<DOC>
[109 Senate Hearings]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:30522.wais]
S. Hrg. 109-791
PROSPECTS FOR THE ECONOMIC EXPANSION
=======================================================================
HEARING
before the
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
__________
JUNE 27, 2006
__________
Printed for the use of the Joint Economic Committee
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JOINT ECONOMIC COMMITTEE
[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]
HOUSE OF REPRESENTATIVES SENATE
Jim Saxton, New Jersey, Chairman Robert F. Bennett, Utah, Vice
Paul Ryan, Wisconsin Chairman
Phil English, Pennsylvania Sam Brownback, Kansas
Ron Paul, Texas John E. Sununu, New Hampshire
Kevin Brady, Texas Jim DeMint, South Carolina
Thaddeus G. McCotter, Michigan Jeff Sessions, Alabama
Carolyn B. Maloney, New York John Cornyn, Texas
Maurice D. Hinchey, New York Jack Reed, Rhode Island
Loretta Sanchez, California Edward M. Kennedy, Massachusetts
Elijah E. Cummings, Maryland Paul S. Sarbanes, Maryland
Jeff Bingaman, New Mexico
Christopher J. Frenze, Executive Director
Chad Stone, Minority Staff Director
C O N T E N T S
----------
Opening Statement of Members
Statement of Hon. Jim Saxton, Chairman, a U.S. Representative
from New Jersey................................................ 1
Statement of Hon. Jack Reed, Ranking Minority, a U.S. Senator
from Rhode Island.............................................. 2
Witnesses
Statement of Dr. Edward P. Lazear, Member, Council of Economic
Advisers....................................................... 3
Statement of Dr. Mickey D. Levy, Chief Economist, Bank of America 30
Statement of Dr. Brad Setser, Director, Global Research, Roubini
Global Economics; and Research Associate, Global Economic
Governance Center.............................................. 35
Submissions for the Record
Prepared statement of Representative Jim Saxton, Chairman........ 46
Prepared statement of Senator Jack Reed, Ranking Minority........ 47
Prepared statement of Dr. Edward P. Lazear, Member, Council of
Economic Advisers.............................................. 49
Editorial, The Wall Street Journal, entitled, ``America at Work'' 58
Chart, entitled, ``Effects on After-Tax Income of Tax Cuts Passed
Since 2001''................................................... 60
Chart, The New York Times, entitled, ``The Rich Get Richer,
Again''........................................................ 61
Prepared statement of Dr. Mickey D. Levy, Chief Economist, Bank
of
America........................................................ 62
Prepared statement of Dr. Brad Setser, Director, Global Research,
Roubini Global Economics; and Research Associate, Global
Economic Governance Center..................................... 74
PROSPECTS FOR THE ECONOMIC EXPANSION
----------
TUESDAY, JUNE 27, 2006
Congress of the United States,
Joint Economic Committee,
Washington, DC
The Committee met, pursuant to notice, at 10 a.m., in room
2118, Rayburn House Office Building, the Honorable Jim Saxton,
Chairman of the Committee, presiding.
Representatives present: Representatives Saxton, Paul,
Ryan, Brady, Maloney, Hinchey, Sanchez and Cummings.
Senators present: Senators Bennett, Reed and Sarbanes.
Staff present: Chris Frenze, Robert Keleher, Brian
Higginbotham, Colleen Healy, Ari Evans, Jeff Schlagenhauf, Chad
Stone, Daniel Dowler, and Matt Homer.
OPENING STATEMENT OF HON. JIM SAXTON, CHAIRMAN,
A U.S. REPRESENTATIVE FROM NEW JERSEY
Chairman Saxton. Good morning.
It is a pleasure to welcome Chairman Lazear of the
President's Council of Economic Advisers before the Joint
Economic Committee this morning. Thank you for being with us.
The Council of Economic Advisers and the Joint Economic
Committee share a common history, and we value the good
relationship that we have had over many years. I would also
like to welcome the members of the second panel, Dr. Mickey
Levy, and Dr. Brad Setser this morning.
Thank you also for being here.
The U.S. economy has grown at a healthy pace in recent
years, according to official data. The U.S. economy advanced
4.2 percent in 2004 and 3.5 percent in 2005.
The pick-up in economic growth since 2003 is largely due to
the rebound in investment including equipment and software
spending.
A combination of accommodative monetary policy and
investment tax incentives enacted in 2003 helped to boost
investment and improve economic growth in recent years.
Since August of 2003, 5.3 million new jobs have been
created and the unemployment rate has fallen to 4.6 percent. As
the Fed noted in a policy report last February, the U.S.
delivered a solid performance in 2005.
In the first quarter of 2006, the economy expanded at a
blistering pace of 5.3 percent. This performance is all the
more remarkable considering the impact of high oil prices and a
tightening of monetary policy by the Federal Reserve.
Although there is some weakness in the real estate sector,
it appears as though a soft landing is the most likely outcome.
The overall economy has proven to be quite resilient.
Very recent data suggests that the U.S. economy is no
longer growing at an unsustainable rate in excess of 5 percent
but advancing at a more moderate rate of about 3 percent.
According to the Blue Chip consensus of economic
forecasters, this trend will continue through most of the next
six quarters.
The Fed has stated that the U.S. economy should continue to
perform well in 2006 and 2007. A variety of forecasts suggest
that the economic growth for 2006 will be about 3.5 percent and
that the economic expansion will continue into 2007.
At this time, I would like to ask the Ranking Member,
Senator Reed, if he has comments that he would like to make.
[The prepared statement of Chairman Saxton appears in the
Submissions for the Record on page 46.]
OPENING STATEMENT OF HON. JACK REED, RANKING MINORITY, A U.S.
SENATOR FROM RHODE ISLAND
Senator Reed. Thank you very much, Mr. Chairman.
Let me also welcome Chairman Lazear to his first hearing,
and I, too, am pleased that Dr. Levy and Dr. Setser will be
participating in the second panel.
The latest Administration forecast, which is in line with
the consensus of other forecasters, is for economic growth to
continue at a more moderate pace than we have seen recently. Of
course, there are risks to that forecast; high energy prices
and cooling housing markets might slow consumer spending more
sharply than forecasters are predicting. And our trade deficit
and dependence on foreign lenders have reached alarming
proportions.
The Federal Reserve has to decide how to deal with these
risks while preserving its credibility on inflation. If the Fed
makes the wrong choice, the economic recovery could end before
it has begun for many American families. That brings me to the
core of my concern about the economy and the Administration's
policies. As much as the President would like to say that his
policies are benefiting all Americans, the fact is that we have
gone through the most prolonged job slump in many decades. Real
wages are not just lagging behind productivity growth. They are
stagnating.
And economic inequality is increasing. While workers are
waiting to see the benefits of this economic recovery show up
in their paychecks, American families are experiencing
widespread economic insecurity in the face of soaring energy
prices, rising health care costs, declining health insurance
and pension coverage, and rising costs for a college education
for their children.
The President's tax cuts have not been the answer. They
were poorly designed to stimulate broadly shared prosperity and
produced a legacy of large budget deficits that leave us
increasingly hampered in our ability to deal with the host of
challenges we face. Moreover, the President's goals of making
his tax cuts permanent and cutting the deficit in half are
simply incompatible. Large and persistent budget deficits have
contributed to an ever-widening trade deficit that forces us to
borrow vast amounts from abroad and puts us at risk of a major
financial collapse if foreign lenders stop accepting our IOUs.
We had a current account deficit of nearly $800 billion last
year. And our international financial debt continues to mount.
I hope we would all agree that raising our future standard
of living and preparing adequately for the retirement of the
baby-boom generation require that we have a high level of
national investment and that a high fraction of that investment
be financed by our own national saving, not by foreign
borrowing. We followed such prosperity-enhancing policies under
President Clinton, but that legacy of fiscal discipline has
been squandered under President Bush.
Most experts believe that the budget deficits we need to
worry about are the long-term structural deficits resulting
from the President's tax cuts, not cyclical deficits resulting
from a temporary decline in economic activity. So I'll be
interested in Chairman Lazear's explanation of just how we can
grow our way out of deficits as he recently wrote in the
Washington Post.
I am also curious about Dr. Lazear's recent statement in
the Wall Street Journal that the President's tax cuts have made
the Tax Code more progressive, which narrows the difference in
take-home earnings. In fact, the President's tax cuts have
widened the gap in take-home earnings. According to the non-
partisan Tax Policy Center, the tax cuts passed since 2001 have
raised the after-tax income of the top 1 percent of Americans
by 5 percent while raising the after-tax income of the bottom
60 percent of Americans by just 2 percent.
Chairman Lazear rightly points out that policies must
increase the opportunities of all workers to acquire skills and
training, but this view doesn't square with the President's
budget, which includes cuts to elementary and secondary
education, student aid and loan assistance for higher education
and job training for displaced workers.
I look forward to Chairman Lazear's testimony.
Thank you, Mr. Chairman.
[The prepared statement of Senator Reed appears in the
Submissions for the Record on page 47.]
Chairman Saxton. Dr. Lazear, the floor is yours, sir.
STATEMENT OF DR. EDWARD P. LAZEAR, MEMBER, COUNCIL OF ECONOMIC
ADVISERS
Dr. Lazear. Chairman Saxton, Ranking Member Reed, thank you
for giving me the opportunity to speak to you today on the
prospects for economic expansion. The American economy is
strong. Even as world growth outside the United States has
strengthened, the U.S. has maintained leadership in economic
growth. The economic outlook remains positive as well.
Let me begin with the current picture of the economy.
Chairman Saxton. Would you mind pulling the microphone a
little closer?
Dr. Lazear. Let me begin with the current picture of the
economy and the Administration's forecast for the next couple
of years. First, real growth of gross domestic product (GDP)
was at 3.2 percent over the four quarters of 2005, and it is
forecast to be at 3.6 percent this year and 3.3 percent the
following year.
We expect rates of inflation of about 3 percent and even
lower going forward from this point. These expectations are
consistent with market data and with the consensus of private
forecasts.
Job growth has been strong over the past couple of years.
The economy has been producing about 2 million jobs per year
for a total of 5.3 million jobs since August 2003. That trend
is expected to continue with some slight modification in 2006
and 2007.
Our monthly estimates of employment growth for 2006 and
2007 are 156,000 and 140,000 respectively. The unemployment
rate which was 5.1 percent in 2005 is forecast to average about
4.7 percent in 2006 and 4.8 percent in 2007. In short, the
economy continues to grow, inflation expectations are moderate,
and the labor market is strong.
There have been some concerns in the past couple of months
that the economy may be slowing. It is better described as
likely moderating from very good growth to good growth. The
first quarter of 2006 enjoyed GDP growth at annual rate of 5.3
percent. While we do not expect growth rates to continue at
that level throughout the remainder of the year, we do expect
that they will be sufficiently high to cause the real GDP
growth over the four quarters of 2006 to be in the neighborhood
of 3.5 percent as mentioned earlier.
We lead the industrialized countries in economic growth,
and we have very good fundamentals for continued economic
expansion. These fundamentals include a flexible labor market,
few impediments to business formation, high levels of
investment in skills and human capital, strong property rights,
well-developed and sophisticated capital markets, low taxes and
an entrepreneurial spirit. Americans' pioneering attitudes and
openness to new ideas and people have been instrumental in
growing this economy.
Although the economic situation is favorable, there are
always risks to continued economic growth. The one that has
received the most attention recently is the housing market.
Partly as a result of higher interest rates, the housing market
has not expanded at the same rapid rates as it has in the
recent past. Most notably, housing starts have fallen by about
13 percent since January of this year. But that decline is best
understood when put in historical perspective. Over the past 45
years, the average for housing starts has been about 1.5
million units per year with a high point actually coming in the
early 1970s. Right now, with housing starts at 1.957 million
for May, they are currently above the level of housing starts
throughout the 1990s.
While some specific housing markets have seen price
declines, in most markets the movement has been limited or
slightly up. The recent nationwide price increases in the range
of 1 to 14 percent are neither sustainable nor necessarily
desirable. Offsetting the moderation in residential
construction has been expansion in commercial real estate and
other business investment.
These latter two components signal strong confidence in the
economy and its ability to expand further. Recent moderation in
consumer spending has been offset by higher growth in exports.
During the last year, consumer spending accounted for about 72
percent of GDP growth which is down a fair amount considering
its importance to GDP growth during the previous 3 years.
Exports and business-fixed investments, on the other hand, rose
to account for 50 percent of GDP growth in contrast to the
earlier 3 years during which they actually subtracted to GDP
growth.
The most noticeable change in the economy since last summer
has been a significant increase in the price of gasoline and
oil products.
Since last May, the price of crude oil is up more than 40
percent and, nationally, the price of gasoline at the pump is
35 percent higher. Higher energy prices crimp family and
business budgets, but thus far, the economy has once again
exhibited resiliency. Although higher energy prices have played
a role in boosting inflation over the past year to 4.2 percent,
the rate of core inflation was only 2.4 percent, up slightly
from the 2.2 percent core inflation rate over the year-earlier
period.
These figures are from the consumer price index, the CPI,
and other measures show even less inflation. Moreover, energy
prices are expected to moderate. The futures price for West
Texas Intermediate crude oil delivered 1 year from now is about
$73 a barrel. At today's prices, that would mean an increase of
about 3 percent over the next year. Gasoline futures are
actually down relative to current prices, so the market is
predicting lower gasoline prices in December than are currently
prevailing.
