[Economic Report of the President (1997)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]

[DOCID: f:erp_c1._]
Economic Report of the President - - - - - - - - - - - - H. Doc. 105-002
[From the online service of the U.S. Government Printing Office]
[wais.access.gpo.gov]


CHAPTER 1--Growth and Opportunity: Creating a New Economic Order

THE AMERICAN ECONOMY TODAY is the healthiest it has been in three
decades. But just as important as the economy's current performance is
the foundation being laid for its future health and strength. Like its
predecessors, this Economic Report of the President, the last of this
President's first Administration, summarizes the present state of the
economy and the accomplishments of the past 4 years. But it also sets
forth the economic legacy this Administration hopes to leave. That
legacy includes a vibrant and evolving set of public institutions,
investments that will provide the basis for continued growth, and an
economic philosophy of government and markets that will help to guide
these institutions and investments. Together these will constitute a
bequest to future generations, contributing to rising living standards,
expanded opportunities, and a greater sense of community.
The real measure of the success of any Administration's economic
policies is not just today's economic statistics, but also the strength
of the Nation's economy in 10 or 20 years' time. Today's economic
policies will be judged favorably if, as a result, growth is stronger,
the environment cleaner, and the number of children growing up in
poverty fewer. History will pronounce these efforts a success if, a
generation from now, opportunity has been expanded in our cities,
tomorrow's senior citizens are at least as economically secure as
today's, and all our citizens have the education they need not just to
cope with but to profit from the challenges of a changing world. If we
can look back upon a record of such accomplishments, we will know that
the last years of the 20th century laid a solid foundation for the 21st.
No Administration starts with a clean slate: each must work with the
assets and the liabilities it has inherited, and each Administration
that follows will to some degree reshape and revise what this one has
built. We are constrained and enabled not just by our physical and our
fiscal inheritance, but also by our intellectual inheritance--by
prevailing modes of thought and by the ways in which we and our
contemporaries view and approach the world. Consequently, it is hard
enough in the present to formulate the policies that will guide us
toward a more prosperous future, harder still to assess today their
impact decades hence.
For more than two decades America has faced several serious
problems: productivity growth has been slower than in the past, income
inequality has increased, and poverty has persisted. In addition,
serious challenges loom for the future, such as the aging of the baby
boom, which threatens to create severe fiscal strains in the next
century. In the last 4 years the Administration has taken important
steps to respond to these challenges. Only if we maintain and extend
these initiatives will we leave a strong legacy for the future.
This chapter begins by describing what will perhaps be viewed as
this Administration's most enduring contribution, the formulation and
implementation of an economic philosophy for the 21st century. The
economic record, which reflects the policies articulated by this
philosophy--policies that have mitigated or reversed many of the
undesirable economic trends of the 1980s and early 1990s--is the second
subject of this chapter. But the task of preparing for the future is far
from complete. The third section of this chapter therefore focuses on
the Administration's agenda for promoting the three complementary goals
of growth, opportunity, and responsibility.

AN ECONOMIC PHILOSOPHY

At the center of the U.S. economy is the market: vibrant competition
among profit-maximizing firms has enhanced economic efficiency and
generated innovation, giving the United States one of the highest
standards of living in the world. Within this market-based economy,
government plays a limited, yet critical, role. It is essential to
understand the proper role of government if the economy's strong
performance is to continue and to improve.
In the past, two opposing visions of the American economy have vied
for dominance. To put it starkly, one is a Panglossian view of an
America of vigorous, self-sufficient individualism, the other of a world
in which government is primarily responsible for our well-being. The
first view is one of Horatio Algers making their way on their own, of
self-reliant entrepreneurs creating wealth from which everyone
eventually benefits. In this vision the main job of government is to
keep out of the way, to do no harm. This economic worldview has its
roots in the writings of Adam Smith, was refined into the classical
liberalism of the 19th century, and has persisted into contemporary
times in the rhetoric of the Reagan Presidency and its supporters.
The second vision is one that distrusts markets. At its extreme,
this is a vision of an America full of monopolistic firms despoiling the
environment and exploiting the masses of workers to earn huge profits
for a handful of managers and shareholders. It sees pervasive market
failures producing dire consequences, such as farmers and workers
precluded from earning a decent living, and large parts of society--
particularly in the inner cities and impoverished rural areas--simply
left behind. The hero of this vision is government, endowed with both
the omniscience and the omnipotence to cure these ills through active
intervention in the market. The New Deal crystallized these currents
into a new kind of liberalism, in some ways antithetical to the old.

THE NEW VISION

Over the past 4 years, this Administration has promoted a third
vision, one that synthesizes and transcends these two polar worldviews.
This vision puts individuals at its center, but it emphasizes that
individuals live within and draw strength from communities. It
recognizes that many have been left behind by the changing economy and
may need government assistance, but that the role for government is
limited: it can and should promote opportunity, not dependence.
This new vision includes a renewed conception of government--one in
which government recognizes both the market's efficiencies and its
imperfections. The government can sometimes make markets work better,
but it is seldom in a position to replace them. Government has its
strengths and its limitations. We need to understand those limitations
and, where possible, work to improve government's performance. The
government cannot ignore the role of market forces in its own programs:
it needs to take advantage of the power of incentives to accomplish its
objectives.
Critics of government often pose a false dilemma: which can do the
job better, the government or the market? Yet the question is seldom
whether government should replace the market, but rather whether
government can usefully complement the market. On this question a
consensus holds that, in many particular circumstances, the answer is
clearly yes. In the trough of the Great Depression, for example, one out
of four workers was without a job--clearly the market was not performing
well. It was that harrowing experience that led to enactment of the
Employment Act of 1946 (the same legislation that established the
Council of Economic Advisers), which assigned to the Federal Government
the responsibility to ``promote maximum employment, production, and
purchasing power.''
Over the years, economists have identified the various circumstances
in which markets fail to produce desirable outcomes, and in which
selective government intervention can complement markets. Competition
may be imperfect, market participants may lack needed information, or
markets may be missing. Would-be innovators and entrepreneurs may fail
to capture enough of the benefits of their activity to justify their
effort, or the users of resources, such as clean air and water, may
escape the full costs of their use, degrading the resources for all.
Although such problems may occur throughout the economy, it is important
for the government to focus on those that are particularly severe. Like
any successful enterprise, it must identify a core mission and pursue
it.

