Testimony of William W.
Beach
Before the Joint Economic Committee
of the House and the Senate of the United States
Senator Schumer, Congresswoman Maloney, Senator Brownback,
Congressman Saxton, and members of the Joint Economic Committee of
the U.S. Congress, I am William Beach, Director of the Center for
Data Analysis at The Heritage Foundation. It is an exceptional
pleasure to testify before you today on the state of the economy
and potential efforts by Congress to alleviate financial and
economic stresses. The views I express in this testimony are my own
and should not be construed as representing any official position
of The Heritage Foundation.
Overview
There is an increasingly held view that the U.S. economy is
slipping into a sustained period of slow economic growth, perhaps
even recession. The root of the worsening economic news is believed
to be the collapsing housing sector and the financial institutions
and practices that surround residential construction and mortgages.
Further, it is beginning to look as though declines in housing
sales, construction, and the mortgage credit industry will continue
in 2008 as the mortgage default rate (principally on adjustable
rate mortgages) increases. It is estimated that something above two
million sub-prime adjustable rate mortgages will reset to a higher
interest rate during the first few months of 2008.
The specter of further declines in home prices, more turmoil in
credit markets, and the emergence of secondary, adverse effects in
other parts of the economy stemming from these price and credit
events has raised concern about the general economy's near-term
outlook. Many analysts believe that evidence of widening economic
difficulties could be seen in last month's employment report, which
contained a much-reduced increase in non-farm payrolls from months
prior. Others see evidence of emerging macroeconomic difficulties
in a relatively poor Christmas retail season and in the
increasingly poor revenue results of many major state
governments.
As everyone on this committee must know, comparatively
definitive evidence of a recession "near miss" or an actual
recession will not be available for a long time, perhaps over a
year. This slow accumulation of data renders the policymakers' job
particularly hard. Do policymakers rally behind an economic
stimulus package that aims at avoiding a recession when we may not
be heading into one at all, or do we frame a recession stimulus
package that assumes we entered a period of negative growth
sometime in November? Or do we operate from the wise counsel of
former CBO Director Douglas Holtz-Eakin that economic growth of
positive or negative 0.4 percent is hardly a difference that a
struggling family will appreciate.
So just what should Congress do? As I will argue later in my
testimony, Congress obviously should do nothing to harm the
economy; it should let the Federal Reserve lead the effort to
stabilize economic activity; and it should keep its focus on
crafting long-term, pro-growth economic policy. Congress should
take this moment of slow growth to do what it does best: set broad
economic policy. In this instance, Congress should concentrate on
signaling to investors and workers alike that its principal focus
will be on improving pro-growth economic policy, mainly in the
areas of tax, regulatory, and spending policies. Serious work by
the Congress in these areas will create greater predictability for
investors and business owners and assure workers that they will
have a better chance of improving their wages through increased
productivity. Efforts to enhance the long run may very well have
immediate, short-run benefits as economic decision makers reduce
the risk premium they place on starting new businesses or expanding
existing enterprises.
What Do We Know About the State of the Economy?
While economic data generally are collected well after the fact
of economic activity, current, admittedly incomplete data indicate
that the economy entered a period of significantly slower growth
during the fourth quarter of last year. Indeed, the data may
support the argument that problems in the housing sector and
related credit markets have now affected a wider array of economic
sectors and interests.
The story in the mortgage industry is becoming well-known and
settled. Most analysts would agree that an excessive inventory of
new housing faced declining demand for housing in 2006 as the Fed
raised rates to reduce inflation risks. At roughly the same time,
the delinquency rates for highly leveraged mortgages, principally
sub-prime, began to rise, largely because many borrowers had taken
payments they could not afford. Some lenders did not follow
traditional underwriting practices that have been crafted to assure
that borrowers have enough income to service their mortgages.
The decline in demand produced drops in new and existing home
prices, which exacerbated the sub-prime delinquency rates: As home
prices fell, the incentive for a sub-prime borrower to stay in a
mortgage lost some of the allure that stemmed from the belief that
the underlying house would continue to grow in value, thus
justifying a loan that might be too great a financial burden
otherwise. Further worsening the macroeconomic picture is the
seemingly relentless upward trend in petroleum prices, which
briefly touched $100 a barrel on futures markets this month.[1]
All of these factors have combined to make a grumpy lot out of
economic forecasters. Let me give you my views.
While I continue to believe that the U.S. economy's strength and
robustness are its principal characteristics, I, too, have
concluded that near-term prospects are poor. For example, the
probability of recession has risen in our models from 35 percent to
40 percent, and I could easily see little or zero growth in GDP
when the fourth quarter estimates are published. The decline in
residential construction will continue for some time; consumer and
investment spending will slow; and growing inventories, principally
in the automotive sector, will become a drag on the economy (where
inventory buildup in the third quarter explains some of the large
4.9 percent growth rate).
