, okay, death
is not going to be considered a taxable event. Therefore, there
will be no stepped-up basis, and whoever gets the asset by
virtue of somebody's death is facing a capital gains tax on the
original basis, just as the individual would have faced it if
he had survived.
That, by the way, is exactly what would happen if the asset
were given to a corporation at the very beginning when the
corporation decides to sell it, and the corporation can live
for 150 years before it decides to sell it. It pays the capital
gains on the original basis.
Chairman Sarbanes. I am going to have to excuse myself
because of another engagement for which I am now quite far
behind. Senator Corzine will take over and conclude the
hearing. But I did not want to leave without thanking the panel
for your contribution. We really very much appreciate it. And I
have looked through the statements and obviously, a good deal
of work went into these statements as well.
This has been a fascinating session. It could go on
indefinitely. And I apologize to Senator Bennett.
Thank you all very much.
Dr. Solow. Since I am closer to this taxable event than any
of my colleagues----
[Laughter.]
--I will take the first crack at it. If it is good public
policy that unrealized gains on capital assets should escape
taxation for time periods measured in generations, in five,
six, seven, eight generations, then I might agree with the
direction of Senator Bennett's comments. I do agree with him to
the extent that I think it is a little odd that death should be
such an important taxable event.
I would think that a reasonable way of dealing with that,
to say that, at the very least, death is a transaction or the
passing on of assets at death is a transaction. And there is
something very peculiar about different treatment of someone
who sells an asset 10 minutes before he or she dies and someone
who forgets to do that and holds the assets for 10 minutes
more.
It would be my choice in view of the equity considerations
and the kind of society that I at least like to think of us as
having, I could be happy if the transfer of an asset at death,
which is, after all, from one person to another person, were
treated as a transaction and what in the modern vocabulary is
stepping up the basis, or what I learned to call constructive
realization of capital gains took place. Then assets would be
treated as if death constituted a sale to heirs. By the way,
not all of those heirs have to be members of the family. They
can be others.
Senator Bennett. But it is an involuntary transaction.
Dr. Solow. No, it is not an involuntary transaction. That
transaction could have taken place earlier, had anyone wanted
to make it, and might have taken place if the tax laws were
different. And not to sell something is as much a voluntary
action as to sell it.
Dr. Stiglitz. Let me just make a couple of points.
First, I think that smart businesses tend to buy insurance
that can pay the capital gains taxes--the estate taxes. So, we
have a vibrant insurance industry, so the issue for most
individuals can be covered.
Senator Bennett. You are assuming that the cost of
insurance is a minor issue to the business. There is a cost.
Dr. Stiglitz. There is a cost.
Senator Bennett. There is no cost-free way out of this.
Dr. Stiglitz. But you have to understand, it is also the
case that in a competitive market, with the tax preferences
associated with the insurance industry, on average, it is not
really a cost.
I really do think that the stepped-up basis is very
distortionary. It is also the case, though, that not forcing a
constructive realization in one form or another leads to this
problem that is well documented, called the locked-in effect,
that it discourages the turnover of assets. And it is very
important to address that issue.
I think that there are a number of ways in which one can
try to facilitate, help people who are facing the kinds of
situations that you describe.
I think that, for instance, under current law, they can, I
believe, have, if they are small businesses, extend the
payments over a number of years. I could imagine extending that
more generally with an interest charge that reflects the cost
of the deferred receipt of the Government. I do not think that
is unreasonable.
Finally, in the end, I do think that, as I look at it from
the point of view of the efficiency effects, not talking about
the equity. I would make a trade-off in which I would have a
step-up of basis, constructive realization and a somewhat
lowering of the estate tax from what it was, but clearly not
the elimination of the estate tax.
Senator Bennett. We could debate this, but my time is gone.
Just one last thing. Dr. Solow, if Howard Hughes had
decided to put his initial stock in a corporation rather than
in his own name, it would have stayed in that corporation for
generation after generation after generation and you wouldn't
object to that because it wasn't an individual. And the people
who ran the corporation would decide when to dispose of those
assets and they wouldn't have had the cost of any insurance
firm to do it. They would make intelligent business decisions
on the disposition of the assets and they would pay the capital
gains tax when it came. You are treating individuals different
than corporations.
Dr. Solow. I would regard that as a loophole and if I were
a legislator, I would consider closing that loophole.
Senator Corzine. Okay. Let me change subjects here.
Mr. Malpass, being an old washed-up bond trader, I thought
you picked the timeframes for increases in debt associated with
the rise in interest rates at a rather interesting time. You
picked the 1980's and you apparently were picking 1982 or 1983,
when we were at the peak of interest rates and debts had
continued to go on.
If you had just turned the clock back 6 years, I think we
were at very low rates, roughly where we are now, 5\1/2\, 6
percent on long-term rates. And the expectations of growing
deficits took us to 13 or 14 percent, if my memory serves me
correctly, about 1982 or 1983, and a clear sense at least of
when I was sitting at the desk buying and selling bonds, that
supply had something to do with the level of anticipated
interest rates.
I think that those levels stayed very high throughout the
1980's. There were some dips as people thought we were going
into recessions or had different problems. But I do not see
that correlation that you pointed out.
Then I wonder about the analysis even under the
circumstances that we see a little stronger economy. No one is
revising down dramatically the kinds of changes in borrowing
arrangements that we are going to have over the next decade and
certainly not as they look out beyond the ending of this tax
cut and the demands that we are going to have with regard to
Social Security and Medicare and Medicaid.
I actually draw almost the opposite conclusion with regard
to my own personal experience of looking at the correlation of
anticipated debt financing relative to interest rates. It is
not a one-to-one correlation. But I would have a hard time
explaining what happened in the late 1970's and in the early
1980's with regard to the expansion of debt.
I do not know whether you want to comment.
Mr. Malpass. Well, there was a huge change in the value of
the dollar in the 1970's. I think what was going on in the
1970's was a mis-estimate by the bond market of the amount of
inflation that was coming out. And so, the yields stayed low. I
imagine that people lost a lot of money being long bonds in the
1970's because there ensued a very high inflation rate, not
because of the fiscal deficit, but because of the change in the
value of the dollar and the inflation that came out of it.
As I look at the graph of the 1980's, it looks to me that
as the fiscal deficit went bigger and bigger and bigger, you
had a steady decline in the 10 year bond yield falling from 10
percent in 1981 all the way down to 7 percent by the late
1980's. And then we have the reverse process, of course, in the
1990's, as we moved toward fiscal surplus. We actually ended up
with an 8 percent interest rate in 10 year bond yields in the
year 2000. Even as we had moved into a solid fiscal surplus,
the bond yields were actually going up. I think that was
related to the growth rate that we had going at that time.
Dr. Stiglitz. Can I say something?
Senator Corzine. It certainly did not stay there very long,
though. It came crashing back down to lower levels when people
thought they were going to be sustainable pay-downs in debt.
Mr. Malpass. It is hard to find the fiscal correlation. We
were moving into a recession and we moved toward rate cuts by
the Federal Reserve.
Senator Corzine. Dr. Stiglitz.
Dr. Stiglitz. The general point that I think you raised is
that interest rates reflect demand and supply for bonds. That
is basic economics. That demand and supply are affected by a
number of variables. In economics, we call it multivariant
analysis. We do regressions. Looking at one variable is likely
to be misleading.
