[Joint House and Senate Hearing, 108 Congress]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-832


 
                  THE ECONOMIC REPORT OF THE PRESIDENT

=======================================================================

                                HEARING

                               BEFORE THE

                        JOINT ECONOMIC COMMITTEE

                     CONGRESS OF THE UNITED STATES

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                               __________

                           FEBRUARY 10, 2004

                               __________

          Printed for the use of the Joint Economic Committee



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                        JOINT ECONOMIC COMMITTEE


    [Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]


SENATE                               HOUSE OF REPRESENTATIVES
Robert F. Bennett, Utah, Chairman    Jim Saxton, New Jersey, Vice 
Sam Brownback, Kansas                    Chairman
Jeff Sessions, Alabama               Paul Ryan, Wisconsin
John Sununu, New Hampshire           Jennifer Dunn, Washington
Lamar Alexander, Tennessee           Phil English, Pennsylvania
Susan Collins, Maine                 Adam H. Putnam, Florida
Jack Reed, Rhode Island              Ron Paul, Texas
Edward M. Kennedy, Massachusetts     Pete Stark, California
Paul S. Sarbanes, Maryland           Carolyn B. Maloney, New York
Jeff Bingaman, New Mexico            Melvin L. Watt, North Carolina
                                     Baron P. Hill, Indiana



        Donald B. Marron, Executive Director and Chief Economist
                Wendell Primus, Minority Staff Director


                            C O N T E N T S

                              ----------                              


                      Opening Statement of Members


Statement of Hon. Robert F. Bennett, Chairman, a U.S. Senator 
  from Utah......................................................     1
Statement of Hon. Carolyn B. Maloney, a U.S. Representative from 
  New York.......................................................     3

                               Witnesses

Statement of Dr. N. Greg Mankiw, Chairman, Council of Economic 
  Advisers.......................................................     5
Statement of Dr. Harvey S. Rosen, Member, Council of Economic 
  Advisers.......................................................     6
Statement of Dr. Kristen J. Forbes, Member, Council of Economic 
  Advisers.......................................................     7

                       Submissions for the Record

Prepared statement of Senator Robert F. Bennett, Chairman........    31
Prepared statement of Representative Carolyn B. Maloney..........    32
Prepared joint statement of Dr. N. Gregory Mankiw, Chairman of 
  the Council of Economic Advisers; Dr. Kristen J. Forbes, and 
  Dr. Harvey S. Rosen, Members, Council of Economic Advisers.....    33


                  THE ECONOMIC REPORT OF THE PRESIDENT

                              ----------                              


                       TUESDAY, FEBRUARY 10, 2004

             Congress of the United States,
                          Joint Economic Committee,
                                                    Washington, DC.
    The Committee met at 2:30 p.m. in room SD-628 of the 
Dirksen Senate Office Building, the Honorable Robert F. Bennett 

(Chairman of the Committee) presiding.
    Senators present: Senators Bennett, Sarbanes, and Reed.
    Representatives present: Representatives Paul, and Maloney.
    Staff members present: Mike Ashton, Gary Blank, Nan Gibson, 
Colleen Healy, Brian Higginbotham, Brian Jenn, Rachel 
Klastorin, Donald Marron, Wendell Primus, Matthew Salomon, 
Frank Sammartino, Chad Stone, and Rebecca Wilder.

 OPENING STATEMENT OF HON. ROBERT F. BENNETT, CHAIRMAN, A U.S. 
                       SENATOR FROM UTAH

    Chairman Bennett. The hearing will come to order.
    We appreciate everyone's attendance here today. We welcome 
you to this hearing on the Economic Report of the President.
    This meeting is the one meeting that is absolutely required 
by legislation. Congress created this Committee, the Joint 
Economic Committee, and the President's Council of Economic 
Advisers at the same time by law in 1946 and in that 
legislation mandated that the Council issue an Economic Report 
every year and officially present it to this Committee.
    So today's hearing is the time when we comply with that 
Congressional requirement. And we will hear directly from the 
authors of the President's Economic Report and discuss with 
them the economic issues that face us today.
    The last few years have dealt us a series of blows. We had 
an already weakening economy that was then hit by terrorism and 
corporate scandals and increased requirements for homeland 
security and defense. Despite what someone might call a 
``perfect storm'' of economic difficulty, recent economic 
indicators tell us what many have already been feeling--and 
that is, that the economy is now experiencing the first stages 
of a strong recovery. 2003 ended with very strong growth, 
averaging 6.1 percent in growth in the GDP in the second half, 
which is the fastest growth in consecutive quarters since 1984.
    The unemployment rate continues to fall. Manufacturing 
activity is increasing. And stock prices continue to rally. 
Over the next year we can look forward to a robust economy and 
the job creation that will follow.
    But what we must focus on now, I believe, is not only 
what's happening today, but what we will be facing 10 years and 
beyond.
    Recent budget projections have spurred a lot of discussion 
about the deficit. And I think we should examine this 
discussion by acknowledging that budget forecasters, however 
well educated and well meaning, are giving us an educated guess 
at best.
    I say over and over again, when presented with a budget 
forecast or a deficit forecast or a surplus forecast, I don't 
know what the surplus will, in fact, be a year from now. All I 
know is that the number that we have before us is wrong. I 
don't whether it will be wrong on the high side or the low 
side, but I can be absolutely certain that it will be wrong.
    And this last year has been no exception to that rule.
    The final number that came in for fiscal 2003 was $80 
billion less than the projected deficit earlier in the year. 
And $80 billion sounds like a huge amount of money and 
therefore a very, very large error. To put it in perspective, 
it is about 3 percent of the size of the total Federal budget 
and it is .007 percent of GDP.
    A forecaster that can come within 3 percent of what is 
going to happen in the future could have a significant career 
as a pollster because that number is within the margin of 
error.
    That does not mean we should dismiss the deficit. In the 
near term it is large but manageable. If we again measure it 
against something instead of just take the total number, 
deficits I believe should always be measured relative to the 
size of the economy in order to account for the economy's 
capacity to absorb them and the Government's ability to finance 
them.
    When measured as a percentage of GDP today's deficits are 
still below the peaks of the 1980s and the 1990s. However, 
continued increases would pose significant economic problems. 
We must therefore turn our attention to Federal spending, where 
recent growth rates are clearly unsustainable.
    We need to slow the growth of discretionary spending--where 
all of the conversation takes place for sure. But we must 
recognize that this discretionary spending is less than half of 
the equation.
    The majority of the spending that we do in this country is 
mandatory spending for entitlement programs. And the biggest 
problem we face in the long run is escalating mandatory 
entitlement spending.
    According to the President's budget and other studies that 
have been done, particularly by the GAO, entitlement spending 
is on track, if we don't do anything about it, to increase from 
10 percent of GDP, where it currently is, to more than 20 
percent in coming decades.
    Historically since the end of the Second World War, tax 
revenues have been below 20 percent. This means that 
entitlement spending could consume the entire tax revenue of 
the country if we don't do something about it. That means we 
would not have any money left for anything else but 
entitlements.
    So long-run fiscal discipline demands that we consider 
serious reform of the massive spending growth connected with 
mandatory spending.
    One of the primary reasons that we are facing this and must 
address the enormous burden that will come on our economy from 
this increase, is that the baby boomers will begin to retire 
towards the end of the decade and move into an area where, 
instead of sending money to the Government in the form of taxes 
on their wages, they will start receiving money from the 
Government in the form of these entitlements.
    As these men and women retire, the Nation faces a serious 
challenge with fewer workers available to support each retiree.
    We need only to look towards Europe, where they are having 
this effect occur in their demographic pattern more sooner than 
we will, to see how devastating this can be, as more and more 
European countries that previously sustained a very significant 
welfare state are now making serious cutbacks in that activity. 
We need to plan a little better than some of the European 
countries have done.
    We will see increasing pressure on Social Security and 
Medicare and we need to undertake a serious review of these 
programs to see where reforms and savings might be obtained.
    I know some have suggested, and I expect that they will 
here today, that the way to return to fiscal discipline in 
their view would be to allow the President's tax relief to 
expire in the years ahead.
    If I may, I think that is short-sighted. Rescinding the tax 
relief would do little to improve the long-run fiscal situation 
that I have described, but it would, in fact, in my view stifle 
the recovery that is just taking hold today.
    The tax cuts had an immediate beneficial effect on the 
economy and contain important elements to encourage work, 
saving, and investment and keep the current recovery going for 
years to come.
    I don't think we should short-circuit these powerful 
incentives by allowing these tax cuts to expire. People need to 
be able to plan for their financial future. They can't do that 
if they don't know what the tax laws will be from one year to 
the next.
    [The prepared statement of Senator Bennett appears in the 
Submissions for the Record on page 31.]
    Chairman Bennett. With that, may I welcome the members of 
the Council of Economic Advisers, Dr. Greg Mankiw, who is 
Chairman of the Council, and Drs. Harvey Rosen and Kristen 
Forbes, members of the Council. We've enjoyed working with you 
and your team in the past. We look forward to further 
cooperation.
    And the other Members of the Committee and I are anxious to 
hear your thoughts about the current state of the economy and 
the various proposals and policy reforms presented in your 
Annual Report.
    Mr. Stark is unable to be with us, so we are happy to 
recognize Mrs. Maloney in the role of the Ranking Member here 
on the Joint Committee.

  STATEMENT OF HON. CAROLYN B. MALONEY, A U.S. REPRESENTATIVE 
                         FROM NEW YORK

    Representative Maloney. Thank you so much, Chairman 
Bennett. And I also want to thank you for holding this hearing, 
which continues a JEC tradition of having the Council of 
Economic Advisers present to discuss the Economic Report of the 
President.
    I want to welcome Dr. Mankiw, as well as Dr. Forbes and Dr. 
Rosen.
    This is a big Report with a very slick cover and a lot of 
chapters, but there is one chapter that is missing. That is the 
chapter that explains why it is good economic policy to lose 
over two million jobs and to completely squander the climate of 
fiscal discipline that President Bush inherited.
    As the New York Times recently noted in one of their 
editorials, Republicans have become a band of ``budget 
buccaneers'' lacking any fiscal integrity.
    The President makes the hollow promise to cut the budget 
deficit in half in 5 years. But the Administration clearly has 
no serious plan to address the deficit, which is still 
projected to be $521 billion in 2004. While it is true that 
both the Administration and the Congressional budget office 
estimate that the deficit will fall as a share of GDP over the 
next 5 years with no new policy changes, long-range projections 
show that this is a temporary improvement and budget deficits 
will explode with the retirement of the baby boom generation. 
The Administration's proposed policies make the 5-year deficit 
worse than it would be with no policy changes. Moreover, making 
all the President's tax cuts permanent will seriously worsen 
deficits beyond 2009.
    This is hardly a picture of fiscal discipline. The 
Administration's budget submitted last week really should be 
given a grade of incomplete for omitting many likely policy 
changes and presidential policies that will make the deficit 
even worse. For example, it leaves out funding for Iraq and 
Afghanistan, the cost of fixing the alternative minimum tax, 
and the true cost of the President's vision to send humans to 
Mars and his plan to privatize Social Security. And while the 
Bush budget continues to include large and unaffordable tax 
cuts, the Administration's unwillingness to provide budget 
figures beyond 2009 hides the true cost of these tax cuts.
    The Administration continues to argue that our Nation's 
fiscal deterioration is due almost entirely to events beyond 
its control, namely the economic recession and the wars in Iraq 
and Afghanistan. But the facts are that the tax cuts already 
passed are responsible for a third of the deterioration of the 
budget outlook for 2004 and 2005. If the tax cuts are to be 
made permanent, this share would only increase in time.
    Dr. Mankiw is on record in his textbook and academic 
research as arguing that persistent large budget deficits are 
harmful to the economy. I would be interested in knowing what 
advice, Dr. Mankiw, you've given the President with respect to 
these ballooning deficits.
    There is another deficit that I am concerned about, the 
jobs deficit that President Bush has presided over. A year ago 
the Administration estimated that nearly two million jobs would 
be added in the second half of 2003--510,000 of them due to the 
President's tax cut. Yet, in fact, less than 200,000 jobs were 
created during that period. To its credit the Economic Report 
of the President acknowledges that job performance has been 
disappointing. On page 48 the Report says, and I quote: 
``Indeed the performance of employment over the past couple of 
years has been appreciably weaker than in past business cycles. 
It has lagged even that of the so-called jobless recovery from 
the 1990-91 recession.''
    Instead, President Bush is on track to be the first 
President since Herbert Hoover to end his term with fewer jobs 
than when he started. We've been gaining jobs slowly since 
August, but at the pace we've seen so far it would take nearly 
2\1/2\ years to erase the current job deficit. President Bush, 
would end his term January of 2005 with a deficit of nearly 1.5 
million jobs. Job creation would have to average 186,000 jobs 
per month from February 2004 to January 2005 just to erase the 
current 2.2 million Bush job deficit completely. We are a long 
way from that and even farther away from full employment.
    References to foreign outsourcing in the Economic Report of 
the President are troubling. I have over here some of the 
comments on the topic that have not been well received by my 
colleagues and I'd like to refer to today's headlines in the 
L.A. Times: ``Bush Supports Shift of Jobs Overseas.'' These are 
direct quotes. Seattle Times: ``Bush Report Sending Jobs 
Overseas Helps U.S.'' The Pittsburgh Post-Gazette: ``Economic 
Report Praises Outsourcing Jobs.'' Orlando Sun in Florida: 
``Outsourcing Jobs Abroad Can Be Beneficial.''
    We need to know how much the President's tax and trade 
policies have contributed to job losses over the last 3 years. 
We also need to see this Administration demonstrate more 
compassion to the workers who have been hurt by this trend.
    House Democrats last week forced the passage of legislation 
that would restore temporary Federal unemployment insurance 
benefits that President Bush and the Republican-controlled 
Congress allowed to expire over Christmas. Following the 1990-
91 recession the Administration of President Bush's father 
provided 20 weeks of temporary Federal unemployment benefits in 
all States until 1.6 million jobs had been created. While the 
President has pledged to extend his tax cuts, he has no plans 
to extend jobless benefits for the long-term unemployed. This 
is hardly a picture of compassionate conservatism.
    In short, this year's Economic Report of the President 
ignores the biggest issues before us: the jobs deficit and the 
budget deficit.
    I look forward to hearing from Chairman Mankiw and his 
colleagues. I look forward to your testimony and I hope that 
you will address the concerns that the Democrats have raised.
    Thank you very much.
    [The prepared statement of Representative Maloney appears 
in the Submissions for the Record on page 32.]
    Chairman Bennett. Tempting as it might be to enter into a 
debate at this side of the rostrum on the comments, I think 
we'll leave the opening comments on both sides as they've been 
made and turn immediately to the panel.
    Chairman Mankiw, you may proceed.

