My testimony has three parts. The first part discusses, rather broadly, the economic achievements of the past four years and analyzes the role that the policies of the Clinton Administration have played in producing this outcome. The second part of my testimony goes into more detail about the current state of the economy and our forecast for the upcoming years. The third part goes through the Economic Report of the President chapter by chapter, highlighting what I think are some of the more important contributions we make to the analysis of economic policy.
In 1992 the national unemployment rate averaged 7.5 percent. Almost 10 million people were looking for work. Over the last 4 years the unemployment rate has come down to 5.4 percent. Not only has the economy created more than 11 million new jobs, over 3 million more than promised, but the new jobs are mostly good jobs: two-thirds of recent employment growth has been in industry/occupation groups paying wages above the median.
Meanwhile underlying inflationary pressures have subsided. In 1992, inflation as measured by the core consumer price index (the core CPI excludes the volatile food and energy components) was 3.7 percent. In 1996 core inflation was only 2.7 percent. The combination of low unemployment and stable inflation has given the United States the lowest "misery index" since the 1960s (Chart 1)*. Some of the key factors contributing to the economy's increased ability to maintain both stable prices and low unemployment are analyzed in the second Chapter of the Report. Among the important ingredients are increasing competition and greater openness to the rest of the world economy.
Economic growth has been strong and sustainable. The economic expansion has been marked by a healthy balance among the components of demand. Private, not public, demand has been the engine of growth. The Administration's initiative to reinvent government has slowed the growth of the public sector. Private sector demand, by contrast, has grown at a 3.3 percent annual rate since the beginning of this Administration, up from 2.4 percent over the previous 12 years. It is particularly heartening to note that investment and exports have led the expansion. Investment is booming: real spending on producers' durable equipment has grown a stunning 10 percent per year since 1993. Not only has investment been a strong component of demand for the past 4 years, but the new structures and equipment that it represents will remain part of the Nation's capital stock, promoting growth and productivity for years to come. The strongest component of growth has been exports, which have increased by 8 percent per year since this Administration took office.
Just as important as today's conjuncture of growth, unemployment, and inflation is the question of whether the economy can continue to grow, with low unemployment and stable inflation. In terms of sound fundamentals, this expansion is one of the strongest in recent memory. In contrast, much of the growth of the 1980s and early 1990s was fueled by large deficits and a quadrupling of the national debt. This path of growth fueled by government spending could not have continued indefinitely. No less important, over that period changes in the tax system created perverse incentives that led to overbuilding of commercial real estate and high vacancy rates. Although investment rates were high, much of this investment did not enhance the long-run productive potential of the economy. Another factor that bodes well for this expansion to continue is the health of the financial system, which has finally recovered from the excesses of the late 1980s.
Not only has the economy grown rapidly and sustainably, but the fruits of that growth have begun to be shared more equitably. In 1995, the most recent year for which data are available, the poverty rate fell from 14.5 percent to 13.8 percent the largest one-year drop since 1984. Poverty rates for elderly and for black Americans reached their lowest levels since these data began to be collected in 1959. Not only have the incomes of every quintile of the income distribution increased, but the largest percentage increase has been seen by the poorest in American society. Median real household income rose 2.7 percent in 1995 and more if, as some believe, the CPI has been overstating actual inflation. The fifth chapter of the Report provides more details on trends in household income and the factors that may account for the recent decrease in inequality, which appears to be larger than the normal cyclical improvement.
Since 1993 this Administration has developed a comprehensive agenda that has contributed to the Nation's current economic health and strength. The key elements of this agenda were reducing the deficit, opening markets at home and abroad, and restoring prudence to macroeconomic management.
Reducing the Deficit
The Administration's most important economic policy accomplishment has been a substantial reduction in the Federal budget deficit. Since the 1992 fiscal year the deficit has been cut, not just in half as the President promised, but by 63 percent from $290 billion in 1992 to $107 billion in fiscal year 1996 (Chart 2). As a share of gross domestic product (GDP), the deficit has fallen over the same period from 4.7 percent to 1.4 percent its lowest level in more than 20 years. In 1992 the U.S. general-government deficit (the combined deficit for all levels of government) was larger in relation to the economy than the deficits of Japan or Germany were to theirs; today it is a smaller fraction of GDP than in any other major industrialized economy.
The dramatic decline in the deficit over the past 4 years is the result of many factors. By far the most important are the fiscal policy changes adopted in the Omnibus Budget Reconciliation Act of 1993 (OBRA93) and the stronger economic performance to which it contributed. Under the policies in place when this Administration took office, the 1996 deficit was projected to rise to $298 billion, even though the projection assumed 5 years of robust expansion.
