It is impossible to understand the mess we’re in today (or to develop plausible ways of cleaning up that mess) without taking into account the quarter century of U.S. tax and economic policies that got us here.
Until 1984, the total amount of debt in the American economy – government, business, and consumer – was largely self-regulated. If the government borrowed too much, interest rates rose. Businesses and consumers then borrowed and spent less. And the economy slowed.
As a result, demand played a crucial limiting role in economic policy. Policymakers could not focus solely on the supply side; they also had to be sure that businesses and consumers would have enough money to buy whatever was supplied.
Key to the pre-1984 system was the fact that U.S. borrowing was financed, for the most part, by U.S. savings. The Internal Revenue Code imposed a 30% flat tax – known to international tax junkies as “the tax on portfolio interest” – on U.S.-source interest paid to foreign lenders. Foreign lenders therefore generally did not lend to American borrowers. This, in turn, constrained the total amount of U.S. debt.
In 1981, President Reagan pushed through what was then the largest tax cut in U.S. history. Economists predicted that the resulting deficits would force interest rates up, crowding out business and consumer borrowing.
They were right.
By early 1984, interest rates were moving steadily upwards. As economists had predicted, the clouds of recession were gathering. Polls suggested that Reagan would be a one-term President.
A tax bill happened to be working its way through Congress. Treasury suggested that Congress add a minor technical change to the bill: repeal of the tax on portfolio interest. The reason given? That a few taxpayers were circumventing the tax by taking advantage of a loophole in the Antilles Protocol to the U.S.-Netherlands Tax Treaty. (Amend the Protocol? Heavens, no!)
Clueless, Congress did as Treasury suggested.
The results were as you might predict. Interest rates began to fall the day the House Ways and Means Committee approved the change. No longer limited to domestic savings, U.S. borrowing mushroomed. The economy boomed. And Reagan was reelected in a landslide.
For over two decades, repeal of the tax on portfolio interest effectively eliminated macroeconomic limits on U.S. borrowing. Government deficits produced no apparent adverse consequences – no matter how large. Policymakers found that they no longer had to ask whether consumers could afford any goods and services produced; consumers simply borrowed the amounts needed. Supply-side economics reigned supreme.
On the flip side, foreign demand for U.S. debt proved insatiable. Bad credit? No problem. We’ll give you a zero-down teaser-rate mortgage. We’ll package it with thousands of others and sell the resulting pools to investors round the world. And they’ll buy, buy, buy.
Until this fall, when the whole house of cards came tumbling down.
What happens to an economy built on temporarily unlimited access to consumer credit? When that credit dries up, the inflated levels of demand it supported become unsustainable. Demand must inevitably fall to some lower level – a level supported by real wages.
What is that level today?
Unfortunately, no one knows. We do know that real wages have remained flat for the past eight years. Growth in consumer demand over that period, it appears, was made possible primarily by growth in consumer credit. That credit is now gone.
It is plausible, therefore, that sustainable demand should not be significantly higher than it was eight years ago – in other words, that our economy needs to shrink by about 20% to get back to a sustainable equilibrium.
To date, our economy has contracted only a small fraction of that amount. If 20% is the right number, there is more pain – much, much more pain – to come.
Whatever its size, there is clearly a gap between the inflated level of demand just before the crash and the level of demand sustainable in the long run. It’s this demand gap that’s driving the current downturn as the economy seeks a lower, more realistic equilibrium.
What this means is that the current recession is not an ordinary business cycle downturn. It is rather part of a major structural realignment. Not surprisingly, the vast majority of economists – who first analyzed our current problems using ordinary business cycle models – have been forced to revise their projections downward again and again.
Unfortunately, this kind of downturn feeds on itself. Inadequate demand? Cut jobs. Don’t have a job? Buy less. A downward spiral with no obvious end in sight. Economists call this “deflation.”
What, then, is the solution? If the problem is a demand gap, fill the gap. This is the theory underlying the $800 billion stimulus package working its way through Congress.
$800 billion is about 5% of GDP. Will a 5% plug be big enough to fill the current hole in demand? My back of the envelope calculations suggest that it won’t be. Even if it is, all the package should do is slow the downward spiral. Unless we are willing to run trillion dollar deficits forever, at some point we’re going to have to let demand fall to levels sustainable without government intervention.
All this sounds really depressing. I want to point out, however, that even if our economy contracts by 20% (economists call a 10% contraction a “depression”), it will still generate enough wealth to feed, clothe, house, and provide medical care for all its citizens at levels far higher than Americans enjoyed in the heyday of the 1950’s and 1960’s.
Yes, Congress should try to slow the fall. If I am right, however, a return to sustainable levels of demand is inevitable. Trying to prevent such a return is no more likely to succeed than trying to stop the tide.
What Congress can do is to take steps to ameliorate the resulting pain. Markets can’t. Congress can.