               STATEMENT OF DR. N. GREG MANKIW, 
             CHAIRMAN, COUNCIL OF ECONOMIC ADVISERS

    Dr. Mankiw. Chairman Bennett, Mrs. Maloney, Members of the 
Committee I am delighted to be here to discuss the release of 
the Economic Report of the President and the current challenges 
facing economic policy. The Economic Report released today 
covers a wide range of issues including recent business cycle 
developments, tax policy, health system regulation, and the 
role of the United States in the world economy.
    I will spend a few minutes giving a macro overview of the 
economy. And I will leave microeconomic issues to my colleague 
Dr. Rosen and international issues to my colleague, Dr. Forbes.
    Over the past few years the economy has had to deal with 
several major contractionary shocks: the end of the stock 
market bubble, corporate governance scandals, terrorist 
attacks, and slow growth among our major trading partners, 
particularly Japan and much of Europe.
    These shocks led to a recession. As judged by GDP, the 
broadest measure of economic activity, the downturn was mild by 
historical standards thanks to expansionary monetary and fiscal 
policy.
    Manufacturing was hit particularly hard, however, and this 
phenomenon is discussed extensively in the new Economic Report.
    Since the last Economic Report was released a year ago, the 
United States economy has gotten stronger. Over the four 
quarters of 2003, real GDP grew at a rate of 4.3 percent, 
significantly above the average growth rate since 1960 of 3.3 
percent.
    This growth was particularly strong in the second half of 
the year after the passage of the jobs and growth tax relief 
bill. The last two quarters of 2003 showed the most rapid 
growth of any 6-month period in nearly 20 years.
    The labor market is also starting to improve. Since August 
the economy has created 366,000 jobs. The unemployment rate has 
fallen from a peak of 6.3 percent to 5.6 percent.
    Like most private sector economists, the Administration 
forecasts continued growth in GDP and employment in the year 
ahead. The future of the United States economy is bright. This 
is a testament to the institutions and policies that have 
unleashed the creativity of the American people and their 
spirit of entrepreneurship.
    History teaches that the forces of free markets are the 
bedrock of economic prosperity. In 1776 as the Founding Fathers 
signed the Declaration of Independence, the great economist 
Adam Smith wrote: ``Little else is required to carry a state to 
the highest degree of opulence and the lowest barbarism but 
peace, easy taxes, and a tolerable Administration of justice, 
all the rest being brought about by the natural course of 
things.''
    The economic analysis presented in this Report builds on 
the ideas of Smith and his intellectual descendants by 
discussing the role that the Government has in creating an 
environment that promotes and sustains economic growth.
    Thank you. I look forward to taking your questions.
    [The joint statement of Dr. Mankiw, Dr. Forbes, and Dr. 
Harvey S. Rosen appears in the Submissions for the Record on 
page 33.]

               STATEMENT OF DR. HARVEY S. ROSEN, 
              MEMBER, COUNCIL OF ECONOMIC ADVISERS

    Dr. Rosen. Senator Bennett, Ms. Maloney, Members of the 
Committee: Thank you for the opportunity to testify on the 2004 
Economic Report of the President.
    My focus will be on the chapters that deal with domestic 
microeconomics. By microeconomic issues I refer to questions 
relating to how society allocates its scarce resources among 
alternative uses. These chapters deal with a very broad range 
of topics including the environment, energy, health care, the 
tort system, and the evaluation of tax policy.
    Diverse as these topics are, our treatment of them is 
unified by the following themes. First, an important reason for 
Americans' high standard of living is that they rely primarily 
on markets to allocate resources. Typically, free markets 
allocate resources to their highest valued uses, avoid waste, 
prevent shortages, and foster innovation.
    Second, importantly, no one directs society to this result. 
Rather it is the outcome of a process in which each consumer 
and each producer makes a decision that maximizes his well-
being. Prices coordinate economic activity by providing signals 
of the costs to society of providing various goods.
    Third, however, under certain circumstances market prices 
may fail to allocate resources efficiently. Under these 
circumstances well-designed Government interventions may 
enhance efficiency. Well-designed interventions must take into 
account how consumers and businesses will react to them.
    Fourth, the fact that the market-generated allocation of 
resources is imperfect does not mean the Government is 
necessarily capable of doing better. In some cases, for 
example, the cost of setting up a Government agency to deal 
with the problem might exceed the costs imposed by the problem 
itself.
    Thank you for the opportunity to testify. I look forward to 
your questions.
    Chairman Bennett. Thank you.
    Dr. Forbes.