Consistent with the improved outlook on energy prices, the
consensus of professional forecasters is that overall inflation
will be a moderate 2.3 percent in 2007 (Q4 over Q4).
Productivity growth is helping to keep inflation pressures
moderate. It also helps the make the United States
internationally competitive and leads to high standards of
living. Productivity growth, how much workers produce per hour,
has been remarkably strong over the past 10 years at an average
annual growth rate of 2.9 percent. Over the past 5 years, it
has been at an annual rate of 3.3 percent. This is the fastest
5-year growth period in nearly 40 years.
Productivity growth in the United States has been
impressing economists for another reason. It is the highest
level of any major industrial economy, and it is growing
faster, too.
While there are no direct ways for policymakers to increase
productivity, as I will discuss later, there are a number of
steps we can undertake to help.
Mr. Chairman, you asked me to comment on the issue of
global imbalances.
The United States is running a current account deficit on
an annualized basis of about $800 billion or 6.4 percent of
GDP. Many observers look at this number with concern. I would
like to make a few comments with respect to the issue of the
current account deficit.
First, let me point out that on the other side of the
current account deficit is the capital account surplus.
Second, I would like to point out that historical records
suggest that countries can be in current account deficits or
surplus situations for very long periods of time.
More important, there is no clear correlation between a
country's surplus or deficit position and economic growth.
Given the lack of obvious correlation, should we still be
concerned about large current account deficits? I believe the
answer is that we should. We must constantly monitor our
international situation for the reason that abrupt changes
could create problems for the U.S. economy. In particular, a
rapid decline in the U.S. current account deficit would
correspondingly imply a rapid decline in the U.S. capital
account surplus. Were this to happen, there could be
significant adverse consequences to the U.S. economy and the
rest of the world. We do not anticipate abrupt changes like
this occurring, but we do not ignore the possibility.
Most importantly, we must make sure that we maintain the
kind of investment climate that allows foreign individuals and
institutions to remain confident in our economy and its ability
to grow and pay returns to investments that they are making.
We should also consider the causes of and potential
remedies to our current saving dearth in the United States.
Major progress could be made by removing impediments to saving
that are incorporated in our current tax structure and also by
continuing to bring down the Federal budget deficit.
This brings me to issues that are perhaps more directly
relevant to the Congress. Mainly, what can we do specifically
to ensure that we grow at high rates and encourage additional
economic growth? First, we must make sure that our marginal tax
rates stay low. The most important way to encourage growth in
the economy is to maintain high rates of returns to investments
both in physical and human capital.
In order to allow for high rates of investment in physical
capital, business taxes and returns to capital investments
through dividends, capital gains and other payments must not be
taxed at high rates. Raising the level of capital per worker
makes workers more productive and leads to higher wages in the
long run. Congress's recent action with the President to extend
the capital gains and dividend tax cuts are very positive moves
in this direction.
Second, the death tax affects saving behavior. The
President has expressed his desire to see the complete
elimination of the death tax, and we believe a such a policy
would be favorable to create a climate that is positive for
saving.
Third, we must ensure that we do not discourage investment
in human capital. The most important source of capital in the
economy is the capital embodied in people through their skills.
To make sure that individuals have incentives to invest in
skills by going to college, graduate school or vocational
schools to obtain other forms of skills on the job, it is
necessary to keep tax rates on wage income low.
If individuals see that the returns to investment in their
skills will only be dissipated through high tax rates on
moderate- to high-wage earners, the incentives to invest in
human capital will be dampened.
Fourth, we must remain open to foreign investment. As I
mentioned earlier, foreign investment has been an important
source of capital for the United States. Approximately 1 in 20
workers is employed in a foreign-owned firm, and about 45
billion workers are employed by firms that engage in
significant amounts of international trade.
As such, we must make sure that we keep pushing for freer
trade, especially in the area of services, which has become a
larger and larger part of our economy.
Fifth, the President has outlined a competitiveness
initiative to make sure Americans have the skills to compete in
the modern world. We must continue to push for reform in K
through 12 education, which has been the weakest component in
our human capital investment structure.
Fortunately, our colleges and graduate schools are the best
in the world. We export education by training large numbers of
foreign students in our American colleges and universities, and
it is good for us to continue to do that. But we must also make
sure that those U.S. individuals who do not necessarily go on
to college also get the skills that are important for them to
compete in a modern American economy.
As such, keeping students in high school, reducing our
drop-out rates and ensuring that the education quality that is
provided to all of our young citizens is high will be important
not only in the near future but as we move into the later years
of the 21st century. The President's efforts over the past
several years to improve education with the No Child Left
Behind Act and community college initiative will help.
Furthermore, we must also strengthen our human capital
infrastructure by working to raise the skill levels of American
workers and by increasing opportunities for education and
training. As part of the competitiveness initiative, the
President has proposed Career Advancement Accounts that workers
could use to obtain the education and training they need to
compete in a global economy.
Career Advancement Accounts are self-managed accounts that
encourage future workers to gain the skills necessary to
successfully enter, navigate and advance in the 21st century
labor market.
In conclusion, our economy is currently very strong, and it
should continue to grow and remain strong because our
fundamentals are positive. There are a number of issues
policymakers need to address, including some that I have not
mentioned here this morning, but ultimately, we must ensure
that we do everything possible to keep productivity growing.
Growing productivity is the key to wage growth and to rising
standards of living. It is also a key picture of our
international competitiveness.
Productivity grows as a result of the investment in
physical and human capital. And physical and human capital are
amplified when incentives remain strong. This means that we
must keep tax rates low, keep openness to investment and
foreign trade, and keep our economy and labor markets flexible.
The President's initiatives for low taxes and his focus on the
improvements of the skills of all Americans are the right moves
for the U.S. economy.
Again, thank you for the opportunity to discuss these
issues with you. I would be happy to answer any questions that
you may have.
[The prepared statement of Dr. Lazear appears in the
Submissions for the Record on page 49.]
Chairman Saxton. Dr. Lazear, thank you very much for a very
comprehensive statement.
In a statement last February, the Federal Reserve stated
that the economy had performed well in 2005 and was expected to
continue to perform well in 2006.
Also on June 10th, the Blue Chip forecast was issued which
essentially said the same thing, projecting that economic
growth would be around 2.8, 2.9, 3 percent.
Is this consistent with what the Administration's forecast
is going forward?
Dr. Lazear. Thank you, Mr. Chairman.
Yes, it is consistent. We recently engaged in an exercise
that we go through a couple of times a year. It is called the
troika process, and it involves three agencies: the Council of
Economic Advisers, the Office of Management and Budget and U.S.
Treasury. And the consensus from the group was that economic
progress is strong and that it will continue to be strong over
the next couple of years. In fact, we recently revised upward
our estimate of the growth in the economy based on first
quarter numbers. So we were initially projecting 3.4 percent
growth for this year and actually revised up to 3.6 percent as
a result of the very strong Q1.
That is also being reflected in the labor market. We are
seeing high employment growth during the first quarter. We also
saw creation of jobs at about the same rate that we had seen
through the previous 2 years, which is a very high rate.
Initial claims on unemployment insurance continue to be at
low rates, so all of these are indications of a strong labor
market, and we anticipate that will continue into the future.
Chairman Saxton. Thank you.
In your statement, you listed four items that you think are
important in terms of keeping the economy in robust shape.
Three of the four included or focused on low tax rates. The
first was that marginal tax rates stay low; the second was, the
estate tax stay in a position where it will positively affect
savings; the third was that incentives to invest in human
capital should be kept in place, again referring to low
marginal tax rates in order to incentivize people to increase
their personal skills with a goal toward increasing their
income.
I don't mean to speak for him, but in his opening
statement, Senator Reed questioned how the Administration's
policy relative to taxes could be sustainable in as much as we
have to worry about revenue.
Would you address that further for the Committee, please?
Dr. Lazear. Sure. Obviously, we are concerned about
revenue. The President stated that his goal was to cut the
budget deficit in half by 2009. As you know, revenues have been
coming in at rates that have been above the projected levels
both last year and during the early parts of this year. So
things are actually looking much better than we anticipated in
terms of revenue growth. In large part this reflects the fact
that the economy has been very strong and when we have a strong
economy with strong GDP levels and strong growth, that tends to
reflect the tax revenues as well. So the budget deficit is
currently moving in the right direction and moving in that
right direction at a very hurried pace and at a much more rapid
pace than we expected. And this is true despite the fact that
we were able to cut taxes and give more money to the American
taxpayer and put that money in their pockets rather than
directly in the hands of the Government. So we view these as
all being positive developments.
I have also looked at the effect of tax cuts on economic
growth. I have reviewed the literature, and this literature is
broadly based. Much of it comes from academia, and it is
written by individuals who are on both sides of the political
spectrum. The general consensus is that the tax cuts have been
effective in bringing about changes that we were anticipating
in 2003 in particular. The dividends in capital gains taxes
have resulted in higher levels of investment and higher levels
of economic growth. So we view those as all very positive
developments and very positive aspects of the policies that
were implemented a few years back.
Chairman Saxton. I remember sitting here during 2002 and
hearing the Administration criticized because job growth was
rather anemic. Then the tax changes that occurred in early 2003
seemed to have a positive effect on investment and the economic
growth that followed the investment. Would you care to comment
on that?
Dr. Lazear. Yes, what we saw after 2003 was that the tax
cuts had an immediate effect on investment and on GDP growth.
What was a bit slower to develop were movements in the labor
market. So what happened initially was, we had very high rates
of productivity growth; GDP went up; productivity went up, but
we were able to obtain these higher levels of productivity and
output without hiring more workers.
That worked for a while. We were able to get more out of
fewer for a while but eventually, the economy needed additional
workers and we saw job growth start to take off a couple of
years ago.
As you mentioned in your opening statement, Chairman
Saxton, we have seen job growth of over 5 million jobs over the
past couple of years, and that trend continues. So we think
that what we saw earlier has now generalized to other aspects
of the economy.
I should also mention that one of the developments that I
view as being quite healthy is that the expansion that was
fueled earlier by housing and by consumption now seems to be
generalizing to other sectors of the economy, particularly
exports and business investment.
I view that as a healthy development because it means that
the economic situation is more robust and perhaps less fragile
than it would have been a year or 2 ago. So I am actually
encouraged by the fact that these developments have occurred
and that we are seeing generalization of the kind of economic
activity that was very strong in the earlier couple of years to
other sectors of the economy that now seem to be important in
growing to us.
Chairman Saxton. Thank you.
Let me just finish up with one question that I find quite
interesting. Because the investment climate has been more
favorable in the U.S. than in many other countries, the United
States has enjoyed a net inflow of foreign-direct investment
particularly in the last few years. These net inflows are
recorded as surpluses in the U.S. financial account.
Given the rules of international accounting surpluses and
the U.S. financial account inevitably produced deficits in the
U.S. current account, should U.S. current accounts be seen as a
sign of relative strength in the U.S. economy compared to the
many other economies in the rest of the world rather than a
problem?
Dr. Lazear. Right now, our deficit in the current account
is about $800 billion, but as you correctly point out, you
don't get to enjoy consumption of these goods without having
something else go on on the other side.
Foreign suppliers are not willing to simply give us their
goods for free. And what they are doing is, they are giving us
their goods because they find the United States perhaps the
most attractive place in which to invest.
As a result, foreign investment in the United States has
been very high. And we have benefited from that foreign
investment in large part through growth not only in investment
activity but in growth of our output and employment as well.
So part of the--part of the story, and we always like to
point out at the Council of Economic Advisers that an important
part of the story whenever we talk about current account
deficits, is that that means that we are getting funds from
abroad, and that is we get those funds from abroad because
individuals abroad see this place, this country, as the most
attractive environment to invest in.
Again, I would return to what I said earlier. I believe
that is because of the fundamentals of the American economy. We
have flexible labor markets. We have relatively low tax rates.
We have a climate of entrepreneurship. All of those factors are
favorable to economic growth and economic investment, and they
have enabled not only American citizens but also foreigners to
invest in ours and enjoy the gains from our productivity.
Chairman Saxton. Thank you.
Senator Reed.
Senator Reed. Thank you very much, Mr. Chairman.
Let us go to the issue which I think is important, this
notion of revenues versus tax cuts. You have looked at the
literature. But there is recent economic analysis by the Joint
Committee on Taxation, the Congressional Budget Office and the
Congressional Research Service, which all find that deficit-
financed tax cuts reduce long-term economic growth because of
the increase in governmental deficits and the resulting decline
in national saving. There is something to be said, and it was
true several years ago when we were running a huge surplus,
which is a thing of the past, that tax cuts could have a
stimulative effect, and they would not adversely affect the
bottom line. But we are literally borrowing money to make tax
cuts, and according to these reports, it will, in the long-
term, affect our growth in a negative way. What is your
comment?
Dr. Lazear. Well, I certainly agree with you that running
long-term budget deficits is a problem, and I think the
President shares that view. We don't want to see deficits
persist for long periods of time. It is not only not good for
economic growth, but it is not good for consumption. It is good
for displacing other kinds of investments. There are many
angles to it, and I don't think anybody favors having sizable
budget deficits.
To my mind, the question is, what do we do about deficit
situations? As you know, center deficits are caused by a number
of different factors. The deficit that we face today to some
extent at least was caused by unanticipated events, wars,
natural disasters, of which we have had our share. And those
kinds of factors do contribute to a deficit situation.
The issue, when you are hit with factors like that, is,
what is the optimal way to finance those expenditures over
time? No one would argue that you want to finance the
expenditures on hurricanes or wars out of current consumption
to finance all of it out of current consumption. Almost any
reasonable economist would argue that we have to smooth that
financing over time.
