March 31, 2006
JS-4150

Remarks of
Treasury Under Secretary for Domestic Finance
Randal Quarles
to the Hinckley Institute University of Utah

Salt lake City, UT-Thank you Kirk [Jowers] for that introduction. It is a pleasure to be here in Utah this morning, and a particular pleasure to be at the University of Utah and the Hinckley Institute, which do so much to foster the informed debate that is crucial to the development of intelligent public policy. I hope our discussion here this morning is a useful contribution to that effort.

The topic Kirk suggested I might address this morning was "Tax Cuts, Deficits, and the Economy", so let me begin where you would expect - with a tour of the headquarters building of the Organization of Arab Petroleum Exporting Countries. I happened to find myself in Kuwait City last week at the end of a long day of meetings and - having a little down time before our flight to Abu Dhabi - we had arranged for a tour of this famous building, which is a showplace designed to display the history and culture of the Arab world not only in the interior exhibits but in the exotic marbles and rare woods of the structure itself. Every stone and moulding told a story, and OAPEC had graciously agreed to provide a guide to help us decipher and understand it.

Interestingly, however, when we arrived at the entrance plaza the guide they had for us was not the architect, nor was it a cultural historian nor an anthropologist nor a curator nor even an expert in comparative politics. Instead, they had chosen to have us taken through the building by the building's . . . engineer. And so, as we toured this exotic and evocative architectural monument, we learned in minute detail about the operation of the hydraulic apparatus, the cleverly concealed air conditioning vents, the sound system, the security cameras, and the back-up power. When we looked at the exquisite screens of Tunisian plaster work, we talked about the utility closets hidden behind them, and when we examined the elaborate walls of Moroccan mosaics, we talked about the grout. Essentially, we were on a tour of the plumbing.

And it struck me that this was a reasonably good metaphor for an increasingly prominent thread in the political debate over economic policy in this country right now.

In the ordinary course, we might expect the focus of economic debate to be on the performance of the real economy and the ways in which that performance might be improved - the equivalent of a building's architecture. Instead, our debate is increasingly not about economics, but about finance - not about our policy choices, but about the ways we have chosen to fund those choices - and finance is not architecture. It is plumbing, but without the human drama. A nation in which the ticket agent printing my boarding pass notices my Treasury ID and wants to ask - not about the unemployment rate, or our economic productivity, or disposable income - but about our national debt as a percentage of GDP, or where the cab driver bringing me in from the airport Wednesday night wants to discuss the unsustainability of our current account deficit, is a nation obsessed with plumbing.

I don't want to deny the importance of finance - it's how I make my living these days, dry and technical though it may be - and there are times when questions of finance might quite appropriately take priority over the more fundamental questions of economic policy, just as plumbing might clearly be the thing to focus on if the dining room is standing in an inch of water. I do not, however, think we are in such times, and thus this current obsession with finance is misguided. In the time I have this morning I hope to make that case.

First, let's look at our economic performance - the "architecture", if you will, that we are discussing. By any measure, economic performance in the United States is quite strong, and looks set to continue so for a good while. Gross domestic product grew 3.5% last year - well above our historical average over the last 20 years of right around 3%, and particularly strong when compared with GDP growth in other developed economies: Germany (1.1%), France (1.5%), Italy (0%), UK (1.8%). Virtually every observer forecasts similarly strong growth in the United States to continue. The President's budget projects a 3.4% growth rate for the current fiscal year, and many private sector forecasters project an even stronger rate.

What is more, the drivers of this economic growth are solidly diverse. Productivity growth remains very strong. Output per hour in the non-farm business sector has risen at an average annual rate of 3.2 percent since 2001, faster than any five-year period in the 1970s, 1980s, or 1990s. And while high levels of productivity growth can sometimes imply low levels of job creation, that does not seem to be the case currently. Unemployment is down to 4.8%, again running lower than the 70s, 80s, and 90s. The economy has created almost 5 million new jobs since May of 2003; two million of them in the last year alone, more than all the rest of the G7 combined. Real disposable incomes have risen 2.2 percent over the past 12 months, and since 2001 real after-tax income per person has risen 8.2 percent, providing continued support for consumer spending. And according to the Federal Reserve, over the past 12 months total industrial production rose 3.1 percent, and manufacturing industrial production rose 4.5 percent, including 0.7 percent in January - the 33rd consecutive month of growth in manufacturing activity.

