President-elect Clinton faces a situation in which US economic policy and the US economy have reached a standoff. Business is sluggish in part because it must carry the weight of past mistakes, both public and private, but also in part because it has been receiving little help from what in other circumstances would be standard policies used by the federal government to stimulate the economy. At the same time, such policy measures have been largely absent because so many of the usual measures that are appropriate during a time of stagnation—tax cuts, boosts in spending, genuinely deep cuts in interest rates—apparently fly in the face of the need to begin resolving the mess left by the excesses of the last ten years.

All this is not to say that it is impossible to improve the economy in its current condition, or to address the problems created by past errors or, indeed, to do both. There are in fact measures that the nation can take to encourage business today and to foster advances in productivity and competitiveness in the future. There are ways to reverse the trend to low investment and high consumption of the last decade without plunging the economy into a yet deeper shortfall from its potential output. But combining these objectives in a workable policy will require serious dedication, including a willingness to take actions that inevitably will be distasteful to one interest group or another, as well as a degree of legislative ingenuity that, at least in recent years, neither the President nor the Congress has been able to muster. In short, the challenge is very great. But then so is the need.

That 1993 presents a critical opportunity to take action on our economy has by now become a cliché. But this does not make the point less true. The economic history of our time has been radically different because Ronald Reagan in 1981 used his election mandate to support the tough measures, including record high interest rates, that Paul Volcker carried out at the Federal Reserve System in order to brake double-digit inflation. Three years later, voters rewarded the President for having done so, forgiving if not forgetting the record high unemployment that had temporarily ensued.

The economic history of our time would have been radically different in yet other ways if President Reagan in 1985 had followed his reelection victory by imposing some combination of spending cuts and tax increases sufficient to eliminate the very large budget imbalance his earlier policies had created. But he chose not to do so, and we thereby lost the chance to correct this problem while our economy was strong. In 1989 George Bush too missed his opportunity. Perhaps because he believed he could not violate his “Read my lips” campaign pledge, President Bush adopted an approach to our economy’s mounting problems that consistently amounted to too little, too late.

It is now Mr. Clinton’s turn. Because of the mounting economic damage done along the way, the easier options that were open to President Reagan in 1985, or even to President Bush in 1989, are no longer available. Our economy today is no longer strong but weak, and our debts are far greater. But unless we are to despair of ever restoring genuine prosperity in this country—a choice that would be wholly out of character both for America and for Americans—the accumulating cost of past inaction only makes seizing this opportunity the more urgent. Now is the time for positive action—not hints and promises, not symbols and tokens, but genuine new action on a scale adequate to correct a failure that has been building for ten years.

We now know that the American public’s dismal assessment of our country’s economic condition was more accurate than the Commerce Department’s. According to newly revised data the recession that began in the middle of 1990 was not so shallow after all. Total real output fell by 2.2 percent, not 1.6 percent as earlier reported, and the decline lasted not six months but nine months. More important, after over two years there is still no sign of a meaningful upturn. There are nearly three million more Americans unemployed than before the recession began (not even counting all the “discouraged” workers who have despaired of finding jobs and therefore stopped looking), and an additional 6 percent of the nation’s industrial capacity is idle.

These are real resources, and the economy’s failure to use them matters. The country’s rate of overall economic output, after allowing for inflation, is barely above what it was when the recession began—or, to put the matter in broader perspective, just 3 percent greater than in late 1988. Real growth since the end of 1988 has therefore averaged not even 0.8 percent per year, less than in any other four year period since before World War II. Americans’ real per capita income also remains below what it was four years ago.


Confronted by persistent stagnation, Congress and the President have taken no significant action toward a more stimulative fiscal policy. On a cyclically adjusted basis—that is, with both revenues and expenditures calculated as if the economy were at full employment—the federal budget (excluding transactions for the savings and loan bailout) showed a deficit equal to 2.6 percent of national income in the 1990 fiscal year. The Congressional Budget Office now projects that the cyclically adjusted deficit will rise to 3.5 percent of national income in fiscal 1993. This rise, not even 1 percent, is not a serious economic stimulus. It especially pales compared to the large fiscal measures enacted during or just after earlier business recessions in the postwar period, like those of 1957–1958, 1973–1975, or 1981–1982.

