ERP_1993

iTransmitted to the (foiigress

January 1993

Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Economic Reportof the President

Transmitted to the CongressJanuary 1993

TOGETHER WITHTHE ANNUAL REPORT

OF THECOUNCIL OF ECONOMIC ADVISERS

UNITED STATES GOVERNMENT PRINTING OFFICE

WASHINGTON : 1993

For sale by the U.S. Government Printing OfficeSuperintendent of Documents, Mail Stop: SSOP, Washington, DC 20402-9328

ISBN 0-16-041592-6


C O N T E N T S

Page

ECONOMIC REPORT OF THE PRESIDENT 1

ANNUAL REPORT OF THE COUNCIL OF ECONOMICADVISERS* 7

CHAPTER 1. PERSPECTIVES ON THE ECONOMY AND ECONOMICPOLICY 19

CHAPTER 2. RECENT DEVELOPMENTS AND THE ECONOMIC OUT-LOOK 35

CHAPTER 3. MONETARY AND FISCAL POLICY IN THE CURRENTENVIRONMENT 73

CHAPTER 4. THE ECONOMICS OF HEALTH CARE 119

CHAPTER 5. MARKETS AND REGULATORY REFORM 169

CHAPTER 6. ECONOMIC GROWTH AND FUTURE GENERATIONS 225

CHAPTER 7. WHITHER INTERNATIONAL TRADE AND FINANCE? .... 279

APPENDIX A. REPORT TO THE PRESIDENT ON THE ACTIVITIES OFTHE COUNCIL OF ECONOMIC ADVISERS DURING 1992 329

APPENDIX B. STATISTICAL TABLES RELATING TO INCOME, EM-PLOYMENT, AND PRODUCTION 341

*For a detailed table of contents of the Council's Report, see page 11.

(iii)


ECONOMIC REPORTOF THE PRESIDENT


Economic Report of the PresidentTo the Speaker of the House of Representatives and the President ofthe Senate:

The last 4 years have challenged the American economy, and theeconomy is meeting those challenges. The longest peacetime expan-sion in America's history ended in the second half of 1990. Whilethe 1990-91 recession was relatively short (8 months compared to apostwar average of 11), the recovery was quite slow by historicstandards but accelerated in the second half of 1992, with realgross domestic product growth over 3 percent and unemploymentfalling.

It is important to understand that the interruption to growthwas temporary. An unusual confluence of forcesthe delayedeffect of the tight monetary policy in 1988-89 designed to head offan incipient rise in inflation, the oil price shock related to the GulfWar, the credit crunch, the problems in financial institutions, theoverbuilding in commercial real estate, the fiscal imbalances, andthe substantial current and prospective defense downsizingall hitthe economy in a relatively short period of time. These events oc-curred in the midst of a worldwide slowdown among the industrial-ized countries which temporarily slowed America's export boomCanada and the United Kingdom were in far steeper recessionsthan the United States, with unemployment rates rising to over10 percent, and Germany and Japan entered recession in 1992.

While the consolidation and transition were painful, the policiesof my Administration have worked with the natural forces of theprivate economy to lay a foundation for stronger growth ahead. In-flation and interest rates are at their lowest levels in a generation.Consumers have trimmed their installment debt and have takenadvantage of low interest rates to refinance their mortgages. Corpo-rations have been raising equity, on balance, for the first time inseveral years. And, despite the economic slowdown abroad, Amer-ica is once again the world's leading exporter and is more interna-tionally competitive than it has been in many years, with produc-tivity once again rising at a respectable rate.

In addition to these short-term problems and challenges, whichthe economy has been successfully weathering, the United Statesfaces serious challenges in sustaining the economic recovery and si-multaneously providing a firmer basis for long-term growth in pro-ductivity, income, and employment opportunities. Throughout myAdministration, I have presented a series of interrelated and com-


prehensive programs to achieve these goals. I strongly believe myproposalssome of which I was able to implement unilaterally,others of which I have worked with the Nation's Governors to ad-vance, others of which have been partially adopted by the Con-gress, and others of which the Congress has thus far refused toenactreflect sound principles. These principles define the appro-priate, though limited role for government in improving the foun-dations and performance of our economy. My fundamental reformagenda included:

Fiscal Reform. In addition to the existing spending limits, Ihave proposed setting new caps on the growth of mandatoryspending to reduce future budget deficits; restore tax incen-tives for saving, investment, and entrepreneurship to spur eco-nomic growth; and reforming the budget process itself, mostnotably by giving the President a line item veto and enacting abalanced budget Constitutional Amendment.

Trade Liberalization. In a series of multilateral, regional, andbilateral initiatives, this Administration has set forth a for-ward-looking program, opening markets not closing them, inorder to expand trade and growth for our Nation and theworld. The North American Free Trade Agreement is an his-toric achievement that offers us the opportunity to create amore prosperous and stable Western Hemisphere. The UnitedStates has taken the lead in the Uruguay Round of GATT.Bringing the Uruguay Round to a successful conclusion re-mains essential to advancing U.S. and global economic prosper-ity.

Regulatory Reform. The Federal, State, and local governmentsregulate too much, and often in inflexible, inefficient, costly,and unnecessary ways. While some government regulation isnecessary, it should be limited to only those areas where seri-ous market failures require attention and should provide maxi-mum flexibility for the private sector to comply with the regu-lations. My Regulatory Moratorium, for example, saved Ameri-can businesses and consumers over $20 billion a year.

In addition to these general areas of economic policy, I havemade important proposals that would provide choice-based educa-tion reform; a more balanced approach to tort, malpractice, andcivil justice reform; job training and insurance reform; market-based health care reform to control costs and provide access for theuninsured; and regulatory reform of the banking system. I wouldespecially like to note my innovative proposals to spread hope andopportunity to the least advantaged in our society. Proposals suchas enterprise zones and home ownership form the basis of my pro-gram to provide millions of disadvantaged Americans with the op-portunity to live free of crime and drugs, in safe neighborhoods,


and with productive employment. These citizens need and deservethe opportunity to have a stake in their communities and in socie-ty.

Americans should take great satisfaction in the fact that totali-tarian, centrally planned economies all over the world are movingtoward pluralistic democratic capitalism. The pace differs and theroad will not be easy. But our advice, encouragement, and assist-ance has been essential. America has illuminated the advantages offreedom and market economies. Not so long ago it was fashionableto argue that all the world's economies were converging towardsome form of socialism; the Communist regimes would ease somerestrictions and allow market forces to play a role in their econo-mies, and the democratic capitalist regimes would continue theirheadlong rush toward ever-larger bureaucratic welfare states. Buthistory has rendered its judgment. The world's economies haveopted decisively for various forms of democratic capitalism, not so-cialism or central planning. Our form of economic organizationadynamic market economy based on individual initiative, entrepre-neurship, personal freedom, and respect for private propertyhasmade America the largest and most productive economy in theworld, providing our citizens with the highest standard of living ofany industrialized country. Our economic success continues to in-spire market-oriented reforms in regions as diverse as the formerSoviet Union, Eastern Europe, Latin America, and China.

America's future can and should be bright. We have the strong-est, largest, most successful economy in the world, with the higheststandard of living. But we cannot take continued economic growthfor granted. The reform proposals I have put forward during myAdministration, if enacted, would greatly enhance long-term eco-nomic growth, providing the foundation for higher living stand-ards, a better legacy of prosperity for our children, improved socialand economic mobility for the disadvantaged, more resources topay for nontraditional goods and services such as a healthier envi-ronment, and for maintaining America's economic and geopoliticalleadership into the twenty-first century.

THE WHITE HOUSE {/JANUARY 13, 1993


THE ANNUAL REPORTOF THE

COUNCIL OF ECONOMIC ADVISERS


LETTER OF TRANSMITTAL

COUNCIL OF ECONOMIC ADVISERS,Washington, D.C., January 8, 1993

MR. PRESIDENT:The Council of Economic Advisers herewith submits its 1993

Annual Report in accordance with the provisions of the Employ-ment Act of 1946 as amended by the Full Employment and Bal-anced Growth Act of 1978.