The issue I think that we confront there is whether we are
financing it at the appropriate level at the appropriate speed
and whether we are doing it at appropriate--in an appropriate
fashion.
That is a tough question, to be honest with you, because
people will have different views on that politically.
My way of looking at this is to rely on market estimates,
and what I mean by that is that when we run a very high
deficit, if we are running a deficit that is too high and one
that is too high for economic growth, we see two things
happening. First, we crowd out business investments. In fact,
that hasn't been happening in recent years. Business investment
has been strong during the first quarter. Business investment
is up about 13 percent.
The second thing that I would look at, and I think the
thing that probably most economists would look at, is what has
it done to interest rates? When we see that the Government is
borrowing at very high rates, that tends to drive up interest
rates because it means that the demand for funds is high for
any given supply of funds available.
Again, we haven't seen higher interest rates. In fact,
interest rates right now, even though they have gone up over
the past couple of years, are quite low by historical
standards.
So we are looking at a situation where long-term interest
rates are down at about 5.1 percent. All of those factors seem
to be consistent with the markets saying that we are probably
doing a good job in financing our current expenditures.
Senator Reed. What has all of this done to the national
saving rate, and how important it is to have a national saving
rate that is positive?
Dr. Lazear. Again, I certainly agree with your pointing out
that the national saving rate is low. In fact, it has been
negative. Not just low. And that is a concern. I would like to
see saving get much higher in the future. I think we need to
save more for the future of our country.
I focused in my earlier statement on tax cuts. I think that
is probably the best way to get at this. We can't make
individuals save. The question I think that you are aiming at
is whether Government saving or Government consumption is
driving out--crowding out--private saving, and again, if that
were the case, we would see the evidence in terms of higher
interest rates.
So my view of this is that, if we look at the markets, if
we look at financial markets, we are not seeing a lot of
evidence that private savings has been crowded out by action by
the Government.
That being said----
Senator Reed. We are not showing a lot of private savings.
Dr. Lazear. Certainly not seeing private saving. But I
would say, we are not seeing private savings declining because
of Government action.
If it were the case that the Government were crowding out
investments, other kinds of activities, we would worry about
that, and we would see that reflected in financial markets. We
don't tend to see that.
The one thing that I think is a concern that you point out
is that this issue of private saving and the private saving
rate having been low is not one that is recent. It has been
true for a long period of time, although I admit it is lower
now than it has been in the past. But we are a very low-saving
country, and the question is, why is that the case?
Now some people believe that part of that is a statistical
artifact; in part, a reflection of the fact that we are not
counting savings in the appropriate fashion. For example, if we
took into account the very large capital gains that we see in
the housing market and in the stock market, and we look at the
change in individuals' wealth, most individuals would think,
gee, I am saving a lot because I have a house now that I bought
at $200,000 that is now worth $400,000. I have saved $200,000
during that period.
It doesn't show up in the difference between current income
and current consumption, but most individuals would think of
this as saving. And so that is another way to look at it, and
many economists believe that is the appropriate way to look at
it.
Senator Reed. You and the Administration have been talking
about not only the rising tide but one that has been fairly
shared. But when you point to the data, it is all aggregate
data on productivity or average income rather than looking at
median wages or median income to get a better picture of how
the wealth is being shared.
And when you look at some of these median numbers, it looks
as though many workers are being left behind even though
productivity is growing, and that the distribution of the
benefits is skewed to the upper income rather than lower
income. Is that accurate?
Dr. Lazear. I would say that part of it is accurate. It has
certainly been true that over the past 25 years, there has been
an increased dispersion between the incomes of the top and the
incomes of the bottom or even the median.
Most of the growth that has taken place in wages in the
economy over the 25 years has been among those individuals who
have had the highest level of skills. This is, I think,
something that is fundamental to our economy, and in some
sense, it is a good thing. And what I mean by it is a good
thing is that it reflects high rates of return to investment in
human capital. We like that part of it. It is a good thing.
Some people invest in skills, and those skills have high
payoffs.
What we don't like is the fact that some people in the
society have been left behind and have not been able to invest
in those skills and enjoy the benefits that are associated with
these investments in level--in high levels of human capital.
And that is an issue, and it is an issue that concerns me, and
I believe it is an issue that concerns the President as well.
One of the first things that he did, as you know, when he
came into office was to institute No Child Left Behind. That is
a step to move in that direction. Obviously, it is not the
entire solution to that problem. But my view is that the only
way to solve the problem of bringing up the bottom is through
higher investment and skills to those individuals. And by the
way, I would argue that that is generally the consensus among
labor economists. I recently did a call with a large number of
labor economists, many of whom were members of the Clinton
administration, and we have basically all come to the same
conclusion, which is that the reason for increased inequality
is not something that has to do with the policies of any
particular administration, Democrat or Republican, but rather
reflects a long-term trend in differences in human capital. So
my view is that we need to address those differences, and I
think that is a very--I think you have focused on a very
important issue and one that is certainly close to my heart.
Senator Reed. I just want to make a final point, which is
that the data suggest that if you look at median earnings and
median family income, there is a great deal of stagnation, and
it goes, I think, to the point you have made several times if
there is not an incentive in your paycheck to upgrade your
skills, then it won't happen. And what we are seeing for the
vast majority of Americans is that this economy is not
producing the kind of gains in their paychecks that we saw in
the past and that we hope to see again. I think that is a huge
problem.
Dr. Lazear. That is the part of your statement that I--that
I don't fully subscribe to. Let me tell you why. While I think
your facts are correct--I certainly don't dispute that--I would
interpret it slightly differently. The person who is the median
worker 5 years ago is not the median worker today. So if you
look, for example, at the median worker in 1994, and you ask,
where is that worker today--let us take the group of workers
between 25 and 34, because they are going to be moving up the
distribution the most, so this in one sense, one extreme, those
individuals enjoyed a 52 percent wage growth from 1994 to 2004.
So it is not that the median worker is being left behind. It is
that, as the economy changes, in its composition in large part,
bringing in new immigrants, the person who is the median worker
is a different individual. That having been said, again, I
don't dispute I think what is your basic point and your basic
point is we need to provide opportunity for all individuals and
for individuals at the bottom as well as for individuals at the
top. And I certainly subscribe to that. So whether we differ on
how to interpret median income or not, I think I would say, I
am on the same page as you are on that.
Senator Reed. Thank you, Mr. Chairman.
Chairman Saxton. Thank you very much.
Senator Bennett.
Senator Bennett. Thank you, Mr. Chairman. And thank you
Chairman Lazear for your being here and for the cogent way in
which you are responding to some of these issues. Let us go a
little farther down the road that Senator Reed started us on.
The productivity growth: You indicated productivity went
up, and wages lagged. And then the job growth took off as we
couldn't handle it with these more productive workers. But
isn't it normal that productivity growth, particularly
following recession, will always lead wage growth and job
growth? Isn't that a normal pattern that we have seen for a
generation or more?
Dr. Lazear. Indeed, it is. It tends to be the case that
when we have a turnaround in the economy, when we have a
recession followed by an economic recovery productive period at
first, and then employment fix-up later and then finally wages
tend to pick up. The same thing was true by the way during the
1990s, so if we look at the recession that occurred in the
early part of the 1990s and we ask, what happened, then in fact
what happened was productivity took off, and it took a while
for wages to catch up. In fact, some of my colleagues who
served in my capacity and as members of the Council of Economic
Advisers during President Clinton's administration were also
concerned about some of these same issues, kept thinking if
productivity is growing, why aren't wages growing, and then in
the late 1990s, we saw wages did start to grow and grew at
fairly strong paces.
If you look at the numbers for Q1 of 2006, we saw some very
strong wage growth during that period. We saw wage growth of
5.3 percent, and I am talking about hourly wages. The picture
is even better I would say for wages if we take into account
not just wages but total compensation.
Senator Bennett. That was going to be my next question.
Go ahead. Let us talk about the entire compensation package
and not just what shows up on the W2 form.
Dr. Lazear. One of the things that has happened over the
past 5 years is that, while hourly wages have gone up but not
gone up by as much as we might have hoped, compensation has
increased at about double the rate of hourly wage growth; in
fact, by some measures, more than that.
So we are looking at compensation that was up by about 2
percent since 2001.
Much of that reflects compensation that takes the form of
benefits. Some of it is health benefits. Health benefits are
good when they improve the health of our workers. We don't view
that as a bad thing. If workers take some of their compensation
in the form of more health insurance, we would like to see that
occur.
So that is not a bad thing. And we do expect that those
trends will tend to--tend to slow down a bit in the future as
health costs tend to get under control, and we hope they will
get under control.
But we also would expect then that at the same time wages
will increase to make up for some of these differences in
increases in benefits.
Senator Bennett. Having been an employer, I know that, when
you look in terms of your labor costs, you don't look at the W2
number. You have to figure in all of the other costs connected
with the job, so that your employee has to return value to the
firm sufficient to cover the entire package of compensation
rather than just the amount that shows up in the wages. So I
have had the feeling that some of the rhetoric around this
issue has focused entirely on the W2 and not recognized that
the entire package which the employer has to pay has in fact
gone up rather substantially.
Taking the entire package--I think this is what I heard you
say, but I want to just emphasize it and nail it down--taking
the entire package, the amount that an employer has to pay for
labor or the flip side of it, the amount of benefit that the
employee gets, has in fact been going up fairly substantially--
in the period since the recovery. Now, is that a fair summary
of where you are?
Dr. Lazear. It is a fair summary. Obviously, we always--we
would prefer more growth to less growth. It certainly is the
case that if we take compensation into account, compensation
has grown at a much more rapid rate than hourly earnings. So as
we move into the future, my expectation is that compensation,
total compensation, which as you point out is what is relevant
from an employer's point of view, is the cost side, it is also
relevant from an employees' point of view, because when we take
wages, wages are only one component of earnings. Pension
benefits, vacation benefits, health benefits, which are the
major components of compensation that don't show up in wages,
are also important parts of an individual's well-being, and we
want to make sure that those continue to grow as well. So I
agree with you. I think we have to take the entire package into
account.
Senator Bennett. There was a time in my career when pension
benefits struck me as being completely worthless. The older I
get, the more valuable they become. Thank you.
Dr. Lazear. Thank you, sir.
Chairman Saxton. Thank you, Senator Bennett.
Mrs. Maloney.
Representative Maloney. Thank you and welcome.
You testified that the deficit relative to the GDP is 3.6
percent this year.
Dr. Lazear. Deficit relative to GDP, you are talking about
for 2005 I think.
Representative Maloney. Yes.
Senator Bennett. I would think it is 2.6.
Dr. Lazear. I think that is right. I want to check the
number just to make sure. Why don't you continue, and I can
listen to you while I am checking?
Representative Maloney. My question really pertains to
long-term sustainability of economic growth with the deficit.
Most economists believe that, 5 to 10 years out, the deficit
will grow definitely, entitlements are going to grow and now,
how can we sustain this with the revenue loss from the tax cuts
and the growth and entitlements and the growth in the deficit?
You have a structural problem that has long range challenges
for the country.
So how do you propose to sustain economic growth with the
structural deficit and expenses that are now part of our
system?
Dr. Lazear. Well, I think that you----
Chairman Saxton. If I can interrupt. My sharp staff behind
me here has given me this the actual percentage of GDP. GDP
that the deficit represents is actually 2.6 percent.
Dr. Lazear. It sounded off. I think the 3.6 number that I
cited was the projected growth for next year for GDP, but
anyway, we have got our numbers straight, and I certainly
understand.
Representative Maloney. The point is not the 2.6 now, which
is not a problem. The problem is the sustainability of--with
the structure of deficit, lost revenue and entitlements and
built-in spending with Social Security, with the baby boomers
and the challenge that we face there.
Dr. Lazear. I agree with you, and in fact, I would say I
would paint an even bleaker picture than you pointed out if we
don't get things under control because we estimate that if we
go forward into 2030 on the level of benefits projected right
now and entitlements projected right now, we will have about 60
percent of our GDP devoted to the Federal budget, and that is
clearly not sustainable, nor would any country tolerate levels
of taxation that would support 60 percent of GDP going to that
part of society.
Representative Maloney. And another challenge is wages not
growing for most workers. So where will spending come from if
wages are not growing? Where is the boost for the economy?
Dr. Lazear. I would disagree with your point that wages are
not growing. Again, I would go back to the numbers that I just
cited for Senator Reed which is that, if you look at the
typical worker----
Representative Maloney. We are talking about money put into
the economy from their wages. Their wages, their take-home pay
is not growing. Maybe they have more vacation time, but their
take-home pay is not growing.
Dr. Lazear. I even mean take-home pay. Let me go back to
the number that I cited before. If we look at the median worker
between 25 and 34 years old in 1994, we compare with that
worker 10 years later. We ask, by how much did that typical
worker's wages grow? It is 52 percent. So although the median
is not growing, that doesn't mean that typical workers' wages
are not growing. So those individuals do see wage increases
over their careers.
Now, I thought----
Representative Maloney. Many people, many Americans feel
with the high cost of gas and with the high cost of housing--
and the housing market is cooling--that their wages are not
growing. I just want to ask one question. You were talking
earlier about the deficit, and you talked about 9/11 and
Hurricane Katrina and the war. Hopefully the war will be over
soon. The President announced he is withdrawing troops. I hope
he will. But you talked about
9/11 and Katrina for the budget deficit. And I would say that
9/11 and Katrina are a very small, a little of the deficit
compared to revenue and other items and with the large revenue
that is lost from the tax cuts, and I would like to ask you
just, at a basic level, do you agree that tax cuts cause a drop
in the Federal revenue?
