[Economic Report of the President (1999)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]




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CHAPTER 1
Meeting Challenges and Building for the Future

THE ECONOMIC POLICIES of the past 6 years have nurtured and
sustained what is now the longest peacetime expansion on record. By
December 1998, the 93rd month since the bottom of the last recession,
18.8 million jobs had been created (17.7 million of them since January
1993). More Americans are working than ever before, the unemployment
rate is the lowest in a generation, and inflation remains tame. This
record of achievement is especially noteworthy in light of the troubles
experienced in the international economy in 1998. The United States has
not entirely escaped the effects of this turmoil--and calm has not been
restored completely abroad. But the fundamental soundness of the U.S.
economy prevented it from foundering in 1998's storms.
This Administration laid a strong policy foundation for growth in
1993 when the President put in place an economic strategy grounded in
deficit reduction, targeted investments, and opening markets abroad.
Since then the Federal budget deficit has come down steadily, and in
1998 the budget was in the black for the first time since 1969. This
policy of fiscal discipline, together with an appropriately
accommodative monetary policy by the Federal Reserve, produced a
favorable climate for business investment and a strong, investment-
driven recovery from the recession and slow growth of the early 1990s.
Even while reducing Federal spending as a share of gross domestic
product (GDP), the Administration has pushed for more spending in
critical areas such as education and training, helping families and
children, the environment, health care, and research and development.
And although international economic conditions have led to a dramatic
widening of the trade deficit, the United States has succeeded in
expanding exports in real (inflation-adjusted) terms by almost 8 percent
per year since 1993.
Clearly, there is much for Americans to be proud of in the economic
accomplishments of the past 6 years. But as recent events in the rest of
the world have reminded us, our prosperity is threatened when the global
economy does not function well. Our immediate challenge on the
international front is to help ensure that the global economy rebounds
and begins to regain strength. Our longer run challenge as we enter the
21st century will be to continue to build and refine the

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international economic arrangements within which countries can embrace
opportunities to grow and develop through international trade and
investment.
Challenges remain at home as well. The restoration of fiscal
discipline is one of the most important accomplishments of the past 6
years. But one very important challenge in the years ahead will be to
maintain that discipline and to ensure that fiscal policy contributes to
preparing the country for the demographic challenges it faces in the
next century. That is why, in his 1998 State of the Union address, the
President called for reserving the future budget surpluses until Social
Security is reformed. In this year's State of the Union message, the
President put forward his framework for saving Social Security while
meeting the other pressing challenges of the 21st century.
A second major development of the past 6 years has been the reform
of the Nation's welfare system, which, together with the strong economy,
has produced a dramatic reduction in welfare case loads. Here the
challenge will be to continue to make work pay for all Americans who
play by the rules and want to work, while preserving an adequate safety
net. Finally, the strength of the American economy over the past 6 years
should not blind us to the inevitability of change and the threat of
disruption that is always present in a dynamic market economy. For
example, difficult agricultural conditions in 1998 put stress on the
new, market-oriented farm policy enacted in 1996. Similarly, the ongoing
wave of mergers among large companies in the financial,
telecommunications, and other industries has raised questions about the
disruptions these reorganizations cause for communities and workers--
questions that go beyond traditional antitrust concerns. Such questions
may be better addressed by broader policies such as maintaining full
employment and promoting education and training. The challenge here is
to capture the long-run benefits from productivity-enhancing change
without ignoring the short-run costs to those hurt by that change.
This chapter provides an overview of these challenges and the
Administration's responses. First, however, we provide some background
by putting the current economic expansion in its historical context.

POLICY LESSONS FROM THREE LONG EXPANSIONS

The current economic expansion is only the third that has lasted at
least 7 years, according to business-cycle dating procedures that have
been applied back to 1854 (Box 1-1). It is useful to review and compare
the histories of each of these long expansions in order to understand
the role of macroeconomic policy in promoting balanced and
noninflationary growth.

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Box 1-1.--The Dating of Business Cycles

Although all signs indicate that the current economic expansion
has continued into 1999, its precise length will not be known until some
time after it has ended. The dating of business cycles is not an
official U.S. Government function. Instead, once it has become clear
that the economy has reversed direction, the Business Cycle Dating
Committee of the National Bureau of Economic Research (NBER) meets to
determine the turning point for historical and statistical purposes. For
example, the July 1990 business-cycle peak was announced April 25, 1991,
and the March 1991 trough was announced December 22, 1992. A popular
recession indicator is two consecutive quarters of decline in real GDP,
but the NBER does not use this approach. Rather, it defines a recession
as a recurring period of decline in total output, income, employment,
and sales, usually lasting from 6 months to a year.
The Employment Act of 1946 (which created the Council of Economic
Advisers) established a policy framework in which the Federal Government
is responsible for trying to stabilize short-run economic fluctuations,
promote balanced and noninflationary economic growth, and foster low
unemployment. Although the U.S. economy has continued to experience
fluctuations in output and employment in the more than half a century
since then, it has avoided anything like the prolonged contraction of
1873-79, or the 30 percent contraction in output and 25 percent
unemployment rate of the Great Depression. Moreover, the three longest
expansions of the past century--including the current one--have all
occurred since the Employment Act was passed.
Each of these three long expansions can be interpreted as an
experiment in macroeconomic policy. The longest--the expansion of 1961-
69, which lasted 106 months--was associated with the first self-
consciously Keynesian approach to economic policy. It was also
associated with Vietnam War spending. The longest peacetime expansion
before the current one was the expansion of 1982-90, which lasted 92
months. Although the economic philosophy underlying the policies of that
period is often characterized as anti-Keynesian, this expansion, too,
featured a stimulative fiscal policy. The current expansion is the only
one of the three in which fiscal policy was contractionary rather than
expansionary, reflecting the budget situation at the time and the view
that fiscal discipline would lower interest rates and spur long-term
economic growth.