Lower spending and increased revenues resulting from OBRA93 and subsequent legislation were responsible for more than $100 billion of deficit reduction in the fiscal year that ended in September 1996. The remaining budget savings are due to a combination of higher-than-expected tax revenues and lower-than-expected spending, which resulted from the stronger economy and a variety of technical factors unrelated to legislative changes. Many of these economic and technical factors are also the product, although less directly, of the Administration's policies including the policy of deficit reduction itself. Even though the Administration felt confident that its policies would significantly improve the economy, it continued to use conservative forecasts for budgetary purposes: growth in every year of this Administration has turned out to exceed these budgetary forecasts.
It is difficult to say with confidence what would have happened had the Administration not put deficit reduction at the top of its economic agenda and pushed through OBRA93. A controlled experiment on the entire macroeconomy is obviously impossible, but a simple analysis can provide some insights. We can say, first of all, that if deficits had continued at the levels projected in 1992, the Federal debt today would be half a trillion dollars higher than the $3.7 trillion currently held by the public. With so much more accumulated debt, and with higher deficits continuing, interest rates would certainly be higher than they are today. The more restrained fiscal policy helped create conditions that enabled the Federal Reserve to maintain a more expansionary stance, that is, lower short-term interest rates than it might have otherwise. It is hard to imagine that the rapid expansion of investment in producers' durable equipment that has supported this expansion could have happened in an environment of higher interest rates.
The effect of deficit reduction on business confidence has been less tangible, but no less important. Business confidence was weak in 1992: business leaders felt genuine concern about the mounting deficits and the political system's evident inability to address the underlying issues. Such anxieties are bad for investment. After 12 years of budgetary excess, however, this government has finally showed that it can bring its own finances under control. But confidence is something that has to be continually renewed. That is why this Administration is committed to continuing to reduce the deficit to zero.
In short, had the Administration not put deficit reduction at the top of its economic agenda, the Nation's debt would surely be much larger, and its economic future bleaker, than they are today. And it is unlikely that the economy would have experienced as healthy an expansion as it has.
Opening Markets at Home
Another cornerstone of the Administration's economic strategy has been an aggressive policy of reforming regulatory structures in key sectors of the economy, including telecommunications, electricity, and banking. In reforming electricity and telecommunications regulation, the Administration's belief was that the proper regulatory structure would enhance competition, which would lead to valuable new services and lower prices. Recent financial reforms have provided greater incentives for competition and innovation, in ways that have reduced the overall cost of regulation to both the government and the banking sector itself while preserving and enhancing the safety and soundness of the Nation's banks. On the environmental front, the Administration has shown that regulatory policies that recognize the importance of incentives can be both cheaper and more effective than traditional regulatory controls. Tradable permits for sulfur dioxide emissions are a prime example. The full import of these and other regulatory changes will not be felt for years to come.
Opening Markets Abroad
The third element of the Administration's economic policy has been an aggressive effort to increase exports through the opening of markets abroad. Two major trade agreements--the North American Free Trade Agreement (NAFTA) and the Uruguay Round accord of the General Agreement on Tariffs and Trade, which established the World Trade Organization--were enacted during the President's first term. The first major fruits of the WTO are now on the horizon, with the December 1996 agreement in Singapore to reduce tariffs on a wide variety of information technology products to zero. The United States will certainly gain, both as a major exporter of information technology and as an importer, as American industries take advantage of new foreign technologies that will lower their costs and increase their productivity. In addition, the value of NAFTA to U.S. exports was proved during Mexico's 1995 financial crisis. Despite Mexico's sharp economic contraction, NAFTA ensured that Mexico kept its markets open to U.S. products, in sharp contrast to the restrictive policies that had followed Mexico's 1982 financial crisis. As a result, U.S. exports were maintained, and by 1996 they had risen to new records. Mexico also benefited because NAFTA prevented any potential recourse to insular and protectionist policies; partly as a result, by the second half of 1995 the Mexican economy had started to recover.
Two other major regional groupings--our Pacific Rim trading partners in the Asia-Pacific Economic Cooperation forum and our Western Hemisphere neighbors have made commitments toward free trade among their members by 2020 and 2005, respectively. More than 200 other trade agreements have been completed since the beginning of this Administration.
As already noted, U.S. exports have boomed, especially in those areas where trade agreements have been reached. Increased trade allows the United States and its trading partners to exploit comparative advantage. These gains from trade are reflected in the fact that wages in jobs supported by goods exports are 13 to 16 percent higher than the national average.
Restoring Confidence in Economic Policymaking
Americans now have more confidence in their government's handling of the economy. Polls show that more Americans rated the conduct of economic policy favorably in November 1996 than at any time in the previous decade. This vote of confidence was the result of a number of factors. First, the government was putting into practice an economic philosophy that not only seemed to be working, but was in accord with the country's basic values. That economic philosophy understands that neither markets nor government can correct all the shortcomings in American society. Government has a place, but government has to know its place. The initiatives outlined above--from getting the deficit under control to securing the long-overdue passage of a new telecommunications bill--were proof that this philosophy could work.
