1999 Economic Report of The President

8/8/2019 1999 Economic Report of The President

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EconomicReportof the

PresidentTransmitted to the Congress

February 1999


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Economic Report

of the President

For sale by the U.S. Governm ent P rint ing Office

Super inten dent of Documen ts, Ma il Stop: SSOP, Wash ington, D.C. 20402-9328

Transmitted to the Congress

February 1999

TOGETHER WITH

THE ANNUAL REPORT

OF THE

COUNCIL OF ECONOMIC ADVISERS

UNITED STATES GOVERNMENT PRINTING OFFICE

WASHINGTON : 1999


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iii

C O N T E N T S

ECONOMIC RE PORT OF THE PRESIDE NT ............................

ANNUAL REPORT OF THE COUNCI L OF ECONOMI C

ADVISERS* ................................................................................

CHAPTER 1. MEETING CH ALLE NGE S AN D BUILDIN G F OR TH E

FUTURE .........................................................................................

CHAPTER 2. MACROECONOMIC POLICY AND PERFORMANCE ..............

CHAPTER 3. BE NE FITS OF A STRONG LABOR MARKET ......................

CHAPTER 4. WORK, RETIREMENT, AN D TH E ECONOMIC WELL-BEING

OF TH E ELDERLY ...........................................................................

CHAPTER 5. REGULATION AND INNOVATION ......................................

CHAPTER 6. CAPITAL FLOWS IN TH E GLOBAL ECONOMY ..................

CHAPTER 7. THE EVOLUTION AND RE FORM OF TH E INTERNATIONAL

F INANCIAL SYSTEM .......................................................................

APPENDIX A. RE PORT TO TH E PRESI DENT ON TH E ACTIVITIES OF THE

COUNCIL OF E CONOMIC ADVISERS DURING 1998 ..........................

APPENDIX B. STATISTICAL TABLES RELATING TO INCOME, EMPLOYMENT,

AND PRODUCTION ...........................................................................

1

7

19

43

99

131

171

219

267

307

319

* For a detailed table of contents of the Councils Report, see page 11

Page


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ECONOMIC REPORT

OF THE PRESIDENT


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3

To the Congress of the United States:

I am pleased to report that the American economy today is healthy

and strong. Our Nation is enjoying the longest peacetime economic

expansion in its history, with almost 18 million new jobs since 1993,

wages rising at twice th e ra te of inflation, th e highest home ownersh ip

ever, the smallest welfare rolls in 30 years, and unemployment and

inflation at th eir lowest levels in th ree decades.

This expansion, u nlike recent previous ones, is both wide a nd deep.

All income groups, from the richest to the poorest, have seen theirincomes rise since 1993. The typical family income is up more than

$3,500, adjusted for inflation. African-American and Hispanic house-

holds, who were left behind dur ing th e last expansion, h ave a lso seen

subst an tial increa ses in income.

Our Na tions budget is balan ced, for th e first time in a genera tion,

an d we ar e ent ering th e second year of an era of sur pluses: our projec-

tions show th a t we will close out th e 1999 fisca l year with a su rp lus of

$79 billion, th e largest in t he h istory of th e Un ited Sta tes. We ar e on

course for bu dget su rp luses for m an y year s to come.

These economic successes are not accidental. They are the result of

an economic str at egy th at we have pur sued since 1993. It is a str at egy

th at rests on th ree pillar s: fiscal discipline, investm ent s in education

and technology, and expanding exports to the growing world market.

Cont inuing with th is proven stra tegy is the best way to ma intain our

prosperity and meet th e cha llenges of th e 21st cent ur y.

THE ADMINISTRATIONS ECONOMIC AGENDA

Our new economic st ra tegy was r ooted first a nd forem ost in fiscal dis-

cipline. We ma de hard fiscal choices in 1993, sending signals t o th e ma r -

ket t ha t we were serious a bout dealing with t he budget deficits we had

inherited. The mar ket responded by lowering long-term interest ra tes.

Lower interest ra tes in t ur n helped more people buy homes a nd borr ow

for college, helped more entrepreneurs to start businesses, and helped

more existing businesses to invest in new technology and equipment.

Amer icas economic success h as been fueled by the biggest boom in pri-

vate sector investment in decadesmore than $1 trillion in capital wasfreed for private sector investment. In past expansions, government

bought more and spent more to drive the economy. During this expansion,

governm ent spending as a sh ar e of th e economy has fallen.

ECONOMIC REPORT OF THE PRESIDENT


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The second par t of our str at egy ha s been t o invest in our people. A

global economy driven by information and fast-paced technological

cha nge crea tes ever grea ter dema nd for sk illed workers. Tha t is why,

even a s we balanced th e budget, we substan tially increased our an nu -

al investmen t in education a nd tr aining. We ha ve opened t he doors of

college to all Amer ican s, with ta x credits and more a ffordable studen tloans, with more work-study grants and more Pell grants, with edu-

cation IRAs and the new HOPE Scholarship tax credit that more

th an 5 m illion Amer ican s will receive th is year. Even a s we closed t he

budget gap, we ha ve expan ded th e ear ned income t ax credit for almost

20 million low-income work ing families, giving th em hope a nd helping

lift t hem out of poverty. Even a s we cut governmen t spending, we ha ve

raised investments in a welfare-to-work jobs initiative and invested

$24 billion in our children s healt h initia tive.

Thir d, to build the Amer ican economy, we ha ve focused on opening

foreign markets and expanding exports to our t rading partners

ar oun d the world. Unt il recent ly, fully one-th ird of th e str ong econom-

ic growth America has enjoyed in the 1990s has come from exports.

That tra de ha s been a ided by 270 tra de agreements we ha ve signed in

th e past 6 years.

ADDRESSING OUR NATIONS ECONOMIC CHALLENGES

We have created a strong, healthy, and truly global economyaneconomy th at is a leader for growth in t he world. But comm on sense,

experience, and th e example of our compet itors a broad show us t ha t

we can not afford to be complacent. Now, at th is moment of grea t plenty,

is precisely th e time to face th e challenges of th e next cent ur y.

We must ma int a in our fisca l discipline by saving Social Secur ity for

th e 21st cent ur yth ereby laying t he foun dat ions for fut ur e economic

growth.

By 2030, th e num ber of elderly Amer icans will double. This is a seis-

mic demographic shift with great consequences for our Nation. Wemu st keep Social Secur ity a r ock-solid gua ra nt ee. Tha t is why I pro-

posed in m y Stat e of th e Union a ddress tha t we invest t he sur plus t o

save Social Secur ity. I proposed that we comm it 62 percent of th e bud-

get surplus for the next 15 years to Social Security. I also proposed

investing a small portion in the private sector. This will allow the

trust fund to earn a higher return and keep Social Security sound

un til 2055.

But we must aim higher. We should put Social Security on a

sound footing for the next 75 years. We should reduce povertyam ong elderly women , who are n ear ly twice as likely to be poor a s

oth er sen iors. And we should eliminat e th e limits on wh at seniors

on Social Secur ity can ear n. Th ese cha n ges will require d ifficult but

ful ly achievable choices over and above the dedicat ion of the

surplus.


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Once we have saved Social Secur ity, we mu st fulfill our obligat ion to

save an d improve Medicar e an d invest in long-ter m h ealth car e. Tha t

is why I have cal led for broader , bipart isan reforms that keep

Medicar e secur e un til 2020 thr ough a dditiona l savings an d moderniz-

ing the program with market-oriented purchasing tools, while also

providing a long-overdu e prescript ion dru g benefit.By saving the money we will need to save Social Security and

Medicare, over the next 15 years we will achieve the lowest ratio of

publicly held debt to gross domestic product since 1917. This debt

redu ction will help keep futu re int erest ra tes low or d rive them even

lower, fueling economic growth well into the 21st century.

To spur future growth, we must also encourage private retirement

saving. In m y Stat e of th e Union a ddress I pr oposed th at we use about

12 percent of the surplus to establ ish new Universal Savings

Accoun tsUSA accoun ts. These will ensu re t ha t a ll Amer ican s have

the means to save. Americans could receive a flat tax credit to con-

tr ibute to their USA accoun ts an d additiona l tax credits to ma tch a

portion of th eir sa vingswith more h elp for lower in come Americans.

This is th e right way t o provide ta x relief to th e American people.

Edu cat ion is also key to our Nations futu re prosperity. That is why I

proposed in my Stat e of th e Union address a plan t o crea te 21st-centur y

schools through greater investment and more accountability. Under my

plan, States and school districts that accept Federal resources will be

required to end social promotion, turn around or close failing schools,

support high-qua lity teachers, an d promote innovation, compet ition, and

discipline. My plan also proposes increasing Federa l investmen ts to help

States and school districts take responsibility for failing schools, to

recruit and train new teachers, to expand after school and summer

school programs, an d t o build or fix 5,000 schools.