KEYNESIAN ACTIVISM IN THE 1961-69 EXPANSION

In the early 1960s the Council of Economic Advisers advocated
activist macroeconomic policies based on the ideas of the British
economist John Maynard Keynes. The Council diagnosed the economy at

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that time as suffering from ``fiscal drag'' arising from a large
structural budget surplus. (The structural budget balance is the deficit
or surplus that would arise from the prevailing fiscal stance if the
economy were operating at full capacity.) The marginal tax rates then in
effect, which were far higher than today's, were seen as causing tax
revenues to rise rapidly as the economy approached full employment,
draining purchasing power and slowing demand before full employment
could be achieved. The problem was not the fact that Federal Government
receipts and expenditures were sensitive to changes in economic
activity--this sensitivity plays an important automatic stabilizing
role, particularly when economic activity falters, as reduced tax
payments and increased unemployment compensation help preserve
consumers' purchasing power. The problem was that the automatic
stabilizers kicked in too strongly on the upside, not only preventing
the economy from reaching full employment but also, ironically,
preventing the actual budget from balancing. Thus, President John F.
Kennedy proposed a tax cut in 1962, which was enacted in 1964, after his
death.
This tax cut provided further stimulus to the economic recovery that
had begun in 1961. The unemployment rate continued to fall, until early
in 1966 it dropped below the 4 percent rate that was considered full
employment at the time. Inflation had been edging up as the unemployment
rate came down, but it then began to rise sharply (Chart 1-1). Although
the changed conditions appeared to call for fiscal restraint, President
Lyndon B. Johnson was reluctant to raise taxes or scale back his Great
Society spending initiatives. Meanwhile Vietnam War spending continued
to provide further stimulus.
At the time, policymakers believed that the rise in inflation could
be unwound simply by moving the economy back to 4 percent unemployment,
but when restraint was finally applied it produced a rise in
unemployment with little reduction in inflation. This so-called
stagflation, together with a slowdown in productivity and a series of
oil price shocks in the 1970s, dealt a serious setback to the prevailing
view among economists that economic policy could be easily adjusted to
achieve the goals of the Employment Act.

THE SUPPLY-SIDE REVOLUTION AND THE 1982-90 EXPANSION

At the beginning of the Administration of President Ronald Reagan in
1981, the economy was bouncing back from the short 1980 recession, but
it was also experiencing very high inflation. President Reagan's program
for economic recovery called for large tax cuts, increased defense
spending, and reduced domestic spending. Although advocates of these
policies invoked the 1964 tax cut as precedent, the justification
offered for this policy was not Keynesian demand stimulus. Rather it was
the ``supply-side'' expectation that substantial cuts in marginal tax
rates would call forth so much new work effort and investment that

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the economy's potential output would grow rapidly, easing inflationary
pressure and bringing in sufficient new revenue to keep the budget
deficit from increasing. In the short run, however, this expansionary
fiscal policy collided with an aggressive anti-inflationary monetary
policy on the part of the Federal Reserve. The budget deficit ballooned
in the deep recession of 1981-82, and it stayed large even after the
Federal Reserve eased and the economy began to recover
Compared with the 1961-69 expansion, the 1982-90 expansion was
marked by higher levels of both inflation and unemployment. But the main
distinguishing feature of this expansion was the large Federal budget
deficits and their macroeconomic consequences. In the early 1980s the
combination of an expansionary fiscal policy and a tight monetary policy
produced high real interest rates, an appreciating dollar, and a large
current account deficit. (The current account, which includes investment
income and unilateral transfers, is a broader measure of a country's
international economic activity than the more familiar trade balance.)
Although borrowing from abroad offset some of the drain on national
saving that the budget deficit represented, and prevented the sharp
squeeze on domestic investment that would have taken place in an economy
closed to trade and foreign capital flows, the effect of this policy
choice was a decline in net national saving and investment after 1984.
As in the 1961-69 expansion, inflation began to rise as the economy
moved toward high employment. By this time, however, the prevailing view
was that inflation could not be reversed

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simply by returning to the full-employment unemployment rate (Box 1-2).
Instead the economy would have to go through a period of subnormal
growth in order to squeeze out inflation.

Box 1-2.--Full Employment and the NAIRU

Maintaining full employment is a major goal of macroeconomic
policy, but how exactly is that objective defined? The prevailing view
in the 1960s was that lower unemployment rates were associated with
higher rates of inflation, and that full employment was defined by the
unemployment rate associated with a tolerable inflation rate. At that
time, the full-employment unemployment rate was thought to be about 4
percent. The experience of the 1970s helped persuade economists that,
once the unemployment rate dropped below a certain level, prices would
not just rise but accelerate (that is, the inflation rate would rise).
The full-employment unemployment rate came to be defined as the
nonaccelerating-inflation rate of unemployment, or NAIRU.
Statistical studies suggest that the NAIRU was higher from the
mid-1970s through the 1980s than it was in the 1960s and that it has
come down somewhat in the 1990s. This evolution has been attributed to a
variety of factors, including changes in the demographics of the labor
force. For example, the United States now has a more mature labor force,
as a consequence of the aging of the baby-boom generation, and more
mature workers tend to experience less unemployment than younger ones.
Although the NAIRU is an indicator of the risk of inflation, estimates
of the NAIRU have a wide band of uncertainty and should be used
carefully in formulating policy. The NAIRU implicit in the
Administration's forecast has drifted down in recent years and is now
within a range centered on 5.3 percent.