GOVERNMENT'S CORE ECONOMIC MISSION

Government's presence in the economy has become so pervasive that we
can easily lose sight of its core mission. A few simple principles can
serve as a guide to rediscovering that core mission.
The criterion for government involvement in any activity should not
be how essential that activity is to the economy, or how many jobs it
generates, or how much it contributes to the trade balance. In the
overwhelming number of cases, the government cannot hope to surpass
private firms at generating output, jobs, and exports. The proper
question in circumstances where a choice between government and the
market arises is whether any reason exists not to rely on markets. Is
there--in the language of economists--a market failure?
The government should focus its attention on those areas in which
markets will not perform adequately on their own, in which individual
responsibility is insufficient to produce desirable results, and in
which collective action through government is the most effective remedy.
Americans are better off in a society in which individuals are
encouraged to exercise as much responsibility as possible. But both
economic theory and historical evidence indicate that, left to
themselves, individuals and firms will produce too little of some goods
like basic scientific research, and too much of others, such as
pollution and toxic wastes. We also know that, without government
assistance, many children from disadvantaged backgrounds may not be able
to realize their full potential. Government social insurance programs
have enabled individuals to make provision for risks that almost all
individuals face and that, at the time the programs were launched,
markets did not--and still largely do not--address effectively. Among
them are programs that provide some insurance against unemployment,
retirement benefits secured against the risk of inflation, and medical
care for the aged.
It is essential to remember, whenever evaluating an existing
government program or contemplating a new one, that the government
cannot direct resources to someone without taking resources away from
someone else. In a full-employment economy such as the Nation enjoys
today and hopes to maintain, misguided subsidies pull resources away
from more productive sectors and divert them toward less productive
ones. Some individuals gain, but society as a whole suffers a net loss.
To prepare the economy, and the government, for the 21st century, we
need to rethink and revitalize our policies to respond to the new
challenges. We also need to strip away outmoded programs that respond
primarily to problems of the past.

AN INTERNATIONAL VISION

In international just as in domestic economic policy, two
fundamentally different visions have long dominated the debate. At one
extreme, countries interact atomistically in an undifferentiated world
of free trade abroad and free markets at home. In this view,
international economic relations are just a matter of opening markets.
The other perspective harks back to 18th-century mercantilism, often
supplemented with metaphors from the Cold War. It replaces ideological
competition with economic competition, and sees the gains on one side of
the border coming at the expense of losses on the other. The trade
deficit, in this view, replaces the missile gap as the measure of our
national inadequacy.
Here, too, this Administration has sought to carve a new path. It
recognizes the benefits of free trade, but also the existence of
international public goods, not just in the trade arena but in other
dimensions of international affairs as well. This new vision does not
split the difference between these two views; rather, it recognizes that
the vision of trade as war is profoundly wrong. Trade is not a zero-sum
game. It does not merely create a winner for every loser: all countries
can gain. As America's trading partners grow, they buy more U.S. goods
and services. As the U.S. economy grows, we buy more of theirs, so that
trade can play a catalytic role in a virtuous cycle of ever-higher
levels of growth and living standards. The opposite is also true:
attempts by many countries in the 1930s to escape from the Great
Depression by pursuing beggar-thy-neighbor policies only made everyone
worse off.
Defenders of free trade can do it a disservice by promoting it as a
way to create more jobs or to reduce bilateral trade deficits. Jobs, the
unemployment rate, and the overall balance of payments are ultimately a
consequence of macroeconomic policies, not of trade barriers. The real
objective of free trade is to raise living standards by ensuring that
more Americans are working in areas where the United States is
comparatively more productive than its trading partners. In a full-
employment economy, trade has more impact on the distribution of jobs
than on the quantity of jobs.
The new philosophy recognizes that unfettered global markets are
not, by themselves, sufficient. Markets function best within an
institutional environment that makes rules to promote free competition
while facilitating the cooperation necessary for a stable world economy.
What is required is general understanding of the issues and difficulties
in international trade and mutual commitments, of the kind embodied in
the General Agreement on Tariffs and Trade and the World Trade
Organization (WTO), not to allow the pleadings of special interests to
interfere with the gains that all enjoy from free international trade.
The new philosophy also recognizes that just as domestic public
goods will be underprovided by free markets at home, so a decentralized
trading system is insufficient to supply public goods that benefit
people around the globe. An important example of an international public
good is economic cooperation, including that essential to maintaining
free trade. Basic research and a clean environment are other examples of
international public goods in which cooperation can provide benefits to
the United States, while also helping other countries. In making these
international public goods available, we need to combine competition in
the international marketplace with cooperation in establishing the rules
of the game.

THE ECONOMIC RECORD

In 1992, against a backdrop of an uncertain and jobless recovery and
rising budget deficits, the then-Governor of Arkansas, campaigning for
President, set two basic goals for economic performance in his first
term: to establish an economic environment in which more than 8 million
jobs would be created, and to cut the Federal budget deficit in half.
Both these goals have been surpassed.

THE ACHIEVEMENTS

In 1992 the national unemployment rate averaged 7.5 percent. Almost
10 million people were looking for work. Over the last 4 years the
unemployment rate has come down to 5.4 percent. Not only has the economy
created more than 11 million new jobs, over 3 million more than
promised, but the new jobs are mostly good jobs: two-thirds of recent
employment growth has been in industry/occupation groups paying wages
above the median.
Meanwhile underlying inflationary pressures have subsided. In 1992,
inflation as measured by the core consumer price index (the core CPI
excludes the volatile food and energy components) was 3.7 percent. In
1996 core inflation was only 2.7 percent. The combination of low
unemployment and stable inflation has given the United States the lowest
``misery index'' since the 1960s (Chart 1-1). Some of the key factors
contributing to the economy's increased ability to maintain both stable
prices and low unemployment are analyzed in Chapter 2. Among the
important ingredients are increasing competition and greater openness to
the rest of the world economy.
Economic growth has been strong and sustainable. The economic
expansion has been marked by a healthy balance among the components of
demand. Private, not public, demand has been the engine of growth. The
Administration's initiative to reinvent government has slowed the growth
of the public sector. Private sector demand, by contrast, has grown at a
3.2 percent annual rate since the beginning of this Administration, up
from 2.4 percent over the previous 12 years. It is particularly
heartening to note that investment and exports have led the expansion.
Investment is booming: real spending on producers' durable equipment has
grown a stunning 11 percent per year since 1993. Not only has investment
been the strongest component of demand for the past 4 years, but the new
structures and equipment that it represents will remain part of the
Nation's capital stock, promoting growth and productivity for years to
come. The second-strongest component of growth has been exports, which
have increased by 7 percent per year since this Administration took
office.