This robust economic performance is reflected not just in income flows, but in asset values as well. Real household net worth is at an all-time high of $51.1 trillion, home ownership is at 70%, another all-time high, and the median net worth of American households rose 1.5 percent between 2001 and 2004. And these asset values are neither being driven nor eroded by inflation: core inflation is a little over 2%, well below our 20-year average of a little over 3%.

All in all, an impressive and encouraging picture. Yet it is one that is rarely discussed in any detail, because our economic debate has come to take these outcomes for granted and to focus instead on what are sometimes quite technical questions of domestic and international finance. It has become common to hear that our economic performance has been generated at the cost of our financial health, or even that our financing practices are already impeding economic progress. In the language of the metaphor that I am beating to death with a stick this morning, the critics argue that the house may or may not be attractive, but that it is fundamentally unlivable because the drains don't work.

What are some of these criticisms? Let's begin with what is probably the most common concern expressed about the federal government's finances: the sheer size of the debt. Federal debt held by the public now totals over $4.2 trillion, up from $3 trillion at the end of the Clinton administration, and almost 6 times the roughly $700 billion outstanding at the outset of the Reagan administration 25 years ago.

Stated that way, the situation certainly sounds alarming. But the absolute size of any debtor's obligations - whether that debtor is an individual, a corporation, or the federal government - tells us very little without looking at the ability of that debtor to service its obligations. One measure of that ability is to compare the size of the debt to total GDP, just as an individual might compare the size of his debt to his total income to see if he has a financing problem. At the end of FY 2005, debt held by the public amounted to 37% of GDP. This ratio is significantly lower than the average of 47% for the 1990s and has remained fairly stable since the Bush Administration took office, ranging from 33% to 37%.

Another way of evaluating the country's debt burden is to calculate interest costs on the debt as a percentage of GDP, again just as an individual might compare his annual payments on his debts to his annual income to determine if he can afford them. In FY 2005, interest expense represented just 1.5 percent of GDP, well below the 3% average of the 1990s. In fact, the average interest expense ratio since FY 2001 has been at the lowest level in more than 25 years. That expense has risen somewhat as monetary policy has tightened and short-term interest rates have risen. But we have a lot of headroom - we could double the interest expense of 2005 before returning to the 1990s average, and even then we would still be well below the average of the 1980s.

We can put our debt burden in further context by comparing it to that of other countries. Even if our debt seems reasonable compared to our own historical practice, are we in a substantially worse fiscal position than other countries of the developed world? To make that comparison, we need to calculate not just the federal debt burden, but those of the states as well, given that international statistics are generally kept for countries as a whole. Adding in the states, our net government debt is roughly 46% of GDP. This is almost a third less than the average of 66% for the rest of the G7, and modest compared to Italy's 106% or Japan's 93%.

So it would appear hard to argue that our debt is currently an unsustainable burden of any sort. It is in fact relatively modest compared to the country's GDP, compared to our capacity to service the interest, compared to our own historical practice, and compared to the rest of the world's advanced economies.

But this brings us to a second concern that is commonly expressed. Perhaps the debt is not currently an excessive burden -- but have our financing practices put it on a dangerous path? We have run a budget deficit for each of the last 4 years, and we are projecting to run a deficit for an additional 4 years. We are currently projecting a deficit of $423 billion for FY 2006, one of the largest dollar figures in history. We finance these deficits by borrowing from the public, and won't borrowing at this rate cause the total debt to become an excessive burden relatively quickly?

In evaluating the consequences of the deficit, the first place to begin is with the stock of debt. Obviously, the implications of adding to the debt stock by running a deficit are different if that stock is quite high when the country begins to run the deficit than if the stock is quite low. As we have just seen, the US total stock of debt was moderate when the country most recently began to run a deficit and has remained moderate throughout this period. This suggests that running a moderate and contained deficit for a specified period is unlikely to materially affect our terms of financing or otherwise create a financing problem.

