THE FISCAL QUICK-FIX CANNOT CURE US
The U.S. economy is in a lot worse shape than anyone thought it would be a few months ago. It's now clear that we are not merely dealing with a cyclical downturn. The world economy, and the U.S. economy with it, is in the throes of major structural realignment. The end of the cold war has already caused tremendous dislocations. At the same time, the globalization of the economy is triggering changes that will be with us for years as the U.S. wrestles with the problem of competing against low-cost rivals.
Parallel to those global trends are structural problems in the U.S. that are going to take a long time to run down. They are the consequences of the 1980s' debt spree: real estate overbuilding, the S&L debacle, and the huge run-up of debt in society--by government, corporations, and consumers.
The question now is whether the U.S. should use fiscal stimulus to get the economy moving again. That could be achieved either by cutting taxes or by raising spending. We have long favored specific tax cuts to stimulate investment, such as R&D tax credits, reinstitution of investment tax credits on new plant and machinery, indexed capital gains, and the elimination of double taxation on dividends. But such cuts would take a long time to work. Thus, some economists insist that we need to increase government spending now and to target the money for projects that boost productivity and investment--even if that adds to the deficit in the short run.
That's the core of the debate now raging between the proponents of fiscal stimulation and those who favor fiscal probity. This is a debate with no easy answers, because strong cases can be made for both points of view, as reflected in our own pages (pages 30 and 31).
The economy is growing, but at an anemic rate. Employment isn't rising, it's falling. On the face of it, this is an economy crying out for fiscal stimulus--especially to offset the sharp cutbacks in defense spending. But there are two powerful reasons why we can't turn on the spending spigot. First, a decade of fiscal irresponsibility has rendered policymakers fiscally impotent. Second, there is a timing problem. Two months before the elections, any fiscal stimulus package is sure to be loaded with a Christmas tree of goodies.
Contrary to what some economists and politicians have been saying, deficits do matter. It is the huge deficit--projected at $375 billion in fiscal 1993, on top of a debt that has ballooned by $2.8 trillion over the last ten years--that is hamstringing U.S. fiscal policy options. The inflation potential of such a huge deficit is the reason why long-term interest rates are still sky-high compared with short-term rates. A quick-fix fiscal stimulus would only exacerbate the deficit, prove that fiscal policy is out of control, and push up long-term rates.
So what we are left with in the short term is monetary policy. It's true that so far monetary policy has not produced a healthy recovery. But here, too, the deficit is the villain. The Fed has cut short rates by five percentage points over the past two years. Normally, long-term interest rates would have fallen in lockstep--but that hasn't happened in the face of these huge deficits. It's no mystery why the Fed hasn't been able to spur bank lending. Why should banks lend to businesses at 6% when they can earn a risk-free 7.3% on U.S. Treasury bonds? Still, the present discount rate of 3% allows the Fed room for more cuts. Lower interest rates will help address the debt problems of consumers and businesses.
Longer term, what is needed is a credible plan to cut the deficit and encourage the engines of growth, such as human capital and business investment. But that will have to wait until after the election, when the newly elected President and Congress will have to plot out a long-term plan for reinvigorating the economy.