July 14, 2001
FINANCE & ECONOMICS
In the balance
MANY economists believe that America's economy has escaped recession and
may rebound in the second half of this year. But a new paper* by Wynne
Godley and Alex Izurieta at the Jerome Levy Economics Institute argues to
the contrary that large, unsustainable imbalances may make a recession
inevitable.
Mr Godley was among the first to argue that America's boom of the late
1990s was unsustainable, for two reasons. First, private-sector spending
was growing faster than income, causing a huge increase in corporate and
household debt. Second, America's current-account deficit had widened to a
record 4.3% of GDP. The current-account deficit has been much discussed by
other economists, but few Americans pay any attention to the private-sector
financial deficit.
The chart (see article) shows the financial balances of the three sectors
of the economy over the past 40 years: the external current-account
balance, the government's budget balance, and the private sector's
financial balance. This last (calculated as the disposable income of firms
and households, minus their spending) is also known as private-sector net
saving, since it is equivalent to saving less investment. By accounting
definition, private net saving and the budget balance combined must be
equal to the current-account balance.
The government's shift from budget deficit to surplus has been much
trumpeted. But far more dramatic has been the private sector's swing from a
surplus of 5.4% of GDP in 1992 to a deficit of almost 7% late last year.
Between 1960 and 1997, the private sector was always in surplus.
The unprecedented switch during the 1990s reflects the behaviour of
households more than of firms. As a result of it, household debt climbed
from 95% of disposable income in the early 1990s to 124% in the fourth
quarter of last year.
Mr Godley argues that private-sector net saving will eventually rise
sharply, as households repair their balance sheets, so driving the economy
into recession. Plenty of economists disagree. A flurry of recent papers
has concluded that the household saving rate, properly measured, is a lot
higher than official figures suggest. If so, fears of a rebound in saving
may be overdone (see article). But the problem is that these studies look
at gross saving rather than net saving (ie, minus investment).
Consider some of the supposed reasons why household saving is higher than
it seems. First, the saving rate as officially measured includes employers'
contributions to pension schemes, but pensioners' benefits from those
schemes are not counted in income. In recent years, large capital gains
have allowed many firms to take a holiday, paying out pensions without
making contributions. That means that household saving has been
understated. Yet if the figure was increased to allow for this, it would
also change firms' financial balance in the opposite direction (as the
increased pension benefits of households show up as an increased cost for
firms). Total private net saving would thus be unchanged.
Second, some have argued that household spending on cars and other consumer
durables should be treated as investment, not consumption, which would lift
gross household saving. Yet since this would boost both saving and
investment, private net saving would again be unaffected.
Third, it is argued that capital gains should be counted as saving. These
do indeed boost wealth, but can be drawn on only if households either sell
assets or borrow against those assets-and there are limits to both. Debts
have to be serviced out of income; if everybody tried to realise their
capital gains by selling shares, prices would crash.
The private-sector financial deficit is therefore a better measure of
sustainability than gross saving. Indeed, this measure is favoured by the
International Monetary Fund and the Bank for International Settlements. In
its latest annual report the BIS points out that, in the past, when a
country's private-sector net saving has fallen sharply below its long-run
average, this has always been followed eventually by a sharp economic
slowdown, as the private sector swung back into surplus and spending
slumped. Examples are Britain and Sweden in the late 1980s, and Japan after
1990. In the first quarter of 2001, America's private-sector financial
deficit shrank for the first time. Could this be the turning point?
What goes up...
The authors consider the likely future path of America's financial
imbalances. Using the latest projections by the Congressional Budget Office
for the budget balance and GDP growth implies that the private-sector
deficit would rise to 8% of GDP by 2006, with debt continuing to explode.
That is clearly unsustainable. Yet, at the other extreme, a turnaround of
the financial deficit is unlikely to be as severe as it was in Britain
after 1989, because high inflation then reduced Britain's scope to cut
interest rates.
America is likely to follow a middle path. If the private sector's balance
reverts to its historical average within three years, Messrs Godley and
Izurieta reckon that this would cause a recession this year, with annual
GDP growth in the five years to 2006 of only 1.1%. Even if the
private-sector deficit fell by only half, to 3% of GDP, annual growth would
average only 2% over the next five years.
To keep the three sectors in overall balance, higher net private saving
must be matched by either a fall in America's current-account deficit or a
swing in the budget from surplus to deficit. Forget about all those hopes
of repaying public debt.
* "As the Implosion Begins...? Prospects and Policies for the US Economy: A
Strategic View". www.levy.org.
Copyright © 2001 The Economist
Jim Devine [EMAIL PROTECTED] & http://bellarmine.lmu.edu/~jdevine