Not only was the substance of economic policy viewed as a success; so was the process of policy development. The establishment of a National Economic Council (NEC) to oversee that process ensured that the economy would get the same attention within the White House that foreign affairs had gotten since the National Security Council was established nearly 50 years earlier. The NEC has effectively coordinated the inputs of the many Federal agencies, to ensure that the President receives the best options and advice, without setting agency against agency in wasteful internal turf battles. Also, the public differences between the Federal Reserve and the executive branch that had sometimes characterized earlier Administrations were replaced with a respect for the central bank's independence.
During the past year, the economy has been stronger than expected. Last February, the Administration projected that real GDP to grow 2.2 percent over the four quarters of 1996, and in July we revised up our forecast to 2.6 percent. This revision was not nearly optimistic enough: with last Friday's release, we now know that real GDP grew 3.4 percent over the four quarters of 1996.
But the road has not been smooth. Chart 3 shows that real growth was weak in the fourth quarter of 1995, and then recovered slightly in the first quarter of 1996. Several transitory factors account for that sluggishness: the two partial Federal government shutdowns in the fall of 1995 and the following winter, unusually severe weather in January, and a strike in March at General Motors. Much of the strong growth in the second quarter was directly traceable to the rebound from these factors.
Growth in the third quarter then slowed once again to a 2.1 percent annual rate as the consumer appeared to withdraw from the fray. A strong rebound in consumption, and a surprisingly large jump in exports, however, led to very strong growth of 4.7 percent at an annual rate in the fourth quarter.
As shown in Chart 4, price inflation measured by the total CPI--the solid line--edged up last year. But all of the increase is attributable to an acceleration in food and energy prices. Excluding these volatile components, the core CPI--shown by the dotted line in this Chart--moved down from 3.0 percent in 1995 to 2.6 percent for the 12 months ending in December 1996. This deceleration was somewhat surprising since the unemployment rate--shown in Chart 5--has been below 6 percent for more than 2 years. And as a result of the strong pace of activity so far this year, unemployment has hovered around 5.3 percent in recent months. Friday's employment report provided further evidence of a robust labor market with an additional 271,000 jobs and the unemployment steady at 5.4 percent. I discuss the reason the economy has been able to operate at higher levels of capacity later in this testimony, and Chapter 2 of the Economic Report contains a thorough analysis of this issue.
We have had strong growth despite fiscal policy that has been very restrictive--as shown in Chart 6. This chart shows that the standardized-employment deficit as a share of potential GDP--a standard indicator of our fiscal position--has fallen for four years in a row. Although the economic recovery has helped reduce the deficit, this chart shows that it has fallen substantially even when the level of activity is held constant. This fiscal restraint is likely to persist for a few more year as the President and the Congress are both committed to balancing the budget by 2002.
In reviewing the last year or so, I would like to raise an issue that relates not to the health of the economy but to measurement. (This issue is treated in greater detail in Chapter 2 of the Report.) Our measure of total real output derived from the spending side of the National Accounts (that is real GDP) has grown at a 2.1 percent annual rate over the two years ending in the third quarter of 1996. It is puzzling that precisely the same concept--called GDI for gross domestic income and measured on the income side--grew substantially faster--at a 3.1 percent annual rate over that period (we do not have GDI for the fourth quarter yet).
The issue has important implications for our assessment of productivity growth. Over these same 2 years, productivity grew at a 1.6 percent annual rate when measured on the income side (which had been the official procedure through last February), but only at a 0.3 percent annual rate when measured on the product side. The truth probably lies somewhere in between. But I am partial to the income-side estimates because of this year's revenue surprise. Tax collections this past April were well above projections. But even if one were to split the difference and say that the truth was halfway in between, then productivity growth over the past year has not differed from the 1.1 percent growth seen since 1973.
Let me now move from the past to the future, and focus more closely on the details of the economic outlook. I will begin with consumer spending. Consumption expenditures grew 2.7 percent in 1996. And almost all of the signs indicate that consumption will continue to be a leading contributor to the ongoing expansion.
The fundamentals for consumer spending remain very positive. Employment growth has been excellent and incomes are rising fast. The stock market boom has also contributed to a big run-up in wealth. As Chart 7 shows, the ratio of net worth to disposable income is now the highest it has been since the 1960s. Consumer confidence, measured by the Conference Board, rose to its highest level this decade in January. Consumer sentiment, measured by the University of Michigan, is also high.