DEFICIT REDUCTION AND THE CURRENT EXPANSION

The economy was out of the 1990-91 recession when President Bill
Clinton took office, but the recovery was weak and job growth appeared
slow. Budget deficits were very large, partly because of the recession
but also because the structural deficit remained large. The President's
economic program sought to get the economy moving again while bringing
the budget deficit under control. It was based on the idea that reducing
the Federal budget deficit would bring down interest rates and stimulate
private investment. With a responsible fiscal policy in place, and with
favorable developments in inflation and productivity, the decline in the
unemployment rate to less than 5 percent did not lead to interest rate
hikes that could have choked off the

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expansion prematurely. In fact, the economy witnessed a combination of
low consumer price inflation and low unemployment that compared
favorably with the low ``misery index'' achieved in the late 1960s. (The
misery index is the sum of the inflation and unemployment rates.) This
time, however, inflation is tame rather than rising.
Judged by the objectives of stabilization policy (inflation and
unemployment), the current economic expansion has been very successful
(Table 1-1). Three-quarters of the way through the eighth year of
expansion, inflation remains low even though the unemployment rate has
been below most estimates of the NAIRU. This situation stands in marked
contrast to the sharply rising inflation experienced at the end of

the 1960s expansion and the milder price acceleration seen at the end of
the 1980s expansion. To be sure, this good inflation performance has
been aided by favorable conditions such as a continuing sharp decline in
computer prices, a drop in oil prices, rapid growth of industrial
capacity, and downward pressure on prices of traded goods due to
weakness in the world economy. And, as discussed in Chapter 2 of this
Report, the Administration (as well as the consensus of private
forecasts) projects a moderating of growth over the next 2 years. What
is significant, however, is that the actions taken over the past 6 years
to reduce the budget deficit created conditions in which the Federal
Reserve could accommodate steady noninflationary growth. And, of course,
the strong economic performance helped improve the budget balance even
further.
Growth in GDP has also been solid. With slower growth in the
working-age population and slower trend productivity growth since the
early 1970s, it is understandable that GDP has grown more slowly

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than it did in the 1960s (Table 1-2). Moreover, growth over the 1980s
expansion partly reflects how far below potential output the economy was
at the start of that expansion, which followed a deep recession, rather
than a particularly strong underlying growth trend. Finally, growth in
aggregate income matters for some purposes, but productivity growth is
what matters for real wages and a rising standard of living over the
longer term. And productivity growth has continued relatively strong
well into this expansion--it has not exhibited the decline that often
occurs late in expansions. Nevertheless, the rate of productivity growth
over this expansion remains well below that achieved in the 1960s,
before the productivity slowdown.
Relatively slow productivity growth continues to prevent the kind of
wage and income growth that produced a doubling in living standards
between 1948 and 1973. As discussed in Chapter 3, however, the sustained
tight labor market that this expansion has created in the past few years
has brought benefits to the vast majority of American workers, including
groups that had fallen behind over the past two decades or so, such as
low-wage workers and minorities. A labor market like that of today has
numerous benefits. It increases the confidence of job losers that they
will be able to return to work; it lures discouraged workers back into
the labor force; it enhances the prospects of those already at work to
get ahead; it enables those who want or need to switch jobs to do so
without a long period of joblessness; and it lowers

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the duration of the typical unemployment spell. It can reduce long-term
structural unemployment by providing jobs and experience to younger and
less skilled workers, thus increasing their longer run attachment to the
labor force. In short, a sustained tight labor market helps the rising
tide of economic growth lift all boats.
This expansion has illustrated how the mix of monetary and fiscal
policy can affect the composition of output. Unlike the expansion of the
1980s, which saw an expansionary fiscal policy restrained by tight
monetary policy, the current expansion has taken place under conditions
of fiscal restraint and an accommodative monetary policy. The 1980s
policy mix brought with it relatively high real interest rates,
declining net national saving and investment, and a large current
account deficit, which changed the United States from the world's
largest creditor Nation to its largest debtor. Strong performance by the
U.S. economy in the 1990s is again associated with a strong dollar and,
most recently, a widening trade deficit, as the United States has
continued to absorb foreign goods while weakness abroad has reduced
demand for U.S. goods. On balance, however, the current account deficits
of the 1990s have been the result of generally rising net national
investment remaining greater than generally rising net national saving.
The current account balance depends on the gap between saving and
investment. But future growth depends on the levels of saving and
investment. Since 1993, net national saving has increased by about 3
percentage points as a share of GDP, to better than 6H percent in the
first three quarters of 1998. The current expansion has been
distinguished by the large contribution of private fixed investment to
GDP growth and the negligible contribution of government spending (Chart
1-2). Strong investment has already been associated with strong growth
in capacity, which has helped keep inflation in check, and may have
contributed to maintaining growth in productivity as the expansion has
matured. Chapter 2 discusses this investment boom in greater detail.

CONCLUSION

Through a combination of sound policy, other favorable conditions,
and of course the energetic efforts of millions of American workers and
businesses, the current economic expansion has achieved both high
employment and low inflation. Longer run trends in productivity and
population growth will ultimately determine how fast the economy grows.
But the investment that has driven the current expansion should pay off
in stronger growth and productivity and higher future standards of
living than otherwise would have been the case. With the Federal budget
once more under control, large deficits will not constrain future policy
choices.

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PRESERVING FISCAL DISCIPLINE

Reducing the Federal budget deficit has been a centerpiece of this
Administration's economic policy. Between 1993 and 1997 the deficit came
down steadily. Last year, for the first time since 1969, the budget was
in the black, with the largest surplus as a share of GDP in over 40
years.
The Administration now projects substantial surpluses in the unified
Federal budget well into the future. (The unified budget includes both
on-budget and off-budget Federal Government programs.) With no further
action, however, the aging of the U.S. population and continued growth
in health care spending per person would eventually push the budget back
into deficit. The favorable near-term outlook has provided an important
opportunity to address these longer term problems. In his 1999 State of
the Union address, the President presented his plan to use much of the
projected budget surpluses to help save Social Security and strengthen
Medicare, while preserving the fiscal discipline that has been so hard
won over the past 6 years.