That said, we expect GDP growth in 2008 of around 2 percent and
monthly employment growth averaging 75,000 jobs. This is slow
growth, but not a recession. The reason I believe we avoid
recession in 2008 is due in large part to the substantial
contributions to GDP from exports. While domestic demand is
expected to grow by about 0.9 of a percent over the next two
quarters, exports are forecasted to expand by 10 percent. Recent
U.S. export growth stems from the lengthening, above-trend growth
in world GDP, largely due to economic strength in Europe and the
long-awaited emergence of China and India to the top tier of
industrial economies.
Economic policymakers need to focus on the economic trouble
spots and the portions of the U.S. economy that are doing
quite well. The temptation will be to see the glass as half empty.
For example, now would be the wrong time to insulate the U.S. from
global economic forces by restricting or regulating international
trade. Moreover, now would be the wrong time (and one can't think
of a right time) to federalize private mortgage contracts or freeze
contracted mortgage interest rates when the vast majority of such
contracts are functioning well and when a key institutional factor
in our current economic strength is the rule of law in the
operation of contracts.
What Should Congress Do?
These cautions, however, should not discourage Congress from
acting to support stronger economic growth. I recommend that
Congress address economic policies in three interrelated areas, all
of which affect near- and long-term economic performance: (1) tax
policy, (2) mortgage markets regulation, and (3) long-term
spending.
Nearly every significant general slowdown in economic activity
is a good time for congressional policymakers to ask: Are we doing
everything we can to support long-term economic growth? That is,
slowdowns are good times to get back to policy fundamentals and
make certain that everything Congress can do to allow the economy
to grow has been done.
I am convinced the Congress is not the best policymaking body
for addressing the short-run challenges of the economy. That role
is better played by the Federal Reserve System. So much of what
Congress does is tied to the budget and appropriation processes,
which take time to reach legislative results. Moreover, Members of
Congress frequently do not have the time or background for keeping
up with financial markets, the ebb and flow of economic data, and
the actions of economic institutions the way the Fed does, or even
as the economic agencies of federal and state governments do. These
institutional factors explain why congressional action often occurs
after the need for action has expired and why the actions it takes
often are not as targeted as they need to be.
However, there are areas of economic policy where congressional
action can be timely and targeted, though it may not intend to be
short-range in focus at all. Those areas involve the reduction of
investment risk.
Investors are driven, in general, by comparative rates of return
when making investment decisions between various opportunities. If
two business opportunities are possible but one has a better rate
of return than the other, then the investor will go with the
superior opportunity--the one with the higher rate of return.
Suppose, though, that outside factors intervene (a flood, war,
regulatory changes) and this otherwise superior investment now
carries more risk than the inferior one. The investor discounts the
rates of return for the greater amount of risk, and if the rate of
return on the first opportunity is still superior, the investor
goes with that same opportunity. If, on the other hand, the risk is
too great to go with the otherwise superior opportunity, the
investor may take the more cautious approach of avoiding risk and
placing funds in the opportunity with the otherwise lower rate of
return.
Tax Policy. What can increase risk? Many factors, of
course, but public policy commonly looms large. Tax increases,
especially if they land on capital, increase the cost of capital
and lower investment returns. When investors are uncertain about
whether taxes will go up or stay the same, they still can act as
though taxes have risen if they judge the risk of an increase to be
nearly equal to an actual increase. And rising uncertainty can have
the effect of driving down investments in riskier undertakings.
Thus, among the first things Congress can do to address the
current slowdown is to pronounce definitively on the tax increases
scheduled for 2009 and 2011. There are projects, new businesses,
and expansions of existing businesses that would be undertaken
today if Congress signaled that taxes would be lower in three
years. Since nearly all major capital undertakings last beyond this
three-year period, it is likely that making all or most of the Bush
tax reductions permanent would stimulate economic activity today as
well as in 2011.
I am probably not the only one here today who knows of
businesses that are preparing now for higher taxes in 20ll. They
are preparing themselves by reducing their riskier projects and
providing for stronger cash flows in 2010. It is altogether
possible that there are projects being cancelled today that would
otherwise go forward if taxes were not scheduled to rise in 2011.
At times like the present, the speech of policymakers is as
important as the policy actions they take. The decision makers in
business and investment are watching Washington closely to discern
the direction Congress will take in responding to this crisis. If
that direction includes tax increases, then investors will find
more favorable economies to support and business owners will, as
much as they can, locate their expanded activities in places with
more favorable tax regimes.
Thus, Congress should signal today what it plans to do on taxes
in two or three years. For my part, I urge the Congress to make
permanent the key provisions of the 2001 and 2003 tax law changes.
Maintaining lower tax rates on labor and capital income will
encourage both labor and capital to work harder now when we need
that greater activity.