Dr. Lazear. There is no doubt in any mind the tax cuts
cause a drop in the Federal revenue initially. That is
certainly true. What tax cuts are able to do, though, is to
help grow the economy. Now----
Representative Maloney. I would agree that some tax cuts
help grow the economy. But when you have deep structural tax
cuts that take out a large amount of revenue for the
Government, you have a structural problem. Alan Greenspan
testified before us in the seat that you are sitting in, it is
very rare and very few economists believe that you can cut
taxes and you will get the same amount of revenues, and he says
it is very--you will get some back, but it is very small, and
it is not a large part of the economy. So what I am basically
concerned about is the sustainability of our economic growth
with the large deficits, the trade deficits, the growing built-
in challenges with Social Security for aging baby boomers and
so forth, and a major revenue source cut out of the budget. And
I would add that everybody talks about the earmarks, but the
Republican majority has really hurt the budget with removing
the caps and not continuing the program of pay-as-you-go, the
Democrats----
Chairman Saxton. The gentlelady's time has expired.
Representative Maloney. May I get his answer?
Chairman Saxton. You can get his answer, but we have to
stop the question.
Representative Maloney. On PAYGO, it is a program where you
do not spend money that you do not have, and that program has
been removed, and that has also added to the----
Chairman Saxton. The gentlelady's time has expired.
The Chairman would like you to answer the gentlelady's
question, please.
Dr. Lazear. I certainly agree with Chairman Greenspan's
earlier statement that tax cuts result in an initial decline in
revenue. The issue I think that you are addressing is what
happens over time. And you made the point that----
Representative Maloney. His statement was over time. Over
time.
Dr. Lazear. I was going to address that. Bear with me. I
will get to you. I will get to it.
And I certainly would not claim that tax cuts pay for
themselves nor do I think that is necessary. My view of tax
cuts is not to cut taxes so that they pay for themselves but
rather to cut taxes so that the economy grows and so that it
has fewer distortions in it. I am more concerned about economic
growth in the private sector than I am about the size of the
public sector. I would rather not see the public sector grow. I
would rather see a more controlled public sector, but my focus
is on, as an economist, is on making sure that we create the
kinds of economic conditions that are favorable to economic
growth in the private sector.
In terms of sustainability, again, I certainly agree with
you. I think that it is extremely important to make sure that
we deal with deficits and that we deal with the expenditure
side as well as the tax side. I am concerned that, as we
project forward, we have not done a good job in thinking about
expenditures. I actually think the President would also agree
with you; he is concerned about entitlements, Social Security,
Medicare, Medicaid and the programs that are going to eat up a
very large part of our budget into the future.
So I don't think we have much of a disagreement there.
The one point where I would perhaps want to take a slight
issue with something that you said is that the tax cuts have
not been helpful or will not be helpful in the long run. In
looking at the economy, and there, I say, numbers speak louder
than words. If we look at the history since 2003, it is very
difficult to argue with the evidence that we see there, that
the growth in the economy has been very strong; the growth in
the labor market has been very strong; growth in investment has
been very strong. So I think we have a slight difference of
opinion there.
Chairman Saxton. Thank you very much.
The gentlelady's time has expired.
Mr. Brady, it is your time, sir.
Representative Brady. Thank you, Mr. Chairman.
What was the increase in Federal revenues last year. Do you
recall?
Dr. Lazear. The increase in Federal revenues, I believe,
was 9 percent, was the number. Yes, I believe it is 9 percent.
Representative Brady. This year it is projected to be
double digit?
Dr. Lazear. 13 percent.
Representative Brady. So just following up that point, the
tax relief that helps spur the economy to create 2 million jobs
every year has actually resulted in close to a 10 percent
increase in Federal revenues last year, and a projected 13
percent increase this year.
Dr. Lazear. Well, revenues are certainly up. I guess the
way I would like to put the point is that I view the tax cuts
as having helped increase the rate of growth in the economy.
I also view a growing economy as consistent with generating
more Federal revenues. So the additional Federal revenues that
we see are attributable in large part to the growth of the
economy, some of which I think can be attributed to the tax
cuts that were initiated primarily in 2003. I would say those
are the ones that were most important in stimulating economic
growth.
Representative Brady. I think at the time, I know with the
triple hit of the 9/11 attacks, which cost almost 2 million
jobs, the recession that we were in and then the collapse of
the dot-coms, at that point, we were at a critical point in the
economy and needed to boost spending in a number of areas. I
think the tax relief helped produce, as you pointed out, the
Federal revenues that we are receiving today.
You pointed out a key issue on the trade balance, that our
account deficit is really related not to just what we buy and
what we sell but how much we consume, what type of investments
we are seeing as a Nation compared to the rest of the world.
One of the keys in our trade balance is related to both our
consuming as a Nation and selling our exports as a Nation.
Representative Brady. One of the keys is finding, not only
new markets for American business services which our free trade
agreements are producing, but also spurring more consumption by
other nations. As you look at the world from China to Europe to
Africa to Central America, to South America, do you forecast
increased consumption and stronger economies outside the United
States? What impact could that have on our economic growth?
Dr. Lazear. Yes. That is a very important point in that
when we will look forward, and we think about where we are, we
have to remember that we are only 5 percent of the world's
population, and of course, since we have a very large and very
rich economy relative to the rest of the world, we are much
greater right now in terms of our economic importance.
But as we look forward, that situation is going to change.
If you have countries like China and India growing at very
rapid rates and they account for over, well over a couple
billion people, we know that they are going to be an important
component in the entire picture. And we have to make sure that
we have access to their markets and that we are able to trade
with them.
Fortunately, the rest of the world actually is doing quite
well right now. Not only are the developing countries like
China and India growing at very rapid paces, but Europe is now
fighting its way back, Japan, after having a very troubled
decade, is doing recently well with growth rates around 3
percent right now.
All of those factors contribute to a situation that will
help our economy as we trade and export and also import from
those individuals and from those countries as well. So I think
the picture looks quite good, and actually looks better than it
did a few years ago in large part because the world is a
healthier place than it was.
Representative Brady. So from your perspective does America
isolating ourselves from the global market increase our
economic growth, or does our engagement in the global market,
especially in prying open new markets, encourage our economic
growth?
Dr. Lazear. I think there is little doubt about this, and
this is one you often you hear economists saying on the one
hand, on the other hand. This is one in which there is no other
hand. Virtually, the entire economics community believes that
trade is beneficial to an economy.
And increased trade improves economic growth.
So we are very much in favor of making sure that we
maintain openness in terms of trade, the Doha round, which is
currently being negotiated, is one that we are hopeful will
conclude in some positive achievements, the bilateral
agreements we have been engaging in over the past few years, I
think, have been helpful in opening up the world. We are a very
productive nation. We are actually a low unit cost nation. So
despite the fact that our wages are high relative to the rest
of the world, we are not a high cost country because we are so
productive. So our costs are actually relatively low as
compared with those countries with whom we trade.
All of those developments mean we can compete and we can
compete successfully when we have openness to other markets.
And we are certainly pushing in that direction. And we believe
that is a very important component of growth as we look forward
to the 21st century.
Chairman Saxton. Thank you, Mr. Brady. The gentleman from
New York, Mr. Hinchey.
Representative Hinchey. Good morning, Mr. Chairman, and
welcome. As you pointed out in your testimony, we have seen
significant amounts of productivity growth and substantial
increases in the profitability of corporations, the
corporations' bottom lines, as well as in the pay of corporate
executives, which has reached extraordinarily high levels,
record levels. We have even seen some growth in the economy but
the growth in the economy itself has been rather modest, 2.6
percent or so, which is really odd in the face of the fact that
we have experienced record amounts of economic stimulation.
We have had record low interest rates, which have been the
primary reason why the housing bubble sustained the economy and
prevented us from going into a deep recession. And we have seen
huge amounts of public spending which have created very, very
large debts.
And given the fact that the interest rates are now going
up, how much longer do you think that we can sustain even the
productivity growth and the corporate profits, let alone the
modest amount of economic growth that we have experienced?
Dr. Lazear. Rising interest rates have certainly had an
effect on various sectors. You pointed out housing in your
question, and I think that housing is one of the areas in which
we have seen the most significant change. The picture in the
housing market is a little bit uncertain. And what I mean by
uncertain is that when we look at these numbers--and I look at
these numbers almost daily--we see some numbers declining, for
example, housing starts have declined by 13 percent since the
beginning of the year. But then, we were surprised yesterday by
the number that showed that new home sales were up by 4.6
percent last month.
So we have things moving in different directions there, and
it looks like the housing market is slowing, I would say, and
slowing a bit, but not slowing by as much as we had perhaps
anticipated or even feared.
The other side to that, sir, that I would point out is that
while the housing market has declined, so we are talking about
residential construction declining, we are seeing a lot of
strength in commercial real estate. And so what we have lost in
housing real estate we are seeing picked up in commercial.
The other component of the economy that has been very
strong is business fixed investment which has also picked up.
So that, coupled with growth in exports, indicates to me that
what we saw initially as being focused on consumption and
housing and I think that was your concern you were worried
about sort of the fragility in some sense of that those
sectors----
Representative Hinchey. My concern is sustaining what
little economic growth we have actually experienced in the face
of the fact that interest rates are going up, somewhat, the
housing market is closing down, and you are facing a growing
disparity in income among people in the economy.
Most of the benefits, the economic benefits, have flown to
people in the upper income brackets. But if you look at, for
example, the effect on the income of the median American
family, when you adjust that for inflation, their income has
dropped off by more than $1,600 over the course of the last 5
years. As a result of that, we are beginning to see a decline
in demand, and this is essentially a demand-based economy.
If you don't have demand, it doesn't matter how much supply
you have. In fact, if you have too much supply and lessening
demand, you are going to be facing a situation of deflation,
which some people have raised as a potential problem for the
future, and I would be interested to hear what you have to say
about that.
But the fact is that what we have--all of these
allegations, the so-called economic growth and prosperity and
rosy pictures that have been painted--are not reflected in the
experiences of the average American family.
The income of the average American family is declining. The
number of people without health insurance is now up over 45
million, and the number of people in poverty in the last 5
years has gone up by 4.5 million people.
So we are seeing people at the lower income level and the
middle income level being seriously economically depressed,
while everyone in the Administration is painting a very rosy
picture about the economy.
It doesn't make any sense to me.
Dr. Lazear. You have covered a lot of territory in your
question. Let me see if I can address a few of your points.
The first one that you made and you have made it twice now
was that there was little economic growth, and I guess I don't
share that view.
Representative Hinchey. It is 2.6 percent average.
Dr. Lazear. Let me read to you the numbers, specifically
real GDP growth was 4 percent in 2003, 3.8 percent in 2004, 3.2
percent in 2005, 5.3 percent of in Q1 of 2006. I don't know
where you got 2.6 percent out of that, maybe you are looking at
a different period.
Representative Hinchey. The Bureau of Labor Statistics has
provided that.
Dr. Lazear. We look at these numbers, and I am quite
confident of these numbers, so I would stand by my numbers. I
believe my numbers on this.
The growth rate in the economy has been very high. I don't
think there is any dispute about that.
The issue I thought that you were coming to in the second
half of your question was one that I did address earlier, it
was this issue of wage growth and how the average individual
was enjoying the gains in the society.
And as I pointed out, I do believe that we have seen growth
in compensation, which it was greater than the growth in wages,
albeit, perhaps not what we would like, we would like to see
higher growth in wages, I agree with you on that. I certainly
would like to see higher growth in wages. I believe it is
coming again.
If I cite the Q1 figures, we did see very strong wage
growth in Q1, and we hope it will continue. These tend to
reflect lags that one sees after a turnaround in the economy.
Whether we will be right, whether the over-95 percent wage
growth that we saw in Q1 will be sustained into the future, we
don't know. But we certainly hope that it will be. And I would
join you in cheering those efforts. But I think that what we
have done and what we believe is that a growing economy and
growing productivity is the best way to make sure that there is
wage growth. If you look at this over the long run and it is
not even a very long run, there is almost a 1-to-1 relation
between wage growth and productivity growth. So for every 1
percent you get in productive growth you get in wages.
During some periods you will see a lag, as I pointed out in
the mid-1990s, we saw a lag, and in the early 2000s, we saw a
lag as well. But we do seem to see somewhat of a catch up right
now and I hope it will continue.
Chairman Saxton. I thank the gentleman. On housing, it
seems to me that the low rates of interest that we saw in the
past years created a great incentive on the demand side. The
housing sector benefited greatly during those periods of time,
but to the point where we saw an increase in prices that made
it somewhat difficult for the average guy on the street to
afford housing. Can you just comment on that and see, where do
you see that going?
Dr. Lazear. Well, last year, we have seen increase in
housing prices in the range of 14 percent. And housing price
increases at that level, I do not believe are sustainable into
the distant future.
In fact, if I felt that there was certainty that housing
prices would increase at 14 percent, I think that is all I
would be investing in right now. I think all of us would do
that. We wouldn't need to worry about anything else.
So I think that seeing rates of growth at that level are
first, not sustainable, and second, as you point out, not even
necessarily desirable, because what that does is it changes the
prices of housing so that the persons in older age groups are
receiving capital gains relative to those in younger age
groups, those outside the housing market who have to buy into
the housing market suffer some capital losses as a result of
that and it is not clear to me at all that that is a healthy
development for the economy.