REACHING SURPLUS

Except during wars and economic downturns, the Federal budget has
stayed roughly balanced for most of the Nation's history. Yet the large
budget deficits that emerged in the early 1980s persisted

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throughout that decade of peace and economic expansion, and then
worsened in the 1990-91 recession (Chart 1-3). In 1992 outlays exceeded
receipts by $290 billion, or 4.7 percent of GDP. When the President took
office in January 1993, the deficit was projected to reach almost $400
billion in 1998 and over $600 billion in 2003, assuming no change in
policy. By 1998, however, receipts exceeded outlays by $69 billion, or
0.8 percent of GDP. (All references to years in this section are fiscal
years running from October through September, unless otherwise
noted.)
Between 1992 and 1998 the Federal budget balance improved by about
5H percent of GDP. In an accounting sense, this dramatic change is
attributable in roughly equal parts to an increase in receipts and a
decline in outlays, both as shares of GDP. More fundamentally, three
forces have been at work: policy changes, faster-than-anticipated
economic growth, and higher-than-expected tax revenues, even after
adjusting for faster economic growth.
In 1993 the President and the Congress enacted a deficit reduction
package designed to cut over $500 billion from the deficits expected to
accumulate over the following 5 years. The program slowed the growth of
entitlements and extended the caps on discretionary spending put in
place in 1990. It raised the tax rates of only the 1.2 percent of
taxpayers with the highest incomes, while cutting taxes for 15 million
working families. Four years later the President and the Congress
finished

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the job of reaching budget surplus by passing the Balanced Budget Act of
1997, which incorporated additional deficit reduction measures.
Strong economic growth also played an important role in reducing the
deficit. Faster-than-expected growth created more income and more tax
revenue. In addition, it reduced unemployment insurance benefits and
outlays for other means-tested entitlement programs--although the effect
of better economic performance is considerably smaller on the spending
side than on the revenue side.
Finally, technical factors boosted receipts and depressed outlays
over and above what policy changes and macroeconomic conditions can
account for. In 1997 and again in 1998, higher-than-anticipated
individual income tax collections were by far the largest source of
technical differences on the revenue side. These appear to have arisen
from higher capital gains realizations and changes in the distribution
of income among taxpayers (a shift toward more taxable income in the
higher brackets), most likely reflecting strong stock market
performance. An important technical factor on the spending side has been
lower-than-expected outlays for Federal health programs (primarily
Medicare and Medicaid), most likely reflecting slower growth in health
care costs economy-wide.

FISCAL POLICY IN AN ERA OF SURPLUSES

Achieving a surplus in the Federal budget has provided the
foundation for tackling longer term problems. Indeed, balancing the
budget has been the critical first step in improving the Nation's future
fiscal and economic strength. The most important of the longer term
problems is posed by the aging of the population, with its implications
for future imbalances in Social Security and Medicare.
Before turning to this issue, however, it is worth emphasizing that
achieving long-run fiscal discipline does not, and should not, preclude
the possibility of running a short-run deficit if needed for
stabilization purposes. The automatic stabilizers in the budget will
continue to be the most important instrument of fiscal policy for muting
short-term fluctuations in economic activity. But as Japan's current
problems remind us, an economy can become mired in stagnation to such an
extent that discretionary fiscal stimulus may be appropriate. The
elimination of large structural budget deficits frees fiscal policy to
undertake such a role if needed.

The Demographic Challenge and Social Security

Social Security is an extremely successful social program. For 60
years it has provided Americans with income security in retirement and
protection against loss of family income due to disability or death.
Social Security retirement benefits are indexed for inflation and
provide a lifetime annuity--a package that has been difficult if not
impossible to obtain in the financial marketplace. In any case, fewer
than half of

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all individuals aged 65 and older received any private pension benefits
in 1994. Social Security benefits are the largest source of income for
two-thirds of those in this age group and the only source for 18 percent
of them. Social Security has achieved dramatic success in helping reduce
the poverty rate among the elderly from 35 percent in 1959 to 10.5
percent in 1997. But Social Security is more than just a pension plan:
it is a family protection plan, and nearly every third beneficiary is
not a retiree. For example, one of every six 20-year-olds will die
before reaching retirement age. For the average wage earner who dies
leaving a spouse and two children, Social Security provides survivors'
benefits roughly equivalent in value to a $300,000 life insurance
policy. In addition, three of every ten 20-year-olds will become
disabled for some period during their working lives, and for them Social
Security provides disability protection.
The most commonly used yardstick to measure the financial soundness
of the Social Security system is the 75-year actuarial balance--the
difference between expected income and costs over the next 75 years. The
Social Security actuaries now project that the current balance in the
trust fund, together with projected revenues over the next 75 years,
will be insufficient to fund the benefits promised under current law. By
2013 payroll contributions, together with the part of income tax
receipts on Social Security benefits that is deposited in the trust
fund, are expected to fall short of benefits. By 2021 the shortfall is
expected to exceed the trust fund's interest earnings, so that the fund
will begin to decline. And by 2032 the trust fund is expected to be
depleted, although contributions would still be sufficient to pay about
75 percent of current-law benefits thereafter. Of course, future taxes
and benefits will depend on a variety of economic and demographic
factors that cannot be predicted perfectly, so the actual problem may be
smaller--or larger--than we now believe. Nevertheless, the actuaries'
intermediate projections imply that the imbalance in the old age,
survivors, and disability insurance program (OASDI, the main component
of Social Security) over the next 75 years amounts to around 2G percent
of taxable payroll (which equals about 1 percent of GDP today).
The key factors contributing to the projected OASDI imbalance are
improvements in life expectancy and a reduction in birth rates, which
have put the United States on a path of rapid decline in the number of
employed workers for every retiree. When the Social Security Act was
passed in 1935, the life expectancy of a 65-year-old American was about
13 years. Today, life expectancy for a 65-year-old is 18 years and
rising. Meanwhile people are retiring earlier. In 1950 the average age
for first receiving Social Security retirement benefits was 68; today it
is 63. As a consequence of these changes, the ratio of employed workers
to retirees has fallen from about five to one in 1960 to three and a
half to one today. In only 30 years' time it will be just two to one and
still falling.