At this time of continued turmoil in the international economy, we

must do more to help create stability and open markets around the

world. We mu st pr ess forwa rd with open t ra de. It would be a ter riblemist ak e, at t his t ime of economic fra gility in so ma ny r egions , for t he

United States to build new walls of protectionism that could set off a

cha in rea ction ar oun d t he world, imperiling t he growth upon which we

depend. At t he sa me t ime, we must do more to make su re th at work -

ing people are lifted u p by tra de. We mu st do more to ensu re t ha t spir-

ited economic competit ion a mong nat ions n ever becomes a r ace to th e

bott om in t he a rea of environm ent al protections or labor st an dar ds.

Strengthening the foundations of trade means strengthening the

architecture of international finance. The United States must contin-ue to lead in stabilizing the world financial system. When nations

around the world descend into economic disruption, consigning popu-

lations t o povert y, it hu rts th em a nd it hu rt s us. These nat ions a re our

trading partners; they buy our products and can ship low-cost

products t o Amer ican consu mer s.


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The U.S. proposa l for cont ain ing fina ncial cont agion h as been t ak en

up around the world: interest rates are being cut here and abroad,

America is meeting its obligations to the International Monetary

Fund, and a new facility has been created at the World Bank to

strengthen the social safety net in Asia. And agreement has been

reached to establish a new precautionary line of credit, so nationswith strong economic policies can quickly get the help they need

before fina ncial pr oblems m ushr oom from concern s t o crises.

We mu st do more t o ren ew our cities an d distressed ru ra l area s. My

Administration has pursued a new strategy, based on empowerment

an d investmen t, an d we ha ve seen its su ccess. With t he critical a ssis-

tance of Empowerment Zones, unemployment rates in cities across

th e coun tr y ha ve dropped dra ma tically. But we ha ve more work to do

to bring t he spa rk of privat e ent erprise to neighborhoods th at ha ve too

long been without hope. That is why my budget includes an innova-

tive New Mark ets initia tive to spur $15 billion in new privat e sector

capital investment in businesses in underserved areas through a

package of ta x credits an d gua ra nt ees.

GOING F ORWARD TOGETH ER IN TH E 21ST CENTU RY

Now, on th e verge of an oth er Amer ican Cent ur y, our economy is a t

th e pinn acle of power an d su ccess, but cha llenges r ema in. Techn ology

an d tr ade a nd t he spr ead of inform at ion h ave tr an sform ed our econo-my, offering great opportunities but also posing great challenges. All

Amer ican s mu st be equipped with t he sk ills to succeed an d prosper in

th e new economy. Amer ica mu st ha ve the cour age to move forward an d

renew its ideas an d institu tions t o meet n ew cha llenges. There a re no

limit s to th e world we can crea te, togeth er, in th e cent ur y to come.

THE WHITE HOUSE

FE BRUARY 4, 1999


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THE ANNUAL REPORT

OF THE

COUNCIL OF ECONOMIC ADVISERS


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9

LETTE R OF TRANSMITTAL

COUNCIL OF ECONOMIC ADVISERSWashington, D.C., February 4, 1999

MR. P RESIDENT:

The Coun cil of Economic Advisers h erewith submits its 1999 Annu al

Report in a ccorda nce with th e pr ovisions of the Em ployment Act of 1946

as a mended by the F ull Employment an d Balan ced Growth Act of 1978.

Sincerely,

J anet L. Yellen,Chair

J effrey A. Fr ank el,Member

Rebecca M. Blan k,Member


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CH A P TER 1. MEETI N G CH AL LE N G E S AN D BU ILDIN G F OR TH E

F UTURE . . .. .. .. . .. .. . .. .. .. . .. .. .. . .. .. . .. .. .. . .. .. .. . .. .. . .. .. .. . .. .. .. . .. .. . .. .. . 19

Policy Lessons from Thr ee Long Expansions ....................... 20

Keynesian Activism in the 1961-69 Expansion............. 21

The Su pply-Side Revolut ion a nd th e 1982-90

Expan sion .................................................................... 22

Deficit Reduction a nd the Current E xpansion. ............. 24Conclusion ....................................................................... 27

Pr eserving Fisca l Discipline .................................................. 28

Reaching Surplus ............................................................ 28

Fiscal Policy in a n E ra of Surpluses .............................. 30

Meeting the Intern at iona l Challenge ................................... 34

Containing the Cris is and Promoting Recovery ........... 34

Stren gthening th e Intern at iona l Finan cial

Architecture................................................................. 36

Embracing Chan ge While Promoting Fairness.................... 37Agricult ure ...................................................................... 38

Mergers ............................................................................ 39

In ter na tional Tra de......................................................... 40

Pr omoting Pr osperity for All Amer ican s ............................... 41

Conclusion ............................................................................... 42

CH A P TER 2. MACROECONOMIC P O LI CY AN D P ERFORMANCE ...... 43

The Year in Review................................................................. 45

The Sta nce of Macroeconomic Policy ............................. 45

Tur moil in Fina ncial Mar kets ........................................ 47Component s of Spending ................................................ 47

The Labor Ma rket an d Inflat ion .................................... 52

Fin an cial Mar ket s .................................................................. 55

The E ffect of Risk on In ter est Ra tes a nd Equ ity

Pr ices ........................................................................... 56

Cha nging Risk Per ceptions an d Fina ncial Market

Development s .............................................................. 57

New Concern s About H edge Fun ds ............................... 63

Financial Market Influences on Spending .................... 67The Invest men t Boom ............................................................ 69

Cau ses of th e Boom ......................................................... 70

Implicat ions of th e Investm ent Boom............................ 73

Macroeconomic Implications of the Y2K Problem ............... 76

C O N T E N T S

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Near-Term Outlook a nd Long-Run F orecast ........................ 83

The Administrat ion Forecast ......................................... 83

Component s of Long-Term Growth ................................ 84

Inflat ion: Flat or F alling? ............................................... 88

What Ha s Held Inflation in Check?............................... 91

The Near-Term Out look .................................................. 95CHAPTER 3. BE NE FITS OF A STRONG LABOR MARKET .............. 99

Economy-Wide Developments in the Labor Market ............ 100

Employment .................................................................... 100

Wages ............................................................................... 101

Disadvanta ged Groups ........................................................... 103

Low-Wage Workers ......................................................... 104

Less Edu cated Work ers .................................................. 105

Blacks an d Hispa nics...................................................... 107

Immigra nts ...................................................................... 109

Single Mothers ................................................................ 112

Overcoming Disadvanta ges in t he Labor Market ......... 116

Benefits to Society of a St rong Labor Mar ket ...................... 116

Welfare Reform ............................................................... 116

Crime ............................................................................... 120

J ob Displacement, Tenu re, an d th e Cont ingent Work

Force .................................................................................... 121

J ob Displacemen t ............................................................ 122J ob Tenure ....................................................................... 123

The Contingent Work Force ........................................... 124

Myths and Realities ........................................................ 126

New Developments in J ob Tra ining an d Lifelong

Learning .............................................................................. 127

CHAPTER 4. WORK, RETI R EMEN T, AN D TH E E CONOMIC

WE LL-B E IN G OF TH E E LDERLY . .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 131

Population Aging, Life Expectan cy, and H ealth Sta tus. ...... 132

Older Workers an d Retiremen t ............................................. 135Long-Term Tren ds in Labor Force Pa rt icipat ion a t

Older Ages ................................................................... 136

Recent Cha nges in th e Labor F orce Par ticipation of

Older Men .................................................................... 139

Influences on th e Timing of Retirement ........................ 141

Un employment an d J ob Loss ................................................ 149

The U npa id Cont ributions of the Elderly ............................. 151

The Economic Well-Being of the Elderly .............................. 152

Income and Consum pt ion ............................................... 153Povert y ............................................................................. 163

Wealth .............................................................................. 166

Are Older Workers Saving Enough for Retirement? .... 167

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CH A P TER 5. RE G U L AT I ON AN D INNOVATION .... ...... ...... ....... ...... 171

Compet ition Policy an d Inn ovation ....................................... 173

Merger Review and Inn ovat ion ...................................... 173

Do Bigger Firms Help or Hu rt Inn ovation? .................. 174

Market Concentrat ion, Compet it ion, and Innovat ion .. 175

Merger P olicy in H igh-Techn ology Mar kets .................. 177Int ellectu al P roperty a nd Antitrust ............................... 181

Network Competition an d Inn ovation ........................... 185

En vironm enta l Regulation a nd Inn ovation .......................... 193

Environmental Policy and Incentives to Innovate ....... 193

Environm ent a l Policy and th e Diffusion of

Technology ................................................................... 201