The reason for this inaction is no secret. The federal budget has never recovered from the three-part policy, adopted at the outset of the Reagan era, of tax cuts combined with a sharp buildup of defense spending and protection of expensive nondefense programs like social security and Medicare. The US economy has never recovered from this policy either. Budget deficits have fluctuated from year to year, of course, but throughout the last decade the deficit has remained far larger as a share of national income than in any previous period, apart from wartime or the Great Depression of the 1930s. Not surprisingly, draining away so much of the nation’s saving to finance the federal deficit has meant skimping on our investment in a more productive economy.

It is no wonder—and it is to their credit—that so many people now resist policies that would widen the deficit still further. The problem is that this welcome and well-founded attitude also means resisting the kind of fiscal stimulus that the United States has used before, often with noteworthy success, to spur the economy’s recovery from serious downturns.

At the same time, monetary policy has recently been stimulative but only cautiously so. The Federal Reserve System did not even begin to undertake a genuine easing of monetary policy for at least a year after the recession began. Within the last year, the Federal Reserve clearly has eased policy, so that short-term interest rates have now fallen by more than just the slowing rate of price inflation. Even so, it is easy to make too much of the measures that the central bank has taken to ease monetary policy. At 3 percent interest for three-month Treasury bills, for example, short-term nominal interest rates approximately match today’s inflation rate. Hence the real short-term interest rate—the excess of the nominal rate over the inflation rate—is about zero. To be sure, a zero real interest rate for short-term liquid assets is lower than that of a year or two ago. But in historical perspective it is not so unusual, especially for this stage of the business cycle. (The average real interest rate on three-month Treasury bills during 1950–1980, including recessions as well as periods of strong economic activity, was nearly zero—just 0.08 percent.)

The Federal Reserve’s reluctance to push interest rates still lower is, at least to some extent, also understandable. With short-term interest rates throughout Europe now several times the level of ours—for example 8 percent in the United Kingdom, nearly 9 percent in Germany, and over 10 percent in France—the widening gap between returns on dollar assets and returns available in other countries has caused investors to act in ways that have driven the dollar to new lows against the deutsche mark and related currencies. The Federal Reserve is naturally reluctant to press further with a domestic monetary policy that would steadily diminish the international value of our money. In light of the continuing stagnation gripping our economy, however, concern for the dollar should not be allowed to stand in the way of further steps toward an easier monetary policy.

Easier money has probably helped business already, and it will continue to do so in either greater or lesser degree as the Federal Reserve chooses. But no one has ever seriously recommended systematically leaving to monetary policy the entire task of boosting the economy out of recession. So the central question facing the new administration remains. Should fiscal policy be more expansionary now? If so, in what ways? And what about our decade-old problem of overborrowing and the underinvestment that follows from it?

In assessing just how weak our still nascent business recovery is, and therefore how pressing the need for additional stimulus from either monetary or fiscal policy (or both), the new administration will have to be honest about the appropriate standard against which to measure the economy’s actual progress. During the year and a half since overall business activity began to expand once again, the average growth rate after allowing for inflation has been 1.7 percent per year: disappointing, to be sure, but how much so? And compared to what? Should we have expected business to expand during this period at the 6 percent per year pace typical of the first year of most previous postwar expansions? Can we now plausibly hope that our economy will grow in the mid-1990s at the 3.1 percent per year rate that prevailed on average (albeit with many ups and downs along the way) from the 1950s through the 1980s?


Calculating precise expectations for productivity growth is a large and complicated task, but it is clear enough that the US economy’s development over the last ten years has been such as to limit our ability, during the years now immediately ahead, to achieve the kind of sustained expansion that we would otherwise have anticipated. In large part as a consequence of our misguided tax and spending policies, during the last decade we have underinvested in just about all of the basic ingredients of strong economic growth. During the last ten years, the federal deficit absorbed on average 3.7 percent of our national income. The entire net saving of American families and US businesses during this period amounted to just 6.2 percent of national income. As a result, the share of our income that we have devoted to investment in new plant and equipment has faltered. Indeed, by some standard measures it had already fallen to the lowest level of any sustained period since World War II, even before the depressing influence of the most recent recession took hold.