              STATEMENT OF DR. KRISTEN J. FORBES, 
              MEMBER, COUNCIL OF ECONOMIC ADVISERS

    Dr. Forbes. Chairman Bennett, Mrs. Maloney, and Members of 
the Committee, thank you for inviting us to testify today. My 
comments will focus on the section of the Economic Report of 
the President covering international economics.
    Increased trade has stimulated United States and global 
growth. This is true not only for traditional forms of trade, 
but also for new types of trade--for example, in services such 
as banking or movies.
    The United States has pursued an ambitious agenda of trade 
liberalization and has been a central force in constructing an 
open global trading system.
    Since foreign competition can also require adjustments, the 
Administration has developed and strengthened programs to 
assist workers and communities negatively affected by trade.
    International capital flows, as well as international 
trade, can generate substantial economic benefits. Capital 
flows have become an increasingly significant part of the world 
economy, an important source of funds to support investment in 
the United States.
    Although international trade and capital flows are often 
discussed separately, they are closely intertwined. For 
example, in the United States the large net inflow of foreign 
capital in recent years corresponds to the large current 
account deficient.
    These patterns reflect fundamental economic forces--
notably, strong growth in the United States that has made 
investment attractive compared to in other countries.
    Public policies can smooth any changes in the United States 
current account and net capital flows by creating a stable 
macro and financial environment, by promoting growth abroad, 
and by encouraging savings in the United States.
    I look forward to answering your questions.
    Thank you.
    Chairman Bennett. Thank you all.
    Dr. Mankiw, you referred to the recession as relatively 
mild by historic terms. It didn't feel like that in many places 
in the country. It felt fairly deep and fairly bitter. And 
we've already seen one revision by the Bureau of Economic 
Analysis--unfortunately they always do it after the fact by 
some significant time lag--showing three quarters of negative 
growth. And now they've said that there was a quarter of 
negative growth before the three quarters started.
    And in your Report there is the assumption that the 
recession in fact began in the last quarter of 2000. Do you 
want to expand on that just a little so that as to look back we 
try to get a clearer picture of what really happened?
    Dr. Mankiw. The official arbiter of when recessions begin 
and end is the National Bureau of Economic Research, as you've 
said. And they originally put the beginning of a recession, the 
peak, in March of 2001. Since then the data has been revised. 
And what we do is we document the revisions in a box in chapter 
of one of the Economic Reports.
    And all the data revisions have moved in the direction of 
saying that the peak was likely earlier. The Bureau has 
suggested that they would revisit this issue when the full set 
of data is in and decide exactly when the date is.
    Our look at the data suggested that the fourth quarter of 
2000 looked like the most likely date for the peak given the 
data that we have now. But, as I mentioned, not all the data is 
in. And as more data comes in, the National Bureau will have 
the opportunity to revisit their decision.
    Chairman Bennett. Well, if that is the case, that means we 
had four full quarters of negative growth.
    Dr. Mankiw. Yes, in terms of the question of whether the 
recession was mild or not, there's different ways of looking at 
it.
    Chairman Bennett. I realize it was relatively mild. It 
wasn't nearly as deep as the recessions that preceded it, but 
it may have been longer than we had previously thought.
    Dr. Mankiw. Yes, yes. There was a negative quarter, then a 
positive quarter, and three negative quarters according to the 
current----
    Chairman Bennett. So if that positive quarter by review of 
the data turns negative, then you'll have five successive 
negative quarters. And that's a pretty long stretch to try to 
come out of. And that might explain why the recovery is having 
so much trouble getting underway.
    Because the previous thought was, well, it was very shallow 
and very short. Why shouldn't we go immediately to back to 
where we were? If, in fact, we're talking about five successive 
quarters, however shallow they may have been, that's a pretty 
heavy hit to have to absorb in order to get job creation and so 
on off the ground. Is that a fair characterization?
    Dr. Mankiw. That's correct. And another feature in terms of 
job creation is we have had very rapid productivity growth. And 
rapid productivity growth sort of raises the bar that the 
economy needs to jump over to get job growth going.
    I mean, the economy is stronger with higher productivity 
growth. And that eventually leads to higher real wages and 
higher living standards. But it does sort of raise the bar that 
we need to jump up over to get the labor market going.
    Chairman Bennett. They tell me my clock is not running, so 
I'll have to watch yours. Maybe I won't watch any at all. I'll 
just go on and on.
    Could you respond, any of you, to some of the comments that 
were made in the opening statement about the loss of jobs? 
We've held several hearings on the disparity between the 
household survey and the payroll survey, both of which are 
conducted by the Bureau of Labor Statistics.
    These are not competing organizations. This same 
organization is telling us at one time that we've lost two and 
a half million jobs and at the same time data suggests that we 
have added a million and a half. This is a 4 million gap, which 
has never occurred before in our history.
    Do you have--any of you--any feeling about what is causing 
this statistical anomaly? Obviously in a political year where 
people are running for office, some will stress the lower and 
talk about Herbert Hoover. And others will stress the higher 
and talk about Ronald Reagan.
    So where indeed are we? Do you have any feel for this?
    Dr. Mankiw. I think the way to think about economic 
statistics is that all of them are imperfect. It is a mistake 
to emphasize any single statistic or data series to the 
exclusion of others.
    What we've seen in the statistics in the labor market is 
that around the summer they've all sort of turned around. The 
labor market is getting better. But different statistics point 
to them getting better at different rates.
    As you correctly point out, the survey of firms, the so-
called payroll survey, shows smaller job gains than the 
household survey, which generates the unemployment rate. If you 
look at other indicators like the falling claims for 
unemployment insurance, they seem more consistent with the 
household survey.
    On the other hand, the payroll survey is based on a larger 
sample. And all things being equal, you prefer larger samples 
to smaller samples. I don't look at any one series at the 
exclusion of the others. You sort of have to look at the 
entirety.
    It may well be true that we'll understand this difference 
over time. I think right now it's a puzzle. We understand some 
of it. We understand, for example, that the self-employed show 
up in the household survey, but not in the payroll survey. But 
we know that's not the full explanation.
    I think part of that discrepancy, which is very large, as 
you pointed out, is a puzzle. And it will generate Ph.D. 
dissertations in the future no doubt.
    Chairman Bennett. Yeah, we can't get at it at this hearing 
here. I will just say that my own conviction is that something 
fairly fundamental, indeed structural, is going on in this 
recovery that has never gone on before and that the ways in 
which we measure the recovery are proving to be faulty. 
Therefore, all of us need to be a little humble as we start 
yelling statistics at each other. It may well be that the 
statistics are wrong.
    If there is the kind of structural change in job creation 
that I think is going on, I don't think the payroll survey is 
necessarily reliable, long-term indicator of what's happening 
in the economy.
    As more and more people end up in places less traditional 
than gets measured by the payroll survey, it may have a large 
sample, but the universe which is sampling is changing to the 
point that it is leaving out a portion of the economy that's 
growing very rapidly. And we could, in fact, be seeing much 
more job creation than that number represents. That's just my 
own view.
    Ms. Maloney.
    Representative Maloney. Thank you very much, Mr. Chairman.
    Dr. Mankiw, the Counsel of Economic Advisers under your 
predecessor, R. Glenn Hubbard, issued a Report forecasting that 
the economy would add nearly two million jobs in the second 
half of 2003, about 500,000 of them contingent on our enacting 
the President's proposed tax cuts.
    And Congress did do what the President wanted. He got his 
tax cuts. How many jobs were actually added in the second half 
of 2003?
    Dr. Mankiw. I don't have that precise number, but you are 
right that the labor market was weaker than the Council and the 
private sector forecasters were expecting a year ago.
    Representative Maloney. And you don't have those numbers at 
all anywhere in your Report?
    Dr. Mankiw. I don't have the precise numbers. On page 98 of 
the Report we do have some for 2003. What I have here is your 
average numbers. The payroll employment went from 130.4 in 2002 
on average to 130.1 in 2003 on average, although I should note 
that this data was as of--when our forecast went to bed on 
December 2nd. I think those data have been revised since then.
    Representative Maloney. Could you get for the Committee the 
actual numbers?
    Dr. Mankiw. We can get the numbers for you. Yes.
    Representative Maloney. Thank you very much. What is the 
level of payroll employment now, compared with what it was when 
President Bush took office?
    In your Report on page 98 it appears that you are relying 
on the payroll survey. However, the Bureau of Labor Statistics 
views the establishment survey, the payroll survey as a more 
accurate indicator of labor market conditions.
    What is the level of payroll employment now compared with 
what it was when President took office? Don't we have a job 
deficit of 2.2 million? And isn't that deficit merely 3 million 
when we focus on merely the private sector jobs?
    Dr. Mankiw. You're absolutely right that the labor market 
has been weak. And that is something that deeply concerns the 
President. The President has said to me many times that his 
first economic priority has been to put America back to work. 
That's been very much the focus of the economic policies he's 
put in place.
    I think we're starting to see the results of that. I think 
the labor market has turned the corner this summer.
    But we still have a ways to go. We want to see more jobs 
created. We want to see the unemployment rate continuing to go 
down. And I expect that will happen over the coming year, as do 
most private sector forecasters.
    Representative Maloney. So do I. I hope we see that. But 
how many jobs do we have to create each month just to keep up 
with the growing labor force, much less recover those 2.2 
million jobs?
    Dr. Mankiw. The population in the labor force tends to grow 
about 1 percent a year. The labor force also depends on labor 
force participation.
    Representative Maloney. So that comes down to how many 
jobs?
    Dr. Mankiw. I don't have that exact number in front of you. 
About 125,000 my staff tells me. And that sounds about right.
    Representative Maloney. Okay. How many jobs per month have 
we created since job growth turned positive last August?
    Dr. Mankiw. As I mentioned in my opening remarks, we've 
created 366,000 in the past five months.
    Representative Maloney. So that's how much per month?
    Dr. Mankiw. That's about 73,000 a month if my arithmetic is 
correct.
    Representative Maloney. So half the required pace. And is 
it fair to say that this has been the longest and most 
persistent jobs recession since the 1930s and that we have yet 
to see a month with satisfactory job growth?
    Dr. Mankiw. We're not satisfied with what's going on in the 
labor market. You're right about that. We----
    Representative Maloney. Has it been the most persistent 
jobs recession since the 1930s?
    Dr. Mankiw. I haven't compared every single one. So I don't 
know the answer to that question. But there's no question that 
it has been a recession that----
    Representative Maloney. You're a famous economist. Could 
you compare it and get it to us in writing?
    Dr. Mankiw. Yes, we could.
    Representative Maloney. Thank you very much.
    Representative Maloney. Looking ahead, the CEA is 
forecasting that the payroll employment this year will average 
132.7 million jobs. And that is about 2.5 million more jobs 
than we have now. And that's an average. So we should reach 
that level in June or July, correct?
    Dr. Mankiw. Under this forecast we should expect 
substantial job increases. We don't have a specific month in 
which we're going to reach that number. That's an annual 
average. We do expect jobs to be coming back. And we do expect 
a robust labor market going forward.
    Representative Maloney. But if you follow the average that 
you projected, it would be June or July.
    And lastly, I'd like to ask on the jobs, do you really 
believe the economy is so strong that it will add 425,000 jobs 
per month in the next six months?
    Dr. Mankiw. No, 425,000 is not the number we're 
forecasting.
    Representative Maloney. What are you forecasting then?
    Dr. Mankiw. Well, do you see the numbers in front of you? 
If you add the annual averages up, it is 2.6 million more on 
average in 2004 than on average in 2003. I should note by the 
way, that in interpreting that number, it's important to----
    Representative Maloney. So if you're going to get the 
annual average, you've got to have the 425,000 jobs per month 
in the next six months.
    Dr. Mankiw. No, that is not correct arithmetically. But the 
thing I want to point out is this is forecasting only about 3 
percent of growth in the number of jobs over next year. That is 
about average for a recovery.
    It's above the recovery we saw in the early 1990s, but 
significantly below the recovery we saw in the early 1980s. So 
it's a very plausible forecast.
    I should note, the specific numbers in that table you're 
referring to were determined in early December before several 
employment releases and before the recent data revision. Some 
of the news reports on that have sort of been comparing sort of 
apples and oranges by comparing those numbers in the table to 
post-benchmark numbers from the Bureau of Labor Statistics.
    Representative Maloney. I guess the main point is is that 
it was forecast that you'd create 2 million last year. You 
didn't. The main point is we are nowhere near making up the 
number of jobs that we have lost. And there's a credibility 
gap.
    Chairman Bennett. Mr. Paul.
    Representative Paul. Thank you, Mr. Chairman.
    I wanted to follow up on a comment you made earlier, Mr. 
Chairman, relating to the mandatory spending versus the 
discretionary spending, which I think is a very important point 
and something that, if we don't eventually address, I think 
it's going to be impossible to get our budget in order.
    I don't think there was ever anything intended originally 
in our history that said that previous Congresses should be 
able to dictate to us what we spend.
    As a matter of fact, I find fault with that and think that 
that has to be challenged some day because it's easy for 
Members of Congress to just write it off and say that's 
mandatory; I can't do anything about it.
    But the way I look at it, I'm responsible for every dollar 
spent this year because I'm voting on it. And I think that 
eventually has to change.
    I also would like to suggest that we do need some deficit 
hawks around here. The deficit is out of control.
    But I think there's something equally important--and that 
is the total amount of Federal spending. As a matter of fact, 
if spending is going up and we balance the budget next year 
with raising taxes, you could say that is being a deficit hawk. 
But that could be very devastating as well.
    And I would like to emphasize that total Government 
spending is something we have to keep our eye on.
    But I want to develop a question around the ideas of the 
free market economists, who have actually come to the 
conclusion that the predictions about future economic growth in 
the economy is based on a fiction.
    And the fiction is that we have deceived ourselves into 
believing that all we have to do is borrow more money and print 
more money and everything is going to be okay without a 
significant amount or an adequate amount of liquidation of 
previous debt and previous mal-investment and that there's no 
reason to think that we might not move into an economy somewhat 
similar to what Japan has been involved in, because the 
spending and printing doesn't solve their problem.
    Right now the consumers--how can we expect the consumers to 
borrow more? They are nearly $2 trillion in debt. They have a 
credit card debt that's $7,000 in debt per household. Total 
debt in this country is $34 trillion and 21 percent of that has 
developed since 1990.
    So we're on a radical increased scale. I mean, it is 
expanding exponentially. The current account deficit along with 
our domestic debt now is over $1 trillion. And that's 10 
percent of the GDP.
    We are required to borrow $2 billion a day from foreigners 
to finance our extravagant living, both Government and 
consumers. And we consume--our Nation consumes 8 percent of the 
world's savings. So the idea that we can encourage consumers to 
borrow more and bail us out I think is really a fiction.
    Our savings rates, our policies, the way we have our tax 
policies, and the way we devalue our money--there's no 
incentive to save. So even the BEA just recently readjusted the 
saving estimate--and they're lower than ever.
    So we don't save. So we don't have a capitalist system. We 
don't save and use our capital. We depend on the creation of 
new money and credit by the Federal Reserve to get our capital.
    And that's a dependency that someday we have to look at, 
because all it does is encourage artificial interest rates, 
mal-investment, and perpetuates a debt bubble that has not 
liquidated itself.
    And the business cycle theory, according to the free market 
economists, claim that you cannot solve the problem of too much 
debt and too much inflation, with more debt and more inflation, 
especially if you haven't had the liquidation that is generally 
the case.
    This has to lead to one thing--and that is the dollar has 
to go down. And the dollar is going down. But instead of 
protecting the savers and protecting those who want to import 
at good prices--and the consumers--we say it's wonderful; it's 
going to bail us out.
    I think that is a fiction. And I would like you to convince 
me otherwise.
    Dr. Mankiw. Okay, you make some very important points. On 
the deficit I think we agree that it needs to come down. The 
President agrees it needs to come down. He's put forward a 
budget, in which it will come down over the next 5 years.
    But longer term, in terms of mandatory spending, this 
becomes an issue that Chairman Bennett and Ms. Maloney have 
also mentioned. There is a very important public policy issue 
regarding the long-term trajectory associated with the 
entitlement programs, Social Security, and Medicare. We have a 
chapter in the Economic Report on Social Security.
    There's no question that the current trajectory they are on 
is not sustainable for future generations. That's why the 
President has repeatedly called for the need to modernize these 
programs to make sure they are sustainable for future 
generations because the path they're on now is not sustainable. 
And we agree with that. And there's a whole chapter in the 
Economic Report of the President making that point.
    On the current account deficit, let me defer to my 
colleague, Dr. Forbes, who is sort of our expert in 
international economics.
    Dr. Forbes. You're right in that the current account 
deficit in the United States is large. And the United States 
has been borrowing a large amount from other countries. The 
deficit reached about 5 percent of GDP last year.
    But in and of itself a large current account deficit isn't 
bad. And it's important to look at a number of other factors.
    One is the total sum of borrowing accumulated from the 
past. Actually in the past the United States has lent abroad 
for many years. I mean, it's only recently the United States 
has started to borrow from abroad in net. So if you look at the 
total net debt owed to foreigners in the United States, it's 
actually quite low by cross-country standards.
    Another factor to consider is that the United States 
current account deficit is balanced by net capital inflows, as 
with any country with a floating exchange rate. And foreigners 
have been very happy to invest in the United States and finance 
the current account deficit because of the strength of the 
United States economy.
    Investors see the United States as a very attractive 
investment opportunity especially in the past few years as 
growth in the United States has consistently outperformed 
growth in other countries.
    So therefore in some ways the current account deficit is a 
symbol of the strength of the United States economy rather than 
a weakness. And it's important to think about all those factors 
when evaluating whether it's a concern.
    Representative Paul. I'd like a follow-up, but my time is 
up.
