Joseph Stiglitz and Pete Peterson: What's Wrong With the U.S. Economy and How to Fix ItPublished: December 01, 2004 in Knowledge@Wharton
In two separate talks at Wharton recently, Nobel prize-winning economist Joseph Stiglitz and Pete Peterson, chairman of The Blackstone Group, lamented what they see as the sorry state of the U.S. economy, and then presented their views on how to fix it. Not surprisingly, the answers offered by Stiglitz, former chairman of the Council of Economic Advisors under President Clinton, and Peterson, former Secretary of Commerce under President Nixon, have little in common, although both fault the Bush administration for failing to adequately address some of the country's toughest issues, ranging from Social Security reform and budget deficits to persistent unemployment and economic inequality.
Peterson, for example, argued that unless the U.S. stops running massive budget deficits and counting on other countries to finance them by buying its bonds, the country is headed for disaster. At some point, foreigners won't be willing to buy any more U.S. bonds, which could then cause a "crash landing - a sudden hard drop in the dollar and a big spike in interest rates, with grave effects on financial markets and the economy."
Peterson, who spoke last month at the Wharton Investment Management Conference, was also promoting his recent book, Running on Empty - How the Democratic and Republican Parties are Bankrupting our Future and What Americans Can Do About It. Peterson, former chief executive of Lehman Brothers, has debated these issues before. In 1996, he wrote Will America Grow Up Before It Grows Old, which dealt with the Social Security system's shaky finances, and in 1999, he wrote Gray Dawn, a book about the financial consequences of aging populations in the United States and Western Europe.
Peterson's current beef is with what might be called the "tax-cut-and-spend" mentality in Washington. Republicans - and Peterson remains a prominent one - want tax cuts, no matter what the costs, he said. President Bush, for example, has made lower taxes the centerpiece of his economic program, yet federal spending rises unabated with such programs as the recently-enacted Medicare prescription drug benefit and wars in Afghanistan and Iraq.
"Some people have forgotten that, though our military is stunningly effective, it's also stunningly expensive," Peterson pointed out. "It's very different from the good old days of World War II, when the military was a little bit like a federal jobs program - quick training of inexpensive troops with inexpensive equipment. In Iraq today, it costs $1 billion a week for two divisions conducting stability operations."
When lawmakers cut taxes but not spending and resort to borrowing, they are just pushing their bills onto the next generation, he noted. "[Economist] Milton Friedman used to remind us that a long-term tax cut isn't a long-term tax cut at all unless it's accompanied by a long-term spending cut. It's essentially a deferred tax, a tax increase on the future."
Democrats are just as guilty as Republicans, he said, although he concedes that the GOP has controlled both the White House and the Congress for the last four years. "Viewed historically, I believe it's fair to say that the Democrats have been the prime movers of the [fact that] federal benefits to individuals have grown six times, inflation adjusted," over the last 40 years.
Several trends, according to Peterson, make politicians' unwillingness to face up to the financial reality more troublesome than ever. Lately, the United States' current account deficit, mainly influenced by the trade deficit, has soared. In the 1980s, it was 3.7% of gross domestic product. Today, it's 5.7% and rising - a situation that has brought a rebuke from the International Monetary Fund, which usually counsels developing countries. "They are reminding us that normally 5% of the current account deficit is a danger point," he noted.
"We spend a lot of time in this country talking about the outsourcing of jobs. I wish we could spend more time talking about the dangers of the outsourcing of savings," Peterson said. The U.S. directly or indirectly absorbs about two-thirds of the current account surpluses of every nation in the world." At the same time, the industrial world is aging, which means that many of the countries the United States counts on to finance its debt soon will have to redirect their funds to tending to their own retirees. That will come at the same time as the retirement of the Baby Boomers here.
"The aging problem in the rest of the world is far more severe. Why? Because their birth rates are lower than ours, and they confront a big drop in young taxpaying workers. Italy and Spain have a birth rate of 1.2 [children per family], and it takes 2.1 babies to sustain population. Japan, because of its birthrate of 1.3, faces a drop in the number of taxpaying workers of 25% in the next 10 years."
