We’re Recovering, So Let’s Talk
Testimony before the Senate Banking Committee, March 12, 2002.

Mr. Malpass is the Chief International Economist for Bear Stearns.
March 15, 2002, 8:00 a.m.

As some of you know from my previous testimony before the committee, I am very interested in seeing higher living standards in developing countries and finding ways for the U.S. to support that process more effectively than we have in the past. One of the global economic features of the 1990s was the sharp increase in the U.S. share of world GDP. Part of this is a tribute to our economic system, but another part reflects the relatively poor economic performance in Japan and many developing countries. As we count our many blessings and work to make our own economy better for all, I think it is in our interest to also spend considerable time and attention working on an appropriate U.S. international economic policy.

I expect a broad-based U.S. recovery in 2002, with support from consumption, inventories, government purchases, and second-half strength in business investment. The U.S economy's natural tendency is to grow. The latest improvement in the outlook is justified by solid U.S. strengths — strong productivity growth and relatively full employment. In recent months, Americans have shown their optimism and their patience when confronted with adversity, traits that I think auger well for the recovery. After some recessions, growth accelerates to high levels early in the recovery due to pentup demand. I don't expect that pattern in this recovery. Unlike previous recessions, consumption continued growing during the recession. It grew 2.5% in the second quarter of 2001, 1% in the third quarter due to the September drop (shown on the graph), and 5.3% in the fourth quarter (quarter-over-quarter, seasonally adjusted annual rates.)

In many ways, the economy is reacting as if it is enjoying relatively full employment.

· For perspective, today's 5.5% unemployment rate compares very favorably to the 6.8% unemployment rate in March 1991 at the end of the last recession, and the 7.8% peak unemployment rate in June 1992.

· Relatively full employment helps explain the growth in consumption during the 2001 recession.

· Of course, I would like to see the unemployment rate substantially lower. Given the strong productivity growth taking place, it's clear that the U.S. economy will again be able to enjoy a sub-5% unemployment without it being inflationary.

After some recessions, home prices and residential investment strengthen. This time, I expect some downward pressure on home prices — the impact of falling prices in other
parts of the economy, lower prices for construction materials and labor, and a lagged effect from the very strong dollar (which puts downward pressure on almost all prices
over time.) However, the downward pressure should be cushioned by strong fundamental factors, including tax incentives, the relative value of houses versus other investments,
readily-available financing, demographics, and the economic recovery.

I expect residential investment to grow at only a 2% rate in the second half of 2002, after some weakness in the first half. I don't expect this sluggishness to have enough impact
on unemployment to be a major factor in the strength of the recovery.

Even though the recession seems to be over, there are still intense pressures in the economy. I think they reflect the aftermath of a deflation caused by dollar strength in the late 1990s. We should see a piece-by-piece recovery unfolding, meaning that some industries, companies, and employee groups have absorbed the shock while others are still in its grip.

In my view, the intensity of the corporate adjustment is pushing the economy quickly through the deflation process, bringing it closer to completion. This ability to digest mistakes and move forward is one of the hallmarks of the American system of business and labor flexibility and is a key factor in our strong long-term growth.

Corporate earnings will probably remain under pressure due to the continuing downward pressure on prices and the weakness in nominal GDP growth rates, especially abroad. Unlike previous declines in corporate earnings, 2001 profitability was depressed by both recession and deflation. As a result, the drop of profits has been deeper and has lasted longer than the average of the seven previous “profit recessions” .

As the U.S. recovery broadens, U.S. monetary policy will be faced with the questions: is growth itself inflationary and, if not, does it require a monetary policy response? In part responding to these questions, short-term interest rates have fluctuated over a relatively wide range in recent years.

My view is that inflation and deflation are more related to changes in the value of money than to economic growth. When a currency loses value, it puts upward pressure on prices. Likewise, when a currency rises in value, it puts downward pressure on prices. Since the dollar is very strong — as judged by its trade-weighted value, its value versus
commodity baskets and its value versus gold — I think there is more likely to be downward pressure on prices than upward pressure.

Even with a recovery, I think the CPI inflation rate will fall substantially in coming months, making an argument against a rapid increase in interest rates and bond yields. As a policy matter, I would like to see a more explicit recognition of the connection between the value of the dollar and the inflation or deflation rate. I think it is important for us to achieve stability in the value of the dollar as a step toward price stability.

