*EPF212 10/01/2002
Text: Bush Adviser Hubbard Analyzes Global Flight from Stocks
(Uncertainty about U.S. economy, policy plays role, he says) (5000)

The shift away from stocks to safer assets such as bonds is global in scope, not simply a U.S. phenomenon, and reflects growing aversion to uncertainty and risk, says Glen Hubbard, chairman of President Bush's Council of Economic Advisers.

In September 30 remarks in Washington to the National Association of Business Economists (NABE), Hubbard said part of the uncertainty concerns economic recovery in the United States.

Another part concerns whether Congress will pass legislation proposed by Bush to make the 2001 tax cut permanent and provide terrorism risk insurance, exercising spending restraint, he said.

Countering higher aversion to risk by stock investors, he said, the president has cut tax rates, proposed more tax cuts and directed federal government money into basic research.

Hubbard cited evidence that higher productivity and low inflation continue to characterize the U.S. economy, boding well for continued expansion. Easy money-supply policy during 2001 from the Federal Reserve should continue stimulating the economy into 2003, he said.

"A mechanical assessment of investment factors suggests conditions primed for investment to begin to recover," Hubbard said. "The wild card, of course, is the timing and pace of this recovery, which likely hinges on the extent of business confidence."

He rebutted predictions that the U.S. economy would fall victim to a second recession, deflation or both. He said there was too much focus on the rising U.S. budget deficit, arguing especially against any proposal to raise taxes.

Following is the text of Hubbard's remarks as prepared for delivery:

(Note: In the text "billion" equals 1,000 million and "trillion" equals 1,000,000 million.)

(begin text)

Economic Outlook and Economic Policy Remarks Of
R. Glenn Hubbard
Chairman, Council of Economic Advisers
National Association of Business Economists Annual Meeting
Washington, D.C.
September 30, 2002

Assessing the Economic Outlook

It is useful to begin with the broad setting for the U.S. economic outlook and policies. Over the long term, productivity growth is the most important determinant of growth and living standards. The structure of an economy, including the institutional and legal framework that support markets, is the key influence on productivity and thus on the sustainable rate of economic growth. Historically, the U.S. model is an undeniable success in this respect.

In particular, the post-1995 boom in productivity growth in the United States stands out from other industrial economies. Most economists now agree that the trend rate of productivity in the United States rose markedly after 1995 ����- from 1.4 percent from 1973 to 1995 to 2.5 percent from 1995 to 2000 ����- probably due to long-awaited payoffs from the revolution in information technology. Productivity has continued to grow at an annual rate of 2.9 percent over the past six quarters, a period which includes both a recession and recovery, so recent data suggest that the productivity acceleration improvement remains intact.

Many have attributed this productivity acceleration to the development of new technologies. While this attribution carries a grain of truth, businesses around the world can all buy the same technology, so the roots of the U.S. advantage lie elsewhere. The U.S. model ����- a flexible, market-based system ����- provides rewards to entrepreneurial, private-sector investments that deploy these technologies in productive risk-taking. The preservation and support of these incentives is central to long-term productivity growth.

The recent behavior of inflation also bodes well for the long term. Inflation remains low and stable in the United States, with minimal impact on economic decisions such as the ability of businesses to plan for the future. The absence of inflationary pressures also means that the Federal Reserve would have policy room in which to maneuver in the near term.

Regarding the near-term outlook, as the Administration does not prepare another official forecast until the next Budget, I would like to walk through the expected mechanics of the current recovery and how recent data affect economists' forecasts of the recovery.

After three consecutive quarters of negative growth in 2001, the U.S. economy has experienced three consecutive quarters of positive GDP [gross domestic product] growth, peaking at 5.0 percent in the first quarter of 2002. While growth did slow to 1.1 percent in the second quarter, the rate is consistent with the now-familiar mechanics of the present economic recovery. The starting point for upward momentum is the legacy of aggressive monetary easing by the Federal Reserve during 2001. Over the course of that year, the Fed cut its target federal funds rate eleven times, lowering the target from 6.5 percent to 1.75 percent, with the most recent reductions occurring in December 2001. Given the well-known lags in monetary policy, these reductions will continue to provide stimulus throughout the remainder of 2002 and beyond.