Another obvious factor determining how likely a series of deficits is to create a financing problem is how large those deficits are as a share of the economy. The 40-year historical average of the deficit as a share of GDP is 2.3%. Last year our deficit was 2.6% of GDP, well within historical norms and substantially below the 3.5% growth rate in GDP itself. So the deficit is making only relatively modest additions to the total stock of debt as a share of GDP. In fact, as I indicated earlier, that share has not increased by more than 4 percentage points since January of 2001.

Finally, the likelihood of a deficit to create a financing problem depends very much on the trend in the deficit itself. Is it projected to be constant or even to grow? Or is it reasonably projected to shrink substantially over the near term? If the former, investors might well incorporate the expected effects of future fiscal deterioration into the current terms of financing. If the latter, then the deficit would be unlikely to have a substantial financing consequence since its contribution to the future fiscal outlook would be limited.

It is for that reason that the administration in 2004 articulated a program of shrinking the deficit in half as a percentage of GDP over the following five years. Debt as a percentage of GDP was projected to be 4.2% in the year this objective was set out, and thus the aim was to reduce the deficit to 2.1% of GDP by 2009. In fact, the administration is ahead of schedule in meeting this objective: the 2004 deficit, which had been projected at over $477 billion in fact came in at only 3.6% of GDP and last year's deficit at only 2.6%. We currently project that the deficit will be 1.4% of GDP in 2009, substantially lower than the 2.1% goal.

It is important to note that this improvement in our deficit position is being driven not simply by expenditure control, though that is important - the President's current budget proposal, for example, would limit overall discretionary expenditure increases, including defense and homeland security, to below the rate of inflation and would actually reduce the amount of non-defense, non-security discretionary expenditure - but is also being driven by an increase in government revenue. Often, we hear the concern expressed that our tax framework - and particularly the tax cuts of 2001 and 2003 - have starved the federal government of customary receipts, and this has resulted in the current period of deficits.

In fact, however, government revenues have been increasing strongly. Net receipts grew 5% in 2004, but then 15% in 2005 - the largest percentage increase in history. And this is not merely a "percentage" phenomenon: total quarterly tax payments in June of 2005 were the largest amounts received in the history of the country, until the September quarterly tax date when that record was broken, a record that lasted until December when it was broken again. The Treasury received roughly $2.2 trillion in taxes in FY 2005, the largest amount ever. And this was not a one-year event. For the first five months of FY 2006 revenue has grown at 10.3%. Corporate taxes are up 30% so far this year, while individual income tax payments have increased over 10% through February. Revenue increases at almost 3 times the rate of inflation, and a revenue to GDP ratio of 18% (in line with the average for the 1990s and somewhat higher than the average for almost any other period of the country's history since World War II), indicate that this is not a question of a tax regime that is starving the government of resources.

But if the level of our debt is on the low(ish) end of most relevant measures and fairly stable, and the level of our budget deficit is moderate as a share of GDP and trending downward, and the level of government revenue is on the high(ish) end of historical averages and rising, are there other concerns that explain this distress about our financial position? The last commonly expressed concern that I will discuss this morning is the view that the United States - not merely the government but the country as a whole - is relying too heavily on foreign capital to finance its activity. We may indeed have a strong economy generating a wealth of investment opportunities, but as a nation we refuse to provide enough savings to fund those opportunities. This difference between national savings and investment is equivalent to the current account deficit and it has grown steadily over the last 9 years to reach over 7% of GDP. This is a high figure, and by most rules of thumb a country running that high of a current account deficit is in immediate risk of a marked reduction in the willingness of outside capital to continue funding activity in the country. If such a reduction happens abruptly, the sudden change in financing conditions can be quite disruptive, and have serious effects on the level of real economic activity.

There are a number of reasons to believe, however, that the United States is capable of maintaining a sizable current account deficit for a much longer period than most other countries, and thus that the current financing situation does not pose a near or medium term risk to the US economy. First, since the risk of a sustained current account deficit is in the accumulation of net external liabilities to a level that foreign creditors are no longer willing to allow to increase, it is important to look at the current level of those liabilities. Just as a budget deficit can be run for a longer period if it begins when the stock of debt is low, so for a current account deficit. The net external liabilities of the US were quite low relative to the size of the economy when the existing period of current account deficits began in 1995, rose markedly during the next 5 years to between 20% and 25% of GDP, then stabilized at roughly that level since 2002. A net external liability position of 20% - 25% of GDP is very manageable for the United States, and suggests that there is substantial room for it to increase before it would begin to pose a financing problem.

