FROM THE OFFICE OF PUBLIC AFFAIRS

1. The successful implementation of fiscal and monetary policy over the past four years has helped make the current economic expansion one of the longest in the period since World War II. Steady and important progress has been made in reducing the federal fiscal deficit since the current Administration took office in January 1993. In FY 1996, the deficit reached its lowest level in relation to GDP since FY 1974, and it is expected to fall further in FY 1997 to around ¾ percent of GDP. The recent agreement between the Administration and the Congress holds the promise that the objective of balancing the budget by FY 2002 will be achieved. At the same time, monetary policy has succeeded in maintaining inflation at a relatively low rate and in promoting the continued expansion of the economy. Flexibility in labor and product markets has helped to foster the creation of a substantial number of new jobs, bringing the unemployment rate down to its lowest level in decades and restraining inflationary pressures. The U.S. authorities should be highly commended for their policy efforts and the resulting outstanding performance of the U.S. economy.

2. At this juncture, a major immediate policy issue is to safeguard against the emergence of inflationary pressures and to prolong the life of the current economic expansion. While there is little evidence of pressures on prices at present, several elements in the current situation raise concerns. In the past year, the economy has shown considerable strength, and it appears more likely than not that this momentum will be carried forward. The economy is operating at a high level of resource utilization and may move to even higher levels in the near term. Moreover, the influence of factors that have restrained inflation (including slowly rising labor costs, appreciation of the U.S. dollar, and increased external competition with weak growth in other major countries) is likely to wane in the period ahead. Such concerns motivated the Federal Open Market Committee’s preemptive increase in the target for the federal funds rate in March, and they point to the need for the monetary authorities to remain vigilant and to be prepared to raise interest rates further in coming months.

3. A forward-looking approach to monetary policy along the current lines, moving in small steps to change the stance of policy as circumstances warrant, is the most effective means of promoting a sustained expansion of the economy and keeping inflation in check, especially given the lags with which monetary policy affects output and prices. In the IMF staff’s view, such an approach is likely to call for a moderate tightening of monetary conditions in the near future. This approach would not, however, preclude the economy from reaching a new, higher level of resource utilization, if as some economists have argued structural changes have taken place that would allow the economy to operate at higher capacity utilization rates without triggering a rise in inflation.

4. More generally, the IMF staff agrees with the view expressed by the authorities that monetary policy needs to pay attention to cyclical conditions, while focusing on containing inflationary pressures during economic expansions in order to permit a gradual ratcheting down of inflation over the course of successive business cycles.

5. While much of the current policy debate in the United States focuses on short-run macroeconomic issues, particularly monetary policy, fiscal and trade policy issues are critically important for the longer-term growth of the economy. The recent agreement between the Administration and the Congress on a broad plan to balance the federal budget by FY 2002 is a welcome development. The agreement also seeks to maintain a balanced budget over the period to FY 2007, a very important consideration given the proposed measures to cut taxes. Prospects that these objectives will be met are good, provided the economy continues to perform well. The key task at hand is to define the specific measures to be taken within the framework of the balanced budget agreement and to move quickly to implement them.

6. While the agreement envisages significant savings in entitlement spending, it also relies on substantial further cuts in discretionary spending, mainly after FY 1999. Such expenditure cuts could prove difficult to implement, given the substantial compression of spending on discretionary programs that has taken place in recent years and the Administration’s desire to raise spending in such priority areas as education and training. Reliance on the further compression of discretionary spending also raises concerns about whether the provision of basic government services, including the development and maintenance of public infrastructure, might be impaired; these concerns could be allayed to some extent by ongoing efforts to improve the efficiency of the public sector. These concerns also could be addressed by some reallocation of discretionary expenditures from defense spending toward areas of higher priority.

7. Although it would not be feasible to change the targets of the balanced budget agreement in a material way, the timing of spending cuts might be brought forward and tax cuts delayed somewhat within the agreement’s framework, in order to achieve an earlier reduction in the budget deficit; this would strengthen the plan's credibility and leave the fiscal situation less vulnerable to adverse shocks. Moreover, a faster pace of deficit reduction would serve in the near term to reduce aggregate demand pressure, reduce the extent to which interest rates may need to be raised, and limit upward pressure on the exchange rate. In the longer term, a more substantial fiscal effort would raise national savings and help to reduce the external current account deficit and growing net U.S. international indebtedness.

8. In recent years, the Administration and the Congress have introduced targeted tax incentives to promote some of their policy objectives. Indeed, changes in the tax system over the past decade have in large part undone the simplification achieved in the Tax Reform Act of 1986. The balanced budget agreement illustrates this tendency with the inclusion of tax credits and deductions for educational expenses. Such incentives, which take the form of tax expenditures, narrow the tax base and make the income tax system increasingly less efficient and transparent. In the coming years, consideration should be given to simplifying the income tax system and to reducing distortions in order to enhance economic efficiency.