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In addition to its effects on Social Security retirement and
disability benefits, this demographic transition will have important
effects on the Medicare and Medicaid programs as well as on the broader
economic environment. Medicare is a Federal program that pays for health
care for the elderly and certain disabled persons; Medicaid is a joint
Federal-State program that provides medical assistance, including
nursing home care, to those with low incomes among the elderly, the
disabled, pregnant women, children, and members of families with
dependent children. Both programs face steeply rising costs over time as
the population ages and as the cost of providing medical care likely
rises further. Federal spending on Medicaid is financed out of general
revenues. Spending on Medicare is financed in two parts: hospital
insurance (part A) is funded through the hospital insurance payroll tax,
whose proceeds go to a dedicated trust fund, and supplementary medical
insurance (part B) is funded through general revenues and monthly
premiums paid by beneficiaries. The intermediate projections of the
Medicare actuaries imply that the hospital insurance trust fund will be
exhausted in 2008.
For the Nation as a whole, the core of the problem is how to provide
a high standard of living for both workers and retirees in the next
century, even though a smaller share of the population will be in the
work force than today. A natural solution is to make workers more
productive, by increasing investment in both physical and human capital.
Investing in productive capital expands the total economic pie, and that
is the prerequisite to meeting the retirement costs of the baby-boom
generation without unduly burdening future workers. The key to
accomplishing this is to increase national saving. The Federal
Government can play its part by maintaining fiscal discipline. Indeed,
the President's proposal to use much of the currently projected budget
surpluses for Social Security and Medicare reform would add about 2
percent of GDP to the contribution of government saving to national
saving over the next 15 years.

The Administration's Policy

In his 1998 State of the Union address, the President proposed to
reserve the budget surplus until agreement had been reached on a plan to
secure the financial viability of Social Security. To accomplish this
task, the President suggested a process of public education and
discussion, followed by the forging of a bipartisan agreement. The
President later set forth five principles to guide the reform process:

 Strengthen and protect Social Security for the 21st century.
This is an overriding goal, and it rules out proposals that fail
to provide a comprehensive solution to the solvency problem. For
example, a plan to divert existing payroll taxes into a new
system of individual accounts, without other, offsetting
changes, would fail the test to the

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extent that it would reduce Social Security's revenues and make
the existing imbalance even larger.
 Maintain universality and fairness. The current program
provides benefits on a progressive basis, and ensuring
progressivity is an important standard by which reform proposals
should be judged.
 Provide a benefit that people can count on. Any proposed reform
of Social Security must continue to offer people a secure base
for retirement planning.
 Preserve financial security for low-income and disabled
beneficiaries. The commitment to the disability and survivors'
insurance aspects of the OASDI program must be maintained.
 Maintain fiscal discipline. Fiscal discipline is essential to
ensure that the emerging budget surpluses are not drained before
Social Security reform has been addressed, and that fiscal
policy plays a helpful role in preparing for the retirement of
the baby-boomers.

In his 1999 State of the Union address, the President put forward a
comprehensive framework for Social Security reform that satisfies these
principles. First, about three-fifths of the projected budget surpluses
over the next 15 years would be transferred to the Social Security trust
fund. Second, about a fifth of the transferred surpluses would be
invested in equities to achieve higher returns, just as private and
State and local government pension funds do. The Administration intends
to work with the Congress to ensure that these investments are made by
the most efficient private sector investment managers, independently and
without political interference. These two steps alone would extend the
solvency of the Social Security system until 2055. Third, the President
called for a bipartisan effort to make further reforms to Social
Security that would extend its solvency to at least 2075.
The President repeated his commitment to ``save Social Security
first.'' He also stated that--if Social Security reform is secured--the
remaining projected surpluses over the next 15 years should be dedicated
to three purposes. First, about 15 percent of the projected surpluses
would be transferred to the Medicare trust fund. The Administration, the
Congress, and the Medicare commission should work to use these funds as
part of broader reforms. Even without such reforms, however, the
transfers would extend the projected solvency of the Medicare trust fund
to 2020. Second, about 12 percent of the projected surpluses would be
used to create Universal Savings Accounts, which would help people save
more for their retirement needs. The government would provide a flat tax
credit for Americans to put into their accounts and additional tax
credits to match a portion of each dollar that a person voluntarily puts
into his or her account. These accounts would not be part of the Social
Security system but would provide additional retirement resources. The
remainder of the projected surpluses over the next 15 years would be

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reserved to improve military readiness and to meet pressing domestic
priorities in such areas as education and research.
Within this framework, the national debt of the United States would
decline dramatically. Debt held by the public would fall from about 45
percent of GDP today to less than 10 percent in 2014. That would be the
smallest burden of government debt on the economy since the United
States entered World War I in 1917.

MEETING THE INTERNATIONAL CHALLENGE

This Administration has been committed from the start to outward-
looking trade and investment policies. And in his 1999 State of the
Union address the President called for a new consensus in the Congress
to grant him traditional trade-negotiating authority that permits trade
agreements negotiated with other nations to be submitted to an up-or-
down Congressional vote without amendment. At the same time he proposed
the launch of an ambitious new round of global trade negotiations within
the World Trade Organization. The general principle behind the
Administration's international economic policy is that open domestic
markets and an open global trading system are a better way to raise
wages and living standards over the longer term than are trade
protection and isolationism. Recent strains on the fabric of the
international economy have increased the allure of protectionism in some
quarters. But the main lesson should be that it is essential to promote
growth in the world economy, to help crisis-stricken economies recover,
and to reform the international financial system in ways that make
future crises less likely without abandoning the benefits that come with
increased international trade and investment flows.
During the year and a half that has elapsed since the collapse of
the Thai currency in July 1997, Asia's currency crisis has developed
into a more widespread crisis affecting many countries around the globe.
As the crisis has spread, it has impacted global commodity markets,
impaired economic development, and imposed extraordinary hardship in the
crisis-afflicted countries, all the while posing risks to growth
worldwide, including in the United States and other industrial
countries. According to projections by the International Monetary Fund
(IMF), global growth is now expected to reach a modest 2.2 percent in
1999, which represents a decline both from the 4.2 percent rate attained
in 1997 and from its long-run historical average of 4 percent.

