[Economic Report of the President (2002)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 1

Restoring Prosperity


Over the past two decades, the Nation has witnessed an impressive
increase in prosperity. Over 35 million jobs were created, and
real income nearly doubled, producing an unprecedented standard of
living. This economic success also serves as an example of what an
open, free market economy--one that relies on the private sector
as the engine of growth--can achieve.

A hallmark of the economy has been its ability to weather adverse
economic developments in a flexible and resilient manner. This is
not an accident but rather a characteristic of an economic system
that relies on market forces to determine adjustments in economic
activity. But such an economy, even in the presence of sound fiscal
and monetary policies, is not immune to business cycles. Economic
activity in 2001 is an example of how a series of adverse developments
can cause setbacks on the road to greater prosperity. The last year
also highlighted the value of continued efforts to strengthen the
policy environment in a way that allows the private sector both to
recover more quickly and flourish more strongly in the future.


Macroeconomic Performance in 2001:
Softer Economy, Harder Choices


U.S. economic growth continued to decelerate during 2001. It was
apparent early in the year that policymakers would face considerable
challenges as the rate of growth slowed from the rapid rates of past
years. The momentum placing downward pressure on economic activity
appeared to subside by midsummer, however, by which time growth of
real gross domestic product (GDP) had come to a virtual standstill.
Economic conditions showed some tentative signs of firming, and
growth prospects were brightening. All that changed on September 11.
The President, Congress, and other policymakers responded decisively
to the damage and disruptions caused by the terrorist attacks, while
continuing to work to strengthen the long-run economic fundamentals.


Aggregate Demand During the First Three Quarters
The deceleration of real GDP in 2001 continued a slowdown in
economic activity that had begun the previous year (Chart 1-1). Real
GDP growth over the first three quarters remained barely positive, at
0.1 percent on an annualized basis; however, the economy steadily
weakened through this period, ending with a 1.3 percent annualized
contraction in real GDP in the third quarter. Although several key
components of aggregate demand rose moderately, overall growth was
dragged down by unusually weak investment spending. Preliminary
evidence indicates a further decline in the fourth quarter due to
weaker economic conditions--especially during the early months of
the quarter--in the aftermath of the September terrorist attacks.
This assessment, however, may be subject to large revision because of
the limitations of existing statistical sources
(Box 1-1).



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Box 1-1. Better Tools: Improving the Accuracy and Timeliness of
Economic Statistics

Economic statistics are valuable tools that economists,
policymakers, business leaders, and individual investors use to
increase our understanding of the economy. The Bureau of Economic
Analysis, the Bureau of Labor Statistics, the Bureau of the Census,
the Federal Reserve, and other  departments and agencies combine
thousands of bits of information from market transactions, consumer
and business surveys, and numerous other sources to produce scores of
economic estimates every month.
The ability of government, consumers, workers, and businesses to
make appropriate decisions about work, investments, taxes, and a host
of other important issues depends critically on the relevance,
accuracy, and timeliness of economic statistics. At turning points in
the economy, such as those marking the beginning or the end of an
economic slowdown, the accuracy and timeliness of data are especially
critical, because at these times fiscal and monetary policy can be
most useful in steering the economy.
Recent economic events have emphasized the importance of timely
economic information. Thus one area deserving considerable attention
is the need for readily accessible real-time data. Investment in
sources of these data could yield handsome dividends, especially at
key junctures in the business cycle.
Moreover, the quality of existing statistics is far from perfect and
could be enhanced with further investment. Even real GDP, generally
thought of as a reliable measure of overall activity in the U.S.
economy, is susceptible to considerable revisions. For example, in
the third quarter of 2000, real GDP was first estimated to have grown
2.7 percent at an annual rate--a subpar but respectable growth rate.
That rate was then revised downward to 2.4 percent and then again to
2.2 percent. Seven months later it was further revised downward to
1.3 percent, providing evidence that the economy had begun to slow
dramatically at that time. A key component of the revision came from
revised data on gross private domestic investment, initially
estimated to have risen 3.2 percent but later revised to show a
contraction of 2.8 percent. Such revisions lead to uncertainty for
both government and private decisionmakers, which can cause costly
delays. Although most revisions are not that large, the average
quarterly revision of real GDP growth over 1978-98 was about 1.4
percentage points in either direction, while real GDP growth averaged
2.9 percent.
In addition to these problems with large revisions, the national
accounts statistics are beset by some growing inconsistencies.
Gross domestic product, the sum of final expenditures for goods and
services produced by the U.S. economy, and gross domestic income,
the sum of the costs incurred and income received in the production
of those goods and services, are theoretically equal. Because of
statistical discrepancies, there has always been some divergence
between these two reported numbers. However, this discrepancy has
been growing lately, raising concerns among policy experts and
business leaders as well as among the producers of the data
themselves. These differing estimates can lead to different readings
of such critical indicators as output and productivity growth.
A number of steps can be taken to improve the accuracy and
timeliness of economic statistics. In particular, targeted
improvements to the source data for the national accounts would go
a long way toward illuminating the causes of the growing statistical
discrepancy. Another cost-effective measure would be to ease the
current restrictions on the sharing of confidential statistical data
among Federal statistical agencies. Such data sharing, which would be
done solely for statistical purposes, is currently hindered by lack
of a uniform confidentiality policy. Confidentiality is of key
importance to all agencies and to the individuals and businesses who
participate in Federal surveys, but a uniform confidentiality policy
would allow agencies such as the Bureau of Economic Analysis, the
Bureau of Labor Statistics, and the Bureau of the Census to
cost-effectively compare and improve the quality of their published
statistics while preserving confidentiality. In the past, attempts
have been made to pass legislation, together with a conforming bill
to modify the Internal Revenue Code, allowing such data sharing under
carefully crafted agreements between or among statistical agencies.
In 1999 such legislation passed the House but stalled in the Senate.
The Administration will continue to seek passage of data sharing
legislation to improve the quality and effectiveness of Federal
statistical programs.
In addition to data sharing legislation, the Administration is
proposing new and continued funding for the development of better
and more timely measures to reflect recent changes in the economy.
For example, these resources would allow for tracking the effects of
the growth in e-commerce, software, and other key services, and for
developing better estimates of employee compensation. The latter are
increasingly important given the expansion in the use of stock options
as a form of executive compensation, as well as for tracking the
creation and dissolution of businesses, given the importance of
business turnover in a constantly evolving economy. Improved
quality-adjusted price indexes for high-technology products are
also an important area for future research. The direct contribution
of these products accounted for nearly a third of the 3.8 percent
average annual growth rate in real GDP during 1995-2000, but current
estimating techniques fail to capture productivity growth in high
technology-using service industries. This shortcoming may lead
to underestimates of annual productivity growth of 0.2 to 0.4
percentage point or more. As the economy continues to change and
grow, the need persists to create and develop such new measures,
to provide decisionmakers with better tools with which to track the
economy as accurately as possible.
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Consumption
Personal consumption expenditures grew 2.8 percent at an annual
rate in the first half of 2001, followed by a 1.0 percent increase
in the third quarter (Chart 1-2). Consumption growth in the first
three quarters was 2.2 percent--notably slower than the 4.8 percent
rate of the previous 3 years.
Spending for all types of consumption slowed in 2001. Growth in
spending on nondurable goods declined to a 1.1 percent annual rate
through the third quarter, from a 4.5 percent rate in 1998-2000. The
sharp decline in nondurable consumption is somewhat surprising,
because swings in this category of consumption tend to be more muted
than those in overall consumption. Consumption of food and of clothing
and shoes decelerated sharply, in a significant deviation from recent
trends. The Bureau of Economic Analysis estimates that food
consumption edged down 0.4 percent in the first three quarters of
2001, after averaging 3.8 percent growth in the previous 3 years;
clothing and shoes consumption rose 1.9 percent after averaging
nearly 7 percent growth in 1998-2000. Energy consumption continued
to be weak, reflecting higher energy prices early in the year.
Growth in durable goods spending also subsided, but remained
relatively strong, in the first three quarters of 2001: purchases
rose 6.1 percent at an annual rate compared with 9.7 percent on
average in 1998-2000. This recent strength has been atypical
because, during most economic downturns,



durable goods spending tends to slow more sharply than nondurable
goods spending. Part of the explanation is that two key durable goods
industries have proved more resilient to the slowdown than in the
past. Furniture and household equipment grew robustly, as the housing
sector stayed healthy in 2001. And although growth in sales of motor
vehicles and parts was anemic early in the year, these sales remained
remarkably high for a period of such marked slowing in overall
activity.
Finally, consumption of services--the least cyclical component of
consumption--grew at a 1.9 percent annual rate in the first three
quarters of 2001, down from a 4.0 percent rate over 1998-2000. Medical
care spending, however, continued its strong upward trend.
These patterns in consumption spending--which constitutes two-thirds
of GDP--reflected several key economic crosscurrents. On the downside,
the decline in equity markets and the deterioration in labor markets
(discussed below) reduced wealth and consumer confidence. On the
upside, housing prices continued to climb, rising at roughly an 8
percent annual rate. In addition, lower mortgage interest rates
sparked the strongest wave of home refinancing ever, transforming
housing equity into more liquid forms of wealth. Refinancing is
estimated to have increased household liquidity (from increased cash
flow and cashouts) by about $80 billion during the year. In addition,
real disposable personal income, aided somewhat by provisions of the
President's tax cut--reduced withholding and the payment of rebates
for the new 10 percent personal income tax bracket--rose at a solid
4.5 percent annual rate during the first three quarters.

