The end of American economic supremacy?

By Hussain Khan

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It is beginning to appear that the events of September 11, 2001 have had such an impact that it could end American economic supremacy in the world. The peril to the US economy has been compounded by fiscal actions taken by the administration of President George W Bush.

The costs of fighting and occupation in Afghanistan and Iraq, reconstruction and relief after September 11, and homeland security combined over the next two years, are expected to explode. Bush has already requested an additional US billion for war funding alone. Administration tax cuts, according to the Congressional Budget Office, will cost the economy nearly three times as much as the costs of reconstruction and defense.

Moreover, these tax cuts are expected to rise to about trillion over the decade. That is assuming that the sunset provisions phasing them out are enacted. If, as seems likely, they are not, the 10-year budgetary costs of the tax cuts will rise by another trillion.

Bush wanted to follow on the footsteps of Ronald Reagan by relying on the theories of the supply-side economists, who believe that tax cuts generate so much additional economic activity that they increase government revenues. In his election campaign, Bush used tax-cut philosophy to appeal for votes. But the enactment of these theories is producing unforeseen negative effects rather than the positive qualities that the original supply-siders had assumed.

They had assumed that by cutting taxes, demand would increase due to surplus money available with the consumers for purchases. But this theory had already failed in Japan. Instead of spending, the Japanese simply increased their savings. The benefits of tax cuts were not cycled into the market to boost the economy, as consumers feared unemployment or business uncertainty. The situation is similar in the US today.

In a scenario changed by September 11, and after the administration's decision to invade Afghanistan and Iraq to attempt to round up terrorists, the strain on the American economy has been so tremendous that these supply-side theories have fallen apart. Uncertainty and unemployment fear has grown due to this scenario. Psychologically, as in Japan, consumers were not encouraged to increase their spending as the supply-siders believed would happen under the tax cut measures. Their benefits were confined to the well-to-do, who simply deposited the extra money instead of spending it.

The federal government enjoyed a projected 10-year budget surplus of .6 trillion when Bill Clinton left the presidential office. But the Bush administration is now confronting sizable annual deficits just three years later. Private economists now forecast a 10-year deficit of around trillion-.7 trillion, excluding the social security surplus. As a share of the economy, government debt and interest payments are expected to double over the next decade.

In a recent annual survey of the US economy, the International Monetary Fund (IMF) last month quoted a White House forecast that the federal budget deficit would explode to a record 5 billion in 2003 and then 5 billion next year. The IMF further quoted the Bush administration that the deficit - 50 percent bigger than that projected just five months ago – had been exacerbated by a weak economy, the Iraq war and a 0 billion tax cut package.

The deficit has thus increased more than 50 percent in just five months. This unforeseen increase is said to have occurred due to the Iraq war and the tax cuts. It actually shows that the tax cuts did not produce the results that the administration had expected. In fact, they were exactly the opposite.

The IMF notes two improvements in the US economy. First, its rate of economic growth was set to rise from 2.25 percent in 2003 to 3.5 percent next year. Second is the high growth in productivity, or output per hour work. As a matter of fact, the expected rise in the rate of economic growth is mainly due to the rise in productivity. If productivity growth were stifled, economic growth would also be affected negatively. And that is the factor about which the IMF has expressed concern in the following words:

"In particular, the worsening of the longer-term fiscal position, including as a result of the recent tax cuts, will make it even more difficult to cope with the aging of the baby-boom generation, and will eventually crowd out investment and erode US productivity growth."

That means that despite some possible improvements in a short-term scenario, the longer-term prospects are doomed to erode productivity growth and hence cut economic growth, leading to eventual crowding out of new investment, while the US has to face the challenge of an aging baby-boom generation. This is the IMF's final conclusion. It added two further worries concerning social security and medicare in the following words:

"The risks to the fiscal outlook appear especially worrisome given the significant actuarial deficit arising from the longer-term demographic pressures on the social security and medicare [health care] systems. As a matter of fact, this temporary increase in the economic growth rate and in the productivity is going to occur at the cost of dismissing hundreds and thousands of workers. It is the result of increasing unemployment, which was accelerated by the 9/11 events. "

The number of employed workers continued to decrease after September 11 and overstocked goods had to be cleared. This situation resulted in a temporary increase in productivity or output per hour of work and hence the increase in the rate of economic growth.

As the IMF has pointed out, this situation cannot continue for long, as interest payments to fund the budget deficits will erode savings and drive out new investment. Increasing unemployment can be expected to erode purchasing power and shrink the urge for consumption and hence decrease demand, in turn bringing about stagnation and stifling growth.