Innovat ion an d Diffusion: An Applica tion t o Clima te

Change Policy .............................................................. 205

The Long-Run Costs of Environmental Regulat ion. ..... 210

Regulat ion an d In novat ion: The Case of the E lectr ic

Power Indu st ry ................................................................... 211

From Innovation to Deregulat ion and Competit ion ............ 213

The Benefits of Deregula tion ................................................. 216

The Ch allenge of a Compet itive Mar ket:

En vironmen ta l an d Social Objectives ................................. 217

CH A P TER 6. CAPITAL F LOWS IN TH E GLOBAL E CONOMY........... 219

Inter na tiona l Capita l Flows, Their Ca uses, and t he

Risk of F ina ncial Crisis...................................................... 221

Tren ds in F inan cial Int egrat ion ..................................... 221

The Cau ses of Increased Capital Flows ........................ 223

The F inan cial Crises of th e 1990s.................................. 225

The Asian Crisis and Its Global Repercussions ................... 227

The Asian Economic Model ............................................ 227

A History of the Crisis an d Its Conta gion ..................... 228

The Ca uses of th e Crisis ................................................. 237

The Ca uses of Conta gion ................................................ 242The Policy Response to th e Crisis ......................................... 245

The Role of the Internat ional Commu nity .................... 245

The Motivation of the IMF Program s in Asia ............... 246

` U.S. Suppor t of IMF Funding ........................................ 249

New Initiatives to Restore Growth in Ea st Asia. .......... 250

Reform of the Internat ional Financial Architecture..... 251

J apa ns Economic an d Finan cial Crisis ................................ 251

Effects of th e Em erging Mark ets Cr isis on th e

Un ited St a tes ...................................................................... 253Macroeconomic Effects ................................................... 253

The Tra de an d Cur rent Accoun t Deficits....................... 255

Conclusion ............................................................................... 265

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CHAPTER 7. TH E E VO LU T IO N AN D RE FORM OF TH E

INTERNATIONAL F INANCIAL SYSTEM . .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. . 267

Reform of the Int ernational Finan cial Architectur e ............ 268

From th e Halifax Summit to the G-22 Reports ............ 268

Greater Tra nspar ency an d Accoun ta bility .................... 269

Reform ing and St ren gthen ing Domest ic Fina ncialIn st itu tions .................................................................. 271

Bett er Cr isis Resolut ion, Including Appr opr iate Roles

for the Official Commun ity and the Private Sector ..... 272

Adoption of Measures t o Reform th e Int ern at iona l

Fina ncial Architectu re ................................................ 276

Fur ther Steps to Strengthen th e Interna tional Finan cial

Architecture ........................................................................ 276

Stren gthened P ru dential Regulation an d Su pervision

in Industr ial Count ries ............................................... 277

Stren gthening Pru dential Regulation a nd F inancial

Systems an d P romoting Or derly Capita l Accoun t

Liberalization in Em erging Markets ......................... 280

Developing New Approaches to Crisis Response .......... 285

St ren gth enin g th e IMF ................................................... 286

Minimizing the Human Costs of Financial Crises ....... 287

Sust aina ble Excha nge Rate Regimes for E mer ging

Market s ........................................................................ 287Eu ropean Economic an d Moneta ry Union ............................ 291

The EMU Schedu le ......................................................... 291

The Benefits an d Potent ial Costs of EMU .................... 293

The Euro as an Interna tional Currency and th e

Implicat ions for th e Dollar ......................................... 297

Conclusion ............................................................................... 305

AP P EN D I X ES

A. Report to the President on the Activities of the Councilof Economic Advisers Dur ing 1998 .............................. 307

B. Stat is t ical Tables Relat ing to Income, Employment, and

Produ ction ..................................................................... 319

L IST OF TABLES

1-1. Stabilization Policy Indicators in Three Long

Expa nsions ...................................................................... 25

1-2. Economic Growth Indicators in Three Long

Expa nsions ...................................................................... 262-1. Growth of Real GDP and its Components During 1997

and 1998 .......................................................................... 48

2-2. Disaster Damage: National Income and P roduct Accounts

Est imat es of Value of Str uctu res and E quipmen t

Dest royed ......................................................................... 82

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2-3. Accounting for Growth in Real GDP, 1960-2007 ............. 85

2-4. Expected Effects of Methodological Changes on th e CPI

an d Real GDP ................................................................ 94

2-5. Administrat ion F orecast ................................................... 97

4-1. Estimated Pension Coverage and Offer Rates for Private

Sector Wage and Salar y Work ers ................................. 1584-2. Gender Differences in Pension Wealth, 1992 .................. 162

4-3. Consumption Pa t terns of Elderly and Nonelderly

Households by Age of Household H ead, 1997 ............. 163

4-4. Poverty Rates Among the Elderly for Various

Demograph ic Groups .................................................... 165

4-5. Sociodemographic Chara cteristics of the P oor a nd

Nonpoor Elder ly Populat ion , 1997 ............................... 165

4-6. Fam ily Holdings of Financial and Nonfinan cial Assets,

by Age of Head of Fa mily, 1995 .................................... 167

4-7. Total and Financial Wealth of Households by

Percent iles ..................................................................... 168

6-1. Capita l F lows to Indust r ia l and Developing Count r ies .. 223

6-2. Five Asian E conomies: External Finan cing ..................... 241

7-1. The Importa nce of Major Currencies on th e Eve of the

In tr oduction of th e E ur o ............................................... 301

L IST OF CHARTS

1-1. Core Inflat ion an d Unemployment in Three Long

Expansions..................................................................... 23

1-2. Contr ibutions to Economic Growth in Three Long

Expansions..................................................................... 28

1-3. The Federal Budget Balance, 1946-98 ............................. 29

1-4. Growth in Real Family Income, 1947-97 ......................... 41

2-1. Un employment Rat e.......................................................... 44

2-2. Inflat ion Rat e ..................................................................... 44

2-3. Net Wor th and the Per sonal Consumpt ion Rate ............. 492-4. Yields on Treasu ry Secur ities ........................................... 60

2-5. Risk Sprea ds ...................................................................... 60

2-6. Equity Pr ices in 1998 ........................................................ 63

2-7. Con t ribu t ion of Investmen t t o Over a ll GDP Gr owth ...... 69

2-8. Corpora te Profit s and Net Interes t Payments ................ 71

2-9. Net Nat ional Saving and It s Components ....................... 72

2-10. Est ima tion of Pot en t ia l GDP Gr owth by Okuns Law .... 84

2-11. Actual Versus Simulated Product ivity Growth ............... 87

2-12. Three Measures of Core Inflation ..................................... 902-13. Inflation and Trend Unit Labor Costs.............................. 91

2-14. Export and Import Prices Versus the CPI and GDP

Price Index ..................................................................... 92

2-15. Inventory-to-Sales Ratio (Nonfarm Business)................. 96

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6-5. Term s of Tra de ................................................................... 255

6-6. Cur ren t Accoun t Balan ce .................................................. 258

6-7. Economic Growth and Trade Balan ces of G-7

Coun tries , 1992-97 ........................................................ 260

6-8 Employment Growth and Trade Balances of G-7

Coun tries , 1992-97 ........................................................ 2606-9. Saving, Investment , and the Current Account Balance..... 261

6-10. Current Account Deficit an d Net Internat ional

Investment Posit ion ...................................................... 264

6-11. Foreign Direct Investm ent Flows ..................................... 264

7-1. Eu ropean Short-Term Int erest Rat es............................... 292

7-2. Eu ropean Long-Term Interest Rates................................ 292

7-3. Interna tional Use of Major Currencies ............................ 301

LIST OF BOXES

1-1. The Dating of Business Cycles ........................................ 21

1-2. Full Employment an d the NAIRU ................................... 24

2-1. The Electrical Revolution, the Computer Revolution,

an d Productivity ............................................................ 76

2-2. Preparing Federal Systems for the Year 2000................. 78

2-3. Account ing for the E nvironment ...................................... 87

2-4. Methodological Changes to Pr ice Measurement ............. 93

3-1. Sources of Wage Dat a ........................................................ 101

3-2. Increasing th e Minimu m Wage ........................................ 111

3-3. The Ear ned Income Tax Credit ........................................ 113

3-4. The Welfar e to Work Pa rtn ership .................................... 118

4-1. Ea sing th e Bur den of Long-Term Car e ............................ 136

4-2. Social Securit y Rules ......................................................... 143

4-3. Age Discriminat ion in th e Labor Market. ........................ 146

4-4. Types of P ension Plan s ...................................................... 147

4-5. Medicar e Reform ................................................................ 150

4-6. The Changing Living Arrangements of the Elder ly........ 1544-7. The Federal Role in Employer-Provided Pension Plans .... 159