The appropriate question is, given everything else, what is
the impact of increased deficits? And viewed that way, I think
it is unambiguously the case that increased deficits mean that
the Government is going to have to borrow more. Reduced
surpluses means that the Government is not buying back as many
bonds as it otherwise would, the same basic story.
When that happens, the interest rates, those will be
reflected in the interest rates relative to what would have
happened in the absence of that action? Lots of other things
are going on in the world. We cannot control them all. But that
clearly is the dominant factor.
Senator Corzine. There are studies out that show those
correlations, I take it.
Dr. Stiglitz. Yes.
Senator Corzine. We probably should cite those for the
record at some point and try to get them in because I think
this is one of those debates. It is like the estate tax that we
have on a daily basis around here.
It would be great to have some objective evidence.
I appreciate it. This is the first time I got to chair a
hearing and I will close it.
Thank you.
Dr. Stiglitz. Thank you.
Dr. Solow. Thank you.
Mr. Malpass. Thank you, Mr. Chairman.
Dr. Krueger. Thank you.
Senator Corzine. This hearing is adjourned.
[Whereupon, at 12:55 p.m., the hearing was concluded.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF ROBERT M. SOLOW
Nobel Laureate in Economics, 1987
Professor of Economics, Massachusetts Institute of Technology
March 12, 2002
I want to thank the Committee for the opportunity to testify today
on the economic outlook. This initial statement will be short and
pointed, because I believe that a lively discussion will get us closer
to where you want to go.
The current economic situation is a living example of the reason
why most economists think of monetary policy as the tool of choice for
short-run economic stabilization purposes. We have been told by the
National Bureau of Economic Research that a recession began exactly a
year ago. The Council of Economic Advisers, in its Annual Report, seems
to think that the recession began on September 12. But then, to
everyone's surprise, including mine, the first revision of data for the
fourth quarter of 2001 showed that real aggregate output actually rose
nontrivially, and gained back everything it had lost in the third
quarter. The preliminary tea leaves suggest that the current quarter
will show a further gain in real GDP, probably faster than the quarter
before.
So with maybe only one down quarter, was it worth calling this a
recession? Perhaps more to the point: Is that really the right question
to ask? I think the answer is No, and focusing on that questions leads
to unnecessary confusion. There are some good reasons to fear that the
current upswing will be weak, at least for a while. Corporate profits
and business fixed investment are still falling. Unemployment will
continue to rise for a while. Much of the strength in the fourth
quarter came from consumption spending, but more than half of that was
on automobiles, and thus very likely borrowed from later quarters,
enticed by temporary incentives. Europe and Japan have been stagnant or
worse, and do not seem to be turning around as rapidly as the United
States. They will not be good markets for American producers; on the
contrary, they will be trying very hard to sell in the United States.
All in all, I was going to conclude that only God knows how the next
few quarters will turn out; but it may be that God has not yet decided.
In this kind of environment, it is hard to know what to do now. The
Federal Reserve doesn't know any better than you or we do. The
fundamental difference is that the Fed can act quickly and then, if it
soon changes its mind, it can reverse itself quickly. It would be
helpful if fiscal policy could be mobilized in tandem with monetary
policy, but you can not reverse yourself.
This lack of maneuverability in fiscal policy explains why the so-
called ``automatic stabilizers'' are so valuable; they do adapt to
events, without requiring you, or anyone, to take action. But they have
been allowed to get weaker, for various special reasons. They are not
likely to be revitalized. Maybe it would be useful if you could enact a
``standard stimulus package'' (which, worked in the other direction,
could serve as a standard cooling-off package). It could be triggered
automatically by events--at one of several levels-- or even proposed by
the President, and subject to a straight up-or-down vote. I realize
that no such thing is likely to happen; maybe you have a better idea.
There should be a more appropriate basis for making stabilization
decisions than wondering if there is or is not a recession, and when it
will end. In fact, I think it would still be a good idea to pass a
stimulus package in spite of the current lack of clarity about which
way the economy is headed. I will explain why, briefly, because that
may help untangle fiscal policy from the inevitable uncertainties of
forecasting that Congress is too ponderous to deal with, unlike the
Fed.
Real GDP in the fourth quarter of 2001 was only about 1 percent
higher than it was in the second quarter of 2000 when the clearly
visible slowdown began. Two years ago the unemployment rate was about 4
percent, compared with 5.8 percent now. Capacity utilization in
industry was then measured at 83 - 84 percent, compared with 74 -75
percent now. Suppose that early 2000 was a desirable state of the
national economy. (Some thought it was a little too prosperous for
peace of mind about inflation; but that requires only a small change in
what I am about to say.)
We have to presume that the economy's aggregative productive
potential has been increasing fairly smoothly since then, because that
is how it usually behaves. The Council of Economic Advisers estimates
that the rate of increase of productive potential is a hair over 3
percent a year. In that case, full utilization of our economy's
potential this spring would entail a real GDP about 6 percent higher
than current output. By this time next year, even if the economy grows
by 3 percent this year (which is slightly faster than the Council's
forecast in the Economic Report ), there will still be a 6 percent gap
of unused economic potential. The gap will be larger if the economy
grows more slowly, and smaller in the opposite case.
That gap cannot be safely closed in a single year. The Fed would
certainly fear that an upswing fast enough to do that is fast enough to
exceed the inflation-safe speed limit, and would choke it off. But it
would certainly be safe to grow fast enough to close some of that gap.
That is why I think there is still room for a modest stimulus package,
if you are capable of enacting a sensible one. By sensible I mean
effective, temporary, and free of partisan sacred cows. The House bill
started off as a ghastly mockery. And it has gotten better, just not
enough better to be acceptable. Accelerated depreciation is not the
best way to promote capital spending, and it fails the test of being
temporary.
I mention all this for a broader reason. All this talk about
whether there is or is not a recession, when did it begin and when will
it end, leads to confusion because nobody knows. Anyway, it
concentrates on the wrong thing. The CEA can make approximate
calculations of economic potential; in effect it already does so. The
Congressional Budget Office does something similar. Focusing on that
would force debate on the right issue, which is where we stand relative
to potential, and would provide a better guide to policy.
I should say that I am one of those who thinks the Economic Growth
and Tax Reduction Reconciliation Act of 2001 was a big mistake. Part of
the ``surplus'' it gave away has already evaporated, as we knew it
would as soon as the economy weakened. And we have converted the rest
mostly into future consumption instead of the future saving and
investment that the country urgently needs as it looks ahead to an
aging population. You should resist any suggestion that stimulus should
take the form of advancing the date at which an ill-advised decision
comes into effect.
Like most observers, I think that monetary policy has done very
well in coping with the past five quarters. Long-term interest rates
have not fallen very much. Nevertheless, if the Fed had behaved more
traditionally the housing sector would not have held up as well as it
has, the auto industry would have had a harder time providing those
successful incentives, and business investment might have fallen even
faster.
Some people complain that the Fed stuck with its contractionary
stance a bit too long in 2000. Maybe it did; hindsight is usually 20-
20. But perfection is the wrong benchmark against which to judge Alan
Greenspan and the Federal Open Market Committee. They are not
omniscient; I have already said that they are, like the rest of us,
uncertain about what will happen next month. What distinguishes the Fed
is the flexibility with which it handled the boom of the late 1990's.
