Remarks at the CNBC Financial Summit
Dr. N. Gregory Mankiw - Chairman, Council of Economic Advisers
May 21, 2004
Today I would like to offer you my views on the state of the economy. I will look both backwards and forward in time--to the challenges the Nation has faced since President Bush took office and to the choices we confront as we move ahead. To preview, I believe the data are now very clear that the economic is on track for a robust recovery. But we should not take prosperity for granted. We face important choices that are critical to sustaining economic growth.
Over the past several years, the economy has had to contend with several powerful contractionary forces. These include the end of the high-tech bubble, the revelation of corporate governance problems, and geopolitical uncertainty stemming from terrorist attacks and the war in Iraq. These events adversely affected business equipment investment, which slowed sharply in late 2000 and remained soft for more than two years. They also depressed the labor market. From December 2000 to August 2003, payroll employment declined by 2.7 million.
Policymakers took prompt and decisive actions to counteract the effects of these adverse shocks to the economy. The Administration and Congress passed substantial tax relief to provide a much-needed economic stimulus. Together with expansionary monetary policy, the tax cuts softened the impact of the recession and helped put the economy on the road to recovery.
The economy took a decided turn for the better in the second half of last year, following passage of the last of the tax cuts, the Jobs and Growth Act. Real GDP has expanded at an annual rate of 5½ percent since mid-2003. This is the best three-quarter performance in nearly 20 years.
The robust recent pace of economic activity is partly attributable to strong growth in productivity. This follows a pattern we have seen for several years. From 2000 to 2003, productivity rose at the fastest 3-year rate in more than a half century. These gains boosted national income, and they reduced inflationary pressures by holding down growth in unit labor costs. In the short run, bursts in productivity add to business profits, but in the longer turn, they benefit workers as well. Economic theory and history both point to productivity growth as the primary determinant of rising real wages.
In addition, the labor market has been moving in the right direction since last summer. The unemployment rate has fallen from 6.3 percent in June to 5.6 percent. It is now below the average level in each of the past three decades. Since August, payroll employment has risen by more than a million. Even the hard-hit manufacturing sector has seen net job creation over the past three months.
Most signs suggest that the economy will expand vigorously in 2004. The index of leading economic indicators has risen impressively over the past 12 months. The Blue Chip consensus of private forecasters predicts that real GDP will expand by 4.2 percent over the four quarters of 2004. This is a bit better than the Administration's December projection of 4.0 percent growth.
One side effect of the economic recovery that has occurred in the United States and abroad is the notable rise in oil prices that we have seen in recent months. The causation between oil prices and economic growth runs in both directions. To some extent, higher prices of oil and other commodities reflect increased demand from one of the most robust global economies we have seen in many years. On the other hand, higher input prices will also tend to put downward pressure on the business expansion.
An important point to bear in mind is that today's supposedly "record high" gasoline prices of $2 per gallon are well below the prices seen in the earlier 1980s when these earlier prices are adjusted for overall inflation. Measured in 2004 dollars, the price of oil reached a peak of $91 per barrel in the early 1980s, and the price of gasoline was $3.00 per gallon. Since 1970, the average price of oil in today's dollars has been about $35 a barrel. By historical standards, therefore, the current price of about $40 a barrel is high, but not by an exceptionally large margin.
Higher oil prices may now be a headwind for the U.S. economy, but standard models indicate that they do not pose a significant threat to the recovery. A recent study by the International Energy Agency, in conjunction with the OECD and the IMF, concluded that a sustained $10 per barrel increase in oil prices would reduce U.S. GDP by just 0.3 percent this year and next. The limited effect partly reflects the fact that our economy is much less dependent on oil than it was 30 years ago. The impact would be larger in some other countries--such as the developing nations in Asia--because their economies are much more dependent on oil.
Although the economy is now headed in the right direction, we should not be complacent. We must ensure that the economy remains on a path of strong, sustained growth. The Nation now faces some critical choices.
One of those critical choices concerns the tax system. Some have proposed reversing course and raising taxes. In my view, this is exactly the wrong policy to increase employment and family incomes. The right approach is to make the tax cuts permanent and reduce the budget deficit over time through spending restraint.