Peterson's own record suggests that the aging trend may not be as worrisome as he predicts. He is in his 70s and still works full time. Besides writing books and chairing Blackstone, he also chairs the Council on Foreign Relations and the Concord Coalition and, until earlier this year, the Federal Reserve Bank of New York. Chances are, with advances in health care and longer lives, other workers may opt to stay equally active. Then again, he might add, they may have no choice.
What does Peterson think America should do to shore up its finances? Fiscal discipline in Washington is the first step, along with reform of both Social Security and Medicare. Regarding Social Security, he calls for a fundamental change - the elimination of the indexing of Social Security benefits to wage levels. This form of indexing means that the United States can't outgrow its Social Security problems with increases in productivity. As productivity rises so do wages, and under the current system, that drags benefits higher. "If we were to eliminate wage indexing, we would eliminate the unfunded liabilities of Social Security," he stated. Without action, lawmakers will eventually have to cut benefits or double payroll taxes.
Peterson also advocates the creation of mandatory national savings accounts to ensure that future generations have enough money for retirement and that the United States no longer has to depend on foreigner bondholders. The funds in these accounts would be managed by a private board and invested in index funds of global stocks and bonds.
Reforming Medicare would be even tougher, he concedes, because the federal health insurance program deals with questions of life and death. At the very least, President Bush should set up a panel of respected individuals, similar to the 911 Commission, partly to sort through Medicare's problems and possible solutions and partly to deal with the larger dilemma of the budget and trade deficits. "The American public needs a massive dose of truth telling," Peterson said. "German theologian Dietrich Bonhoeffer said that the ultimate test of a moral society is the world that it leaves to its children. When I think of how we're passing on unthinkable taxes and debts, and slipping our kids and grandkids the check, I say we are failing that moral test."
Tax Cut for the Rich
For Joseph Stiglitz, who also spoke at Wharton last month, President Bush's economic policies have not only failed to spur much growth but may have exacerbated a host of problems, including rising household indebtedness.
Bush's signature fiscal measure - a cut in the tax rate on corporate dividends - wasn't even originally intended to jolt the sluggish economy, said Stiglitz. Instead, it was a tax cut for the rich that the president dressed up as a stimulus when that became politically convenient. "They said that a dividend tax cut would lead to higher stock prices, and that would lead to more investment. Think about how the economy got into the downturn. It got there in part because of overinvestment."
Stiglitz, after chairing President Clinton's Council of Economic Advisers, served as chief economist at the World Bank, which lends to developing countries. After he publicly criticized the bank, and after the bank's president tried to quiet him, Stiglitz, who is known for being out-spoken, quit.
But given his reputation as one of the nation's top economists, his criticisms carry weight. He won his Nobel prize for research on the ways that information asymmetries distort the efficiency of markets. A famous example is used cars, where sellers know everything about their cars' histories, and buyers know little. In 1979, he received the John Bates Clark award, given to America's leading young economist. And he's the rare economist who tries to popularize the dismal science. Since joining Columbia's faculty in 2001, he has published two books for lay readers, including Globalization and its Discontents.
In his talk at Wharton, Stiglitz argued that President Bush had squandered an historic opportunity created by increasing worker productivity. When the economy is growing at its full potential, higher productivity raises living standards, he pointed out. When it's not, higher productivity becomes a double-edged sword. Companies can get by with fewer workers and may not hire. Unemployment then can rise. "In the last four years, we have failed the challenge of increased productivity and lost the opportunity it affords because we have not had enough economic growth."
Stiglitz estimated that a sub-par economy has cost the country between $1 trillion and $1.7 trillion over the last four years. His figures represent the gap between the actual and potential gross domestic products for those years. Had the economy grown at 3% a year, the country would have accumulated an extra $1 trillion in GDP over that time. At 3.5%, it would have piled up $1.7 trillion. "That could have been used to solve our Social Security problems, do something about health costs, improve our education system or fight another war, whatever your favorite use of the money," he quipped.
