"We are not on the brink of a new era of economic growth."
Last week's news that the economy grew at an annual rate of only 1.3 percent was a real godsend. It came just as Congress is settling down to do battle on the budget. The bad news can be turned into good news if it serves to remind Congress of three economic lessons.
The first lesson concerns the baseline used in making deficit projections. As every budget committee staffer knows only too well, budget projections depend on what you assume about the economy. The economic slowdown, which began last summer, is telling us that the relationship also runs the other way: what you can assume about the economy depends on budget projections.
The difference between the Congressional Budget Office's baseline and the Office of Management and Budget's baseline is unimportant. What is important is the difference between the baseline that reflects action to reduce deficits and one that does not. A no- action baseline can be calculated by estimating the effect that continued high real interest rates and a strong dollar will have on economic growth and the rate of unemployment. If those calculations lead to an estimate of a 1 percentage point drop in average real growth over the next three years, from 3.4 percent to 2.4 percent, and a 0.2 percentage point rise in the unemployment rate, then the no- action baseline deficit for 1985-1988 reads as follows: 1985 -- $225 billion; 1986 -- $260 billion; 1987 -- $330 billion; 1988 -- $405 billion.
The action baseline is necessary to sustain the optimistic assumptions about the economy that apppear in typical static baseline calculations. If the 1986-88 sequence of deficit reductions approximating $50-$100-$150 billion is achieved, then the action baseline can legitimately be calculated from existing static baselines. The point is that the difference between the no-action deficit baseline and the action deficit baseline is not the $300 billion currently estimated. It is closer to twice that level -- $600 billion.
The wide gap between the action and no- action baseline results from simple but compelling logic. If the performance of the economy is going to be unaffected by action to reduce deficits and if such action is politically painful, then why take it? The point is that failure to cut spending growth to the action baseline level during 1985 is like forgoing an investment that yields a very high rate of return. That's bad economics, and, as Herbert Hoover and Jimmy Carter know, bad economics is bad politics.
The second and third lessons are directed at the members of Congress and the administration and the dwindling number of economists in the private sector who claim that we're going to grow out of the deficits. In the past, this group has pointed gleefully to predictions that the economy would slow down in 1983 and 1984 and concluded that we are on the brink of a new economic era of even higher growth.
The best way to combat ignorance is with insight. The second lesson explains why the economy was so strong during 1983 and the first half of 1984. Rapid investment growth was temporarily stimulated by front-loaded depreciation measures that tended to concentrate capital spending into a short interval of time. The pattern of investment in response to rapid depreciation measures is well documented and has made it possible for some economists to predict the economic slowdown we are now experiencing.
We have also learned that a strong economy and stable monetary policy strengthen the currency. When the investment surge ends and the strong dollar sharply reduces exports while increasing imports, economic growth drops sharply. The way out is to unwind the process by cutting deficits, reducing real interest rates, and thereby creating conditions for more sustainable growth of investment output and employment. In addition to the outlook for the economy, the major determinant of investment is the user cost of capital, which in turn is determined by real interest rates and tax provisions. Tax provisions can temporarily cut user cost as they did in 1982 and 1983. Lower real interest rates can do the job just as well and with more lasting effect.
The third lesson is really implicit in the second but it bears emphasis. We are not on the brink of a new era of economic growth. Average real growth in the United States has dropped steadily over the past three decades. It was 4.2 percent in the 1960s, 3.2 percent in the 1970s and 2.1 percent from 1980 through 1984. At the same time the volatility of growth rates steadily increased. While the downward trend may be reversed, such hopes are hardly the basis for formulating sound public policy.
Three groups in Congress need to come together to help turn the currrent crop of bad economic news into good news. The Republican moderates, who can't really bear to do radical surgery on the budget by eliminating some programs, will have to buy into the Senate-administraton deficit-reduction plan, which recognizes that the all-important outyear deficits aren't going to come down without elimination of some programs. The Democrats, who want to squeeze some political mileage out of the 2 percent reduction in COLAs, ought to back off and adopt the notion that share-the-pain-across-the-board cuts in proposed spending growth will be necessary. Last, the conservative Republicans who see us growing out of the deficit problem ought to remain as quiet as they were on the day when 1985's first-quarter growth number was released and cast their votes for a responsible deficit-reduction plan.