Fiscal policy is obviously a very complicated subject, both from an economic and a political perspective. I would like to offer some general thoughts:

In their recent budget forecasts, both OMB and CBO used conservative economic assumptions. Both assumed 2002 growth rates well below the likely outcome and backloaded the growth to the second half of 2002. This had the effect of projecting a sizeable fiscal deficit for FY02, which ends in September. This was understandable given the perceived state of the economy at the time the budgets were prepared.

The budget now looks like it may be in surplus in FY02 and FY03 (and was already assumed to be in surplus in subsequent years.) This is the result of several factors: a shallower-than-expected recession in 2001; the remarkable change in interest rate policy in 2001; strong U.S. productivity growth, indicating a relatively high rate growth rate potential; and Congress's unusually well-timed tax cut in 2001.

The federal budget reflects tremendous growth in the spending and even faster growth in federal receipts. The graph below uses CBO's February forecasts for FY02.

The budget outlook is very sensitive to growth assumptions. No one is very good at forecasting growth rates in either the near-term or long-term. The trend in the 1980s was to over-estimate growth and under-estimate the fiscal deficit. The trend in the 1990s was the reverse — to under-estimate growth and over-estimate the fiscal deficit. These trends applied to both public and private sector forecasters.

I think the latter situation — a tendency to underestimate the growth rate — will be more applicable this year and next in that U.S. productivity growth will probably remain
strong, the result of business and labor flexibility.

Real GDP growth averaged 3.6% in the 1996-2001 period, including the 2001 recession. Given the shallowness of the 2001 recession and the ongoing strength in productivity,
economic growth in coming years is likely to also be strong. Even if we use an average growth rate of 3% going forward, the cumulative fiscal surplus is still large, as is the rate at which the national debt would decline.

If economic growth is as solid as I expect, the glide path for the pay-down of the national debt will be rapid and would not be good economic policy. In effect, our current policy is to levy a stiff level of taxation on the workers and the profitable portion of the private sector to pay off relatively low-cost federal debt. The effect is to improve the federal government's balance sheet while putting pressure on the public's balance sheet.

Given the economic recovery, Congress will probably revisit the 1990s debate about what to do with the fiscal surplus. In my view, tax cuts would help maximize the economic growth rate and gains in median incomes as well. In addition, I think a fiscal surplus, if it emerges, should also provide an opportunity for an improvement in the social security system.

I would like to comment on one recent debate — the issue of whether a fiscal surplus causes lower interest rates. The evidence does not support this conclusion. The 10-year bond yield rose to 8% by early 2000, even as the budget moved toward a large surplus. Over the last year, expectations turned from surplus to deficit, yet bond yields declined for most of the year. In recent days, bond yields have risen sharply despite the growing possibility of fiscal surpluses. As the graph shows, there is no real correlation between the fiscal deficit and the evel of bond yields. Instead, I think bond yields are related to the outlook for inflation, growth and the exchange rate.

I would also like to offer some comments on economic development abroad, something I have worked on extensively over the years.

The U.S. economic recovery is good news for foreign economies. It will probably spark a recovery in Europe and may even help Japan break out of its deflation spiral. Some developing countries will be able to participate in the global expansion, helping them raise their living standards.

However, I am worried about the polarization of the world economy, meaning the wide gap between the U.S. growth rate and growth rates abroad. With each new burst of U.S. growth in the 1990s, it became increasingly apparent that the U.S. was producing (and consuming) an increasingly large share of world output, reaching roughly 35% and climbing. In my view, it is important that developing countries grow faster and begin to narrow the gap in living standards. But very few are.

Over the years, I have advocated a rethinking of our international economic policy and the international financial institutions. I favor a vision of economic development based on stable currencies, lower tax rates, trade liberalization and a firm belief that people at the bottom of the economic ladder should be able to move up. I don't think these principles are applied frequently enough in our international economic policy. My worry is that world growth may remain substantially below its potential, with the shortfall coming disproportionately from the poor.

The likely U.S. economic recovery is very welcome, particularly given the war on terrorism and the turmoil in international affairs. The recovery provides an opportunity for thoughtful economic debate. My statement noted the importance of monetary policy decisions relating to growth and inflation; the fiscal policy decision in the event of renewed surpluses; and the opportunity for constructive change in our international economic policy.