5-1. The Scope of Governm ent Support of R&D ..................... 172

5-2. Elect ronic Commerce and Digit a l Copyr ight Protect ion 183

5-3. Cooperat ive Innovation a nd the Y2K Problem................ 184

5-4. Reverse Engineering and Compatibility .......................... 187

5-5. Recent Tren ds in Air Qua lity ............................................ 196

5-6. Comparing Est imates of Environmental Compliance

Costs Before a nd After Regulat ion ............................... 199

5-7. The Partn ership for a New Generat ion of Vehicles ......... 2025-8. En ergy Efficiency Since the 1970s ................................... 207

5-9. Is There an Environmental Kuznets Curve?................... 212

5-10. The Trend Toward Decentralized Power Generat ion ...... 215

6-1. The Explos ive Growth of Foreign Exchange Trading ..... 224

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6-2. Market-Based (Arms-Length ) Versus Relat ionsh ip-

Based (Insider) F ina nce ................................................ 230

6-3. The Asian Growth Model in Perspective.......................... 232

6-4. Sovereign Spreads in Emerging Markets ........................ 234

6-5. Moral Hazard in Financial Institutions ........................... 238

7-1. Cur ren cy Boards ................................................................ 2897-2. Is Europe an Optimum Currency Area? .......................... 295

7-3. How Does the Dollar Rank Today Against Other

In ter na tiona l Cur ren cies?............................................. 300


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CHAPTER 1

Meeting Challenges and Building forthe Future

THE E CONOMIC POLICIES of th e past 6 years ha ve nu rtu red an d

sust ained wha t is now th e longest pea cetime expan sion on record. By

December 1998, the 93rd m ont h since th e bott om of the last recession,

18.8 million jobs ha d been crea ted (17.7 million of th em since J an ua ry

1993). More Amer ican s a re work ing th an ever before, t he un employ-ment rate is the lowest in a generation, and inflation remains tame.

This r ecord of achievement is especially notewort hy in light of the tr ou -

bles experienced in the international economy in 1998. The United

States has not entirely escaped the effects of this turmoiland calm

ha s not been restored completely abr oad. But th e fun damen ta l soun d-

ness of th e U.S. econ omy preven ted it from foun der ing in 1998s

storms.

This Administration laid a strong policy foundation for growth in

1993 when the President put in place an economic strategy groundedin defici t reduction, targeted investments , and opening markets

abr oad. Since then th e Feder al budget deficit has come down st eadily,

an d in 1998 the bu dget was in t he black for t he first time since 1969.

This policy of fisca l discipline, togeth er with an appropr iat ely accom -

modative monetary policy by the Federal Reserve, produced a favor-

able clima te for bu siness investm ent an d a str ong, investm ent -driven

recovery from t he recession a nd slow growth of th e ear ly 1990s. Even

while redu cing Feder al spending as a sha re of gross domestic product

(GDP), the Administration has pushed for more spending in criticalareas such as education and training, helping families and children,

the environment, health care, and research and development. And

although international economic conditions have led to a dramatic

widening of the trade deficit, the United States has succeeded in

expanding exports in real (inflation-adjusted) terms by almost 8

percent per year since 1993.

Clear ly, there is m uch for Amer icans to be pr oud of in t he economic

accomplishments of the past 6 years. But as recent events in the

rest of th e world ha ve reminded us, our prosperity is th rea ten ed whenthe global economy does not function well. Our immediate challenge

on the international front is to help ensure that the global economy

rebounds and begins to regain strength. Our longer run challenge as

we enter the 21st century will be to continue to build and refine the

19


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20

international economic arrangements within which countries can

embrace opportunities to grow and develop through international

tra de and investment.

Challenges remain at home as well. The restoration of fiscal disci-

pline is one of the most important accomplishments of the past 6

years. But one very import an t challenge in th e year s ah ead will be toma inta in th at discipline an d to ensur e th at fiscal policy cont ribut es to

preparing the country for the demographic challenges it faces in the

next centu ry. That is why, in h is 1998 Sta te of th e Un ion address, the

Pr esident called for r eserving th e fut ur e budget su rpluses u nt il Social

Secur ity is r eform ed. In t his year s St at e of th e Un ion messa ge, th e

Pr esident put forward his fram ework for saving Social Secur ity while

meeting the oth er pr essing challenges of th e 21st cent ur y.

A second m ajor development of th e past 6 year s ha s been t he

reform of th e Na tions welfa re syst em , wh ich , t ogeth er with th estrong economy, has produced a dramatic reduction in welfare case

loads. Here the challenge will be to continue to make work pay for

al l Amer icans who play by the rules and want to work, whi le

preserving an adequate safety net . Final ly , the s t rength of the

Amer ican economy over th e past 6 years sh ould n ot blind u s to th e

inevitabili ty of change and the threat of disruption that is always

present in a dynamic market economy. For example, di f f icul t

agr icul tural condi t ions in 1998 put s t ress on the new, market -

orien ted far m policy ena cted in 1996. Similar ly, th e ongoing wa ve of

mergers among la rge companies in the f inancia l , t e l e -

communications, and other industries has raised questions about

the disruptions these reorganizations cause for communities and

workersquestions that go beyond traditional antitrust concerns.

Such qu estions ma y be bett er a ddressed by broader policies such as

ma inta ining full employment an d promoting educat ion an d tr aining.

The chal lenge here i s to capture the long-run benef i t s f rom

productivity-enh an cing cha nge with out ignoring th e sh ort -ru n coststo those hur t by that cha nge.

This cha pter provides an overview of these cha llenges and th e Admin-

istr ations responses. First , however, we provide some background by

putt ing the cur ren t economic expansion in its h istorical cont ext.

POLICY LESSONS FROM THREE LONG EXPANSIONS

The cur ren t economic expan sion is only the t hird t ha t h as last ed

at least 7 years, according to business-cycle dating procedures thatha ve been a pplied back t o 1854 (Box 1-1). It is u seful t o review an d

compare the histories of each of these long expansions in order to

un derst a nd th e role of ma croeconomic policy in pr omoting ba lan ced

an d noninflationa ry growth .


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21

The Employment Act of 1946 (which created the Council of Economic

Advisers) established a policy framework in which the Federal Gov-

ernment is responsible for trying to stabilize short-run economic fluc-

tu at ions, pr omote balanced an d n oninflat iona ry economic growth , an d

foster low un employment. Although t he U .S. economy has continued toexperience fluctuations in output and employment in the more than

half a century since then, it has avoided anything like the prolonged

contraction of 1873-79, or the 30 percent contraction in output and 25

percent unemployment rate of the Great Depression. Moreover, the

three longest expansions of the past centuryincluding the current

onehave a ll occur red since t he Em ployment Act was passed.

Each of these three long expansions can be interpreted as an experi-

ment in macroeconomic policy. The longestthe expansion of 1961-69,

which lasted 106 monthswas associated with the first self-consciouslyKeynesian approach to economic policy. It was also associated with

Vietna m War spending. The longest peacetime expan sion before t he cur -

ren t one was the expansion of 1982-90, which lasted 92 months. Although

the economic philosophy underlying the policies of that period is often

cha ra cter ized as an ti-Keynesian, this expansion, too, featur ed a stimu la-

tive fiscal policy. The current expansion is the only one of the three in

which fiscal policy was contractionary ra ther than expan sionary, reflect-

ing the budget situation at the time and the view that fiscal discipline

would lower interest ra tes a nd spur long-term economic growth .

KEYNESIAN ACTIVISM IN THE 1961-69 EXPANSION

In the early 1960s the Council of Economic Advisers advocated

activist m acroeconomic policies based on th e ideas of th e Brit ish econ -

omist John Maynard Keynes. The Council diagnosed the economy at

Box 1-1.The Dating of Business Cycles

Although all signs indicate that the current economic expan-

sion h as continued into 1999, its pr ecise length will not be known

un til some t ime a fter it has ended. The da ting of business cycles

is not an official U.S. Government function. Instead, once it hasbecome clear that the economy has reversed direct ion, the

Business Cycle Dating Committ ee of the Na tiona l Bur eau of Eco-

nomic Research (NBER) meets t o determ ine th e tu rn ing point for

historical and statistical purposes. For example, the July 1990

business-cycle peak wa s an nounced Apr il 25, 1991, and th e Mar ch

1991 trough was a nn oun ced December 22, 1992. A popular reces-

sion indicator is two consecutive quarters of decline in real GDP,

but the NBER does not use this approach. Rather, it defines a

recession as a recurring period of decline in total output, income,

employment , and sales, usu ally lasting from 6 month s to a year.


