FROM THE OFFICE OF PUBLIC AFFAIRS

January 31, 2005
JS-2219

Assistant Secretary of the Office of Economic Policy
Mark J. Warshawsky
Statement for the Treasury Borrowing Advisory Committee
of the Bond Market Association

The economy continued to grow at a solid pace over the final three months of 2004, bringing real GDP growth on an average annual basis to 4.4 percent last year, up from 3.0 percent in 2003. Last week's advance report on fourth-quarter Gross Domestic Product showed that real GDP grew at a 3.1 percent annual rate following a 4.0 percent gain in the third quarter. Virtually all of the slowdown in the fourth quarter reflected a wider trade deficit. Excluding net exports, gross domestic purchases grew by a strong 4.7 percent annualized rate in the quarter.

Consumers maintained a healthy spending pace. After increasing at a 5.1 percent rate in the third quarter, the largest quarterly gain in almost three years, real personal consumption expenditures were up at a 4.6 percent annual rate in the fourth quarter. Real disposable personal income grew by an outsized 8.4 percent annual rate in the fourth quarter, boosted by a $32 billion special dividend payout by Microsoft, most of which went into personal income. Loan delinquencies on consumer loans and residential real estate loans are very low, suggesting consumers are not over-extended.

Business fixed investment rose at a 10.3 percent rate in the fourth quarter, down a bit from 13.0 percent in the prior quarter. Investment in equipment and software continued to post rapid growth of 14.9 percent on top of the 17.5 percent gain in the third quarter. Equipment and software investment was up 13.4 percent in 2004 on an average annual basis, and followed an annual increase of 6.4 percent in 2003 and a decline of 5.5 percent in 2002. Investment in structures, typically one of the slowest sectors to recover after an economic downturn, has shown only a few quarters of sporadic growth since the recession, and declined at a 4.1 percent rate in the fourth quarter.

Business investment has been boosted over the past several years by bonus expensing, initiated with the Job Creation and Worker Assistance Act of 2002 and expanded by the Jobs and Growth Act of 2003. That incentive expired at the end of last year, but corporate profits from current production (adjusted to measure inventories and depreciation at replacement cost) are providing strong support to investment going forward. The profit share of gross domestic income rose to a recent peak of 10.2 percent in the first quarter of 2004, the highest since 1997, due to rapid gains in productivity and benign labor costs. In the third quarter (latest available), the profit margin held close to that 10.2 percent share (excluding the effects on profits from the recent hurricanes). Rising profits have led to large gains in cash flow – the internal funds that are available to corporations for investment. Not all of those funds have been tapped for capital expenditures, and the "financing gap" (capital expenditures less cash flow and inventory profits) has been negative on average for the past two years. With the business sector running a financial surplus, corporations have been able to improve their balance sheets.

The trade deficit continued to widen in the fourth quarter and has been a drag on growth for five straight quarters. The deficit increased by $48.7 billion in real terms in the fourth quarter, reaching a record $631.9 billion, and subtracted 1.73 percentage points from GDP growth. Over all of 2004, the deficit took about 1 percentage point from real GDP growth. The increase in the deficit in the latest quarter reflected a 9.1 percent annual rate rise in total imports. In contrast, real exports decreased 3.9 percent. The relatively stronger performance of the U.S. economy compared to its major trading partners, such as the eurozone countries and Japan, continues to be a factor in the widening trade gap. This trade profile underscores the need for our trading partners to adopt policies that accelerate economic activity, so that the United States is not the only engine of world growth. Greater currency flexibility in those economies that lack flexibility would also help to improve trade imbalances.

The U.S. labor market continued its upward trend during the fourth quarter as 606,000 jobs were added to nonfarm payrolls after 402,000 new jobs were created in the third quarter. Those gains brought the increase in the number of new payroll jobs in 2004 to 2.23 million, an average of 186,000 per month and the best year for job creation since 1999. Those figures do not even include the expected upward revision to payroll employment due to the annual benchmarking, the results of which will be reported this Friday by the Bureau of Labor Statistics along with the release of January labor market data. The unemployment rate has come down from 5.7 percent at the beginning of 2004 to an average of 5.4 percent in the final three months of the year, almost a full percentage point below the June 2003 peak.

Prospects for the first quarter of 2005 and throughout the year are highly favorable. The economy's basic fundamentals – high productivity, low inflation, and expanding employment – are sound and point to continued expansion economic activity at a healthy pace this year.

The U.S. economy now appears to be on solid footing after the challenges of the past few years. Return to a healthy economy allows us to turn our attention to some of the issues that will affect the longer-term well-being of our citizens, specifically retirement income security.

The Administration recently released the outlines of our proposal to reform the single-employer defined benefit pension system; the Treasury Department played an active role in the design of this proposal. The retirement security of the 34 million Americans participating in single employer defined benefit pension plans depends on employers keeping the promises they make; however, the current system does not ensure that pension plans are adequately funded. Underfunded plan terminations are also placing an increasing financial strain on the pension insurance system and, through that system, impose an increasing burden on healthy employers who sponsor well-funded pension plans.

To protect participating workers and retirees, to improve the financial status of the Pension Benefit Guaranty Corporation, and to encourage continued voluntary sponsorship of defined benefit pension plans by companies, the President's proposal focuses on three areas:

• Ensuring pension promises are kept by improving opportunities, incentives and requirements for funding plans adequately;
• Improving disclosure to workers, investors and regulators about pension plan status; and
• Adjusting the pension insurance premiums to better reflect each plan's risk and ensure the pension insurance system's financial solvency.

The Social Security system is an even larger and more essential part of Americans' retirement income security. The current system is secure for today's seniors but is not financially stable for future generations and must be fixed. Because of demographic changes and benefit growth, the current system will not be able to afford to pay the benefits scheduled for our children and grandchildren without enormous payroll tax increases or huge benefit cuts. Fortunately, this untenable situation is fixable. President Bush has said that "Social Security is one of the greatest achievements of the American government, and one of the deepest commitments to the American people." The President supports Social Security reform that increases the power of the individual, does not increase the tax burden, and provides economic opportunity for more Americans.

The President wants to see Social Security permanently strengthened for our children and grandchildren, without raising payroll taxes. The President's focus on a permanent strengthening of the system reflects a principled decision not to leave problems to future generations. Delaying permanent reform implicitly places additional burdens on future generations - our children and grandchildren - to foot the bill. By contrast, the permanent and timely reform the President has called for will allow us the most options for strengthening Social Security for future generations.