Point Growth Through Investment
by Eric Rutkoske
Counterpoint Economic Stagnation: Get Used To It
by Chris Foote
Cyclical downturns should be expected in a free market economy. However, the extended duration of the current economic stagnation seems to indicate that we are suffering the consequences of under-investment and huge debt levels characteristic of both the public and private sectors in the 80's. Net investment in productive capital was less than 3% of total income, an alarmingly low level. At the same time, public and private entities, overburdened with debt, began to realize the limits of sacrificing future wealth for current consumption. The economy will flourish only if we develop long term strategies to further develop the capital base.
First, the burden of debt in the corporate sector became severe at the onset of the recession. During the 80's the total volume of corporate debt issues was eight times larger than equity issues. Yet often this debt-generated capital was used for leverage buyouts, restructuring and acquisitions rather than for investment in productive capital. The limits of this corporate strategy have been realized. Corporations began to default on bond obligations, wreaking havoc on financial institutions, especially those with "junk" portfolios. Markets for substandard and even premium debt have become less favorable as the burden of the interest payments became severe.
Government stimulus, through monetary policy and targeted tax cuts, is key to restoring consumer confidence and revitalizing the economy.
As a result, corporations have begun to pull back, cutting costs and improving the health of their balance sheets. Slow growth and unemployment in both the blue- and white-collar sectors are the visible results. Our economic policy must contain provisions which insure an increase in capital investment following this period of corporate retrenchment.
The government must first realize that continued deficit spending in both expansions and contractions in the business cycle will have dire consequences, as private investment is crowded out. Yet, the deficit alone is not the sole cause of our current economic stagnation. In fact, at times during the 80's Japan's deficit, as a percentage of GNP, was almost twice as large as the U.S.'s. However, their spending on net capital formation was three times ours. Thus, the problem is not only the level of fiscal spending but the composition of these expenditures. An increasingly larger portion of fiscal revenues are being devoted to Medicare, Social Security, social assistance, and a nonproductive, ever-growing public bureaucracy. These social transfers do nothing to stimulate the economy, yet for political reasons are often described as "nondiscretionary." Our so-called "discretionary" expenditures on the infrastructure, education, and other investments in productive capital have suffered. If policymakers make fiscal allocations to the human and physical capital base, the economy will necessarily improve.
More likely, monetary policy will provide the necessary stimulus to private investment. The Federal Reserve has already acted to spur the economy by implementing expansionary monetary policy. As interest rates fall, investment in productive capital becomes more attractive to corporations and individual investors. However, concerns over the debt level and low consumer confidence have prevented long term rates from falling in response to the Fed's actions. To alleviate this problem, the rest of our economic policy must complement this change.
Tax policies will be the most important element. Tax breaks must encourage investment in productive capital so that the benefits of the expansionary monetary policy can be realized. First, the government should restore a long-term investment tax credit: this is the single most effective instrument to encourage investment because it changes investors' decision problem at the margin. However, the policy must be enacted quickly so as not to deter investment in the short run as investors wait for the credit to take effect.
Secondly, the capital gains tax needs to be lowered. This cut would encourage investment in new corporate equity issues and investment in productive capital by entrepreneurs. This type of investment has long been the heart of U.S. economic growth. If the economy is to flourish, these policies must no longer be framed as favorable to a particular class. Investment in productive capital improves the general state of the economy and thus does not hurt the working class. By implementing this tax policy, politicians will show a commitment to improving the capital base, thereby improving consumer confidence and capitalizing on an expansionary monetary policy.
Corporate leaders have re-evaluated their positions and improved the health of their balance sheets. The equity market is strong, allowing companies to raise necessary capital for new investment. The Fed has implemented expansionary monetary policy, which has lowered interest rates and made investment relatively more attractive. If policymakers make the decisions described above to capitalize on these changes, the economy should recover nicely. However, if they do not give this direction to U.S. economic policy, the future remains uncertain.
In the late 1980's, it seemed plausible that the business cycle, the rhythmic rise and fall of economic activity over time, had become a thing of the past. The record-setting economic expansion that had begun earlier in the decade showed no signs of slowing.