    Chairman Bennett. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman. I want 
to welcome the members of the Council here.
    The Administration has been constantly lowering its 
forecast for jobs, and I want to ask the witnesses about that. 
The forecast for the number of jobs that we would have in 
calendar 2004, the calendar year in which now find ourselves, 
was 138.3 million in the 2002 Economic Report.
    And if you disagree with any of those numbers as I move 
along, I hope you'll interject and say so.
    In last year's Economic Report that number of 138.3 million 
jobs predicted for 2004 was lowered to 135.2 million jobs. That 
was last year's Report.
    In your most recent Report it has now been lowered to 132.7 
million jobs.
    And as I understand it, based on the lower job numbers for 
late 2003 and January 2004, you have now lowered the forecast 
even further to 131.9 million jobs for this year. Is that 
correct?
    Dr. Mankiw. As far as I know. I can't verify each of those 
figures as I sit here. But you're absolutely right that the 
forecasts for jobs have been coming down.
    Senator Sarbanes. So in just 2 years you've lowered the 
forecast for jobs for the year we're now in by 6.4 million. How 
do you explain that?
    Dr. Mankiw. Well, I think two things. One is that the head 
winds that this economy has been experiencing are stronger than 
all economists, both inside and outside Government, thought 
they were.
    If you look at private sector forecasts for jobs, I think 
you would find a very similar picture to what you paint. So 
there's nothing unusual about Administration forecasts in what 
you're pointing out.
    Secondly, there is this discrepancy between what the 
household survey and what the payroll survey is saying about 
the labor market. And as we discussed earlier, that's an 
outstanding puzzle that I don't think any economist fully 
understands at this point.
    Senator Sarbanes. And you attribute this drop in the number 
of jobs forecast to that factor?
    Dr. Mankiw. To the extent that the household survey is 
showing that more jobs have been created than the payroll 
survey does and that may explain--that may be part of the story 
as to why the payroll survey forecasts have turned out to be 
wrong.
    Or to try to be more precise, we have two surveys of what's 
going on in the labor market. Those two surveys give you some 
significantly different job numbers over the past few years. We 
don't know where truth is. And very likely the truth is 
somewhere in between. And different economists can debate what 
the relative weights are they should give under these different 
surveys.
    Senator Sarbanes. So which job numbers do you use when you 
make these predictions of total jobs?
    Dr. Mankiw. Well, we look at both surveys and we actually 
do forecasts of both surveys. So if you look at the Report 
forecast table, you'll see a forecast of a payroll number. 
You'll also see a forecast of the unemployment rate. And the 
unemployment rate comes from the household survey.
    So we look at both surveys. We try to forecast both 
surveys. For the most part, for the purposes of the forecast, 
it's for the purposes of budget planning, for the purposes of 
coming up with budget numbers. That's why this forecast is put 
to----
    Senator Sarbanes. Which survey do you use in projecting 
these numbers that trail down now from 138.3 million just 2 
years ago to where you are now predicting 131.9 million jobs? I 
mean, that's a drop of 6.4 million jobs. Which survey are you 
using?
    Dr. Mankiw. Well, that particular forecast is a forecast of 
what the payroll survey will show. But we also look at and 
monitor and make forecasts of results from the household 
survey.
    Senator Sarbanes. And what does that show you?
    Dr. Mankiw. Well, you can see the unemployment rate--if you 
look at the same table on page 98 of the Report, you will see 
the forecast for the employment rate there.
    We forecast a decline in the unemployment rate of 6 percent 
in 2003 to 5.6 percent in 2004. That we've already hit. This 
was made, as I said, in early December, even before a November 
number was known----
    Senator Sarbanes. How many jobs go with that forecast?
    Dr. Mankiw. I don't have that number with me, but we can 
get that to you.
    Senator Sarbanes. All right. If you could do that, that 
would be helpful.
    Senator Sarbanes. The International Monetary Fund not long 
ago said, and I'm now quoting from their Report on United 
States fiscal policies and priorities for long-run 
sustainability:
    ``Against the background of a record high United States 
current account deficit and a ballooning United States net 
foreign liability position the emergence of twin fiscal and 
current account deficits has given rise to renewed concern.
    ``The United States is on a course to increase its net 
external liabilities to around 40 percent of GDP within the 
next few years, an unprecedented level of external debt for a 
large industrial country This trend is likely to continue to 
put pressure on the U.S. dollar, particularly because the 
current account deficit increasingly reflects low saving rather 
than high investment.
    ``Although the dollars adjustment could occur gradually 
over an extended period, the possible global risks of a 
disorderly exchange rate adjustment, especially to financial 
markets, cannot be ignored. Episodes of rapid dollar 
adjustments failed to inflict significant damage in the past.
    ``But with United States net external debt at record 
levels, an abrupt weakening of investor sentiments vis-a-vis 
the dollar could possibly lead to adverse consequences both 
domestically and abroad.''
    How concerned are you about this?
    Dr. Mankiw. The United States still remains one of the best 
places in the world to invest. The United States had one of the 
highest growth rates in the developed world last year. 
According to most forecasts it will have one of the highest 
growth rates in the developed world in 2004.
    That high growth rate is the reason why investors around 
the world have found the United States a good place to put 
their money. And as Dr. Forbes said a moment ago, the flip side 
of that capital inflow is a current account deficit.
    A variety of things. As we discussed in the last chapter of 
the Economic Report, there are a variety of ways in which the 
current account deficit will very likely over time move toward 
a balance. Higher growth abroad will tend to increase the 
demand for our exports. And that's one of the reasons why we 
should encourage other countries to pursue pro-growth policies.
    In addition, higher saving in the United States would 
reduce our reliance on capital inflows from abroad to finance 
domestic investments. That's one of the reasons why it's 
important for the budget deficit to shrink over time to reduce 
the drain on national saving from the budget deficit.
    And in addition, it's one of the reasons why we need to 
encourage private saving. And that's why the President has put 
forward his lifetime savings account and retirement savings 
account initiatives in order to change the tax code in a way to 
make private saving more advantageous.
    Of course, private savings is important beyond the current 
account deficit. But increasing private saving will tend to 
reduce the current account deficit over time.
    Senator Sarbanes. Mr. Chairman, I see my time is up. If I 
could just close out.
    I draw from that response that you are not very concerned, 
and I just want to add a quote from Chairman Greenspan on the 
United States current account deficit:
    ``There are limits to the accumulation of net claims 
against an economy that persistent current account deficits 
imply. The cost of servicing such claims adds to the current 
account deficit and under certain circumstances can be 
destabilizing.''
    You're the Chairman. I don't see much concern out of the 
Council. But I'm sure we'll address it again and again as the 
year goes on.
    Chairman Bennett. I'm sure we will.
    Senator Reed.
    Senator Reed. Thank you very much, Mr. Chairman. And thank 
you, ladies and gentlemen.
    In your Report you talk about the Social Security trust 
fund and point out that the 75-year actuarial deficit is the 
usual measure, but it might really underestimate the 
challenges. But 75 years is much longer than we estimate taxes 
or anything else.
    So I'm just curious. What's the 75-year cost of making the 
tax cut permanent, Mr. Chairman?
    Dr. Mankiw. I do not have that number in front of me. I'm 
sorry. We can try to find it for you.
    Senator Reed. Would it be a larger number than the 
difference between Social Security revenues and benefits over 
75 years?
    Dr. Mankiw. I don't have the number. I can't compare it to 
anything.
    Senator Reed. You don't even have sort of an instinctional, 
notational feeling about what the 75-year gap is between 
revenues and expenditures and how does that measure up with the 
tax cut?
    Dr. Mankiw. I'm not sure it would be useful for me to guess 
on that.
    Senator Reed. Does anybody back there have it?
    [No response.]
    Senator Reed. No, you don't just have that kind of number 
at your fingertips today. That's curious. I would think you 
would know the impact over many years of the tax cuts since you 
go to the point of saying how even a 75-year actuarial solvency 
rate for Social Security might underestimate the challenges.
    Dr. Mankiw. I don't have that number, sir.
    Senator Reed. But you'll get it to us?
    Dr. Mankiw. We will try.
    Senator Reed. I don't think it's that hard to calculate. Do 
you have a projection--how long are your projections for the 
tax cut?
    Dr. Mankiw. I think the budget--those are numbers that 
would come out not of the Council of Economic Advisers, but 
come out of the U.S. Treasury and the Office of Management and 
Budget. So those are the institutions that we would go to to 
try to get the numbers. The budget that came out last week went 
out 5 years. But I don't----
    Senator Reed. So as the Chief Economist to the President of 
the United States, who is recommending permanent extension of 
tax cuts--I guess ``permanent'' means at least 75 years--you 
have no idea how much that costs?
    And you also don't know or have any idea of the difference 
between the revenues and the benefits of Social Security, which 
is one of the major costs mandated by law today. You don't even 
have a notion?
    Dr. Mankiw. We have numbers on the Social Security 
imbalance in the Economic Report. I don't have those in my 
head. There's no question that there's a fundamental challenge 
in terms of putting Social Security on a sustainable basis. And 
that's something the President is very focused in on.
    That's why he talked about it in the last campaign. That's 
why he appointed a commission to come up with different models 
for Social Security. And he looks forward to working with 
Congress to try to get that done.
    Senator Reed. As I recall, one of the principles that the 
President enunciated when he was talking about Social Security 
surpluses is that it must be preserved only for Social 
Security.
    Yet in the 10-year budget that we're looking at, that 
principle seems to be violated since Social Security funds will 
be used to effectively cover other expenditures of the 
Government.
    Dr. Mankiw. All the money that's supposed to go into the 
Social Security trust fund is going into the Social Security 
trust fund. But that doesn't mean that we don't have a 
challenge. We do have a challenge.
    The Social Security is, as the President has said many 
times, as the President's budget has said many times, as the 
Economic Report makes clear today, is in need of long-term 
reform and modernization to make it sustainable for future 
generations.
    Senator Reed. I'm just amazed that you don't have even a 
rough estimate of the difference of these cost. That's what I 
find totally amazing from the chief adviser to the President on 
the economy. But let's move on.
    If all the President's budget proposals are implemented, 
will the net effect be to increase or reduce the deficit over 
the next 5 years compared with what is projected in the OMB 
current services projection?
    Dr. Mankiw. The President has said that he wants to make 
the tax cuts permanent. He believes that is important for 
economic growth. He believes it's important to make sure the 
recovery continues.
    And other things equal, cutting taxes does tend to raise 
the budget deficit. That is why other things aren't equal. And 
that is why the President at the same time he's proposing 
making the tax cuts permanent is also proposing spending 
restraint and proposing a budget that would reduce the budget 
deficit in half over the next 5 years through significant 
spending restraint.
    Senator Reed. Well, what happens after those 5 years to the 
budget deficit?
    Dr. Mankiw. As you look further ahead, the long-term 
pressures from the entitlement programs kick in. The 
President's budget from last year called that the real fiscal 
danger because we have these large unfunded liabilities.
    And the budget deficit will tend to rise if these programs 
are not reformed and not modernized. That's why modernization 
of the entitlement programs is such an important priority.
    Senator Reed. So 5 years--after 5 years the deficit 
increases given the President's current budget plan.
    Dr. Mankiw. I don't have the year-by-year numbers, but 
going forward 10, 20, 30 years as the baby boomers retire, as 
the demographic transition hits us, absolutely. There are 
tremendous budgetary pressures coming from that.
    Senator Reed. And I----
    Dr. Mankiw. Everyone acknowledges that. The President's 
budget last year acknowledged that. The Economic Report of the 
President, if you look in the chapter on Social Security, 
acknowledges that.
    Senator Reed. Has the President proposed changes to the 
entitlement programs of his budget to deal with those issues?
    Dr. Mankiw. He's looking forward to working with Congress 
on that issue. He put together a Social Security Commission 
that came out with a variety of models for reform. We used one 
of those models as an illustration in this chapter here. But 
the President has not put forward a specific proposal. And 
that's something we look forward to working with the Congress 
on.
    Senator Reed. Thank you.
    Chairman Bennett. Thank you, Senator. I go back to my 
opening statement, where I said I don't know what the numbers 
will be, but I do know they will be wrong. And I have learned 
while I have been in Congress that the farther out you go, the 
wronger you are.
    A 6-month forecast has a pretty good chance of being fairly 
close. A 1-year forecast, as we've seen last year, missed by 
$80 billion. A 5-year forecast, I guarantee you, is going to 
miss it by more than that.
    No matter how many brilliant Ph.D.s, MBAs, CPAs you gather 
in a room to come up with it, no matter how you program the 
computer, a 75-year projection--I appreciate that you will be 
responsive to Senator Reed and I have every respect for Senator 
Reed--but a 75-year projection of the economic number relating 
to tax cuts is useless. I'm sorry. I guarantee you the number 
will be useless.
    The only reason that we can be sure or we can have a fairly 
good idea of what will happen with Social Security is that 
we're dealing with demographics as opposed to dealing with the 
ebbs and flows of the economy.
    So make your calculation, but for the record I don't put 
any stock in how valuable that number would be in coming to any 
kind of policy decision.
    Let's go back, Dr. Forbes, to the international economy for 
just a minute. Senator Sarbanes raised the issue from the 
International Monetary Fund about where we stand.
    I have never been a fan of the IMF in terms of their 
prescriptions as to what economies ought to do. I spent some 
time dealing with the Russians, who were trying to follow IMF 
restrictions. And they were talking about shock therapy. And if 
I may, the language that came from the Russian ambassador--he 
said, ``We've had plenty of shock and damned little therapy.''
    And the Chinese told the IMF basically to take a hike and 
built their economy the way they wanted instead of the way the 
IMF was instructing them and did substantially better.
    Where are we compared to other developing economies? The 
things we've been talking about here. Is our unemployment rate 
higher or lower? Is our deficit as a percentage of GDP higher 
or lower? Is our level of economic growth higher or lower than 
other countries?
    Can they give us a benchmark as to how well American 
policies are doing as we look around the world at some of the 
other countries that are trying to give us instructions as to 
what we should be doing?
    Dr. Forbes. That's an excellent question. And it actually 
highlights the strength of the United States economy by 
answering the different points you raised.
    Starting with the deficits, the deficit in the United 
States economy right now is higher than in Europe although 
several of the large European countries have seen a significant 
increase in their deficits and are quickly approaching the 
deficit of the United States.
    Chairman Bennett. Let me just take debt as a percentage of 
GDP because deficit is a year-by-year thing. Debt is the 
accumulation of long-term activity. What is our debt 
percentatge of GDP----
    Dr. Forbes. Our debt to GDP I believe is slightly lower 
than in, say, France and Germany, the largest economies in 
Europe, and substantially lower than in Japan, which is the 
second largest economy in the world. Actually Japan not only 
has a much higher debt level, but also a higher deficit on an 
annual basis.
    So compared to other countries in terms of deficits and 
debt, the United States is sort of in the middle.
    According to most other indicators, though, the United 
States is much stronger than the other developed economies in 
the world.
    Growth in the United States next year is expected to be 
double in the United States what it will be in Japan or Europe. 
Growth in Japan and Europe next year is expected to be an 
improvement over recent years and considered strong. But it's 
still only about half of what is expected in the United States.
    On unemployment the United States also does well on a 
cross-country basis. Although unemployment is still much higher 
than we would like to see in the United States, it's still 
substantially lower than in Europe and a bit lower than in 
Japan.
    So according to those standard economic indicators, even 
though we'd like to see a faster recovery in the United States 
and more improvement in the labor market, the United States 
does quite well on a cross-country basis.
    Chairman Bennett. What would happen if the other countries 
in the world became more robust in their economic growth? How 
would that affect us?
    Dr. Forbes. We would be delighted if growth picked up in 
other countries in the world. This is actually something the 
Government has been working on actively through the agenda for 
growth, encouraging other countries to adopt reforms to improve 
growth.
    If other countries grew faster, they would export more from 
the United States That would mean United States exports to----
    Chairman Bennett. They would import. We would export.
    Dr. Forbes. Import more from the United States. Thank you. 
We would export more. And that should help reduce the United 
States current account deficit.
    Actually in the past 3 years, since about 2000, most of the 
increase in the United States current account deficit is 
because of a contraction in exports largely to other large 
economies in the world because growth has been so slow in 
Europe and Japan.
    So if growth picked up in other countries, that would 
directly help the United States economy.
    Chairman Bennett. So this is an oversimplification, but 
basically if the other countries in the world were able to 
follow our economic performance, not only would they be better 
off, but we would be substantially better off as well.
    Dr. Forbes. The global economy would benefit from faster 
growth in all the major economies in the world.
    Chairman Bennett. So maybe we're not doing as badly as some 
of the questions here today might suggest.
    Mrs. Maloney.
    Representative Maloney. Thank you so much, Senator Bennett.
    As someone who has supported some trade agreements, I am 
astonished by the Administration's insensitivity to 
outsourcing. Your Report seems to cheerlead the outsourcing 
while your budget cuts adult training programs and worker 
relocation.
    I certainly understand how trade be can disruptive to some 
communities and some people. But I don't see anything in these 
headlines that were in the papers yesterday about the 
Administration's plans for workers who have just lost their 
jobs.
    Does the CEA have any estimates of the number of jobs lost 
because of outsourcing? In other words, how many people are 
likely to experience disruption from this development?
    Dr. Mankiw. We don't have any official number. We've looked 
at some of the private sector numbers on this. The numbers tend 
to be small, but they are growing.
    And we live very much in a changing world, where things 
that were once non-tradable goods are suddenly tradable goods. 
We're very used to goods being produced abroad and being sent 
here on ships and planes.
    What's new about the world is we're now seeing some 
services produced abroad and being sent here over fiber optic 
cables.
    But the economics are not fundamentally different in the 
two cases. The key question is whether we want to erect 
barriers around our Nation and retreat from the principles of 
free and open trade or whether we want to embrace a free and 
open world trading system and enjoy the benefits of trade and 
get workers into jobs in which the United States has a 
comparative advantage.