9. The rising share of the elderly in the U.S. population will place increasing strains on the Medicare and Social Security systems, with significant implications for fiscal policy over the longer term. Prompt efforts are required to reduce the financial burden that these programs will otherwise impose in order to avoid more draconian measures in the future. Such efforts also could contribute to the increase in national savings and reduction in the U.S. external imbalance alluded to above.

10. The balanced budget agreement addresses the near-term financial problems of the Medicare system, with the measures proposed ensuring the integrity of the system for at least the next ten years. However, the longer-term finances of Medicare remain a critical problem. The Administration’s proposal to establish a bipartisan commission to develop a plan to address Medicare’s longer-term finances should be acted on quickly. It would not be desirable to address the system’s financial needs solely through increases in payroll taxes. To spread the burden more equitably, reform options to be considered might include combinations of increases in the Medicare payroll tax, further constraints on payments to health-care providers, increases in the costs paid by Medicare beneficiaries, and some increase in the age of eligibility. In addition, it has to be recognized that a once-and-for-all fix to Medicare’s long-term finances may not be possible, owing to the difficulties in projecting the demand for health care and the costs of medical services.

11. The financial problems of the Social Security system are less immediate than those of Medicare, but it is no less important that a plan to shore up the system’s longer-term financial position be implemented as soon as possible. The magnitude of the problems of Social Security and options for reform are well-known and have been studied extensively. Estimates suggest that measures equivalent to about a 2¼ percentage point increase in the payroll tax, if enacted promptly, would be sufficient to bring Social Security into actuarial balance. This could be accomplished through a combination of a small payroll tax increase and benefits cuts, including raising the retirement age, increasing the income taxation of benefits, and reducing cost-of-living adjustments to reflect the bias in the consumer price index. By taking such an approach, the burden of ensuring Social Security’s financial soundness could be shared across generations.

12. The appreciation of the U.S. dollar over the past two years mainly reflects relative cyclical positions and policy developments in the major countries, together with the confidence inspired by the strong U.S. economy. During this period, the dollar’s strength has helped to moderate aggregate demand in the United States and limit inflationary pressures, while the high level of U.S. domestic demand and the appreciation of the dollar have contributed to a widening in the external current account deficit.

13. The persistence of large U.S. current account deficits and growing international indebtedness remains a matter of concern, and reducing these imbalances should be an important medium-term objective. By boosting national saving through continuing improvements in the fiscal position, the United States could avoid the crowding out of investment, which would potentially stem from a correction in the external deficit owing to exchange rate movements.

14. The United States continues to be a major force behind the advancement of trade liberalization in new sectors (for example, in telecommunications and intellectual property protection) and through regional and multilateral initiatives. Current efforts to expand international trade include initiatives to broaden membership in NAFTA, to establish a timetable for negotiations on a Free-Trade Area of the Americas, to advance trade liberalization in the Asian-Pacific region on a most-favored-nation basis, and to further the scope for liberalization under WTO auspices. U.S. support for regional market opening on terms supportive of the multilateral trading system and the goal of global free trade is to be commended. Extensive use by the United States of the WTO’s trade dispute-settlement procedures, frequently in conjunction with Section 301 actions, would appear to reflect a shift in U.S. policy in favor of the resolution of disputes on a multilateral basis, and this is also a welcome development. At the same time, the IMF staff urges the authorities to be cautious in their use of unilateral actions and encourages the United States to exercise its leadership role by pushing forward more quickly with trade liberalization in traditionally sensitive sectors.

15. The communique of the 1996 Lyon G-7 summit underscored the importance of developing and transition economy countries giving priority to avoiding unproductive expenditures, in particular excessive military spending, and this is an issue that the IMF also has stressed in its work with these countries. To support such efforts, the IMF staff urges the United States, together with other major countries, to administer their policies on military sales to developing and transition economy countries in a way that avoids encouraging unproductive expenditures and heightening security tensions.

16. The United States has played an important leadership role in the area of official development assistance (ODA). However, U.S. ODA has declined as a share of GDP from its average in the early 1990s of 0.2 percent to around 0.1 percent in 1995 and 1996, and the Administration’s FY 1998 Budget proposed only stabilizing such assistance at historically low levels. The IMF staff urges the authorities to make every effort to ensure that ODA does not fall further and to see that vigorous efforts are made to reverse its decline. U.S. leadership in efforts to raise ODA is important to help reverse a downward spiral in such assistance that appears to have developed on a world-wide basis, and threatens to offset a large part of the potential benefits from special programs such as the initiative for Africa.