So some leveling off of housing prices that we might be
seeing this year, at least to my mind, does not signal any kind
of disaster scenario. In fact, it is probably a move in the
direction of a more sustainable path.
Chairman Saxton. Thank you.
Senator Sarbanes.
Senator Sarbanes. Mr. Lazear, as you are well aware, the
way it works here you have a certain amount of time when you
are recognized to ask questions and get your answers. Now if
you give long answers, we don't get to ask many questions.
In fact, if you give a long enough answer, you can get one
question and then, dance off the stage and then of course,
Chairman Saxton will gavel me down as I try to put another
question to you, frustrated by encountering these long answers.
So I will try to give relatively short questions and
hopefully get relatively short answers and maybe we can move
along here, and then I won't come into conflict with the
chairman, as I try to put yet another question to you.
An article in last Sunday's New York Times illustrated what
has been happening in income distribution over the last 25 to
30 years.
[The New York Times chart, entitled, ``The Rich Get Richer,
Again,'' appears in the Submissions for the Record on page 61.]
Now what it shows is that the distribution of income has
become about as unequal as it was in the 1920s. We had
incredible growth in the post-World War II period for better
than a quarter of a century. But we have seen in recent years
this concentration with respect to the share of income, so that
the top one-tenth of 1 percent is now getting 7 percent, and
the top 1 percent gets 16 percent, and the top 10 percent get
43 percent.
Does this trend concern you? I don't need a long answer. If
it concerns you, I would like to know, if it doesn't concern
you, say so.
Dr. Lazear. It does concern me.
Senator Sarbanes. Now, traditionally economists have called
our income tax system progressive because taxes rise as per
share of income, the higher up you go in the income scale and
that, of course, narrows the difference in after-tax income
compared to before-tax income.
But do you agree with that observation as a general
proposition?
Dr. Lazear. It depends on the actual tax structure.
Sometimes a tax structure can be made more progressive
sometimes less progressive. You would have to be a bit more
specific.
Senator Sarbanes. I do indeed want to be specific. In your
op-ed piece in The Wall Street Journal on May 8th, you said,
and I am now quoting you, the President's tax cuts have made
the Tax Code more progressive, which also narrows the
difference in take home earnings.
[The Wall Street Journal editorial, entitled, ``America at
Work,'' appears in the Submissions for the Record on page 58.]
Now the Tax Policy Center, which, of course, has economists
across the political spectrum, has found just the opposite,
that the net effect of the tax changes since 2001, has been to
raise the after-tax income of the top 1 percent of the
population by 5 percent, and raise the income of the bottom 60
percent of the population by only 2 percent.
And that is illustrated in this chart, this is, the effects
on after-tax income of the tax cuts. And it shows the top 1
percent up 5 percent, the bottom 60 percent, in other words,
more than half the population, three-fifths of it, up 2
percent.
[The bar chart, entitled, ``Effects on After-Tax Income of
Tax Cuts Passed Since 2001,'' appears in the Submissions for
the Record on page 60.]
What is your evidence for the statement in The Wall Street
Journal that tax changes since 2001 have narrow differences in
after-tax income?
Dr. Lazear. I am going to have to give you a slightly
longer answer, but I will try to keep it short so you get to
ask another question. I will speak quickly. When we look at the
tax cuts, first, I want to point out that there have been a
variety of changes in the Tax Code, some of which move in the
direction of progressivity, some of which move in the opposite
direction. Remember that associated with the tax cuts during
this Administration have been reductions in tax rates from 15
to 10 percent, increase in child care credits, reduction in
marriage penalties and some changes in the EITC as well. Those
tend to work in the direction of progressivity.
On the opposite side of that we have seen changes in the
capital gains tax which tend to work against progressivity.
So the issue is really an empirical question. I don't think
one can answer that ex ante.
Senator Sarbanes. This is empirical evidence that the
Policy Center has done----
Dr. Lazear. And I saw your numbers. I have looked at those
numbers carefully, and I have also investigated this quite
thoroughly. We believe that the tax cuts that the President
instituted were progressive in the following sense. If we look
at those tax cuts estimated for 2006, take those right now, and
ask, what would the effect of those tax cuts be on individuals
in, say, the lowest 50 percent of the income distribution, we
estimate that with the tax cuts, they pay 15 percent fewer,
lower taxes than they would without the tax cuts.
Additionally, if we look at the proportion of individuals
who pay no taxes at all, before the tax cuts individuals who
earn $32,000 paid no taxes. After the tax cuts individuals who
pay, I am sorry, who earn less than $42,000, pay no taxes. So
to my mind that is a move in the direction of progressivity.
Senator Sarbanes. I am not challenging that some of the tax
cuts contributed to progressivity.
But if you put them all together and look at the estimates
that the Tax Policy Center has made, I think these are rather
spectacular findings here. In any event, Mr. Chairman, I think
my time is up, as I understand it.
Chairman Saxton. Yeah it was up about a minute ago.
Senator Sarbanes. Let me ask this final question, Chairman
Lazear.
I am always interested in the struggle to maintain
professionalism of people who come into say the Council of
Economic Advisers or other positions from private life, and
then they are confronted with the political demands to, in
effect, be spokesman for an administration policy. It happens
in all administrations, an administration policy which is often
arrived at largely on political grounds.
And I am just curious. Are you encountering that struggle
now as chairman of the CEA?
Dr. Lazear. No, sir, I am not.
Senator Sarbanes. All right. That is all I want to know.
Chairman Saxton. Thank you. Before we go to the gentlelady
let me ask this question as a follow-up to Senator Sarbanes'
question, which I thought was a good one. When we look at the
percentage of taxpayers, Senator Sarbanes talked about the top
1 percent and the bottom 60 percent. I would like to talk about
the top 1 percent and the bottom 50 percent. My numbers are
that the top 1 percent of the wage earners in this country pay
34 percent of the taxes, while the bottom 50 percent of the
wage earners pay just 3.5 percent of personal income taxes.
And I am wondering how you could give the same percentage
of tax cuts to the bottom 50 percent, given the fact that they
pay just 3.5 percent of the taxes, as you would the top 1
percent? It would be a difficult chore, it would seem to me.
Dr. Lazear. Indeed it would. And that is why the numbers
that were cited earlier are not compelling in my mind. It is
virtually impossible to think about tax cuts that would win by
that particular standard.
The reason is this: If you think about people at the bottom
who are paying a small proportion of the total taxes, suppose
you eliminated all of their taxes and you change the taxes for
the very top individuals by 1 percent. Well, obviously, if
those are the individuals who are paying all the taxes in
absolute terms, they are going to get a bigger tax cut. On the
other hand, most people would believe that eliminating entire,
the entire amount of taxes for individuals at the bottom, and a
small fraction of taxes at the top would be a move toward
progressivity, but it would fail on that test. It would succeed
on other tests. That is why these questions become somewhat
more difficult, somewhat more complicated, and do require a bit
of, what I would say, more study before jumping to particular
conclusions and that was what we were trying to point out with
the numbers that we gave, and I think your numbers reinforce
that point.
Senator Sarbanes. Are you asserting that the percentage
cuts given to the bottom 60 percent were equal to the
percentage cuts given to the top 1 percent?
Dr. Lazear. No, the percentage cuts, I am sorry, sir, the
percentage cuts given to the bottom, when we look at the
overall picture, just talking, again, about your--the statistic
that you used, which is take all of the tax cuts combined,
capital gains, dividend tax cuts, take the EITC, add those all
up and then ask what proportion of the tax burden is borne by
low income individuals versus high income individuals, low
income individuals----
Senator Sarbanes. It wasn't a percent of the tax burden, it
was after-tax income----
Chairman Saxton. I would like to thank the gentleman for
his----
Senator Sarbanes. [Continuing.] inequality.
Chairman Saxton. I would like to thank you for your input.
We are about 8 minutes past your time so, Ms. Sanchez, the
floor is yours.
Senator Sarbanes. I was prompted to ask since you asked a
question----
Chairman Saxton. Thank you.
Senator Sarbanes. I thought we ought to keep the record
straight. It is important to do that.
Representative Sanchez. Thank you, Mr. Chairman. And Mr.
Chairman, thank you for being before us today. I have a couple
of questions that I have been following in the last year, since
I have been on this Committee, one with respect to housing and
one with respect to why hasn't Wall Street slapped Washington
for the deficit spending that is going on, and their inability
to--our ability to structure ourselves into what I think is a
big hole coming out of Wall Street, and I am incredibly
interested in why the markets haven't sent a message to us yet.
In talking to Chairman Greenspan, I think it was the last
question that was asked before he left, by me and the Congress,
one of the reasons that he gave us was, you know I asked him,
why hasn't Wall Street gone after us on this?
And he suggested that one of the reasons, one of the major
reasons was that productivity at the high end had increased,
even though the cost for productivity had not, that the influx
of people from the former Soviet Union, and India and China,
high end engineering, mathematics, et cetera, that we were now
using was depressing the wages or keeping the wages down at the
high end of these type of people.
I have noted that high--that the graduating class out in
universities in the United States actually is in high demand,
and the salaries are going up this year for the first time in a
long time of people coming out of there, given that less than
20 percent of the people in the United States carry at least a
BA, I am thinking of them as a higher productivity class, if
you will.
So my question to you is, does it, I was talking to a
colleague last night, and she told me that her daughter, who is
a second-year law student is making more per week than we do as
lawmakers per week. So, obviously, salaries are going up for
people who are getting the education out there.
Does this trouble you, given that Chairman Greenspan said
this is all about to collapse on us, and he viewed that
increases in this level of people were going to begin and bring
down the productivity of the United States? Does this concern
you?
Dr. Lazear. No, I actually view it as a positive
development that the return to investment in education is high.
What does concern me, though, again, is that I would, I
think we need to focus on making sure that all Americans enjoy
the ability, the opportunity to take advantage of these high
returns. It is a good thing when our productivity is high, when
our investment in skills pay off, when our investment in any
kind of capital, physical or human, pay off. And that trend, by
the way, has been going on for a long period of time. So I
don't view it has particularly problematic. I don't see any
robustness issue there which I think is what you were getting
at in your question, is this going to collapse? There doesn't
seem to be any tendency at all at least in the historic data to
suggest that it will.
Representative Sanchez. So you believe that if increases in
the higher end, the high productivity that Chairman Greenspan
at least had alluded to, that the increase in wages which if
nothing else comes out, drops down the productivity, that this
will not be a problem and the capital market will not see this
as a problem for the United States, inflation in other words at
the higher end? Again, we are talking about the top 10 percent
here getting higher wages where the lower end is stuck, we
can't even get a minimum wage through the Congress in over 9
years.
Dr. Lazear. I believe it actually works the other way, that
it is not so much that wages will cause productivity to
collapse, but rather wages are a reflection of productivity. So
in large part, the reason that our individuals are wage earners
at the top of the distribution, top of the skill distribution,
are doing so well is because their productivity is very high,
they are contributing a lot to the economy.
Representative Sanchez. Thank you, I want to get to my
second question. I will add that unfortunately, this President
and this Congress in raising the cost of the interest cost to
student loans and in cutting moneys really to education are
really not investing in education, as the rest of us would like
to see, given your comment about productivity.
Back to this housing issue, you know, I talked to Greenspan
and also, of course, to the new chairman of the Fed now, when
he was in your position before, and coming from California and
having seen the type of market that we have had, my question is
to the issue of interest rates increasing, and probably for the
foreseeable future, seeing them go up even more and the fact
that in order for people to get into homes, they took out ARMs
and, you know, quite frankly things that as an investment
banker that, I just, scream about, 50-year, I think the No. 1
loan out there in California right now is a 40-year, 1 percent
negative amortization loan or 50-year loan, with 0 percent, I
mean just things are incredibly crazy, I think. With this
slowdown, and I know that you talked yesterday about the
housing sales and the new housing sales having gone up but even
developers, I watch this all day long, are very interested in
this issue because Orange County is developer haven, that is
what we export to the rest of the world is new development in
particular.
Even all of the heads of Lennar and other companies said
this surprised them, and they also said that cancellations are
not noted in these housing sales. And then they said that their
cancellation rates are about 30 percent right now. In other
words, the new housing, that this home sales that supposedly
went up yesterday, you could begin to discount by at least 30
percent, because it said their cancellation rates were hitting
that high at this point in this quarter. So they said, it is
definitely slowing down. Almost every major developer said this
yesterday.
So my question to you is, are you worried? And what should
Congress do, as a policy to these ARMs that are coming due, a
quarter of them due in this next year across the Nation, people
not having equity, because as we have seen the new housing
starts and the lack of sales are actually beginning to show,
and the developers are admitting to, will push down, I believe,
even further the sales of existing homes.
Are you worried about these nontraditional or
nonconservative financing methods, and what they are going to
do with respect to foreclosure and lack of equity? And what do
you really see? Are you tracking this? And what do you think
the impact will be to the overall economy nationally, and what
do you think, what do you, I think, Congress can or should do
about anticipating this?
Dr. Lazear. Thank you. Again you, too, have touched a large
number of areas. Let me try to answer in a comprehensive
fashion.
Specifically, let me talk about the ARMs that you refer to.
In fact, we do watch these, and it is a concern for us as
well as for you.
What one worries about, of course, is that as interest
rates go up, one is concerned that individuals then have higher
household payments. At the same time, if they can't make those
payments, increases in interest rates could involve capital
losses in their housing prices, and then they could be in
trouble, and I think that is the concern that you have.
