Did Clinton have anything to do with the shift to surplus?
Clinton was President during a time of rapid business cycle expansion. The reasons for the rapid growth include a change in policy at the Federal Reserve and the stock market bubble.
The Fed abandoned the theory that 6% unemployment was the best that the economy could do without accelerating inflation. Unemployment was allowed to fall to 4% and growth continued beyond the point at which the Fed, in the past, would have pulled the plug. Footnote here
The stock market bubble, a 14 trillion increase in stock holdings over the last decade caused many upper income households to spend freely. This spending, even if it was based on paper increases in wealth that soon disappeared, provided a considerable stimulus to the economy - much the same as we would get from a large increase in deficit spending by the federal government. Footnote here
The economic policies for which Clinton can claim responsibility - e.g., NAFTA, the creation and expansion of the World Trade Organization - served primarily to prevent the majority of Americans from sharing in the gains from economic growth. And then there was welfare reform, which threw millions of poor single mothers at the mercy of one of the lowest-wage labor markets in the industrialized world. Footnote here
In short, Clinton's policies continued the upward redistribution of income and wealth that were the hallmarks of the Reagan era. It was not until 1999 that the median real wage reached its pre-1990 level, and it remains anchored today at about where it was 27 years ago.
Real Wage Graph/chart here
Many observers credit Alan Greenspan, the Fed chief, rather than President Clinton, with the careful management of the economy during the Clinton years. Footnote here
The New Millennium
Recession of 2001
After the great run of the 1990s, the U.S. economy was hit with a recession that started in March of 2001 and ended in November 2001. The start of a recession is when the economy reaches a peak of activity. The National Bureau of Economic Research mainly looks at four activities, which are determined monthly, to gage the start of a recession; current employment, current industrial production, real manufacturing and trade sales, and current real personal income less transfers. The start of the 2001 recession was marked by a slight decline in the current employment and a large decrease in industrial production compared to previous recessions. The figure below shows the decrease in industrial production after mid 2000.
Current Industrial Production
The dark line shows the movement of industrial production in 1999-2001
and the dashed line the average over the past 6 recessions.
Another method to determine when the economy is in a recession is to look at the U.S GDP. The problem with GDP is that it is determined quarterly as opposed to monthly. Historically, a recession is a decline in the GDP over two quarters. The figure below shows percent change in the U.S. GDP from the preceding quarter.
From 1994 to 2000, the economy grew around 4 %; then in Q3 2000 the economy contracted and again in Q1-Q3 of 2001. The red circle marks the recession.
The potential causes of the recession are many. A few of the reasons include the decline in stock market wealth, increases in energy costs and increases in interests. It is beyond the scope of this paper to analyze all of the potential causes. Instead, the burst of the stock market bubble and the subsequent decline in business investment will be discussed.
During the late 1990s, the stock market saw gains like never before. There was much hype about the new economy and everybody thought the economy is going to grow forever. Next, the unthinkable happened. Investors started to realize that new companies could not generate profits and started selling their investments. The figure below shows the value of the NASDAQ starting in 1998.
The NASDAQ peaked above 5000 and fell back to pre 1999 levels by the time the economy entered the recession. The drop in stock values meant that people lost a lot of stock wealth. The meant there was less capital available to invest in businesses.
On a related note, businesses were ramping up capital investment during the 1990s to prepare for the Y2K problem. The next two figures show how the capital investment ramped up during the late 1990s and fell after 2000. The first figure shows the gross domestic private investment in billions starting in 1996. There was steady growth from 1996 to 2000 and then a substantial decline. The start of the decline coincides with the bust of the stock market bubble.
The other figure shows the percent quarterly change in nonresidential private fixed investment starting in 1996. Except for a few quarters, there was over 10% growth in investment from 1996 to 2000. Again, coinciding with the stock market bust, there is a sizeable decrease in the private fixed investment. In fact, there is decrease in private investment starting in 2001 and extends until mid-2003. The stock market bubble and decrease in business investment helped to fuel the recession.
A result of the recession was higher unemployment. The figure below shows how the unemployment decreased during the late 1990s to 4% and then rose up to 5.7% right after the recession and approached 6% in future years. Usually after a recession the unemployment rate starts to decrease and inflation starts to increase. One peculiar item about this recession and subsequent recovery is the unemployment rate is not dropping; in fact, some economists are calling this period “The Jobless Recovery” and are calling for reforms to stimulate job growth. The figure below shows the increase in unemployment and decrease in inflation after the recession.
The decline in private sector jobs is greater than in any of the past three recoveries. This high unemployment is leading to lower standards of living for most families. But the trend of higher unemployment and low inflation follows the Phillips curve.
Use of Monetary and Fiscal Policy to Stabilize Economy
Monetary Policy
The Federal Reserve board tries to cool down hot economies by trying to raise the intended federal funds rate. The converse is also true; if the economy is in a recession the FOMC will lower interest rates to encourage new investment and increases in planned autonomous spending. The following figure shows the intended federal funds rate from 1994 to current.
When the economy was heating up during 1999-2000, the FOMC was starting to raise interest rates to slow down the economy. Then in 2001, the economy went into recession and the FOMC started to decrease interest rates rapidly. In fact, it dropped from 6% in January of 2001 to 1.75% by December 12th the same year. That is a remarkable drop.
Fiscal Policy
The other method to help the economy is to use fiscal policy.