Sincerely,

Michael J. BoskinChairman

David F. Bradford*Member

Paul WonnacottMember


C O N T E N T S

PageCHAPTER 1. PERSPECTIVES ON THE ECONOMY AND ECONOMIC

POLICY 19The Declinists Meet the Facts 20The Revisionists Meet the Facts 23

The Economy's Performance after 1980 26The Real Economic Problems 27Agenda for Reform 30

Fiscal Reform 31Trade Liberalization 31Regulatory Reform 32Education Reform 32Health Care Reform 32Empowering the Disadvantaged 33

Conclusion 33CHAPTER 2. RECENT DEVELOPMENTS AND THE ECONOMIC OUT-

LOOK 35An Overview of the Economy in 1992 40

Early Improvement 41Mixed Performance and Uncertainty 44Second-Half Revival 46Special Factors-Hurricanes 47Low Inflation 47The International Slowdown 49Longer Term Structural Adjustments and Short-

term Performance 50Monetary and Fiscal Policy in 1992 51Summary 57

Recent Economic Performance in Historical Context 57Slow Recovery 58The Recession in Historical Context 59Regional Disparities 60Employment and Productivity Trends 62Summary 65

The Economic Outlook 65The Administration's Economic Projections 65Accounting for Growth 69Summary 71

Conclusion 71

11Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

PageCHAPTER 3. MONETARY AND FISCAL POLICY IN THE CURRENT

ENVIRONMENT 73Macroeconomic Policy in Historical Context 74

Causes of Recessions 75The Limits of Policy 77Summary 82

Recent Economic Developments 82Macroeconomic Policies and Economic Performance

in the 1980s 82Structural Imbalances in the Economy 84External Events 92Summary 96

The Channels of Monetary Policy 96Short-Term Effects of Monetary Policy 97Long-Term Consequences of Monetary Policy 98Indicators of Monetary Policy 101Summary 101

Monetary Policy Since 1970 102Recent Complications for Monetary Policy 106Summary 107

Fiscal Policy 108Tools of Fiscal Policy 108Recent Behavior of Expenditures and Tax Receipts... 109The Budget Process I l lLimitations of Countercyclical Fiscal Policy 113Summary 115

Would Different Policies Have Helped? 115Conclusion 118

CHAPTER 4. THE ECONOMICS OF HEALTH CARE 119Health Care in the United States 119

The Health of the U.S. Population 120Providing and Paying for Health Care Services in

the United States 121Employer-Provided Benefits 123The Government's Role 127Recent Changes in the Provision of Care 129Summary 132

Rising Expenditures, Declining Insurance Coverage 132Trends in Health Care Expenditures 132Health Care Expenditures in Other Developed Coun-

tries 133The Uninsured 134How the Uninsured Use Health Care Services 137Recent Changes in the Number of Uninsured 138Summary 138

Economic Theory of the Health Care Market 139


PageProviding Health Care Services 139Problems of Measuring Quality 139The Supply of Providers 140Health Insurance 141Concerns Over the Distribution of Medical Re-

sources 144Summary 146

Why Are Health Care Expenditures Increasing? 146Prices and Quantities of Health Care 147Recent Increases in Health Care Expenditures 148Components of Price Increases in the 1980s 149Projections of Future Cost Increases 151Summary 154

Proposals for Reform of the Health Care Market 154Administration Proposal 154Managed Competition 159Play-Or-Pay 161National Health Insurance Proposals 162Rate Setting 164Global Budgets 164Politics and Health Care 165Summary 166

Conclusion 167CHAPTER 5. MARKETS AND REGULATORY REFORM 169

Regulatory Reform 170Regulation and Government Failure 171A Balanced Regulatory Policy 172The Regulatory Reform Initiative 173Market Incentives 174Summary 178

Telecommunications: Regulatory Reform and Innovation 178Telecommunications and the U.S. Economy 178Guidelines for Reform in Telecommunications Regu-

lation 180Reforming Telecommunications Regulation 182Summary 190

Regulating Financial Markets and Services 190The Changing Financial Scene 190The Value of Financial Services 191The Changing Role of Government 192Current Issues in Regulatory Reform 195Summary 203

Ownership and Pricing of Natural Resources.. 203Why Does the Government Own and Manage Re-

sources? 204Establishing Markets for the Right to Use Resources 205


PagePricing of Government-Owned Natural Resources 206Reforming Public Resource Policy 211Summary 212

Risks to Health, Safety, and the Environment 212Risk in Perspective 212Risk in the Marketplace 214The Role of Government: Providing Information and

Regulating Risk 215Improving Government Efforts to Address Risk 222Summary 223

Conclusion 223CHAPTER 6. ECONOMIC GROWTH AND FUTURE GENERATIONS 225

Evaluating Growth 227Growth and Intergenerational Fairness 228What Is Economic Growth? 229Economic Growth and the Environment 230Summary 232

The Productive Capacity of the U.S. Economy 233The Physical Capital Stock 233Marketable Wealth 235Human Capital 236Technology 238Organizational Capital and Market Institutions 240Natural Resources 240Limits to Growth? 242Summary 242

Budget Deficits and Future Generations 243Deficits and the Economy: Some Basics 244Correcting Deficits for Inflation and Government In-

vestment 251The Federal Debt and Future Budgetary Problems.... 252Accounting for Intergenerational Transfers 254Summary 258

Highlighting the Cost of Government Retirement and In-surance Programs 258

The Social Security System 259Government Insurance and Credit Programs 262Summary 264

Strengthening the Framework for Growth 265Governmental Policies to Promote Growth 266Tax Structure to Promote Growth 267Consumption Taxes 268Improving the Income Tax 272Summary 276

Conclusion 276


PageCHAPTER 7. WHITHER INTERNATIONAL TRADE AND FINANCE? .... 279

The Evolution of Exchange-Rate Arrangements 282Pegged Exchange Rates Under the Bretton Woods

System 285The Dollar in the Floating-Rate Era 289The Movement Toward a Single Currency in Europe 294Pegs to the Dollar Among Developing Countries 300Exchange Arrangement Options for the Former

Soviet Union 303The Future of Exchange-Rate Relations 306Summary 307

The Changing Role of the International Monetary Fund.. 308The IMF in the Bretton Woods Era and Afterwards.. 308Long-Term Financing, the IMF, and the World Bank 309Summary 310

The North American Free-Trade Agreement 310Trade in Services and Investment 311Intellectual Property Rights 313Agricultural Trade 313Safeguards and Other Trade Rules 314The Environment and Labor 315Other Regional and Bilateral Trade Developments.... 315Summary 317

The Uruguay Round 317Agriculture 317Textiles and Other Important Issues 321Summary 321

Regional Integration and Multilateralism 321Summary 322

Trade Policy Agenda for the Future 323International Trade and Competition Policy 323Trade Rules for High-Technology Industries 324Trade and the Environment 325Summary 326

Conclusion 326APPENDIXES

A. Report to the President on the Activities of theCouncil of Economic Advisers During 1992 329

B. Statistical Tables Relating to Income, Employment,and Production 341

LIST OF TABLES, CHARTS, AND BOXESTables

2-1 Recovery Comparisons 582-2 Recession Comparisons 592-3 Administration Forecasts 662-4 Alternative Forecasts and Deficit Projections 69


LIST OF TABLES, CHARTS, AND BOXESCONTINUEDTables Page

2-5 Accounting for Growth in Real GDP, 1960-98 704-1 Average Annual Percent Change in Personal Health

Care Expenditures Per Capita, Prices, and Quanti-ties: 1960-90 147

4-2 Side-by-Side Comparison of Health Insurance Plans 1557-1 Output Growth and Inflation in the G7 Countries 2877-2 The Increasing Variability of U.S. Exchange Rates,

Output, and Inflation 2907-3 Common Agricultural Policy Expenditures, EC Agri-

cultural Trade, and EC Self-Sufficiency for SelectedCommodities: 1975-90 320

Charts2-1 Real Gross Domestic Product Growth 412-2 Civilian Unemployment Rate 432-3 Nonfarm Payroll Employment 432-4 Consumer Confidence 442-5 Consumer Price Inflation 482-6 M2 Money Stock and Growth Target Ranges 522-7 Ratio of Permanent Job Losers to Total Unemployed... 602-8 Unemployment Rates by State, November 1982 632-9 Unemployment Rates by State, June 1992 63

2-10 Growth in Output per Hour, Nonfarm Business Sector 643-1 Gross National Product Per Capita, 1870-1990 743-2 Civilian Unemployment Rate 763-3 Consumer Price Inflation 803-4 Loans and Securities Held by U.S. Commercial Banks . 863-5 Debt Service Payments as Percent of Disposable

Income 883-6 National Defense Outlays 893-7 Output per Hour, Nonfarm Business Sector 913-8 Consumer Confidence and Personal Consumption Ex-

penditures 943-9 International Real GDP Growth 95

3-10 Real and Nominal 3-Month T-Bill Rates 1003-11 Growth Rates of Monetary Aggregates 1033-12 Velocities of Monetary Aggregates, 1970-92 1033-13 M2 Money Stock and Growth Target Ranges 1043-14 Velocities of Monetary Aggregates, 1988-92 1053-15 Real Federal Spending and Taxation in Recent Recov-

eries 1104-1 Paying for Health Care Expenditures: 1960 and 1990 ... 1254-2 Health Insurance Coverage 1264-3 Real Per Capita Health Care Expenditures 133


Charts4-4 Growth in Real Per Capita Health Care Expenditures Page

in Selected Countries 1344-5 Employer-Provided Health Insurance, by Firm Size:

1990 1364-6 Share of Health Care Expenses Paid Out-of-Pocket 1424-7 Projected Health Care Expenditures as Percent of

GNP 1524-8 Per Capita Personal Health Care Expenditures, by

Age: 1987 1535-1 AT&T's Market Share 1895-2 Single-Family Mortgage Debt Outstanding 2006-1 Capital per Employed Civilian 2346-2 Household and National Private Wealth Per Capita 2376-3 Unified Deficit and Primary Deficit Less Deposit In-

surance Payments 2456-4 Debt Held by the Public as Percent of GDP 2476-5 Net Foreign Investment as Percent of GDP 2496-6 Long-Run Budget Projections as Percent of GDP 2536-7 Social Security Benefits as Percent of Payroll Taxes 2567-1 Exchange Rates of Major Industrialized Countries in

Terms of the Dollar 2877-2 Inflation Rates in Japan, Germany, and the United

States 2917-3 Exchange Rate and Interest Rate Differences: United

States and Germany 2927-4 Central Exchange Rates of Selected EMS Countries 2967-5 Inflation Rates in Selected EMS Countries 2977-6 Interest Rates in the United States and the Major Eu-

ropean Economies 299Boxes

2-1 Recessions and Business Cycle Dating 422-2 Data Revisions and the Severity of the Recession 613-1 The Role of Bank Capital 873-2 The Merits of an Independent Central Bank 973-3 Real and Nominal Interest Rates 993-4 International Interest Rate Differences and Capital

Flows 1074-1 Canada 1224-2 Germany 1234-3 United Kingdom 1244-4 Coordinated Care 1304-5 Measuring Changes in Health Care Expenditures 1484-6 Health Risk Adjusters 1574-7 Oregon Medicaid Waiver Proposal 163


Boxes5-1 If Deregulation Is So Great, Why Has My Phone Bill Page

Gone Up? 1835-2 Federal Crop Insurance and Disaster Assistance 2035-3 Government Creates a Market for Fishing Rights 2075-4 Forests as a Public Good 2085-5 Measuring the Value of Nonmarket Goods 2095-6 Reform of California Water 2106-1 Global Climate Change and Future Generations 2316-2 Gary Becker 2396-3 Superfund Wastes as an Environmental Liability 2416-4 Intergenerational Redistribution from Social Security.. 2556-5 Trust Funds 2616-6 The Growing Liabilities of the Pension Benefit Guar-

antee Corporation 2636-7 Inflation and Capital Gains 2746-8 The Corporate Alternative Minimum Tax 2757-1 Exchange-Rate Arrangements 2837-2 Floating Exchange Rates 2907-3 Real Exchange Rates and Real Interest Rates 2937-4 Pegged Exchange Rates and Disinflation in Argentina. 3027-5 Free-Trade Areas and Customs Unions 3127-6 The Oilseeds Dispute 319


CHAPTER 1

Perspectives on the Economy andEconomic Policy

THE AMERICAN ECONOMY IS THE largest and most produc-tive in the world. Not only does it have the highest per capitalevels of productivity and output of any industrialized country, buteven its modest growth in 1992 surpassed the performance of theother major industrialized countries. The American economy facesserious short-term problems and long-term challenges, however. Aspast Economic Reports of this Administration have stated, theNation cannot take sustained, long-term economic growth forgranted. It must pursue wise economic policies that improve thefoundation and performance of the economy. Such policies are bynature limited but not passive. Activist economic policy reforms cangreatly improve the performance of the American economy, layinga better foundation for the economic growth that provides expand-ed employment opportunities, not just for new entrants into thelabor force but for those seeking upward economic mobility, ahigher standard of living, a richer legacy of prosperity for our chil-dren, the resources to help pay for nontraditional goods and serv-ices such as a healthy environment, and assurance that America'seconomic and geopolitical leadership will extend into the next cen-tury.

Because the last 4 years have been so challenging to the Ameri-can (indeed, to the world) economy and more recent economic per-formance has not been what Americans have come to expect, twocurrents of opinion have gained currency, based on a lack of accu-rate information and faulty analysis. The first, which can be la-belled "declinism," puts forth the notions that America has been insubstantial decline, that America is lagging behind its economiccompetitors, that economic collapse is just around the corner, thatthe United States is deindustrializing, or that foreigners will soonown all (or at least too much) of America. These complaints cannotsurvive a thorough scrutiny based on readily available factual in-formation and sound economic analysis. To be sure, the Americaneconomy does, indeed, face serious challenges, but it does so from aposition of great strength and with the tools and experience neededto overcome them. On one point, however, the prophets of declin-


ism and the authors of this Report fully agree: the Nation cannotand should not take continued economic growth for granted.

The second current of opinion, which can be labeled "revision-ism," uses the recent problems of the American economy to arguethat the general changes in economic policy of the last 12 yearshave somehow been a calamitous mistake, responsible for all theproblems in the economy and none of its remarkable achievements;indeed, the economy would have performed better if the policies ofthe 1960s and 1970s had been continued. Again, to be sure, policiesof the last 12 years were far from perfectly implemented. But, onbalance, economic policy since 1980 has been much superior to thatof the late 1960s and the 1970s. And the performance of the econo-my, fairly evaluated, generally reflects that major improvement inpolicy direction.

THE DECLINISTS MEET THE FACTSContrary to the claims of the declinists, the United States re-

mains the largest, richest, and most productive economy in theworld. With less than 5 percent of the world's population, theNation produces about a quarter of the world's total output ofgoods and services. The American economy is about 2V2 times thesize of the next largest economy, Japan. The average standard ofliving of Americansas measured by gross domestic product (GDP)per capitaexceeds that of any other major industrialized country.Productivity, or output per worker, in the American economy isalso higher than in these other nations.

While it is true that the fortunes of particular industries haveebbed and flowed, America is not deindustrializing. Total employ-ment in manufacturing has fluctuated within a modest range de-pending on economic conditions since 1960. In fact, manufactur-ing's share of total economic output has been roughly constant forthe last 30 years. And the United States accounts for an even largershare of the industrial output of the countries of the Organizationfor Economic Cooperation and Development (OECD)the 24 largestindustrial market economiesthan it did in 1970.

Neither is America losing its overall competitive edge. TheUnited States is the world's leading exporter; indeed, it is moreinternationally competitive than it has been in decades. From 1987to 1991, exports rose from 8 to over 11 percent of GDP. This strongexport performance prevented the recent recession from having afar greater negative impact on U.S. employment and has helpedsustain the economy through a difficult period of sluggish economicgrowth. Although many U.S. manufacturers face stiff competitionin markets with high volume and low profit margins, America has

20


maintained its technological edge in areas that are allegedly atrisk, including microprocessors, advanced telecommunications, andbiotechnology.

Some declinists play on fears of foreign investment, in the sameway that many West Europeans of the 1950s and 1960s played on fearsof the American investment that helped rebuild their economies.These fears are unfounded. Foreign investment helps to buildplants and equip workers, leading to higher productivity and im-proved standards of living. Increasing global integration and thegeneral strength of the American economy are among the reasonsfor the long-term growth of foreign investment in the UnitedStates. Foreign investment is a sign of strength and future pros-pects, not a symptom of decline. In any event, foreign investmentin the United States is a quite modest share of GDP relative to for-eign investment in most other industrialized countries.

What about the recent problems of the American economy?(These problems are discussed in more detail in Chapters 2 and 3 ofthis Report) No economic system is immune to disruption. Evenwell-functioning market economies run the risk of temporary set-backs due to external shocks, policy mistakes, or other disturb-ances. The American economy, which had already experienced afew quarters of slow growth, fell into a recession in the second halfof 1990 that was shorter (8 months, compared with a postwar aver-age of 11) and slightly less severe (output declined 2.2 percent rela-tive to a postwar average of 2.8 percent; unemployment rose 2.8percent, less than the postwar average of 3.4 percent) than otherpostwar recessions. More troubling was the anemic pace of the re-covery that began in March 1991. Unfortunately, the Administra-tion's prediction that this would be the slowest recovery sinceWorld War II proved to be correct. Growth was so sluggish, in fact,that job creation was insufficient to prevent unemployment fromrising even months after the recovery had begun.

The declinists worry that America is losing the competitive eco-nomic race with Germany and Japan and perhaps with other coun-tries as well. This argument must seem somewhat remarkable tothe other major industrialized countries, which not only started outbehind the United States in terms of productivity and per capitaincome but have experienced far more severe economic problemsrecently. The recessions in Canada and the United Kingdom weremuch steeper than the U.S. recession, with unemployment rising toover 10 percent. Germany and Japan entered recession in 1992, asthe American economy was moving from anemic to modest growth.Inflation in some of these countries is still a serious concern, whileinflation and interest rates are at their lowest levels in a genera-tion in the United States.