Among components of final demand, solid consumption growth continues to provide the foundation of continued strength in the growth of GDP. Indeed, as is well known, the household sector has been a source of strength in final demand over the course of the recession and recovery. In addition to enhancing long-term economic efficiency, the tax cut proposed by the President and passed by Congress last spring provided valuable support for disposable incomes.

Substantial cuts in the target federal funds rate by the Federal Reserve have translated into lower mortgage interest rates, supporting housing starts and mortgage refinancing. The upshot has been solid growth in personal consumption expenditures and residential investment that are supporting the recovery.

In addition, growth in GDP has benefited from government purchases associated with enhanced homeland security and short-run inventory dynamics; the latter are estimated to have contributed 2.6 percentage points to GDP growth during the first quarter, and 1.4 percentage points in the second quarter. These factors are likely to continue to contribute a bit in the near term while there is little basis for expectation of dramatic aggregate demand growth stemming from the international sector.

Inventory investment contributed to the economic slowdown, but by early in 2002, the pace of inventory decline slowed, providing a significant boost to production. In some sectors of the economy, evidence suggests that inventory restocking is under way. Over the next several quarters, as inventory and sales growth come together, inventory investment's role in real GDP growth should provide momentum.

However, the key to transforming recovery into robust growth is the pace of business fixed investment. Only with robust business investment will labor markets firm and the economy return to robust job creation. It is not news to this audience that forecasting business investment is a risky proposition. Indeed, a recent summary of empirical research on the determinants of investment noted that the literature was "full of disappointments." Nevertheless, it is useful to do a brief survey of the state of the key determinants of business capital expenditure decisions.

The first is the current state of the capital stock. Over the past two years there has been extensive discussion of a "capital overhang" -���� excess supply of capital in place ����- as a major impediment to an investment recovery. Following growth rates averaging 4.1 percent from 1998 through 2000, the real capital stock grew only 2.9 percent in 2001, and is on track to rise only 2.5 percent in 2002. If there was a widespread capital overhang, and I note that in August 2001 only 23 percent of these responding to the NABE outlook survey agreed, could it still persist? It is possible to construct scenarios of this type. For example, if one believed that the desired capital-output ratio were a constant, and if it were at its desired value at the start of 2001, and if the output lost during the recent downturn will never be recovered (that is, the economy will return to the long-run growth rate, but never rise above it in the near term), then a capital overhang could still persist. However, there are a lot of "ifs" necessary to make this case (though narrow, sectoral capital overhang in areas such as telecommunications may persist).

The second place to look for insight into an investment recovery is the "price," or cost of capital, for which there have been several developments over the past year. Of course, interest rates have declined, reducing the cost of capital for debt-financed investments. Also, the recently passed "Job Creation and Worker Assistance Act of 2002" contains provisions to reduce disincentives to investment -���� specifically, 30 percent expensing. Businesses are permitted to deduct immediately 30 percent of the cost of new qualifying business investments undertaken in the three years starting on September 11, 2001. These tax-based incentives will lower the cost of capital for equipment and software investments. In the other direction, recent declines in equity markets worldwide suggest a rise in the risk premium assigned to investments in equity-financed capital.

How do these recent developments collectively affect investment incentives? To get a ballpark sense of the magnitudes, note that, in the simplest valuation model, the price-earnings ratio of the Standard and Poor's 500 depends on both the discount rate (equity rate of return) and the expected growth rate of earnings. Although the precise figures fluctuate, thus far in 2002, the roughly one-percentage-point decline in the price-earnings ratio can be "explained" by a one-percentage-point rise in the equity risk premium. Alternatively, one could appeal to declines in expected earnings. While earnings expectations have shifted during the year, using earnings forecasts available from Standard & Poor's indicates a one-percentage-point decline as well.

Roughly speaking, then, observable proxies for important equity market information suggests a range from no shift to a percentage-point increase in the equity cost of capital.