We looked at that actually very carefully, because we too
were concerned about that.
What we are finding is at least to this point, there is no
evidence of that happening, in fact, net household worth is up
and bankruptcy rates have been down and down considerably. One
of the good pieces of news in our economy among many but one of
the ones that we focused on in the household level is that
bankruptcy rates are running at about less than half of where
they were in the late 1990s. So part of that, you asked what
Congress could do is, I think, part of that is I think a result
of some of the action you took about a year ago to reform some
of the bankruptcy laws, but what we are seeing is real declines
in bankruptcies right now.
And, again, I think that reflects increases in net worth,
in large part coming not only from the housing market, which,
by the way, is still going up, it is still not--it hasn't
declined. It is still going positive, but also from equity
markets as well.
So it is a concern. It is one that we monitor. It is one
that we continue to look at, and we will continue to look at
it, I think you know I am also a Californian, although from the
north, but I share your views. I have seen markets like this
have booms and busts and it is one that we are on to.
Representative Sanchez. Let me just end, Mr. Chairman, if
you will, by saying that, you know, as somebody who also
invests in the stock market, I would say that the equity
markets, at least from my statements, and I follow
straightforward market investment portfolio, not individual
stocks, has declined over a thousand points as I recall it has
had a little bit of a rally in the last few days, so equities
have actually come down, I believe, over the span of this year.
And my realtors, who were in from Orange County, said that
definitely there is a slowdown, pricing houses, may be a little
up or at the same level, but the number of homes up for sale
the length of the homes up for sale and people actually taking
their homes off for sale, because they can't find buyers is
continuing to increase, and the fact that 25 percent of the
ARMs or, you know, people are going to have to redo their loans
this coming year, I think is a real vital should be a vital
concern to many of us, especially those who have seen heavy
movements in the markets or robust economy because of housing
sales.
Representative Brady. [Presiding.] Thank you. Gentleman
from Texas, Mr. Paul.
Representative Paul. Thank you very much, Mr. Chairman.
Good morning. I have a question dealing with inflation. I see
on page 3 you talk a little bit about inflation, expressing a
little bit of concern, but I don't think a whole lot.
And yet, the Fed seems to be a lot more concerned about
inflation right now.
Even this week, there is the anticipation that they have so
much concern that some in the market believe that the interest
rates might even be raised a half a point rather than just a
quarter point. So they evidently are very fearful and that is
generally what the whole talk is in the financial community.
But I am a little bit bewildered by the way we handle
inflation.
Generally speaking, Treasury, or the Fed, or the Council of
Economic Advisers, in talking about inflation, they never talk
about the depreciation of money. They always talk about some
external force that causes prices to go up. For instance, you
suggest a significant increase in the price of gasoline and oil
prices will push up inflation, of course, some of us see that
as a consequence of inflation. There was a famous economist
once who taught that inflation was always a monetary
phenomenon. And yet we essentially never talk about it.
So here there is, this concedes there is a concern about
inflation, and typically, and this has been the way it has been
for decades now, and I think this is the Keynesian influence in
our system.
And therefore, they make the assumption that prices go up
because there are too much of a healthy economy and we have to
turn the economy off, because the economy is booming too much.
So what do they do? They suggest we raise interest rates to
turn off the growth. Of course, raising interest rates has a
price effect too. That can be so-called inflationary as far as
pushing up prices.
And besides, it challenges the whole notion that if you
have a free market and it is productive and going well,
productivity is the best thing in the world to drive prices
down. So we have, you know, one section of the market is rather
unfettered, it is in the area of TVs and computers. And you
don't have an inflation, price inflation there, prices keep
going down. And so here we are, we refuse to think about it as
a monetary phenomenon, then we get too much growth and we say
too much growth is bad. We have to turn the growth off to crash
the prices or bring the prices down. And at the same time, not
recognize the fact that it is the depreciation of money that
really counts.
And I am just wondering whether you have an opinion of
this, why is there this almost refusal to deal with the
depression of money because if that is, if the economists are
correct that point all the blame at monetary depreciation and
we refuse to deal with it, we can forget about a healthy
economy and your job becomes much worse. How can you adjust for
it? How can an economic adviser give advice to cause a healthy
economy if the basic flaw is in monetary policy?
Dr. Lazear. Thank you.
Well, I would say first just commenting on your sort of
general theme of your question, which is that I seem to show
less concern about inflation than the Fed does, at least in
public statements. I guess I would say that I am, part of that
is because I have confidence in the Fed.
So I don't have to worry about inflation because Ben and
his partners are doing that right now for us. And I think we
will do a good job and we will be successful in controlling it.
But my views are not based on personal knowledge of the Fed
or its board, but rather on the market. I think if we look at
the market indicators, the market also seems to believe
inflation is under control or will be under control.
For example, if you look at things like our forecast or
look at the Tip spread, which is an estimate of what the market
believes about inflation, Bloomberg estimates, all of these are
in the same range, they are all about 2\1/2\ percent going
forward.
So those numbers obviously take into account Fed policy.
But I think that the economy and the forecasters are all pretty
much singing the same song. I think the most important point
you made is one I would strongly agree with, and that is the
best way to control inflation--and what we are talking about in
terms of inflation is increases in real prices, prices of goods
going up relative to our earning power. That is what we really
worry about.
And you mentioned that the best way to control that is
through increases in productivity. And I certainly subscribe to
that philosophy as well. I think that the most effective
control against inflation, the most effective guard is to make
sure productivity stays high. We have done that in the past few
years, productivity growth has been very strong. And I see it
continuing into the near future.
As a result, we have not experienced very high levels of
inflation, even with gas prices going up and maybe we don't
want to call it inflation, because as you point out, most of us
think of inflation as a monetary phenomenon, at least where I
went to school, that is how we think of it, but still the fact
that prices are going up is a concern obviously to consumers.
They haven't gone up very much, except for gasoline and oil
prices, prices have not gone up very much, quarter prices have
been contained, and I think, in large part, because of the
productivity gains to which you alluded.
Representative Paul. May I have one quick follow-up? If
this is true, raising interest rates may well diminish the
product for productivity increase, wouldn't this be true?
Dr. Lazear. When interest rates are raised, it does have an
effect on the economy. As Ms. Sanchez pointed out earlier, we
are already seeing this in the housing market, there is no
doubt the housing market has slowed at least relative to its
past. The question that one has to address is whether we are
willing to tolerate some slowing in the economy in order to
keep what would be viewed as a monetary reason for inflation
under control. We have full confidence that the Fed is looking
at those issues and making the appropriate tradeoffs in doing
that. As I said, I have confidence in them in large part,
because I know the individuals involved. They are very sensible
and very thoughtful people. They have all the data available to
them that I have available to me. And I think they will do the
appropriate and responsible thing.
Representative Brady. Chairman, thank you for your services
leading the Council of Economic Advisers and taking time to
enlighten us today about future prospects to the economy. Thank
you very much.
Dr. Lazear. Thank you, sir.
Representative Brady. The Committee welcomes for its second
panel two distinguished Members, Dr. Mickey Levy, chief
economist for the Bank of America, and Dr. Brad Setser, senior
economist and director of Global Research for the Roubini
Global Economics Group out of New York.
Representative Brady. Gentlemen thank you for joining us
today, Dr. Levy why don't we begin with you.
STATEMENT OF DR. MICKEY D. LEVY, CHIEF ECONOMIST, BANK OF
AMERICA
Dr. Levy. Thank you very much for inviting me to express my
views to you about the economy. In addition to giving you a
brief economic overview, I would like to identify several risks
facing the economy and also discuss why global imbalances are
so large, and what the implications are. I see some narrowing
of imbalances coming our way.
Now, without being redundant with Mr. Lazear, the economy
is really fundamentally sound and, it is important to keep in
mind that the U.S. has the highest potential growth of all
industrialized nations. To put it in perspective, we have $11
trillion economy, so 3\1/2\ percent growth means economic
output or national income is about $375 billion higher than
last year and, it is spread, around and the reason why the U.S.
economy has high potential is because we have generally pro-
growth economic policies and it is very important to keep it
that way.
Going through the economy, everything has been quite
healthy, particularly productivity, and I would note that, in
some sectors, productivity is much higher than the statistics
suggest.
The soft spot that was alluded to in the previous testimony
is while wages have been rising, they have not kept pace with
productivity gains. And the rise in energy prices has tempered
the rise in real compensation. When we think about the
culprits, it is not just higher costs and nonwage costs to
corporations, it is also international competition.
And this is going to continue. We see low cost producers
overseas. It is very difficult to identify the independent
impact of this, but it seems to me it is putting higher demands
on high skilled workers and somewhat lesser demands on lower
skilled workers. And that is just a fact going forward. It is
more severe in Europe.
The right way to address this is not to address the
symptoms of the problem, but rather to increase education and
skill levels.
Now, as for my outlook, I am looking for continued economic
expansion but at a moderating pace. As a consequence of the
higher interest rates, the higher energy prices, and the impact
of the higher interest rates on mortgage refinancing, a natural
consequence, and actually a welcome consequence of the Fed's
rate hikes, will be some moderation in consumption of the rate
of economic growth.
But even with those factors, consumption will continue to
grow. And if you look at the key factors that have historically
driven consumer spending, real or inflation-adjusted disposable
personal income is still growing, even though it has been
suppressed by higher energy prices. And should energy prices
stabilize here, real disposable personal income growth will
accelerate.
Also while real interest rates have gone up a little bit,
they still remain low, particularly in after-tax terms. And
household net worth, that is, stocks bonds and real estate, net
of all household debt, is at an all-time high, and of the
nearly $50 trillion in total net worth, less than 30 percent is
real estate. And so, even if real estate falls by more then I
think, it will not affect the consumer that much. It will slow
things down, but not lead to a decline.
With regard to housing activity, I expect, looking forward,
further flatness, perhaps modest declines in housing activity
and prices, but not large declines.
Once again when we look at the factors underlying what has
historically driven housing, they are all generally positive.
Employment is rising and the unemployment rate is 4.6
percent, and personal incomes on average are rising, and real
after-tax interest rates are low.
Toss in the demographics, and in my view, it is adjustment
process. While I agree that the recent pace of price
appreciation in housing is unsustainable, the adjustment
process suggests that a flattening out and maybe a modest
decline, but not much more.
Capital spending is very strong, reflecting record-breaking
profits, cash flows, low real costs of capital, and other
positive factors. Exports are very strong reflecting global
economies that are quite strong. So if you were to look at the
destination of U.S. exports and what we are exporting, the
outlook is very, very favorable.
The trade deficit is widening, but a key point I am going
to emphasize here is the deficit is widening because the U.S.
is strong. Imports are higher and rising more rapidly than
exports. Forty percent of all U.S. imported goods are
industrial supplies and capital goods, even excluding petroleum
and automobiles. That is because the U.S. is growing faster
than nearly every other industrialized nation--not just
consumption but investments--imports are rising rapidly and a
hefty portion of that rise in imports that is generating the
trade deficit is for business production and expansion and
associated with job creation.
The largest risk to the economy--and we shouldn't
understate these--involve three sources. The first risk is if
the Fed were to inadvertently hike rates too much, causing a
slump in aggregate demand. In response to several questions
about the housing markets and consumer debt, as long as the
economy continues to grow at a healthy enough pace, in the
aggregate, we can withstand higher interest rates. But if the
Fed raises rates too much, which creates a slump in aggregate
demand, which leads to a slowdown in employment and wages--this
is the biggest risk to the economy and to housing.
The second risk is protectionism that significantly raises
the cost of production or otherwise jars international trade
and capital flows and/or elicits retaliatory measures. In this
world of large global imbalances, barriers to trade and capital
are dangerous and have to be avoided.
And the third potential risk is a dramatic or undisciplined
decline in the dollar. I am not anticipating one.
Inflation has risen. It has risen due to excess demand. In
the last couple years, nominal spending growth in the economy
has been about 6\3/4\ percent, which is well above common
estimates of potential, about 3\1/2\. Consequently, inflation
has accelerated and core inflation, even excluding food and
energy, has risen above 2 percent. The Fed has told us it wants
to keep core inflation at 2 percent. And so it will hike rates.
And here is the difficulty for the Fed. It doesn't want to
cause a slump. It has looked at its past history at times when
it is has orchestrated a soft landing and times when it has
tightened too much. It doesn't want to do the latter. But the
difficulty is there is no single measure of monetary thrust
they can rely on. And in addition, monetary policy works with a
lag. But with the markets testing the Fed's inflation fighting
credibility, here is a good analogy: Let's say you told your
kids it is 9 o'clock bedtime. And it is 9:15 and then 9:30 and
you look in and they are still watching TV and it looks like
they are getting more wound up than closing down shop.
What do you do?
The Fed is going to hike rates further. And I am looking
for a 5\3/4\ percent funds rate by year end. I do not think
that would unhinge the economy.
With regard to the trade deficits and the current account
deficits in the global context of large global imbalances, if
all countries had approximately the same rates of economic
growth and investment and saving, imbalances would be very
minor.
But that is not the case.
The U.S. has been growing significantly faster than every
other large industrialized nation since 1990 except for Canada.
And not just consumption has been growing faster but
investments have been growing faster. So there is a tremendous
demand for capital. At the same time, our rate of saving has
been too low.
In the 1990s, during the investment boom, the rate of
national saving was fairly high. The decline in the rate of
personal saving was offset by the Government moving from
deficit to cash-flow surplus. But so far this decade, the rate
of personal saving has stayed so low, and we have budget
deficits. And so the U.S. has insufficient savings relative to
high investment.