Investment Spending
Real gross private domestic investment fell at a double-digit annual
rate (roughly 12 percent) in each of the first two quarters of
2001--the steepest decline in investment spending in a decade
(Chart 1-3). The year began with a sizable inventory liquidation,
which accounted for most of the decline in gross private domestic
investment in the first quarter and subtracted 2.6 percentage points
from the growth rate of real GDP. Inventory reduction remained a drag
on GDP growth in subsequent quarters, with manufacturing industries
shedding inventories at a faster pace than wholesalers and retailers.
By the end of the third quarter, the inventory-to-sales ratio had
returned to a level close to the average over the previous 3 years,
indicating that the downward phase of the inventory cycle may soon
be ending.
Nonresidential business fixed investment contracted sharply in 2001,
in stark contrast to the investment boom from 1995 to early 2000. In
the first quarter this category of investment fell at only a 0.2
percent annual rate--the first decline in 9 years. In the second
quarter, however, it fell at a 14.6 percent annual rate, with
declines in investment in structures and in equipment



and software of 12.3 percent and 15.4 percent, respectively.
Investment in information processing equipment and software alone
fell at a 19.5 percent rate in the second quarter. The widespread
decline in business fixed investment continued in the third quarter
with an 8.5 percent contraction, combining a 7.6 percent drop in
structures investment with an 8.8 percent decline in equipment and
software spending. Capital spending on computers and peripherals
during the second and third quarters was hit particularly hard,
plunging at a 28.6 percent rate.
The housing sector was a bright spot in 2001. Lower mortgage
rates and rising real income helped to support rising residential
investment in each of the first three quarters; growth for the
period averaged 5.6 percent at an annual rate. Investment in
single-family structures rose 6.0 percent, after declining during
most of 2000. Investment spending on multifamily structures rose
briskly at a 15.3 percent rate. Investment in residential building
improvements increased at a 3.2 percent rate.

Government Spending
Government spending--Federal, State, and local levels
combined--added to economic activity over the first three quarters
of the year. Federal Government spending increased at a 2.9 percent
annual rate during this period. In contrast, Federal spending in 2000
fell by 1.4 percent, and over 1995-2000 it grew at only a 0.1 percent
average rate. Last year's increase was driven by national defense
expenditure, which rose 4.4 percent through the first three quarters.
Defense spending on research and development as well as personnel
support accounted for most of the increase. Nondefense expenditure
grew only 0.2 percent in the first three quarters of 2001.
State and local government spending increased 3.8 percent at an
annual rate in the first three quarters. State and local spending has
increased steadily over the past decade, averaging 2.8 percent annual
growth from 1990 to 2000 and 3.2 percent from 1995 to 2000. Investment
by State and local governments rose much faster (4.6 percent a year on
average) than their consumption (2.8 percent) during 1995-2000.
However, consumption expenditure accounts for 80 percent of State and
local spending.

Net Exports
Net exports exerted a smaller drag on economic activity in 2001 than
in 2000. Both imports and exports fell significantly during the year,
but the drop in imports was larger. Real exports of goods and services,
measured at an annual rate, declined $95.3 billion through the third
quarter, mostly because of a decline in exports of capital
goods--especially high-technology goods--as a result of the global
economic slowdown (discussed further below). Over the same period,
real imports declined $105.3 billion. Real imports of services
suffered one of the largest declines on record in the third quarter,
largely because international travel was disrupted in September.
Overall, net exports contributed 0.1 percentage point to real GDP
growth in the first three quarters of the year. By comparison, in 2000
net exports depressed real GDP growth by 0.8 percentage point.

Preliminary Evidence on Aggregate Demand in the
Fourth Quarter
The terrorist attacks of September 11 changed the direction of the
macroeconomy. Before the attacks, the economy had been showing
tentative signs of stabilizing after its long deceleration, and many
forecasters expected real GDP growth to accelerate in the third and
fourth quarters of 2001. Immediately after the attacks, however,
the economy turned down because of the direct effect of the assault
on the Nation's economic and financial infrastructure and because of
the indirect, but more significant, effect on consumer and business
confidence. The drop was sufficient to turn the sluggish period of
economic activity into a recession.
The disruptions to lower Manhattan's telecommunications and
trading facilities temporarily interfered with the normal operations
of key components of the Nation's financial center and caused
dislocations in the Nation's payment system, which processes
trillions of dollars in transactions on a typical business day.
Equity markets shut down temporarily, and when they reopened a week
later, the value of shares fell by $500 billion. Money markets and
foreign exchange markets continued to function during this period
but faced considerable difficulties.
In the New York City area, the closure of much of lower Manhattan
weakened economic activity, especially employment, and had serious
consequences for local businesses that depend on sales from that part
of the city. The local tourism and business travel industries also
sagged. The attack on the Pentagon had less of a direct effect on the
private sector because of the limited destruction of private
infrastructure. Nonetheless, economic activity in the Washington,
D.C., area slumped, primarily because of the need to temporarily
close Reagan National Airport for national security reasons. Local
businesses, such as hotels and restaurants, that provide ancillary
services for travelers were hit particularly hard. As in the New York
City area, small businesses were especially affected, because many
operate from only one business location, whereas large businesses with
operations throughout the country are often better able to weather
local dislocations.
The terrorist attacks also had a significant macroeconomic effect.
The Nation's airspace was shut down for several days after the
attacks, halting passenger travel and deliveries of airfreight.
In addition, cross-border ground shipping was delayed because of
increased security measures. Businesses that rely on highly
synchronized deliveries of inputs were forced to slow down their
assembly lines, and in some cases close plants, creating disruptions
up and down the stream of production.
Beyond the initial impacts, the attacks continued to have a
significant negative effect on the economy as uncertainty about the
future led to a steep decline in consumer and business spending.
Consumers retrenched as they mourned the loss of life and reevaluated
the risks inherent in even the most mundane activities, such as
shopping at malls and traveling by air. Meanwhile businesses adopted
a more pessimistic outlook about the prospects for a speedy recovery.
The underlying psychology was affected again in October, by the
discovery of anthrax spores delivered through the mail distribution
system, although the direct macroeconomic effects of this attack
have been fairly limited.
Preliminary evidence indicates that economic activity at the
beginning of the fourth quarter of 2001 suffered a pronounced
decline. The industrial sector contracted at a faster pace in
October than earlier in the year, and job losses mounted. By November,
however, some tentative signs had emerged that business conditions
were deteriorating at a slower pace.
For example, the decline in industrial production was milder, and
nondefense capital goods spending appeared to have bottomed out, with
new orders recovering from the trough in September. Construction spending
also performed well, as weather in the fall was unseasonably warm.
By December the manufacturing sector, which had been particularly hard
hit in 2001, witnessed increases in the length of the average workweek
and in factory overtime. Meanwhile the Purchasing Managers' Index (PMI)
of the Institute for Supply Management (formerly the National Association
of Purchasing Management) rebounded sharply, with a jump to 48.2 in
December from 39.8 in October. The production component of the PMI
rose to 50.6 from 40.9 in October; the new orders index surged to
end the year at 54.9. Moreover, industrial production in December
was nearly unchanged after several months of sizable declines.
Despite the initial dropoff in consumer confidence after the
terrorist attacks, consumer spending bounced back within the quarter
from its September plunge. Real personal consumption expenditures on
durable goods, nondurable goods, and services rose considerably in
October and November. Purchases of automobiles and light trucks
contributed substantially to the rebound, as consumers responded
favorably to the incentive programs offered by manufacturers and
dealers, such as zero-percent financing and rebates. Automobile
and light truck sales surged to a record 21 million units at an
annual rate in October, then moderated to something closer to the
average 17-million-unit selling pace of the first three quarters.
Even though nominal retail sales of goods excluding motor vehicles
edged down in November and December, falling prices for energy and
consumer goods suggest that real consumption spending continued to
rise.
The performance of financial markets confirmed the view that
economic conditions were firming in the fourth quarter. Stock market
prices rebounded from a sharp decline after September 11 (Chart 1-4).
The Standard & Poor's 500 Composite Stock Index had returned to its
pre-September 11 level by mid-October, and it ended the year near
1150, up 19 percent from its post-September 11 low. Other market
indexes such as the Dow Jones Industrial Average and the Wilshire
5000 rose in a similar pattern.
In addition, credit markets were active in providing funds to
businesses. Low interest rates made bond financing attractive,
especially for investment grade issuers. Lending by commercial banks
for real estate and consumer purchases was rising and generally
higher in the fourth quarter than earlier in the year. Commercial
and industrial lending, in contrast, was lower in the quarter than
earlier. According to the Federal Reserve, banks tightened credit
standards and terms on commercial and industrial loans by late
summer and early autumn. The tightening of non-price-related loan
terms was especially apparent for small firms.






Labor Markets

Private nonfarm payrolls dropped by roughly 1.5 million in 2001,
reflecting the weak economy. The bulk of the decline occurred in
manufacturing, especially in durable goods-producing industries,
where over 1 million jobs were shed after December 2000. In addition,
employment in help supply services, which provide labor to other
industries, fell by about 550,000 jobs. Job losses in manufacturing
and help supply services were offset in part by increases in some
other service industries during the year. The health services industry
logged strong increases in 2001. In recent months, service employment
has been hurt by cutbacks in business travel and tourism, which
have adversely affected employment in air transportation and
travel-related services such as travel agencies, hotels, and
amusements and entertainment.
Labor markets became substantially less tight in 2001. The total
unemployment rate rose from 4.0 percent in December 2000 to 5.8 percent
a year later, still below the average rate for the past 20 years of 6.2
percent. The average duration of unemployment rose by 2 weeks during 2001,
ending the year at 14.5 weeks. More than half of this increase occurred
in the last 3 months of 2001.
Every region saw its unemployment rate rise, as the slowdown in
economic activity was national in scope. The Mountain States experienced
the largest increase, 1.8 percentage points. The smallest increase occurred
in the West North Central States; this region had one of the lowest
unemployment rates in the country at the end of 2000.
The labor force participation rate (the share of the working-age
population either working or seeking work) fell 0.4 percentage point
over the year. Labor force participation has hovered near 67 percent
since 1997, after rising from near 60 percent in 1970. The average
number of discouraged and displaced workers has risen nearly 30 percent
since the beginning of 2001 but remains below the average for the past
5 years.