If you want to see how well they have performed, take a look at the
record of the much more doctrinaire central banks of Japan, the U.K.,
and Europe.
What we have a right to hope for is that the Fed will exercise the
same kind of informed flexibility in the course of the coming upswing,
whatever shape it takes. If the recovery is indeed anemic, then the gap
between current and potential output, which is already ample, will be
widening; there will be no need to move short-term interest rates
higher. Anecdote is piling up that lenders are being extra-cautious, as
a reaction to the Enron swindle. Suspicion falls especially on smaller,
less well-known companies without much of a track record, and they find
it hard to get
credit. Other things equal, this state of affairs should incline the
Fed toward maintaining liquidity and credit ease. (It is this kind of
circumstance that makes me suspicious of even a reasonable formula like
the so-called Taylor rule: Why should the central bank ignore this kind
of market fact?) But if the economy picks up enough speed, the margin
of slack will narrow. In that case, we have to expect the Fed to begin
positioning itself for the inevitable palaver about soft and hard
landings, and interest rates will rise pretty quickly. Having a
flexible monetary policy means learning to live with a certain number
of tentative and even reversible steps. Right now I imagine wait-and-
see is the right attitude.
All of the above was written before I saw Alan Greenspan's
statement to this Committee last week. It contained no surprises,
unless you count his strengthened conviction that the third quarter of
last year would be the only down quarter. At this late date, I would
not count it as a surprise.
There is only one point I would like to call to your attention. Mr.
Greenspan agrees that the upswing now launched is likely to be
``subdued,'' and he gives the standard reasons for suspecting a slow
increase. He waffles a bit, but a little of waffle is justifiable. He
reports that the FOMC forecast is for real output to increase by 2.5 to
3 percent during the four quarters of 2002. That forecast is 6 weeks
old, and thus possibly already out of date. Anyway this pace is just a
bit slower than the estimate I quoted from the Economic Report that
potential output is growing at about 3.1 percent a year. The last
decimal place in such estimates is not to be taken as doctrine, of
course. The underlying point is that in this scheme of things, the gap
between actual and potential output will not narrow during the rest of
this year. That is what matters, not just whether the movement is up or
down. The
implication is that a somewhat faster path for the economy would be
desirable; a
slower path definitely would not.
----------
PREPARED STATEMENT OF JOSEPH E. STIGLITZ
Nobel Laureate in Economics, 2001
Professor of Economics and Finance, Columbia University
March 12, 2002
It is a pleasure to appear before you to provide my assessment of
the outlook for U.S. economic growth and employment and the appropriate
public policies to promote those objectives. I will divide my remarks
into seven sections. In the first, I will discuss the overall prospects
for the short and medium term. In the remaining sections, I shall
address specific policy concerns.
The Overall Prospects
While economists always look into the future with cloudy crystal
balls, they are particularly cloudy when it comes to forecasting
turning points. The question that is repeatedly asked is, is the
recession over? I think, however, that that is the wrong question.
There is little doubt that for the past year, the economy has been
performing substantially below its potential. The potential growth rate
of the economy clearly improved through the 1990's, and even if the
robust growth of the late 1990's could not be sustained, there is a
widespread consensus that the economy has a potential for growth of
between 3 to 4 percent. Taking the mid-point in that range of 3.5
percent, even a positive growth of .5 percent would represent a
shortfall of $300 billion in our 10 trillion economy--an enormous
wastage of resources, even if we were to ignore the tribulations
imposed on those forced into unemployment. Moreover, we should remember
that America's unemployment insurance program is one of the poorest in
the advanced industrial countries. It is unconscionable that benefits
be terminated after 26 weeks. The argument that providing extended
benefits would attenuate search incentives is nonsense: The problem is
a lack of jobs, not the lack of job seeking. I shall return to this
later.
While a great deal of pleasure is being taken in the fact that the
rate of job destruction has been reduced, our economy needs to create a
couple hundred thousand jobs a month to just break even, to ensure that
employment keeps pace with the growing labor force. It is not a mark of
success if the unemployment rate comes down because workers have become
discouraged from working, so the number of job seekers is reduced.
Broadly, there are three types of recessions--those associated with
inventory cycles, overinvestment in capital and housing, and financial
crises. The current downturn is a combination of the first two. Some of
the downturn was associated with a decrease in the stock of
inventories. There were reasons to believe that with the New Economy,
inventory cycles would be attenuated and become less important as a
source of economic volatility, as better control mechanisms kept
inventories better in control, as production methods (just in time
production) reduced the required size of inventories, and as the
overall size of manufacturing in the economy declined. As the economy
nears the end of the period of inventory retrenchment, this source of
negative drag on the growth of the economy will be eliminated. This, by
itself, would suffice to bring an end to the recession; but it will not
be enough to restore the economy to robust growth.
The overinvestment in certain key sectors of the economy has left
an overhang, which will take some time to redress fully. The good news
is that some of these areas are those in which technological advances
have been proceeding at a rapid pace, so that much of the old IT
equipment will become obsolete relatively quickly, before the equipment
wears out, and this will help restore demand for new IT.
There are a number of other negative forces which suggest that the
economy will continue to operate substantially below its potential, and
which represent a substantial risk for a strong recovery.
Consumer Spending
Robust consumer spending has sustained the economy. The U.S.
savings rate remains dismally low, which is not good for the long-run
prospects for growth. Part of the explanation for the sustained
spending is the mortgage refinancing which
resulted from the lowering of interest rates, part from the special
deals that automobile dealers were offering. Given that consumption has
not fallen in the way that it does in a typical downturn, it is
unlikely that an increase in consumption will provide a strong impetus
for growth in the short run. Moreover, there are several reasons to
believe that the forces which have sustained consumption could weaken.
(i) Mortgage rates may well rise; as it is, they have fallen far less
than the short-term interest rates have fallen, partly for reasons that
I will discuss later. (ii) Similarly, it is not obvious that the
special deals on automobiles will continue. (iii) The heavy
indebtedness of the consumer may impose an important dampener on
spending, one which will become especially important if interest rates
rise. As it is, by some estimates, consumers are spending 14 percent of
their income on debt service. (iv) If the unemployment rate is not soon
brought down significantly, fears of job security may increase, and
given the poor unemployment insurance system, workers may be induced to
save as a precautionary measure. (v) One of the primary reasons for the
low savings rate is that through the nineties, households saw their
wealth increase through capital gains, even without putting aside money
out of disposable income. But with stock prices down or increasing
slowly, it will gradually dawn on consumers that their wealth is less
than it once was, or than they thought. The switch to defined
contribution pension systems may exacerbate the resulting instability.
Today, individuals must bear the risk of stock market fluctuations.
Capital Spending
Long-term interest rates have not come down anywhere near as much
as short-term interest rates. One of the reasons for this may be the
increasing uncertainty about the country's long-term fiscal position,
caused in part by the large tax cut, where we seemed to be spending
money before we got it. In addition, there is continuing worry about
problems of valuation in the corporate sector. I served on the SEC
Commission on Valuation, which focused on the difficulties of valuation
in the new economy. While there was general recognition that old
accounting principles might be ill-suited for providing accurate
pictures of the economic prospects of firms, many on the Commission
believed that the market should be relied upon. Enron and Global
Crossing confirmed the suspicions of the skeptics, and today, many if
not most investors feel high levels of uncertainty about the numbers
that many corporations are reporting. This may dampen stock market
prices, at least for a while.