Now, in Japan, where the economy has languished up to until
a couple of years ago, it had a very weak domestic demand, flat
consumption, weak investment and excess saving. Ditto Germany.
While China is poor in GDP per capita terms, and has strong
growth, it has an extraordinarily high rate of personal saving,
over 40 percent, by their official statistics.
The reason why it is so high is they don't have a social
safety net or any retirement programs.
So those countries have excess saving relative to
investment and they export their capital to the United States.
I understand the current account deficit is extremely high.
I am not concerned at all about the U.S. trade deficit, because
it reflects relative strength. What we have to ask is, what are
we doing with the imported capital? What is the rate of return
on it? Are we putting it toward investment that creates future
jobs? Or are we using it for current consumption?
I am concerned about the current account, not because I
think there is going to be a collapse in the economy, and not
because there is going to be a sharp decline in the dollar, but
I think we have to address the factors underlying it.
When you think about the current account deficit in the
United States, you should also think about the current account
surpluses in Japan and China and look at the factors underlying
them. I would like to make several points: One, the large
imbalances are largely a reflection of the U.S. strength, and
its low rate of saving; second, in equilibrium, don't expect
the trade and current accounts to be in balance unless every
country has approximately the same rate of economic growth,
same rate of investment and same rate of saving. Do not expect
an ultimate day of reckoning where the dollar plummets or the
U.S. economy collapses.
I have had the pleasure of sitting down with the top global
portfolio managers in Asia who manage nearly $2 trillion. I
walk away from those meetings with the clear impression that
they are absolutely economically rational in holding a very
large portion of their portfolio in U.S. dollar-denominated
assets.
If you think about it, the U.S. has the fastest growth and
the most credible policymakers, a credible central bank, the
highest interest rates in market and in inflation-adjusted
terms. They are investing in the U.S. for the right reasons.
Don't expect any sell-off and do not expect a sharp decline in
the dollar.
That is just not how portfolio managers work.
In order to think the dollar will fall sharply, you would
have to think those portfolio managers are irrational
economically.
I think there are factors in place that will begin to
narrow global imbalances.
Think about the following.
In the last couple years, Japan's domestic demand has
picked up. That means its consumers after a dozen years of flat
to declining consumption are starting to consume more.
Japan enjoys record breaking profitability, and that is
generating higher investment. Its domestic demand is picking
up, which is going to boost its demand for capital. At the same
time, their rate of personal saving is coming down as
confidence builds.
Dr. Levy. Their excess saving is starting to shrink, and
they will become smaller exporters of capital to the U.S. and
around the world.
Ditto Germany. We are finally starting to see a pick-up in
the German economy largely due to lower German tax receipts and
spending as a percentage of GDP. European economies are picking
up and, once again, you are going to see a pick-up in domestic
demand. Germany's current account surpluses will come down.
Finally, China. In the U.S., consumption is nearly 70
percent of GDP. In Europe, it is about 58 percent. In China, it
is 42. That is going to increase. As the Chinese citizens start
to spend more of their disposable income, the excess of
national savings relative to investment will shrink, and there
will be less sources of capital available to the U.S.
From the U.S. perspective, the Fed's rate hikes and higher
real interest rates are beginning to slow down domestic demand,
and we are seeing that in housing and we are going to see it in
consumption. We are going to see a slowdown. So the demand for
capital is going to come down a little bit. At the same time,
the excess capital from around the world is going to shrink a
little bit.
This is going to serve to begin to narrow the current
account imbalance. It will not eliminate it, because if we
consider the sources of insufficient saving in the U.S., the
primary source is the budget deficit (that is, the Government's
``dissaving''). This has to be addressed. You can't just go
through this exercise by ``arithmetically'' closing the budget
gap as if it was a deficit bean-counting game. You have to
think about policies that both reduce the imbalance, increase
the rate of national savings, and, at the same time, are pro-
growth. In my mind, in most people's minds, this requires
addressing the entitlement programs and the retirement
programs. I think once you do that, it is going to provide you
a lot of flexibility to address a lot of other budget needs.
If you look at the total Government budget imbalance, not
just the cash-flow deficit now, but the long-run imbalance
based on rational estimates of the unfunded liabilities of
Social Security retirement, Medicare, Medicaid, and divide that
by GDP and take the present values, the numbers are scary and
very large: perhaps up to 6 percent of GDP. In the long run,
raising taxes to close that gap in an arithmetic way could
cripple the economy and you end up further away from your
objective, and hurt exactly the people you are trying to help.
And so once again, I think addressing the entitlement
programs is not just a direct way of increasing the rate of
national saving, but it is also an indirect way to provide you
a lot of flexibility to reallocate national resources in a way
that helps current citizens and future citizens. And I will
stop right there.
Representative Brady. Dr. Levy, thank you very much.
[The prepared statement of Dr. Levy appears in the
Submissions for the Record on page 62.]
Representative Brady. Dr. Setser.
STATEMENT OF DR. BRAD SETSER, DIRECTOR, GLOBAL
RESEARCH, ROUBINI GLOBAL ECONOMICS; AND RESEARCH ASSOCIATE,
GLOBAL ECONOMIC GOVERNANCE CENTER
Dr. Setser. I too would like to thank Members of the
Committee for inviting me to testify here today.
I am going to focus my remarks on the one risk to the
outlook. That is the United States' very large current account
deficit. The current account deficit in the fourth quarter of
2005 reached about 7 percent of U.S. GDP, about $900 billion.
It fell slightly in the first quarter, but I think most people
believe that it is likely to remain at least at $900 billion
and perhaps widen during the remaining course of this year.
Current account deficits of 7 percent of GDP in an advanced
economy like the United States cannot be directly compared to
those of major emerging market economies, but it is still worth
noting that a 7 percent of GDP current account deficit is equal
to that Mexico ran in 1994 and 1995 on the eve of its crisis.
The U.S. deficit is quite large. It is also unprecedented for a
major advanced economy to be running deficits of this size.
In my view, these large deficits pose two risks to the
outlook. The first risk is the financing necessary to sustain
deficits of this kind, financing that by and large, despite
what some people have argued, continues to come from official
sources, will not continue to be available. If that financing
should dry up, there would be a sharp adjustment to the dollar,
perhaps a sharp rise in interest rates, and a major change in
both the pace of growth and in the composition of growth.
Sectors such as the housing sector which have benefited from
low-income rates would contract and the export side would
benefit. However, if the adjustment is too abrupt, the sectors
which are contracting would contract faster than the sectors
which are expanding. You cannot create an export industry
overnight.
I think the second risk is that the possibility that there
may not be any adjustment. The U.S. deficits will not only
remain at the current size but perhaps expand. Those deficits
have to be financed by taking on additional debt. That debt is
a claim on our future income. And looking ahead right now, the
net claims on the U.S. are around--net foreign claims are
around 25 percent of GDP. That is certainly going to double in
any gradual adjustment scenario. It could more than double if
an adjustment does not start soon. That implies that the United
States' population isn't just going to be paying for its own
retirees, but will also be contributing to the retirement
income of our creditors in Japan, our creditors in China, and
our creditors in Russia and other oil-exporting states.
These two risks interrelate. If the deficit continues to
expand and the policies needed to reduce the deficit not be put
in place, the risks of a disorderly adjustment go up. That is,
the bigger the deficit, the bigger the risk that the adjustment
process will not be benign, gradual and so forth, but rather
sharp, disruptive, and painful.
Before outlining the specific policies that I believe
should be put in place to address the United States current
account deficit, I want to make three analytical points.
First, the U.S. current account deficit has increased not
because of a rise in investment but, rather, because of a
substantial fall in savings. That was most noticeable in the
years between 2000 and 2003 when net Government savings fell
substantially. Recently, the budget deficit has trended
somewhat down, improving Government savings but household
savings have fallen.
It is true that investment has picked up somewhat since
2003. But that rise in investment has been overwhelmingly
concentrated in residential housing and residential real
estate. There has been, more recently, a bit of a pick-up in
business investment. However, that increase needs to be put
into context. Current rates of investment are still well below
the levels of the 1990s. I would also note, neither residential
real estate nor investment in commercial real estate seems like
an obvious source for the future export revenues that will be
needed to pay our external debt.
Second analytical point. These deficits have not been
financed because the United States is an attractive location
for equity investment. Net equity flows into the United States
have been substantially negative for most of the past 5 years.
The exception is last year, 2005, I think most analysts believe
those flows were influenced heavily by the Homeland Investment
Act. Certainly in the first quarter the pattern of net equity
outflows from the United States reappeared.
There has been a substantial rise in the amount of U.S.
debt that foreigners have been buying, I would argue that rise
has not come exclusively because U.S. debt is attractive to
private individual investors but, rather, because foreign
central banks and, increasingly, oil investment funds. Official
creditors have been providing very large funds of financing to
the United States.
Recorded flows from official creditors fell in 2005. But I
share the judgment of the former chairman of the Council of
Economic Advisers, Martin Feldstein, that the U.S. data
significantly understates official flows in the United States.
Specifically, it does not capture a major fraction of the flows
from China and is failing to capture any of the flows from the
Gulf States.
Third point. In order to keep the current account deficit
at around 7 percent of GDP, the trade deficit has to fall. The
current account deficit is the sum of the trade deficit, the
transfers deficit, and balance on investment income. Over the
past few years, the interest rate that the U.S. has to pay on
its external debt fell substantially. It was above 6 percent in
2000. It fell to around 3 percent in around 2003 and 2004.
As we all know, interest rates are rising. That means the
interest that we will be paying on our external debt is soon
going to rise, and rise significantly. As a result, because of
those increasing net interest payments in order to keep the
current account deficit just at its current elevated level, the
trade deficit needs to begin to fall. I don't see the necessary
steps either here or abroad for that to happen.
The president of the New York Federal Reserve Bank, Tim
Geithner, observed that private markets will eventually force
the United States to adjust, even if policy changes that would
support that adjustment are not put into place. However, he has
also noted that the risk of disruptive adjustments are higher
in the adjustment process is not supported by appropriate
policies.
Here in the United States the most direct, most
significant, and best way we can increase our national savings
is to reduce our fiscal deficit. Academic work suggests a $1
reduction in the fiscal deficit will lead to a roughly 50 cent
increase in national savings--or up to a 50 cent reduction in
the current account deficit. We could also take measures to
produce or demand for foreign oil, something that Menzie Chinn
of the University of Wisconsin has highlighted. Those measures
directly reduce the volume of oil that we need to import, and
also would have impact on global market prices.
What policies are needed outside of the United States? I
would put an emphasis on three:
First, China and other Asian countries need to allow their
exchange rates to appreciate. Their exchange rates are being
held down by their central banks intervening heavily in the
foreign exchange markets.
China needs to do more than just adjust its exchange rates.
It also needs to put in place policy steps that would lead its
low rate of household consumption to rise. I would note that
China's savings rate is rising this year and that its current
account surplus is also rising. That is, necessary policies to
change haven't yet been put in place and haven't yet put into
effect.
Second, more emphasis should be placed on the role of oil-
exporting countries. I don't think Saudi Arabia and the other
Gulf States should be pegging to the dollar. That means that
their currency's external purchasing power has fallen even as
their oil revenues have surged. They need to find more creative
ways to inject some of their huge oil windfall into their
economy rather than lending it back to the United States.
Now I put more emphasis on the role of emerging policies
and less on that which is needed in Europe and Japan because
the increase in the U.S. current account deficit has been
associated with the rise in the surplus of European economies.
But there is little doubt that the willingness of Europe and
Japan to accept further appreciation of their currencies and
base their future growth on current demand will be critical to
sustain an orderly adjustment process.
The United States is undoubtedly an important market for
many of these countries and everyone has a stake in an orderly
rather than disorderly process. But we in the United States, in
my judgment, should not base our policies on an expectation
that other countries will provide us the financing we need, no
matter what we do.
The majority of economists believe that the odds favor an
orderly adjustment process. I certainly hope they are right. I
would also note that this process is yet to begin. It should
begin soon if the odds of an orderly adjustment are to be as
high as the majority think.
Former Treasury Secretary Larry Summers has reminded us
recently that just because large deficits have been financed
relatively easily in the past doesn't mean they will be in the
future. Here in the U.S. we rarely pay attention to the
developments in financial markets in places like Iceland, New
Zealand or Turkey. But all their currencies have fallen sharply
this year, and interest rates in all of these markets are up.
Large and growing current account deficits in each of these
countries helped trigger these market concerns.
This turmoil should provide us with a warning. Experience
teaches us it is better to adjust our policies when markets are
calm, not wait until markets demand change. Thank you very
much.
[The prepared statement of Dr. Setser appears in the
Submissions for the Record on page 74.]
Representative Brady. Thank you.
Dr. Levy, in your statement you note, and I think it is
important, 40 percent of imported goods flowing in the U.S. is
comprised of capital goods in industrial supplies. In other
words, these are not goods that my family is buying to consume.
These are goods that a business is purchasing to produce
something else here in the United States.
Won't these types of imports facilitate increased U.S.
production? Shouldn't they be viewed as favorable, rather than
an item that is being purchased for and imported for
consumption?
Dr. Levy. Yes, sir. They are. Absolutely positive. The
reason why I included those statistics is to dispel the myth
that it is just the profligate consumer that is generating
excess import growth; that it is evenly balanced between the
consumer and business expansion. And once again, if you look at
the record, the U.S. has been growing persistently faster than
nearly every other industrial nation, and that is why imports
are growing rapidly.