Inflation

Inflation remained low and stable in 2001. The consumer price index
(CPI) rose only 1.6 percent during the 12 months ending in December.
Consumer energy prices for fuel oil, electricity, natural gas, and
gasoline tumbled 13.0 percent, reflecting a collapse in crude oil and
in wellhead natural gas prices. In contrast, energy price inflation a
year ago was 14.2 percent. Food prices rose 2.8 percent, the same rate
as a year ago. The CPI excluding the volatile food and energy
components--often referred to as the core CPI--posted another year
of stable inflation. Core inflation was 2.7 percent, up somewhat from
its 2.3 percent average rate over the past 4 years.
The absence of price pressures in the production pipeline helped
hold consumer price increases in check. The producer price index
(PPI) for finished goods fell 1.8 percent in the 12 months ending
in December.
At the start of the year, producer prices had been rising rapidly,
largely reflecting rising energy prices; but PPI inflation fell all
year long as energy prices slumped and economic activity weakened.
Excluding the volatile energy and food components, the PPI for finished
goods rose 0.7 percent during 2001. PPI inflation for intermediate and
crude materials declined throughout the year, sometimes experiencing
periods of steep price declines.

Productivity and Employment Costs
Despite the economic slowdown, nonfarm business labor productivity
grew at a 1.2 percent annual rate during the first three quarters of
the year. Although below the 2.4 percent average rate recorded during
1995-2000, productivity growth has been remarkably strong for this
stage of the business cycle. During previous postwar recessions,
productivity growth averaged 0.8 percent.
Manufacturing productivity, in contrast, edged down at a 0.2 percent
annual rate for the first three quarters of the year, compared with a
0.6 percent decline in the 1990-91 recession. The 2001 figure represents
the first decrease in manufacturing productivity in the past 8 years,
and it reflects the pronounced slump in the industrial sector that began
in mid-2000. A sharp deceleration in durable manufacturing productivity
from a nearly 7 percent rate of growth in 2000 to a 0.8 percent rate of
decline during the first three quarters of 2001 accounted for much of
the change. Nondurable manufacturing productivity grew at only a 0.1
percent rate over the first three quarters of 2001.
Employment costs rose at a slower rate in 2001 than in 2000. Total
wages and salaries for private workers as measured by the employment
cost index (ECI) rose 3.7 percent at an annual rate through the first
three quarters of 2001--slightly less than the 3.9 percent increase in
2000. The total cost of benefits for private industry workers increased
at a 5.1 percent rate through September 2001, down from a 5.7 percent
increase in 2000. The ECI for manufacturing rose 3.3 percent,
combining a 3.8 percent rise in wages and salary with a 2.7 percent
increase in benefit costs. This slowdown in the rate of employment
cost increases should help to moderate future inflationary pressure.

Saving and Investment
National saving, which comprises private saving and government saving,
fell in 2001. As a share of gross national product, national saving edged
down to 17.2 percent during the first three quarters of 2001 from 17.9
percent in 2000. Shrinking Federal Government saving accounted for most
of the decline, as the economic slowdown reduced revenue and caused some
types of automatic expenditure to rise. The personal saving rate
(personal saving as a share of disposable income) averaged 2 percent
in the first three quarters of 2001, up from 1 percent in 2000. Part
of the increase was due to the downpayment on the President's tax
cut, which was sent out in the form of ``rebate'' checks in July
through September. Although the personal saving rate rose in the
third quarter, Federal Government saving declined, the natural
consequence of returning surpluses to taxpayers.
As the current account deficit shrank with the slowing economy, net
foreign investment flows slowed in 2001. As a result, despite the
decline in the national saving rate, domestic sources of saving
funded a larger share of domestic investment. Over the previous 3
years, net foreign investment had been growing by roughly $100
billion a year. After reaching a peak of just over $450 billion in
2000, net foreign investment fell steadily in 2001, its first
decline since 1997. By the third quarter, net foreign investment
had dropped to $355 billion, although this was exaggerated somewhat
by the one-time insurance payment of roughly $40 billion (at an
annual rate) from foreign sources on claims (recorded on an accrual
basis) related to the terrorist attacks.
National saving and investment are key to our long-run prosperity,
and the President's 2001 fiscal initiatives improved incentives for
private saving and investment. Because budget resources ultimately
depend on the health of the economy as a whole, this approach serves
as the best way to enhance budget surpluses over the long run.
In June the President signed the Economic Growth and Tax Relief
Reconciliation Act (EGTRRA, described in more detail later in this
chapter), which removes impediments to private saving by expanding
contribution limits for Individual Retirement Accounts (IRAs), 401(k)
plans, and education savings accounts. Education savings accounts
raise incentives not only to save for education, but also to improve
the quality and productivity of the Nation's work force in the future.
Other provisions of the act, such as lower marginal tax rates, a
reduced marriage penalty, and elimination of the estate tax, provide
strong incentives to work, save, and invest. Another important
initiative is the President's Commission to Strengthen Social Security,
which in December issued its final report on meaningful reform options
to strengthen the Social Security system and improve the ability of
individuals to accumulate and pass along wealth.

The Cyclical Slowdown

Several factors contributed to the deceleration in economic activity
during 2000 and 2001 from its very high levels in the preceding years:
the decline in stock market wealth, the spike in energy prices, an
increase in interest rates, the collapse of the high-technology sector,
and the lingering effects of preparations against the year-2000 (Y2K)
computer bug. With this backdrop setting the stage for sluggish growth,
the economic aftermath of the terrorist attacks in September and the
subsequent precipitous decline in consumer and business confidence late
in 2001 were sufficient to tip the Nation into its seventh recession
since 1960.

Moderation After Very Rapid Growth
The strong growth recorded from 1995 through 1999 was a welcome and
beneficial development, as the private sector reaped the rewards from
its investments in high technology. In particular, the productivity
gains offered by the more intensive use of computers, fiber optic
technologies, and the Internet drove an investment boom in which the
Nation's businesses retooled and upgraded their workplaces for the
21st century. Not surprisingly, the rapid pace of investment then
slowed as the need to adopt the new technologies began to be
satisfied and a more mature investment phase began. Although the
transition to a more moderate growth rate could in principle have
been smooth, in practice additional economic developments created
swings in investment spending that contributed to the significant
slowing of economic activity.

Decline in Equity Values
The decline in equity values starting in early 2000 also helped slow
economic activity by dampening both consumption and business fixed
investment spending. Equity in businesses (both in corporations and
in noncorporate businesses) fell from its peak of $17.5 trillion in
the first quarter of 2000 to just under $13 trillion in the third quarter
of 2001, according to the latest quarterly estimate from the Federal
Reserve's flow of funds accounts. Various studies suggest that every
one-dollar decline in stock market wealth ultimately reduces annual
consumption spending by 3 to 4 cents. Thus the observed $4.5 trillion
decline in wealth could be expected to reduce consumption by $135 billion
to $180 billion, or roughly 1 to 2 percentage points of GDP. Downward
pressure from the equity decline may continue to affect consumption
spending into 2002, because a drop in wealth typically has lagged effects
for 1 to 2 years. Offsetting some of the decline in equity wealth,
however, has been a continued increase in housing wealth. From the
start of 2000 to the middle of 2001, housing prices rose at a steady
9 percent annual pace, increasing housing wealth by $1.7 trillion.
The effect of the decline in equity prices on investment demand was
both direct and indirect. Lower equity prices reduced investment
spending directly by raising the cost of capital for corporations,
and indirectly by causing growth in aggregate demand for final goods
and services to wane.


Surge in Energy Prices

Energy prices surged in 1999 and 2000, reaching extremely high levels
at the start of 2001. Oil prices rose dramatically from $12.00 a barrel
to peak in November 2000 at $34.40 a barrel for West Texas Intermediate
crude, its highest monthly average price since October 1990. Even more
dramatic was the spike in natural gas prices, to the highest price on
record, $8.95 per million Btu in December 2000. This was more than 3H
times the average price over the preceding 6 years. These developments
in energy prices had important ramifications for 2001. Personal
disposable income available for goods and services other than energy
fell as gasoline, heating, and electricity prices soared. Producers
of nonenergy goods and services also suffered as their costs of
production rose--especially in the energy-intensive manufacturing
sector. The decline in demand and the rise in input costs squeezed
profit margins, slowing corporate cash flow and reinforcing the
downdraft on stock market values and capital spending plans.


Higher Interest Rates

Higher interest rates in 2000 and early 2001 also contributed to
the deceleration in activity. The 10-year Treasury yield peaked at
6.7 percent in January 2000, and the 10-year corporate Baa yield hit
8.9 percent in May. Short-term interest rates rose consistently for
a full year before reaching 6.2 percent in November 2000. The higher
interest rate environment slowed economic activity as consumers were
given the incentive to consume less, and investment in plant and
equipment became less attractive.