Instead, the economy has limped along, with the country losing jobs for the first four-year period since the Great Depression. "We should have created something like six million or seven million new jobs. In fact, we have lost net one million new jobs. The only part of employment that's growing is the public sector. The private sector is down 1.5 million."
In addition, the unemployment rate, at 5.4% in September, may understate the job problems, Stiglitz said. It doesn't include people who have become so discouraged that they have given up looking for work. And it fails to account for underemployment - that is, people who work part-time, often without benefits, but want full-time work. Even worse, the number of Americans receiving disability benefits has spiked over the last four years, increasing by one million or about 15%. "If you can't get a job, it's better to be disabled than unemployed. Disability pay is higher than unemployment compensation."
Because President Bush's tax cuts didn't do much for the economy, the Federal Reserve has had to repeatedly reduce the interest rates that it controls. Its cuts haven't induced much business investment. Here again, Stiglitz blames excessive investment in the 1990s. Companies, he said, don't want to borrow, even at low rates, because they haven't deployed the capacity they already have. Lower rates have contributed to a jump in real-estate values - perhaps even a speculative bubble - and a flurry of mortgage refinancings. "You are never sure about bubbles until they break," he noted. "What you can say is that the [Fed's] policy has resulted in a high level of risk."
Refinancings would seem to be an unalloyed good. In theory, they enable homeowners to reduce their mortgage payments. But many households are taking advantage of lower rates by adding more debt. "With a recovery, interest rates rise. And with the amount of debt, that's going to put a dampening on household budgets. It's already leading to increased bankruptcy rates, which are up 44% in the last four years."
Stiglitz concedes that President Bush has faced a host of challenges, from a recession to the Sept. 11 attacks to wars in Afghanistan and Iraq. And the President rightly has said that the economy would have been even weaker without his tax cuts, he added. "But no one, at least no one serious, said in 2001 that we should have done nothing. So that's not the right counterfactual. The right counterfactual is a different tax cut or set of expenditure increases."
Stiglitz would have pursued a four-part plan that aimed more benefits to middle- and working-class households. He would have expanded unemployment benefits to work as an "automatic stabilizer." If the recession had been milder than predicted, the government would have had to hand out less money. Likewise, had the slowdown been more severe, it would have paid more. "It gives the economy the amount of gas it needs." Having the federal government make up for recession-caused shortfalls in state and local tax collections would have adjusted automatically in the same way. "If the economy doesn't go into recession, it doesn't cost a penny."
As for taxes, Stiglitz would not have reduced them for wealthy Americans, who benefited the most from the President's reductions. Evidence from the '90s suggests that a tax cut targeted at the rich wouldn't help the economy, he said. In 1993, President Clinton raised taxes on the wealthiest 2% of Americans, and that didn't hurt the economy. "In fact, their incomes continued to grow."
Nor would Stiglitz have lowered the tax on dividends. Instead, he would have provided investment tax credits for companies. The dividend tax cut, he said, ended up exempting some dividends from any tax. Some corporations don't pay tax. If these firms pay dividends and those payments are tax exempt for shareholders, then the government never taxes this money. "So now the problem is zero taxation."
Stiglitz doesn't exempt President Clinton's policies from criticism. In 1997, Clinton, too, signed off on a tax cut that mainly favored the wealthy - he reduced capital gains taxes - in the name of economic growth. "I opposed that and thought it was a mistake. It contributed to the bubble by making speculation more attractive. And it, too, had little bang for the buck in terms of encouraging savings and growth. Most of the money went to people who had already made their investing decisions."
Even worse, that tax cut, like Bush's, came at a time of rising economic inequality in America. "We used to think of the Roaring '20s, the Great Gatsby period, as a period of growing inequality, and it was. The upper 5% had about 30% of the income. By 1969, that inequality was down to about 15.9%. The remarkable thing is that since then we've gotten back to the older levels of inequality. The top 1% of households owns 38% of the wealth."