2003 June 03 Tuesday
US Tax Cut Bigger Than It Looks, But Will It Work?

Stelzer says the short duration of a large chunk of the tax cut will be extended.

The net result will be to pump some $210 billion in purchasing power into the economy over the next sixteen months—a non-trivial 1.4 percent of GDP. The neo-Keynesians in the White House—yes, such there be—believe that it is necessary to stimulate demand in order to sop up the excess capacity that is deterring new investment in several key industries. Moreover, everyone is underestimating the size of the tax cut. Congress halved the president’s request, and approved $350 billion in tax relief over the next ten years. But Congress managed to keep the figure so low by assuming that taxes will be allowed to return to their prior, higher levels on January 1, 2005. That, say the politicians who have experience with such things, is highly unlikely: congressmen are not about to campaign in November of 2003 on promises to raise taxes shortly after taking office. So the reductions won’t expire, and total tax relief is likely to approach the figure the president originally requested.

David Greenlaw of Morgan Stanley agrees.

The debate over the size of the package -- $350 billion versus $550 billion versus $726 billion -- is essentially meaningless. These amounts represent the total impact over the 2003-2013 period and can be greatly affected by altering the phase-out dates. Under the theory that it is much harder to raise taxes than it is to cut them, there is a strong likelihood that most of the changes contained in this bill will be made permanent at some point. Indeed, there are dozens of provisions of the tax code that are slated to expire every single year and routinely wind up being renewed. So, even though it is being advertised as "only" a $350 billion tax bill, the enactment of this legislation appears to be a major victory for the White House.

Is this tax cut big enough to make a difference to the US and world economies? The problem is that US can no longer serve as the demand source for economic growth. American consumers are saving too little. They have too much consumer debt. The US trade deficit can not continue to grow and the fall in the dollar is finally beginning to reflect that.

Morgan Stanley chief economist Stephen Roach runs thru some of the numbers that demonstrate why the US must go thru a wrenching economic readjustment.

America’s net national saving rate -- the combined savings of households, businesses and the government sector (net of depreciation) -- fell from about 5% of GDP in the mid-1990s to just 1.3% in the second half of 2002. Lacking in domestic saving, the United States has no choice other than to import increased flows of foreign saving -- running ever-widening current account deficits in order to attract that capital. As a result, the world’s dependence on dollar-denominated assets is now at extremes. Currently, about 75% of the world’s total foreign exchange reserves are held in the form of dollar-denominated assets -- more than twice America’s 32% share of world GDP (at market exchange rates). At the same time, foreign investors hold about 45% of the outstanding volume of US Treasury indebtedness, 35% of US corporate debt, and 12% of US equities. All of these ratios are at or near record highs. Never before has the world put more stock in America -- both as an engine of growth and as a store of financial value.

The problem is that the math gets exceedingly tenuous if it is projected into the future. And yet the die is now cast for additional widening of an already massive US current account deficit (a record 5.2% of GDP in 4Q02), suggesting that all of these ratios will have to rise sharply further on the years ahead.

The rise in the Euro and drop in the dollar is effectively exporting US deflation to Europe. The problem is that Germany is already experiencing deflation and this will only make deflation a worse problem in Europe. Yet the US dollar really does have to fall to decrease US demand for imports and to increase world demand for US exports.

The decline in the US dollar against the Euro is limited in terms of how much it can cause a necessary rebalancing of the world economy. One reason for that is that the important growing US-China trade is conducted at a fixed exchange rate.

China has kept the yuan (its official name is the renminbi) fixed at about 8.3 yuan to the dollar since the mid-1990s. For any other big exporter, keeping this peg would be a near-impossible task. Last year, China sold $125 billion in goods directly to the United States, according to the Commerce Department, a big shift up from 2000, when China's U.S. exports came to just $82 billion. Meanwhile, the United States exported just $22 billion in goods to China in 2002.

This has a perverse effect. As the US dollar falls the currency of a very large ($6 trillion dollars per year at current exchange rates) economy that is running large trade surpluses experiences a fall in its currency as well. Does this cause a net improvement in trade balances by shifting demand and supply between America and the rest of the world in a more sustainable direction? Or does it cause greater harm by increasing demand for Chinese goods by lowering their costs?

The stakes in the needed big global economic rebalancing are quite high. Stephen Roach outlines a scenario in which the currently sound US financial system could become unsound if deflationary pressures become too great in the United States.

By contrast, US banks are in good shape at the moment, having gone through a serious shakeout in the early 1990s. But America has record debt loads, especially the household sector, where debt-to-GDP currently stands at a record 80% -- fully 15 percentage points above the ratio prevailing in the recession of the 1990s. The US also has flexible labor markets and a relatively flexible wage-setting mechanism. Should deflationary risks get to the point where Corporate America needs to slash labor costs more aggressively -- both headcount and compensation -- that would severely impair the household sector’s debt-servicing capacity. The result would be a sharp increase in nonperforming loans and a concomitant outbreak of distress in the American banking system.

US consumer debt and the US balance of payments deficit are just two reasons why I do not foresee robust US economic growth. Another problem is that, as John Maudlin points out, the asset bubble of the 1990s has left the US economy with a capital surplus and excess unused productive capacity.

The last problem to look at is the business spending excesses of the 90's. We simply created too much capacity throughout the world to manufacture every conceivable product. Capacity utilization is one of my favorite bellwether statistics. As of May, 2003, US manufacturing was using less than 75% of its capacity. Economists tell us that capacity utilization must be in excess of 80% for significant new business investment to occur. This can happen in two ways: demand can pick up OR companies can go bankrupt thereby reducing capacity.

An asset bubble that causes excess capital spending causes the worst kind of adjustment when the bubble finally pops. A recession caused by a need to put an end to consumer price inflation is nowhere near as difficult to get thru. The great historical economic downturns (e.g. the 1920s Depression) have been caused by capital asset bubbles because the resulting surplus of capital goods takes many years to dissipate.

The competition from China for the production of cheaper consumer goods is an additional source of deflationary pressure contributing to lower capacity utilization in the United States. But the telecommunications and information technology revolution is adding a new form of global competition: competition for services. Many forms of phone-provided services such as technical support for software, order-taking, and reservations scheduling services are being outsourced to India, the Philippines, and other countries. Also, even higher paying jobs such as computer programming are being outsourced to India.

US policy makers are trying monetary expansion and fiscal stimulus to try to get the economy growing briskly. But they are fighting against too many external factors as well as excess consumer debt and the lingering excess capacity caused by the 1990s asset bubble. It is quite possible that the deflation now occuring in Japan, Germany, and other countries will spread to the United States. Even if it doesn't the US economy has too many problems that still need to be worked out before rapid economic growth can resume.

Share |      By Randall Parker at 2003 June 03 02:34 PM  Economics Political


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