In addition, we know from past experience that accelerating the
tax depreciation of capital equipment and buildings or one-year
expensing of business purchases that otherwise would be depreciated
over a longer period of time for tax purposes can help during
periods of slow growth. This was certainly the record in the last
slump.[2]
Demand-side stimulus (tax rebates, the child tax credit, and the
10 percent tax bracket) did little to change the course of the
sluggish economy. The tax rebates of 2001 did little to stimulate
the economy or move it from a prolonged sluggish growth trend.
Indeed, the contraction in investment and thus job creation did not
begin to improve until after the 30 percent partial expensing in
the 2002 act and the 50 percent partial expensing in the 2003 act,
which also cut the tax rates on dividend and capital gain income.
Congress has enacted depreciation and expensing stimulus plans
under Republican and Democrat majorities.
Mortgage Market Regulation. Just as working on better,
more pro-growth tax policy for the long run can have immediate
short-run benefits, so too can supporting long-term recovery in the
mortgage and credit markets. Well-functioning financial markets are
central to long-term growth in jobs, incomes, and general output.
Clearly, the current credit crunch points to the widespread
difficulties that flow from extensive violation of traditional
lending practices and excessive supplies of credit.[3]
So what should Congress do? Four principles should be in
policymakers' minds when framing a policy response to this
crisis.
- Any action should respect private property. When lenders
are faced with a high frequency of defaults, they commonly
negotiate new terms with borrowers rather than face extensive
defaults or delinquencies. We see these negotiations going forward
now. Congress should not act in a fashion that arbitrarily
abrogates or alters these contracts. It should not empower
bankruptcy judges to negotiate new mortgages. It especially should
not pass legislation or support administrative actions that freeze
interest rates. Such actions would set a dangerous precedent of
legislative interference in private contracts that could be more
extensively utilized sometime in the future.
- Congress should not extend new subsidies to the housing
sector. An efficient mortgage credit industry is central to the
country's economic future. Clearing out poorly run and unethical
mortgage companies needs to happen swiftly and thoroughly, and this
side of the market correction is visible every day in the financial
news. It also is important that the under- and non-performing loans
be refinanced or restructured in a way that serves the long-term
interests of borrowers and lenders alike. Federal subsidies to
lenders or borrowers would only lengthen the correction and distort
the costs that the market needs to absorb and discount.
- Lightly reform mortgage credit regulations. If Congress
and the Administration encourage the private renegotiation of
at-risk, sub-prime mortgages, then the sector with the most to gain
(or lose) will be resolving the sub-prime problem. Congress should
review existing regulations to determine the contribution of either
ambiguity in law or failure of enforcement to the turmoil in
mortgage markets. It might also be good to review the
Administration's proposed regulations of Freddie Mac and Fannie
Mae.
- Congressional actions should be temporary and limited.
Whatever Congress does on the regulatory side, those actions should
be targeted to the problem, temporary in duration, and supportive
of private resolution of the non-performing portion of the nation's
mortgage portfolio.
Increasing Confidence in the U.S. Economy by Addressing
Long-term Spending Challenges. While the attention of most
policymakers will be on immediate responses to the current
slowdown, everyone should attend to a factor that's increasingly
important to confidence in the U.S. economy: the seeming
unwillingness of Congress to seriously address the enormous
financial challenges from entitlement spending. Many investors and
organizations that play key roles in the future of the U.S. economy
are worried about long-term growth given the fiscal challenges
posed by Social Security's and Medicare's unfunded liabilities. The
Financial Times recently reported that the lead analyst for
the U.S. at Moody's warned that the credit rating agency would
downgrade U.S. treasury government debt if action was not soon
taken to fix entitlements.
Thus, at a time when the economy is slowing and the speech as
well as the actions of Congress can affect economic activity,
policymakers should take concrete steps that will announce their
intention to address unfunded liabilities in these important
programs. While reforms in these programs may be beyond what this
Congress can do, it is possible to signal change by reforming the
budget rules.
Currently, the federal budget functions as a pay-as-you-go
system, with a very limited forecast of obligations and supporting
revenues. We just do not see in the official budget what may happen
over the next 30 years. The five and ten-year budget windows do not
permit Members or the general public to sense the obligations that
are coming beyond that ten-year time horizon.
A good first step in addressing the long-term entitlement
obligations of the United States would be to show these obligations
in the annual budget. This could be done by amending the budget
process rules to include a present-value measure of long-term
entitlements. Such a measure would express in the annual budget the
current dollar amount needed today to fund future obligations. Such
a measure has been endorsed by a number of accounting
professionals, including the Federal Accounting Standards Advisory
Board.
A solid second step would be to convert retirement entitlements
into 30-year budgeted discretionary programs. Such a move
recognizes that mandatory retirement funding programs for
millionaires that crowd out discretionary spending programs for
homeless war veterans make no sense at all. If we are to contain
entitlement spending and reform the programs driving those outlays,
then a paradigm shift likely will be required. Recognizing Social
Security and Medicare as discretionary programs helps to force
attention on changes that will assure their survival well into the
21st century.[4]
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