Exports
The strong dollar and the weak international situation suggests
prospects for
exports remain diminished.
Technology
A source of some concern is that the economic downturn has led many
firms to decrease significantly their investments in R&D. And
investments in long-term
research--the kind that is likely to result in productivity increases
down the line--has been particularly hard hit, in ways that are hard to
assess from the numbers alone. This is likely to be one of the
lingering costs of not having responded to the economic downturn
earlier, with stronger measures. (I do not include the House or
Administration so-called stimulus package among the stronger measures
that would have made a big difference.)
The one positive (from a macroeconomic perspective) is the
increased military
expenditure; but such expenditures detract from resources that could be
used to increase long-term productivity, and hence to not contribute to
the long-term strength of the U.S. economy.
It will be noted that I have not listed the tax cut as a major
positive factor. Its net impact on the economy is in fact ambiguous. It
was not designed to stimulate the economy, and its regressive features
and other elements of its design suggest that the bang for the buck is
likely to be quite low. On the other hand, the quickly diminishing
surplus (and, in some years, the emerging deficit) that resulted lead
to upward pressures on interest rates. The Fed only controls the short-
term interest rates. What firms care about far more is the longer-term
interest rates that they have to face, and the tax cut has changed the
yield structure adversely, and in ways which are quite dramatic: There
has been an almost 4 percent reduction in short-term interest rates,
with less than a 25 basis reduction in some long-term interest rates.
And while this weakens the prospects for a robust short-term recovery,
its implications for the longer term are even more bleak.
Tax Cut
This brings me naturally to the subject of the tax cut. The tax cut
was not only ill-designed for stimulating the economy in the short run;
it was also badly designed for promoting long-term economic growth. (I
put aside for the moment broader concerns about equity.) There are tax
reforms, for instance, that would have done far more to promote
investment in the short run with far lower budgetary costs, like the
net investment tax credit and better income averaging provisions. I
strongly side with those who believe that when one makes a mistake, one
should recognize it. It is not just the size of the tax cut that was a
mistake, but its design. Given the peculiar structure of the tax bill--
with provisions which expire in 10 years--it is inevitable that the
issues will have to be revisited. It is better that that be done sooner
rather than later.
Foreign Economic Policy
One of the sources of strength of the U.S. economy during the
1990's was increased exports to emerging markets. This was partly a
result of trade opening, partly a result of the robust economy in those
regions. Mismanagement of international economic policy by the IMF has
contributed significantly to a worsening of prospects. Much of Latin
America today faces stagnation, recession, or depression. As people in
these countries look at the performance of their economies over the so-
called reform decade, they see growth rates that are half those that
prevailed in the much criticized pre-reform period (the so-called
import substitution era), though, to be sure, better than during the
lost decade of the 1980's. There is a growing disillusionment with the
IMF, and with the United States, which is seen as responsible for its
policies. While there was consensus in the United States that in the
face of an economic downturn, there should be a fiscal stimulus--the
debate was only over how to design the most effective stimulus--the IMF
was seen as pushing for contractionary policies. The question is being
asked everywhere, why? The asymmetries associated with trade
liberalization of the past have increasingly come to be a source of
resentment, and recent actions in steel have only heightened a
perception of hypocrisy. The European initiative of unilaterally
eliminating trade barriers for the poorest countries (``Everything but
arms'') is one of the few positive developments, but the United States,
by failing to take corresponding actions, is increasingly losing
standing. Unless the United States does something, both to ensure that
the IMF pursues policies which are more in accord with the economic
well-being of the developing countries, and especially the poor in
those countries, and to ensure that there are movements toward a more
balanced trade agenda, it is hard to see a renewal of the kind of
growth in exports to these countries that has played such an important
role in our own country's growth in the future. (There are even more
important consequences for global economic and political stability.)
We won World War II, but we also won the Peace that followed. The
Marshall Plan was not only magnanimous, but it also won lasting allies
in the struggle for peace and democracy. We stand on the threshold of
winning the War against terrorism, but will we win the Peace? Though
the link between terrorism and poverty is complicated, this much is
clear: Unemployment and poverty, especially among young males, provide
fertile feeding grounds. The United States has neither provided aid nor
trade; among the major more advanced developed countries, it is the
stingiest in providing assistance to the less developed. The contention
that aid does not work is simply wrong, and those who assert this must
neither have looked at the evidence nor gone into the field. I have
seen aid work: Small irrigation projects that double or triple the
incomes of desperately poor, education projects that have brought
literacy and meaning to those who otherwise would not have had it,
health projects eradicate river blindness and other diseases that have
plagued some of the poorest countries of the world. Statistical studies
at the World Bank have shown that aid, when appropriately directly, has
significant effects in increasing growth and reducing poverty. To be
sure, not every dollar of aid is well spent, but the same thing could
be said for any other category of expenditures, whether in the public
or the private sector. The Monterey meeting in Mexico on finance for
development is an occasion on which we could make a commitment both to
increased assistance and to explore innovative ways of helping the
developing countries more. It is our moral duty; it is also in our
self-interest.
The continuing large trade deficit of the United States represents
a potential source of instability, not only for the United States, but
also for the world. If an objective outsider were to conduct the kind
of review of the U.S. economy that is regularly conducted for other
countries around the world, the grades would be mixed: The abysmally
low savings rate, the high trade deficit, the worsening fiscal
situation. The problems are all related, and the prospects are that
some could even get worse in the short run. The reason that we have a
large trade deficit, as I noted, in part is due to the strong dollar.
As in the early 1980's, a large tax cut has led to a massive worsening
of the fiscal situation. The trade deficit is simply the difference
between what we invest and what we save. National savings (including
public savings) has gone down from what it otherwise would have been.
The trade deficit would have been even worse, were it not that
investment too has gone down. But when our economy recovers, investment
will increase, and with it there is a good chance that the trade
deficit will worsen. We should be clear: It is not protectionist
policies abroad or unfair trade practices that have caused our
problems, whether they get reflected in the steel industry, the
automobile industry, or elsewhere; it is our overall macroeconomic
framework I suspect the full adverse affects of the tax cut are yet to
be felt.
Addressing the Sources of Our Current Problem
If we are to formulate policies aimed at enhancing the strength of
the economy in the middle to long run, we must understand better the
sources of our current downturn, of the massive underperformance of the
U.S. economy. While every boom comes to an end, there are lessons to
each. Earlier booms and the busts that followed taught us the dangers
of inflation, and of the Fed stepping too hard on the brakes to stop
inflation. We have learned the dangers of excessive inflation; and
inflation was not the cause of the current downturn. The recession of
1991 can
ultimately be traced back to weaknesses in the financial sector, those
in turn in part to the excessive deregulation of the 1980's. I am not
sure that we have learned those lessons, or the lessons of the
excessive exuberance of the late 1990's.
In some ways, it is a familiar pattern: Deregulation in a sector
(here telecommunications) leading to excessive investment in that
sector--in this case the problems exacerbated by breathtaking
technological developments and deregulation in the financial sector.
The Glass-Steagall Act was concerned with the problems raised by
conflicts of interest. It was foolhardy to think that such behavior
would not reappear with its repeal.