CONTAINING THE CRISIS AND PROMOTING RECOVERY

Since the crisis began, the United States has led the international
community's efforts to promote world economic growth, to stabilize
international financial conditions, and to implement reforms to reduce

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the vulnerability of the international system to future crises. These
initiatives are described in detail in Chapters 6 and 7.
A first prerequisite for restoring strong world economic performance
is strong growth in the industrial countries that are the main customers
of the crisis-afflicted economies. This need has been clearly recognized
and addressed in both words and deeds by the United States and its
partners among the Group of Seven (G-7) large industrial nations. In
October the G-7 finance ministers and central bank governors issued a
joint statement indicating that, in their view, the balance of risks in
the world economy had shifted. With inflation low and well controlled,
countries should commit themselves to preserving or creating the
conditions for sustainable domestic growth. Monetary conditions were
subsequently eased in the key industrial countries. In the United
States, the Federal Reserve reduced the Federal funds rate three times,
helping restore confidence and liquidity. Japan, Canada, and most of the
major European countries also lowered interest rates. Japan, a country
in deep recession whose recovery is particularly critical to the growth
prospects of its crisis-afflicted Asian trade partners, has also taken
steps to provide fiscal stimulus and has committed substantial resources
to strengthen its financial system. Much remains to be done, however,
and many private forecasts are for continuing contraction in Japan.
Although it is premature to conclude that the rest of the world economy
is out of peril, conditions have improved noticeably since October, when
it appeared that the world might be headed into a generalized global
credit crunch.
It is important to emphasize that, in serving as an engine of global
growth during this period, the United States will inevitably see an
increase in its already sizable trade deficit, and some sectors,
particularly those heavily exposed to trade, will experience
disproportionate impacts. The result may be a rise in calls for
protection, and it will therefore be important to find constructive
approaches to the disruptions caused by trade. The United States remains
committed to outward-looking, internationalist policies and has urged
the crisis-impacted countries to keep their own markets open.
Beyond working to ensure growth in the industrial world, the
Administration has focused since the onset of the crisis on the need to
contain the international contagion of financial disruption and to
restore the confidence of market participants. The Administration has
supported the IMF in its goal of providing financial assistance to
countries in crisis that are willing to implement the reforms needed to
restore economic confidence and strengthen the underpinnings of their
economies, including their corporate and financial sectors. The emphasis
of IMF programs on financial sector reform reflects the growing
consensus, discussed in Chapter 6, that structural weaknesses,
particularly in the process of financial intermediation, were a key
element in initiating the crisis. It appears that many countries in East
Asia have

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now made considerable progress toward establishing the foundation for
recovery. In addition, an IMF stabilization package for Brazil,
supplemented by bilateral financing, was arranged in November.
As the crisis spread, the Administration recognized that its
contagion threatened even countries that had taken great strides in
implementing sound macroeconomic and structural policies and had worked
to strengthen the fundamentals of their economies. The President
therefore proposed, and the G-7 leaders agreed to establish, an enhanced
IMF facility to provide contingent, short-term lines of credit that
could be drawn upon by countries pursuing strong, IMF-approved policies,
accompanied, as appropriate, by additional bilateral finance. As the
scope of the crisis widened, the resources of the IMF became
increasingly strained. A key step in expanding them was for the United
States to meet its own financial obligations to the organization. The
Administration proposed, and in October the Congress approved, $18
billion in funding, opening the way for about $90 billion of usable
resources to be provided by all IMF members to the liquidity-strapped
institution.
To address the suffering inflicted by the crisis on the citizens of
the affected countries, the Administration has proposed policies to
stimulate economic recovery and alleviate hardship. Another decade of
lost growth like that endured during the debt crisis of the 1980s would
be intolerable, and the Administration recognizes that the industrial
countries must do more than just serve as good customers for the
products of crisis-impacted countries. One problem that is delaying
recovery in several of the Asian crisis countries is that large numbers
of companies and banks, including many that were in good health before
the crisis, now face unmanageable debt burdens. Companies and financial
institutions in Indonesia, the Republic of Korea, and Thailand, for
example, face substantial overhangs of bad debt as a result of high
interest rates and currency depreciations. To address this systemic
problem, the President proposed the exploration of comprehensive plans
to help countries restructure debt and restore the flow of credit needed
for firms to operate. The Asian Growth and Recovery Initiative, jointly
announced by the United States and Japan in November 1998, is designed
to promote this goal. In addition, many crisis-afflicted countries lack
effective social safety nets. Therefore the Administration also sought,
and agreement was reached, to establish a new World Bank emergency
facility to support social safety net spending focused on the most
vulnerable citizens of these countries.