Just as important as today's conjuncture of growth, unemployment,
and inflation is the question of whether the economy can continue to
grow, with low unemployment and stable inflation. In terms of
sustainability and sound fundamentals, this expansion is one of the
strongest in recent memory. In contrast, much of the growth of the 1980s
and early 1990s was fueled by large deficits and a quadrupling of the
national debt. This path of growth fueled by government spending could
not have continued indefinitely. No less important, over that period
changes in the tax system created perverse incentives that led to
overbuilding of commercial real estate and high vacancy rates. Although
investment rates were high, much of this investment did not enhance the
long-run productive potential of the economy. Another factor that bodes
well for this expansion to continue is the health of the financial
system, which has finally recovered from the debacle of the late 1980s,
caused in part by lax regulatory oversight.
Not only has the economy grown rapidly and sustainably, but the
fruits of that growth have begun to be shared more equitably. Between
1993 and 1995, the most recent year for which data are available, the
poverty rate fell from 15.1 percent to 13.8 percent--the largest 2 year
drop in over 20 years. Poverty rates for elderly and for black Americans
reached their lowest levels since these data began to be collected in
1959. Not only have the incomes of every quintile of the income
distribution increased, but the largest percentage increase has been
seen by the poorest in American society. Median real household income
rose 2.7 percent in 1995--and more if, as some believe, the CPI has been
overstating actual inflation. Chapter 5 provides more details on trends
in household income and the factors that may account for the recent
decrease in inequality, which appears to be larger than the normal
cyclical improvement.

THE REASONS

Since 1993 this Administration has developed a comprehensive agenda
that has contributed to the Nation's current economic health and
strength. The key elements of this agenda are reducing the deficit,
opening markets at home and abroad, and restoring prudence to
macroeconomic management.

Reducing the Deficit

The Administration's most important economic policy accomplishment
has been a substantial reduction in the Federal budget deficit. Since
the 1992 fiscal year the deficit has been cut, not just in half as the
President promised, but by 63 percent--from $290 billion in 1992 to $107
billion in fiscal 1996 (Chart 1-2). As a share of gross domestic product
(GDP), the deficit has fallen over the same period from 4.7 percent to
1.4 percent--its lowest level in more than 20 years. In 1992 the U.S.
general-government deficit (the combined deficit for all levels of
government) was larger in relation to the economy than the deficits of
Japan or Germany were to theirs; today it is a smaller fraction of GDP
than in any other major industrialized economy.


The dramatic decline in the deficit over the past 4 years is the
result of many factors. By far the most important are the fiscal policy
changes adopted in the Omnibus Budget Reconciliation Act of 1993
(OBRA93) and the stronger economic performance to which it contributed.
Under the policies in place when this Administration took office, the
1996 deficit was projected to rise to $298 billion, even though the
projection assumed 5 years of robust expansion.
Lower spending and increased revenues resulting from OBRA93 and
subsequent legislation were responsible for more than $100 billion of
deficit reduction in the fiscal year that ended in September 1996. The
remaining budget savings are due to a combination of higher-than-
expected tax revenues and lower-than-expected spending, which resulted
from the stronger economy and a variety of technical factors unrelated
to legislative changes. Many of these economic and technical factors are
also the product, although less directly, of the Administration's
policies--including the policy of deficit reduction itself. Even though
the Administration felt confident that its policies would significantly
improve the economy, it continued to use conservative forecasts for
budgetary purposes: growth in every year of this Administration has
turned out to exceed these budgetary forecasts.
It is difficult to say with confidence what would have happened had
the Administration not put deficit reduction at the top of its economic
agenda and pushed through OBRA93. A controlled experiment on the entire
macroeconomy is obviously impossible, but a simple analysis can provide
some insights. We can say, first of all, that if deficits had continued
at the levels projected in 1992, the Federal debt today would be half a
trillion dollars higher than the $3.7 trillion currently held by the
public. With so much more accumulated debt, and with higher deficits
continuing, interest rates would certainly be higher than they are
today. The more restrained fiscal policy helped create conditions that
enabled the Federal Reserve to maintain a more expansionary stance--that
is, lower short-term interest rates--than it might have otherwise. It is
hard to imagine that the rapid expansion of investment in producers'
durable equipment that has supported this expansion could have happened
in an environment of higher interest rates.
The effect of deficit reduction on business confidence has been less
tangible, but no less important. Business confidence was weak in 1992:
business leaders felt genuine concern about the mounting deficits and
the political system's evident inability to address the underlying
issues. Such anxieties are bad for investment. After 12 years of
budgetary excess, however, this government has finally showed that it
can bring its own finances under control. But confidence is something
that has to be continually renewed. That is why this Administration is
committed to continuing to reduce the deficit to zero.
In short, had the Administration not put deficit reduction at the
top of its economic agenda, the Nation's debt would surely be much
larger, and its economic future bleaker, than they are today. And it is
unlikely that the economy would have experienced as healthy an expansion
as it has.

Opening Markets at Home

Another cornerstone of the Administration's economic strategy has
been an aggressive policy of reforming regulatory structures in key
sectors of the economy, including telecommunications, electricity, and
banking. In reforming electricity and telecommunications regulation, the
Administration's belief was that the proper regulatory structure would
enhance competition, which would lead to valuable new services and lower
prices. Recent financial reforms have provided greater incentives for
competition and innovation, in ways that have reduced the overall cost
of regulation to both the government and the banking sector itself while
preserving and enhancing the safety and soundness of the Nation's banks.
On the environmental front, the Administration has shown that regulatory
policies that recognize the importance of incentives can be both cheaper
and more effective than traditional regulatory controls. Tradable
permits for sulfur dioxide emissions are a prime example. The full
import of these and other regulatory changes will not be felt for years
to come.