The American economy still faces many challenges. To improvethe prospects for long-term growth in productivity, primary andsecondary education badly need improvement; legal, tax, and regu-latory obstacles to entrepreneurship and business expansion mustbe removed; and expanding federal entitlement spending, whichhas contributed to large structural budget deficits, must be broughtunder control. But the view that the Nation is already in decline ormust inevitably falter does not accord with the facts. The future isneither bleak nor predetermined, and America has the ability tosolve the problems that lie ahead.

Basing policy on a faulty analysis of the economy's problems andprospects will not improve economic performance. The economydoes not need answers to false problems. The declinists attributethe economy's alleged ills to fundamental flaws in the free marketsystem. Their response to trade problems is protectionism or "man-aged trade," and they would solve the problems of particular indus-tries with an industrial policy that mandates volumes of new gov-ernment regulations; government subsidies; tax breaks; and newgovernment spending on projects the private sector would eventual-ly undertake itself if free to do so. These notions, while appealingto declinists, avoid the fundamental fact that private markets andan open trading systemnot government regulation and subsi-dieshave been the fundamental source of the remarkable eco-nomic progress industrial nations have made in the postwar era.

The usual argument of the industrial policy proponents is thatJapan's Ministry of International Trade and Industry (MITI), hasbeen the driving force behind Japan's remarkable progress in thepost-World War II era. MITI did play a powerful role in Japan'seconomic progress immediately after the war, but the country'ssuccess is attributable primarily to classic prescriptions: its highsaving and investment rates and the hard work of its labor force.Indeed, MITI attempted to prevent SONY from entering the con-sumer electronic business. In each case, the Japanese firms sensiblyavoided making what would have been very expensive mistakes, notjust for themselves but for the Japanese economy.

In fact, there is no reason to believe that bureaucrats or politi-cians are better able than private individuals or firms to allocateresources to their most productive uses. In the United States, theFederal Government's Synfuels program of the early 1980s, which wasterminated without ever producing a commerically viable product,offers a $3 billion example of the government's inability to second-guess the markets. Another classic example is the French and BritishConcorde SST, which became a multimillion dollar commercial flopand wasted taxpayers' resources in those countries. The very nationsthe declinists envy so much are currently moving away from heavy


government intervention in the workings of the economy. Many of themore advanced social welfare states in Western Europe, includingSweden, France, and the United Kingdom, have, to various degrees,pulled back from their reliance on nationalized industry, outsizedtransfer payments systems, excessive bureaucratic regulation, andhigh rates of taxation.

In short, the declinists are wrong on the facts. America still hasthe largest and strongest economy in the world. It is neither dein-dustrializing, nor losing some overall economic competition withother countries. Although it can improve its competitive position inspecific industries, America still enjoys the highest standard ofliving of the major industrialized countries. But again, the declinistsand the authors of this Report agree on one point: The Nation cannottake continued economic growth for granted.

THE REVISIONISTS MEET THE FACTSThe second group of skeptics argues that the changes in econom-

ic policy most closely associated with the last 12 years (some ofwhich actually began earlier) misdirected the American economyand led to its current problems. Economic policy in the last 12years has aimed primarily at reducing inflation and maintaining itat low levels; restraining growth in regulation; lowering tax ratesto restore incentives to produce income and wealth; controlling gov-ernment spending and targeting it more effectively; expandinginternational trade; and providing for a strong national defense.

What is not generally understood is that this approach was a log-ical outcome of postwar U.S. economic history. Its policies did notentirely succeed but rather left a legacy of impressive accomplish-ments, as well as some notable failures and an important unfin-ished agenda.

The quarter century of rapid productivity growth that followedWorld War II led to substantial increases in living standards andwages for the American people. Most economists describe the rapidproductivity growth of this period as extraordinary, far above thelong-term trend. In part, this growth can be traced to the pent-updemand left over from the Great Depression and World War II; toopportunities to export and help rebuild war-ravaged nations, espe-cially in Europe; and to the dissemination of major technologicalbreakthroughs that had been promulgated during the war, from jetairplanes to communications.

With relatively low unemployment and inflation, rising produc-tivity growth, and generally improving economic performance,America in the 1960s turned its attention to a variety of other con-cerns, including a noble, if controversial, attempt to improve thecondition of the disadvantaged in society through substantial in-


creases in social welfare spending. In the last half of the 1960s andthe first half of the 1970s the introduction of medicare and the vastexpansion of Social Security benefits unrelated to need put in placea variety of forces that caused problems during this period, set intrain serious problems for future government budgets, and createdenormous controversy about the most appropriate way for the gov-ernment to assist those in need.

The economy went through a series of profound changes and dis-ruptive internal and external shocks throughout the 1960s and1970s, including the Vietnam War, rising inflation coupled withstagnating growth, two significant oil price hikes, and a significantincrease in government regulation and spendingas well as in themarginal tax rates facing ordinary American workers. By 1980 in-flation had soared to double digits, and the Nation was caught in asharp but brief recession.

The major goal of the 1980s and beyond was clearly to restorehealthy, noninflationary economic growth. This objective requiredan economic environment with a rate of monetary expansion thatwas slower, more predictable, and more stable than it had been inthe 1970s; reduced growth in government spending; and a concert-ed effort to remove those disincentives from the tax and regulatorysystems that obstruct working, saving, investing, innovating, andentrepreneurship. In short, the economic objectives of the 1980s re-quired a serious reorientation of monetary, fiscal, regulatory, andtrade policies.

Deregulation did not just begin in the 1980s but had its roots inthe Carter and, to some degree, the Ford Administration. However,social regulationregulation of health, safety and the environ-mentexpanded at an accelerating pace throughout the 1970s.With inflation at double digit levels, the Federal Reserve commit-ted itself to a disinflationary policy in late 1979, and while the re-sulting disinflation was quite costlythe unemployment ratepeaked at 10.8 percent in 1982inflation rates dropped to the 4- to5-percent range with a loss of output that was only about a thirdof what many economists and policymakers had predicted.

The tax system was dramatically reformed in 1981 to improveeconomic performance. Tax brackets were indexed for inflation andmarginal tax rates reduced. Capital consumption allowances wereaccelerated, the investment tax credit was expanded, and universalindividual retirement accounts were introduced. In 1986, a majortax reform was enacted with the idea of lowering marginal taxrates and broadening the tax base while removing special incen-tives. Unfortunately, the slowdown in depreciation, full taxation ofcapital gains, elimination of investment incentives, and some otherspecific changes (including a more onerous corporate alternativeminimum tax) would prove to be major problems in the coming


years. The tax reforms stabilized revenues as a share of GDP, whilegovernment expenditures rose relative to GDP. The budget deficitgrew substantially to become a key focus of concern.

When the President took office in 1989, he faced many economicchallenges, not the least of which was the prospect that the alreadylarge budget deficit would grow over time. Several attempts to con-trol the Federal deficit had already been undertaken, such as theGramm-Rudman-Hollings budget law. In 1990 the Congress passedand the President signed a set of comprehensive budget reforms,but these reforms were not sufficient to control growth in the larg-est and most rapidly expanding area of the budgetso-called enti-tlement spending for programs such as medicare and medicaid.

Some progress was made in slowing the growth of regulation, al-though perhaps the most important reform, the risk-based depositinsurance reform proposed by Vice President Bush's Task Force onRegulatory Relief, was not enacted. The intransigence on this issuewould greatly aggravate the costs of cleaning up the savings andloan industry later on. Major new regulatory programs, such as the1990 Clean Air Act Amendments and the Americans with Disabil-ities Act, while designed for the admirable purposes of creating ahealthier environment and bringing the disabled into the main-stream of American life, were much costlier and more cumbersomethan necessary. While some innovations were implemented toreduce the costs imposed by the amendments to the Clean Air Act,such as the emissions allowance trading program on sulfur dioxide,it became increasingly clear that such regulation would lead tosubstantial economic disruption. Budgetary constraints on directgovernment spending to achieve health, safety, and environmentalgoals led lawmakers to impose new and excessive regulations as analternative.

The growth of regulation leads to litigation as various groupsseek to have regulations overturned or recast by the courts. In fact,the courts have developed into a new economic policy forum for theinterpretation of important rules and regulations. Regulatory advo-cates have emerged whose activities have distorted the original leg-islative intent of many programs, imposing heavy direct costs andincreasing uncertainty about private investment decisions. The reg-ulatory reform initiative implemented in the last year of the BushAdministration forcefully laid out the principles of sound regula-tion and carried out some reforms within the constraints of exist-ing statutes. The regulatory system was finally pointed in the rightdirection. The reforms implemented during the first year of themoratorium indicate how great the rewards of a more sensible reg-ulatory policy can be.

While the Administration was moving in the direction of a lesseconomically disruptive regulatory policy, congressional microman-


agement of the economy increased greatly. New regulation is butone example. More serious are new laws that increasingly pre-scribe the precise methods of achieving regulatory outcomes ratherthan allowing private firms and households greater flexibility toachieve the same results at far lower costs.