The general soundness of the household sector is affirmed by the market for new homes. Housing starts have remained at a high level all through this year--despite a significant rise in the mortgage rate. December starts were off, but much of the decline attributable to heavy rainfall in the West. The recent decline in mortgage rates should continue to support housing starts.
The only sign of consumer distress is the recent rise in delinquency rates on consumer loans. But I believe that the rise in delinquencies says more about banking practices than about the financial health of the average consumer. A section on the Financial Condition of Households in Chapter 2 of the Report treats this subject extensively. In brief, over the past several years, banks have mailed unsolicited credit cards in much larger numbers. Many of these people may not have been financially qualified, and fell behind in their payments. For residential mortgages, the other major type of household loan, delinquency rates have declined recently and are near their lowest level in almost two decades. For the consumer, any concerns with liabilities are overshadowed by rapid growth of assets.
As it has been over most of the expansion, private fixed investment was a bright spot in 1996. Investment in producers' durable equipment was particularly robust, growing almost 10 percent over the course of the year--with computer investment being especially strong. The decline in the fourth quarter was due almost entirely to the auto strikes and a drop in business purchases of autos. The high-tech components of business investment, which are so crucial for future growth, continued to grow at a steady pace.
The long-term demand for business structures seems to be gaining in health; investment in nonresidential structures made an unusually large contribution to the extraordinary growth in the fourth quarter. Investment in this area is likely to continue as the market for office buildings works off a large excess supply that resulted from overbuilding during the 1980s. Finally, despite steady inventory investment, the inventory-to-sales ratio remains low. This is good news when we think about the future of this expansion.
I would like to focus now on the outlook for inflation. The unemployment rate has been below 6 percent now for more than 2 years. It fell during 1996 from 5.7 percent in January to 5.3 percent in December. As you can see from Chart 8, it is now slightly below the middle of a range that the economics profession would view as consistent with stable prices. Honesty to the tenets of statistics dictates that we should discuss the band of uncertainty about the natural rate-as well as its level. As can be seen, this band is rather wide. Despite the recent decline in unemployment, however, inflation remains stable. As a result, the economics profession is gradually revising down its estimate of the natural rate.
Some have pointed to the acceleration in wages and salaries as proof that we have reached the region of excess demand. However, wages and salaries are only one part of labor costs, and the growth of other fringe benefits, which consist mainly of health insurance and pensions, have slowed dramatically over the past few years. Most of the slowing has been in health insurance premiums. As a result, hourly compensation--as measured by the employment cost index--has increased only 3.1 percent during 1996--not much different from its rate during the previous 2 years. This pace for hourly compensation, less the 1.1 percent trend for productivity growth, implies that trend unit labor costs are increasing at a 2.0 percent annual rate. As Chart 9 shows, this is below the rate of recent price inflation, so at this point--despite the rapid decline in unemployment--labor costs are not putting any upward pressure on prices.
Now some have said that the slowing of fringe benefits costs, primarily due to health care premiums, may be temporary. So let us entertain the notion that wages and salaries are the best measure of the trend in compensation. In this case, trend unit labor costs would increase by the 3.4 percent rate of wage growth that we have seen recently, less the 1.1 percent trend rate of productivity growth that we discussed earlier--and results in a 2.3 percent estimate of the trend in unit labor costs. This differs little from 2.1 percent increase in the GDP chain price index seen over the past year. In short, wages could continue to rise at their recent rate--without putting pressure on profits.
The case against a near-term outbreak of rising inflation is even stronger. First, as already noted, slow growth in hourly benefits has been holding down labor costs and may continue to do so. Second, corporate profits are very high. Profits as a share of GDP during the first three quarters of 1996 (fourth quarter profits are not yet available) were higher than for any three-quarter period since the 1960s. Thus, profits could be a temporary buffer preventing accelerating wages from being immediately passed through to accelerating prices. Third, our statistical agency (the BLS) is in the process of fixing some problems that have overstated inflation. These fixes have already subtracted 0.2 percentage point from the measured inflation rate--and will lower it another two-tenths during the next 2 years.
So the outlook for the coming year looks to be one of continued growth with low inflation, led by robust consumer spending.
I would now like to turn to the slightly longer term outlook. Last week, the Administration released its new 6-year forecast, it is shown in the attached Table. Although we try to be as accurate as possible in making the forecast, because it is used for budgetary purposes we try to make our forecasts on the conservative side. As a result, in the first four years of the Clinton Administration real growth was always higher than expected and inflation and the deficit were consistently lower than expected.
Our forecast assumes that the President's proposal to balance the budget by the year 2002 will be enacted.
Over the next two years, real GDP is projected to rise 2.0 percent annually. Starting in 1999, the pace of growth is expected to rise to 2.3 percent annually--the Administration's estimate of the economy's potential growth rate. Our real growth assumption is very close to the consensus of Blue Chip forecasters for 1996 and 1997, and to the Congressional Budget Office's January estimate for the 1996-2002 period.