Opening Markets Abroad

The third element of the Administration's economic policy has been
an aggressive effort to increase exports through the opening of markets
abroad. Two major trade agreements--the North American Free Trade
Agreement (NAFTA) and the Uruguay Round accord of the General Agreement
on Tariffs and Trade, which established the World Trade Organization--
were enacted during the President's first term. The first major fruits
of the WTO are now on the horizon, with the December 1996 agreement in
Singapore to reduce tariffs on a wide variety of information technology
products to zero. The United States will certainly gain, both as a major
exporter of information technology and as an importer, as American
industries take advantage of new foreign technologies that will lower
their costs and increase their productivity. In addition, the value of
NAFTA to U.S. exports was proved during Mexico's 1995 financial crisis.
Despite Mexico's sharp economic contraction, NAFTA ensured that Mexico
kept its markets open to U.S. products, in sharp contrast to the
restrictive policies that had followed Mexico's 1982 financial crisis.
As a result, U.S. exports were maintained, and by 1996 they had risen to
new records. Mexico also benefited because NAFTA prevented any potential
recourse to insular and protectionist policies; partly as a result, by
the second half of 1995 the Mexican economy had started to recover.
Two other major regional groupings--our Pacific Rim trading partners
in the Asia-Pacific Economic Cooperation forum and our Western
Hemisphere neighbors engaged in talks toward a Free Trade Area of the
Americas--have made commitments toward free trade among their members by
2020 and 2005, respectively. More than 200 other trade agreements have
been completed since the beginning of this Administration.
As already noted, U.S. exports have boomed, especially in those
areas where trade agreements have been reached. Increased trade allows
the United States--and its trading partners--to exploit comparative
advantage. These gains from trade are reflected in the fact that wages
in jobs supported by goods exports are 13 to 16 percent higher than the
national average. Some critics suggest that the growth in exports was
simply a matter of exchange rates tilting in favor of the United States.
Over the last 4 years, however, the trade-weighted exchange rate of the
dollar (a standard measure of exchange rates with all of the United
States' principal trading partners) changed by only about 2 percent.

Restoring Confidence in Economic Policymaking

Americans now have more confidence in their government's handling of
the economy. Polls show that more Americans rated the conduct of
economic policy favorably in November 1996 than at any time in the
previous decade. This vote of confidence was the result of a number of
factors. First, the government was putting into practice an economic
philosophy that not only seemed to be working, but was in accord with
the country's basic values. That economic philosophy, as enunciated
above, understands both that neither the market nor the government can
correct all the shortcomings in American society. Government has a
place, but government has to know its place. The initiatives outlined
above--from getting the deficit under control to securing the long-
overdue passage of a new telecommunications bill--were proof that this
philosophy could work.
Not only was the substance of economic policy viewed as a success;
so was the process of policy development. The establishment of a
National Economic Council (NEC) to oversee that process ensured that the
economy would get the same attention within the White House that foreign
affairs had gotten since the National Security Council was established
nearly 50 years earlier. The NEC has effectively coordinated the inputs
of the many Federal agencies, to ensure that the President receives the
best options and advice, without setting agency against agency in
wasteful internal turf battles. Also, the public differences between the
Federal Reserve and the executive branch that had sometimes
characterized earlier Administrations were replaced with a respect for
the central bank's independence.

THE ECONOMIC AGENDA

The United States still faces major economic challenges. American
technology, the economy, and society are all changing rapidly. Instead
of ignoring or lamenting these changes, the Nation must embrace them,
transforming problems into opportunities. We can do this only if we set
a coherent economic agenda. This Administration has already accomplished
much with the policies of the last 4 years. In the next 4 years the
Administration will continue to build on those policies, holding fast to
its new vision of the government's role in the economy as the basis for
an agenda to promote growth, opportunity, and responsibility.

GROWTH

Productivity growth has been slow since the early 1970s. Since 1973,
annual rises in productivity in nonfarm businesses have averaged 1.1
percent, a drastic decline from the 2.8 percent annual average that the
Nation enjoyed between 1960 and 1973 (Chart 1-3). Biases in the methods
used to calculate these numbers may exaggerate the slowdown (a question
taken up in Chapter 2), but something has undoubtedly happened to slow
the pace at which output per hour increases (Box 1-1). Slower
productivity growth has the direct consequence of retarding increases in
the Nation's standard of living. It also places obstacles in the way of
solving some of the Nation's other challenges. Americans may be less
supportive of freer trade when trade liberalization has been associated,
however spuriously, with slower growth. It will be harder to balance the
budget over the long term, especially while supporting a growing aged
population, when productivity growth is slow. And workers are more
reluctant to share their resources with those who are worse off when
they feel that their own wages are stagnant.


The sources of economic growth can be grouped under three headings:
increases in physical capital, improvements in human capital, and
increases in the overall efficiency of the economy--the amount of output
per unit of input. The Administration's economic agenda is based on
strengthening each of these three pillars of economic growth.

Box 1-1.--Explaining the Productivity Slowdown

The framework that economists use to decompose growth into
contributions of physical capital, human capital, and their efficiency
can be used to understand the causes of the productivity slowdown. This
slowdown, which began around 1973, was similar in its timing and
magnitude in all the advanced industrial economies. Consequently, it
cannot be explained by purely domestic factors.
Slower growth of inputs--physical capital and human capital--is
not a major cause of the slowdown. The capital-labor ratio has grown a
bit more slowly since 1973, but only enough to account for 0.2
percentage point of the approximately 2-percentage-point decrease in
productivity growth. And the rate of increase of human capital--the
education and experience of workers--has actually increased since the
1950s and 1960s. Human capital growth now accounts for not only a larger
share of productivity growth (27 percent from 1973 to 1994, compared
with 3 percent from 1960 to 1973), but a larger absolute amount as well
(0.3 percentage point versus 0.1 percentage point). Policies to increase
investment, education, and training, however important for other
reasons, do not address the underlying causes of the slowdown.
From an accounting perspective, almost the entire slowdown is
attributable to a decrease in multifactor productivity growth, that is,
the efficiency with which capital and labor are used. Although the
causes are murky, some insight comes from the explanation of the
productivity speedup of the 1950s and 1960s. Some of that era's
abnormally rapid productivity growth resulted from the private sector's
use for civilian purposes of the burst of innovation--largely government
funded--inspired by the war effort in the 1940s. Some important examples
are the digital computer, other advances in electronics, and the
development of nuclear energy. Thus, although we may not fully
understand the causes of the slowdown, policies aimed at increased
support for science and technology are obviously strong candidates to be
part of the solution.