Turning to the other factors, combining interest rates, tax rates and depreciation, and inflation rates in the usual fashion allows one to construct a user cost of capital for corporate investment. Focusing on interest rates and tax parameters alone suggests a decline in the cost of capital on the order of 1.3 percentage points in 2002 (and over three percentage points since the start of 2000). Comparing this decline with the offsets in the equity cost noted above indicates that price incentives to invest have been neutral to positive over 2002.

Of course, another key factor is the availability of internal or external investment funds. There appears to be little evidence of a credit crunch impinging on investment funds from external sources. In addition, although still below their recent highs, corporate cash flow and profits appear to have rebounded from recessionary lows.

Taken as a whole, then, a mechanical assessment of investment factors suggests conditions primed for investment to begin to recover. The wild card, of course, is the timing and pace of this recovery, which likely hinges on the extent of business confidence. Most private forecasters anticipate that these factors will fall into line over the near future, with equipment investment recovering a bit sooner and quicker than investment in non-residential structures.

These mechanics describe a recovery in overall GDP growth along the lines outlined in the most recent (September) NABE survey. The median forecast showed GDP growth averaging 2.9 percent over the second half of 2002, and rising steadily from 3.3 percent in the first quarter of 2003 to 3.8 percent by the final quarter.

Of course, there are risks to such an outlook. For example, the decline in equity prices since the end of May ����- reflecting shifts in the equity risk premium and concerns over, among other things, profitability and the quality of financial data ����- represents a clear loss of household wealth. Indeed, the current business cycle is somewhat unusual in this regard. During a typical postwar cycle, household balance sheet positions are relatively stable while flows of personal income suffer and subsequently recover. In contrast, in the current cycle personal income ����- especially disposable personal income, supported by the tax cut ����- has held up quite well while household balance sheet positions have weakened.

Weakness in household balance sheet positions has raised concerns over the durability of the recovery. As is well known, consumption tends to lose three to five cents for every dollar of lost wealth. In addition, investment also falls because of the higher cost of capital. Combining these effects, a permanent loss of, for example, 20 percent in stock-market value ����- together with other macroeconomic interactions in a standard model, including any offsetting action by the Federal Reserve ����- would reduce the level of real GDP by roughly 0.6 to 1.0 percentage point after one year. While this is a significant impact, it would not overwhelm the upward path of the recovery. Moreover, the reduction in GDP would be a transitory event, with GDP returning to its former path after three years or so.

Some commentators have gone beyond acknowledging these "risks," instead arguing that consumers' financial fragility and deflationary pressures will undermine the recovery and lead to a "double-dip" recession. The basic thesis goes roughly like this. Looking back, the rapid rise in equity prices was the crucial component of the late-1990s economic expansion, yet was unwarranted by fundamentals. This bubble produced the economic boom by fueling consumer spending, which remained robust through the recession of 2001, and housing prices, which have risen sharply since 1997. In this view, these two features are linked in this view because homeowners have been extracting equity from their appreciating home equity in order to sustain their high levels of consumption.

Looking forward, in this scenario, consumer spending and housing prices will undergo inevitable corrections, and aggregate demand will fall. Because inflation in the United States is already low, the drop in demand could cause the inflation rate to fall below zero. The resulting deflation would squeeze borrowers by inflating the real cost of their debts, causing aggregate demand to fall further.

This seems to overstate markedly the likely case for the U.S. economy. As I noted at the outset, the late 1990s witnessed an acceleration in productivity ����- that is, a genuine improvement in economic performance. In addition, much of the price increase in housing in the late 1990s can be explained by two building blocks of the owner-occupied housing market ����- low interest rates and rising real incomes. While the price-rent and price-income ratios have risen, carrying costs of debt are still within historical ranges ����- families are buying the houses they desire and can afford. It is also difficult for a bubble to develop in that market because of the high transaction costs in the housing market. At the heart of a bubble are investors purchasing assets solely with an eye toward selling them at a higher price in the near future. This strategy is costly in the housing market because selling a house typically requires a move, with the attendant transaction costs (such as closing costs and transaction fees). I note as well that in the September NABE survey, nearly 80 percent of the respondents drew the same conclusion: Current levels of housing prices are not a bubble.

