The piece below by Morgan Stanley's Stephen Roach (New York)
Washington is coming to the rescue of a deflation-prone US economy. Or at least it is attempting to do so. The Federal Reserve has led the way, and now the fiscal authorities are joining in. While Republicans and Democrats differ on tactics, they agree on the general dosage of fiscal stimulus over the next year -- about $100 billion, or 1% of gross domestic product. I applaud this rare bipartisan consensus.
Yet, if anything, a short-term stimulus of this magnitude might actually be too little. That's because the United States is close to the brink of outright deflation. For the economy as a whole, GDP-based inflation slowed to just +0.8% in 3Q02, the lowest rate in nearly half a century. Another year of subpar economic growth in the 2% vicinity -- pretty much my personal prognosis -- could well find inflation moving even lower, possibly flirting with the "zero" threshold of outright deflation. The authorities must do everything in their power to avoid such an outcome.
And so Washington has sprung into action. The Federal Reserve has taken the federal funds rate down by an astonishing 525 basis points since early 2001. At 1.25%, this benchmark policy interest rate stands at its lowest level in over 41 years. The Congress and the Bush Administration are now following suit. America certainly needs that. The textbook response to the threat of deflation suggests that all forms of stabilization policy -- fiscal as well as monetary -- be aggressive in attempting to boost aggregate demand. At exceedingly low rates of inflation, the risk-reward calculus urges policy makers to err on the side of excessive stimulus. Such "over-stimulus" can always be corrected -- if and when the economy is on the mend and deflationary perils ebb.
But the US economy also faces profound longer-term challenges. At the top of that list is a seemingly chronic shortage of saving -- the driver of capital formation and the sustenance of any economy's longer-term growth potential. America's so-called net national saving rate -- the sum of personal, business, and government saving after depreciation is deducted -- plunged to a record low of 1.6% of GDP in 3Q02. Not only is that less than one-third the subpar 6% average of the 1990s but it is only about one-sixth the 10% norm of the 1960s and 1970s. This is the domestically generated saving that is left over to fund the expansion of America's capital stock. And now there's less of it available for that purpose than ever before.
Moreover, ever-widening Federal budget deficits run the risk of a further plunge in national saving. That trend was already evident long before the latest fiscal stimulus proposals. In the first quarter of 2000, the budget was actually in surplus to the tune of 2.3% of GDP and the net national saving rate stood at 6.4%. By the third quarter of 2002, the Federal budget had swung into a 1.8% deficit, and the national saving rate plunged to 1.6%. The deterioration in the government's fiscal balance accounted for fully 85% of the depletion in overall national saving since early 2000. Needless to say, without compensating upward adjustments in private-sector saving -- the opposite of what today's consumption-oriented policy makers are seeking -- a steady stream of budget deficits could well push the already depleted national saving rate even lower.
That would be a most unfortunate turn of events. To the extent that America's growth imperatives cannot be financed by domestic saving, foreign investors must provide alternative funding. The US can get that capital only by purchasing goods from overseas, the root cause of its massive trade deficits. Yet in the end, this is a fool's game. America is currently running a record balance of payments deficit amounting to 5% of its GDP. Rising budget deficits that lead to a further reduction of national saving will take the external financing gap up to at least 6%, requiring the US to attract about $2.5 billion of foreign capital each and every business day in 2003.
That's a most precarious foundation for the world's growth engine. Ever-widening Federal budget deficits not only put a strain on the ability of the United States to finance its growth-enhancing investment in plant and equipment, but they also leave America increasingly dependent on foreign lenders to close the financing gap. Currently, overseas investors own more than 18% of the total market value of long-term US securities and fully 42% of outstanding Treasuries -- dramatic increases from the shares of mid-1990s. Such financing arrangements are tenuous at best. There's no guarantee that foreign investors won't demand a price concession on dollar-denominated assets to keep the inflows going. As a consequence, a saving-short US simply may not be able to afford another era of fiscal profligacy without suffering the consequences of a sharply weaker dollar and/or a marked correction in other asset prices. Longer-term fiscal stimulus plans -- such as the one proposed by the Bush Administration -- need to be mindful of this critically complicating factor.
At the same time, tax reform proposals -- however laudable -- need to be judged against the yardstick of national saving objectives. That's not to say that America doesn't need tax reform. The elimination of the double taxation on dividends is one such reform that is long overdue. Such relief has, in fact, long been at the top of my reform wish-list -- especially the strain that would direct relief at the corporate sector. But that begs the more basic question as to whether a saving-short nation can afford a reform that entails a 10-year revenue loss estimated by the Bush Administration to be in excess of $360 billion. Moreover, the wisdom of using dividend tax cuts as a vehicle to provide short-term stimulus can be drawn into serious question. There are certainly other less circuitous options -- such as the payroll tax reductions the Democrats eschew -- that put more high-octane fuel directly in the hands of consumers.
Perhaps the most troubling aspect of the "Washington fix" is the temptation to go back to the same recipe that got America in trouble in the first place -- hyping the stock market and the bubble-induced excesses it prompted in the real economy. Both the Fed and the fiscal authorities seem more than willing to embrace stock-market targeting as a means to jump-start a sagging US economy. Fed officials have been quite explicit about the need to spark a revival in sentiment that could well lead to another rally in the equity market. The Bush Administration has been equally adamant over using dividend tax relief as a means to push up share prices, spur wealth creation, and boost the consumption of wealth-dependent investors. And the Democrats' plan urges stimulus to business capital spending -- the last thing that a deflation-prone economy awash in excess capacity needs. Sadly, this is a movie we've all been to before.
America's policy challenge is daunting, to say the least. But in the end, the authorities must not lose sight of what stirred them into action -- the perils of deflation. For that reason alone, America needs a sizable short-term stimulus. But a saving-short US economy cannot afford the luxury of multi-year tax cuts and outsize revenue losses associated with long overdue and well-intended reforms. Moreover, Washington must heed the lessons of the Roaring Nineties and avoid the bubble-induced pitfalls of stock-market targeting and excess capacity. Politics and economics often work at cross-purposes. America can ill afford such an outcome today