Increasing Physical Capital

The first pillar of economic growth is increases in physical
capital, which enable workers to produce more goods and services.
Because it reduces the government's borrowing, deficit reduction will
remain the key to how much of national saving is available for private
investment in physical capital. The Nation has made great progress in
bringing down the deficit in the last 4 years, but this ground will be
lost unless we address the strains that some of the major entitlement
programs will place on the budget over the long term. As the population
ages, expenditures on Social Security are expected to grow from an
estimated 4.7 percent of GDP in 1996 to around 6.4 percent in 2030, then
stabilize. A much more serious challenge is posed by Medicare and
Medicaid. If nothing is done to reform these programs, their outlays are
projected to grow from an estimated 3.9 percent of GDP in 1996 to 13.0
percent in 2050. Their projected growth is due not just to the aging of
the population, as in the case of Social Security, but also to the
expectation that the volume and intensity of medical services consumed
will continue their rapid rise. Chapter 3 analyzes the factors
underlying these projections and some of their implications for the
future of these programs.
Assuming Federal tax revenues remain at their historically constant
level of around 18 percent of GDP, the projected increase in
entitlements, especially Medicare and Medicaid, will have one of two
effects: either it will balloon the budget deficit, or it will all but
crowd out other vital government expenditures, including those necessary
to sustain long-term economic growth, such as education and research and
development. The deficit reduction of the last 4 years, however, has put
the Nation in a position to address these long-term issues in a manner
that preserves the important achievements of Medicare, Medicaid, and
Social Security.
When the government runs a smaller deficit, it absorbs less private
saving and frees up resources for private sector investment. But public
investments in infrastructure, such as roads, schools, and airports, are
also important. It is false economy to release funds for investment in
one area by cutting back in another where the need and the return are
just as great. Entrepreneurs will be reluctant to build new factories,
homes, and offices if the highways and bridges that link them are
inadequate for the new traffic they generate.
To be sure, government must take pains to see that every dollar it
invests, like every other government dollar, is well spent. We have to
think hard about how to put into place incentives that make such
outcomes more likely. And we have to think carefully about which public
investments should be the responsibility of the Federal Government and
which the responsibility of States and localities. But fear of
misdirected investment should not lead to underinvestment, because too
little investment is costly to future growth. In short, we should not
create an infrastructure deficit while attempting to improve the budget
deficit.

Improving Human Capital

The second pillar of economic growth is improvements in what
economists call human capital: the knowledge, experience, and skills of
the workforce. As the economy has changed, the demands imposed on the
brainpower of the American workforce have increased enormously. As
Chapter 5 reveals, the returns to education, as measured by the
difference in incomes between college and high school graduates, have
risen sharply in the last 20 years. Much of this difference probably
reflects the increasing importance of computer skills in the workplace.
Many American schools do a superb job of human capital formation,
but some are failing at the task. Standardized test scores reflect only
part of the learning that goes on in schools, yet the fact that American
children perform less well on standard science and mathematics tests
than many of their foreign counterparts is a continuing source of
concern. There is no easy answer.
Recognizing the challenge that these changes pose, the President has
set ambitious goals for the Nation's education system: every 8-year-old
should be able to read, every 12-year-old should be able to log onto the
Internet, every 18-year-old should be able to go to college, and every
classroom and library in America should be linked to the Internet.
An array of policies, current and proposed, are directed toward
achieving these goals. The America Reads initiative, working through the
National Service program, will call on thousands of people to mobilize
an army of a million volunteer tutors, dedicated to ensuring that every
child in America can read by the age of 8. A good education in the early
years of a child's life is necessary, but hardly sufficient to endow
that child with the skills that our technological society demands.
Therefore, in addition to early-education programs, we need to promote
technology in the classroom and encourage young people to take more
years of college.
Although the returns to additional years of education are
substantial--between 5 percent and 15 percent--without government
involvement many students would find it difficult to borrow for college.
Not only do they lack a credit history, but they cannot borrow against
expected future earnings--human capital cannot be pledged as collateral.
The result is a classic market failure: markets by themselves do not
provide all the education for which the benefits exceed the costs, even
when the benefits are measured only in narrow economic terms. Since the
G.I. Bill was passed in the 1940s, the Federal Government has had an
acknowledged role in making higher education more affordable. Policies
already implemented by this Administration are bringing us much closer
to the day when every American who wants to will be able to attend at
least 2 years of college. Under the new direct student loan program, for
example, individuals can borrow money for college directly from the
Federal Government and tailor their repayments to suit their own
financial circumstances. Seeking to build on the success of this
program, the President has also proposed tuition tax credits, to support
those seeking higher education, and penalty-free withdrawals from
individual retirement accounts, to encourage them to save for it
themselves.
Meanwhile the Technology and Literacy Challenge initiative is
bringing advanced computer technology into every classroom in the
Nation. It is making significant progress toward ensuring that all
American students are computer literate, equipped with the skills they
will need in the 21st century. Under this initiative, 20 percent of all
the schools in California have already been wired to the Internet--a
good example of government and the private sector complementing each
other. The Federal Government served as entrepreneur for this
initiative, but much of the work was done by 50,000 volunteers, with
many of the Nation's leading high-technology firms donating equipment.
The initiative also stresses the development of educational software and
the training of teachers to harness the potential of these new
technologies.
Other steps are important in preparing the Nation's educational
system for the 21st century. Recent reports have documented the extent
to which America's public schools have become dilapidated. Schools with
leaky and collapsing roofs have had to be closed. Because students need
a more conducive environment in which to learn, the President has
proposed $5 billion in Federal funding to support a program,
administered by the States, that would spend $20 billion for school
construction and renovation. Additional efforts are focused on enhancing
resources for those communities facing the hardest problems (e.g., those
with disproportionate numbers of disadvantaged children), improving
standards through the Goals 2000 program, and promoting new approaches
through the charter school movement.
Education does not end with college. That is why this Administration
has consistently emphasized lifelong learning and employability
security, to boost economic growth and reduce the adjustment costs
associated with a vibrant economy. Unfortunately, the legacy of past
efforts in this sphere has left workers facing a complicated maze of
dozens of government-assisted training programs, each with its own
rules, regulations, and restrictions. The President has proposed
replacing this complex system with a single choice-based system for
adults. This system should use a market-oriented approach, relying on
training vouchers or grants to empower people directly to seek the
training that will help them the most.