THE ECONOMY'S PERFORMANCE AFTER 1980A major success of the economic policies of the past decade was

the reduction of inflation to its lowest level in a generation. Infla-tion held remarkably steady (excluding an occasional run-up or col-lapse of energy prices) into the late 1980s. By then, however, incipi-ent inflationary pressure was beginning to emerge. In a welcomebreak from previous policy, the Federal Reserve attempted to pre-vent a rise in inflation and, indeed, to reduce inflation further.This program of early interventionthe second round of disinfla-tion of the 1980sbrought the inflation rate down to the 3-percentrange that had prevailed during the 1950s and 1960s. This successaugers well for future expansion. As discussed in Chapters 2 and 3of this Report and in the last two Economic Reports of the Presi-dent, however, the additional disinflation, which occurred during atime of adjustment to severe structural imbalances, and the oilshock resulting from the Gulf War ushered in a prolonged period ofsluggish growth.

Partially in response to lower tax rates, the defense buildup, andreduced inflation in the early 1980s, the economy commenced thelongest peacetime expansion in the Nation's history. While the1981-82 recession had been deep, the recovery was exceptionallystrong. Output grew by 3.9 percent in 1983 and 6.2 percent in 1984,the fastest rate since the 1950s. Between 1982 and 1990, the econo-my's growth averaged 3.3 percent per year. The expansion of theeconomy created 21 million additional jobs and 5 million new busi-nesses. The rate of unemployment declined from its peak of 10.8percent at the end of 1982 to 5.2 percent in June 1990, declining forall major industrial, occupational, and demographic categories.

These achievements were accompanied by serious strainsforexample, friction in world trade, a buildup of household and corpo-rate debt relative to income and profits, and budget deficits thatwere large for a prosperous peacetimeall of which threatened toimpede future growth.

In addition to the remarkable growth in employment, severalother labor market developments deserve particular note. Reallabor compensation continued to grow slowly. The wage premiumfor highly skilled relative to younger, less educated workers rosesubstantially. The wage gap between men and women closed byone-fourth, and for the first time in recorded history unemploymentrates were no worse for women than for men.

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Productivity growth rebounded somewhat during the expansionof the 1980s from what it had been in the 1973-81 period, especiallyin manufacturing. There is strong evidence that the inability toseparate out improvements in quality from true inflation in theprice increases in the service sector have led to a systematic under-statement of long-run productivity growth. Improving the Nation'sproductivity growth is the highest long-term economic priorityhigher output per worker hour is the foundation of rising wagesand living standards.

In summary, the change in the basic orientation of economicpolicy was exactly what was needed, given the economic problemsof the period. However, while highly desirable, this change was im-perfectly implemented. The biggest problem was the failure to con-trol the growth of government spending. Second, while the lowermarginal tax rates represented a significant achievement, an op-portunity was missed in the 1986 Tax Act to continue the progresstoward removing the tax impediments to saving, investment, andentrepreneurship that began in the late 1970s and was the hall-mark of the 1981 Tax Act. Worse yet, the tax treatment of invest-ment and entrepeneurship moved in the wrong direction, with dele-terious consequences. Third, trade policy was disappointingly pro-tectionist. Finally, insufficient progress was made in reforming reg-ulation.

A more limited role for government, sound money, expandedworld trade, reduced and more effective and efficient regulation,and lower tax rates were, and still are the correct thrust of eco-nomic policy and were partially responsible for the fact that theeconomy performed much better in the last decade than it did inthe 1970s. Even the deep recession of 1981-82 was a consequence ofthe disinflation made necessary by the policies of the 1970s, whichhad led to double-digit inflation. But numerous problems remain.This course of policy was enacted imperfectly, and some parts notat all. New problems emerged and some old problems persisted.

THE REAL ECONOMIC PROBLEMSThe American economy is neither in long-term decline nor short-

term contraction. It is emerging slowly from a period of sluggishgrowth and a short, about average, recession after the longestpeacetime expansion in history. But it does face serious problemsand challenges.

The fundamental challenge facing the American economy is theslowdown in the rate of productivity growth, which began in thelate 1960s and worsened in the early 1970s. Even small differencesin the rate of productivity growth compounded over long periods oftime can lead to dramatic differences in future standards of living.


With its productivity growing half a percentage point less rapidlythan that of the United States, the United Kingdom went from thehighest standard of living in the world in the late 19th century to astandard of living only two-thirds that of the United States today.Such is the power of compounding. Simply put, raising the rate ofproductivity growth is essential to raising income per capita and isthe foundation of rising real wages. To lay the foundations forhigher and more sustained productivity growth, the followingissues must be addressed.

First, a highly skilled labor force is essential to America's future.The deplorable state of public elementary and secondary educationin the United States is perhaps the Achilles' heel of America's eco-nomic future. Our future labor force first acquires knowledge andskills, or at least the foundation upon which future knowledge andskills must be based, in the schools. On international test afterinternational test, America's students do not stack up well. Theywill not be able to earn as much as or more than their peers tomor-row if they do not learn as much as or more than their peers today.

Second, the Nation saves and invests too little. A higher rate ofcapital formation and more efficient capital allocation are essentialto raising labor productivity. The Nation's tax, regulatory, andlegal systems, as they now stand, pose severe obstacles to a moreefficient and higher rate of capital formation. There is also legiti-mate concern about the appropriate role of government in financ-ing public investment, such as infrastructure and research and de-velopment. The economic criteria that should be used to determinethe appropriate role of government are straightforward: there is arole for government when there are investments that the privatesector will not undertake, perhaps because individual firms cannotfully appropriate the returns to making them, and when the bene-fits to society are likely to outweigh the costs of the investment.

Third, throughout history, the expansion of international tradehas increased the pace of world economic growth and the contrac-tion of international trade has led to worldwide contractions, mostnotably the Great Depression. After several successful rounds oftariff reductions in the General Agreement on Tariffs and Trade(GATT), new forms of trade barriers and problemsbilateral, re-gional, and multilateralhave emerged. Expanding world tradeand opening trade and investment markets worldwide will be enor-mously important to the future economic growth of the Americanand world economies. Opportunities are substantial, but difficultpolitical obstacles remain.

After the need to raise productivity growth, a second major prob-lem is the sluggish short-term performance of the economy and theinadequate pace of job creation. The economy has been throughseveral challenging years. While heightened concern during a


period of slow growth is understandable, the 1990-91 recessionmust be placed in historical perspective. There have been nine re-cessions in the United States since World War II, and each down-turn has been followed by a phase of renewed growth. It appearsnow that the economy is emerging from a period of sluggishness toa period of modest, self-sustaining growth.

An unusual confluence of forces, including the delayed effect ofthe tight monetary policy pursued in 1988 and 1989 (which was de-signed to head off an incipient rise in inflation), the oil price shockrelated to the Gulf War, the credit crunch, the problems in finan-cial institutions, the overbuilding in commercial real estate (wors-ened by the credit crunch and the wild swings in the tax rules), thefiscal imbalances, and the substantial current and prospective de-fense downsizing all hit the economy in a relatively short period oftime. These events occurred during a worldwide slowdown amongthe industrialized countries, slowing America's export boom.

While the consolidation and transition were painful, and earliereconomic policy might well have been somewhat more aggressivein dealing with the short-term problems, unless the economy fal-ters badly in its current or prospective state, fiscal and monetarypolicy should be directed primarily by the long-term goal of en-hancing noninflationary economic growth. If the economy faltersbadly, and unemployment rises or appears likely to do so, it wouldbe wise to combine any short-term fiscal stimulus with simulta-neously enacted long-term spending cuts to reduce future budgetdeficits. This strategy would help allay fears in financial marketsand decrease the likelihood that a rise in interest rates wouldoffset much of the benefit from short-term fiscal stimulus. It wouldalso help promote long-term investment. Monetary policy, now thatit has achieved the lowest inflation rates in a generation andbroken the previous cycle of ever-higher inflation at correspondingstages of successive expansions, should be directed toward main-taining low and stable inflation while providing sufficient moneyand credit to support economic expansion. The last thing the econo-my needs after having gone through two rounds of disinflationthefirst in the early 1980s and the second in the early 1990sis exces-sive money growth that would rekindle inflation and a return to theboom/bust cycles of the 1970s,

A third major problem confronting America is the economic con-dition of the disadvantaged. For several decades the rate of eco-nomic growth greatly reduced the poverty rate. But a combinationof demographic, social, economic, and policy factors has led to a sit-uation where many Americans have little opportunity or incentiveto improve their condition and have a standard of living far belowthat of most Americans. As noted in previous Economic Reports,economic growth is essential to provide rising employment opportu-

29334-230 O92 2 (QL3)Digitized for FRASER

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nities for new entrants into the labor force and those seekingupward economic mobility. But economic growth, by itself, will notbe sufficient to make major inroads in the poverty rate in theUnited States.

