[related materials: A recent talk (7/01); another 3 Bears talk (2/00); and An Older Talk (3/99)]
The Goldilocks Economy and the Three Bears.
Summary: The cheering of the U.S. economy's success should be tempered by the fact of private debt accumulation.
Loyola Marymount University
7900 Loyola Blvd.
Los Angeles, CA 90045-8410 USA
office phone: 310/338-2948; FAX: 310/338-1950
revised March 7, 2000
Many economists describe the U.S. economy as the "Goldilocks economy," one that isn't "too hot" or "too cold," but "just right." Though the boom on Wall Street is part of this happy circumstance, most people should see the Main Street economy as more important. The economy (as measured by gross domestic product, GDP) has grown rapidly, at about 4.3 percent and rising in 1999, despite the Federal Reserve's (the Fed's) hiking of interest rates steadily during the last 6 months. The economy's growth spurt has meant more hiring, driving unemployment rates below those seen in the last quarter-century, to about 4.1 percent of the labor force. Economists had predicted that such low unemployment would inevitably spark an inflationary explosion. But ignoring the rise in oil prices, the inflation rate has been low and stable. Finally, we've seen the economy's boom allowing increased tax revenues, helping the U.S. federal government to run a budget surplus of $124 billion in 1999. This allows the government to "pay down" its debt.
Many forget, however, that in the Goldilocks story our protagonist engaged in home invasion, theft, and property destruction. That is, it was costly to get where we are today, undermining the old economy of job security, safe pensions, and blue collar workers earning "middle class" wages. But even if we can forget this history, we cannot ignore the story's dénouement: the three Bears came back, chasing Goldilocks out of their cottage. Similarly, the "Goldilocks economy" faces the advent of Bears: the U.S. economy is living on borrowed money. We don't know when or if the three Bears will arrive. But their coming could cause a stock-market slump -- or be encouraged by one.
Before discussing the nature of these beasts, note how times have changed: we're no longer concerned with the government's debt, since government now runs a surplus. But other kinds of debt represent more serious problems, since unlike the U.S. federal government, individuals and private companies can go bankrupt, forcing them to slash their spending, while creating problems for creditors. This can break the current boom and delay recovery.
Papa Bear is the immense U.S. trade deficit. The high international value of the U.S. dollar has largely resulted from the U.S. boom in a generally stagnant world (since we buy their stuff but they can't afford to buy as much of ours) and from money flowing in seeking a "safe haven" in Wall Street. The high dollar may sound like a patriot's dream, but it has priced U.S. exports out of the world market and has allowed us to buy imports in mass quantities. This over-spending, which intensified during the Clinton years, has raised the U.S. debt to the rest of the world, magnifying the U.S. status as a net debtor nation. Credit market debt to the rest of the world rose from about 10 percent of GDP in 1990 to over 22 percent in 1999. In turn, this encouraged net property income payments to the rest of the world to double from 1.4 to 2.8 percent of GDP.
Unlike Mexico or East Asian nations, which have faced external financial crises in the past, the world allows the U.S. to pay its debts in its own currency, since the dollar is currently the world currency. The problem is that the rising external debt and interest payments that result from sustained trade deficits encourage confidence in the dollar to fade in favor of the Euro and the Yen, and a move away from the dollar standard. The Fed's Alan Greenspan may want to prevent a steep fall in the dollar's value by raising interest rates even more -- but that encourages recession. Alternatively, he may allow the dollar to fall as confidence wanes: this, however, would mean a rise in import prices and a revival of inflation.
Consumer spending (and its flip-side, low personal saving) is powering the U.S. boom, but Mama Bear approaches. This is the tremendous amount of borrowing that U.S. consumers are doing, getting deeper and deeper into debt: consumer debt rose from 86 to above 95 percent of after-tax income between 1990 and 1999. In 1999, household interest payments and the like have risen back almost to the record level hit in 1990. This rise occurred despite the fact that automobile lease payments aren't counted as debt service even though they play the same role. Whether one borrows or leases, skipping payments leads to repossession.
Why has consumer indebtedness risen? Following the famous "wealth effect," some are borrowing on the belief that the stock market is going to stay high forever. Margin debt to pay for stock-market speculation is also rising steeply, encouraging Greenspan to worry. But most are borrowing because they are having a hard time making ends meet, given the general stagnation of their incomes.
All this threatens to encourage bankruptcies at a time when Congress has passed a new tough-on-debtors bankruptcy law. (We should hope that Clinton vetoes the bill, as he has promised.) Shocked by rising interest rates, revived inflation, a slowdown in growth, or a stock market slump, consumers are likely to retrench and cut back on spending, encouraging a deep recession. In fact, this may happen simply because consumers decide that it's prudent to save more than the 2 percent of income, the current norm.
Baby Bear is corporate debt. After the recession of 1990, corporate debt fell because business has been quite profitable. But since 1994, corporate debt has been soaring, attaining 45 percent of GDP in 1999, even higher than its previous peak of 43 percent in 1990. Profit rates have stopped climbing, so that many companies have started borrowing again to finance expansion of their operations. They also borrow to buy back their own stock (encouraging the stock market to be high), which means that CEOs can cash in their stock options in a lucrative way.
Debt acquired to finance expansion is no big problem as long as the rest of the economy is doing well. But if the economy slumps, it encourages businesses to "down-size" their workforces and to cut wages to restore profitability -- rather than investing in new plant, equipment, and software. Corporate debt thus represents a barrier to recovery, making the Fedís job more difficult. Lowering interest rates when households and corporations are saddled with extreme debt encourages refinancing of old debt (as it did in 1991-92) rather the new spending needed to spur recovery.
Excessive private debt may push the U.S. into the kind of situation now faced by Japan, where half-hearted efforts to "jumpstart the economy" using public works have failed, driving well-known economists (such as M.I.T.'s Paul Krugman) to call for the deliberate creation of inflation to evoke recovery. This would have a depressive effect on the rest of the world, since the U.S. has been stimulating its markets by excessive importing.
But can Goldilocks clean up her act, avoiding ursine incursions? If the U.S. encourages the rest of the world's economies to recover quickly, that would allow the U.S. trade deficit to shrink, as they buy more of our goods. If the Fed allows recent rises in real wages to continue, that may avoid rising consumer indebtedness and bankruptcy rates. In fact, the recent dip in the bankruptcy rate seems connected with the cyclical upswing in real wages. But high wages are precisely what Greenspan seems to fear, since he has used labor-market tightness as an excuse for hiking interest rates.
Gradualism helps: a gradual decline of the dollar's value moderates any inflationary shocks, as does gradual attainment of consumer and corporate sanity about debt. Finally, a gradual fall of the stock market, as opposed to a sudden fall, will also moderate the end of the Goldilocks economy. Perhaps, as in some versions of the story, Goldilocks and the three Bears can achieve a compromise!
A recent talk that I gave on the state of the economy (7/01).
A Talk about Current Events (3/99)