Research and Development

The third pillar of growth is greater economic efficiency--learning
to produce more output with fewer inputs. Additions to the Nation's
technological arsenal through research and development are an important
contributor to efficiency: private industry invests over $100 billion in
research and development each year. This is a huge sum, but it may not
be enough: history and economic theory suggest that, left to their own
devices, private firms will not invest sufficiently in improving
technology, because they themselves do not realize the full benefit
therefrom. Even though the patent system encourages invention by
guaranteeing that inventors retain property rights to their innovations,
many very useful ideas developed in more basic scientific research
cannot (and should not) be patented.
The Federal Government has long played a critical role in promoting
research and development. It has financed growth in telecommunications,
for instance, from that industry's inception, with the first Baltimore-
to-Washington telegraph line, to its latest major development, the
Internet. In agriculture, government-funded research provided the basis
for enormous improvements in productivity that today allow less than 3
percent of the workforce to feed the entire Nation, and have made the
United States one of the world's leading agricultural exporters.
Detractors of government support for research have often distorted
the issue. Some have posed a false dichotomy between basic research, for
which public support is almost universal, and technology, which they say
should remain the province of the private sector. Yet many areas of
technology have huge spillover benefits and therefore would be
underprovided without government support. Critics have also accused
government of trying to ``pick winners''--of seeking to supplant the
market at one of the things it does best. But government support of
technology is not aimed at outguessing the market. Rather, it is focused
on setting up partnerships and other structures to identify, together
with the private sector, those areas in which large benefits to society
are not likely to be produced by the market alone.
In the spirit of the Administration's new vision for the economy,
the Federal Government has placed public-private partnerships at the
center of its research and development policy. The Advanced Technology
Program (ATP), expanded substantially under this Administration, is a
good example. ATP awards matching funds to industry, on a competitive
basis, to conduct research on cutting-edge technologies and processes
that, despite their great economic potential, might otherwise not have
been pursued. The firms themselves set much of the research agenda, but
this pairing has been an effective way to leverage government funding
into larger increases in research and development. The record shows that
the success rate of this and similar programs is indeed formidable.

Increasing Competition

Improving the efficiency of the economy is not just a matter of
improving technology. How the economy is organized plays just as
important a role in creating incentives for firms to use their capital
and labor as efficiently as possible. If the market economy is to
deliver on its promise of growth and prosperity, markets have to be
competitive, because it is competition that drives firms to be efficient
and innovative. Firms, however, often find it easier to increase profits
by reducing competition than by improving efficiency in response to
competition. Monopolies and oligopolies not only can charge
inefficiently high prices and restrict output, but may also have a
diminished drive to innovate.
The traditional way to increase competition is to prevent the growth
of monopoly power in the first place. This Administration has restored
vigor to the enforcement of the antitrust laws, blocking anticompetitive
mergers and, where warranted, prosecuting alleged violators. But
competition is not viable in some industries, namely, those called
natural monopolies. Antitrust enforcement may be of little help in these
areas; instead government regulation can help to ensure that monopoly
power is not abused.
The extent and the form of competition are constantly changing.
Joseph Schumpeter, one of the 20th century's great economists, described
capitalism as a process of creative destruction. New industries
constantly come into existence as old industries are destroyed. The late
19th and early 20th centuries saw the transformation of the economy from
a mostly agricultural to a mostly industrial one. Today services and
information are assuming the lead position, while at the same time
demand for U.S. goods is increasingly coming from abroad. Sometimes
analysts focus on manufacturing as if it still represented the core of
the economy. Manufacturing is important--it is the Nation's largest
investor in research and development and its leading exporter--but
manufacturing employment today represents only 15 percent of total
employment, and service industries also produce many of our important
exports, for example in telecommunications, financial services, and
other intellectual property.
Today, new technologies have expanded the scope for competition in
many sectors that have historically been highly regulated, such as
telecommunications and electric power. Traditional regulatory
structures, however, with their rigid categories of regulation versus
deregulation, and competition versus monopoly, have become increasingly
unhelpful in guiding policy in these areas. These new technologies do
not call for wholesale deregulation because not all parts of these
industries are adequately competitive. Instead they call for appropriate
changes in regulatory structure to meet the new challenges. Such changes
must recognize the existence of hybrid areas of the economy, some parts
of which are more suited to competition, while others are more
vulnerable to domination by a few. Market power in one part of a
regulated industry cannot be allowed to maneuver itself into a
stranglehold over other parts, or else economic efficiency may be
severely compromised. The Administration's regulatory reforms in the
telecommunications and electric power industries have attempted to
achieve competitive balance.
Even as these changes have intensified competition in some parts of
the economy, it remains limited in others. In particular, where goods
and services are locally provided, and where transportation costs are
high, consumers in some areas may have too little choice, even if
providers in the country as a whole are numerous. In parts of the
country, for example, a single hospital may be the only one serving a
large rural area. In the health care sector, new guidelines for
antitrust enforcement were recently issued in response to concerns such
as these, and the Administration has resisted attempts to scale back
antitrust enforcement in this area. The benefits of competition can be
seen in our university system, where competition remains keen--and
perhaps partly accounts for the dominant position American universities
hold in the world of higher education.

