Alan Greenspan's claim that additional stimulus--specifically in the form of the president's proposed tax cuts--is not needed is strangely inconsistent with the Federal Reserve Board's own description of a weakening economy. In its February 11, 2003, semiannual Monetary Policy Report to the Congress, the Federal Reserve Board that Greenspan chairs lowered its growth and inflation forecasts and raised its unemployment rate forecast for 2003 from the 2003 forecasts offered last July. The inflation forecast (based on something called the chain-weighted personal consumption deflator) was cut from a 1.5-1.75 percent range to a 1.25-1.5 percent range, thus suggesting that disinflation is continuing and moving dangerously close to zero. Avoiding inflation or deflation is supposed to be the primary target of monetary policy, yet the Fed chairman argues that no additional stimulus--monetary or fiscal--is needed. What is going on here?
The Economy Is Weak
The criticism by Greenspan of the president's tax rate reductions is the most serious of those he has voiced about the White House economic plans as a whole because many members of Congress take their cue from him on budgetary matters--despite the fact that his bailiwick is monetary policy. In his February 11 testimony to the Senate Banking Committee, Greenspan made three basic points. First, he argued that current economic weakness (growth was 0.7 percent in the fourth quarter of 2002 and has shown few signs of picking up so far this year) is due to "geopolitical factors." Specifically, uncertainty surrounding the impending war with Iraq is, according to Greenspan, the most important reason for weak spending by companies and households. This basic assertion led Greenspan to two other points. Stimulus--whether monetary or fiscal--at this point is "premature." Greenspan further suggested, along with some other colleagues at the Federal Reserve, that if the economy should fail to recover even after the onset or completion of hostilities with Iraq, additional monetary ease is always possible.
I cannot gauge the impact of geopolitical tensions on the state of the economy, but neither can Greenspan or anyone else. The sharp slowdown in the economy during the fourth quarter to a 0.7 percent growth rate from a much more robust 4 percent growth rate in the third quarter occurred at a time when geopolitical tensions had not risen as much as they have in the first quarter of this year. The little bit of experience we have with geopolitical tensions and the economy in 1990 and 1991, should make us circumspect about drawing firm conclusions regarding the impact of such uncertainty on the economy. In the fall of 1990, the economy was slipping into recession while the Fed was holding off on easing as the Congress passed caps on spending growth. With the onset of hostilities in January 1991 and after a very brief and successful conflict with Iraq, markets and the economy responded for a time, but then fell back as the United States experienced a prolonged jobless recovery during 1992 and 1993.
What about the argument that stimulus is "premature"? This is a remarkably complacent view coming from the head of a central bank that has cut rates by 525 basis points since the middle of 2000, only to see nominal GDP growth at the end of 2002 at 4 percent--less than half the rate normally evident seven quarters past a cycle trough. That tepid growth rate is too low to generate profit growth sufficient to support current earnings forecasts. Capital spending growth will languish until profit growth revives. Chairman Greenspan has consistently looked to capital spending as a sign that a sustainable recovery is underway, yet in his testimony he said, "we have yet to see convincing signs of a rebound in business outlays."
Greenspan added that household spending has been "reasonably vigorous," an odd assertion in view of his claim that geopolitical tensions are weakening the economy. It is also an odd assertion in view of preliminary reports we have on household spending in the first quarter. Same-store retail sales rose at a nominal 1 percent year-over-year rate in January while retailers are reporting failure to meet their sales targets during the first six weeks of the new year. Consumer confidence has slipped, perhaps in response to geopolitical tensions, but also perhaps in response to weakness in labor markets. During the seasonally volatile December-January period, employment continued to fall. In January hourly earnings were stagnant for the first time in many months, suggesting that employers are not hiring and, where possible, are capping wage payments to workers.