Moreover, the refinancing gains appear too small to be the pillar of the broad-based strength of consumption spending over the past several years. A study by the Federal Reserve Board estimated that the refinancing wave of 1998 and early 1999 added roughly $10 billion to consumption spending -���� against $6.2 trillion of consumption expenditures in 1999. Refinancing has also been high in 2001 and thus far in 2002, but the same lesson appears to apply. Freddie Mac estimates that in 2001 about $140 billion in equity was cashed out by holders of conventional conforming mortgages, with $50 billion cashed out in the first half of 2002. If a similar percentage of this equity is spent on consumption and home investment as in the earlier refinancing boom, the boost to consumption will be only a part of healthy consumption growth in these years. Instead, robust growth in personal incomes and lower prices ����- especially for automobiles ����- appear to be a more central feature of the sustained strength in household spending.

What about deflation? It is important to remember that deflation is a sustained decline in the general price level. The price level ����- measured, for example, by the core consumer price index ����- continues to rise at roughly 2 percent annually. It is true that the inflation rate for consumer commodities became negative 2001, but it has since changed direction and is headed for positive territory. Services inflation has stabilized at a little more than 3 percent per year.

Most private forecasters expect an increase in the inflation rate from 2002 to 2003 as aggregate demand recovers from the most recent recession. The September Blue Chip survey of private forecasters expects year-over-year CPI [consumer price index] inflation to be 1.6 percent in 2002, rising to 2.4 percent in 2003 as the recovery takes hold. Over the longer term deflation is ultimately a monetary phenomenon under the control of the Federal Reserve, which can easily combat deflation. Another potential risk is increases in crude oil prices. Oil prices have risen roughly $10 per barrel since the beginning of the year. The spot price of low-sulfur West Texas Intermediate crude has risen above $30 per barrel for the first time since February 2001 while the OPEC [Organization of Petroleum Exporting Countries] basket price index (which includes both high- and low-sulfur crude oils) has recently risen above OPEC's target band of $22 to $28 per barrel. A sustained increase in oil prices of $10 per barrel would be expected to lower GDP by about 0.25 to 0.50 percent after six months to one year. Larger increases pose a more substantial risk.

Some commentators focus on the return of U.S. federal budget deficits as a risk to economic recovery; indeed, in the minds of some, proposals to raise taxes become necessary.

Despite essentially no empirical evidence that moderate changes in budget surpluses are related to long-term interest rates, proponents of this view argue that increasing the budget surplus is the key to faster growth. In reality, these concepts are linked. However, the causal links are reversed ����- a stronger economy produces higher revenue and larger surpluses.

At present, the budget is on track to return to unified surplus over the decade, with the near-term shortfalls reflecting primarily the combined influences of recession, the need to prosecute the war on terrorism, and the demands of homeland security. In this setting, the greatest economic risk associated with the budget is failing to prioritize national needs and control the growth of spending. Spending discipline limits the need for growth-reducing taxes in the present and future. Pro-growth tax policies that lower marginal tax rates and reduce the tax on productive risk-taking are good long-run policies to build budgetary resources over the long-term.

Economic growth is a direct consequence of millions of individual decisions to produce, save, and invest. Any added tax burden today would be a step in the wrong direction. Of course, there are upside wild cards as well. An important recent development for the long-run growth outlook was the passage of Trade Promotion Authority (TPA) legislation.

Having signed TPA into law, the President has the authority to pursue an ambitious agenda of agreements to enhance global free trade, with benefits in the United States and the world economy.

Recalling Lessons of the Long Boom

One of the lessons of the past two decades is the centrality of private firms and markets in superior economic performance, their ability to drive innovation and growth, and the importance of maintaining vigilance against impaired market incentives. Deregulation, reductions in marginal tax rates, and victory in the Cold War fueled a long boom in the United States that was interrupted only briefly during the early 1990s. Despite the success of the long boom, during the 1990s, a new orthodoxy took root in Washington. While ostensibly adherent to market principles, this view placed the government at the center of good economic performance. A recent manifestation of this orientation has been the focus on accumulating government budget surpluses as the key, at times to the exclusion of good economic performance.

It is remarkable that we hear it suggested that growth-oriented tax policy might be making matters worse, and some urge its repeal. Economic growth is a direct consequence of millions of individual decisions to produce, save, and invest. Entrepreneurs are at the heart of this equation.