Expanding Trade

The third source of increasing efficiency in the economy is more-
open markets abroad. Like the freeing up of domestic markets, opening of
foreign markets shifts resources into relatively more productive areas.
The Administration will continue to pursue its outward-oriented,
protrade agenda through multilateral, regional, and bilateral means,
expanding on and bringing to fruition initiatives like the Asia-Pacific
Economic Cooperation group and the proposed Free Trade Area of the
Americas.
The global economy, like the domestic economy, is evolving, and its
change brings with it new challenges. A clean environment, a safe
workplace, and competitive markets are important to us internationally
just as they are at home. Trade liberalization can complement these
goals in many ways. Anticompetitive practices abroad, for example,
frequently cohabit with restrictions on trade and may forestall entry of
American firms into foreign markets. Liberalizing trade in agriculture
can lead to a more environmentally sound international allocation of
farming activity. The side agreements to NAFTA, on which the
Administration conditioned its approval of the agreement, demonstrate
that safeguarding a shared environment, promoting better working
conditions, and liberalizing trade are not mutually exclusive goods to
be traded off against each other. Pursuing these goals in the
multilateral framework of the WTO will be increasingly important. At the
same time, it is important that countries not allow domestic regulation
to become a pretext for nontariff trade barriers whose real purpose is
to restrict competition.
Some of the fastest-growing economies are the emerging markets of
the developing world, many of them in East and Southeast Asia. To grasp
fully the opportunities that these new markets offer, the United States
needs to strengthen economic relations with these countries. Chapter 7
sets forth some of the principles on which these new relations will have
to be built.

Improving Public Sector Efficiency

The fourth and final way to increase the overall efficiency of the
economy is by improving the efficiency with which the government itself
does its job. By freeing up resources for potentially more productive
uses in other sectors, and by reducing the cost of regulation,
government reform can raise economy-wide productivity. The Vice
President's reinventing government initiative has been doing just that.
Thousands of pages of Federal regulations have been eliminated, and
thousands more are being streamlined or improved in other ways. Hundreds
of obsolete Federal programs have been eliminated, and red tape has been
reduced dramatically. The Federal civilian workforce has been cut by
more than 250,000, and as a percentage of the Nation's total employment
it is now smaller than at any time since the early 1930s (Chart 1-4).

OPPORTUNITY AND INDIVIDUAL RESPONSIBILITY

America cannot reach its full economic potential if any of its
assets--including its human resources--do not live up to theirs. Just as
the productivity slowdown since 1973 poses a challenge for growth, so
the persistence of income inequality and the entrenchment of poverty of
the past two decades make it more difficult to ensure that all Americans
have the opportunity to make the most of their lives.
Americans of all incomes participated in the economic growth of the
1950s and 1960s. But in the two decades that followed, not only was
overall growth slower, but these shrunken gains were reaped
disproportionately by those at the top of the income distribution. As
already noted, some evidence suggests that this trend may have begun to
reverse itself in the past few years. Chapter 5 discusses trends in
inequality and shows that an important contributing factor is the
increasing wage gap between educated and uneducated workers.
Another major problem is the persistence in some areas of pockets of
poverty. The nationwide poverty rate has hovered between 10 and 15
percent for the past 30 years, but the burdens of poverty


have been spread very unevenly throughout American society. The poverty
rate for blacks fell to its lowest level in 1995, yet over 40 percent of
black children still grow up in poor homes. Poverty seems particularly
entrenched--with poverty rates in some cases exceeding 50 percent--in
the inner cities and in certain remote rural areas. The gap between rich
and poor has a variety of origins. Changes in technology inevitably
confer advantages on some parts of the country more than others, and
citizens and governments in some places have more effectively seized
upon the opportunities offered. Vestiges of discrimination, directed at
the large share of minority members in many communities, may also have
played a role in the geographic entrenchment of poverty.
Government programs have had much success in reducing inequality and
poverty. Government cash transfers lifted over 21 million people out of
poverty in 1995, lowering the poverty rate from 21.9 percent to 13.8
percent. If the effect of all taxes, the earned income tax credit
(EITC), and the valuation of noncash transfers were included, the
poverty rate would be still lower, at 10.3 percent. All told, more than
half of all those who are reckoned poor on a before-tax-and-transfers
basis escaped poverty with the help of government policies.
We must never allow the Nation's social safety net to become
tattered, but it is also imperative to design policies in ways that will
fully integrate our lagging communities into the American economy. The
Administration's approach is based on four principles: providing people
with opportunities to find work, making sure they have the right
incentives to avail themselves of those opportunities, strengthening
communities, and easing the transition between jobs for dislocated
workers. Education, discussed above in the context of economic growth,
also plays an important role in enhancing opportunities.

Work Opportunity

One of the most important contributions that any Administration can
make to the Nation's economy is to ensure that every American seeking
work can find it. The decline in the unemployment rate from over 7
percent in 1992 to below 5\1/2\ percent in 1996 was a major step forward
not only for growth, but also for opportunity. But moving welfare
recipients into jobs takes more than just creating job openings. Access
to transportation, child care, and other infrastructure support will be
needed. Many job seekers will also need to acquire the critical ``soft
skills''--a habit of punctuality, low absenteeism, and so forth--that
will make them effective members of the labor force.
Jobs, skills, and infrastructure are all important, but
discrimination and its legacy can still place obstacles in the way of
some Americans. Some employers continue to deny employment or
advancement on the basis of race or sex. This is illegal as well as
economically irrational, and the Administration is committed to the
vigorous enforcement of equal opportunity laws. But this may not be
enough; affirmative action programs, based not on quotas but on
principles of advancing opportunity, are also called for.