In the five years before the latest recession began, between 1986 and 1990, investment by US businesses in new plant and equipment, after allowing for depreciation, amounted to just 2.3 percent of our national income, well below half of the already paltry 3.6 percent we invested on average in the 1950s, 1960s, and 1970s. The share of national income devoted to such investment before subtracting depreciation declined steadily from a postwar peak of 13.5 percent in 1981 to 10.5 percent in 1990 (and just 9.5 percent in 1991, because of the recession). If we had merely invested enough in the 1980s to keep our stock of factories and machines growing at the pace that had prevailed, on average, during the previous three decades, by 1990 there would have been an average of $65,700 in capital behind each American worker. In fact, there was just $57,600.

Having less capital means being less productive. The inevitable result of this dramatic shortfall in our physical investment has been sluggish growth in productivity—and with it, stagnant real wages and declining job opportunities. But new factories and machines are not the only aspect of our investment that we have neglected during the last ten years. In an effort to find ever more false economies to offset our reckless budget policies, we have steadily cut back on our investment in infrastructure—roads, bridges, port facilities, airports—at all levels of government. We have increasingly stinted on what we devote to educating our work force. Even spending on research and development, the one form of investment that had shown strength in the 1980s, has now been declining in real dollars since 1989.

There is no magic way to wish into being the factories we have not built, or the machines we did not install. There is no wand we can wave that will improve the training of millions of poorly educated workers. Whatever our expectations for the 1990s might otherwise have been, we cannot now expect to achieve the growth of productivity, of economic output, or of incomes to which we might have looked had we invested adequately—in all of the many senses of “investment.”

Moreover, because American business in the 1980s followed the government’s lead in borrowing record amounts, even during a period of below-average investment, our economy now faces a further barrier to vigorous expansion. Many firms have put so much borrowing on their balance sheets that their debts are difficult to service even under the best of circumstances. There is now ample evidence that highly indebted firms undertake both less capital investment and less research and development than otherwise comparable firms with lower levels of borrowing.

Just within the past year, many corporations have usefully begun to restore their balance sheets to manageable condition. Corporate restructuring has been important to this process. The combination of lower interest rates on short-term debt and enhanced internal cash flows, as business has generally recovered, has been even more important. Even so, the average firm’s debt burden remains unusually high, probably high enough to retard the economy’s ability overall to reverse the underinvestment of the past decade.

In addition—in part as a consequence of just this phenomenon of corporate overborrowing, but also in part as a byproduct of the 1980s real estate speculation—nearly every major category of lender in the US financial markets has suffered at least some deterioration in its ability to provide credit to those businesses that are still willing to invest. Many commercial banks have had to take large losses against capital positions that were already strained by unsound loans to developing countries. There is now evidence that the banks whose capital has fallen the most are the ones that have cut back the most on new business lending.

Nor is this problem limited to commercial banks. Many insurance companies have experienced analogous reductions in their “surplus” accounts. Some major finance companies have suffered losses large enough to make their corporate parents wary of committing ever larger amounts of capital to financing activities that are strictly ancillary to their main lines of business. Even the market for “junk bonds” now exhibits a sharply diminished capacity to supply funds to firms seeking to undertake productive expansion.

In sum, the United States economy in the 1990s not only must overcome the legacy of a decade of underinvestment but also must rely on businesses that are less able to finance new investment internally and a credit system that is less prepared to provide external financing. These impediments are no excuse for passively accepting continued economic stagnation. But they do limit the growth that our economy can realistically sustain in the future. The essential task is to restore our economy to the level of prosperity it is capable of achieving, both today and in the years ahead. Kidding ourselves about what we can achieve now will only lead us to adopt policies that will further stunt our growth.

What, then, can the new administration and the new Congress do to spur the American economy out of the lethargy of the past three years? Does 7.5 percent unemployment (and little prospect of substantial improvement any time soon) warrant embarking on a major fiscal expansion, leaving the government’s deficit as a problem for another day? Or would it be better to take steps now to narrow or even eliminate the deficit, thereby not only freeing up saving for investment purposes but also hastening the time when a flexible fiscal policy can return to the country’s economic arsenal? In short, what should we do and when should we do it?

