A Dark Scenario for the U.S. Economy

As readers of this column can’t help but notice, I have been reasonably optimistic about the outlook for the U.S. economy, so optimistic that I may have deprived our readers of the economist’s ever-present “other hand.” Here it is.

The economy may well be on the road to the 4.75 percent annual growth rate that Treasury Secretary John Snow sees in his crystal ball, and that might well achieve the purpose of all economic policy these days—getting George W. Bush a four-year extension on his White House lease. But we may be buying short-term gain at the expense of long-term pain.

Start with Bush’s all-time favorite—tax cuts. Recent upward revisions of the estimated budget deficit put it at over 4 percent of GDP. If experience teaches anything, further upward revisions are in our near-term future. But not all of the swing from surplus to deficit can be blamed on the reductions in taxes. Part is due to increased spending on domestic programs and the War on Terrorism, a portion is due to the decline in revenues as high-earners saw their bonuses and capital gains shrivel; about one-quarter can be laid at the door of the tax cuts.

But in that explanation lurks a problem for the economy: these sources of red ink will continue to operate long after the economy has recovered. The tax cuts are too politically popular, and too much a part of the president’s conservative philosophy, to be reversed in the foreseeable future. Expenditures associated with the implementation of the administration’s muscular foreign policy are more likely to rise than fall, as the stay in Iraq becomes prolonged, nation-building in Afghanistan proves more costly than originally thought, and pressures mount for interventions in Liberia and other places in which the United States has no strategic interest.

Add to that Bush’s big-spending proclivities. The president’s advisors insist that he must go to the electorate, especially the many retirees living in the key state of Florida, with a prescription-drug program. So he has signed on to the largest expansion in the welfare state since Medicare. No one can predict the precise cost of this expensive new entitlement, which will have the government paying for the drugs of all Americans, from Bill Gates and Warren Buffett to the poorest pensioner. But it is “damn the cost and full speed ahead” toward the November 2004 elections.

That adds up to deficits as far ahead as the eye can see. Administration spokesmen argue that when the economy starts to grow, the revenues flowing into the Treasury will wipe out the deficit. At best, that represents the triumph of hope over experience; at worst, the triumph of dissimulation over truth. More rapid growth will, of course, generate more tax revenues—but not enough to offset the combined effects of rising defense and welfare costs, and reduced tax rates.

Enter the staff of the Federal Reserve Board—on tiptoe, so as not to antagonize the president’s men or upset the markets too much. In an important but not loudly trumpeted study, the Fed staff found that every one percentage point increase in the deficit will drive long-term interest rates up by one quarter of a point. I have very good reason to believe that Fed chairman Alan Greenspan has reviewed the study in detail and is satisfied with its soundness.

Since we will have shifted from a 1 percent surplus to something like a 5 percent deficit, a six-point shift, we will be seeing interest rates some 1.5 points higher than they would otherwise be. That will surely slow the economy in the long run.

Worse still is the fact that this recovery is taking place in unusual circumstances. Most recessions correct the imbalances that caused them: excess capacity is sweated out, asset prices decline to more realistic levels, and balance sheets are restored to some semblance of health.

Not so the recession that the National Bureau of Economic Research now tells us ended almost a year ago. Worldwide excess capacity still exists. Balance sheets are not as solid as they might be, as serially lower interest rates have encouraged consumers to borrow against the equity in their homes and businessmen to tap the credit markets. Share prices, especially in the high-tech sector, remain at levels that many observers still consider alarmingly inflated. The trade deficit, which in ordinary recessions would decline as consumers rein in purchases of cars and other imports, instead has soared to 5 percent of GDP.

All of this is sustainable so long as interest rates remain low. But should foreigners decide to unload the hoard of dollars that they are accumulating as we ship them bits of green paper in return for cars, trainers, T-shirts and, increasingly, software, interest rates will have to rise. That would end refinancing of homes, a trend already discernible as interest rates climb. Gone, too, would be zero-interest incentives to buy cars. Higher rates would increase the claim of interest payments on corporate cash flows, and make new investments by businesses more expensive. And they would increase the cost of servicing the mounting pile of government IOUs.

Not a pretty picture. Fortunately, not certain to be the case. It may well be that consumer-led growth will be replaced by the investment-led variety, as businessmen recover their nerve. That would allow the economy to grow while consumers take a holiday from the shops, and pay down their debt. Meanwhile, the lower dollar might just encourage exports and discourage imports, lowering the trade deficit to sustainable levels.

In short, all may come right in the end. My own guess is that it will—America’s risk-taking, entrepreneurial, free-market economy has too much flexibility, too much energy not to be assured a brilliant future.

This article appeared in London’s Sunday Times on July 27, 2003.