Not only the IMF but the Republican-controlled Joint Committee on Taxation as well, using a variety of dynamic scoring assumptions, was forced to acknowledge that these cuts are likely to reduce the economy's long-term growth. Explaining the reason as to why the committee has come to this conclusion, Laura d'Andrea Tyson, dean of London Business School writes:

"Any positive business-investment incentives from lower taxes will be outweighed by the curtailing of national saving and investment caused by mammoth budget deficits. To the extent that larger deficits diminish domestic saving, they eat into productive investment. To the extent that larger deficits are funded by borrowing from the rest of the world they raise the nation's foreign debt and drive future income into servicing this debt. Contrary to the claims of administration ideologues, larger deficits mean lower future living standards.

"The administration argues that its tax cuts are necessary to stimulate growth in a sluggish economy. But this argument is specious. The economy may have needed a temporary infusion of additional demand during the past three years. But temporary tax cuts or spending hikes for hard-pressed working families, unemployed workers, and state governments would have stimulated demand much more effectively than tax cuts for the rich."

The tax cuts were designed to increase demand and employment opportunities, but they have backfired. The average tax cut is said to be about ,000 per person. But half of the taxpayers will get a nominal tax cut of 0 only and one-third receive no benefit at all. The average refund is much higher because the benefit to the few rich taxpayers is very great. When more than half and the additional one-third do not benefit significantly from the tax cuts, how are those blessings going to come about that the supply-side theorists claim in the form of increased overall demand or in the purchasing power of the majority, while the number of the unemployed has peaked to a nine-year high level?

The increase in unemployment is a scourge in itself. A lot of companies like Enron and some airlines have been bankrupted. Those that survived dismissed a lot of their workers as a result of the September 11 events. The Clinton administration had created millions of new jobs and reduced unemployment to less than 4 percent. The events of September 11 reversed this trend. Unemployment is 50 percent higher than the Clinton administration figures, rising to a nine-year high of 6.1 percent. It has remained above that level for the last few months, despite slight negligible monthly adjustments.

The US had just emerged from recession in the beginning of 2001. But September 11 drove growth down again. Growth of at least 3 percent is needed to encourage hiring, say economists, but such growth has not occurred in consecutive quarters since the final six months of 1999. The economy grew only 1.4 percent annually in the first quarter of 2003. In an attempt to boost growth, the Federal Reserve cut short-term interest rates to 1 percent, their lowest level in 45 years.

The US Federal Reserve, the nation's central bank, said at the time that the economy was still weak despite previous cuts in interest rates. But the impact of September 11 was so strong that all these efforts by the Bush administration and the Fed failed to spur growth and create new jobs.

On the contrary, under the so-called jobless recovery, more than 2 million jobs have disappeared since Bush took office in January 2001, reviving memories of 1929 depression. Bush could be the first president since Herbert Hoover, who was in the White House from 1929 to 1933, the years of the Great Depression, to oversee a decline in total US jobs during his term. By contrast, 22 million jobs were created during the Clinton years.

With presidential elections looming next year, Democrats have focused on the economy as Bush's weak spot. Nancy Pelosi of California, the House Democratic leader, has described Bush's economic record as " trillion deeper in debt, three million fewer jobs".

As long as fiscal deficits continue to increase and erode savings and investment, there is no possibility of creating new jobs to significantly reduce unemployment. In addition to the increasing large fiscal deficits, unemployment, slow economic growth and falling living standards, other problems are hovering. One is in the form of the fall in federal revenues. Usually, with yearly growth, however small, revenues also continue to grow every year. But the war adventures of the Bush administration have reversed this historic trend.

In 2003, federal revenues are expected to fall to as far back as the 45-year-old level. The forecast is that the American economy will regress to the level of the 34th American president, Dwight D Eisenhower (1953-61). Federal revenues include a variety of sources of income, one of them tax revenue. If only tax revenue is compared, it is going to fall to about the 60-year-old level of 1943.

The present state of social security is such that one third of the dollars in this account have to be borrowed from outside, as internal revenues are not sufficient to cover costs. This is the largest share of deficit-financed spending in the past 50 years. This deficit spending is forecast to increase 0 billion by 2008. If no cuts are made in social security, medicare, defense and debt service, government spending on everything else - from education to homeland security - would have to be slashed by more than 80 percent to restore budgetary balance. The United States is in for a rough ride.

Hussain Khan holds a Master's degree in Economics from Tokyo University, and worked for a German bank subsidiary selling Japanese stocks to institutional buyers in Japan, the Middle East, Europe and the US. He is an analyst on current affairs and economic issues for various newspapers and magazines. Email: hk@ourquran.com