Recent research shows that cutting marginal tax rates allows entrepreneurial businesses to grow faster, enables greater purchases of capital, and allows small business to afford workers and increase payrolls. Reductions in marginal tax rates also improve access to capital and the vitality of the entrepreneurial sector. These impacts are not confined to the income tax. The estate tax acts as a tax on entrepreneurship. While entrepreneurs constitute a minority of people, they are three times more likely to be subject to the estate tax, making the tax a drag on asset accumulation and risk-taking in the economy.

One source of uncertainty is the specter of failing to make the tax cut permanent, and facing the diminished growth opportunities that would follow. Princeton University economist Harvey Rosen has estimated that the marginal tax rate reductions passed in 2001 will lower the efficiency cost -���� the "deadweight loss" or pure drag on the economy ����- by roughly $40 billion in 2010. To put this figure in perspective, note that it is about the same size as last year's tax rebate of $36 billion ����- and it would happen every year.

Returning to a less-efficient tax system reduces growth. Professor Rosen's results suggest that doing a U-turn on taxes would reduce growth by 0.15 percent annually ����- an impact that CBO [Congressional Budget office] projections would translate to $24 billion in 2010, but rise to $350 billion in 2020. The basic message is straightforward: Placing the future of pro-growth tax policy at risk raises the level of uncertainty and mitigates against rapid recovery and growth. The uncertainty may be removed by the simple act of making the tax cut permanent.

Some commentators argue that this misses an important offsetting channel to the extent that repealing the 2001 tax cut would promote growth by reducing long-term interest rates and stimulating investment spending. While this claim is generally asserted, some reflection is instructive. First, the tax cut must be repealed ����- including the 10 percent bracket ����- without any other legislative add-on. Second, Congress must actually save every dollar of the incremental funds. If so, the estimates of effects of changes in the government budget surplus on interest rates in recent work by Gregory Mankiw of Harvard University and Douglas Elmendorf of the Federal Reserve Board suggest interest rates would decline by roughly 35 basis points or so. I am skeptical that the effects of these changes in long-term interest rates on GDP growth are comparable to the direct incentive effects. The economics of pro-growth tax policy look good by comparison.

Emphasizing Productive Risk-Taking

I want to highlight one aspect of the lessons of the long boom that is of particular importance in the current setting ����- productive risk-taking. As I emphasized earlier, productivity growth is the fundamental determinant of long-run economic success. And productivity growth reflects the success of our economy in identifying, developing, and deploying new innovations and technologies. For this reason, capital allocation ����- channeling scarce savings to the right capital investments ����- is the key to efficiently using investment funds to generate productivity growth.

At the heart of this process lie our financial markets ����- the most efficient and flexible mechanism yet discovered for allocating funds to risky ventures. Financial markets serve the socially invaluable role of distributing investment dollars to the most promising firms and distributing the risk associated with investments to those most willing to bear it. In the aftermath of the recent accounting and corporate governance failures, the President and Congress have undertaken important efforts to improve the timeliness, completeness, and transparency of financial disclosure, which will serve to improve the performance of our capital markets.

However, at the same time we have witnessed a shift away from equity investments toward safer assets. While some commentators have focused on issues in corporate governance in the United States, it is important to recognize that this shift is global in scope. This argues against explanations that are specific to the United States alone, and is indicative of a rise in the risk premium associated with equity investments.

What is the source of this rise in the risk premium and how should it affect views of economic policy? To some extent, global markets may be reflecting greater risks associated with the economic recovery in the United States, which has clear implications for the worldwide pace of economic growth. Some of the underlying uncertainty also relates to policy. While Congress has finally passed, and the President signed into law, Trade Promotion Authority legislation, pro-growth policies like making the tax cut permanent, passing terrorism risk insurance, and demonstrating the spending restraint called for in the President's budget remain unresolved. To the extent that the commitment of the United States to pro-growth policies is resolved, this source of uncertainty may be readily resolved in the policy process.