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22

th at time a s su ffering from fiscal dr ag ar ising from a large str uctur al

budgetsurplus. (The st ru ctu ra l budget balan ce is the deficit or su rplus

that would arise from the prevailing fiscal stance if the economy were

opera ting at full capacity.) The m argina l tax ra tes t hen in effect, which

were far higher t ha n t odays, were seen a s cau sing tax revenues t o rise

rapidly as the economy approached full employment, draining pur-chasing power and slowing demand before full employment could be

achieved. The problem was not the fact that Federal Government

receipts and expenditures were sensitive to changes in economic

activityth is sensit ivity plays an import an t aut oma tic sta bilizing role,

par ticular ly when economic activity falter s, as r educed ta x paymen ts

an d increa sed unemployment compen sat ion h elp preserve consu mer s

purchasing power. The problem was that the automatic stabilizers

kicked in t oo str ongly on t he ups ide, not only preventing the economy

from reaching full employment but also, ironically, preventing theactual budget f rom balancing. Thus, President John F. Kennedy

proposed a t ax cut in 1962, which wa s ena cted in 1964, after his deat h.

This ta x cut provided fur th er st imulus to the economic recovery tha t

had begun in 1961. The unemployment rate continued to fall, until

ear ly in 1966 it dr opped below th e 4 percent ra te t ha t wa s considered

full employment at the time. Inflation had been edging up as the

unemployment rate came down, but it then began to rise sharply

(Cha rt 1-1). Although t he chan ged cond itions appea red to call for fisca l

rest ra int, President Lyndon B. J ohn son was reluctant t o ra ise ta xes or

scale ba ck his Gr eat Society spending in itiatives. Meanwhile Vietn am

War spending cont inued t o provide fur th er st imulus.

At t he time, policyma ker s believed tha t t he rise in inflat ion could be

unwound simply by moving the economy back to 4 percent unemploy-

ment, but when restraint was finally applied it produced a rise in

un employmen t with litt le reduction in inflat ion . This so-called sta gfla -

tion, togeth er with a slowdown in productivity an d a series of oil price

shocks in the 1970s, dealt a serious setback to the prevailing viewamong economists that economic policy could be easily adjusted to

achieve th e goals of th e Em ploymen t Act.

THE SUPPLY-SIDE REVOLUTION AND THE 1982-90EXPANSION

At th e beginn ing of the Admin istra tion of Pr esident Rona ld Reagan

in 1981, the economy was boun cing back from t he short 1980 recession,

but it was a lso experiencing very high infla tion. Pr esident Reaga ns

program for economic recovery called for large tax cuts, increaseddefense spending, a nd redu ced domestic spending. Although advocat es

of these policies invoked th e 1964 t ax cut as precedent , th e just ifica tion

offered for th is policy was n ot Keynesian dema nd stimu lus. Rath er it

was t he supply-side expecta tion t ha t su bstan tial cut s in mar gina l tax

rates would call forth so much new work effort and investment that


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23

th e economys poten tia l out pu t would gr ow ra pidly, easing inflat ionar ypressure and bringing in sufficient new revenue to keep the budget

deficit from increasing. In the short run, however, this expansionary

fiscal policy collided with an aggressive anti-inflationary monetary

policy on th e pa rt of th e Federa l Reserve. The bu dget deficit ba llooned

in the deep recession of 1981-82, and it stayed large even after the

Feder al Reserve eased a nd th e economy began to recover.

Compa red with th e 1961-69 expansion, t he 1982-90 expansion was

ma rked by higher levels of both inflation a nd u nem ployment . But th e

main distinguishing feature of this expansion was the large Federalbudget deficits and their macroeconomic consequences. In the early

1980s the combination of an expansionary fiscal policy and a tight

moneta ry policy produced high r eal inter est r at es, an appr eciating dol-

lar, and a large current account deficit. (The current account, which

includes investment income and u nilatera l tra nsfers, is a broader m ea-

sur e of a coun tr ys int ern at iona l economic activity t ha n th e more famil-

iar tr ade bala nce.) Although borr owing from a broad offset some of th e

dra in on n at iona l saving th at th e budget deficit represented, and pr e-

vented the sharp squeeze on domestic investment that would haveta ken place in an economy closed to tr ade an d foreign capita l flows, the

effect of this policy choice was a decline in net national saving and

investmen t after 1984. As in th e 1961-69 expansion, inflat ion began to

rise as the economy moved toward high employment. By this time,

however, the prevailing view was that inflation could not be reversed

3 4 5 6 7 8 9 10 110

1

2

3

4

5

6

Unemployment rate (percent)

Change in consumer price index, all items excluding food and energy (percent)

1983

1961

1998

1969

Source: Department of Labor (Bureau of Labor Statistics).

Direct investment

Chart 1-1 Core Inflation and Unemployment in Three Long ExpansionsInflation rose late in both the 1960s and 1980s expansions, but inflation hasremained low in the current expansion.

1990 1991


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24

simply by returning to the ful l-employment unemployment rate

(Box 1-2). Instead the economy would have to go through a period of

subn orm al growth in order t o squeeze out inflation.

DEF ICIT REDUCTION AND THE CURREN T EXPANSION

The economy was out of the 1990-91 recession when President Bill

Clinton took office, but the recovery was weak and job growth

appeared slow. Budget deficits were very large, partly because of the

recession but also because the structural deficit remained large. The

Pr esident s economic progra m sought to get t he economy m oving aga in

while bringing the budget deficit under control. It was based on theidea th at redu cing the F edera l budget deficit would bring down int er -

est rates and stimulate private investment. With a responsible fiscal

policy in place, and with favorable developments in inflation and pro-

ductivity, the decline in th e un employment ra te t o less tha n 5 per cent

did not lead to interest rate hikes that could have choked off the

Box 1-2.Full Employment and the NAIRUMain ta ining full employment is a m ajor goal of ma croeconomic

policy, but how exactly is that objective defined? The prevailing

view in t he 1960s was t ha t lower un employment ra tes were asso-

ciated with higher rates of inflation, and that full employment

was defined by the u nem ployment ra te a ssociated with a tolerable

inflation rate. At that time, the full-employment unemployment

rate was thought to be about 4 percent. The experience of the

1970s helped persuade economists that, once the unemployment

rate dropped below a certain level, prices would not just risebut accelerate (that is, the inflation rate would rise). The full-

employment unemployment rate came to be defined as the

nonaccelerating-inflation rate of unemployment, or NAIRU.

Sta tistical studies suggest t ha t t he NAIRU was h igher from t he

mid-1970s thr ough t he 1980s tha n it was in the 1960s and th at it

has come down somewhat in the 1990s. This evolution has been

attributed to a variety of factors, including changes in the demo-

graph ics of th e labor force. For example, th e United Sta tes n ow ha s

a more mature labor force, as a consequence of the aging of the

baby-boom genera tion, and more ma tu re workers t end to experi-

ence less un employment t ha n youn ger ones. Although th e NAIRU

is an indicator of th e risk of inflation, estima tes of th e NAIRU ha ve

a wide band of uncertainty and should be used carefully in

form ulat ing policy. The N AIRU implicit in the Administ ra tions

forecast has dr ifted down in recent years a nd is now within a ra nge

cent ered on 5.3 percent.


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25

expansion prematurely. In fact, the economy witnessed a combination

of low consumer price inflation and low unemployment that compared

favorably with th e low miser y index achieved in t he lat e 1960s. (The

misery index is the sum of th e inflation an d u nemployment ra tes.) This

time, however, inflation is ta me r at her th an rising.

Judged by the objectives of stabilization policy (inflation and unem-ployment), the current economic expansion has been very successful

(Table 1-1). Three-quart ers of th e way t hr ough th e eight h year of expan-

sion, inflation remains low even though the unemployment rate has

been below most estimates of the NAIRU. This situation stands in

ma rked cont ra st t o th e sharply rising inflation experienced at th e end of

th e 1960s expansion a nd t he milder pr ice accelera tion seen at th e end of

the 1980s expansion. To be sure, this good inflation performance hasbeen a ided by favora ble conditions su ch a s a cont inu ing sha rp decline in

computer pr ices, a drop in oil pr ices, rapid growth of indu str ial capacity,

an d downwa rd p ressu re on pr ices of tr aded goods due to weak ness in

th e world economy. And, as discussed in Cha pt er 2 of th is Report , the

Administr at ion (as well as th e consensus of pr ivate forecast s) projects

a moderating of growth over the next 2 years. What is significant,

however, is that the actions taken over the past 6 years to reduce the

budget deficit created conditions in which the Federal Reserve could

accomm odate stea dy noninflat iona ry growth . And, of cour se, the st rongeconomic performance helped improve the budget balance even

further.