    The President is very focused on putting people back to 
work and creating jobs. We don't believe that erecting barriers 
to trade is the way to do that. We believe the way to do that 
is to promote economic growth. And the President has put 
policies in place to do that.
    We believe it's important to train workers. The President 
has pushed hard to improve our community colleges, for example, 
and believes that community colleges are very important 
mechanisms and institutions to help workers make a transition 
from the declining to the growing parts of the economy.
    Representative Maloney. Well, my question was not about 
trade as much as what is the impact having on American jobs? 
And since you do not have any numbers, but I would say that 
most private firms and others see an increase in unemployment 
in the short run and possibly in the long run too.
    And I would like to know what is the Administration 
planning to do to help these workers who are unable to find 
work as a result of this outsourcing. And my understanding is 
that the President's budget cuts adult training and dislocated 
workers assistance by $151 million or roughly 4.8 percent.
    How do you justify that and the fact that the 
Administration canceled an extension of temporary unemployment 
benefits even though we still have a huge job deficit and a 
record number of unemployed workers exhausting their regular 
benefits without qualifying for any additional assistance?
    It is a phenomenon that's here. What are we doing about it? 
Many people are out of work. Hopefully we'd like to create more 
jobs, but there have been forecasts. We have not met that 
forecast. We have a well over 2.2 million job loss and yet 
they're cutting workers' assistance.
    Dr. Mankiw. Well, as we talked earlier, there is some 
discrepancy in the statistics about exactly what the labor 
market looks like today. But it's certainly not as strong as 
we'd like. We believe we have policies in place to make it 
stronger.
    The job market has been getting stronger. The unemployment 
rate is down from 6.3 down to 5.6. That is a very significant 
improvement. Our forecast and private sector forecasts as well 
suggest continuing improvement in the months to come.
    On the issue of training, the President has a variety of 
proposals. He's talked recently about community colleges. He 
has a proposal for personal re-employment accounts in order to 
help workers make a transition to new jobs.
    Representative Maloney. Well, why shouldn't we extend 
unemployment?
    Dr. Mankiw. The President has worked with Congress in the 
past to extend unemployment benefits. The President will 
continue to work with Congress on that issue. The key is to get 
people back to work. That's the most important priority and I 
think we can agree on that.
    Representative Maloney. Part of helping our economy I would 
think would be reducing the deficit. But isn't the President's 
focusing on cutting the budget deficit in half over the next 5 
years misleading? It conveys the impression that you'll keep 
reducing the deficit after that, doesn't it? And that's not 
true when you look the--on page 192--not in your book, but in 
the analytical perspectives, it shows quite a deficit coming if 
we don't change our policies.
    Unfortunately there are no budget tables for the fiscal 
years 2010 and 2014 that show the impact of making the tax cuts 
permanent. Won't all of the costs of these tax cuts have to be 
financed by additional borrowing, which means the deficit will 
be made larger by the tax cuts.
    I find this very troubling. The first set of tax cuts we 
had a surplus. The second time we had a deficit. To make them 
permanent we are really borrowing from our grandchildren--if I 
should be so fortunate to have them.
    And one of the points that Dr. Forbes said that I found 
disturbing, she talked about the fact that we are borrowing so 
much from foreign countries. And I remember in 1992 before we 
started getting the economy moving, there wasn't any money in 
the economy. All of this was going to pay for the debt.
    I don't see how we can make our economy grow if we continue 
to grow the deficit, borrow from foreign countries. One answer 
was that foreign countries are investing in America. But are 
they going to continue to invest in America if we continue to 
grow our deficit?
    It is galloping forward--not in your charts. Yours are only 
good for 5 years. But in the charts here is it galloping 
forward.
    That is a tremendous burden to put on future generations 
for permanent tax cuts. We're going to cut taxes and borrow 
money. We're cutting taxes to borrow money from foreign 
countries.
    Dr. Mankiw. The deficit is unwelcome. It is undesirable. 
But it's also understandable in light of the contractionary 
shocks that----
    Representative Maloney. And it is growing. And the tax cut 
is adding to it, right?
    Dr. Mankiw. It is understandable in light of the 
contractionary shocks that the economy has experienced. We want 
it to shrink. The President has put forward a budget in which 
it will shrink.
    And the fundamental disagreement seems to be over how--not 
whether the deficit should shrink--but how that's going to be 
accomplished.
    Some people think the deficit should be reduced through 
higher taxes. The President has made clear that his priority is 
not to raise taxes on the American people but to reduce budget 
deficits through spending restraint.
    Long term--which I think is the forecast that you were 
looking at--long term the issue of budgetary pressure comes 
from the entitlement programs. As we spoke about a few minutes 
ago, a reform and modernization of those programs is crucial. 
The need for modernization of those entitlement programs is 
true today and it was true 3 years ago when we had budget 
surpluses. That long-term fiscal challenge has not 
fundamentally changed in the past 3 years.
    Representative Maloney. The President's forecasts on jobs, 
the number of jobs lost, the escalating deficits, the forecasts 
of this Administration on the budget speaks for itself. My time 
is up.
    Chairman Bennett. Before I recognize Mr. Paul, just for the 
sake of the record in this discussion, when we're talking about 
letting unemployment--extensions of unemployment compensation 
expire, we've always extended unemployment compensations during 
recessionary times. We've always let them expire when we think 
the economy has started to grow.
    The last time the unemployment compensation was allowed to 
expire during the Clinton Administration unemployment at the 
time, those benefits were allowed to--the extended benefits--
were allowed to expire, unemployment was at 6.6 percent. In 
this Administration it was at 5.6 percent.
    Mr. Paul.
    Representative Paul. Thank you, Mr. Chairman.
    I would like to just start off by reminding the Committee 
that possibly someday we should not refer to tax cuts as a cost 
of Government. That to me indicates the Government owns 
everything. And there's a cost to Government it's to give 
people back what they've earned. That I don't like.
    But I want to get back with Dr. Forbes on this current 
account deficit. Believing that all current account deficits 
aren't the same, I don't very often agree with Alan Greenspan, 
but I think he's expressed the concern about the current 
account deficit.
    I really think the fact that--many economists have 
expressed concern about the deficit. Those who have been 
concerned and don't say, well, they're investing growth in 
America and it's all positive, the fact that the dollar is 
going down confirms that those of us who are concerned see it 
out of balance and this should be something we should be 
concerned about.
    My point about the difference between two current account 
deficits is that yes, in the past we have had deficits, but 
conditions were different. Certainly in the 19th Century they 
were investing in America. We were an industrial country 
building and booming. And they were loaning and there were no 
devaluations. Currencies were more universally accepted. And it 
wasn't a problem.
    Today I think it's a mistake to assume this is the same 
principle and they're investing in America's growth and it's 
positive. I think they do it out of desperation.
    The other countries--you're right. We're better than they 
are. So just because we're a little bit better shouldn't be too 
much reassurance to us that, oh, they're going to send these 
dollars back.
    I still believe what is happening because the reserve 
currency of the world, we have rampant monetary inflation that 
we get a free ride. We export our dollars. We buy cheap goods. 
Our consumers benefit. And then the Japanese and the Chinese 
end up with dollars and they want to artificially keep their 
currencies high.
    So they are more than willing, and I think in the long run, 
mistakenly they send those dollars back to buy Fannie Mae and 
Freddie Mac and Treasury bills. It is a gift to us. It's 
wonderful. But, boy, I don't believe for a minute it's because 
of the strength of America.
    The question is, don't you ever see that there could be a 
difference between two account deficits and that one when it's 
loaned back to us for consumption is quite a bit different than 
sending it in here to build steel plants and build railroads?
    Dr. Forbes. I think you are correct in stating that every 
current account deficit is different. And you do need to look 
at all the economic forces causing that current account 
deficit.
    A current account deficit is equal to the difference 
between savings and investment in a country, so a part of the 
reason for the United States current account deficit is low 
savings--both the Government savings and private savings in the 
United States.
    But part of it also is high investment, that investment is 
higher than savings, so we are borrowing from abroad to fund 
this investment higher than what we can fund domestically.
    Again, as I said earlier, part of the reason for the 
current account deficit is that foreigners do see the strength 
and the potential of the United States economy. That's why they 
are willing to help fund investment and fund the current 
account deficits.
    Also, just to draw on what Chairman Mankiw said earlier, we 
do expect the current account deficit to decrease in the 
future. And even the last trade numbers do suggest a small 
shrinking in the United States current account deficit.
    So it is perfectly reasonable that the current account 
deficit does shrink over time. But there's no reason to 
necessarily expect that this will be a difficult adjustment or 
anything to be concerned about.
    In the mid-1990s there was a large current account 
deficit--not quite as large as today, but still a large 
deficit--and it did shrink gradually without being very painful 
to the United States economy. And it's perfectly reasonable 
that we could see the same situation in the United States in 
the future.
    Representative Paul. On one other subject, possibly for the 
Chairman, Chairman Bennett mentioned that the projections are 
always wrong. And I think everybody recognizes it is very 
difficult to make projections. But revenue projections 
especially are always wrong because economies change quickly.
    But why don't we emphasize more on the spending side? Why 
do we give up so easily? I mean, the Administration has made no 
effort--no vetoes, no effort--to cut anything. They just say, 
well, we have to do everything.
    So whether it's going to the moon or welfare spending or 
education or department of energy or department of homeland 
security or invading another country, there's absolutely no 
restraint on spending.
    So I don't see how we can possibly--I mean, if we're out of 
balance it's dangerous. How can we possibly get it back in 
order if we, the conservatives who are in office now, can't do 
a better job on cutting some spending?
    Dr. Mankiw. It's the President's job to set priorities. 
He's made it very clear many times that his first priority is 
defending the Nation, protecting the homeland, and that's why 
spending on those very important categories in the budget has 
gone up.
    But he also has made it clear that spending restraint is a 
very important part of the economic plan. And that's how he 
wants to get the budget deficit reduced over the next 5 years.
    The budget he put forward this last week showed non-
defense, non-homeland security spending going up by less than 1 
percent. In real terms that means non-defense, non-homeland 
security spending will be actually falling. That is significant 
spending restraint.
    And he's going to be working with Members of Congress to 
get that significantly fiscally conservative budget passed. One 
of the first things he'll be working with Congress on is the 
highway bill. It's going to be very important, as that highway 
bill works its way through Congress, to show our Nation's 
commitment to restraining spending.
    Chairman Bennett. I don't think we need another round, but 
Mrs. Maloney does have one more question she would like to ask. 
Then I will close it out.
    Representative Maloney. I would just like to place on the 
record this statement on employment to really factually put it 
on the record.
    Representative Maloney. But I would like to ask Chairman 
Mankiw, does every dollar of making the tax cuts permanent have 
to be borrowed in the 2010-to-2014 year period? Yes or no?
    Dr. Mankiw. Part of the reason for making the tax cuts 
permanent is to stimulate economic growth and part of the cost 
of the tax cuts will come back in the form of higher economic 
growth.
    There's a chapter in the Economic Report of the President 
on dynamic budget estimations--sometimes they refer to it as 
dynamic scoring--of tax changes. And so part of any tax cut 
will be recouped, but probably not all of it.
    And other things equal, it would be borrowed. That's why 
spending restraint is a policy that goes hand in hand.
    The way I think about it is, the Government faces a budget 
constraint. The only way to make tax cuts permanent is to 
restrain spending. So permanent tax cuts and spending restraint 
are policies that have to go hand in hand because the 
Government faces the budget constraint. You can't cut taxes 
unless you also restrain spending. And that's why the President 
has put forward this budget.
    Representative Maloney. Well, I'm conservative to the 
extent that I don't believe in dynamic scoring. I believe in 
what are the facts that are before you, not what you project in 
the future. That's another argument.
    My question is--and it has nothing to do with dynamic 
scoring--my question is does every dollar of making the tax 
cuts permanent have to be borrowed in the 2010 to 2014 period? 
That's the question, not what's going to happen in the future, 
but does every dollar of making the tax cuts permanent have to 
be borrowed?
    And we hear from Dr. Forbes when we borrow, we're borrowing 
from abroad. So does that have to be borrowed in the period 
from 2010 to 2014?
    Dr. Mankiw. No, it doesn't have to be borrowed. You can 
restrain spending in response to those tax cuts.
    Representative Maloney. But if we have the budget that we 
have now going forward. You're talking about restraining 
spending. You don't know what the expenses are going to be. A 
budget was presented to us that literally left out the war in 
Iraq, left out the war in Afghanistan, left out the Social 
Security projected changes.
    So basically if we move forward, based on my studies we're 
going to have to borrow that money from a foreign country we 
hear from Dr. Forbes.
    Dr. Mankiw. If you assume that you can't restrain spending 
and you're going to cut taxes, then you're going to borrow the 
money, but that's not the policy.
    The policy is--and in fact, you can't cut taxes permanently 
unless you're going to restrain spending because the Government 
has to pay its bills. So spending restraint and making the tax 
cuts permanent go hand in hand as policies.
    Chairman Bennett. Thank you very much for being here. This 
was a little heated conversation, but this is an election year. 
And I think heated conversations in election years are 
inevitable.
    My answer to Mrs. Maloney's question would be ``who 
knows?'' I would note for the record, the historic record, that 
we have had marginal tax rates as high as 92 percent in this 
country. And we ran huge deficits at the time.
    President Kennedy startled everybody when he said we should 
have a tax cut to bring the marginal rate down to 70 percent. 
And there were conservatives, Mr. Paul, in that Congress who 
voted against it on the grounds that we couldn't afford it, 
that the deficit was so high that we couldn't afford to cut the 
tax rate from 92 percent to 70.
    And then I remember when the Congress decided that taking 
more than half of somebody's money was somehow immoral. And we 
cut the top marginal rate to 50 percent.
    Under the prodding of Ronald Reagan we cut the top marginal 
rate to 28 percent. Now, it is 36 percent and coming down as 
the President's tax cuts phase in.
    The interesting thing is that the revenue-to-Government 
measured as a percentage of GDP stayed about the same in that 
whole period. The revenue-to-Government since the end of the 
Second World War has been in a band of about--around 17 to 18 
percent of GDP. Sometimes it's been higher. In the Clinton 
years it got as high as 21 percent of GDP.
    And why was that? Because the actual revenue that came in 
when we, the Congress, cut the tax rate for capital gains was 5 
times the projected revenue that would come.
    You say you don't like dynamic scoring. But the static 
scoring projected that a cut in the capital gains tax rate 
would mean a cut in the capital gains tax realization. And in 
fact, cutting the capital gains tax rate caused people to start 
to make deals that they wouldn't have made before because their 
money was locked in with the higher tax rate. They sold, got 
the capital gain, paid the tax, and tax realizations were 5 
times what the computers at CBO told us they were going to be.
    That's where we got our surplus. The surplus came out of 
that tremendous river of cash that came out of a combination of 
a strong economy and tax cuts.
    Then in California and many other States the State 
legislatures made the terrible decision of assuming that that 
was permanent and that that river of cash would continue to 
come.
    And they built in structural spending into their 
projections on the assumption that the economy would still give 
them the cash that had come in before. And suddenly they were 
faced with the kind of deficit that ultimately drove the 
governor from office.
    I've come back to the theme that I made in my opening 
statement. The economy is fluid. You cannot make projections 5 
years, 75 years in advance and have any confidence whatsoever 
that those will come to pass in terms of economic projections.
    The one thing we can be fairly sure of is that the tax 
realizations in the economy will hover somewhere in the band 
between 18 and 20 percent of GDP. That has been stable from the 
end of the Second World War until now whether the top tax rate 
was 70 percent or 50 percent or 28 percent or 38 percent.
    All we do as we jiggle these tax rates, which we call tax 
cuts and tax increases, is change the distribution of where we 
collect the taxes and try to become as efficient as possible in 
getting the tax revenue from the Government.
    In other words, if we're going to be in that band of 18 to 
20 percent of GDP, we want to do it in a way that damages the 
economy the least. And if we can do it in a way that makes the 
economy as efficient as possible, then the economy grows. And 
18 percent of the much larger figure is in itself a much larger 
number.
    Chairman Mankiw, you have emphasized once again the most 
significant point. And Alan Greenspan has made this point also 
to us a number of times. He says that Congress can set the 
level of spending just about anywhere it wants. You can pass a 
law that says we're going to spend X, Y, or Z and you can spend 
X, Y, or Z. The thing you cannot set is the level of revenue, 
because the level of revenue is a function of how well the 
economy is doing.
    And if you make the mistake that was made in the 1990s of 
assuming that that level of revenue is going to be permanent, 
we would never have a recession, the dot-com bubble was never 
going to burst, the stock market irrational exuberance was 
never going to have a correction. We were never going to have a 
war. Everything was going to keep going.
    And we set spending levels on those assumptions. We paid 
for it. We have a war. We have a recession. The bubble burst. 
And the level of spending that we set in the 1990s is 
unsustainable now without a deficit, without borrowing.
    The main lesson that I think we all need to learn--and 
frankly as Chairman of the Committee, if can say should be a 
motto for the Committee--is that all of us in public life need 
to be a whole lot more humble about our ability to control 
these events.
    And we should adopt our policies with the understanding 
that the economy determines how much money we get. We don't. 
The tax laws don't determine how much money we get. The budget 
doesn't determine how much money we get. The economy determines 
how much money we get.
    And our responsibility on this Committee and you as you 
advise the President should be to come up with a policy to make 
the economy as efficient as possible, as strong as possible, 
grow as rapidly as possible.
    And then we can argue about how to spend the money that 
that economy at about 18 to 19, at top 20, percent of GDP will 
return to us regardless of how we jigger and restructure the 
tax code.
    And with that I think you for your indulgence. The hearing 
is adjourned.
    [Whereupon, at 4:05 p.m., the hearing was adjourned.]