Fourth, the Nation's health care system costs too much and failsto insure too many Americans. Because of its importance to boththe economy and the welfare of all citizens, problems in the healthcare system pose a special threat to future increases in income andliving standards. While Americans enjoy rising life expectanciesand probably the highest quality of health care in the world,health care expenditures, which now account for one-eighth of theeconomy, are rising rapidly. Estimates suggest that one out ofevery seven or eight Americans is not covered by health insurance.The system of health insurance and third-party payment and thelack of incentives to use health services wisely are only a few ofthe factors that are driving up health care costs. Chapter 4 of thisReport describes these issues and proposed solutions in far greaterdetail.

In summary, the economy has short-term problems and long-term challenges. Each of these is discussed in much more detail insubsequent chapters in this Report, and each is amenable to policyreforms that would greatly strengthen the American economy.

AGENDA FOR REFORMIn order to surmount the challenges, solve the problems, and

take advantage of the opportunities confronting the Americaneconomy, government policy in numerous areas needs to be re-formed. Successful implementation of this reform agenda wouldgreatly enhance the prospects for a stronger economy, higher livingstandards, and greater economic and social mobility for the disad-vantaged. It is an activist agenda, but one that points to more limitedgovernment. This is far from a contradiction. The private sector ofthe economy is where most of the jobs are created and incomeearned. Sometimes the government can play an effective role indealing with problems, but too often in the past the governmenthas overplayed that role, creating costly, ineffective, inefficient bu-reaucracies and unnecessarily wasteful spending. The answer is notto let the existing programs continue indefinitely, nor is it alwaysto eliminate government involvement. It is to seek reform based onsound economic principles in a primarily pluralistic democraticcapitalist and federal system, consistent with individual initiative,freedoms, and responsibilities.

A comprehensive agenda for reform has been presented duringthe course of the Bush Administration. Some of the reforms hadtheir roots in proposals made during the Reagan Administration,


while others were entirely new. The President was able to imple-ment some of thfem unilaterally; some of them were partially adopt-ed by the Congress; and others the Congress refused to enact, at leastin a form acceptable to the President. The appropriate thoughlimited role for government in improving the foundations and per-formance of the economy includes, in addition to maintaining asound monetary system with low and stable inflation:

FISCAL REFORM Removing Tax Penalties on Saving, Investment, and Entrepre-

neurship. Despite the substantial and desirable reduction inmarginal tax rates achieved in the 1986 Tax Reform, disincen-tives to saving, investment, and entrepreneurship in the currenttax system were worsened. Restoring tax incentives, such as acapital gains differential, more neutral capital cost recovery orother investment incentives, and elimination of the doubletaxation of saving, should be a high priority. Further, this couldbe accomplished either by reforming the income tax or bymoving to a consumed income tax, as discussed in Chapter 6. Itshould be done in the context of tax simplification. The corpo-rate tax also ought to be explicitly or implicitly integrated withthe personal tax to eliminate the double taxation of corporatesource income, reduce the bias favoring debt as opposed toequity finance, and restore investment incentives. Further, thecorporate alternative minimum tax, which was greatly expand-ed in 1986, should be substantially reformed or repealed.

Limiting and Redirecting Growth of Federal GovernmentSpending. Bringing the budget under control requires limitingthe growth of the mandatory spending that forms the bulk ofthe budget. This will mean a substantial reduction in thegrowth of entitlements, especially for health care. The bestplace to start would be with entitlement payments to well-offindividuals. It is also desirable to continue to reorient spendingto productive investment in infrastructure and research anddevelopment.

Reforming the Budget Process. A good start would be giving thePresident a line-item veto.

TRADE LIBERALIZATION NAFTA. The North American Free Trade Agreement

(NAFTA) offers the opportunity to create a more prosperousand stable Western Hemisphere. It should be adopted by therespective legislatures as rapidly as possible. It will be phasedin over many years, so the fear of economic dislocation isgreatly exaggerated.


Completing the Uruguay Round. To bring the Uruguay Roundof GATT to a successful conclusion remains essential to ad-vancing U.S. and global economic prosperity. (Each of these isdiscussed in more detail in Chapter 7.)

REGULATORY REFORM Utilizing Market Incentives. Wherever possible, command-and-

control approaches that prescribe particular ways of meetingthe objectives of regulation should be replaced by perform-ance standards allowing far greater flexibility to workers,firms, and consumers to meet sensibly chosen standards.

Reform Risk Assessment and Management. There needs to be afundamental reexamination and reform of the Federal Govern-ment's risk assessment and risk management systems. Currentprocedures result in biased estimates of risk and in unevenstandards of risk minimization, with unrealistically strict re-quirements in some areas and missed opportunities for majorreductions in risk in others.

EDUCATION REFORM School Choice. Low- and middle-income families should be

given the opportunity to send their children to schools of theirchoice, whether public or private. School choice will createcompetition, forcing schools to improve their quality in orderto attract students, in much the same manner as do Americanuniversities, which are the best in the world.

National Educational Standards. Families and educators needobjective, widely accepted standards that define children's skilllevels in key areas. Without such standards in place, it is im-possible to evaluate the quality of schools or assess children'sacademic performance.

HEALTH CARE REFORM Improving Access to Health Care. Reforms are needed to pro-

vide insurance to low-income people. The best way to do this isto provide them with tax credits tied to the purchase of healthinsurance to enable them to choose among the options avail-able in the health care market.

Pooling Health Risks. To lower the cost of health care forthose with chronic illnesses, it is important to pool risks amongthe healthy and the chronically ill. Risk pooling should be ac-complished through the use of health risk adjusters and notthrough mechanisms that discourage insurers from providinginsurance to those in poor health.

Access to Health Insurance for Employees in Small Businesses.Regulatory reform is needed to enable small businesses to gain


access to the health insurance market and to reduce the cost ofthis insurance. Small businesses should be encouraged to pooltheir health insurance buying power and should be madeexempt from state benefit mandates and premium taxes.

Malpractice reform. The malpractice litigation crisis must beended and the system overhauled. Litigation over medical mal-practice raises costs directly and encourages the practice ofcostly defensive medicine.

EMPOWERING THE DISADVANTAGED Enterprise 2k>nes. To improve the employment opportunities of

the disadvantage*! in distressed urban and rural communities,enterprise zones should be created. Businesses locating withinthe enterprise zone would be eligible for a tax incentive to en-courage employment of low-income residents.

Weed and Seed. To control violent crime, and to provide socialand economic support to areas where high crime rates andsocial ills are prevalent, neighborhoods should be given assist-ance through job training, drug treatment and prevention, andeducational activities.

Housing and Homeownership. Reforms are needed to increasethe possibilities for low-income families to own their ownhomes in order to have a stake in their communities.

CONCLUSION

Continuing the activist, appropriate, but limited governmentalrole demonstrated by the Bush Administration is the proper basisof economic policy for the 1990s and beyond. Such a role will fosterthe spirit of vitality, creativity, productivity, and resourcefulnessthat has so often described America and its accomplishments in thepast. The major need is for a steady, coherent, coordinated, long-term policy framework.

Without abandoning government's substantial accomplishments,such as greatly mitigating the economic distress attributable to un-employment and poverty, government spending must be mademuch more cost conscious and target effective. Without deludingthemselves about the prospects of instantly promoting the rate ofeconomic growth, policymakers must unravel the disincentives forcapital formation and new business creation that government regu-latory and tax policies have created. Without forgetting the genu-ine needs for greater health, safety, and environmental protection,Americans must begin to clean up the regulatory morass thathinders the country's economic progress. Without ignoring impor-tant national interests, America must resist the lure of protection-ism and managed trade and complete the work of liberalizing trade


throughout the world. Without neglecting the fact that marketssometimes do not work perfectly, it must be recognized that this isthe exception and not the rule, and that governments often fail toimprove on imperfect market outcomes.

America's economic success sends an important message thatfree political institutions, free markets, and economic progress arelinked. Responding to economic challenges to enhance the Nation'slong-term economic growth in an open world trading system is thesingle most important thing Americans can do to ensure the pros-perity of future generations and influence decisively the evolutionof many of the world's economic and political systems towarddemocratic capitalism.


CHAPTER 2

Recent Developments and theEconomic Outlook

OVER THE LAST SEVERAL years, the U.S. economy has beenstruggling through a period of consolidation and transition. In addi-tion to the oil price shock in the second half of 1990, various struc-tural relationships and imbalances contributed to the recession andthe sluggish economic performance including defense downsizing; aboom-bust cycle in commercial real estate aggravated by wideswings in the tax laws and bank regulation; credit market con-straints resulting from the balance sheet, capital, and regulatorydifficulties that financial institutions faced; and a buildup in corpo-rate debt relative to profits and household debt relative to income.The working off of these imbalances added to the economy's cycli-cal difficulties. Changing demographic trends that have slowed theunderlying rate of household formation and the more recent trendtoward corporate downsizing also have played a role in slowing theeconomy. The sluggish economic performance has not been con-fined to the United States: In recent years, Australia, Canada, andthe United Kingdom have been in recession, and Japan and Ger-many entered recession during 1992. Other European countries areverging on recession. Although some countries are adopting policiesto help stimulate their economies, the general slowdown in theinternational economy will act as a drag on U.S. exports andgrowth for some time.