Consistent with our forecast of continued expansion near the economy's potential, we believe that inflation will remain low and stable. Last year, the rate of CPI inflation was elevated by rapid increases in food and energy prices. These prices are not expected to increase any faster than other prices over the next year, and so the rate of increase in the CPI is expected to edge lower--an average of 2.7 percent a year over the forecast horizon. The decline from current inflation also reflects the likely effects of technical adjustments to the computation of the CPI that have been announced by the Bureau of Labor Statistics.
Given the outlook for moderate inflation, we project the chain-weighted GDP price index to grow at 2.6 percent over the forecast period. Combining this with the real GDP growth figures leads us to project nominal GDP growth averaging 4.9 percent over the forecast horizon.
We project that the unemployment rate will remain low. We have revised down our long-term projections of the unemployment rate to 5.5 percent, from 5.7 percent assumed in the Midsession Review. This reflects the increasing evidence that the unemployment rate consistent with stable inflation has moved down a little.
The combination of low inflation and the movement to a balanced budget by the year 2002 will create a very favorable environment for interest rates. Short rates are expected to fall-with the yield on 91-day Treasury Bills leveling off at 4.0 percent. We also see the 10-year rate falling to 5.1 percent over the forecast period. Thus we are projecting that the term structure will flatten slightly to a shape that reflects the historical experience in periods of low and stable inflation.
I believe that the economic assumptions presented in this budget are sound and realistic, like the assumptions in previous budgets. And they are in line with the forecasts of the Blue Chip private forecasters and the Congressional Budget Office.
In the third part of my testimony I am going to outline what I see as some of the most important contributions made by each of the chapters in the new Economic Report of the President.
Many of the ideas and analysis in the Report all center around the theme of the role of government in the new era. This theme, which is woven throughout the document, is set out in the first chapter. This chapter explicates what will perhaps be viewed as the Clinton Administration's most enduring contribution, the formulation and implementation of an innovative economic philosophy.
In the past, two opposing visions of the American economy have vied for dominance. To put it starkly, one is a Panglossian view of an America of vigorous, self-sufficient individualism, the other of a world in which government is primarily responsible for our well-being. Over the past 4 years, this Administration has promoted a third vision, one that synthesizes and transcends these two polar worldviews. This vision puts individuals at its center, but it emphasizes that individuals live within and draw strength from communities. It recognizes that many have been left behind by the changing economy and may need government assistance, but that the role for government is limited: it can and should promote opportunity, not dependence.
This new vision includes a renewed conception of government, one in which government recognizes both the market's efficiencies and its limitations. The government can sometimes make markets work better, but it is seldom in a position to replace them. Government too has its strengths and its limitations. We need to understand those limitations and, where possible, work to improve government's performance. The government cannot ignore the role of market forces in its own programs: it needs to take advantage of the power of incentives to accomplish its objectives. The question is seldom whether government should replace the market, but rather whether government can usefully complement the market.
Over the years, economists have identified the various circumstances in which markets fail to produce desirable outcomes, and in which selective government intervention can complement markets. Competition may be imperfect, market participants may lack needed information, or markets may be missing. Would-be innovators and entrepreneurs may fail to capture enough of the benefits of their activity to justify their effort, or the users of resources, such as clean air and water, may escape the full costs of their use, degrading the resources for all. Although such problems may occur throughout the economy, it is important for the government to focus on those that are particularly severe. Like any successful enterprise, it must identify a core mission and pursue it.
Government's Core Economic Mission
Government's presence in the economy has become so pervasive that we can easily lose sight of its core mission. A few simple principles can serve as a guide to rediscovering that core mission.
The criterion for government involvement in any activity should not be how essential that activity is to the economy, or how many jobs it generates, or how much it contributes to the trade balance. In the overwhelming number of cases, the government cannot hope to surpass private firms at generating output, jobs, and exports. The proper question in circumstances where a choice between government and the market arises is whether any reason exists not to rely on markets. Is there, in the language of economists, a market failure?
The government should focus its attention on those areas in which markets will not perform adequately on their own, in which individual responsibility is insufficient to produce desirable results, and in which collective action through government is the most effective remedy. Americans are better off in a society in which individuals are encouraged to exercise as much responsibility as possible. But both economic theory and historical evidence indicate that, left to themselves, individuals and firms will produce too little of some goods like basic scientific research, and too much of others, such as pollution and toxic wastes. We also know that, without government assistance, many children from disadvantaged backgrounds may not be able to realize their full potential. Government social insurance programs have enabled individuals to make provision for risks that almost all individuals face and that, at the time the programs were launched, markets did not and still largely do not address effectively. Among them are programs that provide some insurance against unemployment, retirement benefits secured against the risk of inflation, and medical care for the aged.