Collapse of the High-Technology Sector

The collapse of stock prices in the high-technology sector--
especially the dot-coms, or Internet-related firms--contributed an
additional drag on economic activity. Prices for high-technology
stocks as measured by the NASDAQ composite index fell 67 percent
from their monthly peak in March 2000 to their monthly trough in
October 2001, returning the NASDAQ to levels last seen in early
1998. By contrast, during the same period the Wilshire 5000 index
fell by a much smaller 32 percent. The drop in the high-technology
stocks represented an important reduction in equity
wealth, but it also signaled a sea change in the fortunes of these
businesses--especially those in the information and communications
technology industries--which had been an important source of economic
gains in the 1995-99 period. Investors both ratcheted down the
earnings prospects of these firms and perceived a greater risk
of investing in both established and more speculative high-technology
businesses. This fundamental reevaluation of information and
communications technology firms led to a swift downturn in the
sector's activity and a reversal of the capital investment boom.


Lingering Effects of Y2K

The runup in capital spending by firms nationwide in anticipation of
and in response to the Y2K event created conditions that exacerbated
swings in high-technology capital spending. Instead of primarily
upgrading existing capital and software, which might have remained
vulnerable to the Y2K bug, most businesses replaced them with the
latest technologies. The resulting bulge in investment spending
around January 2000 generated a tendency toward a subsequent
investment lull. Given that the typical replacement cycle for
high-technology goods is about 3 to 5 years, it is not surprising
that the investment decline that began in 2000 lingered in 2001.

Effects on Inventories and the Capital Stock
The factors just discussed--the transition to more moderate growth
rates, the decline in equity values, the surge in energy prices,
higher interest rates, the collapse of high-technology industries,
and the lingering effects of Y2K--constituted a potent set of adverse
economic circumstances for investment in 2000, with consequences for
2001. The declining stock market and higher interest rates increased
the cost of external financing of new investment. At the same time,
higher energy prices ate into corporate cash flow, which was already
slowing as the economy decelerated. As a result, the financing gap
(capital expenditure less internally generated funds) hit an all-time
high in 2000. Also, by mid-2000 businesses found themselves with
unplanned inventories as demand began to soften, and the result was
a traditional inventory cycle. The accumulation of unwanted inventories
led businesses to slow production further, with consequences for e
mployment growth. This in turn fed the reduction in demand that had
left businesses with rising inventories in the first place.
As the economy slowed, firms found themselves with the desire to
defer future capital spending plans. By some estimates, a ``capital
overhang'' developed in which the actual capital stock exceeded that
desired by firms to meet the lower expected demand in 2000. By late
2001, however, the decline in investment spending had likely eliminated
the capital overhang (Box 1-2).

-----------------------------------------------------------------------------

Box 1-2. Capital Overhang and Investment in 2001
A capital overhang develops when the amount of capital in the economy
exceeds the amount that businesses desire for the production of goods
and services. The emergence of such an overhang complicates both
business planning and policymaking. Businesses often have to alter
their capital spending plans and curtail their investment spending--
sometimes quite abruptly. A large overhang may also reduce the
stimulative effects of tax policies designed to boost investment,
possibly lengthening the recovery time during a period of sluggish
economic activity, especially for the manufacturing sector.
An overhang can arise in various ways. If, for example, rapid growth
is expected in the future, businesses will begin increasing their
investment in advance. If the faster growth is not realized, these
businesses will find themselves with too much capital. A capital overhang
can also arise during a short period of unexpectedly sluggish growth.
If the decline in demand is thought to be sufficiently deep and
persistent, businesses may want to reduce their capital spending
plans, and possibly sell off part of their capital stock, especially
those capital goods that are readily marketable. However, if the
slowdown is sufficiently short, businesses may prefer to reduce
their use of the capital stock rather than sell it, especially
because the market price of capital goods is likely to fall during
such periods. Selling capital and buying it back at a later date can
then be more costly than simply holding onto it and not using it to
its full capacity. Reducing the utilization rate thus helps to
prevent the desired capital stock from falling.
Policymakers have lately been concerned that the changing business
climate may have given rise to a capital overhang over the past 2 years.
Some businesses, especially in the information and communications
technology sector, may have overestimated the potential of the ``New
Economy'' and therefore overinvested in productive capacity. In
addition, businesses throughout the economy were surprised by the
extent of the slowdown in aggregate demand in 2000 and 2001, and
they therefore had to revise downward the path of their desired
capital stock.  Empirical evidence suggests that a capital overhang
did develop in 2000. The overhang was modest for the economy on
average, but various types of capital equipment such as servers,
routers, switches, optical cabling, and large trucks were
disproportionately affected. Estimates of the total overhang must
be interpreted with caution. There is considerable uncertainty
about its size, because it is difficult to estimate precisely both
the capital stock that businesses desire and the capital stock
they actually possess. Better data collection (see Box 1-1) could
help solve this problem in the future. In any case, over the
past year and a half, the decline in investment spending and
depreciation of the existing capital stock combined to slow
capital accumulation sufficiently to eliminate the overhang.
Chart 1-5 shows that the capital stock, which had been growing
at an annual rate above 4 percent over the past several years,
is estimated to have grown just over 2 1/2 percent in 2001.
The remarkable slowdown in capital accumulation during 2001 underscores
the importance of the President's tax relief recommendations for
economic stimulus. The partial expensing provisions and the
elimination of the corporate alternative minimum tax will
encourage business investment, stimulating economic activity
in the short run and laying the foundation for stronger growth in
the long run. The reductions in marginal income tax rates will help
spur investment by providing incentives for flow-through entities,
mainly small businesses, to grow and create jobs. The President's
tax relief will also help foster a smooth and more predictable
transition to a period of sustainable growth.

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From Slowdown to Recession
Even though economic activity had begun to soften in the first half
of 2000, the onset of recession did not arrive until March 2001,
according to the Business Cycle Dating Committee of the National
Bureau of Economic Research (NBER), the arbiter of U.S. business
cycle dates. The committee based this date on its reading of the
economic data through November 2001, especially the four measures
of economic activity it considers most important: industrial
production, the real volume of sales in manufacturing and trade,
employment, and real personal income less transfer payments.
Industrial production peaked in June 2000, real sales in manufacturing
and trade peaked in August 2000, employment peaked in March 2001,
and real personal income less transfers may not have peaked yet.

As the variation in these dates suggests, picking ``the'' month for
the start of a recession involves considerable judgment and is not
without controversy. The employment series appears to play a dominant
role in the NBER committee's decisions. Without a doubt, employment
is a key resource for economic activity, representing about two-thirds
of all inputs into production. In recessions since 1960, however, the
peak in employment has tended to follow the peak in economy-wide activity.
In addition, total industrial capacity utilization, a standard measure of
the employment of capital--the other key input in production--peaked in
mid-2000, suggesting an earlier economy-wide turning point. These
statistical arguments notwithstanding, the evidence is clear that
the industrial sector was already well into a contraction, and real
sales volumes were sagging, before March 2001. Finally, the
economic consequences of the terrorist attacks were critical to
the business cycle dating. As the committee noted in its decision,
``before the attacks, it is possible that the decline in the economy
would have been too mild to qualify as a recession. The attacks
clearly deepened the contraction and may have been an important
factor in turning the episode into a recession.''
The decline in consumer and business confidence following the
terrorist attacks in September had a larger and more durable
macroeconomic effect than the physical destruction and was
sufficient to scuttle any possibility of avoiding a recession.
Chart 1-6 shows, however, that the decline in the University of
Michigan consumer sentiment index following September 11 was less
than the sharp drop following Iraq's invasion of Kuwait in 1990.
Since September, consumer confidence has rebounded noticeably, to
close to the preattack level. By comparison, during the Gulf War
period, consumer confidence remained subdued for a longer period
but then surged when the successful completion of Operation Desert
Storm largely resolved uncertainty about the future.
Overall, the deceleration of economic activity since mid-2000 has
been dramatic. Unemployment has risen, business earnings have
suffered, and government budgets have been strained. As in past
recessions, no single key




factor caused the slowdown and subsequent recession; rather it took
the confluence of a series of unforeseen adverse events. Despite
some similarities shared with previous episodes of sluggish growth,
the 2000-01 slowdown has been unique in many respects and has
required policies to address the particular challenges of these
developments.

Policy Developments in 2001

Both fiscal and monetary policy became expansionary in 2001. The
Federal budget surplus, although still substantial by historical
standards, fell because of deteriorating economic conditions and
changing fiscal priorities after the terrorist attacks. Falling
short-term interest rates and rapid expansion of the money supply
indicated that monetary policy was eased significantly during the
year.