STRENGTHENING THE INTERNATIONAL FINANCIAL ARCHITECTURE

The most important issue raised by the recent international crisis
is how to make sure the world never again faces another one like it.
Unfortunately, there is no silver bullet--no simple solution that would
simultaneously guarantee countries access to global capital flows and
eliminate the risk of a crisis of confidence once again withdrawing that

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access. Even so, international agreement is finally emerging on some
steps that can and should be taken to strengthen the architecture of the
financial system, to make it less crisis prone. Chapter 7 is devoted to
a discussion of potential reforms, including those proposed in recent
reports by working groups of central bank governors and finance
ministers from a group of industrial and key emerging market countries,
informally dubbed the G-22.
The G-22 reports focus on measures to increase transparency and
accountability in the financial operations of individual countries, of
private financial and corporate institutions, and of international
financial institutions such as the IMF and the World Bank. Greater
transparency and accountability will enhance the availability,
relevance, and reliability of information that investors need to
evaluate the risks in lending. The reports also propose a series of
reforms to strengthen domestic financial institutions: improvements in
prudential supervision and regulation are particularly needed to create
stronger incentives for borrowers and lenders to weigh risks and act
with appropriate discipline, thereby reducing the odds of a crisis.
Finally, the reports identify policies that could improve the
coordination of creditors' interests during a future crisis and promote
its orderly, cooperative, and equitable resolution.
Again, no magic formula can prevent the recurrence of currency and
financial crises. But things can be done to limit their frequency, their
impact, and their pernicious tendency to spread from country to country.
Therefore, even as the United States works to contain the current crisis
and help restore growth in the affected parts of the world, it will also
work with the G-7 and through other international forums to implement
reforms of the international financial architecture that will help
achieve this longer term goal. Such reform is crucial for restoring
support in an international economic system based on trade and
investment flows that can contribute to rising global living standards
in the 21st century. Additional necessary steps are described in Chapter
7.

EMBRACING CHANGE WHILE PROMOTING FAIRNESS

The tradeoff between efficiency and fairness is a classic problem in
formulating economic policy. Policies that confer benefits broadly
sometimes confer them unevenly, imposing relatively high costs on a
relative few. In well-functioning markets, the broadly distributed gains
usually outweigh the concentrated losses--often many times over. But
those who are hurt naturally seek relief through the political process,
and if government responds by substituting political remedies for market
outcomes, it can dissipate the aggregate gains.
Increases in the Nation's standard of living over the longer term
require that we embrace change and do not retreat from the constant

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succession of new opportunities and challenges of an ever-changing
world. However, considerations of fairness require that we ensure that
no part of our society bears disproportionate losses for the sake of
achieving net gains for the rest. More pragmatically, achieving
political consensus to embrace worthwhile change sometimes requires
looking out for the interests of those who are visibly harmed, even if
that means sacrificing some portion of the potential gains. Three very
different areas of current policy concern--agriculture, corporate
mergers, and international trade--illustrate these difficult choices.

AGRICULTURE

For more than a decade, a new, bipartisan farm policy has directed
farmers to seek income increasingly from markets rather than from
Federal subsidies. The 1994 Crop Insurance Reform Act and the Federal
Agriculture Improvement and Reform (FAIR) Act of 1996 sought to replace
the farm income safety net, based on government-managed price and income
supports, with a system in which farmers manage their own risk through
crop diversification, transactions in futures markets, and government-
subsidized crop and revenue insurance. However, when the President
signed the FAIR act, he expressed his concern that it failed to provide
an adequate safety net for family farmers, and he reiterated his
commitment to work with the Congress to strengthen that safety net.
Farmers prospered in the first few years under the FAIR act. Net
farm income rose to a record $53.4 billion in 1996 and remained high in
1997, as export demand grew and world commodity prices rose from 1995
levels. In addition, farmers benefited from the transitional payments
provided by the 1996 act, which boosted farm income by about $6 billion
in both 1996 and 1997. In 1998, however, farm income fell, as commodity
prices dropped sharply and farmers confronted a number of weather-
related problems. In response, the Administration insisted on a $6
billion emergency assistance package to boost farm income. Net farm
income in 1998 is estimated to have been about $48 billion, only
slightly less than the 1997 figure of $50 billion. The President has
also pledged to work with the Congress this year to reform the crop
insurance program and farm income assistance.
The experience of 1998 reflected the tension inherent in a farm
policy that is market oriented yet tries to provide an adequate safety
net for family farmers. Current farm policy encourages farmers to make
their planting decisions on an economic basis rather than with an eye to
government support, while helping them manage risk by subsidizing
insurance against both poor harvests and low prices. But to the extent
that farmers have a reasonable expectation that the government will step
in to provide assistance in the event of an emergency, they are unlikely
to take all the appropriate risk management steps themselves. This gives
rise to a moral hazard problem that cannot be

[[Page 39]]

eliminated entirely, because the government will always be under strong
pressure to address what are perceived to be legitimate disasters.

MERGERS

The United States is in the midst of its fifth corporate merger wave
of the century. The value of all mergers and acquisitions announced in
1997 was almost $1 trillion, and activity in 1998 was over $1.6
trillion. By almost any quantitative standard the current boom is
substantial. Measured relative to the size of the economy, only the
spate of trust formations at the turn of the century comes close to the
level of current merger activity. Measured relative to the market value
of all U.S. companies, however, the 1980s boom was roughly comparable in
size.
Qualitatively, the current merger wave is similar to those before
the 1980s in that it is taking place in a strong stock market, with
stock rather than cash the preferred funding source. But unlike the pre-
1980s transactions, many recent mergers are neither purely horizontal
(between firms in the same or similar industries) as in the 1890s and
1920s, nor purely conglomerate (between firms of different industries)
as in the 1960s and 1970s. Rather, they represent market extension
mergers, in which the merging companies are in the same industry but
serve different and noncompeting markets, or synergy-seeking mergers, in
which companies in related markets combine to take advantage of
economies of scope. In contrast to the 1980s, when many mergers were
primarily motivated by financial considerations, today's mergers are
primarily motivated by business strategy and the need to respond to
fundamental shifts in a rapidly changing economy.
The main reason managers give for undertaking mergers is to increase
efficiency. Mergers can encourage greater efficiency by reducing excess
capacity, taking advantage of economies of scale and scope, and
stimulating technological progress. Over time, such efficiencies
translate into lower prices and better products and services for
consumers. However, mergers that increase market concentration can raise
prices and reduce consumer benefits. In addition, mergers, like other
forms of economic change, can disrupt established patterns of economic
and social activity.
When the antitrust agencies--the Federal Trade Commission and the
Antitrust Division of the Department of Justice--review mergers, they do
so with an eye to protecting competition for the benefit of consumers.
They pay considerable attention to market definition--over how large a
market the merged firm might exert market power, and what competitors it
faces in that market--so that the effects of a merger are evaluated in
the proper context. Antitrust enforcement has been rigorous in this
Administration, and mergers receive careful scrutiny. Most have been
found to be procompetitive or competitively neutral. But the minority
that would reduce competition and harm consumers have been challenged.
The current approach, which is aggressive