It is essential to remember, whenever evaluating an existing government program or contemplating a new one, that the government cannot direct resources to someone without taking resources away from someone else. In a full-employment economy such as the Nation enjoys today and hopes to maintain, misguided subsidies pull resources away from more productive sectors and divert them toward less productive ones. Some individuals gain, but society as a whole suffers a net loss.
To prepare the economy, and the government, for the 21st century, we need to rethink and revitalize our policies to respond to the new challenges. We also need to strip away outmoded programs that respond primarily to problems of the past.
The second chapter of the report is discussed in the second section of this testimony, "Recent economic trends and the forecast."
Earlier, I discussed the tremendous steps taken over the past 4 years to reduce the deficit. As important as deficit reduction has been, there is general recognition that it will only have been a temporary palliative if we do not solve the long-term challenges associated with the aging of the population. Chart 10 shows the projected Federal expenditures under current policy for Social Security, Medicare, and Medicaid--all are expected to grow substantially over the coming decades. As the population ages, expenditures on Social Security are expected to grow from 4.6 percent of GDP in 1996 to roughly 6-1/2 percent in 2030, then stabilize. In the case of Medicare and Medicaid, if nothing is done to reform these programs, their outlays are projected to grow from 3.5 percent of GDP in 1996 to roughly 13 percent in 2050. Their projected growth is due not just to the aging of the population, as in the case of Social Security, but also to the expectation that the volume and intensity of medical services consumed will continue their rapid rise.
Chapter 3 of the Economic Report of the President describes the dimensions of the problem and also analyzes the consequences of proposed alternative solutions. There is no national consensus on long-term solutions to these challenges--witness the divided recommendations of the recent Quadrennial Advisory Council on Social Security--but I think that this chapter improves our understanding of the problem. In looking for a solution to the financial problems facing these programs, we need to be mindful of the contributions that these programs have made in increasing economic security.
Social Security
Without changing the current law in any way, Social Security can pay full benefits well into the next century. Thereafter, without any changes in the structure of the program, funding will be sufficient to cover about 70 percent of benefits 75 years from now. The President said in the State of the Union, "We must agree to a bipartisan process to preserve Social Security."
Proposals that have been made for Social Security contain different elements. We need to keep in mind that, from an economic perspective, programs that look quite different can have similar effects on, for example, national savings or on the rate of return to Social Security contributions, but different impacts on transaction costs and risk distribution.
Medicare and Medicaid
In contrast to Social Security, Medicare faces short-term as well as long-term financing challenges. Also, the long-run problems facing Medicare are not as well understood as those facing Social Security, and the possible solutions are more tentative. The sections of Chapter 3 of the Report on Medicare and long-term care within the Medicaid program pay considerable attention to two sets of economic issues; incentive effects and adverse selection. Incentive problems are particularly important because these programs involve a number of players (health care providers and private insurance companies in addition to tax payers and current beneficiaries). Adverse selection--sometimes referred to as cream skimming or cherry picking-creates incentives under many reimbursement schemes for providers or insurers to attempt to get low risk patients; in some cases, profits can be increased more by picking good risks than by providing services more efficiently. Some proposed reforms may exacerbate the potential for adverse selection, thus deflecting incentives in the wrong direction, while other reforms are intended either to reduce its scope or deal with its consequences. As we evaluate these alternatives, we will need to look closely not only at who is affected, but at the key economic impacts--impacts on incentives, on adverse selection, and on competition.
Chapter 4 explores the effects of changes in the economy, such as advancing technology and more competitive product markets, on the American labor market. Some have claimed that a fundamental change in the nature of employment has taken place, with expanding employment concentrated in low-paying jobs, falling wages, increasing layoffs despite a growing economy, and disappearing long-term employment. We present an empirical analysis of the best available data to determine whether these concerns are warranted.
The evidence suggests that the labor market is quite robust and that many of the claims about the deteriorating nature of jobs are exaggerated. A range of evidence points to labor market strength beyond the more common macroeconomic indicators of low unemployment and strong employment growth. Employment growth has been largely concentrated in higher paying sectors of the labor market and the rate of job loss has fallen, one measure is shown in Chart 11. Nevertheless, a few areas weakness persist: Some of the job growth has occurred in low-paying jobs. Chart 12 shows that, by a range of measures, wages have been relatively flat over the past 15 years (although this may be partially an artifact of upward bias in the CPI).
Policies have been put in place and have been proposed that should help reduce these costs. The unemployment insurance system, advance notice provisions, improved portability of pensions and health insurance, and proposed reforms to our reemployment and training services all help ease the transition between jobs. Improved access to education will also provide benefits over the long term.
