When the legendary British prime minister, Harold Macmillan, told his electorate that they never had it so good, he was talking about the UK economy in the 1950s. The same phrase could well be used about the United States today. Some simple facts do indeed show that the US economy has rarely, if ever, been better. To start with, it was the only G-7 country to manage a growth rate above 2% in real terms in the 1990s. Recent growth has been most remarkable of all, since the economy's average rate of increase has been 4% over the last three years. The sustained expansion has reduced the unemployment rate to 4.3% of the labour force, a level not seen since the second half of the 1960s.
Booming private consumption and fixed investment have been the main sources of this expansion. Households have stopped saving and boosted their spending instead. At the same time, spurred by falling computer prices, companies continued to increase equipment outlays. Such a rapid growth of private domestic demand has offset the slackening in exports. But inflation has declined. Against this, with imports surging as demand rose and exports falling, the current account deficit on the balance of payments rose and, for the first time in half a century, the personal sector has moved into financial deficit.
But can these good times continue? Every stock market dip is eyed nervously as the beginning of a terrible downturn, only to see the next day turning into the scene of another bull run. The small increase in official short-term interest rates at the end of June did not stop the markets' euphoria either. Indeed, it seemed like more-business-as-usual within a day. But there is a wisdom that what goes up must come down, which in the case of the US boom begs two questions: When? And how? Looking at the causes of the upturn may help us to come up with some answers.
What kind of productivity?
Three factors explain the excellent US economic performance: strong productivity growth, falling import prices and a marked increase in household wealth. Productivity is very widely seen as being one of the primary drivers of the boom, which is why great care must be taken in looking at it. Productivity has been boosted by a rapid increase in capital formation that has pushed investment to the relatively high level of almost 12% of the net real capital stock of the business sector, well above its peak in any previous cycle since 1945. To be sure, a higher amount of replacement capital is needed than in the past, because of greater expenditures on shorter-lived equipment. Nonetheless, the growth rate of the real net capital stock has picked up in the last few years, reaching rates not seen since 1979.
It is this type of strength which has led to the increase in the sustainable growth rate of the US economy to almost 3%. But what is particularly important to note is that the associated increase in labour productivity has mainly been associated with the boost in the amount of equipment, especially computers and related information technology, used by each worker. There is little evidence that the total productivity of capital and labour has accelerated. The significant gains in 1996 and 1997 can be explained by the cyclical upswing in the economy, but only a small part of the 1998 rise could be used to justify a trend increase.
The growth in labour productivity has meant that unit costs have not accelerated as quickly as wage hikes would indicate. Unit labour costs have been generally well contained, as nominal compensation has barely risen faster than above-average productivity increases. However, competitive pressures have been extreme and corporations have had to contend with falling prices in 1998 that have led to a decline in corporate profit margins.
This stability in costs leads us to the second factor accounting for the US economy's good performance, and that is the sharp fall in import prices. It is important because the fall has restrained inflation and so boosted demand. The import price deflator plummeted in 1998 after declining the year before, with the cost of oil plunging by one-third, directly shaving a quarter of a percentage point off the consumer price index. Commodities were particularly hard hit by the slowdown in world demand. Other import prices also fell, as the dollar appreciated, bringing the largest improvement in the terms of trade since 1983.
The third reason for the boom is to be found in the behaviour of US households themselves. Quite simply, consumers have lowered their saving rates because their balance sheets are in good shape. Although debt has risen rapidly, financial assets have grown faster, while holdings of tangible assets have accelerated too. The net worth of households has increased over 10%, at an annual rate, in the last three years, reflecting stock prices that have grown 23% annually. Households now hold almost a third of their financial assets either directly or indirectly in corporate equities -- up from a quarter three years earlier.
So, can it last?
Regrettably, not all of these positive factors can be expected to persist and slower growth is likely. Plant and equipment investment is expected to slacken as profits weaken and further surges in share prices become less and less likely. Consumer spending will slow too as a result. Despite this slowing in demand, inflation should pick up as oil prices rise from their historical lows and, so far, the exchange rate is little changed from its 1998 average, lessening the prospective fall in import prices.
These factors help to justify the OECD's outlook for US growth: that it should slow to 2% from the second half of this year and hold at that rate into 2000. Despite this slackening of demand, the current account deficit is expected to widen further, reaching 3.5% of GDP next year. Some increase in unemployment also seems likely, though it should still remain well under the OECD estimate of the equilibrium level of 5.5% of the labour force, leaving the economy operating above its potential next year.
No radical shift in policies
Monetary policy has helped keep up the momentum of the upswing. Interest rate cuts last fall averted a possible slowdown, helping asset prices recover. The forecasts suggest that the economy will indeed slacken with only a moderate pickup in inflation. However, if the recent strength of the economy were to persist, and if evidence emerges that the current weak inflationary situation cannot be sustained, then a case may be made for tightening monetary policy.
As for fiscal policy, it has exerted a stabilising influence on the economy in the past year. The general government account registered its second surplus in the past thirty years, resulting in net public debt falling to 42% of GDP from a peak of 47% in 1995. Policy decisions that checked the growth of spending played a role in this development, together with the higher-than-expected increase in tax revenues.
The five-year expenditure control programme agreed by Congress and the Administration in 1997 has now reached a crucial stage that will help determine the medium-term outlook for the budget position. Overall spending was allowed to rise somewhat at the start of the plan, but it will have to fall in nominal terms in the next three years to stay within the legislated spending caps. But spending cuts are difficult when times are good and the budgets are in surplus, since the political demands on the federal purse intensify. Measuring and, in many cases, resisting those demands for more money requires great determination from the authorities. But if Congress can stick to the President's budget proposal limiting the increase in discretionary spending to the inflation rate in the medium term, then net general government debt should fall to around 10% of GDP by 2009, down from its current level of 42%.
That is ten years away, but such a boost to national savings is a key part of the effort that is needed to meet the consequences of ageing in the next 40 years. The boom is unlikely to last forever, but acting on the budget now -- and in the way intended -- will help to ensure that there will be more good times in the future.
©OECD Observer No 217/218, Summer 1999