Growth in GDP ha s also been solid. With slower growth in th e work -

ing-age population and slower trend productivity growth since the

early 1970s, it is underst an dable th at GDP ha s grown more slowly

1961-69

Core inflation rate 1 ................................................................. 1.8 4.4 5.9Unemployment rate 2 ............................................................... 5.1 3.8 3.5

1982-90

Core inflation rate 1 .................................................................. 4.4 4.4 5.1Unemployment rate 2 ............................................................... 7.2 5.3 5.3

1991-present 3

Core inflation rate 1 ................................................................. 3.1 2.3 2.5Unemployment rate 2 ............................................................... 6.3 4.8 4.5

TABLE 1-1. Stabilization Policy Indicators in Three Long Expansions

First6 yearsItem Last12 months7th year

1 Average annual percent change in the consumer price index for all items excluding food and energy.2 Average rate for the period (percent).3 Through December 1998.

Note.Based on seasonally adjusted data.

Sources: Department of Labor (Bureau of Labor Statistics) and National Bureau of Economic Research.


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26

than it did in the 1960s (Table 1-2). Moreover, growth over the 1980s

expansion partly reflects how far below potential output the economy

was at the start of that expansion, which followed a deep recession,

rather than a particularly strong underlying growth trend. Finally,

growth in aggregat e income m at ter s for some purposes, but productiv-

ity growth is what ma tt ers for r eal wages and a rising stan dar d of liv-ing over th e longer t erm . And productivity growth h as cont inued rela-

tively str ong well into th is expansionit ha s not exhibited t he decline

th at often occur s lat e in expan sions. Neverth eless, the r at e of produc-

tivity growth over t his expan sion rem ains well below th at achieved in

th e 1960s, before th e pr oductivity slowdown.

Relat ively slow productivity growth cont inu es to prevent th e kind of

wage an d income growth th at produced a doubling in living sta nda rds

between 1948 and 1973. As discussed in Chapt er 3, however, th e sus-

ta ined tight labor ma rket t ha t th is expan sion h as creat ed in t he past

few years ha s br ough t benefits t o the vast ma jority of Amer ican work-

ers, including groups th at ha d fallen behind over th e past two decades

or so, such a s low-wage workers a nd minorities. A labor m ar ket liketh a t of today has nu mer ous ben efits. It increa ses th e confidence of job

losers that they will be able to return to work; it lures discouraged

workers back into the labor force; it enhances the prospects of those

already at work to get ahead; it enables those who want or need to

switch jobs to do so without a long period of joblessness; and it lowers

1961-69

Real GDP ............................................................................................................ 4.8 4.3Civilian noninstitutional population ...................................................................... 1.5 1.5Civilian labor force ....................................................................................................... 1.7 1.7Nonfarm business sector productivity .......................................................................... 3.0 2.8

1982-90

Real GDP ............................................................................................................ 3.7 2.6Civilian noninstitutional population ............................................................................. 1.2 1.2Civilian labor force ....................................................................................................... 1.6 1.6Nonfarm business sector productivity .......................................................................... 1.3 1.0

1991-present 2

Real GDP ............................................................................................................ 3.0 2.6Civilian noninstitutional population ...................................................................... 1.0 1.0Civilian labor force ....................................................................................................... 1.2 1.1Nonfarm business sector productivity .......................................................................... 1.5 1.4

TABLE 1-2.Economic Growth Indicators in Three Long Expansions[Average annual percent change]

Item

Fromprevious

peak1

Fromtrough

1 Peaks of 1960 II, 1980 I, and 1990 III.2 Through 1998 III.

Note.Based on seasonally adjusted data, except population.

Sources: Department of Commerce (Bureau of Economic Analysis), Department of Labor (Bureau of Labor Statistics), andNational Bureau of Economic Research.


27/448

27

the duration of the typical unemployment spell. It can reduce long-

term structural unemployment by providing jobs and experience to

younger and less skilled workers, thus increasing their longer run

at ta chm ent to the labor force. In short , a su stained t ight labor ma rket

helps th e r ising tide of economic growth lift all boats.

This expansion has illustrated how the mix of monetary and fiscalpolicy can affect th e composition of out pu t. Un like t he expan sion of the

1980s, which saw an expansionary fiscal policy restrained by tight

monetary policy, the current expansion has taken place under condi-

tions of fiscal restraint and an accommodative monetary policy. The

1980s policy mix brought with it relatively high real interest rates,

declining net national saving and investment, and a large current

account deficit, which cha nged th e United St a tes from th e worlds

largest creditor Na tion to its largest debtor. Str ong per form an ce by th e

U.S. economy in th e 1990s is again a ssociated with a str ong dollar a nd ,most recently, a widening t ra de deficit, as th e United Sta tes h as con -

tinued to absorb foreign goods while weakness abroad has reduced

demand for U.S. goods. On balance, however, the current account

deficits of the 1990s have been the result of generally rising net

nat ional investment remaining greater than general ly r is ing net

national saving.

The cur ren t a ccoun t ba lance depends on t hegap between saving an d

investment. But future growth depends on the levels of saving and

investmen t. Since 1993, net na tiona l saving ha s increa sed by about 3

percent age points a s a sh ar e of GDP, to bett er th an 6 percent in th e

first three quarters of 1998. The current expansion has been distin-

guished by th e large cont ribut ion of private fixed investment to GDP

growth and the negligible contr ibution of government spending

(Chart 1-2). Strong investment has already been associated with

strong growth in capacity, which has helped keep inflation in check,

and may have contributed to maintaining growth in productivity as

th e expansion ha s m at ur ed. Cha pter 2 discusses th is investm ent boomin greater detail.

CONCLUSION

Through a combination of sound policy, other favorable conditions,

and of course th e energet ic effort s of millions of Amer ican work ers and

businesses, the current economic expansion has achieved both high

employment an d low inflation. Longer r un tr ends in p roductivity and

population growth will ultimately determine how fast the economy

grows. But the investment that has driven the current expansionshould pay off in str onger growth a nd p roductivity and h igher fut ur e

sta nda rds of living th an oth erwise would ha ve been t he case. With t he

Federal budget once more under control, large deficits will not

constr a in fut ur e policy choices.


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28

PRESERVING FISCAL DISCIPLINE

Reducing th e Feder a l bud get deficit ha s been a cent erpiece of th is

Adm inist ra t ion s economic policy. Between 1993 a nd 1997 th e deficit

ca me d own st ead ily. Last year, for t he first tim e since 1969, th e bud -

get was in t he black, with th e lar gest sur plus a s a sh ar e of GDP in

over 40 year s.

The Administration now projects substantial surpluses in the uni-

fied F edera l budget well into th e fut ur e. (The u nified bu dget includes

both on-budget a nd off-budget Feder al Govern men t progra ms.) Withno further action, however, the aging of the U.S. population and con-

tinued growth in health care spending per person would eventually

push th e budget ba ck int o deficit. The favora ble nea r-term out look h as

provided an importa nt opport un ity to address th ese longer t erm p rob-

lems. In h is 1999 Sta te of th e Union a ddress, the P resident pr esented

his plan to use much of the projected budget surpluses to help save

Social Security and strengthen Medicare, while preserving the fiscal

discipline that ha s been so ha rd won over th e past 6 year s.

REACHING SURP LUS

Except du ring war s an d economic downt ur ns, th e Federa l budget

ha s st ayed rough ly balan ced for most of the Na tions h istory. Yet th e

large budget defici ts that emerged in the ear ly 1980s persis ted

Chart 1-2 Contributions to Economic Growth in Three Long ExpansionsMore than a third of the increase in real GDP in the current expansion came fromfixed investment.

Sources: Department of Commerce (Bureau of Economic Analysis), National Bureau of EconomicResearch, and Council of Economic Advisers.

1961-69 1982-90 1991-present-20

0

20

40

60

80

Share of total increase in GDP (percent)

Consumption Fixed investment Government Net exports


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29

th roughout th at decade of peace and economic expansion, an d t hen

worsened in the 1990-91 recession (Chart 1-3). In 1992 outlays

exceeded receipts by $290 billion, or 4.7 percent of GDP. When the

President took office in January 1993, the deficit was projected to

reach almost $400 billion in 1998 and over $600 billion in 2003,

assuming no change in policy. By 1998, however, receipts exceededou tla ys by $69 billion , or 0.8 per cent of GDP. (All referen ces to year s

in this sect ion are f i scal years running f rom October through

September, unless otherwise noted.)

Between 1992 and 1998 the Federal budget balance improved by

about 5 percent of GDP. In an accounting sense, this dramatic

cha nge is at tr ibuta ble in r ough ly equa l pa rt s to an increa se in r eceipts

an d a decline in outlays, both as sha res of GDP. More fundam ent ally,

th ree forces have been a t work: policy chan ges, fas ter -th an -ant icipat ed

economic growth, and higher-than-expected tax revenues, even after

adjust ing for fas ter economic growth .