At the time I served on the Council of Economic Advisers, we raised
strong concerns about conflicts of interest and problems in accounting
standards and practices, particularly as they related to derivatives
and options. Our concerns have proved to be on the mark. There were
others who raised similar concerns. Arthur Levitt, of course, was right
in calling attention to the conflicts of interest in the accounting
firms, when they simultaneously provide consulting services. FASB
called for a changing of accounting practices to more accurately
reflect the costs of options given to executives. And I strongly
agreed. The Secretary of the Treasury and the Secretary of Commerce,
however, violated basic principles of good governance, which call for
the independence of FASB, and intervened to squash the proposed
revisions. They succeeded.
I have devoted much of my academic life to the economics of
information, and to the consequences of imperfections of information.
The proposed revisions would have improved the quality of information.
To be sure, some firms' economic prospects might have looked worse as a
result, and its stock market price might have fallen as a result--as
well it should. It was inevitable that a day of reckoning would come.
Providing misleading information only delayed the day of reckoning, but
worse, it led to a misallocation of resources, as overinflated stock
prices led to the excessive investment which is at the root of the
economic downturn.
Some contend that it is difficult to obtain an accurate measure of
the value of the options. But this much is clear: Zero, the implicit
value assigned under current arrangements, is clearly wrong. And
leaving it to footnotes, to be sorted out by investors, is not an
adequate response, as the Enron case has brought home so clearly. At
the Council of Economic Advisers, we devised a formula that represented
a far more accurate lower bound estimate of the value of the options
than zero. Moreover, many firms use formulae for their own purposes, in
valuing stock options (charging them against particular divisions of
the firm). However, Treasury, in its opposition to the FASB concerns,
was singularly uninterested in these alternatives. I leave it to others
to hypothesize why that might have been the case.
If we are to have a stock market in which investors are to have
confidence, if we are to have stock markets which avoids the kind of
massive misallocation of
resources that result when information provided does not accurately
report the true condition of firms, we must have accounting and
regulatory frameworks that address these issues. As derivatives and
other techniques of financial engineering become more common, these
problems too will become more pervasive. While headlines and
journalistic accounts describe some of the inequities--those who have
seen their pensions disappear as corporate executives have stashed away
millions for themselves--what is also at stake is the long run well-
being of our economy. The problems of Enron and Global Crossing are
part and parcel of the current downturn.
Energy Policy
There is a widespread agreement among economists that GDP does not
provide a good measure of economic well-being. We should, at the very
least, take account of the degradation of the environment and natural
resources. Bad information systems can lead to bad decisionmaking (as
we have seen recently in the corporate world.) Nowhere is this more
true than in energy policy. Extraction of oil and natural gases may
increase our measured GDP, but it does not increase our economic well-
being commensurately. We should take account of the depletion of our
resource basis, and the degradation of our environment as a result of
carbon emissions. An energy policy which focuses on ``drain America
first'' is not even good for long-run national security, for it leaves
us potentially more vulnerable in the future. Long run economic growth
(correctly measured) and long-run political strength both suggest that
we should focus more on conservation. And basic principles of economics
suggest that what is required is incentives, carrots and sticks. Why
should we think that moral suasion would be more effective in this
arena than it is in any other area of economic activity?
Social Security
I want to conclude with a few remarks about one of our long-term
problems, our Social Security program. Our Social Security program has
been an enormous success. We have brought the elderly out of poverty,
and we have provided a new measure of economic security to the aged.
Transactions costs are low. Improvements in the design of the program
over the years have reduced some of the unintended inequities, reduced
any adverse effects it might have on labor supply, and increased
overall efficiency. There is still a way to go to put it on sound
financial grounds.
Economics is traditionally described as the science of choice. The
legacy of the Clinton years, a huge fiscal surplus, provided us with an
opportunity to make some choices. We could have used some of these
funds to put the Social Security system on sound financial grounds. We
could have fully funded the system, and we could have then decided on
how to proceed in the future. We have largely squandered that
opportunity. Proposals for partial privatization typically leave the
fiscal situation of our Social Security worse off. They do not provide
additional funds to fill in the
gap; some proposals simple force current and future beneficiaries to
take a cut in
benefits. Any reform proposal which does not begin by addressing the
question of how current unfunded liabilities are to be financed is
irresponsible, and should be a nonstarter.
Elsewhere, with Peter Orszag, I have described at greater length 10
myths concerning Social Security that have been widely circulated. One
that has recently received considerable attention is the low return on
Social Security accounts. We should be clear: Social Security funds are
invested well, but conservatively. To the extent that capital markets
work efficiently, then any higher returns that might be received would
simply reflect the higher risk. It is imprudent for those approaching
retirement to invest all, or even most, of their assets in high-risk
investments. If there were a decision to undertake greater risk, the
public Social Security system could do so, again at low transaction
costs. (The transaction costs in the privatized part of the British
system have been estimated to reduce benefits by 40 percent from what
they otherwise would have been!)
Part of the reason that in partial pay-as-you go Social Security
systems, it appears that returns are low is that some of the returns
are used to bear the costs of the unfunded liabilities. The problem of
funding those unfunded liabilities does not go away with partial or
complete privatization. It will have to be borne elsewhere. To assess
the merits of any reform proposal, therefore, one must know how, and
who, will bear these costs. To do otherwise is dishonest. It may put in
jeopardy the long-run prospects of our economy, for a day of reckoning
will come.
Concluding Remarks
I continue to believe that the basic fundamentals of the U.S.
economy remain strong. But I have seen the fortunes of countries change
quickly, as a result of economic mismanagement. The decisions, the
choices, we make today will affect not only economic performance during
the next year, but also our long-run prospects. I believe that the tax
cut that was enacted last spring was based on a serious miscalculation
of our economic situation. It is a decision which, however, is
reversible. If we do not revisit the issue, in the light of the new
information which has come to light and the new situation which has
evolved, the damage which could be done may itself be irreversible--or
at least it will take a long time to undo. It will take political
courage. Much is at stake.
PREPARED STATEMENT OF ALAN B. KRUEGER
Bendheim Professorship in Economics and Public Affairs
Professor of Economics, Princeton University
March 12, 2002
Good morning, Mr. Chairman and distinguished Members of the Senate
Banking, Housing, and Urban Affairs Committee. My name is Alan Krueger
and I hold the Bendheim Professorship in Economics and Public Affairs
at Princeton University. I appreciate the opportunity to share my views
on recent economic developments, particularly as they relate to the
labor market.
The Labor Market Situation and Short-Term Outlook
Although some debate the exact meaning of the subjective definition
commonly used to define a recession, there is little doubt that the
labor market started to turn down in the beginning of 2001, and that
March 2001--the official beginning of the recession according to the
National Bureau of Economic Research--marked a turning point. After
reaching a 30 year low of 3.9 percent in April 2000, the unemployment
rate fluctuated in a narrow range between 3.9 and 4.1 percent for the
remainder of 2000, amid signs that economic growth was weakening.\1\
The unemployment rate increased from 4.3 percent in March 2001 to 4.9
percent in August 2001, and reached a recent peak of 5.8 percent in
December 2001. The rate fell to 5.6 percent in January and fell again
in February to 5.5 percent.
---------------------------------------------------------------------------
\1\ All reported estimates are seasonally adjusted, unless stated
otherwise.
