The Macroeconomic Outlook as of December 1992:
MEMORANDUM FOR TRANSITION MACROECONOMICS DIRECTOR LAWRENCE SUMMERS
From: Brad DeLong
Date: December xx, 1992
Subject: Deficit Reduction and the Short-Run Macroeconomic Outlook
There is substantial concern that immediate steps to reduce the federal deficit might seriously retard the pace of what has already been a much slower-than-average recovery from the mid-1991 business cycle trough. This is a less likely eventuality than the conventional wisdom would suggest for two reasons:
If the deficit is not reduced, the Federal Reserve is likely to raise interest rates fast and hard--thus neutralizing any effect from higher fiscal stimulus.
Investment is so far below its normal range that a recovery of investment to even sub-normal levels would provide a substantial boost to the economy.
I. The Federal Reserve Is Likely to Raise Interest Rates
Typical Yield Curve Patterns at the End of a Recession
After the recession of...
Gap (% Points)
Ratio (Bill to Bond)
END OF 1992
The shape of the yield curve tells us that the market expects rising interest rates. Table 1 shows the pattern of interest rates found at the end of a typical recession. Today the gap between three-month and ten-year yields is half again as large-whether measured in percentage points or as a ratio-as after a typical recession.
Market expectations of rising interest rates after a recession are usually correct. Table 2 shows that the actual rise in three-month interest rates, comparing the post-recession year to the average of the ten years following the recession, has in three of four past recessions been larger than the rise that would have been predicted by taking the gap between the ten-year and the three-month yield as an index of expected rate increases.
Post-Recession Market Yield Spreads as Forecasts of Future Interest Rate Rises
Conclusion: take the yield curve seriously as a forecast of future interest rate movements. Today the yield curve is telling us to expect substantial Federal Reserve tightening in the next few years: the market expects three-month rates to rise to levels close to eight percent. This expected tightening of monetary policy is of a larger magnitude than has been typically seen after a recession.
Implication: The large change in policy stance the market expects from the Federal Reserve suggests that there is little value added in calculating the effect of fiscal policy changes on production and employment without taking account of the Federal Reserve's likely reaction to fiscal policy changes. One view-a view strongly held by the CBO, for example-is that the Bush administration received and the Clinton administration will receive deficit reduction essentially "for free" as far as its effect on output and employment is concerned. In the estimation of the CBO's head, the Federal Reserve has done its best and will do its best to loosen monetary policy in order to neutralize any contractionary consequences of steps toward deficit reduction.
II. Investment Is Far Below Its Normal Range.
Figure 1 plots net investment as a share of national product over the past thirty years (with the 1992 outcome estimated). 1991 and 1992 saw investment as a share of national product fall to levels that have not been seen since the Great Depression.
Net Investment as a Share of National Product
A typical recovery sees net investment rise to about seven percent of national product, giving a boost (relative to the trough) of two percent's worth of national product (and perhaps three percent's worth after multiplier effects are added in) after 1961 or 1970, and of more than three percent of national product (perhaps five percent with multiplier effects) after 1975. Today investment is so low that a rise to "normal" levels during a business cycle expansion would give a boost to the economy of four percent's worth of national product (perhaps six percent's worth after multiplier effects). Even a rise in investment to the anemic level of the deficit-ridden mid-1980s would give a three-and-a-half percent's worth of national product boost to spending (five percent's worth adding in multiplier effects). Thus it is not unreasonable to look forward to an investment-driven boost to production of between one and a half and twice the typical post-recession value.
Conclusion: Unless the decade of the 1980s has permanently destroyed the private sector's capacity and willingness to invest in America at the pace of past decades, the next few years are likely to see a substantial jump in investment. Such a stimulus from the private spending side would imply a recovery that could not be derailed by steps toward deficit reduction.