Tuesday, January 31, 2006

IN HIS STATE of the Union speech tonight, President Bush will be tempted to take credit for the strength of the economy. The recovery that began four years ago has been robust, with gross domestic product growing 4.2 percent in 2004 and 3.5 percent in 2005 despite a slowdown in the last quarter. Productivity -- that is, the value of goods produced for each hour of labor -- has increased even faster than during the boom of the late 1990s and roughly twice as fast as during the previous two decades. But Mr. Bush should not crow too much. For one thing, U.S. prosperity is built on an alarming trade deficit, which symbolizes a broader fragility in the global economy. For another, economic progress is not showing up in higher wages for the typical worker.

The trade deficit has been around for years, so it's tempting to shrug it off. But its size is new -- and unsustainable. Last year's deficit in goods and services is likely to come to a bit over $760 billion, up about 10 percent from 2004 and some 80 percent higher than in the first year Mr. Bush was in office. This means that Americans are living beyond their means: They spend more than they produce, and the excess spending sucks in goods and services from other countries. This cannot continue forever, because the spending binge depends on borrowing from abroad, and there's a limit to how much debt Americans can take on. When consumer spending slows, the whole economy will slow with it: That's what happened in the fourth quarter of last year, when growth fell to 1.1 percent from 4.1 percent in the previous quarter. Meanwhile, there's also a danger that foreigners could tire of lending Americans billions of dollars. If foreigners grow skittish -- perhaps because of a terrorist attack or a loss of confidence in U.S. policymaking following Alan Greenspan's departure from the Federal Reserve -- the dollar could fall and interest rates could rise, squeezing living standards and potentially causing stress in the financial system.

Even if growth and productivity gains can be sustained, there are doubts about what they are achieving. Economists focus on both numbers because they assume a connection to rising living standards: If the economic tide is rising, most boats will rise, too; if workers produce more dollars' worth of goods each hour, they are likely to be paid more. It's hard to believe that these common-sensical connections no longer function at all. But median wages fell in inflation-adjusted terms over the past year, a phenomenon that can't be fully explained by the rising cost of health benefits and other non-wage compensation. Meanwhile, people in the top tenth of the income distribution seem to be pocketing fully half of the nation's economic gains; the richest 1 percent proportionately are doing even better. Economists debate whether this is a temporary phenomenon or some kind of new norm. Either way, this is not the time for Mr. Bush to celebrate the economy without acknowledging disappointing wage gains.

Neither the trade deficit nor the wage problem lend themselves to easy government fixes, but there are things that Mr. Bush could do if he were serious about them. On the trade deficit, the best response is to boost national saving, and the surest way for government to do that is to cut the federal deficit. On wage stagnation, it would be a mistake to intervene directly in labor markets, but growing inequality reaffirms the case for a progressive tax structure. Mr. Bush could show he understands that by rethinking his enthusiasm for tax cuts. If only.