The new administration would do well to keep several specific realities about fiscal policy clearly in mind as it considers how to resolve this dilemma.

The Role of Investment

The main reason why budget deficits are unhealthy is that they eat the economy’s saving and therefore starve the economy’s investment. If the government runs a deficit because it is undertaking genuine investment activities, the economy is a loser only to the extent that the new capital put in place by the government enhances productivity by less than would the private capital it displaces. By contrast, when the government borrows to finance noninvestment expenditures, such as private consumption by recipients of unemployment insurance or other transfer payments, or overseas military spending, there is nothing to replace the investment that the private sector then fails to undertake.

The Role of Unused Resources

When the economy has unused resources, it is possible to stimulate both consumption spending and investment simultaneously. For example, in the severely depressed conditions of 1982, when nearly 11 percent of the American labor force was unemployed and a postwar record share of US industry stood idle, President Reagan’s expansionary fiscal policy—particularly tax cuts—not only stimulated economic consumer spending but probably also led businesses to invest more by strengthening demand for their products. Only as the economy returned to near full employment, beginning in 1984, did the Reagan fiscal policy start to squeeze private investment. When the economy’s resources are significantly underemployed, the problem is not too little saving but too much.

The Absence of Credibility

Americans no longer have faith in government promises to maintain spending and avoid taxes now, while narrowing the deficit later on. President Reagan promised to do that in 1981, and in every year of his administration thereafter. President Bush made the same promise at the outset of his term. Various forms of the Gramm-Rudman-Hollings legislation calling for a balanced budget were supposed to enforce that kind of policy beginning in 1985, and again in 1987 and in 1989. Lack of faith in the ability of our existing mechanisms to achieve such an outcome was the driving force behind the Constitutional amendments requiring a balanced budget offered earlier this year by Senator Paul Simon and Representative Charles Stenholm (both Democrats). The widespread conclusion that even those measures would likewise fail to do the job was probably a major reason why, in the end, they did not get the votes needed for approval by Congress. Today the claim that a federal fiscal stimulus will only be temporary is hardly credible.

The Measure of Debt

From a fundamental fiscal perspective, the distinguishing feature of the Reagan-Bush era is that the US government’s outstanding debt has grown faster than the US economy. By contrast, from the founding of the republic until 1980 the government kept its annual deficits small enough that, apart from wars, the outstanding debt almost always grew more slowly than the economy. Because of wartime borrowing, at the end of World War II the government owed $1.03 for every dollar of US national income. By the time Ronald Reagan took office, the debt ratio had fallen to just 26 cents on the dollar. It is now 52 cents per dollar—exactly double. Under current tax and spending policies, the government’s debt will reach 62 cents per dollar of our national income by the end of the decade and keep on rising thereafter. (See the graph below.) It does not take a financial wizard to realize that a perpetually rising debt ratio, even during peacetime, produces an unstable situation that cannot persist. If we do not adopt new policies that will restrain the growth of our debt to within the growth of our income, at some point a financial crisis will do the job for us.

These basic realities lead, fairly directly, to some useful guidelines to steer fiscal policy initiatives in the new administration:

  1. The administration should recognize that any spending increases or tax cuts enacted next year are highly likely to be still in place several years from now, if not well beyond that. In selecting among the many possible measures that can stimulate either private or government demand for goods and services, therefore, the new administration should concentrate on actions that also help the economy move away from the trends to high consumption and low investment established by the policies of the past ten years.

Among direct spending measures, a focus on increasing investment should lead to programs that either add to our stock of physical infrastructure or improve our deteriorating education systems. Among potential tax cuts, an emphasis on restoring America’s shrunken investment rate means that any significant revenue-losing actions should be limited to measures specifically directed to increasing investment, like restoring the investment tax credit (presumably on an incremental basis). More fundamental tax reforms can also have a useful role. For example, if we replace the current corporate income tax with a business cash flow tax, we not only can increase incentives to investment but also can reduce incentives to excessive corporate borrowing, without any necessary loss of revenue.

