Heed History’s Lessons

 

 

 

Years ago, graduate students in economics were required to take at least one class in economic history. As economists became increasingly interested in elegant mathematical formulas, history counted less and this requirement vanished. The interested public did not seem to mind losing the historical perspective on economics, either. The obsession with daily stock prices became so pervasive that a short cab ride across town would provide all the necessary information to spell the name of the next Internet IPO. And politicians have a vested interest in not putting economics and economic policy in historical perspective since it allows them to focus merely on short-term and sometimes short-lived successes.

Good economic policy, though, requires that history’s lessons are not ignored. Take our recent economic history. The lesson is clearly that economic stability matters. In the past five years, U.S. households experienced an unprecedented roller coaster ride on the stock market and, more importantly, an extraordinary good labor market followed by the worst employment record in a recovery since the Great Depression. However, the focus of economic policy has recently been almost exclusively on economic stimulus, with no concern for long-term stability.

Nobody is saying that stronger growth and better employment growth now will inevitably lead to instabilities in the future. However, the U.S. economy has relied increasingly on borrowed money to generate growth, which could prove detrimental to stable growth. The country as a whole increasingly borrows to pay for record trade deficits, households borrow more to finance consumption, and the government is expected to borrow as far as the eye can see to pay for large tax cuts. Moreover, fiscal irresponsibility exacerbates the first two problems of the trade deficit and household debt.

The biggest policy blunder, when it comes to strong and stable growth, has arguably occurred with respect to federal government outlays. As households and the economy needed better employment opportunities, the Bush administration not only squandered the chance to implement an effective economic stimulus in 2001, but it also mortgaged the future, and thus raised the chance of future economic slowdowns, due to large and largely ill-advised tax cuts. The Congressional Budget Office even called the long-term fiscal trend unsustainable in their updated budget outlook released in December 2003. In order to return to a more sustainable path, the government would have to raise taxes or cut discretionary expenditures, which are already low outside of homeland security and defense. After the deficit party of the 1980s, when deficits soared as high as 6 percent of GDP, the U.S. economy faced a prolonged budget hangover to bring deficits back to more manageable levels. As long as deficits are high, the economy faces the risk of higher interest rates, of slower growth due to less private and public investment, and of fewer stabilizing interventions when things turn sour.

The large budget deficits, however, exacerbate the problem of the U.S. trade deficit. A colleague recently called the U.S.’ record trade deficits, the “trap door under economic growth." Already, the U.S. needs to borrow about $2 billion per day from overseas investors to finance these deficits. At some point, foreign investors will decline to lend more money to the U.S., especially if the federal government also runs large unsustainable deficits that need to be financed through more debt as well. Investors may simply require higher interest rates to continue lending, or they may start withdrawing their funds. Higher interest rates, a rapidly declining dollar, or both could be the result, with detrimental effects on growth and employment. The situation is made even more worrisome by the Bush administration’s ability to offend important international allies. As unilateralism breeds mistrust, the U.S. may have to pay a price, literally, in the form of higher long-term interest rates.

By focusing on large, long-term tax cuts instead of short-term, temporary spending increases and tax relief, fiscal policy did not do as much as could have been done to end the “job loss” recovery. So far, firms have managed to sell their products, despite a bad labor market, by relying on consumers to borrow. With debt at record levels, the risks are that consumers run out of steam, unless wages and employment pick up, and that financial firms may become wary of the high debt burdens households have accumulated and reduce their lending. Less credit, though, would also translate into less consumption and investment.

Long-term economic stability matters. In recent ups and downs in the economy, fortunes and good jobs were gone in a matter of months. Better growth and more employment in the short-run are certainly welcome, but policy must ensure that jobs will not be lost in the near future to another rocky ride on the economic roller coaster. The U.S. faces a number of fault lines due to unsustainable budget deficits, high and rising trade deficits, and record household debt burdens. Policymakers, though, want to shine the spotlight on monthly gains, rather than the debt build-up, ignoring the rising risks. Ignoring history’s lesson, though, that economic instability can quickly destroy savings and jobs will only increase the economy’s risks because policymakers are not held responsible for irresponsible policies. Being responsible, though, requires a serious combination of fiscal responsibility, policies to encourage global growth, and measures to ensure a strong and sustained labor market recovery.

  • Trade Balance and Current Account Balance relative to GDP
    Important measures for the U.S. external balance are the trade balance and the current account balance. The trade balance is the difference between exports minus imports. The current account balance is the trade deficit plus the difference between interest earned abroad on U.S. held assets minus the interest paid to foreigners holding U.S. assets, minus current transfer payments, such as Social Security, from the U.S. to foreign residents. Both balances have been negative for the past twenty years. The current account deficit has been more negative than the trade deficit since 1992. Since then, the U.S. has been paying more on its external debt than it is earning on the assets held abroad by U.S. residents.
    Source: Author’s calculations. Bureau of Economic Analysis, National Income and Product Accounts and Balance-of-Payments.

  • External Indebtedness relative to GDP
    When the U.S. imports more than it exports, it needs to borrow funds from abroad to pay for the difference. Over the past three decades, the U.S. has accumulated large amounts of debt. Until 1986, this external debt was smaller than the assets owned by U.S. residents abroad. However, since then the debt has exceeded the assets held abroad. By 2002, the net indebtedness – the difference between assets held abroad and debt owed to foreign residents – reached 22.8% of GDP.
    Source: Author’s calculations. Bureau of Economic Analysis, International Investment Position.

Dr. Christian Weller is a senior economist at the Center for American Progress.