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Economic Reporting Review

August 9, 1999

By Dean Baker

Federal Debt | Federal Budget | Inflation | The Dollar | Japan | Latin America | Outstanding Stories

FEDERAL DEBT

"For Treasury, an Embarrassment of Riches"
George Hager
Washington Post, August 3, 1999, page E1

This article notes the fact that the Treasury is issuing far fewer bonds and bills than in prior years, because the large budget surplus means that it doesn't have to raise much money by borrowing. (Even though it currently is running a budget surplus, the government still must borrow money to repay bonds or bills that come due this year.) The article points out that the declining volume of new debt issue can have a destabilizing effect on financial markets, since many interest rates throughout the economy are linked to the interest rates in the auctions of new government debt.

While this point is worth noting, the article does not discuss the much larger potential instability that would result from actually paying off the government's debt, as the Administration has proposed. As noted in another article this week ("The Dwindling Market in U.S. Treasury Bills," by Diana B. Henriques, New York Times, 8/5/99; page C1), banks, corporations and pension funds currently opt to hold a portion of their assets in U.S. government debt, viewing it as an absolutely secure investment. If the government actually eliminated the debt, they would no longer have this option. The Federal Reserve Board currently holds approximately $600 billion of government debt, which it uses to conduct monetary policy. If there were no debt, it would have to find some other mechanism through which to manage the money supply. These and other potential sources of financial instability merit examination if the elimination of the national debt is a major national priority.

"Government Plans to Buy Back Bonds and Save Interest"
Richard W. Stevenson
New York Times, August 5, 1999, page A1

This article reports on plans by the Treasury Department to buy back old bonds which were issued at high interest rates, and replace them with new bonds that will carry much lower interest rates. The article grossly misrepresents the potential interest rate savings from such a move by printing without comment an inaccurate statement from Treasury Secretary Lawrence Summers.

Summers is quoted as saying, "These prepayments--in many ways analogous to a homeowner refinancing a mortgage or a company refinancing its debt--would hold out the prospect of for reducing Federal borrowing costs over time."

The proposed buyback of debt is not at all analogous to refinancing a mortgage. In almost all cases, homebuyers have the option to pay back a mortgage in full at any time. (This is occasionally true of business debt, as well.) This means that, if the interest rate falls significantly, a homeowner can benefit by getting a new mortgage at a much lower interest rate. For example, if a homeowner took out a 30-year mortgage at 10 percent interest, and the next week the interest rate fell to 8 percent, the homeowner could refinance at the lower rate, and would only have to incur the transactions cost associated with getting a new mortgage.

By contrast, the government is obligated to pay the full amount of interest on the debt it issued. This means that if it issued a 30-year bond at 12 percent interest in 1980, it is obligated to pay 12 percent interest on that bond, until it matures in 2010. If it chooses to buy the bond back, as Secretary Summers proposes, the government will have to pay a substantial premium to current bondholders. If the current interest rate on 10-year bonds is 6 percent (approximately the current rate), then the premium on the 30-year bond issued in 1980 will be approximately 100 percent of its face value. This will eliminate virtually the entire interest savings the government would receive by buying back this bond before its due date.

The only savings the government might realize on such a buyback is through interest arbitrage. Some rarely traded older issues carry slightly higher interest rates than more frequently traded newer issues. The government can benefit by buying back some of these older issues and issuing newer ones that carry a slightly lower rate. However, the differences in these yields are unlikely to be more than a few hundredths of a percentage point. This means that if the government bought back $10 billion of these older bonds the annual interest savings would be in the neighborhood $3 million. This may still be a desirable policy, depending on the cost of carrying out the auction, but the gains will be a tiny fraction of what they would have been if the government could repay its debt in the same way a homeowner can repay a mortgage.

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FEDERAL BUDGET

"Senate Passes $792 Billion Tax Cut Plan"
Eric Pianin and Dan Morgan
Washington Post, July 31, 1999, page A1

"Senate Approves Big Cut in Taxes, Courting a Veto"
Richard W. Stevenson
New York Times, July 31, 1999, page A1

"Congress Chafing At Spending Caps"
Tim Weiner
New York Times, July 31, 1999, page A1

These articles report on the Senate's decision to approve a Republican tax cut plan. Neither article expresses the size of the proposed tax cuts as either a share of the federal budget or relative to the size of the economy. Without this information, most readers have little basis for assessing the true magnitude of the proposed cuts. (See ERR, 8/2/99).