  1. In following the first guideline, the president must exercise strong discipline to insure both that any new government spending programs will actually produce genuine investment and that any new tax cuts will in fact stimulate private investment. A major reason why Americans have become so skeptical of government spending initiatives in general is that pork-barrel creation of jobs and profits in politically connected industries and districts too often masquerades as useful spending—and fools no one in the process. It is all too easy to label as “investment” almost anything the government chooses to do, ranging from office construction to farm subsidies, to health care, to education support, to inner city social programs. Kidding ourselves about what we are doing, and why, will not help our economy. Increasing our genuine investment activity will.

The same point can be applied with equal force to potential tax reductions. There is a difference between genuinely effective incentives and giveaways. The evidence shows that investment incentives operating at the business level are much more effective in the United States than savings incentives operating at the personal level. Indeed, one of the strongest lessons of the last decade is that we do not know how to use tax policy to boost private saving. In the 1980s the real financial returns available to American savers rose by a sizable multiple of what advocates of tax reduction and tax reform used to say would be sufficient to increase private saving. Yet instead of rising, the saving rate fell sharply.

  1. An across-the-board tax cut has no place in a policy intended both to stimulate economic activity today and to redirect that activity toward investment in the years ahead. The evidence is clear that temporary across-the-board tax cuts have only weak effects on private spending anyway, while permanent ones primarily stimulate private consumption, not private investment. At the same time, because across-the-board tax cuts reduce government revenues, they mean more government borrowing, which absorbs a larger share of scarce private saving and hence leaves even less to finance needed private investment. Our spending on consumption is already at a record high level compared to our incomes, and has been so ever since the Reagan policy took effect.

What America needs is not more consumption, but more investment—in new factories, new machinery, new infrastructure, new research, and a better trained and educated work force. Both consumption and investment help put people back to work today, but investment will also pay dividends in the form of enhanced productivity, and hence a higher standard of living, for years to come.

  1. A desirable target for correcting the chronic fiscal imbalance of the Reagan-Bush years is to restore the ratio of government debt to national income to the declining trajectory that characterized nearly two centuries of US peacetime experience before 1980. By contrast, a minimal target would be to stabilize the debt ratio at its current level. Either way, in constructing this target it is important to include as outstanding government debt the IOUs now accumulating in the social security trust fund, just as if these IOUs were bonds held directly by the public. (The reason for having the social security fund accumulate an ever larger positive balance over the next twenty years or so was to fund in advance part of the retirement payments owed to the extraordinarily large group in our population—the postwar baby-boom generation—that will begin to retire around 2010. If we continue to use the social security surplus merely to make possible a larger deficit in the rest of the government’s operations, then either the baby-boomers will not receive the benefits they have been promised or the government will have to impose huge tax increases on the generations then at work in order to make good on those promises.)

A reasonable estimate of the real economic growth to which we can look forward during the remainder of this decade is perhaps 2.5 percent per year. If we are to hold price inflation to the recent 2–3 percent per year range, then our national income in nominal terms will grow at around 5 percent per year. The minimal objective of just stabilizing the debt ratio at its current level would therefore mean limiting growth of the outstanding debt also to 5 percent per annum. With $3 trillion of government debt now outstanding, 5 percent growth translates into an annual deficit of $150 billion. By contrast, the Congressional Budget Office now projects that under current tax and spending policies the deficit in the 1994 fiscal year (including the part conventionally hidden by the social security surplus) will be $281 billion, even if the economy is then at full employment. The minimal strategy therefore calls for cutting the deficit by $130 billion per year.

A more desirable goal would be to reduce the debt ratio. Under Reagan and Bush the debt ratio rose from 26 cents on the dollar of national income in 1980 to 52 cents today, an average increase of 2 cents per year. Just reversing that increase, so that after another twelve years the debt ratio will be back where Ronald Reagan found it, would mean limiting the annual deficit (again adding back the social security surplus) to just $29 billion—in other words, narrowing the annual deficit by about $250 billion. An intermediate strategy that would reduce the debt ratio only one half as fast as the Reagan-Bush policy raised it, and therefore require twenty-four years to get back to the 1980 level, would permit an annual deficit of $88 billion and therefore require cutting the deficit by about $190 billion.