As the Nation's economic difficulties are resolvedas the dragassociated with corporate and household indebtedness is reduced;banks improve their capital position, become less cautious aboutlending, and face a more-balanced regulatory environment; the ad-justment to defense cuts progresses; and the supply of developedreal estate is brought into balance with demandconditions for astronger, sustained expansion are being laid. Other developmentsthat promise to enhance the prospects for a sustained expansion in-clude low and stable inflation, low interest rates, and rising produc-tivity. Interest rates and core inflationconsumer price inflationexcluding the volatile food and energy componentsare at theirlowest levels in a generation.

In the late 1970s, inflation climbed to disturbing double-digitlevels, exceeding 13 percent during 1979 and 12 percent during


1980. Inflation imposed a heavy burden on the economy, complicat-ing saving and investment decisions and adding to the economicuncertainties that many Americans faced. Additionally, becausetax brackets were not indexed for inflation at that time, increasesin nominal income that barely kept pace with inflation automati-cally pushed taxpayers into higher tax brackets. The severe reces-sion that followed in the early 1980s, the country's worst economicperformance since World War II, was largely a direct consequenceof the disinflation policiesin particular tight monetary policythat successfully reduced inflation from the double-digit levels of1979-80 to less than 4 percent in 1982. Inflation remained in the 4-to 5-percent range for the rest of the decade. While the recession ofthe early 1980s was deep, the loss of output was not nearly assevere as many economists had predicted it would have to be inorder to achieve such a sharp reduction in inflation.

The lower rate of inflation was a significant improvement, andthe economy grew strongly, producing over 21 million new jobs be-tween 1982 and 1990. But concern mounted that progress towardlower inflation had stalled. It seemed that a rate of 4 to 5 percentmight be a new floor below which inflation would be unlikely tofall. In the early 1970s, such rates of inflation had been consideredunacceptably high; in response to such rates, the Nixon Adminis-tration imposed wage and price controls to bring inflation down, inwhat proved to be an unsuccessful effort with costly side effects. Inthe late 1980s, as the economy continued to expand and the unem-ployment rate fell to its lowest level in 15 years, incipient inflation-ary pressures raised fears of a resurgence in inflation. This raisedthe possibility of another round of rapidly accelerating inflationand the costly efforts required to fight itmuch like the severeevents of the late 1970s.

The Federal Reserve was determined to avoid the mistakes of thepast and to act before a new inflationary spiral developed. In orderto prevent a substantial increase in inflation and to resume theprogress toward lower inflation that had begun early in the decade,the Federal Reserve pursued a strategy that tightened monetarypolicy gradually in an attempt to contain the growth of nominaloutput and reduce inflation without causing an actual decline inreal output. This has sometimes been called a "soft-landing" strate-gy. Short-term interest rates rose from about 7 percent in early1988 to about 10 percent in early 1989. By acting in a timelymanner with forward-looking monetary policies, the Federal Re-serve improved the prospects for a reduction in inflation without acostly economic downturn.

As growth slowed in 1989 and early 1990, the Federal Reservebegan gradually lowering interest rates as evidence of poor eco-nomic performance and lower inflationary pressures accumulated.


Interest rates fell gradually from the spring of 1989 until the begin-ning of 1990. In the last quarter of 1990, after it was evident thatthe economy had indeed entered a recession, the Federal Reservebecame more aggressive in lowering interest rates, which contin-ued to fall through 1991 and much of 1992. During this period, thereserves of banks and other depository institutions grew substan-tially. However, the broader money supply measures grew at sur-prisingly low rates and appeared largely unresponsive to increasesin bank reserves and reductions in short-term interest rates (Chap-ter 3). Moreover, the economy did not respond to the decline in in-terest rates as rapidly or as strongly as the Federal Reserve andmany private observers had anticipated.

The soft-landing strategy involved inevitable risks because itslowed aggregate demand growth and made the economy more vul-nerable to potential adverse developments. This strategy mighthave worked if large shocks and other unforeseen factors depress-ing economic activity had not emerged or if the drag they exertedon the economy had been readily observable and easily offset bychanges in policy. However, policies are always conducted in an un-certain environment, and it takes time to recognize problems andimplement policiesand for those policies to take effect.

At the time the various problems facing the economy began toemerge, it was difficult to determine their severity or the kind ofstimulus that would be required to offset them without reversingprogress toward lower inflation. With the benefit of hindsight, amore rapid reduction in interest rates might have reduced thedownward pressures on output and contributed to a healthier re-covery without reviving inflationary pressuresalthough theprogress in reducing inflation could have been slowed. In anyevent, too much reliance was placed on monetary policy, and theeconomy would have benefited from fiscal stimulus (primarily taxincentives), regulatory relief, and policies oriented toward trade ex-pansion.

If the soft-landing strategy failed to avert a recession as a resultof unexpected events, the strategy was highly successful in reestab-lishing progress toward lower inflation. The rate of core inflationdeclined from 5.2 percent during 1990 to about 3.5 percent during1992. Following the decline of inflation from the double-digit levelsof the late 1970s to the 4- to 5-percent range in the mid- to late-1980s, the more recent decline represents the second round of along-term disinflation effort started over a decade ago. The currentlow and stable inflation rate means that households will be able tosave with reduced concern that inflation will erode the purchasingpower of their nominal assets, while businesses will be able tocommit themselves to long-term projects with less uncertainty thatinflation might render their investments unprofitable. As a result


of reduced inflationary pressures and the credibility the FederalReserve has gained from its inflation fight, the economy may bespared the need for the policy reversalsso prevalent from the late1960s through the early 1980sthat resulted in the upward rat-cheting of inflation and wide swings in output and employment.

During the recent period of disinflation, the U.S. economy hasgone through several fairly distinct phases: a period of slow growthstarting in early 1989 and continuing through the first half of 1990;a recession for the next three quarters, with real gross domesticproduct (GDP) falling a total of 2.2 percent; and three quarters ofvery sluggish recovery, with real GDP growing about 1.2 percent atan annual rate. During 1992, the U.S. economy remained in amodest and uneven recovery, with the rate of growth picking up tothe 2.5- to 3-percent range.

Last year's Administration forecast correctly predicted that, byhistorical standards, the economy would grow at a quite modestpace during 1992. Through the middle of the year, employment andincome growth remained sluggish, and consumer and business con-fidence were low. Export growth slowed, restricting what had beena source of strength for the U.S. economy for many years. Howev-er, by midyear the outlook began to improve as unemploymentbegan a gradual decline, nonfarm payrolls began to edge up,income growth picked up, and consumer and business confidencestabilized and then began to rise.

The current Administration forecast predicts that real GDP willgrow about 3 percent during 1993. Growth is expected to continuein the 3-percent range through the mid-1990s. Sustained growthwill require, among other things, a fiscal policy oriented towardspending restraints to reduce the structural budget deficit overtime and tax incentives that enhance growth, a monetary policythat provides sufficient growth in money and credit to sustain theexpansion while maintaining low inflation, regulatory reform thatprovides greater room for the use of market incentives to minimizethe negative impacts of regulation on economic growth, and tradepolicies that succeed in opening markets worldwide and in support-ing growth in the international economy.

The unemployment rate is expected to decline slowly but steadilyduring 1993, averaging 6.9 percent for the year (compared with 7.4percent for 1992) and to continue its slow decline through the mid-1990s. Inflation likely will remain low in 1993 and in coming years,with consumer prices rising in the range of about 3 percent peryear. With moderate growth and low inflation, short-term interestrates are expected to remain low in 1993, and long-term interestrates are expected to decline. In coming years, short-term rates arelikely to increase slightly as the economy continues to expand, andlong-term rates are expected to stabilize as inflation remains low.

38


However, the outlook for interest rates in general and long-termrates in particular depends on fiscal and monetary policies. Policiesthat would lead to higher spending and deficits or higher inflation,relative to what is currently expected, could boost long-term inter-est rates and retard economic growth in the future.

The economy is expected to improve in coming years. But chal-lenges remain. Short-term cyclical performance remains uncertain,various structural imbalances have yet to be worked out, and ahigh rate of productivity growth must be maintained to sustain in-creases in Americans' living standards. Of the various short-termcyclical concerns that remain, the most important center on theneed for improved employment prospects and the related bolsteringof consumer confidence. Corporate restructuring and militarydownsizing are significant structural adjustments that couldhamper job growth.