The Chapter 5 of the Economic Report discusses the rise of inequality. As I said earlier, there is some evidence that the trend of increasing inequality may have been reversed in the last few years. Before discussing this, however, it is important to understand the causes of the increase of inequality itself.
Over thirty years ago, President John F. Kennedy commented that "a rising tide lifts all the boats." Indeed, the events of the decade preceding his Presidency and the decade following it supported this statement. The tremendous economic growth I discussed earlier brought increasing incomes for all families, including the poor. Income inequality fell dramatically. Evidence since the late 1970s, however, suggests that not all boats are necessarily lifted by a rising tide. Chart 13 shows how dramatically the situation changed: during the 1980s and early 1990s, more than half of the households saw their real incomes fall. If the CPI were biased upward there would not be as many losers in absolute terms. The relative picture that the richer the group the greater the gains would, however, be unchanged. Another metric for measuring the increasing inequality is the Gini coefficient which has been risen steadily since 1968 (see Chart 14).
What has caused this increased dispersion in household incomes? At least half of the increased inequality comes from increasing labor earnings inequality for men. Much of the trend in earnings inequality is the result of rising premiums earned by some classes of workers, especially the well-educated and high-skilled. The returns to education grew tremendously during the 1980s and early 1990s, as shown in Chart 15. In 1980, a male college graduate earned one-third more than his counterpart with only a high school education. In 1993 the college premium had grown to more than 70 percent.
There are a number of explanations for this dramatic increase in the returns to college. We can rule out changes in the supply of workers: with large increases in the college-educated workforce, supply effects should have decreased the premium. Instead, the most promising explanations center around increases in the demand for skilled workers. As new technologies have been integrated into the production process, firms have increased their demand for workers capable of using this technology. Evidence indicates, for instance, that workers who use a computer on their job earn significantly more than those who do not.
Skill-biased technological change can certainly account for the rise in earnings inequality between different groups. Interestingly, Chapter 5 shows that even more of the overall increase in earnings inequality is the result of more dispersion within groups that share the same education, experience, and demographic traits. Although there a number of creative theories that can explain increased differentials among seemingly similar workers, there is little empirical evidence on this very important puzzle.
From the early 1970s through 1992 the trend of increasing income inequality was clear and pervasive. Income statistics from 1993 to 1995, the most recent year for which data are available, provide tentative evidence that this trend may have been reversed. The poverty rate fell from 15.1 percent in 1993 to 13.8 percent in 1995, marking the largest two-year reduction in poverty since 1973. And this is based on the official poverty rate which is before taxes. If we include the effects of the Earned Income Tax Credit (EITC), the reduction in the poverty rate has been even more dramatic. Incomes at all points of the distribution have increased since 1993, and the gains have been largest for low-income households (this is shown in Chart 16). This is the first time this has happened since 1973.
The reduction in inequality can also be seen in the Gini coefficient which declined by more last year than in any year since 1968, again without even taking the EITC into account. These reversals, while dramatic, do not come close to undoing the twenty years of increasing inequality. Also, it seems rash to declare definitively an end to a twenty year trend based on two years of data. This is especially the case for a complex phenomenon like inequality whose causes we do not fully understand.
Still, some explanations for the reversal suggest that we are seeing the beginning of a new trend. Part of the progress is due to good macroeconomic conditions, in particular falling unemployment. The Report, however, suggests that poverty and inequality have fallen by much more than would be predicted from aggregate variables alone. More tellingly, the college wage premium has begun to fall (look back at Chart 15). This has translated into a narrowing of the earnings gap between the median worker and the workers at the bottom of the distribution. If this is the consequence of the increased supply of college graduates, we can expect to see further reductions in this premium in the future.
Both short-run and long-run policies are needed to help reduce income inequality further. In the short-run, the Earned Income Tax Credit (EITC) can help raise the incomes of workers with low earnings. In 1995, almost 3.3 million people were lifted out of poverty by the EITC. The recent increase in the minimum wage will further enhance the poverty-reducing power of the EITC. Ultimately, however, transfer payments can only mitigate the consequences of the market. To make lasting changes in inequality we need to address the distribution of incomes among workers. This can be accomplished by providing greater access to education and training programs that help create a more uniformly high-skilled workforce.
Traditionally, markets and government have been viewed as substitutes between which citizens and policy makers had to choose. However, this is a false and counterproductive dichotomy. Chapter 6 describes how markets and government can be seen as complements.
Judiciously crafted public policies can increase the role and effectiveness of market forces in the economy. Markets have tremendous and sometimes unheralded advantages in their ability to collect and distribute information regarding benefits and costs, and to base economic decisions on the efficiency with which resources are used today and in the future. Even here, government plays a role in protecting property, enforcing contracts, and deterring fraud. But insufficient competition, third-party side effects, public goods, imperfect information, and the importance of promoting equality and other social values mean that the government has an important role as well. In those roles, however, government can, should, and does exploit market forces to achieve its goals at least cost to taxpayers, consumers, and the affected industries.