In 1993 the President and the Congress enacted a deficit reduction

packa ge designed t o cut over $500 billion from t he deficits expected t oaccumu lat e over the following 5 years. The pr ogram s lowed th e growth

of ent itlement s an d extended t he caps on discret iona ry spending pu t in

place in 1990. It ra ised t he t ax r at es of only th e 1.2 percent of ta xpay-

ers with the highest incomes, while cutting taxes for 15 million work-

ing fam ilies. Four year s lat er th e Pr esident an d th e Congress finished

Source: Office of Management and Budget.

Chart 1-3 The Federal Budget Balance, 1946-98After a period of persistent large deficits in the 1980s, the Federal budget surplus in1998 was the largest as a share of GDP since 1957.

1946 1952 1958 1964 1970 1976 1982 1988 1994-8

-6

-4

-2

0

2

4

6

Fiscal years

Percent of GDP


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30

th e job of reaching bu dget su rplus by passing t he Ba lanced Budget Act

of 1997, which incorpora ted a dditiona l deficit reduction m easur es.

St rong econ omic growth also played an import an t r ole in redu cing

the deficit . Faster-than-expected growth created more income and

more ta x revenu e. In a ddition, it r educed un employment insur an ce

benefits an d out lays for other m ean s-tested en tit lement progra msalthough the effect of better economic performance is considerably

sma ller on t he spending side th an on t he revenu e side.

Finally, technical factors boosted receipts and depressed outlays

over a nd a bove wha t policy cha n ges an d m acroecon omic con ditions

can accoun t for. In 1997 an d a gain in 1998, higher-tha n-ant icipated

individual income tax collections were by far the largest source of

technical differences on the revenue side. These appear to have

arisen from higher capital gains realizations and changes in the

distr ibution of income a mong ta xpayers (a shift t owar d more ta xableincome in the higher brackets), most likely reflecting strong stock

ma rk et per form an ce. An import an t t echn ical factor on t he spen ding

s ide has been lower - than-expected out l ays for Federa l hea l th

pr ogra ms (pr ima rily Medicar e a nd Medica id), most likely reflectin g

slower gr owth in h ealt h car e costs econ omy-wide.

FISCAL POLICY IN AN ERA OF SURPLUSES

Achieving a su rplus in t he Federa l budget h as pr ovided th e foun da -tion for ta ckling longer ter m problems. Indeed, balan cing th e budget

ha s been th e critical first step in impr oving t he Na tions futu re fiscal

and economic strength. The most important of the longer term prob-

lems is posed by the aging of the population, with its implications for

fut ur e imbalances in Social Secur ity an d Medicar e.

Before t ur ning t o th is issue, however, it is wort h emph asizing t ha t

achieving long-ru n fisca l discipline does not, an d sh ould n ot, pr eclude

th e possibility of ru nn ing a short -ru n deficit if needed for s ta bilization

pur poses. The a ut oma tic sta bilizers in th e budget will cont inue to beth e most import an t instr um ent of fiscal policy for mu ting sh ort -ter m

fluctua tions in economic activity. But as J apan s curr ent problems

remind us, an economy can become mired in stagnation to such an

extent that discretionary fiscal stimulus may be appropriate. The

elimination of large structural budget deficits frees fiscal policy to

un derta ke su ch a role if needed.

The Demographic Challenge and Social Security

Social Security is an extremely successful social program. For 60years it has provided Americans with income security in retirement

and protection a gainst loss of family income du e to disability or dea th .

Social Secur ity ret irement benefits a re indexed for inflation and provide

a lifetime annuitya package that has been difficult if not impossible

to obtain in the financial marketplace. In any case, fewer than half of


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all individuals aged 65 and older received any private pension benefits

in 1994. Social Security benefits are the largest source of income for

two-th irds of th ose in th is age group an d th e only sour ce for 18 per cent

of them. Social Security has achieved dramatic success in helping

redu ce th e poverty ra te a mong th e elderly from 35 percent in 1959 to

10.5 percent in 1997. But Social Secur ity is more t ha n just a pensionplan : it is a fam ily protection plan , and n ear ly every th ird beneficiary

is not a retiree. For example, one of every six 20-year-olds will die

before r eaching retirement age. For t he a verage wage earn er who dies

leaving a spouse and two children, Social Security provides su rvivors

benefits roughly equivalent in va lue t o a $300,000 life insu ra nce policy.

In addition, three of every ten 20-year-olds will become disabled for

some period during their working lives, and for them Social Security

provides disability pr otection .

The most commonly used yardstick to measure the financial sound-ness of th e Social Secur ity system is the 75-year a ctu ar ial balan ceth e

difference between expected income and costs over the next 75 years.

The Social Security actuaries now project that the current balance in

th e tr ust fun d, together with projected r evenu es over the next 75 years,

will be insu fficient to fun d t he benefits pr omised u nder cur ren t law. By

2013 payroll cont ribut ions, together with th e pa rt of income ta x receipts

on Social Security benefits that is deposited in the trust fund, are

expected to fall short of benefits. By 2021 the shortfall is expected to

exceed th e trust fun ds inter est ea rn ings, so th at th e fun d will begin t o

decline. And by 2032 the t ru st fun d is expected to be depleted, a lthough

contributions would still be sufficient to pay about 75 percent of cur-

rent-law benefits thereafter. Of course, future taxes and benefits will

depend on a variety of economic an d demograph ic factors th at can not be

predicted perfectly, so th e actu al pr oblem may be sm alleror larger

than we now believe. Nevertheless, the actuariesintermediate projec-

tions imply that th e imba lance in t he old age, sur vivors, an d disability

insurance program (OASDI, the main component of Social Security)over t he next 75 year s amoun ts to around 2 percent of ta xable payroll

(which equals about 1 percent of GDP today).

The key factors contributing to the projected OASDI imbalance

ar e improvemen ts in l ife expecta ncy an d a r eduction in birt h r at es,

which have put the United States on a path of rapid decline in the

number of employed workers for every retiree. When the Social

Secur ity Act wa s pa ssed in 1935, th e life expecta n cy of a 65 -yea r-old

American was about 13 years. Today, life expectancy for a 65-year-

old is 18 year s an d rising. Mean while people ar e ret iring ear lier. In1950 the average age for first receiving Social Security retirement

benefits was 68; today it is 63. As a cons equen ce of th ese cha nges,

th e ra tio of emp loyed work ers t o ret irees ha s fallen from a bout five

to one in 1960 to thr ee an d a ha lf to one t oda y. In only 30 yea rs tim e

it will be just two to on e a nd still falling.


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In a ddition to its effects on Social Secur ity ret irement an d disability

benefits, th is demographic tr an sition will ha ve import an t effects on the

Medicar e and Medicaid pr ogram s a s well as on th e broader economic

environm ent. Medicar e is a F ederal program th at pays for health car e

for th e elderly and cert ain disabled per sons; Medicaid is a joint Feder -

al-State program that provides medical assistance, including nursinghome car e, to th ose with low incomes a mong the elderly, the disabled,

pregnant women, children, and members of families with dependent

children. Both programs face steeply rising costs over time as the

population ages and as the cost of providing medical care likely rises

further. Federal spending on Medicaid is financed out of general

revenues. Spending on Medicare is financed in two parts: hospital

insurance (part A) is funded through the hospital insurance payroll

tax, whose proceeds go to a dedicated trust fund, and supplementary

medical insurance (part B) is funded through general revenues andmonthly prem iums pa id by beneficiaries. The int erm ediate projections

of th e Medicar e actua ries imply tha t th e hospita l insu ra nce trust fun d

will be exhaust ed in 2008.

For t he N ation as a wh ole, th e core of th e problem is how to pr ovide

a h igh st an dard of living for both workers a nd r etirees in th e next cen -

tu ry, even t hough a sma ller sh ar e of th e popula tion will be in th e work

force tha n t oday. A na tu ra l solution is to mak e workers more pr oduc-

tive, by increasing investment in both physical and human capital.

Investing in productive capital expands the total economic pie, and

that is the prerequisite to meeting the retirement costs of the baby-

boom gener at ion with out un duly burden ing fut ur e workers. The key to

accomplishing th is is t o increa se na tiona l saving. The F edera l Govern -

ment can play its part by maintaining fiscal discipline. Indeed, the

Pr esident s proposa l to use mu ch of th e curr ently projected bu dget

surpluses for Social Security and Medicare reform would add about

2 percent of GDP to the cont ribut ion of governm ent saving to na tiona l

saving over th e next 15 years.

The Administrations Policy

In his 1998 State of the Union address, the President proposed to

reserve the budget surplus until agreement had been reached on a

plan to secure the financial viability of Social Security. To accomplish

this task, the President suggested a process of public education and

discussion, followed by the forging of a bipartisan agreement. The

Pr esident lat er set fort h five principles to guide th e reform process:

Strengthen and protect Social Security for the 21st century. This is

an overriding goal, an d it r ules out proposals t ha t fail to provide a

comprehensive solution to the solvency problem. For example, a

plan to divert existing pa yroll taxes into a new system of individual

accoun ts, without other, offsett ing cha nges, would fail the t est t o th e


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extent th at it would redu ce Social Secur itys revenues an d ma ke th e

existing imbalan ce even larger.