                       Submissions for the Record

=======================================================================

        Prepared Statement of Hon. Robert F. Bennett, Chairman, 
                        a U.S. Senator from Utah

    Good afternoon and welcome to today's hearing on the Economic 
Report of the President. Congress created the Joint Economic Committee 
and the President's Council of Economic Advisers in 1946 and mandated 
that the Council issue an Economic Report each year and officially 
present it to this Committee. In today's hearing we will have the 
opportunity to hear directly from its authors what is included in this 
year's report and to discuss with them the economic issues that face us 
today.
    The last few years have dealt us a series of blows. An already 
weakening economy was hit by terrorism, corporate scandals, and 
increased requirements for homeland security and defense. But, despite 
this ``perfect storm,'' recent economic indicators tell us what many 
have already been feeling, that the economy is now experiencing a 
strong recovery.
    2003 ended with very strong growth, averaging 6.1 percent in the 
second half, the fastest growth in consecutive quarters since 1984. The 
unemployment rate continues to fall, manufacturing activity is 
increasing, and stock prices continue to rally. Over the next year, we 
can look forward to a robust economy and the job creation that will 
follow. What we must begin to focus on is where we will be 10 years 
from now and beyond.
    Recent budget projections have spurred a lot of discussion about 
the deficit. Let's preface this discussion by acknowledging that budget 
forecasts are an educated guess, at best. Historically, we haven't 
always known if the projected numbers are too low or too high, but we 
know they are not the gospel truth. The uncertainty in our economy 
inevitably invalidates even the best-crafted projections.
    In the near term, the deficit is large, but manageable. Deficits 
should be measured relative to the size of the economy to account for 
the economy's capacity to absorb them and the Government's ability to 
finance them. When measured as a percentage of GDP, today's deficits 
are still below the peaks of the 1980s and 1990s.
    However, continued increases in the deficit could pose significant 
economic problems if they persist. We must therefore turn our attention 
to Federal spending, whose recent growth rates are clearly 
unsustainable. We need to slow the growth of discretionary spending, 
for sure, but it is less than half of the equation. The bigger problem 
we face in the long run is rapidly escalating entitlement spending. 
According to the President's budget, entitlement spending is on track 
to increase from 10 percent of GDP to more than 20 percent in coming 
decades. Long-run fiscal discipline demands that we consider serious 
reforms before this massive spending growth comes to pass.
    One particular problem that we must address is the enormous burden 
that will be placed on the economy once the baby boomers begin to 
retire toward the end of the decade. As these men and women retire, the 
Nation faces a serious challenge with fewer workers available to 
support each retiree. We will see increasing pressure on Social 
Security and Medicare. In order to manage this change, we will need to 
undertake serious reforms of these programs.
    Some commentators have suggested that one step in returning to 
fiscal discipline would be to allow the President's tax relief to 
expire in the years ahead. This is short-sighted. Rescinding the tax 
relief would do little to improve the long-run fiscal situation of our 
Government, but would weaken our economy today. The tax cuts had an 
immediate beneficial effect on the economy and contain important 
elements that will encourage work, saving, and investment and keep the 
economy growing for years to come. We must not short circuit these 
powerful incentives by failing to maintain them in law. Moreover, 
people need to be able to plan for their financial future and they 
cannot do so if they don't know what tax laws will be from one year to 
the next.
    We welcome the members of the Council of Economic Advisors to 
Congress today. Dr. Greg Mankiw, Chairman of the Council, and Drs. 
Harvey Rosen and Kristin Forbes, we have enjoyed working with you and 
your team and we look forward to continued cooperation between the CEA 
and our Committee. The other Members of the Committee and I are anxious 
to hear your thoughts about the current state of the economy, and the 
various proposals and policy reforms presented in the Economic Report 
of the President.

                               __________

   Prepared Statement Hon. Carolyn B. Maloney, a U.S. Representative 
                             from New York