When the expansion ended in 1990, government officials quickly blamed the loss of consumer confidence over the Persian Gulf crisis. When the war ended, these officials expected consumers to go back to the shopping malls, to start spending right away, and to get those factories humming again. There was a token "recovery": two anemic but positive rates of growth in the second and third quarters of 1991. But then the economy stalled out completely, with a surprisingly low 0.3 percent rate of growth in gross domestic product for the fourth quarter. Housing starts and factory output remained low, and even white-collar workers were hard hit.
The large deficits of the last decade seriously hamper the government’s ability to address the current economy crisis and leave us with an uncertain economic future.
Of course, governments do not want people to read this type of news every morning in election years. President Bush's long-overdue attempt to use fiscal policy (government spending and taxes), along with the Federal Reserve Board's commitment to low interest rates, are intended to move the government off the sidelines and end the recession. Will it work? I feel the next few years will be so-so at best. The large amount of debt (especially governmental debt) now burdening the economy will inhibit not only the full implementation but also the effectiveness of the government's traditional recession-fighting policies.
The first thing to remember when discussing the current recession is that it really can't be blamed on anyone in particular. Sorry, President Bush, not even the Japanese. Economists don't agree on what causes recessions, but nothing indicates that foreign trading partners have anything more to do with this recession than they did with any other. When recessions do come along, as they regularly do, running a government budget deficit is a good remedy because it puts purchasing power into the hands of citizens and increases spending and production. This remedy will not work for the current recession because the government has already forced the budget-deficit medicine down the economy's throat for the past ten years, even when the economy wasn't sick.
Why does this matter now? Budget deficits, though they can help lift an economy out of recession, can have harmful long-term effects. Most importantly, deficits "crowd out" business investments by forcing the government to compete for loanable funds with businesses and thereby drive up interest rates. Since living standards for workers depend on how many machines and other capital goods the country can accumulate, anything which hampers our ability to invest can be quite damaging in the long run and can prevent us from being competitive with our trading partners.
Unfortunately, $100 billion in fiscal stimulus is an entirely different beast when tied to a pre-existing $200 billion deficit. The strategy of running large deficits even in booms in order to pressure Congress to cut domestic programs, employed by the Reagan and Bush administrations, has now come back to haunt the White House. A sizeable deficit might help get the economy rolling again. However, the government's books are already far in the red, and there is less to room to run a deficit now that the economy really needs it. The long-term costs of running a gargantuan deficit today are too large to ignore.
Does this mean that the situation is hopeless? Not really. Deficits do crowd out private investment, but deficits can also be used to finance an increase the level of public investment in things like schools, roads, airports and other types of infrastructure. America needs significant infrastructure improvement right now (as anyone who has used our congested airports or pockmarked roads already knows). Running a deficit to finance public improvements would at least partially offset the bad long-run effects on private investment while giving the economy a short-run boost.
Sadly, increasing public investment by any appreciable amount doesn't seem to be on the White House's agenda this year. President Bush thinks that a few moderate tax cuts and a few tax breaks on things like houses and children will do the trick. If this plan did work, it might get us out of the recession, but at an appreciable long-run cost.
However, there are reasons to believe that even the tried-and-true tax-cut remedy to recession may not be as potent as usual. Tax cuts work when the recipients of those cuts spend their newfound purchasing power on American goods and services. That puts money in the pockets of other American producers. If these producers also spend, then the cycle continues and the economy improves. If, however, tax cuts are not spent on goods and services but are used by consumers to pay off credit card balances or by firms to retire junk bonds, then little stimulus reaches the real economy.
Until we are able to successfully encourage producers to spend some significant portion of their earnings, the economy will not improve measurably.
About the Issue
Point author: Eric Rutkoske was a senior concentrating in Honors Economics at Michigan
Counterpoint author: Chris Foote was a third year graduate student in the Economics Department at Michigan.
Edited by: the 1992 Consider Staff
Cover by: Art Staff of Consider, 1992