The tax cuts over the past three years provided important stimulus that helped turn the economy around. Without these policy actions, economic conditions would be much worse today. According to simulations of a conventional macroeconomic model, if the President had left the tax code unchanged in response to the adverse economic shocks, about 2.5 million fewer people would be working today.
When assessing the role of the recent tax cuts, it is crucial to consider both short-run and long-run goals. The short-run effects of the tax cuts can be traced in part to a classic Keynesian mechanism. The tax cuts let people keep more of the money they earned. You can see this in the data: Over the past three years, real after-tax income has increased much more than before-tax income. Real disposable income per capita is now at an all-time high.
The boost to income from the reduced tax burden supported consumer spending and helped maintain aggregate demand. This type of stimulus represents conventional short-run stabilization policy. There is nothing novel about it--you can find it in all of the leading textbooks.
In addition to their effects on consumption, the tax packages provided stimulus through several provisions that increased firms' incentives to invest. These provisions include temporary bonus depreciation, enhanced expensing for small businesses, and lower taxes on dividends and capital gains. The lower individual tax rates reduced the tax burden on income from sole proprietorships, partnerships, and S corporations. These various initiatives reduced the cost of capital and, in doing so, boosted investment spending at a crucial time.
The President's tax policy, however, should not be viewed solely from a short-run perspective. The tax cuts were intended not only to counteract the cyclical slowdown by expanding aggregate demand but also to encourage stronger economic growth over the longer run by expanding the aggregate supply of goods and services.
The tax cuts have long-term benefits because they enhance incentives to work, save, and invest. Lower tax rates on labor income provide an incentive to increase work effort. Lower tax rates on capital income--the reward for saving and investment--encourage individuals to do more of these activities. Investment increases the amount of capital available for each worker and also increases the rate at which new technology embodied in capital can be put to use.
Lower tax rates on dividends and capital gains also move the tax system toward a more equal treatment of debt and equity, of dividends and retained earnings, and of corporate and noncorporate capital. A more level playing field increases economic efficiency because it promotes the allocation of capital based on business fundamentals rather than a desire for tax avoidance.
Greater work effort and higher rates of capital accumulation mean higher potential output. The tax cuts will do more than just bring the economy back to its potential level. The tax cuts will put the economy on a new and better long-run growth path. This is why the choice now facing the Nation on taxes is so important. Making the tax cuts permanent is the most reliable way to keep the recovery on track and to boost growth in our standard of living over time.
Some would have us choose differently. In considering the alternatives, we should take a lesson from our major trading partners across the Atlantic. Many European countries have opted for higher taxes and larger governments, and we can see the results. Such a choice can reduce the uncertainty that comes with living in a dynamic economy. But it also means higher unemployment, lower growth, and lower mobility. In many of these countries, it is more difficult to start a business, to tap capital markets, and to switch occupations and start a new career.
It can be tempting for Americans to take the dynamism of the U.S. economy for granted. But we should remember that this dynamism reflects the policy choices we have made, and that the economic stagnation of other nations illustrates the downside of other choices.
One challenge the United States will face in coming years is the budget deficit. The expansionary effects of tax cuts, both in the short run and in the long run, are offset to some degree by the effects of the budget deficits that arise from lower revenues. Deficits can raise interest rates and crowd out of investment, although I should note that the magnitude of this effect is much debated in the economics literature. The main problem now facing the U.S. economy is certainly not high interest rates. But, at some point continued deficits would matter and could impede growth. This is why, as the President has said, spending restraint is so vital.
The Administration would prefer not to have deficits, but deficit reduction is only one of many goals. This is simply a matter of priorities. The President made growth and jobs his number one economic priority.
Yet it is crucial to have a plan to reduce the deficit over time relative to the size of the economy. This is the case under the President's policies. The deficit as a share of GDP is projected to diminish by more than half over the next five years.
The greatest fiscal challenge ahead is the growth in entitlement spending from the aging of the population and the retirement of the baby boom generation. The president's budget correctly called this "the real fiscal danger." Unless the entitlement programs are modernized for future generations, truly worrisome budgetary pressures will arise over the next few decades. This is one reason why, as a prescription drug benefit was added to Medicare, the president moved to include greater choice for seniors and competition among private providers. It is also why the president has stressed the need for fundamental reform of Social Security, including a role for personal accounts.