Fiscal Policy Before the Terrorist Attacks

In February 2001 the President's budget for fiscal 2002 outlined
major policy initiatives for the Nation. These included continuing
the retirement of the Federal debt, providing tax relief for American
families, strengthening and reforming education, modernizing and
reforming Social Security, modernizing and reforming Medicare,
revitalizing national defense, and championing faith-based
initiatives. Although tangible progress has already been made,
fiscal vigilance will be essential to continuing toward these
goals. The Federal budget process needs to be more disciplined,
and spending limits previously agreed upon should be respected.
Too often in the past, budget deadlines were missed and legislation
was consolidated into omnibus spending bills that exceeded
the agreed spending limits. Appropriations in fiscal 2001, even before
the emergency funds made available after September 11, were over $50
billion higher than in 2000--the largest 1-year appropriations increase
in history. The events in September and October precluded an expeditious
completion of the appropriations process in the fall, but the President
and Congress agreed to limit discretionary spending to $686 billion
excluding emergency spending. This new level provides reasonable spending
growth, ensures funding for Medicare and Social Security, and sets an
example for future budget negotiations.
In fiscal 2001 the Federal Government ran the second-largest budget
surplus in history and paid down the second-largest amount of debt in
history, despite the weak economic conditions. Looking forward, the
Federal budget will be in deficit during fiscal 2002 but, with spending
restraint and pro-growth policies, is projected to return to surplus
beginning in 2005. About two-thirds of the decline in the projected
baseline fiscal position since last year may be traced to the weaker
economy and technical revisions. Spending accounts for nearly 20 percent
of the decline, and the EGTRRA provisions account for under 15 percent.
A sound long-run fiscal position holds down unnecessary spending and
removes tax-based impediments to economic growth. As noted earlier, the
tax cut in 2001 was key to mitigating the severity of the slowdown and
simultaneously improving growth incentives. The deterioration in the
surplus from a weak economy is the mirror image of the experience of
the late 1990s, when budget surpluses were fueled largely by a strong
economy. In general, faster economic growth causes budget surpluses,
not the other way around. Moreover, policies that promote job creation
and entrepreneurial activity ultimately increase the size of the economy
and hence provide the resources for future spending obligations.

Tax Relief in 2001
The President laid a strong foundation for growth in 2001 with the
Economic Growth and Tax Relief Reconciliation Act. This package provides
a powerful stimulus for future growth, with reductions in marginal tax
rates that improve incentives and leave in the hands of Americans a
greater share of their own money to spend on consumption, education,
and retirement investment.
The first reduction in marginal tax rates was effective for 2001 and
was reflected in lower withholding during the second half of the year.
In addition, the new 10 percent tax rate bracket, carved out of the
beginning of the 15 percent rate bracket, was reflected in rebate checks
totaling $36 billion, which were mailed to 85 million taxpayers during
the second half. The timing of these reductions in withholding and
rebates proved propitious: they added significant economic stimulus
by boosting purchasing power in the hands of consumers during a period
of sluggish economic activity. The 2001 tax rate reductions were just
the first step in a series of income tax rate reductions to be phased
in by 2006; by that year the 39.6 percent tax rate will have dropped
to 35 percent, the 36 percent rate to 33 percent, the 31 percent rate to
28 percent, and the 28 percent rate to 25 percent.
The tax cut package also provided incentives for saving, investment,
and capital accumulation. Higher IRA and 401(k) retirement contribution
limits are to be phased in over time, with those for persons over 50
phased in more quickly. Beginning in 2002 and continuing through 2009,
the highest estate tax rates are reduced and the effective exemption
amount is increased, reducing an important impediment to the growth of
entrepreneurial enterprises and the overall accumulation of wealth.
In 2010 the estate tax is eliminated. Small businesses will benefit
from the lowering of individual income tax rates for owners of flow-through
business entities such as sole proprietorships and partnerships. In
1998 there were close to 24 million flow-through businesses in the
United States, including 17.1 million sole proprietorships, 2.1 million
farm proprietorships, 1.9 million partnerships, and 2.6 million S
corporations. By 2006, when the personal income tax cut is fully phased
in, the Treasury Department estimates that over 20 million tax filers
with income from flow-through businesses will receive a tax reduction.
Finally, the President's tax cut strengthens families and reduces the
burden of financing education. The marriage penalty is reduced, and the
annual child tax credit is increased from $500 to $600 per child in 2001
and gradually increased to $1,000 by 2010. Adoption credits are doubled
in 2002 from  $5,000 per child; in addition, the credit will apply to
more taxpayers, because the income threshold at which the credit begins
to phase out will rise to $150,000 from $75,000. Contribution limits for
education savings accounts (formerly called educational IRAs) are raised
to $2,000 a year, and distributions are made tax-exempt. The law also
increased the income phaseout range for student loan interest deductions
and made certain higher education costs tax-exempt for households with
less than $130,000 in income.
The initial macroeconomic effects of tax relief have been positive,
strengthening aggregate demand in the face of other downward pressures.
The rebate checks and the lower marginal tax rates alone reduced taxpayer
liabilities by $44 billion in 2001 and by $52 billion in 2002. Adding
in the effects of the other provisions of EGTRRA (such as the education
incentives, child credits, the individual alternative minimum tax,
and marriage penalty relief) brings the liability reduction in 2001
and 2002 to $57 billion and $69 billion, respectively.
In short, the President delivered important tax relief in 2001,
providing a solid foundation for renewed growth in consumer spending
once confidence rebounds, and for an improved investment climate for
businesses. The boost in aggregate demand should help provide a
foundation for economy-wide recovery in 2002.


Monetary Policy Before the Terrorist Attacks

The Federal Reserve aggressively pursued an easier monetary policy
during 2001. With clear evidence that economic activity was sharply
decelerating at the end of 2000 and that inflation pressures were minimal,
the Federal Open Market Committee (FOMC) began cutting the target Federal
funds rate by 50 basis points (hundredths of a percentage point) at an
unscheduled meeting on January 3, 2001. By mid-August the FOMC had lowered
its target Federal funds rate on seven occasions, from 6H percent at the
start of the year to 3H percent (the lowest rate since early 1994). The
target rate reductions were also notable for their rapid succession. The
Federal Reserve lowered the target rate at every scheduled meeting and at
two unscheduled meetings--a sequence of events rare in its history, and
one that underscored the seriousness of the deterioration in economic
conditions. At each meeting the committee also reaffirmed its view that
the risks of weaker economic activity outweighed the risks of higher
inflation. Over the first 8 months of 2001, easier monetary policy
pushed growth in M2 (a broad definition of the money supply) to an
annualized 10 percent rate.
Market interest rates responded to the lower targets for the Federal
funds rate. Short-term interest rates followed in lockstep, with the
3-month Treasury bill rate declining roughly 240 basis points from
December 2000 to early September 2001. Three-month commercial paper
rates, credit card rates, personal loan rates, and 1-year adjustable
mortgage rates also moved down. Long-term rates decreased as well,
but by a smaller amount. Ten-year Treasury yields slid almost 20 basis
points, and rates on 30-year fixed rate mortgages fell about 25 basis
points. Corporate bond yields also receded: yields on corporate Baa-
rated bonds fell roughly 15 basis points. The Merrill Lynch high-yield
bond index was off about 20 basis points.
The pattern of short-term and long-term interest rates during 2001
is consistent with similar periods in the past. History shows that
when the economy has slowed sharply or is in a recession, and
monetary policy has eased significantly, short-term interest rates
have tended to fall more than long-term rates, but the large decline
in short-term rates often proves temporary. In addition, the
widening interest rate spread during 2001 reflected the fact that
long-term rates had edged down in 2000 in anticipation of lower
short-term rates in 2001. On the whole, the pattern of the yield
spread is more a reflection of the circumstances of the recession,
not a factor contributing to it.


The Macroeconomic Policy Response After September 11

In the days and weeks following the September terrorist attacks,
fiscal and monetary actions were taken to address the new challenges.
The President expeditiously requested emergency funds to assist in
meeting humanitarian, recovery, and national security needs. The
Federal Reserve added substantial liquidity through various channels
to help markets function in an orderly fashion in the immediate aftermath
of the attacks, and it continued to ease monetary policy.

Fiscal Policy
In the wake of the attacks, the President took action to ensure the
security of Americans. The President signed the 2001 Emergency
Supplemental Appropriations Act for Recovery from and Response to
Terrorist Attacks on the United States. The $40 billion in funding
assisted victims and addressed other consequences of the attacks.
Funding was provided for debris removal, search and rescue efforts,
and victim assistance efforts of the Federal Emergency Management
Agency; emergency grants to health providers in the disaster-affected
metropolitan areas; investigative expenses of the Federal Bureau of
Investigation; increased airport security and sky marshals; initial
repair of the Pentagon; evacuation of high-threat embassies abroad;
additional expenditures of the Small Business Administration disaster
loan program; and initial crisis and recovery operations of
the Department of Defense and other national security operations. These
measures took needed initial steps toward restoring security and confidence
in the economy. The President also proposed additional funding to help
displaced workers and to extend unemployment insurance in impacted areas.
In September the President signed the Air Transportation Safety and
System Stabilization Act, which provided the tools necessary to aid the
transition of the air transport system to the new security and economic
environment. The law provides $5 billion to compensate for losses to the
industry directly resulting from the attacks; it also allows the President
to issue up to $10 billion in Federal loan guarantees.
The terrorist attacks introduced new risks into the economic
environment. One of the challenges has been to provide an umbrella of
support for economic security that draws on the strengths of the
private sector. The Administration has proposed measures designed to
provide economic growth insurance, or economic stimulus. The central
focus of this effort is to address the immediate needs of those
displaced workers directly affected by the recession and the
terrorist attacks, while also mitigating the effects of these events
on the broader economy. In response to the President's leadership,
the House of Representatives passed such stimulus legislation on two
separate occasions, but the Senate failed to pass such legislation.
In choosing among alternative economic stimulus policies, the government
should favor those that are pro-growth--enhancing long-term incentives
to work, invest, take risks, and expand productive capacity--as well as
remain cognizant of short-term needs. The Administration's approach
includes tax relief for low-income families and extended unemployment
insurance benefits. These types of policies address short-term needs
while also providing purchasing power that helps to ensure steady demand
for businesses.
However, the real solution to the economic woes of displaced workers
is employment. Fully addressing these workers' needs and buttressing
confidence on the part of all households and businesses requires a focus
on job growth. One key to this effort is small businesses and
entrepreneurs, traditionally an important source of new jobs in
the economy. The best policy to help businesses and entrepreneurs
is to reduce their marginal tax rates. The Administration proposes
moving forward the implementation of the marginal tax rate cuts passed
by Congress in the spring of 2001.
Lower marginal tax rates both improve incentives and augment the cash flow
of small businesses. Research shows that entrepreneurs will respond to
these stronger incentives and increased cash flow by expanding their
payrolls and increasing their investments.
A second policy to provide incentives for private sector job creation
is to help businesses overcome uncertainty and restart investment spending.
At the aggregate level, the return to rapid growth requires a resumption
in the growth of capital expenditure. Employment losses have been
concentrated in the manufacturing sector--a sector heavily dependent
on the health of business investment. For this reason the
Administration has focused on growth incentives, such as partial
expensing and reform of the corporate alternative minimum tax, that
target the source of the problem, namely, an investment slump that
has diminished private sector job creation.
Property and casualty insurance is one mechanism by which economies
respond efficiently to risks in the business environment. Insurance
spreads these risks, converting, for each business that takes out
insurance, a potential cost of unknowable size and timing into a set
of smaller premium payments of known magnitude. The events of
September 11 induced a dramatic revision in businesses' perceptions
of the risks facing them. In normal circumstances, such increased
risks are translated into higher premiums.