The tax relief bill of 2001 was introduced by president Bush immediately after his instatement in office, and was approved by congress and signed into law in late May. The bill consisted of four major parts, two of which were characterized by new nomenclature to add a political “spin:”
- Reduction and restructuring of base-level income taxes
- Phase-out of the estate tax (referred to by the Bush administration as the “Death Tax”)
- Increase of the child credit
- 10% deduction for married couples (referred to as elimination of the “Marriage Penalty”)
The income tax changes consisted of tax cuts throughout most income brackets. It also added a new bracket at the bottom of the income scale (bracket 1 in Table 1). This bracket will be phased in by 2008, and will have an upper limit of $7,000 for childless singles, $10,000 for single parents, and $14,000 for married couples. The upper and lower limits of the other brackets remain the same, and the percentage changes to them were made retroactive to 2000 through an immediate refund.
Table 1: Changes to Tax Brackets of Final Tax Relief Bill
*Bush’s proposal = 25%
**Bush’s proposal = 33%
Source: economist.com, whitehouse.gov
Table 2: Other Tax Changes in 2001 Tax Bill
***Proposed by Bush but overturned by congress
Source: SF Chronicle, 2/6/03, economist.com
The president presented a two-tiered rationale for the tax bill. During his campaign in 2000, Bush insisted that the projected budget surplus of the time indicated that taxes were higher than they should have been; the excess revenue should be returned to the workers who earned the money in the first place. Then in 2001, with the economy slumping into recession, the new president postulated that the tax cut was just the stimulus the economy needed. The income that went to taxes could not be invested, so giving more income back to the income earners should spur investment and provide a fresh supply of capital into the economy.
The position of the president was correct for the fiscal situation at hand; the government should not be running a surplus during a recession because failing to inject as much money into the economy as it takes out will make a weak economy worse. Increasing expenditures vs. cutting taxes as a method of attack for this situation has long been a point of friction between America’s two political parties, but more at issue in this case was the size and nature of Bush’s tax cuts.
The first and most often presented rebuttal of the 2001 tax bill was the lopsided return enjoyed the highest income taxpayers. In terms of percentage points, the lowest tax brackets get the highest benefit. In terms of actual dollars, however, the highest tax brackets benefit the most. An employee earning $1 million per year would save $46,000 (4.6% * $1m = 46,000), whereas someone earning only $10,000 could hope to save $500 in 8 years (5% of $10,000 = $500). This is a large apparent disparity, but as an argument against the tax bill it proved ineffective, as the bill passed largely intact in a few short months.
When it passed the bill, congress made parts of the tax cut retroactive to 2000, and the IRS began immediately issuing rebates to most taxpayers. This was designed to be an immediate boost for the economy; having some unexpected money in hand was supposed to stimulate the taxpayers to spend more and stimulate consumption. The anti tax-cut camp was quick to criticize that most of the refunds would probably be saved not spent, and they proved to be right. Only 22% of the refund money was spent.
Ultimately, the economic consequences of the tax cut failed to materialize per the critics’ predictions. Following 9/11, America defined itself as a consumer culture, led by the “America: Open for Business” campaign, and consumer demand remained relatively high throughout the recession. The government surplus did turn into a deficit by the end of 2001, but this happened through the combined effects of the recession and the “war on terror.”
Return to Record Deficit
One problem as a result of the Bush tax cut was an increase in the budget deficit. But, Bush did not intend for the tax cut to create a huge budget deficit. The next figure shows the projected budget surplus or deficit at the beginning of 2002.
As seen in the figure, there was supposed to be a small budget deficit as a percent of GDP starting in 2002 and a return to budget surpluses starting in 2003. But, this did not happen. In fact, the next figure shows that the current budget deficit is one of the worst in the past 50 years.
The next figure shows the budget deficit as a percentage of GDP starting in 1990 and projected through 2005.
There was a swing to surpluses that had not been seen for decades starting in 1998 but the surpluses were quickly erased starting in 2002.
Some people wonder what is the problem with the government running a deficit. The simplest method to see the effect of the budget deficit is to examine the following equation:
(T-G)=NX-(S-I)
where (S-I) is the excess private saving, (T-G) is the budget surplus and NX is the trade deficit. If the budget deficit increases, there are three ways to compensate for the increase. First, private saving has to increase. Second, excess private saving has to increase. Third, the next exports would show an decrease, which translates into more foreign borrowing. The IMF believes the large U.S. deficit is going to soak up limited savings, drive up interest rate and crowd out investment, thus slowing growth. In fact, the following figure shows the IMF’s estimate of impact on GDP of U.S. deficits if they proceed as Bush envisions.
Why do some believe deficits are a problem?
Burden of government debt paying for consumption goods that yield no future benefit, i.e. weapons spending vs. hospital and park building – these costs may have immediate benefit but will become a burden to future generations. The true burden on future generations is created by government spending that is financed by deficits rather than tax revenues and pays for goods that yield no future benefits, or benefits less than their social opportunity cost – for example, meals currently consumed by members of the armed forces. Absolutely nothing is generated in the future as a rate of return, all benefits accrue in the present. Pg. 354
If the federal government creates debt to build a beneficial long-lasting project, then the rate of return on the project is available to cover the interest payments on the borrowed money. If the debt is created to pay for current consumption, there is no future return to balance the extra taxes needed to pay the interest.
References:
Budget of the United States
International Herald Tribune
http://www.iht.com/articles/109911.html
http://www.kowaldesign.com/budget/
http://news.bbc.co.uk/1/hi/business/1110165.stm
EPI issue brief #186 Jan. 24, 2003
Data from and www.bls.gov
Economist.com; August 23, 2001
Economist.com; January 18, 2001
WSJ article IMF, OECD See Economic Risks In Bush’s Budget on 4/15/04