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without being heavy handed, stands in contrast to both the strong
antimerger bias of the 1960s and 1970s and the much more lax enforcement
of the 1980s.
Antitrust enforcement does not and probably should not encompass the
broader range of possible economic and social effects that may be
associated with mergers, such as job loss, change in ownership structure
(including reduced diversity of ownership), and localized service
disruptions. Such effects result not only from mergers but from many
other forces as well, including technological change, deregulation, and
international competition. Indeed, mergers may be more a symptom of
broad change in the economy than a cause. The policies that are best for
dealing with these changes include promoting full employment and
macroeconomic stability, developing a skilled and well-trained work
force, providing adequate unemployment insurance and other safety net
programs, and helping communities adapt to economic change. All of these
have been part of the Administration's economic strategy of the last 6
years.

INTERNATIONAL TRADE

International trade policy has long been a laboratory for addressing
the challenge of balancing efficiency and fairness and for providing
political safeguards for those who might be hurt by change and would
otherwise work to block it. For example, U.S. trade law recognizes that
imports can sometimes be associated with labor displacement and other
disruptions, and it provides for several kinds of relief in these
circumstances. So-called escape clause relief allows temporary measures
to be adopted in cases where rising imports are judged to have been a
substantial cause of serious injury to an industry. And antidumping
duties may be imposed in cases where foreign producers are judged to
have dumped their products in U.S. markets (that is, sold them at less
than fair value).
Trade adjustment assistance is an alternative way of dealing with
disruptions associated with trade. Since 1962 U.S. trade laws have
provided for some kind of cash assistance for workers who have lost
their jobs as a result of trade. In addition, the North American Free
Trade Agreement (NAFTA) provides assistance to workers displaced from
companies that have shut down their U.S. plants and moved production to
Mexico or Canada, and the Administration has supported extending such
assistance to all workers displaced by the movement of work to another
country. In theory, trade adjustment assistance provides compensation
from the broad class of those who gain from trade (represented by the
taxpayers generally) to those who lose from it (workers in trade-
impacted industries), without interfering with the efficiency-enhancing
effects of freer trade. In practice, of course, things are more
complicated if adjustment assistance interferes unduly with workers'
incentives to find new jobs--another moral hazard issue.

[[Page 41]]

Nevertheless, adjustment assistance illustrates the general principle
that it is desirable to address the disruption caused by positive change
rather than block the change itself.

PROMOTING PROSPERITY FOR ALL AMERICANS

From the end of World War II until the early 1970s, the rising tide
of economic growth raised wages and incomes uniformly for American
families of all incomes. For example, just as the median family income
approximately doubled between 1947 and 1973, so did the incomes of
families near the top and the bottom of the income spectrum (Chart 1-4).
Since the early 1970s, however, the pace of income growth has slowed and
income inequality has increased. Median family income in 1997 was about
10 percent higher than in 1973, but income at the 95th percentile (that
is, an income exceeded by that of only 5 percent of American families)
was more than a third higher, whereas income at the 20th percentile was
virtually unchanged.
This Administration has recognized from the start that the stubborn
problems of slow productivity growth and rising income inequality were
among the greatest challenges it would face. And there are heartening
signs that we may have turned the corner. As mentioned earlier,
productivity growth has remained relatively strong in this expansion,
whereas in past expansions it has tended to flag as the expansion
matures. Moreover, as detailed in Chapter 3, low-wage and minority


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workers are enjoying some of the best labor market conditions they have
seen in decades. The Bureau of the Census reports that the Gini
coefficient (a standard measure of income inequality) has recorded no
statistically significant increase since 1993, and the poverty rate fell
to 13.3 percent by 1997, from 15.1 percent in 1993. These trends are
encouraging. However, it is difficult to disentangle the cyclical
effects arising from the particular strengths of this expansion from
possible improvements in underlying trends.
Maintaining macroeconomic stability is a necessary condition for
ensuring that all Americans participate in the country's growing
prosperity. But it is also important to continue to develop policies
that address the challenges of a changing economy and a changing
society, especially in the areas of education and training. Chapter 3
discusses the Administration's initiatives to improve schools, open the
doors of college to all Americans, strengthen America's work force
development system, and promote lifelong learning.

CONCLUSION

The U.S. economy remained strong in 1998 despite a serious weakening
in the international economy and considerable financial turmoil. The
economy's ability to weather these storms is testimony to the soundness
of the policies of the past 6 years and to the underlying strength of
the current economic expansion. Although there is much for us all to be
proud of in this economic success, the Nation still faces important
challenges as it prepares for the 21st century. Chapter 2 of this Report
reviews domestic macroeconomic developments in 1998 and presents the
Administration's forecast for 1999 and beyond. Chapter 3 analyzes the
benefits of the strong labor market in this expansion. Chapter 4
provides a context for the national discussion of Social Security reform
by analyzing work, retirement, and the economic well-being of the
elderly. Chapter 5 examines the role of innovation and regulation as
determinants of long-term economic performance, with particular emphasis
on antitrust policy, environmental regulation, and restructuring of the
electric power industry. Finally, Chapters 6 and 7 analyze recent events
in the international economy from the standpoint of increased
globalization of capital flows and the evolution and reform of the
international financial system.