The complacency implicit in the "premature" view of economic stimulus for the U.S. economy in 2003 ignores the well-documented asymmetric risks that arise at the low inflation rates--below 2 percent--now being experienced in the United States by the Fed's own inflation gauge. No evidence whatsoever indicates that the economy is even close to overheating, and so additional stimulus at this time seems more like a prudent insurance policy (as President Bush has termed his tax rate reductions) than a risky venture (as implied by the Greenspan characterization of stimulus as premature).
Fiscal Stimulus Preferable to Monetary
If economic stimulus is not premature, which kind would be best? A strong case can be made that tax rate cuts and efforts to reduce the overreliance on equity finance implied by a double taxation of dividends are together indeed a prudent course at this point. Broadly, lower tax rates are an attractive form of stimulus because they contribute both to raising the potential economic growth rate by improving resource allocation and to the growth of demand by increasing after-tax disposable income. The result following the president's tax rate reductions in 2001 suggests that fiscal stimulus contributed a good deal more to growth over the last year than monetary stimulus. Between the fourth quarter of 2001, when tax rate cuts began to take effect, and the fourth quarter of 2002, GDP growth was 2.8 percent, with modest consumption growth and strong growth of government spending overcoming a drag from weak investment spending and falling net exports.
A closer look at the data suggests that last year's growth rate would have been closer to 1 percent without the contribution of the last round of tax cuts. Personal tax reductions contributed about $250 billion to the growth of disposable personal income between the fourth quarter 2001 and the fourth quarter 2002. Conservatively estimating, those lower taxes contributed between $150 and $200 billion or between 1.5 and 2 percentage points to GDP growth during 2002. There were no Fed rate cuts during 2002 until November, when the sharp slowdown in spending during the fourth quarter prompted the Fed to reduce rates by 50 basis points from 175 to 125.
The president's proposal to bring forward tax rate reductions already scheduled for future years, to end the double taxation of dividends, and to provide low-income households with increases in child care tax credits might, if enacted promptly, contribute between 0.5 and 1 percent to growth during 2003, although the high end of the range would require swift enactment and making tax cuts retroactive to January 1 of this year. That is modest stimulus indeed and, if anything, it should be increased by bringing forward the 2006 tax cuts to 2003 instead of 2004.
Ending Double Taxation of Dividends
Elimination of the double taxation of dividends provides little immediate stimulus to spending; it is not designed to do so. But it is particularly sound tax policy for a number of reasons that were obvious to most economists before the president proposed them. The current double taxation of dividends has produced three types of behavior that penalize the proper functioning of financial markets and the financing of capital outlays and ultimately the growth of the economy. The double taxation of dividends encourages overreliance on finance through debt. Debt finance requires firms to meet debt service payments, whereas equity finance enables firms to pay a flexible stream of dividends, thereby making it easier for firms with unstable cash flows to ride out business cycles.
The double taxation of dividends also encourages management to retain cash inside the corporation rather than pay it out as dividends, on the assumption that shareholders will be better compensated by the capital gains that accrue from management's supposedly shrewd use of retained cash to expand capacity. The combination of the stock market bubble and the subsequent economic downturn led by a collapse in investment is the best argument against the retained cash strategy. New technology companies that experience a surge in cash flow may not be the best judges of the need to further expand capacity in their area. Elimination of the double taxation of dividends puts pressure on management to pay out cash to investors and allows those investors to decide if they want to reinvest in that firm or elsewhere where prospective growth may be more promising.
Finally, some in Congress have criticized the president's proposal to end the double taxation of dividends because they say that few of their constituents receive dividends. This is like observing on a sunny day that few people are using umbrellas. The double taxation of dividends has indeed reduced dividend payouts, and so far fewer people are receiving dividends. Obviously, an end to the double taxation of dividends, while improving resource allocation, would also increase the constituency for better tax treatment of dividends.
Overreliance on Monetary Policy
During the question and answer period of his testimony on monetary policy to the Senate Banking Committee, Chairman Greenspan conceded that removal of geopolitical uncertainty may not result in a return to sustainable economic growth. In that case, the view he offered was that additional monetary stimulus would still be possible.