This serves the useful economic function of pricing risk, leading the
private sector toward those activities that present a risk worth taking,
and away from foolhardy gambles.
In the aftermath of September 11, however, one concern was that the
economy faced disproportionate increases in terrorism risk insurance
premiums or, in the extreme, a complete withdrawal of this type of
coverage. With this concern in mind, the Administration proposed
legislation to provide a short-term backstop for terrorism risk
insurance that would encourage rather than discourage private
market incentives to expand the economy's capacity to absorb and
diversify risk, and which would expire as soon as the private market
is capable of insuring these losses on its own.
Taken as a whole, the President's policies have improved the
Nation's security, compensated the direct victims of the September
attacks, and aided displaced workers. If the President's terrorism
risk insurance and economic stimulus proposals are passed, they
will further enhance economic security.

Monetary Policy
In the hours, days, and weeks following the terrorist attacks, the
Federal Reserve used its financial resources to provide liquidity and
ensure the functioning of financial markets. The Nation's central bank
injected substantial liquidity into financial markets by promoting the
use of the discount window by depository institutions, increasing the
volume of open market operations, and arranging temporary reciprocal
currency swaps (swap lines) with several foreign central banks.
On September 11, the Federal Reserve made it clear through a press
release that the discount window was available to meet liquidity needs,
and depository institutions responded by employing the discount window at
an unprecedented level. Before September 11 average weekly discount
borrowing during 2001 had been $143 million. During the week of the
attack, however, borrowing ballooned to an all-time high of $11.8
billion (Chart 1-7). In the next 2 weeks, as liquidity pressures
waned, borrowing quickly dropped to the $1 billion to $1.5 billion
range and then returned to levels seen earlier in the year. On the days
that followed the attack, the Federal Reserve also allowed reserves in
the Federal funds market to rise as Federal Reserve float surged because
of the closure of the Nation's air transportation system. In addition,
the Federal Reserve made liquidity available by arranging temporary swap
lines with the European Central Bank (ECB) and the Bank of England, and
by augmenting existing swap lines with the Bank of Canada.
In the week following the attacks, the Federal Reserve eased monetary
policy further at an unscheduled meeting of the FOMC, lowering its target
Federal funds rate H percentage point, to 3 percent. The FOMC reiterated,
in a press release accompanying its decision, that it would continue
to supply large amounts of liquidity to counter the extraordinary
strains in the




financial markets as well as to help ensure the effective functioning of
the banking system. The committee recognized that providing ample
liquidity in the short run could lead to the Federal funds rate trading
well below its target. In fact, in the week following September 11, the
effective Federal funds rate fell to an average of 1.2 percent for the
2 days of the week when liquidity issues were of primary concern
(Chart 1-8).
Despite the devastation to New York's financial center, financial
markets and the banking system resumed business quickly and were
operating at near-normal conditions within just weeks of the terrorist
attacks. The remarkable resiliency of the financial markets and the
longstanding policy of the Federal Reserve to provide ample liquidity
to stabilize markets in the wake of unusual developments combined to
mute the effects of the initial shock.
Since mid-September the FOMC has continued its easing of monetary
policy to help counter the deterioration of economic activity. By the
end of the year the Federal Reserve had lowered its Federal funds target
to 1 3/4 percent, its lowest level in 40 years, leaving the real Federal
funds rate near zero. Meanwhile there was no evidence of increasing
inflation pressures. The lowering of the Federal funds rate target led
to further declines in short-term and long-term market interest rates.
At the end of the year, short-term market interest rates were below 2
percent. The 10-year Treasury yield was 5.2 percent, and 30-year
conventional mortgage rates averaged 7.2 percent.




Economic Developments
Outside the United States

Growth in the rest of the world slowed markedly in 2001. The global
slowdown is attributable to many of the same factors that affected the
United States: weakened investment demand (especially for high-technology
goods), relatively high oil prices in 2000 and early 2001, and the
increased costs and loss of confidence associated with the September
terrorist attacks.
Canada and Mexico, our largest trading partners, saw their economies
soften in 2001. Canadian economic growth began to fall in 2000 as the
deterioration in U.S. economic conditions particularly affected Canadian
exports. Late in 2001 Canada's exports and domestic demand were weakened
further by disruptions and increased uncertainty following the terrorist
attacks. Real GDP growth was 1.4 percent for 2001 as a whole, down from
4.4 percent in 2000, and the unemployment rate stood at 8 percent at
year's end. Mexico experienced zero growth in 2001, following a long
period of expansion; real GDP growth had been 6.9 percent in 2000. The
unemployment rate edged up to 2.5  percent for 2001.
Growth also faltered in Europe. In the euro area (the 12 European
countries that have adopted the euro as their common currency), output
growth slowed significantly in 2001, after weak growth in the second half
of 2000. The unemployment rate remained above 8 percent last year. Because
of constraints imposed by member countries' commitments to the monetary
union, fiscal policy in the euro area remained only slightly stimulative.
With regard to monetary policy, the European Central Bank cut interest
rates by a total of 150 basis points in 2001. Growth in the United Kingdom
declined in 2001, but by less than in continental Europe, bolstered in
part by a 200-basis-point reduction in short-term interest rates. Over
the year, growth fell to 2.3 percent from 2.9 percent in 2000. The
unemployment rate declined to 5.1 percent in 2001, its lowest in 26
years.
Japan fell into its third recession in 8 years during 2001, with
its unemployment rate reaching an all-time high of 5.5 percent as of
November. Although Japan, too, suffered from the effects of the slowing
global economy, it also continued to struggle with its moribund banking
and corporate sectors. Fiscal stimulus and monetary easing have done
little thus far to improve the country's economic prospects.
The newly industrialized economies in East Asia were particularly hard
hit by economic stagnation in Japan and the slump in global technology
investment. High-technology goods account for roughly 40 percent of
these economies'exports. After increasing 8.2 percent in 2000, output
in these economies registered only a 0.4 percent increase in 2001.
In the developing economies as a group, economic growth moderated
from almost 6 percent in 2000 to 4 percent in 2001. Meanwhile growth
for the developing economies in Asia declined from almost 7 percent to
just over 5 1/2 percent. In China, fiscal measures aimed at
infrastructure investment helped maintain rapid growth: Chinese GDP
growth for 2001 was roughly 7 percent. The Middle East and developing
countries in the Western Hemisphere saw GDP growth fall dramatically,
to just 1 to 2 percent in 2001. In contrast, Africa saw growth edge
up from just under 3 percent to 3 1/2 percent.
Two of the world's larger developing economies--Turkey and
Argentina--faced significant financial turmoil in 2001. In Turkey, a
banking crisis and political uncertainty led to high real interest
rates and a sharp drop in output. The Turkish lira was floated in
February 2001 and depreciated sharply against the dollar before
stabilizing. Late in the year Argentina also experienced severe
financial distress, with unsustainable fiscal policy leading to
loss of confidence and a run on bank deposits, culminating in a
default on the country's sovereign debt and dramatic political unrest.


The Economic Outlook

The Administration expects that the economy will recover in 2002. The
economy continues to display characteristics favorable to long-term
growth: productivity growth remains strong, and inflation remains low
and stable.

Near-Term Outlook: Poised for Recovery

Real GDP growth is expected to pick up early in 2002 (Table 1-1).
The pace is expected to be slow initially, followed by an acceleration
thereafter; over the four quarters of 2002 real GDP is expected to grow
2.7 percent. The unemployment rate is projected to continue rising through
the middle of 2002, when it is expected to peak around 6 percent.
As discussed earlier, the decline in aggregate demand during the past
year was concentrated in inventory investment, business fixed investment,
and exports. Of these downward pressures, that from inventory disinvestment
is projected to reverse its course soonest and most rapidly, as the pace
of liquidation is forecast to recede dramatically in the first quarter of
2002. By the end of 2001 inventories had become quite lean, making it
likely that, once sales resume their growth, stockbuilding will boost real
GDP growth.
Growth in business investment and exports may take longer to reassert
itself. Nonresidential investment fell sharply in 2001, and some
downward momentum probably remained at the start of 2002. Still, the
financial  foundations for investment remain positive: real short-term
interest rates are low,




prices of computers are again falling rapidly, and equity prices moved
up during the fourth quarter. Indications late in the year suggested
that these factors were contributing to an upturn in new orders
for nondefense capital goods in October and November. The Administration
projects that business fixed investment will return to positive growth
around the middle of 2002 and resume rapid growth thereafter.
The past year's decline in exports reflects stagnating growth among
the United States' trading partners. Consensus estimates of foreign
growth in 2002 are anemic as well. In these circumstances any rebound
in exports is likely to lag behind the expected recovery of U.S. GDP
as a whole. Imports meanwhile are projected to grow faster than GDP.
As a result, net exports and the current account deficit are likely to
become increasingly negative during 2002.
Consumption growth slowed during the past year but has remained in
positive territory. This slowing may be attributable to the decline
in the stock market from its peak in March 2000. But in the absence
of further stock market declines, such restraint is expected to wane.
Consumption will also be supported by fiscal stimulus and interest
rate cuts. The major provisions of EGTRRA will lower tax liabilities
by about $69 billion in 2002 (up from its contribution of $57 billion
in 2001).