This Administration has recognized throughout its term, andstated explicitly in each of its previous Economic Reports, that theNation faces serious economic challenges and cannot take economicgrowth for granted. The Administration's policies and policy pro-posals have been designed to support sustained increases in the Na-tion's standard of living by raising long-term productivity growthwhile boosting the job base. Unfortunately, the Congress did notenact many of the Administration's key growth proposals in an ac-ceptable form. Included in these proposals were pro-growth fiscalmeasures designed to enhance incentives for entrepreneurship,saving, and investment and to increase economic growth, as well asspending controls aimed at reducing the multiyear structuralbudget deficit. This Administration also has promoted a tradepolicy designed to open markets worldwide, contributing to morevigorous growth, and pursued regulatory reforms to reduce unnec-essary burdens on businesses and consumers.

The Nation has been through difficult economic times over thepast several years, but despite these difficulties, the U.S. economyremains the strongest and most resilient in the world. The recoveryfrom the recent recession has been slow and protracted, but theperformance of the economy during the last 4 years has not beenuniformly weak. Broad-based, readily available information doesnot support the argument that the country's recent economic per-formance has been the worst since World War II. Economic condi-tions, including inflation, interest rates, unemployment, and realgrowth, have been better during the past 4 years than they wereduring the 1978-82 period. Core inflation and interest rates arenow at their lowest levels in a generation, well below the double-digit rates that prevailed 12 years ago. At its recent peak the un-employment rate was 7.7 percent, considerably lower than the peakof nearly 11 percent in the early 1980s and the 9-percent peak


during the 1973-75 recession. And in terms of real GDP andincome, the slow growth of the past 4 years still exceeds the aver-age growth from 1978 to 1982.

The soaring inflation and interest rates of the late 1970s con-demned the U.S. economy to years of declining output, falling in-comes, and rising unemployment. Yet these adjustments, painful asthey were, set the stage for the sustained expansion of the 1980s.For the last several years, the economy has been going through asimilar but much less severe period of consolidation and transition,with structural adjustments and disinflation restricting economicgrowth. This period once again has meant substantial hardship formillions of Americans. But the numerous structural adjustments ofrecent years have been laying the basis for a solid, sustained ex-pansion in the 1990s. As the drag associated with household andcorporate indebtedness is reduced, consumer spending and invest-ment in plant and equipment will increase. As banks improve theirbalance sheet positions and banking regulation and supervisionbecome more balanced, credit conditions will improve. Over time,shifting resources from defense to civilian industries will strength-en the private economy and provide new employment opportuni-ties. Enhanced productivity already has boosted the Nation's com-petitive position in international markets, and low and stable infla-tion will reduce the need for policies that could restrict futuregrowth. Together, these factors will help create a strong, sustain-able recovery, more jobs, and higher incomes in years to come.

AN OVERVIEW OF THE ECONOMY IN 1992The pattern of real GDP growth reveals the slow and uneven

nature of the economy's recent performance (Chart 2-1). The reces-sion of 1990-91 ended in March 1991, following 8 months of decline(Box 2-1). Beginning with the second quarter of 1991, real GDPgrew for six consecutive quarters, although growth averaged only 2percent at an annual rate. Furthermore, the pattern of growth wasuneven. During the final three quarters of 1991, the pace of recov-ery was particularly slow; in the fourth quarter of 1991, the econo-my was essentially flat, with real GDP increasing at only a 0.6-per-cent annual rate. During the first three quarters of 1992, the econo-my grew at a stronger pace, but still well below the average forprevious recoveries.

Uneven growth during a recovery is not unusual. Indeed, everyprevious postwar recovery has shown a "saw-tooth" growth patternwith weaker quarters following, or sandwiched between, strongerquarters. The underlying growth rate was low for much of 1991and 1992too low, in fact, to increase employment appreciably.While real GDP increased for six consecutive quarters after its


Chart 2-1 Real Gross Domestic Product GrowthReal GDP has grown for six consecutive quarters, following three quarters of declineduring the recession.

Percent change6

4.5

2.2

3.3

1.6

3.42.8 2.9

1.7

1.0 1.20.6

1.5

-1.6

-4

I J I

-3.9

I

-3.0

I I I I I1986 1987 1988 1989 90.I 90.ll 90.III 90.IV 91.1 91.11 91.111 91.IV 92.1 92.II 92.Ill

Note: Annual values are IV/IV change. Quarterly values are seasonally adjusted at an annual rate.Source: Department of Commerce.

trough in the first quarter of 1991, the unemployment rate in-creased by 1.2 percentage points, reaching an 8-year high of 7.7percent in June 1992 before trending down for the remainder ofthe year (Chart 2-2). Nonfarm payroll employment remainedalmost flat after the recession ended, declining slightly in late 1991and early 1992, before growing slowly through the end of 1992(Chart 2-3).EARLY IMPROVEMENT

The economy picked up in the first quarter of 1992, with realGDP expanding at an annual rate of 2.9 percentthe strongestgrowth in 3 years. Real consumer spending posted its best quarter-ly performance in over 5 years, rising 5.1 percent at an annualrate. Real final salesreal GDP less the change in business inven-tories, a measure of aggregate demand in the economyrose at anannual rate of 4.7 percent in the first quarter. Real per capita dis-posable personal income also increased, recording its largest gainin 2 years. Consumer confidence, as measured by the ConferenceBoard's Consumer Confidence Survey, reached an 18-year low earlyin the year but then rose more than 50 percent through the spring

41


Box 2-1.Recessions and Business Cycle DatingFor the past year and a half the question of whether the

economy has been in a slow recovery or has continued in reces-sion has been hotly debated. The National Bureau of EconomicResearch (NBER), a private economic research organization, isthe official arbiter determining the beginning and ending datesfor recessions and expansionsthe turning points of the busi-ness cycle. In late December 1992, the NBER Business CycleDating Committee determined that the recession that began inJuly 1990 ended in March 1991, indicating the recession lastedonly 8 months.

During a recession, the economy is in a decline of significantdepth, duration, and diffusion (that is, spread across various in-dustries and sectors); during a recovery it regains the outputlost during the recession. A recovery is typically followed by asustained expansion. To say that the recession ended in March1991 does not mean that the economy was doing well after thatdate; rather, it means that the period of decline had ended andoutput had begun to increase. The recovery was complete bythe third quarter of 1992, when real GDP climbed above theprerecession peak of the second quarter of 1990.

Key economic variables must be examined to determine thebeginning or end of a recession. The components of the Depart-ment of Commerce's index of coincident indicatorsnonfarmpayroll employment, industrial production, real personalincome less transfer payments, and real manufacturing andtrade salesgenerally serve that purpose well. Industrial pro-duction and real manufacturing and trade sales hit their lowpoint in early 1991. Real personal income less transfer pay-ments and nonfarm payroll employment also reached their ini-tial lows in early 1991 but then flattened out, even dippingslightly in late 1991 and early 1992.

The debate also was clouded somewhat by the methodologyused to construct the index of coincident indicators. This meth-odology results in a downward bias that would generate a de-clining index even if the economy were growing very slowly.The Department of Commerce has begun publishing an alter-native coincident index based on revised methodology thatshows a troughthe low point in economic activityin March1991, a result consistent with the NBER dating of the end ofthe recession.

(Chart 2-4). Civilian employment and labor force participationthepercentage of the working-age population working or actively seek-

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Chart 2-2 Civilian Unemployment RateThe unemployment rate fell steadily during the second half of 1992. The recent peak of 7.7percent in June 1992 was well below the 10.8 percent peak following the 1981-82 recession.

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

Source: Department of Labor.

Chart 2-3 Nonfarm Payroll EmploymentNonfarm payroll employment grew slowly during 1992, after being stagnant for much of1991 following the recession.

Thousands110,500

110,000

109,500 -

109,000 -

108,500 -

108,000

I

-110,304June 1990

108,711December 1992

I IJan Apr July Oct Jan Apr July Oct

1990 1991Note: November and December 1992 data are preliminary.Source: Department of Labor.

Jan Apr July Oct1992


ing workrose as the economy appeared to be moving into a sus-tainable recovery and job prospects appeared brighter. After-taxcorporate profits surged nearly 11 percent in the first quarter, thelargest increase in 4 years.

Chart 2-4 Consumer ConfidenceConsumer confidence has been extremely volatile over the last 2 years, turning up againin the final months of 1992.Index, 1985 = 100120

110 -

100 -

1990 1991 1992

Source: The Conference Board.

Other indicators also pointed to an improved economic outlook inearly 1992. Lower mortgage rates helped boost housing construc-tion, with housing starts surging 20 percent over the first 3 monthsof the year. Orders for durable goods rose 7.4 percent between De-cember 1991 and April 1992, and industrial productionthe outputof the Nation's factories, mines, and utilitiesrose 2.2 percent be-tween January and

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