In addition, because US citizens have a large store of foreign assets, changes in our net external liability position are not simply a function of the current account deficit, but can be affected - for both good and ill - by changes in the valuation of those assets. This is why the US net external position has remained fairly stable over the last few years even in the face of a large and growing current account deficit. The dollar value of our foreign assets has increased in a way that has substantially reduced the effect of the additions to foreign holdings of US assets implied by the current account deficit. We cannot expect such sizable valuation effects in perpetuity of course but the available data suggests that they have continued throughout 2005 thus at the very least postponing for a further period the time when US net external liabilities will begin to rise from their current moderate level.

The large US holdings of foreign assets have another implication as well, beyond the potential for these valuation effects. Because US holdings abroad tend to be more heavily in equity investments, both direct and portfolio, and foreign holdings of US assets tend to be more heavily in debt instruments, the return on US international investment has tended to be substantially higher than the return on foreign holdings of US instruments, even though the overall valuations show us with net external exposure. As recently as 2005 - and even in light of our sizable current account deficit - the United States continued to receive from its foreign investment more than it paid out and thus by one quite relevant measure remained a net creditor of the world. This, too, is likely to change as monetary policy has tightened and US short-term interest rates have risen, but it demonstrates that we are likely to wait for quite some time before the growth in our net external liabilities actually begins to pose a financing problem for the United States. And both Alan Greenspan and Ben Bernanke have put forward quite persuasive arguments that, at such time in the future when international capital flows do begin to find destinations outside the United States to a greater degree, we should expect the US economy to adjust quite smoothly without serious consequences for either short-term or long-term growth. Mercifully, given the length of time we've already been at this this morning, I will not walk you through those arguments here, but simply refer you to their speeches over the last few years.

So, after all of this you might reasonably ask, if the US financial position really is as eminently manageable - even routine - as I have claimed this morning, why have so many smart people become concerned? Why has our national debate on economic policy become largely oblivious to the solid marble edifice of economic growth and productivity increase we see all around us and concentrated instead on the pipes and drains of the debt stock and the current account?

Well, part of the answer, or course, is that to make a comprehensible point in 20 minutes on a Friday morning, I have necessarily had to make things appear a little simpler than they really are. Not misleadingly simpler, I think, and not in any way that distorts the basic understanding of the case. But the analysis of some of these issues is complex and it is important that the professionals and academics who think about them get it right. So discussion that makes those of us in the official sector question our assumptions, review our analyses, and justify our actions is always necessary and welcome. I think - given the circumstances I have described -- this particular effort has unnecessarily become too much the center of debate and sucked too much oxygen from the more fundamental questions of economic policy that I think are more relevant right now, and more worth the limited time that the informed general public has to devote to reflection on economics. But I would not want to suggest that there are no issues worth the discussion of intelligent specialists at the right volume level.

But part of the answer, too, is less welcome. For some, particularly in Washington, raising alarms about our ability to finance our policy choices is a way of avoiding a direct and unbiased discussion of those policy choices themselves. We might believe that it is appropriate for government to scale back the burden it places on private enterprise and for families to retain more of the wealth that they work so hard, sometimes over generations, to earn. I certainly do. But if told that these choices have put us at financial risk - that we are relentlessly building a crushing burden of debt for our children and grandchildren or recklessly relying on the rest of the world to fund our living beyond our means and courting an imminent day of reckoning - then any reasonable person would have second thoughts. A responsible citizen might well think "This is the tax regime I prefer, but if we can't afford it, we can't afford it." And for those who wish to oppose the policy without engaging it directly, this approach has the advantage of being very easy to articulate while the answers are - well, complicated. For these people then, keeping the public drumbeat on these questions of finance is the most effective way they have found of avoiding the debate on the more fundamental issues. They fear they would lose that debate, as they have repeatedly lost it in the past.

I would hope that, as we move forward, we will return questions of finance to their appropriate role. Not unimportant, but - at least in our current circumstances - not central. Thank you again for the opportunity to speak to you this morning, and I'd be happy to answer any questions that anyone in the audience may have.