Inflation Forecast

As measured by the GDP price index, inflation was stable at about 2.3
percent during the four quarters ending in the third quarter of 2001.
The Administration expects this measure of inflation to fall to 1.9
percent over the four quarters of 2002. The unemployment rate is now
above the level that the Administration considers to be the center of
the range consistent with stable inflation, and capacity utilization in
the industrial sector is substantially below its historical average.
Despite faster-than-trend growth of output in 2003 and 2004, some
downward pressure will be maintained on the inflation rate, because
the unemployment rate is projected to remain high over that period.
As a result, inflation in terms of the GDP price index is expected to
inch down to 1.7 percent in 2003 before edging up to 1.9 percent over
the forecast period.
In contrast, consumer price inflation is likely to edge up temporarily
over the four quarters of 2002, to 2.4 percent, reflecting energy price
fluctuations. (Petroleum-related goods make up a larger share of consumer
budgets, on which the CPI is based, than of the production of final goods
in the economy, on which the GDP price index is based.) In 2001 CPI
inflation was held down by a 13 percent decline in energy prices. In
2002 petroleum prices are expected to stabilize, and energy price inflation
is projected to be positive, but still moderate. Following a temporary
increase in 2002, overall CPI inflation is projected to edge down and
eventually flatten out at about 2.3 percent from 2003 forward.

Long-Term Outlook:

Strengthening the Foundation for the Future

The Administration forecasts real GDP growth to average 3.1 percent a
year during the 11 years through 2012. The growth rate of the economy over
the long run is determined primarily by the growth rates of its supply-
side components, which include population, labor force participation,
productivity, and the workweek. The forecast is shown in Table 1-2.
The Administration expects nonfarm labor productivity to grow at a 2.1
percent average pace over the forecast period, the same as over the
entire period since the previous business cycle peak in the third
quarter of 1990. This forecast is noticeably more conservative than
the 2.6 percent average annual growth rate of actual productivity from
1995 to 2001. The pace is projected to be slower as a caution against
several downside risks:

 Nonresidential fixed investment has fallen about 6 percent
from its peak in the fourth quarter of 2000, while the level
of the capital stock--and therefore depreciation--remain
elevated. This combination implies that the near-term growth
of capital services is likely to be reduced from its average
pace from 1995 to 2001, leading to slower growth in labor
productivity from the use of these capital services.
 The diversion of capital and labor toward increased security
(which is largely an intermediate product) may reduce the
growth of productivity modestly over the next few years
(Box 1-3). Once the transition phase has been completed, the
enduring restraint on productivity growth is likely to be
small.
 As discussed in Box 1-4, about one-half of the post-1995
structural productivity acceleration is attributable to
growth in total factor productivity (TFP) outside of the
computer sector, perhaps due to technological progress and
better business organization. (The latter aspect is discussed
in Chapter 3.) Although there is no reason to expect this
process not to continue, the Administration forecast adopts a
cautious view in which the pace of TFP growth is near its
longer term average.





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Box 1-3. Increased Security Spending and Productivity Growth
The Nation will spend more on security in the wake of the terrorist
attacks. Economic growth will likely slow because more labor and
capital will be diverted toward the production of an intermediate
product--security--and away from the production of final demand. In
addition, lower output from these direct effects will lower national
saving and investment, and this reduces output a bit further. The
eventual increase in the private security budget is unknown, but for
calibration purposes it is assumed that it doubles. Smaller or larger
changes would produce proportionally smaller or larger effects. Under
these assumptions, increased security costs reduce the level
of output and productivity by about 0.6 percent after 5 years below
what they would have been otherwise.
The United States spends roughly $110 billion a year on security. This
includes the services of Federal, State, and local police (but not the
armed forces). Of this, private business spends about $55 billion, or
0.53 percent of GDP. It is assumed that one-third of the incremental
spending goes to security capital and two-thirds to security labor.
The diversion of two-thirds of $55 billion for additional security
labor diverts about 760,000 workers from productive employment, lowering
labor input to the economy by 0.69 percent. This diversion lowers
production by about two-thirds of 0.69, or about 0.46 percent. The
diversion of one-third of $55 billion from productive investment in
the first year lowers the ``productive'' capital stock by 0.10
percent and lowers production by one-third of that, or about 0.03
percent.
In addition, by reducing output, the diversion also reduces saving and
investment, in turn reducing output further. The diversion in each
subsequent year lowers capital services even more. Assuming a 25 percent
depreciation rate, capital services will have fallen by 0.39 percent
after 5 years, lowering output by 0.13 percent.
The effect of the labor diversion is relatively large and immediate.
The effect of the capital diversion, in contrast, takes a few years to
accumulate. By the fifth year, output will be about 0.6 percent lower,
with 85 percent of that effect arising in the first year or two. Thus
productivity growth will be lower by 1/4 percentage point during the
first 2 years but will be affected only marginally thereafter.
---------------------------------------------------------------------

The other components of potential GDP growth shown in Table 1-2 are
more easily projected. In line with the latest projection from the Bureau
of the Census, the working-age population is projected to grow at an
average 1.0 percent annual rate through 2012. The labor force
participation rate and the work week are projected to remain
approximately flat. In sum, potential real GDP growth is projected to
grow at about a 3.1 percent annual pace, slightly above the average
pace since 1973.
The rate on 91-day Treasury bills fell about 4 percentage points
during the 12 months of 2001, reflecting the series of cuts in the
Federal Reserve's interest rate target in response to the slowing
economy. By the end of December, the Treasury bill rate had fallen
to about 1.7 percent. At this nominal rate, real short-term rates
(that is, nominal rates less expected inflation) are close to zero.
Real rates this low are not expected to persist once recovery becomes
firmly established, and nominal rates are projected to increase
gradually to 4.3 percent by 2005. At that level the real rate on
Treasury bills will be close to its historical average.
The Administration projects that the yield on 10-year Treasury notes
will remain flat at 5.1 percent. The Administration's expectation for
the 10-year rate reflects the assumption that the market yield
embodies all pertinent information about the path of future
interest rates. In 2003 and thereafter, the real 10-year rate is
projected to remain slightly below its historical average. The
projected term premium (the premium of the 10-year rate over
the 91-day rate) of about 1 percentage point is projected to remain
slightly (about 30 basis points) below its historical average.
One important purpose of the Administration forecast is to
estimate future government revenue. To this end, the forecast of
the components of taxable income is crucial. The Administration's
income-side projection is based on the historical stability of the
long-run labor and capital shares of gross domestic income (GDI).
During the first three quarters of 2001, the labor share of GDI
was on the high side of its historical average of 57.7 percent. It
is projected to decline to this long-run average and then remain at
this level over the forecast period. Nevertheless, the Administration
forecasts that wages and salaries as a share of GDI will decline and
that other labor income, especially employer-provided medical
insurance, will grow faster than wages. The capital share of GDI is
expected to rebound in the short run, reflecting an expected cyclical
rebound in productivity, and to remain flat at roughly its historical
average thereafter. Within the capital share, a near-term decline
in the depreciation share (a consequence of the recent decline in
equipment investment) implies an increase in the profit share
from its current level. (Profits before taxes had fallen to 6.7 percent of
GDP by the third quarter of 2001, well below the post-1969 average of
8.1 percent.) The Administration projects an increase in the profit
share over the next several years, so that it averages 8.1 percent
over the forecast period.

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Box 1-4. Is There Still a New Economy?
The late 1990s witnessed what many regard as the birth of a ``New
Economy''--one characterized by the dominance of high-technology
industries, immunity from cyclical downturns, and, most of all, rapid
productivity growth. In the past year, however, high-technology stocks,
especially Internet and communications stocks, led the stock market's
retreat; the 1990s expansion ended; and July's annual revision to the
national income and product accounts caused productivity to be revised
downward. It is useful, therefore, to examine the evidence for a
resumption of the post-1995 acceleration in productivity.
Productivity growth is cyclical: it typically slows relative to its
trend immediately before and after a business cycle peak. Yet over the
four quarters ending in the third quarter of 2001, productivity growth
grew faster than in any comparable period during the last four
decades (Chart 1-9).
Table 1-3 presents the results of an analysis of the factors that
influence productivity growth and compares their influences in two
periods: 1973 to 1995, and 1995 to 2001. According to a model
designed to capture its cyclical behavior, the productivity
acceleration after 1995 would have been stronger
by 0.48 percentage point a year but for the hiring that took place
during this period to accommodate the increase in demand that
occurred before and during 1995. (See the second line in Table 1-3.)
This model estimates that business cycle effects raised productivity
growth noticeably in 1992-94 as the economy emerged from recession,
and reduced it noticeably in 1999, 2000, and 2001 (by 0.8, 0.4, and
1.4 percentage points, respectively). Adjusted for this cyclical
effect, structural productivity has accelerated by 1.70 percentage
points. In short, the latest evidence shows structural productivity
growth continuing to exceed its pace during the period from 1973 to
1995. Because it was reduced by the effects of the business cycle
slowdown, actual productivity growth accelerated somewhat less than
structural productivity: by 1.21 percentage points, to a 2.60 percent
annual rate of growth.
In general, an acceleration in structural productivity can come from
increases in any of the following four sources of growth:

	growth in the amount of capital services per worker-hour
throughout the economy (capital deepening),
	improvements in the measurable skills of the work force
(labor quality),
	total factor productivity (TFP) growth in computer-
producing industries, and
	TFP in other industries.