---------------------------------------------------------------------------
Because, other things being equal, the unemployment rate increases
when the
discouraged workers decide to actively search for work, economists
often prefer to
examine employment growth from the establishment survey, and the
employment-to-population rate from the household survey, in addition to
the unemployment rate. These data tell a similar story. The employment-
to-population rate reached an all-time high of 64.8 percent in April
2000, stood at 64.3 percent in March 2001, and fell to 63.4 percent as
of August 2001. The employment rate continued to fall to 62.6 percent
in January 2002, and increased to 63.0 percent in the latest employment
report, which pertains to February 2002. Unlike the unemployment rate,
the employment rate fell in January 2002, suggesting that the
improvement in the un-
employment rate that month resulted from labor force withdrawal rather
than an
increased rate of job finding. In February, the small decline in the
unemployment rate and the rise in the employment rate both pointed in
the same direction.
Total payroll employment peaked at 132.7 million jobs in March
2001, and was down to 132.4 million in August 2001. It fell to 131.2
million in January 2002, and increased by 66,000 in February, an amount
that is close to the average monthly absolute revision to the series.
(The January and February figures are preliminary and subject to future
revisions.) In the 11 months since March 2001, the month the recession
began, total employment has fallen by 1.4 million jobs. Private sector
employment is down by 1.8 million jobs in this period. By comparison,
11 months after the 1991 recession began, private sector employment was
down 1.5 million jobs, and total employment was also down 1.5 million
jobs. So, looking over a comparable
interval, job destruction was somewhat greater in the private sector in
the latest
recession than in the previous one. Employment continued to drift
downward after the recovery began in March 1991, and reached bottom in
February 1992, with private sector employment down a total of 1.8
million jobs from the peak and total employment down 1.6 million from
the peak.
The latest GDP news suggests that the economy began to turn around
late in 2001 and that the recession likely has ended. I think it will
take more months of data before one can reach the conclusion that the
labor market has reached bottom and is on the upswing, however. I also
suspect that employment growth will remain sluggish for a time to come,
especially for the less skilled. Employment and unemployment tend to be
lagging indicators when the economy begins to improve. This point was
made by Alan Greenspan in his prepared testimony before the House
Committee on Financial Services on February 27. ``Even if the economy
is on the road to recovery,'' he said, ``the unemployment rate, in
typical cyclical fashion, may resume its increase for a time.''
Historically, the lingering effects of high unemployment in the
first stages of a recovery tend to be concentrated among the less
skilled and minorities. This seems to be the case despite the fact that
recessions are becoming more egalitarian in terms of who they affect.
Such a pattern was clearly evident in the early 1990's. When the
recession officially ended in March 1991, the unemployment rate was 6.8
percent. The rate continued to rise for another 15 months, however, and
did not settle below 6.8 percent again until the end of 1993. Moreover,
the unemployment rate rose from 12.3 to 13.5 percent for high school
dropouts in the year after the recession ended, while for college
graduates it held steady at 2.9 percent. The ``jobless recovery''
mainly involved the less skilled.
The current recession started out in a very unusual fashion. As the
following table makes clear, from March to July of 2001, unemployment
rose more for college graduates and those with some college education
than it did for high school dropouts. Since July, however, unemployment
has increased more for high school dropouts and high school graduates
than for more highly educated workers, as is the usual pattern in a
downturn. It is also worth noting that the unemployment rate ticked up
for those with a high school degree or less last month, despite falling
overall.
Table 1: Seasonally Adjusted Unemployment Rate by Education
Age 25 and Older
----------------------------------------------------------------------------------------------------------------
Education March 2001 July 2001 February 2002
----------------------------------------------------------------------------------------------------------------
Less than High School........................................... 6.8 percent 6.8 percent 8.3 percent
High School..................................................... 3.8 percent 4.1 percent 5.3 percent
Some College.................................................... 2.7 percent 3.1 percent 4.1 percent
BA or higher.................................................... 1.9 percent 2.2 percent 2.9 percent
----------------------------------------------------------------------------------------------------------------
Source: Bureau of Labor Statistics.
A similar picture holds by race. From March to July of 2001 the
unemployment rate increased from 3.7 to 4.1 percent for whites, and,
uncharacteristically, fell from 8.4 to 8.1 percent for blacks. From
July 2001 to February 2002, however, the rate increased from 8.1 to 9.6
percent for blacks, and increased more moderately, from 4.1 to 4.9
percent, for whites. The unemployment rate for Hispanics was also
uncharacteristically stable in the beginning of the recession (standing
at 6.2 percent in March and July), and then increased sharply to 8.1
percent by January 2002, before quixotically falling by a percentage
point in February.
The broad nature of the first phase of the latest recession came as
a surprise, but is consistent with the more-than-usual egalitarian tilt
to the early 1990's recession, and probably resulted from the plunge in
capital investment that apparently precipitated the downturn, the
implosion of many dot-coms, and the fact that the cyclically sensitive
manufacturing sector is much more skill intensive than it was 20 or 30
years ago. In any event, it is likely that the egalitarian phase is
over.
There are many theoretical reasons to suspect that job growth would
be slow at the beginning of the recovery.
First, at the beginning of a recovery employers are not sure if
improved conditions will persist, so they expand work hours rather than
hire new employees.
Second, many employers also ``hoard'' skilled workers (for example,
particularly those with specific training) during a recession because
if they let them go it would be costly to hire and train replacements
when conditions improve. Neither of these reasons, however, accounts
for why job growth is particularly sluggish for the less skilled when
the economy begins to turnaround, which seems to regularly occur. In
fact, because of labor hoarding of skilled workers one might expect
that employers are relatively ``overstaffed'' with skilled workers when
the recession ends, and would therefore be less likely to hire skilled
workers.
Third, as Melvin Reder suggested in a 1955 article, in a downturn
many employers raise skill requirements for a given job, rather than
cut pay.\2\ ``Upskilling'' of positions is common in a recession and
probably at the beginning of a recovery as well. Consequently, the less
skilled find their job options even more limited until demand picks up
smartly, while skilled workers take positions further down the job
ladder.
---------------------------------------------------------------------------
\2\ See Melvin W. Reder, ``A Theory of Occupational Wage
Differentials,'' American Economic Review 45(5), 1955, pp. 833-52.
---------------------------------------------------------------------------
Finally, Lawrence Katz of Harvard suggests another reason: ``Think
of a recession as a time when firms reorganize.'' Reorganization tends
to increase demand for skilled workers, who are more flexible, over
less skilled workers. Furthermore, when companies introduce new
technology as part of a reorganization they tend to hire skilled
workers to operate the equipment and release unskilled workers whose
jobs are made redundant.
To some extent, the lingering pattern of unemployment, especially
among the less skilled, after growth resumes is probably inadvertently
reinforced by interest rate cuts by the Federal Reserve. With a lag,
rate cuts stimulate demand for new capital and consumer durables. But
this is a two-edge sword for workers. On the one hand, a general rise
in economic activity increases the demand for all factors of
production, including workers. On the other hand, because machinery is
cheaper than it used to be, in many industries companies replace some
workers with machines, or hire fewer workers than they otherwise would
have, because the machines can do the work at lower cost.
Also notice that capital--especially high-tech equipment--and
skilled labor are generally considered complementary inputs in
production, while capital and unskilled workers are substitutes.\3\ In
other words, high skilled workers are hired to operate and service the
new machines, while less skilled workers are let go because the
machines can do their work.