Maintain universality and fairness. The current program provides

benefits on a progressive basis, and ensuring progressivity is an

import an t st an dard by which r eform proposals should be judged. Provide a benefit that people can count on. Any proposed reform of

Social Security must continue to offer people a secure base for

retirement planning.

Preserve financial security for low-income and disabled beneficiaries.

The commitment to the disability and survivorsinsurance aspects

of th e OASDI program mu st be main ta ined.

Maintain fiscal discipline. Fiscal discipline is essential to ensure

that the emerging budget surpluses are not drained before SocialSecurity reform has been addressed, and that fiscal policy plays a

helpful r ole in prepa ring for th e r etiremen t of the baby-boomer s.

In his 1999 State of the Union address, the President put forward a

compr ehensive fra mework for Social Secur ity reform that sat isfies these

principles. First , about th ree-fifth s of th e projected budget sur pluses over

the next 15 years would be tr an sferred t o the Social Secur ity trust fund.

Second, about a fifth of the transferred surpluses would be invested in

equities to achieve higher retur ns, just as pr ivat e and Sta te and local gov-ernm ent pension funds do. The Administra tion intends to work with the

Congress to ensur e that these investments are made by th e most efficient

privat e sector investment mana gers, independently and without political

interference. These two steps alone would extend the solvency of the

Social Secur ity system u nt il 2055. Third, the P resident called for a bipar-

tisan effort to make fur th er r eforms to Social Secur ity that would extend

its solvency to at least 2075.

The President repea ted h is comm itmen t t o save Social Secur ity first.

He a lso sta ted t ha tif Social Secur ity reform is secur edth e remainingprojected surpluses over the next 15 years should be dedicated to three

purposes. First, about 15 percent of the projected surpluses would be

transferred to the Medicare trust fund. The Administration, the Con-

gress, and the Medicare commission should work to use these funds as

part of broader r eforms. Even without such reforms, however, the t ra ns-

fers would extend the projected solvency of the Medicare trust fund to

2020. Second, about 12 percent of the projected sur pluses would be used

to create Universal Savings Accounts, which would help people save

more for t heir r etiremen t n eeds. The government would provide a flat t ax

credit for Amer ican s to put into their accoun ts and additiona l tax credits

to mat ch a port ion of each dollar th at a per son volunt ar ily put s into his

or her accoun t. These a ccoun ts would n ot be par t of th e Social Secur ity

system but would provide addit ional ret i rement resources. The

remainder of th e projected su rpluses over t he n ext 15 year s would be


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reserved to impr ove militar y readiness a nd t o meet p ressing domest ic

priorities in su ch ar eas a s education an d r esear ch.

Within t his fra mework , th e na tiona l debt of th e United St at es would

decline dr ama tically. Debt held by th e public would fa ll from a bout 45

percent of GDP today to less th an 10 percent in 2014. Tha t would be

the smallest burden of government debt on the economy since theUn ited Sta tes en ter ed World War I in 1917.

MEETING THE INTERNATIONAL CHALLENGE

This Administr at ion h as been comm itted from th e star t t o out war d-

looking trade and investment policies. And in his 1999 State of the

Union address the President called for a new consensus in the Con-

gress to grant him t ra ditiona l tra de-negotiating au thority th at permitstra de agreements n egotiated with other na tions t o be submitted to an

up-or-down Congressiona l vote with out am endm ent . At th e sam e time

he proposed the launch of an ambitious new round of global trade

negotiat ions with in t he World Trade Or ganizat ion. The genera l princi-

ple behind th e Administr a tions int ern at iona l economic policy is th a t

open domest ic ma rkets an d an open global tra ding system a re a bett er

way to raise wages and living sta nda rds over th e longer term th an ar e

trade protection and isolationism. Recent strains on the fabric of the

international economy have increased the allure of protectionism insome quarters. But the main lesson should be that it is essential to

promote gr owth in the world economy, to help crisis-st ricken economies

recover, and t o reform th e intern at iona l finan cial system in ways th at

make future crises less likely without abandoning the benefits that

come with increased inter na tiona l tra de an d investmen t flows.

Dur ing the year a nd a ha lf th at ha s elapsed since th e collapse of

th e Tha i cu rr ency in J u ly 1997, Asias curr ency crisis h as developed

into a m ore widespread crisis a ffecting m an y coun tr ies around th e

globe. As the crisis has spread, it has impacted global commoditymarkets, impaired economic development, and imposed extraordi-

nary hardship in the crisis-afflicted countries, all the while posing

risks to growth worldwide, including in t he U nited St at es an d oth er

industrial countries. According to projections by the International

Monetary Fund (IMF), global growth is now expected to reach a

modest 2.2 percent in 1999, which represents a decline both from

th e 4.2 percent ra te a tt ained in 1997 an d from its long-ru n historical

aver age of 4 percent .

CONTAININ G THE CRISIS AND P ROMOTING RECOVERY

Since the crisis began , the Un ited Stat es has led th e int erna tiona l

communitys effor ts to pr omote world economic growth , to sta bilize

inter na tiona l finan cial conditions, and to implemen t reform s t o redu ce


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the vulnerability of the international system to future crises. These

initiatives ar e described in det ail in Chapt ers 6 an d 7.

A first p rer equisite for r estorin g strong world economic per form an ce

is s t rong growth in the indus t r ia l countr ies that are the main

cus tomer s of th e crisis-afflicted economies. This n eed h as been clear ly

recognized and addressed in both words and deeds by the UnitedStates and its partners among the Group of Seven (G-7) large indus-

trial nations. In October the G-7 finance ministers and central bank

governors issued a joint statement indicating that, in their view, the

balance of risks in the world economy had shifted. With inflation low

and well controlled, countries should commit themselves to

preserving or creat ing th e conditions for sust aina ble domestic growth .

Monetary conditions were subsequently eased in the key industrial

countries. In the United States, the Federal Reserve reduced the

Federal funds rate three t imes, helping restore confidence andliquidity. Japan, Canada, and most of the major European countries

also lowered inter est r at es. J apa n, a coun tr y in deep r ecession wh ose

recovery is particularly critical to the growth prospects of its crisis-

afflicted Asian trade partners, has also taken steps to provide fiscal

stimulus and has committed substantial resources to strengthen its

financial system . Much rem ains to be done, however, an d ma ny pr iva te

forecasts are for continuing contraction in Japan. Although it is pre-

mature to conclude that the rest of the world economy is out of peril,

conditions have improved noticeably since October, when it appeared

th at th e world might be headed into a genera lized global credit crun ch.

It is import an t t o emph asize tha t, in serving as an en gine of global

growth during this period, the United States will inevitably see an

increa se in its alrea dy sizable tr ade deficit, an d some sectors, par ticu -

larly those heavily exposed to trade, will experience disproportionate

impacts. The result may be a rise in calls for protection, and it will

therefore be important to f ind construct ive approaches to the

disrupt ions cau sed by trade. The United Sta tes rem ains comm itted tooutward-looking, internationalist policies and has urged the crisis-

impacted coun tr ies to keep th eir own ma rkets open.

Beyond working to ensure growth in the industrial world, the

Administr at ion ha s focused since th e onset of th e crisis on th e need to

contain the international contagion of financial disruption and to

restore t he confidence of ma rket pa rt icipan ts. The Administr at ion h as

supported th e IMF in its goal of providing fina ncial assist an ce to coun -

tries in crisis that are willing to implement the reforms needed to

restore economic confidence and st ren gthen th e under pinnings of th eireconomies, including their corpora te a nd financial sectors. The empha-

sis of IMF programs on financial sector reform reflects the growing

consen sus, discussed in Chapt er 6, th at st ru ctu ra l weakn esses, par tic-

ula rly in t he process of fina ncial int erm ediat ion, were a key elemen t in

initiating th e crisis. It a ppears t ha t m an y coun tr ies in Ea st Asia ha ve


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now made considerable progress toward establishing the foundation

for r ecovery. In addition, an IMF s ta biliza tion pa cka ge for Br azil, sup-

plemented by bilater al financing, was ar ra nged in November.

As the crisis spread, the Administra tion recognized tha t its cont agion

threatened even countries that had taken great strides in implementing

sound macroeconomic and structural policies and had worked tostrengthen the fun damenta ls of their economies. The Pr esident therefore

proposed, and the G-7 leaders agreed to establish, an enhanced IMF facil-

ity to provide cont ingent, short -term lines of credit th at could be dr awn

upon by coun tr ies pursu ing st ron

Documents

1999 Economic Report of The President