Incentives

Few individuals consciously choose a life of dependency, whether on
public welfare or private charity. True, the environment into which a
child is born, and the opportunities he or she is afforded, strongly
influence whether that child matures into a productive member of society
or becomes dependent on the state. But most economists believe that
incentives also play a role in determining that outcome. When a worker
earns little more from a minimum wage job than what he or she could get
by going on welfare and accepting food stamps and free public housing,
the incentive to work is not strong. In the past, the availability of
welfare made the effective wage for many low-wage workers (i.e., the
addition to income from an extra hour of work) not the advertised $4 or
$5 an hour, but half of that or less.
Over the past 4 years this Administration has increased the returns
to work relative to welfare in several ways. The expansion of the EITC
and the recently legislated increases in the minimum wage have together
increased the return to work for low-wage workers, to the point where a
full-time, year-round minimum wage worker with two children will receive
more income than ever before, even after adjusting for inflation. And
the reforms of the welfare system, including the imposition of work
requirements and time limits on benefits, may provide further
incentives.
Incentives are not only important for individuals, but need to be
designed with businesses in mind as well. The President has taken the
first step in reforming welfare. As important as the public sector's
role in creating opportunity is, however, the private sector must also
participate if welfare reform is to result in better lives for those who
have depended on support in the past. This Administration challenges the
private sector to work with government to help welfare recipients move
into the mainstream of work and opportunity. The welfare-to-work tax
credit proposed by the President last summer is one example of how the
government can help create the incentive for businesses to hire long-
term welfare recipients.

Community

Many of the themes of this Administration's economic strategy are
drawn together in policies that work not just with and for individuals,
but with and for the communities in which they live. Part of any
sensible economic strategy for reducing poverty involves concentrating
on those areas where, as already noted, poverty is most entrenched. The
Federal Government, however, cannot and should not be solely responsible
for revitalizing these communities; rather, the most effective strategy
is to provide local communities with the resources and tools they need
to realize their full potential.
The Empowerment Zone/Enterprise Community initiative incorporates an
entirely new approach to community revitalization. Rather than imposing
restrictive Federal mandates on America's distressed central cities and
rural areas, this effort begins from the premise that local residents
know best how to solve their communities' problems. To be considered for
an Empowerment Zone or Enterprise Community designation, communities
have to meet eligibility criteria, be nominated by their State or local
government, and submit a strategic plan that describes the community's
vision for its future. This competition for designation provides an
incentive for community leaders to develop innovative strategies to
address their problems. The designated communities are then provided
with access to a combination of flexible grants, tax incentives, and
special assistance in removing bureaucratic red tape.
The Administration plans to expand the Empowerment Zone/Enterprise
Community initiative. The Community Empowerment Act, which was
introduced in the 104th Congress, embodies the Administration's proposal
for a second round of zones and communities. This act would designate an
additional 20 zones and 80 communities to receive, over 3 years, $1
billion in tax incentives and $1 billion in discretionary funds. The
Administration will work with the 105th Congress in securing passage of
this extension.

Dislocated Workers

It is a subject of some debate whether the pace of change today is
such that individuals are more likely than in the past to lose their
jobs. Chapter 4 discusses both the evidence concerning changes in the
incidence of job dislocation and its economic consequences. But even if
the risk of job loss is no greater than in the recent past, dislocation
is still hard on workers and their families. The market does not provide
insurance against job loss, which is understandably a source of anxiety
for workers. Economists generally endorse the virtues of Schumpeter's
creative destruction. But for individual workers and their families the
costs of a changing economy are far more apparent than the broader
benefits to society from an economy that is better able to adapt to
changing technology and markets.
In a variety of ways, government can help individuals make the
transition between jobs, and in the process help make the economy more
supple, able to respond quickly to changes in markets and technology.
Unemployment insurance has long been the most important system of
support for dislocated workers. This Administration considers it one of
its special responsibilities to help those in transition between jobs.
One of the harshest ironies of an economy in which employers provide
most health insurance is the fact workers typically lose their health
benefits when they lose their jobs--precisely the time when they can
least afford to purchase health insurance on their own. The
Administration has proposed providing unemployed workers with 6 months
of health insurance through the existing unemployment insurance system.
At the same time, it is important to help the unemployed find new jobs
through job retraining programs and ``one-stop shopping'' career centers
to cushion and facilitate the transition for those hurt by economic
change. Finally, the Administration has worked to make benefits more
portable between jobs. For instance, the Health Insurance Portability
and Accountability Act of 1996 (the Kassebaum-Kennedy bill) ensures that
as many as 25 million workers will not be denied health insurance,
including coverage of preexisting conditions, at their new jobs.
Similarly, pension simplification and improved portability also make it
easier to maintain crucial benefits when changing jobs.

CONCLUSION

The American economy is dynamic. This Administration's economic
philosophy recognizes that American workers and enterprises, interacting
through markets, are the source of that dynamism. The strength of this
economy is its ability to adapt to change; at the same time, its
dynamism sets further change in motion, ultimately enriching the lives
and raising the living standards of all Americans.
Government has a limited but essential role in maintaining this
dynamism. It creates an economic climate in which individuals and firms
can flourish. It promotes competition. It seeks to ensure that all
individuals have an opportunity to make the most of their talents. It
protects our environment, our health, and our safety. This government's
focus embodies elements both of continuity and of change. Many of its
basic economic duties--such as enforcing property rights, maintaining a
stable currency, and granting patents--are enduring, and the
government's role in them is well established. As important as these
areas are, this Report focuses on those other areas where the
government's role is being, and needs to be, redefined.
Government must both adapt to and foster change. The past 4 years
have demonstrated that the Federal Government is up to this challenge.
And the private sector has more than amply demonstrated that it, too,
can fulfill its part in this ever-evolving partnership.
The process is never-ending. Most of the challenges the Nation faces
have deep roots in the past. Just as the productivity slowdown and the
increase in inequality have no single, simple cause, neither do they
have any single, simple solution. No magic policy wand can transport us
back to the income distribution or the productivity growth America
enjoyed in the 1960s. It takes time to respond effectively to, and even
more time to reverse, trends that have been two decades in the making.
To take just one example among myriad: the purely economic benefits of
Head Start take 15 years or more to ripen--the time it takes for a Head
Start child to grow up and join the labor force.
Our assessment of the success of government programs must therefore
go beyond their impact on this year's or next year's GDP. Success will
be measured by the kinds of lives that all Americans will live in the
future. That success will be enhanced by the legacies we leave: not only
investments in people, in the tools of production, and in technology
that will increase our productivity, but also a philosophy of markets
and of government that will guide us in the difficult choices we must
make as we reach out toward the 21st century and beyond.