So the issue is, let us say we want to address the trade
deficit. How do you do it? Well, presumably we want to do it in
a way that increases growth and increases standards of living
rather than a way that hurts the economy and hurts those
citizens that we want to help.
We need to look at the composition of the imbalances, get a
clear understanding of why the imbalances have occurred, and
then think rationally of what policies can be put in place that
both sustain strong economic growth and reduce the imbalances.
Representative Brady. Thank you.
Dr. Setser, over the past 25 years--and I am not an
economist--but the current account deficit tends to mirror the
U.S. economy. The stronger our American economy, the stronger
the accounts deficit is. The larger it is, the weaker our
economy, the smaller it is. And you make the point today that
foreign countries are not investing in the United States
because we are a strong economy, a good place to invest. What
are the reasons for investing--for the foreign investment in
the United States? If we are not a strong economy, why are they
investing?
Dr. Setser. I want to clarify my remarks. My point was that
equity investment from foreigners has been quite low recently,
unlike in the late 1990s. There have been substantial inflows
into U.S. debt markets. Foreigners do find our bonds
attractive. I think that is for several reasons. One, as Dr.
Levy has noted, that some U.S. interest rates are somewhat
higher than those of other advanced industrial countries. I
don't think that those interest rates differentials alone,
though, are sufficient to generate $800 or $900 billion in net
inflow into our debt markets from private individuals and
private market players alone.
And I think if you look closely at the data, a significant
fraction of those votes aren't coming from private individuals;
they are coming from foreign central banks and from oil
investment funds. Why do foreign central banks buy U.S.
dollars? Well, in part, they are buying U.S. dollars in order
to keep the value of their currencies down in the face of trade
surpluses and net capital flows into their own economy. They
take those dollars in and they have to invest them somewhere.
Until now, the majority of those funds have found their way
back to the United States.
Some have characterized this relationship as vendor
financing. Countries want to export to the United States and
lend us the money we need in order to buy their goods.
The oil investment funds have just had a huge influx of
cash. Obviously with oil at 70, there is a lot of money
sloshing around the Gulf, sloshing around Russia, sloshing
around any place that has oil. Their revenues have gone up far
faster than their capacity to spend that money. They haven't
been very creative about finding ways to inject that money into
their economy. The cash is building up faster than they can
find ways to spend it. And they are lending it back to us. That
may not last forever.
Representative Brady. Thank you.
Congressman Hinchey, do you have a question?
Representative Hinchey. Thank you, Mr. Chairman.
First of all, I want to thank both of you for your very
thoughtful and articulate testimony. It was interesting to
listen to both of you.
I want to insert something in the Record to make it clear
about the general economy. Contrary to what we may have got the
impression of as a result of the last testimony, the average
annual growth rate over the last 5 years has been 2.6 percent.
The Chairman left out growth rates of 1.2 and 1.6. And after
you adjust for inflation, compensation of employees' wages plus
benefits has grown at just 1.6 percent, which is half of the
growth in productivity. And after adjusting for inflation, the
income of the typical household has declined by more than
$1,600.
So I would like to ask you to comment on that situation. I
mean, we are confronting a problem in this economy where the
income of the median family, middle-income people, is going
down. It has been dropping off more severely as you get further
down the income scale.
But it is impacting middle-income people very severely, and
that, I think, is going to have a major impact on the economy.
Also, I would be interested if you have any thoughts on the
impact of the alternative minimum tax on median income, and how
that is affecting the economic situation that we are
confronting. We are debating now a major reduction in the
estate tax, but this Congress is paying no attention whatsoever
to the aspect of Federal taxation which is impacting most
severely the middle-income part of our economy.
Dr. Levy. Let me tackle those questions. Firstly, your 2.6
percent includes the 2 years of very soft growth that brings
down your average. But if you look over a 10-year period or 20-
year period, the average economy has been growing about 3.4
percent.
Over the last 5 years it is 2.6 percent.
Dr. Levy. I agree with you.
I think the key point with regard to the median household
is the No. 1 factor we all have to strive for is sustained
economic expansion. All the policies in the world are not going
to help that middle-income household if the economy slumps. So
it is healthy economic growth that is absolutely required, and
that requires healthy economic policies. And we have had
healthy economic policies the last couple of years in
particular. We are now in this transition where the Federal
Reserve has been taking away the monetary accommodation and it
should slow things down, but we have to recognize that stable
inflation is the best foundation for sustained economic
expansion and job creation.
Now with regard to wages, I have been disappointed that
wages have not kept pace with labor productivity gains. There
are reasons for this. One is the higher nonwage costs.
The other is higher energy prices which clearly push up
headline inflation, and we can't do anything about that. We
have to hope energy prices stabilize so real wages rise.
Another factor is international competition. As I noted in
my testimony, it is very hard to isolate the impact of
international competition on wages, but my hunch is the higher
supply of low-wage workers around the world is increasing the
global supply of low-wage workers and putting downward demand
on low-wage workers here.
Meanwhile, there is high demand for high-skilled workers.
This is one of the factors that we have to deal with because it
is not going to go away. And I would say the absolute best way
to deal with it is pro-growth policies that help the people
that you really want to help: build education and skills.
Trying to address the symptoms, like raising the minimum wage,
would absolutely hurt exactly the people you are trying to
help, because it makes them less competitive in a global world
where the costs and the price of tradable goods are falling.
So there is no question we have a major dilemma, and it is
not going to go away, and we have to address it in a fair and
efficient way.
Finally, with regard to the AMT, put it close to the top of
your priority list because it is affecting people in a way it
wasn't designed. The AMT is going to become more and more
onerous; not just the tax burden, but going through the
calculation of how you consume, how you invest: Everything is
being affected by the AMT.
Representative Brady. Thank you, Dr. Levy.
Congressman Hinchey, I would point out that the mitigation
of the AMT was included in the President's tax relief bill he
just signed a few weeks ago and has been a part of all of the
major tax relief measures in the last 5 years.
Mr. Paul----
Representative Hinchey. Could we hear Mr. Setser's response
to my question?
Representative Brady. Yes.
Dr. Setser. I too think that the priority that was placed
on reducing the estate tax relative to the--or limiting the
estate tax--relative to the priority that has been given to
addressing other national needs and other potential reforms in
the tax system has been misplaced.
I certainly agree with Dr. Levy that an economic slump is
unlikely to be good for the median or average worker. But the
problem has been that the economic expansion that we have seen
over the past few years hasn't been very good to the median or
average worker either, for many of the reasons that he
outlined.
I think the policy response that has been adopted by the
Congress and the Administration has tended to augment rather
than to help the situation. Specifically, the priority that has
been placed on steps like reducing the estate tax, steps like
reducing the capital gains tax, steps like reducing the
dividends tax all have come at a time when global competition
has been placing downward pressure on the wages of relatively
low-skilled workers and increasing the returns on capital. So
at a time when international markets are moving in one
direction, increasing inequalities within our society, we have
made policy changes at the Government level that have continued
to add to those inequalities. I think that is a problem.
Representative Brady. Thank you. Mr. Paul.
Representative Paul. Thank you, Mr. Chairman.
It seems to me that the two of you have a slightly
different interpretation of amount of concern we should have
for the current account deficit. I wanted to get just a quick
clarification if I could from Dr. Levy. Your argument is that
these funds aren't just going to consumption, that it
represents some business expansion and business investment when
it comes to the purchase of mortgage securities. Is that
considered consumption or is that considered a business
investment in our calculation?
Dr. Levy. Doesn't matter. Capital is fungible.
Representative Paul. You are arguing that a lot of these
funds are going into business, and Dr. Setser is arguing the
other case.
Dr. Levy. Here is my point. Let us say an Asian central
bank that has excess savings buys U.S. mortgage-backed
securities. Well, that frees up funds for investment in
whatever, including business investment or construction or
residential housing or consumption.
Representative Paul. Let me follow up with Dr. Setser
because his statements are rather emphatic that the current
account deficit has risen largely because of the fall in
savings and a rise in residential investment, not because of a
surge in business investment, arguing the case that it is not
business investments we are borrowing a lot of money from
overseas for consumption.
Now following that, he mentions that this is not an
economic decision by individual investors. This is not a
private market participation. This comes from central banks,
which I think muddies the water. And I just wonder if there is
any reason to think that central bankers--you know, in their
planning that is what central bankers are; they are planners
domestically to centrally--run the economy. Why wouldn't
central bankers get together and say, look, tit for tat; you
buy our securities and we will keep the consumption going.
And because there is this fantastic trust in the dollar, a
remnant of the Bretton Woods Agreement that it is still a
reserved currency, it seems to me like we could be working
toward a dollar bubble. I know Dr. Levy says don't worry about
it. But I think there is room for concern about the setup that
we have, and the dollar being so unique that this is why the
deficit's going to--maybe it will--you suggest there are two
problems: One, it will correct; and two, it will continue to do
it. Let us say the psychology is so powerful and the dollar is
so strong and our military stays strong and we have success
overseas and there is no reason to doubt our preeminence in
economics because we can continue our economic power through
borrowing, what if we continue this until we get a 10 or 12
percent current account deficit? Doesn't this just mean that
someday we have to be prepared for some serious adjustments?
Dr. Setser. Certainly if the U.S. account deficit were to
rise to 10 percent of U.S. GDP, which is where it will be in 3
or 4 years if we don't or our markets don't demand--if we don't
implement corrective policies or the markets don't demand that
we do--that's the track we are on. The deficit has been growing
at a pace that would imply 10 percent of GDP current account
deficits by 2010. So I think your concerns are well placed.
I think that it is important when talking about the dollar
to differentiate between the exchange rate between the dollar
and euro, which is largely determined by market forces and the
exchange rate between the dollar and, say, the Chinese
currency, which is not set by market forces. It is set by the
intervention of the Chinese central bank and the amount of
intervention that China has to do in order to maintain it has
been growing.
At some point--I don't know when that point will be--I
think it is likely that China will conclude that there are
better ways of spending their money than subsidizing American
consumption, and that the domestic monetary consequences of
this very rapid reserve growth will become such that there will
be a reevaluation inside China of this policy choice.
Now that reevaluation hasn't come yet. It may not come next
year, it may not come the year after; but at some point it will
come. The People's Bank of China in my judgment is unlikely to
extend an infinite credit line to the United States, which
implies at some point something will change.
I think it is also important to recognize that right now a
very large amount of the central bank financing from the United
States is coming from a set of countries which are not
necessarily either democracies nor necessarily our allies:
China, Russia, many countries in the Middle East.
Finally, I do disagree with Dr. Levy's argument that we are
currently largely taking on external debt to finance a surge in
investment, including a surge in business investment.
Unambiguously, business investment today is lower than it
was in the 1990s. Unambiguously, residential investment today
is higher than it was in this 1990s. Unambiguously, household
savings today is lower than it was in the 1990s. Unambiguously,
the Government deficit today is bigger than it was in this
1990s. On all of those measures, the overall characterization
that we are taking on more external debt not to finance a surge
in business investment relative to the 1990s is accurate.
Dr. Levy. Let me respond. There is no question the rate of
business growth is lower than the 1990s. In the 1990s we said
it was way, way too high and we were worried about it. Business
investments so far this expansion is growing double digit. That
is very, very healthy. And I like what I see in terms of the
allocation.
I think it is a misuse of the term to imply that the
Chinese are going to get tired of subsidizing the U.S.
Nations that have excess savings relative to investments
have to do something with it. They allocate their resources to
generate the highest risk-adjusted expected rate of return.
As long as the U.S. continues to have healthy economic
fundamentals and healthy economic policies, it will continue to
not have problems attracting foreign capital.
But once again, I think it is critically important to look
underneath the imbalances. But why are they there? Once again,
if we had economic growth along the lines of Europe, less than
2 percent, with unemployment rate twice what we have; or, if in
the last 15 years we had 1 percent economic growth like Japan,
with declining investment, then we wouldn't have such a large
trade deficit. But the fact that there are imbalances, we all
benefit from international trade and international capital. And
not only does the U.S. benefit because we are able to import
capital and put it to work not just for consumption but for
business expansion, but nations that have excess savings are
able, through international capital flows, to put their capital
to work.
So globally the saving in the world seeks investment
opportunities.
There is no question but that when the U.S. runs a current
account deficit. It implies that we are exchanging current
consumption and investment for claims on future U.S. income.
That is OK as the returns on our imported capital are higher
than the cost of financing it. And therein lies the rub.
The Government deficit spending for consumption-oriented
activity does not add to future productive capacity, yet it
does reduce the rate of national savings and that is one area
we need to address.
And I think there is this other area where, Brad, I think
we totally agree, and that is in response to the more than
doubling of energy prices in the last couple of years. You
suggest consumers have maintained their rate of consumption
growth, which has lowered the rate of personal saving and
lowers the rate of national saving. That capital has flowed to
OPEC producers (oil transactions all transacted in dollars) and
a lot of it flows back into the U.S. This rise in oil prices
has clearly been something that 4 or 5 years ago none of us
anticipated, and has clearly increased the current account. We
have to hope that energy prices stabilize and come down; and if
they do, that should contribute to a higher rate of personal
savings in the U.S. and higher rate of national savings. If, on
the other hand, energy prices go up significantly from here,
now that monetary policy is more neutral than accommodative,
then the economic impact could be negative and it could keep
our rate of personal savings in the negative territory.
Representative Brady. I want to thank the panelists for
being here, the Members as well. And this meeting is adjourned.
[Whereupon, at 12:50 p.m., the Committee was adjourned.]
Submissions for the Record
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