    Thank you, Chairman Bennett. I also want to thank you for holding 
this hearing, which continues a JEC tradition of having the Council of 
Economic Advisers present and discuss the Economic Report of the 
President. I want to welcome Dr. Mankiw, as well as Drs. Forbes and 
Rosen.
    This is a big report with a slick cover and a lot of chapters. But 
there seems to be an important chapter missing--the chapter that 
explains why it's good economic policy to lose over 2 million jobs and 
to completely squander the climate of fiscal discipline that President 
Bush inherited. As the New York Times recently noted, Republicans have 
become a band of ``budget buccaneers'' lacking any fiscal integrity.
    The President makes the hollow promise to cut the budget deficit in 
half in 5 years, but the Administration clearly has no serious plan to 
address the deficit, which is projected to be $521 billion in 2004. 
While it is true that both the Administration and the Congressional 
Budget Office estimate that the deficit will fall as a share of GDP 
over the next 5 years with no new policy changes, long-range 
projections show that this is a temporary improvement and budget 
deficits will explode with the retirement of the baby boom generation. 
The Administration's proposed policies make the 5-year deficit worse 
than it would be with no policy changes. Moreover, making all of the 
President's tax cuts permanent will seriously worsen deficits beyond 
2009. This is hardly a picture of fiscal discipline.
    The Administration's budget submitted last week really should be 
graded incomplete for omitting many likely policy changes and 
presidential policies that will make the deficit even worse. For 
example, it leaves out funding for Iraq and Afghanistan, the costs of 
fixing the Alternative Minimum Tax, and the true costs of the 
President's vision to send humans to Mars and privatize Social 
Security. And while the Bush budget continues to include large and 
unaffordable tax cuts, the Administration's unwillingness to provide 
budget figures beyond 2009 hides the true costs of those tax cuts.
    The Administration continues to argue that our Nation's fiscal 
deterioration is due almost entirely to events beyond its control--
mainly the economic recession and executing the war on terrorism. But 
the facts are that the tax cuts already passed are responsible for a 
third of the deterioration in the budget outlook for 2004 and 2005. If 
the tax cuts were to be made permanent, this share would only increase 
over time.
    Dr. Mankiw is on record in his textbook and academic research as 
arguing that persistent large budget deficits are harmful to the 
economy. I would be interested in knowing what advice you've given the 
President with respect to these ballooning deficits.
    There's another deficit that I'm concerned about--the jobs deficit 
that President Bush has presided over. A year ago, the Administration 
estimated that nearly 2 million jobs would be added in the second half 
of 2003--510,000 of them due to the President's tax cuts. In fact, less 
than 200,000 jobs were created during that period. To its credit, the 
Economic Report of the President acknowledges that job performance has 
been disappointing. On page 48, the Report says, ``Indeed the 
performance of employment over the past couple of years has been 
appreciably weaker than in past business cycles . . . [It] has lagged 
even that of the so-called 'jobless recovery' from the 1990-91 
recession.''
    Indeed, President Bush is on track to be the first President since 
Herbert Hoover to end his term with fewer jobs than when he started. 
We've been gaining jobs slowly since August, but at the pace we've seen 
so far, it would take nearly 2\1/2\ years to erase the current jobs 
deficit. President Bush would end his term in January 2005 with a 
deficit of nearly 1\1/2\ million jobs. Job creation would have to 
average 186,000 jobs per month from February 2004 to January 2005 just 
to erase the current 2.2 million Bush jobs deficit completely. We're a 
long way from that and even farther away from full employment.
    References to foreign outsourcing in the ERP and Dr. Mankiw's 
comments on the topic have not been well received here on Capitol Hill. 
We need to know how much the President's tax and trade policies have 
contributed job losses over the last 3 years. We also need to see this 
Administration demonstrate more compassion to the workers who have been 
hurt by this trend.
    House Democrats last week forced the passage of legislation that 
would restore temporary Federal unemployment insurance benefits that 
President Bush and the Republican-controlled Congress allowed to expire 
at Christmas. Following the 1990-91 recession, the Administration of 
President Bush's father provided 20 weeks of temporary Federal UI 
benefits in all States until 1.6 million jobs had been created. While 
the President has pledged to extend his tax cuts, he has no plans to 
extend jobless benefits for the long-term unemployed. This is hardly a 
picture of compassionate conservatism.
    In short, this year's Economic Report of the President ignores the 
biggest issues before us--the jobs deficit and the budget deficit.
    I look forward to Dr. Mankiw and his colleagues' testimony, and I 
hope you address the concerns I've raised.

                               __________

  Prepared Joint Statement of Dr. N. Gregory Mankiw, Chairman of the 
Council of Economic Advisers; Dr. Kristin J. Forbes, and Dr. Harvey S. 
           Rosen, Members of the Council of Economic Advisers

    Chairman Bennett, Ranking Member Stark, and Members of the 
Committee, thank you for the opportunity to discuss the release of the 
Economic Report of the President and the current challenges facing 
economic policy. The Economic Report released today covers a wide range 
of issues, including recent business cycle developments, tax policy, 
the health system, regulation, and the role of the United States in the 
world economy.
    The U.S. economy made notable progress in 2003, propelled forward 
by pro-growth policies that led to a marked strengthening of activity 
in the second half of the year and put the United States on a path for 
higher sustained output growth in the years to come.
    The recovery was still tenuous coming into 2003, as continued 
fallout from powerful contractionary forces--the capital overhang, 
corporate scandals, and uncertainty about future economic and 
geopolitical conditions--was offset by stimulus from expansionary 
monetary policy and the Administration's 2001 tax cut and 2002 fiscal 
package. The contractionary forces dissipated over the course of 2003, 
and the expansionary forces were augmented by the Jobs and Growth Tax 
Relief Reconciliation Act (JGTRRA) that was signed into law at the end 
of May.
    The economy appears to have moved into a full-fledged recovery, 
with real gross domestic product (GDP) expanding 4.3 percent over the 
four quarters of 2003, significantly above the average growth rate 
since 1960 of 3.3 percent. This growth was particular strong in the 
second half of the year, after the passage of the Jobs and Growth tax 
relief bill. The last two quarters of 2003 showed the most rapid growth 
of any half-year period in nearly 20 years. The labor market is also 
starting to improve. Payroll employment reached a trough in August, and 
the economy has since created 366,000 jobs. The unemployment rate has 
fallen from a peak of 6.3 percent to 5.6 percent.
    This Report discusses this turning of the macroeconomic tide, along 
with a number of other economic policy issues of continuing importance. 
The 14 chapters of this Report cover five broad topics: macroeconomic 
policy, fiscal policy, regulation, reforms of the health care and tort 
systems, and issues in international trade and finance. In all of these 
areas, the Report highlights how economics can inform the design of 
public policy and discusses Administration policies.
    The Administration's pro-growth tax policy, in concert with the 
dynamism of the U.S. free-market economy, has laid the groundwork for 
sustainable rapid growth in the years ahead. Well-timed fiscal stimulus 
combined with expansionary monetary policy to offset and eventually 
reverse the contractionary forces impacting the economy. But there is 
still much to be done. The tax cuts must be made permanent to have 
their full beneficial impact on the economy. A stronger economy will 
also result from progress on the other aspects of the Administration's 
economic agenda, including making health care more affordable; reducing 
the burden of lawsuits on the economy; ensuring an affordable and 
reliable energy supply; streamlining regulations; and opening markets 
to international trade. These initiatives are discussed in this 
Economic Report of the President.

                          MACROECONOMIC POLICY

    Chapter 1, Lessons from the Recent Business Cycle, discusses the 
distinctive features of the recent recession and subsequent recovery, 
and draws five key lessons for the future. The recent business cycle 
was unusual in that it was characterized by especially weak business 
investment but robust consumption and housing investment. This makes 
clear the first lesson, that structural imbalances such as the 
``capital overhang'' that developed in the late 1990s can take some 
time to resolve. A number of events contributed to a climate of 
uncertainty in 2003, including the terrorist attacks of September 11, 
2001, corporate governance and accounting scandals, and geopolitical 
tensions surrounding the war with Iraq. The second lesson from the 
recent business cycle is that the effects of the uncertainty from these 
events on household and business confidence can have important effects 
on asset prices, household spending, and investment. Resolution of some 
of the uncertainties appears to have contributed to the resurgence of 
growth.
    Monetary and fiscal policies played a critical role in moving the 
economy back toward potential. Third lesson is that aggressive monetary 
policy can help make a recession shorter and milder. The fourth lesson 
is that tax cuts can likewise boost economic activity. Tax cuts raise 
after-tax income, while at the same time promoting long-term growth by 
enhancing incentives to work, save, and invest. Tax relief enacted in 
2001 and 2002 helped lessen the severity of the recession, while the 
2003 tax cut appears to have propelled the economy forward into a 
strong recovery. Job creation has lagged behind, even as demand has 
surged. Thus, the fifth lesson of the recent recession is that strong 
productivity growth, as was experienced in 2003, means that much faster 
economic growth is needed to raise employment. This productivity 
growth, however, is not to be lamented, since it ultimately leads to 
higher standards of living for both workers and business owners.
    Chapter 2, The Manufacturing Sector, examines recent developments 
and long-term trends in manufacturing and considers policy responses. 
Manufacturing was affected by the economic slowdown earlier, longer, 
and harder than other sectors of the economy and manufacturing 
employment losses have only recently begun to abate. The severity of 
the recent slowdown in manufacturing was largely due to prolonged 
weakness in business investment and exports, both of which are heavily 
tied to manufacturing.
    Over the past several decades, the manufacturing sector has 
experienced substantial output growth, even while manufacturing 
employment has declined as a share of total employment. The 
manufacturing employment decline over the past half-century primarily 
reflects striking gains in productivity and increasing consumer demand 
for services compared to manufactured goods. International trade has 
played a relatively small role by comparison. Consumers and businesses 
generally benefit from the lower prices made possible by increased 
manufacturing productivity, and strong productivity growth has led to 
real compensation growth for workers. While the shift of jobs from 
manufacturing to services has caused dislocation, it has not resulted, 
on balance, in a shift from ``good jobs'' to ``bad jobs.'' The best 
policy response to recent developments in manufacturing is to focus on 
stimulating the overall economy and easing restrictions that impede 
manufacturing growth. This Administration has actively pursued such 
measures.
    Chapter 3, The Year in Review and the Years Ahead, reviews 
macroeconomic developments in 2003 and discusses the Administration 
forecast for 2004 through 2009. Real GDP growth picked up appreciably 
in 2003, with growth in consumer spending, residential investment, and, 
particularly, business equipment and software investment increasing 
noticeably in the second half of the year. The labor market began to 
rebound in the latter part of 2003. Inflation remained well in check, 
with core consumer inflation declining by the end of the year to its 
lowest level in decades. The improvement in the economy over the course 
of the year stemmed largely from faster growth in household 
consumption, extraordinary gains in residential investment, and a sharp 
acceleration of investment in equipment and software by businesses. 
Payroll employment bottomed out in August and rose 254,000 over the 
remainder of the year and a further 112,000 in January. Financial 
markets responded favorably to the strengthening of the economy, with 
the total value of the stock market rising more than $3 trillion, or 31 
percent, over the course of 2003.
    The Administration expects the economic recovery to strengthen 
further in 2004, with real GDP growth running well above its historical 
average and the unemployment rate falling. Boosted by pro-growth 
policies and expansionary monetary policy, and on the foundation of the 
underlying strength of the free-market society in the United States, 
the economy is expected to continue on a path of strong, sustainable 
growth.

                             FISCAL POLICY

    Chapter 4, Tax Incidence: Who Bears the Tax Burden?, discusses the 
analysis of how the burden of a tax is distributed among taxpayers. 
This question is important to policy makers, who want to know whether 
the distribution of the tax burden (between rich and poor, capital and 
labor, consumers and producers, and so on) meets their criteria for 
fairness. The key result is that the economic incidence of a tax may 
have little to do with the legal specification of its incidence. 
Rather, it depends on the actions of market participants in response to 
the imposition of the tax.
    Distributional tables showing the tax burdens borne by different 
income groups are an important application of incidence analysis. When 
used properly, distributional tables can contribute to informed 
decision making on the part of citizens and policy makers. 
Unfortunately, mainstream economic analysis suggests that these tables 
do not always accurately describe who bears the burden of certain 
taxes. This problem does not arise from bias or lack of economic 
knowledge on the part of the economists who prepare these tables. 
Instead, it reflects resource and data limitations, uncertainty about 
some of the economic effects of taxes, and variations in the time frame 
considered by the analyses. Nevertheless, the shortcomings of 
distributional tables can lead to misperceptions of the impact of tax 
changes.
    An important implication of the economic analysis of incidence is 
that, in the long run, a large part of the burden of capital taxes is 
likely to be shifted to workers through a reduction in wages. Analyses 
that fail to recognize this shift can be misleading, suggesting that 
lower income groups bear an unrealistically small share of the burden 
of such taxes and an unrealistically small share of the gain when 
capital income taxes are lowered.
    Chapter 5, Dynamic Revenue and Budget Estimation, examines how 
taxes affect the behavior of firms, workers, and investors and 
discusses the implications for the estimated effects of a tax change on 
revenue. Changes in taxes and spending generally alter incentives for 
work, investment, and other productive activity--a higher tax on an 
activity tends to discourage that activity. Revenue estimation is 
called dynamic if it incorporates the behavioral responses to tax 
changes and static if it does not incorporate these behavioral 
responses.
    To make informed decisions about a policy change, policy makers 
should be aware of all aspects of its budgetary implications. 
Currently, official revenue estimates of proposed tax changes 
incorporate the revenue effects of many microeconomic behavioral 
responses. However, these estimates are not fully dynamic because they 
exclude the effects of macroeconomic behavioral responses. Several 
obstacles have prevented macroeconomic behavioral responses from being 
incorporated in such estimates. This chapter discusses the ongoing 
efforts to provide a greater role for fully dynamic revenue and budget 
estimation in the analysis of major tax and spending proposals. At 
least in the near term, it may not be practical for macroeconomic 
effects to be incorporated in official estimates. But estimates of 
these effects should be provided as supplementary information for major 
tax and spending proposals. Dynamic estimation of policy changes should 
distinguish aggregate demand effects from aggregate supply effects, 
include long-run effects, apply to spending as well as tax changes, 
reflect the differing effects of various policy changes, account for 
the need to finance policy changes, and use a variety of models. Reform 
of entitlement programs remains the most pressing fiscal policy issue 
confronting the Nation.
    Chapter 6, Restoring Solvency to Social Security, examines the 
largest entitlement program. Social Security is a pay-as-you-go system 
in which payroll taxes on the wages of current workers finance the 
benefits being paid to current retirees. While the program is running a 
small surplus at present, deficits are projected to appear in 15 years; 
by 2080, the Social Security deficit is projected to exceed 2.3 percent 
of GDP. These deficits are driven by two demographic shifts that have 
been underway for several decades: people are having fewer children and 
are living longer. The President has called for new initiatives to 
modernize Social Security to contain costs, expand choice, and make the 
program secure and financially viable for future generations of 
Americans.
    This chapter assesses the need to strengthen Social Security in 
light of its long-term financial outlook. The most straightforward way 
to characterize the financial imbalance in entitlement programs such as 
Social Security is by considering their long-term annual deficits. Even 
after the baby-boom generation's effect is no longer felt, Social 
Security is projected to incur annual deficits greater than 50 percent 
of payroll tax revenues. These deficits are so large that they require 
a meaningful change to Social Security in future years. Reform should 
include moderation of the growth of benefits that are unfunded and 
would otherwise require higher taxes in the future. However, the 
benefits promised to those in or near retirement should be maintained 
in full. A new system of personal retirement accounts should be 
established to help pay future benefits. The economic rationale for 
undertaking this reform in an era of budget deficits is as compelling 
as it was in an era of budget surpluses.