The last year has featured two prominent examples of how government is promoting the reliance on markets. The Telecommunications Act of 1996 and the Federal Energy Regulatory Commission's Order No. 888 represent balanced steps toward promoting competition while providing safeguards against the exercise of monopoly power in local telephone and power distribution and, in the case of electricity, transmission as well. States are building on these initiatives to encourage the development of competition in retail electricity markets, and in facilitating interconnection arrangements that will allow new firms to compete in providing local telephone service.
Markets also complement governments goals. Trading of sulfur dioxide emissions permits has been an effective way to reduce the economic costs of improving the environment by abating air pollution. Similar methods could improve the efficiency of controlling greenhouse gases and other pollutants. Spectrum auctions have provided vast improvements in the speed and efficiency with which communications services are offered to the public--along with raising over $22 billion for the Treasury.
Market principles are at the heart of natural resource policy reform. Currently, uses of Federally owned land, primarily in the West, are often heavily subsidized and have caused significant environmental damage. As western State economies become less dependent on resource extraction, and as the nation's interest in protecting the environment has increased, we should be reducing subsidies and turning to market mechanisms, such as transferable extraction rights, to promote more efficient and sensitive land use.
There are proper limits to the role of markets in activities traditionally left to the government. However, government and markets should be regarded as partners, not competitors, in promoting efficiency and in helping policy makers serve the public at least cost to the taxpayer.
Chapter 7 discusses the three major changes in the global economy over the past several years. The end of the Cold War has led to an increased emphasis on economics in international relations. Over a longer horizon, the increasing importance of the East and Southeast Asian economies has been shifting the center of gravity of the world economy West, towards the Pacific. And over an even longer horizon, we continue to witness the globalization of the world economy, a shrinking of economic and intellectual distances through reduced transport costs and improved telecommunications.
As always, changes in the world of ideas parallel those in the real world. For example, the rise of Asia--with growth rates that dwarf those enjoyed recently by the West--has demonstrated that development is indeed possible, and has stimulated a heated debated within the economics community about the optimal policies for spurring development. The transition to the post Cold War world has not been a smooth one, and many of the old ways of thinking persist--with military metaphors extending into the world of trade, with the trade deficit replacing the missile gap as the object of concern.
Economic competition differs fundamentally from the kind of competition that characterized the Cold War. First, economic competition rests on an underlying cooperative structure of fair rules, as embodied in the World Trade Organization and the GATT before it. Second, and perhaps more importantly, international economic relations are clearly positive-sum. Trade promotes the living standards of all participants by allowing us to focus on those areas in which we are relatively productive. For example, jobs supported by goods exports pay about 13 to 16 percent more than the average job in the United States. During the nineteenth century, a substantial part of U.S. productivity growth was caused by the shift from agriculture to industry. Today, exports are our new frontier: shifting resources into export production will be one of the most effective ways of increasing productivity over the long run.
Recent trade developments, as discussed earlier, have been excellent. Indeed, the politics of trade policy may be changing, as more and more firms in America become increasingly dependent on exports -- and visibly so. Partly because of the new export constituency, and our commitments to help those adversely affected by trade, the past four years have probably seen the most important breakthroughs in opening up markets since the establishment of the GATT in the aftermath of World War II. The establishment of the North American Free Trade Area (NAFTA), the completion of the Uruguay Round, and the new APEC and FTAA are dramatic developments.
In order to consolidate and extend these gains, however, it is more important than ever for us to have a guiding principle to justify and evaluate our international economic role. Chapter 7 of the Economic Report suggests that we think of a central goal of international relations as the provision of international public goods and the mitigation of externalities, concepts that have been central in thinking about the role of government at the domestic level. It has long been recognized that the market, if left alone, will tend to underproduce these goods. Just as governments need to provide national defense, protect the environment, and finance basic scientific research, so international arrangements are needed for the provision of international public goods.
Chapter 7 discusses four important categories of such goods: international economic cooperation, peace and order, the environment, and basic research. These are all areas in which international cooperation can provide benefits to the United States, while also benefitting other countries. In the case of basic research, for instance, American exports of educational services (in the form of fees paid by foreign students to American schools) rivals that of wheat. In this environment, knowledge is spilling over in every direction. If nations choose to free ride off of each other's discoveries, the entire world will be worse off for lack of research.
Economic cooperation may be the most fundamental international public good of all. Development and security are one example of spillovers from economic cooperation. All nations benefit as developing countries grow. In addition, economic development may restrain political pressures within countries, increasing international security.
Return Home