Economic Analysis; Ailing Economy: Debt Buildup Called Cause
Leonard Silk – July 29, 1986

What ails the American economy? Why, in the face of strongly growing spending by consumers and the Federal Government, has the economy faltered, and why have American workers been unable to increase their output of goods and services?

Economic growth has slowed to a crawl. From April through June, the nation’s total output, adjusted for inflation, grew at an annual rate of only 1.1 percent. Productivity – the output per hour of all persons employed in private businesses – rose by only one-tenth of 1 percent last year. In nonfarm businesses, productivity actually fell by three-tenths of 1 percent.

Business spending on plant and equipment has stagnated. Corporate profits have weakened. The stock market, after a spectacular two-year run-up that ignored the sluggish recovery, has sustained sharp setbacks. Rising interest rates and the weak economy were factors in yesterday’s drop of 36.14 points in the Dow Jones industrial average. [ Page D1. ] Although not all economists agree, the main suspect in the choking off of the nation’s economic growth is the excessive buildup of debt. ”We have simply been living way beyond our means,” M. Louise Curley, an economist at Scudder, Stevens & Clark, the investment advisory concern, says.

Some economists worry that, after three and a half years of expansion since the severe 1981-82 recession, the economy may be headed for another slump. Even more troubling to many is the economy’s failure to recover fully from that severe recession or to show a healthier rate of growth. Since the middle of 1984, the American economy has grown at only 2 percent a year. The Administration’s View

The Reagan Administration’s budget director, James C. Miller 3d, has defended its assumption that the economy will accelerate to a growth rate of 4.5 percent in 1987 after the current slowdown, saying that ”the very factors that explain why real growth is less than anticipated in 1986 also explain why we believe the economy will perform better than expected in 1987.”

But some economists believe that the Administration’s projected speedup for next year is a means of justifying its budget projections, with an assumed reduction in the deficit.

The most publicized contributor to the debt explosion has been the Federal budget deficit, of course. Since 1981, when the gross Federal debt reached $1,003.9 billion, or more than a trillion dollars, it has soared to $2,112 billion this year. That estimate is almost certainly low. According to the Government, the annual budget deficit is expected to reach $220 billion this fiscal year, partly because economic growth was slower than expected. That would break 1985’s deficit record of $212.3 billion.

But the soaring American debt is driven not just by Federal budget deficits. Business borrowing has grown, much of it to finance highly leveraged mergers and acquisitions, and so has consumer borrowing. According to the Federal Reserve, total private and public debt reached $8.2 trillion in 1985, twice as much as in 1979. It has grown at double-digit rates, far faster than national income during the past four years.

That pace has broken a stable relation between total debt and income. For two decades before 1982, total domestic debt had held steady at about 160 percent of the rising gross national product. Since 1982, the ratio of total debt to G.N.P. has leaped to 200 percent.

Raymond M. Mullaney and Ronald L. Garner of the Capital Companies, a Boston-based financial services concern, consider this shooting up of total debt ”profoundly disturbing.”

Since debt must be repaid out of earnings, they see three possibilities for the economy: Growth could be sufficiently robust to service the debt; an epidemic of defaults and liquidations could reduce the debt, or the Government could print more money, enabling borrowers to repay creditors with cheaper dollars. That, of course, would be creating inflation.

They rule out robust growth as improbable; to the contrary, they expect a recession within two years.

While the Administration no longer expects 4 percent growth this year, and is predicting 4.5 percent growth for 1987, 52 leading economists, just surveyed by Blue Chip Indicators of Sedona, Ariz,, are forecasting 3.3 percent in 1987, and the Federal Reserve Board, in its midyear review presented to Congress by its chairman, Paul A. Volcker, expects only 3 percent to 3.5 percent next year.

But even at such relatively optimistic rates of growth, total debt would still grow faster than national income.

The second possibility, a staggering wave of defaults and liquidations, would result from a deep and prolonged recession. Indeed, even without a recession, defaults and loan losses have already been rising. Inflation Is Expected

The Capital Companies’ economists put their money on the third possibility, inflation. They see it coming as a consequence of efforts by the Government and the central bank to prevent a serious slump. ”Servicing an ever-increasing debt while real productivity remains flat or declines,” they say, ”will bring inflation and an erosion in our standard of living. The concurrent loss of international markets will aggravate the problem further.”

Similarly, Lawrence Chimerine, chairman and chief economist of Chase Econometrics, is worried about the debt-to-G.N.P. ratio. Unless it is curbed, he expects it to have ”serious consequences” for the long-term United States economic performance.

”The economy has been relatively weak,” he said, citing the slow growth of only 2 percent over the past 18 months. Indeed, he noted that growth over four and a half years had averaged only 2.5 percent, well below the historical average. In addition, Mr. Chimerine stressed, ”all of this debt has been incurred at a time when we have had incredibly high real interest rates, which are supposed to deter the accumulation of debt.”

Finally, ”household income has been growing very slowly, in part because of the wage cutbacks in industries that are being increasingly affected by foreign competition,” he added. In Mr. Chimerine’s view, some of the increase in household debt reflects an attempt by many families to sustain living standards when income is not rising.