These are large budget changes, even under the minimal strategy that would merely stabilize the debt ratio. There is no shortage of possibilities for cutting spending or increasing taxes in order to achieve deficit reduction on this scale; nor is there any lack of political debate over which choices would be the right ones for the country to make. Various groups offering a range of options have recently proliferated.1 The more useful among them have already laid out the basic choices to be made, such as how higher taxes—to the degree they are necessary—could be combined with unavoidable spending reductions; how deeply we could cut defense spending, and how to limit the government’s exponentially growing outlays for medical care.

In the end, these choices are about more than just arithmetic, indeed about more than just economics. They are political in the most fundamental sense and involve not only differing visions of the desirable role of government but countless practical choices over such matters as school lunches, the space program, law enforcement, highways, health care—and, to be straightforward about it, which industries and which interest groups get tax breaks and which don’t.

For the most part, they will be difficult choices. That is why the opportunity to make them comes around so infrequently. It is the job of the new president and the new Congress not to let this year’s opportunity pass by.

  1. Today, when the economy has substantial unemployed resources, is not the right time to carry out a full-blown program of tax increases and spending cuts designed to correct the government’s chronic fiscal imbalance. But it is the right time to enact such a program to be phased in over several years as the economy returns to full employment. Doing so will help eliminate the fear that once a renewed business expansion is under way, stimulative monetary policy might combine with a reckless fiscal policy to produce a new round of price inflation. Enacting a credible program to reduce the deficit would enable the Federal Reserve to adopt policies that are genuinely supportive of the recovery. Doing so would also help bring down interest rates in the bond and mortgage markets, where rates have remained high despite the sharp decline in short-term rates, because investors are (sensibly) discounting their concerns about future inflation as well as the strong likelihood of continued large deficits, and hence continued high real interest rates, in the future.

The program must be both real and credible—real in ways that the Gramm-Rudman legislation about the deficit was not, and credible in ways that the failure of Gramm-Rudman has made it much harder to achieve. How, in light of the accumulated baggage of our past failures, can we now go about addressing this problem?

More may be said in favor of a Constitutional amendment to limit the deficit than most sensible economists have yet admitted. But vague and unenforceable Constitutional amendments, like those offered earlier this year, are no more an answer than the not-so-vague but equally unenforceable mechanisms we have already tried. As I have argued before in these pages,2 simply enshrining the general concept of budget balance in the Constitution, without any firm notion of which revenues and expenditures must be officially included in the budget, is just an invitation to fiscal sleight of hand. And what happens when even the official budget does not balance? Which spending programs are cut? Which taxes go up? An amendment that spelled all this out in sufficient detail to be enforceable might well do some good. But so far no one has seriously offered such a proposal, presumably because inserting this kind of detail would alter the nature of the Constitution—and, some would argue, debase it.

The right answer to the deficit problem at this time is a legislative program, one that differs from our past efforts in at least two important ways. First, it will not be credible if it leaves the hard choices—which spending programs to cut, which taxes to raise—for future deliberation. Doing so would only guarantee that these choices are never made at all. Mr. Clinton and the new Congress are more able to make these choices, and more able to make them now, than either they or anyone else will be for a long time.

Second, because we are no longer seeking to solve our chronic budget problem in a strong economy, as Mr. Reagan and even Mr. Bush could have done, a legislated deficit reduction program will be more credible today if it links whatever spending cuts and tax increases it calls for not merely to the passage of time but to the recovery of the economy. No one would, or should, believe that the administration will actually carry out previously planned budget cuts if the economy weakens and even more Americans are out of work. If the administration said it would make such cuts in such conditions, it would only damage the program’s credibility. Making future deficit reduction explicitly contingent on a progressive return to full employment—that is, on the success of the initial accompanying stimulus program—is the best way to make it genuinely credible in today’s depressed circumstances. At the same time, the credibility of any program for economic revival will also depend on how honest the administration is about what “full employment” means. In the years immediately ahead our economy may simply be unable to generate the number of high-paying jobs we had not long ago.

Making hard choices about spending and taxes, combining short-run fiscal stimulus with long-run deficit reduction, linking the schedule of future budget actions to future economic performance—these would be unprecedented steps, at least within our country’s recent history. But the threat to our economy—indeed, to our society—represented by simply going along as we have for the last decade is sufficiently great to warrant, even to require, new forms of action. Meeting that threat probably represents for Americans the greatest economic policy challenge of our time.

This Issue

December 3, 1992