TFP growth is the increase in aggregate output over and above that
due to increases in capital or labor inputs. For example, TFP growth
may result from a firm redesigning its production process in a way that
increases output while keeping the same number of machines, materials,
and workers as before.
Business investment was relatively strong during the past 6 years,
so that even after declining during the past year, nonresidential fixed
investment remained (at 12.0 percent of GDP in the third quarter of 2001)
well above its postwar average (10.7 percent of GDP). Investment in
information equipment and software was especially strong after 1995,
and likewise remains above its historical average share of GDP, although
it, too, has fallen from levels of a year ago. As Table 1-3 shows,
investment in information technologies added 0.60 percentage point to
the increase in structural productivity growth after 1995. The buildup
of capital outside of information technology maintained about the
same pace after 1995 as before, and so did not contribute to the
acceleration of productivity.
The Bureau of Labor Statistics measures labor quality in terms of
the education, gender, and experience of the work force. The agency
uses differences in earnings paid to workers with different
characteristics to infer relative differences in productivity.
Measured in this way, labor quality has risen as the education and
skills of the work force have increased. Because that increase
occurred at about the same rate before and after 1995, however,
the contribution of labor quality to the recent acceleration in
productivity has been negligible.
The rate of growth of  TFP in computer-producing industries has been
rising, as evidenced by the rapid decline in computer prices. Computer
prices did not fall as rapidly in 2000 as they did from 1997 to 1999;
however, their rapid descent resumed in 2001. Using computer prices as
an indirect measure of productivity growth in the computer-producing
industries, calculations indicate that computer manufacturing accounts
for 0.16 percentage point of the economy-wide acceleration in productivity.
The final contribution comes from accelerating TFP in the economy
outside the computer-producing industries. The contribution of this
source is calculated as a residual; it captures the extent to which
technological change and other business and workplace improvements
outside the computer-producing industries have boosted productivity
growth since 1995. This factor accounts for about 0.90 percentage point
of the acceleration, or about half of the total. Taken at face value, it
implies that improvements in the ways capital and labor are used
throughout the economy are central to the recent acceleration in
productivity, but it is equally an illustration of the limits on
our ability to account for the acceleration.
In summary, structural labor productivity growth and TFP growth
remained strong through 2001. This growth argues that the New Economy
remains alive and well.

-------------------------------------------------------------------
The Administration believes that the economy may be able to grow faster
than assumed in the budget, once the new tax policy is in place. The
reductions in marginal tax rates are expected to lead to increases in
labor force participation and increased entrepreneurial activity. The
budget, however, uses economic assumptions that are close to the consensus
of forecasters. As such, the assumptions provide a prudent, cautious basis
for the budget projections.






The Policy Outlook:
An Agenda for Economic Security

The events of 2001 have brought home to us a simple lesson: We cannot
be complacent about the security of American lives. Nor can we be
complacent about our rate of economic growth, our gains in productivity,
or our
successes in the international marketplace. The war against terrorism steps
up the demands on our economy. We must seek every opportunity to remove
obstacles to greater efficiency and seek new ways to combine our
workers' skills, our new technologies, the drive of our entrepreneurs,
the efficiency of our financial markets, and the strength of our
small businesses to yield faster growth. As we integrate ever more
closely our own resources, so must we also extend this integration
abroad, addressing the economic roots of terrorism and securing the
gains from worldwide markets in goods and capital. This is our economic
challenge.
The United States boasts a more rapid long-term rate of productivity
growth than do other major industrialized economies. Nonetheless, the
Administration is committed to seeking opportunities to enable the economy
to grow even more rapidly in the future. Growth, of course, is not an
end in itself. As the President has said, we seek ``prosperity with a
purpose.'' Economic growth raises standards of living and generates
resources that may be devoted to a variety of activities in the market
and beyond.
Growth can fund environmental protection, the good works of charitable
organizations, and a wide variety of nonmarket goods and services that
benefit the United States, other industrialized economies, and developing
economies alike.
To build upon our past success and rise to our new challenges, we
must remove impediments to growth and build the institutions necessary
to foster improved economic performance. For example, as noted in Chapter
7, one of the President's top priorities is the U.S.-led effort toward
more open global trade. Trade raises the productivity of Americans, and
the United States has an opportunity to reap significant gains from
future trade agreements.
Another area of interest is science and technology, long an important
source of economic growth. For example, although information technology-
producing industries account for roughly one-twelfth of total output,
they contributed nearly a third to economic growth between 1995 and 1999.
They generate some of the best and highest paying new jobs and contribute
strongly to productivity growth. Technology also improves our quality of
life. New agricultural technologies are increasing crop yields while
reducing the need to spray herbicides and insecticides on our foods or
into the atmosphere. More generally, however, it is important to
establish incentives that will ensure continued growth in innovation
and the new technologies that will define the 21st century. We must
not only invest in basic research, but also ensure that the
intellectual property of innovators is secure at home and abroad.
Getting the most out of the economy's resources also means avoiding
unnecessary costs. Prominent among these are the costs--in terms of
slower economic growth and waste--associated with the Federal tax code.
The entire tax system would benefit from changes to address its complexity
and inefficiency. With the President's leadership, progress has been made
with the individual income tax by reducing marginal tax rates and improving
tax fairness. Much more needs to be done, however, to ease the burden of
taxation on the economy, to help it generate resources and increase
productivity.
The current tax code imposes multiple layers of taxation, whose
inefficiency costs may be as high as H percent of GDP a year, according
to the Treasury Department. In addition, tax complexity is much more
than an irritant around April 15: it, too, imposes real costs on
taxpayers and the economy. Taxpayers bear the cost in terms of the
billions of dollars they spend--on recordkeeping, tax help, and
their own valuable time--trying to comply.
Tax compliance costs range from $70 billion to $125 billion a year.
The economy also suffers because tax complexity raises the uncertainty
surrounding business decisions, wastes resources, reduces our
international competitiveness, and lowers productivity. These are
costs that produce few benefits. They are largely avoidable. To get
the most out of our economy, we must investigate options for tax reform.
The deregulation of the economy over the past 25 years has been a
tremendous source of economic flexibility and productivity growth. We
must build on that success. Deregulation of several key sectors during
the 1970s and 1980s has brought substantial benefits to consumers
and to the economy at large. In the 20 years following the beginning
of airline deregulation, the average fare declined 33 percent in real
terms. Rates for long-distance telecommunications dropped 40 to 47
percent in the 10 years following deregulation of that market.
Partly because of increased competition arising from reductions in
banking regulations, banks have greatly expanded the financial services
they offer customers, including important new tools for diversifying
risk. Together these price declines and quality improvements across a
range of deregulated industries have yielded substantial economic
benefits. One study estimates the combined economic benefit of
deregulating just three industries--airlines, motor carriers, and
railroads--at about H percent of GDP each year.
This important strength of our economy must be protected against
unintended interference and extended to new spheres. Competition and
incentives to compete are at the core of exploiting opportunities to
achieve faster growth. (Chapter 3 discusses competition policy.) The
rule of law is central to efficient markets. Today, however, frivolous
lawsuits and the lure of windfall recoveries are transforming America
from a lawful society to a litigious one. The litigation explosion imposes
a variety of costs on all of us--as much as 2 percent of GDP by one
estimate--and damages the prospects for growth. The inefficiencies in
our tort system are a pure waste, an unnecessary tax on our attempts
to grow faster. To reduce this wasteful distortion we must address the
incentives that lead to unnecessary torts and unreasonably large settlements.
We must reexamine the provision of economic security for every
individual American. For example, Chapter 2 of this Report examines
the changing nature of retirement security and documents the widely
accepted need for reform. Personal accounts within the national
retirement system would enhance the ability to diversify retirement
portfolios, including diversifying part of retirement security away
from the unsustainable current system. In doing so, they could for
the first time provide rights of ownership, wealth accumulation, and
inheritance within the Social Security framework.
We must design an efficient set of institutions that meet the short-
run needs of displaced workers and move them quickly toward productive
activities. The past year has displayed an extreme form of the shocks
to which our economy may be subjected. The President's vision of
economic security recognizes that many events impact the economy
all the time. We should think comprehensively about these policies
and focus our efforts on incentives for getting workers back to
work, and quickly. Resources should be devoted flexibly to basic
needs and retraining, without creating an incentive for unnecessarily
long spells between jobs, because benefits extended under the wrong
conditions create a ``tax'' when a new job is taken and those
benefits are lost.
Finally, getting the most out of the economy will require an emphasis
on efficiency in government as well. If government spending grows
without discipline, billions of dollars will be siphoned away from
private sector innovation, taxes will rise, and growth will suffer.
The President's Management Agenda seeks to shift the emphasis of
government toward results, not process. It aims to replace the present
Federal Government hierarchy with a flatter, more responsive
management structure and to establish a performance-based system.
Chapter 5 of this Report examines fiscal federalism and shows how
this approach to the structure of Federal programs may usefully be
extended to the conduct of intergovernmental relations, particularly
in education, welfare, and health insurance for low-income Americans.