October 15, 2003

The 1990s Boom Was Interrupted

Ricardo Caballero of MIT believes that the U.S. was in the middle of a generation-long shift to a richer, higher capital-intensity growth path when the NASDAQ crash occurred--and that there is no reason to think that the United States cannot grow in this decade at the same boom-time rates at which it grew in the late 1990s:

FT.com Home US: ...the correct comparison instead is between the current capital-output ratio and the long-run equilibrium ratio under plausible conditions. If we follow the latter strategy, and assume that private saving remains at its (recent) historical levels, the conclusion is very different from that of the pessimists: the new equilibrium capital-output ratio should be about 1.6, well above the current 1.36. In other words, the 1990s boom still had energy when it was interrupted. What lies behind this jump in the long-run capital-output ratio? The accelerating decline in machinery prices, which is a consequence of technological progress in machinery-producing sectors. (Here I conservatively assume that the decrease returns to its historical trend, slower than that of the 1990s.)

But not everything looks so favourable. In the calculations above I assume that the sources of funding available during the 1990s remain in place. In particular, I assume that fiscal saving does not disappear and that external saving decreases only gradually. Are these assumptions warranted? If all goes well, the external side is less complicated than is generally thought. The $500bn in external financing that the US requires each year is a huge amount - but we are talking about the US at a time when the global alternatives are not very exciting or are too small to make a difference. Of course, the dollar may suffer turbulence in the medium run. This could happen if, for political reasons, the US keeps pressing China and other Asian economies to revalue their currencies; this would entail a fall in those countries' reserve accumulation, most of which is being invested in US government securities.

However, the real danger lies in the other source of funds: public savings. If the fiscal accounts - particularly for the medium and long term - are not improved, the whole benign equilibrium may collapse. In the capital output calculations above, I assumed balanced fiscal accounts. If we assume sustained fiscal deficits of 4-5 per cent of gross domestic product that are not compensated for by a one-for-one increase in private savings (which seldom happens), the new equilibrium capital-output ratio falls as low as 1.1. In this scenario, the pessimists are correct and the US has a large excess- capacity problem; the obvious corollary of this is a huge increase in the long-run interest rate.

The US economy is indeed a "tightly coiled spring", with plenty of growth potential - definitely enough for a very good second half of this year and beginning of next year, but also way beyond that. However, this opportunity will be squandered unless a much sounder fiscal path is credibly outlined soon.

Well, Ricardo believes that there is one thing that could disrupt the American economy's long-run growth: the Bush administration's lousy debt-generating fiscal policy.

Posted by DeLong at October 15, 2003 05:18 PM | TrackBack


I understand his point about the negative impact from public dissavings but is the term recent v. historical level of private savings confusing? Let me be specific. Over the 150 to 1980 period, wasn't the private savings rate above 9% but its recent levels are closer to 5% to 6%? What am I missing here?

Posted by: Harold McClure on October 15, 2003 07:34 PM

Well, there you go then. "Tighly coiled spring," hoo-hah. Replace one bubble with an even bigger one, sure. Bah. The Armageddon Boys have locked us in the hold and blown a hole in the hull. I continuously marvel at the reading of tea leaves while the deck slopes steeper and steeper. I want people to get MAD, not ponder.

Seriously, folks: what if all you educated fellows are too far into the Way Things Are (supposedly), with too much to lose (I've been there), to see what's coming?

On the other hand, maybe I'm too attached to melodrama. I read this blog all the time and probably have no business commenting on such distinguished, reasoned discourse. I've also waited for at least 30 years for this Grand Illusion to shrivel up and die and it hasn't yet. :-) Joke's on me. Carry on, and may the best man win. If only.

Posted by: John H. Farr on October 15, 2003 09:20 PM

Isn't the Bush plan to cut the deficit by half to 2.5% of GDP?

The Bush administration starts with an ideology that running a surplus is bad. To err on the deficit side does not bother them. They claim that models like Ricardos underestimate the economic stimulus from the lower tax rates, in spite of the lack of evidence to support the GOP belief.

Broder in the WaPo points out that all the Democrat presidential talk about rolling back the Bush tax cuts will not happen because the Democrats would first have to roll over DeLay and the GOP controlled house. Barring a revolt of fiscal conservatives, that will not happen. Whoever, is elected in 2004, we are probably stuck with collecting too little revenue for a while. The one bargaining chip a new administration might have is the AMT fix. There will be enormous pressure to fix it. A Democratic president could demand a revenue neutral fix and run up the top tax rates a little. Remember that the Clinton tax increase for the top rate had zero GOP votes in the house. The Clinton tax cuts (EITC, capital gains, etc) did gather some GOP votes.

Ricardo should work on refining his model for a 2.5 to 6% deficit. It is difficult to see a political dynamic that would return the US to surplus in the near future.

Posted by: bakho on October 16, 2003 06:29 AM

If one of the Democratic Presidential candidates could transform Caballero's argument into plain common sense English, they could advocate rolling back some of the tax cuts and it would be a part of a message of optimism. Borrow from Reagan. We want morning again in America! I think a figure like this (though better written) might just be the ticket:

"Some may doubt it but I believe the American economy is like a coiled spring waiting to be unleashed. But if this is so, why are we losing jobs every day and losing hope? The problem is that we have a sickness in the economy. The economists tell us we need healthy public and private savings to transform our economy to build the next stage, the greatest prosperity in American history. I believe we can do it. The new technologies are in place. We just need to harness them to industry. But, then, if this is so why are we stuck here, losing jobs and losing hope? It's not the people. The people are not the problem. George Bush government is the problem because his Government is digging the deepest deficits in American history. What they are doing is digging a hole that is draining our national savings, and draining the hope of the future. We can have morning again in America, but we have to balance the books."

Sorry about all the mixed metaphors.

Posted by: wetzel on October 16, 2003 06:46 AM

So Ricardo doesn't believe in Ricardian equivalence.

Posted by: Daniel L on October 16, 2003 08:52 AM


I think you are onto something. Dr. Caballero does appear to be assuming a 6% private savings rate and a 2.5% (or less) government deficit (as a share of income), which might be a generous assumption. In 2002 at least, the sum of private and public savings was near zero. It is indeed a generous assumption to run his model with a 3.5% or more national savings rate. So even under optimistic assumptions, the Bush fiscal fiasco leads to the dire conclusions reached by Dr. Caballero.

Posted by: Hal McClure on October 16, 2003 10:43 AM


The Decline of Corporate Income Tax Revenues - 10/16/03

Corporate income tax levels have fallen to historically low levels and are projected to remain at low levels even after the economy recovers. Yet Congress, despite these low corporate receipts and a sharp deterioration in the budget outlook, is considering significant new tax breaks for corporations.

Posted by: anne on October 16, 2003 11:21 AM

There is no chance given this radical Republican Congress that the structural budget deficit will singificantly lessen. Fiscal policy is the problem, and fiscal policy will stay the problem though productivity is terrific.

Posted by: anne on October 16, 2003 12:00 PM
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