The second Times article discusses polling data that suggest "that Americans want increased social spending more than they want a tax cut." This comment misrepresents the current state of the political debate. Under the baseline budget proposals, social spending will be cut when measured in either inflation-adjusted dollars or as a percentage of GDP. With Clinton's proposed additions, spending may stay roughly even when measured in inflation-adjusted dollars, but will still decline measured as share of GDP. The current political debate is therefore over the extent to which spending should be cut, not over whether it should be increased from current levels.

"GOP's Ax No Match for Pork Barrel"
Michael Grunwald
Washington Post, August 3, 1999, page A1

This article discusses recent spending patterns in a wide variety of domestic programs. It notes that spending in many areas targeted by the Republican Congress in the 1994 election has not decreased significantly. The article repeatedly refers to this spending as "pork barrel." Some of the items that fall into this category are summer youth employment and training, adult education, and trade adjustment assistance. The article does not indicate the criteria it uses to distinguish the legitimate functions of government from pork barrel programs.

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INFLATION

"Economy Continues Expansion"
Tim Smart
Washington Post, July 31, 1999, page E1

This article reports on the latest data on personal income and expenditures. It discusses the possibility that the economy may be growing so rapidly that it will lead to inflation, in which case the article twice asserts that the Federal Reserve Board will "have to" raise interests to slow the economy. While the Federal Reserve Board may choose to raise interest rates, this will be a decision based on its assessment of the state of the economy and its main priorities. It will always have the option not to raise interest rates.

It may opt not to raise interest rates, even in the face of somewhat higher inflation, if it places a higher priority on protecting workers' jobs than on keeping the lowest possible inflation rate. Also, to some extent inflation may be attributable to factors that are little affected by interest rates, such as the rising world price of oil. The Federal Reserve Board could decide that it would be wrong to deliberately slow the U.S. economy and throw people out of work if inflation edges upward due to such factors.


THE DOLLAR

"Alarm Sounds for Weak Dollar"
Paul Blustein
Washington Post, August 4, 1999, page E1

This article discusses the recent decline in the value of the dollar. The article begins "remember the laughably lame euro, the new currency of a united Europe whose swift plunge on foreign exchange markets humiliated its continental backers? Well that was last month's story."

While the article is correct in pointing out that there had been several articles last month and in the previous two months (see ERR, 5/31/99, 6/7/99, 7/19/99) reporting on the "humiliating" decline in the euro, the recent rise of the euro suggests that these earlier articles were ill-founded. In a system of floating exchange rates, currencies always fluctuate for random reasons. The fall in the euro did not reflect any of the underlying factors that would be expected in economic theory to lead to a weak currency, such as excessive inflation or a bloated trade deficit.

These earlier articles had attributed the weakness of the euro to slow European growth. While there may be some psychological reason why an investor would choice to hold a currency based on the growth rate of an economy, there is no theoretical reason that would warrant such behavior. Since the high value of the dollar was causing the United States to run trade deficits that will be unsustainable in the long-run, it was reasonable to expect the sort of reversal in the value of the euro that we seem to be seeing at present.

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JAPAN

"Empty Isles Are Signs Japan's Sun Might Dim"
Nicholas D. Kristof
New York Times, August 1, 1999, Section 1 page 1

This lengthy article discusses Japan's economic prospects for the next century. It's main theme is that Japan is facing serious economic problems due to a declining population and low productivity growth. The article's contentions are contradicted by basic economic theory and a large body of economic data.

While the article repeatedly asserts that the prospect of a declining population threatens Japan's economy, there is absolutely no reason to believe that this will be the case. One of Japan's biggest problems at present is that it is a very densely populated country. As a result, land is enormously expensive, forcing families to live in houses and apartments that are quite small compared to other industrialized nations. The projected decline in population discussed in this article would relieve some of the overcrowding and allow people to enjoy more living space on average.

A declining population may also be a boon in terms of dealing with pollution and, in particular, the problem of global warming. Under an international agreement negotiated two years in Kyoto, Japan, the industrialized nations will have to reduce their greenhouse gas emissions back to their 1990 levels by 2008-2012. It is likely that further reductions in emissions will be necessary if severe damage from global warming is to be prevented. If the population decline projected in this article proves accurate, it will be possible for Japan to meet targets for stable or declining emissions while holding its per capita level of emissions constant. In countries with growing populations, like the United States, it will be necessary to reduce per capita emissions, at some cost, in order to reach internationally mandated targets.