However, the evident rise in the risk premium may reflect as well a rise in aversion to risk by equity investors. In light of the importance of productive risk-taking to economic progress, it is useful to ensure that policies reflect an appropriate "supply" of and "demand" for productive risks. The President has taken a leadership role in supporting the research, entrepreneurs, and firms that undertake risky investments. The largest Federal investment of research dollars provides a foundation of basic research on which innovation may develop.

Lower marginal tax rates and elimination of the death tax support the start-up, survival and growth of entrepreneurial ventures. Permanent extension of the R&E [research and engineering] tax credit will support new technologies. Expensing of 30 percent of new investment provides incentives to adopt new technologies and modernize facilities.

These policies reduce the hurdle rate of return for a new risky investment. Partial expensing of new capital investments has reduced the cost of corporate capital equipment by 2.4 percent. Lowering the marginal tax rates has a comparable impact on small business and entrepreneurs who file under the individual income tax. In each case, the impact of these policies has been to lower the barriers to investments in productive, if risky, activities. It is equally important to devote attention to the other side of the market for investment funds and to promote policies that support an ownership society with a broad-based commitment to productive risk-taking. Individual benefits to risk-taking reflect their social productivity.

Even with the most recent equity market downturn, the stock market remains above the long-run trend that prevailed in 1996 ����- before the large market run-up. And the return on equities for "buy and hold" long-term investors greatly exceeds "safer" bonds. For example, from 1929 to 1994, total real returns on 10-year Treasury bills averaged 1.7 percent. In contrast, the S&P yielded 6.5 percent ����- a risk premium of 4.8 percent.

An important aspect of reaping individual benefits from risk-taking is learning to manage risk. The starting point is investor education -���� an area in which the President has taken an important leadership role. On February 1, he proposed to enhance investor education of self-directed pension funds, a policy rapidly enacted by the House of Representatives. In addition to education, it is important to remove impediments todiversification and portfolio management.

As part of his proposals on pension reform, the President called for the ability of 401(k) participants to diversify away from company-specific stock after three years in a plan. More generally, it is useful to recognize that taxes both impeded the rebalancing of portfolios ����- capital gains are taxed upon realization, for example -���� and lower the after-tax return to risk-taking. These facts are a reminder that at the core of an ownership society is a reduction in the tax-based impediments to saving and wealth accumulation. In the near-term, it is desirable to make permanent the marginal tax rate reductions in the President's tax cut. Over the long term, the United States must continue down a path of fundamental tax reform that promotes saving, investment, and international competitiveness.

Extending Pro-Growth Policies to International Economic Policy

Let me close by noting that the President is engaged as well in enhancing the globalization of productive risk-taking and the philosophy of an ownership economy. A longstanding question in development economics has been succinctly put by Nobel Prize winner Robert Lucas, who asked why capital does not seem to flow to the poorest countries. After all, in such countries, with investment and growth at very low levels, marginal returns to capital accumulation would likely be high, so capital should flow in from richer countries. Also, domestic citizens in those countries should save and allocate their saving to these same high-return projects.

An important piece of the puzzle is that developing financial capacity for growth is more complicated in practice than in theory. Clearly defined rules of law, accounting, and investor protection are required to make external financing by firms, investment, and growth possible.

These linkages are important; research by economists has identified large effects of "good governance" on the cost of capital, investment, and growth. Simply trying to attract foreign capital via efforts at financial liberalization or aid that ignore this critical link to building private-sector financial capacity is unlikely to generate growth.

Likewise, in discussions of emerging markets, it is essential to observe that economic growth is the key to improving living standards. Economic growth does not appear like manna from heaven. Instead, pro-growth policies are important. Over the long term, good policies are needed to achieve growth. Proper domestic policy choices are not only in the direct interest of individual countries but are required for assistance from international financial institutions to be useful. The central economic policy issue is not how to use international financial institutions to provide assistance but to ensure that policies promote economic growth.

The President's international agenda ����- global free trade, Millennium Challenge Accounts, and emerging markets strategies ����- place an emphasis on building the infrastructure for capital markets that improves both the response to inflows of capital and the capacity for domestically generated growth.

(end text)

(Distributed by the Office of International Information Programs, U.S. Department of State. Web site: http://usinfo.state.gov)

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