---------------------------------------------------------------------------
\3\ For a survey of evidence on capital-skill complementarity, see
Daniel Hamermesh, Labor
Demand, Princeton University Press, 1996. For evidence on high-tech
equipment and skill up-
grading see David Autor, Lawrence Katz, and Alan Krueger, ``Computing
Inequality: Have
Computers Changed the Labor Market?'' Quarterly Journal of Economics,
113(4), November 1998, pages 1169 -1213.
---------------------------------------------------------------------------
This leads me to the conclusion that the best way to avoid another
``jobless recovery'' is by stimulating demand for less skilled workers
and by raising the skills of the unemployed. I think the interest rate
cuts and the recently passed accelerated depreciation allowance will
stimulate demand for more highly skilled workers. In looking forward, I
would recommend policies that would increase employment of less skilled
labor, such as job training.
Another important aspect of the labor market concerns wages. Table
2 (at the end of this testimony) reports real hourly wages by decile of
the wage distribution each year since 1973 based on Current Population
Survey Data.\4\ As is well-known, real wages fell considerably for
lower paid workers from 1979 to the mid-1990's. (This table uses the
BLS's new research series CPI to deflate wages, so the decline in real
wages in the 1980's was not as great as it is with the conventional CPI
deflator.) Real wage growth was very strong after 1996, however.
Notably, most of the ground that was lost for those at the bottom in
the 1979-95 period was regained in the last 5 years. The weakest wage
growth in the last decade was for those in the middle of the
distribution, a phenomenon that I previously called ``the sagging
middle.''
---------------------------------------------------------------------------
\4\ These data were kindly provided by Jared Bernstein.
---------------------------------------------------------------------------
Most research finds that real wages have moved slightly
procyclically since 1970, although I agree with Katharine Abraham and
John Haltiwanger that ``the cyclicality of real wages is not likely to
be stable over time.'' \5\ The exceptionally low unemployment in the
late 1990's, combined with two minimum wage increases, spurred the
impressive wage growth in the second half of the 1990's, especially for
the least paid workers.\6\ In the latest downturn, nominal wage growth
slowed down, but inflation slowed even more, so real wages continued to
grow.\7\ This factor has probably bolstered consumer spending, which
was surprisingly robust during the downturn.
---------------------------------------------------------------------------
\5\ Abraham, Katherine and John Haltiwanger. 1995. ``Real Wages and
the Business Cycle.'' Journal of Economic Literature 33, no. 3, pp.
1215-64.
\6\ See, e.g., Lawrence Katz and Alan Krueger, ``The High-Pressure
U.S. Labor Market of the 1990's,'' Brookings Papers on Economic
Activity. 1999:1, pp. 1-87.
\7\ See Jared Bernstein, ``What Drove Low Wages Up in the 1990's?''
Mimeo., Economic Policy Institute, 2002.
---------------------------------------------------------------------------
A rising tide continues to lift all boats, and the late 1990's
provides ample evidence that strong economic growth greatly helps all
segments of society. But the
effect of a rising tide on employment does not appear to occur
immediately. In the early 1990's, weak employment growth lingered long
after the national economic tide began to rise. Moreover, research
suggests that a given change in economic conditions has a more gradual
effect on labor demand in a recovery than in a recession.\8\ As Edward
F. McKelvey, a Senior Economist at Goldman Sachs observed after the
latest unemployment report, ``It would be premature to say that there
is going to be heavy net hiring soon.''
---------------------------------------------------------------------------
\8\ See James R. Hines, Hilary Hoynes, and Alan B. Krueger.
``Another Look at Whether a Rising Tide Lifts All Boats,'' The Roaring
Nineties: Can Full Employment Be Sustained, edited by Alan B. Krueger
and Robert Solow, New York: Russell Sage and Century Fund, 2001.
---------------------------------------------------------------------------
Unemployment Insurance
Because I expect unemployment to linger at relatively high levels
in the beginning of the recovery, I think it is important and
appropriate that last week both Houses of Congress passed, and the
President signed, a bill to extend unemployment insurance (UI) benefits
for an additional 13 weeks.
But I think recent history highlights the importance of making
additional reforms to make unemployment insurance a more efficient and
more effective automatic stabilizer. First, the automatic triggers that
temporarily turn on extended benefits without Congressional action
should be set at more realistic levels. The State triggers are
connected to the insured unemployment rate; that is, the fraction of
covered workers who receive benefits. The insured unemployment rate
must exceed 5 percent for extended benefits to be provided, and must be
120 percent above the rate in the corresponding period in each of the
prior 2 calendar years. Because insured unemployment has drifted down
relative to the BLS's total unemployment rate, and because the natural
rate of unemployment has declined, it is very unlikely that a State
will automatically trigger extended benefits. In practice, the
automatic triggers have become beyond reach, and we rely on Congress to
vote for extended benefits during a downturn.
It should not be necessary for Congress to have to agree to ad hoc
extended UI benefits when it is clear that the economy has deteriorated
in a specific region. Realistic automatic triggers would be much more
expedient and more efficient. Funds would be saved if extended benefits
were more closely targeted to specific States experiencing severe
economic distress, rather than applied nationwide. Furthermore, if
extended benefits turned on more quickly in contracting areas,
consumption would be smoothed and the downturn would be less severe.
Second, the financing of UI could do more to stabilize the economy
and discourage layoffs. To pay for benefits, the UI system builds up
reserves during prosperous times and draws them down during slack
times. A common measure of the health of trust funds is the reserve
ratio: The ratio of accumulated trust fund balances to annual payroll.
A higher reserve ratio provides more protection in an economic
downturn.
Unfortunately, the UI reserve fund in several States--most notably,
New York and Texas--were quite low even before September 11.\9\ Phillip
B. Levine, an economist at Wellesley College, calculates that to remain
solvent through a severe recession, like the one experienced in the
early 1980's, unemployment insurance funds would require a reserve
ratio of at least 1.25 percent.\10\ Using this standard, 16 States were
at risk of insolvency in a severe recession based on their reserve
funds as of the first quarter of 2001. In New York the reserve ratio
was 0.28 percent and in Texas it was 0.22 percent.
---------------------------------------------------------------------------
\9\ See Alan B. Krueger, Economic Scene; ``Now is the time to
reform unemployment insurance--before it is really needed.'' The New
York Times, January 4, 2001, p. B2.
\10\ Phillip B. Levine, ``Cyclical Welfare Costs in the Post-Reform
Era: Will There Be Enough Money?'' Mimeo., Wellesley College, December
28, 2000.
---------------------------------------------------------------------------
This predicament arose because many States did not build up their
funds during the 1990's, and because experience rating--that is, the
extent to which a business's payments increase with its past record of
laying off workers--is poorly implemented. If the funds become
insolvent, they will borrow from the Federal Government at close to
market rates, and probably tighten eligibility standards to stem the
shortfall. I would recommend considering that the States be required to
implement real experience rating and maintain ample fund balances
within 3 years (for example, after the economy improves sufficiently).