According to economic theory, a declining work force should lead to higher output per worker. The level of output per worker is determined by the capital/labor ratio. If the capital stock remains constant and the number of workers falls, then this will increase the capital/labor ratio, leading to more output per worker.

Another way of viewing this issue is that a declining labor force should lead to a labor shortage, as workers retire in greater numbers than workers are entering the work force. When there is a labor shortage, workers have their choice of jobs. This means that the least productive, and therefore lowest-paying, jobs are likely to go unfilled. As workers shift from less productive to more productive jobs, the average productivity of the work force increases. In this way, a labor shortage should lead to higher productivity and higher wages.

The article also includes comments about the relative rates of productivity growth in the U.S. and Japan that are contradicted by the economic data. For example, it asserts that "Japan's Total Factor Productivity, the broadest measure, is growing by only about half of 1 percent per year, much less than half the level of the United States." According to the most recent data from the Bureau of Labor Statistics, total factor productivity growth has averaged just over 0.1 percent annually since 1979.

Some of the statements in the article seem to reflect an extremely poor understanding of the functioning of a market economy. For example, it comments on the projected rise in the portion of the non-working population: "This means that simply for Japan to retain its present per capita income, each worker will have to increase output to make up for the growing number who are idle." While this is true, there are no examples of developed market economies, except those afflicted by war or natural disaster, where output per worker has not increased over any long period of time. In Japan, according to data from the OECD, output per worker has been increasing at an average rate of more than 2.5 percent annually over the last 20 years. If it can sustain this rate of productivity growth in the next century, then the impact of productivity growth in raising living standards will be more than 10 times as large as the impact of demographics in reducing living standards.

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LATIN AMERICA

"Deep Recession Envelops Latin America"
Anthony Faiola
Washington Post, August 5, 1999, page A1

This article reports on the recession that is hitting most of Latin America. The article asserts that "Latin America roared to life economically" in the '90s. A chart accompanying the article calls the nineties "a decade of spectacular economic growth." It is worth noting that many nations in Latin America have not grown much more rapidly in the '90s than in the '80s, and almost none have experienced "spectacular" growth, at least compared to that of other developing nations or their own past history.

For example, prior to the onset of the recession last year, Columbia's growth rate in the '90s averaged 4.4 percent, Venezuela's 2.2 percent and Brazil's 3.4 percent. These figures are not much better than their respective '80s growth rates of 3.6 percent, 1.1 percent and 2.7 percent. The current recession will virtually guarantee that all these nations' growth performance will be worse in the '90s than in the '80s.

Even the growth rate of best performers is unlikely to appear particularly good by the end of the decade. Argentina's growth is likely to average only about 3.5 percent and Chile's about 6.0 percent. By comparison, China's growth has averaged over 10 percent in this decade, and Malaysia's 8.6 percent between 1990 and 1997. In the period from 1960 to 1980, Argentina, Mexico and Brazil had average growth rates of 3.4, 6.8 and 7.3 percent, respectively.

The article also claims that "the economic situation is clearly more dire in nations that have yet to adopt free-market reforms." It does not indicate the basis for this assertion. A chart accompanying the article shows that Chile and Argentina, probably the two leading examples of economies that have undergone the reforms advocated in the article, have unemployment rates of 11 percent and 15 percent, respectively.

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OUTSTANDING STORIES OF THE WEEK

"The American Middle, Just Getting By"
Louis Uchitelle
New York Times, August 1, 1999, Section 3 page 1

This article examines the living standards of typical middle income households. It both presents statistical data on the income of the middle class over the last three decades and examines the lifestyle of four middle-income families in the Cincinnati area.

"House Cuts Could Force S.E.C. Layoffs"
Gretchen Morgenson
New York Times, August 3, 1999, page C1

This article reports on a provision in a bill approved by the House Appropriations Committee that would lead to a 7.6 percent cutback in funding for the Securities and Exchange Commission. The article points out that this cut would lead to a substantial reduction in S.E.C. oversight at a time when the volume of stock trading and new stock issues is soaring. In addition, stock trading is taking new forms, as Internet transactions account for a growing proportion of stock trades.

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Dean Baker is a senior research fellow at the Preamble Center and at the Century Foundation.


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