Beyond taxes and spending, there is another critical choice facing the Nation--the choice regarding our role in the world economy. The world trading system is undergoing dramatic changes. We are all used to goods being produced in one country and transported to another on ships or planes. We are less used to services being sent across borders over fiber optic cables. As technology expands the range of commercial activities that can be traded internationally, more American workers are exposed to global competition. The recent debate over offshore outsourcing of some service-sector jobs shows that this increase in global competition can be a source of anxiety for many families.
The basic laws of economics, however, have not changed. Free markets remain the best way to promote growth, create good jobs, and ensure rising living standards. That is why the President has actively sought to open markets.
Some would respond to the recent challenges facing the economy by erecting trade barriers. But we will not prosper by hiding behind walls or by filling our harbors with rocks.
History teaches that a retreat to economic isolationism is a recipe for economic decline. For example, the Smoot-Hawley tariffs of the 1930s contributed to the hardship of that period. By contrast, the North American Free Trade Agreement, negotiated by the first President Bush and implemented by President Clinton, took effect just as the U.S. economy began a spree of growth and job creation.
The right response to these recent challenges is to maintain a commitment to a free and open system of world trade. Open markets allow American firms to sell world-class products in the large global economy, and they give American households and businesses the freedom to buy the greatest variety of goods and services at the best prices. Because of international trade, American children have more toys in their toy boxes and more clothes in their dressers, while American parents have the opportunity to sell the fruits of their efforts into the large global marketplace. Open trade allows American businesses to buy the best equipment and materials, and this benefits their workers, owners, and customers.
A Montana newspaper, the Missoula Missoulian, recently wrote an editorial about fly fishing that illustrates well the gains from trade. Until the 1970s, the artificial flies used by fisherman in this country were mostly produced domestically. Tying flies is labor intensive and hard work, so now it is mainly done abroad. The resulting availability of lower-cost imported flies allows the average fisherman to buy a larger and more diverse selection. Some flies are still made in the United States, but these are special ones--the very best and the most expensive. Meanwhile, the U.S. sport fishing industry has thrived and is booming in Montana. Montanans who a generation ago would have been commercial fly tiers can now get better-paying jobs building boats, making rods, and leading fishing tours. Trade in fishing lures has been good for fishermen, good for Montana, and good for people around the world. Good for everyone--except the fish.
As trade expands and the world economy evolves, it is natural to ask what new jobs will be created in the future. That question is best answered by market forces. Policymakers should foster an environment in which businesses will expand and jobs will be created. The President's initiatives to reform the tort system, to ensure a reliable energy supply, to make health care more affordable, and to streamline the regulatory burden will remove barriers to prosperity and promote sustained economic growth.
Policymakers should not try to determine precisely which jobs are created, or which industries grow. If government bureaucrats were capable of such foresight, the Soviet Union would have succeeded as a centrally planned economy. It did not, providing the best evidence that free markets are the bedrock of economic prosperity.
It is hard to predict what changes American ingenuity will bring to the U.S. economy. For example, over the past half century, new technology has led to great advances in farm productivity. As a result, the number of Americans working on farms has declined from almost 20 percent of the workforce in 1940 to about 2 percent today. In 1940, no one could have predicted that some of the grandchildren of farmers would become website designers and CAT scan operators. But they did, and at much higher wages and incomes. Farming remains a vital sector of the economy, but we would be far poorer today if public policy in 1940 had stifled the forces of change in order to keep 20 percent of Americans on farms.
At the same time that we recognize the gains from free and open markets, we must appreciate that any economic change, whether arising from trade or technology, can cause painful dislocations for some workers and their families. Public policy should ease the transition and help workers prepare for the global economy and the jobs of the future.
The President's policies are aimed at doing exactly that. He has proposed a "Jobs for the 21st Century" initiative to help prepare U.S. workers to take advantage of better skilled, higher paying jobs. Since 2002, he has nearly tripled spending on Trade Adjustment Assistance. His 2005 budget provides more than $20 billion for worker training and employment programs.
As the economy grows and changes, the choices facing the Nation are clear. Raising taxes and turning inward, as some have proposed, would depress economic growth. The better choice is to continue the President's policies to fuel growth and capitalize upon the strength and creativity of the American people.