The current recovery is fragile. By the first half of 1985 the investment boomlet that is fueling continued economic strength will very likely have died. The temporary stimulative effect of investment-targeted tax meas2 can be expected to atrophy sharply by the end of 1984. The depressing effect of high real interest rates will remain. In a slowing economy, the political will to address the problem of lowering federal deficits will weaken at the very time when action is needed most. Simultaneously, the help provided by state and local government surplusses in financing federal red ink will begin to dry up as will the foreign demand for dollar assets by dollar- sated investors outside the United States.
There are both near-term and longer-term reasons for this gloomy scenario. In the near term, one must accept the argument that the strong 1984 investment rebound will slow down. Over the long term, one must believe that the outlook for real interest rates will remain above historical levels of 2 or 3 percent. There exists solid evidence to support both reasons for deep concern over the sustainability of the current recovery.
Given the tax-cut antidote for high real interest rates -- investment tax credits (ITC) enacted in 1981-82, the accelerated cost recovery provision (ACRS) -- why should we expect investment to tail off? Put simply, the antidote will wear off, and for two reasons.
First, a drop in the user costs of capital, induced by ACRS and ITC, results in a one-shot increase in the stock of capital that firms want to own. Once they buy the capital -- once they invest -- the stimulative effect is over unless there is another tax cut or a further drop in real interest rates. The response to past corporate tax cuts like ACRS and ITC has typically peaked about two years after enactment.
The sharp rise in investment during 1984 is consistent with past experience. Past experience also suggests that the investment response to tax-cut medicine trails off rapidly after two years.
Signs of the slowdown in investment are already apparent. Investment was growing at an annual rate of 30 percent at the end of 1983, but grew only at an annual rate of 8 percent during the third quarter of 1984.
Much has been said about the existence -- or lack thereof -- of a link between federal deficits and interest rates. Denying that deficits cause high interest rates is like denying that neg harmful effects . . . before the invasion comes. The effects of deficits are cumulative. But deficits are only harmful if they pile up a national debt at a faster rate than the economy grows.
Until 1974 deficits were manageable. The ratio of our national debt to GNP -- our ability to carry the debt -- fell from 107 percent right after World War II to 24 percent in 1974. Since then it has crept up, rising to 29 percent in 1981 and 41 percent in 1984. Under currently forecast tax and spending policies, it will top 50 percent in 1989.
During the 1980s both deficits and debt relative to GNP have been positively associated with real interest rates. What -- other than a high and rising debt-to-GNP ratio, together with (up until now) the 1981-82 tax cuts that have enabled firms to pay high interest rates and still justify investment -- can explain three- and six-month real rates of 7 percent and longer-term real rates of 9 percent? Perhaps most important, the current outlook is for continued increases in debt to GNP. Investors, looking to the future as they buy long- term securities, must factor into rates they demand now the future pressure on real rates coming from a steadily rising debt burden.
If no action is taken on deficits -- and remember they needn't be eliminated, but only cut to a size that doesn't push up the debt-to-GNP ratio -- we will find 1985 to be a very unpleasant year. Deficits go up during recessions at the very time when spending cuts or tax increases required for their reduction is most painful and therefore least possible politically.
Every voter can think seriously about how much he wants from his or her government. If the decision is to maintain spending at 24 percent of GNP, then be prepared for higher taxes. If one can entertain spending cuts of about $80 billion per year for the remainder of the decade, then taxes can be raised by less -- maybe by about $50 billion a year. If no consensus can be reached on how spending is to be cut or how taxes are to go up, that will be a shame. A prolonged and bitter argument won't make the fundamental problem go away.