This would shore up the long-run financing of the State programs. In
addition, a study by Phillip B. Levine and David Card of U.C. Berkeley
estimates that the unemployment rate would decline by six-tenths of a
percentage point if industries were fully experience rated--that is, if
employers in an industry were required to pay the full additional costs
of unemployment benefits for layoffs in that industry.\11\
---------------------------------------------------------------------------
\11\ David Card and Phillip B. Levine, ``Unemployment Insurance
Taxes and the Cyclical and Seasonal Properties of Unemployment,''
Journal of Public Economics, vol. 53, February 1994.
---------------------------------------------------------------------------
The Federal Government sets minimum standards for State
unemployment insurance programs and has a history of encouraging
experience rating. This is a unique aspect of the American system of
UI, and may in part help to account for the
relatively low unemployment in the United States compared to other
economically
advanced countries. Better experience rating could be accomplished by
increasing the 5.4 percent maximum tax rate on high-layoff employers,
and by requiring the States to have at least 10 different rates. Some
States currently only have two rates: 0 or 5.4 percent. In addition, I
would recommend that the per employee taxable earnings cap--which range
from $7,000 to $10,000 in most States--be raised, which would allow
better experience rating at lower tax rates and make the financing of
the program less regressive. Raising the caps and lowering the rates
would also increase demand for less skilled workers. Improved
experience rating would discourage employers from laying off workers,
and help to internalize the externalities layoffs impose on society.
Third, unemployed workers who are otherwise eligible for UI but are
searching for a part-time job (that is, because of family obligations)
are ineligible for benefits in most States. These workers pay into the
system, but they are prevented from receiving benefits. States could be
required to expand eligibility. Workers who would be made eligible for
UI benefits as a result of this reform would be primarily single-
parent, female, and low-income workers.
I realize that Congress is likely to be reluctant to make
additional changes to UI having just voted to expand benefit payments,
but perhaps a commission could be established to study longer-term
issues in UI, including the automatic triggers,
financing, and eligibility requirements of the State programs.
Conclusion
Since the summer of 2001 the downturn has looked more like a
typical downturn, with the labor market softening more for the less
skilled and minorities than for highly educated, white workers.
Recessions typically last longer and are more severe for the less
skilled and minorities. Job growth early in a recovery is typically
weaker for these groups as well. My guess is that the typical pattern
will continue in the near future, but I have to confess a great deal of
uncertainty as the recession initially was unusual in terms of the
breadth of groups of workers affected. Additionally, the temporary help
sector is much larger than it was in the early 1990's, and it is
possible that employment adjustment over the business cycles will be
quicker because the option of hiring from temporary help firms enhances
labor market flexibility.\12\ If this is the case, employment growth on
the upswing may not lag economic growth as much as it has in the past.
Nevertheless, it is probably more likely than not that higher
unemployment will linger for less skilled and minority workers in the
beginning of the recovery--and such a process has already begun if the
recession ended in the fourth quarter of 2001.
---------------------------------------------------------------------------
\12\ See, e.g., Lawrence Katz and Alan Krueger, ``The High-Pressure
U.S. Labor Market of the 1990's. Brookings Papers on Economic Activity.
1999:1, pp.1-87.
---------------------------------------------------------------------------
To have a balanced recovery I would argue that policy has to be
balanced as well. Fiscal and monetary policies are in place to lower
the costs of capital and stimulate growth. Because of the phenomenon of
capital-skill complementarity, this will likely increase demand for
employment of skilled workers and reduce demand for employment of less
skilled workers in the future. Policies are also in place (that is,
extended UI benefits) to maintain consumption. To the extent that
further policy initiatives are sought to stimulate job growth, I would
expect that policies geared to stimulate demand for hiring less skilled
workers would be most effective. Such policies could include job
training, the Targeted Jobs Tax Credit, and a temporary reduction of
payroll taxes. But I think it is also important to recognize that there
will be pressures on the Federal budget as the baby boom cohort retires
because of Medicare and Social Security commitments, so policies to
address short-run cyclical adjustments should be careful not to weaken
the long-run budget outlook.
Table 2: Real Hourly Wages by Decile of the Wage Distribution
(2000 Dollars)--DECILE:
----------------------------------------------------------------------------------------------------------------
Year 1 2 3 4 5 6 7 8 9
----------------------------------------------------------------------------------------------------------------
1973........................... $6.03 $7.28 $8.65 $10.06 $11.53 $13.23 $15.36 $17.57 $22.07
1974........................... 5.96 7.15 8.49 9.83 11.26 12.96 15.02 17.31 21.84
1975........................... 5.80 7.09 8.38 9.72 11.27 13.13 14.86 17.31 21.86
1976........................... 6.25 7.26 8.44 9.76 11.34 13.20 15.13 17.59 22.11
1977........................... 6.18 7.16 8.36 9.72 11.40 13.09 15.19 17.95 22.02
1978........................... 6.27 7.40 8.62 10.05 11.77 13.50 15.59 18.42 23.09
1979........................... 6.55 7.47 8.77 10.32 11.68 13.53 16.00 18.65 22.90
1980........................... 6.19 7.32 8.59 9.97 11.55 13.43 15.59 18.47 22.62
1981........................... 6.29 7.17 8.54 9.76 11.26 13.31 15.52 18.30 22.66
1982........................... 6.06 7.06 8.44 9.82 11.44 13.35 15.72 18.52 22.93
1983........................... 5.87 6.93 8.27 9.69 11.38 13.27 15.89 18.41 23.29
1984........................... 5.74 6.97 8.22 9.67 11.45 13.31 15.78 18.78 23.64
1985........................... 5.65 7.04 8.28 9.70 11.56 13.47 15.69 18.92 23.44
1986........................... 5.64 7.21 8.52 10.05 11.78 13.83 16.19 19.13 24.17
1987........................... 5.62 7.15 8.55 10.12 11.78 14.01 16.13 19.17 24.62
1988........................... 5.63 7.10 8.50 10.12 11.71 13.92 16.22 19.35 24.81
1989........................... 5.62 6.99 8.38 10.02 11.64 13.60 16.18 19.35 24.44
1990........................... 5.70 7.06 8.47 9.98 11.63 13.48 15.99 19.24 24.55
1991........................... 5.81 7.12 8.49 9.93 11.69 13.52 15.92 19.11 24.69
1992........................... 5.79 7.05 8.43 9.85 11.78 13.45 15.93 19.24 24.33
1993........................... 5.76 7.03 8.42 9.89 11.68 13.67 16.09 19.41 24.70
1994........................... 5.70 6.96 8.27 9.70 11.47 13.51 16.05 19.54 25.12
1995........................... 5.68 6.95 8.30 9.77 11.37 13.46 16.04 19.42 25.09
1996........................... 5.65 7.00 8.38 9.78 11.31 13.36 16.09 19.45 25.16
1997........................... 5.84 7.21 8.50 9.90 11.58 13.58 16.14 19.66 25.57
1998........................... 6.16 7.44 8.71 10.36 11.91 14.00 16.65 20.07 26.31
1999........................... 6.25 7.60 9.01 10.44 12.27 14.40 17.01 20.60 26.92
2000........................... 6.31 7.77 9.08 10.51 12.26 14.51 17.19 20.91 27.50
2001........................... 6.51 7.85 9.36 10.73 12.52 14.65 17.46 21.14 28.25
----------------------------------------------------------------------------------------------------------------
Source: Economic Policy Institute analysis of CPS data.
Note: Hourly wages were deflated by the BLS Research Series CPI deflator.