He believes this applies to some corporate borrowing as well. ”There are so few investment projects with a meaningful rate of return,” says Mr. Chimerine, ”that it is better for corporations to use their cash – or even to borrow – to buy back their own stock, buy somebody else’s stock, or engage in hostile takeovers.”

In a recent symposium sponsored by the World Policy Institute, Mr. Chimerine warned that if the debt-to-G.N.P. ratio keeps rising, all the possible outcomes would be ”bad” -inflation, continued high real interest rates and an overvalued dollar that would ”keep crippling our competitiveness in world markets.”

”Real” interest rates – stated rates minus inflation – remain historically high at 5 percent or more, and the trade deficit this year is likely to reach a record $150 billion. This is true even though interest rates have declined recently, with the Fed having reduced the discount rate this year from 7.5 percent to 6 percent, and the dollar has dropped 40 percent in value against other currencies since February 1985.

All these adverse developments are connected. The huge and growing Federal and private borrowing – an enormous appetite for money – has held real interest rates high. High interest rates have made the trade deficit worse and attracted a huge capital inflow into the United States from foreign countries earning dollar surpluses. The capital coming in has kept the dollar too high and hurt American exports and import-competing industries by making exports more expensive and imports cheaper, thereby causing the loss – and export – of many American jobs.

Many American industries, especially manufacturing, mining and agriculture, have sustained heavy losses of jobs and sales, both abroad and at home. With oil prices and commodity prices down worldwide, the American Southwest and the farm belt are in deep trouble. And banks that have lent heavily to oil producers, farmers, real estate operators and third world countries share their problems, and expect still more. Unemployment, after dropping to 7 percent in 1984 from a recession peak of 11 percent, has been stuck there ever since. That means 8.5 million people are out of work. 1.7 Million Jobs Lost In a new study for a Brookings Institution symposium, William H. Branson of Princeton University estimates that the dollar’s appreciation has cost 1.7 million American jobs. Employment in mining was most sensitive to the dollar’s movements, he found: Every 1 percent increase in the dollar’s value prompted a four-tenths of 1 percent decline in jobs. Durable-goods manufacturing was the second most responsive, with every 1 percent of dollar appreciation resulting in a two-tenths of 1 percent loss of jobs.

Transportation and public utilities, wholesale and retail trade, finance and real estate, and services, by contrast, all responded insignificantly to the dollar’s rise.

Thus, the overvaluation of the dollar, stemming in large measure from rapidly rising American debt, appears to have helped cause persistently high unemployment, as well as a shift of jobs from goods to service industries. But there are deeper factors, including the high level of American wages, the spread of medium and low-technology industries to other countries (including poor developing countries), and the failure of American management to modernize as rapidly as foreign competitors, especially Japan. Added to that are the low national savings rate, the high cost of capital and the low return on capital investment in the face of worldwide overcapacity in steel, chemicals, minerals and other basic industries.

The world’s economies are interwoven, and this makes it extremely difficult for the United States to solve its problems on its own. In his testimony before the Senate Banking Committee, Mr. Volcker stressed that sluggish growth, financial instability, third world debt and trade imbalances were worldwide problems and interlocked, and they are at the heart of America’s problems.

The orthodox solution for a nation’s problems of insufficient growth, overcapacity and unemployment – orthodox since John Maynard Keynes’s General Theory of Employment, Income and Money of 1936, just 50 years ago – has been for Government to increase demand for the goods and services that a nation has the capacity to produce. And the prescription for increasing demand has been to cut taxes, step up government spending and enlarge the budget deficit. This prescription, crowned by the enormous deficit-financed war effort in World War II, ended the depression of the 1930’s. Some economists still consider it the right prescription. Dangerous Implications

But the huge buildup of deficits and debt, combined with the growing weight of foreign trade and fluctuating exchange rates in a closely knit world economy, makes it difficult and even dangerous, perhaps impossible, for the United States to escape its burdens simply by increasing total demand through still greater public or private borrowing. The harvest would likely include greater inflation, a further loss of international competitiveness, more people out of work, and a worsening of protectionism, with dangerous implications for the world economy and polity.

Mrs. Curley of Scudder, Stevens & Clark contends that it is a misreading of Keynes to contend that his one solution to a sluggish economy was to stimulate demand. Rather, she said, he also put major stress on stimulating investment. And he was well aware, as during World War II, of the problems of inflation that would stem from excessive consumption and insufficient savings.

Increasing savings and investment in new plant and equipment, as well as research and development, remains the essential answer to the productivity problem.

Neither today’s America nor today’s world fits the national model of depression-born unemployment or of war-created excess demand and inflation very well. The economy is global – it still consists of nation states, with separate currencies, loosely bound together and rivaling each other for international markets.

In the United States, post-Keynesian economists believe that, to achieve more rapid growth, investment needs to be spurred by bringing down interest rates. That task will require a narrowing of budget deficits and a slowing of the growth of private as well as public debt, they say.