December 6, 2001 | Testimony on Federal Budget
Chairman Toomey, Congressman Pascrell, and members of the committee, my name is William Beach. I am the Director of the Center for Data Analysis at The Heritage Foundation. It is a great privilege for me to be with you this morning and to speak on this important topic. You should know that my remarks today reflect my own views on this subject and not necessarily those of The Heritage Foundation.
There is increasingly little doubt that the U.S. economy currently is in recession. The visible and widely noted economic slowdown that began in the spring of 2000 worsened over the summer and fall. The service and financial sectors joined manufacturing in contracting during the winter of 2001, and the recession officially began in March. Why is the U.S. economy in a recession now after nearly a decade of economic growth?
I hold the view that recessions occur as a result of policy errors compounded by an external shocks to the economy. While we will have to wait several years for a thoughtful economic history of the 1990s, I imagine historians will point to two policy errors and the events of September 11 as important to the contraction of 2001.
First, they doubtless will note the unusually large expansion of money and credit in 1998 and 1999 that was intended to support the conversion of the nation's computer systems to Y2K compliance. No doubt the monetary expansion did just that, but it also allowed banks and venture capital firms to supply credit for new business startups. Again, I imagine history will show that a significant portion of the dot-com bubble was due to the Y2K monetary expansion.
The second policy error has two faces. First, the monetary loosening of 1998 and 1999 was followed by the monetary tightening of 1999 and early 2000. The Federal Reserve increased interest rates in an attempt to nip inflation in the bud (a bud which had been nurtured by their careless watering of the year before). The economy slowed; the speculative bubble began to burst; and the Fed loosened, but did so in vain.
The other face of this second policy error stems from the first: the expansion of the late 1990s increased the tax burden on labor and capital as incomes rose. Indeed, the weight of expansion-related taxes may well have been nearly two percent of Gross Domestic Product by 2000, or roughly equivalent to the federal surplus. This burden produced economic distress as the economy weakened. Required rates of return on long-term investments grew as the tax premium expanded, and grew further still as near- and medium-term economic prospects darkened.
It is in this context that Congress now is debating the composition of an economic stimulus bill. The events of September 11 doubtless worsened the economic contraction and have necessarily introduced into the debate proposals to ameliorate harm related to the terrorist attacks.
Perhaps the debate's most interesting feature is how it has helped clarify the economic differences between a demand-based approach to strengthening economic performance and a supply-based approach. I suspect this additional clarity is not entirely evident, even to those most closely involved in the debate. The statistical and rhetorical record, however, should be very useful to future disputants.
What do I mean by additional clarity? While still too early to tell definitively, the small boost to household disposable income that stemmed from the summer's tax rebate program (a key provision of the tax legislation signed into law by President Bush on June 7, 2001) appear to have had little effect on consumption expenditures. Not only do opinion surveys show that households devoted the lion's share of their rebate checks to debt repayment and savings, but new data from the Federal Reserve indicates a spike in savings commensurate with the size of the rebate and its timing. This additional information on the effects of tax rebates during economic slowdowns re-enforces findings about the disposition of earlier rebate efforts, likewise intended to boost consumption expenditures during economically distressed times.
This additional evidence on how households will likely "spend" subsidies and one-off rebates from the federal government is most welcome to analysts focused on stimulus measures that work on the deep structure of economic activity: incentives, investment, and long-term expectations. It shows the futility of efforts solely or mostly devoted at on raising aggregate demand through spending. And, while these lessons are hard for Washington policy makers to learn, the statistical record being made during this recession likely will guide a higher proportion of future lawmakers toward the more effective and economically sensible route of tax rate reduction.
Our own work on various economic recovery proposals points to the greater importance of policy change directed at incentives, investments, and long-term economic expectations. On November 9, 2001, my colleagues, Mark Wilson, Rea Hederman, Ralph Rector, and I published an analysis of two leading stimulus proposals then pending in the United States Senate: a plan by Senator Grassley that reflected President Bush's recommendations and a plan associated with the Senate leadership, Senators Daschle and Baucus. We used a standard model of the U.S. economy, the DRI/WEFA U.S. Macroeconomic Model, to estimate the economic effects of the two plans. We also employed the CDA Individual Income Tax Model to estimate the year-by-year changes in federal revenues stemming from the changes in tax law proposed by the two plans.
The proposal advanced by Senator Grassley consisted of the following seven major components:
The Senate leadership plan relied much less on tax cuts and more on spending programs. That plan contained the following nine provisions:
Every economic indicator in the DRI/WEFA model points to the superiority of an approach to economic recovery that depends on reducing the costs of work and investment. For example, over the period Fiscal Year 2002 through Fiscal Year 2006,
The Grassley proposal (which, again, closely reflected the plan advanced by the Bush administration) clearly would lesson the depth of the recession and shorten the time over which the economy would pass before returning to pre-recession growth levels. One question, however: Just how much of these economic benefits stem from the acceleration of the individual income tax rates alone? After all, the Grassley plan contained a number of spending proposals advanced by the Senate leadership in their proposal.
To answer that question, we estimated the economic effects of just the rate reductions using the same model of the economy and over the same five-year time period. These results are being announced today for the first time. We found that the rate reductions alone in the Grassley-Bush plan account for
While it is possible to point to times in our history when spending programs made a significant difference to employment and output, these moments almost always are associated with extraordinary national mobilizations. Ours is not one of those times, even though the events of September 11 and since have produced a level of national resolve not seen since the beginning of World War II.
We have a recession produced by policy errors and aggravated by hostilities. The errors affected investment and incentives, and they call forth policy responses that are focused on investment and incentives. The hostilities devastated key elements of our economic superstructure and distressed the lives of hundreds of thousands of innocent and productive citizens. Those hostilities call forth policy responses that are compassionate and generous.
In neither case, however, are the needs of the injured or the weaknesses of the economy met through highway construction, park renovation, agricultural subsidies or the host of other spending programs that bear a weak connection at best to the economic slowdown and the terrorist attacks.
I thank you for the opportunity to appear before your committee.
William Beach is Director of the Center for Data Analysis at The Heritage Foundation.