The notion that the U.S. economy will recover spontaneously after Iraq, and that if it doesn't monetary policy can restore growth, may prove as wrongheaded an assertion by Greenspan as his flirtation with the "new paradigm" view of the economy at the top of the stock market bubble. The fact is that the economy has been remarkably unresponsive to massive reduction in short-term interest rates over the past two years. Many point to the surge of refinancing as evidence that monetary policy has helped to stimulate the economy. Actually, the persistent weakness of the economy--in particular, profits and the stock market--has driven funds into the bond market, which, in turn, drove down long-term interest rates by enough for households to benefit substantially (up to $100 billion annually) from refinancing of their homes. In effect, the refinancing vehicle is a way for households to tap into the equity of their homes in a period when weak economic activity and falling inflation push down interest rates. Whether this will be a long-run benefit for the economy remains to be seen in view of the substantial rise in mortgage indebtedness as a share of house values that has occurred over the past several years.
Whatever the case, the success of further monetary ease in producing sustainable growth for the economy is certainly in doubt. Another refinancing wave would require interest rates on ten-year treasuries to drop to about 3.25 percent. That outcome will only occur if the U.S. economy enters a double-dip recession or if deflation intensifies. Neither event would be good for the economy nor evidence of the efficacy of further monetary stimulus upon which Greenspan would rely so heavily in the event of another economic slowdown.
The Wrong Policy Mix
The thrust of Greenspan's policy prescription to avoid a possible double-dip is to rely on a mix of tighter fiscal policy and easier monetary policy. That mix is a classic recipe for a sharp weakening of the dollar. I and others have suggested that a sharp weakening of the dollar might help foster a global economic recovery by increasing the pressure on central banks in Europe and Asia either to stop supporting their currencies artificially or to print more money. But it is not clear that a weaker dollar policy is one that Greenspan would, upon reflection, recommend.
An easier-money recovery effort that puts fiscal policy on hold and that sharply weakens the U.S. dollar would have the United States attempting to export another recession to the rest of the world. If foreign central banks resisted and continued to buy dollars heavily while sterilizing foreign currency intervention--the current situation--the weaker dollar would have little stimulative effect. On the other hand, if foreign central banks capitulated and let the dollar fall sharply, thereby curtailing their purchases of U.S. government notes and bonds, the rise in interest rates that Greenspan is so eager to attribute to larger budget deficits would occur along with higher inflation expectations in the United States.
The "prudent" course that Greenspan recommends--essentially, leave it to monetary policy--could result in a much larger rise in interest rates than would occur with the balanced tax cuts implied by lower tax rates and an end to the double taxation of dividends. Tax cutting improves both the supply and demand growth of the economy while more stimulative monetary policy operates only on demand. Beyond that, lowering tax rates is an effective way to impart the spending discipline on Congress that Greenspan wisely favors and supported in his testimony to the Senate Banking Committee.
Let's Hope Inflation Stops Falling
Is it Greenspan's fear of deficits and his belief that they lead to higher interest rates that heavily incline him to rely on monetary policy rather than fiscal policy to encourage sustainable economic growth? Ironically, the easy money, tighter fiscal mix carries with it more risk of higher interest rates through a sharply weaker dollar and higher inflation expectations than do the modest tax rate cuts proposed by President Bush.
This is not a very surprising conclusion when you think about it. Why should printing more money be as good for the economy as lower tax rates would be? Lower tax rates encourage more work and better resource allocation, thereby providing "real" stimulus for the economy whereas easier money can only stimulate demand growth, and in a period of chronic excess capacity, it has, unfortunately, been quite unsuccessful at doing even that.
If Greenspan wants to keep monetary policy on hold, that is his call. But to suggest at the same time that canceling further tax rate cuts of the sort that have contributed strongly to growth over the past year is ill advised. Stimulative tax rate cuts are needed now. If all goes well and growth does return to 3.5 or 4 percent, Greenspan will have plenty of room for complacency two years down the road when, we can all hope, prices actually start to rise again.
John H. Makin is a resident scholar at AEI.