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Last Friday’s news that U.S. economic output surged by 5.8 percent in the first three months of 2002 was welcomed by President Bush with guarded optimism. Although the economic rebound was greater than anticipated by many in the administration, not all of the news was good. Business investment, the key to the historic growth of the late 1990s, fell for a fifth consecutive quarter and consumer spending, which accounts for two-thirds of Gross Domestic Product (GDP), actually fell by 2.6 percent from the previous quarter.
As Philadelphia Federal Reserve Bank President Anthony Santomero has noted, much of the growth was caused by the most dramatic increase in government spending in 40 years. Following the 9/11 terrorist attacks, Congress authorized $40 billion in spending for redevelopment and increased military spending by 19.6 percent. So in many ways, to describe Friday’s number as a 5.8 percent increase in “economic growth” is misleading. It would be more accurate, although more of a mouthful, to describe it as a 5.8 percent increase in the most common statistical measure of the economy’s size.
Increases in government spending will increase GDP in the short-term because government spending accounts for roughly one-fifth of GDP. But since government must confiscate resources from taxpayers and debt markets to finance its outlays, government spending increases impede long run economic growth by misallocating resources that would be better utilized in the private sector. Thus, Friday’s news that the GDP increase was fueled by government growth was ominous news.
Cognizant of this fact, the Bush administration used the weekend to continue its push for Trade Promotion Authority and the permanent implementation of the tax cut passed last June. Uncharacteristic for an incumbent politician, Bush actually emphasized some of Friday’s bad news to make his case: Beyond the prolonged lull in business investment and more modest consumer spending, the stock market also shows signs of weakness and corporate earnings continue to disappoint. Last week, the Dow Jones Industrial average fell by 350 points and finished under 10,000 for the first time since mid-February.
Although stock market performance is often a useful indicator of underlying economic activity, many macroeconomists argue that this was the shortest recession in history because of the money lost by stockholders and venture capitalists. While no one would suggest that the $4 trillion loss in paper wealth helped the economy, the fact that the loss was not concentrated among banks and other lending institutions softened the blow. Commercial banks remained well capitalized through the stock market plunge and subsequent recession; when coupled with the easing cycle of the Federal Reserve, this allowed for strong growth in commercial loans for new homes, cars, and home improvements and appliances.
While healthy bank balance sheets and consumer spending kept the recession short and mild, the incentives to borrow and buy are beginning to peter out. Mortgage rates and car loans are edging upward, and much data indicates that the growth was largely a one-time response to attractive financing terms. Moreover, the slowdown in inventory liquidation by businesses – another one-time event – contributed 3.1 percent to GDP growth. During the recession, businesses cut output and offered huge discounts to rid themselves of higher-than-expected inventories. This process slowed in 2002 as unsold goods declined in quantity and businesses no longer felt the need to slash prices to rid themselves of inventories.
Things have improved, but by how much is anyone’s guess. If policymakers could possess enough information to enact policies to guarantee economic growth, the Soviet Union would still be alive and well today. But, with that in mind, here is a list of five policies the Bush administration should pursue to ensure that Friday’s optimism is not fleeting:
As long as these incursions on well-functioning private markets continue, so too will the current market dislocation, leaving market movements entirely unpredictable and unstable.
Friday’s growth figure may turn out to be an aberration caused by an inordinate increase in government spending and a slowdown in inventory liquidation, but if Congress and the administration pursue the above policies, a robust economic expansion could continue. By taking steps to relieve American entrepreneurs of unnecessary burdens and disincentives, policymakers could foster the very growth that they are so fond of taking credit for at election time.