                               REGULATION

    Chapter 7, Government Regulation in a Free-Market Society, 
discusses the role of the free market in providing for prosperity in 
the United States and considers situations in which Government 
interventions such as regulations would be beneficial. An important 
reason for Americans' high standard of living is that they rely 
primarily on markets to allocate resources. The Government enables the 
system to work by enforcing property rights and contracts. Typically, 
free markets allocate resources to their highest-valued uses, avoid 
waste, prevent shortages, and foster innovation. By providing a legal 
foundation for transactions, the Government makes the market system 
reliable: it gives people certainty about what they can trade and keep, 
and it allows people to establish terms of trade that will be honored 
by both sellers and buyers. The absence of any one of these elements--
competition, enforceable property rights, or an ability to form 
mutually advantageous contracts--can result in inefficiency and lower 
living standards. In some cases, Government intervention in a market, 
for example through regulation, can create gains for society by 
remedying shortcomings in the market's operation. Poorly designed or 
unnecessary regulations, however, can actually create new problems or 
make society worse off by damaging the elements of the market system 
that do work.
    Chapter 8, Regulating Energy Markets, discusses economic issues 
relevant to several energy markets, including natural gas, gasoline, 
electricity, and crude oil. While energy markets generally function 
well, some parts of the energy industry have characteristics associated 
with market failures. These could stem from the large fixed costs 
required to construct distribution networks for electricity and natural 
gas that give rise to market power in the form of a natural monopoly. 
Alternatively, the market may not function well in the presence of 
negative externalities, such as when energy producers and consumers do 
not fully take into account the fact that burning fossil fuels may 
cause acid rain or smog.
    Minimizing disruptions is an important consideration in the design 
of regulations to address shortcomings in energy markets. Federal, 
State, and local regulations can have conflicting goals. If the 
conflicting goals are not balanced, competing regulations could lead to 
worse problems than the market failures the regulations attempt to 
address. Moreover, regulations need to be updated as markets evolve 
over time to ensure that their original goals still apply and that 
these regulations are still the lowest-cost means of meeting those 
goals.
    The chapter also examines global trade in energy products. The 
United States benefits from international trade in energy products 
because meeting all U.S. energy needs from domestic sources would 
require significant and costly changes to the U.S. economy, including 
changes in the types of transportation fuels used by Americans. But 
this leads to the possibility of occasional supply disruptions. An 
important consideration is that the price of oil is set in global 
markets, so that disruptions to the supply of oil from areas that do 
not supply the United States affect domestic prices of oil even if U.S. 
imports are not directly affected. Fortunately, changes in the U.S. 
economy over the past three decades and the increasing sophistication 
of financial markets have diminished the impact of supply disruptions 
and temporary price changes on the United States.
    Finally, the chapter considers the role for Government in 
subsidizing research and development into new energy sources. In 
general, policy makers should avoid forcing commercialization of new 
energy sources before market signals indicate that a shift is required. 
One potential problem with forcing this process is that technological 
breakthroughs may lead to alternatives in the future that are hard to 
imagine today. Premature adoption of new technologies would raise 
energy costs before the need arises, causing society as a whole to 
spend more on energy than needed.
    Chapter 9, Protecting the Environment, discusses market-oriented 
approaches to safeguarding and improving the environment. While the 
free-market system typically promotes efficiency and economic growth, 
the absence of property rights for environmental ``goods'' such as 
clean air and water can lead to negative externalities that reduce 
societal well-being. This problem can be addressed by establishing and 
enforcing property rights that will lead the interested parties to 
negotiate mutually beneficial outcomes in a market setting. If such 
negotiations are expensive, however, the Government can design 
regulations that consider both the benefits of reducing the 
environmental externality as well as the costs of the regulations.
    Regulations should be designed to achieve environmental goals at 
the lowest possible cost, promoting both environmental protection and 
continued economic growth. Indeed, economic growth can lead to 
increased demand for environmental improvements and provide the 
resources that make it possible to address environmental problems. Some 
policies aimed at improving the environment can entail substantial 
economic costs. Misguided policies might actually achieve less 
environmental progress than alternative policies for the same cost. 
Environmental risks should be evaluated using sound scientific methods 
to avoid possible distortions of regulatory priorities. Market-based 
regulations, such as the cap-and-trade programs promoted by the 
Administration to reduce common air pollutants, can achieve 
environmental goals at lower cost than inflexible command-and-control 
regulations.

              REFORMS OF HEALTH CARE AND THE LEGAL SYSTEM

    Chapter 10, Health Care and Insurance, discusses the roles of 
innovation, insurance, and reform in the health care market. U.S. 
markets provide incentives to develop innovative health care products 
and services that benefit both Americans and the global community. The 
breadth and pace of innovation in the provision of health care in the 
United States over the past few decades have been astounding. New 
treatment options, however, have also been associated with higher costs 
and concerns about affordability. Research suggests that between 50 and 
75 percent of the growth in health expenditures in the United States is 
attributable to technological progress in health care goods and 
services. A strong reliance on market mechanisms will ensure that 
incentives for innovation are maintained while providing high-quality 
care in the most costefficient manner.
    Health insurance plays a central role in the workings of the U.S. 
health care market. An understanding of the strengths and weaknesses of 
health insurance as a payment mechanism for health care is essential to 
the design of reforms that retain incentives for innovation while 
reining in unnecessary expenditures. Over-reliance on health insurance 
as a payment mechanism leads to an inefficient use of resources in 
providing and utilizing health care. Reforms should provide consumers 
and health care providers with more flexibility, more choices, more 
information, and more control over their health care decisions.
    Chapter 11, The Tort System, discusses the role of the U.S. tort 
system and the considerable burden it imposes on the U.S. economy. The 
tort system is intended to compensate accident victims and to deter 
potential defendants from putting others at risk. Empirical evidence, 
however, is mixed on whether the tort system effectively deters 
negligent behavior. Moreover, the tort system is a costly method of 
providing insurance against a limited number of injuries. Research 
suggests that tort liability also leads to lower spending on research 
and development, higher health care costs, and job losses.
    Ways to reduce the burden of the tort system include limits on 
noneconomic damages, class action reforms, trust funds for payments to 
victims such as in asbestos, and allowing parties to avoid the tort 
system contractually. The Administration has proposed a number of 
reforms to reduce the burden of the tort system while ensuring that 
people with legitimate claims can recover damages.

                    INTERNATIONAL TRADE AND FINANCE

    Chapter 12, International Trade and Cooperation, discusses how 
growing trade helps to spur U.S. and global growth. Since the end of 
the Second World War, international trade has grown steadily relative 
to overall economic activity. Over time, countries that have been more 
open to international flows of goods, services, and capital have grown 
faster than countries that were less open to the global economy. The 
United States has been a driving force in constructing an open global 
trading system. The Administration has pursued, and will continue to 
pursue, an ambitious agenda of trade liberalization through 
negotiations at the global, regional, and bilateral levels.
    New types of trade deliver new benefits to consumers and firms in 
open economies. Growing international demand for goods such as movies, 
pharmaceuticals, and recordings offers new opportunities for U.S. 
exporters. A burgeoning trade in services provides an important outlet 
for U.S. expertise in sectors such as banking, engineering, and higher 
education. The ability to buy less expensive goods and services from 
new producers has made household budgets go further, while the ability 
of firms to distribute their production around the world has cut costs 
and thus prices to consumers. The benefits from new forms of trade, 
such as in services, are no different from the benefits from 
traditional trade in goods. Outsourcing of professional services is a 
prominent example of a new type of trade. The gains from trade that 
take place over the Internet or telephone lines are no different than 
the gains from trade in physical goods transported by ship or plane. 
When a good or service is produced at lower cost in another country, it 
makes sense to import it rather than to produce it domestically. This 
allows the United States to devote its resources to more productive 
purposes.
    Although openness to trade provides substantial benefits to nations 
as a whole, foreign competition can require adjustment on the part of 
some individuals, businesses, and industries. To help workers adversely 
affected by trade develop the skills needed for new jobs, the 
Administration has worked hard to build upon and develop programs to 
assist workers and communities that are negatively affected by trade.
    The Administration has also worked to strengthen and extend the 
global trading system. International cooperation is essential to 
realizing the potential gains from trade. Trade agreements have reduced 
barriers to international commerce, and contributed to the gains from 
trade. A system through which countries can resolve disputes can play 
an important role in realizing these gains.
    Chapter 13, International Capital Flows, discusses the economic 
benefits and risks associated with the transfer of financial assets, 
such as cash, stocks, and bonds, across international borders. Capital 
flows have become an increasingly significant part of the world economy 
over the past decade, and an important source of funds to support 
investment in the United States. Around $2 trillion of capital flowed 
into all countries in the world in 2002, with around $700 billion 
flowing into just the United States. Different types of capital flows--
such as foreign direct investment, portfolio investment, and bank 
lending--are driven by different investor motivations and country 
characteristics. Countries that permit free capital flows must choose 
between the stability provided by fixed exchange rates and the 
flexibility afforded by an independent monetary policy.
    Capital flows can have a number of benefits for economies around 
the world. For example, foreign direct investment can facilitate the 
transfer of technology, allow for the development of markets and 
products, and improve a country's infrastructure. Portfolio flows can 
reduce the cost of capital, improve competitiveness, and increase 
investment opportunities. Bank flows can strengthen domestic financial 
institutions, improve financial intermediation, and reduce 
vulnerability to crises.
    A series of financial crises in emerging market economies, however, 
has raised some concerns that financial liberalization can also involve 
risks. In countries with weak institutions, poorly regulated banking 
systems, or high levels of corruption, capital inflows may not be 
channeled to their most productive uses. One approach to limiting the 
risks from capital flows when legal and financial institutions are 
poorly developed is to restrict foreign capital inflows. Experience 
suggests, however, that capital controls impose substantial, and often 
unexpected, costs. Instead, countries are more likely to benefit from 
free capital flows and minimize any related risks, if they adopt 
prudent fiscal and monetary policies, strengthen financial and 
corporate institutions, and develop sound regulations and supervisory 
agencies. The Administration has promoted policies to help countries 
reap the benefits from the free flow of international capital.
    Chapter 14, The Link Between Trade and Capital Flows, shows that 
trade flows and capital flows are inherently intertwined. Changes in a 
country's net international trade in goods and services, captured by 
the current account, must be reflected in equal and opposite changes in 
its net capital flows with the rest of the world. The large net inflow 
of foreign capital experienced by the United States in recent years has 
funded more investment than could be supported by U.S. national saving. 
Corresponding to these inflows is the large U.S. current account 
deficit. These patterns reflect fundamental economic forces, notably 
strong growth in the United States that has made investment in this 
country attractive compared to opportunities in other countries.
    An adjustment of the U.S. current account deficit could come about 
in several ways. Faster growth in other countries relative to the 
United States could increase demand for U.S. net exports. Trade flows 
could also adjust through changes in the relative prices of U.S. goods 
and services compared to the prices of foreign goods and services. Any 
reduction in the U.S. current account deficit would also require 
reduced net capital inflows into the United States. This might occur if 
U.S. national saving increased, reducing the need for foreign funds to 
finance U.S. domestic investment, or if U.S. investment declined, so 
that the United States required less capital inflows. Lower investment 
is the least desirable form of balance of payments adjustment, however, 
as it could slow the expansion of U.S. productive capacity and reduce 
economic growth.
    It is impossible to predict the exact timing or magnitude of any 
adjustment in the U.S. current account balance. After a large increase 
in the U.S. current account deficit in the 1980s, the ensuing 
adjustments were gradual and benign. Public policies can facilitate 
smooth changes in the U.S. current account and net capital flows by 
creating a stable macroeconomic and financial environment, promoting 
growth abroad, and encouraging greater saving in the United States.

                               CONCLUSION

    The future of the U.S. economy is bright. This is a testament to 
the institutions and policies that have unleashed the creativity of the 
American people and their spirit of entrepreneurship. History teaches 
that the forces of free markets are the bedrock of economic prosperity.
    In 1776, as the Founding Fathers signed the Declaration of 
Independence, the great economist Adam Smith wrote: ``Little else is 
requisite to carry a state to the highest degree of opulence from the 
lowest barbarism but peace, easy taxes, and a tolerable administration 
of justice: all the rest being brought about by the natural course of 
things.'' The economic analysis presented in this Report builds on the 
ideas of Smith and his intellectual descendants by discussing the role 
of the Government in creating an environment that promotes and sustains 
economic growth.
  

                                  
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